Balance of Payments Adjustment, 1945 to 1986: The IMF Experience


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Henceforth the Committee were left to indulge themselves in "a purely theoretical exercise without any practical meaning" Emminger a, It was a "very low point" when they realised the Shultz-Volcker position. Henceforth they realised it was "pointless to keep on arguing" de Vries a, , Section 4 describes the policy process from Nixon's election victory to the revised IMF Articles of Agreement which legitimised floating. The system of fixed exchange rates collapsed for a variety of reasons. In , efforts to revive the system were abandoned in large part because of the attitudes of the Nixon-Ford Treasury Secretaries.

The success of their and Friedman's advocacy in favour of a floating system was conditional on the attitude of "benign neglect" that they encouraged Presidents Nixon and Ford to adopt. As the fixed exchange rate system collapsed, Nixon was preoccupied with the Watergate crisis. From Victory in Europe to Defeat in Vietnam, Americans had been spared the choice of being for or against Nixon in only two national elections and When his Treasury Secretary John Connally wanted to "hit Nixon right where he lived" he taunted him with the prospect of being the one-term Herbert Hoover of his time Rather and Gates , Between Hoover's Presidency and the policy hegemony of the Hoover Institution economists , Franklin Roosevelt was the perennial President and then Nixon was the perennial candidate.

Sections 4. In March , Roosevelt suspended the internal convertibility of the dollar into gold the nationalisation of gold. In August , Nixon's New Economic Policy NEP froze wages and prices and suspended the external convertibility of the dollar into gold the demonetisation of gold. The following section describe Nixon's NEP 4.

The remaining sections analyse the final collapse of the par value system, first as an orthodox narrative 4. Concluding comments are provided in section 5. First, this essay is concerned with competing attitudes towards the "Eleusinian mysteries" of the international monetary system Schlesinger , It is largely organised around the intellectual battles between the International Monetary Fund and the international influence of Milton Friedman.

Both sides have no shortage of detractors; both sides have a tendency to generate polemical heat. Indeed, unsympathetic critics have detected faith and mythology at the heart of both the Chicago and IMF views of the world. According to John Kenneth Galbraith, the market was perceived by Chicago economists as "a mystique, a supernatural endowment which evokes, not technical, but religious, attitudes" cited by Navatsky , 3.

According to Charles Kindleberger , 29 flexible exchange rates were synonymous for Chicago economists with "God", although Harry Johnson, not Friedman, was the Archbishop of Canterbury. Vested interest groups, it was believed, would capture that power. In the alternative, Chicago view, the IMF was an integral part of the post-war planning system which sought to override market forces.

In Johnson's judgement, this IMF system "rested on a foundation of mythological belief and conventional assumption". Fixed exchange rates delivered power and prestige to those who administered the system and "practical" bankers found it impossible to comprehend how a floating rate system would work. Johnson, therefore, invoked economic sociology and "institutionalism" as appropriate vehicles to explain international monetary arrangements c, , ; , 12; see also Caves , Mainstream economists, such as Rudiger Dornbusch , reflected that "When it counts, the IMF can be relied upon to be disappointing".

Others, such as Senator Paul Douglas, complained in that attempts to discuss flexible exchange rates with American IMF representatives or officials of the US Treasury elicited only a "tropismatic response" cited by Yeager , , n Numerous observers detected in the official world a "theological aversion to exchange rate flexibility" Williamson , Prior to the advent of the IMF there were "no rules of the game except the devil take the hindmost".

Under the IMF system, "the cardinal rule of the game was consultation" Coombs , In , the IMF decided that an unauthorised change in the par value of the Czechoslovakian koruna transformed that country into "a sheep so black that it should not be allowed to run with the flock". The offending country was informed that they could retain IMF membership only if it "confessed" its "sin" and "purged itself of the charges", which it refused to do Southard , This essay attempts to explain why fixed exchange rates were embraced with such determination and to explain why the solutions proposed by par value advocates became "swamped and lost to sight" Fleming , 3.

Part of the reason for their failure was that they were confronted by an academic heretic who, having nailed his theses first in Germany, just as a predecessor had done four and quarter centuries before pursued his heresy with extraordinary tenacity. Friedman's intellectual rebellion against 'papal' authority invoked the right of national economic sovereignty, and after almost 'thirty years' of intellectual and political schism, the 'Treaty' of Jamaica resembled the Treaty of Westphalia in terms of the toleration offered to 'heretical' floaters.

The IMF sat at the centre of the monetary universe until it was replaced at the centre by market forces in "a sort of 'Copernican revolution'" Emminger , These international bankers regarded themselves as members of a "club" who policed the international monetary order Jacobsson , Roosa, a prominent member of the club, described their activities in terms of "military doctrine: rings of outer and inner defences for the defence of the dollar and for the system" Volcker and Gyohten , They regarded themselves as pugilists going into combat against any undisciplined or self-interested national economic policy which might deliver a price of foreign currency different from that which the policemen had decreed.

No account of the fall of the Bretton Woods system would be complete without an attempt to discuss their role and the intellectual consequences of their "undeviating" devotion to the par value system Southard , 23; de Vries a, They took their responsibilities seriously. The IMF was regarded as having come of age in the late s Krause , Nixon , 25 recalled that Arthur Burns launched a "titanic" rearguard action to preserve the par value system.

As their system entered the 'iceberg years' the official IMF historian recounts that they literally rearranged their chairs so as to pretend that it was not the Executive Directors who were discussing "limited" flexibility of exchange rates. Moreover, "there was stress on the word 'limited' Pointedly, they did not discuss regimes which were inconsistent with the par value system".

These "fourth floor" deliberations, which took place during the first nine months of the First Nixon Administration, reinforced their view that they should maintain their course de Vries a, ; McChesney Martin , Within the first two months of the Second Nixon Administration these prizefighters were forced to "throw in the towel" Emminger a, They "seemed to be more buffeted than in control of events" de Vries a, Within a remarkably short period of time, speculation about a return to a par value system was regarded as a "consolation for traditionalists sick with nostalgia" Machlup , Secondly, this essay does not attempt to adjudicate between fixed and floating diehards.

Instead, it seeks to analyse the process by which Friedman's case became fertile: first by converting the academic community and then by transforming the international monetary system. Thirdly, Friedman was neither the first nor the only economist to make the case for flexible exchange rates Machlup , Others such as James Meade , , 4 patiently spelt out the limitations which might prevent the price mechanism from working effectively with respect to exchange rates. But Meade , , described his preference for increased flexibility as "an academic exercise The "dangers" of flexibility were "real possibilities.

For this reason the authorities of the Western countries are extremely unlikely to adopt an uncontrolled system of freely floating exchange rates". In comparison, Meade's , 'case' could hardly be described as advocacy: "I am not absolutely convinced myself that fluctuating exchange rates necessarily lead to inflation". Friedman's case, while cautious about the possibilities of persuading policy makers, contained no such self-disparaging caveats and was by far the most influential in the debates that followed.

As the IMF officials rearranged their chairs so as to navigate the international monetary system through turbulent waters, Friedman pressed Nixon to destroy the Bretton Woods system. Finally, Section 2 describes a process that may display some 'general' characteristics about the interaction between economists and the policy process. Section 3 is more likely to display the 'special' characteristics associated with the atypical political processes of the Nixon Administration. As the international monetary policemen struggled to patch-up the fixed exchange rate system and began to consider allowing more elastic 'bands' around the par values, Nixon was utterly consumed by Watergate and foreign policy especially relations with China and the Soviet Union and the wars in Vietnam and the Middle East.

His Treasury advisers wished to bury Bretton Woods: in international negotiations they offered 'faint praise' for a revised par value system whilst guaranteeing their right to float the dollar. The system had been in crisis throughout the s, but the advice that Nixon received from his task force on the balance of payments and from his Treasury Secretaries was very different from the advice that Presidents Johnson, Kennedy and Eisenhower had been offered. The crucial American participants in the efforts to patch up the system were motivated by a different perspective about the desirable end-state than were their predecessors.

The collapse of the patched up Bretton Woods system has usually been attributed to the failure to transcend national self-interest or, more often, to the insurmountable problems associated with maintaining exchange rate fixity after the oil price shocks of the s. One historian asked why the outcome the legitimisation of flexible exchange rates differed "so totally" from the original intentions of those who sought to save the system Williamson , Events may have moved too fast to save the system de Vries , But the world had also been turned intellectually upside down by the revolutionary advocacy of flexible exchange rates.

One of Friedman's co-authors offered a four word paragraph by way of explanation: "Market forces had triumphed" Schwartz , There was also, however, an intellectual triumph for those who advocated the ascendancy of market forces. Certainly, the final outcome may well have been different had Nixon and Ford and their Treasury Secretaries been committed to fixed exchange rates.

This has previously been acknowledged, as has the importance of "key personalities" pressing for flexible exchange rates Scammell , ; Williamson , But the intellectual dimension of this policy volte-face has usually not been brought to the forefront. Friedman a, reflected about the "extraordinary importance of accidents of personality" with respect to monetary outcomes; and Shultz and Simon were both firm advocates of flexible exchange rates. Nixon, under their influence, was also not inclined to defend the patched up Bretton Woods system.

It is impossible to quantify these direct and indirect intellectual influences, but it seems reasonable to conclude that such influences were highly significant and therefore worthy of detailed scrutiny. It was accorded three sentences in both the volume and the monumental National Bureau of Economic Research Retrospective on the Bretton Woods System ; plus eight sentences in the official history of the period, sixteen sentences plus footnotes in Yeager's history and one sentence in Solomon's history Horsefield a, b; de Vries and Horsefield ; de Vries , , a; Bordo and Eichengreen This essay therefore supplements the orthodox chronology and analysis.

From Adam Smith to Alfred Marshall [], most respectable economic opinion accepted the "simplicity and naturalness of Free Trade" over the corruption and "moral harm" associated with Protection. The Bretton Woods agreement was designed to provide the post-war international stability to facilitate the approach towards both Free Trade and Full Employment. Per Jacobsson , 12, 14 and his associates who policed the fixed exchange rate system believed that they were providing a vital ingredient that relieved businesses of the uncertainty associated with exchange rate instability, thus lowering costs and contributing to the expansion of world trade.

They also believed that the IMF was the institution which guaranteed exchange stability. They did "not think that anyone would seriously dispute" the "purposes" of the IMF in this regard. The "strengthening of the existing exchange structure" was believed to be "in the general interest". The simultaneous pursuit of these three post-war policy objectives posed a dilemma. According to one influential Keynesian observer, it was "hardly an exaggeration to say that instead of being on a Gold Standard we are on a Labour Standard" Hicks , 55, 64, , , But Bretton Woods was a dollar standard backed by gold and the single instrument of monetary policy had to target the two objectives of maintaining a fixed exchange rate and low levels of unemployment.

John Hicks noted that the international repercussions of these national Labour Standards were a "very grave preoccupation". This led to the conclusion "from which we can hardly escape" that a second policy instrument was required: "there really is something in the Employment argument for Protection". Since fixing exchange rates in terms of gold was "the best guarantee of solidity that mankind had yet discovered", this created "a strong case for Import Restrictions, as a means of facilitating expansion without weakening the Balance of Payments".

Friedman a, believed that underpinning these sentiments lay an undue emphasis on the short rather than the long run consequences of policy. Certainly, Robert Solow a, , a leading advocate of Full Employment, favoured Free Trade, but "elementary realism" led him to conclude that "significant steps" towards Free Trade "will come very slowly, if indeed they come at all Influential players in the political arena such as George Meany , , the President of the American Federation of Labor and Congress of Industrial Organisations, calculated that between 'unfair' imports had cost , job opportunities for Americans.

In , the US Labor movement was actively campaigning for the Burke-Hartke Bill which sought to impose import quotas on a wide spectrum of goods Shultz and Dam a, As Full Employment advocates went on the offensive, Free Trade advocates were "on the defensive" Irwin , Within Nixon's White House, the devaluation of the dollar was regarded as "the strongest argument we had to repel protectionism" Volcker , 7.

Later, as part of his "long struggle of escape" from his Marshallian heritage, Keynes , chapter 23; JMK IX [], found wisdom in mercantilist writings. As Friedman a, 2 highlighted, Keynes advocated a tariff in as a remedy for unemployment. It is believed only by those who gain an advantage from it" Joan Robinson , 6, This essay examines the interaction of these three revolutionary or reforming imperatives.

The Free Trade reforming cause dates from the Smith-Ricardo attacks on mercantilism; the Full Employment imperative dates from the Keynesian revolution of the s.

But the Bretton Woods "founding fathers" were also revolutionaries. These "zealots" had given institutional expression to the "revolutionary ideas" of banishing the "twin devils" of the s: depression and beggar-thy-neighbour trade policy, involving competitive currency devaluation Reisman , 82; de Vries , ; Campos , Indeed, some of the bankers, such as Federal Reserve Board chairman William McChesney Martin , , 12, invoked the authority of Keynes to justify "the restraining conscience" that they exerted on those who might be tempted to pursue Full Employment without an appropriate anti-inflationary discipline.

It was necessary "to pool some of our sovereignty", that is, to relinquish national power to the IMF, the institution that was evolving into a world central bank. The public servants who policed the international economy believed that before 'us' lay the deluge of competitive devaluations. They also assumed that after 'us' lay a similar fate: "a path leading into unknown darkness" Caves , In this sense, they came to display some of the characteristics of an ancien regime.

The leading post war textbook asserted that flexible exchange rates would reduce the volume of international trade by increasing risk Samuelson , Fixed exchange rates and a fixed price of gold were the Newtonian certainties upon which the Bretton Woods system rested Volcker and Gyohten , 7. The League of Nations , , , , outlined the "proved disadvantages of freely fluctuating exchanges If there is anything that inter-war experience has clearly demonstrated, it is that paper currency exchanges cannot be left free to fluctuate".

This system "would almost certainly result in chaos". The actual system adopted in the thirties "The Devaluation Cycle" was believed to be "associated with disturbances not very different from those associated with freely fluctuating exchanges". In addition to the s analogy, apocryphal Swiss bankers were often conjured up to demonstrate the compelling nature of the case against floating rates. Galbraith's , , n9 banker informed him that the Swiss response to a devaluation of the US dollar might be a competitive devaluation "late the same afternoon".

The "art" of central banking was regarded as "one of the keystones in the arch of our civilisation" McChesney Martin , This civilisation had been challenged in the s by the "economic barbarism" associated with floating exchange rates Coombs , 4. The history of the IMF was "the record of one of the ways in which that challenge was met" Horsefield a, 5. But the IMF historians who chronicled the response to that challenge barely mentioned the intellectual forces that would help to destroy the Bretton Woods system.

Fixed exchange rates were the "central core of the new international cooperation" and the IMF "opposed all suggestions" which resembled the system that prevailed after de Vries , 40, This was both "the critical fact" and the critical weakness of the position taken by the international policemen de Vries , Those who supported par values were perceived to have been "trapped in channels that were far too conventional" Volcker and Gyohten , According to one influential Chicago floating advocate the obsession with the s was based on a misconception about the realities of the world economy: they were "guarding the gates of hell rather than guarding legitimate business".

The "old central bank devil" tended to "believe that they know better than the market does". Academic economists, therefore, had to provide an "educational process" for the bankers Johnson , , 48; , This essay explores the process by which the international policemen responded to this educational process. They first ignored, then confronted and then were defeated by the challenge of Friedman's case for flexible exchange rates.

For Friedman a, 30, , 71; a, , the macroeconomic pursuit of Full Employment was "a modern invention for producing inflation". The system of extensive controls over foreign exchange transactions was "one of the few really new economic inventions of modern times". This system had been "perfected" in by Hjalmar Schacht "primarily in order to despoil the Jews". Friedman advised an Israeli audience that "As a Jew, rather than an economist, I say to you, why don't you get rid of the false appearance, why don't you abolish the exchange controls and make your practise conform to your values.

Set your people free". Friedman first formulated his case for flexible exchange rates in as part of his contribution to the rehabilitation of Germany. His memo formed the basis of his famous case which transformed academic perceptions and which helped to undermine the Bretton Woods system. As the par value system finally collapsed, IMF officials were acutely aware that "funeral orations" were being preached over their "casket" Southard , 1.

Friedman [], was delighted to see "another nail in the coffin". The IMF historians unintentionally perhaps conjured up the image of a living organism equipped with head, heart, backbone and self-interest. With the inauguration of the fixed exchange rate system, the "world consciously took control of the international monetary system" Gold , The Bretton Woods Founding Fathers intended that within this world currency bloc "fundamental disequilibrium" could also be corrected by changes in exchange rates.

But the Articles had a "protean quality" and the IMF sought to be "mistress in her own house". According to Jacobsson, the IMF Charter was "a living tree capable of growth and expansion within its natural limits" over which they had the authority to adopt "final" interpretations. Officials apparently reached decisions about what was in the interest of the world and then searched for a legal authority on which to base a pronouncement Gold , It was envisaged that the power of this body would relentlessly expand until it became "an International Federal Reserve System" Roosa , In the policemen decided that "jurisdiction over rates of exchange is at the heart of the Fund's function and that constriction of that jurisdiction could maim the Fund's authority" Gold , , , As the international monetary system was collapsing the IMF Managing Director reassured the Governors that the Fund was still "at the heart of the system" de Vries a, The dollar was regarded as the "backbone" of the IMF system Blessing , But for the dollar to provide the backbone for this living organism to flourish required the willing cooperation of US officials.

The bankers were very protective towards their creature: par value changes were regarded as "comparable to major surgery on a human patient But this supposedly benign Frankenstein could not withstand the attitude of "benign neglect" on the part of US Treasury Secretaries and Haberler, the chairman of President-elect Nixon taskforce on the balance of payments and Consultant to the US Treasury Volcker and Gyothen , Shultz agreed that the international monetary system "had a life of its own", but reflected also about the "self-deception" of some key players Shultz and Dam a, The proponents of exchange rate fixity were regarded by their opponents as doomed to play the role of the monstrous "Cerberus-like" dog preventing re-entry into the mythological hell of the s Johnson a, This artificially constructed body began to associate its own prestige with the health of the world economy.

Perceived national self-interest had to be constrained by the obligation to abstain from any policy discretion that might break the "rules" of their membership and to respond to the disciplinary alarm bells of an outflow of gold and foreign exchange reserves. The Fund imposed a "Code of Conduct" on the world: exchange rates were "at the heart of the code" Gold , When obliged to discuss exchange rates in , the IMF insisted that "The fulfilment of national needs demands the protection of international safeguards" the abandonment of which would pose "grave risks" de Vries b, , Thus fixed exchange rates allowed the international Leviathan to impose an almost Hobbesian contract by asserting "the primacy of the general interest in a matter which concerns the welfare of all" Witteveen , Friedman , , , argued that one of the major advantages of flexible rates was that "it makes it so much easier for the layman to understand the merits of free trade".

This debate over the relative merits of the price mechanism as a social organiser involved two rival perceptions of what constituted the authentic American tradition. The Chicago view was that liberalised international trade, capitalism and therefore liberty were being undermined by the Frankensteins of trading blocks and the State.

Capitalism and Freedom was organised around the theme "How can we keep the government we create from becoming a Frankenstein that will destroy the very freedom we establish it to protect" Friedman , 2. In the post-war period closer and closer approximations to Full Employment were visibly associated with higher and higher rates of open wage and price inflation. Some national policy makers wanted the discretion to pursue Full Employment, but since adverse inflation differentials were usually inconsistent with the maintenance of a fixed exchange rate the "sacred" symbol of national strength , price and wage inflation had to be suppressed through Exhortation and Controls Goodwin By , moral suasion in the US had been supplemented by Guidelines: specific numbers attached to targeted productivity gains and tolerable wage settlements.

Chicago economists opposed these controls and Shultz was frustrated that he had to wait until to remove them Shultz and Dam a, But according to the Council of Economic Advisers CEA Report, the Guidelines were "in the tradition of America, asking those to whom the society has entrusted economic power to exercise it in ways consistent with the national interest" cited by Shultz and Aliber , The CEA chairman explained that the Guidelines attempted to "harness this sense of social responsibility to the national interest in price stability or balance of payments equilibrium" Ackley , It was thus becoming increasingly clear that fixed exchange rates, the pursuit of Full Employment and the absence of exchange controls were three sides of a triangle, only two of which could be connected by the same straight line.

Typically, politicians 'solved' the problem by trampling on the Free Trade tradition by imposing import surcharges and capital controls thus maintaining reforming credentials and electoral respectability with respect to the pursuit of Full Employment. The policy responses to the adjustment crises experienced by the three dominant parties at the Bretton Woods conference raised the spectre of the protectionist 'solution' of the s.

In the late s, high unemployment led the Canadian authorities to seek a competitive advantage by depreciating the Canadian dollar while the Governor of the Bank of Canada advocated import controls Marsh , Paul Samuelson [], warned that this import surcharge might "feed the fires of protectionism The internal aim of Nixon's NEP was to reduce both inflation and unemployment; the external aim looked suspiciously similar to the protectionist sentiments that spawned the Smoot-Hawley tariffs Plumptre , Much of the literature on Bretton Woods has been organised around the "holy trinity" of adjustment, liquidity and confidence Eichengreen , Yet there was another "holy trinity": the three apparently inconsistent post war policy objectives of Full Employment, Free Trade and fixed exchange rates.

Friedman's counter-revolution has been described as the "monism of monetarists" Sargent and Wallace , Yet Friedman raised the standard of revolt against both the Labour Standard and the Bretton Woods standard of fixed exchange rates. The fulfilment of the second international objective was a necessary though not sufficient condition for the achievement of the first domestic objective.

Indeed, some of Friedman's domestic proposals were designed to facilitate the introduction of flexible exchange rates. It was therefore also incapable of defending a fixed exchange rate. But Friedman [], , n13 noted that "it would be equally appropriate to present the proposed domestic framework as a means of implementing flexible exchange rates".

Fixed exchange rates, Friedman believed led to suppressed inflation, which subverted the price mechanism and opened the door for Protection. Floating exchange rates would stimulate international trade and capital flows because they were "a substitute for present or prospective restrictions" Friedman b. Friedman c, supplemented the case for Free Trade with the notion that there was a "natural" end-point for the macroeconomic pursuit of Full Employment: using monetary policy to target unemployment was akin to "a space vehicle that has taken a fix on the wrong star".

Removing 'restrictions' or 'imperfections' at both the international and the micro economic level would produce better inflation-unemployment outcomes. The macro economic pursuit of Full Employment would be defeated by micro economic reality the short-run Phillips curve would shift out in an adverse direction. The Chicago view was that Free Trade was required to permanently shift the Phillips curve downwards Shultz and Aliber , , Thus policy activism at a microeconomic and international level would produce better outcomes than macroeconomic discretion.

The Chicago choice lay between a permanent shift of the Phillips curve a in a beneficial direction through Free Trade and microeconomic reform or b in an adverse direction following the macroeconomic pursuit of Full Employment through the operation of the forces expressed by neoclassical price theory. In contrast, Friedman's Keynesian opponents hoped that restricting prices and wages would allow macro economic policy to produce better inflation-unemployment outcomes by interfering with the allocative mechanism of neoclassical price theory.

Ellis , specifically discussed the constraint imposed by the IMF commitment to "exchange rate revisions only at infrequent intervals" and asked: "What is going to give? Does not full employment achieved under a system of rigid prices almost inevitably imply For Friedman any short run benefits from this Faustian "bargain" were countered by the long run threat it posed to Free Trade the reforming imperative with the longest lineage.

He sought to undermine two of the three pillars of the post-war order, in part, because they had combined to subvert the third. Those who argued for fixed exchange rates were guilty of the same perverted logic as the military strategists whose televised exploits in Vietnam were traumatising the world: "It was necessary to destroy the city to save it" Friedman b, An extraordinarily successful campaign was conducted to convert economists, bureaucrats, Prime Ministers and Presidents.

In , Presidential Candidate Kennedy declared his unalterable commitment to defend the dollar and his opposition to monetary policy as the "sole means" of controlling inflation Roosa a, Two "sacred" symbols Full Employment and the Bretton Woods system were jettisoned and replaced by another "sacred" symbol: monetary targeting Parkin As Nixon , , reflected, Friedman's "magic" solution of floating exchange rates "offered an appealing escape".

The "only regret" that Friedman had in leaving his position in the wartime US Treasury was that he played no role in the construction of the Bretton Woods system Friedman and Friedman , Not only might he have been one of the architects of the regime of fixed exchange rates, but had he stayed at the Treasury he might also have attended the first annual IMF meeting in Washington in September Friedman b, ; , 59; [], , n2 reflected about what he believed to be the corrosive short sightedness that the Washington atmosphere generates.

He also acknowledged the 'corrupting' influence that "the prevailing Keynesian temper" exerted over his own thinking.

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However, in September , he returned to the University of Chicago. Henceforth, he would be one of the leading players in the "intellectual Bretton Woods" that preoccupied economists and policy makers in the s and early s Caves , Friedman dates the beginning of his "active involvement in the political process" to the founding meeting of the Mont Pelerin Society in April He observed that in post-war England "price, wage and exchange controls were extensive and rigid" Friedman and Friedman , Shortly afterwards, the Bretton Woods system faced one of its earliest crises, and Friedman played an important role in persuading one of the founders of the post-war international monetary system to float their exchange rate.

On 17 November , Canada imposed what Donald Gordon , 22 , the Deputy Governor of the Bank of Canada, described as "drastic limitations" on imports so as to preserve the fixed external value of the Canadian dollar. On 17 April , Friedman made the case for floating the Canadian dollar to Gordon, prior to a University of Chicago Round Table radio broadcast the following day.

Friedman formed the distinct impression that Gordon had never properly encountered the argument before Friedman and Friedman , In the broadcast, Gordon emphasised that Canadian policy was driven, in part, by the desire to prevent "the spread of communism". Unfortunately, these responsibilities had generated inflation. Friedman , 22 replied that "direct controls through rationing and price controls" were "bad ways of fighting inflation". Friedman then outlined the policy agenda to which he devoted his professional life: "the most effective and efficient way of solving problems is by using the traditional mechanism of a free price system and the general mechanism of broad credit control, foreign exchange rate change".

Gordon's , 22 initial response to Friedman was to draw the same distinction that Solow a, later made between long-run objectives and short-run possibilities. Gordon also remarked that Canadians had to "keep in mind our obligations under the International Monetary Fund". Friedman , 22 replied that he welcomed the attachment to the "long-run virtues" of relying on the price mechanism but "heartily" disagreed with the view that controls were required to "solve the short-run problem".

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Galbraith's , , n1 efforts to control wartime prices in the United States were redoubled as a result of an envious glance north at the apparent successes achieved by the Canadian Wartime Prices and Trade Board, which had been directed first by James Coyne and then by Gordon. The variables included in the traditional approach include trade balance, price level in the country, foreign price level, volume of imports, nominal exchange rate, exports and real effective exchange rate.

The study considered balance of payments as an intermediate target of monetary policy. Furthermore, the role of capital account in the evaluation of the adjustment process of the BOP was considered; and the study found two avenues in which monetary authorities would prefer to influence the establishment of BOP. In the face of negative shock of capital outflows, the monetary authorities have two alternatives; first either reduce production in response to decline in investment, or second, use external reserves to forestall the overwhelming impact of domestic demand.

Regulating capital flows by using interest rate could compound the problem by producing negative consequences and escalate the problems in the financial sector. The study applied the unit root tests, structural breaks tests, and Ordinary Least Squares estimation techniques. The study found that Central Banks policies are highly influenced by the type of exchange rate regime of the country. Theoretical Framework of the Model. According to Khan and more recently Obadan , the Monetary Approach to Balance of Payment can be traced to the studies of David Hume and the revival of the classical price-specie-flow mechanism.

However, two principal developments spurred the uncommon upsurge in the application of MABP approach. These include the research team of the University of Chicago led by Milton Friedman and the Polak-led team of the International Monetary Fund IMF with a special interest in proffering solution to the monetary policy crises experienced by most central banks globally especially among the LDCs..

In the late s and early s, Mundell and Johnson a, b, c contributed to and developed some essential aspects of the MABP. Since then, there has been a torrent of contributions to this important theory of the balance of payment. Obadan identified the following assumptions of the MABP. First is the assumption of a small and open economy that is both an international prices of goods and interest rate taker. This implies that the small open economy is an active participant in global economic transactions and relations. Second is the assumption of perfect capital mobility and perfect currency substitution among economies involved in the global international economic relations.

This assumes that the domestic and international interest rates equilibrate but only diverge at disequilibrium. The law of one price which applies here connotes that the MABP relies on efficient global markets. Third, the MABP assumes a stable demand for money function. An addendum to this assumption is that money demand and its determinants income, prices etc are fixed overtime; and. Fourth is the assumption that exchange rates ensures that external reserves flows between countries in order to adjust to payment disequilibrium.

Essentially, the MABP is a theory of the overall balance of payments which rejects separate evaluation of the current and capital accounts. The overall BOP surplus is:. Hence both domestic and foreign assets are assumed to be perfect substitutes. Also, the MABP assumes that the balance of payment is a monetary process that hypothesizes that the disequilibrium in the BOP is a reflection of a similar imbalance existing between domestic supply of and demand for money see Khan, Owing to the hypothesized disequilibrium in the BOP, an automatic adjustment process is expected.

Obadan aptly summarises the nature of the adjustment process. First, when money supply is greater than the demand for money, the following outcomes are expected: residents in the economy that is experiencing the adjustment process are expected to experience an increase in their expenditure on foreign goods, financial assets and services with a deficit in the BOP that leads to a fall in foreign exchange reserves with an associated decrease in money supply that eventually culminates into money supply equilibrating the demand for money. Second, when the demand for money is greater than the supply of money, the followings are the obvious occurrence.

Residents will experience a drastic reduction in their expenditures on foreign assets, goods and services. The BOP will experience a surplus with increase in both foreign exchange reserves and money supply leading to equilibrium between the demand for and supply of money. The demand for money component in its fundamental formulation represents a money demand function in which the demand for real money balances is assumed to be a stable but linearly homogeneous function of a number of macroeconomic factors expressed below:.

Where is nominal demand of money balances,. Equation 2a and 2b mean that the demand for money is a function of prices, wealth or real income and interest rate. Prices and real income are hypothesized to be positively related to. This implies that the more the income that is available in the economy, the more the money that the residents will have to purchase more goods and the higher the price level, the more the money that would be required to purchase any desired asset, good or service.

Conversely, interest rate is hypothesized to be negatively related to. This implies that higher interest rates lower the volume of money people hold for transactionary and precautionary purposes. Assuming that the income velocity of money is a function of only interest rate and has invariant tendencies towards the changes in income; the demand for money balances becomes:. Where represents the inverse of velocity as a function of the interest rate and is defined as nominal income.

If the income velocity is hypothesized to be insensitive to the interest rate. The Cambridge version of equation 3 is stated as:. Where represents the ratio of the desired nominal money balances nominal income. Equation 4 says that the demand for money is a function of price and real income. Dividing both sides of equation 4 by gives the demand for the stock of real money balances as a stable, linearly homogeneous function of real income. The demand for money function expressed in equation 5 represents the domestic demand for money.

The second component of the MABP model represents the supply of money function in which the supply of money is depicted as the product of the money multiplier and the monetary base also known as high-powered money. The monetary base is expected to change as the lending capacity of commercial banks changes, in which case the increase in base money has the tendencies to expand while the reduction in base money reduces the supply of money.

Hence, the base money identity is written as:. Substituting 7 into 6 above, the money supply equation can be redefined as:. The final component of the MABP is the money market equilibrium condition often stated as:. Obadan critically analysed the conditions that almost always necessitate the adjustment mechanism that cause the condition in 8 above to occur.

The adjustment mechanism varies with the different exchange rates regimes. Under the fixed exchange rate regime, money supply adjusts to equilibrium with money demand using the channel of international flows of money via BOP imbalances. During the flexible exchange rates regime, money demand will adjust to an equilibrium position with exogenous money supply through the channel of exchange rate changes while where the exchange rate system is flexible but with intervention from the apex bank or regulatory authorities to keep exchange rate dirty float or managed float at a determined level, both the exchange rate and the international money flows experience a change.

Materials and Methods. Annual time series data for the Nigerian economy were used for the estimation of our models. The study covers the period to From the theoretical framework, the model representing the first component of MABP is specified as:. Where money balances , wealth or real income , domestic interest rate , real price level and real exchange rate are similar to , , and in model 2 above but represents the logarithm of nominal money balances, domestic interest rate, price level, real income and real exchange rate in equation Equation 10 similar to equation 2 because it hypothesizes that real money balances are positively related to real income being an increasing function of real income.

Domestic interest rate being the opportunity cost of holding money relative to financial assets is expected to be negatively related to real money balances. Obadan , Khan and, Arango and Nadiri have argued that a depreciation of the domestic currency is expected to increase the financial worth of foreign financial assets held by domestic or resident portfolio holder if they perceive this to mean an increase in their wealth. This would eventually increase the demand for money. Hence an increase in real exchange rate is hypothesized to increase the demand for money.

But if the exchange rate depreciation occurs in a debtor country such as Nigeria, the Naira value of wealth is expected to decrease and this is expected to reduce the demand for money. Therefore, exchange rate is hypothesized to be negative see Khan and Sajjid, and Khan, The second component of the MABP can be expressed mathematically in terms of money supply as:.

Equation 11 expresses money supply as equal to the sum of prices, foreign reserves and domestic credit to the economy. This also expresses money supply as consisting of external foreign reserves and domestic credit to the domestic economy components. The dollar convertible in gold became the international standard and the burden of balance of payment adjustment kept on deficit countries.

Consequently, the international monetary system was still anchored in a key-currency and featured by a hierarchical and asymmetrical nature. Hence, the IMF would help to soften the external adjustment of deficit countries, avoiding deflationary process and enabling the maintenance of trade with other countries as well as high levels of employment and income, as stated in its Articles of Agreement. In order to fulfill this function, the new institution was endowed with a treasury to which all member countries contributed.

During the conference, two views were confronted. The US insistence on limits to loans to countries running balance of payments deficits finally paid off when the Fund began limiting the duration of the IMF loans and imposing macroeconomic policy conditionalities on borrowers to guarantee repayment at the agreed dates. Therefore, actually, the IMF institutional practices have also mirrored the hierarchical and asymmetrical feature of the Bretton Woods system and US interests. These policies were defined according to a macroeconomic model called financial programming 8 , which specified a few macroeconomic identities and an even smaller group of behavioral relations connecting monetary policy variables to the balance of payments components Carvalho, ; De Vries The two last ones were mainly developed inside the IMF by economists of the research department, respectively, Alexander and Pollack As De Vries , p.

For many problems, no readily available theory or doctrine applied to which the staff could resort … Thus, the staff using its practical experiences, expanded the boundaries of economic knowledge, especially in the s and s. Hence, the policy conditionalities that were imposed on borrowers consisted mostly of fiscal and monetary contractionary policies. Lower aggregate demand should reduce imports and raise exportable output surpluses, reducing the absorption of real resources and restoring balance of payments equilibrium.

Balance of Payments

In other words, it did not assume as part of its mission to change the ways borrowing countries set their policies. The pressures coming principally from the US executive Directors pointed to the concern with the time a country could take to repay its debts and the postponement of attempts at equilibrating its balance of payments, rather than a concern with default per se and even less with shaping domestic policies in borrowing countries.

The IMF main clients were developed countries and this institution had a marginal role in the provision of international liquidity. The Marshall Plan, external procurements and the foreign external investments of US corporations enabled the financing of current account deficits and few countries needed to resort to the IMF Block, ; De Vries In this context, in parallel to traditional macroeconomic conditionalities, the Fund also defined structural conditionalities, that is, the commitment to changes in the structure of institutions and incentives of the borrowing country De Vries ; Carvalho, It also led developed countries to appeal to the international financial system for resources, in a context of floating exchange rates, instead of borrowing from the Fund.

As a result, the Fund underwent an important change of character: from a cooperative institution, where countries could be lenders or borrowers in different moments, it became a financial intermediary, in which developed countries would only be lenders and emerging countries could only be borrowers Carvalho, In the context of the Latin American debt crisis of the s, the IMF became the manager of the negotiations between private banks and borrowers countries. Therefore, the IMF programs hired by Latin American countries after the debt crisis of the s and by Latin American and Asian countries during the financial crisis of the s were programs of adjustment demand-management policies and structural reforms.

Indeed, capital account liberalization enhanced even further the role of the American dollar as international reserve currency as the US hegemony in the post-Bretton woods era has been anchored in its financial power From the beginning of the s, key IMF publications Rogoff et al. IMF , p.

Financial stability was assumed to be one of the key preconditions for liberalization, as the empirical results suggested, while financial globalization was assumed to be the best way to achieve this goal. However, it remained rather unclear regarding the interdependencies between existing low financial stability, high reform efforts in this field, and simultaneous liberalization of the capital account Priewe, As developed countries did in the s, emerging economies also tried to make sure that they would not have to appeal to the Fund and subject themselves to intrusive conditionalities.

From that point on, two unprecedented situations arose: i the IMF focused its attention on the advanced economies crisis; ii it took part in the rescue of some of these economies in cooperation with the European Commission EC and the European Central Bank ECB , the so called Troika - while until then the IMF had acted on its own. In the academic literature, the IMF was seen as prescribing such policies regardless of the specific circumstances in countries that applied for loans to overcome balance of payments or foreign exchange problems.

This perception also dominated the media coverage. A debate about macroeconomic theory and policy within the mainstream has been triggered. Recently, the IMF has been portrayed as moving toward being a critic of austerity, inequality and unrestricted capital movements. Yet, only a little part of the new analytical approach translated into practice, as Vernengo and Ford also supported With hindsight, it is clear now that this movement did not occur in a straight line.

In the following, its evolution will be traced in chronological order. The IMF became a leading spokesman for coordinating fiscal stimulus in the more dramatic drop since the Great Depression of the s.


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The final declaration of the G meeting of November in Washington promised to "use fiscal measures to stimulate domestic demand, with quick effect". We must reshape our global economic system so that it reflects and respects the values we celebrate in everyday life" Westmore, IMF Managing Director Dominique Strauss-Kahn emphasized that fiscal stimulus was being embraced as an integral part of countercyclical economic policies. As a result, "global fiscal stimulus is essential to meet the aggregate demand and restore economic growth. The IMF calls for these tax incentives to be adopted in all countries where this is possible, both in emerging economies, as in developed economies".

By saying that it could not be possible everywhere, the IMF restricted its use because "although the combination of fiscal policy and monetary policy can give significant contribution to prevent a vicious cycle of recession and deflation, some countries have restrictions on funding, while others are limited by high levels of debt".

The measures differed considerably in their scope and included broad liquidity provision to financial institutions, purchases of long-term government bonds, and intervention in key credit markets. In an IMF staff position note, Klyuev et al. This was done with an unprecedented cooperation with the EU, as many of these countries, like Hungary, Latvia and Romania, had already expressed their intention to join the euro.

In the end, the IMF had to abide with the refusal of the Latvian government to devalue their currency and their choice to pursue the path determined by the EU in return for additional loans and the perspective of accessing the euro. Their paper underlined three essential problems. When the need of an easier monetary policy arose, the nominal interest rate rapidly meets its zero lower bound, a liquidity trap situation.

Second, they pointed at the potential relevance of fiscal policy as a countercyclical tool, when monetary policy and quantitative easing reach their limits. Yet, in face of the already high levels of fiscal debt and deficit, it would be largely desirable to adopt a countercyclical approach after the crisis in order to create fiscal space. The third problem lied on the pre-crisis assumption of the non-neutrality of financial regulation in macroeconomic terms.

Based on that experience, Blanchard et al. The search for macroprudential policies was launched, driving mainstream economists to think about the architecture of post-crisis macroeconomic policy. The authors even admitted to consider non-commercial banks financial institutions as relevant agents to start or to spread financial crisis. This recommendation came in a very different setting than the immediate aftermath of the crisis.

Since the second half of , when the acute danger of another Great Depression appeared to have subsided, conservative convictions focused on fiscal consolidation came forcefully back.

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They acquired greater importance in the EU than in other advanced countries, causing considerable differences in their "post-crisis" economic policies. Hence, the Troika was created. According to Fritz et al. It is worth noting that, while historically it acted on its own or with the BIS as representative of the creditors, in the Troika the IMF operated as a minor associate for the first time in its history. The repayment of the bailout was scheduled to happen in several disbursements from May to June But it also required that most private creditors holding Greek government bonds should sign a deal accepting extended maturities, lower interest rates, and a Both rescue packages kept the country afloat and enable it to stay in the euro zone, but it came in exchange for harsh austerity measures that have deepened the Greek recession, currently in its sixth year, with skyrocketing unemployment rate.

Ireland had to agree to pay interest of 5. A new set of conditionalities was signed between the parties, providing some less stringent measures. As for Portugal, the deal carried similar conditions, but with the particularity that it had to be endorsed by the main opposition parties. They were even harsher than the requirements of the IMF to emerging countries in the s and s section 2. Here, the most peculiar feature of the nature of the crisis in the Eurozone stands up as culprit.

The members of the EMU lost the ability to issue currency and can no longer have exchange rate adjustment.

De Vries, Margaret Garritsen 1922-2009

As Aglietta , p. It imposes rigid exchange rates, regardless of their condition and underlying realities and deprives them of monetary autonomy. In these conditions, the required conditionalities lead to a much deeper economic contraction. As such, the fund said it lowered its own standards on debt sustainability, setting with the EMU too high lending levels for Greece, while not pushing hard enough on Greek debt restructuring. The report also points out that the IMF and its partners significantly underestimated how much various austerity measures, such as spending cuts, layoffs and tax increases, would impact the Greek economy, facing a deep recession and an extremely difficult time managing to pay back.

They found that, in advanced economies, stronger planned fiscal consolidation has been associated with lower growth than expected, with the relation being particularly strong substantially above 1 , both statistically and economically, early in the crisis. One key moment of the disagreement between them came during the negotiations for the second rescue package to Greece.

Spain had resisted asking for international help, after watching the requirements placed on Greece, Portugal, and Ireland.

Balance of Payments Adjustment, 1945 to 1986: The IMF Experience Balance of Payments Adjustment, 1945 to 1986: The IMF Experience
Balance of Payments Adjustment, 1945 to 1986: The IMF Experience Balance of Payments Adjustment, 1945 to 1986: The IMF Experience
Balance of Payments Adjustment, 1945 to 1986: The IMF Experience Balance of Payments Adjustment, 1945 to 1986: The IMF Experience
Balance of Payments Adjustment, 1945 to 1986: The IMF Experience Balance of Payments Adjustment, 1945 to 1986: The IMF Experience
Balance of Payments Adjustment, 1945 to 1986: The IMF Experience Balance of Payments Adjustment, 1945 to 1986: The IMF Experience

Related Balance of Payments Adjustment, 1945 to 1986: The IMF Experience



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