Abstract: This article reviews the historical evolution of the international monetary system since the 1870s from the gold standard to the Bretton Woods system and the post-Bretton Woods system. The defining characteristic of the post-Bretton Woods system is the dollar standard, under which the US dollar (USD) was decoupled from gold and the political, economic, financial and military strength of the United States sustained global faith in the currency. However, the outbreak of the global financial crisis in 2008 betrayed the defects of the post-Bretton Woods system, including the deflationary tendency and increasing inequality and instability. The reason behind these deficiencies is that the USD as a national currency has been acting as an international reserve currency. On China’s part, with intensified opening-up endeavor and fast economic development, it has now become one of the most important participants in the international monetary system. On one hand, it needs to pursue its own interests while coping with risks and uncertainties; on the other hand, China should actively participate in the reform of the international monetary system.
Key Words: International Monetary System, Gold Standard, Bretton Woods system
Professor Gao Haihong is the founder of the Research Center for International Finance at the Institute of World Economics and Politics (IWEP) of the Chinese Academy of Social Sciences (CASS). Her new book The Changing International Monetary System: Theory and Chinese Practice, covers most of the major issues in this field and embodies her decade-long work on the subject matter.
China’s opening-up, to a large extent, is a process of integration into the international trade and monetary system. Over a long period of time, China has been a rule taker rather than a rule maker. But this has fundamentally changed since the 2008 global financial crisis.
On one hand, with four decades of hard work, China has emerged as the world’s biggest trader, the second largest economy, largest foreign reserve holder (though sometimes overtaken by Japan), one of the biggest creditor nations (with a net overseas asset of 2.3 trillion USD in 2019) and the third largest shareholder of the International Monetary Fund (IMF). Renminbi internationalization also made great headways, and the currency entered the SDR basket with the third largest weight. It’s legitimate that China, with these achievements, demands a greater say for itself and other developing economies in the international monetary system.
On the other hand, despite the role of the USD as the reserve currency in the global monetary system (including the post-Bretton Woods system), the United States has not been fulfilling its responsibilities especially since 2008, even advocating “America First” under the Trump administration. Under such circumstances, US fiscal and monetary policy will inevitably undermine the dollar’s supremacy. If old economic theories still hold, people should be seriously worried about the potential impact of the extreme fiscal expansion and limitless monetary easing on the international monetary system. After the “Nixon Shock”, will there be a “Biden Shock”?
Before opening-up, China was immune to shocks from global monetary turmoil. But now, as one of the most important participants in the international monetary system, any turbulence and change could have a huge impact on the sustained growth of the Chinese economy. Therefore, China must actively seek to reform and improve the system.
Over the years, Chinese scholars have conducted in-depth research on the deficiencies of the international monetary system and proposed paths of reform. Given the more complicated situation today, further studies need to be done in this area. It’s imperative that China develops strategies to cope with global monetary crises as well as solutions and roadmaps for reforming the current system. I have no doubt that Prof Gao’s new book will be a great addition to this effort.
I. EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEM: FROM THE GOLD STANDARD TO THE POST-BRETTON WOODS SYSTEM
An international monetary system is supposed to serve two major functions: providing global liquidity and adjusting balance of international payments. To enable these functions, three questions need to be answered: what is the standard / reserve currency, how to determine the exchange rates, and how to manage cross-border capital flows. Different answers to these questions shape different systems.
1. Gold standard
Gold was the standard in the international monetary system during the 1870s and World War I (WWI). The gold standard is characterized by free conversion of a currency into gold based on its metallic content and the free movement of gold among countries. A country’s gold production and trade balance determine its gold reserve which then determines its total money supply. In other words, under the gold standard, there is a ceiling and floor of a country’s money supply as determined by its gold reserve. The United Kingdom (UK) had trade deficits for the best part of this period; but since it maintained positive investment income, the UK had been recording surplus in its current account until the 1930s. With sufficient gold reserve, the Great Britain Pound (GBP) was the dominant currency in international payment and settlement under the gold standard, and the Bank of England served as the “world’s bank”. The GBP was the de-facto standard back then.
The outbreak of WWI in 1914 led the UK to press the pause button on the gold standard. The exchange rate of GBP against USD was 1 to 4.86 before the war based on their metallic contents. However, during the war, the UK experienced severe inflation while the situation was better in the US, and when the war was about to end, the UK government devalued the sterling to 1:4.7 against the USD. The rate further slid to 1:3.44 in 1920 when control over it was relaxed by the UK government who tightened monetary policy in the hope of resuming the gold standard. As a result, for the two years after the war, the UK recorded a decline in credit growth by 20% and a price drop by 34%. In 1922, at the price of an unemployment rate of as high as 14%, the UK finally pushed the pound’s exchange rate back up to 1:4.61. Three years later, then chancellor of the Exchequer Winston Churchill restored the gold standard, and maintained the GBP’s exchange rate above the pre-WWI level of 1:4.86.
In theory, the gold standard is capable of automatic adjustment, addressing disequilibrium in international payments and stemming excessive inflation or deflation. For example, if country A sees price hikes as a result of fiscal monetization, while country B has stable prices, then A will have a current account deficit against B which then causes gold to flow from A to B. To maintain the same rate for its currency to convert into gold, A will have to tighten money supply, while B feels free to increase it. Consequently, A will have lower prices and more export, while B, higher prices and more import. This adjustment process continues until the balance of payments is resumed. During the process, A has exported its inflation to B.
For the gold standard to work, all participants must follow the rules. If B, worried about domestic price hikes, prevents local banks from expanding money supply with gold inflow, then the gold standard will fail in its capacity of automatic adjustment. Take the UK and the US for example. After WWI, while the UK worked to resume the gold standard by tightening monetary policy, the US refused further monetary expansion. As a result, the UK had less and less gold in reserve, while the US had more and more. Unless it further tightens the policy, the UK would not be able to maintain the exchange rate at 1:4.86, which means it would also fail to keep the pound at gold parity. In retrospect, had the UK lowered GBP’s metallic content and its exchange rate against the USD, things may well have been different. But the UK, insisting that the GBP should have a permanent metallic content, did not do that. Decline in its gold reserve forced the UK to cease using the gold standard in 1931. Many countries followed, and the world entered a time of disorderly competitive depreciation. That major economies turned to the “beggar-thy-neighbor” approach in trade and foreign exchange policies during this period significantly exacerbated the Great Depression in 1929-33.
2. The Bretton Woods System
The post-war Bretton Woods System is characterized by the gold standard and a fixed exchange rate regime based on the USD. According to The Articles of Agreement of the International Monetary Fund, currencies shall keep a fixed interest rate against the USD with an acceptable fluctuation range of 1%, while the USD is anchored at 35 against 1 ounce of gold. Other currencies were anchored to the USD rather than to gold, and USD reserves served as substitute for gold reserves, which relieved the pressure on countries with a modest pool of the metal.
IMF members were only allowed to devalue their currencies when they experienced fundamental disequilibrium and had obtained the approval of the Fund. However, there was no clear definition as to what was “fundamental disequilibrium”. It’s generally understood as disequilibrium that cannot be addressed by adjusting domestic policies alone. In that case, the IMF would provide credit facility for the country to make it less necessary to devaluate its currency. All members shall put a certain amount of gold and local currencies at the Fund in accordance with their economic strengths in order to support those who had trouble with their balance of payments. A member state, when borrowing (USD in most cases) from the Fund, must exchange with its local currency, and buy it back with USD after three or five years. The Bretton Woods System is generally believed to have three main deficiencies.
First is the Triffin Dilemma. Under the system, the USD was the only means of payment and settlement in global trade. To meet global demands for trade, the US had to be able to provide enough “dollar liquidity”. Robert Triffin, the Belgian economist, pointed out in 1960 that the Bretton Woods system relies on the faith in dollar among global holders of the currency; more specifically, it relies on whether global holders are convinced that the US government can continue to ensure that the USD is anchored at 35 against 1 ounce of gold. However, while demand for dollar liquidity grew with the boom in global trade, growth in gold supply was limited. As a result, the ratio of overseas USD holdings to the gold reserve of the US continued to rise. That eventually shook global faith in the US government to maintain the conversion rate between its currency and gold, and led the Bretton Woods system to collapse.
Triffin was right that lack of gold would lead to the collapse of the system, but the process unfolded along a path different from what he had expected. In fact, with the European and Japanese economy picking up with more competitive exports, the US saw a declining surplus in trade in goods, an increasing deficit in trade in services, and rising military expenditures overseas. While the United States’ current account surplus decreased, its capital account (including the government’s overseas loans, foreign aids and private capital outflows) was always recording a deficit that was usually bigger than the current account surplus. With a worsening balance of payments, the US had to depend more on exporting dollars to improve the situation , which reversed the “dollar shortage” in the 1950s to 60s and produced a “dollar overhang” instead. Therefore, what had fundamentally undermined the Bretton Woods system was oversupply of the dollar, but the reason behind was not trade boom causing dollar supply to overgrow relative to gold as Triffin had predicted; instead, it was the US’ continuous balance of payment deficit to blame.
This long-standing deficit indicated that the USD was overvalued. In the late 1960s and the early 1970s, the price of gold in USD continued to rise in nonofficial markets. Speculators were selling dollars and buying gold in official markets, while doing the opposite in nonofficial markets for profits. At the end of 1949, the US had a gold reserve that exceeded its short-term liabilities to foreign countries including bonds and securities by 18.2 billion dollars; yet, a year later, the gap narrowed to less than 5 billion dollars. From 1950 to 1957, the gold reserve of the US declined by 1.3 billion dollars per year on average, plunging by almost 3 billion dollars in 1958 alone. With the rise in expectations for a USD that would increasingly depreciate against gold, more and more speculators turned to sell off their dollars and rushed to buy gold instead. In 1948, the US accounted for two thirds in the global currency reserve; by the end of 1960, its gold reserve fell to 19.4 billion dollars, while it had 18.9 billion dollars of current and long-term liabilities to other countries. At this time, the US still had enough gold reserve to meet the demand for USD-to-gold conversion among foreign institutions and individuals, even though the supply was only 500 million dollars over the demand. However, by 1970, the country’s gold reserve further slid to 14.5 billion dollars, while it owed a whopping 40.2 billion dollars to foreign countries, in which current debt alone had outsized its gold reserves, standing at 23.4 billion dollars. In 1971, while other governments were holding over 40 billion dollars of gold and private owners, over 30 billion dollars, the US only had gold of over 10 billion dollars. In August 1971, France converted 92% of its foreign exchange holdings into gold; in the same month, the UK government asked the US Treasury to transport 3 billion dollars of gold from Fort Knox to the Federal Reserve’s vault in New York. With the gold reserve quickly exhausted, then US President Nixon declared on August 15, 1971 that the country would close the Gold Window and scrap its promise to keep the US dollar anchored at 35 against 1 ounce of gold, which marked the collapse of the Bretton Wood System.
The second deficiency is the failure to adjust imbalance of international payments. As the last resort, the Bretton Wood System allowed its member states to adjust the exchange rate when there was “fundamental imbalance” in their international payments, but only provided a very limited scope of adjustment of 1%. Under the gold standard, cross-border flow of gold could help fix the imbalance. But under the Bretton Wood System’s fixed exchange rate regime, monetary policy tightening or expansion was the only way to resume the balance, despite the fact that maintaining balance of international payments usually goes against a country’s other macroeconomic policy goals.
For example, in 1962, then British Prime Minister Harold Macmillan once suggested that the US depreciate the USD to 70 against 1 ounce of gold, which was declined by then US President Kennedy who believed that this move would signal a US economy in poor condition but didn’t want to tighten policy either. In late 1960, the US had a worsened balance of payments as well as mounting unemployment and inflation pressure. To narrow the deficit in its balance of payment, the Fed should have tightened the monetary policy e.g. by raising the interest rate, while other economies should have taken expansionary monetary policy. However, back then there was the consensus across the US that the paramount goal was full employment and to keep the unemployment rate at or below 4%, and this made it hard for the Fed to tighten monetary policy. The US also tried to contain capital outflow by capital control. For example, it began to collect the interest equalization tax (IET) in 1963 to prevent US residents from purchasing financial assets abroad. However, most of the attempts failed or incurred very high costs, which left the Nixon administration with no choice but to depreciate the USD. The currency devalued by 7% against gold, and other currencies were allowed to deviate from the dollar by as much as 2.5%. In March 1973, as the exchange rate of currencies around the world all began free-floating, the Bretton Woods System finally became history.
Charles de Gaulle proposed the third problem. The former French President pointed out that it is risky to build a currency system based on a single currency. The USD was essentially viewed as equivalent of gold in the Bretton Woods system. De Gaulle claimed that the de facto dollar standard “allowed the United States to live beyond its means and forced the European surplus countries to finance the US military empire overseas.”
Under the Bretton Woods system, countries had to hold a portion of their foreign exchange reserves in USD because it was almost the only currency that could be used as a medium of exchange, a means of settlement, and a store of value in cross-border trade and investment. This permitted the US to print "IOUs" in payment for foreign resources without worry of foreign countries demanding products, services, or financial assets in compensation. In other words, the system allowed the US to impose a seigniorage tax on the rest of the world in exchange for global liquidity.
There should be no inflation and the dollar's international buying power should not diminish if countries raise their holdings of USD reserves in pace with the rise of international trade. Prices in the US remained largely constant in the early 1960s, with the CPI growing by 6.54% between 1960 and 1965. Between 1965 and 1970, the CPI increased by 23.07%, an average yearly increase of 4.25% , due to the substantial increase in fiscal deficit caused by the Vietnam War and the Great Society programs initiated by Lyndon B. Johnson. The actual domestic purchasing power of USD had fallen, implying that it was overpriced in comparison to gold and other currencies. Overseas citizens whose holding of USD was diluted were also paying inflation taxes to the United States.
At the beginning of the Bretton Woods system, the US was providing liquidity to the international monetary system through the capital account deficit (Marshall Plan, etc.). But as the current account shifted from a surplus to a deficit, the US began to provide liquidity by increasing its liabilities. Rueff explains the essence of this shift by a metaphor of a tailor and a customer:
“…if I had an agreement with my tailor (the surplus country) that whatever money I (the US) pay him he returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him.”
In this way, the tailor (the surplus country) continues to tailor for his customer, only earning more IOUs, while all the client (the US) has to do is to write IOUs. But no one knows what and how much the tailor might get out of those IOUs.
3. Post-Bretton Woods System
After the Bretton Woods system dissolved in 1973, the subsequent “post-Bretton Woods system” (or really “non-system”) was characterized by (1) multiple international reserve currencies albeit featured by USD, (2) multiple exchange rate systems but mostly with floating ones, and (3) free flow of capitals but under varying degree of capital control.
The fundamental feature of the post-Bretton Woods system is a dollar standard instead of gold exchange standard. After convertibility of the USD to gold was terminated, for the foreign holders, USD is just an “IOU” issued by the American government and guaranteed by the state credit.
Without the gold peg or any intrinsic value, how could the USD function as the reserve currency when it was once backed by gold but still collapsed? The answer is: in the breakdown of the Bretton Woods system, the vote of no confidence was given not to the USD but to the promise of a fixed peg of $35/ounce made by the American government. When the dollar was decoupled from gold, the scope for speculation narrowed, and the Triffin dilemma disappeared. After the Bretton Woods system, while the dollar depreciated sharply against gold , its depreciation against other currencies was relatively mild and fluctuated in both directions. This suggests that the fundamental role of USD as the standard currency has not been overturned. Although the dollar is no longer pegged to gold, it has not lost its credit because of America's strong political, economic, financial and military power.
The post-Bretton Woods era has witnessed rampant cross-border capital, volatile exchange rates, and even more currency, debt, balance of payments and financial crises. However, it is undeniable that the global trade and financial integration have been greatly enhanced; although the average growth rate of the world economy is significantly lower than before, it has avoided the long recession that occurred under the gold standard. Despite widespread dissatisfaction, the reasonableness of the post-Bretton Woods system was not seriously challenged, at least until the outbreak of the global financial crisis of 2008.
II. THE FLAWS OF THE CURRENT INTERNATIONAL MONETARY SYSTEM AND CHINA'S POSITIONING
The global financial crisis of 2008 placed a stop to this. In the following year, the UN-mandated Stiglitz Commission identified three major flaws in the post-Bretton Woods system: deflationary bias, inequality and instability. The root cause of these deficiencies is the USD, a national currency that serves as an international reserve currency.
What is “deflationary bias”? Non-reserve currency countries often have to accumulate large amounts of foreign exchange reserves to avoid current account deficits and ensuing crises of currency, finance or economy. The accumulation implies a "freezing" of purchasing power. If the countries with current account surpluses do not increase their expenditure accordingly (which means a reduction in the current account surplus or even the emergence of a current account deficit), global demand will be reduced by the unilateral adjustment of the deficit countries and the global economy will fall into recession.
The absence of a mechanism to resolve the disequilibrium in the balance of payment is the fact that in the post-Bretton Woods system, the free flow of capital has effectively cancelled out the role of the exchange rate adjustment mechanism. In particular, the cross-border flow of speculative capital has created a great deal of uncertainty in the balance of payments. The US, for example, has run a current account deficit almost every year since 1980, but the dollar exchange rate is determined to a greater extent by the direction of capital flows. When US domestic interest rate is high, the USD tends to appreciate rather than depreciate due to capital inflows, despite the US current account deficit. Exchange rate misalignment could be persisting over time.
What are the inequalities? With a floating exchange rate regime, non-reserve currency countries had to accumulate large amounts of foreign exchange, but holding these assets yields only a very low return. The large accumulation by non-reserve currency countries, especially developing countries, has resulted in a very unequal allocation of global resources. By holding large amounts of foreign exchange reserves, developing countries are paying a seigniorage tax to the US.
Early on, supporters of the post-Bretton Woods system claimed that with floating exchange rates, countries' need for foreign exchange reserves would be reduced to a minimum. When there was a shortage of "international liquidity" to act as a medium of exchange and a means of settlement, a country with sufficient creditworthiness could borrow enough dollars from the global market. But the Asian financial crisis completely overturned this argument. Because of the “counter-cyclicality” of capital flows, the more developing countries need dollar liquidity, the harder it is to get it. In 1970, before the collapse of the Bretton Woods system, global foreign exchange reserves were only US$45 billion, rising to US$300 billion in 1979. From 1973 to 1979, global foreign exchange reserves grew at a rate of 17%, significantly higher than the 9% of the 1960s.
To protect themselves against speculative capital in the aftermath of the Asian financial crisis, the central banks of developing countries had to increase their accumulation of USD reserves, which were irrelevant to meeting "international liquidity" needs. In 1990, the ratio of foreign exchange reserves to GDP in developing countries was 5%, a figure that rose to 30% in 2018. At the end of 2020, global foreign exchange reserves amounted to US$12.7 trillion. In 1999, USD reserves took up 71% of all foreign exchange reserves. It dropped to the lowest level in more than two decades in 2020, but still stood at 59%. Whatever the purpose of the accumulation of foreign exchange reserves, they have virtually wasted the resources that should have been used for consumption and investment in the developing countries, while the US consumes those resources without worrying about paying back.
The most fundamental problems with the current global currency system are: on the one hand, the standard currency, or the “anchor” as some economists call it, is the USD, which has no intrinsic value and is backed entirely by credit; on the other hand, the US Congressional Budget Office predicts that the national debt-to-GDP ratio will reach 103% in 2023, exceeding the peak since World War II, reaching 250% by 2050. The continued increase in the national debt will make it difficult for the Fed to change its low interest rate policy, which in turn will make it difficult for the US to change its current account deficit that has persisted for almost 50 years. The long-lasting current account deficit has left the US with a net foreign debt of over US$14.1 trillion, or around 67% of its GDP, which is expected to grow even more. By contrast, the US was a net creditor before the collapse of the Bretton Woods system. In the following five decades, the tailor in Rueff’s figurative story seems not to care about tirelessly sewing clothes, even though it has been uncertain whether the customer would pay his debt or not. The customer, however, has been enjoying the good old days of getting new clothes without paying "real money." How long will the tailor have to wait before he asks his customer to "turn" the IOUs into real resources? The tailor's remarkable patience could be the biggest mystery in contemporary finance.
Obviously, China is an important player in the post-Bretton Woods system and basically the super-patient tailor. We see American lawmakers railing against China's trade surplus in front of a camera, but we probably will not see them secretly cheer for China's purchase of US Treasury bonds for accumulation of USD reserves.
For more than a decade, I have frequently quoted Mr. Phillips Swagel, former chief of staff of the White House Council of Economic Advisers and currently the director of the Congressional Budget Office, in explaining this strange phenomenon. His explanation, though targeted at the appreciation of the renminbi, nails the real thinking of the US government about China maintaining its trade surplus with the US and accumulating USD reserves.
“If China’s currency is undervalued by 27 percent, as some have claimed, US consumers have been getting a 27 percent discount on everything made in China, while the Chinese have been paying 27 percent too much for Treasury bonds. One might wonder why the United States is complaining in the first place. Revaluation would end the Chinese fire sale. Americans will pay more for everything from shoes to electronics. Other global investors will buy up US bonds the Chinese no longer want – and Americans might even save a bit more –but the Treasury and the public will have to pay higher interest rates. A stronger yuan will mean not just a steeper cost of financing government debt, but also higher payments for US homeowners on those frothy interest-only mortgages. And do not expect US job gains from revaluation. China’s undervalued currency has cost jobs, but they were lost in Malaysia, Honduras, and the other low-cost countries from which US clothing and toys will be sourced as Chinese exports slow.”
He asked,
“Why pressure China to revalue? US policymakers surely understand the downsides of a yuan revaluation for the US economy. And they certainly must realize that their very public campaign only makes it more difficult for the Chinese to take action. Could it be that this is the point? A cynic might hope that the push for a Chinese exchange-rate change is not a response to misguided political pressures, but is instead a devious attempt to prolong the enormous benefits the United States derives at China’s expense from the fixed dollar-yuan exchange rate. Or perhaps this is accident, not design. Either way, the administration has come up with a brilliant strategy to keep the good times rolling.”
In my acquaintance with Mr. Swagel, I believe he is an honest person.
It is fair to say that the current international currency system has long been riddled with holes. No one knows how far this old car in disrepair could go. For most countries, they have no choice but to stay until it is capsized.
But China is not one of these countries; it has its own choice. China and its neighbors have been trying hard albeit in vain over the last few decades, especially since the 1998 Asian financial crisis. In 2009, China took on its own way, but soon found that there was no easy way at all. The new book by Professor Gao Haihong illustrates the tortuous journey that China and its neighbors have already travelled. As she demonstrates in the book, there is always a good way for China as long as it keeps trying.
It is the duty of an international finance scholar to think of danger in times of peace and to share the worries of their motherland. I wish Professor Gao Haihong every success in her future research on the reform of the global currency system.
This article is the preface the author wrote for the book The Changing International Monetary System: Theory and Chinese Practice by Dr. Gao Haihong of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. The text is slightly abridged and translated by China Finance 40 Forum (CF40). The translation is not reviewed by the author. The views expressed herein are the author’s own and do not represent those of CF40 or other organizations. With space limits, the notes and references have been omitted in this article. For full text please download the PDF.
