CHAPTER 9 Reform of the International Monetary System, or Nonsystem?

Harold James
Published Date:
June 1996
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The dollar crisis of August 1971 clearly constituted a threat to the Bretton Woods parity system, but it also challenged the most fundamental underpinning of the Bretton Woods order, the belief in a general and progressive liberalization of international trade and payments. The American action, and the manner of its implementation, appeared to herald a protectionist response to external imbalances. Within a few days, many of the discussions of the 1960s about the reserve problem had become obsolete. Instead, the new and urgent task lay in remaking an international monetary system so that countries could solve adjustment problems effectively and without embarking on trade measures that would harm the welfare of the world as a whole. The reform effort, which constitutes the subject of this chapter, proved extremely arduous. Only after a number of false starts, as well as very large external shocks and a proliferation of institutions attempting in their own way to deal with the growing international anarchy, could any durable reform results be achieved.

The system before the 1970s had hinged fundamentally on a rule, the commitment of national authorities to the maintenance of a fixed parity. Though the classical Bretton Woods system was obviously not a pure gold standard, its impersonal and rule-based character was symbolized by the position of gold as an international store of value and a major reserve unit. At the end of 1970, gold represented two fifths of the sum of international reserves. After the crisis of August 15, 1971, the share of nongold reserves in the world’s total mounted rapidly. The demand for international reserves was more than filled in a technical sense (a major inflation of reserves began), but perhaps not in a spiritual sense. Once the link with the dollar at the $35 price had been broken, gold appeared more than ever to some as the only major store of value that could not be manipulated at the urging of national governments. After August 15, 1971, paper or fiat money was triumphant in the international system, but the demise of gold left for many a vacuum in the world’s monetary order.

I’ve come to a decision, Charles. From now on, I refuse to take the dollar seriously.”

When the rule was broken, however, the tasks devolving on the institution that had supervised its implementation became greater rather than lesser. Because the breakdown of the par value system created greater turbulence and larger current account imbalances, the call for coordinating action became louder. Over the period 1966–70, the average sum of global current account imbalances had been $26 billion; in 1971–75 it was $76 billion.1 In the course of the 1980s, the imbalances would increase yet further, as the evolution of capital markets made possible their financing. The end of fixed parities created new incentives for banks to engage in international transactions, and new possibilities for gain. Most banks had previously confined themselves to domestic activity; by the 1970s, they sought a wider field. While current account imbalances became larger, and in many cases their financing became easier, in some instances the private markets were unwilling to finance these imbalances, and international financial institutions in consequence had a newly enlarged role thrust upon them (see Tables 9-1 and 9-2).

Table 9-1.Summary of Payments Balances on Current Account1(In billions of U.S. dollars)
Industrial countries20.3–10.819.80.5–2.232.7–5.6–40.10.6–1.2
United States9.17.621.27.5–11.3––2.7
United Kingdom–1.3–6.9–2.6–
Other industrial countries5.5–8.1–5.1–9.6–12.6–3.5–12.3–26.3–15.5–14.4
Developing countries
Oil exporting countries6.768.335.440.330.22.268.6114.365.0–2.2
Non-oil developing countries–11.3–37.0–46.3–32.6–28.9–41.3–61.0–89.0–107.7–86.8
Source: International Monetary Fund, World Economic Outlook, 1983. p. 185.

On goods, services, and private transfers.

Source: International Monetary Fund, World Economic Outlook, 1983. p. 185.

On goods, services, and private transfers.

Table 9-2.Ratio of IMF Quotas to Selected Economic Indicators(In percent)
Aggregate IMF quotas in relation to:
World imports9.64.24.4
World nongold reserves57.018.218.5
Nongold reserves of developing countries49.913.717.5
Current account imbalances of industrial countries1117.357.927.0
Overall imbalances of industrial countries1153.758.588.7
Current account imbalances of developing countries171.919.234.7
Overall imbalances of developing countries1196.544.654.2
Source: International Monetary Fund.

For the group of countries indicated, the figures shown are the ratios of aggregate Fund quotas or maximum absolute access for those countries to the aggregate of those countries’ current account imbalances or overall imbalances summed without regard to sign. Overall balance is the sum of the current account and capital account balances.

Source: International Monetary Fund.

For the group of countries indicated, the figures shown are the ratios of aggregate Fund quotas or maximum absolute access for those countries to the aggregate of those countries’ current account imbalances or overall imbalances summed without regard to sign. Overall balance is the sum of the current account and capital account balances.

The practical activities of the IMF in all fields—in providing surveillance of exchange and monetary policies, in providing balance of payments assistance, and also in attempting to redesign the system—as a result increased rather than decreased. The uncertainty as to the use of gold in the international monetary system also affected the IMF, whose gold holdings had increased very substantially in the last years of the par value system (from 1965 to 1971, the Fund’s gold almost doubled).2 Seen institutionally, the traumas of 1971 to 1973 were less a fundamental break than the prelude to a period of energetic and intensive surveillance of the international monetary order. In order to ensure that this was as effective as possible, some modification of the legal framework for the activity of the IMF was required.

Trade Liberalization

One of the signs of the emerging crisis in the Bretton Woods system in the late 1960s was the attempt of countries to change and manipulate the international financial system for national advantage. The United States depended increasingly on the status of the dollar as a reserve currency in order to finance its overseas military expenditure. The United Kingdom feared any reform that would erode its own reserve status. France wanted to halt what it regarded as an American abuse of the system. Germany felt that its surpluses were leading to an inflation imposed from the outside; but Germany and Japan at the same time did not want a change in the international system that might affect their own powerful export performance. Some developing countries wanted to tie reserve creation to greater development assistance. National currencies consequently became a playball of international politics.

Once, however, the system had collapsed, the danger existed that the battleground between nations for relative advantage would shift to a more destructive area, and that countries would fight for increased national prosperity and status by resorting to trade measures. Trade restriction constitutes an obvious and immediate response to current account imbalances. Such action, however, would have been likely to undermine the basis on which the “miracle” of postwar growth had been achieved.

The 1950s and 1960s had been decades of the opening of world trade. The U.S. Trade Expansion Act of 1962, which gave the President authority to undertake radical reductions in tariff rates, as well as constituting “one of the greatest legislative accomplishments of Kennedy’s presidency”3 was “the high point of trade liberalism.”4 The Kennedy Round (1964–67) of negotiations under the General Agreement on Tariffs and Trade (GATT) was the most comprehensive reduction of barriers to trade in manufactured products, in which the participants abandoned the item-by-item discussions of the past and adopted an “across-the-board” approach to the reduction of barriers to trade, involving linear tariff reductions. The result was a 35 percent average reduction in industrial tariffs and the general acceptance of an antidumping code.

By the end of the decade the momentum for trade liberalization, the great engine of postwar economic growth, had fallen away. The Common Agricultural Policy (CAP) of the European Economic Community (EEC), implemented in 1966, imposed a flexible external tariff and severely restricted U.S. agricultural exports to Europe. The EEC refused to discuss the CAP in the context of the GATT Kennedy Round. The emergence of balance of payments problems in the world’s largest economy, which had until then unhesitatingly and unquestionably been the main initiator and sustainer of the liberalization process, produced a new and more assertive approach to trade policy. In 1970, the U.S. Congress almost passed the Mills bill, which would have imposed quotas on textiles and shoes. It put pressure on the administration to formulate its own response to the challenge of foreign imports. At the fateful Camp David meeting, on August 13, 1971, Nixon explained his problem in characteristic terms: “We don’t confront a theory, we confront a fact. We can screw around with an exchange rate but Mills is coming in with an import surcharge.”5 The 10 percent surcharge on a broad range of imports, imposed by President Nixon as part of the August 15, 1971 package, was imitated by other countries with similar problems: by Denmark and Argentina already in 1971. The new round of GATT after 1973 (the Tokyo Round) proved much more difficult than its 1960s predecessor.

The mechanisms of the GATT were also circumvented in the course of the 1970s. In the United States, the issue of free trade versus protectionism had always been highly controversial. Political pressures worked to undermine the practice of free trade even at the height of its influence. After 1977, in dealing with the sensitive issue of Japanese-American trade, the device of the VER (voluntary export restraint) provided an increasingly popular way round the GATT’s strict prohibition of industrial quotas. U.S. trade partners would be obliged to take responsibility for limiting the flow of goods. In theory VERs were intended to avoid “market disruption,” but in practice they were often invoked at very low levels of actual imports.6 In the case of the most promising manufactured export for many industrializing countries, textiles, the same principles were applied.

Even within the framework of the GATT, there was an increasingly discriminatory practice that was at odds with the principles of the Agreement. In 1974 the Long-Term Arrangement Regarding International Trade in Cotton Textiles (of 1962) was replaced by the much more comprehensive Arrangement Regarding International Trade in Textiles, the so-called Multifiber Agreement, as a consequence of alarm in industrial countries about the rapid growth of textiles and clothing exports from developing countries. (From 1960 to 1970 production of textiles and clothing in developing countries had grown at 58 percent and 66 percent, respectively, compared with a rise of 46 percent and 24 percent in the developed countries.)7 The new arrangement included all textiles of wool, cotton, and synthetic fibers. It relied on a discriminatory targeting of countries for trade control in contravention of the most-favored-nation (MFN) nondiscriminatory rule at the heart of the GATT process. (It also imposed welfare losses on the restricting countries,) By the mid-1980s, one expert concluded that the GATT was in “a state of breakdown.”8

The Floating Option

Solving the exchange rate issue as a result had very far-ranging implications for the future of world economic cooperation. A failure would be likely to end the prospect of “one world” and split the world into competing and rival trade blocs. Between 1971 and 1974 the international monetary system moved toward floating, not so much because this was an agreed solution, but because it emerged out of a failure to produce an agreed solution.

There were few significant political advocates of floating (although it commanded a substantial academic following) at the beginning of the “disintegration of Bretton Woods.” Karl Schiller, the German Economics Minister and at first the only enthusiastic political “floater” on the international stage, was outvoted in the German cabinet in a debate over the international position of the deutsche mark, and resigned in 1972. After 1972, the new U.S. Treasury Secretary, George Shultz, also believed that floating represented the best outcome, but he was at least at the outset unwilling to articulate this position in an international context which was looking for a “solution” to the currency problem. In June 1972, the Chief Economist of the U.S. Office of Management and Budget, the Chicago economist Arthur Laffer, when discussing this issue with IMF officials merely argued not “that a floating rate system would be a preferred alternative but rather that it might not be such a bad alternative.”9

In fact, floating emerged as the only possible solution because of unwillingness to agree over the character of a fixed rate system. The final outcome as a result came commonly to be described as a “nonsystem” (Gottfried Haberler added acerbically “by those whose blueprints have not been followed.”)10 Within a few years, countries had adopted a wide variety of different strategies for the management of exchange rates. In 1975, countries accounting for 46 percent of foreign trade of IMF members were floating their currencies independently, with differing degrees of intervention; 14 percent had pegged their currency to a single currency (usually the dollar); 12 percent had adopted a peg of composite currencies; and 23 percent of international trade was accounted for by countries engaged in a joint float (principally within the European context).11

The G-10 at Work

At first the consensus hope was that discussion between national authorities would lead to a new stability. “Is it not possible,” the Bank for International Settlements (BIS) asked in its Annual Report for 1972, “for statesmen to guide public opinion to see the advantages of restoring the exchange parity to equilibrium?”12 The first response to the “Nixon shock” was to attempt a solution within the system, using the existing mechanism of the G-10 deputies and ministerial meetings. Immediately after August 15, 1971, Paul Volcker proposed that the G-10 should begin a discussion of exchange rate realignments and a return to general convertibility at fixed parities, even though this might well prove a hopeless task. “This initial effort may well have a relatively high probability of failure—but, even if it fails in its immediate objectives, it could be important in keeping open the path to ‘benign regionalism’…. To try and fail is not to lose. It will tend, in all probability, to maintain a more constructive attitude internationally than an appearance of turning our back.”13 Following this strategy, the Chairman of the U.S. Federal Reserve Board, Arthur Bums, asked Jelle Zijlstra, President of the Netherlands Bank and of the BIS (and a former Prime Minister of the Netherlands), to act as an “honest broker” in determining an “area of settlement” for the G-10.14 Zijlstra’s discussions produced a recommendation for a change in the overall payments balance somewhere between the $ 13 billion demanded by the United States and the $8–8.5 billion figures provided by the IMF and the Organization for Economic Cooperation and Development (OECD). But when it came to drawing the consequences for exchange rates, he felt that he could only recommend a very modest devaluation of the dollar against gold. As a result, the Zijlstra suggestions did not result in any breakthrough.

At the Rome meeting of the G-10, November 29 to December 1, 1971, Paul Volcker began the exposition of the American position with a paper recommending an average appreciation of the non-U.S. OECD currencies of 11 percent relative to the rates before the floating of the deutsche mark, as well as wider margins (to make the position of speculators more difficult), and in addition a greater measure of defense burden sharing (to take the strain off the U.S. balance of payments). In the discussion, Treasury Secretary John Connally surprised the Europeans, who had been thinking in terms of the small 5–6 percent change of the dollar rate debated in the Zijlstra talks, and suddenly began “hypothetically” to speak about a U.S. devaluation of 10 percent. The German Economics Minister, Karl Schiller, responded by stating that the maximum that Germany could revalue the deutsche mark against the dollar was 12 percent. The French Finance Minister said that he had no authority to negotiate an agreement, and the discussion in consequence failed to reach a conclusion. Connally was very visibly frustrated at the inconclusiveness of the G-10 approach: two weeks later he complained at a meeting between the French and American Presidents in the Azores (December 13–14, 1971) that “in my judgment we can’t keep on month after month holding these Group of Ten meetings without some specific results.”15 The G-10 gave too much play to the Europeans, and produced too much pressure on the United States.

Indeed, the high political meeting of the Azores did produce an agreement where the G-10 had reached an impasse. France became the authorized spokesman for European concerns in a bilateral European-American discussion. Before French President Georges Pompidou saw Nixon, he held talks with the German Chancellor Willy Brandt, and agreed to restrain American pressure for a large German revaluation. After the Azores discussion with Pompidou, Nixon accepted at last that the dollar should be devalued by increasing the price of an ounce of fine gold from $35 to $38.

The new pattern of exchange rates could then be set in the meeting of G-10 ministers and governors at the Smithsonian Institution in Washington on Friday and Saturday, December 17 and 18, 1971.16 As a bargaining tactic, Connally held out the threat that if there was no agreement on an overall pattern of rates this time, the result would be a generalized floating. He stated that he “likes floating,” but acknowledged “responsibilities vis-à-vis other countries.” He also put the meeting under time pressure by insisting on a 3 p.m. deadline for the Saturday meeting and ruling out the possibility of continuing further discussions on the Sunday.

The atmosphere of the meeting was described as “carpet trading” by the German Minister, Karl Schiller, The Managing Director of the IMF continually jotted down new numbers as the participants haggled. The beginning was inauspicious. The French Finance Minister, Valéry Giscard d’Estaing, thought it would have been better to delay the discussion until the end of January, and reflected that fundamentally the current meeting had no real purpose. It was Schiller who first broke through the hesitancy of governments to commit themselves to a new rate. Germany agreed to a 13.57 percent revaluation of the deutsche mark against the dollar rate of May 1971 (before the German float).

Connally then turned his attention on the Japanese Finance Minister Mikio Mizuta, with a statement that it was “irresponsible that Japan does not move.” There should be a 20 percent yen revaluation; only gradually did Connally modify this into a demand for at least a 4 percent difference in Japanese and German revaluations vis-à-vis the dollar. In private, he told other finance ministers of his fear that Mizuta might commit hara-kiri if pressed too far. Mizuta said that the 20 percent figure was “out of the question … unprecedented in history,” and the G-10 would be “responsible for political, social and economic repercussions,” and create “a bigger world recession.” Eventually, after telephone conversations with Tokyo, he agreed to a 16.9 percent revaluation of the yen, and referred subsequently to “the greatest economic shock that Japan had experienced since the end of the World War.”17

The determination of the other parity values was much easier. France and the United Kingdom did not change the gold rate, and thus appreciated by 8.6 percent against the dollar; Italy and Sweden devalued by 1 percent against gold, and thus appreciated their currencies by 7.6 percent against the dollar. Canada would continue its float. The general outcome was a devaluation of the dollar by about 10 percent against the other G-10 currencies.

As it turned out, the Smithsonian rates lay quite close to the figures produced in August by the IMF Research Department, which had given a Japanese revaluation of 15.3 percent as necessary for balance of payments adjustment, a German rate of 12,5 percent, and 9.4 percent for Italy, 8.7 percent for France, and 7.2 percent for the United Kingdom. (The Federal Reserve Board’s August calculations were also very close: Japan, 15 percent; Germany, 12.5 percent; France and Italy, 6 percent; and the United Kingdom, 5 percent.)18 The political process had ended, after a good deal of tension and suspicion and hostility, with figures very close to those proposed by the technical economists in the first place. With this measure, the world’s currency crisis might have come to a conclusion—but it did not.

New Uncertainty

At the Smithsonian, the G-10 also accepted the Volcker suggestions, originally made at the Rome meeting, for wider margins (2.25 percent each way from a central rate, or 4.5 percent in all) of permitted exchange rate movements than the 1 percent each way provided under the Bretton Woods system. Richard Nixon euphorically described the complete package as “the conclusion of the most significant monetary agreement in the history of the world.”19

In practice, it soon became clear that the Smithsonian had solved very little. The U.S. trade balance deteriorated dramatically, as a result of the fall in export prices and the inevitably slow adjustment of demand to the new export prices (the so-called J curve). More important, the United States delivered a second, and final, blow to the par value system. The Smithsonian parities might have held, had it not been for a highly expansive U.S. monetary policy—the result of a political determination by the U.S. administration, and the acquiescence of the Federal Reserve System, not to let international considerations stand in the way of domestic economic objectives. (These were also political objectives: President Nixon believed that he could draw a lesson from history. He thought that the Federal Reserve System’s concern about the current account deficit and its tightening of interest rates had lost him the very narrow 1960 presidential election. The moral for him was that he should avoid losing his re-election bid in 1972 in a similar fashion.) Nixon, having publicly celebrated the agreement, launched a policy that in effect dismantled that agreement as a sacrifice to his own political future. In 1972, U.S. M2 rose by 12 percent.20 The administration hoped that the wage and price controls imposed over the August weekend would channel all the monetary growth into economic expansion. The U.S. economy did indeed grow rapidly, and sucked in imports. In 1971 the trade deficit had been $2.27 billion, in 1972 it was $6.42 billion, and an improvement only came in 1973. it was the late summer of 1972 before the Federal Reserve started to apply restraint.

The dollar had remained the leading international reserve currency, despite its devaluation. The rest of the world’s large dollar reserves were in practice inconvertible in the absence of an official gold price, and the U.S. expansion produced a large international monetary growth. The surplus countries were committed to expand because of the large inflows of dollars. Monetary growth in 1971 in Japan was 25.5 percent; in Switzerland 18.2 percent; and in Germany 12.3 percent; in 1972 the effects of U.S. monetary expansion were almost as dramatic (the figures were 22.1, 13.4, and 13.7 percent, respectively).21 Deficit countries could also expand as they looked at the U.S. example (monetary growth in the United Kingdom was 13.3 percent in 1971 and 16.5 percent in 1972). In a fixed rate system with increasing doubts about its sustainability, discipline crumbled. Everyone could expand. The combination of U.S. monetary policy and the large reserve role of the dollar now constituted a greater threat than ever.

The Europeans complained about the “indifference” of the U.S. government toward short-term capital outflows and the deteriorating trade balance, which appeared to indicate a renewed version of the policy of “benign neglect.” They started to develop once more plans for a European currency area—the outcome that Volcker had envisaged as the logical response to American actions, and now described as “benign regionalism.”22 In March 1972, the European countries realized some of the reform proposals of the late 1960s by agreeing that their currencies would only move within narrower (2.25 percent) margins relative to each other, and not in the wider band (4.5 percent) now permitted under the Smithsonian agreement. If currencies reached the outer 2.25 percent limits of their bilateral rate, both the central banks involved were committed to intervene to correct the situation. This narrow intra-European band of fluctuation was generally known as “the EC snake in the Smithsonian tunnel.”

The first indications of a crisis in the new international system came from the United Kingdom, the only major industrial country apart from the United States with a large deficit position. British policy had been highly inconsistent. The United Kingdom had joined the European snake, but at the same time the government encouraged a very fast rate of monetary expansion and explained that it did not feel itself limited by exchange rate commitments. In his annual budget speech in April 1972, the Chancellor of the Exchequer, Anthony Barber, had said: “It is neither necessary nor desirable to distort domestic economies to an unacceptable extent in order to retain unrealistic exchange rates, whether they are too high, or too low.”23 Between June 16 and 22, 1972, $2.6 billion moved out of the United Kingdom, two thirds going into deutsche mark, and on June 23, 1972, the British government announced a temporary float of sterling. The subsequent history of the snake was volatile, and in its initial incarnation, the arrangement was effectively destroyed in January 1974 when a crisis forced the French franc out. France rejoined in 1975, but in March 1976 opted out for the second time.

The inflow of 1972 into Germany opened once again the heated domestic debate waged since the late 1960s on how to prevent such external events leading to an increase in the German money supply and in inflation. Karl Schiller’s solution was to let the external rate float once more, but an unstable external rate was unpopular politically and was opposed by much of the industrial and banking world. The critics argued that it would make German foreign policy particularly difficult, as the pressure imposed on the French franc would alienate France. The alternative to floating involved the use of provisions in the Law on the External Economy in order to impose restrictions on capital movements.

Already in March 1972, the Bundesbank had imposed a requirement that banks make a cash deposit of 40 percent of any sum borrowed from abroad (Bar-Depot). Capital controls appeared as a way of stabilizing the exchange rate and thus preserving Franco-German harmony and with it stability in the EEC. The President of the Bundesbank, Karl Klasen, suggested this course in a letter of June 26, 1972 to the -Federal Chancellor, Willy Brandt, without the knowledge of Schiller, and it provided the basis for a bitterly divisive cabinet discussion on June 28, 1972. The day before, Switzerland had acted against the inflow by implementing a similar measure, prohibiting foreign purchases of securities and property. During the cabinet debate, Schiller attempted to suggest a joint European float against the dollar, although it was highly doubtful whether France would have been willing to join.24 But a large part of the argument concerned itself with domestic, not international, politics. The government had been weakened by parliamentary defections during the debates over ratification of the treaties negotiated by Brandt to recognize the eastern borders of the Federal Republic, and Brandt had just decided to hold premature elections later in the year. The great attraction of Klasen’s suggestion lay in the promise that controls might be a way to keep the deutsche mark stable until after the elections, and the cabinet voted unanimously against Schiller.25 Nonresidents now required a permit to buy domestic bonds; and the Bar-Depot provisions were tightened.

The German move found immediate American support. Arthur Burns, a committed supporter of fixed rates, issued a statement welcoming the German announcement. In July 1972, the Federal Reserve system began for the first time since the August 1971 crisis to intervene in the exchange markets to support the dollar against the deutsche mark. The U.S. Treasury acquiesced in a move designed to frustrate what it termed “disorderly markets.”26 In practice, the stabilization was only ephemeral.

A Final Collapse

The system held for a few months, as Klasen had promised, until well after the German parliamentary elections in September 1972. But in January 1973 major movements started once more. On January 11, the United States announced the end of wage and price controls, and flows out of the dollar began. On January 20, Italy introduced new measures to halt capital flight, with the unintended consequence that there was a new dramatic flow of funds into Switzerland, to which on January 23 the Swiss National Bank reacted by stopping intervention in the currency markets “until the situation calms down.”27 In practice, this meant that the Swiss franc was now floating.

At the beginning of February 1973, the instability extended further as press reports about the record U.S. balance of payments deficit in 1972 appeared at the same time as 1972 German figures showing a DM 14 billion ($4.4 billion) surplus on the basic balance, and a large surplus on the long-term capital balance, reflecting the scale of foreign purchases of German securities. After the crisis had broken out, a highly secret plane trip by Paul Volcker to negotiate new parities provided the five minutes to midnight initiative for a rescue in the drama of the fixed par value system. On February 8, 1973, in Tokyo, he insisted on a new revaluation of the yen by at least 10 percent against the dollar. The Japanese authorities eventually agreed to a free float until they reached a dollar rate for the yen of 264 (which would have amounted to an appreciation of 17 percent). One of the decisive impetuses came from the message from the German Finance Minister, Helmut Schmidt, that “if you don’t accept, there will be economic war between the United States and Japan” (Schmidt had secured the transfer of responsibility in the German government for money and credit policy from the Economics to the Finance Minister). On February 9, 1973, the Bank of Japan closed its foreign exchange market, and the float began. Volcker’s proposal to the Europeans, which he unfolded in Bonn, involved a 10 percent dollar devaluation against the European currencies. On February 10, 1973, the European markets closed. The IMF’s management immediately reached the conclusion that “if the crisis led to widespread floats, this should not be opposed, and it should be recognized that the float might be prolonged”; but also that “bearing in mind continuing sensitiveness on the part of the U.S., the Fund should have a ‘low profile’ in any negotiations that might be called so as not to prejudice its role in the reform.” In other words, the Fund had decided that fixed parities were dead and that it would only destroy itself were it to stage a quixotic attempt at their resurrect ion.28 In the final crises of spring 1973, however, the IMF still appeared to he hanging onto the principle of fixed rates.

When the new package for the de facto dollar devaluation as negotiated by Volcker was presented in Washington by Treasury Secretary Shultz, it sounded only half convincing. At the same time as stating the new parity, Shultz also said that the United States had “undertaken no obligations to intervene in foreign exchange markets” and that the United States would end capital controls (the interest equalization tax and the Federal Reserve voluntary program for bank restraint in foreign lending). Behind the scenes he was as unhelpful in maintaining the new parities or rescuing the system as could be imagined. He did not return the anxious telephone calls of the German Finance Minister Helmut Schmidt, and he showed no signs of being concerned about the situation.

It is perhaps more surprising that calm set in for a few weeks in February 1973 than that in March frenetic trading resumed on the foreign exchange markets. On March 1, 1973, as the Bundesbank needed to issue DM 8 billion on a single day (equivalent to 16 percent of the currency in circulation), Vice-President Otmar Emminger came to the conclusion that the markets had sounded “the death knell for the Bretton Woods parity system.” On the evening of March 1, Volcker in the United States had already reached the conclusion that “he could not find that there was any strong backbone in Europe to resist current developments.”29 The next day, the Bundesbank announced that it was not in a position to keep the dollar rate steady. On March 3, the Managing Director of the IMF sent a telex to the German Finance Minister recommending massive currency interventions. But by this time the death rattle of par values had already begun.

On March 4, 1973, the EEC Finance Ministers considered a joint float, and the debate continued at two enlarged G-10 meetings in which the smaller EEC states also participated, on March 9 and 16. The fundamental breakthrough occurred in between these two sessions, at the EEC Council of Ministers on March 11–12, when France agreed to join the German float, on the condition of a deutsche mark revaluation of 3 percent relative to the French franc. The United Kingdom ruled itself out by insisting on extravagantly impossible conditions (“essential” conditions including financial “support without limits of amount, without conditions, and without obligation to repay or to guarantee”), and Ireland and Italy also remained outside the new EEC currency system.30 The G-10 on March 16 simply ratified the results of the Council of Ministers. In meetings of the G-10 deputies on March 9, the representatives of both the IMF and the OECD had made clear the view of their institutions that, “the present structure of rates should be defended. Unlike other crises in the recent past, the latest one was not due to inadequate exchange rates. Finally, if the present rates were not defended, the outlook for agreed rates would be dim indeed.”31 But one week later, the G-10 accepted the principle of floating, with the proviso that “official intervention in exchange markets may be useful at appropriate times, to facilitate the maintenance of orderly conditions, keeping in mind also the desirability of encouraging reflows of speculative movements of funds.”32

The impetus that drove the EEC was not so much any intellectual predisposition to accept market principles in the sphere of exchange rates, but rather the force of the speculative movements of capital created by the existence of one-way betting opportunities. The major imbalances between the national economies loaded the chances for the world’s bankers realize speculative profits to such an extent that they could not be convinced to remain inactive by any amount of persuasion by finance ministers in institutional settings such as the G-10 about the stability and desirability of the old system. Short of correcting the fundamental imbalances, which would have required a major sacrifice of domestic political objectives, the only way of keeping stability in the world’s financial system would have lain in the imposition of capital controls so extensive that they would have progressively paralyzed the world’s trade. This, however, would have been another, and absolutely certain way, of destroying not just the Bretton Woods system but also the philosophy and the hopes that had underlain it.

The United States in particular was not willing to undertake a dramatic adjustment with the enormous associated domestic political costs for the sake of no more than a remote possibility of rescuing a “system.” George Shultz made the point almost as bluntly as John Connally might have done when he said that “Santa Claus is dead.”33 The United States would not act as a global monetary savior, if this meant altering the chances for a reelection of President Nixon.

Institutional Reform

The dictation of events by the market took place at the same time as politicians, civil servants, and central bankers were considering institutional ways of reforming the international system. The experiences of November and December 1971 destroyed any confidence the U.S. administration had had in the G-10 as a suitable forum for international monetary debate. It suffered institutionally from the overrepresentation of Europeans, and perhaps also, some Americans thought, from the nonrepresentation of the developing world. The EEC members caucused in advance of meetings. And in the final analysis, as at Rome in December 1971, the Europeans had refused to come to a conclusion.

At the same time, the U.S. administration distrusted the IMF as it was then run. Partly the suspicions lay in personal factors, in Connally’s belief that the Managing Director, Pierre-Paul Schweitzer, had expressed his lack of support for the Viet Nam war too publicly, or that he was personally unsuited, or that he allowed the staff of the Fund too much leeway. Connally’s initial luncheon meeting with Schweitzer was widely remembered by both Treasury and Fund officials as a fiasco, in which the Treasury Secretary repeatedly left the room to make telephone calls and eventually left in a state of agitation.34 The crisis of 1971 made the relationship much more strained; and the United States resented the public way in which Schweitzer called for a dollar devaluation. In the summer of 1972, the IMF Executive Board moved very quickly in working on reform within the context of the Fund. The result was a paper on “Reform of the International Monetary System.” The belief that this reform exercise was being hurried, and that in consequence the interests of the United States would be ignored, formed the final charge in the American list of complaints against Schweitzer.

The Fund paper tried to draw lessons from the 1971 debacle. “A major task will be to ensure that the balance of payments targets of countries, in particular industrial countries, will be compatible with one another as well as realistic both domestically and within the framework of the international economic situation.” There should be more prompt par value adjustments. In determining the new parities, the Fund would “rely on one or more objective indicators,” which would be oriented toward analysis of the balance of payments.35 (A model would be the Research Department’s work in proposing altered rates before the 1968 G-10 meeting in Bonn, and again before and during the August 1971 crisis.) For the United States, this looked like too much interventionism by the Fund.

Before the 1972 Annual Meeting, the United States insisted that Schweitzer should not be reappointed to a full term when his current term expired in September 1973, and this apparent American high-handedness provoked a demonstrative show of support at the meeting for Schweitzer, with a long sustained round of applause for the Managing Director. The French Finance Minister, Giscard d’Estaing, complained publicly at the meeting that “in an international organization governed by democratic principles, it would be inconceivable that the attitude thus taken by the great majority should ultimately be disregarded.”36 U.S. officials also devoted a great deal of energy to the issue of the selection of a new Managing Director. They started by looking for a European candidate who was not “inclined to monetarism” (that is, to the wish to apply discipline to the United States); and eventually supported the candidacy of the Secretary-General of the OECD, Emile van Lennep.37 But many developing countries reacted strongly against the idea of a figure chosen by the United States to replace the popular Schweitzer. As a result, the new Managing Director was the Netherlands economist (from the Rotterdam School of Economics) and former Finance Minister Johannes Witteveen, It would be wrong to see the strains between the United States and multilateral institutions solely in terms of personality conflicts. The fundamental tension in the relationship came as the result of the United States being unwilling to submit itself to the discipline required for a continued maintenance of the parity system.

Witteveen’s managerial style was more austere, less collegial, and rather closer to Jacobsson-style high-level diplomacy, than Schweitzer’s. Sometimes he was called “the professor” by the IMF’s staff. He provided an impressive and dominating intellectual presence at ministerial meetings, and during his tenure gained respect from figures as diverse in their political views as Helmut Schmidt and the very pro-market Treasury Secretary of the Ford administration, William Simon (who held Witteveen in high esteem while regarding the management of the World Bank with suspicion). The Witteveen approach involved the preparation of impressive technical arguments for a particular course of action, while keeping silence about the more political and contentious calculations that surrounded them. In the atmosphere of the 1970s, this looked the most promising way of preserving the Fund’s influence and appeal among the world’s governments.

Any institution charged with designing a reform had to grapple with the basic problem. Its chances of success from the outset were small, in view of the permanent tension between an American suspicion of being dictated to by a multilateral institution, and the non-Americans’ fear of multilateral institutions being manipulated in accordance with U.S. policies and interests. This almost insurmountable obstacle was euphemistically described at the time38 as “a failure of political will”; but it would have required very large quantities indeed of political will to persuade either Americans to play Santa Claus again or non-Americans to think that the United States could possibly be Santa Claus.

After deliberations within the G-10, the industrial countries came to the conclusion that the reform process was to be managed within the context of the Bretton Woods system and the Bretton Woods institutions, but not by the Executive Board of the IMF. Its instrument was the “ad hoc Committee of the Board of Governors on Reform of the International Monetary System and Related Issues,” or the Committee of Twenty (C-20). The Twenty were the Governors of the Fund corresponding to the 20 “constituencies” that existed for the appointment of the Fund’s Executive Directors. Since the Committee was to include for each of the constituencies a finance minister, a central bank governor, and a senior civil servant (or “deputy”), the meetings began with 60 members, in addition to the Managing Director, and the Committee’s own staff. The meetings as a result tended to be unworkably large, to be dominated by what the chairman of the C-20 deputies later called “multilateral monologue”; and the practical work in actuality depended on the deputies (who met for two to five days every second month) and the subcommittees they formed.

The intention of the C-20 was highly ambitious: “to consolidate all that earlier work and to build, as at Bretton Woods, a complete design for an international monetary system that would last for 25 years.”39 In the immediate aftermath of the Smithsonian discussion, the C-20 had been envisaged as only a part of a complete reform exercise, which would involve the OECD as well as other institutions in the consideration of trade issues, and also of the monetary system. In April 1972, at the G-10 meeting that had begun the discussion of reform, the U.S. representative had wanted the new body to consider the relationship between the IMF and the GATT, and arrive at a general division of “burden sharing” in commercial as well as financial matters between surplus and deficit countries, but the continental Europeans had objected to the prospect of recommendations about the appropriate shape of their “economic space.”40

The first meeting of the C-20 took place during the IMF Annual Meeting in September 1972. The Finance Minister of Indonesia, Ali Wardhana, was elected chairman of the Committee, and Jeremy Morse of the Bank of England chairman of the deputies. The debates for the next 15 months, until January 1974 when the Committee recognized the failure of its broad mission, revolved around the conflict between an American position and a widely held alternative viewpoint that came to be most articulately and forcefully presented by France and its representatives. The United States insisted on the establishment of some automatic mechanism for forcing surplus countries to reduce their surplus positions. The Europeans responded by arguing that the principle of equality in the international system required a provision for the convertibility of dollar reserves into gold or foreign exchange. As crystallized in the phrases “adjustment” (United States) and “asset settlement” (Europe), these positions resulted in a complete deadlock. Could there be an escape route?

The parallels with the negotiating positions at Bretton Woods are quite striking, and some participants of the C-20 discussions and many observers since have enjoyed pointing out the irony of how the national stances reversed 28 years after the 1944 meeting.41 Now it was the United States that was left with the arguments of Lord Keynes. The American negotiators, not the British, were concerned with preserving limits on the convertibility of their reserve currency, while their parliamentarians muttered about applying the scarce currency clause to other countries; and the Europeans and the Japanese, not the Americans, resisted the application of measures to force expansive measures on countries with large creditor positions. But these similarities in argumentation should not lead to the conclusion that American political or economic power had also declined to correspond with the British position in 1944. The United States had suffered merely a relative slippage: and as in 1944, its negotiators believed that the United States should not be obliged to carry all the costs and burdens of probable adjustment, and successfully sustained that belief through the course of the complex negotiations.

The American standpoint was announced lucidly and forcefully by Secretary of the Treasury George Shultz during the September 1972 annual Fund and Bank meetings. Shultz began with the recognition that most countries wanted to maintain a fixed parity, and suggested that the SDR should become the formal numeraire of the system. But “in a system of convertibility and central values, an effective balance of payments adjustment process is inextricably linked to appropriate criteria for changes in central values and the appropriate level, trend, and distribution of reserves.” He then argued that a “surfeit of reserves” indicated a need for adjustment: “disproportionate gains or losses in reserves may be the most equitable and effective single indicator we have to guide the adjustment process.” Implementing these proposals would require the “guardianship of the International Monetary Fund, which must be prepared to assume an even more critical role in the world economy.”42

These proposals appear in a more developed form in a paper circulated by Paul Volcker and J. Dewey Daane (a member of the Federal Reserve Board) after the November 1972 meeting of C-20 deputies, in which the issue of dollar convertibility was linked to the establishment of compulsion toward the surplus countries. It used the concept, already discussed in the IMF Executive Board, of “objective indicators.” “The most promising approach is a system in which disproportionate changes in a nation’s reserves in either direction serve as objective indicators that balance-of-payments adjustment measures are needed.” Under Bretton Woods, “while overt competitive devaluations have not been important, many countries [that is, Germany and Japan] still more or less consciously have aimed for payments surpluses and adapted their economic policy instruments to that end.” “Reserve indicators” would he used to establish a “convertibility point” (this is renamed in later versions of the Volcker plan as “primary asset holding limits”): if a country’s reserves rose above this point, it would no longer be eligible to convert them into primary reserve assets. If at this point the country failed to take action to promote expansion as a way of achieving adjustment, it would be subjected to “sanctions” or graduated pressure applied by the IMF.43

A subsequent U.S. paper spelled out the underlying objectives of the American negotiators. “The international monetary system cannot in the U.S. view function on a sustained basis with a settlement mechanism and obligations which are certain and definite, and an adjustment mechanism which is uncertain and indefinite.” The purpose of indicators lay in calling attention to emerging disequilibria, suggesting which “nation of nations should take corrective action,” and inducing “international pressures against countries which refused to correct large or persistent imbalances.”44 Or, as Volcker put it even more candidly, there was “just no possibility of the United States accepting mush on the adjustment side and good red meat on the convertibility side, the sort of balance some deputies seemed to be envisaging.”45

An important part of the U.S. position involved the argument that in the existing system, the Fund consultations under Article VIII or Article XIV had insufficient impact to produce the adjustment required for the working of the international monetary mechanism.

A European alternative proposed a different kind of indicator, using not reserve levels, but the “basic balance” concept employed by the IMF: the current account and net long-term capital movements. The problem with the indicator concept was, as French officials pointed out, that it might give information to markets that would allow them to anticipate the likely action of monetary authorities, and thus frustrate the effects of intervention; and because its operation in practice would require an international arbiter or umpire in order to make a judgment about what would be sustainable or desirable capital movements. But such a verdict would be hard to reach, the Fund acknowledged. “In this regard it is scarcely likely that an international organization in the foreseeable future could administer changes in parity using objective indicators.”46 The Italian C-20 deputies, Rinaldo Ossola and Silvano Palumbo, proposed a multilateral asset settlement, in which the United States would pay or receive SDRs equivalent to its deficit or surplus, and ceilings would be imposed on the holdings of reserve currencies.

France wanted to retain fixed par values, and the fundamental equilibrium and exchange rate notions “that had been the foundations of the Bretton Woods system.”47 In the eyes of Giscard d’Estaing, August 1971 had not been a faillire of the principle of fixed parities but rather a “condemnation of the usage made of it by the largest reserve currency country.”48 Reform would require asset settlement as a way of ending the dollar’s “exorbitant privilege.” His criticism seemed especially valid in the light of U.S. behavior after August 1971. A consistent French objective lay in ending the excessive role of national currencies in international reserves with the purpose of “banaliser le dollar.”49 A later French proposal attempted to heal the transatlantic rift and make concessions to the U.S. intention to force surplus countries to adjust by suggesting that countries whose reserves rose above a certain level should make additional deposits at the IMF that would be subject to charges (“negative interest”).

The aversion of France for floating came partly from an intellectual tradition of attachment to fixed values (a very candid French internal memorandum explained that, if anything, the French economy had suffered slightly under the par value system, because its social structure produced higher cost increases than its neighbors’ and thus an overvalued exchange rate). It also reflected the conviction that the international monetary order should not be used as a field for the exercise of power politics; that the system as operated in the 1960s had allowed the United States to exercise hegemony; and that in a floating order, regional exchange rate blocs would emerge. In the European case, “inside the Community, the relative weight of the most powerful countries, and notably that of the Federal Republic of Germany, will be increased.”50 In this way, the debate about the reform of the monetary system appeared to be a struggle for world power and influence in a new world order.

The deputies’ technical groups considered the details of the indicators and adjustment process proposals, and evolved a solution based on a fundamentally subjunctive argument: what would a model for adjustment and convertibility look like? The politics of such an arrangement were deliberately set aside in the hope that the eventual solution would be so intellectually compelling as to dissipate the recalcitrant objections of national politicians. The precedent for this aspiration lay in the great example of the Bretton Woods proceedings. One analysis of the reform failure later concluded that the technocrats had stumbled because of their unwillingness to provide politicians with a politically acceptable model of adjustment, and that if the IMF staff rather than the inadequate C-20 secretariat had been given the task they might have prepared a coherent general blueprint, which the politicians could then have accepted triumphantly as their own work and the outcome of the reform initiative.51 By 1973, however, the political divergences had become too large simply to be bridged by a technocratic arrangement.

Another of the deputies’ technical groups examined the problem of disequilibrating capital flows. The greater room for international maneuver for banks, and the new profit opportunities in foreign exchange transactions, were evidently a consequence of the collapse of the par value system. Like the participants of Bretton Woods, the reformers worried about the extent to which a system might be destroyed by the movement of capital. It was in this context that suggestions were debated along lines that in the long run eventually led to the formulation of capital adequacy requirements for commercial banks. One proposal involved “slow[ing] down the growth of the [Eurocurrency] market and … reduc[ing] inequalities in the competitive positions of domestic and Euro-currency banking” by applying reserve requirements to banks’ foreign currency operations. The majority in this group, however, came to the conclusion that “any attempt to impose coordinated restrictions on the marker would either be ineffective because the market would be driven elsewhere or would jeopardize a useful and efficient capital market.” The view that the market should not be interfered with was strongly supported by representatives of developing countries, who saw in the Euromarket “an important source of external finance, which they could ill afford to lose.”52 The international financial chaos was indeed in the 1970s accompanied by a lending boom, which eventually burst, but only in 1982.

In any case, in the climate of the early 1970s these questions were set aside because of the inordinate attention given to the high politics of the convertibility and adjustment dilemma. Common international regulatory standards, as eventually evolved in the 1988 Basle Agreement, would bring some measure of discipline to cross-national banking flows and reduce the attractions of movements designed primarily to overcome particular national regulatory or accounting provisions. But such agreements lay in a rather distant future. At this stage, the international financial community was not prepared to accept such an international regulatory standard. Only the collapse of some banks linked as a result of foreign exchange dealings, in particular of the Bankhaus I.D. Herstatt in June 1974 and then in October of the Franklin National Bank of New York (and major losses of the Lugano subsidiary of the Crédit Suisse in September 1974), made bankers more aware of the existence of a problem.53 Even after this, the discussion of regulation proceeded very very slowly.

By September 1973, detailed models of the adjustment and convertibility processes had been prepared, including the mechanism of reserve indicators, graduated pressures, and the possible suspension of convertibility for a country with a large surplus (subject to a decision that would be made by the IMF). There was a fundamental deadlock, with one side insistent on adjustment and the other side on settlement. Only the turmoil caused by the oil price shock in lare 1973 at last forced the participants to rethink their positions. Then the markets developed largely independently of the wishes or intentions of policymakers. The monetary expansion and the activity of international financial markets meant that the reserve problem disappeared altogether as a global concern: there were clearly sufficient reserves, although the extent of global imbalances meant that they were badly, or unequally, distributed. In addition, the United States remained by default the major issuer of reserves. Both the major potential alternative suppliers of a new reserve currency, Germany and Japan, feared the potential effects of reserve use on their own ability to control domestic monetary behavior and the external exchange rate. In consequence, they were for the moment unwilling to take many of the liberalization measures that might have made their currency more attractive as a reserve asset.

The Price Surge

In the early 1970s, the growth of the world’s money stock accelerated sharply. Between 1961 and 1969, it had grown fairly consistently at annual rates of between 6 percent and 9 percent; in 1971 it rose to 11.7 percent, in 1972 to 12.8 percent, and in 1973 to 13.0 percent.54 The new push was fueled not only by Nixonian expansionism—though that was the principal cause. U.S. developments were seen elsewhere partly as a model, partly as an excuse for imitation. The consequences in terms of national policy of a fixed rate system plagued with increasing doubts and decreasing discipline have already been noted. The result was a simultaneous cyclical expansion of the major world economies of a kind not seen in the 1950s and 1960s, and an intensification of inflationary pressure.

World trade also grew at a very fast pace at the beginning of the new decade, both in terms of values and quantities. Indeed Figure 9-1 indicates how the volume of world exports rose above a growth trend line after 1968. (A logarithmic scale is used so that a constant growth rate appears as a straight line.) The sudden shocks occurring through the decade, and shown in the figure, might be interpreted as a worldwide reaction to ovetheating, and a return to the older trend in the 1980s of increased exports and the step by step establishment of global interdependence.

Figure 9-1.World Exports

(Logarithmic volume, with calculated trends)

Source: United Nations, International Trade Statistics Yearbook.

One of the most striking consequences of the international inflation of the early 1970s was the surge of commodity prices. Between 1970 and 1973, world prices of nonfuel commodities rose by 70 percent, and food by 101 percent. To many at the time, these developments appeared so dramatic that they could only be explained in terms of the approaching exhaustion of the world’s natural resources. The inputs required by modern industrialized and technological production—minerals, fertilizers for agricultural production, fuel—seemed finite. Predictions of rising consumption were placed along estimates of existing supplies. Daily events underlined the drama of the “limits to growth.”55 Some fertilizer plants shut down in the United States in 1970 because of a shortage of natural gas, and in consequence fertilizer prices rose, and increased the costs of food production, particularly in developing countries. Chance climatic influences also played a role. Widespread harvest failures in the U.S.S.R., China, India, Southeast Asia, and parts of Africa led to a doubling of U.S. wheat prices.56 The most dramatic developments concerned the price of petroleum.

Until the beginning of 1971, oil prices had been nearly stable in nominal terms. The price of a barrel of Saudi Arabian light crude had been $1.93 at the beginning of 1955, and in January 1971 was $2.18. Because of world inflation, the real price of oil had fallen throughout the 1960s, despite rapid economic growth and a consequent rise in demand. The highly political nature of petroleum production appeared to be working to keep down the oil price. The argument that political influences—the ascendancy of the industrial oil consuming countries—were responsible for low prices came to be even more compelling in the inflationary environment of the early 1970s. Producer countries began to resent an international system that produced such an unequal result. Then currency instability made the world economy more unjust. The fact that the oil price was set in dollars and that in 1971 and 1973 the dollar was devalued relative to other major industrial currencies increased the unease of the producers. The Kuwaiti Oil Minister is reported to have said: “What is the point of producing more oil and selling it for an unguaranteed paper currency ?”57 By January 1973, the price of Saudi Arabian light crude had risen to $2.59, a substantially slower increase than that of the commodities index.

The other dramatic commodity price changes of the early 1970s raised questions about the international distribution of wealth and power in a much sharper form than ever before. The Organization of Petroleum Exporting Countries (OPEC), which had been created in 1960 as an instrument to protect oil interests, especially with regard to prices and revenues from oil exports, had been largely inert until the beginning of the 1970s. In 1970 the Libyan government negotiated substantial rises in prices and taxes, which formed the basis of OPEC agreements concluded in 1971 at Teheran and Tripoli intended to maintain the real value of oil revenues. After the dollar devaluations, the oil prices were altered accordingly.58 In 1973, oil producers started to use oil as a weapon to alter both politics and the price structure, an instrument of “oil nationalism.”59 Throughout the year, oil prices increased; and an acute conflict over pricing broke out in the fall. The petroleum market tightened with the outbreak of the Yom Kippur war in October, and the application of sanctions against those countries that openly supported Israel. In December, the producers applied their power to the market, and the price increased almost fourfold from the October levels. Saudi light crude was now selling at $11.65.

The new oil prices transformed the discussion of the world’s balance of payments problems. It was difficult for importing countries to alter their energy consumption habits immediately, and they faced greatly increased import bills. A massive and unanticipated transfer of wealth took place as the oil revenues of OPEC tripled in 1974 (from $33 billion to $108 billion), a sum representing more than one eighth of total world exports.60 The result of the shock indeed turned out to be a transformation of the overall balance of payments (excluding reserves and exceptional financing) of the industrial countries from a deficit of $7,279 million in 1973 to one of $22,530 million in 1974; and for the non-oil developing countries a surplus of $10,970 million in 1973 turned into a deficit of $307 million the following year. The United States, whose payments situation had improved in 1973, with an overall payments deficit of $5,234 million, deteriorated again to $8,815 million in 1974. Germany, which was highly dependent on imported energy, moved from a surplus of $9,481 million in 1973 to a deficit of $692 million in 1974, and the U.K. deficit increased from $2,127 million in 1973 to $6,978 million in 1974. Japan, moving into its first recession since the Second World War, kept a positive balance only as a result of the collapse of domestic demand. The oil exporting countries, on the other hand, generated huge surpluses: the figures for the overall balance of payments show an increase from $3.6 billion in 1973 to $38.5 billion in 1974 (individual 1974 figures: Saudi Arabia, $10.4 billion; Iran, $7.2 billion; Nigeria, $5.1 billion; and Venezuela, $4.5 billion).61

For the industrial importers, the oil price shock raised the question of policy adaptation. The higher price might be regarded as the imposition of a new and unexpected tax that would depress incomes and growth. Should the effects be offset by some measure of fiscal stimulus, even at the risk of higher rates of inflation? The answer to this question inevitably depended heavily on the pattern of national domestic politics. Some states with painful memories of inflation, such as France and Germany, and some states that for other historical reasons were highly sensitive about their dependence on imported energy, such as Japan, took the course of speedy adjustment by deflating their economies. In other countries, where the internal political situation was unstable and where politicians feared the effects of depression, the painful day was deferred. Adjustment, which had been the most thorny issue in the C-20 discussions, now posed a more acute, more politicized, and more apparently insoluble problem than ever.

A Temporary Halting of Reform

Much of the impetus for systemic reform had already disappeared after the currency crisis of March 1973. The C-20 ministerial meeting in March had responded by reiterating that the group had reached “general agreement on the need for exchange-market stability and on the importance of Fund surveillance of exchange-rate policies.” But there was a recognition that “floating rates could provide a useful technique in particular situations.”62 At the beginning of 1974, as the C-20 deputies met in Rome to bury the reform discussion, the IMF’s Managing Director, Johannes Witteveen, stated the shift in the world consensus about international currency management. “In the present situation, a large measure of floating is unavoidable and indeed desirable.”63 But by this time, the Middle East oil embargo against the Netherlands and the United States, and the dramatic oil price increases announced at the end of 1973, had transformed the international economic situation, and posed a very different and threatening kind of adjustment problem. Oil finally both drowned the larger reform project, and at the same time eased the achievement of a limited agreement.

The C-20 deputies met on January 14–15, 1974, and there followed a ministerial meeting on January 17 and 18. Both sets of meetings agreed not to pursue reform proposals in the current international environment, but rather to recommend some much more modest patchwork repairs to what had remained of the old system: the strengthening of the IMF’s surveillance function by the addition of a continuing body for ministerial meetings, and the elaboration of conditions and rules for floating. Institutionally, the gravity of the situation and the magnitude of the adjustment problem after the oil crisis required a stronger Fund that would exercise surveillance. At the end of the discussion in the deputies’ meeting, Paul Volcker said: “The structure of the Fund was adaptable to any system, and the Fund itself might become more important in the absence of complete reform than otherwise.”64 As Witteveen pointed out in the ministerial meeting, widespread worries about the ability of the private sector to recycle the petroleum-induced imbalances required the activity of international institutions as a stabilizing influence. “The Euro-currency market would certainly have an important role to play in the financing of the deficits of oil-consuming countries, but a certain amount of concern had already been expressed about the development of that market and he did not believe that it would be wise to rely on it completely to finance the enormous current account deficits that were expected to develop.”65

Floating as a principle of conduct became ever more attractive, and the day after the Rome meetings, after new flows out of the French franc, France announced that it was Leaving the European snake and embarking on an independent free float. The optimists hoped, as one of the deputies put it in the Rome meeting, that “as floating rates stabilized and were better understood, that they would gradually approximate a fixed rate system.”66

The final outcome of the C-20 was published as the Outline of Reform in June 1974, after a last meeting of the Committee in Washington. The C-20 on this occasion declared that: “it may be some time before there is a return to a system based on stable but adjustable par values or to general convertibility; nor will the full arrangements for management of the adjustment process and of global liquidity necessarily be feasible in the period immediately ahead.”67 But a reformed system should have reserve indicators defined in a way agreed by the IMF; provide for the convertibility for the settlement of imbalances; not use controls on capital transactions to maintain inappropriate exchange rates; manage global liquidiry through the use of the SDR as the principal reserve asset; ensure that the adjustment, convertibility, and liquidity arrangements were mutually consistent; and, finally, promote a net flow of real resources to developing countries. The C-20 left as a legacy an important and new institutional mechanism, as well as some theoretical innovations and a political controversy.

The Europeans had proposed in the C-20 ministerial discussions the alteration of the structure of the Fund so as to provide for a “new permanent decision-making organ in the Fund on ministerial level,” with 20 members corresponding to the Fund constituencies or the composition of the C-20.68 This proposal led to the creation of what was called the Interim Committee (in lieu of a permanent Council), which took on a substantial policymaking task.

The most substantial theoretical outcome of the C-20’s deliberations about rules for a new system was a lengthy discussion of the principles for the management of floating exchange rates. The original paper prepared by the IMF’s Research Department was frequently discussed in the IMF at Executive Board meetings, and went through 50 drafts. An initial proposal for the general establishment of “target zones” was rejected. It proved almost impossible to define what was meant by the “manipulation” of exchange rates. The guidelines as eventually elaborated recommended intervention “to prevent or moderate sharp and disruptive” daily and weekly fluctuations. A country should not “act aggressively” in interventions—that is, attempt to push the market in the direction in which it was moving—except when such action constituted part of an effort to “bring its exchange rate within, or closer, to some target zone of rates” agreed in consultation with the IMF. Countries with floating exchange rates would also be encouraged to define a broad objective for the development of reserves.69 In practice, however, the target zones provided for in these guidelines were never created; and this topic remained a theme for largely academic debate over the next two decades.

Already during the C-20 discussions, a much more potentially controversial subject had re-emerged: the question of the flow of resources to the developing world. At the same time as the C-20 was replaced by the Interim Committee, a parallel Joint Ministerial Committee on the Transfer of Real Resources to Developing Countries (known as the Development Committee) was created. The oil price increase had created an unprecedented shock to poorer oil consuming economies. The current account deficit of non-oil developing countries rose from $4.8 billion in 1973 to $28.8 billion in 1974 and $38.5 billion in 1975.70 But the oil shock had also given an example of how commodity producers could use economic power apparently to alter the functioning of the international economic system and, as a result, contributed to the acute politicization of international economics. This issue will be the theme of Chapter 11.

Looking back on the experience of the C-20, the chairman of the deputies, Jeremy Morse, said that the reform process had been destroyed by inflation: “High levels of inflation make it hard to maintain par values or, more generally, a fully structured international system.” Those who had pushed most vigorously to replace the old system with a more flexible system of rates had argued that the causation worked in the reverse direction and that it was fixed parities that transmitted and perpetuated international inflation. Morse now spoke about the creation of an “internationally managed system” that was neither a planned nor a market system. But it was beginning to shift as the discussions had developed toward a market order. Morse acknowledged: “If the reformed system incorporates … a policy bias towards par values, market forces in the period ahead may continue to push the other way.”71 Two years later, at the IMF Annual Meeting in Manila, U.S. Treasury Secretary William Simon said: “market forces must not be treated as enemies to be resisted at all costs, but as the necessary and helpful reflections of changing conditions in a highly integrated world economy with wide freedom for international trade and capital flows.”72

A dramatic shift had occurred: from a widely held consensus that some kind of internationally planned response to the crisis of the world economic system was required, to an urgent insistence by the most powerful countries that only the market, and no amount of reform of the system, could provide a solution. Why did this shift occur? To a large extent the answer lies in the changing understanding of the mechanics and implications of reform. This in turn was a response to international inflation and to its most obvious and disruptive manifestation, the oil price shock. Higher petroleum prices raised fundamental issues about the operation of the international system and made much more urgent a resolution of the reform discussion.

The international financial system was well on the way to becoming a “nonsystem.” The result of divergent national policies and the response of increasingly active international capital markets to that divergence first produced increased pressure on rules that seemed to limit the scope for countries’ realization of their national interest. Then many of the fundamental rules of the system were discarded. With regard to monetary relations, all the members of the IMF came to he in breach of the Articles of Agreement by 1973.73 With regard to international trade, the GATT rules were being evaded and circumvented through arrangements such as the Multifiber Agreement. Particularly after the setbacks to growth, many countries wanted to continue explicitly pro-growth Keynesian policies and saw international rules as constraining their options. Most participants in the international order nevertheless became profoundly worried by the prospect of living in a ruleless world. They attempted to salvage some of the rules in a partial form. The GATT was not abandoned. The international monetary system was to be reformed, despite the failure of the C-20 debates. In regional contexts, notably in Europe, there were attempts to save essential elements of the fixed parity system.

Once a system is abandoned, it is very hard to agree on a new set of rules. Floating became generally accepted as an outcome of the systemic crisis, less because of the theoretical preferences of the main actors than because it required the least rules for its operation. Even then, attempts to draw up “guidelines for floating” proved difficult, because it appeared to defeat the point of the exercise, which lay in not making choices and leaving decisions to the market.

As each successive crisis exploded on the world stage, the feeling grew that the new situation was too tough to be handled by the old system, and in this way, stage by stage, the system was demolished. First the August crisis of 1971 convinced all countries that new parities were needed to achieve international adjustment of payments imbalances. The currency crises of 1972 and 1973 persuaded politicians that arriving at a new parity structure was a practically impossible feat. Then the commodity and oil price booms added a new dimension to the adjustment problem, in that the amount of adjustment required became radically unpredictable. Looked at in one way, crises were needed to break a system of rules that had become too inflexible—and also to punish the politicians who had tried to manipulate them. The actual outcome showed that the process of breaking rules was likely to lead to more and more pronounced disturbances. Breaking the classical Bretton Woods system brought temporary relief, but then the enormous costs and mounting instability became more apparent. The world began to look for a new guide to monetary policy.

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