Mark Carney: The evolution of the international monetary system
Remarks by Mr Mark Carney, Governor of the Bank of Canada, to the Foreign Policy
Association, New York, 19 November 2009.
* * *
In response to the worst financial crisis since the 1930s, policy-makers around the globe are
providing unprecedented stimulus to support economic recovery and are pursuing a radical
set of reforms to build a more resilient financial system. However, even this heavy agenda
may not ensure strong, sustainable, and balanced growth over the medium term. We must
also consider whether to reform the basic framework that underpins global commerce: the
international monetary system. My purpose this evening is to help focus the current debate.
While there were many causes of the crisis, its intensity and scope reflected unprecedented
disequilibria. Large and unsustainable current account imbalances across major economic
areas were integral to the buildup of vulnerabilities in many asset markets. In recent years,
the international monetary system failed to promote timely and orderly economic adjustment.
This failure has ample precedents. Over the past century, different international monetary
regimes have struggled to adjust to structural changes, including the integration of emerging
economies into the global economy. In all cases, systemic countries failed to adapt domestic
policies in a manner consistent with the monetary system of the day. As a result, adjustment
was delayed, vulnerabilities grew, and the reckoning, when it came, was disruptive for all.
Policy-makers must learn these lessons from history. The G-20 commitment to promote
strong, sustainable, and balanced growth in global demand - launched two weeks ago in
St. Andrews, Scotland - is an important step in the right direction.
What is the international monetary system and how should it function?
The international monetary system consists of (i) exchange rate arrangements; (ii) capital
flows; and (iii) a collection of institutions, rules, and conventions that govern its operation.
Domestic monetary policy frameworks dovetail, and are essential to, the global system. A
well-functioning system promotes economic growth and prosperity through the efficient
allocation of resources, increased specialization in production based on comparative
advantage, and the diversification of risk. It also encourages macroeconomic and financial
stability by adjusting real exchange rates to shifts in trade and capital flows.
To be effective, the international monetary system must deliver both sufficient nominal
stability in exchange rates and domestic prices, and timely adjustment to shocks and
structural changes. Attaining this balance can be very difficult. Changes in the geographic
distribution of economic and political power, the global integration of goods and asset
markets, wars, and inconsistent monetary and fiscal policies all have the potential to
undermine a monetary system. Past systems could not incent systemic countries to adjust
policies in a timely manner. The question is whether the current shock of integrating one-third
of humanity into the global economy - positive as it is - will overwhelm the adjustment
mechanisms of the current system.
There are reasons for concern. China's integration into the global economy alone represents
a much bigger shock to the system than the emergence of the United States at the turn of
the last century. China's share of global GDP has increased faster and its economy is much
more open.1 As well, unlike the situation when the United States was on the gold standard
with all the other major countries, China's managed exchange rate regime today is distinct
from the market-based floating rates of other major economies. History shows that systems
dominated by fixed or pegged exchange rates seldom cope well with major structural shocks.
This failure is the result of two pervasive problems: an asymmetric adjustment process and
the downward rigidity of nominal prices and wages. In the short run, it is generally much less
costly, economically as well as politically, for countries with a balance of payments surplus to
run persistent surpluses and accumulate reserves than it is for deficit countries to sustain
deficits. This is because the only limit on reserve accumulation is its ultimate impact on
domestic prices. Depending on the openness of the financial system and the degree of
sterilization, this can be delayed for a very long time.2 In contrast, deficit countries must
either deflate or run down reserves.
Flexible exchange rates prevent many of these problems by providing less costly and more
symmetric adjustment. Relative wages and prices can adjust quickly to shocks through
nominal exchange rate movements in order to restore external balance. When the exchange
rate floats and there is a liquid foreign exchange market, reserve holdings are seldom
required.3 Most fundamentally, floating exchange rates overcome the seemingly innate
tendency of countries to delay adjustment.
A brief review of how the different international monetary regimes failed to manage this
trade-off between nominal stability and timely adjustment provides important insights for
current challenges.
The evolution of the international monetary system
The gold standard
Under the classical gold standard, from 1870 to 1914, the international monetary system was
largely decentralized and market-based. There was minimal institutional support, apart from
the joint commitment of the major economies to maintain the gold price of their currencies.
Although the adjustment to external imbalances should, in theory, have been relatively
smooth, in practice it was not problem-free.4 Surplus countries did not always abide by the
conventions of the system and tried to frustrate the adjustment process by sterilizing gold
inflows. Deficit countries found the adjustment even more difficult because of downward
wage and price stickiness. Once the shocks were large and persistent enough, the
consequences of forfeiting monetary independence and asymmetric adjustment ultimately
undermined the system.5
1978). China, on the other hand, is very open, with imports/GDP around 30 per cent, and it accounts for an
ever-increasing share of world trade.
2
There is, however, an important welfare loss in pursuing unbalanced growth. Domestic consumers are made
worse off by reduced purchasing power, and thwarting adjustment via sterilization leads to mounting
quasifiscal costs and distorts the domestic financial system. The important point is that balanced global growth is
sustainable global growth.
3
Except in exceptional circumstances, such as a near-term market breakdown, which creates a severe lack of
liquidity and warrants intervention.
4
For example, under the price-specie flow mechanism, if a country ran a trade surplus, gold inflows would
occur, raising the price level and thus causing imports to increase and exports to decrease until the balance of
trade was equilibrated.
5
More generally, the gold standard suffered from the fact that the money supply was dependent on the supply
of gold. Inadequate gold supply led to deflation in the 1880s, which was only alleviated by major gold
discoveries in South Africa, Western Australia, and Canada in the following decade. Even then, concerns with
respect to the supply of gold remained.
BIS Review 147/2009
The gold standard did not survive World War I intact. Widespread inflation caused by
moneyfinanced war expenditures and major shifts in the composition of global economic power
undermined the pre-war gold parities. Crucially, there was no mechanism to coordinate an
orderly return to inflation-adjusted exchange rates. When countries, such as the United
Kingdom in 1925, tried to return to the gold standard at overvalued parities, they were forced
to endure painful deflation of wages and prices in order to restore competitiveness. Though
this was always going to be difficult, it proved impossible when surplus countries thwarted
reflation.
During the Great Depression, with an open capital account and a commitment to the
goldexchange standard, the United States could not use monetary policy to offset the economic
contraction.6 Fidelity to gold meant that the deflationary pressures from the United States
spread quickly, further weakening the global economy. Unable to adjust to these pressures,
countries were forced to abandon the system. Though deficit countries experienced the first
crisis, all countries suffered from the eventual collapse - a lesson that was repeated in
subsequent systems. ̈
Bretton Woods
The Bretton Woods system of pegged, but adjustable, exchange rates was a direct response
to the instability of the interwar period. Bretton Woods was very different from the gold
standard: it was more administered than market-based; adjustment was coordinated through
the International Monetary Fund (IMF); there were rules rather than conventions;7 and capital
controls were widespread.
Despite these institutional changes, surplus countries still resisted adjustment.
Foreshadowing present problems, countries often sterilized the impact of surpluses on
domestic money supply and prices. Like today, these interventions were justified by arguing
that imbalances were temporary and that, in any event, surpluses were evidence more of
virtue than "disequilibria." In contrast, the zero bound on reserves remained a binding
constraint for deficit countries, which eventually ran out of time.
The Bretton Woods system finally collapsed in the early 1970s after U.S. policy became very
expansionary, its trade deficit unsustainable, and the loosening of capital controls began to
put pressure on fixed exchange rates. Once again, all countries suffered from the
aftershocks.
The current hybrid system
After the breakdown of the Bretton Woods system, the international monetary system
reverted to a more decentralized, market-based model. Major countries floated their
exchange rates, made their currencies convertible, and gradually liberalized capital flows. In
recent years, several major emerging markets adopted similar policies after experiencing the
difficulties of managing pegged exchange rate regimes with increasingly open capital
accounts. The move to more market-determined exchange rates has increased control of
domestic monetary policy and inflation, accelerated the development of financial sectors,
and, ultimately, boosted economic growth.
Unfortunately, this trend has been far from universal. In many respects, the recent crisis
represents a classic example of asymmetric adjustment. Some major economies have
frustrated real exchange rate adjustments by accumulating enormous foreign reserves and
sterilizing the inflows. While their initial objective was to self-insure against future crises,
reserve accumulation soon outstripped these requirements (Table 1). In some cases,
persistent exchange rate intervention has served primarily to maintain undervalued exchange
rates and promote export-led growth. Indeed, given the scale of its economic miracle, it is
remarkable that China's real effective exchange rate has not appreciated since 1990
(Chart 2).
This flip side of these imbalances was a large current account deficit in the United States,
which was reinforced by expansionary U.S. monetary and fiscal policies in the wake of the
2001 recession. In combination with high savings rates in East Asia, these policies generated
large global imbalances and massive capital flows, creating the "conundrum" of very low
long-term interest rates, which, in turn, fed the search for yield and excessive leverage. While
concerns over global imbalances were frequently expressed in the run-up to the crisis, the
international monetary system once again failed to promote the actions needed to address
the problem. Vulnerabilities simply grew until the breaking point.
Some pressures remain. The financial crisis could have long-lasting effects on the
composition and rate of global economic growth.8 Since divergent growth and inflation
prospects require different policy mixes, it is unlikely that monetary policy suitable for United
States will be appropriate for most other countries. However, those countries with relatively
fixed exchange rates and relatively open capital accounts are acting as if it is. If this
divergence in optimal monetary policy stance increases, the strains on the system will grow.
Postponed adjustment will only serve to increase vulnerabilities. In the past, the frustration of
adjustment by surplus countries generated deflationary pressures on the rest of the world.
Similarly, today, the adjustment burden is being shifted to others. Advanced countries -
including Canada, Japan, and the Euro area - have recently seen sizable appreciations of
their currencies.
The net result could be a suboptimal global recovery, in which the adjustment burden in
those countries with large imbalances falls largely on domestic prices and wages rather than
on nominal exchange rates. History suggests that this process could take years, repressing
global output and welfare in the interim.
The way forward
To avoid these outcomes, there are several options.
The first is to reduce overall demand for reserves. Alternatives include regional reserve
pooling mechanisms and enhanced lending and insurance facilities at the IMF. While there is
merit in exploring IMF reforms, their effect on those systemic countries that already appear
substantially overinsured would likely be marginal. As I will touch on in a moment, the G-20
process may have a greater impact.
On the supply side, several alternative reserve assets have been suggested. The motivation
of these proposals is primarily to redistribute the so-called "exorbitant privilege" that accrues
to the United States as the principal supplier of reserve currency. As such, the United States
receives an advantage in the form of lower financing costs in its own currency. This
advantage would be shared (and possibly reduced in aggregate) if there were competing
reserve currencies. In turn, this could marginally reduce the collective imbalances of reserve
currency countries.9,10
Over the longer term, it is possible to envision a system with other reserve currencies in
addition to the U.S. dollar. However, with few alternatives ready to assume a reserve role,
the U.S. dollar can be expected to remain the principal reserve currency for the foreseeable
future. Despite the exuberant pessimism reflected in the gold price, total gold stocks
represent only $1 trillion or about 10 per cent of global reserves and a much smaller
proportion of global money supply.11 The renminbi's prospects are moot absent convertibility
and open capital markets, which would themselves likely do much to reduce any pressure for
a change.
Increased use of Special Drawing Rights
At first glance, Special Drawing Rights (SDRs) would be an intriguing alternative reserve
asset.12 Using SDRs appeals to a sense of fairness in that no one country would enjoy the
exorbitant privilege of reserve currency status. Like a multiple reserve currency system, it
may reduce the aggregate incentives of countries that supply the consistent currencies of the
SDR to run deficits. In addition, there appears to be no technical reason why the use of
SDRs could not be expanded.
However, the question must be asked: to what end? Merely enhancing the role of the SDR
would do little either to increase the flexibility of the system or change the incentives of
surplus countries. By providing a ready swap of existing reserve currencies into a broader
basket, SDR reserves could also further displace adjustment onto other freely trading
currencies, thus exacerbating the imbalances in the current system. Indeed, by providing
instant diversification, SDR reserves could entrench some of the existing strategies of
surplus countries.
This would change if the proposal were taken to its logical extreme: the SDR as the single
global currency. Setting aside the fact that the world is not an optimum currency area (not
least due to the absence of free mobility of labour, goods, and capital), this appears utopian.
While the level of international co-operation has certainly increased since the crisis, it would
be a stretch to assert that there is any appetite for the creation of the independent global
central bank that would be required.13 As a result, any future SDR issuance is likely to be ad
hoc.14
A substitution account
Greater use of SDRs might be best suited to encouraging a transition to a more stable
international monetary system by facilitating any desired reserve diversification. Establishing,
on a temporary basis, an enhanced substitution account at the IMF would allow large reserve
holders to exchange U.S.-dollar reserves for SDR-denominated securities, thereby
diversifying their portfolios. With the IMF bearing the risk of changes in the U.S.-dollar
exchange rate, an appropriate burden-sharing arrangement among its members would have
to be agreed upon.
A substitution account would create considerable moral hazard, since reserve holders would
be tempted to engage in further accumulation. In addition, a substitution account would not
address the fundamental asymmetry of the adjustment process. Thus, it would appear
essential that a substitution account mark the transition from the current hybrid system to an
international system characterized by more flexible exchange rates for all systemic countries.
In general, alternatives to the dollar as the reserve currency would not materially improve the
functioning of the system. While reserve alternatives would increase pressures on the United
States to adjust, since "artificial" demand for their assets would be shared with others,
incentives for the surplus countries that have thwarted adjustment would not change. The
common lesson of the gold standard, the Bretton Woods system and the current hybrid
system is that it is the adjustment mechanism, not the choice of reserve asset, that ultimately
matters.
With the adjustments that would arise automatically from floating exchange rates or
unsterilized intervention muted, the burden is squarely on policy dialogue and co-operation.
A practical solution: the G-20 and shared responsibility
The G-20 framework moves in the right direction. It stresses countries' shared responsibility
to ensure that their policies support "strong, sustainable and balanced growth." Under the
framework, members have agreed to a mutual assessment of their monetary, exchange rate,
fiscal, and financial policies, with the assistance of the IMF and other international financial
institutions. The implications of these policies for the level and pattern of global growth and
the risks to financial stability will be reviewed by finance ministers and governors in
preparation for agreement on any common actions by G-20 leaders in Canada and South
Korea next year.
There are several reasons why this mutual assessment process has the potential to develop
shared understanding and encourage action across a range of countries. There is a clear
timetable. A comprehensive set of policies will be considered. Policy-makers at the highest
levels are directly involved, with international financial institutions in a supportive, rather than
leading, role. Finally, discussions will take place at the G-20, where all major economies are
present and where China has assumed a very constructive, leadership role.
Framework discussions would be complemented by successful implementation of the G-20
financial reform agenda. These reforms, when combined with the peer review process of the
Financial Stability Board (FSB) and external reviews by the IMF, could increase actual and
perceived systemic stability and thereby reduce reserve accumulation.
Canada's macroeconomic strategy and the G-20 framework
Canada will bring to these discussions one of the soundest financial systems in the world
and a macroeconomic strategy that contributes to sustainable and balanced global growth.
Our economy is one of the most open and our policy response to the crisis has been one of
the most aggressive. Starting from the strongest fiscal position in the G-7, Canada's fiscal
stimulus this year and next will total 4 per cent of GDP. Monetary stimulus has been both
unprecedented and timely.
As a result of these policy actions, the IMF projects that Canadian domestic demand will be
the strongest in the G-7 next year. With a current account that has shifted from a surplus of 2
per cent of GDP in the first quarter of 2006 to a deficit of 3 per cent today, Canada is doing
its part to rebalance global growth.
Consistent with the objectives of the G-20 framework, Canadian policy is guided by
transparent and coherent frameworks. The Government of Canada has announced a fiscal
plan to return its budget to broad balance by 2015. The cornerstone of the Bank's monetary
policy framework is its inflation target, which aims to keep the annual rate of CPI inflation
close to 2 per cent. It is in this context that we view the exchange rate.
A floating exchange rate is a central element of our monetary policy framework. It allows
Canada to pursue an independent monetary policy appropriate to our own economic
circumstances. Although there is no target for the Canadian dollar, the Bank does care why
the exchange rate moves and what the potential impact will be on output and inflation. The
challenge for the Bank is to understand the reasons behind currency movements,
incorporate those into our assessments of other data, and set a course for monetary policy
that works to keep total demand and supply in balance and inflation on target.
In the current environment, such determinations are more important than usual.
Recent indicators point to the start of a recovery in Canadian economic activity following
three consecutive quarters of sharp contraction. This resumption of growth is supported by
monetary and fiscal stimulus, increased household wealth, improving financial conditions,
higher commodity prices, and stronger business and consumer confidence.
However, heightened volatility and persistent strength in the Canadian dollar are working to
slow growth and subdue inflation pressures. The current strength in our dollar is expected,
over time, to more than fully offset the favourable developments since July.
On 20 October, the Bank reaffirmed its conditional commitment to maintain its target for the
overnight rate at the effective lower bound of 1/4 per cent until the end of June 2010 in order
to achieve the inflation target.
To put it simply, the Bank looks at everything, including the exchange rate, through the prism
of achieving our inflation target. For example, we do see a risk that a stronger-than-assumed
Canadian dollar, driven by global portfolio movements out of U.S.-dollar assets, could act as
a significant further drag on growth and put additional downward pressure on inflation. As I
mentioned previously, movements in currencies could reflect current challenges in the
operation of the international monetary system, which may result in the displacement of
adjustment pressures onto a handful of currencies.
Whatever happens, the Bank retains considerable flexibility in the conduct of monetary policy
at low interest rates, consistent with the framework that we outlined in our April Monetary
Policy Report.
If downside risks materialize, the Bank will use that flexibility to the extent required in order to
achieve our price stability mandate. If upside risks materialize, the Bank will also act to
achieve our price stability mandate. While the underlying risks to our October economic
projection are roughly balanced, the Bank judges that, as a consequence of operating at the
effective lower bound, the overall risks to our inflation projection are tilted slightly to the
downside.
Conclusion
To conclude, this crisis was caused in part by failures to meet the same challenges that
bedevilled previous international monetary systems. The common lesson of the gold
standard, the Bretton Woods system, and the current hybrid system is that it is the
adjustment mechanism, not the choice of reserve asset, that ultimately matters. In this
regard, any greater use of SDRs might be best suited to encouraging a transition from the
current hybrid system to an international monetary system characterized by more flexible
exchange rates for all systemic countries.
While surplus countries can delay adjustment, in the end, all nations suffer when the system
breaks down. In the current environment, growing strains could spur protectionism, both in
trade and finance, or alternatively, raise sanctions.15 The negative consequences for the
global economy would be considerable.
All countries should accept their responsibilities for promoting an open, flexible, and resilient
international monetary system. Responsibility means recognizing spillover effects between
economies and financial systems and working to mitigate those that could amplify adverse
dynamics. It means submitting their financial policies to peer review within the FSB and
external review by the IMF. Fundamentally, it means adopting coherent macro policies and
allowing real exchange rates to adjust to achieve external balance over time. Indeed, in a
world of global capital, all systemically important countries and common economic areas
should move towards market-based exchange rates.
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