In response to the worst financial crisis since the 1930s, policy-makers around the globe are providing unprecedented stimulus to support economic recovery and are pursuing a radical set of reforms to build a more resilient financial system. However, even this heavy agenda may not ensure strong, sustainable, and balanced growth over the medium term. We must also consider whether to reform the basic framework that underpins global commerce: the international monetary system. My purpose this evening is to help focus the current debate.
While there were many causes of the crisis, its intensity and scope reflected unprecedented disequilibria. Large and unsustainable current account imbalances across major economic areas were integral to the buildup of vulnerabilities in many asset markets. In recent years, the international monetary system failed to promote timely and orderly economic adjustment.
This failure has ample precedents. Over the past century, different international monetary regimes have struggled to adjust to structural changes, including the integration of emerging economies into the global economy. In all cases, systemic countries failed to adapt domestic policies in a manner consistent with the monetary system of the day. As a result, adjustment was delayed, vulnerabilities grew, and the reckoning, when it came, was disruptive for all.
Policy-makers must learn these lessons from history. The G-20 commitment to promote strong, sustainable, and balanced growth in global demand – launched two weeks ago in St. Andrews, Scotland – is an important step in the right direction. What Is the International Monetary System and How Should It Function?
The international monetary system consists of (i) exchange rate arrangements; (ii) capital flows; and (iii) a collection of institutions, rules, and conventions that govern its operation. Domestic monetary policy frameworks dovetail, and are essential to, the global system. A well-functioning system promotes economic growth and prosperity through the efficient allocation of resources, increased specialization in production based on comparative advantage, and the diversification of risk. It also encourages macroeconomic and financial stability by adjusting real exchange rates to shifts in trade and capital flows.
To be effective, the international monetary system must deliver both sufficient nominal stability in exchange rates and domestic prices, and timely adjustment to shocks and structural changes. Attaining this balance can be very difficult. Changes in the geographic distribution of economic and political power, the global integration of goods and asset markets, wars, and inconsistent monetary and fiscal policies all have the potential to undermine a monetary system. Past systems could not incent systemic countries to adjust policies in a timely manner. The question is whether the current shock of integrating one-third of humanity into the global economy – positive as it is – will overwhelm the adjustment mechanisms of the current system.
There are reasons for concern. China's integration into the global economy alone represents a much bigger shock to the system than the emergence of the United States at the turn of the last century. China's share of global GDP has increased faster and its economy is much more open.1 As well, unlike the situation when the United States was on the gold standard with all the other major countries, China's managed exchange rate regime today is distinct from the market-based floating rates of other major economies. History shows that systems dominated by fixed or pegged exchange rates seldom cope well with major structural shocks.
This failure is the result of two pervasive problems: an asymmetric adjustment process and the downward rigidity of nominal prices and wages. In the short run, it is generally much less costly, economically as well as politically, for countries...