And second, balance sheet effects can have material impacts – affecting the link between current account deficits and external debt burdens, as well as the external adjustment process itself. A corollary of financial globalisation has been the increased importance of market forces, rather than institutionalised inter government agreements, in providing incentives for policy makers within systemically important countries or regions to follow policies that are mutually consistent – notwithstanding the longevity of the Bretton Woods sisters (the IMF and the World Bank). The second important feature of today’s world is the rising economic importance of a group of Asian emerging market economies who heavily manage their exchange rates. As a result, the international monetary system has mutated into a ‘hybrid’ system in which some systemic countries float their exchange rates while others fix or manage them. One implication is that the pressure for adjustment to any given shock can be very asymmetric relative to a floating rate world. Thus, market driven exchange rate changes are likely to be concentrated on particular blocs rather than diffused across the system as a whole. As Obstfeld and Rogoff and others have pointed out, this is a situation which could create some difficult policy frictions. These have the potential to undermine free trade, and weaken world growth. The third feature is the continued dominance of the US dollar as both a reserve currency as well an anchor for those countries that choose to fix or manage their exchange rates. But nowadays countries have choices.

It is, of course, conceivable that these imbalances will prove to be relatively short lived. They might be driven by underlying influences that prove to be largely temporary – for example an investment overhang in East Asia, which is eventually worked off, or a purely cyclical divergence in growth rates between major regions, or a short lived spike in world oil prices. But at the moment there is little sign of this – rather the reverse. It is therefore worth reflecting whether today’s international monetary system (IMS) is sufficiently robust to ensure that global imbalances can be financed, contained or corrected through the normal mechanism of market forces, without crisis; or failing that, whether institutional arrangements exist to resolve collective action problems and conflicting priorities without damage to the wider world economy. There are three key features of today’s IMS which are particularly relevant in thinking about this question. The first is financial globalisation which has totally transformed the landscape over the past two decades. Total financial wealth has risen sharply relative to GDP; and investors are now able and willing to hold a higher proportion of their portfolios in external assets. The trend to larger external asset and liabilities has been particularly significant in industrial countries, whose external assets and liabilities relative to output roughly tripled between 1990 and 2003, reaching average levels of more than 200 per cent of GDP. This has two effects. First, the expansion in external balance sheets has relaxed the constraints on the financing of countries’ savings and investment imbalances.