The politics of international economic relations 7th ed

4 The Multinational Corporation and GlobalHorizontal and Vertical FDI and the KK Model 141Internalization Theory 142 Product Cycle Theory 143Obsolescing Bargain Theory 143Oligopoly Theor

The Politics of International

Economic Relations

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The Politics of International

Economic Relations

S E V E N T H E D I T I O N

J O A N E D E L M A N S P E R OThe Doris Duke Charitable Foundation

J E F F R E Y A H A R TIndiana University

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

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Joan Edelman Spero, Jeffrey A Hart

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1 2 3 4 5 6 7 13 12 11 10 09

To Alexis, Eva, and Isabella Spero

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The Original Bretton Woods System 14U.S Leadership 16

Multilateral Management Under U.S Leadership 17

Financial Interdependence and Pluralism 20The Nixon Shock and the Emergence of Floating Exchange

Petrodollar Recycling 25

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Interdependence 28Growing Financial Interdependence 28Liquidity: The Problem of the Dollar 29Adjustment Under Floating Exchange Rates 30Stability and Crisis Management 35

Europe’s Efforts to Build a Regional Monetary System 40Globalization 42

Globalization of Financial Markets 42Economic and Monetary Union 46Adjustment 48

Regional or Country-Based Crises 54Crises Involving Banks and Other Financial Institutions 58The Subprime Mortgage Crisis 59

Preventing Future Crises 61Global Monetary Governance in the Twenty-First Century 62

The Havana Charter 73The General Agreement on Tariffs and Trade 74U.S Leadership 76

Structural Change and Protectionism 79

An Old Issue: Agriculture 92The New Protectionism 93

Globalization 98New Forms of Trade 98

The Marrakesh Agreement 105New Trade Challenges 107Shifting Power Relationships 110

4 The Multinational Corporation and Global

Horizontal and Vertical FDI and the KK Model 141Internalization Theory 142

Product Cycle Theory 143Obsolescing Bargain Theory 143Oligopoly Theory 144

The Tariff-Jumping Hypothesis 145The Importance of the Home Country 145

Possible Negative Effects of MNCs 148National Economic Control 150Interference by Home Governments of Multinationals 153Multinationals and the National Political Process 155International Regimes for Foreign Direct Investment 157National Governance 158

Regional Governance 166International Governance 169

Governance in the United Nations 172Bilateral and Minilateral Governance 173International Investment Agreements 173The Multilateral Agreement on Investment 174

Liberal Theories of Economic Development 193Marxist and Neo-Marxist Theories of Development 194The Structuralists 195

Contrasting Marxist and Structuralist Perspectives 197Weaknesses of the Three Perspectives 198

Dependence 201

Globalization 204

The Original Bretton Woods 213The Link Between Aid and Foreign Policy 213Stagnation of Aid 215

Financial Flows in the Era of Interdependence 217Confrontation and the New International Economic Order 217Privatization of Financial Flows 219

The Decline of Aid in the 1980s 221The Debt Crisis of the 1980s 224Debt Crisis Management 228Debt Fatigue 230

Globalization 232Emerging Markets 232Financial Crises of the 1990s 233Common Causes, Distinct Consequences 239Financial Flows to the Poorest Developing Countries 240Financial Flows in the Twenty-First Century 241Millennium Development Goals 243

The Impact of Financial Flows 245Conclusion: The Future of Financial Flows 248

Bretton Woods: Isolation from the Trading Order 257Import Substitution 257

Trade Expansion and Declining Terms of Trade 259Unity and Confrontation 262

Interdependence: Strategies to Increase Southern Power 265Commodity Power and the New International Economic

Globalization: Joining the Trade Regime 277

The Rise of the BRICs 280

North–South Trade in the Twenty-First Century 287

Bargaining for Greater Control 303

Political Factors that Influence the Location of Foreign DirectInvestment 305

Arguments about the Positive Impact of MNCs on Economic

MNCs and the Antiglobalization Movement 325

The Future: Cooperation or Conflict? 328

Seven Sisters 340

Decline of the Oligopoly 342

Negotiation 343

The First Oil Crisis: Unilateral Power 344

The Second Oil Crisis: A System Out of Control 349

Oil in the Caspian Region 363Changing Economics of Oil at the End of the Twentieth

The Creation of an Eastern Economic Bloc 379Western Economic Warfare 381

Forces of Change in the East 384Gorbachev’s Economic and Political Reforms 388The Failure of Perestroika 390

Problems of Transition from Communism 392Yeltsin: Crisis and Reform 393

Russian Foreign Economic Policies under Yeltsin and the West’s

The Crisis of 1998 397Domestic Economic Policies of the Putin Regime 398International Economic Relations in the Putin Era 400Economic Reform in Eastern Europe 401

Cold War and Isolation 405Deng Xiaoping’s Economic Reforms 408China: Regional Power or Global Economic Superpower? 415

11 Conclusion: Globalization and Governance 427

The Evolution of International Economic Governance 428Challenges for Global Governance 432

Characteristics of a New System of Governance 435

GLOSSARY 441

ACRONYMS 475

INDEX 481

The first edition of The Politics of International Economic Relations, published in

1977, was written to fill a void in the study of international relations—thegap between international politics and international economics Since 1977,that gap has narrowed significantly International political economy has emerged

as a new and increasingly prominent field in political science Theoretical andempirical analyses of the politics of international economic relations appear regu-larly in professional books and journals Although the most important bridgebuilding has come from political scientists, now economists are also includingpolitical variables in their analyses and applying economic theory to the study

of political behavior A new and diverse generation of students is being madeaware of the interrelationship between economics and politics and is learning touse and integrate the tools of these disciplines

Much has happened since 1977 to reinforce this academic evolution Aboveall, turbulence in the world economy has heightened the political aspect ofinternational economic relations The persistent problems of the dollar and otherinternational currencies, the many trade disputes between the United States and itsmajor trading partners, crises in world oil markets, and the continuing debt crisis

in the Third World have obliged scholars to reexamine the assumptions thatseparated the disciplines of economics and political science for over a century.The focus and organization in this book has not changed much since the firstedition was published This edition of The Politics of International Economic Relationscontinues the previously established tradition of separating the discussion intoproblems faced by developing countries and former communist countries and pro-blems that primarily affect industrialized capitalist countries In the fifth edition,

we added new material that reflected major changes in the international systemsince the end of the Cold War Also in the fifth edition, we discussed and tried

to explain the increasing pragmatism of domestic and foreign economic policies inmany parts of the Third World, but especially in the faster-growing developing

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countries Last, the fifth edition added material on the growing gap between thepoorest regions of the world and the richest ones.

The sixth edition provided new information about the various monetary ses of the late 1990s, the early years of the World Trade Organization, the con-tinuing rapid growth in foreign direct investment, the integration of the formerlycommunist countries into the capitalist world economy, and a rethinking of the-ories of economic development that followed the Asia Crisis of 1997–1998.Finally, the sixth edition explored the relationship between globalization andgovernance in greater depth than in previous editions

cri-This seventh edition of The Politics of International Economic Relations wascompleted before the outbreak of the global financial and economic crisis thatbegan in the United States in 2008 and spread throughout the world That crisiscontinues to unfold as this book goes to press

The causes of the crisis, which will long be debated, include imprudentlending by financial institutions, especially U.S bank lending in the so-calledsubprime mortgage market; excessive borrowing by financial institutions tosupport new and risky operations; the creation of complex securitized financialinstruments whose risks were not fully understood and that were acquired andtraded around the world; outdated and ineffective financial regulation and super-vision at a national level; and inadequate systems for global financial manage-ment The consequences of the crisis on global economic stability, prosperity,and equity will unfold in the coming years

The causes and ramifications of the crisis of 2008 and beyond are not itly discussed in this edition However, many of the complex and interrelatedaspects of the upheaval are explained and foreshadowed in The Politics ofInternational Economic Relations For example, this edition discusses the creation

explic-of new financial instruments, the globalization explic-of financial markets and financialinstitutions, and the resulting frequency of global financial crises It explainsthe growing interdependence of national economies and the evolution of globalfinancial management systems, as well as the limitations of multilateral gover-nance in a global world Throughout the study, there is a focus on the needfor systemic leadership especially by the United States and the EuropeanUnion, the critical role of the U.S economy, and the inability of United States

to manage the global system unilaterally The concluding chapter looks ahead tothe need for improved systemic management and reform in a global economy.Carolyn Merrill, Executive Editor at Wadsworth, shepherded the seventhedition through a more than usually fraught gestation Her experience and sangfroidare much appreciated David Estrin, the development editor, was cheerful andreliable throughout the process Thivya Nathan, Katherine Hayes, Sara Abbott,and Michael Lepera saw the book through production Our thanks to all

About the Authors

Joan Edelman SperoJoan E Spero is currently a Visiting Fellow at the Foundation Center From 1997

to 2008, Ms Spero was President of the Doris Duke Charitable Foundation,which makes grants in the performing arts, environmental preservation, medicalresearch and prevention of child abuse

Ms Spero served in the U.S Department of State as Undersecretary forEconomic, Business, and Agricultural Affairs (1993–1997) and as Ambassador tothe United Nations for Economic and Social Affairs (1980–1981) She was a corpo-

Professor at Columbia University (1973–1979) Ms Spero graduated from theUniversity of Wisconsin and holds a master’s and doctoral degrees from ColumbiaUniversity

Jeffrey A HartJeffrey A Hart is Professor of Political Science at Indiana University, Bloomington,where he has taught international politics and international political economy since

1981 His first teaching position was at Princeton University from 1973 to 1980

He was a professional staff member of the President’s Commission for a NationalAgenda for the Eighties from 1980 to 1981 Hart worked at the Office ofTechnology Assessment of the U.S Congress in 1985–1986 as an internal contrac-tor and helped write their 1987 report, International Competition in Services He was

a visiting scholar at the Berkeley Roundtable on the International Economy from

1987 to 1989 His major publications include The New International Economic Order(1983), Interdependence in the Post Multilateral Era (1985), Rival Capitalists (1992), The

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Politics of International Economic Relations (5th and 6th editions; with Joan Spero),Globalization and Governance (1999; edited with Aseem Prakash), and scholarly articles

in World Politics, International Organization, British Journal of Political Science, New PoliticalEconomy, and Journal of Conflict Resolution

interna-to complex multilateral arrangements such as the World Trade Organization.International regimes can affect the nature and degree of international interactionamong members Regimes are shaped by political factors such as the distribution

of power among the players, the degree of shared goals and interests, and thenature of leadership within the system

International economic systems are clusters of regimes that include, amongother things, rules for trade, investment, and monetary flows In the half-centurysince the end of World War II, there have been three international economicsystems: the Bretton Woods system, which prevailed from World War II until1971; the system of interdependence from 1971 to 1989; and, from 1989 tothe present, the contemporary system of globalization

B R E T T O N W O O D SFor nearly two decades, the Bretton Woods system was effective in controllingconflict and achieving the common goals of its members The rules, institutions,

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and procedures of the system were embodied in three organizations created ing and immediately after World War II Named for the New Hampshire town

dur-in which two of the organizations—the International Monetary Fund (IMF)and the World Bank—were created, the Bretton Woods system consisted ofthose two organizations plus the General Agreement on Tariffs and Trade(GATT) These three institutions have evolved significantly over time butremain cornerstones of international economic governance to the current day.During the Bretton Woods era, international economic interaction was stilllimited but growing In the early years of Bretton Woods, many countries wererecovering from the devastation of the war and were in no position to competeinternationally Tariffs, quotas, and exchange controls protected national marketsand hampered the international flow of goods and money International invest-ment was limited and concentrated heavily in raw materials and retailing, not inmanufacturing

The Bretton Woods system rested on three political foundations: the centration of power in a small number of states, the existence of a cluster ofimportant interests shared by those states, and the presence of a dominant powerwilling and able to assume a leadership role.1 The concentration of bothpolitical and economic power in the developed countries of North Americaand Western Europe enabled these countries to dominate the Bretton Woodssystem They faced no challenge from the communist states of Eastern Europeand Asia (including the Soviet Union), which were isolated from the rest of theinternational economy in a separate international economic system Although theless-developed countries (LDCs) were integrated into the world economy, theyhad no voice in management because of their political and economic weakness.For much of this period, many developing countries in Africa and Asia were stillsubordinated within colonial empires Finally, Japan, weakened by the war andlacking the level of development and the political power of North America andWestern Europe, remained outside the management group for much of theBretton Woods era As a defeated power, Japan was not initially a member ofthe Bretton Woods institutions It joined the IMF and World Bank in 1952and did not become a member of the GATT until 1954 The concentration ofpower facilitated the system’s management by confining the number of actorswhose agreement was necessary to establish new international economic regimesand to carry out management within the agreed upon system

con-Management also was made easier by a high level of agreement among thesystem’s powerful members on the goals and means of the international economicsystem The developed countries shared a belief in capitalism and liberalism andrelied primarily on market mechanisms and private ownership These countries alsoagreed that the liberal economic system required governmental intervention In theera after World War II, national governments assumed responsibility for the economicwell-being of their citizens, and employment, stability, and growth became importantobjects of public policy The welfare state was a response to the Great Depression,which created a popular demand for governmental intervention in the economy, andout of the theoretical contributions of the Keynesian school of economics, whichprescribed governmental intervention to maintain adequate levels of employment

The developed countries also favored a liberal international economic tem, one that relied primarily on a free market with a minimum of barriers tothe flow of private trade and capital The experience of the Great Depression, inwhich proliferation of exchange controls and trade barriers led to economicdisaster, remained fresh in the minds of public officials Although these countriesdisagreed on the specific implementation of this liberal system, all agreed that anopen system would maximize economic welfare At the same time, governmentsrecognized that international markets could be unstable and sought to designmechanisms to manage crises and control conflict.

sys-Some governments also believed that a liberal international economic systemwould lead not only to economic prosperity and economic harmony but also tointernational peace.2 One of those who saw such a security link was CordellHull, the U.S secretary of state from 1933 to 1944 Hull argued that

… unhampered trade dovetailed with peace; high tariffs, trade barriers,and unfair economic competition, with war… if we could get a freer flow

of trade—freer in the sense of fewer discriminations and obstructions—sothat one country would not be deadly jealous of another and the livingstandards of all countries might rise, thereby eliminating the economicdissatisfaction that breeds war, we might have a reasonable chance oflasting peace.3

The common interest in economic cooperation was enhanced by the break of the Cold War at the end of the 1940s The economic weakness of theWest, some officials felt, would make it vulnerable to internal communist threatsand external pressure from the Soviet Union Economic cooperation becamenecessary not only to rebuild Western economies and to ensure their continuingvitality but also to provide for their political and military security In addition,the perceived communist military threat led the developed countries to subordi-nate their economic conflict to their common security interests

out-The developed market economies also agreed on the nature of internationaleconomic management, which would involve the creation and maintenance of aliberal system This strategy would require the establishment of a stable interna-tional monetary system and the reduction of barriers to trade and capital flows sostates would have a favorable environment for ensuring national stability andgrowth The state, not the international system, bore the main responsibility fornational stability and growth Thus, the members of the system shared a verylimited conception of international economic management: regulation of theliberal system by removing barriers to trade and capital flows and creation of astable monetary system

Finally, international management relied on the dominant power to lead thesystem As the world’s foremost economic and political power, the United Statesclearly was in a position to assume that responsibility of leadership The U.S.economy, undamaged by war and with its large market, great productivecapability, financial facilities, and strong currency, was the dominant world econ-omy The ability to support a large military force plus the possession of nuclearweapons made the United States the world’s strongest military power and the

leader of the Western alliance The European states, with their economies indisarray due to the war, their production and markets divided by nationalboundaries, and their armies dismantled or weakened by the war, were not in aposition to assume the leadership role Japan, defeated and destroyed, was at thattime not even considered part of the management system.

The United States was both willing and able to assume the leadership role.U.S policymakers had learned an important lesson from the interwar period.The failure of U.S leadership and the country’s withdrawal into isolationismafter World War I were viewed as major factors in the collapse of the economicsystem and of the peace U.S policymakers believed that after World War II theUnited States could no longer isolate itself As the strongest power in the postwarworld, the United States would have to assume primary responsibility for estab-lishing political and economic order With the outbreak of the Cold War, yetanother dimension was added to the need for U.S leadership Without suchleadership, the U.S government and its allies abroad believed, the economicweakness in Europe and Japan would lead to communist political victories.Furthermore, the Europeans and the Japanese—economically exhausted bythe war—actively encouraged this U.S leadership role They needed assistancefrom the United States to rebuild their domestic production and to finance theirinternational trade The political implications of U.S leadership, therefore, wereviewed as positive, because political elites in these countries felt that U.S eco-nomic assistance would alleviate domestic economic and political problems andencourage international stability What the Europeans feared was not U.S dom-ination but U.S isolation; the late entry of the United States into both worldwars was fresh in their minds

Throughout the Bretton Woods period, the United States mobilized theother developed countries for management and, in some cases, managed the sys-tem alone The United States acted as the world’s central banker, provided themajor initiatives in international trade negotiations, and dominated internationalinvestment

This coincidence of a limited degree of international economic interactioncombined with favorable political conditions—the concentration of power, thecluster of shared interests, and the leadership of the United States—provided thepolitical capability equal to the tasks of managing the international economy.The Bretton Woods system enabled Europe and Japan to recover from thedevastation of the war, established a stable monetary system, encouraged moreopen trade, finance, and investment, and in turn led to a period of rapid eco-nomic growth

I N T E R D E P E N D E N C E

By the 1970s, however, the Bretton Woods system was replaced by a new national economic system characterized by interdependence Changes in thenature of international economic interaction and a shift in the balance of poweramong the key players led to a restructuring of the international economic order

inter-Important economic changes increased the management challenges facingthe system Ironically, it was the very success of Bretton Woods that led to thesechallenges Economic growth and ongoing international liberalization combinedwith innovations in computing and telecommunications technologies led tohigher volumes of international economic interaction and growing penetration

of national economies by international trade, investment, and monetary flows.The reduction of barriers to trade and capital as well as the revolution in infor-mation technologies enabled an expansion in international economic interactionamong the developed market economies: larger international capital flows, thegrowth of international trade, and the development of international systems ofproduction As a result, national economies became more interdependent andmore sensitive to economic policy and events outside the national economy.The problem was heightened because this sensitivity grew at a time when,more than ever, states were expected to ensure domestic economic well-being.Because of the influence of external events, states found it increasingly difficult tomanage their national economies The greatest disruptions were caused byperiodic monetary crises that forced dramatic revaluations of currencies anddisrupted trade

Interdependence led to two reactions and two different challenges to theunderlying liberal consensus on which the system was based One reaction was

to erect new barriers to limit economic interaction and, with it, dence An open international system, in this view, no longer maximizedeconomic welfare and most certainly undermined national sovereignty andautonomy Some critics argued that a continued focus on tariff reductions was

interdepen-no longer appropriate in an increasingly tariff-free world ecointerdepen-nomy Nontariff

partly as a response to reduced tariffs Pressures grew not only for new forms

of protection and managed trade, but also for efforts to strengthen regional

These regional groupings were not on the whole protectionist, although thepossibility always existed that new barriers to extra-regional trade and investmentflows would be erected even as internal ones were being dismantled

Another reaction was to go beyond Bretton Woods and the idea of a limitedmanagement to new forms of international economic cooperation that wouldmanage interdependence An open system, according to this viewpoint, maxi-mized welfare but required, in turn, new forms of international managementthat would assume responsibilities and prerogatives formerly undertaken by thestate These views led to efforts to establish a regular series of internationaleconomic summits and attempts (mostly unsuccessful) to coordinate nationalmacroeconomic policies In the 1980s, new initiatives were taken to upgradethe multilateral trade regime with a new and more ambitious multilateral trade

During the period of interdependence, changes in power and leadership alsoaltered political management of the international economic system Although thedeveloped countries remained the dominant political and economic powers,states outside the group challenged their right to manage the system In

particular, the LDCs sought to increase their access to the management and, thus,

to the rewards of the international economic system In the 1950s and 1960s,most colonies had gained their independence and now sought to improve theireconomic performance and their influence in the international economic system.Some developing countries took a pragmatic approach to multilateral man-agement, seeking to work within the prevailing regime and to play a greaterrole within the system Other developing countries dissented from the liberalfoundation of international management, arguing that open monetary, trade,and financial systems perpetuated their underdevelopment and subordination tothe developed countries These countries sought to develop their economiesboth by protecting themselves from international economic interaction and bytrying to make their development a primary goal and responsibility of the system.The oil crisis of the early 1970s led to an effort on the part of these countries toalter the rules of the game and to create what they called a New InternationalEconomic Order

In the 1970s and 1980s, the Soviet Union and the countries of EasternEurope also sought limited participation in the international economy Changes

in domestic and international policy in the two key communist countries—theSoviet Union and the People’s Republic of China—opened up the possibility ofgreater East-West economic interaction Gorbachev’s perestroika, or restructur-ing, sought to move the Soviet economy more in the market direction and toopen up trade, finance, and investment relations with the West This move hadthe unforeseen result of hastening the Soviet Union’s economic decline andhelping to bring about the breakup of the Soviet empire In contrast, China’seconomic reforms led to rapid growth Expectations of political liberalizationgrew within China until the suppression of the student demonstrations in

More important, power shifted within the group of advanced industrialnations In the 1960s, Europe experienced a period of great economic growthand dynamism in international trade Six European countries had united in 1957

to form the EEC, a trading bloc rivaling the U.S economy and a potential cal force By 1986, the six countries became twelve and the EEC evolved into theEuropean Union (EU), whose goal was not only the elimination of trade barriersand the creation of a customs union but also the removal of all barriers to themovement of capital, labor, and services Japan’s economic development waseven more spectacular In the 1960s, Japan became a major world economicpower and joined the developed countries’ condominium By the 1980s, Japanwas a powerful economic competitor to both the United States and Europe

politi-In the 1970s and 1980s, a weakened dollar and a weakening balance of tradediminished U.S international economic power During much of this period, theUnited States suffered from“twin deficits” in both government spending and thebalance of payments At the same time, Europe and Japan became more andmore dissatisfied with the prerogatives that leadership gave the United States andincreasingly criticized those prerogatives, especially the dollar system and U.S.payments deficits The United States, for its part, was increasingly dissatisfiedwith the costs of leadership

The relaxation of security tensions in the early 1970s reinforced the ing attitudes toward U.S leadership, especially in Europe but also, to a lesserdegree, in Japan Détente and the lessening of the perceived security threatweakened the security argument for Western economic cooperation and U.S.leadership Europe and Japan were no longer willing to accept U.S dominancefor security reasons, and the United States was no longer willing to bear the eco-nomic costs of leadership.

chang-Although U.S dominance was increasingly unsatisfactory for the UnitedStates, Europe, and Japan, no new leader emerged to fulfill that role Europe,although economically united in a common market, lacked the political unitynecessary to lead the system West Germany and Japan, the two strongest eco-nomic powers after the United States, were unable to manage the system bythemselves and, in any case, were kept from leadership by the memories ofWorld War II

Because of the growth in international economic interaction and conflictsamong the key players, the era of interdependence was characterized by periodiccrises and conflict among members The powerful members of the system sought

to address the management problems by developing new mechanisms for lateral cooperation They instituted reforms of the Bretton Woods institutions,including a major revision of the international monetary regime and a greaterfocus on economic development They also created new cooperative arrange-ments such as the Group of Seven economic summits to supplement the existinginstitutional structure As a result, the period of interdependence ushered incontinuing liberalization, the gradual evolution of international economicinstitutions, and the adaptation of the system to the new level of internationaleconomic interaction and the changed balance of power

The most dramatic changes were political The end of the Cold War had aprofound impact on the international economic system With the fall of theBerlin Wall and the collapse of communism, the political bases of the globaleconomy shifted dramatically The great divide between the capitalist andcommunist worlds and their respective economic systems disappeared The ide-ology and practice of capitalism spread to Eastern Europe, Russia, the formerSoviet republics, and even to China and Vietnam Developing countries thathad opposed the liberal international economic order chose to join the prevailing

consensus Thus, the system became truly global from a geographical perspective.With differing levels of effectiveness, governments throughout the world adoptedcapitalist policies: deregulation, privatization, and international liberalization.Trade barriers were reduced, exchange controls were removed, and investmentbans were eliminated Former communist countries and developing countries alsojoined the Bretton Woods institutions and agreed to play by their rules.

This change in economic beliefs and practices was accompanied by cant technological developments New information technologies increased thecapacity and decreased the costs of computing and communication and madepossible the ever-increasing internationalization of production and finance.Increasingly, goods, capital, technology, and even people were able to movefreely across international boundaries Globalization led to more open marketsfor goods and services, to global firms producing and distributing products inmultiple markets, and to global financial markets in which currency, debt,and equities were traded 24 hours a day around the globe The technologicalrevolution of the Internet created further changes in the nature of internationaltrade, investment, and finance

signifi-The impact of globalization was uneven signifi-The speed of economic changeaccelerated and flows of capital and goods became more volatile, causing rapidand sometimes wrenching changes for hundreds of millions of people Manycountries, companies, and individuals were beneficiaries of globalization.Numerous developing countries in Asia and Latin America prospered becausethey were able to attract foreign investment and technology and to expand ex-ports Others, unable to compete on world markets, were left behind The poor-est countries, especially those in Africa, were unable to expand their trade orattract investment; they became even more marginal

The end of communism in the former Soviet Union and Eastern Europecreated new demands on the system for resource flows, economic interaction,and participation in management of the system Many countries of EasternEurope made great progress in the transition from communism to capitalismand from isolation to participation in the rules, institutions, and procedures ofthe international economic system It was still unclear at the dawn of thetwenty-first century whether others, especially Russia and China, would beable to make that transition and become full members of the global economicsystem

Globalization also altered the building block of the international system—the sovereign nation state Globalization further undermined the ability of gov-ernments to manage their economies through national economic policies such asinterest and exchange rate policies In the period of globalization, the challenge

to national policy went beyond economic management As internationaleconomic interaction penetrated more deeply into national economies, it calledinto question the ability of governments to pursue other national goals such asenvironmental preservation and labor policies

Furthermore, because of the geographic spread of the system, states becamevulnerable to disruptions from around the world In particular, financial disrup-tions originating in developing countries or former communist states threatened

economic stability throughout the system Because the international economicsystem was not designed to address these global crises, globalization thus furtherchallenged the system of international rules and institutions governing interna-tional economic relations.

As in the era of interdependence, two opposing reactions to the new lenges to national sovereignty emerged Some political actors called for themodernization and expansion of international economic rules, institutions, andprocedures In their view, the advantages of globalization and the inevitability

chal-of its progress made it imperative to update the system by expanding national cooperation and rule-making Other political actors, concerned aboutthe economic and political impacts of globalization, called for limitations oninternational economic liberalization In their view, globalization served thewealthy, not the poor, and threatened the environment and labor Many ofthose opposed to globalization challenged the role of the Bretton Woods institu-tions as tools of the wealthy countries that did not address the needs of the poor

inter-in both developed and developinter-ing countries

Finally, the end of the Cold War and the creation of a global, capitalisteconomy altered power relationships The United States emerged as the world’sonly superpower, able to project its economic, military, political, and even

continental-sized U.S economy and U.S businesses proved to be powerful,flexible, and adaptable to the new, competitive global economy Americantechnological superiority, particularly its role as the leader in information tech-nology, put U.S companies in a strong competitive position Thus, U.S busi-nesses and financial institutions were able to play a powerful role in internationalmarkets Furthermore, with the collapse of communism and the success of the

model

However, power in the economic arena was not as unequal as in the cal and security arenas Balancing the United States was a series of regionaleconomic powers, including the traditional great powers France, Germany,and the United Kingdom continued to dominate Western Europe Japan wasthe economic superpower of Asia In addition, countries like Brazil, China, andIndia began to emerge and to vie for economic leadership in their regions.Economic integration also created new power relationships The member-ship of the European Union (EU) grew, creating an economic powerhouse ofaround 496 million consumers by 2008, gross domestic product (GDP) andtrade levels roughly equal to those of the United States, common regulatory sys-tems, and a common currency EU economic integration has become the basisfor greater political unity, including plans to develop a common foreign and de-fense policy as well as military cooperation

politi-While economic integration in Latin America is far behind that of Europe,regional economic cooperation through Mercosur and the Andean CommonMarket has emerged in a vibrant way in South America In Asia, the countries ofthe Association of Southeast Asian Nations (ASEAN) agreed on a plan tocreate a free-trade area in the region The revival of regional integration efforts

in the 1980s and 1990s reinforced—rather than undermined—the trend towardopen markets and a liberal world economic order.

The dramatic changes that began in the 1990s and continued into thetwenty-first century—globalization, American hegemony, and the effects of theend of the Cold War—fundamentally altered the international economic system.Governments sought to respond to the new order by modernizing institutions,rules, and procedures and by developing new techniques to manage crises andpursue common interests Governments also updated the international tradingregime by replacing the GATT with the World Trade Organization (WTO),which held an expanded mandate and broader powers In addition, they modi-fied the IMF to enable it to respond to new types of financial crises At the sametime, governments sought to respond to their domestic constituents, whoexpressed concern about the impact of globalization on economic well-beingand on other national objectives The tension between the dynamism andbenefits of globalization on the one hand and the threat to national sovereigntyand policies posed by globalization on the other hand emerged as a central theme

of the era

C O N C L U S I O NSince the end of World War II, the world economy has been regulated by threesystems (see Table 1.1) During the Bretton Woods system, the establishment of

a stable world economy was seen as a management problem for major powers,and particularly for the United States as the world’s largest national economy.During the period of interdependence, responsibility for management shiftedgradually from the United States to a group of nations including the UnitedStates, the wealthier nations of Western Europe, and Japan The main politicalproblem facing the international economy in the current period of globalizationwas how new forms of governance would develop and whether they would beable to deal with three key challenges: (1) the continued political responsibility

of governments for the economic welfare of their citizens in the face of increasedglobalization of the world economy, (2) the transition of the formerly com-munist countries to democracy and their full participation in the world economy

T A B L E 1.1 International Economic Systems, 1945–Present

Dates Name of System Type of Management or

Governance 1945–1971 Bretton Woods system Superpower management 1971–1989 Interdependence Collective management 1989–present Globalization Global economic governance

as capitalist market economies, and (3) the reduction of inequalities within andacross nations If these tasks were not addressed in a way that satisfied the needs

of the marginalized nations of the world, these countries would perceive thesystem to be illegitimate and would continue to provide support for those whowished to destroy it (or to replace it with something else) Thus, as the worldmoved from the Bretton Woods system, to interdependence, and then toglobalization, many of the world’s economic elites concluded that it wasnecessary to move beyond the idea of superpower or collective management ofthe world economy toward a more ambitious goal—to establish a legitimate gov-ernance system On their success would hinge the future of the world economy

E N D N O T E S

1 On the idea of the need for a leader, see Charles P Kindleberger, The World inDepression, 1929–1939 (Berkeley and Los Angeles, Calif.: University of CaliforniaPress, 1973) Kindleberger’s early speculations on this issue have resulted in anenormous number of works on what is now called“hegemonial stability theory(HST).” See the bibliography for citations of these works

2 Kenneth Waltz, Man, the State and War (New York, N.Y.: Columbia UniversityPress, 1969) For a discussion of how liberal ideas motivated U.S foreign economicpolicy after World War II, see David P Calleo and Benjamin M Rowland, Americaand the World Political Economy (Bloomington, Ind.: Indiana University Press, 1973).For more recent works on this topic, see G John Ikenberry,“Creating Yesterday’sNew World Order: Keynesian‘New Thinking’ and the Anglo-American PostwarSettlement,” in Judith Goldstein and Robert O Keohane, eds., Ideas and ForeignPolicy: Beliefs, Institutions, and Political Change (Ithaca, N.Y.: Cornell University Press,1993); Erik Gartzke,“Kant We All Just Get Along? Opportunity, Willingness, andthe Origins of the Democratic Peace,” American Jounal of Political Science, 42(1998),

1–27; and Edward D Mansfield, Power, Trade, and War (Princeton, N.J.: PrincetonUniversity Press, 1994)

3 Quoted in Richard N Gardner, Sterling-Dollar Diplomacy in Current Perspective: TheOrigins and Prospects of Our International Economic Order, expanded ed (New York, N.Y.:Columbia University Press, 1980), 9

Governing the International

Monetary System

The international monetary system is at the center of the international omy This system provides the framework for trade, investment, and othereconomic transactions and payments across international boundaries Money isalso central to national sovereignty The ability to issue currency and the accom-panying ability to influence its value are important prerogatives of national gov-ernments and tools of domestic economic policies This chapter examines hownations have worked together to create and manage international monetary sys-tems and how governments have sought to balance the need for internationalcooperation with the desire to maintain sovereignty over national currenciesand national economies This chapter explores how those responsible for managingthe system have sought to provide the three central functions of any internationalmonetary system: adequate liquidity, timely adjustment, and confidence in thestability of the system

econ-Just as any national economy needs an accepted currency, the internationaleconomy requires an accepted vehicle for exchange Unlike national economies,however, the international economy lacks a central government that can issuecurrency and manage its supply Historically, this problem was solved throughthe use of gold and national currencies In the nineteenth century and first half

of the twentieth century, gold was used to back currencies and to settle tional accounts.1

interna-In the nineteenth century and early twentieth century, the British pound plemented gold by serving as a reserve, transaction, and intervention currency.After World War II, the U.S dollar became the key international currency.Dollars were held as reserves by central banks; the dollar became indispensable

sup-12

✵

for international trade, investment, and finance; and dollars were used to intervene

in exchange markets to influence exchange rates

An international monetary system must also have means for adjustingimbalances in international payments In national economies, payments imbal-ances among regions are adjusted more or less automatically through movement

of capital and through fiscal and monetary policies In international economicrelations, disequilibria in payments can be settled by financing, by changingdomestic economic policy to shift trade and investment patterns, by rationingthe supply of foreign exchange through exchange controls, or by allowingthe currency exchange rate to change Effective adjustment can be promoted

by international cooperation, but successful cooperation depends primarily onimplementing domestic policies to achieve international solutions, a politicallydifficult task

In the Bretton Woods system, adjustment was based on a fixed exchange

changes, and adaptation of national policies During the periods of dence and globalization, a mix of adjustment mechanisms existed Exchange ratesamong major members of the system floated; that is, they changed frequently

interdepen-in response to market conditions as well as to government interdepen-intervention.Complementing these floating exchange rates were fixed rates among groups

of countries, such as the EU, and fixed rates between two countries, as was thecase with countries that linked their currencies to the dollar or to other majorcurrencies Under floating rates, frequent exchange rate changes driven by mar-kets were supplemented by intervention by national authorities in currency mar-kets, financing, and changes in national economic policies

The tension between international adjustment needs and domestic politicalrequirements is a central dilemma of international monetary relations For exam-ple, it is often necessary but politically difficult to implement policies that reducegovernmental budget deficits and inflation in order to stabilize a country’s ex-change rate or to reduce the deficit in its balance of payments Such policiesgenerally result in lower growth rates and higher levels of unemployment in theshort term but higher rates of growth and employment in the long term It istempting for governments to put off the domestic economic reforms necessary

to defend a declining currency or to delay adjustments that might reduce thesize of a balance-of-payments deficit because the necessary adjustments are likely

to be politically unpopular

Finally, a stable international monetary system promotes international change and economic prosperity, whereas instability disrupts international trans-actions, threatens financial institutions, and damages domestic economies A loss

ex-of confidence in the system can create economic and political disaster Duringthe Great Depression of the 1930s, for example, competitive exchange ratedevaluations, competing monetary blocs, and the absence of international coop-eration contributed greatly to economic breakdown, domestic political instabil-ity, and war During the financial crisis of 1997–1998, Asian currencies, financialinstitutions, businesses, and even governments collapsed and threatened theworld economy as a whole While instability and crises cannot be eliminated in

an international monetary system, they can be reduced and managed Thus, one

of the political challenges of international monetary management is to preventand manage periodic crises and thereby promote systemic stability

T H E B R E T T O N W O O D S S Y S T E MThe Original Bretton Woods System

In July 1944, representatives of 44 nations met on an estate in Bretton Woods,New Hampshire, to create a new international monetary order Their goal was

to establish an international economic system that would prevent another nomic and political collapse and another military conflict Their beliefs were thatprevious monetary systems that relied primarily on market forces had provedinadequate and that the world needed a publicly managed international mone-tary order.2

eco-U.S policymakers involved in creating the new economic order had cluded that the failure of U.S leadership was a major cause of the economicand political disaster.3During World War II, U.S leaders thus decided that theUnited States would have to assume the primary responsibility for establishing apostwar economic order That order would be designed to prevent economicnationalism by fostering free trade and a high level of international interaction

con-A liberal economic system, ensured by international cooperation, would providethe foundation for a lasting peace Thus, during two years of bilateral negotia-tion, the United States and the United Kingdom, the world’s leading economicand political powers, drew up a plan for a new system of international monetarymanagement.4

The Anglo-American plan, approved at Bretton Woods, became the firstpublicly managed international monetary order For a quarter of a century, inter-national monetary relations were stable and provided a basis for growing interna-tional trade, economic growth, and political harmony among the developedmarket economies The new order was intended to be a system of limited man-agement by international organizations For the first time in history, two publicinternational organizations, the International Monetary Fund (IMF) and theInternational Bank for Reconstruction and Development (IBRD, alsoknown as the World Bank), were created to perform certain monetary functionsfor the international system

The rules of Bretton Woods, set forth in the articles of agreement, providedfor a system of fixed exchange rates Public officials, fresh from what they per-ceived as a disastrous experience with floating rates in the 1930s, concluded that

a fixed exchange rate was the most stable and conducive basis for trade Thus, allcountries agreed to establish the parity, or value, of their currencies in terms ofgold and to maintain exchange rates within 1 percent, plus or minus, of parity.The rules further encouraged an open system by committing members to the con-vertibility of their respective currencies into other currencies and to free trade.5The IMF was to be the keeper of the rules and the main instrument of publicinternational management Under the system of weighted voting, the UnitedStates exerted a preponderant influence in that body IMF approval was necessaryfor any change in exchange rates, and it advised countries on policies affectingthe monetary system Most important, it could advance credits to countries withpayments deficits The IMF was provided with a fund composed of membercountries’ contributions in gold and in their own currencies The original quotastotaled $8.8 billion In the event of a deficit in the current account, countriescould borrow from this fund for up to 18 months and, in some cases, for up tofive years

Despite these innovations in public control, the Bretton Woods agreement phasized national and market solutions to monetary problems The Bretton Woodspolicymakers expected that national monetary reserves, supplemented when neces-sary by IMF credits, would finance any temporary balance-of-payments disequili-bria The agreement made no provision for the creation of new reserves; newgold production was considered sufficient In the event of structural disequilibrium,policymakers expected that there would be national solutions—a change in thevalue of the currency or an improvement by other means of a country’s competitiveposition The agreement gave few means to the IMF, however, to encourage suchnational solutions

em-The Bretton Woods planners expected that the international economywould recover and the system would enter into operation after a brief transitionperiod of no more than five years To facilitate postwar recovery, the plannerscreated the World Bank to make loans that would facilitate a speedy recovery

By 1947, however, it had become clear that the Bretton Woods system wasnot working and that the Western economic system was on the verge of col-lapse World War II had destroyed the European economic system, which hadbeen based heavily on international trade Its productive capacity had beendestroyed or disrupted, its overseas earnings had turned into debts, its shippingwas decimated, and its payments deficit was large and growing WesternEurope was faced with vast import needs, not only for reconstruction but alsofor mere survival.7

The Bretton Woods institutions were unable to cope with Europe’s problems.The IMF’s modest credit facilities were insufficient to deal with Europe’s hugeneeds and, in any case, the IMF could make loans only for current-accountdeficits, not for capital and reconstruction purposes The resources of the WorldBank, which was designed for capital investment, were woefully inadequate By

1947, the IMF and the World Bank admitted that they could not deal with thesystem’s economic problems.8

The economic crisis of 1947 was directly linked to political problems.Germany lay in ruins economically and politically The governments of Italyand France, faced with pressures from powerful labor unions, were highly unsta-ble Britain, partly due to its economic difficulties, was withdrawing from Indiaand Palestine and abandoning its political and security commitments to Greeceand Turkey More important, the Soviet Union seemed willing and able to takeadvantage of the West’s economic plight and political instability to further its aim

of territorial expansion in Europe The Soviet Union had forcibly establishedcommunist governments in the countries it occupied at the end of the war—Hungary, Romania, Poland, and Bulgaria—and it had pressured Iran andTurkey for territorial concessions Communist guerrillas were making significantheadway in Greece, and large communist parties in the governments of Italy andFrance tried to take advantage of labor unrest In addition, the Soviet Unionrefused to cooperate with the allies on a postwar settlement for Germany.9

U.S LeadershipBecause of these economic and political crises, the United States assumed agreater leadership role in international monetary management The strength ofthe U.S economy, the lessons of the interwar period, and security incentivesmade U.S leadership acceptable at home both economically and politically.The Europeans and Japanese also accepted U.S management Economicallyexhausted by the war, they needed U.S assistance to rebuild their domesticproduction, finance their international trade, and provide a setting for politicalstability Thus, after 1947, the United States began to manage the internationalmonetary system by providing liquidity and adjustment

By 1947, it was clear that neither gold nor the pound could continue toserve as the world’s money Gold production was insufficient to meet the de-mands of growing international trade and investment Because of the weakness

of the British economy, the pound was no longer able to serve as the primaryworld currency The only currency strong enough to be used to meet the risingdemands for international liquidity was the dollar The strength of the U.S.economy, the fixed relationship of the dollar to gold ($35 an ounce), and thecommitment of the U.S government to convert dollars into gold at that pricemade the dollar as good as gold In fact, the dollar was better than gold because itearned interest and could be used for trade and finance

A major stumbling block to the dollar’s emergence as the world’s key rency, however, became apparent: a huge dollar shortage The United States wasrunning huge trade surpluses, and its reserves were immense and growing Forthe system to work, this flow would need to be reversed; the United Stateshad to run a payments deficit That is just what happened

cur-From 1947 until 1958, the United States encouraged an outflow of dollars,which provided liquidity for the international economy Dollars flowed outthrough U.S aid programs: the Truman plan for aid to Greece and Turkey, aid

to underdeveloped countries, and, most important, the Marshall Plan, whichfrom 1948 to 1952 gave 16 Western European countries $17 billion in outrightgrants.10 U.S military expenditures in North Atlantic Treaty Organization(NATO) countries and in the Korean War provided another source of dollarliquidity Thus the dollar became the world’s currency, and the United Statesbecame the world’s central banker, issuing dollars for the international monetarysystem.

In addition to providing liquidity, the United States managed imbalances inthe system It facilitated short-term adjustment through foreign aid and militaryexpenditures, which helped offset the huge U.S trade surplus and the Europeanand Japanese deficits In addition, the United States abandoned the BrettonWoods goal of convertibility and tolerated European and Japanese trade protec-tion and discrimination against the dollar For example, the United States ab-sorbed large volumes of Japanese exports while accepting Japanese restrictionsagainst U.S exports It supported the European Payments Union, an intra-European clearing system that discriminated against the dollar, and it promotedEuropean exports to the United States Finally, the United States used the lever-age of Marshall Plan aid to encourage devaluation of many European currencies

to support national programs of monetary stabilization

To encourage long-term adjustment, the United States nurtured Europeanand Japanese trade competitiveness Policies for economic controls on the de-feated Axis countries were scrapped Aid to Europe and Japan, including theMarshall Plan aid to Europe, was designed to rebuild productive and export ca-pacity In the long run, U.S leaders expected, such European and Japanese re-covery would benefit the United States by widening markets for U.S exports.11The system worked well Europe and Japan recovered and then expanded.The U.S economy prospered partly due to the dollar outflow, which led to thepurchase of U.S goods and services Yet by 1960, the Bretton Woods systemwas in trouble again

Multilateral Management Under U.S Leadership

The economic foundation of the U.S management of the international tary system was confidence in the U.S dollar This confidence was based on thestrength of the U.S economy, the enormous U.S gold reserves, and the com-mitment to convert dollars into gold But ironically, the system also relied on aprocess that eventually undermined the very confidence on which the structurewas built: the constant outflow of dollars from the United States The U.S defi-cit and the foreign holding of dollars provided sufficient liquidity for interna-tional transactions If, however, the deficit continued, and if outstanding dollarholdings abroad became too large in relation to gold reserves, confidence in thedollar—and thus in the entire system—would be jeopardized.12

mone-By 1958, the United States no longer sought a payments deficit The Europeanand Japanese recoveries were nearly complete Balances of payments were improv-ing, and official reserves were growing steadily By the end of 1959, European andJapanese reserves equaled those of the United States U.S gold holdings, however,

had fallen and dollars held abroad had risen In 1960, for the first time, foreign dollarholdings exceeded U.S gold reserves.13Private long-term capital outflow, caused to

a great extent by direct investment abroad and foreign military and aid expenditures,contributed to payments deficits (see Figure 2.1)

The first run on the dollar, which occurred in November 1960 when ulators converted dollars into gold, signaled the end of the unilateral system ofU.S management The dollar system did not collapse The United States wasstill able to play a strong leadership role, and the dollar and its economy re-mained healthy But the United States could no longer manage the system alone.Henceforth, the United States would be obliged to join in collective manage-ment, that is, to seek the cooperation of other members of the system

spec-At the end of the 1950s, the IMF, largely inactive during the period of U.S.unilateral management, began to play a more important role, largely by lendingfunds to Europeans and others to finance temporary payments disequilibria.Increases in the fund’s quotas at this time facilitated the more active role Theprincipal functions of monetary management, however, were performed by amultilateral group of the major states One important new form of multilateralmanagement was central bank cooperation Since 1930, European central bankershad met together regularly at the Bank for International Settlements (BIS) inBasel, Switzerland, but the United States had never become a member and hadnever participated in their frequent meetings.14After the dollar crisis of 1960, how-ever, high officials of the U.S central bank, the Federal Reserve, joined themonthly meetings, although the United States did not join the BIS until 1994.U.S participation enabled the Basel group to control important aspects ofthe international monetary system The bankers provided ad hoc crisis manage-ment by supporting currencies that came under pressure The group also regu-lated the price of gold In 1961, the bankers agreed to control gold speculation

by centralizing gold dealings through a “gold pool,” a mechanism by which thebankers bought gold when it fell below $35 an ounce and sold it when it roseabove that limit The bankers also cooperated in exchange markets and began toplay an important role in the burgeoning Eurocurrency market (see next section)

by investing, intervening, and accumulating information Finally, the bankersregularly exchanged information about national policies that affected the interna-tional monetary system

A second management system developed at this time was the Group ofTen (G-10) The Group of Ten was formed in December 1961 when represen-tatives of ten industrial countries—Belgium, Canada, France, Germany, Italy,Japan, the Netherlands, Sweden, the United Kingdom, and the United States—met to create the General Arrangements to Borrow (GAB), a $6 billion fundfor exchange rate management that was under the control of the ten members.15The G-10 soon became a forum for discussion and exchange of information, avehicle for negotiating monetary reform, and a mechanism for crisis manage-ment In 1968, for example, the group stopped a dollar crisis and eased pressure

on the U.S gold supply by creating a two-tier gold system: a private market inwhich the price of gold could fluctuate freely and a public market in which thegroup agreed to sell one another gold at $35 an ounce

A series of bilateral arrangements between the United States and othermembers of the Group of Ten supported this multilateral management system.These arrangements included currency swap arrangements and standby creditlines to be used by central bankers for crisis management; special long-termU.S bonds denominated in foreign currencies that countries agreed to hold inlieu of converting dollars into gold; and German agreements to purchase U.S.military equipment and to continue to hold large amounts of U.S dollars to off-set the cost of U.S troops stationed in Germany.16

Finally, the United States sought to shore up the system by improving theU.S balance of payments and by reestablishing confidence in the weakeningdollar Unilateral U.S efforts included a tax on foreign securities designed tomake borrowing in the United States less desirable and thus reduce capital out-flows, capital restraints on U.S foreign investment, the tying of foreign aid to thepurchase of goods and services, a decrease in duty-free tourist allotments, andprograms to encourage U.S exports However, the United States was unwilling

to alter its expansionary macroeconomic policies despite the pressures this put onits balance of payments.17

Multilateral management mechanisms not only prevented and containedcurrency crises but also achieved a major reform of the system In the early1960s, inadequate liquidity was shaping up to be a crucial problem Once theUnited States solved its balance-of-payments problems, as was expected, therewould be a liquidity shortage and a need to provide alternative forms of interna-tional money The problem of the future, international monetary policymakersbelieved, would not be too many dollars but too few.18

In 1968, after five years of negotiations by the Group of Ten, an agreementwas reached to create Special Drawing Rights (SDRs), artificial internationalreserve units created by the IMF that could be used to settle accounts among

central banks Significantly, the new form of international liquidity would bemanaged not by the United States alone but by the Group of Ten jointly, asthe Europeans were given veto power on the creation of new SDRs.19The $6billion of the new “paper gold” created was small compared with total worldreserves at that time (close to $100 billion in 1970);20nevertheless, for the firsttime in history, the international monetary system had an internationally createdand managed asset Ironically, just at this point the system began to crack.Continuing currency crises in 1967 and 1968 heralded the eventual demise ofthe Bretton Woods regime and the emergence of a new international monetarysystem.

F R O M B R E T T O N W O O D S T O I N T E R D E P E N D E N C E

Financial Interdependence and PluralismThe emergence of a high level of financial interdependence played a centralrole in the collapse of the first postwar monetary system The return to con-vertibility of the Western European currencies at the end of 195821and of theJapanese yen in 1964 made possible the huge expansion of international finan-cial transactions Multinational banks became the vehicles for large interna-tional financial flows Beginning in the 1960s, the number of multinationalbanks increased rapidly In 1965, only 13 U.S banks had branches abroad,but, by the end of 1974, 125 did The assets of the U.S banks’ foreignbranches rose from about $9 billion in 1965 to over $125 billion in 1974.Concomitantly, there was an expansion of foreign banks in the United States.The number of foreign branches and agencies in New York City, for example,rose from 49 in 1965 to 92 in 1974 The total assets of these branches andagencies in the same period rose from $5 billion to $29 billion, and by theend of 1974 foreign banks operating in the United States had total assets of

$56 billion.22

Financial interdependence was also a result of the internationalization ofproduction Multinational corporations that controlled large pools of liquid assetsbecame sophisticated in moving their capital from country to country to takeadvantage of interest rate spreads or expected exchange rate adjustments Inthe 1960s and 1970s, as crises multiplied and risks increased, the movement ofsuch capital became an important part of financial management.23

A final source of financial interdependence in this period was theEurocurrency market Eurocurrencies are national currencies—dollars, marks,francs, pounds, yen—held and traded outside their home country, primarily inEurope For example, branches of U.S banks or foreign banks in London acceptdollar deposits and lend those deposits in the form of dollars The Eurocurrencymarket originated in the late 1950s, primarily with Eurodollars, and grew tohuge proportions in the 1960s and 1970s, reaching almost $1 trillion in assets

by 1978 (see Figure 2.2).24 The market flourished largely because it was trolled neither by state regulation nor by constraints of domestic money markets

con-Thus, it was able to establish highly competitive interest rates that attracted hugesums Because the Eurocurrency market consisted largely of short-term money,funds in the market were highly mobile and highly volatile.25

These new forms of financial interdependence made possible huge tional capital flows that put great strain on the international monetary system

interna-In a fixed exchange rate regime, as previously noted, governments facingbalance-of-payments disequilibria had several policy alternatives If the disequi-libria were small or short term, governments could finance the imbalances orimpose exchange controls If the disequilibria were structural, governmentscould either change the value of their currencies—devalue or revalue them—

or alter domestic fiscal or monetary policy to restore balance However, cal leaders often were reluctant to take politically risky measures to addressstructural imbalances The failure to resolve these disequilibria led to largespeculative international capital movements Efforts to intervene in exchangemarkets to prevent change were overwhelmed by rapid and massive inter-national financial flows, which made it impossible to maintain the fixed value

politi-of currencies within a range politi-of plus or minus 1 percent Crises developed andgovernments eventually were forced to alter both exchange rates and nationaleconomic policies

Financial interdependence also interfered increasingly with national nomic management, especially with national monetary policy Interest rates, forexample, became a less effective means of managing the national economicsystem Low interest rates, used to stimulate an economy, led to an outflow ofcapital to countries with higher interest rates Conversely, high interest rates,