Out of the woods and into one crisis after another

By William Keegan

LONDON: Do we need a World War III before policymaking can be galvanized into a convincing reform of the international monetary system?

The observation was made, jokingly of course, by a senior participant at a conference last weekend in Ditchley Park, Oxfordshire, north west of London. Ditchley was a sanctuary to which Winston Churchill would occasionally retreat during the World War II. These days it is known as one of those places where the great, the good and the occasional journalist gather to discuss problems on an unattributable basis.

The point about the World War III reference is that it took the shock of the World War II to induce governments, led by the United States, to set up what was known as the Bretton Woods system of "fixed but adjustable exchange rates". And it was the perception that the economic chaos of the interwar years had contributed to the outbreak of the World War II that haunted government officials and economists when they designed the monetary rules for the post-war world at Bretton Woods, New Hampshire, in the summer of 1944.

Another war (Vietnam) was the proximate cause of the breakdown of the Bretton Woods system. The inflationary financing of that conflict put intolerable strains on the dollar, which had been the linchpin of the system. When the dollar was devalued, and exchange rates allowed to float in the 1970s, oil-exporting countries were badly hit because their exports were priced in dollars. But they found they could flex their muscles, and the Organization of Petroleum Exporting Countries (OPEC) raised prices dramatically.

Oil price rises aggravated inflationary trends, and exchange rates fluctuated wildly under the new "floating" system. Indeed, the chaos of the 1970s was one reason for the setting up of the European exchange rate mechanism, which led on to the single European currency. The architects of the ERM aimed at "a zone of monetary stability in Europe". But the hope was that, when inflation was brought under control, exchange-rate fluctuations would also be ironed out between the three major currency blocs -- the dollar, the deutschmark (now the euro bloc) and the Japanese yen.

Inflation may be under control, but exchange rates still fluctuate far more than most experts would have expected. Exchange-rate gyrations, and losses on foreign exchange borrowings, were features of the Southeast Asian financial crisis of summer 1997. One of the key problems was the volatility of capital flows. Under the Bretton Woods system, there were widespread controls over capital movements, which made it easier to control exchange rates. Now it is a commonplace that investment and speculative flows across foreign exchanges dwarf the demand for currency used in ordinary trade transactions.

The freedom of capital movements was much favored by the Group of Seven and the International Monetary Fund (IMF). Although the Asian crisis has prompted something of a rethink, it was clear last weekend that most participants at Ditchley (discussing Managing global economic problems: public and private sector roles) did not seriously question the advantages of what is known as "globalization" and the free flow of capital.

Some reluctantly agreed that the jury was still out on whether Malaysia, by introducing capital controls, had alleviated the impact of the crisis. Others favored the "Chilean" system of financial disincentives on short-term deposits from overseas, although there was some dispute as to how effective these were in practice.

It was also interesting that one or two experts had a good word to say for the way Malaysia had, before the crisis, discouraged foreign currency borrowing that was not covered for the exchange rate risk.

The prevailing view, however, seemed to be that this is globalised capitalism and everybody has to live with it. There will be more crises, although of different kinds. (Thus there has not been a repetition of what the banks did in the late 1970s and early Eighties: lend huge sums to help Third World countries with their balance-of-payments problems, sums that many of those countries could never hope to repay.)

True, there was much emphasis on "crisis prevention" via greater "transparency" in the behavior of governments and financial institutions. There was also strong support for efforts to improve "prudential supervision" of the world's financial system. But in the end most of the heated discussion tended to get down to crisis handling after a resigned tour of the "crisis- prevention measures".

The big issues are shrouded in appalling jargon. At one stage someone discussing the usefulness of the IMF's "lending into arrears" was firmly asked what this meant. Far from meaning that the IMF carries on lending to a nation, such as Russia, that is behind with its repayments to the IMF itself, "lending into arrears" is what happens when the IMF carries on helping a crisis-driven economy despite the fact that the country is defaulting on its private-sector debts.

"Bailing out" by the IMF refers to the way the fund was seen in a number of East Asian cases, as well as in Russia, to pour money in by one route, only for it to come out by another and let banks and other investors off the hook.

The discussion at Ditchley and elsewhere is about "bailing in" -- ensuring that private-sector lenders from abroad take some of the strain when things go wrong. In the 1980s it was easy to get bankers to agree a rescheduling package, even if it did not seem so at the time. The multiplicity of bondholders makes such agreements more difficult, so the hot topic now is how to secure clauses that enable a majority of bondholders (70 percent) to agree on the rescheduling or writing-off of debts.

But Paul Volcker, former chairman of the U.S. Federal Reserve -- who can be quoted because he was not at the Ditchley conference -- believes the world's financial community is indulging in interior decoration of what is known as the "financial architecture" -- not reconstructing it. True reform, he argues, requires an effort to control the fluctuations in exchange rates that have proved so disruptive, and often precipitated crises.

There was not, however, much appetite at Ditchley for target zones for exchange rates. The answer, said a veteran official, was a single world currency. He didn't say whether that needed to be preceded by a World War III.

-- Observer News Service