Global Finance: Past and Present

• Author: Alan M. Taylor
• Position: Professor of Economics and Chancellor's Fellow at the University of California
• Pages: 28-31

Policymakers in two eras of globalization faced the same "trilemma" of difficult policy trade-offs

Page 28

Despite occasional manifestations of disappointment and distrust, the globalization of economic life is now almost taken for granted. Nowhere has this trend been more pervasive than in global financial markets in the past few decades. Capital flows have surged in volume, in both the developed and the developing world, creating new opportunities for economic benefit and difficult challenges for policymakers. The dust has by no means settled.

It may surprise some readers to learn that the paragraph above describes not only 2004 but also 1904, during the era of globalization that spanned the years 1870 to 1914. The striking parallels between that era and the current era of globalization have been described in many recent studies. These parallels raise a number of questions about the evolution of the global economy in the 19th century, its collapse in 1914, and the rebirth of globalization at the end of the 20th century.

With Maurice Obstfeld (University of California, Berkeley), I have explored these events systematically, which resulted in our new economic history of global capital markets and the attendant political-economy problems. We found that economic policymaking has, throughout, been characterized by a fundamental macroeconomic policy trilemma that all governments face. That is, it is not possible for a government simultaneously to peg the exchange rate, keep an open capital market, and enjoy monetary policy autonomy. In this article, I synthesize our evidence for the pervasiveness of the trilemma and draw lessons for today's policymakers.

Rise and fall of globalization

In the early 19th century, international finance was, in many respects, a fairly direct descendant of its 17th-century predecessor and was still dominated by London and Amsterdam. Institutionally, the more or less laissez-faire attitudes that had prevailed since 1688 allowed these markets to mature. But the volume of capital remained small and was confined mostly to finance within Europe, and technological progress was slow. However, this was all to change in a matter of a few decades, with the development of a global financial market and its assorted handmaidens-the telegraph and other improvements in transportation and communications; the increasing rate of growth of European settlement; and the arrival, through imposition or imitation, of institutional "modernization." Of particular importance for the story we tell was the emergence of the classical gold standard as an international monetary regime. The world economy of 1913 was vastly different from the early 19th-century one.

But this economy imploded under the strain of the two world wars and the Great Depression, as well as under the political-economy tensions that accompanied this era of unprecedented upheaval. By the mid-1930s, the free flow of goods, people, and capital was almost at a standstill. The better part of the 20th century-at least since 1929 and perhaps since 1913-is a tale of radical experimentation in political economy and monetary policy that naysayers, beginning with economic historian Karl Polanyi, predicted would doom economic integration for good. For many decades, they appeared to be right.

Enter John Maynard Keynes and Harry Dexter White, architects of the postwar economic order known as the Bretton Woods system, with the IMF as one of its foundations. The IMF embodied a new macroeconomic paradigm, with currency pegs and capital controls as cornerstones. Because the role of free capital flows in the crises of the 1930s had come under suspicion, the IMF espoused capital con-Page 29trols. Similarly, floating rates were associated with speculation and instability and, hence, the disruption of...