8 International Monetary Arrangements and Future Adaptation Loukas Jsoukalis* HE FIRST SECTION OF THIS PAPER surveys the main developments T that have taken place in the international monetary system since the early 1970s. The abandonment of fixed exchange rates and the partial privatization of the creation of international liquidity represent a clear shift to the market and a negation of the postwar idea of a collectively managed system with tight official control over financial markets. The second section draws up a provisional balance sheet of the changes introduced during the previous decade and touches upon some of the links between international money and the real economy. It examines the experience of floating exchange rates as well as the effects of short-term volatility and the persistent misalignment of currencies. It then discusses the relationship between floating rates and the autonomy of national monetary policies. The role of international banks in balance of payments financing, the outbreak of the debt crisis, and the heavy adjustment burden imposed on many developing countries are also examined. The emphasis is clearly placed on the growing costs and deficiencies of the new "system." Although a major monetary reform exercise a la Bretton Woods is deemed to be politically infeasible and also perhaps counterproductive, a *Dr. Tsoukalis is a Fellow of St. Antony's College, Oxford and Director of Economic Studies at the College of Europe in Bruges, Belgium. The author is grateful to all participants at the IMF/GDI seminar at Cumberland Lodge and especially to Mr. Narasimham, who acted as discussant for his paper, for their extremely helpful comments. This paper is a modified version of a chapter in Tsoukalis, 1985. ©International Monetary Fund. Not for Redistribution MONETARY ARRANGEMENTS AND ADAPTATION 165 process of gradual adaptation of existing arrangements is advocated in the third section. The objective would be to bring about some form of collective management that corresponds better than the current arrangements to the present level of international financial interdepen- dence. This adaptation is discussed with respect to the management of exchange rates and the coordination of macroeconomic policies as well as the role of the International Monetary Fund in the process of adjustment. In view of the slowness of many Western industrialized countries, and especially the United States, to move along this road, crises in the system may eventually play the role of catalyst for reform. The New "System" The international monetary system was radically transformed during the 1970s. The first important turning point came in August 1971 when the U.S. Administration unilaterally decided to end the convertibility of the U.S. dollar into gold, which had been one of the main pillars of the postwar system. This convertibility had, in fact, for some years before 1971 been largely a myth; it was able to survive only so long as the main holders of dollar assets refrained from exercising their formal right to demand convertibility into gold. The suspension of dollar-gold convertibility led to the de facto establishment of a dollar standard. Despite long periods of weakness of the U.S. currency and the high degree of volatility of exchange rates, invoicing practices in international trade and the asset composition of commercial and central banks have shown remarkably little shift to other national currencies or composite units. Some diversification away from the dollar has taken place, especially toward the deutsche mark and to a lesser extent the yen, establishing the elements of what can be called a multiple currency standard. However, this diversification has been limited, and the dollar still remains by far the most important interna- tional unit of account, means of payment, and store of value. The process of diversification was, in fact, reversed during the recent period of strength of the U.S. currency that was at least partly associated with high nominal and real interest rates. Gold was finally demonetized under the Second Amendment of the Fund's Articles of Agreement after a long and often acrimonious debate, in which the U.S. and France played as usual the role of protagonists. But gold has not disappeared from the scene. It has remained stored in the vaults of central banks which have been extremely reluctant to use it, except in extremis as collateral, for balance of payments financing. In some respects, gold can be regarded as an asset of last resort. ©International Monetary Fund. Not for Redistribution 166 LOUKAS TSOUKALIS Fixed exchange rates, the other main pillar of the Bretton Woods System, were abandoned in March 1973, when most of the major currencies were floated against each other. What was presented at the time as a temporary expedient, with governments giving in to market pressures, was finally legalized in Jamaica in 1976 and was later incorporated in the Fund's Articles of Agreement. Floating was now legal, as was, in fact, any exchange rate system that a member country cared to choose. The legalization of floating was, however, accompanied by a recognition of the need for at least a minimum degree of management of exchange rates and for the joint supervision of the policies pursued by member countries that might directly or indirectly influence exchange rates. This led to the surveillance function being entrusted to the Fund. Another important qualitative change that took place in the 1970s (but that, unlike the other two changes already mentioned, did not require any rewriting of the rules) was the partial privatization of the creation of international liquidity. This happened through the large-scale financing of balance of payments deficits that followed the 1973 oil price rise. The growth of international credit and capital markets, which developed outside the control of national authorities, had started much earlier. But 1973 was the turning point of a new era of exponential growth. This has had a major effect on international monetary and trade relations. The role of international banking dramatically changed, at least during the second half of the 1970s, the trade-off between adjustment and financing of payments deficits. During the same period it also contributed to the explosion of international liquidity, which became more endogenous. Although the international monetary system was radically transformed in the 1970s, some observers would still refuse to talk in terms of a breakdown of the postwar order, because of the survival of some important elements that constituted the original Bretton Woods System. Market convertibility remained, and in many industrialized countries it was extended to capital transactions. On the other hand, some form of multilateral management of the System was preserved, although the role played by the Fund and international cooperation in general were inevitably affected by the change of the exchange rate regime and developments in international banking. With the abandonment of fixed exchange rates and the lack of any clear rules governing the floating system, the Fund lost an important function. The concrete effects of its surveillance role over the exchange rates of the major currencies are not easily discernible. With very limited resources to deal with the recycling problem of oil surpluses, which was mainly taken care of by the commercial banks, the Fund was allowed to play only a limited role in the mid- and late 1970s. In recent years, however, as the international debt crisis developed and private bankers ©International Monetary Fund. Not for Redistribution MONETARY ARRANGEMENTS AND ADAPTATION 167 began to get cold feet, the situation has changed once again. More and more countries have been forced to resort to the Fund's conditional finance. Agreement with the Fund came to be seen increasingly as a precondition for further bank loans to countries trying to cope with the servicing of their external debt. The Fund also played a crucial role in complex debt rescheduling negotiations that involved the governments of debtor and indirectly also of creditor countries and the central banks from both sides, as well as a host of international banks. With the advent of floating exchange rates, international economic policy coordination was seen by some countries as having lost much of its raison d'etre. After all, floating rates were introduced mainly because of their promise to restore the autonomy of national monetary policies. But as the contradiction between international financial interdependence and national monetary sovereignty, irrespective of exchange rate re- gimes, became increasingly apparent, interest in international coordina- tion of national macroeconomic policies has resurfaced. The Bretton Woods conference of 1944 had produced a set of basic rules intended to provide the framework for monetary relations among sovereign countries. These rules were a form of written constitution, and the Fund was designed to ensure their day-to-day application. The common rules agreed were neither comprehensive nor inflexible and, as with any written constitution, their interpretation and application were to a large extent a function of the objective needs and the prevailing balance of power in the system itself. The Bretton Woods System was an integral and indeed absolutely crucial part of the postwar effort, led by the United States, to liberalize international economic relations on a multilateral basis. Yet it was also built on a clear assumption that, as regards monetary affairs, the invisible hand of the market had to be firmly guided by national public authorities and international institutions. Monetary systems in the past had devel- oped in a more spontaneous and gradual way; Bretton Woods, on the contrary, signified a conscious attempt to design a new international system which would remain under collective management. The developments of the last ten years or so have brought about a clear shift to the market. The new system, and it is probably a question of semantics whether the current set of arrangements can be described as a system, has loose rules regarding exchange rate adjustment, and the creation of international liquidity and reserve assets.