Chapter 24: Examining the Exchange Rate Mechanism (1969–70)
- International Monetary Fund
- Published Date:
- February 1996
Reform of the International Monetary System was being advocated as early as the middle of 1968. In particular, proposals were being put forward to alter the par value system so as to permit greater flexibility of exchange rates. Academic economists, for example, were proposing methods by which exchange rates could be adjusted more readily and were suggesting that they have some interchange of ideas with the banking and business world.1 Those monetary officials who were not yet advocating reform had, as a minimum, become seriously concerned about the functioning of the system. The developments described in the preceding four chapters had made it clear that one crisis quickly followed another. Many officials were worried that these crises, plus the prolonged deficit in the U.S. balance of payments, placed the stability of the international monetary system in jeopardy.2
At the 1968 Annual Meeting, even as the accomplishment of amending the Articles of Agreement to incorporate the SDR facility was being hailed, Mr. Schweitzer gave recognition to these developments and concerns. His remarks to the Board of Governors on September 30, 1968 ended on this note:
I should be the first to recognize that we have much unfinished work on our hands. The world does not stand still and the effort to improve the monetary system which serves it is an unremitting task. Standing as it does at the heart of the system, the Fund is deeply committed to this task. The Fund has given evidence of that commitment in the past through its flexible response to the needs of the times. It will remain alert to those needs and actively explore what contribution it might make to the further strengthening of the world monetary system. Continuing attention will have to be paid to the working of the adjustment process, the long-term structure of reserves, and the role of reserve currencies within that structure. These, Mr. Chairman, are major issues for the Fund in the period ahead.3
In the last few months of 1968, attention centered on the probable need for adjusting the exchange rates of the currencies of at least some of the large industrial countries, the Bonn meeting in November being aimed specifically at discussing the rates for the French franc and the deutsche mark. No changes in exchange rates were made, however. As a consequence of this further evidence that par values were exceedingly difficult to change, the feeling was growing that amendment of the Bretton Woods arrangements with respect to the supply of liquidity, which had just been approved, would have to be supplemented by amendment with respect to the process of balance of payments adjustment in general and the exchange rate regime in particular. Recommendations that some kind of meeting or conference be called to reconsider the general system by which exchange rates were altered under the Fund’s Articles of Agreement began to be made quite frequently, even by highly placed monetary officials.
These developments prompted the Executive Directors to agree in January 1969 to a thoroughgoing review of the mechanism of exchange rate adjustment, the first such review since the Fund’s Articles had entered into effect. After a year and a half of deliberations they produced a report, The Role of Exchange Rates in the Adjustment of International Payments.4 The present chapter gives an account of these deliberations and the resulting report, and explains the lack of action by the Board of Governors at the Annual Meeting in Copenhagen in September 1970.
Proposals for improving the adjustment process, especially the exchange rate mechanism, stemmed largely from two problems which, after about 1965, began to disrupt the previously smooth operation of the international monetary system. One, the imbalance that had plagued international payments for ten years seemed to be perpetual; and its prolongation implied that the process of balance of payments adjustment was not working properly. Two, short-term capital movements, which had become of unprecedented dimensions, were seriously adding to the difficulties of attaining payments equilibrium or of preserving exchange rate stability.
The imbalance in world payments consisted principally of the coexistence of a large deficit in the balance of payments of the United States and sizable surpluses in the balance of payments of a number of other industrial countries. The U.S. deficit, which when it first emerged in the late 1950s had been welcomed as a way to redress the chronic world dollar shortage of the early postwar period, and which had been considered temporary, persisted into the late 1960s, becoming especially large after 1965. This deficit had been a source of concern even before apprehensions about the working of the balance of payments adjustment process became serious in 1968. The reader of Part One will recall these concerns and that periodic improvements and deterioration in the U.S. external payments position had profoundly affected the discussions on the need for a new reserve asset in the monetary system.5 The reader of Part One will recall mention also of a number of steps taken by the U.S. authorities to reduce external deficits. Among the measures taken were extraordinary ones aimed at curbing the outflow of private long-term capital, particularly of direct investment in Europe: an interest equalization tax had been introduced in 1963 and extended in 1965, and a voluntary foreign credit restraint program providing guidelines to banks and other financial institutions for the reduction of their dollar outflows had been introduced in 1965.
Measures to restrain capital outflows had been emphasized in a context in which huge long-term capital transfers, both private and official, were the primary cause of the U.S. payments deficit. In 1965, for instance, the United States had had a surplus on current account (defined here as in the Fund’s Annual Reports for these years as the balance on goods, services, and private transfers) of $6.0 billion. This surplus, while sharply lower (by $1.6 billion) than the current account surplus in 1964, had been, nonetheless, much higher than those in most previous years except 1964.6 There was, however, a large deficit on capital account because U.S. long-term private investment continued to be very large—about $4.5 billion a year—as the United States had for many years been the main exporter of funds for direct investment and, in addition, capital payments and transfers abroad by the U.S. Government had remained substantial, more than $3 billion a year. Together with short-term capital flows, the deficit on capital account in 1965 had been $7.5 billion. The overall deficit, as measured on the official settlements basis, had thus been $1.5 billion.
Year-by-year developments in the U.S. balance of payments position in the next few years indicate the complex of factors underlying the U.S. external deficits and the attempts to deal with these deficits. In 1966 the voluntary foreign credit restraint program continued to operate under guidelines that were increasingly restrictive, and there was a decline in the net outflow of private long-term capital that outweighed increases in the outflow of government payments. A tightening of general credit conditions in the United States to curb growing inflationary pressures led also to a considerable inflow of short-term banking funds. The capital account deficit was accordingly reduced to $4.3 billion. However, the slack that had been prevalent in the U.S. economy was ending, and as domestic activity expanded to close to capacity and U.S. prices began to rise, imports rose considerably. As a result, a marked deterioration of the U.S. current account took place; the surplus was only $4.1 billion. Thus in 1966 the United States still had an overall deficit—of about $200 million.
To contain inflation and to dampen imports, the U.S. Administration in January 1967 announced its intention to propose certain tax measures to take effect at mid-year, including a 6 per cent surcharge on the income tax liabilities of individuals and corporations. In August, when the expected budget deficit had become much larger than that initially forecast, the Administration proposed that the surcharge be at the rate of 10 per cent and requested that the planned reductions in certain excise duties be postponed. These proposals remained under consideration in the Congress for many months. Also during 1967 the voluntary foreign credit restraint program continued to apply, the interest equalization tax was amended and extended for two years beyond July 31, 1967, and the Administration was given discretionary power to vary the effective rate of the interest equalization tax within a specified range, actually applying new effective rates in August.
In 1967 the balance of payments deficit worsened considerably. Aggregate domestic demand expanded rapidly, the rise in prices accelerated, imports again surged upward, and the current account surplus deteriorated further, to $4.0 billion. At the same time, net capital outflows once more increased, and the capital account deficit reached $7.4 billion. Official transactions accounted for most of the increase in capital outflows: there were virtually no advance debt repayments to the United States by foreign governments in 1967, as there had been in 1966, and loans by the Export-Import Bank rose sharply. The private long-term capital position showed a much smaller deterioration. The voluntary foreign credit restraint program, together with rising interest rates in the United States, had induced U.S. corporations to borrow abroad for their overseas operations in amounts greater than ever before; and there had been large placements of bonds and other securities in the U.S. securities market not only by Canada, which customarily borrowed large amounts in U.S. markets, but also by many developing countries. The overall U.S. deficit reached $3.4 billion, the highest since 1960 and considered at the time to be a large sum. Foreign reserves of the United States at the end of 1967 had declined to $14.8 billion, from $19.4 billion at the end of 1960, and liabilities to foreign official agencies in these seven years had risen from $11.9 billion to $19.3 billion.
Tighter U.S. Measures in 1968
It was evident that inflation in the United States had been accelerating since the latter part of 1965, when military expenditures associated with the war in Viet-Nam had increased. Hence, on January 1, 1968, President Johnson, in a special New Year’s Day message, announced a new, comprehensive program both to slow down inflationary pressures at home and to improve the balance of payments. He again urged the Congress to enact a 10 per cent surcharge on individual and corporate income taxes, and leaders of business and labor were asked to make more effective the existing voluntary program of wage and price restraint. On the external side, mandatory controls on direct investment abroad were introduced. New outflows on account of direct investment to countries in continental Western Europe and other developed nations not heavily dependent on U.S. capital were to be stopped altogether in 1968. Net new investments in other developed countries would be limited to 65 per cent of the 1965–66 average, and such outlays in developing countries would be limited to 110 per cent of the 1965–66 average. The program also required that businesses continue to repatriate foreign earnings in line with their 1964–66 practices. The voluntary program for banks and other financial institutions was also tightened, with the restraints now to be formulated in such a way that there would be a net repatriation of funds from continental Western Europe.
In addition to the measures controlling capital outflows, the new program included a proposal for congressional action to reduce the balance of payments impact of foreign travel by U.S. residents; reductions in net government expenditures abroad, partly through negotiations with other countries designed to minimize the foreign exchange costs of maintaining U.S. troops in Europe; consideration of possible legislative measures in the area of tax rebates on exports and special border tax charges, depending on the outcome of negotiations with other countries aimed at reducing the international trade impact of differences among national tax systems; more intensive efforts to promote exports; and the development of new incentives for foreign investment and travel in the United States.
For the calendar year 1968, the U.S. authorities expected the new program to yield balance of payments “savings” of $3 billion, of which $1 billion was to result from the measures to curb direct investment outflow and $0.5 billion from the tightening of the voluntary program for banks and other financial institutions. The U.S. balance of payments would, accordingly, be brought back to equilibrium, or close to equilibrium.
During the course of 1968, because the economy continued to be overheated, further measures were taken. On the fiscal side, the tax increase proposed to the Congress by the Administration in 1967, including the 10 per cent income tax surcharge, was enacted in June 1968, and was accompanied by substantial cuts in government expenditures. On the monetary side, the discount rate was twice raised, reserve requirements against demand deposits at large banks were increased, and open market operations were directed toward a tighter monetary policy.
Primarily as a result of the measures taken, but also because purchases by countries abroad of existing U.S. corporate securities on U.S. markets doubled, there was an exceedingly large turnaround in the U.S. capital account in 1968. It improved by $7.5 billion. The overall payments position on an official settlements basis moved from a deficit of $3.4 billion in 1967 to a surplus of $1.6 billion in 1968—a favorable swing of $5.0 billion. These surpluses imparted to the dollar a new and timely strength in foreign exchange markets after the middle of 1968 and through most of 1969, and thus it was not seriously affected by the crises of 1968 and 1969 that disturbed European currencies (described in Chapter 22). Nevertheless, the current account in 1968 worsened further, by some $2.6 billion, and the surplus was only $1.4 billion.
Discussions of U.S. Deficit
The management and staff and the Executive Directors had been following these developments in the U.S. economy and balance of payments position very closely, especially through the Article VIII consultations. Assessing the situation at the beginning of 1969, the Fund staff believed that, despite the surpluses of 1968 and the renewed strength of the dollar in exchange markets, the U.S. external accounts had a very unbalanced structure. Traditionally, the United States had had a large trade surplus, and a resulting large current account surplus that had helped to finance long-term capital outflows. The trade surplus, however, had gradually dwindled from $6.8 billion in 1964 to $3.9 billion in 1967 and to only about $0.6 billion in 1968. The staff believed that the crux of the U.S. payments problem was that the loss of a trade surplus yielded a current account surplus much too small to cover the substantial outflows of private long-term capital and government expenditures abroad.
At about this time a new Administration, which took office in January 1969 under President Richard M. Nixon, introduced additional measures to deal with the domestic inflation and the external deficit. For the fiscal year 1969/70 there were to be downward adjustments in expenditures, repeal of the tax credit for investment, and extension of the surcharge on individual and corporate income tax at the prevailing rate of 10 per cent during the second half of the calendar year 1969 and at 5 per cent during the first half of 1970. The budget was expected to yield a surplus in the fiscal year 1969/70 of $6 billion. (The fiscal year 1968/69 had ended with a surplus of $3 billion, compared with a deficit of $25 billion in the fiscal year 1967/68.) In addition, the Federal Reserve Board once again raised the discount rate and the reserve requirements on demand deposits. Policy measures addressed specifically to the balance of payments, such as mandatory controls on U.S. direct investment abroad and the voluntary restraints on bank lending to foreign borrowers, were not substantially altered.
The tighter financial restraints produced a marked slowdown of economic activity in the United States in 1969. Prices, however, continued to rise rapidly and the strength of inflationary forces was manifested in the largest increases in prices and unit labor costs in almost two decades. The restrictive financial policies combined with the persisting inflationary momentum of the economy produced a striking mixture of balance of payments results—generally disappointing in the current account but favorable in the capital account. The trade surplus was less than $0.7 billion and the current account surplus was only $0.8 billion. On the other hand, a heavy influx of banking funds made for an inflow of foreign capital to the United States which, as in 1968, offset a moderate increase in the outflow of U.S. capital to other countries. Thus, in 1969 the overall surplus on an official settlements basis reached a record high figure of $2.9 billion.
Executive Directors’ Positions
As expressed in their Annual Report for 1970, the Executive Directors considered that neither of the two bases commonly used for measurement, the official settlements basis or the liquidity basis, represented a valid gauge of the external payments position of the United States. They regarded as a preferable guide the basic balance, a concept developed within the Fund, as a better measurement of members’ payments positions. Basic balance was defined as the balance on goods, services, and private transfers (that is, the current account) plus net long-term capital. The basic balance of the United States showed a deficit in 1969 of about $2.5 billion.
In 1970 the U.S. economy continued to be sluggish and unemployment rose, but the inflationary forces built up over several years continued to exert strong upward pressure on costs and prices. Because exports increased considerably, the U.S. surplus on current account rose to $2.1 billion. However, U.S. banks liquidated the large volume of Eurodollar liabilities that they had acquired during the period of credit stringency in 1969, and an outflow of liquid banking funds reversed the surplus on an official settlements basis to an unprecedented deficit of $9.8 billion. The basic balance was again in deficit by about $2.5 billion. By the end of 1970 the official reserves of the United States were down to $14.5 billion, the lowest they had been in the postwar period. Moreover, U.S. liabilities to foreign official agencies had risen to $24.4 billion, much higher than they had ever been, exceeding U.S. official reserves by close to $10 billion.
In July 1969, and again in April 1970 and in January 1971—that is, three times within a year and a half—the Executive Directors considered the domestic and external economic and financial problems of the United States. The occasions were the 1968, 1969, and 1970 Article VIII consultations. The views expressed by the Executive Directors as they considered the U.S. position in these years are indicative of the views on the U.S. balance of payments that were being expressed by other monetary officials, privately and publicly, both at the time and later.
Of primary concern to most of the Directors were the implications of the continued U.S. deficit for the international monetary system. They had just finished introducing SDRs into the system to improve the mechanism for creating liquidity, and now they were worried about the mechanism for balance of payments adjustment. They were especially mindful that, as the staff had stressed in its reports, the strengthening of the U.S. balance of payments was a basic prerequisite to improving the adjustment process and restoring confidence in the soundness and effectiveness of the international monetary system. Whatever the Fund might do in the foreseeable future to bolster the system, a better U.S. balance of payments position was vital to a successful outcome of the Fund’s efforts. Against this background, the Executive Directors were therefore eager that the U.S. authorities should be successful in their endeavors to cool off the inflation in the domestic economy and to bring about “an impressive improvement” in the balance of payments, whatever definition of “deficit” was used.
At their meeting in July 1969, the Executive Directors recognized the difficulties of being a high official in the U.S. Government: his actions and decisions, or absence thereof, had not only a national but a worldwide impact. By contrast, the Executive Directors’ own positions were relatively easy. Nevertheless, they tried to come up with specific suggestions, some believing, for example, that the U.S. authorities put undue weight on monetary policy instead of fiscal policy, and some regretting the lack of an incomes policy. Most were concerned lest the deteriorating U.S. trade situation provoke greater protectionist sentiment and practices in the United States.
Several Executive Directors, notably Messrs. Johnstone, Lieftinck, Plescoff, Schleiminger, and Stone, stated forcibly that the U.S. authorities had to deal decisively with inflation and the inflationary psychology that had taken hold in the United States, stressing that the world economy could not function successfully so long as rapid inflation continued in the United States. Mr. Stone said that he had examined the U.S. national accounts in detail and had concluded that there was not much evidence that the anti-inflationary policies were working. Data showed that the growth of the gross national product at constant prices had slowed down; but he was less interested in slowing down output than in slowing down expenditure. Lower output aggravated inflation. Expenditure itself had actually been rising, causing higher prices and higher costs. Productivity had been increasing, but at slower rates than before. In addition, the U.S. balance of payments position, in Mr. Stone’s view, was now worse and showed no sign of improvement.
At their meeting in April 1970, the Executive Directors were more critical of U.S. endeavors “to curb inflationary pressures by a gradual adjustment process that would slow down the rise of demand without inducing an undue rise of unemployment.” In the opinion of Mr. Palamenghi-Crispi, for instance, “evenhandedness,” “fine-tuning,” “jaw-boning,” “gradualism,” and other terms used to denote the U.S. domestic economic policies of the last several years ought to be replaced by a policy of “firm-handedness.” In contrast, some members of the Executive Board, including Mr. Nguyên Huu Hanh (Viet-Nam) and Mr. Plescoff, observed that the U.S. domestic economy was much healthier in April 1970 than it had been in the previous July. In their view, the U.S. authorities had been exerting strenuous efforts to bring inflation under control.
The Fund’s Annual Report for 1970 termed the need to rectify the U.S. payments position the most urgent remaining task in the field of international payments, a view reiterated by the Managing Director at the Twenty-Fifth Annual Meeting in Copenhagen.7 Noting that the U.S. basic balance was currently in deficit by $3–4 billion at an annual rate, he stressed that improvement in the U.S. payments position depended greatly on the current program of the authorities to stabilize the domestic economy.
Moreover, Mr. Schweitzer believed that “until the payments position of the United States [was] brought into balance, it [was] important that the deficit should be financed by the use of U.S. reserve assets to the extent necessary to avoid an excessive expansion of official holdings of dollars by other countries.”8 He went on to say that such a policy was necessary if control over the issuance of SDRs was to provide the means of regulating the aggregate volume of world reserves. In effect, contrary to U.S. practice, the United States would have to use its gold or SDRs for international payments rather than let U.S. dollar liabilities increase.
This statement was the first mention of what later was to become known as “asset settlement,” that is, the idea that all countries should settle their payments deficits and surpluses by the transfer or receipt of gold, SDRs, or any other reserve asset that might be agreed upon. This idea contrasted with the Bretton Woods system of “on demand” convertibility, under which a reserve center might finance its deficits by the building up of liabilities subject to conversion at any time, and which meant that a reserve center might lose reserves by conversion in amounts greater or less than its deficit. Asset settlement was to become one of the issues heatedly debated after 1971 when discussions on international monetary reform intensified.
On January 8, 1971 the Executive Directors, in taking up the staff’s report for the 1970 Article VIII consultation, again reviewed the U.S. economy. The U.S. authorities, in a two-year anti-inflationary program, had succeeded in slowing down the economy. In fact, virtual recession was at hand as employment had been sacrificed in an attempt to halt and reverse inflation. Nevertheless, despite the decline in employment, prices and wages had not fallen and the goal of price stability had been illusive.
Noting these developments, the Executive Directors, especially Mr. Lieftinck, commented that the United States had paid a heavy price—a stagnating economy, mounting unemployment, and decreasing levels of productivity—for its efforts to combat inflation. The poor results were, for that reason, all the more depressing. From the experience of the United States, as well as from the experiences of other countries, they concluded that it was extraordinarily difficult to stem a strongly entrenched inflation.
Mr. Viénot (France) and Mr. Brofoss brought out other aspects of the U.S. payments deficit which were becoming sources of increased concern, and even agitation, to some officials abroad. Mr. Viénot inquired, rhetorically, whether the introduction of SDRs had, in fact, eliminated the generation of deficits in the U.S. external accounts. His question had reference to the argument that many monetary officials had advanced earlier in supporting the establishment of SDRs and their later activation: the SDR facility would enable reserve creation to take place under controlled regulation and thereby eliminate the need for the United States to run deficits as a way to add to the supply of world reserves. Citing the continuing U.S. deficits and the resultant accumulation of reserves abroad, Mr. Viénot, as Mr. Giscard d’Estaing had done at the 1970 Annual Meeting, asked the Fund to re-evaluate the foreseeable needs of the world economy for liquidity.
Mr. Brofoss was concerned about the massive acquisition by both the private and public sectors of the United States of foreign physical assets and claims, which he estimated at more than $70 billion from 1960 to 1969. The export performance of the U.S. economy, he stressed, had to be considered in the context of the tremendous expansion of production by U.S.-owned enterprises in European and other foreign countries. Goods which had previously been recorded in the export statistics of the United States itself were now recorded in the trade returns of countries where subsidiaries of U.S. companies were operating. U.S. receipts, which had once appeared under the heading “merchandise exports” were now reflected in the statistics as “earnings from direct investments”; the latter had been increasing by about $0.5 billion a year. Even these figures did not reveal the full story. The net income of U.S. subsidiaries operating in countries abroad was much higher. The major part of their profits, together with amortization funds, was plowed back in the form of new equipment. Consequently, these companies had established and consolidated an even firmer grip on some of the most rapidly growing fields of production in the world.
Countries in Surplus
The counterpart of the dwindling U.S. current account surplus and the large U.S. capital deficit was current account surpluses for many other industrial countries significantly larger than what might be considered “normal,” and vast capital flows into many of these countries. In addition to the current account surpluses and capital inflows of Canada, France, the Federal Republic of Germany, and the United Kingdom (noted in earlier chapters), Belgium-Luxembourg, Italy, Japan, the Netherlands, Norway, and Switzerland also had sizable trade or current account surpluses, or both, in varying degrees, for at least some of the years 1968–70. The figures for 1970 illustrate the pattern and relative size of surpluses. Current account surpluses were recorded by Japan ($2.1 billion), the United Kingdom ($1.9 billion, the highest it had yet reached), the Federal Republic of Germany ($1.7 billion, much below its current account surpluses of 1968 and 1969), Canada ($1.4 billion, the largest ever experienced by that member), Italy ($1.3 billion, less than half its surpluses in 1968 and 1969), and Belgium-Luxembourg ($0.9 billion, much above the surpluses of 1968 and 1969). Overall balance of payments surpluses, including all capital movements, were registered by the Federal Republic of Germany ($6.2 billion), the United Kingdom ($3.0 billion), France ($2.0 billion), Canada ($1.6 billion), Japan ($1.1 billion), the Netherlands ($0.7 billion), and Belgium-Luxembourg ($0.5 billion).
The situation of Japan, which has not been commented upon previously in this volume, merits some description here.
Late in 1965, under the stimulus of a sharp increase in exports and of expansionary monetary and fiscal policies, Japan’s economy began a period of rapid growth, which was also to be the longest period of uninterrupted expansion in the country’s recent economic history. The gross national product in real terms increased at an average annual rate of more than 13 per cent from 1967 to 1969 and by 11 per cent in 1970.
Recessionary conditions in Japan’s major trading partners in 1966 and 1967, however, meant that the current account position did not become very strong until early in 1968. In fact, in 1967 there was a large current account deficit after sizable surpluses in the preceding two years. By 1968 the economic upswing in other industrial countries, especially in the United States, began to bring about increases in Japanese exports. These increases reached nearly 25 per cent in 1968, 23 per cent in 1969, and 21 per cent in 1970. Hence, Japan’s high and sustained rate of economic growth was now accompanied by large and expanding current account surpluses that were only partially offset by net capital outflows. In 1968 there was a current account surplus of $1.0 billion and an overall balance of payments surplus of $1.1 billion. In 1969 the trade surplus reached an unprecedented $3.7 billion, the current account surplus was $2.1 billion, and the overall surplus was $2.3 billion. Accordingly, Japan’s foreign exchange reserves, which were about $2.0 billion at the end of 1967, had doubled by March 1970.
Japanese imports increased sharply during most of 1970. The trade surplus in that year thus rose only moderately, to $4.0 billion. The current account surplus declined slightly, to $2.0 billion, and the overall surplus fell to $1.4 billion.
The economy of Japan, like that of other members, was regularly examined by the Executive Directors. In January 1969, on the occasion of the 1968 Article VIII consultation, they praised the Japanese authorities for the remarkable rate of growth of Japan’s economy and for the spectacular reversal during 1968 from economic slack to economic boom and from external deficit to surplus. They commented that Japan’s economy compared with that of other countries seemed unusually flexible and unusually responsive to monetary policy measures. Messrs. Plescoff and Stone doubted that the Fund should offer advice to the Japanese authorities, who were doing extremely well on their own. Most of the Executive Directors did, however, recommend that consideration be given to liberalizing the remaining impediments to imports, invisibles, and capital transfers.
In February 1970, in the course of the 1969 Article VIII consultation, the Japanese authorities stated their belief that the monetary measures which they had been taking would keep the domestic economy on an even keel, while a slowing down of foreign demand, coupled with a rising rate of imports, would keep the balance of payments surplus within bounds. However, the staff foresaw possible threats by 1970 or later to domestic stability from the strong balance of payments position. The extremely favorable competitive position of Japanese exports in world markets might, the staff thought, be underestimated by the authorities.
At the Executive Board meeting, Mr. Suzuki elaborated the balance of payments aim of the Japanese authorities: a current account surplus, offset for the most part by aid to developing countries and other long-term capital exports, and only a gradual increase in official reserves. Since the deficit on invisibles tended to increase with economic growth, the trade surplus would have to be big enough to cover the deficits both on invisible account and on capital account.
The Executive Directors again commended the Japanese authorities for their continuing success, Miss Fuenfgelt pointing out some parallels with the economic situation of the Federal Republic of Germany: rapid increases in exports, large trade surpluses, and offsetting capital exports. She drew attention to the freedom of trade and capital movements in Germany, however, and like other members of the Executive Board, including Mr. Dale, said that there was considerable scope for the Japanese authorities to liberalize restrictions on imports and similar impediments, both to trade and to capital transfers abroad, and to give up export incentives. Many Executive Directors queried whether the removal of limitations on trade or capital outflow would, in fact, increase Japanese payments abroad to any appreciable extent.
By January 1971, in the course of the 1970 Article VIII consultation, the staff was able to report to the Executive Directors that in 1970 the Japanese authorities had resolved the conflict posed by domestic inflationary pressures and a strong balance of payments position and had made substantial adjustments in their balance of payments policies. Measures to promote exports had been de-emphasized. Import restrictions had been liberalized. Tariffs had been changed to permit more imports. A program to increase foreign aid by considerable amounts had been instituted. Other measures to liberalize capital flows, both inward and outward, had been taken. Finally, accumulation of official reserves had been moderated, partly by encouraging private commercial banks to strengthen their net asset positions. As a result, wholesale prices were stable, the current account surplus was smaller, and the increase in official reserves had been sharply reduced.
Once more the Executive Directors noted the competent management of the economy by the Japanese authorities and, in the words of Mr. Schleiminger, characterized “the dynamism of the Japanese economy as breathtaking.” Nonetheless, they noted that the growth of Japan’s economy had not been entirely balanced and advised that the time had come for the authorities to pay greater heed to investment in infrastructure, to domestic shortages of foodstuffs, to the effects of economic growth on the environment, to the problems associated with very rapid urbanization and industrialization, to housing, to education, and, more generally, to the well-being of the people. Mr. Suzuki assured the Executive Directors that the Japanese authorities were well aware of these requirements of economic policy.
The Problem of Adjustment
That the pattern of deficits and surpluses in world payments during the late 1960s persisted and even worsened in 1970 and 1971 gave rise to what monetary experts labeled “the problem of adjustment,” as distinct from “the problem of liquidity” discussed in Part One. “Adjustment” of international imbalance was considered a “problem” because neither of the traditional ways of correcting balance of payments disequilibria—changes in internal monetary and financial policies or changes in par values—seemed to be available. A number of factors made changes in internal policies less effective than they had been in the 1950s. Not least among these factors were the acute difficulties many countries were experiencing in halting or reversing inflation, however much they shifted their internal policies, and the likelihood that changes in such policies might touch off heavy flows of banking funds.
Consequently, interest was focused on adjustments of par values, one of the primary instruments of the Bretton Woods system for correcting a “fundamental disequilibrium.” In practice, however, changes in par values also seemed to be ruled out. For most of the large industrial countries, a change in par value had major political repercussions. As a result, needed changes were being delayed too long. For some years the difficulties of par value changes by the United Kingdom and the United States, whose currencies were held by others as reserves, had been recognized: changes in the rates for reserve currencies altered the value of reserves held by other countries. Devaluation of the dollar was tantamount to an increase in the dollar price of gold and hence involved the further complication that devaluation of the dollar would reward those who had been converting their dollar holdings into gold and penalize those who had been willing to augment their holdings of dollars. Now, in addition, political leaders feared the consequences of downward changes in their par values on the inflationary pressures in their economies or of upward changes in their par values on the competitive positions of their exports and on domestic employment. Therefore, it was also becoming increasingly awkward politically for the authorities of France, the Federal Republic of Germany, and Japan, for example, to propose changes in their par values.
It was to solve this problem of adjustment that proposals for altering the par value system were being made. All such proposals had in common the objective of making exchange rate changes easier or more automatic.
Increasingly Disruptive Capital Flows
The second major problem facing the international monetary system in the late 1960s was that large flows of short-term capital now took place and radically transformed the environment in which international financial relations were conducted.
Greater Size and Mobility
During the decade of the 1960s, short-term capital grew by what seemed at the time to be astronomical amounts and became much more likely to move from one money center to another.
A number of factors underlay the phenomenal build-up of short-term capital and its increasing shiftability between major currencies. For one thing, there was a large growth of liquid liabilities in U.S. dollars. These were, of course, the counterpart of much of the U.S. payments deficit, which was financed heavily by the accumulation of dollars by foreign official and private entities. For a long time after World War II, the U.S. dollar had been the strongest currency in the world, and it had become the “intervention currency” (the currency used by central bankers to intervene in their exchange markets to keep exchange rates within the prescribed margins around their par values), the most widely used “vehicle currency” (the currency used by traders and investors to make international payments), and the principal “reserve currency” (the currency in which central banks kept their reserves). Hence, official and private holders of liquid assets had been willing to augment their holdings of dollars almost without limit.
A factor contributing initially to the mobility of these funds was the convertibility of Western European currencies in the late 1950s and the achievement by these currencies of a strength that they had not enjoyed since before World War I. Holders of dollars became much more prone than before to switch into other currencies.
The broadening and growth of the Eurocurrency market was still another factor facilitating short-term capital transactions. Already by 1966 what was originally the Eurodollar market, because the market was in Europe and because most transactions were in dollars, had broadened into a Eurocurrency market, in which operations in an increasing number of currencies other than the dollar—especially the deutsche mark and the Swiss franc—were carried out.9 Even in its first few years the market experienced a rapid growth. By 1966 it had already become one of the world’s largest markets for short-term funds: within eight years after its beginnings in 1958 its net size had grown to more than $10 billion and its gross size to over $20 billion. But this amount was small compared with the manifold increases of the next few years. After some expansion in 1967, the Eurocurrency market in 1968 experienced its largest growth so far, reaching an estimated $30 billion, on a gross basis, by the end of that year. During 1969 its further expansion was estimated at 50 per cent, to about $45 billion, and by the end of 1970 it had expanded by another 30 per cent, to an estimated $57 billion.10
Furthermore, international financial integration accompanied the worldwide economic integration that was a dominant feature of the decade of the 1960s. U.S. banks, for instance, opened many overseas branches. The number of international banks in London—the center for handling Eurocurrency funds—and the size of their deposits swelled appreciably. Bankers of various countries developed intimate working relationships with one another. In effect, a progressive internationalization of banking operations developed. The customers of commercial banks, such as resident companies in good standing, could, for example, borrow as readily from foreign as from domestic banks, should the divergence in interest rates make such a change profitable.
The elimination of exchange and capital controls, along with the competitive edge enjoyed by banks operating in Europe over banks operating in the United States, were important factors in the emergence and expansion of the Eurocurrency market itself. For example, banks operating in the United Kingdom, unlike banks operating in the United States, were not subject to legal reserve requirements or to official interest rate ceilings in respect of their dollar transactions. The absence of such regulations enabled banks based in London to pay higher deposit rates and to operate with narrower margins than banks based in New York. Such differential treatment of national and offshore banking operations was typical not only for the United Kingdom but also for most other countries where important offshore banking centers developed.
Another factor that stimulated the rapid growth of the Eurocurrency market, particularly in the late 1960s and early 1970s, was the action taken by the U.S. authorities, as part of the balance of payments program, to restrict the flow of funds from the United States. The mandatory controls over U.S. direct investment abroad that were introduced in January 1968 were especially relevant in this regard. U.S. companies wishing to finance new or additional foreign investment had to rely more on funds raised outside the United States, and U.S. banks, constrained in lending to residents abroad, including foreign branches of U.S. companies, had to raise funds outside the United States if they wanted to avoid losing out in the growing international loan business. They therefore established branches in London and elsewhere, thus shifting a large part of their international business from New York to offshore banking centers. The much more restrictive monetary policy on which the U.S. authorities embarked in 1969 likewise stimulated the growth of the Eurocurrency market. There was a substantial drain of funds from the United States to more profitable investment outlets; in addition, U.S. banks relied heavily on their London branches for borrowing.11
There was still another factor that brought about the growth of large and mobile short-term funds. As the world economy became more integrated, ties between and within business enterprises (apart from banks) were getting larger and were increasingly extending beyond national boundaries. The close connections between businesses based in different countries and the growth of giant multinational corporations meant that there existed on the world scene companies with sizable balances of working capital that had ready access to borrowing facilities in many countries and that had the ability and know-how to take advantage of interest rate spreads or crises in confidence in currencies in the countries where they operated. A telephone call enabled these companies, within minutes, to switch their excess balances, or even their working funds, from one currency to another. In fact, it became a matter of good management by the executives of these companies to make such shifts of short-term capital so as to safeguard their liquid balances, especially against losses from currency depreciations.
In the late 1960s, the inducement for interest arbitrage also became greater than it perhaps had ever been. There were marked variations among the major countries in the phase of the business cycle through which they were passing, and important differences in the intensity of their rates of inflation. Also, for the first time since the 1930s monetary policy, in contrast to fiscal policy, became a principal instrument of domestic economic management in nearly all the industrial countries. These factors combined to give rise to wider and more persistent differentials in interest rates between the industrial countries than had existed earlier.
For all these reasons, movements of short-term capital had by 1968 become enormously large, swift, and volatile.12
By the mid-1960s there was another facet to the problem of short-term capital. The scale and speed of capital movements meant that the instruments used in the late 1950s and the first half of the 1960s to cope with these movements—the drawing down by a country of its exchange reserves, the international network of swap arrangements, the extension to a country under pressure of short-term credits by other countries or by the Fund, and the countering of capital flows by shifts in interest rates by national monetary authorities—were no longer adequate to the task. Even acting in unison, the monetary authorities of the main industrial countries were less able to counter the effects of short-term capital outflows on the reserve positions of countries subjected to unexpected capital flight or the repercussions on the domestic monetary positions of countries experiencing sudden capital inflows. Accordingly, monetary authorities were put in the position of repeatedly having to deny that they were contemplating par value changes, and then, suddenly, changes in par values were forced upon them by the pressure of capital movements. Moreover, when speculators profited from the changes in exchange rates wrought by their own movements of capital, they were encouraged to act again.
Because of the continuous imbalance in world payments and because of the risk of sudden pressure on the exchange rate of any major currency, restrictions on trade and capital movements were reimposed. The liberalization of trade in manufactures, which had been the great accomplishment of the 1950s, had been well maintained, and the Kennedy Round of tariff cuts of 1967 carried still further the liberalization of such trade from tariff barriers. But measures indirectly restricting or distorting international trade, in the form of nontariff restrictions, aid-tying, and a strong preference for domestic production in the granting of government contracts, had been retained or were imposed by many countries. Most notably, measures to control capital flows were being intensified.
Moreover, many officials had begun to worry that the harmonious and cooperative economic relationships which had prevailed since the late 1940s, and which had even been strengthened in the early 1960s, might come to an end. There was danger that the world’s main trading and investing nations would regress into a vicious spiral of restrictions and retaliations.
Initial Review of Exchange Rate Mechanism
These were the circumstances which caused the Executive Directors to agree in January 1969 to examine the mechanism of exchange rate adjustment as set out in the Fund’s Articles. They were prompted also to undertake such a review because they were concerned that decisions regarding the exchange rates of major currencies, like other key decisions in the Fund’s field of interest, were increasingly being taken outside the Fund and that the initiative for any serious consideration of whether, and how, the par value system should be altered might fall to bodies other than themselves.
These concerns had been sharpened by events in the latter part of 1968. The Bonn meeting in 1968 had brought home clearly the distinct possibility that the Ministers and Governors of the Group of Ten might assume a leading role in discussions about changes in par values. And Mr. Roy Jenkins, the Chancellor of the Exchequer of the United Kingdom, in a speech to the House of Commons upon his return from the Bonn meeting had urged that a “new international monetary conference” like the one at Bretton Woods, be assembled. His remarks were reminiscent of those of Mr. Henry H. Fowler, Secretary of the U.S. Treasury, some years before in connection with questions of international liquidity. Doubts had been raised before about the appropriateness of the par value system, but these had been raised primarily by academic economists in the United States and the United Kingdom, where there had always been many detractors of the par value system and supporters of freely fluctuating rates. Now the calls for reform of the par value system had spread from the universities to official circles and were being taken up by leading newspapers and public personalities throughout the world.
Hence, when Mr. Schweitzer told the Executive Directors that he believed it preferable to use the existing machinery for international consultation, and suggested that they begin in mid-January 1969 to exchange views, in a preliminary way, about the need for greater flexibility in the exchange rate system, they welcomed the idea. Most of them did not favor an “international monetary conference.”
From January 15 to March 10, 1969 the Executive Directors held ten discussions covering a broad range of topics relating to the need for, and possible techniques of, greater flexibility of exchange rates. So sensitive were the discussions, or even the fact that discussions were in process, that they were not held in the Executive Board room nor in the usual seating arrangement around the Board table. Instead, the sessions were held in a large conference room on another floor of the Fund’s building, with the chairs arranged as for a seminar. Thus, there was no suggestion of any kind that the Board was deliberating, even informally, on the par value system.
In this setting, referred to as “fourth floor meetings,” the Executive Directors discussed a number of papers on the exchange rate mechanism prepared by the staff. They considered, for instance, general guidelines that might be used to adjust balances of payments.13 They debated particular techniques for altering the par value system through the use of slightly wider margins around par values, through the use of small changes in exchange rates or par values, and through the use of what were being referred to by economists as gliding parities or crawling pegs, that is, changes in par values at specified intervals. They discussed as well the merits and demerits of a dual exchange rate system, that is, one with a separate exchange rate for capital transactions. Pointedly, they did not discuss regimes that were inconsistent with the par value system—a general system of freely floating exchange rates, substantially wider margins around par values, or automatic adjustment of par values in accordance with selected indicators.
The Executive Directors did not come to any specific conclusions as to whether the par value system could be improved. They reviewed the original rationale of the par value system and the assumptions on which it had been based, and reiterated views about the par value system similar to those that had been expressed formally by the Executive Board in the past.
They did distinguish stability of exchange rates from rigidity of exchange rates, emphasizing that changes in par values had been contemplated as one of the means of balance of payments adjustment and that certainly par values were supposed to be altered from time to time. Nonetheless, they recognized that the enormous expansion in the volume of short-term funds that could potentially move from currency to currency in response to expectations regarding rates of exchange had vastly changed the framework in which countries operated from that envisaged at the Bretton Woods Conference and that had been reflected in the Articles of Agreement. The drafters of the Articles, as the Executive Directors pointed out in their Annual Report for 1969, had been well aware that a country might have to alter its exchange rate because of changes in its relative real economic position. But these architects of the par value system had not envisaged that a country would have to be so much concerned about the public’s views on the strength of its currency. Also, speculative capital movements had been expected to be suppressed rather than financed; in fact, limitations had been put on members’ access to the Fund to finance capital outflows, and the Fund was empowered to request a member to impose capital controls as a condition for the use of the Fund’s resources.
The Executive Directors, nevertheless, announced their intention to continue their study of the subject of exchange rates. Their further study would investigate whether a limited increase in flexibility of exchange rate variation would be desirable and attainable with the necessary safeguards, and the means by which any such increased flexibility might be achieved. There was stress on the word “limited.” Further flexibility of exchange rates might involve some “limited” change in the par value system, but, conceivably, it might involve only a more active use of the existing system. Commenting that other economists and exchange rate practitioners were vigorously studying the exchange rate mechanism, they emphasized that any changes that might be made in the mechanism ought to preserve the essential characteristics of the par value system—stability of rates and rates that were internationally agreed. The stability of exchange rates at realistic levels had made a key contribution to the balanced expansion of international trade, and the determination of the rate of exchange for each currency was a matter of international concern. Those characteristics were, they believed, as beneficial for the world as they were twenty-five years before when the Articles had been written.
The Conclusions in Context
These conclusions concerning the exchange rate mechanism were reached at the same time—in the first nine months of 1969—that the Executive Directors were deliberating on the first allocation of SDRs and the substantial increases in quotas that were to follow the fifth general review of quotas. For some years, as we have seen in Part One, they had taken the position that easing the supply of world reserves was closely connected with the balance of payments adjustment process. Consequently, before committing themselves to changes in the system of par values, they wished to see the effects on the monetary system of supplementing the supply of liquidity.
The preference of the Executive Directors for caution in changing the par value system was representative of the thinking at the time of the highest financial authorities in their countries. As a way of gauging international financial opinion on the topic of exchange rate flexibility, the Managing Director, at the 1969 Annual Meeting, encouraged the Governors to express their thoughts. The Governors who responded all praised the contribution of the par value system to the expansion of international trade since World War II and categorically rejected the replacement of that system by any general system of fluctuating rates. But they had divergent views about the value of proposals for “limited” flexibility of exchange rates.
One position was expressed by Mr. Giscard d’Estaing (France) and Mr. Blessing (Federal Republic of Germany). Their views reflected mutual distaste for any greater flexibility of exchange rates. Mr. Giscard d’Estaing, explaining that the Common Market could not “survive daily fluctuations or ‘crawling’ uncertainty,” said that France would not refuse to participate in such studies of exchange rate flexibility as might be undertaken, but he warned that introducing flexibility into exchange rates was not an easy way out of international monetary difficulties—“a sort of monetary LSD.”14 Mr. Blessing, noting that the floating rate just introduced for the deutsche mark was temporary, said that he very much preferred to see more flexible monetary, fiscal, and economic policies pursued in various countries rather than making exchange rates more flexible. “The fundamental problems of our time,” he said, “cannot be solved by technical devices but only by greater monetary discipline and by better coordination of the economic and fiscal policies of the various countries.”15 Mr. Fukuda (Japan) agreed with this position, saying that “the question of changing the exchange rate system can and should be resolved within the framework of the present system through improvement in management and operations.”16
Mr. David Kennedy (United States), in some contrast, supported the further study of proposals for “limited flexibility,” which “need not be looked upon as radical new departures from the mainstream of developments in the monetary area.” He called attention to several characteristics of the existing situation, and in particular expressed two views that were reflected in Mr. Dale’s position in the deliberations of the Executive Directors in the coming year. One, given the pivotal role of the dollar in the international monetary system, the initiative for even limited exchange rate adjustments would continue to lie with countries other than the United States. Two, the possibility of encouraging a bias toward currency devaluations, in contrast to revaluations, ought to be guarded against.17
Some of the Governors were much more eager for the study of exchange rate flexibility to continue. Mr. Jenkins (United Kingdom), who reminded the Governors that in November 1968 he had told the House of Commons that the time had come to consider both the objectives of international monetary arrangements and the institutions for implementing them, very much welcomed debates on and studies of methods to introduce flexibility into the exchange rate system. He elaborated his views about these methods, stating his preference for a very slight widening of the margins, perhaps to 2 per cent above and below par.18 Mr. Colombo (Italy) spoke favorably of the crawling peg.19
The Managing Director and the Executive Directors concluded that they had sufficient support to proceed with their study of exchange rate flexibility.
Continued Review by Executive Directors
By the time the Executive Directors again took up the subject of exchange rate flexibility, late in 1969, the November 1967 devaluation of sterling had begun to show results and changes had been made in the par values for the French franc and the deutsche mark. The position of the U.S. dollar in exchange markets was strong, with an inflow of funds and overall surpluses in 1968 and 1969 as noted above. The world’s exchange markets were again calm, and international payments seemed less unbalanced. Hence, there was less of a sense of urgency about finding a way to induce more frequent changes in par values. Nonetheless, the problem of adjustment had replaced the problem of liquidity as the prime topic of international monetary discussions, and monetary experts everywhere were continuing to discuss techniques for introducing greater flexibility and automaticity into the exchange rate mechanism.
Difficulties of Agreement
In December 1969 the Executive Directors agreed to hold informal sessions to discuss exchange rate adjustment, on the basis of an agenda proposed by the staff. Many of the Directors, notably Messrs. Johnstone, Lieftinck, and Stone, wanted to broaden the study beyond the particular techniques for adjusting exchange rates, to an examination of the whole adjustment process. The latter would have included, for example, a review of the concept of fundamental disequilibrium, consideration of the special role, if any, of reserve currency centers in the adjustment process, the nature of the disturbances to the adjustment process in recent years, and the contribution that exchange rate changes might make to mitigating these disturbances. A compromise was agreed: the main focus of the informal sessions would be on the techniques for adjusting exchange rates, but there would also be some examination of the balance of payments adjustment process.
The year 1970 thus commenced with a series of informal sessions of the Executive Directors on the mechanism of exchange rate adjustment that were carried on intensively for the next eight months. As a starting point the Executive Directors had before them a number of technical staff papers, all of which dealt with what was called “limited flexibility of exchange rates,” as opposed to more generally flexible rates. One staff paper, for instance, compared the method of changing par values under the Bretton Woods system with a number of alternatives, all of which provided for adjustments in par values by a series of small changes regularly over time. Another paper set out some reflections on the procedure for changing par values based on the experience with the deutsche mark in September and October 1969. The conclusion was that a fluctuating exchange rate as a transition to a fixed par value might help to make the best of a temporary absence of the conditions needed for a successful instantaneous change of par value, but that a continued absence of such conditions would cause major problems for an exchange rate regime based on effective par values. A third paper assessed the main economic consequences that might be expected from a modest widening of the effective margins of fluctuation in spot exchange rates around a par value beyond the maximum 1 per cent laid down in the Articles. The conclusion was that the advantages of slightly wider margins might not outweigh the disadvantages for countries such as those in the eec that wanted to keep their rates in line with each other or for countries that could not hope, through slight exchange rate variations, to achieve any significant equilibrating flows of short-term capital. The Executive Directors had before them, as well, technical papers prepared by the U.S. authorities and by several other monetary experts.
It proved difficult for the Executive Directors to arrive at a common view, even on exchange rate flexibility of a limited nature. Several of the Executive Directors for developing members, as well as some of those for industrial members, remained unconvinced of the need for any change in the par value system, while those who favored introducing flexibility could not agree on a method. Given these divergences, it was problematic for some months whether they would submit any conclusions or recommendations to the Board of Governors.
There was another complication. As the General Counsel pointed out, any of the possible techniques even for limited exchange rate flexibility—such as widening the margins slightly or using a sliding parity or a crawling peg—required amendment of the Articles of Agreement. As a result of the meeting of the Deputies of the Group of Ten in April 1970, it seemed unlikely that the countries of the Group of Ten would be willing to consider fresh amendments to the Articles at that time.
Arguments Against Exchange Rate Flexibility
The developing countries, like the industrial ones, did not have a unified position on the subject of exchange rate flexibility. Arguments against flexibility were put forward by Mr. Madan and Mr. Kharmawan. Mr. Madan explained that greater exchange rate flexibility in the system in general meant for the developing members that the prices of their export products, and correspondingly their terms of trade, would be even more unpredictable and more variable than at present. Furthermore, the developing countries had probably changed their par values under the existing par value system more often than had the industrial countries; hence, they were less interested in finding an alternative system.
Mr. Kharmawan outlined the positions of the developing countries that had elected him. For years the Fund had been advising them to create conditions of internal and external stability as a prerequisite for a balanced and sustained growth of their economies and as a means of achieving stable exchange rates. In the Fund’s philosophy, exchange rate stability and fiscal and monetary discipline were interlinked. What, then, were the implications of the interest some developed countries now showed in studying the possibility of introducing flexibility into the exchange rate system? Would the introduction of such flexibility, consciously or unconsciously, lead to a postponement of the measures to be taken in the monetary and fiscal fields?
The authorities of the members that had elected him, Mr. Kharmawan continued, doubted that this inquiry into exchange rate flexibility was necessary. Their view was that, if the tools available in the framework of the Bretton Woods system, including the possibility of changing a par value in the event of fundamental disequilibrium, had been correctly used at the right time, distortions and disequilibria might not have occurred and speculative short-term capital movements might have been averted. As long as there were no convincing arguments for introducing exchange rate flexibility, their preference was for making use of the existing tools, and perhaps for redefining the concept of fundamental disequilibrium in order to make the Bretton Woods system easier to implement.
Mr. Kharmawan added to his argument by referring to the Fund’s rather grudging acceptance of flexible exchange rates in the past for members with weaker economies than those of the industrial members. Why was it that flexibility was now being considered to give leeway to members with major currencies widely used in international trade? Mr. Williams (Trinidad and Tobago) supported the views expressed by Mr. Kharmawan and asked for the staff to study the likely effects of exchange rate flexibility on the developing members.
Messrs. Lieftinck, Plescoff, Stone, Suzuki, and van Campenhout, all appointed or elected by industrial or other developed countries, were also disinclined to change the par value system. Together with some other Executive Directors, they particularly rejected any purely automatic version of the crawling peg, or any system under which exchange rates would change week by week by minute fractions of 1 per cent.
Mr. Lieftinck, although willing to consider an upward crawling peg, regarded exchange rate policy as too important to be left to purely automatic arrangements. He favored retaining the par value system, but instituting greater enforcement of the Fund’s rules against a member maintaining or imposing balance of payments restrictions and extending less short-term balance of payments credit to a member in trouble. Members in disequilibrium would then have to adjust their par values more frequently.
Mr. Plescoff underscored the remarks of Mr. Giscard d’Estaing at the 1969 Annual Meeting to the effect that nobody wanted lasting floating rates and that the crawling peg would cause problems. Perhaps margins of about 2−2½ per cent on either side of parity could be considered because they might provide for better management of reserves. To authorize governments to make small changes in par values would not overcome the political difficulties of par value adjustment. Indeed, the situation would be worse in that small changes in par values would not enable governments to justify orthodox economic stabilization programs that might be unpopular.
Against the background of his strongly held views about the dangers inherent in the world inflationary situation that was developing, Mr. Stone strongly opposed the crawling peg in all its variants because it would lead to a weakening of countries’ determination to pursue policies that would keep inflation firmly under control.
Mr. Suzuki stated that the Japanese authorities had a negative attitude toward greater exchange rate flexibility. By increasing the chances of combining continued inflation with successive depreciations of the currency, exchange rate flexibility would lead to a further loosening of discipline in economic management. The Executive Directors, he said, had no actual experience with the application of a more flexible exchange rate system and did not seem to be moving toward a consensus on the proper direction to take to obtain greater flexibility. Was it not better to maintain the present system with some improvement in its management?
Mr. van Campenhout believed that none of the techniques proposed for exchange rate flexibility—crawling pegs, fluctuating rates, wider margins—was sufficiently attractive to be introduced as a permanent legal feature of the international monetary system. If some rate flexibility was considered necessary, any measures that deviated from those prescribed by the Fund’s Articles of Agreement could be approved on an ad hoc basis. This procedure would have the advantage that the deviating measures would be subject to international surveillance, through consultations or even through the imposition of sanctions, by an international organization that was already well established. Therefore, the Executive Directors should explore the additional authority that could be given to the Fund to permit members to use unorthodox techniques in certain defined circumstances, or possibly to authorize a temporary departure from the par value system for the entire membership. Were this line of thought to be pursued, one question that would have to be considered was whether such broad powers for the Fund would weaken the present system of par values or reinforce it. Another was whether the Fund could take the initiative in assuming such powers: member governments might regard any suggestion by the Fund that it acquire this much authority in the exchange rate field as a violation of their sovereignty.
Arguments for Exchange Rate Flexibility
The need for examining techniques to increase flexibility of exchange rates nonetheless received the support of several Executive Directors. These Directors thought that, even if the Executive Board did not formally agree on a particular technique, the Executive Directors ought to give serious consideration to ways in which par values could be more readily altered.
In Mr. Dale’s opinion, the Board could take either of two general attitudes. It could take the view that, because there was now calm in exchange markets after the par value changes of the last five months of 1969, there was no need to proceed with any urgency. Or it could take the position that, although the existing quiet in the exchange markets lessened the immediate significance of the discussions, every effort should be made to prevent the kind of crisis that had occurred in the past year.
Mr. Schleiminger emphasized the experience of the recent past, which showed that it was the countries that had applied financial and monetary restraint that had been most pinched by the existing system of par values and that had encountered difficulties which had even led them into clashes with the letter of the Fund’s Articles of Agreement. That was the reason why the Board of Governors had endorsed the intention of the Executive Directors to proceed with their study. The role of the Executive Directors was to present a range of solutions, perhaps eliminating those that would have no chance of being seriously considered. The Executive Directors should now, therefore, offer a spectrum of possible methods for achieving better balance of payments adjustment, including adjustment through the exchange rate system, rather than limit themselves to a mere statement of policy objectives. The intention at this stage was not to find a common denominator but to stake out the area within which greater exchange rate flexibility might be possible, thus preparing policymakers to make the choice, which would inevitably be a political one.
Mr. Johnstone likewise favored a review of the techniques for achieving exchange rate flexibility. He took the position that there were causes other than lack of financial discipline, such as structural changes in the world economy and shifts in international demand, that could lead to inappropriate exchange rates.
Mr. Mitchell, too, argued for a full-scale review of schemes for exchange rate flexibility and for a report to the Board of Governors. The public, he stated, had been encouraged to believe that the mechanism of exchange rate adjustment was a principal topic for discussion by the Fund in the year 1970, and it was important for the world’s image of the Fund that some positive step be taken at the Annual Meeting in September. He argued further that the more the subject of adjustment of exchange rates was aired, the more the political inhibitions that obstructed adjustment would be undermined. It was, he went on, these political inhibitions, more than imperfections in the Fund’s Articles of Agreement, that were delaying needed changes in the exchange rates of the major currencies.
Debate on Techniques
Examination of the possible techniques for introducing some limited exchange rate flexibility into the par value system also revealed divergent viewpoints.
Several Executive Directors had already been vocal in their distaste for crawling pegs or sliding parities. The main objection of the Executive Directors for the eec countries to the crawling peg was its upsetting consequences for the harmonization of their exchange rates. Therefore, interest centered on wider margins. But here there were debates about the extent to which wider margins would, or would not, lessen speculative capital flows. Mr. Palamenghi-Crispi and Mr. Bustelo defended wider margins as helpful in restraining speculative capital movements, against the doubts of Mr. Omwony and Mr. Suzuki. Mr. Dale and Mr. Huntrods especially liked wider margins, noting that they would be optional for all members, which should make it possible for members of the eec, who were trying to keep the relations between the exchange rates for their six currencies fairly fixed, to have smaller margins among themselves.
Mr. Dale further argued for the use of “presumptive criteria” that might serve as “indicators” to signal the need for a change in par value. Mr. Kafka and others, however, had grave doubts whether the Fund ought to be involved in the formulation of “presumptive indicators.” Mr. Suzuki contended that there could be no meaningful presumptive criteria applicable to all members because the economic situation of every member was different. Moreover, should presumptive criteria be used, speculation against a currency could occur if the public knew what the criteria were and which countries were not living up to them.
A few Executive Directors, including Mr. Kafka and Mr. Schleiminger, recalling the successful transition by the Federal Republic of Germany to a new par value through use of a short-lived floating rate, suggested as a possible solution that the Fund be able legally to approve or concur in justified deviations from the par value system in exceptional situations for individual countries. It had been awkward in the past for the Fund not to be able legally to permit such situations. The subsequent discussion, however, revealed the difficulties of developing suitable codes of approval for the wide variety of members’ situations that would arise in practice. Should there be a time limit to the Fund’s approval? Should there be a suspension of margins or of par values? How would the Fund concur in the effective changes of par values being made? What, if any, conditions should be attached?
Positions of Deputies of Group of Ten
While these informal sessions were in progress, the Deputies of the Group of Ten met in Paris on April 23, 1970. According to the report of the Economic Counsellor, who attended that meeting, there was a unanimous view that the issue of greater exchange rate flexibility ought to be kept within the confines of the range of limited possibilities that the Fund had been considering. There was a strong endorsement of the basic elements of the Bretton Woods system and agreement not to change the fundamentals of that system. There appeared also to be a strong general desire to do as much as possible without amending the Articles of Agreement. This desire to work within the existing Articles had two implications: the existing Articles ought to be applied as broadly as possible, and acquiescence by the Fund could be resorted to where formal approval was not possible.
The majority of the Deputies of the Group of Ten thought that the most important way in which to achieve greater flexibility of exchange rates was to facilitate small adjustments in par values. Most of the Deputies also expressed a preference for maintaining the need for the Fund to concur in such small adjustments. There was a marked decline from their previous position in respect to the importance the Deputies attached to slightly wider margins. They realized that wider margins could not be achieved without amendment of the Articles of Agreement. Indeed, many Deputies believed that the case for wider margins as an antispeculation device had not been proved. There was general sympathy for a fluctuating exchange rate for a short period, but belief that it would not be desirable to legalize long-term deviations from the par value system.
Attempts at Consensus
These positions of the Deputies of the Group of Ten placed the Executive Directors in somewhat of a quandary. How far should they go along the “stretch-the-Articles” road? Some of them indicated that, from the reports they had from the representatives of their countries to the Deputies’ meeting, the United States, Italy, and the Federal Republic of Germany had by no means ruled out amendment of the Articles of Agreement. Mr. Lieftinck objected to the “policy of acquiescence.” The Articles, he said, constituted an international treaty, and the agreement entered into by countries when they became members of the Fund should be carried out in good faith. Furthermore, the present international monetary system could be weakened step by step if the rules of the game were no longer observed. Mr. Palamenghi-Crispi and Mr. van Campenhout also warned against acquiescence by the Fund to situations that it could not approve formally; a practice developed for marginal situations could easily turn into a major modus operandi, and the Bretton Woods system could be undermined.
Both to help the Executive Directors find common ground and to try to formulate a report that the Executive Directors might submit to the Board of Governors, the staff in March and April 1970 had been drafting possible outlines of a report and revising them as the discussions went along. By the middle of May the staff had drafted a long Part I, tentatively entitled “Description and Analysis,” and at the end of June the staff circulated a draft of Part II, entitled “Implications for Policy.”
Part I of the draft found general acceptance among the Executive Directors; but Part II, which contained possible recommendations by the Executive Board, encountered new objections. Three Directors, Mr. Dale, Mr. Palamenghi-Crispi, and Mr. Schleiminger, were now favoring something like a crawling peg and seemed to be willing to amend the Articles of Agreement accordingly. However, in line with his previously expressed views, Mr. Stone was especially resistant to “U.S.-German-Italian proposals” for small and frequent changes in par values. The Australian authorities, and probably the South African and New Zealand authorities, would, he thought, simply not be prepared to agree to amendments to the Articles that would open the door to easy changes in par values, floating rates, or crawling pegs. In addition, reflecting the recent agreement of the eec countries to coordinate their exchange rate policies and to arrive at a common position on whatever changes were to be made in the exchange rate mechanism, many of the Executive Directors for the eec countries wanted to minimize any emphasis on exchange rate flexibility. They argued for an “open document” that reflected the dissenting or minority opinions as well as the majority opinions.
Agreement by Executive Directors
Toward the end of July 1970 the discussions became intensive as the Executive Directors held informal sessions in both the morning and the afternoon on July 22, 27, 29, and 31 to consider the draft report. Most Directors favored sending Part I to the Board of Governors as indicative of their efforts and discussions of some eighteen months and to supply supporting material for Part II. They differed, however, on whether the report should be the responsibility of the Executive Directors, if they could agree, or of the staff, in which case it would be an annex to a report of the Executive Directors. Part II was amended to include the possibility of a crawling peg, with an indication that different views existed about it.
In August, after several more informal sessions and further revisions of Part II, the Executive Directors began to meet in formal session to take final action on the draft report, on which near agreement had been reached. After half a dozen formal meetings, at which the substance of the final report as well as its format and transmittal were discussed, the Executive Board took a decision on August 12, 1970 approving the report, entitled The Role of Exchange Rates in the Adjustment of International Payments, for publication and transmittal to the Board of Governors. The status agreed upon for the report was that Part II, entitled “Implications for Policy,” gave the views of the Executive Directors with respect to the policy aspects of the subject and Part I, entitled “Review and Analysis,” contained the descriptive and analytical material on which their views were based.20
The Executive Directors had spent some one hundred hours in the preparation of the report. The number of hours spent by the staff in preparing drafts under high pressure had been far greater, and the Executive Directors expressed warmest thanks to the staff for its contribution to the study.
The main elements of Part II were, briefly, as follows:
One: The par value system, based on stable but adjustable par values at realistic levels, remained the most appropriate general regime to govern exchange rates in a world of managed national economies. Any particular regime of exchange rate adjustment had both advantages and disadvantages when compared with other possible arrangements. Technical or organizational arrangements could never serve as substitutes for correct policy decisions. Judgment on the advisability of instituting any change in existing arrangements or in their implementation involved a weighing of the balance between potential benefits and potential costs. The risks that would be involved in any general departure from the par value system would not be justified by such special benefits as could be foreseen therefrom.
Two: The par value system was based on stability of exchange rates but not rigidity. Changes in par values were to be related to the correction of fundamental disequilibrium. The Executive Directors had discussed proposals to get members to make a quicker response to an emerging or imminent fundamental disequilibrium by changing their par values, but they had not reached an agreed conclusion. The term “fundamental disequilibrium” had never been defined, but the Fund would continue to study the elements to be taken into account in judging its presence and magnitude.
Three: Under the par value system, a change in the par value of a member’s currency might be made only on the proposal of the member. This provision remained appropriate, although the expressions of views by the Fund at any time under established procedures should not be precluded.
Four: The Executive Directors rejected three alternative exchange rate regimes that had been proposed, viz., (a) a regime of fluctuating exchange rates, (b) a regime based on par values agreed with the Fund but allowing substantially wider margins, and (c) a regime under which par values would be adjusted at fixed intervals on the basis of some predetermined formula to be applied automatically. They recognized that any one of these regimes could in some respects and on certain assumptions perform more satisfactorily than the existing par value system, with not inconsequential benefits. But the disadvantages would clearly outweigh the potential advantages.
Five: The Executive Directors had considered three ways in which additional flexibility might be introduced into the par value system, all of which would require amendment of the Articles of Agreement. These were (a) prompt and small adjustments in par values in appropriate cases, say, 3 per cent in any 12-month period, or a cumulative amount of 10 per cent in any 5-year period, without the concurrence of the Fund; (b) a slight widening of the margins around par values from 1 per cent to 2 per cent or, at most, 3 per cent; and (c) temporary deviations from par value obligations. Some of the issues involved in these techniques, such as the necessary amendments to the Articles, were still open. They would continue their study of these issues in the period ahead.
In sum, the report of the Executive Directors, while supporting the par value system and rejecting widely different exchange rate arrangements, set out for the Board of Governors the ways in which the par value system might be made more flexible and the issues involved in introducing such techniques. In effect it invited the Governors, as the world’s monetary authorities, to indicate what future course of action they might desire. In particular, did they wish the Fund’s Articles of Agreement to be amended to provide for greater flexibility of exchange rates, and if so, how?
Reactions of Governors
To proceed with their consideration of these proposals, the Executive Directors looked to the Governors at the Twenty-Fifth Annual Meeting, held in Copenhagen from September 21 to 25, 1970. But at that meeting the Governors made it very clear that they did not want to pursue the subject of exchange rate flexibility much further, certainly not if it involved amending the Fund’s Articles of Agreement.
Mr. Barber (United Kingdom) and Mr. Fukuda urged that, since frequent changes in exchange rates might enhance capital speculation, attention should be given instead to an analysis of capital movements.21 The speeches of the Governors for the countries of the eec reflected their recent decision at The Hague to create, in the course of the 1970s, an economic and monetary union among themselves. Mr. Schiller (Federal Republic of Germany) referred to the intended harmonization of their exchange rate policies.22 Mr. Witteveen (Netherlands) described at some length the possibilities for adjusting par values under the existing Articles and recommended that the Articles not be changed for that purpose.23
Italy, a member that had previously been in favor of introducing a moderate degree of flexibility into the international monetary system with regard to par values, exchange rates, and transitional regimes, took the position, in the words of Mr. Ferrari-Aggradi (Italy), that exchange rate flexibility had become an issue “strictly connected with that of the future monetary arrangements within the European Economic Community.” He explained that the eec countries would have to formulate a common policy on this subject. Meanwhile, it was necessary for the proper functioning of the eec that, once agreement on common economic policies had been attained, the margins of the currencies of the countries involved should be progressively reduced and ultimately eliminated. In effect, the European currencies would have to move together vis-à-vis the dollar within a wider band, while oscillating within a smaller band against each other or not fluctuating at all.24
After the devaluation of the franc in August 1969, France had recovered from the severe economic difficulties which it had faced at the time of the previous Annual Meeting, and it was Mr. Giscard d’Estaing who most adamantly opposed any change in the “Bretton Woods charter, which aimed at putting an end to a quarter of a century of frequent parity changes and the general practice of competitive devaluations. Greater flexibility would weaken the will to protect currencies against inflation.”25
Referring to the possibility of wider margins around par values, Mr. Giscard d’Estaing, too, stressed the agreement of the eec countries to work out a plan, by stages, for creation of an economic and monetary union, and the implications of this union for exchange rates: the less flexibility, the better. “They cannot but realize what consequences a widening of the fluctuation bands would have for their own organization.” They had already agreed “not to use, among themselves, the facilities that would be introduced at the world level.” Accordingly, he summed up his position as “minimum flexibility and maximum stability.”26
Mr. Kennedy was thus virtually alone in being receptive to the idea that the Executive Directors might examine more precisely the forms an amendment to the Articles of Agreement might take. But even he phrased this suggestion very cautiously as being conditional on “the evolving situation” and on whether “our objectives and experience subsequently make it desirable to move in that direction.”27
After studying the statements made by the Governors at the 1970 Annual Meeting, the staff concluded that it would not be profitable for the Fund at this stage to resume a discussion of the economic merits and demerits of various suggestions for greater exchange rate flexibility. However, the General Counsel believed that some additional light might be thrown on some of these issues by a study of the manner in which the Articles of Agreement could be amended, and the Legal Department worked in the latter part of 1970 and early in 1971 to draft possible amendments to the Articles. When the Deputies of the Group of Ten met in Paris in March 1971, the only topic on their agenda was exchange rate flexibility. They recognized that the Fund would not be able to permit wider margins without amendment of the Articles, and they were not inclined to such action.
As a result, two conferences, attended by academic economists, private bankers, and businessmen from several different countries, were held in 1969, one in January at Oyster Bay, New York, and one in June at Bürgenstock near Lucerne, Switzerland. The papers that were presented at, or resulted from, the two conferences were published as Approaches to Greater Flexibility of Exchange Rates: The Bürgenstock Papers, arranged by C. Fred Bergsten, George N. Halm, Fritz Machlup, and Robert V. Roosa, and edited by George N. Halm (Princeton, 1970).
Developments in the U.S. balance of payments, mentioned only briefly in earlier chapters, are described later in this chapter.
Opening Address by the Managing Director, Summary Proceedings, 1968, p. 29.
Reproduced in Vol. II below, pp. 273–330.
The data used here for the U.S. balance of payments and reserve positions were, for the most part, taken from the Fund’s Annual Reports, which in turn were based on data of the U.S. Department of Commerce. Although balance of payments figures are often subsequently revised from those available currently, the views expressed and decisions taken at the time, which form the subject of this history, are usually based on the initial data.
Opening Address by the Managing Director, Summary Proceedings, 1970, p. 22.
Ibid., p. 18.
The origin of the Eurocurrency market and developments in its early years were described by Oscar L. Altman in “Foreign Markets for Dollars, Sterling, and Other Currencies,” Staff Papers, Vol. 8 (1960–61), pp. 313–52; “Recent Developments in Foreign Markets for Dollars and Other Currencies,” Staff Papers, Vol. 10 (1963), pp. 48–96; and “Euro-Dollars: Some Further Comments,” Staff Papers, Vol. 12 (1965), pp. 1–16.
Annual Report, 1969, pp. 84–86, Annual Report, 1970, pp. 92–96, and Annual Report, 1971, pp. 103–10, contain details on the expansion of the Eurocurrency market in the years 1968 through 1970. Estimates of the size of the Eurocurrency market were published by the Morgan Guaranty Trust Company in its World Financial Markets, and by the Bank for International Settlements in its Annual Reports. A description of the structure of the market and of the institutional mechanics can be found in Geoffrey Bell, The Euro-Dollar Market and the International Financial System (London, 1973), and in Andrew Shonfield, ed., International Economic Relations of the Western World, 1959–1971, Vol. 2—International Monetary Relations, by Susan Strange (London, 1976), Chap. 6.
Fuller explanations of the rapid growth of the Eurocurrency market in the late 1960s and early 1970s are given in Eisuke Sakakibara, “The Euro-Currency Market in Perspective,” and in Paul de Grauwe, “The Development of the Euro-Currency Market,” in Finance and Development, Vol. 12, September 1975, pp. 11–13 and 14–16, respectively.
There was renewed interest in the theory of international short-term capital movements and in empirical investigation of such movements. For a survey of the studies made, see Zoran Hodjera, “International Short-Term Capital Movements: A Survey of Theory and Empirical Analysis,” Staff Papers, Vol. 20 (1973), pp. 683–740.
See J. Marcus Fleming, Guidelines for Balance-of-Payments Adjustment Under the Par-Value System, Essays in International Finance, No. 67 (Princeton, 1968), 31 pp.; reprinted in his Essays in International Economics (London and Cambridge, Massachusetts, 1971), pp. 268–95.
Statement by the Governor of the World Bank for France, Summary Proceedings, 1969, p. 60.
Statement by the Governor of the Fund for the Federal Republic of Germany, Summary Proceedings, 1969, p. 202.
Statement by the Governor of the Fund and the World Bank for Japan, Summary Proceedings, 1969, p. 32.
Statement by the Governor of the Fund and the World Bank for the United States, Summary Proceedings, 1969, p. 55.
Statement by the Governor of the Fund for the United Kingdom, Summary Proceedings, 1969, pp. 36–40.
Statement by the Governor of the Fund for Italy, Summary Proceedings, 1969, p. 68.
The report was released on September 13, 1970. It is reproduced in Vol. II, below, pp. 273–330.
Statements by the Governor of the Fund for the United Kingdom and the Governor of the Fund and the World Bank for Japan, Summary Proceedings, 1970, pp. 67–69 and 73–74.
Statement by the Governor of the World Bank for the Federal Republic of Germany, Summary Proceedings, 1970, p. 37.
Statement by the Governor of the World Bank for the Netherlands, Summary Proceedings, 1970, p. 97.
Statement by the Governor of the Fund for Italy, Summary Proceedings, 1970, pp. 123–24.
Statement by the Governor of the World Bank for France, Summary Proceedings, 1970, p. 83.
Ibid., p. 86.
Statement by the Governor of the Fund and the World Bank for the United States, Summary Proceedings, 1970, p. 92.