International Finance: The International Monetary System

The International Monetary System

The rules and procedures for exchanging national currencies are collectively known as the international monetary system. This system doesn't have a physical presence, like the Federal Reserve System, nor is it as codified as the Social Security system. Instead, it consists of interlocking rules and procedures and is subject to the foreign exchange market, and therefore to the judgments of currency traders about a currency.

Yet there are rules and procedures—exchange rate policies—which public finance officials of various nations have developed and from time to time modify. There are also physical institutions that oversee the international monetary system, the most important of these being the International Monetary Fund.

Exchange Rate Policies

In July 1944, representatives from 45 nations met in Bretton Woods, New Hampshire to discuss the recovery of Europe from World War II and to resolve international trade and monetary issues. The resulting Bretton Woods Agreement established the International Bank for Reconstruction and Development (the World Bank) to provide long-term loans to assist Europe's recovery. It also established the International Monetary Fund (IMF) to manage the international monetary system of fixed exchange rates, which was also developed at the conference.

The new monetary system established more stable exchange rates than those of the 1930s, a decade characterized by restrictive trade policies. Under the Bretton Woods Agreement, IMF member nations agreed to a system of exchange rates that pegged the value of the dollar to the price of gold and pegged other currencies to the dollar. This system remained in place until 1972. In 1972, the Bretton Woods system of pegged exchange rates broke down forever and was replaced by the system of managed floating exchange rates that we have today.

The Bretton Woods system broke down because the dynamics of supply, demand, and prices in a nation affect the true value of its currency, regardless of fixed rate schemes or pegging policies. When those dynamics are not reflected in the foreign exchange value of the currency, the currency becomes overvalued or undervalued in terms of other currencies. Its price—fixed or otherwise—becomes too high or too low, given the economic fundamentals of the nation and the dynamics of supply, demand, and prices. When this occurs, the flows of international trade and payments are distorted.

In the 1960s, rising costs in the United States made U.S. exports uncompetitive. At the same time, western Europe and Japan emerged from the wreckage of World War II to become productive economies that could compete with the United States. As a result, the U.S. dollar became overvalued under the fixed exchange rate system. This caused a drain on the U.S. gold supply, because foreigners preferred to hold gold rather than overvalued dollars. By 1970, U.S. gold reserves decreased to about $10 billion, a drop of more than 50 percent from the peak of $24 billion in 1949.

In 1971, the U.S. decided to let the dollar float against other currencies so it could find its proper value and imbalances in trade and international funds flows could be corrected. This indeed occurred and evolved into the managed float system of today.

A nation manages the value of its currency by buying or selling it on the foreign exchange market. If a nation's central bank buys its currency, the supply of that currency decreases and the supply of other currencies increases relative to it. This increases the value of its currency.

On the other hand, if a nation's central bank sells its currency, the supply of that currency on the market increases, and the supply of other currencies decreases relative to it. This decreases the value of its currency.

The International Monetary Fund plays a key role in operations that help a nation manage the value of its currency.

The International Monetary Fund

The International Monetary Fund (www.imf.org) is like a central bank for the world's central banks. It is headquartered in Washington, D.C., has 184 member nations, and cooperates closely with the World Bank, which we discuss in The Global Market and Developing Nations. The IMF has a board of governors consisting of one representative from each member nation. The board of governors elects a 20-member executive board to conduct regular operations.

The goals of the IMF are to promote world trade, stable exchange rates, and orderly correction of balance of payments problems. One important part of this is preventing situations in which a nation devalues its currency purely to promote its exports. That kind of devaluation is often considered unfairly competitive if underlying issues, such as poor fiscal and monetary policies, are not addressed by the nation.

Member nations maintain funds in the form of currency reserve units called Special Drawing Rights (SDRs) on deposit with the IMF. (This is a bit like the federal funds that U.S. commercial banks keep on deposit with the Federal Reserve.) From 1974 to 1980, the value of SDRs was based on the currencies of 16 leading trading nations. Since 1980, it has been based on the currencies of the five largest exporting nations. From 1990 to 2000, these were the United States, Japan, Great Britain, Germany, and France. The value of SDRs is reassigned every five years.

SDRs are held in the accounts of IMF nations in proportion to their contribution to the fund. (The United States is the largest contributor, accounting for about 25 percent of the fund.) Participating nations agree to accept SDRs in exchange for reserve currencies—that is, foreign exchange currencies—in settling international accounts. All IMF accounting is done in SDRs, and commercial banks accept SDR-denominated deposits. By using SDRs as the unit of value, the IMF simplifies its own and its member nations' payment and accounting procedures.

In addition to maintaining the system of SDRs and promoting international liquidity, the IMF monitors worldwide economic developments, and provides policy advice, loans, and technical assistance in situations like the following:

• After the collapse of the Soviet Union, the IMF helped Russia, the Baltic states, and other former Soviet countries set up treasury systems to assist them in moving from planned to market-based economies.
• During the Asian financial crisis of 1997 and 1998, the IMF helped Korea to bolster its reserves. The IMF pledged $21 billion to help Korea reform its economy, restructure its financial and corporate sectors, and recover from recession.
• In 2000, the IMF Executive Board urged the Japanese government to stimulate growth by keeping interest rates low, encouraging bank restructuring, and promoting deregulation.
• In October 2000, the IMF approved a $52 million loan for Kenya to help it deal with severe drought. This was part of a three-year $193 million loan under an IMF lending program for low-income nations.

Most economists judge the current international monetary system a success. It permits market forces and national economic performance to determine the value of foreign currencies, yet enables nations to maintain orderly foreign exchange markets by cooperating through the IMF.

The EU and the Euro

The biggest news on the foreign currency front over the past few years is the adoption of the euro by the European Union (EU). Twelve member states of the EU use the euro instead of their old local currencies: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain.

Nations that adopt the euro participate in a single EU monetary policy and are subject to fiscal guidelines requiring them to keep deficits to a certain level and to balance their federal budgets by 2006. Although it will reconsider the matter again, Britain has refused to adopt the euro and has stuck with the pound sterling. This reflects England's traditional sense of “apartness” from continental Europe and its reluctance to give up sovereignty over its economic policies.