International Monetary Policies, Interdependence, and Debt

INTERNATIONAL MONETARY POLICIES, INTERDEPENDENCE, AND DEBT Enzo GrMi .S THE BRETTON WOODS SYSTEM OF FIXED EXCHANGE RATES was breaking down in the late 1960s and early 1970s, was believed that a system of flexible exchange rates would afford member countries a higher degree of monetary independence. Freed from the balance-of-payments (read balance-of-trade) equilibrium constraint, monetary policy could have been directed to the achievement of domestic objectives, most notably the desired degree of internal price stability, independent of that of the rest of the world. Greater autonomy in national monetary policies and less interdependence in inflation (and perhaps output) rates were expected to be the main benefits of more flexible exchange rates. Moving away from fixed exchange rates would not only have reduced the "common currency standard" characteristics of the Bretton Woods system and the strong economic interdependence implicit in it, but would also have lessened the policy conflicts arising from the perceived asymmetry in the sharing of adjustment burdens between balance of payments deficit-prone and surplus-prone countries. It would have, in addition, reduced the "exorbitant privilege" retained by the reserve issuing country (the United States), whose degree of monetary autonomy was unparalleled within the system. It was also thought that the preservation of the liberal trade system developed in the post-World War II era would be made easier with a more automatic balance-of-trade adjustment mechanism in place. Enzo Grilli is assistant director of the Economic Analysis and Projections Department of the World Bank and professorial lecturer at SAIS. The opinions here expressed are those of the author and should not be attributed to the organizations with which he is currently affiliated. 11 12 SAIS REVIEW The world moved towards a more flexible exchange-rate regime by leaps and bounds after 1971, but neither the degree of monetary interdependence nor the sources of policy conflicts among major members of the international monetary system have appreciably diminished. In fact, the degree of monetary interdependence, as exemplified by the increased correlation of price and interest-rate changes across countries, was greater in the 1970s than in the 1960s and has become even stronger in the 1980s. Monetary authorities have faced different types of internal economic conflicts when they attempted to use monetary policy to attain domestic targets. When they tried to direct monetary policy against inflation , currencies tended to appreciate strongly, placing a large part of the burden of strong anti-inflation policies on those sectors of their economies most exposed to international competition. When, instead, they tried to use monetary policies to sustain economic activity and employment, the constraint turned out to be an increase in the rate of domestic inflation, directly and/or via depreciating currencies. Given the divergence in the economic targets being pursued at times by the various members of the international monetary system and, more recently, the differences in their fiscal-monetary mixes, serious external policy conflicts also arose. Developing countries, for example, saw in the global deflationary bias of the anti-inflationary policies pursued by the major industrial countries in 1979-81 the main cause for the emergence of the debt crisis in 1982. They contended that a collapse of world demand for their exports, coupled with high rates of interest, transformed a manageable medium-term problem into a near unmanageable short-term crisis, which required on their side unnecessarily high internal adjustment costs. Serious policy conflicts also arose between industrial countries. European governments saw the main cause for their monetary impotence in the monetary-fiscal mix pursued by the United States in the 1982-84 period. In their view, ever higher dollar values, the result of restrictive monetary and expansionary fiscal policies in the United States, prevented them from relaxing their monetary stance in the face of domestic economic stagnation and rising unemployment. The rest of the industrial world felt in those years that its policy options were constrained by the effects of policy initiatives of the largest member of the international monetary system, and the one whose currency continued to play in it a key role, not only as a generalized vehicle for real transactions, but also as an international asset. No exchange-rate system can...