System Malfunction

AuthorWilliam R. White
PositionChairman of the Economic and Development Review Committee of the Organisation for Economic Co-operation and Development. He writes in his personal capacity.

The global economy today is characterized by various kinds of international imbalances, any of which could cause a future crisis. It seems worth asking whether these various imbalances have a single root—the absence of an international monetary system. It is a simple fact that we no longer have internationally agreed rules of behavior to constrain the shorter-term actions of individual sovereign states with a view to longer-term benefits for all.

There were such rules under the gold standard that preceded World War I and under the Bretton Woods system that followed World War II but imploded four decades ago. There are such rules today in the euro area. But at the global level there are none. Major countries can, and generally do, pursue their own short-term interests, not least through lower interest rates and other unconventional monetary policies to stimulate the domestic economy regardless of the implications for other countries. This runs the longer-term risk of unexpected consequences at home, not least the possibility of future inflation and other domestic imbalances. Moreover, by creating international imbalances of various kinds, such policies may also act against the longer-term best interests of other countries.

Who is concerned with the good health of the global economy as a whole? Since the demise of the Bretton Woods system, the IMF—which oversaw the system—has been concerned primarily with monitoring the behavior of its member countries and providing conditional assistance to countries in need. Nevertheless, the IMF has continued to express concern through various channels about national policies it does not deem in the best interests of the global community. However, for many large countries, these policy recommendations count for little more than advice. The United States, although the world’s largest international debtor, has freedom of action thanks to the continued use of the dollar as the principal reserve currency. As for large creditor countries, the IMF’s influence over their policies has always been very limited.

Global imbalances

When economists talk of global imbalances, they may be referring to a number of different concerns. The most long-standing source of concern is current account imbalances—the difference between what a country spends abroad and what it receives from foreign sources. The current account measures net imports and exports of goods and services, income (such as salaries and dividends), and transfers (such as remittances and pensions). By definition current account surpluses and deficits are equal to net capital flows. The risk is that countries with large current account deficits can lose the confidence of those who are the source of such flows, which can culminate in a foreign exchange rate crisis. Such crises commonly hurt both output and employment. Ironically, despite repeated warnings about this possibility for the United States, which has run regular current account deficits since the 1960s, no crisis has materialized. In contrast, major increases in current account imbalances among countries in the euro area did eventually lead to crisis, shattering the belief that such crises were impossible inside a single-currency zone.

A second kind of global imbalance, related to gross cross-border capital flows, has received increasing attention in recent years. For all its presumed merits, hot money, funds that flow from one country to another from investors seeking the highest returns, can wreak havoc on smaller countriesâboth on the way in and on the way...

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