Construction of an Ad Hoc International Financial System Policy Coordination

Economic SummitsFred Thompson2 Structural Interdependence Structural interdependence is the reason that policymakers might consider the joint determination of economic policies. Structural interdependence refers to the interconnectedness of nations’ markets for goods and services, financial markets and payments systems.

Economic SummitsFred Thompson3 International Policy Externalities Structural interdependences can results in international policy externalities: a benefit or cost for one nation’s economy owing to a policy undertaken in another economy. A locomotive effect occurs when an increase in real income in one economy spurs an increase in real income in another. A beggar-thy-neighbor effect occurs when a policy action benefits the residents of the home country at the expense of residents in another nation.

Economic SummitsFred Thompson4 International Policy Cooperation and Coordination There are two ways that nations may work together to achieve their economic objectives. International Policy Cooperation is the adoption of institutions and procedures by which policymakers can inform each other of their objectives and share data. International Policy Coordination is the joint determination of economic policies within a group of nations, intended to benefit the whole.

Economic SummitsFred Thompson5 Potential Benefits of Coordination 1.Take account of and minimize policy externalities 2.Achieve a larger number of policy objectives with available instruments 3.Policymakers may present a “united front” in the face of home political pressures that could push them to adopt harmful policies.

Economic SummitsFred Thompson6 Potential Drawbacks to Policy Coordination 1.Must sacrifice or forego some domestic interests 2.Must trust that counterparts are willing to make sacrifices 3.Coordinated policies may have negative consequences such as higher inflation (e.g., Bonn Summit of 1978)

Important Meetings, Events, and Organizations

Economic SummitsFred Thompson8 Bank for International Settlements: An Overlooked Institution Created in 1930 by private U.S. banks and the governments of 10 advanced economies. Based in Basle, Switzerland. Serves as an international loan trustee, as an agent of central banks, center of economic cooperation (e.g. Basle Agreement).

Economic SummitsFred Thompson9 Economic Summits November 1975 French President, Valery Giscard d’Estaing hosts the first economic summit. France, US, UK, Germany, Japan (G5). Italy added to represent the EU (G6). Agreed to a system of flexible exchange rates. Countries would intervene when needed to ensure stability.

Economic SummitsFred Thompson10 Jamaica Accords January 1976 meeting of IMF member country nations. Amended the articles of agreement of the IMF to recognize flexible exchange rate systems. Member nations could adopt an arrangement of their own choice.

Economic SummitsFred Thompson11 Summits “Institutionalized” –Summits made an annual event President Ford hosts the second summit. Invites Canada (G7). Summits now occur ever summer, rotating from country to country. British PM, Tony Blair, adds President Yeltsin (Russia) as a “full member” for the 1998 Birmingham Summit (G8).

Economic SummitsFred Thompson12 Plaza Agreement –September Meeting of the G5 central bankers and finance ministers. Had been meeting quietly for a number of years. Discussed the value of the US dollar. Announced a belief that the dollar was overvalued and that the nations would intervene on a coordinated basis to drive down the value of the dollar.

Economic SummitsFred Thompson13 Louvre Accord –February 1987 Meeting of the G7 (less Italy) central bankers and finance ministers. Announced that the dollar was now “consistent with economic fundamentals.” Would only intervene when required to ensure stability. Managed float system emerges.

Economic SummitsFred Thompson14 Groups –The main G’s G7 refers to the meetings of the central bankers and finance ministers of the G7 nations. G8 refers to the heads of state of the G8 nations meeting at the economic summits. G10, G7 plus Belgium, the Netherlands, and Sweden.

The Gold Standard and the Bretton Woods System

Economic SummitsFred Thompson16 The Gold Standard Came into effect in the mid-1870s when most of the major economies unilaterally pegged to gold. Nations fixed the value of their currency relative to gold via a mint parity rate. They also established convertibility, or the ability to exchange the currency for gold.

Economic SummitsFred Thompson17 The Gold Standard Pegging the value of each currency to gold, established an exchange rate system by indirectly establishing exchange rates. The mint parity rates could be used to determine the exchange rate.

Economic SummitsFred Thompson18 The Gold Standard

Economic SummitsFred Thompson19 The Gold Standard Long-run price stability Short-run price instability Numerous financial crises Suspended in 1914 after the beginning of WWI. Return to gold standard in 1925 led to collapse.

Economic SummitsFred Thompson20 The Bretton Woods System Forty-four nations participated in the conference. Primary architects were Harry White of the U.S. and John Maynard Keynes of the U.K. Ratified in 1944 Though known as the Bretton Woods Conference, it was officially called the International Monetary and Financial Conference of the United and Associated Nations.

Economic SummitsFred Thompson21 The Bretton Woods Conference Organizations Created

Economic SummitsFred Thompson22 Bretton Woods System System of adjustable pegged exchange rates. U.S. dollar was the anchor of the system because it was pegged to gold. All other participating nations could peg to gold or to the dollar. All chose to beg to the dollar, a dollar- standard exchange rate system was created.

Economic SummitsFred Thompson23 The Dollar-Standard System

Economic SummitsFred Thompson24 The 1960s Trouble for the Dollar Glut of dollars due to Vietnam war and programs of the “Great Society.” Dollar believed overvalued relative to the currencies of Japan and some Western European economies, e.g., Germany. Dollar becomes target of foreign exchange speculators. U.S. and European countries intervene in the gold market. Britain devalues in 1967 and holders of the pound experience a 15 percent capital loss.

Economic SummitsFred Thompson25 The Dollar and the Mark (from Grabbe, 1999) On May 4, 1971, the Bundesbank buys $1 billion on the exchange market to maintain the parity value. On the next day they buy $1 billion in the first hour of trading. Bundesbank abandons the parity rate and lets the mark float upward relative to the dollar. Austria, Belgium, the Netherlands, and Switzerland follow suit.

Economic SummitsFred Thompson26 End of the System Faced with a major run on the dollar, President Nixon suspends convertibility of the dollar. The system falls into disarray. Market is closed on extremely volatile days.

Economic SummitsFred Thompson27 Smithsonian Agreement In an attempt to restore order to the exchange market, 10 leading nations meet at the Smithsonian institution on December 16 and 17, A new system of exchange parity values determined. Dollar, however, is still not convertible to gold. Nixon hails the agreement as the “most significant monetary agreement in the history of the world.” System collapses in 15 months and a de facto system of floating rates emerges.

The Ad Hoc Exchange Rate System The Various Types of Arrangements Today

Economic SummitsFred Thompson29 Current Arrangements

Economic SummitsFred Thompson30 Dollarization Dollarization is the replacement of the domestic currency with the currency of another nation. Two possible problems are the loss of seigniorage revenues and the loss of discretionary monetary policy. Seigniorage is the revenue created through the manufacturing of money, and can be quite important to developing nations. Examples are Panama, El Salvador and Ecuador.

Economic SummitsFred Thompson31 Currency Board Establishes and maintains a hard peg between the domestic currency and another currency. Issues domestic notes. Notes issued depend on the value of the exchange rate and the amount of foreign reserves. Hence, monetary base is determined by the stock of foreign reserves.

Economic SummitsFred Thompson32 Currency Board - Continued Replaces central bank –Cannot hold domestic debt. –Not a lender of last resort –Does not set reserve requirements Theoretically shielded from political pressure. E.g.: Argentina, Estonia, and Bulgaria.

Economic SummitsFred Thompson33 Pegged and Pegged with Bands Parity value established relative to another currency. Central bank must conduct monetary policy to maintain parity. “Parity band” allows limited flexibility on either side of the parity rate. Band can be very narrow or very wide. E.g.: Bangladesh, China, and Egypt.

Economic SummitsFred Thompson34 Currency Basket Peg Currency is pegged to a “basket” currencies. Parity value is the weighted average of a basket of currencies in various quantities. Each currency has an implicit weight assigned to it. Provides some degree of flexibility against individual currencies. E.g.: Poland and Chile.

Economic SummitsFred Thompson35 Crawling Peg Parity value is changed on a periodic basis. Crawl is typically designed to compensate for differences between the economic performance of the pegging country and the country being pegged to. Bands may be established around the crawling parity rate. Bands may be symmetric or asymmetric. E.g: Chile, Hungary, and Poland.

Economic SummitsFred Thompson36 Managed Float Currency value is determined in the interbank market. Monetary authority may intervene periodically to maintain stability. Sometimes referred to as a “dirty float.”

Economic SummitsFred Thompson37 Floating Value of domestic currency is determined in the foreign exchange market. Forces of supply and demand are the sole determinants of currency value movements.

Alternative Exchange Rate Systems

Economic SummitsFred Thompson39 Monetary Unions An extreme type of coordination is for a nation to give up its own currency and adopt a currency common to it and a coalition of other nations. That is, form a monetary union. For a monetary union to succeed, the coalition must represent an optimal currency area.

Economic SummitsFred Thompson40 Optimal Currency Area The theory of optimal currency areas is a means of determining the size of a geographic area within which residents’ welfare is greater if their governments fix exchange rates or adopt a common currency. An optimal currency area is on in which labor is sufficiently mobile to permit speedy adjustments to payments imbalances and regional unemployment so that exchange rates can be fixed or a common currency adopted.

Economic SummitsFred Thompson41 Exchange Rate Target Zones A target zone is a “intermediate” approach to exchange rate management that limits exchange rate volatility while still permitting some variation in countries currency values. Specifically, a target zone is a range of permitted exchange rate variation between upper and lower exchange rate bands that a central bank defends by purchasing or selling foreign exchange reserves.

International Debt Debt Relief for the Poorest Nations?

Economic SummitsFred Thompson43 Debtor / Creditor Status Net Debtor Nation –A nation whose total claims abroad are less than the total foreign claims on the nation. Net Creditor Nation –A nation whose stock of foreign financial assets is greater than the stock of foreign-held domestic financial assets.

Economic SummitsFred Thompson44 The US and Net Debtor Status It is neither necessarily good nor bad to be a net debtor. The US is the world’s largest net debtor, primarily because of record FDI inflows. The US has been a net debtor in the past, and it spurred an industrial revolution.

Economic SummitsFred Thompson45 Debt Relief Debt relief for the poorest nations is one of the most pressing international economic policy issues today. Beginning in the early 1980s, the stock of international debt became so large that many developing nations could no longer make all of their debt service payments.

Economic SummitsFred Thompson46 Debt Relief / Institutions Paris Club –Forum for multilateral negotiations between debtor and creditor nations. London Club –Forum for negotiations on private debt owed to commercial banks. Millennium Fund –Private sector donations for debt relief

Economic SummitsFred Thompson47 Debt Relief Despite the efforts undertaken in these organizations, during the 1990s, the debt stock of the poorest nations doubled in 5 years. At the start of 2000, less than half of the debt obligations were being fulfilled, with $US60 billion in arrears.

Economic SummitsFred Thompson48 Debt Relief In 1996, the leaders of the G7 nations agreed upon the HIPC (Heavily Indebted Poor Countries) Initiative, intended as a means to qualify nations (originally 26) and deliver debt relief. The HIPC initiative failed to deliver relief after 3 years, as only seven nations qualified and none saw any debt relief.

Economic SummitsFred Thompson49 Debt Relief In 1999, public pressure lead to the Cologne Debt Initiative (CDI). The CDI was intended to deliver faster and deeper relief. Expanded list of countries.

Economic SummitsFred Thompson50 Problems 15 percent of debt stock owned by nations not part of the CDI negotiations. 50 percent of the debt stock not being serviced as is. Hence, forgiveness of stock may not help that much. Public financing issues.

Economic SummitsFred Thompson51 Current Status For current information on HIPC, visit the web sites of the International Monetary Fund and the World Bank.

Economic SummitsFred Thompson52 Balance of Payments Accounting Balance of Payments Accounting IBalance Balance of Payments Accounting IIBalance of Payments Accounting