It is a pleasure to be back here at Cato and to be invited to speak once again at this annual conference. This is one of die premier ongoing monetary policy conferences, and the participants, both at the podium and in the audience, attest to its prominence.
This is a session on international monetary arrangements, and there has already been an interesting discussion. I find myself in substantial agreement with the comments of John Taylor, so I do not wish to repeat his points. What I will try to do is put the rules-based approach to international monetary policy coordination in a context that I hope will help us understand some of the past failures so we might avoid them in the future. In many ways, I will simply be reminding us of some principles we all have known for some time, yet which we seem to forget all too frequently.
A Little History of Efforts at International Central Bank Coordination
The dream of international coordination or cooperation among central banks is not new. Through much of the late 19th and early 20th centuries, we witnessed an international rules-based effort grounded in the classical gold standard. The idea was that each country was expected to maintain convertibility of its paper currency into gold at an agreed-upon nominal rate. The foundation of the system was grounded in the parities agreed upon by the countries involved. These parities amounted to the specification of a fixed exchange rate regime among the participating countries. Of course, like any fixed exchange rate regime, it meant that pressures arising from the external balance could put limits on domestic monetary policy and fiscal policy options. This reality ultimately proved to be the regime's undoing.
The arrangement mostly worked during the early 20th century. The outbreak of World War I, however, placed enormous strains on the finances of the warring countries. The European nations had to finance large deficits through a combination of external borrowing and inflation. In most cases, the countries suspended convertibility to prevent large gold outflows. Following the war there was a strong interest in Europe to restore die prewar parities. Unfortunately, external debt and high inflation made this virtually impossible. Despite years of effort, including meetings (public and private), and conferences among central bankers attempting to coordinate actions, misalignments persisted, requiring massive gold flows, particularly from Great Britain to France and the United States. This undermined the credibility of the regime, and it never fully regained the success or stability it once enjoyed. By 1933, the entire system had collapsed. The United States abandoned its peg to gold in April 1933 because of the constraints it placed on domestic monetary and fiscal policies seeking to address the Great Depression.
Later, following World War II, world leaders again sought to create a new framework for international financial coordination. The Bretton Woods system laid out rules to bring stability to exchange rates and international capital flows. The new system once again attempted to establish an essentially fixed exchange rate regime by requiring diat each...