International Political Economics and Financial Systems

International Political Economics

The international financial system has changed significantly over the past thirty years. Among the most significant changes, the Bretton Woods system collapsed, regulations regarding transborder capital flows have eased and the Euro was created. Each of these major changes has contributed significantly to the global financial system we have today.

The Bretton Woods system was devised in the wake of the Second World War and was based on pegging the world’s major currencies to the value of gold. The pegs were to be within 1%. By 1968, Bretton Woods had been adapted to a floating rate system. The U.S. dollar, the reserve currency under Bretton Woods, was unable to maintain its peg. The U.S. dollar became overvalued in relation to gold.

The Smithsonian Agreement of 1971 ended the gold pegs for good. The U.S. had unilaterally ended the gold standard the year prior. This agreement set the stage for the development of international currency markets. The first stage, however, saw exchange rates negotiated, rather than be backed by the value of silver or gold (Investopedia, 2009).

Once the free float of major currencies was established, the next step in the development of global financial markets was the freeing of global financial flows. International trade agreements have been signed at an increasingly rapid pace since the U.S. And Canada signed the first major free trade act. While the flow of goods has improved as a result of these agreements, the flow of capital has freed the most. This impacts the world’s financial system in a number of ways. The first is that it increases the efficiency of resource allocation, but in doing so it also increases the volatility of global financial markets (Eichengreen, 2004). Speculation, both directly on currency markets and indirectly with foreign investment, contributes to this volatility.

Another major change in the global finance system is the creation of the Euro. When the U.S. dollar began to lose prominence in the 1970s, the other major world currencies were all in smaller economies. They were important, but never a threat to supercede the preeminence of the dollar. The euro absorbed some of these powerful currencies, such as the mark and the franc, and became a world currency in its own right. The euro provides global financial markets a realistic, viable alternative to the dollar, the first real one since the pound prior to World War Two (Pollard, 2001).

As yet, the euro has not superceded the dollar as the primary medium of exchange in the global financial markets. That it provides a viable second option is of comfort to investors, however. It provides stability to the global financial system as well, since investors need not focus exclusively on the dollar as a safe haven. They can move between the euro and the dollar, which increases the efficiency of the global financial markets and helps to normalize the price of both of these currencies.

The final major change in the global financial markets is the increase in the use of derivatives. The increasing use of derivatives has been hotly debated. Proponents take the view that they help hedge against risk, thus improving the efficiency and effectiveness of the international financial system; others argue that derivatives are dangerous and that the use of leverage distorts markets and leads to excessive speculation (Sheppard, 2004). In either case, derivative instruments are here to stay, and have had a significant impact on the global financial system.

One emerging issue that may become the major issue of the next decade or so is the ongoing soft peg of the yuan to the dollar. This is creating an egregious distortion of the market for the yuan, resulting in a massive wealth transfer to China that may well destabilize the global financial system when a free float of the yuan is finally allowed.

2. There are a handful of characteristics that define the classic socialist system. The central government has a monopoly on all resources, and often on retailing as well. This leads to an excess of bureaucratic control. Budgets are soft, since the value of the currency is not likely to be determined by the market anyway. Socialist states use a command and control management structure as a substitute for the profit motive. This structure is less efficient, so production levels cannot match those of capitalist states. Ultimately, the lack of productivity and the large number of distortions lead to economic collapse (Tesche, 1993).

Since the collapse of the Soviet Union, the pace and nature of economic reforms has differed greatly in the former Soviet states. These range from regions with a virtual continuation of communist dictatorship (Belarus, Transnistria) to full-scale embrace of the free market (Estonia in particular). Russia’s economy has only opened somewhat, and only to small and medium sized enterprises (SMEs). For the most part, the major firms in the economy are controlled by powerful businessmen with close ties to government. Freedom of capital flows has improved slightly, but the Russian economy overall remains under significant government control. The economy has grown substantially since the breakup of the U.S.S.R., however, in large part due to oil and gas revenues. Outside of the major cities, however, the Russian economy is worse than it was during the Soviet days.

The Baltic states (Estonia, Latvia and Lithuania) have embraced the market economy. They have joined the European Union and leveraged their historic trade links along the Baltic (and in the case of Estonia a share cultural heritage with Finland) to attract capital inflows and make investments in the economy. The governments of these three countries have opened their economies significantly. Among the post-Soviet states, Estonia has by far the highest GDP per capita, and the only other nations to best Russia’s total are Latvia and Lithuania (CIA World Factbook, 2009).

The other former Soviet states have yet to embrace capitalism. Nations like Ukraine, Belarus and Moldova continue to have economic policies not far removed from those they held under Soviet rule. Each of these countries have varying degrees of political interference in their economies, but maintains a command and control structure with respect to major industries and has not freed their legal system from its constraints. The result is that these three former Soviet Eastern European nations lag Russia’s economic performance.

On the other side of Russia, China is attempting to maintain a socialist state while building its economy. The Chinese economy is relatively free for SMEs, but major industries remain under tight command and control. The Chinese banking and financial systems in particular are controlled closely by the government, following in the Korean and Japanese models of economic growth.

In this respect, China has chosen that in the name of economic growth it will maintain the more totalitarian aspects of socialism while doing away with the social aspects. Peasants remain poor while tens of millions of urban Chinese join the ranks of the emergent middle class. At some point, however, China’s government will need to decouple itself from the economy, putting the yuan in free float, removing government control of the banking system and allowing for growth in large enterprise regardless of government connections.

Works Cited:

No author. (2009). Smithsonian agreement. Investopedia. Retrieved December 13, 2009 from

Eichengreen, B. (2004). Capital flows and crises. MIT Press. Retrieved December 13, 2009 from

Pollard, P. (2001). The creation of the euro and the role of the dollar in international markets. Federal Reserve Bank of St. Louis. Retrieved December 13, 2009 from

Sheppard, M. (2004). The politics of the oversight of OTC derivatives markets: Is there any evidence of systemic risk? Paper presented at the annual meeting of the International Studies Association, Le Centre Sheraton Hotel, Montreal, March 17, 2004. Retrieved December 13, 2009 from

Tesche, J. (1993). The socialist system: The political economy of communism. Southern Economic Journal. July 1, 1993. Retrieved December 13 from

No author. (2009). GDP per capita. CIA World Factbook. Retrieved December 13, 2009 from

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