The European Monetary System: A Quest for Stability

THE EUROPEAN MONETARY ______ SYSTEM: A QUEST FOR STABILITY Mark S. Thorum ? "uringthe last decade, the West has witnessed the greatest economic turmoil since the crisis of the 1930s. The OECD countries have experienced , in rapid succession, currency disturbances that forced a change from fixed to flexible exchange rates; a precipitous increase in international oil prices; a substantial change in the balance-of-payments position of OECD members; the worst recession in 40 years; and the difficulty of sustaining economic growth without fueling inflation. These problems have led to additional negative developments—monetary instability, creeping trade protectionism, energy shortages, and the growing gap between developed and developing nations—all magnified by a globally interdependent economy in which monetary shocks and disturbances are quickly transmitted internationally. Nowhere else is this more evident than in the foreign exchange markets, particularly with regard to the U.S. dollar. So interdependent are the exchange rates of the world's principal trading nations, and so dominant the dollar in the international financial order—or disorder—that it would be illusory to contend that the new European Monetary System (EMS) and the U.S. dollar each functions in a sphere unto itself. Yet their essential relationship remains to be defined. In this context, it is useful to look at some ofthe major factors in the international monetary crisis that prompted the Europeans to pursue a monetary union, and to consider the possible implications of the EMS for the monetary system in general and U.S.-European relations in particular. Mark S. Thorum received the MA. degree from SAIS in May 1981, having also earned a diploma from the Institut d'Etudes Politiques de Paris. He has served as a research assistant with the International Atomic Energy Agency and with UNESCO. 171 172 SAIS REVIEW From the end of World War II to the late 1960s, the West enjoyed a climate of relative monetary stability based on the U.S. dollar as the principal source of global liquidity. The various currencies were exchanged at fixed rates based on their dollar value. Foreign governments and central banks used the dollar as their major reserve asset. Commodity prices were expressed in dollars. In short, the U.S. dollar served as the vehicle currency in the world monetary system. The dollar's rise in the international monetary system was a necessary development. The European countries emerged from the war in a disastrous economic state: inconvertible and depreciating currencies, inflation, and a shortage ofgold and currency reserves. In contrast, the dollar was freely convertible and backed by large gold reserves. An additional factor was the failure ofthe architects of the Bretton Woods system to provide explicitly for the systematic creation of sufficient global reserves to meet the growing liquidity needs of expanding international trade and investment. The increase in the supply of gold was insufficient to this end and the infant International Monetary Fund, with its modest resources, played a minor role in supplementing international liquidity. The responsibility of performing the duties ofa world central bank thus fell upon U.S. monetary authorities. Ofthe $8.5 billion increase in global reserves during the 1949-1959 period, the United States furnished $7 billion through the increase in its liabilities to foreign monetary authorities. During the reconstruction of Europe, the dollar became all the more sought after because only America could provide the necessary goods for the rebuilding of Europe. Europe's special relationship with the United States had been characterized by fixed exchange rates; a fixed gold price; the pursuit by all, including the reserve currency nations , of balance-of-payments equilibrium; and a policy of free trade. The dollar's role as the primary reserve currency conferred special privileges on the United States—the ability to avoid costly adjustment measures; the ability to finance past and future deficits cheaply through the benefits ofseigniorage; and the politico-economic influence afforded by the ability to lend to other nations. More importantly, however, overall deficits deriving from the combined effects ofcurrent and capital account transactions could be settled in a vehicle currency ofwhich the U.S. monetary authorities had an unlimited quantity—dollars. So long as other nations were willing to accumulate dollar claims...