Reform the International Monetary System or Reform the Nation-State System?

_{This is the second in a series of two essays written} in 1995 (see below "The Finances of the Nation-State and the Global Foreign Exchange System" and the introduction for greater context). In the event, the solution to some of the problems outlined in this essay has been the use of ITC technology, coupled with international capital market and trade liberalization, to advance globalization (see "Musings On The Global Economy"). In effect, in the past ten years or so, the international monetary system has been reformed a lot less and with much less volatility than the nation-state system has been reformed, a process that is still ongoing.

_{Reform the International Monetary System or Reform the Nation-State System? (June 14, 1995)}

_{In spite of the foreign exchange regime change from fixed to floating rates since 1973, macroeconomic imbalance has persisted in many countries, and in the context of many discussions in the literature it is expressed most specifically as an external adjustment problem (current account deficit/surplus) but it is intimately related to internal fiscal imbalance. This lack of achievement of external and internal balance under the floating exchange rate regime, as many had in principle expected, coupled with the costs of trade perceived to be associated with foreign exchange rate volatility and exchange rate misalignment, has given rise to proposals of reform of the so-called international monetary system. In this essay we shall discuss and evaluate proposals for reform involving increased international economic policy coordination and other alternatives as well as the problems and feasibility of these proposals in a global setting.}

_{As we consider the merits and demerits of the floating rate regime and proposals for reform, it becomes evident that a crucial aspect in determining our conclusions is the point of view that is highlighted concerning the root cause of foreign exchange rate volatility and the concept that we hold of national autonomy with respect to fiscal policy.}

_{As John Williamson explains, the real exchange rate is linked to the real economy in that it is the main determinant of 'the division of domestic output between home and foreign markets and the distribution of domestic demand between home and foreign sources' of supply. Therefore the costs of exchange rate misalignment, as measured by a deviation from a fundamental equilibrium exchange rate, can be damaging to the real economy especially for those countries which have a relatively high proportion of economic output linked to international trade and financial flows. Williamson points out that 'a real exchange rate significantly out of line with that needed to sustain medium-run macro-equilibrium presents false signals to business that can misdirect investment or induce inappropriate closure of productive activity.' It is for these underlying reasons that economic policy makers around the globe are concerned with the level of foreign exchange rates and the intensity of exchange rate volatility. When considering proposals for reform, therefore, it is important to identify the fundamental causes of exchange rate misalignment and volatility. For as Feldstein points out, if we misidentify the causes of misalignment and volatility, a policy-directed target for foreign exchange rates may only exacerbate certain external and internal macroeconomic disequilibria and increase pressures which may lead to further volatility and misalignment. On the other hand, Williamson and, for example, proponents of the ERM sustain that a policy-directed target zone will provide a framework in which economic policy can be aimed at achieving external and internal adjustment towards equilibrium as measured by certain economic criteria.}

_{In light of these considerations, if it is believed that the adoption of the floating exchange rate regime has encouraged nation-states to pursue economic policies which have led to chronic imbalances, specifically fiscal imbalances and trade imbalances, and if it is believed that speculation is the main cause of exchange rate volatility and misalignment which decouple prices from fundamentals, then the question of how and to what extent to reform the international monetary system becomes of central importance. If, however it is believed that price distortion and speculation are the result of imbalanced economic policy of which foreign exchange rate misalignment and volatility are symptoms, then the pursuit of a more balance-oriented economic policy at the national level, with or without conscious international policy coordination, would naturally lead to more moderate and stable fluctuations in foreign exchange rates. Therefore, if the political leadership of the several nation-states continues to be incapable of pursuing more balance-oriented economic policies, then the question of how and to what extent to reform the nation-state system becomes more relevant than the question of reforming the international monetary system.}

_{The former point of view supports an affirmative evaluation of the case for international policy coordination as a means of reform, while the latter point of view suggests caution and skepticism but by no means rejects totally the case. Let us now take a closer look at the feasibility of and problems with the case for international coordination and other alternatives as proposals for reform in the global setting.}

_{When we speak of policy coordination in a strict sense as a matter recent historical practice, we refer to international forums such as the G-5, the G-7, or the IMF. The G-7 is essentially a semi-annual forum for the finance (or treasury) ministers of the major industrialized countries accompanied by the heads of government on an annual basis. The finance ministers' main influence is on national monetary policy in conjunction with the national central bankers. Their policy decisions and also public pronouncements can have significant effects on exchange rate movements. There have been examples of policy coordination which have moved the value of the USD to more desirable levels as the history has shown. The main policy instruments of the ministers and the central bankers are interest rates and foreign exchange market intervention. The developments of the 1980s led to a set of objective macroeconomic indicators - monitored by the IMF - including budget deficits, current account balances, and inflation which could trigger coordinated policy action in terms of interest rates and exchange market intervention aimed at correcting some of the national account imbalances. The tendency toward policy coordination in this context has receded in the 1990s as fiscal and current account imbalances have persisted and monetary policy makers have concentrated more of their attention on the domestic environment. As Frankel pointed out, the question of whether monetary policy improves or worsens the current account had not been resolved.}

_{In a broader sense, Williamson offered a blueprint for international economic policy coordination based on the idea of target zones. His plan includes targets for real exchange rates, interest rates, national fiscal policies, and debt to GDP ratios. This blueprint is more complete than the G-7 coordination framework because it explicitly considers national fiscal policy and provides for its internationally managed coordination to achieve a targeted path for the growth of domestic demand.}

_{The problems with these two frameworks for international policy coordination arise when the interconnections between monetary policy, national fiscal policy, national account imbalances and exchange rate fluctuations are considered. Let us accept the view that exchange rate volatility is caused by monetary and fiscal policies which lead to imbalances between saving and investment and between revenue and expenditure which become expressed as current account imbalances, government budget deficits, and accumulated debt. It is important to note that in constitutional democracies (which in the form of nation-state there are about 70 bodies politic recognized as such including the major trading nations) monetary and foreign exchange policy are made by the executive branch in some form of collaboration between the finance ministry and the central bank. The ultimate and legal responsibility for fiscal policy lies with the national legislative bodies (congresses and parliaments). Now, in this general framework we have three policy tools; monetary policy, fiscal policy, and exchange rate policy of which two can be controlled - in the floating exchange rate regime this means monetary and fiscal policy - and two targets; internal and external balance. Therefore in order to achieve balance and maintain exchange rate stability discipline must be exercised, in some combination, through monetary and fiscal policy. In the G-7 framework for international economic policy coordination, finance ministers, by virtue of the constitutional arrangements, focus on coordinating monetary policy as a discipline towards two-target balance across nation-states. In this context, and since balance requires discipline in both monetary and fiscal policy, a more relevant issue of the G-7 experience becomes the apparent failure, with the possible exception of Germany (where the central bank enjoys the utmost of independence and a single mission enshrined by statute) of monetary policy to discipline fiscal policy. Therefore it is correct to ask the question 'are finance ministers and central bankers the right groups on whose shoulders total responsibility for internal and external balance should lie?'. The Williamson blueprint rightfully takes into account that national fiscal policy and debt management are crucial aspects of discipline, balance, and stability, but it also underlines the realistic possibility (slim) of successful coordination of balanced fiscal policies across national legislative bodies.}

_{In a fixed or semi-fixed exchange rate regime, the two policy tools which can be controlled are indeed foreign exchange policy and fiscal policy while monetary policy becomes subordinate to maintaining the chosen exchange rate parities. In this regime, it is the fixity of the exchange rate which is supposed to act as the anchor of discipline on fiscal policy in order to maintain balance and stability. We can point to two historical experiences of fixed or semi-fixed regimes, the Bretton Woods system, and the European ERM, both of which exploded under pressures from imbalances.}

_{Problems and objections connected with the notion of internationally coordinated fiscal policy are often expressed as undue limits imposed on the independence of national economic policies and as a sacrifice of national autonomy and preferences in order to make the 'world features' of coordination proposals to work. Some argue that a certain loss of national independence is attributable to deregulated financial markets and the high degree of global short-term capital mobility, and furthermore that this is the cause of exchange rate volatility and impedes national governments from managing their economies. This line of argument has led to alternative proposals to international policy coordination aimed at " ... greater financial segmentation between nations ..." and "permitting their central banks and governments greater autonomy." These include Tobin's proposal of a small tax on foreign exchange operations which would be small enough to not affect commercial trade and long-term capital investments, but steep enough to render short-term trading less profitable, and that of dual exchange rates - a fixed rate for commercial transactions, and a floating rate for capital transactions. Both these proposals take the point of view that short-term volatility is caused by speculation which may have perverse effects on the real economy. There are several problems with these proposals. First, taxes and dual rates may only cause further distortion. It is difficult to always separate current account from capital account transactions, and to know how much of short-term capital movement has a stabilizing effect on financing current account deficits. Secondly, a tax regime would not only entail bureaucratic administrative costs, it would be feasibly difficult to enforce around the globe as enough foreign exchange centers would not adhere to the regime so that those centers which did would lose massive amounts of business. Finally, even if this perceived greater national government autonomy were achieved, why should it be expected that governments would behave any differently than they have in the past?}

_{If we consider again the view that price distortion and speculation are the result of imbalanced economic policy of which foreign exchange rate volatility is a symptom, then it is neither necessary nor helpful to interpret policy coordination as a sacrifice of autonomy imposed top-down through an international or supranational institutional pyramid. Through self-discipline we enhance autonomy and independence. Ideally, fiscal discipline should begin locally and from there be extended to the national legislative bodies, and then to the international, or better still, directly to the global level. If top-side institutions and systems can encourage and foster local discipline, so much the better. But it a waste of time and an empty wish to expect finance ministers, central bankers, and IMF technicians to tinker with institutional arrangements and systems in the hope that stability and equilibrium will follow automatically. We should not expect external and internal adjustment to come as a result of our choice of exchange rate regime. It is the ensemble of local realities which imply the world feature - as a result of several cases of self-discipline and sacrifice. Our views of sacrifice, then, depend on which end of the pyramid we choose to emphasize.}

_{The real conclusion is that we have twice depended upon fiscal policy as the main determinant of (dis-) equilibrium. It does not really matter what type of exchange rate regime is in place. Imbalanced fiscal policies will cause disequilibria, and these disequilibria will be manifest in one way or another sooner or later ... whether through the foreign exchange system, the financial system, the economic system, the political system, or the social system, or any combination of the above interconnected realities.}

_{Tinkering with the international monetary system or reforming it substantially may indeed have some effect on the management of foreign exchange rate volatility. But at the end of the day it is fiscal imbalance which is the root cause of chronic macroeconomic disequilibria. The daily shenanigans of the foreign exchange market are symptoms, not causes, of these disequilibria. In fact the global foreign exchange system has worked well in absorbing the recurrent shocks caused by this (nation-) state of affairs.}

_{On the eve of the most recent G-7 summit in these last days, John Chretien, PM of Canada, on the problem of currency market volatility, urged G-7 countries to stabilize markets by following sound monetary and fiscal policies.}

_{"Attempting to return to fixed or targeted exchange rates is no longer a realistic option in deregulated financial markets, and Canada's experience with floating exchange rates showed that they served a useful function by providing time for governments to make necessary economic adjustments."}

_SOURCES

_{Feldstein, M., "The Case against Trying to Stabilize the Dollar", American Economic Review, 79, No. 2, May, 1989.}

_{Frankel, J., "Obstacles to International Macroeconomic Policy Coordination", IMF Working Paper No. WP/87/29, April, 1987.}

_{Tobin, J., "A Proposal for International Monetary Reform", Eastern Economic Journal, 4, pp. 153-159, 1987.}

_{Williamson, J., The Case for Roughly Stabilizing the Real Value of the Dollar, American Economic Review, 79, No. 2, May, 1989.}