'Globalizing Capital: A History of the International Monetary System,' by Barry Eichengreen

by: Arnold Landy

Economist Barry Eichengreen offers great insights into the workings of the international monetary system from 1850-2008 in the second edition of Globalizing Capital (Princeton University Press: 2008). This book shows the strong influence that the monetary system has had on the world economy at various points in history.

The most dramatic example began in 1929, as nations’ rigid reliance on the gold standard facilitated the spread of the Great Depression from country to country. Under the gold standard, the major countries of the world were linked by a common policy whereby nations pledged to convert their currency into gold at a fixed price upon demand by anyone who would present it for such an exchange. This system maintained the value of paper money relative to gold and relative to the currencies of other countries. Countries saw that maintaining fixed currency values facilitated trade with other countries, as importers and exporters were freed from the risk of financial ruin that might otherwise result from fluctuations in currency values between the time an order was placed and the receipt of payment.

The rigid linking of currencies to the price of gold was thought to prevent trade imbalances between countries. If a country imported much more than it exported, the flow of money outward would cause the general price level to drop, which would make additional importing less attractive and make one’s exports more competitive. Another benefit of the gold standard was that the promise to exchange for gold gave the public confidence in paper currency printed by central banks. Unfortunately, this became a double-edged sword.

Here is the Eichengreen script (simplified) of the Great Depression. In 1927, the U.S. Federal Reserve began to raise interest rates in order to curb stock market speculation. The increased rates attracted savings from overseas, which caused declines in economic activity in Europe, which had previously been awash in loan capital from the U.S. This, in turn, caused other countries to raise their own interest rates in order to keep their capital and their gold (gold was money) from fleeing to the U.S and to the other countries that had already raised their rates. Rising interest rates spread from country to country and depressed economic activity. The economic decline led to bank failures which shrank the money supply and led to deflation, which further suppressed the economy. Nations hesitated to step in as lender of last resort to banks because that required them to print quantities of new money to liquify the banks, which would detract from their ability to maintain the link between their currency and gold (there’s that pesky gold standard, again).

In fact, rescuing banks might have been counterproductive, as the printing of money not backed by gold would lead to fears of devaluation and cause investors to withdraw their national currency - denominated bank deposits, which would worsen the crisis further. In other words, reliance on the gold standard threw the world into what would now be called a negative feedback loop, consisting of shrinking bank deposits, imploding supplies of money, deflation and economic contraction.

Eichengreen finds confirmation of the gold standard’s role in transmitting the Depression among countries, as he ties the eventual recoveries by various countries to the their subsequent abandonment of the gold standard, together with reflation and their embrace of flexible exchange rates: first the U.K., then the U.S., then France.

Later chapters in the book cover the Bretton Woods Agreement (1944-1973), the subsequent breakdown of pegged exchange rate, and the various currency crises through 2008. Bretton Woods was an attempt to peg currency exchange rates within a 1% range, while providing mechanisms for cooperation and policy coordination among the member countries. Its purpose was to facilitate trade. It broke down for the same reason that all such rigid systems break down - it failed to accommodate the changing economic experiences and political needs of its members. The Asian currency crisis of the late 90s was similar to earlier crises in that it consisted of the cracking of a framework of pegged exchange rates.

This book also provides brief, but instructive treatment of countries that have used currency boards to peg their exchange rate to the dollar (like Argentina, which did it until pressures caused them to devalue and abandon the peg, and Hong Kong). There is also some discussion of our ongoing trade imbalance with China, wherein China exports goods to the U.S. and keeps its currency exchange rate low by investing in U.S. government debt.

Eichengreen summarizes the factors surrounding the creation of the Euro currency, which has succeeded at promoting trade and economic growth among its members. He provides an insightful case for its continued survival, even as individual members may find themselves under strain from time to time, unable to accelerate the printing of money to prime the national economy. His point is that any country that seriously considers abandoning its reliance on the Euro currency in order to engage in monetary stimulus will experience an outflow of funds from its banking system as investors will want to avoid having their Euro bank deposits converted to a new national currency that will almost certainly lose value. The decline of bank deposits would depress that nation’s economy even further. Awareness of the likelihood of this scenario will likely keep the Euro family together for the foreseeable future.

Globalizing Capital presents a comprehensive story. Eichengreen’s insights on the mechanisms by which the Great Depression traveled from country to country have been quoted extensively by such experts on the Great Depression as Christina Romer, chair of the Obama Administration's Council of Economic Advisers, and Ben Bernanke, chairman of the Federal Reserve. Overall, reading this book requires some effort, but it gives the reader a solid understanding of how evolving changes in the international monetary system have directly affected the course of economic history.