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THE GLOBAL CAPITAL MARKET: Capital Mobility 3

Understanding the Evolution of International Capital Mobility

The broad trends and cycles in the world capital market over the last century reflect changing responses to the fundamental policy trilemma. Before 1914, each of the world’s major economies pegged its currency’s price in terms of gold, and thus, implicitly, maintained a fixed rate of exchange against the currency of every other major country. Financial orthodoxy saw no alternative mode of sound finance. Latin American interludes of floating exchange rates were viewed from the main financial centers with “fascinated disgust,” to use the words of Bacha and Diaz-Alejandro (1982).

The gold standard system met the trilemma by opting for fixed exchange rates and capital mobility, sometimes at the expense of domestic macroeconomic health. Between 1891 and 1897, for example, the U.S. Treasury allowed the domestic money stock to contract sharply in the face of persistent speculation that the dollar would leave gold. This policy led to banking panics and a harsh deflation. A populist movement led by William Jennings Bryan and others agitated forcefully against gold, but lost. The balance of political power began to change only with World War I, which brought a sea-change in the social contract governing the industrial democracies (Temin, 1989). Organized labor emerged as a political power, a counterweight to the interests of capital.

Although Britain’s return to gold in 1925 led the way to a restored international gold standard and a limited resurgence of international finance, the gold standard helped propagate a worldwide depression after the 1929 New York stock market crash. Many countries abandoned the gold standard in the early 1930s and depreciated their currencies; many also resorted to trade and capital controls to manage independently their exchange rates and domestic policies.

However, countries in the “gold bloc,” which stubbornly clung to gold through the mid-1930s, showed the steepest output and price-level declines. Eventually in the 1930s, virtually all countries jettisoned rigid exchange-rate targets, open capital markets, or both in favor of domestic macroeconomic goals.