Eichengreen Barry - Gold Standard in Theory and History

Barry Eichengreen and Marc Flandreau

The financial globalization that followed the collapse of the Bretton Woods System opened a new chapter in the history of international monetary relations. The founding fathers of Bretton Woodsthe eminent British economist John Maynard Keynes and US Treasury official Harry Dexter White prominent among them sought to create a more perfect international monetary order conducive to financial stability and economic growth. Their system was crafted to contain destabilizing flows of hot money and to allow governments to adjust policy to domestic conditions. For a few years it seemed to work. But by the 1970s international financial markets had regained the upper hand. International capital flows seemingly unprecedented in scope first undermined fixed currency pegs. Following the transition to floating exchange rates, financial markets threatened officials seeking to avail themselves of their newfound freedom with capital flight, the collapse of the currency, and inflation. When US President Bill Clintons advisor James Carville famously remarked that if reincarnated he wanted to come back as the bond market, he was only articulating many officials sense of helplessness when confronted by a world of global finance.

Critics of the current system contend that the generalized float now prevailing provides neither the stability needed for effective international specialization nor the flexibility required for independent action. Turbulence and volatility in international financial markets disrupt firms production and investment decisions. Misaligned currencies confer arbitrary competitive advantages, evoking complaints from those who produce in competition with imports. The temporary trade restraints adopted in response are not easily removed once the exchange-rate fluctuation is reversed.

Dissatisfaction with current arrangements naturally prompts proposals for reform. Virtually all such proposals seek to limit exchange-rate variability by establishing a system of multilateral currency bands (or their variants: crawling pegs and target zones). The member states of the European Union, among whom economic integration is particularly close, have established the European Monetary System (EMS), a multilateral exchange-rate grid, to limit the variability of their currencies. Countries as diverse as Finland, Sweden, Mexico, Argentina, and Estonia have pegged their exchange rates to the currencies of major trading partners for various periods of time.

But the decision to peg the exchange rate is easier to issue than to enforce. In 19923, the European Monetary System erupted in a crisis that expelled two major participants, Italy and the United Kingdom, from its Exchange Rate Mechanism and forced the remaining countries to widen their fluctuation bands from to 15 per cent. The Mexican policy of pegging the peso to the dollar came asunder in 1994, when an attempt to realign led to a full-blown panic and financial collapse.

The implication is that pegging the exchange rate has become exceedingly difficultsome would say impossible for any length of timein todays world of liquid financial markets and quicksilver capital flows. The resources commanded by currency traders far exceed the reserves of central banks. By forcing governments seeking to defend the currency to raise interest rates to politically insupportable levels, the markets have the capacity to demolish the peg at any time.

Things may have been different under the Bretton Woods System of pegged-but-adjustable exchange rates, but this was because controls limited international capital movements, sheltering currencies from market pressures. In todays globalized capital markets, where capital controls have become exceedingly expensive to enforce, countries will inevitably gravitate toward greater exchange-rate flexibility.

The gold standard is the obvious challenge to this conventional wisdom. When it prevailed, currencies were successfully pegged against one another despite the presence of open capital markets. Yet exchange rates were stabilized within 1 per cent bands for extended periods, a record of stability that remains unparalleled even today.

Popular images of the gold standard reflect present problems as much as past realities. When the first edition of this book appeared a dozen years ago, the appeal of the gold standard was its association with price stability. Countries were just emerging from the high inflation of the 1970s. The fact that prices had been little different in 1870 and 1913 recommended the system to those who valued price stability. In the course of the last ten years, inflation was brought under better control, and its threat was superseded in the eyes of many by the problem of exchange-rate instability. Correspondingly, the appeal of the gold standard today is as a mechanism for stabilizing exchange rates and smoothing the balance-of-payments adjustment process.