Chapter

10 Exchange Crises and Changes in the World Economy

Author(s):
Margaret De Vries
Published Date:
June 1986
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After the Smithsonian agreement of December 1971, monetary officials hoped that the new currency alignment would provide the basis for a viable regime, and a temporary arrangement was introduced in which central rates could be substituted for par values and in which the permitted margins were widened. The rates of the Smithsonian agreement were short-lived, however. In June 1972, after another massive speculative attack on the pound sterling, the authorities of the United Kingdom decided they could not maintain the exchange rates for the pound sterling within announced margins. Not only did the sterling rate begin to float but so did the rates for the currencies of 16 other countries that were pegged to it. Then, in January and February of 1973, most of the remaining fixed exchange rates among the major currencies became unmoored. The worst exchange crisis in at least 25 years ended with floating rates being introduced successively for the Italian lira, the Swiss franc, the Japanese yen, and the currencies of a number of primary producing members. The United States proposed a 10 percent reduction in the par value of the dollar, and the dollar underwent its second devaluation in 14 months. Six countries of the European Economic Community (Belgium, Denmark, France, the Federal Republic of Germany, Luxembourg, and the Netherlands), together with Norway and Sweden, agreed to maintain stable rates for the currencies only against each other; notably, their currencies would fluctuate against the dollar. (This “snake in the tunnel” agreement also proved temporary: in March 1973, the spread between the rates for some currencies began to widen and the snake left the tunnel; and in January 1974 France left the snake for six months. For some time thereafter only a “mini-snake” existed.) Almost all the Fund’s developing members decided to maintain relatively stable rates for their currencies with respect to a single currency, usually the dollar, the pound sterling, or the French franc; in effect, the rates for their currencies moved with the rates for these major currencies.

Although there was a certain degree of official intervention in exchange markets, and national monetary authorities consulted each other about the prevailing rates, the new floating rates in general responded to market forces of demand and supply for foreign exchange. When the authorities intervened in the markets to influence the exchange rates for their currencies, the floats involved were referred to as “managed” or “dirty,” as distinct from “clean” floats which were free from official intervention.

Another development in international monetary arrangements was that gold was driven out of use in international financial settlements. In March 1968, national monetary authorities, no longer able to maintain the price of gold at $35 an ounce for all transactions, relegated private transactions (that is, gold used for nonmonetary purposes) into a separate market where prices could be freely determined. The official gold price was later raised, first to $38 an ounce and then to $42.22, reflecting the U.S. dollar devaluations, but speculative demand for gold forced prices in private markets to levels three and four times the official price. With such a gap between the private market and the official price, no one wanted to sell gold at the low official price and virtually all official transactions in gold came to a halt.

In many people’s eyes, as of September 1974, the floating rate system was working much better than had been initially predicted or feared. Its success was considered evident in December 1973 when exchange markets were able to weather sudden large economic problems precipitated by the fuel shortage and sharply higher prices for oil. While relationships between currencies changed markedly, there was an absence of the disruptions in foreign exchange transactions, forced market closings, quick massive shifts of capital, and resulting panic over reserve losses that had characterized economic events of lesser moment in the declining days of the par value system. Hence, the then Secretary of the U.S. Treasury, George P. Shultz, the principal architect of the managed floating rate regime, said in March 1974 that he regarded the introduction of a system of floating rates as his greatest achievement.

Nonetheless, unlike par values, prevailing exchange rates lacked firm foundation in an internationally agreed set of rules or code of conduct, and many observers saw dangers in the existing situation. The Managing Director, H. Johannes Witteveen, emphasized that higher oil prices and energy supply shortages would place much greater strains on international monetary relations in 1974 and that the hazards of competitive depreciation and of proliferation of mutually frustrating restrictions on trade and capital flows were greater than at any time since the 1930s. To bring about a reform of the world monetary system, the Committee of Twenty worked intensively from September 1972 until June 1974 on the many technical and complex issues involved. Final agreement was not possible, however, and instead a framework for a proposed evolving international monetary system was agreed on June 12–13. Under this evolutionary process, some interim steps were implemented immediately, while other steps continued to be negotiated and were taken later.

CHANGES IN THE WORLD ECONOMY

These crises in exchange rates and in the international monetary system can be seen as the direct result of the basic changes that had occurred in the world economy since World War II. The basic changes had been so profound and fundamental that they had gradually completely transformed all international economic and financial relations.

Foremost was international economic integration. Instant worldwide communication and global mobility had unified diverse economies. For the first time, the term “world economy” had meaning: it no longer consisted of the sum of the economies of a number of distinct units; it was the economy of all nations together. The oil crisis of 1973–74 was a graphic demonstration of how closely integrated the economies of all industrial and all developing countries had become. But the world’s economic interconnections had for many years already been indicated by a continuous expansion of world trade that was nothing short of remarkable and that persisted in the 1960s and early 1970s despite repeated currency crises. In the decade from 1960 to 1970 the volume of world trade went up by more than 8 percent a year and the trade of several industrial countries rose considerably faster. In more and more countries, imported products had become so numerous that they were no longer distinguishable from domestically produced goods.

Production had also become international. Ties between, and within, corporations had grown and extended beyond national boundaries. As an illustration, automobiles for all the major U.S. producers were being built in Canada, the Federal Republic of Germany, Japan, and the United Kingdom, and components for models assembled in the United States were being produced in a number of plants outside the United States. But multinational corporations with operations on a global scale consisted not only of companies with headquarters in the United States but also in France, the Federal Republic of Germany, Italy, Japan, the Netherlands, and the United Kingdom. The topic of multinational corporations had itself become of sufficient complexity that it had become a separate discipline of international economic study.

Labor, too, had become very mobile. Skilled as well as unskilled workers moved readily from one country to another, especially within Europe, and the ease with which professionals practiced in countries other than those of their origin had considerably accelerated.

International Financial Integration A second change in the world economy that had gradually developed after currencies had become convertible was international financial integration. U.S. banks, for instance, had opened many overseas branches, and the number of foreign banks undertaking operations in London, the center for handling Euro-dollars, had swelled appreciably. Bankers of various countries throughout the Western Hemisphere, Europe, Asia, and the Middle East had developed close working relationships with one another. In effect, a progressive internationalization of banking operations had taken place.

The close interconnections between banks and the growth of multinational corporations had direct consequences for foreign exchange markets. There had developed in the world economy companies with sizable balances of working capital, ready access to borrowing facilities in many countries, and the ability and know-how to take advantage of interest rate spreads and currency crises in the countries where they operated. With a telephone call, these companies could, within minutes, switch their excess balances, or even their working funds, from one currency to another. In fact, it had become a matter of good management for the treasurers of these companies to make such shifts to safeguard their balances, especially against loss from currency depreciation.

The enormous size of capital balances and flows had also given a new dimension to international financial affairs—for example, it was being estimated in 1974 that the Euro-dollar market might reach $200 billion by 1976. Capital shifts of the equivalent of several billion dollars within a few weeks’ time were not unknown. The extreme volatility of capital flows, in response to interest rate differences or anticipations of exchange rate changes, was in large part responsible for undermining the international monetary order that existed until the late 1960s. Accordingly, the influence of exchange rate, monetary, and financial policies on balance of payments capital accounts had become at least as important a consideration in determining these policies as their impact on trade and other current account items.

The implications of such an economically intertwined world were far-ranging. Markets not only for goods but for capital, business enterprises, and even labor had exceeded the span of national control. As a result, economic decision makers had a great deal less freedom than previously in the formulation of national economic policies. This was true not only for exchange rate and trade policies affecting the external sector of economies but also for internal policies affecting interest rates, credit expansion, domestic investment and employment, government taxation and expenditures, or the newer incomes policies. Economists were re-examining their traditional theories of international trade, exchange rate determination, and balance of payments equilibrium. Theories based on assumptions about immobility of factors of production, incomplete knowledge on the part of producers and consumers, and physical barriers to the movement of goods and persons had become obsolete in a world of swift transportation and communication approaching the speed of light. Increasing attention was being given to the economics of interdependence and of a transnational economic system.

Additional Dramatic Changes Another salient feature of international economic relations was the rapidity with which economic forces could, and did, change. For some years before the mid-1970s economic forecasting had been a hazardous occupation. Within a few months surpluses turned to deficits and full employment deteriorated. But the pace of change had greatly accelerated in the 1970s. The impact of higher oil prices announced toward the end of 1973 particularly demonstrated how quickly the outlook for countries’ economies and their balance of payments positions could be reversed.

Still another change in the world economy, perhaps the most significant of all, was that by 1974 no one nation dominated the world economic stage. Since the end of World War II the relative economic strength of the Western European nations and of Japan had been much improved. In the early 1970s the oil producing countries had also become economically strong. All of this meant that economic power had become distributed among a number of countries. In addition, and as became clear in the UN General Assembly’s special session of April 1974 on raw materials and economic development, the Third World countries had become aware of, and had demonstrated, their potential economic clout, especially when acting in unison.

Through the 1950s the key decisions bearing on international economic relations were made by two or three large industrial countries. In the 1960s and 1970 and 1971 the key decisions concerning international monetary arrangements were usually the result of conferences among several major industrial countries, usually acting as the Group of Ten. Thereafter, developing countries, too, were brought into the decision-making process, such as in the Committee of Twenty, created in mid-1972, and by 1974 increasingly greater attention was being paid to the consequences of all international economic relations for developing countries. In the international trade field, concern increased, for example, over their access to the markets of industrial countries; in the international monetary and finance fields, it increased over the availability of financial assistance for developing countries.

Still another way in which the world economic environment of the early 1970s showed substantial differences from that of the 1950s and 1960s was that most countries were suffering from historically high rates of inflation, which showed no signs of abating. Inflation had become a worldwide phenomenon and the prime concern of the world’s political leaders. Not only were nearly all countries plagued with very rapidly rising prices, but, in an anomaly previously unknown to economists, inflation coexisted with unemployment. Except in one or two countries where the trend had been reversed, satisfactory ways to control inflation kept eluding economists and monetary officials.

Moreover, in an interdependent world, rising costs and prices were almost instantaneously transmitted, in a cost-push inflationary spiral, from one economy to another. Similarly, transfers of capital between countries, which influenced the amounts of liquidity in an economy, had direct repercussions on the rates of inflation experienced. As a result, national economic authorities had become greatly troubled because inflation in other countries was aggravating their own inflationary difficulties.

Another significant economic trend in the early 1970s was concern with the world’s dwindling supply of natural resources and the adverse ecological effects of ever-rising population levels and living standards. There was an enhanced awareness that the raw materials and primary commodities essential for world prosperity and economic growth were exhaustible. Shortages not only of oil but also of foodgrains and fertilizers were being felt, and there were expectations of shortages of other commodities. These considerations had led many economists at the time to deliberate seriously “the limits to economic growth.”

ELUSIVE GOALS

The above changes brought about a world economy in the 1970s that was vastly different from that existing 30 years earlier. The new world economy made it much more difficult for central bankers and economic policymakers, including those in the international economic institutions established after World War II, to achieve the four principal objectives of economic policy that, for the previous three decades, had been their goals: full employment, price stability, economic growth, and balance of payments equilibrium.

The new world economy came into being not because of the failure of the economic policies pursued since World War II but rather because of their success. Although, admittedly, the world as of the middle of 1974 still faced severe poverty, dire contrasts in levels of income and living standards, resource shortages, and famine, the new problems that had emerged had been created by the enormous outpouring of wealth, commodities, and capital that had resulted from the successful pursuit of economic policies after World War II. It is in the light of this much altered world that the developments in international monetary arrangements of the early 1970s must be viewed.

In sum, the international monetary system that was designed during World War II buckled when it was subjected to entirely new types of economic pressures. By the same token, it was not easy for monetary officials in the early 1970s to put together a new and viable system that fitted the existing world economy. New international monetary machinery required a mechanism to assure quick correction of imbalances in international payments; a mechanism that apportioned the responsibilities for such correction between deficit and surplus countries and that enabled all countries to maximize employment. Also needed was a currency unit for monetary reserves that was sufficiently stable in value and had features to make it a reserve asset in which monetary authorities could have confidence. At the same time, any system had to ensure economic growth, especially the economic growth of developing countries. But, it was the very goals of external payments equilibrium, full employment, price stability, and growth for which the Fund was formed that had become elusive in this new world economy.

Chronology, 1966–71

1966
February 23To increase the supply of liquidity provided through the Fund, a second increase in Fund quotas was agreed, with a general increase of 25 percent for all members and special increases for 16 members. The Fund’s resources were enlarged from $16 billion to $21 billion.
March 3The Managing Director, Pierre-Paul Schweitzer, proposed to the Executive Directors, and then to the Group of Ten, an approach to reserve creation through the Fund that would include distribution of any new reserve asset to all members.
April 25Mr. Schweitzer spoke out publicly in favor of a reserve-creating scheme that would apply to all Fund members.
September 20The Fund extended and liberalized the facility for compensatory financing of export shortfalls that it had introduced in 1963.
November 23To ensure the effective participation of all Fund members in discussions about reserve creation, the Executive Directors, who as a group represented all Fund members, agreed to hold a series of meetings with the Deputies of the Group of Ten to discuss “a contingency plan” for reserve creation (i.e., a plan that could be implemented when and if additional reserves should be needed). Such joint meetings were unprecedented.
November 28–30The first joint meeting of the Executive Directors and the Deputies of the Group of Ten was held in Washington. The Group of Ten had gradually come to accept the idea of a reserve plan that would apply to all Fund members.
1967
January 25–26The second joint meeting of the Executive Directors and the Deputies of the Group of Ten was held in London, but still no broad support was shown for any one reserve-creating plan. The finance ministers of the countries of the European Community (EC), meeting separately in The Hague, requested their experts to study “ways of improving international credit facilities within the Fund.” It began to appear that some plan based on “special drawing right” in the Fund might be acceptable, provided that there was agreement also to EC suggestions that would require, among other changes in the Fund, a voting majority of 85 percent of the Board of Governors for any allocations of SDRs.
February 23 and 28The Fund staff stepped up examination of possible reserve-creating schemes, especially those based on drawing right in the Fund, and circulated revised illustrative plans.
March 17Henry H. Fowler, Secretary of the U.S. Treasury, in a speech before the American Bankers Association urged immediate agreement on a plan for reserve creation.
April 24–26 and June 19–21The Executive Directors and the Deputies of the Group of Ten met for a third time, in Washington, and for a fourth time, in Paris. The SDR began to take shape, as most features of a contingency plan were worked out.
July 17–18 and August 26The ministers and governors of the Group of Ten met in London and agreed on voting majorities and reconstitution provisions for a plan for deliberate reserve creation.
September 29After four years of negotiations, an outline of a contingency plan for the deliberate creation of reserves was ready. At the Annual Meeting in Rio de Janeiro, the Board of Governors approved an “Outline of a Facility Based on Special Drawing Rights in the Fund” and requested the Executive Directors to begin drafting amendments to the Articles of Agreement that would establish an SDR facility in the Fund and make certain changes in the Fund’s rules and practices, including rules pertaining to voting majorities.
September 29Primarily at the urging of the African members, the Board of Governors requested the Fund and the World Bank to study jointly the problem of stabilization of the prices of primary products.
November 18–29The United Kingdom, experiencing severe payments deficits and reserve losses, devalued the pound sterling from $2.80 to $2.40 per pound, a devaluation of 14.3 percent in terms of dollars. The Fund approved a $1.4 billion stand-by arrangement for the United Kingdom.
December 1The Executive Board began consideration of a draft of a proposed amendment to the Articles of Agreement.
1968
March 16–17Following a flight from the dollar and a rush into gold after the devaluation of the pound sterling, the central banks of seven industrial countries agreed to buy and sell gold at the official price of $35 an ounce only in transactions with monetary authorities. A two-tier market thus emerged with two prices for gold, one price for official transactions and another, determined by market forces, for private transactions.
March 29–30The ministers and governors of the Group of Ten met in Stockholm to resolve differences over several points in the proposed First Amendment to the Articles of Agreement being drafted by the Executive Directors.
April 16The Executive Board completed its work on the Amendment and submitted its report to the Board of Governors.
May 31The Board of Governors, by mail ballot, approved the Proposed First Amendment, which was then submitted to members for acceptance.
June 4–19For the first time in several years, the French franc came under severe pressure and France drew $745 million from the Fund. The United Kingdom also drew the $1.4 billion authorized under its stand-by arrangement approved in November 1967.
September 20At the urging of several Executive Directors for developing members, the Fund reviewed its policies on the use of resources under stand-by arrangements. Guidelines were adopted to ensure uniform and equitable treatment for all members.
November 20–22Recurrent crises in exchange markets for the French franc and for the deutsche mark caused the Group of Ten to meet immediately in Bonn to discuss possible measures, including adjustments in the exchange rates for these two currencies. No exchange rate action was agreed.
December 31Owing to the balance of payments difficulties encountered by several industrial members, drawings from the Fund for the year totaled $3.5 billion, the largest annual amount since the Fund commenced operations in 1947.
1969
June 20After the pound sterling devaluation of 1967, the U.K. payments position improved only slowly and the Fund approved another stand-by arrangement for the United Kingdom, for $1.0 billion.
June 25After careful study of the problem of stabilization of the prices of primary products, the Fund introduced a new facility to finance international buffer stocks of primary products.
July 28The First Amendment to the Articles of Agreement entered into force.
August 6The Special Drawing Account (the new separate account for SDRs) came into existence.
August 10France’s payments difficulties continued and France devalued the franc from 0.180 gram of gold per franc to 0.160 gram (i.e., by 11.11 percent).
September 19The Executive Board approved a stand-by arrangement for France for $985 million, and shortly thereafter France purchased $500 million under the arrangement.
September 29The Federal Republic of Germany had had continuous payments surpluses, and speculation persisted that the deutsche mark would be revalued. To stem excessive inflows of short-term capital, the authorities allowed the rate for the deutsche mark to float.
October 3The Board of Governors approved the Managing Director’s proposal to make a first allocation of SDRs in an amount of SDR 9.5 billion over a basic period of three years to begin January 1, 1970.
October 17The Executive Board agreed to a second renewal of the General Arrangements to Borrow (GAB), under which the Fund could borrow up to $6 billion from its ten largest industrial members. The renewal was for five years to begin October 24, 1970.
October 26The Federal Republic of Germany ended the floating rate for its currency by revaluing the deutsche mark from 25 U.S. cents per deutsche mark to 27.3224 U.S. cents (i.e., by 9.39 percent).
November 7As the exchange rate system established at Bretton Woods came under increasing criticism from both university economists and some government officials, the Executive Directors resumed the review of the role of exchange rates in the adjustment of international payments that they had begun earlier in the year in connection with their Annual Report for 1969.
December 1–30The Executive Directors took a series of decisions preparatory to the first allocation of SDRs, thus making it possible for the first operations and transactions in SDRs to begin.
December 30In a reversal of past policy, the Fund agreed to buy gold from South Africa.
December 31Drawings from the Fund for the year totaled $2.5 billion, the largest total to date for any year except 1968.
1970
January 1The first allocation of SDRs was made, for SDR 3.5 billion.
February 2France drew the $485 million remaining under its standby arrangement with the Fund.
February 9After long discussion in the Executive Board and the holding of special meetings by the Group of Ten, an increase in Fund quotas under the Fifth General Review was approved by the Board of Governors. If all members increased their quotas to the maximum proposed, total quotas would rise from $21.3 billion to $28.9 billion.
May 31Canada experienced difficulties with capital outflows to the United States and, after eight years with a fixed exchange rate, again introduced a floating rate.
September 13The Executive Board reported to the Board of Governors on the role of exchange rates in the adjustment of international payments, but no radical changes in the exchange rate mechanism were proposed. In closing the Annual Meeting in Copenhagen, the Chairman of the Board of Governors observed with regard to exchange rate flexibility that “there seems to be a consensus in favor of further study by the Fund but against any radical or major changes.”
October 26The Fund decided that restrictions or restraints on commercial transactions that resulted in payments arrears are exchange restrictions subject to the Fund’s approval.
November 25The Fund made the buffer stock financing facility available to members for tin, the first commodity for which use of the facility was approved.
1971
January 1The second allocation of SDRs was made, for just over SDR 2.9 billion.
May 9–11To stem heavy capital inflows, the Federal Republic of Germany and the Netherlands allowed the rates for their currencies to float, the Belgo-Luxembourg Exchange Institute enlarged the free market for capital transactions, and Austria revalued its currency.
July 16The first purchases under the buffer stock financing facility were made by Bolivia and Indonesia, followed by Malaysia on August 6.
August 15After several years of large payments deficits, losses of gold reserves, and large accumulations of dollar liabilities abroad, the United States informed the Fund that it would no longer freely buy and sell gold for the settlement of international transactions, thus suspending the convertibility of officially held dollars. Two main features of the Bretton Woods system—par values and dollar convertibility—were thus no longer operative.
August 16–28Exchange rates were in disarray, as Fund members introduced various exchange rate arrangements. Rates for several major currencies were allowed to float. There was an atmosphere of crisis among monetary officials as the Bretton Woods system began to collapse.
October 1The Board of Governors adopted a resolution calling for immediate study of measures to improve or reform the international monetary system. A process of negotiating a widespread reform of the world monetary system began.
December 17–18After four months of trying to reach agreement, the Group of Ten concluded the Smithsonian agreement, providing for a realignment of the currencies of the major industrial countries and an increase in the official price of gold from $35 to $38 an ounce. This agreement represented the first time in world monetary history that several countries had negotiated their exchange rates around a conference table.
December 18Since the traditional system of par values and narrow margins was no longer in effect for all members, the Fund established “a temporary regime of central rates and wider margins.”

Note: This article was published earlier in a slightly different form in Finance & Development (Washington), Vol. 11 (September 1974), pp. 10–12.

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