A Lego Approach to International Monetary Reform

Abstract

The international monetary arrangement that has prevailed for the last 40 years has been a disaster. During four waves of banking crises, with most of the affected countries also experienced currency crises. These crises led to recessions and extended periods of slow growth. Every country that experienced a banking crises previously had a boom and an increase in investor demand for its securities, which led to an increase in prices and usually an increase in currency prices. These booms morphed into banking crises when investment inflows slowed, which often occurred when lenders recognized that the external indebtedness of these countries was increasing at rates too rapid to be sustainable. This pattern in cross border investment inflows is very different from the one advanced by proponents of floating currencies in the 1950s and 1960s. Their articles have become the monetary constitution for the currency arrangement that has prevailed since the early 1970s. They claimed that if currencies were free to float, deviations between the market prices of currencies and the long-run average prices would be smaller because changes in currency prices would track differences in national inflation rates, but instead the deviations have been much larger. They claimed there would be fewer currency rates, but instead there have been many more and most have occurred with a banking crisis. Proponents claimed that each country would be more fully insulated from shocks in its trading partners, instead countries have been pummeled by variability in inflows. The primary objective of international monetary reform is to dampen sharp cross border investment inflows. The Lego-approach to reform involves selections from two menus. One involves the institutional innovations or frameworks for implementing measures to reduce the sharp variability in cross border investment inflows. The more ambitious institutional innovations involve a new institution like the International Monetary Fund (IMF) or a rejuvenation of the IMF. The least ambitious arrangement involves a decision by countries to follow similar policies to dampen the scope for cross border investment inflows.