Exactly 50 years ago this month, President Richard Nixon announced the end of the US dollar’s convertibility to gold. The announcement shook the financial world then and effectively ended the Bretton Woods system.
As is always the case when politicians fail, he pointed to an invisible enemy. Alluding to a conspiracy, he blamed speculators for his currency’s woes (sounds familiar?). What he did not say was that the US had been printing so much dollars to finance its domestic needs and the Vietnam War that the US dollar’s gold parity had been eroded to a level where its convertibility could not possibly be honoured.
The Bretton Woods system was the last of a series of gold-based fixed exchange rate regimes. Initiated by the US and Britain as World War II was winding down, the idea was to have fixed exchange rates that would provide the certainty of making cross-border trading less risky and thereby encourage global trade.
International trade, it was felt, would ensure the prosperity needed to avoid another ruinous war. Being gold-based, the US dollar was made the anchor currency with its value pegged at US$35 per ounce of gold. The dollar was to be fully convertible at that rate.
The exchange rate of other currencies was fixed against the dollar according to their gold backing, as determined by the amount of gold reserves held and outstanding money supply. As every currency was fixed against the dollar, all currencies were effectively fixed against each other. Countries could hold their reserves either in gold or the dollar.
Bretton Woods also saw the establishment of the International Monetary Fund (IMF) and the World Bank, the former to help countries with temporary balance of payment and trade imbalances avoid having to devalue their currency.
The key advantage of gold-based fixed exchange rate systems was the monetary discipline it imposed on governments. Governments could not increase their money supply beyond the rate of increase in reserves. Any increase beyond would erode gold parity and, over time, necessitate a devaluation. And devaluations can be painful both economically and politically.
The flip side of this advantage was the system’s key disadvantage; it placed governments in a straitjacket. Domestic money policy flexibility was minimal, if existent. Thus, governments could not easily undertake counter-cyclical policies without risking serious deviations from parity. Left alone, the pro-cyclical tendency of the system would accentuate economic cycles, making booms and recessions even worse.
As was the case with prior fixed exchange rate regimes that had collapsed, the unravelling happened when the anchor currency did not keep to the rules. The dollar was so much in excess of parity that by the end of 1973, it had gone from US$35 to almost US$200 per ounce, ending the decade at US$800 per ounce.
By 1973, the Bretton Woods system was dead and buried. Since then, the world has been on a mixed bag of systems, everything from fixed pegs at one end to free floats at the other end of the spectrum. Many countries chose to be in between these two extremes with various forms of managed floats.
As with everything in economics, the choice involves trade-offs. Pegged or fixed rates ensure exchange rate stability against the currency to which it is pegged, but the cost is loss of domestic monetary independence. Subservience will maintain the peg for as long as needed — à la Hong Kong, but any attempt at monetary independence will cause serious problems, as was the case with Argentina in 2002.
Free floats imply constant small changes in exchange rates but they provide for full monetary policy independence. The exchange rate simply adjusts to policy changes. Instead of the binary choice at the extremes, managed floats attempt to have a little of both — some exchange rate stability and some monetary policy independence.
This is through managing the home currency to float within an upper and lower bound. Managing here implies interventions whenever the exchange rate goes outside the desired band. The trade-off is dependent on the size of the band. The wider the band, the more monetary policy flexibility and vice versa.
Though less frequently these days, there have always been calls for a new global financial architecture ever since the collapse of Bretton Woods. Such an architecture would have at its core, a new exchange rate regime. Yet, half a century later, it has yet to materialise. Why is this so?
There are several reasons a new arrangement has yet to happen. First, experience with currency arrangements has not been good. At least three gold-based systems have collapsed in recent history. Each time, it was because the anchor currency government, such as the US under Bretton Woods, had cheated on the rules.
Even regional currency arrangements such as the European Monetary System (EMS), which preceded the currency union, eurozone, were torn apart by conflicts among members. Recall the 1993 sterling crisis and Britain’s departure from EMS, following its quarrel with Germany, events that led directly to the infamous speculative attack on the pound and the Bank of England’s massive losses.
A second reason is the fact that such arrangements will invariably require the subjugation of domestic priorities to external dictates. For most contemporary governments, this would not be palatable both economically and politically.
The third reason has to do with changes in technology that has made cross-border capital flows faster and much larger than earlier times. There is a well-known trilemma in international finance literature that dictates that fixed exchange rates and monetary policy independence are simply not possible in the presence of free capital flows.
Fixed exchange rate regimes, even gold-backed ones, are no panacea. It should be noted that some of the biggest speculative attacks have been under fixed exchange rate systems or its variants, such as managed floats.
Recent examples are Britain of 1993, the Asian currency crisis of 1997/98 and Argentina 2002. Even small deviations in policy can, over time, cause serious misalignment of the exchange rates. And it is such misalignment that speculators seek to take advantage of. Given fixed or target exchange rates, speculators are effectively presented with a one-way put option with little downside risk.
If the misalignment was large, the correction would be severe. Proponents of fixed exchange rate gold-parity systems often argue that, with fiat currencies and no constraint on governments, there is little check on the debasement of currencies. This argument ignores, however, the market’s ability to discipline governments, sometimes, through speculative attacks. While it may not be immediate, markets can and do discipline misbehaviour, and savagely too.
The sterling crisis, Argentina, Greece, the Asian financial crisis and even the global financial crisis are recent examples. History has shown repeatedly that when bad policies lead to bad equilibriums, disciplining forces are unleashed and even the most powerful of nations can be brought to their knees.
Dr Obiyathulla Ismath Bacha is professor of finance at the International Centre for Education in Islamic Finance (INCEIF)