The Bretton Woods System became unsustainable as the US began to allow money supply to grow well beyond the gold reserves held by the US Government. When the System collapsed in 1972, the world’s monetary system was converted to a fiat money regime in which major international currencies freely floated against each other. The post-Bretton Woods era represented a new era in which governments would be given more or less a free hand to pursue their national interests and domestic policy agenda without the rigid constraints imposed by a Gold Exchange Standard. Unfortunately, the initial experience under the new regime was far from satisfactory. In my view, financial and macroeconomic stability cannot exist without an effective monetary anchor. For many centuries, the linkage to the precious metals had provided an external monetary anchor. Of course, the Gold Standard or Silver Standard had many shortcomings but it nevertheless provided an externally imposed discipline against monetary expansion. However, under the fiat money and floating rate regime, financial and macroeconomic stability can only be achieved if we have “3 Ds”! What does “3Ds” stand for? The first D stands for “Monetary Discipline”, the second “Fiscal Discipline” and the third “Market Discipline”. Conceptually, the removal of the external monetary anchor in the form of backing by precious metals must be replaced by these three types of discipline. If any of these three disciplines breaks down, then serious consequences or even a financial crisis may occur. Let me address these three disciplines in turn.
Of course financial innovation and the creation of highly opaque and leveraged financial derivative products, such as CDOs, also helped amplify the severity of the problem and transmit the shockwaves across the global financial system. The result: the global financial system nearly collapsed. Fiscal discipline More often than not monetary discipline breaks down because of the lack of fiscal discipline. One major reason why the US had to abandon the Bretton Woods system was the huge fiscal burden of financing the war in Vietnam, which also led to a sharp deterioration of the current account position of the US. There have been many examples of Government spending beyond their means resulting in the piling up of government or public debt. In the case of Argentina, the lack of fiscal discipline eventually brought down the Currency Board System that had served as an anchor of monetary stability for Argentina since 1991. In the case of Europe, the sovereign debt crisis that we are seeing now has been the consequence of a breakdown of the fiscal prudence and discipline over many years. Very few people would now doubt that macroeconomic and financial stability could be achieved in the longer run in the absence of fiscal discipline. Market discipline This is probably the most complex if not intriguing dimension of the three disciplines needed to maintain financial and macroeconomic stability. Traditionally, we all believe that market forces would be the last guard when national authorities failed to exercise monetary or fiscal discipline or both.