CHAPTER 10 Personalities and Institutions The Redesigning of the International Monetary Order

Harold James
Published Date:
June 1996
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The end of the classic Bretton Woods system and the failure of the attempts to restore it were accompanied by very large current account imbalances in most countries. To a great extent the immediate cause of these lay in the oil price shock; and the immediate problem lay in the adjustment required by the increased cost of petroleum imports. As oil importing countries responded to their new deficits, they set off a major world recession. Or, to put the point in another way, the shock involved a massive transfer of resources to the oil producers, whose failure to spend their new wealth instantaneously slowed down the expansion of the global economy. More-over, the end of fixed parities removed a discipline and allowed almost all countries to pursue faster monetary expansion, with the result that the world money supply grew (Figure 10-1). Widespread floating thus immediately accelerated international inflation. This chapter examines the changes required in the international system as a result of the new transfer problem and the new need to redefine the practice of surveillance in an order no longer based fundamentally on a rule. The uncoupling of the international system was formally recognized in 1976 with the Jamaica agreement and in 1978, when the Second Amendment of the IMF’s Articles of Agreement came into effect.

Figure 10-1.World and U.S. Monetary Growth

(In percent)

Source: International Monetary Fund, International Financial Statistics.

Countries tried to find new rules in the national policy setting: for instance, regarding money creation, where the application of the rule was often described as monetarism. It became evident that different countries were following differing kinds of rules, with varied policy consequences, some deflationary, others inflationary. This produced both larger current account imbalances between oil importing countries as well as with the oil exporters, and generated a series of blows to confidence. This chapter also looks at such crises and how the international order was involved in their resolution (the development was particularly dramatic in the United Kingdom and Italy). Finally, it tells the story of the international development of an intellectual revolution in economics, involving the casting off of Keynesianism as it had been understood in the 1960s in favor of the establishment of a medium-term framework as an essential element in an anti-inflationary commitment. This new development can be traced both in high-level summit diplomacy, and also, in a more intellectually rigorous fashion, in a new approach on the part of the IMF.

I’ll say this—you’ve really got to admire his gall.”

The challenge to the world financial order can be assessed in terms of the three familiar aspects of liquidity, confidence, and adjustment.

Liquidity. The financing of such large current account balances would have seemed an insuperable challenge in the circumstances of earlier decades. Now, in practice, the immense liquidity generated first as a consequence of U.S. monetary policy and then by the oil transfers was handled apparently unproblematically by the private sector (though at the outset many bankers were nervous about their capacity to handle such large flows), A major modification of the Bretton Woods system took place in this regard. Whereas the Bretton Woods system had attempted to institute rules on international reserve creation, private flows now led to a large and inflationary expansion of international liquidity.

Confidence. In the fixed parity system, confidence was a question of the ability of national authorities to maintain the trust of markets in their currencies. The major problem lay above all in ascertaining the stability of the pound and the dollar. The confidence problem was now privatized, or transferred away from the public sector, in the same way as was the provision of liquidity. Supposing the banks cracked under the strain? The failure of a major international bank (Bankhaus I.D. Herstatt, Germany) in 1974 raised questions about the stability of the international financial system. International institutions had two choices; either they could attempt to act as intermediaries and transfer some of the risk away from the private sector, or, alternatively, they would be obliged to concern themselves with prudential questions involving bank regulation,

Adjustment. The possibility of borrowing appeared to delay the necessity of adjustment. The requirement of maintaining economic growth was used as a justification of such delay. The political strain of adjustment remained an acute issue in international debate and became more intense because of exaggerated expectations about the jobs and growth that state economic policies might provide.

With the collapse of the rule-based international financial order between 1971 and 1973, it became uncertain how relations between members of the system should be regulated. Two fundamental alternatives existed: either responses would be extemporary and improvised, with powerful and charismatic personalities reacting on an ad hoc basis to pressing emergencies, or there might be a reinvigoration of institutionalized ways of managing a monetary order, with a more effective application of the principle of surveillance.

This chapter examines the rise and then the eclipse of a new conception for the management of international monetary affairs through the evolution of a pattern of personal relationships between political leaders. This phenomenon coincided with, and influenced, the process of the discussion of reform of the international financial system. The new personal and ad hoc diplomacy was clearly far removed from the vision of Bretton Woods, in which a system of rules and quasi-judicial decisions had been expected to guide relationships between states. In 1976–77, the IMF concluded its last programs with major industrial countries. The experience of Italy and the United Kingdom in negotiating these agreements produced so much bitterness that industrial countries subsequently shrank from using the Fund. In the course of the 1970s personal contacts, with an implicit code of honor and shame, temporarily filled the gap left by the breakdown of rules ordering the system. This was monetary management by a small elite. Just before the First World War, the German businessman and philosopher Walther Rathenau claimed that Europe’s economic destiny was ruled by 300 men.1 In the 1970s, the circle—still composed entirely of men—was rather smaller. It came to play a crucial role in the mid-1970s, in the face of the crisis of the world financial system, a major world recession, and a threat to the political legitimacy of many advanced industrial democracies. World GDP, which had grown by a clearly excessive 6.0 percent in real terms in 1973, rose by 1.8 percent in 1974, and a humble 0.7 percent in 1975. For the industrial countries, the respective rates of growth were 5.7 percent and 0.7 percent, and then in 1975 a contraction of 0.3 percent. The shocks produced in the aftermath of the currency and then the oil crises, and by rising inflation and the widening of current account imbalances, fostered the idea that policy should be made through high-level crisis management. At the same time, the institutional discussion advanced to provide an alternative vision of how affairs might be conducted, and an alternative mechanism. Previous strategies seemed to have failed. In the light of the repeated failure to achieve agreement over balance of payments positions, in 1975 the IMF’s Annual Report stated that “even though countries may be expected to continue using monetary policy to influence their exchange rates, effective multinational coordination of monetary policy for balance of payments purposes cannot be an immediate goal.”2

The urgency that drove the world’s statesmen together to consider financial and economic problems was a product of political crisis and of grave doubts about political stability. Some of the leading figures, and in particular the German Chancellor Helmut Schmidt, felt the profound conviction that they faced the last opportunity to rescue a threatened order.

The highly personalized financial diplomacy of the 1970s depended too much on the characters of individual leaders to survive for long after the key players left the stage; but it left a mark on the management of international financial conditions. First, it enabled a compromise over the outstanding issue of reform of the international financial system; and second, it led to a redesigning, for the altered circumstances created by the collapse of par values, of the IMF. In this way, it did have a longer-term impact that outlasted the immediate problems. As a way of managing the international financial system, the personalized approach of the mid-1970s was damaged by the change in U.S. administration in 1977, but it remained as a European approach. The same personalities who created summit diplomacy a few years later inspired the European Monetary System (EMS).

The longer-term results of this period are therefore not to be found so much in the intense outbursts of diplomatic activity and attempted high-level problem solving, but rather in two basic facts. First, that Western democracies and their economic systems survived the trauma of the oil price shocks, but at a substantial cost paid through increased inflation, reduced growth, and higher levels of unemployment. World real GDP never grew again at the pace of 1972 or 1973. Second, during this period, in part as a consequence of the high level of diplomatic activity, a reformed institutional mechanism was created for dealing with problems of the international economic order. The Second Amendment of the IMF’s Articles of Agreement provided the legal basis for a cooperation exercise that was fundamentally more robust than the excessively personalized business of summit diplomacy. The institutional reforms lasted much longer, and were ultimately to prove more successful, than the diplomatic processes that had given birth to them. A few years later, in the European context, personal diplomacy produced a new institutional mechanism, the EMS.

An Insuperable Challenge

The problems of rising inflation, with wide national differences in inflation rates, resulting in large current account imbalances, shaped the international economic landscape of the 1970s. The IMF’s 1974 Annual Report described inflation as the dominant problem of contemporary economic policy. “Inflation is a world-wide problem that must be dealt with before it gets further out of hand.” It recommended as a response planning for “a somewhat lower pressure of demand on resources than has been customary” and tighter controls of national budgets.3 Once the severe downturn of 1974–75 coincided with continuing high levels of inflation, the situation appeared almost impossible to solve. The 1975 Annual Report reasserted the need to reduce inflation, but added: “Unfortunately, this clear lesson of recent experience cannot readily be translated into precise guidelines for current policy, inasmuch as the present situation is so different from that in previous postwar periods—more economic slack and more inflation—as to make it very difficult to judge the degrees of monetary or fiscal expansion that might prove sufficient to restore adequate levels of resource utilization at a satisfactory pace without touching off new difficulties regarding inflation; the issues involved are controversial, among both economists and the general public.”4 In 1976, the IMF recommended the adoption of a gradual approach in bringing down inflation, using such instruments as wage or incomes policy as well as fiscal restraint and aiming at “a rate of economic growth only marginally above the assumed rate of growth in economic capacity.”5 By 1979 the Annual Report concluded that “it is clear that the suggested strategy of policy has not led to satisfactory results; for the industrial countries, average rates of inflation and unemployment have not been reduced.”6

In the light of the almost impossible strains placed on policymaking, it is natural that policymakers looked for new approaches: new forms of cooperation, and new ways of thinking about economic processes. The debates that took place within the IMF about an appropriate policy stance, which were reflected in the statements in the Annual Reports quoted above, are only one instance, albeit a particularly influential one, of a shift in thinking about economics. Later in the chapter, it will be suggested that the IMF pioneered the shift away from “bastard Keynesianism” and toward more medium-term and supply-oriented policies.

The Library Group

The personalized approach in practice began to be formalized on March 25, 1973, when U.S. Treasury Secretary George Shultz invited the French, German, and British Finance Ministers (Valéry Giscard d’Estaing, Helmut Schmidt, and Anthony Barber) to an informal meeting in the ground floor library of the White House, with the additional presence of the undersecretaries or deputy ministers, Derek Mitchell (United Kingdom), Claude Pierre-Brossolette (France), Karl Otto Pöhl (Germany), and Paul Volcker (United States). During the September IMF meeting in Kenya, their Japanese colleague, Kiichi Aichi, invited the four Finance Ministers and their under-secretaries to dinner and then convened a short meeting of the Finance Ministers on their own. Later this group, institutionalized as the Group of Five (G-5) ministers, also invited central bank governors.7 This format continued as the G-5 until 1986, when most of its functions were taken over by an enlarged Group of Seven, or G-7, with the addition of Canada and Italy.

There were frequently self-conscious references to “our small group.” Giscard d’Estaing described the group as “a private, informal meeting of those who really matter in the world,” “a matter of conversation between a very few people and almost on a private level.” Schmidt saw his colleagues as “hidden from the public, and from the authority of the IMF.” Shultz thought of them as “people of vision and breadth … who could understand positions far wider than those of their own country.”8

The Summit

When almost simultaneously in 1974 Schmidt became Chancellor of Germany and Giscard d’Estaing President of France, they attempted to apply Shultz’s concept of collaboration at the level of heads of state. Schmidt’s version of the scheme initially involved appointing five distinguished elder statesmen to reflect on ways of dealing with the oil crisis. During the Helsinki conference of July 1975, Giscard d’Estaing and Schmidt then agreed on a summit meeting in order to consider ways of reviving the Western economies. Initially, the United States was suspicious. The new U.S. Treasury Secretary William Simon feared that the two Europeans might attempt to use a summit as a means of reimposing the fixed exchange rates for which France in particular longed. During the plane journey from Helsinki to Bucharest at the end of the conference, President Ford told reporters: “I am not going to discuss whether there will or won’t be an economic conference. [The Europeans] wanted us—and I agreed—to recognize that there was this interrelationship, this interdependence, and in the months ahead, we will keep a very close liaison, because economic recovery of the free world—this includes more than the four countries—is vitally important to the political stability of the free world.”9

The result of American hesitancy proved highly beneficial for the resolution of the outstanding debate over reform of the international monetary system, as the delay was filled with a very productive negotiation. Simon took the issue that had been at the center of the C-20 debates and treated it as a political issue, which could be solved bilaterally between the United States and France at a political level rather than being pondered by technical experts more distanced from the world of practical politics. Because of the strength and personal warmth of the Giscard-Schmidt rapport, France could represent Germany in the debate and act as the defender of European interests. It was in fact such an obvious solution to the C-20 gridlock that others later claimed responsibility for devising it: the Organization for Economic Cooperation and Development (OECD) Working Party 3 for instance, in November 1975, when the process was already well under way, suggested Franco-American bilateral talks.10 In this way the process that had led originally to Bretton Woods was recreated: an intense period of exchanges between politically well-connected individuals who developed a close personal relationship.

The negotiations were conducted at the level of deputy ministers: Edwin H. Yeo III, Under-Secretary of the Treasury for Monetary Affairs, for the United States, and Jacques de Larosière, Director of the Treasury, for France. They held altogether 17 meetings over the course of three months, some in Washington but most in Paris. This was a different relationship to that prevailing at the political level. Yeo and de Larosière were technocrats rather than visionaries: but the consequence of this more modest approach brought a greater willingness to compromise. While the visionaries derived succor from the ghost of Charles de Gaulle and looked for the certainties and the intellectual appeal of a fixed rate system (and eventually succeeded in devising one for Europe), the technocrats in the end succeeded in producing a new vision that might be a suitable basis for a global economy. The attraction of fixed rates and an alteration of the world’s reserve system to the Europeans and Japanese had been that this represented the only institutional way of constraining the United States; and the latter opposed such a solution for the same reason. How could these apparently immutable differences be overcome?

As Simon had feared, de Larosière started with a robust statement of France’s traditional commitment to the principle of par values. Article IV, Section 1 of the new Fund Agreement should refer to “the aim of establishing stable but adjustable exchange rates.” The United States would then be drawn into the philosophy that lay behind the European snake. The IMF “will notify members, as soon as international economic conditions exist, that par values will be re-established.” Then de Larosière proposed a “collective agreement” between central banks to prevent erratic fluctuations, accompanied by a “secret agreement” to determine “when conditions would be disorderly and erratic, and how central banks should intervene.” There should be a pattern of regular meetings between central bankers and between finance ministry officials. Yeo responded by pointing out that currency intervention was not always a source of stability and drafted a much more permissive version of Article IV. The experience of the European snake was cited by the United States as an example of the destabilizing effects of fixed exchange rates. In the U.S. draft, the purpose of the Agreement would be “to establish a framework for the promotion of exchange stability, the maintenance of orderly exchange arrangements, and the pursuit of exchange policies that contribute to adjustment. Each member undertakes to collaborate with the Fund and with other members toward these ends.”11

By November 15, 1975, the two negotiators had arrived at a “Memorandum of Understanding.” The final proposals for the stabilization of exchange markets involved regular meetings of central bankers, but included no formal decision-making machinery and no compulsion on states to agree on specific criteria as to what might constitute “erratic movements.” There would be consultations daily between central banks, weekly between finance ministry officials, and quarterly between finance ministers. The IMF should be excluded from these meetings: the debates of the central bankers “would be concerned with the hurly-burly of market operations, and might well be analogous to meetings of’rug merchants.’ In contrast, the Fund should be more analogous to a judge, who keeps away from the daily pressures of the market place and holds himself ready to take a longer and more considered view of developments when required.12 Article IV of the Fund Agreement would be worded, as in the American proposal, to permit a range of exchange rate systems.

This paper formed the basis for the exchange rate discussion at the world’s first economic summit, in Rambouillet on November 15–17, 1975, and for a memorandum initialed by the U.S. Treasury Secretary and the French Minister of Economy and Finance. Rambouillet was a carefully secluded meeting, in the grand and formal setting of an eighteenth-century chateau built around a medieval fortress. The press was excluded. Giscard d’Estaing wanted to create the mood of a “house party” for the prime ministets or presidenrs, foreign and finance ministers of six major industrial countries (France, Germany, Italy, Japan, the United Kingdom, and the United States).

At the initial session, President Ford spoke of the need to work for a general recovery among the industrial countries in 1976. “We believe that achievement of mutually compatible domestic policies to achieve these goals can be enhanced by discussions here and by our Ministers to compare economic prospects and to achieve a better understanding—on how national economic policies impact on one another with a new view toward determining if serious incompatibilities in objectives and policies exist.” The summit also discussed in later sessions the details of the U.S.-French monetary negotiations, East-West trade, and energy policy. U.S. Secretary of State Henry Kissinger made an appeal to work with some of the oil producing states: “with cooperation we can separate the moderates from the radicals within OPEC [Organization of Petroleum Exporting Countries], the LDCs from the OPEC countries, and prevent a lot of other ‘PECs.’”13

At Ford’s initiative, the summit produced a communiqué to announce the beginning of a new international cooperation. The public summit declaration announced “efforts to restore greater stability in underlying economic and financial conditions in the world economy” and “to counter disorderly market conditions, or erratic fluctuations, in exchange rates.” 14 At the subsequent press conference, Giscard d’Estaing spoke of “limited flexibility in the system.”15

As by-products of the meeting, the participants pressed the United Kingdom not to flirt with trade restrictions. Such pressure was not necessarily productive. Ironically, this discussion may have actually made the United Kingdom more willing in the upheavals of the following year to try to use protectionism as an instrument of blackmail applied against the international community. And France urged negotiations with the OPEC countries through the Conference on International Economic Cooperation, which had been established at a French initiative. The British Prime Minister, Harold Wilson, on the other hand, delivered a warning against the unnecessary proliferation of international institutions.

The Second Amendment of the Articles of Agreement

The major practical work of the summit was the establishment of an exchange rate agreement, after the long and complicated negotiations in which France seemed to have moved away from its attachment to par values. The agreement moved its way through the international institutions: first through the G-10, which in December 1975, “discussed the United States-French proposals to intensify consultation procedures on exchange rate movements and underlying factors” and restated the objectives of better international surveillance of liquidity and the establishment of the SDR as the principal reserve asset in the international monetary system.16 Then a meeting of the IMF Interim Committee in Jamaica in January 1976 under the chairmanship of the Belgian Finance Minister, Willy de Clercq, accepted the Rambouillet proposals as the basis for reform. But, at Jamaica, there were no provisions for asset settlement or for any control of the supply of international liquidity. It is in fact difficult to see how governments could have controlled the Eurocurrency market, whose main feature lay precisely in its uncontrollability. The SDR was at the margin of the new system, no longer at its center. It is this aspect of the abdication of control that led the IMF’s official historian to conclude that the Jamaica agreement was “an early embodiment at the international level of neoconservative thinking favoring free markets and private enterprise rather than governmental regulation, thinking that was later to become dominant in the United Kingdom and in the United States. The middle of the 1970s was an unlikely environment for the Fund to be converted into the supranational central bank or the stronger international regulatory agency as implied in a stricter international monetary system.”17

By March 1976, the drafting of the Amendment within the Fund was complete, and by the beginning of April 1978, the Second Amendment had been accepted by 97 members with 83.97 percent of the voting power of the IMF. The legal and judicial nature of the Fund’s activity meant that the process of amendment was an extraordinarily long-drawn-out process and that subsequently many of the participants became dissatisfied or disillusioned.

The new system involved the acceptance of the principle of nonfixed exchange rates and an active role of the central institution in the international monetary order—the IMF—in prompting national authorities to accept realistic exchange rates. Such a regime would avoid both the disruptions caused by the “excessive” fluctuations of exchange rates and an undue rigidity of rates, which would hinder the international adjustment process. In this way, the reform might produce a return to “more orderly conditions.”18

Among the most important provisions of the Second Amendment many were limiting or restrictive, including, first, the continuation of the principle of special majorities, with 85 percent of the votes required on many major issues of Fund policy, so that the United States, the European Community (EC) countries if they acted as a bloc, or the developing countries, all had a veto power. Second, transactions in SDRs between member countries were made easier, a very partial step toward making the SDR the principal international reserve asset; but the United States successfully pressed for low SDR interest rates to block the possibility of a rapid movement out of the dollar and into the SDR. Third, there was no longer an official price of gold. Gold, as a consequence, definitively ceased to be an international currency. Fourth, with regard to exchange rates, the United States had consistently refused to accept in Article IV any wording that expressed a disapproval of floating.

In lieu of a system of rules, the new Article IV set out a new philosophy of management of the international economy. Section 1 referred to the obligation of members of the Fund “to assure orderly exchange arrangements and to promote a stable system of exchange rates” (that is, not “a system of stable exchange rates”). Section 4, in practice, indefinitely postponed (at least as long as the United States was opposed) the readoption of par values. “The Fund may determine, by an eighty-five percent majority of the total voting power, that international economic conditions permit the introduction of a widespread system of exchange arrangements based on stable but adjustable par values. The Fund shall make the determination on the basis of the underlying stability of the world economy, and for this purpose shall take into account price movements and rates of expansion in the economies of members.” If ever there was to be a return to a fixed standard, it could not be gold or any national currency (the anchors of the so-called Bretton Woods system), but the SDR or another common unit agreed by the IMF. In practice, it seemed unlikely that a new stable system would be put in place soon. As a result, the system would be a managed one, rather than one created simply by an automatic rule. The new Article IV, Section 3 stated that the Fund “shall exercise firm surveillance over the exchange rate policies of members, and shall adopt specific principles for the guidance of all members with respect to those policies.”

It is important to note that the amended articles did not include any explicit provision for the surveillance of domestic economic policies; but equally that the exchange rate and its problems inevitably provided an indicator reflecting the outcome of a large number of choices made about national economic policy: about financial and monetary management, the openness to capital movements, and also the degree of openness to trade and the extent of flexibility in labor and product markets. In this way, exchange rates provided a guide to assessing all links of the national to the international economy. The weakness of the Bretton Woods system had been the increasing absence of any adequate mechanism for encouraging members of the system to adjust exchange rates promptly to altered circumstances, The new Article IV mentioned above was intended to avoid the problems that had dogged the par value regime. The Annual Report set out the new mission in the following way: “One of the tasks of Fund surveillance will be to identify exchange rate policies leading to inappropriate rates at an early stage, and thus to reduce the economic costs and international frictions associated with such rates.” 19 Surveillance would in addition include (under the provisions of Article VIII, Section 7) the issue of international liquidity and would have as an objective making the SDR the “principal reserve asset in the international monetary system.” The principle of surveillance was not new. Indeed, it had been stated in the original Article I(i) of the Atticles of Agreement, establishing a “machinery for consultation and collaboration on international monetary problems.” Surveillance had been practiced through the regular consultations held under Article XIV for countries with nonconvertible currencies, and later also through consultations with member states that had accepted convertibility. The intention of the Jamaica agreement was simply to strengthen an already existing practice.

The specifics of surveillance were set out in an IMF decision of April 1977. The general principle was that “a member shall avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.” The Fund would initiate discussions with members outside the framework of the regular Article IV consultations in the case of deliberate manipulations carried out “for balance of payments purposes”: if a country practiced protracted large-scale intervention in foreign exchange markets, if it maintained an unsustainable level of borrowing or excessive lending, if it introduced or intensified or maintained restrictions on current account or capital account transactions, if it pursued monetary or other domestic financial policies providing abnormal encouragement or discouragement of capital flows, or if the exchange rate seemed to be “unrelated to underlying economic and financial conditions.” (The last condition was added, at the insistence of countries committed to the principle of fixed rates, so as to avoid the impression that countries who through a floating rate left their policy to the market could thereby automatically avoid the surveillance of the Fund.) This was a very long list of circumstances requiring Fund action and a restraint on members’ action: but, in practice, these Fundinitiated discussions were very rarely applied.20

Although it turned out that the 1980s were replete with circumstances in which exchange rates moved wildly and without relation to “underlying economic conditions” and with balance-of-payments-oriented actions, the Fund intervened only on two occasions to initiate special consultations. Article IV consultations often included formal or informal discussions of exchange rate artangements, however. The two “special” consultations took place in response to complaints about exchange rate policies by other Fund members: Some Scandinavian countries complained about the extent of the Swedish 15.9 percent devaluation of October 1982; in 1987 the United States criticized the large current account surplus and what it believed to be an undervaluation of the Korean won (the first instance in which any kind of formal Fund proceeding was launched with regard to a surplus country). In this sense, the provisions of Article IV with regard to exchange rate policy represented more of a pious code filled with a hope of liberalization than a serious attempt to change countries’ policies by specific intervention on the part of the Fund.

Some surveillance occurred in other forums. Central bankers continued to meet in Basle at the Bank for International Settlements, and the G-10 remained a crucial grouping of central bank governors. Since, however, there was no longer any provision for the regular meetings of central bankers, finance ministry officials, and ministers as originally suggested by de Larosière, surveillance in practice depended in part on the regular Fund consultations (known as Article IV consultations after the Second Amendment, in which the original purpose of the consultation process as a discussion of the removal of exchange restrictions was obliterated). In practice, Article IV consultations for the major industrial countries involved an assessment of their macroeconomic stance, and frequently a detailed examination, with recommendations, on fiscal policy, as well as a discussion of monetary policy. But exchange rate policy was in general such a highly politicized topic, and so sensitive to leakages, that it was more or less tacitly excluded from reports produced by the consultations procedure (even though it was the rationale for them). In 1983, it was agreed that for some members of the Fund these consultations need not be held annually, but should occur at least every two years, and in 1987 a mechanism for “bicyclic” consultations was introduced, though in 1992 the Fund moved back to the principle of the annual cycle.21 Over time, a demand for increased public disclosure about the surveillance process developed. From 1990, brief summaries of the individual consultations reports and of the following discussion by the Executive Board were included in the Annual Report.

Surveillance would not be a separate part of the Fund’s activities, but would rather constitute a prerequisite for effective support operations. As a result of the consultations exercise, the IMF would be aware of problems that might potentially require financial assistance. In consequence, the Fund’s financial programs, and the conditonality attached to them, might be regarded as nothing more than an extension of the surveillance procedure. The Fund rapidly reached the conclusion that “the effectiveness of the Fund’s role depends not so much on formal or rigid procedures as on the quality and candor of the dialogue between the Fund and each of its member countries. In implementing surveillance, the Fund should therefore rely as much as possible on persuasion, rather than prescription.”22

The process involved a continual exchange of information as a means of persuasion. Since it was a global exercise, it also constituted a channel through which members could influence the policies and conduct of other states: either through the Fund’s bilateral Article IV negotiations or through discussions and information about the state of the world economy. The Article IV consultations provided the basis for statements about world economic developments (and the role of national policies in these developments). This was the conceptual foundation for the forecasting and diagnostic exercise associated with the World Economic Outlook. It was especially critical since discussion of economic problems focused increasingly on the global scenario: on the large current account imbalances that had emerged in the late 1960s, and their implications for exchange rates; on the impact of commodity price shifts (and particularly of the oil price increase); and, in the late 1970s, on the contribution made by growth in one or two of the large industrial economies toward world economic developments.

The first World Economic Outlook paper, with projections of macroeconomic indicators for the seven largest industrial economies, had been prepared in 1969. At the beginning, many skeptics treated it as little more than “academic discussion”;23 but it became quite crucial in the wake of the major shocks of the 1970s, when it began to appear as a useful compass for an uncertain economic voyage. In 1973 the exercise was extended in order to make the forecasting of country performance compatible and consistent, so that projections were adjusted in account of those for other countries. At the crucial meeting of the C-20 after the oil price increase, the IMF’s Managing Director, Johannes Witteveen, used World Economic Outlook estimates as a basis for discussion of the appropriate response.24 The figures showed such Large imbalances that it was clear that any attempt at sudden adjustment would produce a dramatic collapse of economic activity throughout the world. Full adjustment thus had to be delayed.

Supplying information and ideas—as well as funds—now became the major means by which the IMF would seek to guide the evolution of economic policymaking. Witteveen was particularly impressed with the possibilities for the new instrument. From 1974, the timing of the preparation and discussion of the World Economic Outlook reports in the Executive Board was adjusted to fit the pattern of Interim Committee and Annual Meetings, and to provide a basis for discussion of trends in world economic development and the effects on the development of payments positions. At the end of 1973, in addition, and in line with the increased emphasis placed on discussion of global economic developments as a way of guiding decisions in individual countries, the Fund undertook so-called special consultations on international currency relations, at first with the large industrial countries. The World Economic Outlook mechanism allowed a continual interplay between the ideas of the IMF, partly formed through their regular contact with member country officials, and, at the political level, the views of countries expressed through their constituency representatives on the Executive Board. In this way, it provided an institutional channel to mediate between “technocrats,” on the one hand, and “politicians,” on the other. These different pressures became particularly evident later in the 1970s, as international demands increased that Germany and Japan should pursue more expansive policies. The question of how Fund forecasts could be made more useful in policy discussions raised the difficult issue of whether governments should be publicly confronted with alternative forecasts for statistics as politically sensitive as growth rates and inflation levels.

The general and advisory aspect of surveillance in fact soon took on a semipublic aspect, as first in 1978 the Managing Director’s Note on the World Economic Outlook was given to the press, and then, from May 1980, the World Economic Outlooks themselves were published—although initially much of the forecasting involved in the preparation of “scenarios” was omitted. One of the purposes of making data and projections available is to inform and guide the shape of national debate about economic policymaking in the world’s major economies (which of course influence the environment for other countries), and the openness of information, and its availability for public debate, is clearly a major facilitating factor. The discussion of surveillance had become more urgent in the course of 1978. At this time, rapid depreciation of the dollar, especially against the yen, but also against European currencies, increased fears about the consequences of currency floating for international trade. The imperative for greater surveillance that also pushed the Europeans into the European Monetary System in 1978–79 made other countries demand a more effective application of surveillance.

Debate within the IMF about the appropriate character of policy was conducted largely in terms of a discussion of World Economic Outlook recommendations. The shift in thinking, replacing a short-term strategy by a medium-term approach, was quite abrupt. In immediate terms, it was a response to the mixture of stagnation and inflation in 1975. In 1975, the primary concern of the IMF Research Department in compiling the World Economic Outlook had been the possibility of a dramatic worldwide collapse in demand as a response to the transfer of income to higher saving and lower spending oil producers; the recommendation thus reflected the belief in a general need for reflation. “Present policies might not provide sufficient stimulus to assure a strong and well sustained recovery. On this issue, the possibility should be recognized that consumer spending (counted on to lead the recovery in its earlier phase) and business fixed investment (expected to resume expansion after its customary cyclical lag) may be more subdued than in earlier postwar recoveries…. Policies that were overly cautious could prolong the underutilization of resources, lead to widespread pressures for a rapid shift to expansionary measures, and forego the beneficial effects of gains in productivity stemming from the resumption of solid economic growth and the absorption of slack.” Only just over one year later, the tone of the equivalent document had changed dramatically. “The recent experience indicates that, unless the currently high rate of price inflation is brought down and inflationary expectations are eradicated, the effects of policies aimed at stimulating growth and employment are likely to be shortlived…. It would seem to be in the interest of the entire international community and of the international adjustment process for the industrial countries to pursue policies directed toward the abatement of price inflation and of inflationary expectations.”25

In practical terms, the new advice meant an increasing skepticism about the use of incomes policies as the primary weapon against inflation, and a greater use of monetary and fiscal discipline. In intellectual terms, the reports reflected an analysis of shifts in current account position as a consequence of the behavior of investment and savings levels, a type of analysis that subsequently became the academic orthodoxy of the 1980s.26 These new points emerge very clearly in the late 1970s: there was a “deep-seated” problem of lower productivity and potential GNP in industrial countries, attributable to “the relative weakness of capital formation in the 1970s compared with the previous decade.” Short-term fiscal measures could not resolve this problem. “It is a lesson of experience that decisions to change the stance of fiscal and monetary policies should not be based on the movement of economic indicators over a very short period.”27

The alteration of thinking within the IMF was an outcome of internal policy debates. In the mid-1970s, Witteveen became increasingly frustrated with the shape of policy in major industrial countries and believed that there had been too much financing and too little adjustment. He worked very closely in elaborating the new approach with the Research Department, which had been hostile to the new low-conditionality financing initiatives (the oil facilities) prepared by the Fund. Some of the area departments also pressed in the same direction: in 1978, for instance, demanding a firmer line against inflation and an insistence that making forecasts about likely inflation levels should not run the risk of being interpreted as an endorsement of inflation. Finally, discussion of the World Economic Outlook in the Executive Board and the interventions of directors from countries with a greater sympathy for stability helped to tighten the new stance.28

The full development of this approach still lay in the future. In the second half of the 1970s it appeared to many that the most important forum for the exercise of international surveillance lay not with the multilateral IMF, but rather with the post-Rambouillet device of the “summit,” excluding multilateral institutions, excluding developing countries, excluding oil producers, excluding the EC, and including only “our small group.” How far did this appearance correspond with reality?

The Industrial Countries Totter

The summits came to play a new role in the international coordination of economic policy with the U.S. change in administration from President Ford to President Carter. However, this radically new approach to international economic cooperation proved much less important or successful in rescuing Western countries (as well as others) than the older international institutions: in large part because the summit politicized the process of gaining economic consensus to an excessive extent. The crises of the mid-1970s raised the question for policymakers: use personal high-level contacts or use the IMF? The second alternative proved by far the most fruitful.

The second world economic summit, in Puerto Rico, occurred too soon after the first to produce any major new initiatives. Its major achievement lay probably simply in the limitation of summit inflationism. Meetings of selective groups of countries have a tendency to become gradually larger as the excluded demand inclusion, and the included look for allies for their positions. At Rambouillet, President Giscard d’Estaing had invited the Italian Prime Minister, Aldo Moro, in part because he hoped for greater support for the French view, and in part in order to confer international standing and prestige to strengthen the position of the then very weak Italian government. The G-5 thus became a G-6 at the summit level. At Rambouillet, the United States made it clear that Canada should be invited to attend subsequent meetings. There was now a G-7. At Puerto Rico, the United States successfully resisted the inclusion of the Netherlands. In advance of the meeting, Americans had feared that “if we insist on Canada, the Europeans [especially the Germans] will insist on the Dutch.”29 (Finance minisrers’ meetings, on the other hand, remained in the G-5 context until the mid-1980s.)

After Puerto Rico, the economic and political situation of some members of the G-7 deteriorated abruptly, especially Italy and the United Kingdom. Political legitimacy collapsed, with discussions of whether the United Kingdom was becoming ungovernable, and stories of military putsch plans against the government, while in Italy corruption scandals (the biggest of which was the Lockheed affair) shook weak coalition and minority governments. Sometimes the crisis was interpreted more generally, as a stage in the gradual undermining of liberal democracies. Where, as in Italy or the United Kingdom, the breakdown of political confidence was most acute, the more tempting became the postponement of economic adjustment to the income and payments shock. The incentives to spend a way out of the problems grew larger. Such policy responses inevitably affected the external economy and produced a payments and currency crisis. Then the next move in crisis management for the affected countries involved the presentation of domestic problems as part of a general international difficulty that called for international support action. Embattled political elites hoped that they could solve their problems at the expense of the rest of the world, and planned to call for international assistance on the grounds that their own positions were endangered.

The United Kingdom

In the United Kingdom growth rates had collapsed from the overheated 7.7 percent (real GDP) in 1973 fueled by property speculation and the establishment of so-called fringe banks, into a contraction of 1 percent in 1974 and 0.7 percent in 1975. Government policies under both Conservative (until 1974) and Labour administrations emphasized growth, but accepted a powerful position of the labor unions, and led first to a surge of demand accompanied by financial and property speculation and then a stagnation combined with increasing rates of inflation (stagflation). The domestic crash of 1974 required a rescue operation by the Bank of England to support the banking system. The external collapse came rather later than the internal economic crisis, as Britain’s external account for the moment benefited from the inflows of the petrodollars generated in the Middle East by the higher oil prices and deposited in London as one of the world’s major financial centers. As a result, sterling balances swelled once again, and delayed the apparent need for adjustment; but once again their potential liquidation posed a frightening menace to the stability of the U.K. economy.

In 1975, the current account deficit was only half the record level of 1974, which had been a product both of the oil crisis and the prolonged industrial conflict that eventually brought down the Conservative administration of Prime Minister Edward Heath; but it was still very large ($3.4 billion). Britain drew extensively on the IMF, taking a stand-by arrangement in the first credit tranche of SDR 700 million (about $850 million) in addition to a drawing of SDR 1,000 million (about $1,215 million) of the special resources available at the IMF to help in financing delayed adjustment to the oil price shock (the oil facilities: see Chapter 11). A new currency crisis began in March 1976, when Nigerian sales of sterling as part of an effort to reduce sterling balances coincided with sales of sterling by the Bank of England and a reduction in the Bank’s minimum lending rate (the replacement for bank rate as the guiding interest rate). The combination of British actions may have been part of a deliberate maneuver. It is likely that some figures within the U.K. Treasury were looking for a way of raising international competitiveness through a devaluation of sterling by around 5 percent.30 The markets certainly interpreted these actions as a signal that the government wanted to move to a lower exchange rate. As a result, sterling overshot downward, and the Bank of England suddenly needed support. It negotiated a $5.3 billion credit from major central banks of the G-10 for six months; with the condition added on at the insistence of U.S. Treasury Secretary William Simon that the United Kingdom would then negotiate a high-conditionality stand-by arrangement with the IMF. “In agreeing to this [package],” Simon informed President Ford, “the British Government has accepted the strict conditionality which the IMF would require.”31 In the middle of these negotiations, the Labour Party leader Harold Wilson abruptly resigned as Prime Minister and was succeeded by James Callaghan, a man scarred by his experience as Chancellor of the Exchequer with the 1967 sterling devaluation. A package of economy measures agreed in July was not sufficient to convince the markets of the stability of sterling, and a precipitate new movement out of the currency began in September. The Chancellor of the Exchequer, Denis Healey, had to return to London from Heathrow airport where he was on his way to the IMF Annual Meeting in Manila to confront the financial crisis, and ask for a stand-by facility from the IMF for the United Kingdom’s remaining credit tranches.

The negotiations proved extremely difficult, in part because of the IMF’s proposed terms, which included a £3 billion reduction of expenditure for the year 1977/78, and which Healey rejected. The major obstacle, however, lay in the deep division of the British cabinet, which meant that no U.K. official was able to negotiate with the IMF team for the first two weeks of November. The left of the Labour Party criticized Healey’s proposals for budgetary cuts. Some members of the cabinet believed that Britain should deal with the payments problems by imposing import restrictions. Others thought that the threat of such steps might offer a useful tactical measure, and that the United Kingdom could use its pivotal position in the world economy to blackmail international institutions. On November 23, 1976, for instance, the U.K. Foreign Secretary, Anthony Crosland, told the cabinet: “The Government should then say to the IMF, the Americans and the Germans: if you demand any mote of us we shall put up the shutters, wind down out defence commitments, introduce a siege economy. As the IMF was even more passionately opposed to protectionism than it was attached to monetarism, this threat would be sufficient to persuade the Fund to lend the money without unacceptable conditions.”32 There were grounds for thinking that this strategy might be persuasive and that the world would be scared by the prospect of an imminent British collapse. At one point, Ed Yeo III, the Under-Secretary for Monetary Affairs at the U.S. Treasury, said: “We feared that if a country like Britain blew up, defaulted on its loans, and froze convertibility, we could have a real world depression.”33

Throughout the November negotiations, the United Kingdom tried to push the IMF into a softer position. Healey worked through the U.S. and German governments to apply pressure on the Fund not to be “too tough.” At first he believed that an alternative might lie in German assistance, since the Germans might use some of their $32 billion reserves to fund the outstanding sterling balances and remove the threat to the British currency. For some time it looked as if the German Chancellor, Helmut Schmidt, might agree, but the Bundesbank contemplated the surrender of German reserves with horror.34 The Vice President of the Bundesbank, Karl Otto Pöhl, both resisted the use of the Bundesbank’s reserves and tried to use his influence to prevent the IMF modifying its negotiating stance. The U.S. Treasury was equally resistant. In the caustic words of Edmund Dell, the British Secretary of State for Trade, Simon “did not understand that the magical economic theory in vogue in some parts of Britain required him to lend his country’s money to support the enlightened policies of the UK Government.”35

The crisis was resolved only after President Ford asked the IMF’s Managing Director Witteveen to travel to London. Healey still thought, mistakenly, that the Witteveen trip was intended to soften the stance of the IMF mission in London. On the contrary, it implied a demonstrative statement that the U.K. government should negotiate with the IMF and not with the U.S. (or the German or any other) governments.36

In the two-year stand-by arrangement that was then rapidly agreed (the letter of intent was sent on December 15, 1976), the United Kingdom committed itself to maintain an incomes policy; make public spending cuts of £1.5 billion in 1977/78 and £2 billion 1978/79 (in addition to the £1 billion included in Healey’s July 1976 economy package); reduce the forecast Public Sector Borrowing Requirement from £10.5 billion to £8.7 billion 1977/78; and hold domestic credit expansion to £9 billion in 1976/77, £7.7 billion 1977/78, and £6 billion 1978/79. Healey stated that “I am satisfied that the resultant course of sterling M3 [currency in circulation and bank savings and deposit accounts] will be consistent with reduction of inflation.”37

In fact, in retrospect it appears that the decisive measures had been taken before the end of the negotiations. First, already in early 1976, after two years of discussion, spending by government departments had moved to a cash limits basis. The effects of this were still uncertain at the end of 1976; in practice, it proved an effective way of limiting expenditure at a time of high inflation rates. Second, the United Kingdom recognized that monetary targets had a useful role to play in making economic policy. Domestic credit expansion had already been reintroduced into the Bank of England’s operating framework in January 1976. On October 21, 1976, the Governor of the Bank of England, Gordon Richardson, argued for the establishment of publicly announced monetary targets. The eventual letter of intent for the IMF program included a reference, not just to domestic credit expansion, but also to sterling M3. Third, on October 25, Prime Minister Callaghan publicly called for the elimination of sterling balances, which had been so prominent an aspect of the chronic British financial problem since the 1950s. (in fact, the United Kingdom had been committed to a diminution as a consequence of joining the EC.)38 At the beginning of 1977, Britain concluded a $3 billion facility with the G-10 for the orderly reduction of sterling balances, Fourth, the U.K. payments position was beginning to turn around in any case, because of the growing production of North Sea oil, and the market’s assessment of the future effects of petroleum on sterling. It was precisely in November 1976 that the large British Petroleum Forties field in the North Sea opened up.

The result of all these measures and developments was that for 1976/77 the Public Sector Borrowing Requirement fell £2.4 billion below the amount agreed in the IMF stand-by arrangement, domestic credit expansion showed a contraction in 1977, large capital inflows began, and 1977 produced a current account surplus. Denis Healey retrospectively argued that he, the government, and the financial community had been misled by the figures on 1976, and that the United Kingdom could have done without the IMF “if we—and the world—had known the real facts at the time.”39

In an obvious sense this is true; but in terms of the changing British perception of the appropriate role of economic policy, it misses the contribution of the 1976 crisis. The IMF crisis was used internally by civil servants, especially in the Treasury, and by ministers who wanted a return to a policy of greater stability.40 The experience of a dramatic crisis altered the way politicians talked about economics. On September 28, 1976, at the Labour Party conference, one day before the United Kingdom sent the formal application to the IMF, Callaghan stated: “We used to think that you could just spend your way out of a recession … I tell you, in all candour, that that option no longer exists and that in so far as it ever did exist, it only worked … by injecting bigger doses of inflation into the economy, followed by higher levels of unemployment.” This speech marked a profound turn in British politics. These were the “words which effectively buried Keynes”41—at least as regards British interpretations of fiscal policymaking.


Like Britain, and for similar reasons, Italy reacted initially to respond to the oil shock with expansionist measures. Weak governments needed to spend as a way of buying popularity and thus fueled nominal demand, while at the same time being unable and unwilling to curb the monopolistic positions of unions. Unlike Britain, growth in Italy continued at very high rates well into 1974 (5.4 percent real growth in GDP for the whole year). But the balance of payments problems that emerged were similar, and Italy’s Treasury Minister began negotiations with the IMF so secret that even the other economic ministers of the Italian government were kept in the dark.42 In April 1974, the Italian government drew SDR 1,000 million ($1,200 million), in order to finance the oil-related part of the deficit, imposed credit ceilings on banks and began to tighten interest rates, and placed restrictions on foreign travel. The measures led to a sharp fall in domestic demand and production, the contractionary effect was much greater than had originally been anticipated, and in 1975 the current account balance improved quite dramatically (from a deficit of $8,004 million in 1974 to one of $525 million in 1975).43

The reform program did not last the course: in part because the indexation of wages through the scala mobile provided a way of rolling the inflationary impetus on from one year to another; and in part as a result of the extreme political uncertainty. In 1975, as a consequence of indexation, real wages rose 10 percent, and unit labor costs in lira terms 33 percent. This affected the profitability of enterprises and led to a business contraction. In 1975, real GDP fell by 2.7 percent. The Christian Democrat coalition government, backed only by a minority in parliament and faced with poor regional election results, reacted nervously to signs of recession. In August 1975, it increased public spending and also encouraged a rapid monetary growth. The Director General of the Treasury is alleged to have advised the Governor of the Bank of Italy to open his window and “throw out packets of 10,000 lire notes.”44 Even without such action, M2 grew by 23 percent in 1975, and the IMF target for Italian total domestic credit (the equivalent of domestic credit expansion for the British case) was overshot. The government anticipated the worsening of the payments position once more by drawing on the IMF oil facility and simultaneously negotiating for credit from commercial banks,45

In January 1976, as a renewed foreign exchange crisis broke out, Italy began discussions about a new IMF stand-by arrangement. At the same time, the government negotiated for a $1,000 million five-year EC credit (concluded in March). Both sets of discussions were highly problematic, as the government officials refused to discuss the estimated revenues for 1975 and 1976 and appeared to be “in a fog.” The EC negotiators recognized at the time of their loan that the Italian Treasury could not possibly keep within the target for the monetary financing of the budget.46 But there were overriding political considerations. In June parliamentary elections took place, which were preceded by forecasts of losses for the ruling coalition, and rather heavy-handed public warnings from the United States and Germany on the dangers of including communists in government. But the deliberately generous approach of the EC made the IMF negotiations even harder, as the IMF team would have had to put in a tighter set of targets, if it were to be realistic, than those already accepted by the Europeans.

After the election, a vulnerable minority cabinet struggled to rule, and at the same time to convince the EC and the United States of its weakness and neediness. Like their equivalents in Britain, the leading Italian politicians painted the potential world political consequences of their failure in apocalyptic terms. In December 1976, the Prime Minister, Giulio Andreotti, noted, rather threateningly: “were Italy to collapse both politically and economically, Italy would not be the only loser.”47 But after the summer of 1976, both the United States and the EC rejected the new Italian approach. The U.S. Treasury Secretary noted; “The Italians and others [presumably in London] would be seeking to elicit the easiest possible terms for the maximum amount of money. One way of doing this would be to isolate the United States, put the United States in the position of being visibly the hard term lender. (Our proposed solution to this problem has been to use the IMF as the lending vehicle. The IMF tends to diffuse individual country’s roles.)”48 At the same time, the EC made the conclusion of a Fund loan the condition for further EC credit. In November, the U.S. and German governments both pressed the Italian government to accelerate its negotiations with the IMF.

The Italian government spoke bitterly of the “ganging up of Germany and the United States with the Fund.” It complained that from its point of view “this introduced a political element into the Fund negotiation which had been muted in earlier negotiations.”49 In early December 1976, the Italian Prime Minister visited Washington, and in January 1977, Bonn, in order to plead for more sympathetic treatment and create a linkage of the credit issue with the North Atlantic Treaty Organization and defense considerations. The Governor of the Bank of Italy, Paolo Baffi, complained to the IMF’s Managing Director that Italy’s treatment was harsher than that applied to the United Kingdom.50 By early March 1977 the IMF team was contemplating breaking off the discussions, although the Italians had “of course… warned of social political consequences which I doubt if anyone is capable of fully assessing but which could clearly be far-reaching.”51

The continued pressure worked as a mechanism for chipping away at the scaia mobile. Bonuses and severance pay were excluded from indexation; above certain levels of income indexation increases were to be paid in nonnegotiable five-year treasury bonds (this measure came at the direct suggestion of the IMF); and changes in value-added tax were taken out of the index.52 In this way at least one part of the mechanism that had led to accelerating inflation was dismantled. The letter of intent, delivered on April 6, 1977, included provisions for reducing the government deficit and controlling total domestic credit, but also reducing the rate of price increases through changes in the indexation procedure and the maintenance of a competitive exchange rate. The lira would not be maintained at excessively high levels: “Intervention in the exchange market will therefore have the purpose only of smoothing disruptive short-term fluctuations in the exchange rate.” Like the U.K. program, Italy’s adjustment was highly successful quite quickly. The current account improved rapidly, and foreign confidence returned, with the result that Italy never used the stand-by arrangement whose negotiation had been so controversial. As in the United Kingdom, the external pressure of what the Italians called the “international community” enabled a weak and divided government to impose an effective reform course.

These traumatic episodes pushed the United Kingdom and Italy into the adoption of better policies. In the process of appearing as an external ogre, forcing polices that altered the internal political balance of member countries, however, the IMF succeeded too well. In the 1967 U.K. crisis, the IMF’s terms had been too easy; now they appeared too harsh to be politically viable except in moments of extreme danger and desperation. The major memory and legacy of the experience made the Fund appear as a draconian lender of last resort, whose interventions should be feared and avoided. As a consequence, these proved to be the last Fund programs negotiated with major industrial countries; and the Fund changed involuntarily into an institution concerned more directly with development problems and no longer with the provision of financial support for the industrialized world.

Policy Divergence

The stories of the Italian and British responses to the inflationary crisis of the 1970s differed very dramatically from those of other leading industrial countries, notably Germany, Japan, and the United States, in all of which external adjustment to the oil crisis was much quicker and more effective (although the United States for a Long time failed to take measures to adjust domestic energy prices and consumption to the new circumstances created by the oil shock). Some European countries, especially the Benelux and Scandinavian countries, faced problems similar to Italy and Britain, with a powerful and organized labor force and a traditional commitment to social harmony. But in small and open economies, the ability of these interests to assert themselves was substantially reduced by the fact of cross-national competition. The smaller countries could not afford to buck the international trend and postpone adjustment British or Italian style; but this adjustment, and the partial abandonment of the notion of a socially harmonious, planned, and ever more prosperous economy caused major social and political upheavals, with widespread strikes and also increased political instability. Of the smaller European economies, the only two that ignored adjustment were rather exceptional: Portugal, in the midst of a revolution, and Ireland with its geographic proximity and strong economic ties (including a pegged currency) to the United Kingdom.53

The pattern of quite radical swings between fiscal contraction and expansion was a characteristic of the adjustment of all industrial economies, but the different trajectories reflected differing domestic situations and varying degrees of willingness and capacity to adjust. One of the critical difficulties in Italy and the United Kingdom, for instance, lay in an insufficient acceptance of the contribution to stabilization made by an appropriate monetary policy. Another was the reluctance to alienate labor unions. Where, on the other hand, domestic costs were reduced at an early stage, and where sustained anti-inflationary monetary policies were adopted, the results of adjustment appeared as recessions, but also as exceptionally strong balance of payments positions.

The great diversity of policies and of inflation rates created large current account imbalances, placed a strain on exchange rates, and so posed a challenge to the integration of the world economy. The IMF tried to recommend a common international policy framework, involving a restraint over aggregate demand. However, “because of all the uncertainties involved, along with the particular risk of generating adverse employment effects, the approach is very likely to be—and should be—a gradual one.” In order to restrain the competing claims of different groups within the national economies, the IMF frequently recommended some kind of state action: in particular, “increased attention might be given in this regard to the use of incomes policy—as a supplement to sound fiscal and monetary policies, but not as a substitute for them.”54

Growth in Germany fell off dramatically in 1974, and in 1975 the government adopted an expansionary program much bigger even than that provided after the 1967 Law on Stability and Growth to counter the recession of the mid-1960s. Net government borrowing in 1975 amounted to 3.6 percent of GNP; although since overall state indebtedness was low, such deficits did not produce the financial destabilization that characterized Italy or the United Kingdom. The greater extent of German stability was also due in part to a different institutional framework for setting wages. Negotiations were conducted by a limited number of unions each responsible for one sector of industry (unlike in the British case, where one of the difficulties lay in the multiplicity of unions); and without any of the indexation provisions that poisoned Italian industrial politics. In the 1970s, the economic consensus as expressed by the independent Council of Economic Experts held that the major cause of unemployment lay in the rise in the German real wage position.55 How might German wages be influenced by policy measures short of the formulation of an incomes policy, which would carry major political risks? The outcome of the German negotiations clearly depended heavily on the expectations of future inflation hold by unions and employers’ organizations. The introduction of monetary targeting by the Bundesbank in December 1974 appealed to politicians, economists, and labor negotiators primarily as a way of influencing expectations about future inflation (and as a rather superior instrument than the implementation of a direct wages policy, with the risks such a strategy involved of pulling the state into the arena of social conflict).

For the central bank, the motivation behind targeting had been rather different. There had been a concern with monetary growth during the years of the fixed parity system, and the need to control domestic money had been presented as the major attraction of floating rates. The Bundesbank had anxiously followed the development of bank credit since the 1950s. The fears about fixed parities derived from the effect of currency inflows on German monetary behavior, and intensified in the early 1970s as money markets became more active. In 1972, the EEC central bank governors, on a German initiative, discussed monetary targeting, and in December 1972 the Council of Ministers Resolution on Anti-Inflationary Measures included the suggestion that by 1974 money increases should be linked with the performance of real GNP. Monetary control would provide the most valuable weapon in the fight against inflation: a new monetary rule to replace the discredited exchange rate rules of the Bretton Woods par value system. In December 1974, the Bundesbank’s Central Council voted to adopt a target for 1975 of 8 percent growth for central bank money (cash plus banks’ minimum reserves at the central bank) and laid the basis for a monetary anti-inflationary policy.56 This came to play a crucial part in German stability.

The shock that shook Japan as a consequence of the oil price development was even greater than that experienced by Germany. After a decade of exceptionally high growth rates, real GDP contracted by 1.4 percent in 1974. The rate of rise of wholesale prices doubled (to 31.4 percent). The external sector was hit not only by the actual rise in petroleum prices; in addition, exporting, the engine of Japanese growth, became more difficult because of shortages of bunker oil and because other countries responded to the petroleum shock with protectionist measures. The current account showed the first substantial deficit since the 1950s ($4.7 billion). As in Germany, the sharp economic reversal delivered a blow to the political system. Many commentators assumed that the oil crisis had brought the end of the Japanese miracle. Newspapers described panic in Japan, and a “disaster” brought by higher oil prices, which only the optimists dared to label as “hypochondria.”57 As a result, stabilizing the economy became a task of national urgency, in which the reduction of inflation took the highest priority.

Japan adopted a form of monetary targeting at almost the same time as Germany. From 1975 the Bank of Japan published what it called “forecasts” of M2 and certificates of deposits. As in Germany, the announcements were intended to influence the outcome of a coordinated wage-bargaining process (the annual “spring negotiations offensive”), and thus to reduce the impact of monetary tightening on the labor market. As a result of the policy innovation, fluctuations in the Japanese money stock and rates of inflation were both greatly reduced (the average inflation rate was 10.8 percent in 1970–75, 6.4 percent in 1975–80, and 2.7 percent in 1980–85).58

Like Japan and Germany, the United States in the mid-1970s came to view inflation as a serious threat. The Treasury Secretary told the IMF Interim Committee that “a further reduction in the rate of inflation was essential to bring about sustained growth and prosperity.”59 Publication of monetary targets began in 1975, although, until 1978, the practice of shifting the target period forward each quarter made it difficult to follow the overall course of increases in the money stock.60 Through the twist of political logic, however, the application of anti-inflationary measures led to higher levels of inflation as American voters chose an alternative political program to the austerity course offered by the Ford administration. In the presidential election of 1976, economic stimulation formed a major element of Jimmy Carter’s campaign pledge. (Later, when confronted by German boasting about the success of anti-inflationary strategy, Carter’s advisers retorted that “it also helped usit won us the election.”) Once elected President, Carter started to turn the promises into reality. The result increased even further tensions between the major industrial countries, and called into question the mechanisms for the arbitration of economic conflicts and the coordination of policy.

Jimmy Carter’s presidency began with the attempted introduction of a $50 per person tax rebate, which was opposed by fiscal conservatives in Congress and then withdrawn. In January 1978, a new $25 billion expansion package to come into effect in the fall of that year was announced. After 1976, as the government’s fiscal policy loosened, the current account balance deteriorated, American inflation rates increased, and after 1977 a net capital outflow began. At this point, the United States, like the United Kingdom and Italy before, looked for international action to resolve domestic economic difficulties.

International Linkage

For U.S. policymakers, the best hope of keeping the American stimulus program on track, and avoiding a payments deterioration and a crisis of confidence, lay in the coordinated simultaneous promotion of expansionist measures throughout the industrial world. The recommendation that surplus countries in particular had a duty to increase their growth rates had been formulated in discussions at a conference of “trilateral” economists in 1976 at the Brookings Institution by Lawrence R. Klein of the University of Pennsylvania.61 It became popularized as the “locomotive theory,” and was endorsed by the U.S. administration when Treasury Secretary W. Michael Blumenthal explained the new package to Congress. “By adopting this stimulus program, the United States will be asserting leadership and providing a better international economic climate. We will then ask the stronger countries abroad to follow suit.”62 By 1978, the locomotive enthusiasts were suggesting on the basis of Klein’s world economic LINK model that an additional 1 percent growth in Germany would be followed by expansion in the Netherlands, Belgium, Canada, and Japan and would cut $1 billion off the U.S. trade deficit in a year and $3 billion within two years.63 (Ironically, the LINK model had been used earlier by the United States in preparations for the Rambouillet summit, in order to demonstrate that additional U.S. growth would bring only small benefits to Europe.) The discussion showed the importance of accurate economic modeling in shaping policy decisions and increased the significance for practical politics of the IMF’s World Economic Outlook exercise.

Germany, in particular, initially strongly opposed external pressure to expand, and the political use of forecasts based on what its policymakers viewed as dubious or implausible assumptions. Helmut Schmidt disliked the lectures from American economists in the new administration, Under-Secretary of State Richard Cooper and Assistant Secretary of the Treasury C. Fred Bergsten, who accompanied Vice-President Walter Mondale on a mission to Bonn in early 1977. He thought them inexperienced politically, since they had not been through the politics of the first oil shock. And, in general, he disliked any kind of lecturing from economists. When the British government appeared eager to join an alliance of world reflationists, Schmidt enjoyed pointing out that the U.K. inflation rate of 18 percent was a signal neither of stability nor of success. Schmidt nevertheless felt compelled to continue negotiating with the United States, in the hope that his persuasion might lead to the adoption of a more realistic energy policy.

As preparations for the May 1977 London summit unfolded, it became clear that there would be a clash between the surplus and deficit countries. At the summit, the British Chancellor of the Exchequer, Denis Healey, predictably called for more Japanese and German action, and equally predictably hinted at the possibility of a British protectionist response were there to be a failure to expand sufficiently. On the other side, the German negotiators wrestled with the wording of the summit declaration in order to put a warning shot across British and American bows. The phrase inserted into the communiqué by Karl Otto Pöhl, with French help, provided a neat summary of the German position, but also of a more general concern with inflation and its consequences. “Inflation is not a remedy to unemployment but one of its major causes.”64

At the same time as the summit attacked inflationism, the surplus countries nevertheless committed themselves to forecasts that promised faster revival. Playing with forecasts is obviously always much easier politically than altering policy. The Japanese Prime Minister Takeo Fukuda announced a target of 6–7 percent. The United States had begun by pressing him to achieve a heroic 8 percent. In the event, real GDP in Japan grew by 4.8 percent in 1977 and 5.0 percent in 1978, a respectable result, but not sufficiently impressive to disarm the foreign critics. Germany provided forecasts of 4.5 to 5.5 percent growth, and this was also the target figure cited by Schmidt at the meeting (although the OECD forecasts for Germany were substantially Lower). The IMF World Economic Outlook prepared in June had taken the national forecasts (Germany 4.5 percent and Japan 6 percent) and in consequence arrived at the overoptimistic figure of 4.5 percent real growth for all industrial countries. The rates of real GDP growth actually obtained in 1977 were a disappointing 2.5 percent for Germany and 3.5 percent for all industrial countries.65

The summit was followed by further political discussion of the implications of the targets adopted. On May 25, 1977, Blumenthal reiterated the agreement of the London summit concerning the adjustment of payments imbalances and said that Germany and Japan had agreed not to resist pressures for the appreciation of the deutsche mark and the yen. This encouragement to the markets to push up the German and Japanese currencies so as to curtail their export performance soon became known in the United States as “talking the dollar down,” and in Japan and Europe as “malign neglect.” By January 4, 1978, the dollar had fallen by 13.5 percent against the deutsche mark over a year, and Federal Reserve Board Chairman Arthur Burns persuaded the Carter administration to promise intervention against “disorderly market conditions.”

The pressure on the surplus countries increased through 1977 and 1978 as it became clear that they had fallen well short of their London summit targets. It appeared also within the IMF, and especially in discussions in the Executive Board. At the September 1977 Interim Committee meeting, the Managing Director of the IMF described the German and Japanese situation as “less satisfactory” because of shortfalls in planned public expenditure.66 In early 1978, Witteveen made his criticisms more widely known by announcing in a public speech: “For surplus countries, notably Germany and Japan, stronger expansion of domestic demand has been rendered even more urgent because of the substantial appreciations of the external values of their currencies over the past half year or so…. I would like to add that the adoption of cautious, carefully controlled policies of expansion should now be considered by countries where the balance of payments is not much of a constraint, if any, and where domestic inflation is low or, though relatively high, would not be aggravated.”67 In the summer, he called the German and Japanese expansions “quite disappointing.”68

The 1977 IMF Annual Report had called for a medium-term strategy in which a return to higher growth rates would allow the absorption of unutilized resources. In 1978, the Report was much more explicit, laying out a mediumterm scenario for a coordinated adjustment of the balance of payments of the industrial countries. In this version, the four countries in relatively strong positions, the United States, Germany, and Japan (as well as Switzerland, which also had an exceptionally strong balance of payments) “could lead the economic recovery,” while many of the other industrial countries “had to give overwhelming attention to balance of payments and inflation problems.”69

In 1978, the World Economic Outlook exercise suggested that the Japanese policy stance of attempting to reduce current account surpluses was appropriate, but that in order to achieve it, further action would be required. “The recent appreciation of the yen and the trade liberalization measures adopted by the authorities should facilitate this adjustment. Further liberalization measures are, however, likely to be required in the future. There is no doubt that higher domestic growth and absorption of unused productive capacity will be essential if a substantial reduction in the current account surplus and a gradual stabilization of the yen are to be attained over the next two or three years.” For Germany, “a reduction in the current account surplus… would contribute to a better distribution of current account balances among the industrial countries…. A policy of domestic expansion is thus an important element of the strategy that seems likely to lead to a gradual stabilization of the exchange rate.”70 The feeling that Germany and Japan had not done enough to stimulate the international economy as a whole spilled over into the discussion of other issues. In the long debates in the IMF Executive Board over the thorny issue of quota increases, in particular the Executive Directors of the other industrial countries opposed the idea of a special increase for Germany and Japan (which would have been merited arithmetically on the basis of the quota formula calculation) because this might appear as a reward for countries that had failed to adjust their balance of payments in view of the changed situation after the oil shock.71

In fact, both Japan and Germany were divided internally by policy debates about the desirability of increased public spending; and those on the side of reflation were eager to use “international pressure” as one of their stronger arguments. In Japan, both the Ministry of International Trade and Industry, and a powerful group of politicians in the Liberal Democratic Party, argued that Japan should increase its fiscal stimulus. The IMF supported this position. In the 1960s, Japan’s social expenditure had been relatively low at a time when spending in other industrial countries expanded quickly, and the 1970s provided an opportunity to catch up. Levels of benefit and the extent of inclusion in the social security system both indeed eventually became much more generous. In Germany, the labor unions and the left of the Social Democratic Party called for a public investment program that should cost at least 1 percent of GNP.

On the other side stood the finance ministries and the central banks. The German Bundesbank was proud of its independence in determining German monetary policy (though the provisions of the Bundesbank Law obliged it to support the government’s economic policy); and was committed to an anti-inflationary strategy. But in the circumstances of 1977–78, the imposition of monetary control seemed almost impossible. The requirements of internal and external stability ran counter to each other. Large inflows had taken place in 1977, and the Bundesbank tried to discourage them by lowering interest rates and imposing a new form of capital control (the prohibition of the purchase of medium-term securities by nonresidents). Lower interest rates, however, encouraged German expansion. In 1978, the Bundesbank saw German money supply moving for the first time well beyond the targeted expansion,72 in part as a result of its large purchases of foreign exchange, designed to stop the further appreciation of the deutsche mark (between July and October 1978, its reserves grew by $8 billion). Germany’s leading economic research institutes sharply criticized the “inflationary development of the money supply.”73 The Bundesbank’s President, Otmar Emminger, stated in June 1978 at a meeting of the Central Bank Council that evidence of a higher level of economic activity showed the stimulus proposal to be now no longer necessary. Karl Otto Pöhl, now Vice-President of the Bundesbank, stated that the criticisms of U.S. officials were “exaggerated.”74

The Chancellor, Helmut Schmidt, only partly supported the idea of budgetary expansion, and needed to be persuaded of its desirability by Keynesian-minded officials in his own office. He eventually saw concessions as an opportunity to present a miracle of the kind that in earlier eras Ludwig Erhard and Karl Schiller had been able to conjure for the German people. But he thought that the external discussion of German affairs would help him to overcome internal opposition to his program. His strategy is said to have consisted in: “Let’s wait a while, until after the summit. Make them force me to do it.”75 The motivation was complex: in part the strategy aimed to deal with domestic policy, in part it intended to bargain concessions from the United States on energy issues.

Since two thirds of U.S. oil requirements were domestically produced, and major new fields were opening up in Alaska, the U.S. balance of payments was proportionately less affected by petroleum price developments than those of the non-oil producing Europeans. But U.S. energy consumption was immense, and oil imports had risen sharply since the OPEC crisis ($5 billion in 1972, $27 billion in 1975, and $45 billion in 1977).76 Relatively small savings could lead to a big cut in imports and thus vitally affect the balance of supply and demand on international markets. Inducements to save fuel, which could easily be provided through a raising of the artificially low American energy prices, would bring a substantial benefit to European consumers, though they might well be unpopular with the American electorate and Congress. Was not this a case too, where international pressure might be exerted on a government to change policy?77 Both Germans and Americans might benefit from exposure of their political problems to the glare of critical international attention; and this is exactly what the summit process could provide.

The Bonn summit of July 16–17, 1978 in fact was preceded by a number of occasions on which Schmidt played up the international angle of economic policy discussions. At the EC Council of Ministers on April 7–8, 1978, he proposed, together with Giscard d’Estaing, the creation of the European Monetary System as a “zone of monetary stability in Europe”; and at the same time agreed to “concerted action” to promote European economic recovery. In June at an OECD ministers’ meeting, the secretariat’s joint reflationary plan was endorsed together with a proposal for raising domestic energy prices in member countries (that is, the United States) to international levels. Japan had already made its own commitment to greater growth after a series of bilateral negotiations with the United States that had culminated with a trade agreement in January 1978.

At the summit itself, Prime Minister Takeo Fukuda repeated the 7 percent growth pledge (he had already become known as Mr. Seven Percent in Japan); and in September 1978 his government passed an additional public works program amounting to around 1.5 percent of GDP. Schmidt too agreed to a German growth package, which he said would provide a stimulus of 1 percent of GNP. The actual program provided for DM 12.5 billion spending, and at the same time the Bundesbank agreed to raise the ceiling for the public sector borrowing requirement. Oil prices in the United States would, Carter promised, be raised to the world level by the end of 1980, and measures would be taken to save imports of 2.5 million barrels a day by 1985.

The question of compliance with the promises extended in the Bonn deal very soon became highly controversial in the case of each of the three major partners. For the United States, the decontrol of oil prices required a complicated domestic political negotiation in the difficult circumstances of an impending presidential election. In April 1979, President Carter agreed to decontrol, and simultaneously made the petroleum companies’ gains more politically acceptable through the imposition of a windfall profits tax. So the American promise was kept, in the end. But for the Europeans, and especially for Helmut Schmidt,78 the delay in keeping it seemed profoundly harmful. After the Iranian revolution and the fall of the Shah, oil prices leaped ahead. The American subsidization of oil imports contributed to the surge of the spot oil price, and made the consequences of the second oil shock of the decade much more devastating than those of the first.

In Germany, the 1978 fiscal measures contributed to subsequent expansion—they may have added as much 1 percent to GNP in 1980, and then in following years somewhat less79—but they left a very bitter political legacy. New jobs had been created; but as a result of the new oil shock tax revenues did not rise. Although the government deficit as a proportion of GDP fell in successive years after 1977 (from 2.13 percent to 1.81 percent in 1980),80 the discussion of the stimulus measures altered during the course of the new oil crisis. In contrast to the position after the first oil shock, after the second Germany’s current account deteriorated. A “myth” of the “disastrous expansionary policies” evolved,81 and influenced the increasing criticism of government economic policy by the junior coalition partner in the government, the Free Democratic Party, and the Economics Minister Count Otto Lambsdorff. As a result, Schmidt took his coalition into the 1980s with a rapidly weakening political base. At the same time, the economic basis of the German system began to appear more fragile. The Bundesbank reacted to the overshooting of money supply targets in 1978 by reducing the targets for 1979 (a 6–9 percent corridor) and 1980 (5–8 percent), with the actual outcome being 9 percent growth in 1979, and then an undershooting at 4.8 percent in 1980. As a result of the Bonn summit, Germany seemed to have a weaker economic position and less opportunity to take corrective action.

The strategy of using foreign pressure to achieve a domestic decision (a process known in Japan as gaiatsu) had clearly misfired. The macroeconomic effects of the stimulus package proved to be far less significant than the much longer lasting political-psychological repercussions. Adjusting at the insistence of someone else made those responsible for the decision domestically look weak, when the results (as happens almost inevitably) turned out to be different from those originally anticipated. After 1978, “locomotive” became a very dirty word, especially in Germany and Japan. Even the term “coordination” was rejected as being associated with an inappropriate “ambitious international demand management.”82 The Germans tried hard to develop an alternative image to explain their uncomfortable international position. Germany and Japan were not locomotives, but cyclists. What would happen in a bicycle race if the riders pedaling around the stadium continually got off to pump up their tires? Only in 1990, as they tried to explain the positive effects of German unification on their neighbors, would Germans use the term “locomotive” again.

A similar response to that in Germany to the aftermath of external political pressure occurred in Japan, although for different reasons. The stimulus package in that country was more substantial, but led to a growth in public spending and public deficits that generated its own political momentum, and proved difficult to reverse. The public sector financing requirement as a proportion of GNP rose from 7.0 percent in 1975 to 10.2 percent in 1979, and by 1979 public sector debt amounted to 55 percent of GNP (by comparison, it stood at 36 percent in the United States and 30 percent in Germany).83

From late 1978, the Ministry of Finance began a sustained campaign against “excessive” expansion and overlarge public deficits: these would restrict the scope for future policy, crowd private borrowers out of the capital market, and lead to a resurgence of inflation. Government expenditure should rather be financed through increases in consumption taxes. The perception of inappropriate foreign pressure at the Bonn summit in the end drove Japan to stabilize and reduce its fiscal deficits, not to expand them.84

One repercussion of the Bonn debacle should be noted. It had been a coordination exercise that had fundamentally failed. The motives that inspired it, however, and the search for a more balanced world economic path were by no means inappropriate. When the mechanism failed, and the participants sought a scapegoat, they attributed the responsibility to the most conspicuously politicized part of the exercise, the summit. The IMF’s World Economic Outlook, which was less politicized and instead offered a mixture of information and recommendations, attracted far less opprobrium, even though its implications had coincided with the political pressures of the Bonn summit. The experience may have suggested that a less political form of cooperation may stand greater chances of success.

A Global Solution

Logically, a number of alternatives existed as to how to deal with the continued problems posed for the rest of the international system by the decline of the dollar. The most global solution would have been the creation of a formal mechanism for moving away from a dollar reserve system and toward an SDR-based or multicurrency system. It had been debated in the context of the reform discussion and reflections on the future of international reserves and the desirability of “asset settlement” since the early 1970s.85 Replacing reserve currencies by the SDR would stabilize the international system and realize the objective stated in Section 7 of the new Article VIII, “promoting better international surveillance of international liquidity.” Proposals for a conversion of dollar reserves through a “Substitution Account” at the IMF were in 1978 viewed favorably by the U.S. administration, perhaps out of a concern that further shocks to the dollar would adversely affect the international standing of the United States.

The proposal ran into difficulties because of the same circumstance that had originally led to the prolonged international crisis and a search for an extended role of the SDR: the weakness of the dollar. The Substitution Account would buy the dollars offered to it by the holders of reserves. Its assets would therefore consist largely of depreciating dollars, while its liabilities would be in harder SDRs: inevitably, this development would soon produce a large hole in the account, which could only be filled by an exchange guarantee on the part of the United States, or the mobilization of the Fund’s gold holdings. The first solution involved the United States in a potentially very large obligation; the second raised the issue of the adequacy of the Fund’s gold holdings and the threat of a collapse of the planned substitution account in the event of a sharp depreciation of the dollar. While the dollar continued to fall, this dilemma remained critical; when the dollar began to rise again in 1980, the proposed account became apparently less urgently necessary, and the proposal was dropped. In consequence, the SDR remained a marginal element in the world monetary system, accounting for a smaller share of global reserves, and a disappointment to its supporters. By the beginning of the 1990s, one commentator observed that “it now barely maintains life, like a plant set into unsuitable soil.”86 Instead, national currencies remained the overwhelming component of official holdings of reserves; and of those national currencies, the dollar was still preponderant. As a share of international reserves, dollars amounted to 68.6 percent in 1980, and were still 56.4 percent of the total in 1990. Although the proportion of reserves held in yen doubled over the course of the 1980s, in 1990 it still only represented 9.1 percent of international reserves. The deutsche mark held a much bigger share, 14.9 percent in 1980 and 19.7 percent in 1990.87 For both these currencies, the reserve role brought major difficulties and concerns. Especially in Europe, the failure of global solutions to the problem of international monetary disorder was the major cause of a renewed interest in regional answers.

A European Initiative

The currency movements of 1977–78, the decline of the U.S. dollar, and the interpretation of European leaders, especially Helmut Schmidt, that this reflected the personality and policies of the U.S. President, prompted in Europe a rediscovery of the political virtues of fixed parity values, which culminated in the creation of a new EMS.88 The high-level personal diplomacy now moved, in the face of U.S. political and economic weakness, from an international to the European arena. The Substitution Account was overtaken and partly superseded by a European initiative to deal with the European difficulties arising from the weak dollar. Whenever shifts out of the dollar occurred, funds did not move equally into all European currencies, but disproportionately into the deutsche mark, as well as the Swiss franc. As a result, the deutsche mark rose against the French franc and the currencies of most of its other neighbors. The European exchange rates consequently did not reflect economic fundamentals so much as the effects produced on the markets by dollar disturbances. The substitution concept, the neatest way of solving the problem, however, developed too slowly, and had none of the political impetus that propelled the regional alternative. After the Europeans’ own proposals became reality, substitution was allowed to fade away. The United States, which had initially been sympathetic, essentially changed tack and opposed the external discipline that such a solution would involve. In addition, the weakness of the dollar directly affected the performance of the European economy. Low German growth, which had been the major complaint of other countries at the Bonn summit, could also he seen as the consequence of the excessive revaluation of the deutsche mark caused by the flight out of the dollar. The weakness of the German economy in turn affected most of all its European neighbors. Robert Triffin formulated the objectives of the new European initiative very neatly: to create “an oasis of stability less at the mercy of the backwash effects of US policies and policy failures.”89

Some commentators, including the chief French negotiator of the EMS, also interpreted Schmidt’s motivation as a need for an act of political revenge after President Carter had canceled the U.S. neutron bomb project, which Schmidt had championed in Germany at a substantial cost to his standing in his own party.90 The new economic understanding also had an inner-European political content, and only became attractive for Germany after the French parliamentary elections of March 1978, the surprising victory of the right in the Chamber, and with it the strengthening of the position of President Valéry Giscard d’Estaing.

The basis of the new idea had already been set out earlier, in 1977, by the new President of the European Commission, Roy Jenkins, who subsequently stated that he was in effect looking for some kind of visibly dramatic action that would distinguish his presidency from that of his predecessor. Humiliated by Giscard d’Estaing over the issue of his presence at the 1977 London summit, criticized in the press, depressed by a gray and damp Brussels summer, and encouraged by his wife to snap out of his psychological low, Jenkins “began to feel that if I wanted to escape from these doldrums rather than wallowing in self-pity I had better strike out with some major new initiative.”91 He came to the conclusion that the Community should return to the goal of monetary union. After discussions with the Commission and with Community foreign ministers, he announced his view in a lecture at the European University in Florence in October 1977. Schmidt initially reacted with a gloomy resignation: Europe, he said, “needed a lead, as did the whole world, but he insisted that a German Chancellor could not give it.”92 In early 1978 Jacques van Ypersele, the Belgian Chairman of the EC Monetary Committee, developed the initiative further in a series of papers in which he developed a proposal for a European unit of account, to be issued by a European Monetary Cooperation Fund, which would move away from the dependence of the old snake on dollar reserves.93

The German Chancellor’s skeptical stance changed after renewed weakness of the dollar, after the French elections, and above all after bilateral negotiations with Giscard d’Estaing. On April 7–8, 1978, at a meeting of the European Council in Copenhagen, the two leaders announced a plan for the more extensive use of the European unit of account for transactions between member governments and for joint intervention against the dollar and third currencies. The plan envisaged a reordering of the international monetary system that “leaves the dollar on one side,”94 as well as multilateral international financial institutions. At the European Council meeting in Bremen (July 6–7, 1978), the basic principles of the Schmidt-Giscard plan were agreed.

From their time as Finance Ministers, Schmidt and Giscard d’Estaing had been intrigued with the workings of the Bretton Woods system, and liked its certainties. In the crises of 1972, both had preferred capital controls to floating, and had resisted the American (and the German Economics Minister Schiller’s) insistence on the inexorability of the liberalization process. One of their British counterparts in the negotiations of 1978 concluded rather acerbically that “they allowed it to be believed that they were experts on the exchange markets. In the early stages of the negotiation of the EMS they thought they could afford to repudiate expert advice.”95 Writing retrospectively about 1972, Schmidt stated: “I was and today still am in principle a supporter of fixed parities, because they serve best the interests of the international division of labor and free world trade and in this way promote the best for all economies.”96

The proposed European structure even resembled the Bretton Woods structure as modified in the great liquidity discussions of the 1960s, with the European currency unit (ECU) playing the role of the SDR in the narrower European system. (Although there is an important distinction. The SDR was designed to meet the need for additional reserves, a need which in the case of the ECU did not exist.)97 In the original scheme, there would even have been a European Monetary Fund. The EMS was an attempt to make the par value system work by choosing a smaller context. Like the classical system, it was intended to bring discipline to bear on national governments, and also on the bargaining of labor and business groups in a national setting. The commitment to a fixed rate would make it clear that the consequences of high pay settlements would be reduced competitiveness and increased unemployment. Stable exchange rates might in this way be hoped to lead to reduced inflation levels. The origins of the EMS were exclusively European, and the exercise of reinventing Bretton Woods in a regional context was at first not regarded by the IMF with great sympathy. The Fund’s energies had been exhausted after the early 1970s battles to save a fixed exchange rate system in countries with highly divergent inflation rates, and it was suspicious at first of any new experiment on these lines. The United States was also worried about the Schmidt-Giscard proposals and fearful about their likely impact on the dollar.98

Like many of the major international monetary and currency agreements of the past half-century, including Bretton Woods as well as Rambouillet, the EMS came out of a very complicated and meticulously prepared but fundamentally bilateral process. At the beginning, there had been trilateral talks, and a senior British civil servant participated in the drafting of a proposal for the European Council. The negotiations broke down because the United Kingdom preferred a global approach to international monetary reform in the context of existing institutions and in particular of the IMF, to a narrow European initiative.99 As a consequence, the field was left to France and Germany. Although the EMS compromise appeared to be even-handed, as in the case of Bretton Woods, in practice the system evolved out of the original conception to suit the preferences and requirements of the state with the surplus position. There existed, however, a substantial common interest. For France, the major attractions lay in the establishment of an external anti-inflationary anchor for the franc (in internal documents the EMS was sometimes described as “une solution de rigeur”). For Germany, it was a system that would limit any excessive appreciation of the deutsche mark as a result of capital inflows. As a consequence, for both countries, the system could be envisaged as avoiding the necessary adjustment through deflation that was required for a fight against inflation in the floating rate regime.100

The details were worked out in a series of discussions between Horst Schulmann, from Schmidt’s Chancellery, and the former Governor of the Bank of France, Bernard Clappier, and embodied in a paper accepted at the Franco-German summit in Aachen (September 1978). They settled all the details, Roy Jenkins said, “over everybody else’s head.”101 They were the White and the Keynes, or the Yeo and de Larosière, of European monetary integration. But, in the same way as the Canadian plan brought together the concepts of Keynes and White, a “Belgian compromise” in the European case overcame the final hurdles to agreement.102

Within Germany, the original conception of the monetary system had been criticized by the Bundesbank, which insisted that exchange rate alterations would become necessary from time to time and that the new system should be more flexible in this regard than the Bretton Woods mechanism as realized in practice. The Bundesbank’s opposition killed the idea of a European Monetary Fund. It also wanted to ensure that currency intervention obligations under the new arrangements would not frustrate the management of German monetary policy: the intervention system should not be allowed to run at the expense of the strong currency. The Bundesbank presented these arguments in discussions with the German government, in the G-10 central bank governors’ meeting in Basle in July 1978, again in the G-10 on November 13, 1978 at which the EMS plan was presented by Jenkins, and when Chancellor Helmut Schmidt made an unprecedented visit to a meeting of the Bank’s Central Council.103 Schmidt assured the Bundesbank that the EMS would not mean higher inflation levels, but at the same time implied that it might by calling the plan a necessary “political sacrifice.” He said that if there were to be a future conflict between the intervention requirements of the EMS and the Bundesbank’s duty of maintaining monetary control, the German government would support the bank. But he gave no written undertaking to this effect. In practice, in designing the EMS, Germany used its position on the EC Monetary Committee in order to limit the extent of intervention obligations within the system and to frustrate the idea of an issue of ECUs by the European Monetary Cooperation Fund.104

At the beginning, the objections on the part of central banks had by no means been confined to the Bundesbank. In July, the Italian and British central bank governors had been outrightly opposed to the Schmidt-Giscard plan, which they regarded as “unworkable.” Too strict a disciplinary framework could only produce a surge in unemployment in countries that were already suffering from that scourge. The governors also argued that “Italy wished to join but could not and the U.K. possibly could but did not want to,” and concluded that the new mechanism would in reality be nothing more than the creation of a mechanism for linking the French franc to the snake.105 The central negotiating point between France and Germany lay in whether the new system should be a parity grid, in which rates were to be established between all the members, or a system built around a common accounting unit.106 Germany preferred the former approach, in that it imposed intervention duties on all the members rather than on the strongest currency, which would be likely to be furthest from a central reference unit. Under the latter, a one-sided appreciation of the deutsche mark relative to the common unit would have obliged Germany alone to intervene to maintain the parity. The solution chosen took the German preference for the parity grid as the basis for the management of the EMS, with the result that the EMS closely resembled the old snake.

The creation of a currency basket unit, the ECU, was more of a cosmetic concession to the French approach, as was the inclusion of a “divergence indicator” (this was the core of the Belgian compromise). This indicator involved no obligation to intervene and merely created a nonbinding “presumption” of responsibility. By the time of the Aachen summit, it had become clear that the paper contained rather more Schulmann than Clappier. Clappier gave the impression of having been outmaneuvered and of being a rather unconvincing defender of the EMS plan.107 Later, the then Bundesbank Vice-President, Karl Otto Pöhl, boasted of having “turned the original concept on its head by making the strongest currency [and not the ECU] the yardstick for the system.”108 In fact, as the Danish central bank Governor, Erik Hoffmeyer, concluded in his study of the international monetary system, “the ecu as a numeraire is purely an accounting device.”109

Initially, Germany’s prospective partners had doubts. Italy was fearful. The British Labour government thought the scheme too European, and feared that fixed parities might stand in the way of policies to reduce unemployment.110 Its recent experience with the IMF had convinced it of the virtues of a global vision of the monetary system. The cabinet paper prepared by the U.K. Treasury even cited the opposition of the IMF staff on the grounds that the EMS might “diminish the standing or role of the IMF in the world monetary system” and weaken the development of the SDR as the world’s major reserve currency.111 But regard for the feelings of the IMF did not represent the real reason for Britain’s failure to join, which was grounded on a fear of external discipline. Even in France, there were doubts. Giscard d’Estaing held up the final French agreement while a solution was negotiated to the politically very intricate issue of Monetary Compensation Amounts (the variance of exchange rates established for agricultural products in the Community under the Common Agricultural Policy, artificially determined rates quite different from market exchange rates). As a consequence, the EMS began operating on March 13, 1979, and not on January 1, as had been planned.

Did this new system collide with the requirements of an international monetary system? Initially, some of the IMF staff had been skeptical about a new regional system. One of the questions put in the staff paper on the EMS was whether the increased commitment of a major group of industrial economies to domestic economic and financial stability would decrease the chances of global growth. The EC might also develop a different approach to the controversial issue of program conditionality.112 On December 14, 1978, Roy Jenkins visited Jacques de Larosière, the recently appointed Managing Director of the IMF, to explain the European initiative.113 He was convincing. At the informal meeting of the Executive Board to discuss the EMS one week later, the reaction was overwhelmingly positive to a system that reflected “members’ understandable wish for more stability in exchange relations than they had had in the past.”114

The Crisis of the Dollar

The view that U.S. weakness precluded effective international coordination appeared to be borne out by the developments of 1978 and 1979. The slide of the dollar continued through the summer and fall of 1978. From September 1977 to October 1978, it fell by 40 percent against the yen and 13 percent against the deutsche mark. At first, the United States reacted with conventional monetary policy responses: a rise in the discount rate to 6½ percent in January 1978 to 7¾ percent by August and then to 9½ percent on November 1. On October 24, 1978, the U.S. government imposed voluntary price and wage controls, in which a 7 percent limit would be policed through guidelines on the distribution of public contracts. On November 1, 1978, a dollar “rescue package” involved as well as the further tightening of monetary policy, the increase of the currency swap arrangement with the Bundesbank to $6 billion, with the Bank of Japan to $5 billion, and with the Swiss National Bank to $4 billion;115 and the issue of “Carter bonds” denominated in yen and deutsche mark. These were measures that earlier had been vehemently rejected by the United States, when the German central bank President Emminger and IMF Managing Director Witteveen had raised the possibility early in 1978.116 U.S. Treasury Under-Secretary Anthony Solomon appeared to reverse the U.S. preference for floating when he said, “We have moved into a very activist definition of countering disorderly markets and, in fact… we are determined to have stability in exchange markets. Michael Blumenthal also changed his tone, stating that “the United States does not need to pursue dollar depreciation to buy market position…. The adminstration firmly rejects such tactics.” For the IMF it reflected “the growing realization that the market cannot always be relied upon to perform the function of dampening fluctuations in exchange rates.”117 In addition, the United States drew $3 billion (SDR 2.3 billion) from the IMF, with no conditionality attached (since this was a U.S. reserve tranche drawing), and sold SDR 2 billion ($2.6 billion) from its holdings. The United States used the borrowed funds to intervene actively in the foreign exchange markets, although the extent of U.S. intervention was greatly exceeded by that of other countries (from October 1977 to December 1978, U.S. net official purchases amounted to $10 billion, while other authorities bought $37 billion U.S. dollars).118

At the end of 1978, the Iranian revolution and the overthrow of Shah Reza Pahlavi set off a new wave of political and economic instability, with chaos on the markets and uncertainties about the security of oil supplies. Partly because of its status as a safety currency in a period of political crisis, the dollar remained surprisingly stable on exchange markets. It rose against the yen and the deutsche mark, and the large currency flows of 1978 into Germany were reversed. Then the search for financial security produced a surge in asset prices and a wave of gold speculation. At the beginning of 1979, the price of gold had been just over $200 an ounce. In the second half of 1979, war between Iraq and the Islamic Republic of Iran broke out. After the seizure of the U.S. embassy in Teheran and its staff by Iranian revolutionaries, the United States froze Iranian deposits in domestic and foreign branches of U.S. banks and demonstrated the fundamentally political character of a paper currency. The Soviet Union’s invasion of Afghanistan heightened political nervousness. The price of gold surged to a high of $875 an ounce on January 21, 1980.

Asset and gold inflation in turn brought domestic political consequences. In 1979, as it became clear that inflation would become an issue in the forthcoming Republican campaign for the presidency, Carter made further demonstrative efforts to fight inflation. He appointed the Chairman of the Federal Reserve Board, William Miller, as Treasury Secretary, and the President of the Federal Reserve Bank of New York, Paul Volcker, as Board Chairman. On his way to the Annual Meeting of the IMF in Belgrade, Volcker was harangued by Helmut Schmidt about the consequences of American neglect and irresolution. Currency intervention mechanisms and the swap network could not on their own produce international economic stability. “One cannot in the final analysis restore the confidence of participants in the market in the economic development of the United States through currency interventions.”119

Volcker, returning to the United States prematurely from the Belgrade meetings, at the meeting of the Open Market Committee on October 6, 1979, secured an agreement to concentrate on the direct control of bank reserves even at the risk that this might produce volatile (and very high) interest rate levels, and to shake expectations about inflation levels. As a result, October 6, 1979 became a watershed, widely recognized as “a real turning point” or “the most significant date in recent monetary history.”120

The London summit declaration, the creation of the EMS, and the dollar defense action had a profound impact on thinking about economic policy, and prepared the way for the reduction of inflation levels in the 1980s and a return to greater stability. Already in 1977, in the wake of the Italian and U.K. crises, there had been evidence that many industrial countries were abandoning fine-tuning, the attempt to adjust fiscal and monetary policies frequently in response to demand conditions; instead they began to look much more for a medium-term framework.121 The 1979 Annual Report of the IMF referred to “the wider recognition that inflation not only leads to instability but also over the longer run adversely affects growth and employment opportunities, constitutes an important first step on the road to a more stable international monetary system.” IMF reports also warned about the wrong kind of stimulatory or compensatory measure: “The 1970s also revealed more clearly the types of economic incentive that are conducive to growth, and in this regard pointed up the need to minimize the negative effects of governmental redistributive income programs on productivity and economic growth, notwithstanding the laudable intent of such programs.”122 This view was also set out quite explicitly in the Interim Committee: “the Committee agreed that the top priority being given in many countries to the fight against inflation must not be relaxed.”123

The change in the leading figures in the world of international finance also coincided with an alteration in the management of the IMF. After Witteveen had made it clear that he did not wish to be reappointed for a second five-year term, the largest quota-holders in the Fund began to look for a suitable successor. The need for a powerful and authoritative personality meant that rumors circulated initially about the appointment of the British Labour Party Chancellor of the Exchequer, Denis Healey, the veteran of the 1976 U.K.-IMF agreement who enjoyed the reputation of being a political “bruiser.” The eventual choice was less irascible. Jacques de Larosière was an aristocratic and coldly rational Frenchman whose gift for persistent negotiation in the face of apparently irreconcilable differences had produced the Jamaica agreement. He became the Fund’s Managing Director in June 1978. The IMF was now guided by one of the makers of the new direction in international economic management, who appreciated the linkages between high-level economic summitry and the desirability of a steadier and more institutionalized approach.

The dollar defense strategy constituted a watershed. On an international level, the situation of Bonn had been reversed. It was now not a case of the United States demanding Japanese or German expansion, but rather of Germany asking that the United States should undertake stabilization. But there was no international forum for this kind of influence; and the decision itself was not taken at German insistence or with international objectives in mind, but rather in accordance with domestic priorities that now set the struggle against inflation as a precondition for economic recovery. In the final analysis, very large countries would only undertake measures (including those affecting the international economy) that corresponded to the outcome of their own internal debates on policy priorities.

The pendulum between rules and discretion in the international order had swung a long way toward discretion after the breakdown of the Bretton Woods “rules.” Discretionary choices pushed the responsibility for making choices—for instance, about when to tackle inflation—back to the level of national politics. In some cases, most strikingly in the United Kingdom and Italy, the burden of that decision posed a heavy strain on the political machinery. Discretion can lead to an overburdening of the political process. The flexibility of exchange rates in the 1970s had reduced external limits on politics. Before 1972, the exchange rate constraint created an obligation to follow sound and judicious fiscal and monetary policies (except perhaps in the United States, where the nature of the Bretton Woods system as it developed in practice meant that the restraint had to be self-imposed). The consequence of being free was greater flexibility, and this allowed political decisions, almost invariably aimed at sustaining greater economic expansion, which in the longer run would limit the room for maneuver more decisively than had the obligation to maintain a par value. Present freedom was being bought at the price of future limitations, as markets eventually responded to signs of fiscal imbalance.

The discretionary approach to international coordination, which reached a high point at the Bonn summit in 1978, produced a strain on the international mechanism analogous to the dilemmas posed by the new freedom in domestic policy. With the absence of rules or methods of arbitration on who should begin with adjustment, coordination in practice too often tended to mean the alternation of attempts at persuasion using economic arguments, with hints or threats of wider political implications, for instance with regard to trade or security policy. It is not surprising that all the participants subsequently felt aggrieved, and that states in Europe and Asia with a strong economic capacity found pressure from the state with a commanding security presence inappropriate and destabilizing.

The experience of the oil crisis in the end confounded both the pessimists and the optimists. It did not lead, as the pessimists had predicted, to the collapse of advanced industrial countries or of the democratic order. But it could not be solved, as the optimists hoped, simply by improved coordination between countries. Differences in the timing of the adoption of stabilization measures created very large current account imbalances. Attempts to synchronize action and to coordinate expansion ended in bitter recriminations. Politicians and their electorates, torn helplessly between desire for expansion and fear of inflation, used the opportunity of coordination attempts to blame policy failures on the other players in the international system.

The outcome of too much discretion was a wish to return to a more adequate management of the system. This was most easily effected in national political settings, where monetary control offered precisely a depoliticized, rules-based approach that would take some of the excessive burden off the political system. Central banks after the mid-1970s tried to impose new rules in the form of monetary targets; but international flows of money and international policy considerations frequently endangered the attainability of these targets. In the EMS, a major group of states attempted to move back in a collective cross-national effort to a more rules-based system, and to limit the room in which currencies could float. In the global international arena, on the other hand, the debates about monetary reform and the outcome that resulted in the Second Amendment of the Fund Articles of Agreement laid down less a basis for a move toward rules than a legal foundation for an approach to coordination based on discussion, persuasion, and the exchange of information. The logical outcome of this approach was less coordinated formulation of policy than the reaching of a common understanding about a stable policy framework, in which markets were exposed to as few surprises and shocks as possible. The principle of surveillance as incorporated in the revised Articles was universal and all-embracing. It covered countries with IMF programs, as well as those without. It included the notion of structural adjustment in all countries with chronic balance of payments difficulties. whether developed or developing,124 It reflected the theoretical or intellectual revolution of the 1970s. In order to secure such adjustment, advice in many cases needed to be linked with the provision of resources during the adjustment period.

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