mervyn king : the international monetary system speech by mr mervyn king, governor of the bank of england, at the “ advancing enterprise 2005 ” conference, london, 4 february 2005. * * * later today the g - 7 finance ministers and central bank governors meet in london. markets are speculating on what the communique will or will not say about exchange rates. on such matters a private exchange of views might serve us rather better than a public statement. what is a matter for public discussion, however, is the mix of exchange rate regimes we see in the world today, and the consequences for international monetary stability. the current international monetary system comprises three large currency blocs : the dollar, the euro, and an asian bloc of currencies that are to varying degrees fixed against the dollar. these blocs, of broadly comparable size, produce more than twothirds of world output in total. given their size, the choice of exchange rate regime of one bloc has a significant effect on the options available to the others. countries have always faced constraints in choosing their exchange rate regime. any country can have only two out of the following three – an independent monetary policy, a fixed exchange rate and an open capital account. at various times countries have tried – and failed – to have all three. but in a world of large currency blocs decisions about exchange rate policies are interdependent. a monetary stimulus in the us will have a different effect on the euro area if, say, asian countries have flexible exchange rates rather than fixed rates against the dollar. so the choice of exchange rate regime by any one bloc both depends on and affects the choices of the others. how did we end up in this position? under the gold standard of the late 19th and early 20th century, exchange rates were fixed and capital flowed freely internationally. domestic monetary policy was subordinated to the demands of the gold standard, except in time of extreme crisis when the need for flexibility overcame the desire to adhere to the standard. from the end of the second world war until 1971, the member countries of the bretton woods system had a formal commitment to fixed but adjustable exchange rates, and capital accounts were largely closed to give members the flexibility to operate independent monetary policies. since the breakdown of the bretton woods arrangements, countries have been free to make quite different choices of exchange rate regime, and have not hesitated to do so. as international financial markets have developed, there has been a general movement to flexible exchange rates supported

by credible domestic monetary policies. that is a sensible use of the price mechanism to respond to complex and unpredictable shocks. two particularly important exceptions have been the gradual fixing of the exchange rates between members of the european union, culminating in monetary union, and the more or less formal policies of the newly industrialised asian countries and japan to keep the value of their currencies stable against the dollar. moreover, the asian central banks have been accumulating large dollar reserves. for most of the post - war period, the quantity of central bank reserves held by asian central banks was of the same order of magnitude as the reserves held by the g - 7. over the past 15 years, both japan and non - japan asia have rapidly increased their reserves, which are now nearly ten times as large as the combined reserves of the rest of the g - 7. two thirds of these reserves are in dollars, a much larger proportion than the us share of world output. the counterpart to the asian bloc ’ s current account surpluses and acquisition of dollar reserves has been large current account deficits in the us. there is nothing inherently wrong with such ‘ imbalances ’. in principle, they reflect the use of financial markets to allocate savings from around the world to the most profitable investment opportunities. but there is likely to be a limit to the amount of debt that one country can issue as a result of persistent deficits before investors start to worry about its ability or willingness to repay. when the country in question is also the issuer of the reserve currency, the rapid build - up in the assets denominated in the reserve currency contributes to the potential instability of the international monetary system. that might result in nominal exchange rate movements that are far larger than those needed for an orderly rebalancing of asset positions. it is easy to see how each bloc can view this possibility as the responsibility of the others. 1 but that misses the point : the current global imbalances are the natural result of policy decisions by all three blocs. they are, in the language of economists, a general equilibrium outcome. it is therefore meaningless to try to identify the culprit, and blame any one bloc ’ s woes on another. so where does this analysis leave us? let me identify three challenges for the future. first, do we still need a reserve currency as a source of global liquidity? in a world of free capital movements, and developed financial markets, there is no obvious need for