IMF management holds a joint press conference at the IMF Headquarters in Washington July 3, 2012 (IMF Staff Photograph/Stephen Jaffe)
IMF management holds a joint press conference at the IMF Headquarters in Washington July 3, 2012 (IMF Staff Photograph/Stephen Jaffe)

The story thus far: The global economy faces large adjustment challenges that in some respects resemble the situation in the early years of the Bretton Woods era, albeit with different structural constraints.

The IMF and other International Financial Institutions (IFIs) can help their members deal with the adjustment challenges ahead, but only if members agree on a set of obligations and responsibilities they owe to each other and the system writ large. Members must agree, in effect, to delegate monitoring and collective enforcement of international agreements to institutions of international cooperation. And, yet, independent, sovereign states will not voluntarily bind themselves to supra-national institutions, however well-intentioned, that lack legitimacy and which enforce rules the states have not endorsed. This underscores the point made in earlier posts that IMF quota reform (to endow the IMF with renewed legitimacy) is inextricably tied to how the institution can assist its members rise to the adjustment challenges of the 21st century.

So, what are the obligations and responsibilities that members owe to each other and the system?

In some respects, they are the same as the obligations underpinning the Bretton Woods system. While it might seem hopelessly naïve or perhaps overly optimistic in the jaundiced age in which we live, the goal of the Bretton Woods system was to create a global economy in which independent sovereign states would be free to pursue national development objectives — including the pursuit of full employment — provided their actions did not impose harm on others. This would only be achieved, it was believed, if countries had access to resources on fair and reasonable terms (i.e., at world prices). Markets and not political agreements should govern resource allocation, in contrast to the imperial scramble for resources that prevailed in the 19th century and the attempts to secure preferential and exclusive access in the inter-war period by means of trade restrictions and bilateral payments clearing arrangements.

The architects of the Bretton Woods system also recognized that global prosperity would be promoted by reducing the tariff and non-tariff barriers that had been erected in the Depression. This would, it was argued, promote the efficient allocation of resources and raise incomes.

This objective imposed the requirement that governments not use restrictions on international payments either as a non-tariff trade barrier or as a means of making international prices less transparent. Members therefore agreed to ensure their currencies were convertible (freely exchangeable at market exchange rates) for current account transactions. The process was asymmetric, however, with countries in a stronger balance of payments position (the U.S. and Canada) moving more quickly, while a transition period provided more time to adopt convertibility for countries suffering from severe shortages of foreign exchange and rebuilding war-ravaged economies.

Members also agreed to a quasi-gold standard system of exchange rates under which they fixed their currencies to the U.S. dollar and the dollar pegged to the price of gold. Importantly, it was not — though widely believed to be — a system of fixed exchange rate. It is true, however, that exchange rates quickly became ossified. Regardless, this feature was crucial in terms of sustaining the cooperative approach to facilitating adjustment: the IMF reviewed members' adherence to commitments to current account convertibility, while the Bretton Woods exchange rate arrangements gave assurance that other members were not "defecting" from the agreement to eschew beggar-thy-neighbour exchange rate manipulation in order to secure a competitive advantage. As long as a member adhered to the agreed exchange rate parity — readily observable in foreign exchange markets — it was meeting its international obligations.

These obligations of the Bretton Woods era remain relevant to the adjustment challenges of  today. A felicitous adjustment path for all members of the international community requires the same commitment to current account convertibility and eschew measures that prevent the efficient allocation of resources through exchange and payments control. Moreover, some agree on the need for exchange rate adjustment and prevent of the use of policies designed to achieve or sustain a competitive advantage and shift the burden of adjustment to others. But this agreement need not entail a system of fixed exchange rates that ultimately undermined the Bretton Woods system.

At the same time, the remarkable development of global capital markets over the past four decades imposes obligations with respect to the capital account. This would be the counterpoint to the Bretton Woods-era commitments on current account convertibility. In this respect, past proposals along these lines have been the subject to vociferous opposition, hostility and suspicion: the fear that such commitments would lead to forced openings of national financial systems in opposition to Keynes' famous dictum, "keep finance national." Indeed, such opposition effectively blocked an earlier, ill-timed attempt to secure international agreement on the eve of the Asian financial crisis. The worry then was that sovereign states would lose the capacity to pursue the wholly legitimate goals of their choosing, especially the pursuit of full employment, if they were required to open their financial systems or would be limited to imposing restrictions under pressure from the IMF.

Such concerns were, I believe, largely unjustified — most countries actively pursued capital account liberalization to secure access to foreign capital markets and the risk-sharing properties of international diversification. Nevertheless, the debate on IMF "jurisdiction" over capital accounts and a multilateral agreement on capital flows serve to highlight two key issues.

The first issue is that capital markets do not necessarily lead to efficient outcomes. Lest there be doubts about that proposition, one need only reflect on the past five years. Financial markets operate in an environment of imperfect, asymmetric information. And this implies that outcomes are subject to principle-agent problems, moral hazard and adverse selection. Legal, accounting and corporate governance frameworks have evolved to address these problems, while prudential regulation seeks to minimize the systemic risk of individual irresponsibility.

What is true at the domestic level is magnified at the international level for the simple reason that national legal and regulatory frameworks do not extend beyond borders. The creation of the Financial Stability Forum in the wake of the Asian Financial Crisis was an acknowledgement of this problem. And since the global financial crisis the re-named Financial Stability Board has sought to coordinate national regulatory regimes to avoid regulatory arbitrage.

Moreover, in contrast to the domestic context, international capital markets are not governed by bankruptcy frameworks that help resolve key coordination problems and promote timely, orderly restructuring of sovereign claims. In this respect, the Bretton Woods architecture was, and remains, incomplete. Going forward, therefore, a key objective should be the development of a better framework for the resolution of sovereign debt crises.

To be fair to John Maynard Keynes and Harry Dexter White, the two key architects of the Bretton Woods system, this was not a critical omission given the widespread use of capital controls in the early years of the Bretton Woods system. The pervasive use of capital controls then reflects the second key issue to be considered in thinking about obligations and responsibilities in the early decades of the 21st century: the iron constraints of the trilemma.

The trilemma establishes the policy set from which countries must choose their exchange rate, capital account and monetary policy options. A country can opt for a fixed exchange rate, open capital markets and pursue an independent monetary policy aimed at maintaining full employment, but not all three. The choice of two determines the third. Under the Bretton Woods system, members chose to fix their currencies in terms of the U.S. dollar and to use domestic stabilization policy to achieve full employment, but, in order to break the "golden fetters" of the gold standard, members had to restrict capital flows. Absent such controls, countries facing current account deficits would be faced with the prospect of either speculative attack on the exchange rate or deflationary pressures through the gold standard's price-specie flow mechanism (which would be inconsistent with the full employment objective).

Given the adjustment challenges faced today, a return to the Bretton Woods obligations is unlikely; nor is it desirable. As noted previously, there are enormous potential gains from inter-temporal trade to be reaped between countries facing different demographic challenges. Efficient global capital markets can help members capture these gains. Yet, in a fundamental sense, this will require a concert effort on the part of the international community to "complete" Bretton Woods by getting the right framework for global capital. Today's obligations of adjustment therefore include a commitment to the work of the Financial Stability Board as well as to efforts to construct a better framework for the timely, orderly restructuring of sovereign debt.

Getting agreement on these obligations will create the positive sum game that the IMF and other institutions of international cooperation were designed to support. It would also address the pervasive gloom that clouds economic prospects in the New Age of Uncertainty.

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