Global Financial System In The 20th Century And Beyond

Introduction

The international monetary system facilitates transactions between countries and enables international trade, while the international financial system serves to provide investment capital required for economic activities. After World War II, the major economic powers sought to establish a stable monetary system to support growing global trade and prevent the economic crises that contributed to the war. The Bretton Woods Conference in 1944 led to the creation of the International Monetary Fund (IMF) and the World Bank, along with a system of fixed exchange rates tied to the U.S. dollar and gold. This provided stability and confidence in international transactions for over 25 years. However, the system began breaking down in the late 1960 s due to domestic inflationary policies, global imbalances, and increasing mobility of capital. The end of fixed exchange rates led to a new era of floating rates, financial globalization, and integrated markets. Reforming and stabilizing the international monetary system remains an ongoing challenge. The key is establishing mechanisms for adjustment, sufficient liquidity, and confidence-building measures, along with global coordination and leadership.

Bretton Woods and the Fixed Exchange Rate System

In July 1944, delegates from 44 nations met at the Bretton Woods Conference in New Hampshire to develop a new international monetary system. The disastrous monetary events preceding WWII convinced world leaders that a formal system was needed to govern international currency and exchange rates.

The conference led to the creation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank). The IMF was tasked with overseeing the new system of fixed exchange rates that was agreed upon.

Under this system, member countries pegged their currencies to the U.S. dollar, which was pegged to gold at $35 per ounce. Governments could buy or sell their own or other currencies to maintain, within a 1% margin, the fixed exchange rate with the dollar. This provided monetary stability and facilitated growing world trade in the postwar period.

The IMF played a central role by providing short-term loans to countries facing balance of payment troubles. This allowed countries to maintain their peg without enacting protectionist trade policies. The new system was a dramatic shift away from the volatile floating rates that defined the turbulent 1930 s.

Fixed Exchange Rate System

The postwar Bretton Woods system established a system of fixed exchange rates in order to stabilize the global economy. Under this system, countries pegged their currencies to the U.S. dollar, and the U.S. dollar was pegged to gold at a rate of $35 per ounce.

This provided stability by fixing currency values, avoiding the currency volatility that contributed to the economic problems of the 1930 s. Pegged rates also allowed countries to pursue independent monetary policy goals while maintaining stable exchange rates.

The choice of pegged rather than floating rates reflected a desire for stability after the turmoil of the interwar period. Policymakers saw fixed rates as a compromise between the rigid gold standard of the late 19 th century and the monetary anarchy of the 1930 s.

The pegged system required countries to maintain exchange rates within 1 percent of parity by intervening in foreign exchange markets. If a fundamental disequilibrium emerged, a country could change the par value, but this action was discouraged unless absolutely necessary.

This system came to be known as the Bretton Woods system, named after the New Hampshire location where global leaders hammered out the agreements in 1944. The combination of fixed rates and the dollar-gold link provided stability and confidence to the international monetary system for over 25 years.

Role of the US Dollar

The United States dollar played a pivotal role in the postwar Bretton Woods monetary system. As the dominant global economy after World War 2, the US dollar became the world’s reserve currency. This gave the dollar a special status alongside its use as an international transaction currency.

Being the reserve currency provided economic and political advantages to the United States, known as seigniorage privileges. As other nations held significant dollar reserves for international transactions, they were essentially providing an interest-free loan to the US. This allowed America to run persistent deficits and export inflation abroad via other central banks absorbing excess dollars.

The dollar’s reserve status also gave the United States power to impact other economies via exchange rate policies. With the dollar acting as an anchor currency, countries had limited policy options if they wanted to maintain their dollar peg. Overall, the supreme position of the dollar was a cornerstone of American hegemony in the postwar era.

Breakdown of Fixed Exchange Rates

The fixed exchange rate system established at Bretton Woods ultimately broke down due to a combination of factors in the late 1960 s and early 1970 s. Two key issues were inflation in major economies, especially the United States, and increasing international capital mobility.

Inflation began rising in the US and other countries in the late 1960 s as a result of expansionary fiscal and monetary policies. This strained the fixed rate system as countries had to frequently adjust their currencies to maintain their peg to the dollar. The US was reluctant to adjust the dollar’s value in terms of gold, despite rising prices domestically.

At the same time, technological changes and financial innovation led to rapidly increasing capital mobility across borders. This allowed for destabilizing flows of speculative capital in and out of currencies. If markets perceived a currency was overvalued, speculators could short the currency, forcing countries to spend reserves defending their peg. This “currency war” dynamic made fixed rates difficult to sustain.

With inflation reducing faith in the dollar’s value, and capital mobility enabling attacks on currencies, the fixed system established at Bretton Woods collapsed in 1973. This was a pivotal turning point toward floating exchange rates and greater financial globalization in subsequent decades.

Financial Globalization

In the late 1960 s and 1970 s, a “financial revolution” emerged with the rapid growth of international financial markets and increased financial integration between countries. Several key factors drove this financial globalization:

• Growth of the Eurodollar Market - Eurodollars are U.S. dollar-denominated deposits in banks outside the United States. The Eurodollar market expanded rapidly starting in the 1950 s as U.S. multinationals and overseas banks began placing dollar deposits in European banks to avoid regulations. This allowed dollars to flow outside U.S. control.

• Overseas Expansion of U.S. Banks - Regulatory changes in the 1970 s allowed U.S. banks to expand overseas operations and financing through international branches. This facilitated dollar lending abroad and further growth of the Eurodollar market.

• Domestic Financial Deregulation - Regulations on interest rates and financial services were lifted in the U.S. and other advanced economies. This enabled more complex financial products and activities like securitization.

• Capital Account Liberalization - Many countries removed capital controls, allowing for free flows of financial capital across borders. This dramatically increased international capital mobility.

The growth of the Eurodollar market and deregulation of domestic and international finance drove greater integration. Money and finance became highly mobile and interconnected globally. This meant economic and monetary policies in one country could immediately impact other nations, for better or worse.

Integrated Markets

The freeing of financial markets starting in the 1970 s led to increasing integration between markets around the world. Financial deregulation enabled corporations to more easily move funds across borders and access wider sources of capital.

This encouraged the creation of a single globally integrated market for corporate ownership. Multinational corporations are now able to raise funds from investors worldwide through cross-listings on major stock exchanges. Ownership of corporations has become more internationalized.

Equity markets, debt markets, and currency markets have become more unified globally. For example, global foreign exchange trading underwent rapid growth and innovation with derivatives and electronic trading. Financial institutions expanded operations across borders.

Overall, the globalization of finance led to more opportunities for diversification and risk management. But it also increased systemic risks, as shown by financial crises spreading rapidly across borders. The increased integration of markets poses challenges for regulation and stability.

Instability and Crises

The stability of the Bretton Woods system began to break down in the late 1960 s and early 1970 s due to a number of factors. Persistent balance of payments deficits in the United States led to an oversupply of dollars globally. This threatened the convertibility of dollars into gold at the established rate of $35 per ounce. Speculators began betting heavily against the dollar, causing destabilizing capital flows. The US was also strained by the costs of the Vietnam War and rising domestic inflation.

In 1971, President Nixon made the decision to suspend dollar-gold convertibility, effectively ending the Bretton Woods system of fixed exchange rates. Currencies were allowed to float freely and find their own exchange rate level based on supply and demand. This led to greater volatility in currency values and instability in global trade and investment.

With the rise of global financial markets, currency crises and contagion became an ongoing threat to stability. Speculative attacks on currencies could quickly spread from one country to another as investors withdrew funds, causing values to plummet. The Asian Financial Crisis of 1997 was an example, as currency devaluations and stock market crashes in Thailand, Indonesia, South Korea and beyond reverberated across emerging markets. The increased integration of global finance meant that risks were transmitted more rapidly across borders.

Policymakers struggled to effectively regulate the growing web of global financial connections and flows. The International Monetary Fund took on a larger role in coordinating currency bailouts during crises. But the fundamental dilemma remained between national autonomy on monetary policy and exchange rates versus the need for international coordination and stability.

Reform Efforts

A number of reform efforts have aimed to build a more stable and equitable international monetary system since the collapse of Bretton Woods. The main institutions leading these efforts are the International Monetary Fund (IMF) and the Group of 20 (G 20).

The IMF has implemented a series of changes to its lending practices and oversight in response to crises over the decades. After the Latin American debt crisis of the 1980 s, the IMF shifted to emphasize poverty reduction, good governance and economic stability in developing nations. Following the Asian financial crisis in the late 1990 s, the IMF introduced new facilities for crisis prevention and management. Reforms enacted after the global financial crisis of 2008-09 focused on strengthening surveillance and monitoring of global systemic risks.

The G 20, comprising finance ministers and central bank governors from the world’s largest advanced and emerging economies, has pushed major IMF governance reforms. Emerging markets like China, India and Brazil were given greater voting shares and representation through these changes. The G 20 has also coordinated international policy responses to recent crises. At the 2009 London Summit for example, G 20 leaders pledged over $5 trillion in fiscal stimulus to boost growth and prevent further financial turmoil.

While the international monetary system remains flawed, the ongoing reform efforts by the IMF and G 20 have helped strengthen the global financial architecture. More inclusive governance and targeted capacity building for developing nations remain priorities going forward. Overall coordination of monetary, fiscal and structural policies across borders is needed to promote stability and crisis resilience.

Conclusion

The postwar Bretton Woods system established a framework for international monetary cooperation, with fixed exchange rates pegged to the US dollar and gold. This provided stability and enabled global trade to flourish. However, the system began to break down in the late 1960 s due to domestic inflationary policies and the growth of international capital markets.

The end of fixed exchange rates led to a new era of financial globalization and integration. Deregulation enabled the rapid development of global finance, but also increased instability and made countries more vulnerable to crises. The frequency of financial crises highlighted the need for reform of the international monetary system.

Looking ahead, the challenges are complex. Technical reforms are needed to ensure smooth adjustments between currencies and sufficient global liquidity. But political challenges are equally daunting, as coordination and cooperation between nations remain difficult. The role of the dollar as a reserve currency grants the US unique privileges and responsibilities. Leadership from major economies and multilateral forums like the IMF will be critical in building a resilient monetary system for the 21 st century.