Over the past few years, there has been frequent talk about the need for international coordination of monetary policies. In particular, central bankers outside the United States have urged the Federal Reserve to consider the impact of its policies on emerging market economies.
As the Fed expanded its balance sheet after 2008, capital flowed from the United States particularly to emerging markets, prompting their currencies to appreciate and their central bankers to plea for less U.S. monetary accommodation. In 2013, as the Fed started to discuss the eventual need to normalize policy, the grievances from abroad reversed, but were no less urgent. While the Fed has merely slowed the expansion of its balance sheet – rather than reversed it – emerging market currency depreciation and capital outflows are now the source of discontent.
In fairness, the real issue is volatility, both in exchange rates and capital flows, that can lead to a poor allocation of resources. If they maintain the free capital of flow, and if their financial systems are globally integrated, emerging economies have few tools to dampen the impact of capital floods and droughts.
But it is worth asking what sort of policy cooperation is both desirable and feasible. At its heart, this discussion is about the international financial architecture, a term that experts use when referring to things like exchange rate regimes and capital controls. Perhaps the most famous system was the regime of fixed exchange rates and capital controls established in 1945 by an international conference at Bretton Woods, New Hampshire. The Bretton Woods system was a response to the disastrous policy and economic experience of the period between the two world wars.
Even without capital mobility, a fixed exchange rate system ties inflation rates to one another. Bretton Woods did just that. From the mid-1950s through the 1960s, the median inflation rate among industrial countries fluctuated in the range of 1 to 4 percent. Individual country experiences where somewhat different, but also were narrowly bounded. Most of the time, the gap between inflation rates for nations ranked at the 25th and 75th percentile was no more than 3 percentage points. In the graph below, this interquartile range is bounded by the blue and gray lines. The Bretton Woods period extends to 1971, denoted by the vertical red line, when the fixed-exchange rate regime gave way to the current floating-rate era.
Countries: Australia, Belgium, Canada, Switzerland, Germany, Finland, France, Greece, Italy, Japan, Korea, Luxembourg, Netherlands, Norway, New Zealand, Portugal, Sweden, Turkey, United Kingdom, United States
All countries report data to the OECD Main Economic Indicators Starting with 1955, except for Norway with starts in 1960.
Source: OECD Main Economic Indicators through FRED
The post-Bretton Woods experience of the 1970s was different. Very different. Inflation skyrocketed in many countries. The median inflation rate rose well over 10 percent, and the spread between inflation rates in different countries widened sharply. But, beginning in the mid-1980s, things calmed down. By the mid-1990s, prices were rising at a remarkably steady 2 percent annual rate. A pace that was maintained right up to the financial crisis. Perhaps even more remarkably, the range of inflation across OECD economies over the past 20-plus years was roughly half of what it had been during the Bretton Woods era.
The natural conclusion from this experience (as depicted in the figure above) is that inflation targeting did a better job of coordinating monetary policy across countries than Bretton Woods. Perhaps that shouldn’t have been a surprise. After all, isn’t it easier to maintain macroeconomic stability when you have both a flexible exchange rate to help absorb external shocks and a policy interest rate to focus on domestic objectives such as price stability and maximum sustainable employment?
Where does this experience leave us today? The answer is that when central bankers share a common inflation objective, it already serves as a powerful coordinating force. Because national policy mandates will always focus on domestic considerations, it seems unrealistic to hope for much more.
Perhaps what central bankers should insist on – whether they work in emerging markets or in advanced economies – is not that other countries take their interests explicitly into account, but that each central bank live up to its commitment of keeping inflation both low and stable. Doing so will require taking account of other countries’ prospects, at least insofar as they influence domestic developments. If the advanced economies also act to preserve financial stability, they will have gone a long way toward establishing a supportive framework for global expansion. That was the goal of Bretton Woods.