Ever since the collapse of the Bretton Woods architecture, the world monetary system has been torn between two conflicting forces. The more powerful of the two is the concept of flexible exchange rates, which established itself in the ideological climate of economic liberalism that gave it legitimacy. The other, somewhat weaker force originates in the belief that total exchange-rate flexibility is harmful to economic growth and free trade. It has prompted the many empirical attempts to stabilize the system and-most important-it has led to the creation of the euro.
The yet unsettled debate between these rival concepts has acquired a fresh intensity. The quickening pace of globalization gives even greater urgency to the underlying question: Can a globalized economy function in the long run without a global currency? Implicit in this query is a crucial choice between two alternatives: Will the dynamics of globalization lead to the establishment of a world monetary system, or will monetary fragmentation eventually trigger a reversal of globalization? This debate seems academic during quiet spells-but flares up at the slightest tremor. In truth, monetary calm is an illusion: somewhere, there is always an imbalance that needs clearing. The crisis in the emerging and transition economies provides a sobering reminder: to my mind, it illustrates the harmful consequences of the present shortage of international monetary cooperation.
It is up to our nations-foremost among them the United States and the European nations-to remedy that deficiency. I am among those who are convinced that the advent of the euro creates ideal conditions for a revival of global monetary cooperation. It is a historic opportunity that a revamped G-7 should seize in order to establish financial stability. Without the latter, the gains of globalization may be jeopardized by rising protectionism-a phenomenon whose sporadic manifestations are already visible.
Let me begin with a discussion of the three lessons I have drawn from the Asian crisis-since, in many respects, this crisis is truly emblematic.
Some observers see it as a crisis of market principles and of unrestricted capital movements. Others, by contrast, see it as a crisis of government interventionism. Still others read it as a crisis of the international financial institutions. In other words, the global market, public policies, or multilateral financial actions are to blame-depending on which interpretation one chooses. Curiously, these different points of view run across conventional schools of thought and political trends. I think there is a good reason for this: the Asian crisis is, in fact, the outcome of an interaction between the failings of markets, the failings of governments, and the failings of the international monetary system.
The international capital market has an unquestionable responsibility in the Asian crisis. International investors-chiefly the commercial banks-agreed to invest in Asia without measuring the risks incurred. They fueled speculative bubbles in the emerging Asian economies even as the region was suffering a loss of competitiveness and a credit explosion. When the crisis erupted, the investors-with the commercial banks once again in the lead-abruptly pulled out. The local exchange rates and real economies overreacted, costing the Asian countries an estimated average 7-8 points of GDP. The scale of this overreaction was certainly unwarranted, since it was partly corrected a few months later. This is a far cry from the rational capital movements-with their stabilizing virtues-described in political-economy textbooks. The markets are intrinsically imperfect, as is their information.
Governments, too, bear a major responsibility in the Asian crisis. International investors were deluded by the economic distortions that the Asian governments had introduced (or had allowed to develop) in the workings of local markets. Such distortions include unsuitable exchange rates defended by the monetary authorities, implicit guarantees to investors in the absence of financial-sector regulation, and tax breaks or other benefits reserved for certain business sectors. The result was an inefficient allocation of resources, of which South Korea-despite its unquestionable professionalism in some areas-probably provides the best illustration. Again, this bears little resemblance to the enlightened state that the Asian model's defenders offered us as a benchmark before the crisis. Governments are neither omniscient nor always benign. With excessive interventionism, they prove to be poor investors in the long run, occasionally corrupt, and often captive to pressure groups.
Multilateral institutions also must shoulder some of the blame for the crisis we have just experienced. Their interventions have not always been appropriate for preventing the recent crises or indeed for solving them. They may have encouraged governments and local banks as well as international investors to take excessive risks in the emerging countries. The application of predetermined solutions may also have helped aggravate the crises under way. Most important, however, the international community has tended to intervene belatedly because of the decline of the G-7 and the problems this created for international monetary cooperation. The efficiency of the multilateral financial institutions was severely undermined as a result.
The combination of these three factors seems a plausible explanation for the escalating intensity of the crises and the ever-greater resources that the international community has had to deploy to deal with them. In my view, however, the decline of the G-7 and of monetary cooperation bears a special responsibility in this development. The decline has substantially weakened the scope of preventive action by the multilateral financial institutions in response to governments' economic policies and to unstable investor behavior. Countries whose financial systems had not been adjusted were allowed to lift all controls on capital movements with the rest of the world, and in some cases they were actually encouraged to do so.
What is to be done in these conditions? We might be tempted to take the easy way out-namely, to let the present low-cooperation situation prevail. The argument would be that the world's rising monetary and financial instability is due to fixed exchange rates and the support they have received from the international community, notably the International Monetary Fund. The corollary of this position is that strict curbs should be placed on IMF interventions. In a universe in which all agents were perfectly informed, we might assume that this recipe would ensure international monetary and financial stability-provided that economic policies converged. But we know that this is not the case. In practice, policy convergence-whether in the monetary or the fiscal sphere-has not proved to be a sufficient guarantee of monetary stability.
The alternative solution would be to strengthen international monetary cooperation, and the focus should be on exchange rates. Not that exchange rates should be manipulated-quite the contrary. However, they do exhibit three characteristics that make them irreplaceable as tools of international monetary cooperation. First, they are, by nature, variables of common interest. Second, as relative prices of currencies, they provide reliable confidence indicators for the economic policies carried out in the different currency zones. Third, exchange rates are valuable signals of economic imbalances.
This leads us to recommend a reform of the system aimed at providing greater stability-but without introducing a "fixed factor" that could compromise the growth of unsynchronized economic regions. Several approaches are possible here. They all hinge on the notion of a cooperative effort focused on the dollar-euro link, which forms the basis of the international monetary system. This implies an intensive dialogue between US and European authorities.
The first purpose of the cooperation should be to address the following question: What is the desirable fluctuation band for the dollar against the euro, in view of the goals stated earlier? If this question is left unasked, which is the case today, then there is a strong risk that the system will continue to drift-sparking financial crises such as those we have seen in recent years. The form such cooperation would take can be more or less coercive.
The most ambitious form would be to adopt "target zones," as Fred Bergsten advocates. The agreement would specify the fluctuation bands around central rates for the euro, the dollar, and the yen, which would be regularly adjusted to reflect differentials in inflation and in economic fundamentals. The central rates would be chosen so as to ensure the economies' internal and external balance. The band should be wide enough (10-15 percent) to absorb the exchange-rate variations due to short-term economic fluctuations. It would be made public in order to confine central-bank interventions to situations involving severe imbalances. The central banks would be obliged to intervene at the margins.
A less ambitious variant of target zones would be to adopt the principle of compulsory action when the exchange rates approach the fluctuation limits, but without making public the central rates and the fluctuation bands. This is the solution that most closely resembles the Louvre Accords of 1987. In practice, it is more flexible than the first option, as it leaves the monetary authorities some leeway for deciding when and how to act, while keeping their credibility intact since they would be making no public commitments.
The establishment of target zones seems desirable to me, as they are the only credible framework for organizing currency fluctuations. The problem with target zones, however, is that they have not won any consensus in the G-7 or among experts. One objection to them runs as follows. Introducing fluctuation bands would admittedly reduce the volatility of forward exchange rates relative to spot rates. But the bands' credibility would be heavily eroded by the inability of the central banks to commit themselves to unlimited intervention at the margins. A second counterargument is that target zones could foster "self-fulfilling" speculative attacks because the defense of the bands creates a conflict between the monetary authorities' domestic and external goals, undermining the credibility of the latter. In truth, it is the lack of consensus between the major monetary powers that limits the credibility of target zones-not the target zone's lack of credibility that prevents a possible consensus.
In the short run, if a G-7 agreement on target zones seemed too difficult to reach, the minimum requirement would be to agree on "reference parities": any overstepping of these boundaries would oblige governments and central banks to decide on concerted action without awaiting the next official G-7 or IMF meeting. This would be a significant step forward from the present arrangement, which requires no consultation. The reference exchange rates would not be made public, and they would be regularly adjusted to reflect changes in economic fundamentals.
Thus, even if no consensus emerges on target zones, there are ways in which international monetary cooperation can be dramatically strengthened even today. Steps can be taken in a flexible manner, progressively leading to more ambitious solutions-such as target zones-as mutual confidence develops between G-7 governments and central banks.
It must be emphasized, however, that the quality of the cooperation depends on the quality of the currencies. Unfortunately, studies on the monetary policy of governments and central banks seldom address this quality issue. The monetarist arguments for regulation through quantitative management of the money supply have exerted such intellectual dominance that the quality of the currency is almost never discussed any more. In the past, it was inherently demonstrated by the functioning of the gold standard. While the issue may seem less urgent in the leading industrialized nations, the same is not true of the emerging economies.
Improving the quality of currencies requires closer multilateral monitoring. The first step is to improve our knowledge of the emerging economies thanks to the application of recognized accounting standards, the creation of a reliable statistical system, and an effort on the part of these countries to engage in continuing dialogue with their creditors. It would also be desirable to ensure a wider dissemination of the IMF's macroeconomic studies, naturally without violating the confidentiality of the information provided by national governments.
Improving the quality of currencies also calls for tighter financial discipline in the countries that have liberalized their capital movements. I am referring not only to the control of public expenditures and deficits, or the creation of "central-bank money"-a precondition for monetary stability. In the countries that have opened up to capital flows, international cooperation must also tackle the conditions in which broad money-i.e., bank credit-is created. It is especially urgent to reach agreement on stricter prudential rules than those prevailing today. On this point, the consensus among experts is sufficient to allow the rapid adoption of effective measures within the setting of the Financial Stability Forum. The IMF and the World Bank should be explicitly mandated to direct the implementation of these measures, and should be given the resources to incite compliance by the countries concerned. These basic prudential rules should cover the transparency of banking-sector and corporate accounts, bad-loan provisions, and the capital-adequacy ratios laid down for each category of receivables. To this array should be added the introduction of an effective bankruptcy law and a deposit insurance system.
The notion of giving more favorable treatment to the "virtuous" countries that agree to observe these rules and to conduct sound macroeconomic policies is attractive, although it should be implemented with caution. The recent decision to open a credit line for "virtuous" countries hit by a "contagion" effect is a first step in this direction. The political dimension of the issue would, of course, require the active involvement of the G-7 in defining the incentives and their linkage to macroeconomic and financial monitoring of countries.
The Asian crisis once again raised the issue of the special responsibility of movements of short-term capital. Admittedly, short-term capital does more than fuel speculation; it is also one of the normal means of financing economic activity. However, in countries where the financial system has not been cleaned up, the flows tend to amplify monetary crises with a singular force. In these countries, the adhoc imposition of capital exit controls during a crisis is surely not a good idea, because it is a unilateral and blind move. The notion of a modest, worldwide tax on all cross-border capital movements-advocated by the economist James Tobin-is not shocking in principle, but highly problematic in its efficacy. By contrast, the Chilean solution of "taxing" capital inflows in vulnerable countries does not involve the same difficulties. The IMF should therefore examine these options in greater detail.
These various measures still do not address the moral-hazard risk, which, unless we are careful, could prove devastating in the longer run. The international community's financial support for crisis-hit countries serves mainly to reimburse private creditors. The risks incurred by the latter are therefore, in the last resort, partly covered by the international community. This is an unwelcome incentive to financial imprudence.
The solution consists in involving private creditors more extensively in settling crises. However, since such loans are contracts governed by private law, the involvement must obviously be arranged-in principle-on a voluntary basis. As an inducement, creditors who agree to join in a restructuring program could be offered particularly attractive guarantees. The presence of multiple creditors is not an obstacle to this "bail-in" approach: in the recent crisis, commercial banks-far less numerous than bondholders-were responsible for 80 percent of the sudden capital outflows. The solution was applied to Mexico in 1982 and, although more timidly and belatedly, to South Korea in 1997 and Brazil in 1999.
Nevertheless, in the event of an unusually severe crisis requiring international assistance, we should not rule out the possibility of imposing a coherent restructuring of all debt categories. Only the IMF and the Paris Club, of course, would have the power to force a debt restructuring on private creditors. Moreover, loan contracts should include a clause allowing such restructuring under an international aegis if a serious crisis occurs. It should be emphasized that it is in the collective interest of private creditors for a third party to order a restructuring when the risk of financial panic is high.
Before concluding, I would like to return for a moment to what, in my view, constitutes the historical responsibility of the G-7.
Today, it has become fashionable to criticize the IMF and to blame it, if not for the crises themselves, at least for the scale of the recent episodes. This was not the case a few months ago. It should be remembered, however, that the IMF's actions in Asia, Russia, and Brazil were carried out with the full backing of its board of directors-that is, of its member states, notably the G-7. It is all the more inappropriate for G-7 countries to attack the Fund today, as they were ultimately responsible for the international monetary and financial order; they failed to take on that duty owing to the vain disagreements among themselves and between their governments and central banks.
As a result, the G-7 has not sufficiently adapted to the new global economic environment, in particular the explosion of international capital flows and the rise of the emerging economies. As Fred Bergsten rightly emphasizes, the G-7 has a special responsibility in the playing field without rules, constraints, or sanctions that has been built on the ruins of the Bretton Woods system. The G-7 must now fill this gap by contributing rapidly and decisively to the development of a new international financial architecture.
First, the G-7 must define a more coherent set of operating rules for the IMF. It must give the Fund the means to act, particularly by granting it broader authority to negotiate with countries that come to it for help; the G-7 also must increase the IMF's financial resources. After the quota increases now under discussion, IMF resources measured against international trade volume will stand at only 11 percent of their 1945 level: this does not make sense.
Second, the G-7 must reform itself in order to take better account of the interests of the emerging economies and to achieve the flexibility needed to adjust to global change without being paralyzed by short-term conflicts of interest. In particular, the G-7 structure needs revamping in order to separate the activities concerning relationships between the two or three main currencies (euro, dollar, and the yen) from broader initiatives requiring an adequate representation of small and emerging countries.
The establishment of these new ground rules must rest on close cooperation between the main industrialized countries, at government and central-bank level. Indeed, their governments and central banks must be fully aware that their international responsibilities, in an open economy, are simply an extension of their domestic obligations. Under such conditions, the international monetary system will be able to gain strength and meet the challenges of the years ahead.
Just as the euro was one of the major challenges of the late twentieth century, I am convinced that the creation of a global currency will be one of the prime challenges of the twenty-first century. It is the necessary counterpart to the further globalization of our economies. We must begin to think about it today. A first step in this direction might be the definition of a basket of currencies whose weightings-unlike Special Drawing Rights (SDRs)-would be based on objective, regularly updated data.
In closing, I would like to return to the question with which I began this discussion: are currency fluctuations a good thing or a bad thing? One thing is certain: they are a fact of life that cannot be eliminated. Even in the days of the gold standard, currencies could be devalued and were subject to swings determined by their relative quality. The existence of fluctuations should not, in itself, be the subject of concern; rather, it is the fact that (a) these movements are disorderly, (b) all too often-as with the yen and dollar in 1995-96-they are justified neither by the respective quality of the currencies, nor by business-cycle timing differences, nor by credible prospects of divergence in budgetary and monetary policies, and (c) they are liable to induce persistent misalignments in the currency markets.
I believe, therefore, that it is vitally necessary to set up a framework for currency fluctuations, so that currencies will no longer exert a disruptive effect on trade and growth. The measures needed to improve the organization of the international monetary system can be summed up in the following four proposals:
- The G-7 should reform its own operating procedures in order to achieve greater efficiency in the type of actions required. It must no longer be paralyzed by conflicts of interest in the short run, notably between its governments and central banks. The G-7 also should force itself to define a more coherent doctrine for the use of the IMF.
- The IMF should become the guarantor of the quality of its members' currencies. For this, it must incite its members more forcefully than in the past to abide by strict prudential rules. When concrete risks of a national or international liquidity crisis develop, the Fund should also make sure that the role of lender of last resort is effectively performed at the global level.
- The creation of target zones would certainly be the best way to ensure orderly currency fluctuations. I realize there is no unanimous support for the idea, but I see no credible long-term alternative. In the short run, however, an arrangement involving mandatory concerted-action mechanisms-triggered by the crossing of preset limits-would have the practical advantage of being rapidly negotiable among the G-7.
- If we want globalization to be beneficial to all, we must start thinking today about the creation of a global currency. A currency basket, based on more objective data than the present Special Drawing Rights, would be a first step in this direction.