Subject to Revision

September 1968

THE DOLLAR AND THE INTERNATIONAL MONETARY SYSTEM

Richard N. Cooper

Yale University

The winter and spring of 1967-68 saw international monetary relations among countries badly unsettled by a devaluation of the pound sterling and eleven other currencies, a massive rush to buy gold, and a heavy flight from the French franc, all in rapid succession. These disturbances were aggravated by failure to keep the world's two largest free enterprise economies on an even keel: inflationary demands rose sharply in the United States after 1965, and Germany, in contrast, experienced its first true recession since the end of the Second World War. As a result, the United States experienced its largest balance-of-payments deficit and became alarmingly large.

Such developments do not touch directly the man-in-the-street, except perhaps to give him a vague sense of uneasiness. But he should not be indifferent to the nature and operation of the international monetary system--using that term to denote both the formal rules and the informal conventions governing international trade and payments--for they in fact strongly influence his opportunities for employment, the prices he pays, and the wages he receives, in short, his standard of living. In these terms, the present international monetary system has served the world extremely well. The past two decades have seen a growth in world production and trade, and in standards of living, that is unrivaled in history.

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Even the self-proclaimed laggards in economic growth, such as Britain, have grown rapidly by historical standards. And while the less developed countries have not shared fully in this rapid growth, taken as a group they too have performed well by the standards of the past. In addition to having grown rapidly, the world economy has been kept on a relatively even keel over the period, and inflation in the major countries has been moderate.

While there is ample room for self-congratulation, there is also a danger of becoming smug. Nineteen twenty-nine too followed a prolonged period of prosperity. Although the present international monetary system has done well, it contains certain tensions -- internal contradictions, Marxists would call them -- that threaten to prevent the continuation of this prosperity into the next two decades unless new and imaginative policies are adopted to cope with them. The pages that follow attempt in succession to describe the formal features of the present international monetary system, to outline the unexpected developments and emerging strains that exist within it, to discuss the U.S. balance of payments deficit as both a cause and a consequence of those strains, and to consider measures that might be adopted, both within the present system and outside it, to relieve the strains.

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# I. The Present International Monetary System

The basic outlines of the present monetary system, agreed at an international conference in Bretton Woods, New Hampshire in 1944, were in direct response to the economic and political disasters of the 1930s. At that time, economic depression and financial collapse had been transmitted rapidly from one nation to another. Each country felt itself trapped in a web of relationships which it was too small to influence and from which it could not escape. Some, such as Germany, turned to radical political solutions and did break sharply with the international order; others, to varying degrees, stayed with it and suffered the economic consequences.

The postwar international monetary system was designed therefore to serve a twofold objective of protecting from international intrusion the recently-adopted governmental commitment, in virtually all major countries, to maintain full employment, and to do so while still fostering efficient use of the world's resources. More fundamentally, its aim was to introduce monetary order into a world of interdependent nations: to define and police certain rules of good international behavior.

The aims of the new international monetary system were laid down in the Articles of Agreement of the International Monetary Fund, which was established "to facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic

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policy ... to promote exchange stability ..." and to provide countries "with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national and international prosperity." The rules of conduct called on each nation to specify a fixed and single rate at which its currency would be sold for others and to eliminate any artificial restrictions of the freedom of its residents to make payments to other countries for the purchase of goods and services. These rules approximate those that prevail within a single country, with a single currency freely usable to buy anywhere. There were several important differences, however. First, the injunction against restrictions did not extend to purchasing ¢ securities, making loans, or establishing businesses -- movements of capital, in the economists' jargon. Second, exchange rates between currencies were not absolutely fixed. They were permitted to vary within one percent on either side of the declared parity, allowing some slight flexibility between rates.

More important, exchange parities could be changed occasionally, but only under conditions of fundamental balance-of-payments⁴ with international agreement. In principle, such changes in parity could be either upward or downward; in practice, with only three exceptions, all changes have been downward, despite the fact that balance-of-payments surpluses have been quite as numerous as deficits.

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The logic of fixed and only rarely changed exchange rates combined with freedom from controls over foreign trade in goods and services required adequate international reserves to finance the inevitable imbalances in payments -- differences between total payments to foreigners and total receipts from foreigners, before allowing for the residual financing. By long tradition, gold provided the most important form of international reserve. It was almost universally acceptable among banks and governments, and could therefore be used to settle residual debts between one country and another. But, for reasons to be given below, gold was likely to be insufficient in amount and inappropriately distributed among countries to fulfill this role adequately in the new system. The International Monetary Fund (IMF) was therefore established with the dual purpose of policing the new rules and of providing occasional financial support to member countries, through its own lending operations, to make adherence to the rules possible. Only when it became clear that a country's foreign trade position could not be indefinitely sustained -- when it was in "fundamental disequilibrium," in the undefined terms of the IMF -- would a change in exchange parity be in order.

The IMF was in fact only one part of a three-part plan for international economic cooperation in the postwar era. As noted, it was to provide occasional balance-of-payments support to member countries. A second institution, the International Bank for Reconstruction and Development (often called simply the World Bank) was created to lend long-term development capital, raised in the major capital markets of the world, to member countries to assist them first in reconstruction from the

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ravages of war, then in the process of economic development. The third part of this overall design was to be an International Trade Organization to establish and implement rules for the conduct of international trade, and in particular to encourage reduction of the very substantial barriers to trade imposed during the Great Depression and the Second World War. This organization never came into formal existence, but its principal purposes have been pursued under the auspices of the General Agreement on Tariffs and Trade (GATT).

The main features of this system for dealing with financial inter-
actions among countries can be etched more sharply against the background
of the principal alternative arrangements that in fact prevailed at
various times and to various degrees in earlier years. These systems involve,
respectively, completely fixed exchange rates, flexible exchange rates,
and extensive resort to direct controls over international transactions.

Under the pre-1913 gold standard, national currencies were tied to
gold -- immutably, it was thought -- at fixed prices, and this in turn
implied fixed exchange rates between currencies, except for a small margin
arising from the cost of shipping gold from one country to another. Under
this system, a country experiencing a deficit in its international pay-
ments would finance it by selling gold. The outflow of gold in turn would
reduce the domestic supply of money, tending to push interest rates up-
ward and to produce a decline in business activity. Unemployment was
likely to result, at least temporarily. In addition, business cycles
were transmitted rapidly from country to country under this system, for a downturn
in one country would reduce its imports, causing payments deficits else-

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where and inducing contractions there. An attempt was made to restore
this system after the First World War, but even then countries were be-
coming more desirous of gearing monetary policy, still in its formative
stages, to stabilizations of the domestic economy, an assignment that
often conflicted with balance-of-payments requirements. Engulfment of
the world in the Great Depression strongly reinforced this tendency and
doomed continued acceptability of a gold standard international system.

In the years immediately following the First World War, and again
for a brief period in the 1930s, flexible exchange rates seemed to offer
relief from the rigors of the gold standard system. Exchange rates, far
from being tied rigidly one to another, were allowed to vary freely from
day to day according to the dictates of supply and demand, like commodi-
ties in the commodity markets. This arrangement did not prove to be fully
satisfactory either. In the unsettled postwar years, speculation for
or against a particular currency, by keeping its value too high or de-
pressing it excessively, often impeded needed processes of adjustment
and either contributed to economic depression or to rampant inflation.
Later, in the 1930s, some governments deliberately depressed the inter-
national value of their currencies to stimulate domestic employment--but
at the expense of employment in other countries. In neither period did
flexible rates prove to be workable.

Direct governmental controls over international transactions--
regulations concerning which payments could be made, to whom and for
what--first came into prominence during the First World War. They were
revived by several countries, notably Nazi Germany, in the 1930s and

their use became widespread during and after the Second World War. Such controls badly disrupted the trading world. To mitigate the obvious inefficiencies they introduced, such as resulted for example when two countries both in serious payments difficulty restricted trade with each other, pairs of countries entered into bilateral trading arrangements. These usually led to trade discrimination, often became instruments of diplomatic manipulation, and always were highly disruptive of political relations between participants and non-participants. By the late 1940s it was widely recognized that extensive and indiscriminate national use of direct controls did not represent a viable system of international trade and payments.

The framework of the present payments system was designed to provide exchange stability, yet by allowing for changes in parities to avoid the straight-jacket of the gold standard. It was designed to preclude the need for controls over trade by providing adequate financing for temporary balance-of-payments deficits, yet also to provide a suitable mechanism for correcting lasting imbalances. Above all, it was designed to provide a forum and a frame of reference in which international economic cooperation could supplant economically disruptive and politically damaging competition in the use of national policies to protect each nation's balance of payments.

As noted at the outset, this system has been highly successful. Thanks largely to vast improvements in the use and direction of domestic economic policies, depressions have been avoided and economic growth has been high and relatively steady. Although many less developed countries

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have countered the trend, direct controls by the major industrial nations
were drastically reduced by the mid-1960s. Serious balance-of-payments
disturbances had not disappeared, but the system provided enough flexi-
bility to prevent these, in most cases, from becoming a substantial bar
to progress. International trade has flourished.

The payments system laid down in 1944 was not entirely realized
in practice, however, due to certain subsequent developments. Chief
among these were the emergence of the U.S. dollar as an international
currency and, indeed, as a widely accepted reserve asset, like gold;
and the great increase, especially after 1958, in the degree of economic
interdependence between nations, especially the international mobility
of capital. Both these developments, which will be discussed below,
represented natural but nonetheless substantial departures from the
basic design. First, however, a word should be said about the role
of gold in the present international payments system, for that is a
necessary prelude to discussion of the dollar.

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## II. Further Developments and Emergent Strains

### Gold

The payments system outlined in 1944 depended heavily for its efficient operation on the use of international reserves, of which far and away the most important component was gold. But at the close of the Second World War most of the officially held gold was in the hands of the United States; by 1947 the U.S. share exceeded 70 per cent. The U.S. Treasury determined the world price of gold by offering to buy or sell gold at a fixed price of $35 an ounce, plus or minus a small commission, from or to other monetary authorities "for legitimate monetary purposes." It also supplied gold to U.S. users, such as dentists and jewelers, to fill the gap between U.S. production and U.S. consumption.

The international monetary system could not function properly with the gold so heavily concentrated in the hands of one country, particularly a country that had a surplus in its international payments. There simply were not enough reserves elsewhere, even when supplemented by the meagre lending powers of the IMF, to finance the large imbalances of the late forties in the absence of stringent controls over international payments.

The maldistribution of gold, however, merely aggravated a difficulty which was bound to arise, though possibly not for a long time. For use of gold as a commodity and its use as an international money, at a fixed and unvarying price, are basically incompatible in today's world. As a commodity, the demand for gold is affected by the growth in world income and by the prices of those commodities, such as silver, platinum, and palladium, that

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compete with gold in desirable properties. Recently the commodity demand for gold has been rising sharply, even apart from speculative demands, about which more will be said below. Total consumption of gold in the United States alone amounted to $225 million worth in 1967, up two and a half times from 1960. Of this, only $63 million were satisfied out of domestic production, the remainder being supplied from the Treasury's gold stocks. Private demands have also been growing rapidly elsewhere in the world.

As a monetary reserve, the demand for gold could also be expected to grow rapidly. As noted above, the international payments system depends heavily on the financing of international imbalances. The more successful the system --- the more rapid the growth in income and trade --- the larger these financing requirements would be, though perhaps not rising in proportion.

New supplies of gold amount to just under $1.5 billion a year. They come from the mines of the world --- 75 per cent of new production from South Africa --- supplemented from time to time by gold sales by Russia, which like most communist countries lies outside the international payments system. Given a fixed price for gold, new supplies --- apart from Russian sales, which depend largely on Russian harvest conditions and are entirely arbitrary as far as western needs are concerned --- depend on the costs of mining gold. With rising wage and other costs, and with the best mines gradually being exhausted, a steady or rising production of gold depends crucially on technological improvements in gold mining. These have not been absent, but despite them production has declined in most gold mining countries, with the important exception of South Africa. And there too production

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has levelled off.

A payments system based on gold reserves thus confronted the world with a grim prospect: inadequate supplies to satisfy the competing private and official demands for it at a fixed price of $35 an ounce. That being so, speculation has taken place on a rise in the price of gold, and speculative demands for gold in the mid-sixties added heavily to the already large demand for gold.

Raising the official price of gold offers a possible way out. A higher price would at once increase the value of existing production and of existing gold stocks, and it would undoubtedly also stimulate new production. The standard objections to this course of action are four. First, revaluing $40 billion in official gold and large additional amounts in private hands by the stroke of a pen would be strongly inflationary, creating pressures that in practice could be compensated by restrictive monetary and fiscal policies only with difficulty, if at all. Second, the distribution of the capital gains would be heavily skewed in favor of the wealthy countries, which hold most of the monetary gold; and the principal continuing beneficiaries of the price increase would be South Africa and the Soviet Union, both of which have already benefited greatly from what amounts to a commodity price support scheme for a major export product. Third, a once-for-all increase would offer only a temporary solution to the problem of inadequate supplies, eventually (though perhaps not for a long time) a further price increase would be required. Finally, and most fundamentally, revaluing gold would ratify the continued use of gold for international settlements and would incur unnecessarily the real costs of mining gold from