Monetary Standards and Financial Crises

Found this slideshow by nobel laureate Robert Mundell (one of the guys behind the Mundell-Fleming model) at Rodriks weblog. It concerns the evolution of monetary systems and analyzes the current crisis problem. I found a few remarks particulary interesting. At slide 8 – in the victorian age:

In the nineteenth century, the British Empire was the first-among-equals great power, the pound sterling was the most important currency in the world, and London was the financial center of the world.

There were no major banking crises that affected the stability of the system.

I dunno if this is really correct – well, maybe there were no all-encompassing banking crises, but there were financial crises even during the gold standard of the late 19th century. At least that’s what I remember from the books I read about it (mainly Eichenberry). Mundell goes on to argue that there were no banking crises during Bretton Woods, and his general argument is that fluctuating exchange rates are one of the key sources of banking crises.  I think there are many good points to Mundells argument, although I think he fails to spell out in detail why exactly fluctuating exchange rates are so harmful, in this particular slideshow.

I myself am kinda ambivalent towards the question of fluctuating vs. fixed exchange rates. I know that great liberals like Friedman and Hayek were in favor of fluctuating exchange rates. But it runs into the political problem of great economic  powers like the US (or maybe some day China og the EU) abusing the system by flooding it with money, inflating the global economy. I see Mundells argument that fluctuating rates incites economic nationalism, especially when one of the currencies (the dollar in this case) becomes a sort of “key” currency with the privileges and political ramifications this entails (seignorage privilege for example, making US politicians less accountable to good economic governance). But Mundell is also blind to the political side of this, in my opinion. The fixed rate system of Bretton Woods was simply a ticking timebomb, waiting to burst – because it’s impossible to leave a system of fixed exchange rates in to the hands of politicians. They are not able to enforce it, because enforcing it requires them to spend political capital in the process. The idea behind the Bretton Woods was that politicians were to deflate their economies whenever tradedeficits arose, to curb the damage to competitiveness inflicted by inflation. But US politicians would never do this, as they could simply finance the deficit by printing money. In the end the gravitational pull of the “Triffin dilemma” became irresistible, forcing Nixon to abolish the system of fixed rates.

It seems that Mundell simply assumes that if we could just get politicians to agree on a “world currency” and a suitable framework of governance for this currency (rules, institutions like the IMF etc.), a fixed exchange rate system would be preferable to the system of fluctuation. My objection is that this is not plausible – politicians will always look for ways to abuse systems like this, to satisfy their own electoral needs. So the problem is to find a system that is most robust towards this sort of abuse.

I once read an essay about the “Denationalization of money” by Hayek. Back then I found it utterly implausible that you could have that many currencies without the system drowning in transactions costs. However I recently saw a show on National Geographic about the history of the dollar (geeky, I know), and apparently for a substantial amount of the 19th century, US banks each had their “own” version of the dollar. Which meant that there were 500+ different currencies in the us for several decades. Of course this system was rife with problems of monetary fraud. But I still find it fascinating that it seemed to work – if money can be identified with specific banks, this should have an accountability effect on the banks to spur economic responsibility. Of course the system was abolished eventually, in favor of a centralized dollar (and, much later, a central bank). Maybe it didn’t work – or maybe it was politically opportune to abolish it. Who knows. All I know is that it solved much of the problems with “fake money”.

Anyways, read the whole slideshow – it’s interesting. And the last part about the “Goats of international finance” is not without humor. Oh, and I disagree with him that Lehman shouldn’t have been allowed to fail. But that’s mainly because I personally think that the whole “too big too fail”-concept reeks with moral hazard.