“We learn from history that we do not learn from history.”

Georg Wilhelm Friedrich Hegel

In 2008-2009, when confronted by the gravest global economic crisis in 80 years, G20 governments and their central banks responded promptly and appropriately by providing ample liquidity to financial markets, avoiding pro-cyclical fiscal policies and resisting protectionist trade measures that would invite retaliation. By taking these steps, they avoided the three critical policy errors that propagated the global economic stagnation of the Great Depression and, quite possibly, prevented a catastrophic collapse of global output — they also seemingly refuted Hegel.

The euphoria that accompanied this cooperation was relatively short lived, however. While emerging markets quickly returned to growth, many advanced economies, suffering the after-effects of financial excesses, struggled to close output gaps and bring unemployment down. The “green shoots” of growth that heralded much promise in early 2010 did not wither and die, but neither did they bear full fruit. Today, even as encouraging employment growth in the United States provides grounds for a modicum of optimism, the global economy remains dangerously unbalanced.

To be sure, financial markets have responded to the continuing crisis in Europe with aplomb, buoyed by the introduction of the European Central Bank’s Long-Term Refinancing Operation in December 2011 and the US Fed’s recent commitment to hold interest rates steady for an extended period. Yet, these monetary responses — as necessary and welcome as they are — are not a panacea; absent supporting efforts to secure global rebalancing, they could underwrite the status quo and contribute to the buildup of even more vulnerabilities, rather than grease the wheels of adjustment and stimulate investment.

The challenge is to strike the right balance between financing and adjustment.

The international monetary system (IMS) is at the core of this dilemma. This reflects the fact that, in an integrated global financial system, the IMS is where two key relative prices — real interest rates and real exchange rates — are determined.[1] Real interest rates can be thought of as the relative price of current versus future consumption. When they are high, because the return on investment is high, individuals save more (consume less today) in order to enjoy higher consumption tomorrow. Think of real exchange rates, meanwhile, as the relative price of domestic versus foreign consumption. When a country’s real exchange rate appreciates, foreign goods are cheaper to buy; domestically produced goods are more expensive to foreigners. As such, real exchange rates distribute demand between countries (or within currency zones). In theory, with perfectly integrated financial and goods markets with perfectly flexible prices, the two are determined simultaneously to equilibrate savings with investment and global demand with global supply. In that happy state, full employment is more or less assured.

In practice, however, markets are not perfectly integrated and prices are not perfectly flexible, especially the “price” of labour — wages. And, in contrast to theory, real-world economies are not always at full employment — although market forces may move an economy closer to full employment over time, this adjustment process is neither instantaneous nor frictionless. As a result, governments adopt a range of policies to shield their economies from external shocks to protect employment and implement measures to accelerate the pace of economic development. These policies may have spillover effects on others, and affect the determination of real interest rates and real exchange rates.

The IMS determines how these potential spillovers are managed through “rules of the game” that determine the appropriate balancing of financing and adjustment.

Following World War II, the Bretton Woods system of fixed exchange rates provided the monetary cooperation needed to promote this balance until the early 1970s. Because private capital flows were limited by the near-universal use of capital controls (and the memory of losses incurred in the 1930s), balance of payments crises originated in the current account — from imbalances between private-sector savings and investment and government dissaving. Since saving and investment decisions reflect long-term, inter-temporal optimization, the first rule of international finance was: adjust to permanent shocks, finance temporary shocks.

With private capital flows limited, the International Monetary Fund (IMF) had the resources needed to close gaps in the balance of payments. Member countries undertook fiscal adjustment — reducing spending or raising taxes — as the quid pro quo for the IMF financing that smoothed their adjustment process.[2] Eventually, however, countries sought the benefits provided from access to private capital markets, while capital controls became progressively more porous, and country after country liberalized the capital account. But this evolution of the system was not accompanied by a corresponding change in international arrangements for dealing with financial crises. The consequences of this institutional gap have been replayed again and again over the past 15 years or so, as the global economy has lurched from one financial crisis to another, and the IMF has responded to these crises with, more or less, the same tools it used to assist members in balance-of-payments difficulties in the halcyon age of the Bretton Woods system.

At the same time, since the collapse of the Bretton Woods system in the early 1970s, we have lived with what might facetiously be described a “Maoist” IMS. While we have not seen a hundred different regimes “bloom,” the past several decades have at least featured an increase in the number of exchange rate regimes.[3] In this respect, the current “non system,” as it was dubbed by economist John Williamson, is interesting from a long-term historical perspective. Indeed, the current situation is somewhat reminiscent of the dysfunctional international monetary arrangements of the interwar period. Fixed, and managed exchange rates supported by foreign exchange intervention, currency unions in non-optimal monetary areas pursued for political objectives and lacking the needed supporting legal and policy frameworks, and the adoption of "prudential" capital controls to stem currency appreciation, all combine to create an international monetary "non-system" that, like the monetary disorder of the 1930s, threatens to destroy aggregate demand and spread the risk of deflation.

Many developing countries did maintain some form of an exchange-rate peg throughout the post-Bretton Woods period. And, as long as these countries — individually and collectively — were small, and the global economy was growing at a robust pace, the consequences for global adjustment were minor. Issues of international adjustment were resolved by the major industrial countries that had floated their exchange rates. This was the case, for example, in the mid-1980s when imbalances were an issue among a handful of countries. Today, however, with emerging market economies with fixed or quasi-fixed exchange rates accounting for a rising share of global GDP, the potential for larger imbalances and the problem of difficult, protracted disputes over adjustment increases.

If the countries that are presently struggling with high public debt burdens are to grow, even as they increase savings, real exchange rates and global real interest rates must adjust so that their current account deficits are reduced or transformed into surpluses; surpluses elsewhere must decline or turn into deficits. Efforts to thwart this process in order to defer adjustment and target current account surpluses could result in insufficient global aggregate demand, as each country pursues the elusive surplus goal. But what is feasible for one, is impossible for all. In these circumstances, Keynes warned, countries will be tempted to shift the burden of adjustment to others through beggar-thy-neighbour policies "injurious to national and international prosperity." As the 1930s demonstrated, such policies beget retaliation.

From this experience, Keynes concluded that international monetary cooperation was essential to get “the rules of the game” for the timely, sustainable resolution of balance-of-payments difficulties. That is why he worked to ensure that the IMF, as guardian of the Bretton Woods system, would help its members strike the right balance between financing and adjustment. A similar spirit of cooperation is necessary today to facilitate the rebalancing of the global economy, which is needed for all members of the global community to return to full employment through strong, sustainable and balanced growth.

Such cooperation is required to refute Hegel.


[1] Real interest rates are “nominal” interest rates — those determined in financial markets — adjusted for inflation. If i represents the nominal interest rate, and π is the rate of inflation, the real interest rate is iπ. Similarly, the real exchange rate between two currencies is the nominal, or market, exchange rate adjusted for differences in price levels between the two countries. Changes in the real exchange rate, therefore, reflect changes in the nominal exchange rate and differences in inflation rates.

[2] This accounts for the pun, frequently cited in the Bretton Woods era,  that IMF stands for “It’s Mostly Fiscal.”

[3] Although widely misquoted as “let a thousand flowers bloom,” Mao was, in fact, less ambitious and referred to a “hundred flowers.”

This evolution of the system was not accompanied by a corresponding change in international arrangements for dealing with financial crises.