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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

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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.

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- 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.

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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.

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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;

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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.

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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