The borrower of last resort: international adjustment and liquidity in a historical perspective.

Author:Vasudevan, Ramaa

If the operation of the gold standard from the last two decades of the nineteenth century, until the outbreak of the world war was in essence a sterling standard, the Bretton Woods system instituted after the Second World War in effect forged a dollar standard. The crux of these arrangements was the emergence of the monetary liabilities of a single country as the principal means of settlement of balance of payments between countries, internationally. It is argued that the stable functioning of the international monetary system depends on the dominant country acting as the international lender of last resort, injecting liquidity through their central role in international financial intermediation (Kindleberger 1982; 1985; 1996). In this paper, I have argued that the efficacy of this mechanism hinges on the ability of the "leading" country to draw short-term capital flows and stem the efflux of capital in the face of growing trade deficits and dwindling reserves, in short its ability to act as a "borrower of list resort."

The paper surveys the actual workings of the international gold standard before tracing the historical process by which the floating dollar standard was established after the collapse of the Bretton Woods system. The comparative historical analysis yielded interesting insights into the manner in which international liquidity was generated and the implications of the dominance of the monetary liabilities of a single country in the settlement of international payment balances. The privileged position of the currency of a single hegemonic country in the international monetary system imparts a degree of elasticity to adjustments in the developed core of the global economy. The mechanisms for liquidity creation and adjustment do not, however, depend on the dominant country retaining a "creditor" status. Rather, financial intermediation is made possible by the country's ability to continue to incur liabilities without undermining its privileged status. Historically specific, institutional mechanisms, which relate both to imperial hegemony and international diplomacy, played a critical part in enabling the leading country to perform the role of financial intermediation by extending its short term monetary liabilities. A pivotal role is played in these mechanisms by triangular patterns of adjustment with the periphery that allow the dominant country to borrow from surplus countries and pass the burden of deflationary adjustment shocks to peripheral debtor countries.

International liquidity in the post-Bretton Woods System is in effect based on triangular settlement mechanisms that parallel that of the international gold standard period. In comparing the emergence of the post-war dollar standard to the pre-1914 gold standard it is argued that the eurodollar markets that arose in the sixties played a role that was analogous to that of the markets for sterling finance bills and the imperial network in the sterling standard period. While recognizing that the specific institutional mechanisms were quite distinct in the two periods, the purpose of this analogy is to focus on the role of such parallel monetary mechanisms in preserving the dominance of the key currency.

The International Gold Standard

Conducting the International Orchestra

The prewar "international gold standard" emerged in the last two decades of the nineteenth century, when most countries had shifted from silver and bimetallic standards to a gold standard. This international monetary regime can be seen to reflect the British domination of the international financial system as the largest capital market and trader. (1) The stability of the international monetary system, during this period, is ascribed to the management of the system by the Bank of England. The Bank of England played the role of "the conductor of the international orchestra" and was able to calibrate international movements of gold, on the basis of relatively small gold reserves, by manipulating the bank rate (Sayers, 1970; Eichengreen 1987)

The ability of the Bank of England to manage the system was by no means absolute (Gallaroti 1995). Faced with the dual, often-contradictory pressures of protecting its profit and competitiveness on one hand, and on the other, the need to maintain reserves against a possible drain on the exchequer (Gallaroti 1995; Pressnell 1968), the Bank deployed a variety of means to make the discount rate effective in the chaos of unregulated short term flows that constituted the money market. Until the 1870s, the techniques of monetary control were rudimentary and marked by frequent changes in the bank rate. In the eighties, the Bank of England often resorted to gold devices and interventions in the gold market rather than frequent discount rate fluctuations, to protect its gold reserves. It was only at the turn of the century that bank rate policy actually became effective. Thus, while the Barings crisis in 1890 was "managed" without significantly raising the bank rate; the 1907 crisis was contained through the deployment of the Bank rate, with a negligible intervention in the gold market (Sayers 1985).

The efficacy of the instrument of the Bank rate was conditioned by institutional and historical developments, in particular the tremendous growth of private international capital flows--the "financial revolution" that was taking place in England in this period. The emergent source of dynamism in the English banking system derived from the growth of deposit banking. Through the eighties and nineties, with the rapid development of joint-stock banks, merchant banks and discount houses (the heirs to bill brokers) as integral components of the British financial system, there emerged a parallel growth of monetary mechanisms. Alongside the proliferation of international trade in the last quarter of the 19th century, the spread of sterling bills as a mechanism of finance that was independent of the Bank of England, had also gained prominence (de Cecco 1984). Deposits in the joint-stock banks became an important source of the cash required by discount houses and bill brokers to discount the growing volume of bills of exchange.

The concentration of joint-stock banks, with the wave of amalgamations witnessed in this period accentuated the challenge to the power of the Bank of England (de Cecco 1984, 95). The joint-stock banks were not subject to the austerity imposed by Peel's Act, and they were under no obligation to keep reserves with the Bank of England and could circumvent the restrictions on the creation of banking liabilities. The proliferation of deposit banking underscored the diminished influence of the Bank of England on the money market, since this source of liquidity creation was untrammeled by reserve requirements. Comprehension of the workings of the gold standard and the ability of the Bank of England to manage the system has to take into account the history of competition and contradiction between the Bank of England and the joint-stock banks (Pressnell 1968, 180; de Cecco 1984, 99).

The Bank of England embarked, through this period, on a process of conquest of the rediscount market and sought to bring bill brokers back into its fold (de Cecco 1984). This competition for bill business, created potential pressures on the Bank of England's reserves and would have implications for the balance of payments through drains or reductions in inflows. Interest rate manipulations could be used to regulate the demand for bills and the inflow of gold, and thus served as an alternative to maintaining large reserves. The period was, at the same time, dogged by fears of declining reserves that put a damper on initiatives at monetary reform that sought to extend the Bank's flexibility in the fiduciary issue of notes. However, despite the constraints of acting within the 1844 (Peel's Act) limits on notes issues, the banking system evolved to accommodate a growing volume of finance on the basis of a relatively "thin film of gold." (2)

It has been argued that the small stock of gold reserves with the Bank of England betrayed its essential vulnerability (Gallarotti 1995). The Bank displayed a manifest "reluctance to place British liquidity on the altar of international demand for money in restrictive periods" (139) and abated public panic "not by marshalling its own resources but by asking major British financiers and foreign central banks and governments for funds or special accommodations" (130).

To illustrate, consider the 1907 crisis that was precipitated by a contraction in the U.S. economy following a speculative run on copper and the collapse of the Knickerbocker trust. In response to the threat of a gold drain, the Bank of England raised the bank rate from 4.5% to 7% in response to the pressure placed by the demand for gold in the United States to shore its financial system. The Bank of France faced with a potential adverse spillover effect took it upon itself to discount British bills heavily. The gold reserves of France, a creditor country, were thus made available in the London gold market, pre-empting a further rise in the discount rate. (3) Gold flows from the continent were then recycled to the United States, which borrowed largely on bills on London.

It is true that through the period there was an incessant preoccupation with the British Treasury's dwindling gold reserves and the declining ratio of reserves to liquid foreign liabilities. (4) But the "thin film of gold" that was sustaining international liquidity was in fact a reflection of the strength of the Bank of England bank rate policy. Its efficacy hinged precisely on this ability to draw gold bullion from surplus countries and recycle liquidity in order to manage crisis. Sterling thus came to take on the mantle of an international currency, with the use of gold in the settlement of international payments becoming increasingly less important. However, the gold reserves remained...

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