Understanding Interdependence

The Macroeconomics of the Open Economy

Peter B. Kenen

• Publisher: Princeton University Press
• Year: 2021
• Print ISBN: 9780691034089
• eBook ISBN: 9780691231136
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

Drawing together new papers by some of today's leading figures in international economics and finance, Understanding Interdependence surveys the current state of knowledge on the international monetary system and, by implication, defines the research horizon for the future. Covering topics including the behavior of exchange rates, the choice of exchange-rate regime, current-account adjustment in classical and Keynesian models, the extent and effects of capital mobility, international debt, the stabilization and reform of the formerly planned economies, European monetary union, and international policy coordination, the book underscores the importance of these subjects and identifies lessons for policymakers.


The contributors to the volume are Michael Bruno, Ralph C. Bryant, Richard N. Cooper, Michael P. Dooley, Barry Eichengreen, Stanley Fischer, Charles A. E. Goodhart, Peter Hooper, Peter B. Kenen, Paul R. Krugman, Henri Lorie, Jaime Marquez, Ronald I. McKinnon, Michael Mussa, Maurice Obstfeld, John Odling-Smee, Assaf Razin, Dani Rodrik, Mark P. Taylor, and John Williamson.

I

APPRAISING EXCHANGE-RATE ARRANGEMENTS

1

The Endogeneity of Exchange-Rate Regimes

BARRY EICHENGREEN

THE INTERNATIONAL monetary system has passed through a succession of phases characterized by the dominance of alternatively fixed or flexible exchange rates. Indeed, one of the more remarkable features of the last hundred years of international monetary experience is the regularity with which one regime has superseded another.¹ The quarter century leading up to World War I was the heyday of the classical gold standard, when exchange rates were pegged to gold and to one another over an increasing portion of the industrial and developing world. The war provoked the breakdown of the gold standard and was followed by an interlude of floating rates. Countries returned to gold in the second half of the 1920s, only to see their laboriously constructed fixed-rate system give way to renewed floating in the 1930s. The Bretton Woods Agreement of 1944 inaugurated another quarter century of exchange-rate stability. The next episode of floating began in the early 1970s and now seems to be in the process of being supplanted, mainly in Europe, by a move back toward fixed rates.

How are these repeated shifts between fixed and flexible exchange rates to be understood? Although the literature contains many illuminating studies of particular episodes in the history of the international monetary system (the rise of the gold standard or the breakdown of Bretton Woods, for example), it shows few attempts to develop general explanations for shifts between fixed- and flexible-rate regimes.² Similarly, although the discipline of international economics contains many models of the collapse of fixed-rate regimes and of the transition from floating to pegged rates, few of the models attempt to endogenize the factors responsible for these shifts.³ That is my goal here. I advance six hypotheses with the capacity to explain the alternating phases of fixed and flexible exchange rates into which the last century can be partitioned.

Before proceeding, some caveats are in order. First, I shall limit my attention to the dominant exchange-rate regime prevailing in the industrial countries at a given time. Thus, I treat the 1950s and 1960s as a period of fixed rates and the 1970s and 1980s as a period of floating, despite the fact that certain countries allowed their exchange rates to float in the first period or pegged them in the second. The hypotheses considered here are designed to shed light on changes over time in the dominant exchange-rate regime, not to illuminate cross-country variations.

Second, I make no claim for the novelty of the hypotheses considered here. All of them may be found in the literatures that have grown up around particular episodes in the history of international money and finance. The contribution of this discussion is rather to show how these hypotheses might be developed into a unified framework for studying the endogeneity of exchange-rate regimes.

Third, I make no pretense of systematically testing theory against evidence. Doing so would require more space than is afforded by one essay. But an important property of a satisfactory explanation for the endogeneity of exchange-rate regimes is that it can be empirically validated or rejected. The evidence presented here is intended to illustrate whether—and if so how—subsequent investigations might go about this task.

Fourth and finally, there is nothing necessarily incompatible about the six perspectives considered. It will be clear as we proceed that the overlap among competing hypotheses is considerable. An adequate account of the endogeneity of exchange-rate regimes will have to incorporate several explanations.

1 Leadership

A first perspective associates the maintenance of fixed exchange rates with the exercise of international economic leadership by a dominant power. This application of “the theory of hegemonic stability,” associated with the work of Charles Kindleberger (1986), regards exchange-rate stability as an international public good from which all participants in the international monetary system benefit. But the public-good nature of exchange-rate stability means that the benefits of any one nation’s contribution to the maintenance of the fixed-rate system accrue not just to its residents but to foreigners as well. This gives rise to a problem of collective action in which this stabilizing influence tends to be undersupplied. Countries may fail to refrain from actions that destabilize the fixed-rate regime if the benefits of those actions accrue to them alone but the costs are shared with their neighbors.

Hence, there is need for a “hegemon,” or dominant power, to internalize these international externalities. If one country is large enough to reap the lion’s share of the benefits of international monetary stability, it will willingly bear a disproportionate share of the burden of stabilizing the system. Alternatively, an unusually powerful nation may be able to compel other countries to contribute their fair shares to regime maintenance. The analogy is with a dominant firm in an imperfectly collusive cartel. The dominant supplier— Saudi Arabia in the Organization of Petroleum Exporting Countries (OPEC), for example—may willingly adjust its production to maintain cartel stability in the face of defection by one or more of its rivals, because it reaps the largest absolute benefits from the collective restriction of output. Alternatively, it may threaten to apply sanctions against potential defectors in order to compel their cooperation.

Variants of this interpretation of the preconditions for international monetary stability are found in Viner (1932), Gayer (1937), Brown (1940), and Nevin (1955), all of whom suggest that the troubled life and early demise of the interwar gold standard reflected inadequate leadership. The interwar gold standard, they allege, was destabilized by the absence of a dominant economic power to oversee its operation. By implication, the superior operation of the nineteenth-century gold standard was attributable to the leadership exercised by the British nation and its monetary agent, the Bank of England. Kindleberger’s contribution was to frame the argument more analytically and to generalize it, suggesting that the return to fixed exchange rates after World War II and the relatively smooth operation of the Bretton Woods system for a quarter century thereafter were attributable to the beneficent influence of U.S. hegemony.

Two objections can be raised to this interpretation. First, the public-good characterization of fixed exchange rates, however appealing, is of question able validity. In 1992, for example, Argentina stabilized its exchange rate against the dollar. Is it not accurate to say that essentially all the benefits of this action accrued to the Argentine Republic? Similarly, the members of the European Monetary System (EMS) have pegged their currencies to one another without the support of the world’s leading economic power, the United States. Is it not also accurate to say that the benefits accrue to EMS participants and not to other countries, including the United States?

Second, the association of hegemony with international monetary stability may be a misreading of the evidence. As I have argued elsewhere (Eichengreen, 1989, 1992), the picture of Britain’s having single-handedly operated the classical gold standard tends to be overdrawn. London may have been the leading international financial center prior to World War I, but it had significant rivals, notably Paris and Berlin, both of which possessed their own spheres of influence. The prewar gold standard was a decentralized, multipolar system, the smooth operation of which was hardly attributable to stabilizing intervention by a dominant economic power. Similarly, given the perspective afforded by distance, neither the design nor the maintenance of the Bretton Woods system seems solely attributable to the stabilizing influence exercised by the United States.⁴ Great Britain succeeded in securing extensive concessions in the design of Bretton Woods, notably the right to maintain exchange controls on capital-account transactions (for a transitional period of perhaps five years) and current-account transactions (for an indefinite period) and to alter the exchange-rate peg unilaterally in the event of fundamental disequilibrium. When exchange-rate stability was threatened in the 1960s, rescue operations were mounted not by the United States but collectively by the Group of 7 (G-7). Effective leadership by a dominant economic power may have been absent in the 1930s and following the collapse of Bretton Woods, but it is far from clear that the surrounding intervals of exchange-rate stability were predicated on its presence.

How might one test more systematically for differences over time in the prevalence of international economic leadership that are sufficient to explain changes in the adequacy with which different fixed-exchange-rate regimes worked? Kindleberger (1986) has sought to operationalize the concept of economic leadership by suggesting five functions that the hegemon must undertake to stabilize the operation of the international economic system: it must (1) maintain a relatively open market for distress goods, (2) provide countercyclical, or at least stable, long-term lending, (3) police a relatively stable system of exchange rates, (4) ensure the coordination of macroeconomic policies, and (5) act as lender of last resort by discounting or otherwise providing liquidity in financial crisis. The extent to which the presumptive leader has carried out these functions in different periods might be studied by measuring, for example, the openness of its market to distress goods, or fluctuations in the time profile of its long-term lending.

A problem in this approach is that a stable “international economic system,” the dependent variable with which Kindleberger is concerned, is not the same as a stable system of (fixed) exchange rates. Whether the latter is a necessary condition for the former is unclear. Conversely, it is questionable whether functions (1), (2), (4), and (5) are necessary conditions for carrying out function (3). Might not a hegemon support a system of fixed exchange rates without at the same time, for example, engaging in stable long-term lending? Even if countercyclical lending by the leading creditor country contributes positively to the maintenance of fixed rates, it need not be essential.

Our discussion has skipped glibly over the difficulty of measuring the concepts associated with this view. How open must a market be to be “relatively open” to distress goods? How does one distinguish “distress goods” from other exports? Only in the financial realm has some progress been made in operationalizing such notions. Eichengreen (1987) used time-series methods to investigate whether the Bank of England’s discount rate exercised a disproportionate influence over discount rates worldwide under the gold standard. Employing Granger causality tests to investigate the bivariate relation between the Bank of England’s discount rate and rates of the Bank of France and the German Reichsbank, he found that changes in the Bank of England’s rate had a strong tendency to provoke subsequent adjustments in the other rates, although evidence of reverse causality was weaker. For the EMS period, Giovannini (1989) and Cohen and Wyplosz (1989) report similarly that changes in German interest rates have had a much stronger tendency to prompt changes in interest rates in other EMS countries than is conversely true.⁵

Even for those inclined to uncritically accept this evidence, inferring the validity of the leadership hypothesis from the timing of interest-rate changes nonetheless remains problematic. Even if changes in the Bank of England’s rate led (and led to) changes in the rates of other central banks during the gold-standard years, and, even if changes in German rates have done the same under the EMS, this speaks only obliquely to the importance of leadership— as the concept is formulated above—in the operation of these systems. It says nothing about the willingness of Britain or Germany to bear a disproportionate share of the burden of stabilizing the system or to compel other countries to contribute their fair shares to regime maintenance. And it fails to distinguish an alternative hypothesis: that the discount rates of these so-called “center” countries were only serving as focal points for the international cooperation that really was critical for regime maintenance.

2 Cooperation

Thus, a second explanation, formulated in reaction to the first, emphasizes international cooperation. In this view, international monetary stability, of which fixed exchange rates are one aspect, requires collective management. The stability of exchange rates under the classical gold standard, in the second half of the 1920s, for a quarter of a century after World War II, and in Europe in the 1980s, is attributed in this view to sys...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• List of Figures
• List of Tables
• Introduction
• Part I: Appraising Exchange-Rate Arrangements
• Part II: Exchange Rates and the Adjustment Process
• Part III: The Integration and Functioning of Capital Markets
• Part IV: Stabilization and Liberalization
• Part V: Coordination and Union