The ghost of Bretton Woods continues to haunt international economic policy-making. Its cornerstone was a regime of fixed exchange rates, with the US dollar acting as the anchor currency. This preference for fixed or semi-fixed exchange rates is the distinguishing characteristic of post-war international economic policy, even though this century is littered with the wreckage of fixed exchange rate systems that have failed - from the Gold Standard in the 1930s to Bretton Woods in the early 1970s and the EU's Exchange Rate Mechanism last year.
The Bretton Woods regime was one in which currencies were pegged to the US dollar which, in turn, was pegged to the price of gold. Adjustments were allowed, but on1y under the supervision of the International Monetary Fund. And the imposition of capital controls effectively gave governments greater control over domestic interest rates. Those countries with balance of payments problems were obliged to tighten economic policies to curb domestic spending. Foreign monetary authorities had to intervene in the foreign exchange markets to maintain the value of their currencies within 1 per cent of the dollar parity. The intervention took place in US dollars, with the US Treasury ready to sell or buy gold at the then official price of dollars 35 per ounce.
The principal aim of US exchange rate policy was the maintenance of a fixed par value for the dollar. Devaluation of the dollar was not an option. Any shift out of dollars into gold was seen as undermining the world's monetary structure.
The cracks in Bretton Woods first started to appear in the early 1960s. The US began to accumulate balance of payments deficits as capital outflows outweighed the surplus on US trade. Foreign central banks acquired increasing amounts of US dollars as they intervened to maintain parity in the face of rising US deficits. They were not stupid though and, worried about the prospective value of their dollar holdings, started to convert into gold. Between December 1958 and August 1971, the US Treasury sold a net dollars 10bn of gold, halving its stocks. Protection of the US gold stock soon became the objective of American exchange rate policy.
The sharp reduction in the US gold stock combined with a big increase in foreign holdings of dollars put a question mark over the US commitment to convertibility. Sterling's devaluation in 1967, largely the result of a deterioration in the UK balance of payments, created market pressure on the dollar. With the Vietnam war increasing US inflation and worsening the current account position, it was not long before the dollar fell from grace and took the Bretton Woods system with it. On 15 August 1971, Richard Nixon suspended convertibility of dollars into gold. By the end of August all leading currencies except the French franc were floating.
The Smithsonian Agreement of December 1971 attempted to revive Bretton Woods through a negotiated realignment of currency rates, which comprised a widening of the intervention bands to 2.25 per cent and an effective 10 per cent devaluation of the dollar. It did little to stop the downward pressure, and the dollar was devalued by a further 10 per cent in February 1973.
The following month the system of fixed parities was abandoned and the central bankers adopted a regime of floating exchange rates. However, the new system in practice became a 'managed' float, with policy makers looking for a super-improved Bretton Woods Mark II.
The first ever Group of Seven communique (more properly the G10), at the Rambouillet Summit in 1975, treated foreign exchange intervention as a tool to counter 'disorderly market conditions'. The US often intervened in the 1977-79 period of the Carter administration, when the dollar was under heavy pressure.
During the first Reagan administration, intervention was minimal, in line with free-market and monetarist philosophy. During the 1980s, the internationalisation of financial markets changed things. The lifting of exchange controls and general deregulation combined to stimulate cross-border flows of capital.
Capital movements dominated the determination of exchange rates, superseding the traditional textbook theory of purchasing- power parity. Central banks found it increasingly difficult to control exchange rates. President Reagan found this out when changes in domestic economic policies, which included a tightening of monetary policy and loosening of fiscal policy through tax cuts and defence spending, attracted a vast inflow of capital. The dollar rocketed.
But the Germans and Japanese did not take kindly to finding their currencies slumping. Worries were inevitable over imported inflation, growing external imbalances with associated protectionist threats, and fears of currency misalignment upsetting the international financial system.
Free floating was thus effectively abandoned when the G7 agreed at the New York Plaza Hotel in September 1985 that 'some further orderly appreciation of the main non-dollar currencies against the dollar is desirable.' However, the dollar was already falling because of the infamous 'twin deficits'. By 1987, the US authorities had to intervene for the first time in seven years. The G7 Louvre Accord in February of that year agreed to 'co-operate closely to foster stability of exchange rates around current levels'.
Every year since, G7 official communiques have carried briefer and blander references to exchange rate policy. Nowadays, if economic fundamentals are driving a currency up or down, the central banks become a bit like King Canute. (Daily turnover in the foreign exchange market is now close to dollars 1,000bn, 95 per cent of it unrelated to actual trade in manufactured goods.)
This was certainly the case with the de facto break-up of the ERM last year. The ERM, like a lot of fixed or semi-fixed currency systems, can operate for long enough if parity adjustments are made quickly in response to fundamenta1 pressures. However, an unwillingness to devalue, often for political reasons and for reasons related to prospective participation in the European Monetary Union, created a lot of pent-up pressure. The main problem for the ERM was not exchange rate misalignment but interest rate misalignment. The markets knew that the ERM was not sustainable if it meant that double-digit interest rates accompanied double-digit unemployment rates. And so it proved.
There is also a more fundamental point that in a world of mobile capital, the ERM, and systems like it, are simply unstable and unworkable. More recently, the dollar has posted record lows against the Japanese yen and is slipping against the mark, which is being re-rated by the market. Capital is flowing out of the US in search of better returns, while Japanese cash is staying at home as financial institutions recover from the collapse of the bubble economy.
The G7 central banks are probably best advised to stand aside, especially as there is no apparent dollar misalignment on the scale of the early 1980s. Long term, the dollar will weaken. An economy that has a low level of national savings, low productivity, and a poor track record on fiscal policy and the balance of payments, will tend to see its currency depreciate over time. That is the history of the past 25 years in the foreign exchange market, where investors have tended to sell the Anglo-Saxon currencies and buy currencies of the strong, low-inflation economies: the mark, Swiss franc and yen.
What of the future? Managed floating will likely remain the best bet, although in Europe policy- makers still hanker after the ERM, and in many cases are still smarting after the markets disrupted the glorious march to full-scale monetary union. Here in Britain, the financial establishment seemingly has a long-time preference for an overvalued exchange rate, perhaps reflecting the dominance of the City over manufacturing industry.
But whether it was the decision to rejoin the Gold Standard in 1925, the 'pound in your pocket' saga in 1967, or ERM entry in 1990, it has always ended in tears. We never seem to learn. Even if Europe does end up with a single currency, and by definition a single central bank and single government, the European central bankers should remember that the dollar and yen will still mean currency fluctuations.
I think also that there has been far too much focus on the exchange rate as the centrepiece of economic policy. More attention should be paid to raising activity and improving the long-term prospects for the real economy, and at the same time ensuring that monetary and fiscal policies are both complementary and sustainable. Get all that right and the exchange rate will look after itself.
Neil MacKinnon is chief currency strategist for Citibank.
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