Political economy

Cooperation in international monetary relations. International monetary relations
may require the resolution of serious problems of cooperation. A fixed-rate system may,
in fact, give governments incentives to “cheat,” such as to devalue for competitive
purposes while taking advantage of other countries’ commitment to currency stability.
Even a system as simple as the gold standard might have relied on agreements among
countries to support each others’ monetary authorities in times of difficulty. An enduring
monetary system, in this view, requires explicit cooperation among its principal
members.
The welfare gains associated with inter-state collaboration in the international
monetary realm are several. First, reduced currency volatility almost certainly increases
the level of international trade and investment. Second, fixed rates tend to stabilize
domestic monetary conditions, so that international monetary stability reinforces (and
may even increase) domestic monetary stability. Third, predictable currency values can
reduce international trade conflicts: a rapid change in currency values often leads to an
import surge, protectionist pressures, and commercial antagonism.
These joint gains may be difficult to realize because they can require national
sacrifices. Supporting the fixed-rate system may require painful national adjustment
policies to sustain a country’s commitment to its exchange rate. This can lead to
international conflict over the international distribution of adjustment costs. For
example, under Bretton Woods and the European Monetary System, one country’s
currency served as the system’s anchor currency. This forced other countries to adapt their monetary policies to the anchor country, and led to pressures on the key-currency
government to bring its policy more in line with conditions elsewhere. Under Bretton
Woods, from the late 1960s until the system collapsed, European governments wanted
the United States to implement more restrictive policies to bring down American
inflation, while the U.S. government refused. In the EMS in the early 1990s,
governments in the rest of the European Union wanted Germany to implement less
restrictive policies to combat the European recession, while the German central bank
refused. International and regional currency systems have often been beset by conflicts
over how to allocate the burden of adjustment among countries. Generally speaking, the
better able countries are to agree about the distribution of the costs of adjustment, the
more likely they are to be able to create and sustain a common fixed-rate regime.
Historical analyses tend to support the idea that inter-governmental cooperation
has been crucial to the durability of fixed- rate monetary systems. Barry Eichengreen
(1992) argues that credible cooperation among the major powers before 1914 was the
cornerstone of the classical gold standard, while its absence explains the failure of
interwar attempts to revive the regime. Many regional monetary unions, too, seem to
obey this logic: where political and other factors have encouraged cooperative behavior
to safeguard the common commitment to fixed exchange rates, the systems have endured,
but in the absence of these cooperative motives, they have decayed (Cohen 2001).
Two of the most recent such regional ventures, Economic and Monetary Union in
Europe (EMU) and dollarization in Latin America, are illustrative of the operation of
these international factors. Dollarization appears largely to raise ideal-typical
coordination issues, as national governments consider independent choices to adopt the U.S. dollar. The principal attraction for dollarizers is association with dollar-based
capital and goods markets; the more countries dollarize, the greater this attraction will be.
On the other hand, while the course of EMU from 1973 to completion did have features
of a focal point, especially in the operation of the European Monetary System as a
Deutsche mark bloc, the more complex bargained resolution of the transition to EMU
went far beyond this. This bargaining solution involved agreement on the structure of the
new European Central Bank, the national macroeconomic policies necessary for
membership in the monetary union, and a host of other considerations. These difficult
bargains were unquestionably made much easier by the small number of central players,
the institutionalized EU environment, and the network of policy linkages between EMU
and other European initiatives.
Despite the importance of these international factors, it is unquestionable that
international monetary cooperation rests on the foundation of national currency policies.
And national policies are also subject to substantial political economy pressures.