Monetary Relations

Theory and History

Neoclassical economists typically make a number of assumptions when examining the international monetary system, among the most significant being that financial firms and investors act independently of one another, that multinational banks have little home bias in their lending and investing decisions, and that, under fully liberalized global capital markets, firms and countries with objectively similar economic profiles will face homogeneous credit, insurance, and bankruptcy conditions. These analysts model the global monetary system as a decentralized, self-equilibrating market. Within this cognitive framing, national decisions to depart from fully liberalized capital accounts appear suboptimal. Yet the neoclassical approach ignores the role played by states in constituting the rules and institutions within which market transactions occur.

Political scientists in contrast assume an international political economy. World markets are embedded in and permeated by social institutions, including formal international governmental organizations (IGOs; with membership limited to sovereign states) as well as informal clubs and processes, each associated with norms, laws, or rules, [Page 1619]and standardized procedures. Yet there is neither a world government nor a collective and authoritative enforcement mechanism for global market transactions. Those who defy the “rules” of exchange (honor contracts, represent merchandise honestly, don't bribe, and don't manipulate prices) may be punished by the market in the form of reputational losses. Powerful states also possess a host of additional punishments and inducements, particularly access to their home markets, that core country governments may deploy to get the rules, compliance from others, and occasional exceptions for themselves that they desire. Neoclassical economics does not model these nontrivial special privileges.

International monetary transactions over the past century and a half have occurred within four broad monetary eras. Three were characterized by sets of rules and social institutions designed and enforced by representatives of a dominant state or states, while the fourth period was an ultimately unsuccessful attempt to establish a durable regime.

During the classical gold standard era, roughly 1870 to 1914, the major trading states pegged their paper currencies (fiat monies) to gold, with incumbent governments promising to redeem this paper on demand. The system's anchor was the credibility of the promises of key states, particularly Britain, to exchange intrinsically valueless paper for a preset quantity of precious metal.

The second period was the two interwar decades of unsuccessful attempts to reconstruct the prewar gold standard. With its industrial economy decimated by World War I, Britain especially tried to reestablish sterling convertibility at the prewar gold parity but gave up in 1931. Barry Eichengreen observes that the major industrial capitalist states, responding to pressure from demobilized soldiers, all quickly instituted universal male suffrage following World War I, subsequently making it politically very difficult to reimpose the rigid and harsh automatic-adjustment procedures built into the gold standard. In a contrasting explanation for the failure to establish a durable monetary regime, Charles Kindleberger famously contended that the crucial brake on interwar monetary stability was that the only state with sufficient economic and political resources to lead, the United States, was insufficiently committed to doing so. There was no solution until after World War II.

...