International Monetary System: Bretton Woods, Floating Exchange Rate & European Monetary System

In this article we will discuss about Bretton woods, floating exchange rate and European monetary system.

International monetary system refers to the monetary and exchange rate arrangements adopted by the countries for the smooth functioning and expansion of international trade. International monetary system influences the interdependence of open national economies. Efficiency of an international monetary system depends on to what extent it helps the countries to achieve the twin objectives of internal balance and external balance.

Internal balance requires the full employment of a country’s resources and domestic price stability. External balance is attained when a country’s current account is neither so deeply in deficit that the country may be unable to repay its foreign debts in future, nor so strongly in surplus that the foreigners are put in the same trouble.

Bretton Woods System (1945-73):

The inter-war experience has shown that- (a) gold standard could not be restored in future; (b) floating exchange rates were a cause of speculative instability and were harmful to international trade; and (c) national governments would not be willing to maintain both free trade and fixed exchange rates at the cost of long-term domestic unemployment. In view of this experience, the monetary authorities of the world felt the need for international cooperation to establish a stable international monetary system.

With this objective in mind, the representatives of 44 countries held a conference in Bretton Woods, New Hampshire, in 1944 and signed the Articles of Agreement of the International monetary Fund (IMF). The result of this conference was the establishment of a new monetary system, called Bretton Woods system.

Bretton Woods’s system provided a compromise between fixed and floating exchange rate systems. It was a modified gold-exchange standard in which the member countries maintained adjustable pegs relative to U.S. dollar. The U.S. undertook to exchange gold for dollars with foreign central banks at a fixed rate.

The new system aimed at- (a) establishing international harmony and exchange rate stability associated with the gold standard; and (b) allowing individual countries the freedom to pursue their own macroeconomic policy.

Features of Bretton Woods System:

The following are the main features of Bretton woods monetary system:

I. Establishment of International Monetary Institutions:

For the smooth functioning of the new system, the conference at Bretton Woods proposed the establishment of:

(i) International Monetary Fund (IMF) to achieve exchange rate stability and to provide short-term finance to the member nations to meet their temporary balance of payments deficits.

(ii) International Bank for Reconstruction and Development (IBRD), or popularly known as the World Bank, to assist in the post-war reconstruction and development of the member nations.

(iii) International Trade Organisation (ITO) to promote international cooperation in the matters of trade.

Of these three proposals, the ITO did not materialise, though later on the General Agreement on Tariffs and Trade (GATT) was formed in 1948. IMF and IBRD were set up and started functioning in 1947 and 1946 respectively.

II. Objectives of IMF:

Bretton Woods’s international monetary system, which involves the maintenance of stable exchange rates and a multilateral credit mechanism, was institutionalised by the IMF. IMF was established with an objective of providing exchange stability throughout the world and increasing liquidity so that balanced multilateral trade is promoted through the cooperation of member countries.

The main goals of the IMF, as summarised in the Articles of Agreement, are as follows:

(i) To promote international monetary cooperation;

(ii) To facilitate the expansion and balanced growth of international trade;

(iii) To promote exchange stability;

(iv) To assist in the establishment of a multilateral system of payments;

(v) To give confidence to members by the Fund’s resources available to them under adequate safeguards; and

(vi) To shorten the duration and lessen the degree of payments disequilibrium.

III. Pegged Exchange Rate System:

The monetary system set up under the Bretton Woods agreement is generally known as pegged exchange rate system. Under this system, each member nation was required to define the value of its currency in terms of gold or the U.S. dollar and to maintain (or peg) the market value of its currency. In other words, it called for fixed exchange rates against the U.S. dollar and an unchanging dollar price of gold (i.e., $35 an ounce).

The member countries held their official international reserves largely in the form of gold or dollar assets and had the right to sell dollars to the U.S. for gold at the official price. Dollar was to function as the key reserve currency. In other words, the dollar was the ‘Nth currency’ in terms of which N-1 exchange rates of the system were defined.

The U.S. was not to intervene in the foreign exchange market. Usually, the N-1 foreign central banks intervened to fix the system’s N-1 exchange rates, while the U.S. was responsible for fixing the dollar price of gold.

IV. Adjustable Parities:

While each country’s exchange rate was fixed, the IMF allowed changes in the exchange rate under controlled conditions.

The provisions of the Articles of Agreement which relate to the adjustments in the par values of currencies are summarised below:

(i) A member country shall not propose to change the par value of its currency except ‘to correct a fundamental disequilibrium’, and it shall do so after consultations with the IMF.

(ii) A country can change the parity value upto 10% by simply informing the IMF.

(iii) For changes more than 10% but below 20%, the country was required to obtain prior approval from the IMF.

(iv) For any change exceeding 20%, the approval by two-third members of the Fund was necessary.

(v) The Fund discouraged competitive currency devaluations.

V. Lending Facilities:

The Fund aimed at providing credit facilities to the member countries to tide over their balance of payments problems- These credit facilities to a member country normally depended upon its quota, i. e., the member’s contribution to the Fund. Each member contributed to the Fund one-fourth of its quota in the form of gold or American dollars, and the remaining three-fourth in its own currency.

The IMF had certain permanent, temporary and special credit facilities for its members. However, after a certain, limit, heavy borrowing from IMF were allowed under increasingly stringent supervision of the borrower’s macro-economic policies. This supervision, over the domestic policies of the heavy borrower country is called IMF conditionality.

VI. Convertibility:

To promote efficiency of multilateral trade, the IMF Articles of Agreement required that the member countries should make their currencies convertible as soon as possible. A convertible currency is that which may be freely used in international transactions. For example, The U.S. and the Canadian dollars became convertible, in 1945.

This meant that Canadian residents who acquired U.S. dollars- (a) could use them to make purchases in the U.S., or (b) could sell them in the foreign exchange market for Canadian dollars, or (c) could sell them to the Bank of Canada, which .then had the right to sell them to the U.S. Federal Reserve in return for Canadian dollars or gold.

The IMF Articles called for convertibility on current account only. By doing so, the designers of the Bretton Woods system wanted to facilitate free trade, while avoiding the possibility of economic instability caused by private capital movement.

VII. Special Role of U.S. Dollar:

The U.S. dollar was generally recognised as the post-war world’s key currency and the U.S., was required to play a special role in the Bretton Woods system because of- (a) the size of the American economy, (b) devastation in Europe, and (c) bulk holding of world’s stock of gold reserves by the U.S; The U.S. dollar became the intervention currency, i.e., the currency most countries exchanged for their own currencies when intervening in the exchange market.

The U.S., on the other hand, was not obliged to intervene in the exchange market, but instead was obliged to exchange gold for dollars with other central banks on demand at the par value. That is why Bretton Woods’s system is also known as a gold-exchange standard. In short, the U.S. dollar became international money, i.e., a universal medium of exchange, unit of account, and store of value.

VIII. Special Drawing Rights:

Under the Bretton Woods system, the international reserves of the member countries could consist of three assets, i.e., gold, IMF reserve tranche positions, and reserve currencies (mainly dollar).

In 1969, the First Amendment to the Articles of Agreement of the IMF provided for the fourth reserve asset, Special Drawing Rights (SDRs). SDRs, which are simply book-keeping entries, can be exchanged for national currencies with other central banks and the IMF. The allocation of SDRs to the member countries was made in proportion for their quotas.

Problems of Bretton Woods System:

Bretton Woods’s system suffered from the following three basic problems:

I. The Problem of Maintaining Internal and External Balance:

Under the Bretton Woods system, the countries (other than the reserve currency country U.S.,) face the problem of establishing internal and external balance. To achieve the internal and external balance simultaneously, exchange rate changes (i.e., expenditure switching policies) and fiscal policy changes (i.e. expenditure changing policies) were needed.

But the possibility of exchange rate changes could give rise to speculative capital flows which undermined fixed exchange rates. This problem is graphically explained in Figure-1.

In Figure-1, Schedule II shows combinations of exchange rates and fiscal policy that hold output constant at full employment level (Y_f) and thus maintain internal balance. It is a downward sloping curve because currency devaluation (i.e., a rise in R) and fiscal expansion (i.e., a rise in government expenditure (G ↑) or fall in taxes (T ↓) both tend to raise output.

To the right of II, fiscal policy is more expansionary than needed for employment. Thus there is overemployment. To the left of II, fiscal policy is too restrictive and there is unemployment.

Schedule XX shows how much fiscal expansion is needed to hold the current account (CA) surplus at X as the currency is devalued by the given amount. Since the rise in R increases net exports, the current account is in surplus, relative to its target level, above XX schedule. Similarly, below the XX schedule, the current account is in deficit relative to its target level.

The II and XX schedules divide the diagram into four zones of economic discomfort. In Zone One, the level of employment is too high and the current account surplus too great. In Zone Two, the level of employment is too high, but the current account deficit is too great. In Zone three, there is under-employment and excessive deficit. In Zone Four, underemployment is coupled with a current account surplus greater than the target level. The point of intersection of II and XX (i.e., Point 1) is the point where the economy achieves both internal and external balance.

Suppose, to start with, the economy is at point 2, where there is underemployment and an excessive current account deficit. Only the combination of devaluation and fiscal expansion (indicated in the Figure as 2 → 1) can move the economy to internal and external balance (i.e., point 1).

Expansionary fiscal policy alone can eliminate the unemployment by moving the economy from point 2 to point 4, but the cost of reduced unemployment is a larger external deficit. Contractionary fiscal policy alone can achieve external balance (i. e., point 4), but the output and employment falls and the economy moves away from internal balance.

Thus, the Bretton Woods system requires stability of exchange rate. This leaves fiscal policy as the only tool for bringing internal and external balance in the economy. But, the above account has shown that the fiscal policy alone is insufficient to achieve the two goals of internal and external balance.

II. The Confidence Problem:

Another fundamental problem of the Bretton Woods system was the confidence problem. This problem, which was first diagnosed by Robert Triffin in 1960, relates to the reserve currency (dollar) as an asset and arises when the foreign official dollar holdings exceed U.S. gold holdings.

Since the U.S. had promised to convert dollars for gold at $35 an ounce, it would no longer have the ability to meet this obligation if all dollar holders simultaneously try to convert their dollars into gold.

This would lead to a confidence problem; other countries would lose confidence in the dollar as a reserve currency. Continuous increase in the stocks of dollar reserves of other countries means continuous U.S. payments deficits. The U.S. will be viewed as a country with a chronic deficit and the dollar will cease to be attractive.

III. Asymmetric Position of Reserve Centre:

The Bretton Woods system involved two basic asymmetries, both resulting from the U.S. dollar’s central role in the international monetary system:

(i) Because central banks pegged their currencies to the dollar and accumulated dollars.as international reserves, the U.S. could influence the economic activity both at home and abroad through its monetary policy.

In contrast, all other countries were unable to influence their own economies or foreign economies through monetary policy; they must passively ‘import’ the monetary policy of the reserve centre.

Suppose, for example, the U.S. adopts an expansionary monetary policy. The increase in money supply in the U.S. will reduce the interest rate below those prevailing abroad. This will cause an excess demand for foreign currencies in the foreign exchange markets.

To prevent their currencies from appreciating against reserve currency (dollar), all other central banks will be forced to expand their money supply, and reduce their interest rates down to the level established by the reserve centre (U.S.).

(ii) Any foreign currency can devalue its currency against the dollar in conditions of fundamental disequilibrium, but the U.S. has no option to devalue dollar against foreign currencies.

Decline and Collapse of Bretton Woods System:

The Bretton Woods system functioned well during 1950s. But after that, conditions emerged at the international scene which led to the decline and ultimately collapse of the Bretton Woods system in 1973. The failure and fall of the system was mainly due to its own weaknesses and contradictions.

The following is the historical account of the functioning of the Bretton Woods system, and its eventual fall:

i. Formal Functioning of the System:

The Bretton Woods system was a system of fixed exchange rates. Nations defined the value of their currencies in terms of gold or the U.S. dollar and maintained the market value of their currencies within ± 1% of the defined par value. These fixed exchange rates were to be changed only in case of ‘fundamental disequilibrium’. The U.S. promised to redeem all dollars with the central banks of other countries in gold on demand at the fixed price of $35 per ounce.

The smooth and successful functioning of the Bretton Woods system required adequate increase in international reserves (i.e., liquidity) to meet the requirements of expansion of trade. This is how the Bretton Woods System was formally supposed to function. The key factor in this functioning was the acceptability of the dollar.

If anything were to happen that would shake the world confidence in the ability or desire of the U.S. to exchange dollars for gold, the system could collapse. This is exactly what happened with the Bretton Woods system.

ii. Easy Liquidity Position during 1950s:

Expansion of trade required increase in international reserves. Since major part of international reserves (i.e., gold and dollars) were in U.S.A., growth of international trade required an outflow of gold and dollars from U.S.A. in the early period, the supply of dollars outside the U.S. came from the Marshall plan and other American foreign aid programmes, contributions to the World Bank, multinational investments, and American defence expenditure abroad.

The small deficits in the U.S. balance of payments in 1950s were welcomed because they increased international liquidity. The U.S. gold stock was huge, the dollar was as good as gold, and the weak European economies faced a ‘dollar shortage’, i.e., they needed international reserves.

It appeared that the Bretton Woods system, by permitting the expansion of international monetary reserves at much faster rate than the rate under a system restricted only by the supply of gold, would solve the major problems of gold standard.

iii. Period of Crises:

The period of 1960s witnessed recurring balance of payments crises, each more serious than the last. This period of crises culminated in 1971, when the official convertibility of dollar ended. Then came the 1973 crisis, in which the Bretton Woods system finally collapsed.

The U.S. moved from a position of balance of payments surplus of $ 4 billion in 1947 to that of a deficit of over $29 billion in 1970. The dollar shortage of 1950s turned into dollar glut of 1960s and early 1970s. The U.S. official gold stock fell from about $25 billion in 1949 to about $10 billion by 1971.

The depletion of U.S. gold reserves and the huge accumulation of dollars and dollar-convertible assets held by other countries perpetuated a crisis of confidence. In 1971, the Central Bank of Germany alone held enough dollars to exhaust the entire gold stock of the U.S. at $35 an ounce price. The atmosphere was dominated by the fears that the U.S. might devalue the dollar relative to gold.

iv. The 1971 Crisis:

In 1971, a flight from the dollar began, strong currencies were in great demand by the individual sellers of dollars. There was hectic activity in the foreign exchange markets and the central banks with strong currencies had to buy massive amounts of dollars in order to maintain exchange rates at the official par value.

In a vain effort to stem the tide, the central banks of strong currencies closed foreign exchange markets for a short period, allowed their currencies float upward temporarily, imposed exchange controls, and even charged negative rates of interest on foreign-owned deposits.

Thus, the international monetary system was confronted with two interrelated problems- (a) there was a general desire to sell dollars; and (b) the traditional buyers of dollars (i.e., foreign central banks) were not willing to purchase them. The foreign central banks began to redeem with the U.S. some of the huge dollar balances they were acquiring.

On August 15, 1971, President Nixon announced- (a) the suspension of dollar convertibility into gold; 0b) the imposition of surcharge of 10% on imports; and (c) the freezing of wages and prices. By the action of suspension of dollar convertibility into gold (or by ‘closing the gold window’), the U.S. withdrew its commitment to buy and sell gold at $35 per ounce.

This led to severing the link between gold and international value of dollar, and there- by abrogated the IMF agreement. President Nixon justified the suspension of convertibility on the ground that it was necessary to ‘defend the dollar against speculators’ who ‘have been waging an all-out war on the American dollar.’

But, in reality, this step was designed to force the foreign governments to raise the value of their currencies against dollar. The 10% tax on all imports into the U.S was also to remain effective until America’s trading partners agreed to revalue their currencies again of the dollar. Domestic wage-and-price freeze aimed at reducing U.S. inflation.

The foreign governments were, thus, left with two alternatives; (a) either to continue to maintain the existing exchange rates by accumulating more and more dollars without their convertibility into gold, and (b) to revalue their currencies in terms of dollar.

Simultaneous revolution of foreign currencies against dollar means devaluation of dollar against all foreign currencies. The foreign countries were reluctant to revalue their currencies because revaluation would make their goods more expensive relative to U.S goods and would -therefore have harmful effect on their exports and domestic economies.

v. Smithsonian Agreement (1971):

In response to President Nixon’s announcement, the currencies of the major industrial nations were left to float vis-a-vis the dollar on the one hand, and negotiations on international monetary reform began on the other.

Ultimately, an international agreement was reached in December 1971 at the Smithsonian Institute in Washington, D.C. Under the Smithsonian agreement, on average, the dollar was devalued against foreign currencies by about 8%, and the 10% import surcharge which the U.S. had levied to compel the realignment was removed.

The official gold price was raised to $38 per ounce. But, the dollar price of gold was now a non-price and had no economic significance because the U.S. did not agree to resume sales of gold to foreign central banks. The Smithsonian agreement also allowed the currencies to fluctuate within a wider range of 2.5%.

vi. The 1973 Collapse of the System:

Unfortunately, the Smithsonian agreement proved to be short ­lived. Sharp deterioration of the U.S. current account in 1972 and sharply higher U.S. monetary growth led to the general feeling that the Smithsonion devaluation of the dollar had been insufficient. Throughout 1972, there were further speculative capital flows out of dollars and into other currencies.

In February 1973, President Nixon announced a second devaluation from $38 to $42.22 per ounce of gold. In March, the major industrial countries abandoned their new parities. This was the end of the Bretton Woods system.

It was hoped that the adjustable pegs might once again be restored as soon as the exchange markets calmed down. But, these hopes gradually faded with the passage of time.

vii. America’s Inflationary Policies:

Many economists view the U.S. expansionary macroeconomic policy package of the late 1960s as a major blunder that eventually led to the collapse of Bretton Woods’s system by early 1973.

Over expansionary U.S. fiscal policy (mainly due to America’s involvement in Vietnam conflict) contributed to the need for a devaluation of the dollar in the early 1970s and the fears that this would happen caused capital flows out of dollars, which in turn increased foreign money supplies.

Higher U.S. money growth fueled inflation at home and abroad, making the foreign policy-makers increasingly reluctant to continue importing U.S. inflation through fixed exchange rates. When the U.S. (the reserve currency country) speeded up its monetary growth, it led to an automatic increase in monetary growth rates and inflation abroad because the foreign central banks had to purchase the reserve currency to maintain their exchange rates and expand their money supplies in the process.

The explanation of the collapse of the Bretton Woods system is that the foreign countries were forced to import U.S. inflation. In order to stabilise their domestic price levels and regain internal balance, they had to abandon fixed exchange rates and allow their currencies to float.

Thus, the history of the Bretton Woods system’s breakdown is the history of unsuccessful attempts by the countries to reconcile internal and external balance under its rules. The system of fixed exchange rates made it difficult for the countries to attain simultaneous internal and external balance without discrete exchange rate adjustments.

The architects of the Bretton Woods system had hoped that its most powerful member (the U.S.) would see beyond purely domestic goals and adopt policies geared to the welfare of the world economy as a whole. When the U.S. became reluctant to shoulder this responsibility after the mid 1960s, the fixed exchange rate system collapsed.

viii. Contradictory Nature of Bretton Woods System:

In fact the real and more fundamental reason for the collapse of the Bretton Woods adjustable peg system is the inherent weakness of the system itself. This adjustable peg system involved a latent contradiction between- (a) constant exchange rates, (b) autonomous national macroeconomic policies, and (c) international capital mobility.

The nations were unwilling to dispense with the second feature, and did not like to impose controls necessary to nullify the effects of the third feature. Thus, the first feature (i.e., the fixed exchange rates) must go. This is exactly what happened with the Bretton Woods adjustable peg system.

Conclusion:

In short, the Bretton Woods system was a unique example of an international monetary order created by conscious human effort rather than evolution. The creation was fatally flawed by a contradiction inherent in the system itself.

The system served its purpose at least adequately; it succeeded in promoting expansion of multilateral economic activity. But, this very success of the system also provided strength to its flaws, and ultimately shattered that system because it became inappropriate to changed circumstances.

Floating Exchange Rate System:

With the breakdown of the Bretton Woods adjustable peg system, most of the countries of the world have adopted managed floating exchange rate system 1971. Under this new system, the currency of a country is allowed to float on foreign exchange market and determined its exchange rate according to the market forces.

Floating rate does not mean complete absence of official intervention. The monetary authorities of a country may intervene to restrict the fluctuations in the exchange rate within certain limits.

Arguments for and against Floating Exchange Rates:

1. Arguments for Floating Exchange Rates:

The weaknesses of the Bretton Woods system led many economists to advocate floating exchange rates during early 1970s.

They gave the following main arguments in favour of floating rates:

(i) Under the floating rates, the government would be able to use monetary policy to reach internal and external balance.

(ii) Under a system of floating exchange rates the inherent asymmetries of Bretton Woods’ system would disappear. These asymmetries were the result of the dollar’s central role in the international monetary system.

(iii) Even in the absence of an active monetary policy, the swift and relatively painless adjustments of market-determined exchange rates would help the countries maintain internal and external balance in the face of fundamental disequilibrium.

2. Arguments against Floating Exchange Rates:

The critics of the floating exchange rates advanced the following counter-arguments:

(i) The central banks, which are now free from the obligation to fix their exchange rates, might embark upon inflationary policies.

(ii) Floating exchange rates might lead to destabilising speculation. Speculation on changes in the exchange rates can lead to instability in foreign exchange markets, and this instability, in turn might have adverse effects on countries’ internal and external balance.

(iii) Floating exchange rates would make international prices more unpredictable and thus harm international trade and investment.

(iv) If the Bretton Woods rules on exchange rate adjustment were abandoned, the door would be opened to competitive currency practices harmful to the world economy.

(v) The floating exchange rates would not really give countries more policy autonomy. The changing rates would increase the uncertainty in the economy without really giving macroeconomic policy greater freedom.

Floating Exchange Rates in Operation:

In order to have an idea of the actual functioning of the floating exchange rate, a brief survey of the historical events since 1973 is attempted below:

a. First Oil Shocks and its Effects (1973-75):

In 1973, the Organisation of Petroleum Exporting Countries (OPEC) sharply increased the world oil prices; by March 1974, the oil prices had quadrupled from its pre-war price of $3 per barrel to $ 12 per barrel. This created huge balance of payments deficits for the oil importing countries and balance of payments surpluses for the oil exporting countries.

This oil shock had the same macroeconomic effect as a simultaneous increase in consumer and business taxes had. The consumption and investment slowed down everywhere, and the world economy was thrown into recession.

At the same time, by directly raising the prices of petroleum products and the cost of energy using industries, the increase in the oil price caused the price level to jump upward. Thus, an unusual macro-economic phenomenon emerged which involved a combination of stagnating output and high inflation. Economists termed this phenomenon as stagflation.

b. Regaining Internal and External Balance:

In order to regain internal and external balance, the developed countries adopted expansionary fiscal and monetary policies during 1974-75. As a result of these policy measures, recovery from recession occurred and inflation rate fell. But, unfortunately, the unemployment failed to return to pre-recession levels, even as output recovered. The less developed countries financed their oil deficits in part by borrowing funds that the OPE countries deposited in the banks of industrial countries.

c. Second Oil Shock (1979-80):

The period of 1979-80 witnessed the second of oil price increase. Oil prices rose from $ 13 per barrel in 1978 to $32 per barrel in 1980. Once again the oil importing countries faced stagflation. Inflation increased sharply in all the industrialised countries, output growth slowed and unemployment rose.

The oil importing less developed countries ran persistently high balance of payments deficits. Heavy borrowings from the developed countries’ banks caused serious problem of debt crisis in less developed countries. The restricted monetary policies to control inflation led to the reduction of employment and output in the industrial countries.

d. Successful Working of Floating Rates:

During the period between 1973 to 1980, the floating rates seemed, on the whole, to function well. Specifically, it is unlikely that the industrial countries could have maintained fixed exchange rates in the face of the stagflation caused by two oil shocks. Particularly, the international adjustment to the first oil shock may be aptly considered as a success for the floating exchange rates.

Freed of the need to defend a fixed exchange rate, each country had chosen the monetary and fiscal response that best suited its goals. The easy borrowings of the less developed countries from the developed countries’ financial markets helped them to maintain their own spending and economic growth. The resultant increased capacity to import of the less developed countries from industrial countries also helped in mitigating the intensity of the 1974-75 recessions.

e. The Great Recession and the Adjustment Policies (1980 and after):

The years after 1980 brought a number of dramatic changes in the world economy. On the positive side, inflation rates throughout the industrialised world fell to their lowest levels since the Bretton Woods years. Some measure of price stability seemed to have been restored.

But on the negative side, the disturbing events of this period were so severe that they threatened the world trading and financial system. Many economists and policy-makers began to think the floating exchange rates as the major cause of the world’s economic problems and proposed a return to more limited exchange rate flexibility.

Contractionary monetary policies adopted by the industrial countries, after the second oil shock threw the world economy into the most severe recession since the great depression of 1930s. In 1982, and 83, the unemployment rates throughout the world rose to the unprecedented levels of the post-World War II period.

The poor economic performance and heavy deficits in the balance of payments during 1980s led the industrial countries to adopt protectionist policies. The problem of debt crisis in the less developed countries has become still more serious.

Lessons from Experience:

The question now arises- Whether the experience of floating exchange rate system supports the viewpoints of its advocates or critics? The answer to this question will help in arriving at definite judgment about the reforming of the current exchange rate system. The following are the broad lessons from the experience regarding the functioning of floating exchange rate system.

I. Greater Autonomy:

There is no doubt that the floating exchange rates gave the central banks greater autonomy to control their money supplies and to choose their preferred trend rates of inflation, but these floating rates also allowed a much larger international divergence in inflation rates and the exchange depreciation did not offset these inflation differentials over the floating rate period.

II. Illusion of Greater Autonomy:

The critics pointed out that the argument of greater autonomy under floating rates was only an illusion.

Two arguments have been given in this regard:

(i) Changes in exchange rates would have, such wide macro- economic effects that central banks would feel compelled to intervene heavily in foreign exchange markets, The experience has given support to this view.

After 1973, central banks intervened repeatedly in the foreign exchange markets to alter currency values. The post-1973 floating of exchange rates is often characterised as a ‘dirty float’ rather than a ‘clean float’.

(ii) The advocates of floating exchange rate system had argued that central banks would not need to hold foreign exchange reserves, but the central banks continued to hold foreign exchange reserves and these reserves increased considerably during the floating rate period.

III. Symmetry:

Since central banks continued to hold foreign reserves and intervene in the foreign exchange markets, the international monetary system did not become symmetric after 1973. The dollar remained the primary component of the official reserves of most of the countries.

IV. Automatic Stabiliser:

Experience has provided sufficient evidence in favour of the floating exchange rate operating as an automatic stabiliser.

(i) The world economy has undergone major structural changes since 1973. These changes have led to changes in the relative national output prices. Under such a situation, it is doubtful that any form of fixed exchange rates would have been viable.

(ii) The industrial economies operating under fixed exchange rate system certainly would not have weathered the two oil shocks as effectively as they did under floating rate system.

(iii) The effects of the U.S. fiscal expansion after 1981 illustrate the stabilising properties of a floating exchange rate. As the dollar appreciated, the U.S. inflation slowed down, American consumers enjoyed an improvement in their terms of trade and economic recovery was spread abroad

(iv) There is, however, an evidence against floating exchange rates. There was poor economic performance of industrialised countries in the 1970s and 1980s as compared to the 1950s and 1960s. Unemployment rates in these countries rose sharply after 1960s and labour productivity and real gross national product growth rates fell. These adverse developments occurred after the adoption of floating exchange rates.

But, this coincidence does not prove that, these developments were caused by floating rates. Various structural changes, such as, oil price shocks, restrictive labour market practices, worker displacement due to increase in the export of less developed countries, etc., might be the likely causes.

V. Destabilising Speculation:

If the speculators expect a further rise in the price of foreign currency (e.g., pound) when it is above the trend level and expect a further fall in the price of foreign currency (pound) when it is below and level, they tend to buy the foreign currency (pound) when its price is above the trend and tend to sell when its price is below the trend. This is the case of destabilising speculation. Foreign exchange rates have exhibited much more-day-to-day fluctuations than its advocators would have predicted.

There are a number of cases when the speculators produced destabilising effects. But, over the longer period, however, exchange rates have roughly reflected fundamental changes in monetary and fiscal policies, and their movements do not appear to be the result of destabilising speculation.

VI. Price Discipline:

Another argument against floating exchange rates is that they weaken internal price discipline and allow more inflation. The fixed exchange rate system puts more pressure on the deficit countries to deflate than on the surplus countries to inflate.

Thus, allowing the governments to switch over to flexible exchange rate system on the average, releases more inflationary policies, there is evidence that inflation did increase after 1973 and remained high through the second oil shock. But, the experience of disinflation in the industrial countries after 1979 proved that the central banks could control inflation under floating rates.

VII. International Trade and Investment:

Critics of floating rates had predicted that international trade and investment would suffer as a result of increased uncertainty. This prediction was certainly wrong on the investment side because international financial intermediation expanded considerably after 1973, as countries lowered barriers to capital movement. There is however, controversy about the effect of floating exchange rates on international trade.

The use of forward markets expanded dramatically, as the advocates of floating rates had foreseen and innovative financial instruments were developed to help the traders avoid exchange rate risks. But, the critics argue that the costs of avoiding risks are high and as a result of these costs, international trade has grown more slowly than it would have under the fixed exchange rate system.

VIII. Policy Coordination:

The floating exchange rate system has not succeeded in promoting better international coordination of macroeconomic policies. On many occasions, the countries could have attained macroeconomic goals more effectively by adopting a joint approach to common objectives.

But, the same problem also exists under the fixed exchange rate system. For example, under fixed exchange rates, countries can always devalue their currencies unilaterally to attain national goals.

Conclusion:

The actual experience does not fully support either the advocates or the critics of floating exchange rates. But an important lesson which one draws from the experience is that no exchange rate system functions well when international economic cooperation breaks down and the countries act on the basis of their narrow self-interest. The Bretton Woods system failed when the U.S. unilaterally adopted over-expansionary policies.

Similarly, the worst problems of the floating rate system arose when the developed countries failed to take coordinated action on common macroeconomic problems. There is no question of going back to fixed exchange rate system. Greater cooperation among nations can improve the functioning of the floating exchange rate system.

Reform of International Monetary System:

The present monetary system, i.e., the managed floating rates, has emerged in 1971 after the failure of Bretton Woods’s adjustment peg system. Experience has shown that the new system has also not been functioning fully well and is not without weaknesses.

Another lesson from experience is that as a solution to the problem what is required is not the replacement of the floating rates by the old adjustable peg system, but reforming the existing system to make it workable in a better way.

Various issues relating to the reforming of the present international monetary system can be classified in two broad groups- (a) issues relating to reserve assets, and (b) issues relating to exchange rate system.

Issues Relating to Reserve Assets:

With freely floating currencies, international reserves are unnecessary. So it might be thought that the substitution of managed floating for the adjustable peg system would reduce the need for reserves. But, this did not happen.

The huge American payments deficits of 1970-73 greatly expanded international reserves of dollars. Thus, there was dollar overage at the time when Bretton Woods system collapsed.

This means that there was huge holdings of inconvertible dollars that the central banks did not want, but could not dispose of without disturbing the exchange markets. Also since 1973, total international reserves (other than gold) have grown more slowly than the value of total world exports.

Thus, it was never felt that the world reserves are excessive. The problem instead centred upon the composition of reserves, and particularly to the role of currency reserves and the asymmetric position of the U.S. as a reserve centre. Thus, during floating exchange rates the world continued to face the same problems of confidence and asymmetry as it did under Bretton Woods’s system.

Other problems of the reserve assets are discussed by taking each asset separately:

i. Gold:

The general attitude towards gold in recent years has been to phase it out as a reserve asset. The recent actions have also been consistent with this goal. The IMF no longer accepts gold in Fund transactions, and gold has been displaced by the SDRs for IMF purposes. The IMF has also disposed of one-third of its gold holdings.

The amended Articles of Agreement do not require currencies to be pegged to gold; thus there is no official price of gold. There have been very few central bank gold dealings in recent years. In short, gold has become basically an inactive asset.

But, this, however, does not imply that gold’s long history as a monetary asset is about to end. The sharp rise in the price of gold has generally increased the market value of gold reserves, both absolutely and relative to other reserve assets.

Gold has also become the most volatile reserve component because of its changing price. Under such conditions, it is not unlikely that the large payments imbalance may induce the central banks to start dealing in gold. Then the passive gold will acquire an active role.

ii. SDRs:

The IMF wants that the SDRs should become the principal reserve asset. But, there is a long way to go for achieving this goal. At present, SDRs account for less than 3% of world reserves. They have been moderately used.

The U.S. and the U.K. have both been significantly active with the allocation of SDRs, and less developed countries have sold-substantial amounts of SDRs to the oil exporting countries. Thus, for making SDRs a principal reserve asset, it is necessary that the role of reserve currencies be formalised and limited.

iii. Reserve Currencies:

The role of dollar has been and continues to be the major issue of international monetary reform. Since 1973, discussions have mainly focused on ways to make dollar more like other currencies, i.e., to reduce the asymmetrical position of the U.S.

Two proposals have been put forward in this direction- (a) the establishment of an IMF substitution account which will accept dollar deposits from central banks and, in return, provide an equivalent amount of SDRs; (b) multi-currency intervention requiring a basket of currencies to replace the dollar as principal currency. But both these proposals have not materialised.

In practice, however, there has been a definite tendency to reduce the role of dollar and make it share its unique position with other currencies.

The following facts confirm this tendency:

(i) The central banks have been diversifying their holdings of foreign exchange and reducing their reliance on dollars.

(ii) The creation of the European Monetary System (EMS) necessarily reduces the dollar’s share in the total currency reserves by adding up another non-dollar currency, i. e., European Currency Unit (ECU).

(iii) The decision of a small group of countries, mainly oil exporting countries, to diversify the currency composition of their newly acquired liquid holding also reduced the relative importance of dollar.

(iv) There has been some increase in the use of non-dollar currencies for intervention purposes; many nations now peg to currency baskets rather than to the dollar.

(v) SDR has displaced the dollar within the IMF as a unit of account.

Thus, the traditional view that an efficient international monetary system requires a dominant currency to take a leadership role, has been abandoned. There is now a general feeling among the world community that the international monetary system is a matter of collective concern.

Issues Relating to Exchange Rate Regime:

Bretton Woods adjustable peg system was abandoned because it ceased to be feasible due to the basic weakness inherent in the system. It contained contradictory features- (a) stable exchange rates; (b) autonomous national macroeconomics policies; and (c) extensive international transactions.

The nations were unwilling to dispense with the second feature and did not like to impose controls necessary to nullify the effects of the third feature. Thus, the first feature must go.

Now the floating exchange rates have come to stay and most of the countries of the world have acknowledged that they are prepared to live with floating rates for the indefinite future.

The current controversy is no longer concerned with whether a general system of adjustable pegs should be reintroduced, or with the relative merits of fixed versus floating rates. On the contrary, the controversy is regarding whether and how intervention ought to be internationally regulated under the managed floating exchange rate system.

In order to avoid disorderly fluctuations in the exchange rates and allow the national intervention in accordance with some international guideline, various formal rules have been suggested. The IMF, on two occasions, has made general statements on the subject.

The Fund issued in 1974 the Guidelines for the management of Floating Exchange Rates, and in 1977 the Text of Executive Directors Discussions of Exchange Rate Policy Surveillance. But the debate regarding the formal rules continues. At present, the discussion centres round four types of norms for behaviour.

a. Leaning against Wind:

The idea of leaning against the wind was put forward in the IMF Guidelines as a measure to reduce the exchange rate fluctuations. ‘Leaning against the wind’ implies the correction of disorderly market conditions. The basic idea is that central banks should intervene to resist but not neutralise market forces.

In other words, short-term exchange rate fluctuations should be reduced, but long-term trends should be dictated by the market Most of the actual interventions since 1973 seems to have been of this sort.

There are two main weaknesses of the policy of leaning against the wind:

(i) The countries may lean too much and prevent needed exchange rate adjustment.

(ii) The policy may result in speculative capital movement and thus may increase exchange rate fluctuations. A depreciation of a currency, for example, may cause speculators to sell that currency if they feel that authorities are resisting the depreciation. This will induce further downward movement.

b. Targets:

The use of targets is another proposal to avoid large fluctuations in the exchange rates. Target values should be set for the various exchange rates and authorities should then intervene so as to move exchange rates towards these targets.

The idea of the use of the targets has been favoured by those who would like to return to adjustable pegs, but also realise that it is not practicable. The targets are not to be interpreted as pegs that must be maintained. Indeed, the targets can be altered or abandoned if they lead to too much intervention.

c. Objective Indicators:

Some individuals have recommended that indicators should be used and the countries should alter their intervention policies when these indicators signal the existence of substantial disequilibrium.

A country is required to stop leaning against the wind, or to alter its exchange rate target, when the total of such intervention reaches a pre-set limit. The problem with the use of indicators is that they can induce speculative movement.

Suppose, a country is selling its own currency in the foreign exchange market to prevent an appreciation. If the country accumulates reserves up to the point where the indicator would require that intervention should stop, the speculators would increase their purchase of the currency in anticipation of its subsequent appreciation.

d. Reference Rates:

Still another proposal is that the reference rates should be set and revised periodically at levels consistent with the national economic policies of the countries involved. The aim of such a proposal is not to directly reduce exchange rate fluctuations, but to help prevent aggressively nationalistic intervention policies.

The danger of this proposal is that the reference rates might be regarded as pegs and therefore bring back some of the problems of adjustable peg system.

Conclusion:

The following conclusions emerge from the above discussion of international monetary reforms:

(i) The system of managed floating exchange rates has come to stay and there is no move to go back to adjustable peg system.

(ii) The current debate is not over the relative merits of fixed or floating exchange rates, but regarding whether and how intervention ought to be internationally regulated under the managed exchange rate system.

European Monetary System (EMS):

The European Monetary System (EMS) is a step towards European economic integration. It aims at providing a zone of monetary stability and better economic relations. Full monetary union has been the ultimate goal of the European Economic Community (EEC).

The objective of the EEC countries was to have stability of fixed exchange rates among themselves, but, at the same time, to have flexibility in the exchange rates with the rest of the world. To achieve this objective, a strategy of gradualism was adopted.

The first step in this strategy was the attempt to establish a system called the “snake-in-the-tunnel” in 1972. It refers to a band of exchange rate fluctuations for the currencies of the member countries narrower than the bands adopted by the other countries in general after the Smithsonian agreement.

Under this system, the EEC member countries (West Germany, France, Belgium, the Netherlands, Luxembourg and Switzerland) would confine stabilisation efforts to maintaining the current fixed rate relationships only among their own currencies, while allowing their currencies to float against all others. This arrangement continued after the collapse of the Bretton Woods system in 1973.

In March, 1979, eight members of the EEC (i.e., West Germany, France, Italy, Belgium, Denmark, Ireland, Luxembourg, and the Netherlands) introduced a new arrangement, known as European Monetary System (EMS). Under this system, the member countries agreed to fix their mutual exchange rates and float jointly against the U.S. dollar.

Objectives and Working of EMS:

The following are the main features of the EMS:

i. Purpose of EMS:

In the words of the European Monetary Council- “… the purpose of the European Monetary System is to establish a greater measure of monetary stability in the community. It should be seen as a fundamental comprehensive strategy aimed at lasting growth with stability, a progressive return to full employment, the harmonization of living standards and the lessening of regional disparities in the Community. The European Monetary System will facilitate the convergence of economic development and give fresh impetus of European Union.”

ii. European Currency Unit (ECU):

Under the EMS, the member countries contribute 20% of their reserves of gold and dollar holdings to the European Monetary Cooperation Fund. In return, they receive equal- valued quantities of European Currency Units (ECUs). ECU is a composite currency (just like the SDR) containing specified amounts of EEC currencies.

ECU is used for the official transactions within the EEC. The intention is that the EMS should become the EEC central bank, with the ECU as the EEC currency. The medium-term goal is to set up a European Monetary Fund to issue ECUs and extend credit to member country central banks.

iii. Exchange Rate Mechanism:

EMS provides a system of fixed but adjustable exchange rates. Each participating currency has a central exchange rate expressed in terms of the ECU. The member countries undertake to maintain exchange rates with fluctuation margin of plus or minus 2.25% (6% for the Italian Lira).

When a currency’s market exchange rate diverges sufficiently, from the central rate, the member country that issues the currency is expected to intervene and take other policy actions to correct the situation.

iv. Symmetric Intervention:

EMS rules call for a symmetric intervention procedure when an exchange rate reaches the limit of its range. In this procedure, the weak-currency country loses reserves and a strong- currency country gains.

For example, if the French frank depreciates to its upper limit against the German DM, the French central bank must rectify the situation by selling the DM reserves. At the same time, the German central bank must lend the necessary DM to the central bank of France.

v. Periods of Strain:

The IMF has identified 18 distinct periods of strain within the EMS between March 1979 and August 1986. These periods of strain are marked by the reports of substantial interference in the exchange market by intervention, capital and exchange controls, or measures of monetary policy motivated by exchange rate developments. On average, there have been exchange rate realignments once every ten months.

Despite these periods of strain, the EMS has proved to be durable and relatively successful system. The continuing operation of the EMS is mainly due to the monetary cooperation of its members, particularly due to the extension of credit from strong-currency members to weak-currency members.