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We no longer have internationally agreed rules of behaviour in the financial markets

The original Bretton Woods settlement, by providing for fixed exchange rates and a link to gold imposed a degree of control over international financial exchanges, which were primarily mechanisms for facilitating international trade. With the development of the Eurodollar markets in London in the mid-1950s, which had not been foreseen by the architects of Bretton Woods, banks and other financial institutions were able to create an international network for trading financial assets, which largely avoided domestic policy regimes.  As a result, money could be rapidly moved from one jurisdiction to another amplifying the elasticity of the system, but without any effective system of control. Today, as William R White says, “we no longer have internationally agreed rules of behaviour.”[1] As a result financial institutions and individual states can pursue policies which arise from their own short-term concerns, without consideration of the long-term benefits to the global economy.  Borio says that, “the Achilles heel of the present-day international monetary and financial system (IMFS) is that it amplifies the key weakness of domestic monetary and financial regimes, their ‘excess financial elasticity’’’.[2] One aspect of the power of the commercial institutions is the success of Chinese and Brazilian companies in raising large amounts of capital in the offshore markets, as noted above. While major domestic imbalances, of the kind that we have seen in China may be the ultimate cause of economic and financial problems, the lack of control over international financial flows can intensify difficulties and make a problem into a crisis.  As White notes, the SE Asian crisis of the late 1990s showed how hot money can wreak havoc on smaller countries, as investors rush to withdraw their funds, or to invest in a particular country, White adds that “problems with currency mismatches – in which assets are denominated in a domestic currency and liabilities, such as loans, are in a foreign currency – can destroy whole banking systems.”[3] One only has to consider the large amount of US Dollar debt acquired by Chinese property companies from offshore centres; the outcome may well be an unhappy one for all concerned. In Figure 26 the separation of financial flows from trade flows is shown by way of illustration. It is also true that no country can completely protect itself from policy decisions made in the larger economies or from the behaviour of the international financial market. For example, the exchange rates of individual currencies are largely determined by short-term trading considerations, rather than longer term policies. Referring to the Quantitative Easing (“QE) policies of the US and Eurozone, and the extraordinarily low interest rates for the Dollar and other reserve currencies, White says that, “spillovers from the monetary policies of large advanced economies are disruptive.”[4] I can do no better than to quote from White’s summary of the present situation: “What passes for an international monetary system today is not really a system because it has no rules. It lacks an automatic international adjustment mechanism for current account imbalances. It allows massive spillovers, including gross capital flows, from larger countries (especially the United States) to smaller ones with potentially damaging implications. It is dangerously unanchored with respect to global credit and monetary expansion, and it lacks an international lender of last resort with adequate resources.”[5]

In its 85th Annual report, the BIS echoed concerns about the elasticity of the the International Monetary and Financial System (“IMFS”), saying that, “the IMFS tends to hide the risk of financial imbalances – that is, unsustainable credit and asset price booms that overstretched balance sheets and can lead to financial crisis is and serious macroeconomic damage. These imbalances occur simultaneously across countries, deriving strength from global monetary ease and cross-border financing. Put differently, the system exhibits ‘excess financial elasticity’: think of an elastic band that can be stretched out further but that, as a result, eventually snaps back all the more violently.”[6] There we have it, we need to look both at domestic imbalances and also imbalances within the IMFS, at both halves of the equation.

© Andrew Palmer, 2016, not to be reproduced

[1] White, William R – “System Malfunction”, Finance & Development, March 2015, p.44

[2] Borio, Claudio – “The international monetary and financial system: its Achilles heel and what to do about it”, BIS Working Papers No 456, August 2014, Berne, p.1

[3] White, William R – “System Malfunction”, Finance & Development, March 2015, p.45

[4] White, William R – “System Malfunction”, Finance & Development, March 2015, p.46

[5] White, William R – “System Malfunction”, Finance & Development, March 2015, p.47

[6] BIS 85th Annual Report, 2015, Berne, p.83

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