bruni from gold to euro 2010 revised
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This version: August 2010
Franco Bruni
A SHORT HISTORY OF THE INTERNATIONAL
MONETARY SYSTEM:
"DALL'ORO ALL'EURO"
1. Introduction : international exchange rate regimes and the “incompatible trio”
This paper offers a very synthetic analysis of the evolution of the international monetary system,
starting from the last part of the 19th
century. Economic history is one way to introduce institutions
in economic theory and policy; it shows how the functioning of markets, described by abstract
models, is in fact influenced by institutions, habits, ideas, political equilibria and international
relations. An historical approach helps in understanding the current functioning of certain parts of
the international monetary order that are less developed and that resemble the past workings of
more advanced regions. Moreover, sometimes history recurs: past theories, ideas and economic
arrangements come back into fashion, and institutions get reshaped in ways that remind us of older
times. An example is the recent globalisation process that is better understood by using some
knowledge of the first globalisation that took place during the “gold standard” years before the First
World War. But the aim of these notes is not so much to tell the history as to highlight the concepts
on which each exchange rate regime was based, both in its theoretical design and in its practical
application.
Table 1 shows the division into periods on which the next sections are based. Section 2 starts with
the so-called gold standard , which prevailed until the First World War. The next period is a long
and complex one, which reaches the end of the Second World War. This period will be dealt with in
Section 3 in a rapid and schematic way, in spite of its great interest due also to the fact that it
includes the Great Depression which is often used as a benchmark for analyzing the international
crisis started in 2007: in fact during the interwar period international payments and exchange rates
could not be organised as a widely accepted and stable “system”. After the Second World War, the
important Bretton Woods years, dealt with in section 4, followed. Following the Bretton Woods
agreement a system of fixed exchange rates connecting a large number of countries managed to
survive until the beginning of the „70s, a decade of wildly fluctuating currencies and monetary
disorder briefly discussed in section 5. After several efforts and proposals to organise a reformed,
world-wide system of fixed exchange rates, the Bretton Woods “Articles of Agreement” were
modified in 1976, and the world officially entered the period of freely floating exchange rates that
continues today. But Europe reacted to the costly disorder of the „70s by renewing its frequent, past
efforts to set up a regional system of currencies in order to keep inter-European exchange rates
much more stable than the exchange rates with extra-European currencies. This effort resulted in
the European Monetary System (EMS) discussed in section 6. Eventually the EMS evolved in the
Economic and Monetary Union (EMU), which gave rise to the eurozone. The new common
currency was introduced in 1999 and has now an increasing role in global monetary and financial
markets. Section 7 summarises the ups and downs of the dollar over the four decades following the
end of Bretton Woods, including the evolution of the $/€ exchange rate since the creation of the
euro.
Before entering the discussion of the exchange rate regimes, it is useful to introduce the concept of
“incompatible trio”, a simple and valuable tool for analysing their functions and evolution. The trio
2
is the set of the following three elements, that cannot stay together, even when each of them is
considered desirable and beneficial :
i) fixed exchange rates ;
ii) freedom of international capital movements ;
iii) autonomy of national monetary policies.
It is easy to show that it is impossible to keep the three elements completely viable in conjunction
with one another. The explanation can make use of simple formal macro-models (it is equivalent to
the Macro 1 theorem stating that, with perfect capital mobility, a fixed exchange rate renders
monetary policy ineffective), but can also be purely intuitive: two autonomous, national monetary
policies can be very different which give rise to very different interest rates, which, given ii), will
trigger continuous capital flows toward the higher interest country. These flows will incapacitate the
central banks from keeping a fixed exchange rate between the two currencies, except in the very
short term, and in any case, the interventions required to peg the exchange rate will tend to
neutralise the difference between the two monetary policies, as the more expansionary country will
have to buy back its currency and vice-versa.
As a consequence of the incompatible trio, each time an international monetary order aims at
keeping the exchange rates, to some extent, fixed (element “i)” of the trio), it has to give up, to the
same extent, either the freedom of capital movements or the autonomy of national monetary
policies, or a combination of part of ii) and part of iii). This fact will be very clear from the
discussion of the gold standard, as well as from the history of the Bretton Woods regime and of the
EMS. Each time the same question will come up: how the fixed exchange rate regime managed the
incompatible trio problem ? The answer will always deepen the understanding of the working of
the system.
2 The gold standard
A system of international payments settled with precious metals has prevailed in many periods of
the world‟s economic history starting from very ancient times. The more recent “gold standard” can
be considered to have started sometime in the 19th
century. A reasonable conventional year is 1879
when the US dollar became again convertible into gold. The gold standard ended with the First
World War, even if, during the period between the two world wars, several countries, including the
UK, tried to resuscitate it.
There are four main aspects that characterise the gold standard.
Gold parities. The gold standard was a fixed exchange rate system that did not result from an
international “treaty” or from an “accord” between the participating countries. It was simply the
consequence of the fact that many countries were unilaterally adopting two basic rules: their
domestic currency was convertible into gold at an absolutely fixed price1, and gold could be freely
transferred in and out of the country. As a consequence, a fixed exchange rate could be naturally
defined between any couple of currencies of the system, coinciding with the ratio of the price of
gold in the two countries, which was called the “gold parity”. For example, if “the franc” were
convertible into f ounces of gold, and “the mark” into m ounces, the gold parity between the two
currencies would be f/m marks per franc.
1 Which means that the central bank or the commercial banks that had the domestic money supply on the liability side
of their balance-sheet were available to accept each unit of that money in exchange for a fixed amount of gold.
3
Gold arbitrages. Whenever the market exchange rate between two currencies was different from the
gold parity, “gold arbitrages” would take place, with operators buying gold in one country and
selling it in the other, at a profit. Gold arbitrages would trigger sales of the currency which was
more expensive than its gold parity and purchases of the cheaper currency and would thus push the
market exchange rate back toward the gold parity. Using the two currencies of the example above,
suppose the market value of the franc in terms of marks were e>f/m. It would then be convenient to
start from 1 mark, convert it into m ounces of gold, transport these ounces from “Germany” to
“France”, sell them for m/f francs and then sell the francs on the currency market to obtain em/f>1
marks, thus making a profit while increasing both the supply of francs and the demand for marks
and therefore tending to push the market exchange rate e towards the gold parity f/m. Gold
arbitrages were therefore the automatic mechanism that kept exchange rates fixed during the gold
standard. If the costs of transporting gold between the two countries (“transaction cost”) are taken
into account, it is easy to understand that arbitrages did not take place until the market exchange
rate reached a point sufficiently far from the gold parity to guarantee a profit larger than the
transaction cost. As a consequence, the market exchange rate was in fact free to fluctuate in a band
around the gold parity bound by two so-called “gold points”. The band became wider the larger the
transaction cost2.
The “Hume mechanism” and the “rules of the game”. In the gold standard there was a built-in
mechanism facilitating the maintenance of the equilibrium of the countries‟ balance of payments
and therefore the stability of the world‟s financial markets. This made the gold standard itself more
robust and long-lived. It is called the “Hume mechanism”, from the Scottish philosopher David
Hume who, as early as 1752, gave a description in his “On the Balance of Trade” of what is often
named the “price-specie-flow mechanism”. The working of the mechanism is based on the
following four steps:
- International flow of gold. A deficit (surplus) of a country‟s balance of payments is settled with
gold, which flows to the surplus country as the accepted international means of payment. The
international gold flow can also be triggered by the arbitrage described above, following an
incipient depreciation of the currency of the deficit country.
- Money supply changes. As countries guarantee the convertibility of their currency into gold,
they have also to maintain the supply of each currency proportionally to the amount of gold
available in each country to back its money supply. This means that monetary policies must
follow, more or less automatically, what are still called “the rules of the game”: being restrictive
when there is a balance of payments deficit and vice-versa. A gold outflow (inflow) will
therefore cause a decrease (increase) of the money supply of a deficit (surplus) country3.
- Price level changes. If we suppose that the price level of each country is sufficiently reactive to
the quantity of money (applying some sort of “quantity theory of money and prices”), we can
conclude that the deficit (surplus) country‟s prices will become relatively lower (higher) and
will consequently favour (hinder) the international competitiveness of its domestic production
and its net exports.
2 Suppose in the above example that the cost of transporting gold from Germany to France is T%. This allows reselling
in France only m(1-T) ounces, obtaining m(1-T)/f francs to be exchanged for em(1-T)/f marks. The arbitrage is not
convenient if em(1-T)/f <1, or e<f/m(1-T). With the opposite reasoning, the transportation of gold from France to
Germany is found not to be convenient when the market exchange rate is higher than the other “gold point” limiting the
following corridor : f(1-T)/m< e < f/m(1-T). 3 The mechanism through which money was “destroyed” after a gold outflow might seem difficult to understand: were
banknotes torn up? Note that the destruction happened mainly via the money-credit multiplier of the banking system:
losing gold reserves, banks found themselves with riskier balance sheets, which induced them to restrict their supply of
credit (provision of loans and purchases of securities) which caused the shrinkage of banks‟ deposits and therefore of
the country‟s money supply.
4
- External equilibria restored through changes in the balance of trade. The increase (decrease)
of net exports of the deficit (surplus) country cures its balance of payments, restoring external
equilibrium.
The role of international capital mobility and of “stabilising speculation”. The working of the gold
standard rested not only on the international flows of gold but also on a free and abundant
international mobility of financial capital. This is particularly clear with reference to:
- Stabilising expectations and speculations. Markets were deeply convinced that gold parities
between currencies would never be changed, as the content of gold of each currency was a non-
modifiable characteristic crucial for guaranteeing its acceptability as a medium of exchange4. As
a consequence, when market exchange rates were moving away from parities, everybody
expected them to revert soon to equilibrium. In other words, exchange rate expectations were
systematically “stabilising”5, triggering off stabilising speculations
6 even before any gold
arbitrage could take place. Gold arbitrages, to be sure, often remained potential arbitrages, but
they still had a role in forming stabilising expectations on exchange rates and thus in causing the
international movements of financial capital required by speculative currency operations. The
gold standard could actually function with very limited international gold flows.
- Central banks‟ interest rate policies. Relying on the high degree of capital mobility, central
banks would often manoeuvre the domestic level of short term interest rates (for instance
changing their official discount rates) in order to re-equilibrate the balance of payments. This
move was highly effective as exchange rate expectations were “stabilising”, as noted above. A
deficit country with a weakening currency, for instance, would immediately attract a substantial
capital inflow when its interest rate was raised a little, as speculators could count not only on the
higher yield but also on a favourable change of the exchange rate, as the weak currency was
expected to appreciate to appreciate soon and to revert toward the gold parity. Note that
interest-rate-policy-induced capital flows, while helping to keep equilibrium of the total balance
of payments, were hindering the working of the “Hume mechanism” in maintaining equilibrium
in the current account of the balance of payments7.
To the four “defining” aspects of the gold standard that have been just described, several
considerations and comments can be added that help to deepen the understanding of how the regime
worked and evolved over time.
The gold standard and the “incompatible trio”. In which way did the fixed exchange rate regime of
the gold standard manage to solve the problem of the “incompatible trio” discussed in section 1?
The fixity of exchange rates was out of discussion, and the role of international capital mobility was
quite important, as explained above, during the gold standard decades that were times of very
substantial financial globalisation (as stressed below). Therefore, the solution of the trio problem
could not but rest on the fact that countries gave up the autonomy of national monetary policies. In
fact, with gold convertibility the supply of money in each country was regulated by the international
circulation of gold. As explained above, countries‟ monetary policies were following, more or less
automatically, the so called “rules of the game”. The creation and destruction of base money took
place only through the balance of payment channel. The quantity of money in each country was
4 At the most markets could expect short, temporary suspensions of convertibility, which in fact sometimes took place
in some countries. 5 Which is no more the case in modern times, with unconvertible currencies. In fact market expectations often amplify
current changes in exchange rates triggering destabilising speculation. 6 Stabilising speculation consisting of purchases of weak currencies and sales of strong ones, causes currency prices to
revert to their equilibrium values, which were in fact expected to prevail after each deviation from gold parities. 7 But this was good when it allowed countries to run for some time the current account deficits or surpluses (and the
corresponding differences between domestic real investment and saving) that were needed for the optimal global
allocation of real capital.
5
really “endogenous” in the general equilibrium system of the global economy. The macroeconomic
theory of short-run monetary policy stabilisation had not yet been invented. In general one can state
that there was no ambition to manoeuvre national monetary policies in an autonomous way.
The degree of “symmetry” of the gold standard and the role of the UK. In theory the gold standard
was a completely “symmetric” system. An exchange rate regime is symmetric when all
participating countries are in the same position with respect to the regime, none of them playing a
special role, enjoying special privileges or following special rules. The typical non-symmetric
system is one where the international means of payments coincide with the national currency of one
of the countries which then becomes the “centre” of an "asymmetric" system. The symmetry of
exchange rate systems is a characteristic that will be discussed in some depth in reference to the
Bretton Woods and to the EMS regimes, where it was a very important issue. In the gold standard it
was less important, but the regime was much less symmetric than it could have been in theory. This
was the consequence of the fact the British pound had a "special role", as it was kept on reserve
outside the UK as a very close substitute for gold. The position of the UK was therefore somewhat
different from that of the other gold standard countries. To some extent it played the role of the
"central country" in the system and it was able to keep its balance of payments in a deficit position
for long periods with a weaker obligation to convert into gold the pounds kept outside the country.
In other words, the UK deficit was to some extent self-financing. As a consequence the UK
monetary policy enjoyed a certain degree of autonomy and was highly influential in determining
other countries' monetary policies8. The special position of the British pound arose spontaneously,
without the support of an international agreement. It was not so much the consequence of the
weight of the UK in the world economy, nor of the amount of the gold reserves of the UK9, as of
the leading position of the UK banking industry and financial technology.
The flexibility of prices and the stability of the price level. The Hume mechanism makes clear that
the flexibility of price levels, both upward and downward, was very important in the gold standard:
the regime couldn‟t have worked in a Keynesian world with rigid and sticky prices10
. In fact, during
the gold standard years, the flexibility of aggregate price levels was pronounced, as was the
flexibility of individual relative prices (and wages) that conveyed important signals for a good
allocation of resources. Flexible prices did not generate aggregate price stability; on the contrary,
with prices depending on money supplies and money supplies following the availability of gold,
price levels had rising and declining phases as a consequence both of Hume-type international
gold flows and of a common world price trend, mainly determined by productive conditions in the
gold mines. When costs and productivity evolved less favourably in the gold sector than in the rest
of the economy, the world supply of gold would become scarce and generated, via a slow-down of
money supplies, a downward trend in the world price level. Vice-versa, when the production of gold
became more convenient and abundant (also as a consequence of the discovery of new mines), a
world-wide inflationary trend would tend to influence all national price levels. But this price level
8 In a fixed exchange rates system with freedom of capital movements, the "incompatible trio" problem can be solved
also with a "leader" country setting the monetary policy stance for the other ("followers") countries of the system. This
happened, as the next sections will show, both in the Bretton Woods (with the dollar as a leader) system and in the EMS
(with the Deutsche Mark as a leader). 9 On the contrary, in the UK gold reserves were relatively less abundant than in France, Russia and even Italy !
10 The so called flex-price monetary model, in its fixed exchange rate version, is the most appropriate theoretical macro
tool for looking at the gold standard. It includes a supply-determined real income equation, the quantity theory of
money, the purchasing power parity and a relation linking the change in the money supply to the balance of payments.
In fact it represents the paradigm prevailing in the economic thinking of the gold standard times, when the aggregate
supply curve was conceived as a vertical line on the full employment level of national product, determined by the
availability of resources and by the productivity of the available production technologies. Price and wage levels would
be flexible enough to quickly adjust clearing goods and factor markets and eliminating excess demands, excess supplies
and unemployment.
6
instability consisted in relatively moderate waves of rising and declining prices: the system was
incompatible with the very steep inflation that the economies experienced during wars and inter-war
periods after the end of the gold standard when money creation was freed from the constraint of
gold convertibility. The system was also incompatible with the permanent and accelerating
inflationary trend that characterised many economies in the second part of the 20th
century, caused
by an undisciplined management of the money supply, which had been impossible when the
creation and acceptability of money were linked to its gold base. It is in this specific sense that one
can state that the gold standard was anchoring the money supply mechanism, thus yielding “price
stability”.
Financial stability, banking crises and "lending of last resort". In a system where gold was backing
the circulation of money, the gold reserves of the banking system were crucial for its liquidity and
solvency. When, for instance, a balance of payments deficit was draining reserves out of a country,
some banks suffered a liquidity crisis and could become insolvent before being able to reduce their
loans and bring their reserves-to-total-assets-ratio back to a more sound level. Moreover, during the
gold standard period, competition was brisk in the banking industry, and financial markets were
deeply globalized with lenders taking risks by betting on the success of a luxuriant entrepreneurship
which borrowed to finance the exploitation of a continuous flow of new inventions and technical
progress. Such a bright business atmosphere was very favourable for the growth of production and
trade, but profit opportunities were associated with substantial risks of failure of both enterprises
and banks. The stability of the banking system was therefore an important issue, and bank crises
were frequent and often very serious. Central banks were supervising the situation. Central
banking, to be sure, was at that time more a matter of monitoring “systemic risk” and pursuing
financial stability policies than of monetary fine-tuning of the macro cycle11
. In managing bank
crises and helping banks out of liquidity crises, monetary authorities could even temporarily create
money beyond the limits of gold reserves. They could go as far as allowing temporary suspensions
of convertibility. A typical instrument of central banks‟ stability policies was the so called “lending
of last resort” (LOLR) with which liquidity was made temporarily available to banks that were
worth rescuing12
and could not find financing on the marketplace. The “art of central banking”
rested a lot on LOLR, as it allowed some flexibility and discretion in the management of the money
supply, in spite of the discipline imposed by convertibility. LOLR is still today an important
instrument for financial stability policies, both at a national and at the international level13
, and the
theories that dictate the optimal way to use that instrument are still centred around the famous
principles dictated by Bagehot during the gold standard years14
. The main aim of these principles is
preventing “moral hazard”, i.e. a riskier behaviour of bankers counting on the fact that, in case of
difficulty, the central bank would step in and help them with LOLR15
.
11
Monetary policy was still not conceived as a tool for short-run macroeconomic stabilisation. Moreover the gold
standard, as already noted above, implied (given the “incompatible trio”) an endogenous money supply, with no room
for autonomous national monetary policy. Central banks were therefore mainly pursuing financial stability and taking
care of “systemic risks”, i.e. the risk that the failure of one or more banks could affect the solvency of a very large part
of the banking sector. 12
According to the superior information of the central banker. 13
LOLR is also important in lending to sovereign states and it is a responsibility of International Monetary Fund. 14
Walter Bagehot, Lombard Street, 1873. 15
Moral hazard would make LOLR a cause of greater financial instability, the opposite of an instrument to pursue
financial stability. The four Bagehot rule are the following:
i) lend to the open market, i.e. in the interest of the system as a whole and not of individual privileged
intermediaries;
ii) only lend to illiquid but solvent banks, thus avoiding to transform emergency lending into a socially worthless
bailout of mismanaged institutions;
iii) always lend at a penalising interest rate, higher than the market rate: to charge a risk premium to the borrower
and to avoid that LOLR originates excessive creation of liquidity;
7
The end of the gold standard. It is easy to understand when and why the gold standard ended16
. The
First World War destroyed it completely because it naturally brought to an end the two basic pillars
on which rested its functioning, as explained above: the convertibility of currencies into gold and
the free international circulation of the precious metal. For obvious reasons the war induced
countries to prohibit the free outflow of gold as well as to finance public expenditure by allowing
the money supply to grow beyond the quantity that could be backed by gold reserves. During the
period between the two world wars, as described in the next section, there were tentative
restorations of the gold standard: but the rules of the game were not followed as nationalisms and
protectionism disrupted the global economic and political climate, making the gold standard regime
unsustainable. Some say that the end of the gold standard was also the end of a formidable period of
market-based global economic progress and economic freedom the end of a “belle epoque”.
Something "modern" and up-to-date in the ancient gold standard system? Is the study of an
exchange rate system that prevailed so many years ago purely a matter of economic history, or are
there some features of the gold standard that can teach us something relevant for the current
international monetary and financial system? The latter statement is probably correct, as the
evolution of the world economy in the last 15-20 years has brought back some important aspects
and issues that were central in the scenario of money, banking, and finance of the gold standard
years. The main ones are: the new (“second”) process of globalisation and international financial
integration; the new importance of international price-wage competition and flexibility; the new
crucial role played by technical progress in influencing economic growth from the supply side and
in nourishing the demand for venture capital and, in general, for the finance of risky innovations;
the new emphasis on monetary discipline and on the credibility of monetary policy to keep price
stability17
; the new importance of banking and financial crises18
in an increasingly competitive
capital market where there is a revival of “classical (pre-keynesian) central banking” which moves
its main focus away from the fine-tuning of the macro cycle and back to financial stability policies,
prudential regulation and crisis management. It is therefore possible to conclude that it is currently
relevant to devote some attention to the gold standard years.
3 The interwar period
As noted above, the World War One caused the breakdown of the pillars of the gold standard. The
events reported in Table 2, which lists some of the important dates of the following years, show that
the attempted restoration of the gold standard was made difficult and somewhat artificial by several
factors. Some of them are also among the ones at the roots of the progressive deterioration of
iv) always lend asking good securities as a guarantee, so that central bank lending becomes a way to mobilise
temporary illiquid assets, cannot be seen as the beginning of the bailout of a failing institution and of the
deterioration of central banks‟ balance sheets.
16
In section 4 it will appear that this is not the case for the Bretton Woods system, on the death of which different
stories and theories can be told. 17
There has been even a diffusion, in different parts of the world (from Argentina, to Hong-Kong, to Bulgaria) of
(more or less successful) currency boards, which substitute central banks with an automatic rule to create or destroy
money according to the amount of foreign reserves that flow in and out of the country: a mechanism that mimics the
money supply process in the gold standard with the aim of enhancing the credibility and anti-inflation effectiveness of
monetary policy. 18
The international crisis started in 2007, to the extent that it was also due to a weakened discipline of the supplies of
money and credit, can also be considered in the light of gold-standard-type rules: in fact some stress a parallel between
the recent crisis and the great depression of the 30s‟ which can be (see section 3) variously connected to the failure of
the restoration of the gold-standard.
8
international relations that, following the Great Depression of the „30s, brought to the Second
World War. Some say that the World War One has been an inconclusive test for hegemonic power
in Europe that really did not end before ...1945.
Post-war Inflation. Faith in a prompt return to “normal” pre-war gold parities overlooked the
profound changes that war had brought. Among them the enormously inflated money supplies and
price levels. Setting at 100 pre-war values, in 1920 currency in circulation was 294 in the UK, 541
in France, 1230 in Germany 769 in Italy, while the respective cost of living indexes were 278, 424,
1158 and 455. Even in the Us money and prices had nearly doubled. In France, from 1920 to 1926,
consumer prices increased again fast, by approximately 50%. In December 1922 German prices
were 1475 times the pre-war level and in the following year astronomical hyperinflation brought
them above 1 trillion times the pre-war level. With such high and different changes in price levels,
returning to the old gold parities was a distorting manoeuvre implying, at least, a period of severe
deflation. The extent of the deflationary effort of a country implied a decision on how the financial
burden of the war was to be shared between taxpayers, unemployed and savers. Savers were
completely expropriated by German inflation and privileged by the less inflationary policies of the
UK. Anchoring currencies to gold became less and less credible with the passage of years during
which the potential elasticity of non-convertible money supplies had been exploited as much as
possible, with completely nationalistic attitudes, without any preoccupation for international
monetary order. The gold standard could really be looked at as a “barbarous relic”, as Keynes wrote
in 1924.
German reparation payments. The political and economic problem of German reparations – that is
how much of the cost of the war the victors, particularly Britain and France, could demand from
Germany – caused tensions in international relations during the whole interwar period, until it was
used by the Nazis as an excuse for their aggressions. These tensions had frequent repercussions on
international capital flows and speculations, disturbing the reconstruction and the functioning of the
gold standard. Initially, reparations were set at a level clearly unsustainable for Germany (Keynes‟
famous book, “The Economic Consequences of the Peace”, made forceful arguments in favour of
moderating the requests); later, mitigations were obtained notwithstanding the punitive approach to
the problem kept by France, with Germany always protesting and considering the burden excessive.
The problem was complicated by its relation with the issue of inter-allied war debts: wartime and
early post-war loans left the US government a net creditor with respect to Great Britain and France,
the former having both borrowed and lent and also turning out as a net creditor. The British
gradually developed an attitude favourable to forgiveness of reparations in exchange for
cancellation of war debts, while France argued that wartime loans were contributions for a common
cause and resisted concessions to Germany; as for the US, for a long time they opposed the linkage
of the issue of war debts to the one of reparations: European newspapers would even refer to Uncle
Sam as uncle Shylock. To administer the reparation payments the Bank for International
Settlements (“the bank of central banks”) was created, later entrusted with other important tasks and
today one of the most influential international institutions.
A multi-polar, unstable, gold-exchange standard, disobeying the “rules of the game”. The
weaknesses of the reconstructed interwar gold standard are evident when its mechanisms are
compared with both the “pure” theoretical model of the system and its pre-WW1 incarnation. While
the latter saw the British pound in a “special position”, widely used as a reserve instrument without
asking conversion in gold to the issuing country, the habit of keeping reserves in currencies instead
of gold was more the rule than the exception in the interwar gold standard experiment which, for
this reason, deserves to be called “gold-exchange” standard (like the subsequent post-WW2
gold+dollar Bretton-Woods system). The mechanism was rather confused as not only the British
pound, but also other currencies, like the US dollar and the French franc, were kept in non-
9
converted reserves. New York was eroding the primacy of London as an international financial
centre but also Paris had ambitions. A multi-polar international monetary system tends to be
unstable, absent a strong multilateral cooperation. As the interwar climate of international relations
rendered cooperation discontinuous and difficult19
, competing centres-currencies caused
destabilising capital movements and caused a degeneration of the attempted reconstruction of the
gold standard.
But the most important cause of failure of the reconstruction was that the “rules of the game” were
systematically disobeyed: inflows of capital and gold – like the large ones that entered in different
periods the US and France – were not translated in national monetary expansions while outflows
were often sterilised and did not result in sufficiently restrictive monetary policies. This indiscipline
showed that domestic objectives were prevailing over international rules, was an obstacle to the re-
equilibrium of the balances of payments and caused an increasingly unbalanced international
distribution of gold (that became highly concentrated in the US and France). The uneven and non-
self-equilibrating allocation of the precious metal disrupted the functioning of the international
monetary system and possibly worsened the deflationary impact of the scarcity of the global supply
of gold that (rightly or wrongly) some thought inadequate for the needs of a gold-anchored
payment systems.
Great Depression. The second decade of the interwar period was made very different from the first
by the Great Depression. Two years after the Wall Street crash of 1929, preceded and possibly
caused by an unchecked credit boom fuelling stock and other asset prices bubbles, a banking crisis
started in Europe but was then tragic in America. A long phase of global depression of production
(see Fig.1), incomes and employment followed , reinforcing nationalistic and protectionist
tendencies, obstructing international trade and nourishing socio-political tensions that were
certainly not extraneous to the explosion of WW2. Economists and historians are still discussing on
the causes of the depression; comparisons with the crisis exploded in 2007 offer new stimuli and
fresh material for a useful and interesting debate. The Great Depression has been a very complex
event that cannot be explained by a single cause. But it is reasonable to state that its direct and
indirect connections with the dysfunctional pseudo-gold-standard are substantial. Already during
the „20s deflationary policies, required by the targeted adoption of the pre-war gold parities,
weakened parts of the world economy; the instability of the international system caused
macroeconomic indiscipline, speculations, trade-depressing protectionism and monetary disorder;
and, when the depression was biting, monetary policies refrained from being adequately
expansionary also because of a somewhat surreal need to defend the currencies‟ gold standard.
Nationalism, lack of international coordination and leadership. The “pure” textbook gold standard
does not require international treaties or agreements when it is the automatic result of the
generalised adoption of a credible internal convertibility of each national currency. But, as
explained above, the interwar period could not set up anything like the pure gold standard. The very
“dirty” version of the gold-exchange standard that was enacted would have needed an intense effort
of international cooperation which was impossible given the existing climate of international
relations. The world was still struggling with the need to adapt its organisation, its governance, its
distribution of powers and incomes, to the formidable technical, socio-political and cultural changes
brought about by the new century. As a symbolic example just consider the fact that the very large
bank that started the crisis, Creditanstalt, had been the financial queen of a disappeared central
European empire. Nationalism was among the harmful reactions to the perceived high cost of
19
In spite of the famous friendship between the governors of the New York Fed, Benjamin Strong, and of the Bank of
England, Montagu Norman, and of their very frequent – though often contentious – contacts with the governor of the
Banque of France and with Hjalmar Schacht, the President of the Reichsbank: see the fascinating bestseller by
L.Ahamed, “Lords of Finance”, Penguin 2009.
10
adapting the world to the novelties. To coordinate the difficult transition period of the international
community was an acrobatic task: it could have been tried through a leader-country. But the pre-war
economic and political leaders, like the UK, were no longer in the condition to lead, while the
future, post-WW2 leader, the US, was still dominated by a tendency to isolationism and did not
want to lead. Unfortunately, it turned out that a new tremendous war was needed to convince the
world to make a serious effort to redesign its economic, monetary and financial order.
4 Bretton Woods
Bretton Woods is a resort in New Hampshire where an international agreement was adopted just
before the end of the second world war to establish a fixed exchange rate system that survived for
more than a quarter of a century.
The guiding ideas of the Bretton Woods Agreement (hereafter: BWA) were part of the post-war
idealistic climate generating plans for a peaceful world and for a rapid reconstruction. Economic
growth would spread, supported by international co-operation and co-ordination of policies and by a
set of new international institutions like the International Monetary Fund, the World Bank, the
General Agreement for Tariffs and Trade, and the European Economic Communities. There was a
clear intention to avoid keeping the world in a situation similar to the one that prevailed during the
inter-war period, when international relations remained tense with monetary disorder and a high
degree of protectionism suffocating international trade and economic growth, thus triggering
recessions and indirectly favouring the political developments that caused the second global
conflict. The aim was to go back to the free trade atmosphere of the pre WW1 gold standard years,
with fixed exchange rates helping international trade, but without the constraints imposed on
monetary policies by generalised gold convertibility.
The last part of the inter-war period had seen a complicated evolution of international economic
relations with several commercial and monetary agreements between groups of countries.
International trade suffered and protectionism was used (to put it in a schematic way) to pre-
determine the equilibrium of countries‟ balance of payments, as imports were allowed (often
through the issue of specific authorisations) only to the extent that exports had taken place. In a
mechanism like that, international means of payments were unnecessary, and therefore there was no
need for a global monetary and exchange rate system.
The BWA wanted to innovate in a radical way, giving rise to an international payments system
compatible with free trade and serving as an incentive for the growth of international trade which
appeared as the key factor to promote economic growth. The result of the negotiation was a fixed
exchange rate system, monitored and supported by an international institution, the International
Monetary Fund (IMF), which secured a privileged status for currencies of countries with freedom
of trade ("convertible currencies"), and by a system of international reserves where US dollars
played the same role as gold.
Fixed exchange rates were thus obtained, differently from the gold standard case, as part of a
complex international agreement. The intention was to rely on the short term stability of exchange
rates to facilitate international trade, but to allow medium-to-long term flexibility to accommodate
the need of countries to choose somewhat different inflation policies. The US decided to make the
11
dollar convertible into gold at the fixed price of 35 $ per ounce20
. The other countries would declare
the dollar parities of their currencies and their central banks would have to intervene on the foreign
exchange markets to keep the respective currencies within a ± 1% band around their dollar parity.
A lasting disequilibrium of the balance of payments of a country would require its central bank to
keep intervening while the economic policies of that country were directed to reverting to external
equilibrium. The IMF could help central banks' interventions by administering the mutual lending
of their reserve assets. If these actions were insufficient, a so-called "fundamental disequilibrium"
could be acknowledged and the country could then announce a change in the dollar parity of its
currency21
. A parity change could be opposed by the IMF only on the grounds that it was not a cure
for a "fundamental disequilibrium", as it could be shown to be a "competitive devaluation" aimed at
increasing the market share of the country's exports. A fundamental disequilibrium could also be the
result of the fact that a country had had for some time an inflation rate higher than its competitors.
Therefore the realignment of central parities was the mechanism of the BWA devised to enable
countries to have different inflation policies22
and a corresponding medium-to-long term flexibility
of the exchange rate.
The incompatible trio problem in the BWA was thus in part solved by avoiding targeting completely
fixed exchange rates. But the solution rested also on the fact that many countries decided to
maintain controls on international capital movements23
. The US was nearly the only country with
fully free inward and outward capital mobility24
. While the welfare value of free trade in goods and
services was widely acknowledged all over the world, and the promotion of world trade growth
was, as noted above, an important aim of the post-war international strategy, the freedom of capital
movements was generally not considered a valuable objective of international co-operation25
. On
the contrary, financial speculation was seen by many as the worst enemy of exchange-rate stability
while controls on capital movements were considered a crucial instrument to promote stability and
trade growth. As to the third element of the trio, the autonomy of national monetary policies, the
spirit of the BWA was initially focused on keeping it fully alive, as Keynesian aggregate demand
stabilisation policies were widely considered an indispensable tool to cope with different national
problems and macroeconomic disturbances26
. In spite of this, during the life of the Bretton Woods
system, its actual functioning became rather different from the initial spirit of the agreement. US
monetary policy started to dominate, with other countries following the management of the
American money supply. As explained below, this decreased autonomy of national monetary
policies was a consequence of the fact that exchange rates were kept much more fixed than the
BWA would have allowed. Fixed exchange rates triggered interventions of non-US central banks,
creating a nearly automatic link between their money supplies and the US supply of dollars27
.
20
Non US monetary authorities could ask the US treasury to convert their dollar reserves into gold at the fixed
conversion price. The dollar parity, as mentioned in the previous section, had been set at 35$ per ounce by Roosvelt in
1934. 21
While the US could change the gold/dollar parity. 22
In more general terms: different macroeconomic policies. 23
Often the set of controls was the one in force in times of war! 24
This helped the country's banking industry to quickly establish a formidable dominance of the world financial
markets, as London's international role was sacrificed by the pronounced financial protectionism maintained by the
UK after the war. 25
Only at the end of the '70s (see below) there was a world-wide understanding of the welfare value of the freedom of
international capital mobility. 26
It was during the Bretton Woods years that textbook IS-LM theories of macroeconomic stabilisation were developed
and became the orthodoxy both in academia and among policy makers. 27
An expansionary monetary policy by the US caused an incipient appreciation of non $ currencies, triggering
purchases of dollars by non US central banks thus expanding also their money supplies. The opposite happened when
the US restrained monetary growth. The best theoretical model to explain this mechanism, typical of the way the
incompatible trio problem affected the working of the BWA, is the Mundell IS-LM fixed exchange rate framework
applied to a small economy unable to influence foreign interest rates.
12
Therefore, the "de facto" solution of the trio problem turned out to be different from the one initially
embedded in the Agreement.
The supply of international money in the BWA was composed by gold reserves plus dollar reserves,
with dollars considered equivalent to gold on the basis of the fixed conversion price guaranteed by
the US. The two components of the international means of payment justify the fact that the Bretton
Woods system is often named “gold exchange” standard. The possibility to finance international
trade with dollars made the supply of international money much more flexible than in the pure gold
standard28
. But, during the 1944 discussion that led to the Agreement, the UK delegation, under the
leadership of Lord Keynes, had proposed a very different and much more flexible system to supply
international means of payment. Keynes' idea was to establish a super-national central bank able to
"create" its own money, named "bancor", to be circulated in the system of national central banks
through loans extended by the super-national institution and through its purchases of various assets.
Such a "world central bank" would have been able to regulate the supply of international means of
payments according to the varying needs of international trade. The US strongly opposed Keynes'
proposal and the international institution that was established by the BWA was the IMF, which had
no possibility of creating money: its function, besides monitoring the entire operations of the
Agreement, was only to pool part of national central banks‟ reserves and to make available these
pooled funds for lending to those central banks that suffered a temporary shortage of reserves and
had to intervene to combat the depreciation of their national currencies. The IMF was thus created
as an institution of mutual support among the central banks with the task of mobilising existing
reserves (not of creating new ones) for the benefit of exchange rate stability.
The first part of the life of the BWA (until the beginning of the „60s) was a neat success. By 1958
many currencies, including the Italian lira, were declared “convertible” (as issuing countries had
liberalised imports of goods and services)29
and became full members of the system. Initially there
was a dollar shortage, as countries outside the US needed reserves to finance post-war balance of
payment deficits due to imports for reconstruction. Dollars were gradually provided by US foreign
aid, foreign investments and imports, and the system could work effectively, favouring the growth
of international trade and the fast recovery of the world economy, especially of Europe and Japan.
Exchange rates were fairly stable, as very few realignments were required.
The second part of the life of the Bretton Woods system (during the „60s) saw an accelerating
balance of payments deficit of the US, which spent and invested abroad overabundant amounts of
dollars, transforming their initial shortage into a dollar overhang. The other countries purchased
dollars to prevent the appreciation of their currencies, accumulating very large foreign exchange
reserves. The dollar overhang started soon to become a serious problem, creating uncertainty and
tensions in the workings of the Bretton Woods system. To stop the accumulation of dollars by
countries outside the US, the appreciation of the other currencies should have been allowed by
realigning the central parities. But this solution was avoided, and the medium-to-long term
flexibility of exchange rates, allowed by the BWA, was not exploited. On the contrary, the
Agreement was increasingly interpreted as a system of completely fixed exchange rates, which was
not in line with its original spirit. As there was also some liberalisation of capital movements, the
incompatible trio implied an increasing dominance of the US monetary policy, which reduced other
28
Even if the fixed conversion price of dollars constituted an element of rigidity that could potentially prevent the
system to supply the amount of international liquidity required by the growth of international trade: see below the
analysis of the so called "Triffin's problem". 29
The establishment of the European Economic Community (1950) was very helpful for reaching convertibility, as was
the organisation of the European Payments Union (1950-58) which centralised at the Bank of International Settlements,
in Basle, the multilateral settlement of debts and credits between European countries.
13
countries' autonomy in controlling the money supplies and the price levels30
. In fact dollar
purchases had as a counterpart a net creation of non-dollar currencies, causing world-wide
inflationary pressures. These pressures were the indirect consequence of an expansionary aggregate-
demand management in the US: European inflation came to be considered imported inflation (from
the US). To the extent that both inflation and the dollar overhang were disliked outside the US, the
crisis of the system became deeper and part of the dollar reserves were converted into gold.
Speculation started to bet on a possible increase of the official dollar price of gold, and the amount
of gold reserves of the US Treasury decreased sharply in comparison with the amount of dollars
held outside the country. When US-dollar expenditures abroad further accelerated following
military spending for the Vietnam war, the final crisis of the Bretton Woods system became
inevitable: in August 1971 the convertibility of the dollar into gold was discontinued.
The end of the Bretton Woods system can be rationalised along two different conceptual lines that in
part contradict each other but in part complement each other :
- Triffin‟s problem. According to Robert Triffin the fact that the Bretton Woods system of
exchange rates was still indirectly based on gold would have limited the supply of international
money required by the potential growth of the world economy and of international trade. In
order to keep the dollar convertible into gold at a fixed price, the dollar component of the supply
of international money could not be expanded at a faster rate than the supply of gold31
: the
system was therefore inadequate in providing international means of payments – in the same
way and for the same reason as the pure gold standard had been inadequate – and it would soon
enter into a crisis like the gold standard (see Figure 2). What worried Triffin, to be sure, was not
so much the potential death of Bretton Woods as the possibility that, to keep the system alive,
the rate of growth of the world economy and of international trade would have been slowed
down by restrictive policies, in order to adapt it to the otherwise inadequate supply of
international money. This would cause a credit crunch and a stagnation of the world economy
from lack of world liquidity. His suggestion was to create a world currency similar to the
“bancor” proposed by Keynes at Bretton Woods32
and regulate its supply according to the needs
of world trade. But the “Triffin‟s problem” can also be read as a forecast that the system would
have been destroyed by a speculative attack on the dollar conducted by the markets via gold
purchases, justified by an expected increase in the dollar price of gold based on the ever
decreasing ratio between US gold reserves and the amount of dollars outside the US. In this case
the solution could not be simply an increase in the official price of gold, as speculation would
then start expecting and aiming at new gold price increases33
; the “dollar exchange standard”
characterising the BWA would therefore have to be abandoned, with a complete crisis of the
system. As this is exactly what happened at the beginning of the „70s, Triffin‟s forecast34
appears accurate and deserves consideration also as an explanation for the crisis. As such, its
main weak points are two. First is the fact that when the system entered its crisis, the IMF had
already increased the supply of international means of payments by creating and distributing
30
In the “spirit of the BWA” the solution of the trio problem rested mainly on the medium term flexibility of exchange
parities and on a substantial degree of interference with the freedom of capital movements. In reality the application of
the Agreement dealt with the trio problem in a rather different way, mainly by sacrificing the third element of the
incompatible trio: the autonomy of national monetary policies, which were made dependent on US monetary
management. 31
With the dollar component of the supply of international money growing faster than gold, a point would be reached
where the amount of dollars outside the US would exceed the dollar value of the gold in reserve with the US Treasury.
At that point dollar convertibility would be no longer sustainable. 32
See above. 33
Gold convertibility is never sustainable if the market does not believe that the gold content of a currency is part of its
genetic, non modifiable characters. This belief was clearly present during the pure gold standard period (see section 2
above) and was the base of its strength and of the stabilising nature of exchange rate expectations. On the contrary this
belief was weaker during the much weaker re-established interwar gold standard. 34
Which had been formulated approximately one decade before.
14
among member countries “special drawing rights”. Second is that if the crucial problem had
been the dollar/gold ratio, as in Triffin‟s reasoning, after the end of the Bretton-Woods system, a
pure “dollar standard” could have been adopted, thus keeping fixed exchange rates without
dollar convertibility; however, this was not the case because when dollar convertibility was
discontinued, fixed exchange rates were also abandoned.
- An “irresponsible” US monetary policy. An alternative explanation of the end of Bretton
Woods is one that de-emphasises the gold issue, which is at the core of Triffin‟s reasoning. The
real issue, according to this view, was that the system had been working (differently from what
had been the original “spirit” of the BWA) with completely fixed exchange rates, solving the
incompatible trio problem with the dominance of US monetary policy. This solution could work
only to the extent that the US would take into account other countries‟ policy preferences in
managing the supply of dollars. In other words: the US could function as the money leader of
the world only if they took responsibility for the stability of world prices. As this did not happen
during the „60s, when the US “exported” inflation to an extent that was disapproved by other
countries (especially Germany), the system became unsustainable. This was understood by
markets, which precipitated the crisis of the BWA with a speculative attack. The attack was
conducted also on gold prices but, unlike Triffin‟s explanation, the crucial problem was not the
gold base of the system: it was the fixity of exchange rates supported by an inadequate solution
of the incompatible trio problem. Since a better solution was not available, this argument
explains why exchange rates started to float freely after the end of Bretton Woods.
Redundancy, schizophrenia and asymmetry. The above explanations of the end of Bretton Woods
can be combined using the concepts of redundancy, schizophrenia and asymmetry, in a way which
will also help in understanding the problems of the European Monetary System (EMS) of the „80s.
In a system of fixed exchange rates between N currencies, only N-1 bilateral parities can be
independently fixed, as the other exchange rates will then result as a consequence. The so called
"Nth currency problem" consists of finding a way to use the remaining degree of freedom
("redundancy") to anchor the value of all the currencies in terms of goods (i.e."fixing the nominal
anchor of the system"). In the pure gold standard this was done in an automatic way, as fixed
exchange rates were based on the gold content of the various currencies: the undisputed anchor was
the price of gold. In the gold exchange standard of Bretton Woods, the degree of freedom was used,
again, to fix the price of the dollar (this time, only the dollar) in terms of gold. But as the price of
gold could not become too misaligned with respect to the prices of other goods and services, US
monetary policy should have guaranteed also the stability of these other prices, i.e. of the world
price level, which was an objective shared by many countries. Here, the issue of the asymmetry35
of
the system is crucial: Bretton Woods was asymmetric in the sense that the dollar and the US
monetary policy had a very special role. A similar issue will characterise the EMS during the 80s
with Germany and the Deutsch Mark (only informally and "de facto") playing the role of the central
country and currency. In an asymmetric system of fixed exchange rates, the monetary policy of the
"central" country, even when the gold convertibility of its currency is absent36
, plays a fundamental
role in fixing the nominal anchor, as it determines the price level in the whole fixed exchange rates
area. If the central country's monetary policy does not deliver price stability37
, the other countries
must choose between keeping prices stable, in which case there is a crisis of the leading role of the
central country and of the asymmetric nature of the system38
, and the stability of the exchange rate
with the central country. In the case of Bretton Woods, there was the additional complication of the
35
Note that the asymmetry is one way to solve the incompatible trio problem by giving to one "central" country the
responsibility of leading the monetary policy of the whole area where exchange rates have been fixed. 36
This was the case in the EMS of the '80s when the dominant "central" country was the inconvertible Deutsche Mark. 37
Or if it delivers too much price stability, compared to the desires of the other countries of the fixed exchange rate
area: as happened with the Deutsche Bundesbank in the EMS, at the beginning of the '90s. 38
The anchor becomes the constant price level desired by the non-central countries.
15
convertibility of the dollar into gold: if the US did not deliver price stability and the other countries
were to prefer the latter to the stability of the exchange rate with the dollar, this would have caused
a change in the dollar-gold parity which was the official anchor and the apparent base of the system.
It happened that countries outside the US showed some schizophrenia in choosing between the two
alternatives. On one side there was the possibility of sticking to the objective of price stability,
abandoning the dollar peg, and pushing the US (by requesting the conversion of dollar reserves into
gold) to abandon the fixed gold price. This would have meant a symmetric interpretation of Bretton
Woods, coherent with the original spirit of the post-war agreement. The other alternative was to
stick to the asymmetry and follow the inflationary monetary policy of the US, keeping stable
exchange rates with the dollar. An incentive to follow this second route was the idea that a crisis of
the value of the dollar would have meant a disastrous end of the world's monetary order, while
highly fixed exchange rates with the dollar were a condition to keep favouring international trade
and capital flows. Schizophrenia resulted, for market operators as well as for monetary authorities,
in a lot of uncertainty, inconsistency, and differences in choosing between price and exchange rate
stability. France, for instance, was more for abandoning the central role of the dollar while Italy
helped a great deal in defending its role. The result was that both price and exchange rate stability
were lost, and the world entered the '70s with wildly fluctuating exchange rates and high and
variable rates of inflation, i.e. with a lot of monetary disorder.
The "gold pool" and the end of the monetary role of gold. Consider one of the two alternatives
described above, the one where countries choose to stick to the dollar peg and to accept importing
US inflation. In this case a solution has to be found for the problem of the price of gold which
becomes misaligned with the general price level in terms of dollars. During the '60s this problem
was dealt with by organising the "gold pool", i.e. a system of concerted intervention of central
banks on the world gold market (involving also the gold for jewellery and other industrial non-
monetary uses) to avoid the increase of its price, in order to win a battle with an overwhelming
speculation. Italy was an important protagonist of the gold pool, while France and Russia, with
different motivations, were aggravating the problem by asking the US Treasury to convert their
dollar reserves into gold. The pool succeeded in controlling the dollar price of gold for some years,
but with increasing difficulty. When Bretton Woods ended, and the dollar was declared no longer
convertible into gold, the world entered an era of accelerating "demonetisation" of gold, whose role
in the system of international payments has been steadily decreasing. But even now a substantial
part of the reserves of many central banks, including Italy's, consist of gold. This sometimes raises a
question: what should we do with this gold? What is the best way to celebrate the end of an era, the
end of the noble and ancient monetary role of gold? No clear answer has yet emerged to this
question four decades after the end of the last international monetary system (indirectly) based on
gold.
5 The Seventies
In August 1971 the President of the USA decided to discontinue the gold convertibility of the
dollar. For a while the international community tried to keep fixed exchange rates without
convertibility, i.e. with a pure dollar standard. With the so called Smithsonian Agreement, a new set
of fixed parities was decided, with the dollar depreciated by 10-20% and with bands around the
parities larger than before. But the agreement had a very difficult life and, starting in 1973, "de
facto" pure floating of exchange rates prevailed39
. From 1973 to 1976 several studies and projects
were made, by academicians, policy makers, and by the IMF, with the aim of reforming the
39
A dollar standard remained in the sense that the US dollar kept its role as the main currency of the world from all the
possible points of view, being by far the most used currency in settling payments, invoicing, quoting prices, keeping
central banks‟ reserves, denominating international trade and financial contracts.
16
international monetary system and keeping stable exchange rates. But eventually nothing could
prevent the final surrender to floating rates leading to the change of the Articles of Agreement of the
IMF in 1976, where the commitment of central banks to defend the parities was cancelled. It is
since then that the world has lived officially in a regime of floating exchange rates.
In the meantime European countries, which in 1970 already, with the "Werner Plan", had started to
draw a project for creating an economic and monetary union, tried more than one time, in various
forms and groups, to reach agreements to keep intra-European exchange rates more stable than the
exchange rates of European currencies with the dollar. In 1972, for instance, the so called "snake in
the tunnel" was organised with intra-European exchange rates allowed to float in a band around
their parities narrower (the snake) than the band (the tunnel) where exchange rates with the dollar
were allowed to float. Several arrangements failed (Italy went on a pure float starting in 1973), but
the efforts never really stopped until the European Monetary System was set up in 1979 (see
below).
In fact during the entire decade, exchange rates were very unstable everywhere. Vicious circles
started with currency depreciation causing inflation in many countries, by raising import prices, and
higher inflation causing a new period of depreciation nourishing further inflation, and so on. With
wild capital movements, exchange rate changes were unable to isolate countries from international
macro shocks and allow them to conduct autonomous monetary policies. Speculative capital flows
tried to profit from exchange rate fluctuations and thus made them even larger and more
destabilising. This instability created an incentive for even stricter controls on international capital
movements, in spite of the fact that the "incompatible trio" would have allowed lifting controls once
fixed exchange rates had been abandoned. Controls on capital movements gave countries the
illusion of being able to keep following very different economic policies, thus avoiding
international macroeconomic discipline. The overall scenario became one of unprecedented
monetary and macroeconomic disorder and instability. Inflation rates became very high and
diverse, raising above 10% in the USA, well above that level in several European countries, and
approaching 25% in Italy40
. It is fair to say that advanced industrial countries became frightened by
these developments and that this helps explain why their macroeconomic behaviour changed so
much in the following decade, as we will see below.
The end of Bretton Woods, to be sure, was not the only cause of the monetary disorder of the '70s.
It was not even the main cause; one can even say that it was in part a consequence of the enormous
macroeconomic shock that hit the world economy during the decade -- the oil shock. It is reasonable
to state that if the Bretton Woods system had not fallen in 1971 for the reasons that have been
explained in the previous section, it would have been inexorably ended less than a couple of years
later by the fact that the price of oil quintupled in 1973-4. A second oil shock followed in 1979-80
with oil prices tripling. This is not the place to discuss the many aspects of the oil crises of the '70s
which resulted from the sudden exploitation of the oligopolistic market power of major oil-
producing countries (members of an organisation called OPEC) and which constituted a major
event in economic history with noteworthy consequences on economic thinking. But it is important
to understand the link between the oil shock and exchange rate instability.
The main point is that the oil shock was an aggregate supply shock. While aggregate demand shocks
can be cushioned by "textbook" measures of monetary and fiscal policies ("aggregate demand
policies"), supply shocks are much more difficult to deal with. The reason is that they give raise to
opposite evils, inflation and unemployment, and put aggregate demand policies in a "dilemma"
situation where contrasting inflation worsens unemployment, and vice versa. Consider Figure 3.
40
While in Germany inflation never went above 7-8%.
17
Aggregate demand shocks (for example a speculative bubble in investment expenditure, or a sudden
decrease in exports due to a crisis of world trade) can cause the system to move from long run
equilibrium E to E', where inflation goes together with over-employment (economic activity above
the full employment level Y*), or to E'', where deflation of prices parallels the unemployment of
resources. Aggregate demand policies (monetary and budgetary restrictions and expansions,
respectively) can cure the disequilibrium, pushing AD back into its original equilibrium position.
The stabilising power of demand policies is much lower with aggregate supply shocks. A negative
shock (for example a sudden increase of the price of imported oil raising significantly the marginal
and average cost curves in nearly all the industries of the economy) pushes AS towards AS', with
the system moving from long run equilibrium E towards E', resulting in higher prices coupled with
unemployment. Aggregate demand policies curing the latter (AD towards AD') exacerbate inflation,
while policies directed to combat inflation (AD towards AD'') worsen unemployment. The only way
to avoid the dilemma would be to restore the original position of the AS curve with "supply
policies" (for instance: industrial policies increasing productivity, lowering the oil-energy content of
production processes, etc.) that are very difficult to implement and can be effective only in the
medium-long term. Short-run stabilisation must therefore rely only on AD policies, choosing a
point between A and B. The choice amounts to trading off inflation with unemployment and will be
determined by a number of structural characteristics of the various economies that also explain the
preferences of their authorities along the trade-off.
Consider, for instance, the difference between Italy and Germany. During the '70s Italy was a
dualistic economy with a very weak southern part which would have suffered in an unbearable way
the short-term cost of severe anti-inflationary policies. On the contrary, Germany was in the
position to reduce employment by firing part of the numerous foreigners working in an economy
sufficiently robust to bear the costs of restrictive macroeconomic policies. Moreover Germany's
stronger aversion for inflation was deeply rooted in its history, which had seen episodes of
hyperinflation destroying the social and political equilibrium of the country. It was therefore natural
and logical for Italy and Germany to make different choices in the post oil-shock inflation-
unemployment trade-off, with Italy accepting a much higher inflation rate. But with very different
inflation rates, it is impossible to keep fixed nominal exchange rates, as countries' competitiveness
would diverge too much and cause excessive balance of payments disequilibria and trigger
irresistible speculative attacks on the currency market.
The differences between the countries' "social preferences" along similar trade-offs between
inflation and unemployment constitute therefore a first, important link between the oil crisis and the
exchange rate instability of the '70s. But there are other links. One is the fact that the trade-offs
themselves generated by the common oil shock in the various countries were often very different. In
some countries the trade-off resulting from the shock was more favourable than in other countries,
as it allowed them to combat unemployment with smaller increases in inflation. These differences
can be explained not so much by the different weights of oil imports in the balance of payments of
the various countries as by different socio-political characteristics41
. A negative supply shock
diminishes the real income of a country, and the problem arises of how to distribute the burden of
this cost among the factors of production and the citizens42
. The country's institutions and markets
41
Different structural aspects are therefore at the roots of both different trade-offs and different preferences along the
trade-offs. 42
Suppose the world is made of only two countries: one is oil consuming (Oc) and does not produce oil while the other
produces only oil (Op). With the available supply of capital and labour Oc is able to produce 100 physical units of its
product using 10 imported units of oil. Oc exports 10 units of its product (to Op) and uses 90 units for domestic
consumption and investment. The units of both Oc's product and of oil are defined in such a way as to set their initial
prices to 1. The real domestic product (GDP) of Oc can be calculated from the supply side (value added) as production -
imports = 100 - 10 = 90, or from the demand side as consumption + investment + exports - imports = 90 + 10 - 10 = 90.
The current balance of payments of Oc is in equilibrium: exports - imports = 10 - 10 = 0. Suppose now that the price of
18
can make this distribution easy and uncontroversial, or they can be such as to cause a fight between
individuals, groups, factions, social classes, and categories in order to try to avoid bearing the
respective, proportional burden of the collective loss of real income. In the case of the oil price
increase, one can think of this fight as a struggle to elude the payment of the respective parts of the
"oil tax" that OPEC levied on industrial countries and that each of them, taken as a whole, could not
avoid paying. The way this fight takes place is via inflation, the so called "cost-pushed inflation" or
"supply-shock-induced inflation". Individuals or categories that have some market power and are
therefore able to influence price-fixing mechanisms will try to do so in order to protect the
respective shares of real income from participating in the unavoidable loss of national income. This
effort will set a vicious circle in motion with prices running one after the other and generating an
inflation spiral. A typical spiral is caused by unions asking wage increases,43
which leads firms to
increase prices, which lowers again real wages and causes a new round of nominal wage increases,
and so on. The stronger this fight, the higher the unemployment cost of suffocating it with
restrictive demand policies, like a monetary restraint that tends to stop cost-pushed inflation by
creating a general lack of liquidity in the markets that curbs aggregate demand44
. In other words, the
more intensive is the fight to avoid the burden of the supply shock, the less favourable is the shape
of the inflation-unemployment trade-off generated by the shock itself.
What determines the intensity of the fight? The answer is that the fight will be harder the stronger
is the market power of the various agents of the economy, i.e. the more distant the situation is from
pure competition. Imagine an economy where there are no unions, no cartels, no monopolies or
oligopolies: every agent, every firm, every worker, is a pure price (or wage) taker. In this case the
collective cost of a supply shock (the burden of the "oil tax") will tend to get distributed
automatically among agents in proportion to their real incomes, without inflation spirals. On the
contrary, when several agents have some power on prices (including wages, i.e. the price of labour)
the potential for an inflation spiral will be very high, except if these non-purely competitive agents
oil is raised from 1 to 2 and that it is impossible in the short run to modify the oil input coefficient of Oc's production.
Suppose that also the price of Oc's product must remain unchanged. The real value of Oc's imports, measured in terms
of units of its production, becomes then 20. Only 80 is left for domestic consumption and investment. Real domestic
product becomes 100 - 20 = 80 on the supply side: if 80 is demanded the oil price increase will not cause
unemployment. As far as the demand side is concerned let us make the hypothesis that Op spends all the extra value of
its exports of oil in additional purchases of Oc's products. The balance of payments of both countries remains in
equilibrium and aggregate demand of Oc's products is 80+20-20=80, equal to aggregate supply and therefore to the
equilibrium value of Oc's GDP. With these hypotheses the oil shock is a pure supply shock consisting in the fact that the
"size of the cake" for domestic uses of Oc's citizens shrinks from 90 to 80, equal to the smaller value of the income
distributed domestically to the factors of production (value added). The unit price of Oc's product can still be in
equilibrium at the previous level, equal to 1, and both inflation and unemployment can be avoided. But in order to reach
this result the decrease of GDP must be distributed among the agents of Oc's economy. The "cake" is smaller by 10
units, in real terms: in one way or another citizens must eat less. It is very difficult to make this happen without some
kind of a quarrel on income distribution triggering inflation. 43
In the case of an oil price supply shock wage increases are originally demanded to compensate for the loss of
purchasing power of nominal wages following the increase in the price of goods and services the production of which
uses imported oil. 44
While positive demand shocks cause inflation because too much nominal demand chases too few goods, the typical
supply-shock induced inflation derives from a fight on income distribution originating from the fact that the negative
shock decreases real aggregate income. In the numerical example of the footnote above such a fight would push the
price of Oc's product above its initial level. But to sell 80 units of that product at a price higher than 1 nominal
aggregate demand must be higher than 80. This can happen provided that monetary and budgetary policies are enough
expansionary to sustain this level of demand. Suppose the fight is such as to push Oc's product prices to 1.25. Nominal
aggregate demand must in this case amount to 80x1.25=100. Suppose now that aggregate demand policies do not want
to allow 25% inflation to result from the oil shock: monetary policy, for instance, can be as restrictive as needed to keep
the price of Oc's product to 1. But if the fight keeps the "supply price" at 1.25 a nominal aggregate demand of 80 will
cause real production and real aggregate demand to be only 80:1.25= 64 with unemployment (and excess capacity or
negative output gap) reaching (80-64)/80=20%. The stringer the fight, the higher the required supply price, the larger
the unemployment cost of price stability.
19
are able to get together to accept an income policy which prevents the fight for distribution via a
collective decision, possibly favoured by an appropriate action or persuasion by the government, on
how to distribute the burden of the supply shock45
. Therefore, a complex set of institutional and
socio-political characteristics determines the shape of the inflation-unemployment trade off
generated by a given supply shock. This contributes to explain why the same oil shock triggered
very different inflation rates in different countries, and thus caused exchange rate instability and
monetary disorder.
Another link between the oil shock and the exchange rate instability of the '70s is based on the fact
that the oil price increases acted not as a pure supply shock but as a complex and uncertain mix of
supply and demand shocks. The demand component of the shock was deflationary as industrial oil-
consuming countries had to pay a much higher oil import bill, diverting aggregate demand away
from their productions, while oil producing countries were unable to spend on imported industrial
products the extra-income coming from the increased value of their exports following higher oil
prices. The reason was that the major oil producing countries' social and political structures were
based on very narrow oligarchies with enormous income inequalities and concentration of wealth:
once the sheikhs increased the cash flows resulting from oil exports, they simply deposited much of
the extra money into international banks. They thus helped industrial countries to finance their
balance of payments deficits46
but caused a lack of demand of industrial goods. In other words, the
oil crisis redistributed world income among countries favouring those with lower propensity to
spend and thus caused a decrease in international aggregate demand. If OPEC countries had
profited without delay from the increase in the value of exports to start a catching-up process of
economic development, they would have done so by importing goods, services, plants and
equipment from industrial countries. This would have prevented the depressing effect of the current
account deficits of oil importers and the oil crisis would have been a pure supply shock47
.
The fact that the oil shock also had a negative aggregate demand effect caused additional exchange
rate instability, as it increased the differences in the way oil-consuming industrial countries
perceived and reacted to the shock. The supply-shock-induced inflation was compared to the
demand-shock-induced stagnation and there was much discussion on which effect should be most
feared. The comparison was difficult and uncertain also because it was far from clear how long the
45
The literature on this issue argues that the relationship between the average degree of market power and concentration
of an economy's agents and the potential inflation of supply shock tends to be bell-shaped (∩) shaped with inflation on
the vertical axis. This is because both a highly competitive economy and a highly centralised one are able to keep the
distributive struggle in check, while the worse fight takes place when the degree of concentration is high but not
extreme, with several agents being price setters and too numerous to accept an incomes policy and find an agreement
pre-empting the struggle. Italy (especially during the '70s) was a typical case of this "worse case scenario", with several
competing unions on the labour market and competitive oligopolies on the product markets. On the contrary, Germany
was an example of a socio-political scenario sufficiently centralised for stabilising incomes policies to be successful. As
to the left part of bell, the USA could represent a highly decentralised country with a low propensity to develop supply-
shock generated inflation. 46
The so called "recycling of petrol-dollars". 47
The intuitive understanding of the difference between a "pure supply oil shock" and a mixed demand-supply shock
can perhaps be enhanced using the highly simplified numerical example of the footnotes above. The "pure supply
shock" case has already been described using the hypothesis that Op spends all the extra value of its exports of oil in
additional purchases of Oc's products. Let us now make the opposite extreme hypothesis, namely that Op keeps
purchasing the same amount of Oc's products as before the increase of the price of oil. In this case the current balance of
payments of Oc suffers a deficit of 10, equal to the value of Op's current surplus, and aggregate demand for Oc's
products (80+10-20=70) falls short of aggregate supply: 80 is no longer a sustainable level of Oc's GDP as the
restrictive supply shock has been accompanied by a deflationary demand shock. If the latter is not compensated by
expansionary monetary or fiscal policies it will trigger a downward adjustment of Oc's production and employment
and/or of the price of Oc's product.
20
two components of the oil crisis would have lasted48
. Different assessments and perceptions of the
situation, as well as concrete differences of the aggregate demand (and supply) oil shocks that hit
the various industrial countries, caused different policy reactions followed by different inflation
rates and thus unstable exchange rates. Moreover, the weakness of international aggregate demand
for industrial goods created an incentive for the competitive devaluation of several currencies,
uselessly trying to escape from the effects of the global demand shock with the zero-sum game of
beggar my neighbour exchange rate policies. These policies were intrinsically inflationary, as they
increased the average propensity of countries to expand the money supply.
To sum up: exchange rate instability, inflation, and monetary disorder prevailed during the '70s
mainly because huge increases in the international price of oil acted as a formidable macroeconomic
shock. The links between the oil shock and exchange rate instability were of three main types:
i) To the extent that oil price increases were a supply shock (due to the increased cost of the
energy required to produce goods and services) an inflation-unemployment trade-off
emerged for oil-consuming industrial countries. Their economic policies reacted
differently to this trade-off and, as a result, triggered exchange rate instability, because the
relative degrees of aversion to inflation and unemployment ("social preferences") were
different in different countries, due to differences in their socio-political characteristics.
ii) The shape and severity of the trade-off itself were different in different countries, again
depending on structural differences in social, political, and economic factors.
iii) To the extent that the oil shock was in part also a negative aggregate demand shock (due
to the lack of imports of industrial goods by oil producing countries), the various countries
had an additional reason to perceive the shock in different ways and to react differently,
with differing consequences on the value of their currencies. They also had an incentive to
try to acquire a larger share of the insufficient export market by resorting to competitive
devaluation and thus accelerating the instability of exchange rates.
The monetary disorder of the '70s motivated a strong reaction at the end of the decade when, at
the global level, strong anti-inflation policies were adopted. The USA were leaders of this
turnaround while European countries succeeded in stabilising the exchange rates among their
currencies with an accord, the European Monetary System (starting in March 1979), which was
also a powerful means to fight inflation and which gradually brought Europe to plan for a
complete monetary unification.
6 The European Monetary System and the Economic and Monetary Union in Europe
Plans for stabilising intra-European exchange rates had been around for years in the European
Community and, during the first part of the '70s resulted in some short-lived agreements (the so
called "snakes" allowing parallel fluctuations of European currencies vs the dollar). But it was only
48
As far as the supply component of the shock was concerned there was a doubt on how long OPEC could keep oil
prices "above long term competitive equilibrium": but the discussion was complicated by the fact that this shadow price
of oil was probably not coincident with the very low pre-shock price and in any case highly uncertain. As to the demand
shock, the problem was to forecast the evolution of the propensity to spend in imported products of OPEC countries. It
is probably fair to say that the demand component of the shock turned out to vanish fairly quickly (well before the end
of the '70s), while the supply shock lasted longer, then changed its sign (with oil prices precipitating), then came back
again. Potentially it is still a problem even if over time the oil-content of industrial products has been decreasing very
much applying energy saving technologies. This makes today's oil shocks much less frightening and destabilising than
the ones experienced in the '70s.
21
in March 1979 that a rather successful story began with the establishment of the European
Monetary System (EMS) which lasted 20 years leading to the adoption of the single currency, the
euro, in 1999.
The initial aims of the EMS can be classified into 4 categories:
a) Co-ordinate the efforts to combat inflation. The experience of the '70s and of the '73-'74 oil
shock had been frightening and the idea was not to allow the second shock ('79-'80) to have the
same consequences. To base an exchange rate agreement on a strong anti-inflation target is
atypical and must be kept in mind to understand well how the EMS was organised and
functioned.
b) Avoid the recourse to "competitive depreciation" by European countries seeking a larger share
of a weakening international demand and trying to reduce, with "beggar my neighbour policies",
the current balance of payments deficits that were caused by oil price increases.
c) Protect intra-European exchange rates from the destabilising effect of the US$ instability. The
dollar was in a very unstable and uncertain period, indirectly causing the instability of European
currencies: a weak dollar triggered a strengthening of the Deutsche Mark (DM) with respect to
weaker European currencies, while a strong dollar had the opposite effect. The reason was that
speculative sales (purchases) of US$ had a natural counterpart in purchases (sales) of DMs,
because the German currency was the only European currency with a large international liquid
market49
. Intra-European exchange rate instability was thus generated without any justification
except the uncertain and unstable US$ scenario.
d) Protect the functioning of the European Common Agricultural Policy (CAP). CAP was at the
time the major European common economic policy. It consisted in fixing each year
"intervention prices" for the major agricultural products, i.e. prices at which the Community
guarantees to buy any excess supply, thus putting a floor to market prices. This took place
through lengthy and delicate political bargaining to find a compromise between the different
agricultural interests of member countries. But exchange rate instability was able to quickly
destroy the political equilibrium that was reached in fixing intervention prices. An appreciation
of the DM with respect to the Italian lira, for instance, would have suddenly decreased the
relative competitiveness of German vs Italian agricultural products that had been guaranteed
with the compromise. Complex technical devises were invented to isolate intervention prices of
agricultural products from currency prices, but it soon became clear that the only way to
effectively protect the functioning of the CAP was to increase the stability of European bilateral
exchange rates.
The EMS consisted in an exchange rate agreement plus an accord on reciprocal credit facilities
among the central banks of the participating countries.
The exchange rate agreement was based on three elements:
- A bilateral parity grid between participating currencies.
- An agreement to keep each bilateral market exchange rate within a 2.25%50
band around the
bilateral parity, both with suitable macroeconomic policies and, when the effect of these
policies were insufficient, with interventions by central banks on currency markets. The
interventions were compulsory when the market exchange rates reached the floor or the ceiling
of the band.
- A procedure to perform realignments of bilateral parities when they could not be avoided, to re-
equilibrate national competitive positions distorted by substantially different inflation rates. It is
49
In theory an operation in US$ would have had a neutral effect on intra-European exchange rates only if its counterpart
had been proportionally divided among the various European currencies, like a sale (purchase) of 100 US$ coupled with
a purchase (sale) of a basket of European currencies worth 100 US$. 50
Exceptions were made initially for some countries, including Italy whose currency started with larger ( 6%) bands.
22
important to note that the agreed procedure required consensus among the governments of the
participating countries (thus excluding unilateral realignment decisions) and that the procedure
was aimed to make realignments as infrequent and small as possible.
Reciprocal credit facilities allowed each central bank to borrow from other central banks of the
EMS, when it needed reserves to intervene and keep its currency within the band. The crucial
facility was the Very Short-Term Financing Facility (VSTFF) enabling each central bank to obtain
loans of unlimited amount, to be reimbursed within 45 days51
, to support its currency. Suppose for
instance that the French frank depreciated to the point of reaching the limit of the band: the Banque
de France could then borrow an unlimited amount of a strong reserve currency (usually Deutsche
marks lent by the German Bundesbank) and use the loan to buy franks on the market, thus avoiding
the French currency to go beyond the limits of the band. The existence of the VSTFF was a very
important feature of the fixed exchange rate system, aimed at discouraging unjustified but
potentially self-fulfilling speculative attacks.
These characteristics of the EMS were such as to make it a powerful mechanism of anti-inflationary
discipline. In fact, when the EMS started, participating countries had very different inflation rates.
Germany was the leader of price stability, even if its inflation was substantial, around 6%. To the
other extreme Italy's inflation was above 20%. The EMS was constructed in such a way as to push
all inflation rates towards the lowest of the group. This happened because the system created an
incentive for policy makers of inflation-prone countries to correct their policies towards price
stability.
To understand the working of this incentive mechanism let us consider the case of a country with
high inflation. If its exchange rate were kept stable in the EMS, the international competitiveness of
the country would decrease, deteriorating its balance of payments and triggering speculative sales of
its currency. The exchange rate would then depreciate with respect to all currencies with lower
inflation including that of the country with the lowest rate of inflation. Vis-à-vis this most virtuous
currency the exchange rate would quickly reach the limit of the band around the EMS bilateral
parity. Once the limit was reached the country had two alternatives.
(i) It could intervene, supporting its currency by spending official reserves, until they were
exhausted and then borrowing additional reserves through the reciprocal credit facilities. But
borrowing reserves had a cost and, if loans were required for a period longer than the
maturity of the VSTFF, they were no longer unconditioned: to keep borrowing, the country
had to commit itself to adopt economic policy plans to lower inflation.
(ii) It could devalue its parity in the EMS parity grid. But this was possible only within the
realignment procedure, i.e. with an ad-hoc meeting of the monetary authorities of the EMS
countries and a consensus to allow the adoption of a new parity grid. The procedure required
time to be started and had an uncertain result : the country could be allowed to devalue only
to an extent insufficient to restore the degree of competitiveness lost because of high
inflation. In the meantime, expected realignments triggered speculative attacks on weak
currencies rendering their devaluation more urgent and increasing the cost of the
interventions required before the realignment decision. In fact low-inflation-strong-currency
countries had an incentive to delay the realignment and then to allow only a limited
devaluation of the parity of the high-inflation country's currency, as this would consolidate
the low-inflation countries' advantage in terms of international competitiveness. Therefore
the position of the authorities of a high-inflation-weak EMS currency was difficult.
Moreover, when it came, the decision to realign EMS parities was very official and widely
51
In 1987 the period was extended to 75 days.
23
reported on the front pages of newpapers, so that the devaluing country's authorities paid a
substantial political cost52
.
Both alternatives had therefore costs and limits sufficiently serious to create an incentive for the
high-inflation country to bear the (often smaller) costs of a third alternative: i.e. putting in place the
economic policies (mainly monetary and fiscal restrictions and income policies) required to rapidly
decrease the inflation rate from which the problem originated.
In principle a fixed exchange rate system does not require that participating countries have low
inflation. It is sufficient, for the system to be sustainable, that inflation rates are sufficiently similar,
to avoid fixed exchange rates resulting in substantial modifications of the countries' relative
competitiveness. But it is important to note that the EMS inflation-disciplining mechanism
described above was highly asymmetric, as it stimulated high-inflation countries to move toward
price stability, while it gave no reason to a low-inflation country to allow a faster increase in its
price level. When the currency of the lowest inflation country would reach the limits of its bilateral
bands with high inflation currencies, unlimited interventions could be done by the country's central
bank to avoid further appreciation, without consuming official reserves. The central bank had
simply to put on the market its own currency and then sterilise the monetary expansion resulting
from interventions. The strong currency country enjoyed an improving competitiveness and had an
incentive to delay and limit the realignment which was indispensable for high inflation countries.
The asymmetry of the EMS discipline was fundamental in causing the convergence of European
inflation rates, not towards an average but towards the minimum level. Inflation policies of all
European countries became increasingly "German"; staying in the EMS was interpreted by the
markets as a commitment to behave in a "German" way, which increased the anti-inflation
credibility of the monetary policies of countries which used to suffer the reputation of being
inflation-prone, like Italy and France. Technically, economists said that countries like Italy and
France, by committing to a fixed exchange rate with the DM, were borrowing credibility from the
Bundesbank. Credibility increased the effectiveness and lowered the unemployment cost of pre-
announced disinflation policies, as it lowered expected prices and therefore kept wages from rising.
Moreover this virtuous circle gradually diminished speculative attacks against weak currencies,
making it easier to keep EMS exchange rates stable.
The disciplining effect of the EMS took several years to obtain a sufficient convergence of inflation
rates. In the meantime the system had to be managed so as to survive in spite of decreasing but still
substantial inflation differentials. Which was done in different ways during the various phases of
the EMS life that are described below.
In the EMS agreement there was also a role for the so called "European Currency Unit" (ECU), a
basket composed by specified quantities of the various participating currencies. The ECU had been
in existence also before the EMS, as an accounting currency used to measure various prices and
quantities in the economic organisation of the European Community (like intervention prices of
agricultural products or wages of employees of EC organisations). When the EMS was created, the
ECU increased its official importance as, for instance, part of EMS central banks' reserves and
reciprocal debts and credits were denominated in ECU, proving an increasing solidarity between the
52
The political cost had often two opposite components : the general reputational cost caused by the currency's
weakness and the critiques of the country's exporters arguing that the devaluation had been obtained too late and was
insufficient to restore the loss of competitiveness caused by a substantial period with high inflation and fixed exchange
rate.
24
participating countries and showing their trust in the success of the system53
. The new role of
"official ECUs" triggered the development of the market for "private ECUs". Some bank deposits,
bonds, insurance policies, were spontaneously denominated in ECUs by market participants also in
view of the fact that the European basket could help to hedge against fluctuations of individual
currencies' values. The amount of private ECUs increased and the basket currency had a certain
success. Some hoped that its role as a "parallel currency" could grow to the point of crowding out
the national currencies making the basket, gradually and spontaneously, the single currency of
Europe. But this idea was wrong and the role of ECUs remained much more limited. Moreover it is
important to stress the fact that the ECU did not perform any essential function in the exchange rate
agreement of the EMS54
.
In particular it must be clear that the EMS was not an agreement to limit fluctuations of the
participating currency's exchange rates with respect to the ECU ! The parity of each currency was
also expressed in terms of ECUs and the changes of the market exchange rates of the ECU with the
various national currencies were calculated and monitored, but the whole model of the EMS was
based on the objective of limiting the fluctuations of bilateral exchange rates between the various
participating currencies. The difference is very important. When the EMS was invented, during the
discussions that took place in 1978 to decide its characteristics, there was a French position strongly
in favour of an ECU based EMS, where the commitment of central banks would have been to keep
the market value of their currencies in terms of ECU inside a fluctuation band. The German position
then prevailed, where the commitment was to intervene when bilateral exchange rates reached the
limit of a band centred on bilateral parities. This meant that each central bank had to control the
exchange rate of its currency with respect to every other national currency and therefore, in
particular, with respect to the strongest one, the DM. Germany's low inflation policy would thus
gradually prevail in Europe. If the French proposal had been adopted, the disciplining effect of the
EMS would have been much weaker and much more symmetric: by pegging the value of a basket
of currencies, monetary policies of participating countries would have caused a convergence of
inflation rates towards the mean, as opposed to the minimum inflation rate of the group55
. With the
French proposal the EMS monetary area would not have become a "larger DM area", with
countries' attitudes towards inflation becoming increasingly similar to the German one. Fixed
exchange rates would have been maintained with a higher average inflation rate in the whole EMS
area, in contrast to one of the initial objectives of the EMS which, as noted above, was to lower
European inflation.
In order to consider the various stages through which, along a period of 20 years, the EMS
succeeded in leading Europe to adopt a single currency, it is convenient to keep in mind the issue of
the "incompatible trio" that, as explained in previous sections56
, always comes up when a fixed
53
The Deutsche Bundesbank, for example, proved to be available to run a substantial exchange rate risk by accepting to
denominate in ECU part of the loans it made, within the reciprocal credit facilities, to provide weak-currency-countries'
central banks with Deutsche Marks to be used for interventions in support of their currencies. 54
In fact a description of the essential elements of the EMS was provided above without any reference to the ECU. 55
Suppose, for simplicity, that the ECU is a basket of 10 currencies with equal weights. Suppose 9 of the 10
participating countries have 10% inflation and one has no inflation. With the bilateral parity grid EMS model that was
adopted, each of the 9 inflation-prone currencies rapidly reaches the limits of its bilateral fluctuation band with the zero-
inflation currency and its central bank must either intervene or bear the costs of a request for realignment, or accept
"German" discipline quickly reducing its inflation rate towards zero. On the contrary, with the ECU based EMS model
proposed by France, 9/10 of the basket behaves like a 10% inflation currency: the market exchange rate of the 9
inflation-prone currencies with respect to the ECU tends to depreciate only by approximately 1% (9/10 of 10%) per
year, moving slowly away from the ECU parity and thus allowing the countries to keep their higher inflation policies.
Intuitively, the French system appears as one where the EMS area inflation policies tend to converge towards an
average rate chosen, so to speak, "democratically" by averaging national attitudes towards inflation, while with the
bilateral-parity-grid-based EMS inflation rates tended to be "dictated" by the less inflation-prone country. 56
See sections 1, 2, and 3.
25
exchange rate system is adopted. Exchange rates cannot be completely fixed when international
capital mobility is perfect and national monetary (inflation) policies are conducted in different and
autonomous ways. How was the incompatible trio problem solved in the case of the EMS? The
answer changes along the life of the system even if it is possible to say that there was a gradual,
nearly continuous process leading to a situation where, with the introduction of the euro, exchange
rates became completely fixed, capitals were fully mobile and the solution of the trio problem
consisted in totally abandoning the autonomy of national monetary policies which were delegated to
a single common central bank.
But this final solution was difficult to reach. At the beginning national monetary policies were very
different and at the end of the 70s' some feared that a fixed exchange rate system would have meant
giving up the unification of Europe's capital markets by delaying the liberalisation of capital flows
or even strengthening controls on international capital movements. This view turned out to be
pessimistic. The history of the EMS proved to be one of increasing fixity of exchange rates joined
with increasing freedom of capital movements: this development was made possible by decreasing
the autonomy of national monetary policies.
The "baby EMS": 1979-1982. During the first years of its life the agreement was very weak and
fragile as inflation rates in the participating countries were very high (nearly 10% on average) and
very different (an average absolute difference of about 5%). There was no strong co-ordination
effort to reduce the differences in national monetary policies. The incompatible trio problem was
therefore very acute. It was managed by giving up in part the freedom of capital movements and in
part the same fixity of exchange rates. The severe set of controls was maintained that had been
present and even strengthen during the 70s' in several countries including, in particular, Italy and
France. Realignments of the EMS parities took place 7 times during these years, often with
substantial parity changes.
The "young EMS": 1983-86. The EMS became more robust as its built-in incentive mechanisms
triggered strongly anti-inflation policies in many countries. The average inflation rate of the
participating countries became lower than 5% with the average absolute difference between national
inflation rates shrinking to about 2.5%. In spite of speculative attacks against the weaker currencies,
there was a stronger resistance to realignments, that were delayed as much as possible and took
place only 4 times during the period, with smaller parity changes that during the "baby years".
Inflation-prone countries were allowed to depreciate to an extent smaller than the loss of
competitiveness due to their higher inflation, which increased the disciplining effect of the EMS.
Moreover, following a global trend towards financial deregulation, international capital controls
were weakened in many countries57
. With fixer exchange rates and freer capital movements the
solution of the incompatible trio problem could not but rely, at least in part, on a reduction of the
degree of autonomy of national monetary policies. During this period of the EMS life the reduction
took place by granting an implicit leadership to the Deutsche Bundesbank as far as decisions on
interest rates and liquidity management were concerned: the other national central banks
deliberately followed the monetary policy moves of the German authorities, thus making the EMS a
"greater DM area" and contributing to the solution of the trio problem. It must be stressed that this
solution was very informal: there was no explicit agreement to make the German central bank the
"orchestra director" of European monetary policies. Such an implicit solution could only work
temporarily. It must also be noted that the German leadership was not controversial during this
period58
: it was welcomed and accepted gladly by the weak currency countries which, so to speak,
57
During this period France nearly completes liberalisation while in Italy a reform starts that gradually decreases the
formidable degree of financial protectionism of the country. 58
As it became later, particularly at the beginning of the '90s.
26
competed to become "more German that the Germans" in monetary policy matters. The political
incentive-based, asymmetric disciplining mechanism of the EMS worked therefore very effectively.
The "mature EMS": 1987-1991. In 1987 the so called Basle-Nyborg accord reinforced the
reciprocal short-term credit facility that central banks could use to stabilise the EMS currencies,
encouraged the central banks to intervene also before the market rates reached the limits of the band
but, on the other hand, recognised officially that exchange rate stability was unsustainable without
substantial convergence of national inflation rates and monetary policies. A long period of further
strengthening of the EMS started, during which the average inflation rate of participating countries
was around 3% with an absolute average difference of the order of 1%. The liberalisation of capital
movements was completed and no realignment of the parities took place during the 5 years period59
.
With increasingly fixed exchange rates and increasingly free capital movements, the incompatible
trio problem required a new step in the direction of reducing the autonomy of national monetary
policies. The implicit leadership of the Bundesbank of the "young EMS" became insufficient: it was
too informal and its credibility was also threatened by the new political and economic problems that
Germany started to have, following the crisis of the neighbouring communist countries and the
planned reunification of the Eastern with the Western part of the country, making more difficult the
exercise of an effective German leadership in Europe. Moreover, currency markets during this
period were characterised by frequent speculative episodes mainly due to the uncertainty and
instability of the dollar and to the consequences on intra-European exchange rates. An explicit, long-
term scheme was needed to convince the markets that European national monetary policies were
really giving up their autonomy in favour of substantial steps towards monetary unification. This
was provided by the so called Delors Plan (1988-9) where the basic elements of the Maastricht
Treaty are drawn in a very convincing way, including a gradual path towards a single currency and
a common central bank. The plan was still an informal document, prepared by a committee of
experts (Europe's central bankers and independent economists) chaired by the President of the
European Commission. But market operators were impressed by the plan and believed in its
feasibility, "lending" to the politicians the time needed to enact the complex institutional steps
needed to carry it out. Speculators behaved in a more stabilising way, making it possible, in a series
of difficult years, to avoid EMS realignments and to keep stable European exchange rates. In the
meantime the European Commission and the European Council translated the Delors plan, also
calling an Intergovernmental Conference of member states, into the text of the Maastricht Treaty
which was finalised and signed by European governments between November 1991 and February
1992. The Treaty set also a final date (January 1999) for the introduction of the single currency in
those countries where macroeconomic conditions would have converged in a sufficient way.
Therefore the "mature EMS" period, after having registered a great success in lowering inflation
rates, stabilising exchange rates and liberalising capital movements, ended with a very important
institutional result on the road to European monetary unification.
The EMS crisis: 1992-93 (-95). Precisely when the EMS had reached its best possible success,
celebrated by the signature of the Maastricht Treaty, it was hit by a very serious crisis. A very
strong speculative attack took place during the summer of 1992 causing the abandonment of the
EMS by the Italian lira and the British pound, which started to float, and triggering a series of
realignments devaluing the Spanish and the Portuguese currencies. A new speculative attack hit the
French Franc one year later, in spite of the fact that the macroeconomic fundamentals of France
were good. Proposals to go back to controls on capital movements were refused and it was possible
to avoid an unjustified realignment when Germany declared to be ready to grant unlimited support
to the Franc-DM parity and when the decision was taken to widen the bands around the EMS
59
The only exception being a "technical" realignment of the parities of the Italian lira required by the narrowing of its
6% special band to the normal width of 2.25%.
27
parities from 2.25% to 15%. Some considered this decision as the end of fixed exchange rates.
But in fact market exchange rates were pegged again very near to the central parities with the very
large band serving only as a disincentive to speculators whose operations could be at any time
confronted with a sudden depreciation depriving them of their profit opportunities. For the EMS
currencies the crisis period ended in 1993 even if the following year was a very difficult one due to
the financial crisis of Mexico and of the international bond market. For Italy, whose currency had
been thrown out of the system, the crisis was longer, due the difficult political and economic
situation of the country, and the last formidable speculative attack, causing a violent depreciation of
the lira, took place in 1995.
Why did such a serious crisis take place precisely when the "mature EMS" had reached its most
ambitious objectives, including the signing of the Treaty of Maastricht ? The causes of the crisis
can be found in a series of phenomena that suddenly decreased the credibility of the single currency
plan embodied in the Treaty. The expectation of monetary unification had provided the solution to
the incompatible trio problem during the preceding years: the sudden loss of credibility triggered
immediate speculation against the system of fixed exchange rates60
. The phenomena that weakened
the credibility of European monetary unification can be classified in three categories. 1) Political
difficulties to ratify the Treaty. The Treaty had been signed by the governments but, in order to
come into force, it had to be ratified by the legislative branch in all the undersigning countries61
.
The ratification process turned out to be more difficult than expected. In fact it started in Spring
1992 with "no" votes prevailing in the Danish referendum. Markets thought that the probability of a
successful ratification process was very low. 2) Problems following German unification. The
unification of East and West Germany was a very costly process and a substantial burden for
German public finances62
. To avoid both excessive tax increases and inflation, Germany decided to
increase its government deficit but keep very restrictive monetary policy. This policy mix would
have produced high interest rates and attracted substantial capital inflows from abroad, thus
allowing an easier financing of the unification process. But high interest rates were not desirable for
the rest of Europe where, on the contrary, the weak economic cycle would have benefited from a
monetary stimulus. This contrast rendered more difficult and controversial the co-ordination of
EMS countries‟ monetary policies. Markets were impressed by the evidence showing how the
“optimal” monetary policy could be substantially different in the various countries of an area which
was planning to adopt a common currency. The “one-size-fits-all ?” problem of monetary
unification became more important causing a decrease of the credibility of the Maastricht project.
3) Difficulties in macroeconomic convergence. To be admitted in the common currency area the
Treaty required a country to fulfil 5 macroeconomic “convergence criteria” setting limits,
respectively, to its inflation rate, long term interest rates, exchange rate volatility, public deficit and
public debt. It became suddenly clear that many countries would have had a lot of difficulties in
meeting some of these criteria. There was a high probability that in January 1999 the euro area
would be composed by very few countries and that the other countries would abandon their
convergence efforts going back to macroeconomic indiscipline and inflation. The credibility of the
Maastricht project suffered from these pessimistic forecasts of European macroeconomic
convergence, triggering speculative attacks based on an expected appreciation of the Deutsche
60
Consider the case of the French Franc, whose macroeconomic fundamentals were very good: the market thought that
they were good precisely because France had been disciplining itself in the framework of the EMS and considering the
final aims of the Maastricht Treaty. But what if the Treaty turned out to be unable to bring the single currency into
existence ? One could suspect that France would have gone back to its old inflationary vices triggering the devaluation
of the frank and the end of the EMS. The success of the EMS-euro story was heavily dependent on the credibility of the
single currency project, that needed some years to be completed. 61
Even if only one country (among those the government of which has signed) does not ratify, such an international
treaty cannot come into force for the others. 62
Very large public transfers were required for the restructuring of Eastern Germany‟s firms and to limit the West-East
wage differential which could have caused excessive migration of eastern workers to the West.
28
Mark which had already an international role and which would benefit from the strong anti-inflation
stance of German economic policy.
The three categories of causes of the EMS crisis can also help to explain why the crisis came to an
end after nearly two years. In spite of the initial difficulties the ratification process was successful
and by the end of 1993 all EU countries had ratified the Treaty, including Denmark where a second
referendum was held one year after the first resulting in a victory of the “yes” vote. After all
countries had ratified it, the Treaty came automatically into force and the markets realised that the
national political systems had completed the complex institutional path required to give up the
power to conduct national monetary policies. German unification was successfully managed and
had some initial favourable macroeconomic impact, allowing Germany to adopt a less restrictive
stance of its monetary policy, thus narrowing the divergence from the policy desired by other EMS
countries. Macroeconomic convergence accelerated: markets were particularly impressed by the
fact that inflation fell below the hard floor of 5-6% also in a country like Italy where the exchange
rate had suffered a tremendous series of depreciations in the preceding 2-3 years63
.
Towards EMU. With the end of the EMS crisis a new period of strength started for the EMS,
favoured by the increasing probability that markets associated to the success of the Maastricht plan.
This renewed expectation of complete monetary unification acted as a solution to the incompatible
trio problem. There were still doubts on which currencies would eventually be able to join the euro
area and sometimes markets feared that only a few would be admitted, rendering the introduction of
the euro a less significant event and leaving “out in the cold” some potentially very weak
currencies. But the creation of a European Central Bank and of the euro was considered
increasingly probable. In January 1994 the so called “second phase” of the Economic and Monetary
Union (EMU) started with the creation of the European Monetary Institute (EMI), based first in
Basel and then in Frankfurt. According to the Treaty the EMI should supervise the macroeconomic
convergence of the potential euro area and should take care of all the technical preparations
required to set up the European Central Bank (ECB). In fact a substantial process of convergence
took place in the five years that followed. One of the most difficult steps was the reduction of
Italy‟s enormous public deficit which fell from nearly 10% of GDP to less than 3%, as required by
Maastricht‟s convergence criteria64
. During this period the Italian currency was also able to re-enter
the EMS fixing new parities with the other 11 currencies of the system. In May 1998 the European
Commission gives its technical judgment : 11 out of the 15 EU member countries could share the
common currency. This judgment was then confirmed by the political decision of the European
Council. Only the UK pound, the Danish Krone, the Swedish Krone and the Greek Drachma
remained outside the initial composition of the euro area65
, which started in January 1999 with the
introduction of the new common European currency66
the happy end of the EMS life‟s story.
63
A very severe and courageous income policy was in part the cause of this successful anti-inflation effort. 64
This nearly miraculous reduction was also the result of a virtuous circle triggered by the decrease in the interest cost
of the public debt. As the markets came to consider the admission of Italy in the euro area more likely, the exchange
risk premium in Italian interest rates decreased, thus favouring the reduction of the deficit and effectively increasing the
likelihood of the admission of the lira in the euro. 65
The exclusions were expected by the markets and were not a serious political problem. The UK and Denmark, which
were fulfilling the main convergence criteria, did not wanted to join the euro since its start and had obtained the
introduction of a special opt-in clause in the Treaty. Sweden was hesitant and found convenient the fact that it did not
fulfil the exchange rate criterion. Greece was anxious to be part of the euro area but also conscious that it still needed a
couple of years to meet the convergence criteria (in fact Greece joined the euro area in 2001). 66
The ECB substituted the EMI since June 1998, with full powers to decide and then implement the monetary policy
strategy of the whole euro area.
29
7 The dollar’s ups and downs
In this short story of the international monetary system, the US dollar has been left at the beginning
of the „70s, when the end of Bretton Woods deprived it of its official central position in the system.
But the dollar remained the de facto central currency of the world and its strengths and weaknesses
kept being crucial for the world economy; they were caused by the evolving divergences between
the policies of the US and of the other countries, by differences in interest, inflation and real growth
rates, by the behaviour of the US balance of payments, by rapidly changing market expectations and
by the often turbulent sentiments of the speculators as well. It has been recalled that fluctuations of
the dollar were important during the disorder of the „70s‟ Great Inflation and that the EMS was
constructed also to defend intra-European exchange rates from the tensions produced by the dollar‟s
ups and downs. In fact, part of the story of the European efforts to converge towards EMU is
intertwined with the Us currency‟s fluctuations. Then, when the euro was introduced, the heart of
the chronicle of the international monetary system became the time profile of the euro-dollar
exchange rate.
It is therefore useful to keep in mind, at least, a schematic summary of the main phases of the
dollar‟s fluctuations in the last four decades.
The Seventies. In 1971, after the abandonment of the convertibility in gold, the dollar abruptly lost
approximately 10% of its average value with respect to the major currencies in the world. The
Deutsche Mark (DM) rapidly became the most important alternative reserve currency. In terms of
DM, the dollar kept losing value during the decade, more or less steadily, with stops and small
inversions only in ‟73-‟75: see Figure 4. In January 1980 the DM price of the dollar was more than
50% cheaper than nine years before. Two other (less important) international currencies went
through periods of even stronger revaluation with respect to the dollar: the Swiss Franc and the
Yen, but the latter depreciated a lot in ‟79-‟80. Other minor European currencies followed in part
the DM revaluation while the French Franc was weaker and the Pound and the Lira were much
weaker most of the time. After 1977 also the Canadian dollar, an important currency for Us trade,
depreciated with respect to the US dollar. Therefore, on average, the US currency lost much less
value (approximately another 10%, most of it in 1977-8, in addition to the first 1971 adjustment)
than with respect to its major German competitor. Inflation rates were the main cause of exchange
rate changes and Us inflation grew to two digit levels at the end of the decade, substantially higher
that Germany‟s.
The Eighties and the Nineties. During the two subsequent decades, as can be seen in Figure 4, the
time profile of the dollar, with respect to a basket of European currencies mimicking the future
euro, can be divided in four stages. Five years of very strong appreciation until March 1985,
followed by less than three years of even faster depreciation; then a long period, more than seven
years, until late in 1995, of high instability, with 6-7 short and violent ups and downs, of an order of
magnitude of around 20%; finally, for five years until 2000, a neat trend of revaluation with a short
stop and inversion only in 1998.
One must remember that, during these two decades, Europe fought inflation with the EMS,
overcame the difficulties of convergence and reached the targeted monetary unification.
30
Disinflation was also the main reason behind the rising dollar in the first stage. Under the new chair
of the Fed, Volcker, US monetary policy changed drastically: new limits were announced to the
expansion of the quantity of money and interest rates skyrocketed67
driving capital inflows and
speculative bets on dollar appreciation. The rise of the dollar went beyond what fundamentals
would have justified, becoming a self-fulfilling speculation; the trade balance suffered and a long
series of deficits of the US current account started which practically never ended, transforming in
less than a decade a typical net-lender-country in a net debtor. The excesses of the dollar stimulated
international cooperation of governments and central banks: in September 1985 the famous Plaza
Accord was reached between the G5 to depreciate the dollar by coordinated interventions in
currency markets.
The dollar, to be sure, had already started to depreciate starting the second stage of the „80s-„90s
period. The loss of value of the US currency was fast, as speculators contributed to the inversion. A
new summit was called in February 1987, achieving the so called Louvre Accord to prevent the
dollar from further declining. There was no immediate effect of the accord and the dollar slide
continued.
Later, during 1988, central banks‟ interventions started to influence the exchange rates and their
commitment to intervene was sometimes credible for the markets. This was one of the reasons for a
new rise in the dollar starting the third stage of rapid ups and downs. These fluctuations had various
justifications but were often hardly based on fundamentals: destabilising speculative activity was
concentrating on the dollar; in the meantime the Japanese yen was losing value and importance and
a “mature” EMS was trying to keep European parities stable in spite of the difficulties caused also
by the instability of the dollar. European efforts were successful until 1992, when the EMS crisis
exploded for reasons that, as explained in section 6, had little to do with the dollar.
Towards the end of 1995 the last stage of the „80s-„90s dollar story started, with a pretty neat trend
of appreciation justified by the brilliant growth of the US, pushed by technical progress,
investments, abundant capital inflows68
, and a speculative bubble of stock prices. In 1997-8 the
global markets were hit by a serious financial crisis in several Asian countries and by the Russian
crisis. But the positive dollar trend was only briefly interrupted in 1998 and kept going after the
introduction of the euro, in January 1999. During its first 2-3 years of life the new currency
depreciated and stayed low with respect to the dollar, as the cycle of the US economy was
appearing brighter than Europe‟s.
The last decade, with the euro. Consider Figure 5. The starting initial $ price of the euro (1.168)
was fixed on the 31st of December 1998 in such a way as to equal the $ price of the ECU, the
virtual-basket-currency already in existence69
.
i - As just said, the market depreciated the $ per euro by more than 25%, for more than two years:
among the reasons there were better US growth perspectives and higher (even if declining) US
interest rates (see Figure 6).
67
Also as a consequence of the policy mix with expansionary fiscal policies, decided by the new President Reagan who
lowered taxes and increased military expenditures. 68
More than sufficient to finance the increasing deficit of the current account of the balance of payments. 69
As the ECU (see section 6 above) was a basket of specified quantities of national currencies (not exactly the same
currencies that were unified into the euro) its $ price was equal to the sum of the quantities of the component currencies
each multiplied by its current market exchange rate in terms of US dollars.
31
ii - Then, from the second part of 2001 to the end of 2004, a steep trend appreciated the euro by
more than 50%. US growth was much less brilliant (see Figure 7), the terrorist attacks worsened
international relations, the current US balance of payments (Figure 7) was deteriorating faster and
the Fed had pushed interest rates very low, even if the higher ECB rates were somewhat lowered in
2003 (Figure 6), probably also to ease the upward pressure on the euro.
iii - In fact, a sudden weakening of the euro happened during 2005 (more than 10%), starting
precisely when US interest rates were brought above Europe‟s (Figure 6) and when capital inflows
in the US70
appeared strong enough to finance the big American current account deficit.
iv - From 2006 to mid-2008, when the international financial crisis worsened a lot, the euro
appreciated again very much (more than 30%). The ECB increased its interest rates less and slower
than the Fed, probably also to avoid favouring the booming appreciation which was not favourable
to Europe‟s exporters. The main cause of the $ weakness, though, was the continuous increase of
the US current account deficit71
(Figure 7).
v - When the Lehman bankruptcy made the crisis really frightening, a new phase of the dollar/euro
exchange rate started which is probably still going on now. There are ups and downs in this phase,
often difficult to explain. But a partial explanation is that, when the crisis looks worse (like in late
2008 and at the beginning of 2009, and like during the sovereign debt crisis72
from late 2009 to the
spring of 2010), the dollar appears as a safe-heaven, in spite of the crucial role of the US in the
financial disaster. The market thinks that, at least, behind dollar assets there is a central bank, that is
ready to print money to reimburse them, and a centralised federal government, while these
conditions seem absent in the euro area where even governments risk becoming bankrupt. On the
contrary, when the crisis looks nearer to become smoother or to end, like during the central part of
2009, the dollar tends to weaken as risk aversion decreases in the markets where speculation
resumes, mostly by opening short positions in dollars73
against investments in other currencies (that
are expected to appreciate and/or have higher interest rates) and in assets with high expected
yields/capital gains at least partially offset by high risk.
70
In particular, investments of official reserves by the central banks of China and other emerging economies 71
In fact, before the US subprime problem exploded, several economists were expecting a global financial crisis to start
elsewhere, on the Us currency market, with a flight from the dollar precipitated by the market‟s refusal to keep
financing the unsustainable path of the US deficit. 72
Involving first Ireland and Dubai and then Greece, Portugal and Spain. 73
Or closing previously existing long positions: in both cases the impact on the exchange rates is like that of dollar
sales.
32
Table 1
INTERNATIONAL MONETARY REGIMES
1879 - 1913 (+1925-1931 ?) :
GOLD STANDARD
1914 – 1944 :
WARS, ATTEMPTED RESTORATION OF THE GOLD
STANDARD, GREAT DEPRESSION, PROTECTIONISM
AND VARYING BILATERAL AND REGIONAL
ARRANGEMENTS
1945 – 1971 (or ‟73, or ‟76 ?) :
THE INTERNATIONAL MONETARY SYSTEM OF
BRETTON WOODS
THE ‘70s :
FLOATING EXCHANGE RATES, MONETARY DISORDER
AND PROPOSALS FOR REFORM
1979 – 1999 :
THE EUROPEAN MONETARY SYSTEM (EMS)
1999 - … :
THE ECONOMIC AND MONETARY UNION (EMU) AND
THE EUROZONE
33
Table 2
Some dates in the interwar period 1914-1920 War-induced fast inflation everywhere, gradually slowing down in the following years
1919 US, where inflation had been milder, brings the dollar back to gold standard
The Paris peace conference opens where no other issue caused more trouble and delay than
the problem of German reparations
1921-1923 German hyperinflation, leading to the introduction of the Rentenmark, a new currency
“backed by land”
1923 French and Belgian troops invade the Ruhr valley, when Germany was late in meeting a
reparation payment for that year
1925 UK (Churchill) goes back to the pre-war gold parity after deflationary policies
1925-1928 35-40 currencies stabilized (often with deflationary policies) and, more or less
strictly, back to a gold-standard (a façade?)
1928 France back to gold at an undervalued parity (around 20% of the pre-war parity) after Poincaré
stopped inflation and depreciation; undervaluation causes massive inflows of gold into France
(a problem for, among others, the UK)
1929 Following several years of credit boom and stock-price bubbles (sucking capital and gold from
Europe - less from France) a tremendous Wall Street crisis ignites the chain of events leading
to the Great Depression
1930 The Smoot-Hawley Tariff Act of the US starts the protectionist wave triggered by the crisis
The Bank for International Settlements is established (in Basel) to administer the settlement of
German reparation payments
1931-1933 International banking crisis “starting” with Creditanstalt in Austria, then spreading everywhere,
to Germany, the UK and devastating the US
1929-1933 35 countries, including the UK (1931), leave the gold standard, with widespread competitive
Depreciations
1933-1934 US (F.D. Roosvelt taking office) leaves the gold standard and then goes back to gold at 35$ per
ounce (40% depreciation)
1933-1939 A “Gold Block” (France, Switzerland, Italy, Belgium, The Netherlands, Luxembourg, Poland)
tries to remain formally with a gold standard at overvalued parities but suffers deflation,
delays recovery from the depression, introduces controls on capital movements and on trade,
that depress international commerce and render the standard progressively meaningless and
vanishing (around 1936), moving towards a new wartime regimes
In 1936 the French franc depreciates more that 35% and then enters a “Tripartite Monetary
Agreement” with the US and the UK : the agreement can be read both as an anticipation of a
military alliance and as a preview of a post-war IMF-type cooperation between central banks‟
exchange rate policies
34
Figure 1
Manufacturing output in various countries, 1928-36 (1928=100)
Source: N.Wolf, “Europe‟s Great Depression: Coordination Failure After the First World War”,
CEPR Discussion Paper No. 7957, August 2010.
35
Figure 2
Triffin’s Problem
IMD
IMS
D
B
GS
C
A
IMD
T1 T2 TIME IM
D = demand for international money : growing exponentially like world production and trade in an increasingly
integrated global market;
GS = linear trend of the supply of gold to be used for international payments, depending on the potential growth of gold
mining;
T1 = point of crisis of a "pure gold standard" system of international payments; suppose the solution to the crisis is a
Bretton-Woods type of arrangement, adding AB of dollars to the supply of international money, thus creating a "gold
exchange standard", with the ratio BA/AT1 such as to guarantee the fixed conversion price of dollars into gold;
IMS = trend of the supply of international money in a gold exchange standard: the trend keeps a fixed ratio between the
dollar component and the gold component (CD/CT2 = BA/AT1) so as to guarantee the convertibility of the dollars into
gold at the given initial fixed price;
T2 = point of crisis of the Bretton-Woods type gold exchange standard : it is inevitable, given the exponential speed of
growth of IMD
: the reform in T1 has bought some time but a crisis (point T2) will eventually happen.
Note that after T2 the international community has the following three alternatives. i) To try to stick to gold exchange
standard and convertibility implementing restrictive policies to slow the growth of trade and the demand for
international means of payments (bending IMD towards IM
S), thus producing stagnation for lack of international
liquidity. ii) To try to save dollar convertibility by increasing the price of gold in terms of dollars, thus raising the slope
of the IMS line: but eventually the new line will cross the IM
D exponential again. The market will anticipate this and
speculate on a new expected increase in the price of gold, thus rendering the defence of convertibility increasingly
difficult. iii) Abandoning convertibility ("end of Bretton Woods") trying to regulate IMS (making available the right
amount of fiat international money, including non convertible dollars) in such a way as to meet the needs of world
growth as expressed by IMD (in other words: bending IM
S towards IM
D).
36
Figure 3
Demand and Supply shocks
P
AD‟
AD AS
E‟
AD‟‟ E
E‟‟
Y* Y
Aggregate Demand Shock
AD‟
P AD AS‟
B
AS
E‟
AD‟‟
E
A
Y* Y
Aggregate Supply Shock
37
Figure 4
US dollar’s ups and downs: 1970-2000
38
Figure 5
US dollar’s ups and downs: 1999-2010
39
Figure 6
Monetary policy interest rates during the life of the euro
40
Figure 7
Current balance of payments, growth and inflation
during the life of the euro
Current account of the BP in % of GDP
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