Previous posts, here and here, argued that the adjustment challenges that loom large in the global economy require international agreement on the obligations and responsibilities that members owe to each other and the system.
For the avoidance of doubt, these challenges are not limited to the advanced economies that are struggling under high public burdens and ageing populations. Emerging markets that have pursued export-oriented growth strategies with remarkable success will have to adjust to an external environment that is less encouraging to continued growth of their exports. Moreover, if they are to continue the process of development, they will have to avoid the middle-income trap — as these countries travel down the path of development, wage rates will rise, reducing the competitiveness of their exports; continued growth and rising prosperity will have to come from productivity gains.
The challenges of adjustment are, in short, many and varied. They will not be easily addressed. And the risk is that individual countries will try to evade or shift the burden of adjustment to others; alternatively, that some countries seek to gain access to resources and markets amongst themselves on preferential terms and to the exclusion of others.
The global economy has been in this situation before. Almost a century ago, the financial, economic and political shocks of the Great War — renamed the First World War when another great war erupted two decades later — bequeathed a similar legacy of adjustment challenges.
The individual responses adopted by members of the international community led to global economic stagnation in the 1930s. In the process, the last vestiges of the gold standard, which had been created under the leadership of the Bank of England in the last quarter of the 19th century, including the remarkable degree of financial integration, were lost.
One interpretation — by no means universally accepted — is that the global crisis of the inter-war years reflected gaps in the global governance. The problem, it is argued, stemmed from the fact that the underlying social consensus on which the economies of major European countries were based changed as a result of the terrible carnage of the Great War. Not to put too fine a point on things: in contrast to the pre-war period, labour was mobilized as returning soldiers who fought together and saw their comrades decimated in the killing grounds, often as a result of incompetent or merely uncaring leadership. Those who answered the call of country in 1914, returned in 1919 with a sense that their sacrifices on the battlefield should be rewarded at home. Most significantly, they wanted stable wages; and they wanted a better distribution of the adjustment burden.
Indeed, the one thing on which Keynes and his intellectual opponents agreed is that wages had become far less flexible, though they differed on the source of that "stickiness." And, of course, they vehemently disagreed on the appropriate policy response. Regardless, the fact that wages were less flexible than they had been under the classical gold standard of pre-war years meant that the automatic, symmetric adjustment mechanism embodied in the price-specie flow mechanism was blocked up.
Moreover, governments struggling under burdensome war debts anxiously guarded their gold reserves, while creditors sought to insulate their economies from the effects of incipient gold flows on prices. In effect, the system became asymmetric: governments with current account surpluses willingly accumulated gold reserves, but rather than accommodating the impact of those inflows through higher prices, governments sterilized these effects in order to avoid the loss of competitiveness that passive adherence to the rules of the gold standard would have entailed.
It was as if all countries wanted to grow their economies through net exports. Of course, this is a logical impossibility. Yet, given the debt burdens borne by most countries, deficit countries had no alternative. But, with surplus countries sterilizing gold inflows, the full burden of international adjustment was on the deficit countries. And, with wages "sticky" downwards, the inevitable result was higher unemployment and deflation (as global liquidity was "locked up" in the gold reserves of a few central banks).
Faced with debt loads that increased in real terms with each round of deflation and lacking any other means to facilitate adjustment except wait for higher unemployment to reduce wages, is it really a surprise that some countries defected from the "good" equilibrium of open markets and liberal trade? Once some countries adopted beggar-thy-neighbour policies that were "injurious to national and international prosperity," others quickly followed. The result was a transformation of the global economy from a positive sum game to a zero sum game of shifting adjustment burdens to other players.
A key element in all this was the debt burdens which countries shouldered at the close of the Great War, exacerbated, in the case of Germany, by the reparations payments imposed by the Treaty of Versailles. But this was a general problem; it was not restricted to Germany. During the war, the U.K. had borrowed massively from New York banks and on-lent much of their dollars to their allies for the purchase of arms and as inducements to remain in the fight. As problems emerged in the inter-war periods, efforts were made to reduce German reparations to a more manageable level and there were repeated attempts to sort through the complex web of inter-twined debts owed by the combatants. Unfortunately, these efforts were too little, too late.
Global cooperation on monetary, economic and political affairs floundered and the world was soon again at war.
Even as the Second World War raged in Europe and Asia, however, attention turned to post-war international monetary arrangements. The goal was to create a system that — while not necessarily more symmetric than the dysfunctional gold standard of the inter-war years — would assist countries strike a judicious balance between financing and adjustment and encourage them to eschew beggar-thy-neighbour policies. The International Monetary Fund was created to provide short-term balance of payments financing and facilitate the pooling and recycling of global liquidity. At the same time, members introduced capital controls as a means of squaring the "trilemma" circle.
The Bretton Woods agreement that created the IMF and the World Bank did not directly address the issue of debts that countries carried at war's end. Rather, Britain's huge obligations were dealt with on a bilateral basis, typically through very long-term rescheduling at low interest rates. (The final instalment on Canada's loan to the U.K. was only paid a few years ago, for example.) At the same time, the U.S. provided indirect debt relief to Europeans struggling to recover through the Marshall Plan. In addition, because the Bretton Woods system was predicated on the continued use of capital controls, international capital flows would be largely in the form of official lending — either directly or by the IMF and the World Bank. There would be no large-scale private international capital flows such as those that prevailed in the heyday of gold standard. Accordingly, the absence of an explicit framework for restructuring the debts of sovereign states was not, therefore, deemed to be an issue.
In this respect, the Bretton Woods system was "incomplete." It is a speculation on my part, yet I think it is fair to say that Keynes and Harry Dexter White looked ahead to a time when capital controls would become porous and would be removed by governments that sought the benefits that access to global savings would provide. The IMF Articles of Agreement includes a clause (Article VI) that prohibits the use of IMF resources to meet a member's obligations to the private sector — in the vernacular, to "bail out" private creditors. The point here is that if IMF resources are used to service debts held by the private sector, they would not be available to cover needed imports. It would be more difficult, in short, for the IMF to assist the member strike a judicious balance between financing and adjustment. A strict interpretation of the clause would force private sector creditors to negotiate a reduction in their claims.
The problem is that Article VI has been honoured more in the breech than in its observance. This isn't entirely surprising. As capital account crises have supplanted the balance of payments problems over the past 30 years, the IMF has been on the horns of a terrible dilemma: it could apply Article VI and risk a protracted crisis as the member is shut out of global capital markets or adopt a more flexible interpretation of the clause in order to assist the member meet its obligations to private creditors and retain access to capital markets. The fact that members invariably seek the latter is key.
Fearing the leap of faith that a restructuring entails, members typically choose to try to deal with the debt problem through Bretton-Woods-style adjustment: reducing domestic absorption (reducing private consumption, investment and government expenditures) in order to reduce the current account deficit. But that approach is broadly compatible with balancing financing and adjustment when the problem is a current account crisis equivalent to a few percentage points of GDP; it is far less effective when dealing with a capital account crisis 10 or more percentage points of GDP. There should, arguably, be a better targeting of responses. Capital account crises should be addressed by capital account solutions — not the policy instruments designed for the Bretton Woods era of capital controls. That era no longer exists.
All of this argues in favour of a better framework for the timely, orderly restructuring of sovereign debt. This need not be an international bankruptcy. The private sector has, over the past decade, demonstrated considerable innovation in terms of mobilizing debt exchanges to achieve timely restructurings. But, as the current legal battle with Argentina's pari passu clause demonstrates, the issue remains open.
Getting the international financial system that is needed to address the adjustment challenges of the 21st requires more work. The goal is the timely, orderly adjustment of obligations.