a stable price environment. If a country faced an outflow of dollars it signalled the need to take corrective measures. This could be via tighter monetary and fiscal policies, incomes policies or even devaluation. At this time it was adjustment to the US that coordinated policies amongst the industrialised nations, which in turn provided the basis of international currency stability. The key point is that if stable exchange rates were desired, price levels had to be relatively stable, or at least moving in line with one another.
The pre-eminent position of the US, crafted from the two World Wars, was becoming strained in the 1960s as cost differences and levels of productivity started to widen between industrial countries. This was most visible in Germany and Japan. Post-war both countries channelled their savings into rebuilding new, efficient industrial plants, and arms expenditures were restricted by the victorious powers. This was coupled with significantly lower labour costs.
The US, in contrast, was channelling savings into military expenditures, which later increased further as a product of the Vietnam War. The result was that the dollar was fixed at an overvalued level and sales of goods from Germany and Japan flourished. The first cracks started to appear in the US economy by late 1958. From 1958 to 1960 the US ran up deficits of $11.2bn. This led to an accumulation of dollars held by foreign corporations, which in turn spawned the Euro-dollar market. A portion of these dollars were converted into gold and so began the reversal of the reserves the US had built up as a result of the First World War.
The emergence of the floating exchange rate system
In March 1968 the US established a two-tier market rate for gold in an effort to mitigate the drain on their gold reserves. In this system all central-bank transactions in gold were insulated from the free market price. Central banks would trade gold among themselves at $35 per troy ounce but would not trade with the private market. The private market could trade at the market price and there would be no official intervention. By 1970, however, US gold reserves were down to $11bn, a fall of around 61% in ten years.
The end came in August 1971, when there were massive outflows of dollars. Much of the speculative activity was in favour of the Deutschmark, partly due to relatively favourable interest rates. On 15 August 1971 President Nixon announced the closure of the gold window; in other words, the dollar would no longer be converted into gold. This effectively meant that the Bretton Woods Agreement to establish a new monetary order had foundered. Official parities and intervention points were suspended and most major currencies began a clean or managed float.
In December 1971 negotiations got underway at the Smithsonian Institution in Washington to arrange the devaluation and stabilisation of the dollar. Eventually new parities were agreed against the dollar. These reflected varying rates of devaluation for the dollar: approximately 17% for the yen,13.6% for the Deutschmark, and, remarkably, 8.6% for sterling. The governments agreed to hold the exchange rates within a range of 2.25% of the agreed parities.
In early 1973 there was a further exodus out of dollars and in February 1973 the dollar was devalued by 10% and the official price of gold raised to $42.22 per ounce. Pressure still continued on the dollar, as inflation was on the rise as well as the prospect of further devaluation. In late 1973 the Yom Kippur War and the sudden increase in the price of oil caused further turmoil in the markets. The subsequent spike in inflation and the recession of 1974/75 created such payment imbalances that a return to fixed parities was impossible.
This ushered in a system of floating exchange rates.
Floating exchange rates
In the 1970s currency instability emerged as the accepted policy and this received the benign nomenclature of a float. The 1974 Economic Report of the US President, summarising the move away from fixed exchange rates, read:
The year 1973 may be characterised as one of continuing adjustment to past disequilibria. Early in the year the governments of most major countries abandoned attempts to fix exchange rates at negotiated levels. While central banks continued to intervene to some extent, foreign exchange markets played the major role in determining the exchange rates that would clear the market. The process was marked at times by unusually large fluctuations of market exchange rates. [2]
Note the reference to the key element in any definition of a free or floating exchange rate system – exchange rates are determined by free market forces. When a government intervenes in the foreign exchange market to influence exchange rates by buying or selling currency the system can be called a managed float or a dirty float. The float is dirty because there has been a deliberate interference with pure market forces of demand and supply.
Stability under the floating rate system
The fundamental flaw of the floating rate system, experienced on many occasions, is that exchange rates can move to levels far removed from any notion of long-term competitive levels. It could be argued that it is not correct to talk of undervaluation or overvaluation in a floating rate system. After all, it is the market that determines the level and it cannot be wrong. However, speculation is an inherent part of a floating system and this does create overvaluations and undervaluations in the exchange rate.
Overvaluations generate slumps in the internationally exposed sectors and can lead to deindustrialisation and protectionism, while undervaluations will generate inflationary pressures by allowing import prices to rise as the exchange rate falls. This has undoubtedly been the case for the UK, for example, which is dependent on imports of food and raw materials. It has also become an issue for a number of countries which are pegged to the dollar, notably those in the Middle East.
Moreover, a rise in interest rates as part of an anti-inflation package may encourage an inflow of funds. This will increase the price of the currency and will make the economy less internationally competitive. These circumstances detract from satisfactory economic performance. In this context the exchange rate should guide the central bankers on when to ease up and when to restrain. The official mantra, however, is that stability rather than an appropriate level of the exchange rate is their objective. The G7 revealed this intention when it said on 3 October 2009:
We confirm our shared interest in a strong and stable international financial system. Excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability. We continue to monitor exchange rates closely, and cooperate as appropriate.
Governments have introduced the goal of economic convergence – sustainable non-inflationary economic growth – as the means to achieve this foreign exchange stability.
The choice of exchange rate system is extremely important as it determines the process and impact of any adjustment and indeed has become the focus of discussion within Europe. I shall now look at these adjustment mechanisms in more detail.
Adjustment mechanisms with floating exchange rates
The proponents of a floating exchange rate will cite its flexibility and self-correcting nature. With a floating exchange rate, a balance of payments disequilibrium should be rectified by a change in the external price of the currency – a self-correcting mechanism.
For example, if a country has a current account payments deficit then the currency should depreciate. The effect of the depreciation should be to make the country’s exports cheaper and imports more expensive, thus increasing demand for goods abroad and reducing internal demand for foreign goods, therefore dealing with the balance of payments problem. Conversely, a balance of payments surplus should be eliminated by an appreciation of the currency.
However,
