Monetary Policy and Free Trade- Part I

After the II World War, monetary policy was quickly addressed by the world leaders who proposed to reaffirm it against the governments regulatory control. They argued that it was not to be used anymore by national governments to artificialy regulate trade deficit.

This international initiative sustained that the market economies should uphold their inherent competitive nature (supply and demand), by discouraging countries to depreciate their currency in order to obtain  commercial bilateral and temporary advantages.

According to the theories of uncovered interest parity (Fisher Hypothesis) and parity purchasing power (Cassel 1918): two currencies have different purchasing power, which differential may be overcome by inflation rates. An example of one measure of PPP is the Big Mac Index made popular by the Economist magazine which looks at the prices of a Big Mac burger in McDonald’s restaurants in different countries.

This pictoresque illustration serves to show that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country.

The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued (The Economist.com).

In other words, both imports and exports would balance one another and exempt governments from imposing strong expansionary monetary measures. There would be market regulation over policy increases in the size of the money supply, or decreases the interest rate, such as expanding currency production and restraining foreign currency exchange.

Global monetary affairs came about after the shock effect of the Great Depression in 1929, when international trade was largely restricted to currency blocs, like the sterling area and the British empire. the US State Secretary Cordell Hull (1933-1944) was a strong believer in a `Economic Security` concept based on the premise that the fundamental cause of the wars lay in economic discrimination and  trade warfare.

The regulatory effect would be introduced to prevent wild fluctuations in exchange rates and sudden currency depreciation, those could disastrously stall international trade from flowing freely (like was happening in the 1930s).

The key note was convertibility of currencies. In Bretton Woods is born the system of `adjustable parities` for international payments, returning to the gold standard as it was before the war, only this time using $U.S. as the world’s new central banks reserve currency. Ongoing only until the world’s gold supply could be reallocated via the international trade ways.

The U.S. dollar became the currency with the most Parity Purchase Power and the only one backed by gold. The other countries would buy and sell dollars to keep market exchange rates within plus or minus 1% of the value.

It was a system of fixed exchange rates regulated by newly created intergovernmental financial authorities: The IMF and World Bank. The debate that ruled the discussion was between UK’s Maynard Keynes, worried about England’s post war deficit defending the deflationary measures of a world `bancor`that could issue money and mediate trade between deficit and superavit countries. While on the other side stood Dexter White for the U.S. concerned about inflationary countries.

The IMF represented a pool of national currencies and gold, subscribed by quotas issued to the member states. This institution was in charge of managing the countries deficit and overview national currency devaluations that could trigger  a decline in imports. Each country’s quota would represent their relative economic power and they would pay a credit deposit of 25% in gold or dollars, that the IMF would use as loans according to size of each country’s quota. This is to say a chance for the country with a structural deficit on their balance of payments to buy their loan in foreign currency or gold, eliminating any PPP differential (maintaining stable currency exchange rates, instead of inducing a cut on the imports).

The Marshall Plan didn’t come about until the IMF reserves proved to be insufficient and only when the funds of the U.N. affiliated World Bank turned out to be over-tightly managed in securities by Wall Street. That left zero margin for European countries with deficits and no guarantees of liquidation to access loans. The GATT also was created later. Both outside the scope of this policy.

For the adjustable parities regime of Bretton Woods to work, gold had to have a fix price, each country had to decide their own parity to the dollar when declaring it to the IMF, and countries could not go over the 1% oscillation in currency exchange rate, except in a long run deficit in the balance of payments, otherwise, if temporary, they had to resort to IMF loans.

The IMF decadence however came about the end of the 50s, when its political goal, of security economics took over its fundamentally sensible and strictly macro economic inspiration. Within the context of Cold War, under pressure of keeping developing countries economies open, The World Bank relaxed its loan policies, supporting unstable regimes in South America and even contributing to what would be called the Green Revolution in the 60s.

The U.S. final attempt to rejuvenate the IMF was to create a system of triangular trade, profiting from raw material trade with under developed nations, using the surplus to sell dollars to Europe that would repay by making the U.S. the market for their products.

The U.S. internal struggle to keep gold at $35 an ounce turned sour when gold was rated higher in the open market in comparison to its fixed quote by the central banks, especially when the U.S. had to force a deficit in its balance of payments to keep the system from loosing its triangular liquidity, while at the same time a long term deficit would erode the systems confidence in the dollar as the reserve currency. European loyalty to U.S. military protection in the Cold War prevented a gold rush and kept the dollar as the reserve currency, until a reform of the system could no longer be postponed.

After the war, the U.S. produced half of the manufactured goods in the world and held half of its monetary reserves. Through the 50’s the U.S. held a balance of payments deficit in order to finance loans and troops abroad. in the 70s, the U.S. already had less than 15% of the world reserves.  The U.S. commitment to fix exchange rates and compromise to convert dollars in gold upon demand was no longer sustainable. in 1967 the IMF replaces the U.S. dollar as reserve currency by the famous special drawing rights in parity with the U.S. dollar exchange rate, but non transferable except between banks and the IMF.

Each Member State would be given SDR in a 1 to 3 proportion of their quotas and these accrued interest of 1.5%.

The SDR were created to stop nations from selling dollar-pegged gold to the open market and keep the dollars instead. The European Nations owed American defense policy protection and took upon them a voluntary loss by holding on to the dollars. The SDR were created as a benchmark to put a value on the allies relationship but with no commodity/equity market to go along with that. With Vietnam war the western loyalty was put to trial against the dollar and in 1970 the U.S. gold  coverage of foreign reserves were depleted down to 22%.

Nixon finally put an end to dollar-gold conversion, except on the open market. Nixon also adopted restrictive measures to American imports. First a more flexible clause was introduced to allow for a 2.25% margin of devaluation on agreed exchange rates, but eventually in 1976 currencies were back to floating and exchange rates were no longer in the center of governments monetary policy.

To rescue the system there were the Smithsonian Agreements in 1971 which devalued the dollar down to $38/ ounce and allowed for trading bands or margins in exchange rates to up or down 2.25% , continuing in exclusive with the special drawing rights. Ultimately the Agreements failed to discipline the pressure of gold against dollar.

in 1972 the gold became a floating asset and during the following ten years all the nations abandoned the currency peged exchange market. in 1973 the market opened one morning as a floating currency regime.