Eichengreen Globalising capital
he international monetary system is the glue that binds national economies
together. Its role is to lend order and stability to foreign exchange markets, to
encourage the elimination of balance-of-payments problems, and to provide
access to international credits in the event of disruptive shocks. Nations fi nd it
diffi cult to effi ciently exploit the gains from trade and foreign lending in the
absence of an adequately functioning international monetary mechanism.
Whether that mechanism is functioning poorly or well, it is impossible to understand the operation of the international economy without also understanding its monetary system.
Any account of the development of the international monetary system is
also necessarily an account of the development of international capital markets. Hence the motivation for organizing this book into fi ve parts, each corresponding to an era in the development of global capital markets. Before World
War I, controls on international fi nancial transactions were absent and international capital fl ows reached high levels. The interwar period saw the collapse
of this system, the widespread imposition of capital controls, and the decline
of international capital movements. The three decades following World War II
were then marked by the progressive relaxation of controls and the gradual recovery of international capital fl ows. The fourth quarter of the twentieth century was again one of signifi cant capital mobility. And the period since the
turn of the century has been one of very high capital mobility—in some sense
even greater than that which prevailed before 1913.
This U-shaped pattern traced over time by the level of international capital
mobility is an obvious challenge to the dominant explanation for the post1971 shift from fi xed to fl exible exchange rates. Pegged rates were viable for
the fi rst quarter-century after World War II, the argument goes, because of the
limited mobility of fi nancial capital, and the subsequent shift to fl oating rates
was an inevitable consequence of increasing capital fl ows. Under the Bretton
Woods System that prevailed from 1945 through 1971, controls loosened the
2
constraints on policy. They allowed policymakers to pursue domestic goals
without destabilizing the exchange rate. They provided the breathing space
needed to organize orderly exchange rate changes. But the effectiveness of
controls was eroded by the postwar reconstruction of the international economy and the development of new markets and trading technologies. The
growth of highly liquid international fi nancial markets in which the scale of
transactions dwarfed offi cial international reserves made it all but impossible
to carry out orderly adjustments of currency pegs. Not only could discussion
before the fact excite the markets and provoke unmanageable capital fl ows,
but the act of devaluation, following obligatory denials, could damage the authorities’ reputation for defending the peg. Thus, at the same time that pegged
exchange rates became more costly to maintain, they became more diffi cult to
adjust. The shift to fl oating was the inevitable consequence.
The problem with this story, it will be evident, is that international capital
mobility was also high before World War I, yet this did not prevent the successful operation of pegged exchange rates under the classical gold standard.
Even a glance back at history reveals that changes in the extent of capital mobility do not by themselves constitute an adequate explanation for the shift
from pegged to fl oating rates.
What was critical for the maintenance of pegged exchange rates, I argue
in this book, was protection for governments from pressure to trade exchange
rate stability for other goals. Under the nineteenth-century gold standard the
source of such protection was insulation from domestic politics. The pressure
brought to bear on twentieth-century governments to subordinate currency
stability to other objectives was not a feature of the nineteenth-century world.
Because the right to vote was limited, the common laborers who suffered most
from hard times were poorly positioned to object to increases in central bank
interest rates adopted to defend the currency peg. Neither trade unions nor
parliamentary labor parties had developed to the point where workers could
insist that defense of the exchange rate be tempered by the pursuit of other
objectives. The priority attached by central banks to defending the pegged exchange rates of the gold standard remained basically unchallenged. Governments were therefore free to take whatever steps were needed to defend their
currency pegs.
Come the twentieth century, these circumstances were transformed. It was
no longer certain that, when currency stability and full employment clashed,
the authorities would opt for the former. Universal male suffrage and the rise
of trade unionism and parliamentary labor parties politicized monetary and
fi scal policymaking. The rise of the welfare state and the post–World War II
commitment to full employment sharpened the trade-off between internal and
CHAPTER ONE
3
INTRODUCTION
external balance. This shift from classic liberalism in the nineteenth century to
embedded liberalism in the twentieth diminished the credibility of the authorities’ resolve to defend the currency peg.1
This is where capital controls came in. They loosened the link between
domestic and foreign economic policies, providing governments room to pursue other objectives such as the maintenance of full employment. Governments may no longer have been able to take whatever steps were needed to
defend a currency peg, but capital controls limited the extremity of the steps
that were required. By limiting the resources that the markets could bring to
bear against an exchange rate peg, controls limited the steps that governments
had to take in its defense. For several decades after World War II, limits on
capital mobility substituted for limits on democracy as a source of insulation
from market pressures.
Over time, however, capital controls became more diffi cult to enforce.
With neither limits on capital mobility nor limits on democracy to insulate
governments from market pressures, maintaining pegged exchange rates became problematic. In response, some countries moved toward more freely
fl oating exchange rates, while others, in Western Europe, sought to stabilize
their exchange rates once and for all by establishing a monetary union.
In some respects, this argument is an elaboration of one advanced by Karl
Polanyi more than half a century ago.2
Writing in 1944, the year of the Bretton
Woods Conference, Polanyi suggested that the extension of the institutions of
the market over the course of the nineteenth century aroused a political reaction in the form of associations and lobbies that ultimately undermined the
stability of the market system. He gave the gold standard a place of prominence among the institutions of laissez faire in response to which this reaction
had taken place. And he suggested that the opening of national economic decision making to parties representing working-class interests had contributed to
the downfall of that international monetary system. In a sense, this book asks
whether Polanyi’s thesis stands the test of time. Can the international monetary history of the second half of the twentieth century be understood as the
further unfolding of Polanyian dynamics, in which democratization again
came into confl ict with economic liberalization in the form of free capital mobility and fi xed exchange rates? Or do recent trends toward fl oating rates and
monetary unifi cation point to ways of reconciling freedom and stability in the
two domains?
1
The term embedded liberalism, connoting a commitment to free markets tempered by a
broader commitment to social welfare and full employment, was coined by John Ruggie (1983).
2
Polanyi 1944.
CHAPTER ONE
4
To portray the evolution of international monetary arrangements as many
individual countries responding to a common set of circumstances would be
misleading, however. Each national decision was not, in fact, independent of
the others. The source of their independence was the network externalities that
characterize international monetary arrangements. When most of your friends
and colleagues use computers with Windows as their operating system, you
may choose to do likewise to obtain technical advice and ease the exchange of
data fi les, even if a technologically incompatible alternative exists (think
Linux or Leopard) that is more reliable and easier to learn when used in isolation. These synergistic effects infl uence the costs and benefi ts of the individual’s choice of technology. (For example, I wrote this book on a Windowsbased system because that is the technology used by most of my colleagues.)
Similarly, the international monetary arrangement that a country prefers will
be infl uenced by arrangements in other countries. Insofar as the decision of a
country at a point in time depends on decisions made by other countries in
preceding periods, the former will be infl uenced by history. The international
monetary system will display path dependence. Thus, a chance event like
Britain’s “accidental” adoption of the gold standard in the eighteenth century
could place the system on a trajectory where virtually the entire world had adopted that same standard within a century and a half.
Given the network-externality characteristic of international monetary arrangements, reforming them is necessarily a collective endeavor. But the multiplicity of countries creates negotiating costs. Each government will be
tempted to free-ride by withholding agreement unless it secures concessions.
Those who seek reform must possess political leverage suffi cient to discourage such behavior. They are most likely to do so when a nexus of international joint ventures, all of which stand to be jeopardized by noncooperative
behavior, exists. Not surprisingly, such encompassing political and economic
linkages are rare. This explains the failure of international monetary conferences in the 1870s, 1920s, and 1970s. In each case, inability to reach an
agreement to shift the monetary system from one trajectory to another allowed it to continue evolving of its own momentum. The only signifi cant
counterexamples are the Western alliance during and after World War II,
which developed exceptional political solidarity in the face of Nazi and Soviet threats and was able to establish the Bretton Woods System, and the European Community (now European Union), which made exceptional progress
toward economic and political integration and established the European Monetary System and now the euro.
The implication is that the development of the international monetary
system is fundamentally a historical process. The options available to aspiring
5
INTRODUCTION
reformers at any time are not independent of international monetary arrangements in the past. And the arrangements of the recent past themselves refl ect
the infl uence of earlier events. Neither the current state nor the future prospects of this evolving order can be understood without an appreciation of its
history.
Conclusion
since the collapse of the Bretton Woods System in the early 1970s, a slow but then dramatically accelerating shift away from the earlier regime of peggedbut-adjustable exchange rates has occurred. As late as 1970 the idea of fl oating the exchange rate was almost unheard of except as a temporary expedient in extraordinary circumstances. But by 1990 roughly 15 percent of all countries had moved to fl oating rates. By 2006 this share had risen to nearly 30 percent. The movement away from pegged-but-adjustable rates was especially prominent in the advanced countries. By 2006 such intermediate arrangements had essentially disappeared, in favor of monetary unifi cation in Europe and fl oating elsewhere. In emerging markets, where monetary unifi cation was generally not an option (at least not yet), soft pegs did not disappear, but fl oating similarly gained ground.1 These trends are most immediately the consequence of rising capital mobility. In the aftermath of World War II, memories of the debt crisis of the 1930s and the fact that defaulted foreign bonds had not yet been cleared away discouraged investors from looking abroad. Those who might have done so were constrained by tight controls on international capital fl ows. The maintenance of capital controls had been authorized by the Articles of Agreement negotiated at Bretton Woods in order to reconcile exchange rate stability with other goals: in the short run, concerted programs of postwar reconstruction; in the long run, the pursuit of full employment. Those capital controls were integral to the Bretton Woods System of pegged but adjustable rates. By loosening the link between domestic and foreign fi nance, they allowed governments to alter domestic fi nancial conditions in the pursuit of other goals without immediately destabilizing the exchange 1The “not yet” alludes not so much to the possibility of monetary unions in other parts of the world as to the likelihood that EU members presently classifi ed as emerging markets will eventually adopt the euro (a process that began with Slovenia in 2007). By the time they do so, of course, many of them will presumably have graduated to advanced-country status. 229 CONCLUSION rate. Controls were not so watertight as to obviate the need for exchange rate adjustments when domestic and foreign conditions diverged signifi cantly, but they provided breathing space to organize orderly realignments and ensured the survival of the system. Controls on capital movements were also seen as necessary for reconstructing international trade. If volatile capital fl ows destabilized currencies, governments might again be tempted to defend them by raising tariffs and tightening import quotas, as they had in the interwar years. If countries devalued, their neighbors might again retaliate with tariffs and quotas of their own. The lesson gleaned from the 1930s was that currency instability was incompatible with a multilateral system of free international trade. Insofar as the recovery of trade was necessary for the restoration of global growth, so were currency stability and, by implication, limits on capital fl ows. But the conjunction of free trade and fettered fi nance was not stable. Once current account convertibility was restored at the end of the 1950s, it became diffi cult to know whether a specifi c foreign exchange transaction had been undertaken for purposes related to trade or currency speculation. Firms could under-invoice exports and over-invoice imports to spirit capital out of the country. More generally, it became impossible to keep domestic markets tightly regulated once international transactions were liberalized. As fi nancial markets joined the list of those undergoing decontrol, new channels were opened through which capital might fl ow, and the feasibility of keeping fi - nance bottled up diminished accordingly. The consequence was mounting strains on the Bretton Woods System of pegged but adjustable rates. Governments could not consider devaluing without unleashing a tidal wave of destabilizing capital fl ows. Hence parity adjustments during the period of current-account convertibility were few and far between. The knowledge that defi cit countries hesitated to adjust rendered surplus countries, now fearing the cost, reluctant to provide support. And the freedom for governments to pursue independent macroeconomic policies was constrained by the rise of capital mobility. When doubts arose about their willingness to sacrifi ce other objectives on the altar of the exchange rate, defending the currency could require interest-rate hikes and other painful policy adjustments that were politically unsupportable. Confi dence in currency stability and ultimately stability itself were the casualties. These same unstable dynamics are evident in the evolution of the European Monetary System constructed by the members of the European Community after the breakdown of Bretton Woods. Exchange rate stability was necessary for the smooth operation of Europe’s customs union and for the construction of an integrated European market. To buttress the stability of intra-European rates, CHAPTER SEVEN 230 capital controls were therefore maintained when the EMS was established. Controls provided autonomy for domestic policy and breathing space for organizing realignments. But again, the conjunction of free trade and fettered fi - nance was not stable. The liberalization of other intra-European transactions, which was after all the raison d’etre of the European Community, undermined the effectiveness of controls, which were themselves incompatible with the goal of constructing a single European market. Once controls went by the board, the EMS grew rigid and brittle. The 1992–93 recession then forced the issue. Currency traders knew that governments had limited political capacity in an environment of high unemployment to raise interest rates and adopt the other policies of austerity needed to defend their currency pegs. When the attacks came, governments were forced to abandon the narrow-band EMS. The obvious conclusion is that greater exchange rate fl exibility is an inevitable consequence of rising international capital mobility. It is important, therefore, to recollect the period prior to 1913 when high international capital mobility did not preclude the maintenance of stable rates. Before World War I there was no question of the priority attached to the gold standard peg. There was only limited awareness that central bank policy might be directed at targets such as unemployment. And any such awareness had little impact on policy, given the limited extent of the franchise, the weakness of trade unions, and the absence of parliamentary labor parties. There being no question of the willingness and ability of governments to defend the currency peg, capital fl owed in stabilizing directions in response to shocks. Workers and fi rms allowed wages to adjust because they knew that there was little prospect of an exchange rate change to erase the consequences of disequilibrium costs. Together these factors operated as a virtuous circle that lent credibility to the commitment to pegged rates. The credibility of this commitment obviated the need for capital controls to insulate governments from market pressures that might produce a crisis. The authorities could take the steps needed to defend the currency without suffering dire political consequences. Because the markets were aware of this fact, they were less inclined to attack the currency in the fi rst place. In a sense, limits on the extent of democracy substituted for limits on the extent of capital mobility as a source of insulation. But with the extension of the electoral franchise and the declining effectiveness of controls, that insulation disappeared, rendering pegged exchange rates more costly and diffi cult to maintain. Karl Polanyi, writing more than half a century ago, described how the operation of pegged exchange rates had been complicated by the politicization of the policy environment.2 Polanyi saw the spread of universal suffrage and 2Polanyi 1944, pp. 133–34, 227–29, and passim. 231 CONCLUSION democratic associationalism as a reaction against the tyranny of the market forces that the gold standard had helped to unleash. The consequent politicization of the policy environment, he recognized, had destroyed the viability of the gold standard itself. The construction after World War II of a system in which capital controls reconciled the desire for exchange rate stability with the pursuit of other goals would not have surprised Polanyi. Nor would the politicization of the policy environment. What would have surprised him, presumably, was the resurgence of market forces, the extent to which they undermined the effectiveness of capital controls, and how they overwhelmed the efforts of governments to stabilize their currencies.3 A consequence of the market’s unanticipated resilience was the post-1971 shift toward more fl exible exchange rates. But this trend was uneven. Managed fl oating is most evident in emerging markets—by which is meant middle-income countries increasingly integrated into global fi nance. Unlike the poorest countries, these middle-income countries have the institutional capacity to defi ne and implement an independent monetary policy. They are able to substitute infl ation targeting for a rigid exchange rate peg as the anchor for monetary policy. They too fi nd the enforcement of capital controls more diffi - cult as their fi nancial markets develop, and they too are conscious of a larger constituency favoring integration with global capital markets. For all these reasons, a growing number of them fi nd managed fl oating a logical option for exchange-rate policy. Poorer countries—countries that might be referred to as “not yet emerging” markets—lack the same capacity to run an independent monetary policy. The underdevelopment of their fi nancial markets means that controls on capital fl ows are still relatively effective. They are reluctant to throw open their capital markets, since it is not clear that foreign capital will fl ow into appropriate uses or be prudently managed. For them, relaxing capital controls goes hand in hand with developing domestic fi nancial markets and institutions— which means that it will be a slow and laborious process. And so long as restrictions on capital mobility remain in place, pegging the exchange rate remains viable. But if less-developed countries see in their advanced-country counterparts an image of their future, as Karl Marx wrote, then the future will bring better developed fi nancial markets and institutions, political pressure for 3It is understandable that neither he nor John Maynard Keynes, Harry Dexter White, and the other architects of the postwar international monetary system, working in the aftermath of the Great Depression, appreciated fully the resilience of the market or anticipated the extent to which markets would frustrate efforts to tightly regulate economic activity and, in the case of exchange rates, to use capital controls as a basis for management. CHAPTER SEVEN 232 the relaxation of statutory restrictions on fi nancial freedom, and pressure to shift toward more fl exible exchange rates. Anyway, that is one image of the future. Another is suggested by Europe. There the tension between capital mobility, political democracy, and pegged but adjustable exchange rates was met not by fl oating the exchange rate but by eliminating it, if not entirely then at least within the euro area where separate national currencies were replaced by the euro. Of course, nothing ensures that Europe’s grand experiment will succeed. In particular, it is not clear whether the members of the euro area will successfully meet Polanyi’s challenge. In an age of embedded liberalism, the commitment to free markets is tempered by the pursuit of full employment and other social goals, and monetary policy is a handmaiden to these loftier objectives, not an end in itself. It is not clear that a euro area made up of a collection of national economies all still with quite different structures will be able to agree on what single monetary policy best meets these needs. Europe not being a political federation, it is not clear that its countries will succeed in defi ning a common set of interests, much less in charging the European Central Bank with carrying them out. To be sure, Europe has many things going for it. Its national economies continue to converge. It has gone further than other parts of the world in building a functional set of regional political institutions. Europeans have a shared heritage and a reasonably common understanding of the social goals to which monetary and exchange rate policies are ultimately subservient. They have an incentive to make a success of their grand monetary experiment insofar as its collapse would be a blow to the larger project of European integration. Even in narrowly fi nancial terms, the costs of exiting from the euro area would be extremely high. All these are reasons to think that Europe will have to make its monetary union work. But what is feasible in Europe is not likely to be feasible elsewhere. Asians and Latin Americans fantasize about regional monetary union, but fantasy is not reality. In these other regions, different countries have drawn different lessons from past confl icts, and there is less willingness to compromise national sovereignty in order to create a regional monetary union. The ability to agree on the social goals for which monetary policy should be enlisted is correspondingly more limited. But as economic and social systems develop, countries there too will feel pressure to move toward more open political systems and more open fi nancial markets. There too the combination of political democracy and capital mobility will force the abandonment of currency pegs. Floating will be the remaining alternative. A fl oating exchange rate is not the best of all worlds. But it is at least a feasible one.
Conclusion
since the collapse of the Bretton Woods System in the early 1970s, a slow but then dramatically accelerating shift away from the earlier regime of peggedbut-adjustable exchange rates has occurred. As late as 1970 the idea of fl oating the exchange rate was almost unheard of except as a temporary expedient in extraordinary circumstances. But by 1990 roughly 15 percent of all countries had moved to fl oating rates. By 2006 this share had risen to nearly 30 percent. The movement away from pegged-but-adjustable rates was especially prominent in the advanced countries. By 2006 such intermediate arrangements had essentially disappeared, in favor of monetary unifi cation in Europe and fl oating elsewhere. In emerging markets, where monetary unifi cation was generally not an option (at least not yet), soft pegs did not disappear, but fl oating similarly gained ground.1 These trends are most immediately the consequence of rising capital mobility. In the aftermath of World War II, memories of the debt crisis of the 1930s and the fact that defaulted foreign bonds had not yet been cleared away discouraged investors from looking abroad. Those who might have done so were constrained by tight controls on international capital fl ows. The maintenance of capital controls had been authorized by the Articles of Agreement negotiated at Bretton Woods in order to reconcile exchange rate stability with other goals: in the short run, concerted programs of postwar reconstruction; in the long run, the pursuit of full employment. Those capital controls were integral to the Bretton Woods System of pegged but adjustable rates. By loosening the link between domestic and foreign fi nance, they allowed governments to alter domestic fi nancial conditions in the pursuit of other goals without immediately destabilizing the exchange 1The “not yet” alludes not so much to the possibility of monetary unions in other parts of the world as to the likelihood that EU members presently classifi ed as emerging markets will eventually adopt the euro (a process that began with Slovenia in 2007). By the time they do so, of course, many of them will presumably have graduated to advanced-country status. 229 CONCLUSION rate. Controls were not so watertight as to obviate the need for exchange rate adjustments when domestic and foreign conditions diverged signifi cantly, but they provided breathing space to organize orderly realignments and ensured the survival of the system. Controls on capital movements were also seen as necessary for reconstructing international trade. If volatile capital fl ows destabilized currencies, governments might again be tempted to defend them by raising tariffs and tightening import quotas, as they had in the interwar years. If countries devalued, their neighbors might again retaliate with tariffs and quotas of their own. The lesson gleaned from the 1930s was that currency instability was incompatible with a multilateral system of free international trade. Insofar as the recovery of trade was necessary for the restoration of global growth, so were currency stability and, by implication, limits on capital fl ows. But the conjunction of free trade and fettered fi nance was not stable. Once current account convertibility was restored at the end of the 1950s, it became diffi cult to know whether a specifi c foreign exchange transaction had been undertaken for purposes related to trade or currency speculation. Firms could under-invoice exports and over-invoice imports to spirit capital out of the country. More generally, it became impossible to keep domestic markets tightly regulated once international transactions were liberalized. As fi nancial markets joined the list of those undergoing decontrol, new channels were opened through which capital might fl ow, and the feasibility of keeping fi - nance bottled up diminished accordingly. The consequence was mounting strains on the Bretton Woods System of pegged but adjustable rates. Governments could not consider devaluing without unleashing a tidal wave of destabilizing capital fl ows. Hence parity adjustments during the period of current-account convertibility were few and far between. The knowledge that defi cit countries hesitated to adjust rendered surplus countries, now fearing the cost, reluctant to provide support. And the freedom for governments to pursue independent macroeconomic policies was constrained by the rise of capital mobility. When doubts arose about their willingness to sacrifi ce other objectives on the altar of the exchange rate, defending the currency could require interest-rate hikes and other painful policy adjustments that were politically unsupportable. Confi dence in currency stability and ultimately stability itself were the casualties. These same unstable dynamics are evident in the evolution of the European Monetary System constructed by the members of the European Community after the breakdown of Bretton Woods. Exchange rate stability was necessary for the smooth operation of Europe’s customs union and for the construction of an integrated European market. To buttress the stability of intra-European rates, CHAPTER SEVEN 230 capital controls were therefore maintained when the EMS was established. Controls provided autonomy for domestic policy and breathing space for organizing realignments. But again, the conjunction of free trade and fettered fi - nance was not stable. The liberalization of other intra-European transactions, which was after all the raison d’etre of the European Community, undermined the effectiveness of controls, which were themselves incompatible with the goal of constructing a single European market. Once controls went by the board, the EMS grew rigid and brittle. The 1992–93 recession then forced the issue. Currency traders knew that governments had limited political capacity in an environment of high unemployment to raise interest rates and adopt the other policies of austerity needed to defend their currency pegs. When the attacks came, governments were forced to abandon the narrow-band EMS. The obvious conclusion is that greater exchange rate fl exibility is an inevitable consequence of rising international capital mobility. It is important, therefore, to recollect the period prior to 1913 when high international capital mobility did not preclude the maintenance of stable rates. Before World War I there was no question of the priority attached to the gold standard peg. There was only limited awareness that central bank policy might be directed at targets such as unemployment. And any such awareness had little impact on policy, given the limited extent of the franchise, the weakness of trade unions, and the absence of parliamentary labor parties. There being no question of the willingness and ability of governments to defend the currency peg, capital fl owed in stabilizing directions in response to shocks. Workers and fi rms allowed wages to adjust because they knew that there was little prospect of an exchange rate change to erase the consequences of disequilibrium costs. Together these factors operated as a virtuous circle that lent credibility to the commitment to pegged rates. The credibility of this commitment obviated the need for capital controls to insulate governments from market pressures that might produce a crisis. The authorities could take the steps needed to defend the currency without suffering dire political consequences. Because the markets were aware of this fact, they were less inclined to attack the currency in the fi rst place. In a sense, limits on the extent of democracy substituted for limits on the extent of capital mobility as a source of insulation. But with the extension of the electoral franchise and the declining effectiveness of controls, that insulation disappeared, rendering pegged exchange rates more costly and diffi cult to maintain. Karl Polanyi, writing more than half a century ago, described how the operation of pegged exchange rates had been complicated by the politicization of the policy environment.2 Polanyi saw the spread of universal suffrage and 2Polanyi 1944, pp. 133–34, 227–29, and passim. 231 CONCLUSION democratic associationalism as a reaction against the tyranny of the market forces that the gold standard had helped to unleash. The consequent politicization of the policy environment, he recognized, had destroyed the viability of the gold standard itself. The construction after World War II of a system in which capital controls reconciled the desire for exchange rate stability with the pursuit of other goals would not have surprised Polanyi. Nor would the politicization of the policy environment. What would have surprised him, presumably, was the resurgence of market forces, the extent to which they undermined the effectiveness of capital controls, and how they overwhelmed the efforts of governments to stabilize their currencies.3 A consequence of the market’s unanticipated resilience was the post-1971 shift toward more fl exible exchange rates. But this trend was uneven. Managed fl oating is most evident in emerging markets—by which is meant middle-income countries increasingly integrated into global fi nance. Unlike the poorest countries, these middle-income countries have the institutional capacity to defi ne and implement an independent monetary policy. They are able to substitute infl ation targeting for a rigid exchange rate peg as the anchor for monetary policy. They too fi nd the enforcement of capital controls more diffi - cult as their fi nancial markets develop, and they too are conscious of a larger constituency favoring integration with global capital markets. For all these reasons, a growing number of them fi nd managed fl oating a logical option for exchange-rate policy. Poorer countries—countries that might be referred to as “not yet emerging” markets—lack the same capacity to run an independent monetary policy. The underdevelopment of their fi nancial markets means that controls on capital fl ows are still relatively effective. They are reluctant to throw open their capital markets, since it is not clear that foreign capital will fl ow into appropriate uses or be prudently managed. For them, relaxing capital controls goes hand in hand with developing domestic fi nancial markets and institutions— which means that it will be a slow and laborious process. And so long as restrictions on capital mobility remain in place, pegging the exchange rate remains viable. But if less-developed countries see in their advanced-country counterparts an image of their future, as Karl Marx wrote, then the future will bring better developed fi nancial markets and institutions, political pressure for 3It is understandable that neither he nor John Maynard Keynes, Harry Dexter White, and the other architects of the postwar international monetary system, working in the aftermath of the Great Depression, appreciated fully the resilience of the market or anticipated the extent to which markets would frustrate efforts to tightly regulate economic activity and, in the case of exchange rates, to use capital controls as a basis for management. CHAPTER SEVEN 232 the relaxation of statutory restrictions on fi nancial freedom, and pressure to shift toward more fl exible exchange rates. Anyway, that is one image of the future. Another is suggested by Europe. There the tension between capital mobility, political democracy, and pegged but adjustable exchange rates was met not by fl oating the exchange rate but by eliminating it, if not entirely then at least within the euro area where separate national currencies were replaced by the euro. Of course, nothing ensures that Europe’s grand experiment will succeed. In particular, it is not clear whether the members of the euro area will successfully meet Polanyi’s challenge. In an age of embedded liberalism, the commitment to free markets is tempered by the pursuit of full employment and other social goals, and monetary policy is a handmaiden to these loftier objectives, not an end in itself. It is not clear that a euro area made up of a collection of national economies all still with quite different structures will be able to agree on what single monetary policy best meets these needs. Europe not being a political federation, it is not clear that its countries will succeed in defi ning a common set of interests, much less in charging the European Central Bank with carrying them out. To be sure, Europe has many things going for it. Its national economies continue to converge. It has gone further than other parts of the world in building a functional set of regional political institutions. Europeans have a shared heritage and a reasonably common understanding of the social goals to which monetary and exchange rate policies are ultimately subservient. They have an incentive to make a success of their grand monetary experiment insofar as its collapse would be a blow to the larger project of European integration. Even in narrowly fi nancial terms, the costs of exiting from the euro area would be extremely high. All these are reasons to think that Europe will have to make its monetary union work. But what is feasible in Europe is not likely to be feasible elsewhere. Asians and Latin Americans fantasize about regional monetary union, but fantasy is not reality. In these other regions, different countries have drawn different lessons from past confl icts, and there is less willingness to compromise national sovereignty in order to create a regional monetary union. The ability to agree on the social goals for which monetary policy should be enlisted is correspondingly more limited. But as economic and social systems develop, countries there too will feel pressure to move toward more open political systems and more open fi nancial markets. There too the combination of political democracy and capital mobility will force the abandonment of currency pegs. Floating will be the remaining alternative. A fl oating exchange rate is not the best of all worlds. But it is at least a feasible one.
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