Off Balance

by Paul Blustein

  4 See Ian Bremmer and Nouriel Roubini (2011), “A G-Zero World,” Foreign Affairs, March/April.

  5 See Charles Kindleberger (1973), The World in Depression, 1929-39, Berkeley: University of California Press.

  The G-Zero theorists have drawn criticism — rightly, in my view — for exaggerating US impotency. But this is a matter of degree, not direction. Although no other country appears likely to displace the United States as the world’s premier power in the foreseeable future, Washington’s grip on multilateral institutions is significantly looser than it was before the crisis, particularly given the rise of China, which is much less sympathetic to US interests and values than the traditional allies of the G7. Whereas the widespread view of the US economic model as superior to others once instilled American officials with formidable influence over the policies of international economic institutions, the crisis rendered that trump card unplayable. Policy making at the global level has thus become far more cumbersome than before. The chapters of this book about the IMF and FSF show how precipitous these shifts in power have been.

  Can international institutions rise to the tasks being thrust upon them in a world where massive amounts of capital traverse borders, continents and oceans? In short, is the global economy governable? Answering those questions requires an understanding of how these institutions and arrangements work, the roles they played before and during the crisis and the challenges they now face. It also requires understanding the historic transition these institutions are undergoing — the result of the immense geopolitical changes that the crisis wrought. This, in turn, necessitates a look back at the institutions’ origins and evolution, which is the subject of the next two chapters.

  2

  The Hegemon Cometh: A Concise History of the Global Financial System’s Governing Institutions

  The BIS and the 1930s

  Basel, a town of stereotypical Swiss orderliness near the French and German borders, was the destination of Montagu Norman, governor of the Bank of England, and Hjalmar Schacht, president of the German Reichsbank, in January 1939. The two men were travelling together after attending the christening in Berlin of Schacht’s grandchild, who was named Norman in the Englishman’s honour. The outbreak of World War II was less than a year away, but as central bank chiefs, Norman and Schacht had established a warm friendship based on their membership in a fraternity that they liked to believe was capable of transcending national boundaries and rivalries. The closeness of their bond, and that of other central bankers, was attributable in no small part to what might be called their fraternity house — the BIS, located in a converted hotel across from the Basel train station.1

  1 See Gianni Toniolo (2005), Central Bank Cooperation at the Bank for International Settlements, 1930–1973, New York: Cambridge University Press, for much of the historical material in this section. The anecdote about the christening of Schacht’s grandchild is cited in chapter 22 of Liaquat Ahamed (2009), Lords of Finance: The Bankers Who Broke the World, New York: Penguin Books.

  The BIS was created in 1930 for the purpose of collecting and disbursing the reparations Germany owed to the European countries it had fought in World War I. At that time, two million Germans were unemployed and the Weimar Republic was threatening to default; as part of an effort to defuse this explosive situation, the international community entrusted the managerial responsibilities to a technocratic, faceless institution that central banks would own and control. Even after Adolf Hitler came to power and repudiated reparations, the BIS remained in operation because the leading central bankers of the day found it a congenial place to get together. Central bankers view themselves as conducting policy on an ethereal, apolitical level, and the BIS offered a refuge where they could interact with their peers at a comfortable distance from the pressures exerted by their governments and parliaments. On the second Sunday of nearly every month, the heads of major central banks (or their alternates) would gather over a sumptuous dinner, followed by meetings the next day — a routine they carried on throughout the 1930s, even as Europe girded for war. This monthly meeting was the reason for Norman and Schacht’s joint trip.

  The camaraderie of central bankers was an anomaly in a decade infamous for its uncoordinated economic policies and the disengagement of the world’s leading power. The United States’ refusal to join the League of Nations and its raising of protectionist walls with the Smoot-Hawley Tariff of 1930 were the most glaring examples of Washington’s lack of interest in playing the role of hegemon. In the epidemic of mutually destructive policies that made the Depression as great as it was, the central banks not only failed to reverse the trend, they exacerbated it. Some shackled their nations’ economies to the gold standard for far too long; instead of lowering interest rates, which could have halted deflation and economic contraction, they did everything possible to maintain their currencies’ stated gold values, even though doing so accelerated the spread of bankruptcies and joblessness. Others contrived to drive down their exchange rates to boost exports and curb imports. One of the most notorious instances of these “beggar-thy-neighbour” policies was a battle of competitive devaluations between Denmark and New Zealand, both major butter producers, in a mad scramble to gain advantage for their butter in the lucrative British market. Monetary chaos begat bank panics, which begat tighter squeezes on businesses and farms, which begat protectionism and even outright trade wars, with a number of governments going so far as to pursue autarky — policies aimed at eliminating virtually all need for foreign trade.

  Through it all, the BIS remained a place where central bankers could meet. Even during the war, when the sound of warplanes and anti-aircraft fire were regularly audible in Basel, the BIS continued to function as a facilitator of transactions for central banks, though its board was divided between Allied and Axis control, and communication between the staff and board was conducted mainly by post. Unsurprisingly, the challenge of maintaining strict neutrality between the warring sides ended up tainting the BIS with Nazism; the bank facilitated German seizures of gold from Czechoslovakia shortly after Hitler’s troops invaded Prague, and some of the gold held in Germany’s BIS accounts turned out to have been confiscated from Belgium and Holland. Worst of all, a portion of that gold was evidently looted from concentration camp victims. As a result, an effort at the end of the war to abolish the BIS nearly succeeded, but central bankers, who did not want to give up their sanctuary, staved off its elimination.

  The BIS is the only international economic institution that predates World War II, and it continues to this day to serve as a club for central bankers. Its current headquarters, built in the late 1970s, is a cylindrical-shaped building — one of the most distinctive landmarks in Basel — sometimes likened to a nuclear plant cooling tower or a chess rook or the flat-topped mountain where aliens land in the movie Close Encounters. Spotless, retro-style white-leather sofas and chairs line the lobby and corridors, matching the architecture. About 590 staff members work in this building and another building nearby on the various services — chiefly economic research and management of foreign exchange reserves — that the BIS performs for the 60 central banks that own it. The work those staffers perform, however, is secondary to the more important function of providing a super-secure, high-tech and luxurious venue for private meetings of central bank officials, as well as bodies such as the FSB and the Basel Committee on Banking Supervision. In brightly lit conference rooms off the lobby, participants sit in upholstered swivel chairs around circular or oval tables made of finely grained wood with an array of video screens at in the centre. At each of the three-dozen-odd seats is a microphone and audio equipment for listening to the simultaneous interpretation piped in from booths in the back. The dining room on the eighteenth floor affords a panoramic view of the Rhine rolling past Basel’s quaint spires, with Germany’s Black Forest off in the distance — a suitably high-altitude ambience from which to sip and savour the epicurean offerings of the bank’s chefs and sommeliers.

  T
he other institutions involved in the governance of the global financial system were created after the war — in some cases, many decades later. That story unfolds in the remainder of this chapter and the one that follows. In the immediate postwar years, two conditions prevailed that helped ease the task, at least for a while, of managing these institutions and fostering financial stability.

  The first condition was the near-absence of international private capital movements. In most countries during the late 1940s and the 1950s and 1960s, governments maintained tight controls over cross-border financial flows; obtaining foreign currency was permissible only for strictly limited purposes, such as the payment by importers for a shipment of goods. Moreover, most nations curbed sales of their currency to foreigners. As we shall see in the latter part of this chapter, the relaxation of this condition in the last three decades of the twentieth century necessitated the establishment of more institutions and rule changes, as the international community scrambled to keep pace with the modernization and globalization of finance.

  The second condition that pertained after the war was the readiness, willingness and ability of the United States — which generated roughly half of the world’s GDP in 1945 — to take its place in the world. No longer would Washington be shy about asserting its hegemonic aspirations.

  The IMF and the Bretton Woods Agreement

  As World War II was nearing its end, economist John Maynard Keynes was enjoying worldwide fame for his ability to foresee where the world was going catastrophically wrong. His warnings in the 1920s against the imposition of excessive German reparations and the maintenance of a rigid gold standard had been proven particularly farsighted. His ideas were thus bound to play an outsized role when he arrived in Bretton Woods, New Hampshire, in late June 1944 — three weeks after the invasion of Normandy — for a conference of more than 40 nations on how to design the postwar economic order. But Lord Keynes of Tilton, the title he now held by dint of a peerage, was attending as a British delegate, so although his arguments would hold sway on some major issues, he was obliged to yield on others to the Americans, led by Assistant Secretary of the Treasury Harry Dexter White, who was as ornery as Keynes was erudite. Some of the debates about the global economy raging today are strikingly redolent of the differences between the positions of these two men.2

  2 See Barry Eichengreen (2011), Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System, Oxford: Oxford University Press, chapter 3 for much of the historical material in this section, as well as Toniolo, Central Bank Cooperation, chapter 8, and Ahamed, Lords of Finance, chapter 22.

  Keynes and White shared common visions of creating a monetary system that would eradicate practices — especially beggar-thy-neighbour currency devaluations, slavish devotion to gold and manic speculative flows of capital — that they viewed as the worst evils of the 1930s. During the two years of negotiations prior to Bretton Woods, they had reached broad agreement on rules for a system in which countries would fix their exchange rates while maintaining the ability to adjust them as circumstances changed — a comparatively stable arrangement that would be aided by the immobility of capital across borders. One major advantage of such a system was that it would help foster a dismantling of protectionist trade barriers; countries would presumably be more willing to open their markets to imports if they could be assured that trading partners would refrain from constantly cheapening their currencies.

  But Keynes favoured a much more ambitious approach, in part because he wanted to rid the world, as much as possible, of large trade imbalances, which he viewed as potentially destabilizing. Furthermore, he wanted to do it in a “symmetrical” way, with both surplus and deficit countries sharing the responsibility. All too often in the past, he reasoned, the burden had fallen almost entirely on deficit countries, which were obliged to curb imports, thereby sending a contractionary impulse to the global economy. In his view, rules that induced surplus nations to increase imports would be more likely to produce broadly beneficial outcomes.

  Keynes’s scheme — “complicated and novel and perhaps Utopian,” as he admitted — involved effectively imposing levies on countries that ran chronic trade surpluses or deficits. It would work as follows: a new global currency, called “bancor,” would be created for use in all international trade (although each country would retain its own national currency for domestic transactions). This system offered monetary advantages because the vicissitudes of gold mining would no longer determine the amount of money available for lubricating global economic activity; rather, a new institution called the International Clearing Union would issue bancor to countries in rough proportion to their trade volumes. The clearing union would then act as a sort of middleman for countries’ payments to each other for imports and exports, with deficit nations drawing down bancor as needed and surplus countries accumulating the new currency. In another, related feature of the system, penalties would give countries strong incentives to keep their trade roughly in balance. That is, nations whose bancor balances got too big — either positively or negatively — would be assessed interest charges on those balances.

  Even before delegates convened at the stately Mount Washington Hotel in Bretton Woods, Keynes’s plan had been shelved, because it contravened the interests of the United States — or at least, US interests as they were perceived at the time. The US economy was then running large trade surpluses, and American officials did not want any restrictions on the additional surpluses they assumed would remain a constant feature of their nation’s economic landscape. Little did they imagine how deficit-ridden the US economy would eventually become — and how attractive a system of symmetrical rules would look. (Washington did accept a provision, called the “scarce currency clause,” that authorized the imposition of tariffs against the goods of countries whose surpluses were so large the IMF couldn’t obtain their currencies. But this obscure mechanism has never been invoked.)

  After about three weeks of meetings and conviviality, the Bretton Woods conferees approved a plan that was close to the approach White favoured — that is, with no bancor or clearing union. The newly created IMF would police a system of fixed exchange rates, with each member country required to keep its currency’s value within a narrow range and seek permission of the Fund before raising or lowering that range by more than 10 percent. Importantly for the Americans, the agreement enshrined the dollar’s status as the world’s pre-eminent currency. The greenback had already surpassed the British pound as the most-used unit in international commerce; when a product was sold internationally, it was usually priced and invoiced in dollars, and dollars constituted the bulk of the foreign exchange reserves held by central banks. Now the US unit was firmly at the centre of the new system, exchangeable into gold at US$35 per ounce, with all other countries declaring fixed values for their currencies in terms of the dollar. When countries ran into problems that might lead to a devaluation, they could borrow dollars from the Fund for use in propping up their currencies, provided they met the Fund’s conditions for how to put their economies back on a sound footing.

  Thus, the pattern in which many international economic arrangements were to be forged in the postwar era was set. As undisputed hegemon, the United States would lead the way in designing institutions and striking agreements that provided global public goods for countries that wished to avail themselves of those goods. Although US officials would not get their way in every debate, and often had to compromise, the rules would broadly suit American interests, augment Washington’s ability to shape global outcomes and minimize constraints on US policies while applying some limitations to the policies of others.

  As Keynes foresaw, his own country — the dethroned hegemon — would be among the constrained.

  Bretton Woods I

  Considering the “special relationship” between the United States and the United Kingdom, the message that US Treasury Secretary George Humphrey sent in late November 1956 to his British
counterpart, Chancellor of the Exchequer Harold Macmillan, was stunning for its iciness. The United States would support an IMF loan to Britain, which desperately needed the money to avoid a devaluation of the pound, only when the latter was “conforming to rather than defying the United Nations,” Humphrey told Macmillan.3

  3 James Boughton (2001), “Was Suez in 1956 the First Financial Crisis of the Twenty-first Century?” Finance and Development 38, no. 3. Much of the other history in this section can be found in Eichengreen, Exorbitant Privilege, chapter 3.

  This naked use of American power was an extraordinarily vivid example of the advantages that the Bretton Woods agreement afforded the United States. It came during the 1956 crisis over the Suez Canal, which Egypt had nationalized, prompting British, French and Israeli forces to invade. The administration of US President Dwight Eisenhower led worldwide condemnation of the invasion, including a United Nations General Assembly resolution. But much more potent was Washington’s willingness to use its leverage at the IMF, where it held the largest amount of votes on the executive board and could thus exercise substantial control over the Fund’s lending decisions. Once British policy makers realized that they might be unable to get the international funding they needed to defend the pound, they backed down and announced a withdrawal of their forces.