Thursday, May 25, 2017

Money Matters: An IMF Exhibit -- The Importance of Global Cooperation. Globalization and Integration (1989-1999)

Transition to the Free Market

With the fall of the Berlin Wall on November 9, 1989, the Iron Curtain began to recede. Within two years, Communism was a thing of the past in Bulgaria, Czechoslovakia (later the Czech Republic and Slovakia), Hungary, Poland and Romania. For former Eastern bloc countries, the transition from central planning to a free market economy was not easy and progress was uneven. They have, however, taken the first steps toward joining the global economy.

Hungary began its reforms early and built up a vigorous market economy in the early 1990s. Under its Solidarity-led government, Poland plunged into the free market. Almost immediately GDP fell by 10%, real wages fell by 40% and electricity prices rose by 300%. Though painful, the strategy proved successful: by the early 1990s, Poland had completely divested itself of central planning and was well on its way to prosperity. The Czech Republic opted for a more gradual approach to economic reform than Poland, possibly losing precious time by delaying the inevitable. Romania spent the 1990s reforming its socialist economy.

Collapse of the Soviet Union

Collapse of the Soviet Union
The revolutions in Eastern and Central Europe also shook the U.S.S.R. Soviet debate on economic reform began in 1986, but produced only minor palliatives. Growth stagnated, and foreign debt doubled between 1986 and 1991.

Economic reform proved to be the final issue that drove the old Soviet empire apart. In 1990, the Baltic Republics – Estonia, Latvia and Lithuania – declared their independence. By late 1991, the Soviet Communist Party voted itself out of existence, and soon the U.S.S.R. itself was replaced by 15 independent republics. Progress in establishing a market economy has varied from country to country in the former Soviet Union. Western aid, loans, and investment have speeded the transition.

Recovery From Debt

The debt crisis seemed to be over, as most Latin American economies grew themselves out of debt in the 1990s.

In 1994, however, Mexico devalued the peso and had to work out another adjustment program with the IMF. In 1998, Brazil was shaken by a loss of investor confidence. Flight from the Brazilian real began. Prompt action by the IMF and other international lenders in cooperation with Brazil’s government, helped stabilize the economy. In a globalized economy, no major country could be allowed to fail.

Progress In Africa

The 1990s have been a decade of progress for Africa. In South Africa, apartheid was eliminated and democratic elections brought in a multiracial government under Nelson Mandela. Since 1994, the economies of the sub-Saharan African countries have been growing an average of 5% a year. Much remains to be done, however, to improve infrastructure, increase investment, raise health and living standards and meet the challenge of globalization.

Asia in the 1990s

Asia is a continent of remarkable political, cultural, social and economic diversity. Despite this, the region is thoroughly integrated in the world economy. Asia includes the world’s most populous country, the world’s largest democracy and the world’s second most productive economy.

Economic setbacks of the late 1990s in Korea, Indonesia, and Thailand are thought to be a temporary exception to Asia’s unrivaled economic growth over the past 50 years.

Meltdown in Asia

Meltdown in Asia
In 1997, as investor confidence waned, Southeast Asia suddenly found itself in one of the worst financial crises of the postwar period. The crisis threatened to spread economic malaise to fragile transition economies and provoke recession in the industrial world. By early 1998, the IMF had provided $36 billion to support reform efforts as part of an international support package worth some $100 billion. Because of the severity of the crisis, however, corrective measures are likely to take several years.

European Economic Unity

For the first time since the Roman Empire, Europe now shares a single currency – the euro. Introduced January 1, 1999, the euro represents the culmination of European economic integrations, which began in the 1950s.

Cooperation in Europe

Cooperation in Europe
The European Union manages political and economic cooperation among its 15 member countries. Born in the hope that shared sovereignty would make another war in Europe unthinkable, the European Union is dedicated to creating an ever closer political and economic union among the peoples of Europe.

Economic and Monetary Union

The introduction of a common euro currency marks the final phase of Europe’s Economic and Monetary Union (EMU). As of January 1999, the euro is the currency for eleven countries (four European Union countries have opted out at this time):

  • Euroland (the euro zone) accounts for almost 20% of world trade and world GDP.
  • Euroland is the world’s second largest economy.

The New Millennium

If the somber history of the first half of the twentieth century – two world wars and the Great Depression – can teach one lesson, it is the need for cooperation among nations. In the second half of the century, the IMF and other international institutions such as the United Nations, the World Bank, and the World Trade Organization have been part of the most sustained effort in history to achieve that cooperation.
"In a world of accelerating history, the future is already with us, calling for a high sense of responsibility, for bold action, and for intense cooperation between member countries." - Michel Camdessus, IMF Managing Director (1987–2000)

Looking to the Future...

We can anticipate a further integration of markets and massive global private capital flows.

We can also anticipate tough challenges: poverty, aging of populations, and a surge in extremism and violence if the inequalities between the poorest and most affluent countries are not reduced.

The IMF will meet these challenges by responding to the needs of each of its members and by responding to the systemic needs of a globalized world.

By International Monetary Fund

Source: International Monetary Fund

Thursday, May 18, 2017

Money Matters: An IMF Exhibit -- The Importance of Global Cooperation. Debt and Transition (1981-1989)

Countries Don't Go Bankrupt
"If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has." - John Maynard Keynes
"If you owe your bank a billion pounds everybody has a problem." - The Economist
During the 1970s, Western commercial banks had loaned billions of recycled petrodollars to the developing countries, usually at variable, or floating, interest rates. So when interest rates began to soar in 1979, the floating rates on developing countries' loans also shot up:
  • Higher interest payments are estimated to have cost the non-oil-producing developing countries at least $22 billion during 1978-81. At the same time, the price of commodities from developing countries slumped because of the recession brought about by monetary policies.
The time bomb was set.

What Went Wrong?
grotesquely high interest rates

  • Between 1979 and 1982, interest rates more than doubled worldwide, dramatically raising the cost of loans.
  • The U.S. dollar exchange rate improved, making the dollars needed to repay loans more expensive.
  • Widespread recession dried up the markets for the exports of developing countries.
  • Real prices for the export commodities that were essential to the developing economies fell to their lowest levels since the Great Depression.
"The time bomb was the debt burden and grotesquely high interest rates being carried by the Third World to the profit of the Western banks." - Les Gibbard
"Countries don't go out of business....The infrastructure doesn't go away, the productivity of the people doesn't go away, the natural resources don’t go away. And so their assets always exceed their liabilities, which is the technical reason for bankruptcy. And that's very different from a company." - Walter Wriston, Citicorp Chairman

Who Was to Blame?

Why did Western banks loan so much money to the developing countries?

Many developing countries were good loan prospects in the 1970s:
  • Many produced raw materials, foodstuffs, or manufactured goods that were in demand.
  • Growth rates looked even better than for industrial countries.
  • From 1960 to 1980, Latin America's economic growth rate was nearly twice the U.S. rate.
  • Even Eastern European countries seemed a good risk, because of the climate of detente and growing East-West trade.
Why did developing nations borrow such huge amounts?

As long as interest rates were low and inflation was high, the loans fueled their economies at little cost:
  • With high inflation, by the time the dollars had to be repaid, their real value had decreased.
  • Meanwhile, the borrowers could invest the money in economic development.

It worked. Between 1973 and 1980, the economies of oil-importing developing countries grew an average of 4.6%, compared with 2.5% for the industrial world.

Time Bomb Explodes

Poland found itself unable to pay the interest or principal on its massive loans in 1981. In 1982, the Mexican government declared it could no longer make payments on its debts. Argentina, Brazil and others soon followed. Thirty countries had fallen into arrears by the end of 1984. Billions of dollars were at stake.

The global monetary system was under threat. How could the world solve the debt problem?

Developing Countries: Just Don’t Pay?

If countries simply defaulted, everybody would suffer from the resulting economic and political instability:
  • The lending banks and investors would lose their money. For some, bankruptcy might follow.
  • Once it defaulted, a country would be unable to obtain future loans or investment, slowing economic growth and encouraging political instability.
  • Industrial countries that traded heavily with the debtor countries would lose those markets.
An individual or company that defaults on a loan goes bankrupt. But what happens if a country defaults? No one knew the answer.

Industrial Countries: Just Ignore It?

The banks that loaned the billions of dollars should have known better:
  • Why should the world bail out banks and investors who had made poor loan decisions?
  • If it should, who was to pay for the bailouts?
Both developing countries and banks found themselves in a difficult position. But could industrial countries afford to disregard the plight of the debtor countries?

Solving the Problem

With the Mexican crisis in 1982, the IMF took on the coordination of a global response. It realized that nobody would benefit if country after country failed to pay its debts.

The IMF had no magic remedy. The resolution of the crisis involved concessions from all concerned, to help debtor countries get back on track:
  • Industrial Countries: An immediate infusion of cash from industrial country governments
  • The Banks: Further lending and rescheduling of current debts by commercial banks, or "bailing the banks in"
  • The Debtors: An adjustment program, usually with IMF financial assistance
The IMF’s initiatives calmed the initial panic and defused its explosive potential. However, a long road of painful reform in the debtor countries, and additional cooperative global measures, would be necessary to eliminate the problem.

"Bailing the Banks In"

When the Mexican crisis struck, Jacques de Larosiere, the IMF's managing director, told the banks that the IMF rescue plan would not work without a sizable contribution from them. Instead of bailing out the banks, the IMF would "bail them in."

Mexico would need $8.3 billion in 1983:
  • $1.3 billion from the IMF
  • $2 billion from governments
  • $5 billion from the banks
The banks regarded the program as "forced lending," but all 526 of them paid up within a month.

Conditionality for Debtor Countries

To qualify for IMF financial assistance, a debtor country had to set up an adjustment program, which usually included:
  • Setting realistic exchange rates
  • Reducing fiscal deficits
  • Reducing inflation by restricting the creation of credit
  • Limiting external borrowing to reasonable amounts for growth-oriented purposes.
Some countries, such as Chile and Bolivia, responded remarkably to the stabilization plan in only a few years. However, for many countries, the process was more painful and prolonged. Unemployment, inflation, and stagnant growth persisted into the 1990s.

The Baker PlanAttempted Rescue

The Baker Plan, proposed by U.S. Treasury Secretary James Baker in 1985, envisioned further concessions by all three parties involved: commercial banks and multilateral financial institutions would increase lending, while indebted countries would make greater efforts at fiscal, financial, and monetary reform.

Initial enthusiasm for the Plan quickly faded. The Baker Plan had only limited success because it merely delayed payment of the debt, rather than reducing it.

Reducing the Burden

More radical action was deemed appropriate. In 1989, US Treasury Secretary Nicholas Brady proposed writing off some of the debt principal, rather than merely rescheduling it as had been done since 1982.

The Brady Plan was hailed as the beginning of the end of the debt crisis, which had plagued financial markets for nearly a decade. Still, many developing countries thought it did not go far enough toward reducing their burden.

Regional Economic Integration

Although regional trading blocs are not new, the enormous increase in trade alliances among neighboring countries have resulted in higher tariffs and trade restrictions for countries outside the group. Such regional protectionist measures during the 1930s prolonged the economic malaise of the Great Depression. Hence, region blocs had been initially regarded with suspicion.

Since 1948, over 150 regional trading associations have been formed. Over 65 of those came into existence during the 1980s and 1990s.

Why the rapid rise in the number of trade alliances? What benefits are there for individual member countries? Will the increase in these alliances improve or threaten the growth of world trade?

Regional Trading Associations

The purpose of a regional trade association is to protect and expand trade among neighboring countries through agreements that range from reducing trade barriers to harmonizing internal policies. Overall world trade will also benefit if regional trading associations help members grow without instituting protectionist policies that inhibit trade with outside countries.

Although not all regional trade associations have had positive outcomes, some have certainly thrived. These successes encourage confidence that regional associations will promote trade - both internally, among members, and externally, throughout the world.

The 1980s witnessed huge advances in the most ambitious of all regional integration efforts–the European Community. In the following decade this progress would result in the formation of an economic union that would rival the economic and political might of the United States.

The longest-lived example of a monetary union is Africa’s fourteen member CFA franc zone, which has used a common currency pegged to the French franc since 1948. The zone helped to support Africa’s most successful market integration.
The Asian Tigers
The Asian Tigers

During the 1980s the so-called "Four Tigers" - Hong Kong, South Korea, Singapore, and Taiwan Province of China - achieved astonishing economic growth. In addition, Japan, which already boasted the world's second largest capitalist economy by the 1970s, continued its impressive economic expansion.

Although all are located in East Asia, these areas have acted independently and never formed a regional trading bloc.

The Power of Private Capital

By the 1990s, transfers of private capital from one country to another had reached thousands of billions of U.S. dollars each year. Largely unregulated by governments and transmitted through cyberspace, international capital flows sought profit wherever it could be found.

Is Anyone in Control?

Although incoming capital flows helped countries develop, the sudden reversal of flows, or "capital flight," could cause panic and financial crisis.

Fearing that control over money had been transferred from national authorities to the private sector, many called for better monitoring of international capital flows (by institutions like the IMF) or even restrictions on these transfers.

Growth of Capital Markets

By the end of the decade, international capital markets had grown to an extent unimagined in 1980:
  • In the United States, transfers of stocks and bonds between domestic and foreign residents rose from 10% of GDP in 1980 to 93% in 1990.
  • Japan's corresponding figures were 7% and 119% of GDP.
  • Gross international equity flows - $800 billion in 1986 - had by 1990 exceeded $1.44 trillion.
So great was the growth that some feared control of the monetary system was shifting from monetary authorities to the private sector.

Growth of Foreign Exchange Markets

As a result of the unprecedented growth of international capital markets, foreign exchange markets (where one national currency is sold for another) also experienced a surge in activity.

Thaw in the East

With remarkable speed and surprisingly little violence, the Iron Curtain fell in 1989, radically changing the political and economic conditions that had been in place in Europe since World War II.

For years, Communist countries had been plagued by stagnant economies, low productivity, inefficient industry, and constant shortages of consumer goods. One by one, the Communist regimes of Eastern Europe collapsed in 1989. Was this the end of the centrally planned economies?

1989 Year of Anti-Communist Revolutions

In April, Poland’s Communist government legalized the Solidarity party. After elections in June, the Polish Communist party became the first to allow itself to be turned out of office. Nobel Prize winner and Solidarity leader Lech Walesa later became the first freely elected president.

In November, massive demonstrations by almost a million Czech citizens culminated in democratic reforms and the resignation of the country's Communist leaders. Dissident liberal playwright Vaclav Havel became president after free elections were held at the end of December.

The first real breach of the Iron Curtain occurred in May, when Hungary dismantled barriers on its border with Austria. In October, the Hungarian Communist party dissolved, after instituting democratic and economic reforms.

On November 9th, East Germany opened its borders and dismantled the Berlin Wall. Over the next month, 133,000 people moved west. To stem the flow, West Germany issued a plan on November 28 for Germany’s reunification. After economic union took place in July 1990, East Germany ceased to exist.

On November 10th, after over 35 years in power, Todor Zhivkov was forced to resign his positions as Bulgaria’s head of state and Communist party leader. Shortly afterwards, protesters obtained democratic reforms, including free elections and the repeal of the Communist party’s monopoly of power.

By International Monetary Fund

Source: International Monetary Fund

Thursday, May 11, 2017

Money Matters: An IMF Exhibit -- The Importance of Global Cooperation. Reinventing the System (1972-1981)

Would Floating Rates Sink the System?

In spite of the surprising U.S. decision in 1971 to take the dollar off the gold standard, the world still clung to the old system. In attempts to set more realistic exchange rates, the U.S. dollar was devalued and stronger currencies, like the German mark and the Japanese yen, were revalued. But even after two devaluations, the flight from the U.S. dollar continued. No new set of exchange rates could be sustained. Finally, in early 1973, fixed exchange rates based on gold were abandoned altogether and currencies were left to float. Although governments continued to intervene, market forces now determined exchange rates.

Could an international monetary system based on floating rates actually work?

Monetary Revolution

For thousands of years, "money" had been based on a tangible, valuable commodity such as gold or silver. In the early 1970s, the international community abandoned the security and discipline of a fixed-rate metal standard. In its place, the world adopted a system of "floating" exchange rates: each currency’s value moved up or down depending on international demand and the amount of confidence in its country’s economy.

Floating Rate Systems

Free Floating Exchange Rate

The currency's value is determined solely by supply and demand in the market, rather than official policy. Countries generally permit a free float only as a temporary solution, because it could result in excessive fluctuations. Such fluctuations disrupt international transactions by constantly altering the cost of goods and value of payments between companies in different countries.

Managed Floating Exchange Rate

Managed Floating Exchange Rate
This type is similar to a free floating exchange rate, but a government intervenes by buying or selling its own currency to minimize fluctuations. Australia, Canada, Jamaica, Japan, the Philippines, the United States, and others adopted this type of exchange rate.

Currency Peg

The currency's value is pegged to a basket of currencies or to another country's currency. Many developing countries pegged their exchange rates to the SDR or to the currency of an industrial country with which they traded heavily.

The European Snake

Beginning in mid-1972, the EEC stabilized its own currencies in relation to one another. This system was dubbed the "European Snake." Each country agreed not to allow its currency to fluctuate more than 1 1/8% up or down from an agreed central exchange rate. The EEC currencies floated jointly against the dollar. The Snake was the forerunner of the European Monetary System, which went into effect in 1979.

With the collapse of the Bretton Woods system, had the IMF outlived its usefulness?

Critics argued that the world no longer needed an organization designed to monitor a system that was now obsolete.

But the IMF adapted to the new circumstances and actually began to take an even more influential role in the world’s monetary system.
  • Instead of monitoring fixed exchange rates, the IMF took on the responsibility of exercising firm surveillance over its members' exchange-rate policies.
  • To help countries with balance of payments deficits, the IMF increased its lending activities.

OPEC Takes Center Stage

OPEC Takes Center Stage
The fourth Arab-Israeli conflict broke out in October 1973. Over the next three months, the price of crude oil shot up 300%! Global energy and financial crises ensued.

Did the war cause the oil crisis? The answer is yes, and no:

  • Because of the war, the Organization of Arab Petroleum Exporting Countries (OAPEC) declared an oil embargo against the United States and the Netherlands - countries judged too friendly to Israel. The embargo caused severe energy shortages over the winter of 1973-74.
  • At the same time, the Organization of Petroleum Exporting Countries (OPEC) sharply raised the price of crude oil. Although OPEC acted mainly for economic reasons, the war did serve as a catalyst. (OPEC includes the OAPEC countries, plus other non-Arab oil exporters such as Indonesia, Ecuador, and Venezuela.)

Ultimately, it was the steep oil-price increases of the 1970s, not the politically motivated 1973 embargo that intensified high inflation, caused a global recession, and drastically altered most countries' balance of payments.

OPEC's Point of View

  • The U.S. dollars OPEC received for oil fell in value during the early 1970s, because of devaluations and depreciation.
  • Oil prices had not kept up with other commodities. Between 1960 and 1973, the price of oil increased a mere 25% - far less than other commodities.
  • Underpricing had caused oil to be wasted. OPEC price increases and production cuts were necessary, to protect resources from depletion.

Dealing with the Energy Crisis

  • In December 1973, a large part of the British work force began to work a three-day week to conserve electricity.
  • In the United States, year-round daylight saving time went into effect in 1974, and the national speed limit was lowered to 55.
  • In Europe, stores could not keep up with a high demand for bicycles.
  • India's prime minister, Indira Gandhi, set an example in November 1973 by riding to and from work in a horse-drawn cart.
  • The oil embargo caused serious gasoline shortages in the winter of 1973-74.

Petrodollar Problem

While oil importers accumulated huge bills they could not pay, oil exporters accumulated large amounts of U.S. dollars - more than they knew how to use. These dollars were known as "petrodollars."

Is there such a thing as TOO MUCH money?

Oil-exporting countries found themselves with so much money, they could not spend it fast enough. Some had small populations; many were still at early stages of industrialization. They could not import enough from the countries that bought their oil to keep from piling up enormous dollar surpluses.

The world economy would contract if all that money was taken out of circulation (i.e., not spent or loaned to someone else to spend). Oil exporters needed investment outlets for their petrodollars.

Recycling Petrodollars

Borrowers' Market

The solution to one problem created another. Recycling petrodollars through the banking system slowed economic contraction, but did not alleviate massive payment imbalances. As a result the debts of oil-importing countries - especially developing countries - continued to pile up:

  • The foreign debts of 100 developing countries (excluding oil exporters) increased 150% between 1973 and 1977.

Could the economies of the debtors withstand the inflationary pressure of the sudden, enormous oil-price increase?

Without the discipline of a fixed standard, could the new floating-rate system cope with such massive trade and monetary imbalances?
"The international monetary system is facing its most difficult period since the 1930s."
H. Johannes Witteveen
Managing Director of the IMF
January 15, 1974


The 1970s ushered in many firsts: the first handheld calculator, the birth of the first test-tube baby, and the first personal computer. And, for the first time in history, high inflation joined a stagnant economy for a prolonged period of time. By 1979, this unprecedented combination had a new name: stagflation.

Inflation Unchecked

Inflation was already underway in the early 1970s because of increased commodity prices, as well as excess liquidity created by countries no longer disciplined by the gold standard. Inflationary pressures increased when the dramatic rise in oil prices raised the price of manufactured goods and food. The resulting decrease in demand and production led to fewer jobs and a stagnant economy.

Rush from the Dollar

The value of the U.S. dollar kept sinking, despite attempts by the U.S., German, Japanese, and even OPEC governments to halt its fall.

Why did the rest of the world care?

The U.S. dollar was still the primary reserve currency of the world. Countries holding dollars, instead of gold, as a reserve asset did not want to see the value of their assets fall.

Gold Rush

In 1979, investors, including Saudi Arabia and other oil-producing nations, backed away from holding U.S. dollars as reserves, since they could no longer count on them to retain their value. They sold their surplus dollars for alternative reserve assets, like German marks, Japanese yen, and Swiss francs. In addition, dollar holders increasingly wanted non-monetary assets such as gold and silver, as well as art and real estate. This pushed gold prices from $200 per ounce in early 1979 to $875 less than a year later.

Silver Rush

How Much Silver Does Your Money Buy?

The price of silver shot up, doubling in both 1979 and 1980. The cost of silver flatware followed suit. The money that bought an entire place setting in 1978 purchased only one utensil in 1980.

War on Inflation

Desperate times called for desperate measures. Governments around the world fought inflation in 1979 and the early 1980s by raising interest rates to record highs in order to tighten the money supply and reduce pressure on prices.

How Do Higher Interest Rates Reduce Inflation?

How Do Higher Interest Rates Reduce Inflation
Central banks control interest rates on funds that they lend to individual banks and on funds loaned between banks. If the central bank raises these interest rates, individual banks are forced in turn to raise the rates they charge their customers. Borrowing money becomes more expensive, so less is borrowed. Economic activity slows, less money is earned, and less money is spent. Demand for goods and services falls. To revive shrinking demand, providers of goods and services lower their prices, and inflation slows.

Cost of the War on Inflation

Stopping inflation came at great cost. In addition to decreasing the money supply, high interest rates reduced spending, output, and employment. The world economy was pulled into the deepest recession since the 1930s. World Trade fell in 1981 for the first time since World War II.

Stabilizing the Dollar

To slow inflation and stop the fall of the dollar, the U.S. government adopted a dramatic anti-inflationary policy in October 1979. It made borrowing money more difficult and more expensive. The policy worked, interest rates soared. By the end of 1981, inflation had been brought under control and the value of the dollar had stabilized. But the anti-inflationary policy also plunged the U.S. economy into recession.

Chain Reaction

Since capital now flowed across borders with ease, higher interest rates in one country attracted capital away from others. U.S. anti-inflationary policies pushed interest rates to record levels. As the high U.S. rates attracted capital, other countries were forced to raise their interest rates to compete. High interest rates around the world caused spending to contract sharply, throwing the global economy into recession.

By International Monetary Fund

Source: International Monetary Fund

Thursday, May 4, 2017

Money Matters: An IMF Exhibit -- The Importance of Global Cooperation. System in Crisis (1959-1971)

A Growing Economy Needs Growing Liquidity

Increased trade and interdependence accompanied the stunning economic growth of the 1950s and 1960s:

  • A typical 1960s U.S. telephone required 48 imported materials from 18 different countries. 
  • Foreign trade was a matter of economic survival for some nations. In 1960, Britain's imports and exports equaled 43% of its gross domestic product. West Germany's equaled 45%.

Growing Economy
The rapid expansion of production and trade in the 1950s and 1960s required a constantly expanding supply of monetary reserves to increase total liquidity. Gold, the primary reserve asset, could not be mined fast enough to meet this demand. As a result, the U.S. dollar, and to a lesser extent, the British pound, were used as reserve assets.

  • By the mid-1960s, a full third of the total market-economy reserves was held in U.S. dollars and British pounds, with the remainder in gold. 

As Good as Gold

How does a national currency like the U.S. dollar become a reserve asset, adding to the world’s total liquidity?

  • The United States runs a balance of payments deficit by spending more money in other countries (buying their products, investing in them, or giving them dollars) than they spend in the United States. 
  • The extra dollars are held by the countries’ central banks. The banks do not ask the United States to redeem them for gold or another currency. As long as foreign banks accept and hold dollars as if they were gold, the dollars act as reserves.

How long could the world rely on the United States and the United Kingdom to run balance of payments deficits and supply the necessary additional liquidity? Could the United States and the United Kingdom continue to create more dollars and pounds when their own reserves of gold were gradually declining?

The U.S. dollar fueled the growth of the world's economy, but at a price: inflation at home and reduced gold reserves.

"Too little liquidity could permit a crisis to develop in which most of the world would tend toward economic stagnation and would suffer from declining trade." 
Pierre-Paul Schweitzer
Managing Director of the IMF,
November 16, 1964

Decolonization and Development

Uhuru (Freedom)
"Yesterday's dream is today's reality: we now have our Uhuru. We will guard Uhuru with all our might."
Jomo Kenyatta
Prime Minister of Kenya, 1964
The colonies and dominions once controlled by European nations gained their independence starting in 1947, with India and Pakistan. In 1957, Ghana (formerly the Gold Coast) was the first African colony to achieve independence. Others in Africa and Asia followed rapidly over the next few decades.

The euphoria of independence quickly gave way to the sobering reality of the obstacles ahead. For many developing countries, independence brought civil war and economic chaos. Most developed "dual economies" - the majority of their people continued to live in poverty, while some urban, industrial areas achieved rapid economic growth.

"I am sure that every one of us will celebrate Independence Day with great joy. We are celebrating a victory. Yet it is essential that we remember even on that day that what we have won is the right to work for ourselves, the right to design and build our own future."
Julius K. Nyerere
President of Tanganyka (now Tanzania), 1962

The Foreign Exchange Famine

With independence came expectations of a better life. New governments promised modernization and prosperity. Leaders and citizens alike hoped to share in the economic success of the industrial Western world. To do this, they needed money, not just their own "soft" currencies, but foreign exchange in the form of internationally accepted "hard" currencies.

Where would the newly independent countries find the capital and additional liquidity needed to modernize and grow their economies?

The Dollar Glut
"Providing reserves and exchanges for the whole world is too much for one country and one currency to bear."
Henry H. Fowler
U.S. Secretary of the Treasury
Dollar Glut
Increasingly, the IMF and the international community realized that the Bretton Woods system - based on the gold standard and using dollars as the main reserve currency - had a serious flaw. The postwar "dollar gap" abroad had become a "dollar glut" by 1960.

Liquidity and Deficit

Continuous U.S. balance of payments deficits during the 1950s had provided the world with liquidity, but had also caused dollar reserves to build up in the central banks of Europe and Japan. As the central banks redeemed these dollars for gold, the U.S. gold reserves dipped dangerously low.

How could the threatened system be fixed?

If there were too many dollars out there, why didn't the United States simply stop spending so much abroad?

The United States enjoyed the benefits of being able to spend money freely, such as acquiring commodities and consumer products from abroad. In addition, the U.S. foreign-policy goal of containing Communism in the face of the Cold War and decolonization kept the dollars flowing.

Triffin's Dilemma

Testifying before the U.S. Congress in 1960, economist Robert Triffin exposed a fundamental problem in the international monetary system.

If the United States stopped running balance of payments deficits, the international community would lose its largest source of additions to reserves. The resulting shortage of liquidity could pull the world economy into a contractionary spiral, leading to instability.

If U.S. deficits continued, a steady stream of dollars would continue to fuel world economic growth. However, excessive U.S. deficits (dollar glut) would erode confidence in the value of the U.S. dollar. Without confidence in the dollar, it would no longer be accepted as the world's reserve currency. The fixed exchange rate system could break down, leading to instability.

Triffin's Solution

Triffin proposed the creation of new reserve units. These units would not depend on gold or currencies, but would add to the world's total liquidity. Creating such a new reserve would allow the United States to reduce its balance of payments deficits, while still allowing for global economic expansion.
"A fundamental reform of the international monetary system has long been overdue. Its necessity and urgency are further highlighted today by the imminent threat to the once mighty U.S. dollar."
Robert Triffin
November 1960
The Incredible Shrinking Gold Supply

While the total number of U.S. dollars circulating in the United States and abroad steadily grew, the U.S. gold reserves backing those dollars steadily dwindled. International financial leaders suspected that the United States would be forced either to devalue the dollar or stop redeeming dollars for gold.

The dollar problem was particularly troubling because of the mounting number of dollars held by foreign central banks and governments:

  • In 1966, foreign central banks and governments held over 14 billion U.S. dollars. The United States had $13.2 billion in gold reserves, but only $3.2 billion of that was available to cover foreign dollar holdings. The rest was needed to cover domestic holdings.

If governments and foreign central banks tried to convert even a quarter of their holdings at one time, the United States would not be able to honor its obligations.

Gold Supply

Searching for Solutions

In the early 1960s, the world searched for ways to remedy the flawed Bretton Woods system of a fixed dollar-gold exchange rate:

  • Western Europe and the United States cooperated to try to support the price of gold in the face of strains caused by speculators and hoarders. 
  • The United States adopted policies aimed at slowing the flow of dollars abroad. 
  • The IMF focused on adding liquidity without relying on gold or dollars. A new reserve asset, the SDR, was created to increase the total world money supply.

Could these efforts save the Bretton Woods international monetary system, or were its flaws so fundamental that a complete overhaul was needed?

The International Response

Europe and the United States Cooperate: The Gold Pool

In 1961, Belgium, France, West Germany, Italy, Switzerland, the Netherlands, the United States, and the United Kingdom agreed to contribute gold to a fund that could be used to support the price of gold at $35 per ounce, as decided at Bretton Woods. Gold could be sold from the pool if high demand threatened to raise its price on the open market.

The End of the Gold Pool

After 1966, dramatic increases in private gold buying by hoarders, speculators, and industrial users exhausted the gold pool supply. Member countries were forced to dip into their own gold reserves to meet the demand.

A rush to purchase gold from November 1967 to March 1968 finally caused the pool to disband.

The American Response

Decreasing the Dollar Drain

Alarmed at the flow of dollars abroad, the United States enacted policies designed to stem the flood.

  • Tied Aid: More aid dollars were required to be spent on U.S. exports. In 1960, less than half of U.S. laid money was spent on U.S. products and services. By the mid-1960s, the proportion was close to 90%.
  • Interest Equalization Taxes: Special taxes passed in 1963 and 1964 made it more expensive for non-U.S. citizens to buy U.S. stocks and bonds or borrow U.S. dollars.
  • Voluntary Capital Control Program: In 1965, President Johnson launched a program to discourage U.S. corporate investing and spending abroad.

Initially, these and other efforts helped reduce the U.S. balance of payments deficit. In 1965, it reached its lowest level since the 1950s.

U.S. Policy Failure

The balance of payments deficit continued, despite government efforts to eliminate it.

  • U.S. military spending abroad soared due to new involvement in Vietnam and continuing NATO responsibilities.
  • U.S. tourists were spending several billion more dollars abroad than foreign tourists spent in the United States.
  • U.S. private investment abroad continued to grow. Income from previous investment abroad continued to grow. Income from previous investments provided a substantial dollar inflow, but not enough to offset the overall balance of payments deficit.
  • The U.S. trade surplus was rapidly diminishing, finally becoming a deficit in 1971.

The IMF Response

The Debate

Beginning in 1963, discussions on how to solve the international liquidity problem took place within the IMF and among its member nations.

  • Some countries, such as France, wanted to set up additional international credit with strict rules for its use and payment - but continue to rely on gold as the main reserve asset.
  • Others, such as the United States and the United Kingdom, wanted to create a new reserve unit to be used as freely as gold or the reserve currencies.

Which countries would receive the new reserve unit?

  • The leading industrial countries favored a limited participation.
  • The IMF and developing countries advocated giving all members - industrial and developing - a proportional amount of the new reserve unit.

The Decision

The Special Drawing Right (SDR) that was finally adopted in 1968 represented a compromise. It was essentially a new reserve unit, rather than additional credit, but because of certain restrictions, it could not be used as freely as gold.

SDRs were to be allocated to all participating IMF members, according to the size of their IMF quotas.

The SDR: Mixed Success

The additional liquidity provided by the SDR was quickly assimilated into the international monetary system. However, by the time the first SDRs were allocated in 1970, the world did not need more liquidity, since the United States had not reduced its balance of payments deficit. In fact, precisely in 1970-72, a big jump in the U.S. deficit caused a tenfold increase in members’ currency reserves. The SDR was designed to offset a dollar shortage that never materialized.
"...the first creation of international paper money, literally out of thin air."
The Economist, 1970
Problem Persists

Flight from the Dollar

Flight from the Dollar
The efforts to mend the Bretton Woods exchange-rate system were no match for the severe exchange-rate crises of the late 1960s. Continual balance of payments deficits finally forced Britain to devalue the pound in 1967. People speculated that the dollar might soon follow. Private holders rushed to exchange their dollars for gold.

As a result, in 1968, the United States stopped redeeming privately held dollars for gold. Only central banks could still redeem their dollars at the fixed rate of $35 per ounce. Unable to get gold, private holders now sold their dollars for stronger currencies, such as the German mark, the Japanese yen, the Swiss franc, and the Dutch guilder.

For a time, many central banks, particularly the West German Bundesbank and the Bank of Japan, bought dollars to defend the U.S. currency and keep their own currencies from appreciating. This ended in May 1971, when the central banks began to redeem their dollar reserves for ever greater quantities of U.S. gold.

U.S. gold reserves were vanishing. If dollar redemption continued, they would soon be gone!

Bretton Woods System Collapses

On August 15, 1971, the United States stunned the world by declaring that it would cease redeeming dollars for gold from its reserves. With this, the dollar's link to gold was severed, dismantling the foundation of Bretton Woods. The financial system that had helped bring a quarter century of prosperity to the industrial world had finally collapsed.

With nothing concrete backing the U.S. dollar, would the world lose confidence in it? What would replace the Bretton Woods system?

By International Monetary Fund

Source: International Monetary Fund