CONCEPTUAL QUESTIONS
2.4 A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM
Floating Rate Systems Floating exchange rate systems allow currency values to fluctuate according to market supply and demand without direct interference by government authorities. In these systems, there are no official bounds on currency values. Nevertheless, government intervention in the foreign exchange markets can and does have an impact on currency values, especially in the short term. An increase in a currency value under a floating exchange rate system is called anappreciation and a decrease in a currency value is called adepreciation.As under fixed exchange rates, when one currency rises in value, the other must fall.
In floating rate systems, values are determined by supply and demand.
The major advantage of a floating exchange rate system is that changes in inflation, wage levels, and unemployment in one country are not forced on another country, as they are in a fixed exchange rate system. Consider our earlier example of a fixed exchange rate system with higher inflation in China than in Indonesia.
With a fixed exchange rate, international consumers eventually will see lower prices on Indonesian goods than on Chinese goods because of higher Chinese inflation and the fixed exchange rate. This will be good for the Indonesian economy and bad for the Chinese economy, unless China can either bring inflation under control or adjust the exchange rate. Floating exchange rates can adjust to the differential inflation, and allow a single worldwide price for goods from all countries. Floating rate systems tend to insulate domestic economies from changes in inflation, wage levels, and unemployment in other countries.
The major disadvantage of a floating rate system is the flip side of its major strength. Because exchange rates change continuously, it is difficult to know how much a future cash flow in a foreign currency will be worth in the domestic currency. The good news with floating rate systems is that the financial markets develop financial contracts (currency forwards, futures, options, and swaps) that allow market participants to hedge their exposures to currency risk.
2.4 A BRIEF HISTORY OF THE INTERNATIONAL
Date Event Causes and repercussions
1914 Collapse of the Prior to 1914, gold is used to settle trade balances in a pegged exchange rate system.
classical gold standard Breakdown of the system leads to a period of floating exchange rates.
1925 Gold exchange standard United Kingdom and United States hold gold reserves. Other currencies are convertible into gold, dollars, or pounds in a pegged exchange rate system.
1930s Global depression The gold exchange standard fails and exchange rates begin to float. Protectionist trade policies and the breakdown of the gold exchange standard lead to a global depression.
1944 Bretton Woods Price of gold set at $35/ounce. Other currencies are convertible into dollars at Conference pegged rates. The IMF and the World Bank also are created at Bretton Woods.
1971 Bretton Woods Most currencies begin to float. Repeated attempts to resurrect a fixed rate system system collapses end in failure.
1976 Jamaica Agreement Floating rates declared acceptable, officially endorsing the system in place.
1979 European Exchange Rate ERM created to maintain currencies within
Mechanism (ERM) created a band around central rates. European Currency Unit (Ecu) created.
1991 Treaty of Maastricht European community members agree to pursue a broad agenda of reform leading to European monetary union (Emu) and a single European currency.
1992 Exchange rate volatility Uncertainty over the outcome of Emu ratification votes leads to a breakdown of the leads to ERM breakdown ERM. Bands widened to ±15 percent as England and Italy fall out of the system.
1995 Mexican peso crisis The peso plummets in value and is allowed to float. The stock market rebounds.
1997 Asian crisis Falling currency and asset values in Asian countries cause political upheaval in Indonesia and economic difficulties throughout the region.
1998 Russia’s currency crisis The value of the ruble plummets along with the values of other Russian assets. The stock market recovers fairly quickly.
1998 Brazil’s currency crisis The real plummets in value and is allowed to float. The stock market rebounds.
1999 Euro replaces the Ecu On January 1, 1999, the euro replaces the Ecu on a one-for-one basis.
The currencies of participating Emu countries are pegged to the euro.
2002 Argentina’s currency crisis The peso plummets in value and is allowed to float. The stock market rebounds.
2002 Eurozone in force The euro begins public circulation, replacing the currencies of Emu participants.
The expectation is that all EU members eventually will adopt the euro once their economies meet the convergence criteria, although Denmark, Sweden, and the United Kingdom may continue to opt out.
2008 Global financial crisis Real and financial asset prices fall in the worst financial crisis since the Great Depression. Governments intervene to provide liquidity to the markets.
FIGURE 2.6 A History of the International Monetary System
Prior to 1914, major countries operated on what is known as theclassical gold standardin which gold was used to settle national trade balances. World War I upset this standard and threw the international monetary system into turmoil. In 1925, a gold exchange standardwas instituted in which the United States and England held only gold reserves while other nations held gold, U.S. dollars, or pounds sterling as reserves. Reserves are used by central banks to manage their BoP and foreign exchange positions. The system lasted until 1931, at which time England withdrew under pressure from demands on its reserves as a result of an unrealistically high pound sterling value. To maintain competitiveness most other nations followed England in devaluing their currencies relative to the price of gold.
The global depression of the 1930s was fueled by this breakdown of the international monetary system and by the protectionist trade policies that followed.
Currency speculation during this period was rampant, causing wild fluctuations in exchange rates. There was no way to hedge currency risk, because there was not an established forward exchange market at the time. Businesses were at the mercy of a very fickle monetary system.
Bretton Woods: 1944 – 1971
In addition to creating the IMF and the World Bank, the Bretton Woods Conference created a fixed or pegged exchange rate system that lasted for 25 years. Under the Bretton Woods system, the price of an ounce of gold was set in U.S. dollars at
$35 per ounce. Each nation agreed to maintain a fixed (or pegged) exchange rate for its currency in terms of the dollar or gold. For example, the German mark was set equal to 1/140 of an ounce of gold, or $0.25/DM. Under this form of gold exchange standard, only U.S. dollars were convertible into gold at the official par value of
$35 per ounce. Other member nations were not required to exchange their currency for gold, but pledged to intervene in the foreign exchange markets if their currency moved more than 1 percent from its official rate.
The post-WWII monetary system was relatively stable.
The Bretton Woods system worked passably well until the late 1960s. Deval- uations were common as the market periodically imposed its own values on the world’s currencies, but by-and-large the system facilitated cross-border trade and economic development. During the 1960s, U.S. inflation rose as the U.S. government borrowed money to finance the war in Vietnam. High U.S. inflation caused the market price of gold to rise above $35 per ounce and the market value of the dollar to fall below the official rate relative to foreign currencies. A run on the U.S. dollar ensued as speculators (investors, financial institutions, and governments) rushed to buy gold with dollars at the price of $35 per ounce. Finally, on August 15, 1971, President Nixon surrendered to market forces and took the United States off the gold standard. Many currencies were already floating by this time. This date marked the end of the Bretton Woods exchange rate system.
Exchange Rates after the Fall of Bretton Woods
Efforts to Resurrect a Pegged Exchange Rate System during the 1970s After the col- lapse of Bretton Woods, several unsuccessful attempts were made to resurrect a gold exchange standard. The first of these, the Smithsonian Agreement, was signed in Washington, D.C., by the Group of Ten in December 1971.3 This agreement devalued the dollar to $38 per ounce of gold and revalued other currencies relative to the dollar. A 4.5 percent band was established to promote monetary stability.
Currencies began to float in the early 1970s.
In April 1972, members of the European Economic Community (EEC) — the pre- decessor to the EU — established a pegged system known as ‘‘the snake within the tunnel’’ or ‘‘the snake.’’ The term snake refers to the fact that the pegged currencies floated as a group against non-EEC currencies. The tunnel refers to the band allowed around the central currency rates in the system.
Both the Smithsonian Agreement and the snake proved unworkable in the presence of continued exchange rate volatility. Countries frequently were forced to either devalue their currency or fall out of these pegged systems until an agreement could be reached on a new target price. Realignments were the rule of the day.
The Bank of England allowed the pound sterling to float against other currencies in June 1972. The Swiss franc remained in the EEC’s exchange rate mechanism until January 1973, at which time it, too, was allowed to float. In February 1973, the U.S. government devalued the dollar from $38 to $42.22 per ounce of gold.
Currency values fluctuated even more severely following the 1973 – 1974 OPEC oil embargo.
This was a period of unprecedented financial risk. High volatility in floating exchange rates contributed to high levels of currency risk. Interest rate risk was on the rise as inflation grew in many countries. The OPEC oil embargo resulted in higher oil price risk. Market participants faced a nemesis — financial price volatility — for which they were ill-prepared.
In January 1976, the IMF convened a monetary summit in Jamaica to reach some sort of consensus on the monetary system. Exchange rate volatility was still too high and policy objectives too diverse for governments to form an agreement on a fixed rate or pegged system. However, participants did agree to disagree. Under the Jamaica Agreement, floating exchange rates were declared acceptable, officially acknowledging the system already in place and legitimizing the basis for the floating rate system still used by many countries today.
In 1979, the European snake was replaced by the ERM. The ERM relied on central bank cooperation to maintain currency values within a±2.25 percent band around ERM central rates. The United Kingdom (England, Northern Ireland, Scot- land, and Wales) subsequently was admitted with a±6 percent band around central rates. The ERM attempted to combine the best of the fixed and floating rate sys- tems. First and foremost, currency risk was reduced because exchange rates tended to remain relatively stable within the ERM. The system did not require the highly restric- tive monetary policies that accompany a fixed rate system, as the band allowed some movement around the central rate. Allowable currency movements varied in the ERM for different currencies and at different times. The German mark, historically the most stable of Europe’s currencies, usually was kept within a band of±2.5 percent around the central rate. If a currency moved outside its ERM range, EU central banks would either cooperate in buying the currency to keep it within its ERM band, reset the allowable band around the central exchange rate, or revalue the currency within the ERM.
The U.S. Dollar during the 1980s During the mid-1980s, the dollar rose in value relative to other currencies. During this time, foreign governments complained that the high value of the dollar was causing inflation in their economies because of the high prices of U.S. imports. The U.S. government complained of a widening trade deficit due to the poor competitive position of high-priced U.S. goods. The dollar reached its high in early 1985, climbing to DM3.50/$ against the German mark.
In September 1985, the Group of Ten met in New York and agreed to cooperate in bringing down the value of the dollar and controlling exchange rate volatility.
In fact, the dollar had already begun to devalue during the spring and summer of 1985. By February 1987, the dollar had fallen to what many believed to be
its equilibrium value. At that time, the Group of Five (France, Germany, Japan, the United Kingdom, and the United States) met in France and agreed to promote stability in currency markets around current levels.
The 1991 Treaty of Maastricht and European Monetary Union The most important international monetary development of the past half century is theEmu, which aims for economic and monetary union within Emu countries. To achieve this objective, 17 EU countries have exchanged their currencies for the euro ( ). Figure 2.7 displays the members of the EU and lists theEurozonecountries that have adopted the euro.
The timetable for Emu was established in the 1991 Treaty of Maastricht and included the following dates:
■ 1999: The euro replaced the Ecu in the ERM, becoming a unit of account but not yet a physical currency. The exchange rates of participating countries were pegged to the euro at that time.
■ 2002: The euro began public circulation alongside national currencies on January 1, and then replaced the currencies of participating countries on July 1, 2002.
Voters in Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxem- bourg, the Netherlands, Portugal, and Spain ratified the Maastricht Treaty. Voters
There were 27 members in the EU as of December 2011 (see map), with 17 participating in the Eurozone.
The expectation is that all 27 member states eventually will adopt the euro, although Denmark, Sweden, and the United Kingdom may continue to opt out. New EU members are expected to adopt the euro once their economies meet the convergence criteria.Candidates for further EU enlargement (in dark gray on the map) include Croatia, Iceland (not shown), Macedonia, Montenegro, and Turkey.
EU members (27)
Austria, Belgium, Bulgaria, Czech Republic, Cyprus, Denmark, Estonia, Finland, France, Germany,
Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, United Kingdom
Participants in the Eurozone (€) Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, Spain Planned expansion of the Eurozone Bulgaria, Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania Chose to opt out of the Eurozone Denmark, Sweden, United Kingdom Not participating: Switzerland
Finland
Estonia Latvia Lithuania
Poland Czech
Rep Slovakia Austria Hungary
Romania Slovenia
France
Spain
Italy
Greece Bulgaria
Cyprus Malta
Portugal
Sweden
Denmark United Kingdom
Ireland Neth
Belgium Lux
Germany
FIGURE 2.7 The European Union and the Eurozone Source:European Union (http://europa.eu/index_en.htm).
in Denmark, Sweden, and the United Kingdom rejected the treaty, but retained the option of joining Emu at a later date.
A single-currency zone is viable only if the participating countries have similar economic and monetary policies. The Maastricht Treaty established the following convergence criteria for entry into the Eurozone to ensure relatively homogenous economic and monetary conditions in participating countries:
■ Inflation rates within 1.5 percent of the three best-performing EU countries
■ Budget deficits no higher than 3 percent of GDP
■ Exchange rate stability within the ERM for at least two years
■ Long-term interest rates within 2 percent of the three best-performing EU countries
■ Government debt less than 60 percent of GDP
The most important criteria are low inflation, low budget deficits, and exchange rate stability.
By the end of 1997, there was convergence in inflation, interest rates, and budget deficits in the participating Emu countries. According to the European Commission, average EU inflation was 1.6 percent in 1997. The average budget deficit fell from 6.1 percent of GDP in 1993 to just 2.4 percent in 1997. Budget deficits were 3 percent or less in each participating country. There was less convergence in the amount of public debt outstanding. Only 3 of the 11 Emu participants met the 60 percent debt limit of the Maastricht Treaty, with Belgium (122.2 percent of GDP) and Italy (121.6 percent) the worst offenders. Greece did not meet any of the treaty’s convergence criteria and was unable to join until 2001. New EU members are expected to adopt the euro once they have met the convergence criteria. Indeed, the Eurozone recently has been expanded to include Estonia, Malta, Slovakia, and Slovenia.
Countries adopting the euro must meet convergence criteria.
The largest impediments to Emu remain the divergent monetary, fiscal, political, and social conditions within participating countries. Some countries, such as Ger- many, enjoy high standards of living, while others have much lower average incomes.
Workers in high-wage countries are vulnerable to competition from elsewhere within Europe as monetary union equalizes wages across the continent. Workers in less well-to-do countries that have been protected from foreign competition by their national government are also at risk. The hope is that increased trade and general consumer welfare will more than compensate for these local losses.
The EU is comparable to the United States in size and trading power; each contributes about one-fifth of the world’s GDP. The next largest producer is China, accounting for about 13 percent of the world’s GDP. The EU’s 27 countries contain about 500 million people, compared with 1.3 billion in China, 1.2 billion in India, more than 300 million in the United States, and about 125 million in Japan.
Currency Crises and the Role of the IMF
The IMF’s goal is to promote financial stability.
According to the Bretton Woods agreement, the mission of the IMF is to make short-term loans to countries with temporary funding shortages. The IMF has assisted many countries in times of stress, such as during the oil shocks of the 1970s, the debt crises of the 1980s, and the currency crises of the 1990s. Proponents of the IMF claim that these interventions promote financial stability, while critics claim that the IMF’s medicine — in the form of currency devaluations, austerity programs, or other arrangements — can be worse than the disease.
This section describes several currency and stock market crises that illustrate the role of the IMF in helping countries achieve economic stability. In each crisis, conditions were triggered by
■ A fixed or pegged exchange rate system that overvalued the local currency
■ A large amount of foreign currency debt
In each case, the government depleted its foreign currency reserves in defense of the currency and was unable to maintain the fixed exchange rate.
The Mexican Peso Crisis of 1995 During December 1994 and January 1995, the Mexican peso lost nearly 50 percent of its value against the U.S. dollar. The stock market also fell by nearly half in local (peso) terms during this time. The combined effect of the peso depreciation and stock market crash was a 70 percent drop in the dollar value of Mexican stocks. Figure 2.8 displays the real (inflation-adjusted) value
0 1 2 3
Jan-94 Jan-98 Jan-02 Jan-06 Jan-10
Mexican peso value Stock market value
FIGURE 2.8 The Mexican Peso Crisis of 1995
Source:The equity index (from www.msci.com) and exchange rate (from
www.bis.org/statistics/eer/) are stated in real (inflation-adjusted) terms to adjust for relative changes in the purchasing power of the peso. (See Section 4.5 for an explanation.) Values start from a base of 1.00 on December 31, 1993.