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Rethinking the international monetary system – IMF blog

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By Atish Rex Ghosh

Fifty years ago the world changed. On August 15, 1971, US President Richard Nixon closed the “gold window,” suspending dollar convertibility. Although it was not Nixon’s intention, this act effectively marked the end of the Bretton Woods system of fixed exchange rates. But, in truth, with the rise of cross-border private capital flows, a system based on fixed exchange rates for major currencies was no longer viable and Nixon’s decision – decried at the time as an abrogation of international responsibilities. of America – paved the way for the modern international monetary system.

The Bretton Woods collapse prompted a fundamental rethinking of what would give stability to the international monetary system.

The Bretton Woods era

When the Bretton Woods system was established in 1944, the dominant narrative was that competitive devaluations, foreign exchange restrictions, and trade barriers worsened, if not caused, the Great Depression. As a result, IMF member countries would only be allowed to change their exchange rate parity in the event of a “fundamental imbalance” – the idea being that the stability of individual exchange rates (excluding competitive devaluations) would lead to stability. of the overall system. Importantly, however, only the member country could propose a change in parity – the only power of the IMF was to approve or not to approve the proposed change.

The system incorporated elements of the old “gold standard” system, but now, instead of currencies being directly tied to gold, countries set their exchange rates against the US dollar. In turn, the United States has promised to supply gold, on demand, in exchange for dollars accumulated in foreign central banks at the official price of $ 35 an ounce. All the currencies linked to the dollar thus had a fixed value in terms of gold.

In an extraordinary surrender of national sovereignty for the common good, member governments have pledged to maintain a fixed parity for their exchange rate against the US dollar unless they are faced with a “fundamental imbalance” in their balance. payments. The IMF would lend reserves (usually dollars) to allow central banks to maintain parity in the face of temporary balance of payments shocks without “resorting to measures destructive of national or international prosperity”.

The system has worked reasonably well for over two decades. However, cracks appeared. Governments of deficit countries with overvalued currencies have often delayed necessary devaluations for fear of political repercussions. Meanwhile, surplus countries, which enjoyed a trade competitiveness advantage, had no incentive to revalue their currencies.

The experience of the 1960s showed that this artificial stability of individual exchange rates could delay the necessary adjustment, ultimately leading to traumatic balance of payments crises which resulted in system instability, especially if any of the major economies (eg UK) was involved. The increase in private capital flows meant that any whiff of a possible devaluation would send billions of dollars from a deficit country – thus precipitating the devaluation – to surplus countries that would find it difficult to contain the inflationary consequences of capital inflows. .

In the early 1970s, the United States suffered such a balance-of-payments crisis, mainly due to its lax domestic monetary and fiscal policies as it sought to finance the costs of the Vietnam War and its programs. the “Big Society”, as well as the reluctance of the large surplus countries (Germany and Japan in particular) to revalue their currencies. As the US gold reserves hemorrhaged, Nixon decided to close the gold window. Although designed as a ploy to force surplus countries to revalue their currencies, since the dollar was the linchpin of the system, Nixon’s action effectively brought the system down.

New system, new way of thinking

The collapse of Bretton Woods (and its short-lived successor, the Smithsonian Agreement) prompted a fundamental rethink of what would give stability to the international monetary system.

In designing the Bretton Woods system, the presumption had been that pegging individual currencies against gold or the dollar would make the system stable. However, in the process, US officials argued that simply fixing the exchange rate would bring rigidity, not stability. Attempts to maintain the peg (including through exchange restrictions or capital controls) when the exchange rate was no longer in line with national policies resulted in only costly – and ultimately futile – delays. in the exterior fit.

The new way of thinking was that the stability of the system would come less from the stability of individual exchange rates. in itself, and more domestic policies geared towards domestic stability (orderly growth with low inflation), which would result in stable but not excessively rigid exchange rates, thus allowing for a timely external adjustment, and thus contributing to stability of the entire international monetary system. While countries were no longer required to declare and maintain a fixed parity for their exchange rate, in order to prevent possible competitive devaluations / depreciations or other monetary manipulation, the IMF was tasked with exercising “firm surveillance”. On the exchange rate policies of its members.

Subsequent experience (especially in the aftermath of the 2008 global financial crisis) has shown that even such national stability may not be enough for system stability when dealing with systemically important countries. More recently, countries now regularly discuss the external implications of their internal policies with the IMF. And although they are never required to change these policies as long as they promote their own national stability, they can be encouraged to consider alternative policies if these also better promote the stability of the system.

What the future may hold in store for us

The collapse of the fixed exchange rate system shook the world in 1971. But monetary systems exist to meet the needs of humanity, and as our societies evolve, so do our societal systems. The world of 1971 was not what it was in 1944, just as our world today bears little resemblance to the realities of 1971. Today, fundamental transformations are accelerating development, deployment and development. adoption of digital currency. Could a digital transformation of the international monetary system soon be underway? Whatever the evolution of the system, the fundamental principle that its stability will depend on international monetary cooperation will remain.


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