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IV

MONEY AND FINANCE

The international economy, like domestic economies, requires a common monetary
standard to function smoothly. For individuals and firms to buy and sell and to
save and invest, they need some generally acceptable and predictable unit of account
against which other goods can be measured, a medium of exchange with which
transactions can be carried out, and a store of value in which wealth can be held.
National currencies serve this purpose within countries: for example, Americans
buy, sell, save, and invest in dollars. In international trade and payments, a variety
of possible common measures can be imagined; in practice, however, the two
pure cases are a commodity standard and an international currency standard.
Economic actors could use a widely traded commodity, such as gold or pork
bellies, against which to measure other goods; or they might arrive at some fictitious
unit in which goods could be priced. The former approximates the classical gold
standard; the latter, present-day special drawing rights, which are a sort of “paper
gold” issued by the International Monetary Fund and equal to a mix of national
currencies. Because reaching agreement on a fictitious international currency is
difficult, such national currencies as the dollar or the pound sterling have often
been used as the basis for international payments.
If the international monetary system provides the measures needed to conduct
world trade and payments, the international financial system provides the means
to carry out trade and payments. For many hundreds of years, financial
institutions—especially banks—have financed trade among clients in different
nations, sold and bought foreign currencies, transferred money from one country
to another, and lent capital for overseas investment. If, as is often averred, the
international monetary system is the “Great Wheel” that enables goods to move
in international trade, the international financial system is the grease that allows
the wheel itself to turn.
In the modern era (since 1820 or so), there have been, essentially, four well-
functioning international monetary systems; each has had corresponding
international financial characteristics. From about 1820 until World War I, the
world was on or near the classical gold standard, in which many major national
currencies were tied to gold at a legally fixed rate. In principle, as Lawrence Broz
and Barry Eichengreen explain (in Readings 13 and 14, respectively) the gold
standard was self-regulating; should any national currency (and economy) move
out of balance, it would be forced back into equilibrium by the very operation of
the system. In practice, the pre-World War I system was actually a gold-sterling