The Past and Present of International Finance

Yesterday we broadly traced the historical development of globalized trade and its cycles over the past 200 years. That this process has always depended on a parallel and relatively stable financial system goes without saying. Indeed, even in the ‘financialized’ world of today – a world in which capital markets and the monetary system that supports them generate vast wealth without being necessarily rooted in ‘economic realities’ – the symbiotic relationship between generalized trade and financing remains. But even if this relationship endures, the broader story here is actually one of disjunction – an evolving disjunction between capital movement and trade. But how did this split happen? How did it develop over recent history? To grapple with these questions, let’s turn today to Barry Eichengreen’s highly-acclaimed Globalizing Capital: A History of the International Monetary System for some answers.

The inheritance of monetary history

Eichengreen begins his analysis of the modern international monetary system by positing a simple assumption – financial institutions are indeed subject to the ‘inheritance of history’. In an interlinked world, in other words, nations have never had the opportunity to make monetary decisions that are ultimately independent from other nations. Each one has influenced the costs and benefits of another’s individual financial preferences. They have further influenced, for example, capital flows, their negotiating costs, and the free-riding behaviors often associated with them, to name but a few. According to Eichengreen, it is this reciprocity, embedded as it is in a complex reality, which explains why the development of the international monetary system is fundamentally a historical process – a process in which reformers and conservatives alike can never make decisions that are independent of past monetary arrangements.

The monetary system in five steps

If the above axiom is true, how should one then parse the development of the modern international monetary system and its capital markets? Eichengreen chooses to tell the tale (at least from the later 19^th century onwards) in five parts.

• Beginning in the pre-World War I or ‘gold standard’ phase, we see governments not having to subordinate currency stability to other objectives. Central banks therefore made it their business to safeguard pegged exchange rates while operating under the gold standard; and since no one doubted that they would, there was little or no motivation for speculators to attack these rates. (The banks pursued this policy, by the way, while capital mobility was high.)

• In the interwar period, due to the severe economic decline we all know too well, we see the partial collapse of the ‘pegged’ system. As a result . . .

• The Bretton Woods System, which prevailed from 1945 through 1971, departed from the gold standard by introducing pegged exchange rates that were adjustable under specific conditions. But governments, and the seemingly modest adjustment they had made here, now faced new challenges. Increasingly powerful trade unions, major changes in voting patterns, and the growing success of parliamentary labor parties meant that governments could no longer automatically opt for currency stability over full employment. Capital controls were therefore introduced and the International Monetary Fund (IMF) and International Bank for Reconstruction and Development (IBRD) were created to monitor national economic policies. By limiting capital mobility, the newly introduced controls accounted for higher levels of participatory democracy and made partially pegged exchange rates still possible.

• Eventually the Bretton Woods organizations’ ability to enforce capital controls became increasingly problematic as capital flows grew. Indeed, once current account convertibility was restored, it became almost impossible to determine whether a foreign exchange transaction was related to trade or to currency speculation.

• With this later (and new) inability put in place, we thus entered ‘The Brave New Monetary World’ we know today. Because international transactions – and financial markets more generally – became more liberalized, domestic markets could no longer be tightly regulated. At the same time, and in stark contrast to the pre-WWI era, the willingness and ability of governments to defend currency pegs was no longer taken for granted, which led to two major developments – lost confidence in currency stability followed closely by the demise of the stability itself.

When we stop and think about it, Eichengreen’s five-phased history does have lessons to teach us. It confirms, for example, that fixed exchange rates became untenable with increased capital flows and a higher level of democracy. Second, and perhaps more importantly, it confirms that over time free trade and ‘fettered’ financing stopped being as mutually reinforcing as they once were. That was a bad thing, as already noted, but to be fair the post-1971 shift towards floating exchange rates did yield some positive goods too.

• Most advanced economies shifted to floating exchange rates. While as late as 1970, floating exchange rates were almost unheard of, over a quarter of states had moved to this system by 2006

• Emerging economies became increasingly integrated into global finance and developed the institutional capacity to define and implement independent monetary policies. (‘Managed floating’ gave them the ‘breathing space’ to pursue and implement needed political measures without subjecting them immediately to market forces.)

• Finally, in poorer countries (‘not yet emerging markets’) the control of financial markets and their capital flows became more effective.

Fair enough, these positives did appear in the post-Bretton Woods world, but so did financialization and the large-scale unmooring of trade and finance that has followed in its wake. The social costs of this development have been significant, but one must ask if everyday people are now just the idle playthings of indifferent financial gods.

The Eurozone as an antidote to financialization – salvation or disaster?

Has the Eurozone, at least in its initial attempts to resolve “the tension between capital mobility, political democracy and pegged but adjustable exchange rates,” managed to provide a human response (or even rebuttal) to the great disjunction that Eichengreen describes in his text? Was the appropriate decision made not to float exchange rates but to eliminate them altogether, at least in a significant part of the world? And by resorting to a single currency, did social goals manage to trump, at least to some degree, the coopting of free markets by potentially destructive capital flows that seek to compound the generation of capital rather than goods?

Back in 2008, when the second edition of Globalizing Capital was published, Eichengreen suggested that this kinder, gentler European option might be succeeding. In contrast to Asia and Latin America, many Western European states had learnt from past experiences and now shared a reasonably common understanding of the social goals to which monetary policies should be subservient. Yet just four years later, Europe’s grand experiment seems closer to collapse than success. In a external pagerecent articlecall_made in Foreign Affairs, Eichengreen now predicts that the Euro will at best remain a weak currency or, at worst, be abandoned. At the same time, faith in the dollar has been seriously undermined. With the international monetary system resting on the Dollar and the Euro, even if in de facto ways, will the world come to replay the financial dislocations of the 1930s or the 1970s? We will address this issue on Thursday and Friday, after taking a close look at the future of international trade regime in tomorrow’s podcast. What we can say for today, though, is that the major disjuncture we have seen develop between trade and financial systems in recent history continues apace.

In this edition of ‘Conversation with History’, Barry Eichengreen talks about his latest book, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System

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