A crisis 'in' or 'of' the system

Mary attended the 2013 Y20 summit in Saint Petersburg where she represented The University of Melbourne's Faculty of Business and Economics. She is a Bachelor of Commerce student and is currently studying the Sponsorship Publications officer of the Economics Association of Australia.

Abstract

The objective of this paper is to evaluate from a historical perspective whether with regards to the Gold Standard and other crises that have plagued the international monetary and financial framework, the GFC emerged within the system or as a result of the current framework. This paper highlights various reforms proposed by a \stakeholders followed by a G20 specific reform course.

Section 1 provides an analysis of former regimes, including the Gold Standard, the Bretton Woods system and the current framework with regard to key crises including the Great Depression and recent Global Financial Crisis. With consideration of the context in which each framework operated and each crisis emerged, an assessment of surrounding factors is also incorporated.

Following on from the evaluation of the current framework within Section 1, Section 2 details reform solutions ranging from those in favor of greater regulation including David Hetherington’s (of Per Capita Institutes) proposal to institute ‘Yourbank’, the international clearing union and deregulation and further flexibility in exchange rates..

Section 3 concludes the report with a G20 specific reform course to be adopted during the 2013 Russian presidency and further into the 2014 Australian presidency placing particular emphasis upon the centrality of the G20 Framework for strong sustainable growth (FSSG), the implementation of Basel III, the operation of the Financial Stability Board and the Troika to the attainment of this course of action.

Recommendations

In light of the 2013 G20 Russian presidency’s focus upon sustainable development and international financial architecture reform a reform course grounded in the operations of the G20 is proposed. Such a reform course is rooted in the G20 Framework for strong sustainable growth (FSSG), the implementation of Basel III, the operation of the Financial Stability Board and the Troika.

The centrality of the FSSG is primarily based upon its ability to facilitate international policy coordination and its operation under the G20 thereby ensuring ongoing progress and accountability. Similarly, Basel III presents an ideal opportunity to institute capital standards into domestic law and regulations on an international scale. Of particular importance is the key role in which the Basel Committee’s Regulatory Consistency Assessment Programme (RCAP) plays in manifesting the ideas posed within the Basel III report. This body ensures that the rules presented within the report are supervised, implemented within industry and analysed based upon the outcomes reached.

The Russian presidency has progressed on the issue of improving the international financial architecture. This paper seeks to evaluate areas in which this can continue throughout 2013 and into the 2014 Australian presidency. Specifically, as emphasised by Russia the G20 should work towards further increasing the efficiency and legitimacy of the IMF governance structure, the implementation of the IMF's 2010 Quota and Governance Reform, doubling the IMF quota resources and reviewing the IMF quota formula in a manner that reflects the weights of its members, strengthening the IMF surveillance framework and multilateral analysis. Australia as a member of the Troika plays a key role in the continuation of strengthened and consistent reform to the current architecture.

Introduction

In August of 1971, recognising what he perceived to be necessary reforms to an urgently needed new international monetary and financial system (IMFS), US President Richard Nixon announced the suspension of the dollar’s convertibility to gold. This pivotal moment in history referred to as ‘The Nixon Shock’ marked the breakdown of the Bretton Woods System and culminated in the formation of the current international monetary and financial system. Nixon argued for this resolution on the basis of the need for more jobs, to stop the rises in costs of living and to stop attacks on the dollar by financial speculators.

Approximately 40 years on and in the wake of the GFC, unemployment has peaked at record levels across the globe, inflation continues to plague various economies and speculation remains an enduring risk to financial stability . The (IMFS) is yet again at a critical juncture in its course.

An evaluation of the effectiveness of the former international monetary and financial systems is conducted. This ranges from the Gold Standard which involved member nations fixing their currencies to gold, the Bretton Woods system which was characterised by fixed yet adjustable nominal exchange rates to the current framework or lack of framework dubbed by its critics. Each regime is evaluated in reference to the extent to which the crisis, thriving upon the flaws within the system, developed due to the financial architecture in place and the manner in which the shock was absorbed resulting in the collapse or recovery of each respective regime.

This evaluation into the International Monetary and Financial Framework will source the foundation of reforms outlined and examined within the latter portion of the paper. These reforms range from support for further deregulation and flexibility in exchange rates as proposed by Dadush and Eidelman (2011) 1. This is followed by an examination of the Bretton Woods Projects call for a Keynesian-inspired international clearing union eradicating the need for self-maintained foreign exchange reserves but rather a pool of reserves that are managed by the clearing union on an international scale. The final reform highlighted includes Per Capita Institute’s proposal to institute a ‘Your Bank’ Initiative within Australia offering ‘vanilla’ deposit and transaction products intending to offer lower-cost, no-frills banking services thereby addressing the anti-competitive nature of the banking sector and the ‘too big to fail’ dilemma. Data is obtained from various sources including the IMF’s World Economic Outlook Database (2011).

Finally, a G-20 specific reform course is highlighted to be adopted during the 2013 Russian presidency and further into the 2014 Australian presidency placing particular emphasis upon the centrality of the Troika to the attainment of this course of action. This recommendation places particular emphasis upon the G20’s Framework for Strong, Sustainable and Balanced Growth.

Section 1: Historical Survey of former regimes with regard to key crises

An evaluation of the effectiveness of the past and present international monetary and financial systems is conducted through an examination of the central crises that have emerged during their respective sovereignties particularly assessing the extent to which the crisis thriving upon flaws within the framework developed due to the financial architecture in place and the manner in which the shock was absorbed resulting in the recovery or collapse of each system .

In accordance with previous studies, this paper defines financial crises as events involving bank runs, dramatic rises in default rates followed by large losses of capital resulting in government intervention, bankruptcy, or compulsory merger of financial institutions (Gorton, 2012)2.

1.1 The Gold Standard

An evaluation of the Gold Standard is undertaken with respect to the Great Depression . This evaluation encompasses the extent to which the cause of the Great Depression was systematic and consequently attributed to flaws within the Gold Standard framework, the manner in which the system absorbed the shock and its recovery.

The Gold Standard which underpinned the international monetary framework approximately between 1870 through to 1944 was a monetary system theoretically characterised by utilising a fixed quantity of gold as the standard economic unit of account (International Monetary Fund, 2013)3.

According to Bernanke and James (1991)4, the value of a given currency under this system equated to the credibility of the government to maintain that standard as opposed to its theoretical value: a fixed quantity of gold. Therefore, the Gold Standard was prone to speculative attacks. As such it is asserted that this inherent flaw in part fostered a series of events detailed below that eventually culminated in the development of the Great Depression.

Accordingly, Bernanke and James (1991)5 claim that due to hearsay as to whether the pound and later the dollar would become devalued, volatility in capital flows heightened . Whilst Britain surrendered to speculation, abandoning gold in 1931, the US clung to the Gold Standard adopting an approach instead of contractionary monetary policy which increased interest rates and fostered an environment in which other economies raised interest rates to entice capital inflows. As the demand for safer assets, namely gold rose, its relative value increased. This was problematic as the principle concept underlying the gold standard framework required a fixed quantity of gold to equal a fixed amount of currency which was in this case, the dollar. Essentially this necessitated a drop in the value of the dollar as the value of gold increased. The successive devaluations of the dollar and other currencies lead to deflation. The longer a country clung to this system the greater the deflation experienced. During a period of reduced output, this magnified the severity of the crisis particularly adversely affecting prices, output and unemployment.

Subsequently, Japan, Denmark and various other Scandinavian countries deserted the Gold Standard in 1931 and were followed by the US and Italy between 1932 and 1933. The regime eventually collapsed following the France-led gold block’s (the remaining seven nations that held the gold standard during the great depression) abandonment of the system.

The limitations of the Gold Standard framework were critical to the development of an environment in which the Great Depression emerged. Further to this, as propagated by Bernanke and James (1991)6, it also inflamed the severity of the crisis, thereby prolonging the recovery stage and culminating in its collapse.

1.2 Bretton Woods System

The Bretton Woods framework which functioned between 1944 and 1971 encompassed a system of fixed yet adjustable nominal exchange rates. Although the framework eventually collapsed it saw the establishment of a system of rules, institutions, and procedures to regulate the international monetary system, including the formation of the International Monetary Fund (IMF) and the World Bank. According to Schularick and Taylor (2012) the frequency of crises within the Bretton Woods era was virtually zero, when liquidity hoards were plentiful and leverage was low. Alternatively, post 1971 as the BWS was dismantled and the current framework emerged, these conditions no longer existed, giving rise to the development of frequent crisis .

Bush, Farrant and Wright (2011) 7highlight that the period in which the BWS functioned coincides with remarkable financial stability and sustained high levels of global growth. However, it must be noted that this does not encompass causality. Specifically it is difficult to ascertain as to whether the BWS was successful in delivering prosperity and financial stability, or whether it was successful due to operating during a period of prosperity and financial stability. They emphasize that the short 24 year period in which it existed lends credibility to the latter relationship.

Unlike the eventual deterioration in the Gold Standard framework which was catalysed by the effects of the Great Depression, Bush, Farrant (2011)8 suggest that the BWS collapsed due to inherent flaws in its design. They specifically identify the cause to be the constraints on global liquidity caused by the restricted supply of gold and the size of US balance of payments deficits. This occurred as global demand for reserves had to be met through increased US external liabilities. This in conjunction with high levels of inflation which were passed onto other economies through their exchange rate pegs prompted the floating of the US currency, effectively ending the Bretton Woods system.

Evidently, although the BWS era is an anomaly in that it was not subject to a major crisis during the period in which it operated, as argued by Bush, Farrant (2011)9 the prosperity and financial stability achieved during the time in which it operated may have in fact fostered the success of the BWS as opposed to resulting from it.

1.3 The Current Framework

An evaluation of the current framework is taken with respect to the Global Financial Crisis. This evaluation encompasses the extent to which the cause of the crisis can be attributed to flaws within the current framework and the manner in which the system absorbed the shock..

The Global Financial Crisis which is broadly accepted to have been instigated largely by the bursting of the US housing bubble, and to a lesser extent due to a large US trade deficit and high levels of foreign investment from China into US firms is rooted deeper in the fundamental flaws within the current international financial framework. The financial crisis that originated in the US spread to other economies swiftly through free flow of capital on institutionalized financial markets. The current framework has facilitated increased net capital flows; however, this has been accompanied by the build-up of large imbalances between countries and stock imbalances (liang, 2012)10. This high level of capital mobility is correlated with high incidences of banking crisis as shown in Figure 1.

Further to this, increased levels of current account deficits are also correlated to an increased probability of banking crisis modelled as shown in Figure 2.

Section 2: Reforms posed to the current framework

The current framework has prompted various reform solutions from a vast spectrum of interested stakeholders. A select few reform solutions are proposed beginning with support for further deregulation and flexibility in exchange rates as proposed by Dadush and Eidelman (2011)11. This is followed by an examination of the Bretton Woods Projects call for a Keynesian-inspired international clearing union eradicating the need for self-maintained foreign exchange reserves but rather a pool of reserves that are managed by the clearing union on an international scale. The final reform highlighted includes Per Capita Institute’s proposal to institute a ‘Your Bank’ Initiative within Australia offering ‘vanilla’ deposit and transaction products intending to offer lower-cost, no-frills banking services thereby addressing the anti-competitive nature of the banking sector and the ‘too big to fail’ dilemma.

2.1 ‘Your Bank’ Initiative

A key issue within the financial sector specifically within Australia is the oligopoly market in which the ‘Big Four’ banks namely CBA, ANZ, Westpac and NAB operate. The current regime has facilitated an environment in which the ‘bir four’ possess enough market power and influence such that they take larger risks at the expense of the government whom they expect will bail them out. As a potential source of competitive pressure the following reform solution is proposed.

Hetherington’s principle recommendation of the report titled “What Price Stability? Market design in the Australian banking sector” (2012)12 targeted at rectifying the ‘too big to fail’ dilemma within an Australian context is a new publicly owned bank specifically named YourBank, offering ‘vanilla’ deposit and transaction products . By offering lower-cost, no-frills banking services its key objective is to provide an alternative to the ‘Big Four’ banks that practice a near monopoly with the Australian market. It would mirror the services provided by the Commonwealth Bank up until it was privitised between 1991-1996 This would be manifested as an online service thereby enabling it to deliver services cost-effectively and would underpin its ongoing commercial viability.

Hetherington (2012)13acknowledges that the ‘YourBank’ proposal involves public costs, specifically establishment costs and lowered profits from taxing of the banking sector. However, he asserts that costs will be outweighed by the commercial profits and lowered banking costs to consumers and businesses. Additionally, Hetherington recommends that banks be subject to mandatory mortgage default insurance hence removing the moral hazard of the implicit guarantee by making explicit the costs of insurance.

2.2 Bretton Woods Project

The Bretton Woods project, as its name suggets, is in favour of returning to a Bretton Woods style regime. Specifically, the BWP committee propose the establishment and operation of an international clearing union (Chowla, Sennholz and Griffiths, 2009) 14.They assert that it would eliminate the need for self-maintained foreign exchange reserves through a process in which reserves are pooled together and managed on an international scale by the clearing union. In doing so the international clearing union which would assume the role of a central bank, would issue its own currency, a unit of exchanged dubbed the bancor which would be allocated to countries on the basis of imports and exports.

The essential objective of instituting an international clearing union is to prevent competitive devaluations, mitigate the deflation that stems from surplus countries unwillingness to stimulate aggregate demand for deficit countries.

The authors of this proposal argue that its implementation would assist stabilisation of international exchange rates, prices of commodities, reduce global imbalances and encourage international economic cooperation, whilst also reducing vulnerability to crisis.

2.3 Deregulation and Further Flexible Exchange Rates

Alternatively, reforms have also encompassed calls for maintenance of the current framework of the international monetary and financial system. This course of action as supported by Dadush and Eidelman (2011)15 refers to the considerable benefits that deregulation has proposed.

It is asserted that the current framework facilitated rational adjustments during a historic downturn. The key principle underlying their proposal is that the framework operates successfully rather domestic policy must adjust accordingly. Evidence indicates that exchange volatility is less than during those periods which preceded the collapse of former regimes. Dadush and Eidelman (2011)16 allude to statistics indicating a mere seven of the forty largest economies experienced an appreciation in their real exchange rates by more than 10% from pre-crisis ten-year averages .

They argue that the current framework has therefore proved itself resilient enabling each country to respond to their individual circumstances in an appropriate manner including through either temporarily or permanently adopting a more flexible exchange-rate regime. It is based upon this notion that they assert that the ramifications of the crisis are a result of each countries response not the framework in which they operate.

Possible reform solutions proposed therefore encompass further flexibility in the Chinese renminbi thereby allowing for a reduction in tensions , a greater role in reserves and currency appreciations. However of greater significance to their proposed reforms is the return to a stable, sustainable and fiscally sound growth path for the US and Eurozone allowing for a return to normal levels of international interest rates and restore confidence in main reserve currencies.

Section 3: G20 Specific reform course

In light of the 2013 G20 Russian presidency’s focus upon sustainable development and international financial architecture reform a reform course grounded in the operations of the G20 is proposed. Such a reform course is rooted in the G20 Framework for strong sustainable growth (FSSG), the implementation of Basel III, the operation of the Financial Stability Board and the Troika.

The centrality of the FSSG is primarily based upon its ability to facilitate international policy coordination and its operation under the G20 thereby ensuring ongoing progress and accountability. Similarly, Basel III presents an ideal opportunity to institute capital standards into domestic law and regulations on an international scale. Of particular importance is the key role in which the Basel Committee’s Regulatory Consistency Assessment Programme (RCAP) plays in manifesting the ideas posed within the Basel III report. This body ensures that the rules presented within the report are supervised, implemented within industry and analysed based upon the outcomes reached.

The Russian presidency has progressed on the issue of improving the international financial architecture. This paper seeks to evaluate areas in which this can continue throughout 2013 and into the 2014 Australian presidency. Specifically, as emphasised by Russia the G20 should work towards further increasing the efficiency and legitimacy of the IMF governance structure, the implementation of the IMF's 2010 Quota and Governance Reform, doubling the IMF quota resources and reviewing the IMF quota formula in a manner that reflects the weights of its members, strengthening the IMF surveillance framework and multilateral analysis. Australia as a member of the Troika plays a key role in the continuation of strengthened and consistent reform to the current architecture.

Conclusion

Through this juxtaposing evaluation of the effectiveness of the IMFS ranging from the Gold Standard, the Bretton Woods system and the current framework with respect to crises including the Great Depression and the Global Financial Crisis, a broader understanding of the relative advantages and disadvantages to the current framework . This has sourced the foundation of reforms outlined and examined within the latter portion of the paper.

These reforms range from support for further deregulation and flexibility in exchange rates as proposed by Dadush and Eidelman (2011) . This is followed by an examination of the Bretton Woods Projects call for a Keynesian-inspired international clearing union eradicating the need for self- maintained foreign exchange reserves but rather a pool of reserves that are managed by the clearing union on an international scale. The final reform highlighted includes Per Capita Institute’s proposal to institute a ‘Your Bank’ Initiative within Australia offering ‘vanilla’ deposit and transaction products intending to offer lower-cost, no-frills banking services thereby addressing the anti-competitive nature of the banking sector and the ‘too big to fail’ dilemma. Finally, this paper highlighted a G-20 specific reform course to be adopted during the 2013 Russian presidency and further into the 2014 Australian presidency placing particular emphasis upon the centrality of the G20 Framework for strong sustainable growth (FSSG), the implementation of Basel III, the operation of the Financial Stability Board and the Troika to the attainment of this course of action.

Bibliography

Bernanke, B, James, H., ‘The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison’ the National Bureau of Economic Research, 1991, pp. 33 – 68,

Chowla, P.,Sennholz, B., and Griffiths, J.,’Dollars, devaluations and depressions: How the international monetary system creates crises, 2009

Dadush U., Eidelman V., ‘The international monetary system: If it ain’t broke, don’t fix it’, VoxEU.org 2011

Gorton, G, 2012. Some Reflections on the Recent Financial Crisis, Trade, Globalization and Development: Essays in Honor of Kalyan Sanyal, 2012

Hetherington D,. What Price Stability? Market design in the Australian banking sector, Per Capita Institute Publications, 2013.

International Monetary Fund, 2013. The end of the Bretton Woods System (1972–81) International Monetary Fund, 2013

Liang, Y, Global inbalances and Financial Crisis: Financial Globalisation as a Common Cause. Journal of Economic Issues, 2012., XLVI/2, 353-362.

O. Bush, K. Farrant 2011. Reform of the international monetary and financial system, Financial Stability Paper, No. 13, 1-24.

 

Appendix