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Monetary Disorder

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Currency chaos is back, highlighting demands for a revised international monetary order. The rapid decline of the dollar and the pound, as also of the renminbi — now more firmly tied to the dollar than ever — is fanning tensions. Some of the ghosts of the 1930s have returned — in particular, the fear of unfair trade advantages caused by competitive devaluation. US Treasury Secretary Timothy Geithner has already accused China of currency manipulation.

There are two sharply contrasting approaches to getting currencies right. One is to have an international conference where experts can suggest models to calculate exchange rates and politicians can negotiate. But history suggests that collective negotiations are unlikely to succeed. At the 1987 Louvre conference, there was not even any agreement about what had been concluded.

The second, better, approach is agreements in each country on the appropriate basis for monetary policy. If these are widely accepted and mutually consistent, a stable international monetary system will emerge.

There have been two models for such a consensus. In the first, a century ago, confidence was underpinned by gold. More recently, it has depended upon human intellect to solve policy problems. The end of inflation and "the great moderation" of the past three decades were fundamental to the liberalisation of large parts of the world and to increased confidence, trade and prosperity.

The search for a monetary rule during the latter period had two phases: in the earliest attempt, the emphasis was on monetary targeting. In the second, more successful, phase, more and more countries adopted either explicit or implicit inflation targets. But inflation targeting was never an obvious concept, and the financial crisis has discredited it. In 2003, Ben Bernanke, then a governor of the US Federal Reserve, stated in a speech that many Americans considered inflation targeting "foreign, impenetrable, and possibly slightly subversive". That feeling is stronger now.

It was always uncertain how much central banks should attempt to correct or limit asset-price bubbles when there was no corresponding rise in inflation. Rising asset prices lead to a general increase in purchasing power, because many asset holders are willing (and able) to borrow more. Many Europeans have argued in recent years that monetary policy should take asset-price movements into account, whereas American policymakers and academics largely resisted this approach.

Asset prices and consumer-price inflation may move in different directions, as they did in the 2000s, and weighing both factors would produce inconsistent recommendations. As a result, central banks ran the risk of no longer appearing to follow a clearly formulated policy guideline. The credibility associated with a simple rule disappeared.

After the financial crisis, we have become wiser. Formulating monetary policy has become a more complex process, but also a more politicised one, which is why it is likely to become more chaotic, with sharp differences between national approaches.

As divergences become explicit, the demand for a wider political debate about monetary policy and for political involvement in its formulation will become more intense. The Bank of England's Monetary Policy Committee (MPC) has often been presented as a pioneer in making monetary policy transparent. But the transparency that resulted from publication of who voted for and against rate increases led to public viewing members as hawks or doves.

If it is clear how one will vote, there will be increased demand for a public debate about who should be chosen. In Europe, a debate about the political accountability of European central banks has been simmering since before the European Central Bank was even established. Differences will lead to a demand for a greater political say.

This looks like a dramatic repeat of the inter-War story, when it was impossible to obtain consensus about policy and mutually consistent policy frameworks. Then, too, central banks were blamed when their policy framework (the gold standard) disintegrated. Consequently, nationalisation of the central bank became a major platform of the British or French left. That, in turn, cleared the way for manipulation of currencies in the interests of exporters, businesses, and labour unions.

The result was international monetary chaos — precisely the path we are heading down now.

Harold James is Professor of History and International Affairs at the Princeton University
Copyright: Project Syndicate, 2009.

(This story was published in Businessworld Issue Dated 16-11-2009)