Today’s world economy appears to be increasingly bent on finding a new anchor. Whether it will be the reincarnation of the gold standard, a new Bretton Woods, or something altogether different is yet to be revealed.
Back in 1976, in accordance with the Jamaica accord, the world economy underwent a shift towards a new monetary system that represented a major departure from the security of managed exchange rates. The new system, branded as the Jamaican monetary system, that is celebrating its 40th anniversary, was predicated on a set of novel principles, which included the following:
- system of floating exchange rates introduced
- allowing member countries to choose their own exchange rate system
- decline in the monetary role of gold
The new system was instrumental in securing the expansion of the world economy throughout the following decades, which were marked by ever new highs in trade and investment flows. In general the case for flexible exchange rates is quite strong as currency flexibility allows the economy to accommodate external shocks such as sharply lower oil prices, while lowering the pressure on the country’s output and the balance of payments. Flexible exchange rates also allow countries to maintain sufficient levels of forex reserves while at the same time raising the efficacy of economic policy instruments such as interest rates. But while greater exchange rate flexibility may have its merits, the costs may be quite substantial as well, particularly in a global economy that is increasingly interconnected by cross-country trade and investment.
Indeed, more recently, the world economy hit a string of speed bumps, as countries took advantage of the scope for exchange rate flexibility to indulge in competitive devaluations. After the peak of the 2008 financial crisis, America’s QE set off a chain reaction that was accompanied by “quantitative easing” in other parts of the developed world as well as among emerging markets. In the CIS region, bouts of rouble weakness have also engendered waves of competitive devaluations in parts of the “near abroad”. The worry in global financial markets this year has been that China’s currency could post losses potentially leading to stronger impulses towards competitive devals elsewhere in the world economy.
In today’s world economy the paradigm of cooperation and mutual economic openness has given way to greater protectionism, as has been the case in the 1930s during the Great Depression. But while back in the 20th century the main instrument of protectionism was trade barriers in form of higher import tariffs, this time around it is complemented by the use of competitive currency devaluation. The pattern of mutual devaluations contributed to the deceleration in global economic growth through depressing demand, which today has resulted in the so-called “new normal” – lower global growth for longer. Against the backdrop of mounting signs of competitive currency adjustments the IMF has called for greater monetary policy coordination to forestall further damage to global trade and investment flows.
Another problem in the world of flexible exchange rates is the rise in volatility in financial markets and the lack of a credible anchor. High levels of exchange rate volatility may generate significant swings in capital flows (particularly in those cases when long-term funds are lacking and are dominated by speculative capital flows), while uncertainty in financial markets may be detrimental to trade flows and investment growth. Unbridled exchange rate depreciation can also generate surges in inflation that affect most adversely the poor strata of the population. The poor are also the ones that are less equipped than the wealthy to adjust to extreme exchange rate volatility.
The overall balance of pros and cons with regard to exchange rate flexibility will depend on the circumstances of each particular country, but as was with the exit from the Great Depression that culminated in the creation of the Bretton Woods system, today’s world economy appears to be increasingly bent on finding a new anchor. Whether it will be the reincarnation of the gold standard, a new Bretton Woods, or something altogether different is yet to be revealed, but what may well be in store is that a post-crisis setting will likely be characterized by a change in system of global exchange rates.
