Last three decades have not been very forgiving for the global monetary system. There have been numerous sovereign defaults, many large bank failures, several local currency and banking crises and then one mega-crisis along with the deepest recession in last 70 years. When did life become so complicated?
At the risk of oversimplification I am going to suggest a date! 15th August 1971. That was the date on which President Nixon of US announced the abolishing of Gold Standard under the Bretton Woods system. This day onwards, currencies started floating freely against each other. The initial reaction of most countries was one of the two. Large economies were fine with letting their currencies float since the volatility in the exchange rate was not significant - this included Germany, UK, Japan etc. Smaller countries chose to peg their currency to one of the major currencies - mostly driven by the currency of choice for their largest trading partners. Majority chose USD, some went with Pound Sterling.
Over a period of time, the policy makers in the emerging economies discovered the strategy of currency management for export promotion. A very interesting analysis of this strategy has been done in a paper by Prof. Sebastian Morris of IIM Ahmedabad. Parallely, as capital became more mobile globally in the 80s and 90s, many emerging economies started seeing significant movement of capital in and out. Some discovered to their peril the footloose character of large part of these flows - also termed "hot money". The Asian Financial Crisis of 1997 was a testimony to this. Coupled with the cheap currency led export promotion and the need to have large forex reserves in the wake of the crisis, most Asian economies built massive piles of reserves (now running into trillions of dollars).
The world is now divided into three camps - monetarily speaking! Many of the advanced economies which run current account deficits and capital account surpluses in one camp, some advanced economies and many large economies which run currency account surplus and capital account deficits and the rest of the world. US and UK lead the first camp, Germany/Japan amongst advanced economies and China/East Asia amongst emerging economies lead the second camp. The second camp accumulates reserves or has depreciating currencies. The first camp has an ever increasing issuance of government debt to the reserve accumulators. (India belongs to the third camp - it accumulates reserves only when there is massive capital account surplus, else the moderate capital surplus typically balances out its almost always positive current account deficit.)
The funny (or tragic depending on your beliefs in fairness, human nature and geopolitics!) thing is that this state of affairs is thoroughly unstable. Whatever equillibrium the global financial system achieves is always likely to be very fragile since the actors in the above state of affairs are soveriegn states with very limited influence on each other! Consider the US-China exchange on the currency management by China and loose monetary policy of US Fed. Neither can directly control what the other is going to do to its internal monetary policy but both are likely to be strongly affected by it. It almost seems like one needs to coin a new phrase to describe this phenomenon of politics getting intertwined with monetary policy - "moneto-politics" maybe (along the lines of "geopolitics").
There is no easy way out of this. Central banks and governments across the world will keep managing their monetary policies and currencies independently. That may not always be the optimal outcome for everyone concerned. However, till most of the participants see more benefits of coordinated action than the to-each-his-own policies, the instability remains an inherent feature of the modern monetary system. Maybe one should do a game-theory analysis of monetary policy conduct of major economies!
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