November 1990

U.S. Policy: Bretton Woods to Present

B. Dianne Pauls, of the Board's Division of "U.S. dollar of specified gold content."2 Foreign International Finance, prepared this article. monetary authorities were obliged to intervene in foreign exchange markets to maintain the value of their within 1 percent of their dollar Over the past thirty years or so, the United parities. Monetary authorities in major foreign States has operated under two distinct exchange countries undertook this intervention in dollars; rate regimes. The first, which lasted effectively the U.S. Treasury stood ready to sell gold to from December 1958 to March 1973, was the them or buy it from them at the official price of Bretton Woods system of fixed exchange rates. $35 per ounce. In light of this commitment by the In the second, which began in March 1973 and and the dominance of the U.S. has continued to the present, exchange rates economy, the dollar was the principal reserve have been subject to managed floating. This and, aside from gold, the principal article traces the evolution of U.S. exchange rate reserve asset of the Bretton Woods system. policy through these two regimes, focusing for Sterling remained a reserve currency, but it was each on the broad objectives of U.S. policy, only a minor one for countries outside of the operational objectives and approaches, and the British Commonwealth. major episodes in policy during the period. Because the responsibility for intervention in exchange markets lay with foreign authorities, direct U.S. intervention during the Bretton THE BRETTON WOODS SYSTEM: Woods era was extremely limited. Before August DECEMBER 1958 TO MARCH 1973 15, 1971, U.S. operations were restricted largely to two types: selling gold to foreign authorities The system of fixed exchange rates was provided for the dollars acquired by those authorities in for in the Articles of Agreement, the charter for exchange market intervention; and, later, buying the International Monetary Fund that was nego- dollars from foreign authorities in return for that tiated at Bretton Woods, New Hampshire, in country's currency, which the United States had 1944. Although the Articles went into force in acquired by drawings on the December 1945, the system of fixed exchange swap network and the issuance of bonds denom- rates envisaged at Bretton Woods became fully inated in foreign currencies. Only after the dollar operational only at the end of 1958, when most had been declared inconvertible into gold, had major foreign currencies became convertible for the private sector into dollars for current account transactions.1 Under the Bretton Woods system, par values were established for the currencies of 2. Initially, the par value of the dollar was defined by the IMF member countries in terms of gold or the President at $35 per ounce of gold under the authority granted to him by the Gold Reserve Act of 1934. The Congress modified the par value of the dollar to $38 per ounce of gold in the Par Value Modification Act, passed in February 1972. This act was subsequently amended in September 1973, to redefine the par value as $42.22 per ounce of gold. When the 1. In 1958, among European countries, only also Second Amendment to the Articles of Agreement was ap- permitted convertibility for the proceeds of capital account proved on October 19, 1976, the Congress repealed the Par transactions. The was not convertible for Value Modification Act but retained the value of $42.22 per current account transactions until 1964. ounce of gold for the purpose of valuing the U.S. gold stock.

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892 Federal Reserve Bulletin • November 1990

been devalued in the , early 1960s, when the United States began to and still was under downward pressure in ex- cumulate deficits in its balance of payments. (See change markets, did U.S. authorities undertake the glossary for a definition of this term and much direct intervention in the exchange market. others used in this article.) From 1960 to 1967, as U.S. residents continued to invest in the recon- Broad Objectives struction of Western Europe and , large of U.S. Exchange Rate Policy capital outflows generally outweighed surpluses in the U.S. trade and current accounts. Foreign In establishing the Bretton Woods system, the monetary authorities began to accumulate dollars IMF's Articles of Agreement heavily stressed as they intervened to maintain the value of their exchange rate stability. The intent was to dis- currencies in the face of growing U.S. payments courage the competitive that were deficits. In turn, they purchased gold more and viewed as contributing to economic and financial more from the U.S. Treasury with these dollars. chaos in the 1920s and 1930s. The Articles for- The Treasury sold, net, more than $10 billion mally permitted adjustment of a currency's par worth of gold between December 1958 and August value only if the country's balance of payments 1971, cutting its gold stock in half (see chart 1). was in "fundamental disequilibrium." This was Sales to and in the London gold market to an imprecise concept, but it came to mean that stabilize the market price around the official price exchange rates would be adjusted only as a last accounted for much of this total. Even if gold resort and only in conjunction with other policies were not immediately demanded, there remained to redress the disequilibrium. the threat that it could be demanded by foreign Given the widespread concern about competi- monetary authorities. To preserve the credibility tive devaluations and the goal of maintaining a of the offer to convert dollars into gold and, with system of fixed exchange rates, the overriding it, the stability of the Bretton Woods system, the objective of U.S. exchange rate policy was the protection of the U.S. gold stock became the key maintenance of a fixed par value of the dollar. operational objective of U.S. exchange rate pol- Keeping the dollar a leading standard and store icy. The government adopted five approaches to of value provided a stable center for the world's meeting this objective. monetary structure. Revaluations of foreign cur- rencies against gold and the dollar, though few, Operations in Foreign Currencies. As the first were more readily accepted by the United States line of defense, U.S. authorities resumed opera- than devaluations, which were considered appro- tions in foreign currencies in the early 1960s, priate only if unavoidable. of the after a hiatus of nearly thirty years. The Trea- dollar, under the Bretton Woods system, could sury, using the Federal Reserve Bank of New be achieved only by an increase in the dollar York as its fiscal agent, began operations in 1961. price of gold without a commensurate increase in the price of gold in terms of other currencies. 1. U.S. gold stock and gold and foreign exchange Hence, it could not be accomplished without the reserves of foreign G-10 countries, 1958-71

cooperation of foreign authorities. Moreover, Billions of dollars Billions of dollars most U.S. policymakers ruled out devaluation of the dollar: They saw it as likely to disturb the world economy by increasing the propensity to shift reserves out of dollars and into gold and thereby undermining confidence in the fixed ex- change rate system.

Operational Objectives and Approaches

The credibility of the U.S. commitment to con- Gold is valued at $35 per ounce. The data are for the end of the periods, vert dollars into gold came into question in the except for 1971, for which the data are for the end of August.

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U.S. Exchange Rate Policy: Bretton Woods to Present 893

Glossary

Balance of Payments. The balance of payments mimarks , Swiss francs, Italian lira, Belgian francs, and is defined in various ways. Under the Bretton Austrian schillings. Earlier issues, also called Roosa Woods system, analysis of longer-run fundamen- bonds, were denominated in dollars and had special tals tended to focus on the basic balance, consist- maturity and interest rate provisions. ing of the current account plus net long-term capital flows. From the perspective of potential SDRs. Special drawing rights are international claims on the gold stock, however, policymakers reserve assets created by the International Mone- generally used the official settlements balance— tary Fund. The IMF has allocated a total of SDR the basic balance plus net private short-term 21.4 billion in six allocations since the SDR was capital. Unless otherwise specified, the concept established in 1969. The amount allocated to a used in this paper for the Bretton Woods period is participant is proportionate to its quota in the Fund the official settlements balance. Under the regime at the time of the allocation. The value of the SDR of floating exchange rates, measures of the overall initially was defined in terms of gold, at SDR 35 per balance of payments were abandoned and atten- ounce. After the move to widespread floating of tion focused on current account positions. exchange rates in 1973, the value of the SDR was redefined in terms of a basket of currencies. Ini- Carter Bonds. Carter bonds were two- to four-year tially, the currencies were those of the sixteen notes denominated in marks and Swiss francs and countries that had a share in world exports of goods issued publicly by the U.S. Treasury in the German and services in excess of 1 percent on average over and Swiss capital markets between late 1978 and the period 1968-72—the G-10 countries plus Austra- January 1980. They were issued to supplement for- lia, Denmark, Norway, Spain, Austria, and South eign currency resources for U.S. intervention. Africa. The composition and weights for the basket of sixteen currencies were revised in July 1978 to Group of Five or G-5 Countries. The countries are reflect export shares for 1972-76. In 1981, the Fund France, Germany, Japan, the , and decided to restrict the currencies in the basket to the United States. those of the five most important countries in world trade—the United States, , Japan, or G-7 Countries. The countries France, and the United Kingdom. include the G-5 countries plus and .

Group of Ten or G-10 Countries. The countries Swap Network. The swap network is a series of were those members of the IMF participating in bilateral arrangements between the Federal Reserve the General Agreements to Borrow—originally, and fourteen foreign central banks and the BIS Belgium, Canada, France, Germany, Italy, Japan, providing standby reciprocal facilities for obtaining the Netherlands, Sweden, the United Kingdom, foreign currencies. The facilities provide for the and the United States. In 1984, Switzerland joined swap (simultaneous spot purchase and forward sale) the G-10, making in fact eleven countries, but by of each other's currency by the Federal Reserve and convention the name remains the G-10. The usage the respective foreign . Swap drawings of G-10 throughout this article includes Switzer- typically have a three-month maturity, with an un- land, even though it was not a member of the IMF, derstanding that they may be more or less automat- because it was party to the various agreements ically rolled over for another three months. regarding exchange rates and before joining the G-10 had an agreement parallel to the General Warehousing. In a warehousing operation, the Agreements to Borrow to lend its currency to the Federal Reserve buys foreign currencies spot from IMF. the Exchange Stabilization Fund, and simultane- ously sells back the proceeds for delivery at a Roosa Bonds. Roosa bonds were medium-term specified future date. Because both purchase and bonds denominated in foreign currencies issued to sale are made at a given exchange rate, neither side official institutions of foreign countries intermit- incurs additional exchange rate risk; interest earn- tently from 1962 to 1971, in an effort to defend the ings on the foreign currencies warehoused accrue U.S. gold stock. They were issued in German to the Federal Reserve.

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894 Federal Reserve Bulletin • November 1990

It acted under the authority granted it by the mostly to purchase dollars unwillingly held by for- Gold Reserve Act of 1934, which established the eign monetary authorities, thereby assuming the Exchange Stabilization Fund for the purpose of exchange rate risk on those holdings. Otherwise, stabilizing the exchange value of the dollar. Be- those dollars could have been converted into gold. cause the ESF's resources were meager, the To obtain medium-term credit, the Treasury Treasury was anxious for the Federal Reserve to issued "Roosa bonds," named after then Under- participate for its own account in foreign cur- secretary of the Treasury Robert V. Roosa. rency operations.3 The Federal Reserve had op- These bonds were designed to be attractive to erated on a very limited ad hoc basis for its own foreign monetary authorities as an alternative to account in the forward exchange market in 1961. converting dollars into gold. Part of the foreign In early 1962, the Federal Open Market Commit- currency proceeds from Roosa bonds was used tee (FOMC) authorized operations in foreign to extinguish swap debt that otherwise would currencies, first on an experimental, then on an have lingered beyond the one-year limit set by ongoing basis. In 1963, the Federal Reserve the FOMC on such drawings. authorized the "warehousing" of foreign curren- Finally, the Treasury also could obtain foreign cies for the ESF, and in that year, it made a currencies by drawing on its credit facilities with warehousing-type transaction. By temporarily the International Monetary Fund. However, be- selling some of its foreign currency holdings to fore 1961, the IMF's supply of usable nondollar the Federal Reserve for dollars through ware- currencies was limited by the small size of the housing, the ESF was able to continue to pur- quotas of its other members. In that year, the chase foreign currencies even after it had ex- United States and the other Group of Ten coun- hausted its initial dollar resources. tries negotiated a mechanism to increase the po- To supplement resources for foreign currency tential availability of their currencies to the IMF operations, various credit facilities were devel- under the General Arrangements to Borrow. oped. Beginning in 1962, the Federal Reserve established a network of reciprocal currency Stabilizing the Market Price of Gold. A second agreements (swap facilities) with the major for- approach used to protect the U.S. gold stock was eign central banks and the Bank for International an attempt to stabilize the private market price of Settlements. By the end of 1967, this network gold around the official price of $35 an ounce. consisted of lines with fourteen central banks and The United States was concerned that if the the BIS. Drawings on swap lines were explicitly market price were allowed to rise appreciably of short term, and were intended to finance or above the official price, foreign monetary author- accommodate short-term capital flows believed ities would convert their dollar holdings into gold to be seasonal or temporary in nature. They were at the official price in order to profit by later not intended as a substitute for more fundamen- reselling the gold at the higher market price. To tal adjustment in the balance of payments. For its eliminate this potential source of pressure on part, the Federal Reserve used its swap drawings U.S. gold reserves, in 1961 the United States and seven other countries formed the Gold Pool, a consortium to sell officially held gold in the 3. The ESF had an initial capital of $2 billion derived from London market to keep the private market price the proceeds of the 1934 of the U.S. gold stock below $35.20 an ounce (roughly the cost of from $20.67 to $35.00 per ounce. Subsequently, the Bretton delivering in London gold purchased in New Woods Agreements Act directed the Secretary of the Treasury York). The nominal share of the United States in to pay $1.8 billion from the ESF for the U.S. quota subscrip- tion in the IMF, thereby reducing the ESF's appropriated Gold Pool sales was 60 percent; in fact, the share capital to $200 million. The ESF grew over time through was larger because other central banks converted subsequent revaluations of gold, interest receipts, and net the dollar proceeds of their Gold Pool sales at the profits resulting from foreign exchange operations. Beginning in 1978, SDRs allocated by the IMF to the United States or Treasury's gold window in order to replenish otherwise acquired by the United States became resources of their gold stocks. Although the Gold Pool later the ESF, and the ESF was authorized to issue SDR certificates became a gold-buying as well as gold-selling to the Federal Reserve to help finance the ESF's foreign currency operations. syndicate, most of its transactions were sales;

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given the large U.S. share in the pool, in the end lating growth, and monetary policy emphasized these sales played a major role in the decline in redressing the capital outflow. In 1961, debt- U.S. gold reserves. Ultimately, in March 1968, management and monetary policies sought to the Gold Pool was closed, and a two-tier market sustain short-term interest rates while allowing for gold was adopted with a fixed price for official long-term rates to decline. This policy, called transactions and a flexible price in the private Operation Twist, was aimed at discouraging cap- market. The United States continued to sell gold ital outflows while encouraging business and to foreign monetary authorities at $35 an ounce, residential investment. The investment tax and they, in turn, agreed not to sell gold in the credit, introduced in October 1962, was designed private market. to boost investment without lowering long-term interest rates and possibly exacerbating capital Freeing Gold for International Settlement. outflows. In 1963, tax rates were reduced, and The amount of U.S. gold reserves that were the Federal Reserve increased its discount rate in "free," or available for transactions with foreign July from 3 to 3V2 percent "to minimize short- monetary authorities, was limited by the legal term capital outflows prompted by higher interest requirement that U.S. monetary authorities hold rates prevalent in other countries." gold equal to 25 percent of the value of domestic In addition, a comprehensive program of cap- currency as backing for the currency. In a third ital controls was adopted, which targeted the approach to protecting the U.S. gold stock, this three main types of capital outflow: American gold cover was repealed, also in March 1968, portfolio and direct investment abroad, particu- freeing up additional gold reserves for interna- larly in Western Europe and Japan, and foreign tional settlement.4 borrowing in the United States. The interest equalization tax, initiated in 1963, was a reaction Redressing the Balance of Payments. The to the growing issuance of foreign bonds in the fourth approach used to protect the U.S. gold United States: Markets for these issues were stock was to redress the balance of payments developing slowly in other countries, and interest deficit, both directly through commercial policies rates were lower in the United States than and capital controls and indirectly through de- abroad. The tax was designed to curtail sales of mand-management policies. Devaluation of the new issues of stocks and bonds by foreigners to dollar was ruled out by U.S. policy and could not U.S. residents. The Federal Reserve's Voluntary be accomplished unilaterally in any case under Foreign Credit Restraint Program, established in the Bretton Woods system. 1965, was intended to limit funding in the United 5 A sharp deterioration in the U.S. current ac- States of U.S. banks' foreign operations. U.S. count, which recorded a deficit in 1959, funding of direct foreign investment by U.S. prompted the United States to tie its foreign aid corporations was limited by a Commerce Depart- to its exports and played some role in the adop- ment program, begun on a voluntary basis in tion of more restrictive monetary and fiscal pol- 1965 but made mandatory in 1968. icies in that year. As the economy entered a recession in 1960, the current account returned Creating a New Reserve Asset. While trying to to surplus, but the United States continued to run remedy the payments deficit, U.S. policymakers deficits in its balance of payments as a result of recognized the need for a systematic means to capital outflows. During the Kennedy Adminis- provide for growth in international liquidity with- tration, fiscal policy was directed toward stimu- out putting pressure on the role of the dollar in the international monetary system. An expand-

4. The Gold Reserve Act of 1934 required 40 percent gold cover on Federal Reserve notes in circulation and 35 percent 5. As a traditional borrower in U.S. markets, Canada was cover on deposits at Federal Reserve Banks. In 1945, these exempted from both the interest equalization tax and the requirements were reduced to a uniform 25 percent. In March Voluntary Foreign Credit Restraint Program on the under- 1965, the 25 percent gold cover on deposits at Federal standing that it would not serve as a conduit for capital flows Reserve Banks was eliminated. to the rest of the world.

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896 Federal Reserve Bulletin • November 1990

ing world economy could be expected to gener- During the summer of 1964, the U.K. balance of ate a secular increase in the demand for interna- payments deteriorated sharply, largely because of tional reserves—dollars and gold. That demand a stimulative fiscal policy. After the Labor Party's had been met through the early 1960s by a victory in October 1964, selling pressure on ster- buildup of official claims on the United States as ling intensified as the new government's policies foreign monetary authorities intervened to main- showed little prospect for redressing the pay- tain the value of their currencies against the ments deficit. The U.K. government strongly op- dollar. Gold and foreign exchange reserves of the posed the devaluation of sterling. The United foreign G-10 countries tripled over the Bretton States endorsed this position and participated in Woods period, as chart 1 shows. Most of the international credit packages to bolster U.K. re- growth reflects an increase in foreign exchange serves, including increases in the Federal Re- (essentially dollars), which, as is evident from serve's swap line with the Bank of England in the chart, was not matched by a rise in the U.S. 1964 and 1966. When sterling again came under gold stock. Hence, confidence in the ability of downward pressure in the second half of 1965, the the United States to meet calls on the gold stock Federal Reserve joined a number of European diminished. Thus, reliance solely on increases in central banks and the Bank of Japan in purchasing U.S. liabilities to foreign official institutions for sterling in the market. Exchange rate risk on the an increase in world reserves was seen to be sterling acquired was covered by agreements with inconsistent in the long run with maintaining the the Bank of England. convertibility of the dollar into gold. After intermittent recoveries and bouts of sell- In light of this fundamental tension, the final ing pressure, sterling again came under persistent approach to protecting the U.S. gold stock and downward pressure beginning in the spring of the stability of the Bretton Woods system was to 1967, for several reasons: U.K. monetary policy create a reserve asset whose supply could be eased; tensions mounted in the Middle East systematically increased as the world economy culminating in war; and the U.K. trade position expanded. This approach was proposed by the steadily deteriorated, especially after the closing United States and eventually resulted in an of the Suez Canal. In an effort to support sterling, agreement to create SDRs (Special Drawing U.S. authorities purchased it in the market on a Rights of the International Monetary Fund) swap basis (that is, they bought sterling spot through the First Amendment to the IMF Arti- against redelivery to the market at a future date). cles of Agreement, which was adopted in 1968 After several increases in the Bank of England's and became effective the following year. The first official lending rate failed to relieve the pressure allocation of SDRs was made in January 1970. on sterling, the U.K. authorities devalued the pound in November 1967. No major country followed the United Kingdom in devaluing; Major Episodes and U.S. Responses nonetheless, the devaluation of sterling brought into question the basic premise of the Bretton Responding to the strains that divergent macro- Woods system that par values of reserve curren- economic policies, structural changes in the cies should be regarded as fixed. world economy, and resulting payments imbal- By late 1967, U.S. inflation had risen, and the ances placed on the Bretton Woods system, balance of payments had worsened as a conse- monetary authorities devalued and revalued cur- quence of the economic expansion associated rencies or on occasion allowed them to float. The with the Vietnam War. Rapid advances in Ja- United States generally welcomed revaluations pan's international competitiveness, following its but considered devaluations appropriate only if postwar reconstruction, exacerbated the U.S. they were unavoidable. However, when sterling payments imbalance. In this context, selling came under pressure intermittently in 1964-67, pressure shifted from sterling to the dollar. The the United States was concerned that the deval- pressure took the form of record private pur- uation of the other major reserve currency would chases of gold in London and shifts of private exert substantial market pressure on the dollar. funds from dollars into continental currencies.

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U.S. Exchange Rate Policy: Bretton Woods to Present 897

The United States reaffirmed its commitment to controls in foreign countries proliferated, and maintain the official price of gold at $35 per ounce intervention by foreign central banks to slow the and, acting jointly with other members of the appreciation of their currencies against the dollar Gold Pool, continued to stabilize the market was substantial, even though they were no longer price through sales in the London market. The defending fixed dollar parities. Federal Reserve also enlarged its swap lines, A system of fixed parities among the currencies which were used to absorb some of the dollars of the G-10 countries was re-established through a flowing to foreign central banks; and to a limited negotiated realignment of exchange rates in the extent it sold foreign currencies forward to the Smithsonian Agreement of December 1971. The market. However, heavy sales of gold by mem- dollar was devalued in terms of gold to $38 per bers of the Gold Pool tended to encourage further ounce; other currencies generally were revalued speculative buying as market participants came against the dollar by varying amounts. These to expect that, given the implied loss of gold, changes in parities resulted in an effective deval- these operations would be abandoned. Indeed, uation of the dollar of nearly 10 percent on aver- the Gold Pool was disbanded in March 1968, and age against the other G-10 currencies. The amount the two-tier pricing system was established. of the devaluation fell short of the best U.S. Continued deterioration in the U.S. trade and government estimates of what would be required current accounts was offset in 1969 by increases in to restore the U.S. external position to a sustain- U.S. monetary restraint, which supported the able balance. Other G-10 countries, however, dollar. However, once U.S. monetary conditions would not agree to a larger devaluation of the eased as domestic economic activity slowed, the dollar. Recognizing that somewhat more flexi- deterioration in the external accounts again came bility in exchange rates was desirable, the G-10 to the fore, and by 1971 the dollar came under authorities widened the margins for intervention heavy selling pressure. U.S. authorities re- to 2Va percent to permit small adjustments in sponded initially with limited forward sales of exchange rates without changes in par values. The foreign currencies and swap drawings to mop up United States made no commitment to defend the part of the purchases of dollars by foreign central Smithsonian parity for the dollar through inter- banks. Some foreign countries, notably Germany, vention or to restore the convertibility of the abandoned parities and began to allow their cur- dollar into gold: Intervention was still left to rencies to float in May 1971. After selling pressure foreign monetary authorities if they wanted to on the dollar intensified and foreign central banks maintain their new parities. The United States did stepped up their demands for gold conversions, agree to examine the case for a more thorough President Nixon, on August 15, 1971, suspended reform of the international monetary system, convertibility of dollars into gold or other reserve which led to the establishment in 1972 of the assets for foreign monetary authorities. He also Committee on Reform of the International Mone- announced a temporary 10 percent surcharge on tary System and Related Issues (the Committee of imports to ensure "that American products will Twenty, or C-20). It also terminated the import not be at a disadvantage because of unfair ex- surcharge and the job development credit. change rates" and a 10 percent tax credit to As downward pressure on the dollar continued businesses that invested in American-made equip- after the Smithsonian Agreement, and the United ment (the job development credit). Use of the States refrained from intervening to defend the Federal Reserve swap network was suspended dollar, market participants began to doubt that after the closing of the gold window. Foreign foreign monetary authorities would continue to authorities then had the choice of continuing to buy inconvertible dollars. As selling pressure on pile up dollars in their official reserves that were the dollar mounted, the United States, in July now inconvertible into gold or allowing their cur- 1972, resumed limited sales of foreign currencies rencies to appreciate. The United States no longer to defend the dollar's Smithsonian parities, and intervened in the market to support the dollar. By the swap network was reactivated. the end of August, all major currencies except the New concerns about the durability of the French franc were floating. The use of exchange Smithsonian Agreement surfaced in early 1973,

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898 Federal Reserve Bulletin • November 1990

after the Swiss authorities permitted their curren- continued expansion of international trade and cies to float and Italian authorities adopted dual productive capital flows."7 exchange rates. (The United Kingdom had al- Although some issues were never completely ready allowed sterling to float, in June 1972.) In resolved, the Committee of Twenty described a this context, a tightening of monetary policies reformed monetary system in its Outline for abroad, the partial relaxation of the U.S. wage- Monetary Reform issued in June 1974. The sys- price controls imposed in August 1971, and the tem had five broad features: sluggish response of the U.S. trade account to 1. An based on stable the dollar's depreciation in the Smithsonian re- but adjustable par values. It would include the alignment helped renew downward pressure on right to float in particular situations, subject to the dollar. In February 1973, the dollar was Fund authorization. devalued a second time, by 10 percent in terms of 2. A greater symmetry in adjustments to the gold to $42.22 per ounce. Nearly all other major balance of payments. Under the old system, a currencies accepted the full devaluation of the country in deficit that was losing reserves was dollar, and the yen floated to an even higher pushed more quickly than a country in surplus to level. At the same time the dollar was devalued, deal with its balance of payments problem, either U.S. authorities stated their intention to phase through demand-management policy, or by ad- out all controls on capital outflows over the next justing the par value of its currency. The U.S. two years.6 They expected that the second de- authorities, in particular, believed that because valuation of the dollar would be sufficient to the exchange rate parities of other currencies remedy the disequilibrium in the U.S. balance of were defined in terms of the dollar so that the payments, but the market was not persuaded. dollar was the residual currency, other countries The dollar fell to its new floor against the major were allowed to maintain undervalued currencies continental European currencies, a development and accumulate payments surpluses, while the that triggered massive intervention by some for- United States ran deficits. As a means of reme- eign central banks. Ultimately, in March, the dying this asymmetry, countries in surplus would system of fixed parities effectively was sus- now have a larger responsibility for correcting pended, and the G-10 authorities de facto their payments positions. adopted generalized floating of their exchange 3. Multilateral surveillance. In the context of a rates. par value system in which convertibility could be suspended, the United States favored an interna- tional reserve indicator as an objective gauge of MANAGED FLOATING: MARCH 1973 whether a country's policies were consistent TO DATE with overall equilibrium in the balance of pay- ments and with adequate growth in global liquid- Initially, the move to generalized floating was ity (at existing par values). The use of this widely viewed as a temporary means of coping indicator was thought to put more pressure on with speculative pressures, rather than as a per- countries in surplus to adjust. manent feature of the international monetary 4. Convertibility. European authorities focused system. In the discussions of the Committee of on the lack of mandatory convertibility of dollars Twenty, the par value system still was regarded under the Bretton Woods system and believed as the "normal" regime, and "the task of mon- that if the United States were required to finance etary reform was viewed as one of improving the its payments deficits with reserve assets (gold, Bretton Woods system so that it would operate SDRs, and Fund drawings), it would have a without frequent crises, and in a more symmet- greater incentive to adopt policies to eliminate its rical fashion" than previously, "to facilitate the deficits. The United States wanted to limit the

7. Robert Solomon, The International Monetary System 6. U.S. capital controls were dismantled in early 1974. 1945-1981, rev. ed. (Harper & Row, 1982).

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convertiblity of dollars beyond a certain point for jority vote of the IMF membership, effectively surplus countries as a means of encouraging a more giving the United States a veto over such a move. symmetric adjustment of payments imbalances. Article IV also provides for surveillance over 5. Better international management of global the Fund's members to ensure effective opera- liquidity. The SDR would become the principal tion of the international monetary system and reserve asset, and the role of gold and reserve compliance with members' general obligations, currencies would be reduced. which include (1) "endeavoring to direct eco- Meanwhile, the increase in worldwide inflation nomic and financial policies toward . . . fostering in 1972-74, associated in part with the runup in orderly economic growth with reasonable price oil prices in 1973, led to a divergence in rates of stability;" (2) "fostering orderly economic and inflation across countries and increased strains financial conditions and a monetary system that on countries' external positions; these problems does not tend to produce erratic disruptions;" were aggravated by the worldwide recession in and (3) "avoiding manipulating exchange rates or 1974-75. Under these circumstances, a system of the international monetary system in order to par values seemed even less viable than before. prevent effective balance of payments adjust- Moreover, the world economy had been func- ment or to gain an unfair competitive advantage tioning reasonably well under a mixed floating over other members." This new Article IV was system for a few years. The United States shifted incorporated, along with a number of other sig- from favoring a system of stable, but adjustable nificant changes, in the Second Amendment of par values, with floating in particular situations, the IMF's Articles of Agreement, which became to explicitly advocating a system of floating ex- effective April 1, 1978. change rates as a long-run option. The Committee of Twenty recognized that the Broad Objectives of U.S. Exchange Rate international monetary system was in flux and Policy that it might be particularly difficult in the cir- cumstances of the time to return to a par value In conjunction with the decision in March 1973 to system. However, it recommended the immedi- suspend the commitment to intervene in support ate adoption in the interim of "appropriate guide- of fixed parities against the dollar, the G-10 lines for the management of floating exchange countries issued a communique stating that "of- rates." These were agreed to in 1974, though ficial intervention may be useful at appropriate many of the rest of the committee's recommen- times, to facilitate the maintenance of orderly dations were not adopted because there was market conditions "(emphasis added). An even- never a return to a par value system. tual return to a par value system was assumed, Floating was finally legitimatized at the Ram- and intervention was viewed as a way to main- bouillet Economic Summit among the major in- tain order in the interim. Subsequently, as a dustrial countries in November 1975. The agree- system of floating exchange rates came to be ment reached there, which had been worked out regarded as the norm, the statement about inter- in advance between the representatives of the vention in the Rambouillet Declaration was United States and France, had two basic ele- changed to "countering disorderly market condi- ments. The first was to "deepen, systematize, and tions" (emphasis added). The Rambouillet for- broaden" daily consultation among the monetary mulation was repeated in the IMF's Principles authorities, including central banks, of the larger for the Guidance of Members' Exchange Rate countries with regard to exchange market inter- Policies.8 This concept has since guided U.S. vention. Second, Article IV of the IMF's Articles of Agreement, governing exchange arrangements, was to be revised to permit a member to choose 8. International Monetary Fund, Selected Decisions and its own exchange arrangements—including float- Selected Documents, Fourteenth Issue (IMF, April 30, 1989). ing. Under the revised article, completed in 1976, These principles, first adopted in April 1977, specify that a return to a generalized par value system, if "(1) A member shall avoid manipulating exchange rates or the international monetary system in order to prevent effec- deemed appropriate, requires an 85 percent ma- tive balance of payments adjustment or to gain an unfair

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900 Federal Reserve Bulletin • November 1990

exchange rate policy and appears in both the 2. Net official purchases of dollars and the foreign U.S. notification to the IMF of its exchange exchange value of the dollar, 1973-90 arrangements and the FOMC's Foreign Currency Directive.9 A precise official definition of "disorderly mar- ket conditions" has never been attempted. In a narrow sense, the phrase has been understood to mean market disruptions of very short duration. In a broader sense, the phrase has referred to episodes in which policymakers deem market exchange rates to be clearly out of line with economic fundamentals. In his testimony before the Joint Economic Committee in January 1989, Alan Greenspan, the Chairman of the Federal Reserve Board, interpreted the phrase "counter- ing disorderly market conditions" as fostering exchange rate stability, consistent with under- standings among the Group of Seven (G-7) coun- Net official foreign purchases of dollars are those by thirteen major for- tries. eign countries. The foreign exchange value of the dollar is its weighted aver- age against the currencies of the foreign G-10 countries; the weights used are total trade for 1972-76. This series is plotted monthly. The 1990 data Operational Objectives and Approaches for both series are for the first seven months.

Since 1973, the frequency and size of U.S. for- eign exchange operations have varied, as chart 2 rate fluctuations. Throughout the floating-rate illustrates. Intervention was substantial in 1977— period, other countries' intervention policies 79, when the dollar was deemed unacceptably have been mixed, with some countries adopting a low. U.S. operations were minimal during the consistently more active policy than the United first Reagan Administration, in line with its pol- States. icy of limiting government interference in mar- Although episodes of U.S. intervention have kets generally; they were directed mainly at been relatively infrequent since 1973, the countering short-run market disruptions. Inter- amounts involved sometimes have been sizable. vention was substantial again in the autumn of Accordingly, the United States at times has 1985, when the dollar was regarded as unaccept- taken steps to increase foreign currency re- ably high. By far the most extensive U.S. inter- sources for intervention, particularly when the vention operations, however, have taken place dollar was under sustained downward pressure. since the Louvre Accord of February 1987; since The overall size of the Federal Reserve's swap then U.S. operations have been guided largely by lines with other central banks was enlarged. A informal understandings with the other G-7 coun- new swap line between the ESF and the Bundes- tries about the limits of tolerance for exchange bank was established in early 1978, and the ESF became an active partner in the financing of intervention at that time. During 1978, the Trea- competitive advantage over other members. (2) A member sury sold SDRs for foreign currency, drew on its should intervene in the exchange market if necessary to counter disorderly conditions which may be characterized reserve position at the IMF, and began to issue inter alia by disruptive short-term movements in the ex- securities denominated in foreign currencies in change value of its currency. (3) Members should take into the private market ("Carter bonds"). In late account in their intervention policies the interests of other members, including those of the countries in whose curren- 1980, U.S. authorities for the first time began to cies they intervene." build up substantial foreign currency reserves 9. The U.S. notification to the IMF was amended following through purchases in the market and from other the Plaza Agreement of September 1985 to provide for central banks, after having first covered out- intervention "to counter disorderly market conditions, or when otherwise deemed appropriate." standing foreign currency liabilities.

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U.S. Exchange Rate Policy: Bretton Woods to Present 901

During times when the dollar's exchange value many and Switzerland. Between October 1974 raised particular concern—in 1977-79, 1984-85, and March 1975, U.S. authorities made gross and 1987—it became a significant factor in Fed- purchases of $1.4 billion, and the central banks of eral Reserve decisions regarding monetary pol- Germany and Switzerland made somewhat larger icy. Furthermore, consultation and cooperation dollar purchases. The dollar did not recover until on macroeconomic policies by the major indus- March, when U.S. interest rates stabilized while trial countries have increased over the floating- foreign interest rates declined. rate era amid a growing perception that the The first sustained period of U.S. intervention existing international monetary arrangements under the floating-rate regime occurred in 1977— have not exerted as much equilibrating influence 79. By 1977, rapid growth in U.S. domestic on payments imbalances, or provided as much demand had contributed to a deterioration of the independence for monetary policies, as had been U.S. current account balance, which swung from hoped. Wide swings in exchange rates have a surplus of more than $4 billion in 1976 to a occurred, contributing to large trade imbalances deficit of more than $14 billion in 1977; it had and resource reallocations, and pointing up the also contributed to a pick-up in inflation to nearly need for more compatible policies among the 7 percent (December to December), up from major countries. 5 percent in the previous twelve months. Short- term interest rates in the United States rose Major Episodes and U.S. Responses during 1977, and the Federal Reserve raised its discount rate twice by year-end. But, with Ml The first time U.S. authorities intervened follow- expanding at a rate well beyond the upper limit of ing the adoption of generalized floating was in the target range set by the FOMC, the perception July 1973. Concern over rising U.S. inflation, in exchange markets was that the Federal Re- forecasts of vastly higher energy imports, and the serve was too slow in responding to inflationary potential ramifications of the Watergate affair pressures. These conditions contrasted with weighed on the dollar; at the same time, a those in Germany and Japan, where a more rapid tightening of German monetary policy supported policy response to inflationary pressures resulted the mark and associated European currencies. in slower economic growth, contributing to sur- As the dollar fell, trading became increasingly pluses in current accounts. disorderly, with many banks refusing to quote As the depreciation of the dollar intensified rates. In these circumstances, U.S. authorities around the turn of the year, the Federal Reserve intervened to counter disorderly conditions in responded by raising its discount rate in January the markets. 1978 to 6'/2 percent, citing developments in for- The scale of operations was expanded a bit in eign exchange markets. However, the pace of the winter of 1974-75. Inflation in the United U.S. inflation quickened to 9 percent in 1978, in States was still worrisome, whereas price pres- part reflecting the past depreciation of the dollar; sures in many other industrialized countries were meanwhile, inflation in the other G-10 countries, abating. Though worldwide, the recession was on average, declined—from 5Vi percent in 1975 most severe in the United States. The Federal to slightly more than 4 percent in 1978. Efforts to Reserve had begun to ease money market condi- reduce the U.S. trade deficit by curbing oil tions in the autumn of 1974, and the federal funds imports also were unsuccessful. The Federal rate plummeted from 13 percent in July 1974 to Reserve engineered further firming in money 53/8 percent in March 1975. With interest differ- market conditions through the spring and sum- entials between dollar and foreign currency as- mer, but the growth of Ml still exceeded its sets eroding, the dollar depreciated. U.S. author- targeted range and the dollar continued to fall. ities intervened at first to cushion the dollar's Noting both disorderly conditions in exchange decline. In mid-January 1975, they became more markets and the serious U.S. inflation problem, concerned with the dollar's progressive slippage, the Federal Reserve in August 1978 raised its and stepped up intervention in support of the discount rate Vi percentage point further to 73/4 dollar in concert with the central banks of Ger- percent. This move and subsequent increases in

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902 Federal Reserve Bulletin • November 1990

the autumn provided only temporary support for of SDRs; a drawing on the U.S. reserve position the dollar. Between May and October 1978, at the IMF by the Treasury; and issuance of President Carter announced a series of measures Carter bonds.11 to fight inflation, including delays and reductions With these resources, U.S. authorities inter- in the amount of scheduled tax cuts, budgetary vened aggressively, sometimes in concert with restraints, and voluntary wage-price guidelines. other central banks. Net official purchases by Following the announcement of the last two U.S. authorities in the market from October 1977 measures in October, the dollar tumbled still through the end of 1978 amounted to about $10 further, hitting on October 30 a record low on the billion, while foreign authorities bought about trade-weighted index compiled by the Federal $37 billion. In 1978, the major central banks more Reserve Board staff. Two days later, a dollar- than financed the current account deficit, with defense package was announced. It included a net official purchases more than double the $15 further hike in the discount rate by an unprece- billion deficit. dented full percentage point, to a then historic In the first half of 1979, the dollar recovered high of 9Vi percent. In unveiling the package, somewhat, but by mid-June it came under re- President Carter stated that "the continuing de- newed selling pressure. The second oil-price cline in the exchange value of the dollar is clearly shock in 1979 added substantial upward pressure not warranted by the fundamental economic sit- to price levels worldwide and restricted output. uation" and "as a major step in the anti-inflation In the United States, these problems were acute: program, it is now necessary to correct the Inflation already was more rapid than in most excessive decline in the dollar." foreign economies, and the data pointed to a During 1977-79, U.S. authorities also took slowdown in economic activity. In contrast, for- steps to bolster their resources for intervention. eign economic growth had not yet begun to In December 1977, the President announced an decline, with German and Japanese authorities explicit undertaking to intervene in concert with having committed themselves to stimulative fis- other countries to support the dollar. In January cal packages at the Bonn Economic Summit in 1978, the Treasury stated that the ESF would the summer of 1978. Policymakers in most for- henceforth be used as an active partner in the eign countries responded to the hike in oil prices financing of intervention, and that a new swap by tightening monetary conditions, but the Fed- line with the Bundesbank had been established. eral Reserve, responding to signs of weakness in Furthermore, in March, the Federal Reserve's the U.S. economy, took less vigorous steps, swap line with the Bundesbank was doubled, and raising its discount rate 1 Vi percentage points in the Treasury sold SDRs to the German central three moves in the third quarter of 1979. Never- bank for marks. The Treasury also indicated that theless, the growth of U.S. monetary aggregates it was prepared to draw on its reserve position at remained well above projected rates during the the IMF to acquire foreign currencies. To further summer of 1979. Furthermore, U.S. energy pol- support the dollar, the Treasury announced in icy was widely regarded in exchange markets as May that it would resume auctioning gold to the being in disarray. The subsequent shake-up of public.10 Finally, as part of the November 1, the Carter cabinet raised concerns in exchange 1978, dollar-defense program, a $30 billion pack- markets about political leadership as well. Under age of foreign currency resources to finance U.S. these circumstances, U.S. authorities intervened intervention in cooperation with foreign authori- substantially during the summer of 1979 to resist ties was put together. It consisted of an increase the dollar's decline. in Federal Reserve swap lines with the central The continued weakness in the dollar and banks of Germany, Japan, and Switzerland; sales other signs of rapidly deteriorating inflation ex-

10. The U.S. Treasury had auctioned a small amount of gold—1.3 million ounces—during 1975-77 to underline the 11. In 1978, the FOMC extended the warehousing facility U.S. policy position that gold was no longer a monetary asset to include the U.S. Treasury's General Fund, which used the and should be treated like any other commodity. warehousing facility for the proceeds of the Carter bonds.

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U.S. Exchange Rate Policy: Bretton Woods to Present 903

pectations, including sharpiy rising prices of gold strengthen as the U.S. economy performed fa- and other commodities, were important consid- vorably compared with other economies. Infla- erations in the adoption of new monetary oper- tion in the United States had begun to wane, ating procedures by the Federal Reserve on while in several other countries, especially the October 6, 1979. The shift in operating proce- traditionally low-inflation countries of Europe, it dures entailed a greater emphasis on the control remained high relative to postwar experience. of banks' nonborrowed reserves and, therefore, The U.S. economy also showed more resilience, less control of the federal funds rate. These bouncing back from the sharp downturn in the procedures were intended to assure better con- second quarter of 1980; output in most European trol over the growth of the monetary aggregates economies stagnated and unemployment in- and, in general, to damp inflationary pressures. creased. As the U.S. economy rebounded and The Federal Reserve also increased its discount the Federal Reserve continued to emphasize rate a full percentage point to 12 percent and nonborrowed reserves, interest rate differentials imposed a supplemental reserve requirement on moved sharply in favor of dollar assets. Two banks' managed liabilities. additional factors lent further support to the Following the change in operating procedures, dollar later that fall: The election of Ronald U.S. interest rates rose sharply, but political Reagan suggested to the market a political com- developments in late 1979 weighed on the dollar. mitment to bringing down inflation; and the These included the taking of U.S. hostages by global pattern of external balances shifted in Iranian militants, the threat by Iranian authori- favor of the United States. The U.S. current ties to withdraw funds from U.S. banks, the account swung into surplus in the second half of freezing of Iranian assets in U.S. banks, and the 1980, reflecting a strong improvement in non-oil Soviet invasion of Afghanistan. trade as a result of the past depreciation of the During the first quarter of 1980, the dollar dollar. strengthened. The demand for money and credit In the fall of 1980, U.S. monetary authorities was increasing rapidly: Inflationary expectations still had outstanding foreign currency obligations were mounting, as increases in consumer prices in the form of swap debt and maturing Carter topped 14 percent in the year ending in March bonds to cover. As the dollar began to 1980; and financial markets were anxious about strengthen, they purchased the foreign curren- the Carter Administration's economic policies, cies needed to cover those obligations when they including the imposition of credit controls in judged that doing so would not depress the March. The Federal Reserve continued to re- dollar. strain the growth of nonborrowed reserves, and Even after the outstanding obligations were interest rates in the United States soared, with covered, U.S. authorities continued to purchase the federal funds rate increasing nearly 4 percent- foreign currencies to build up U.S. foreign cur- age points, in barely four months, from 133/4 rency reserves. Before this time, the Federal percent in December 1979 to 175/s percent in Reserve and the Treasury had had essentially no April. U.S. authorities took advantage of the long-term net asset position in foreign currencies dollar's rebound to acquire foreign currencies to (see chart 3). U.S. authorities decided to acquire repay debt incurred as a result of dollar-support foreign currency balances to avoid having to operations in 1978-79. finance intervention by incurring swap debts with Subsequently, as economic activity in the sometimes reluctant foreign monetary authori- United States contracted sharply in the second ties. In addition, they judged that the dollar's quarter of 1980, short-term interest rates in the strength could well be temporary. The dollar had United States plummeted. Between April and been supported primarily by unusually favorable July, the federal funds rate fell more than 8 interest differentials and, in an environment of percentage points, prompting a sharp decline in volatile interest rates, these might narrow, put- the dollar. During this period U.S. authorities ting downward pressure on the dollar. intervened heavily to slow the dollar's fall. The Federal Reserve and the Treasury inter- By September 1980, the dollar began to vened in this manner from October 1980 through

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904 Federal Reserve Bulletin • November 1990

3. U.S. net foreign currency balances, 1962-90 of the Federal Reserve's policy of gradually

Billions of dollars equivalent reducing money growth to noninflationary levels. From 1981 through early 1985, the dollar con- 40 tinued to strengthen, for several reasons. U.S. • 30 monetary conditions were restrictive in the con- text of a robust recovery, and prospects for • 20 continued large U.S. fiscal deficits exerted up- 10 ward pressure on real interest rates. Meanwhile, + monetary authorities abroad initially were reluc- 0 tant to raise interest rates because their recover- I I I I 1 I I I I I I I I I I [ I I I 1 I, I I, ,1„1 ,1 I I I J ies appeared more fragile. Investment, including 1965 1970 1975 1980 1985 1990 foreign investment, boomed in the United States, Foreign currency balances are valued at historical cost. The data are for the end of the periods, except the datum for 1990, which is for the end of July. attracted by the increasingly favorable business climate. In addition, dollar-denominated assets mid-February 1981, purchasing nearly $7 billion were sought as a "safe haven" following the equivalent of German marks and small amounts onset of the international debt crisis and amid of Swiss francs and French francs. As of Febru- apprehensions about the political situations in ary 1981, their combined net position in foreign some European countries. currencies (marks, yen, and Swiss francs) was U.S. intervention operations from April 1981 $6 billion equivalent. This position compares through 1984 were very limited, occurring on with net foreign currency liabilities that peaked only twenty days, in line with the Administra- at $3.5 billion equivalent (valued at February tion's view that the strong dollar was an indica- 1981 exchange rates) in September 1979. tion of the robust U.S. economy and not a cause In early 1981, the new Reagan Administration for concern. Moreover, most of these operations decided to move away from what it judged to were undertaken at the urging of foreign mone- have been the heavy intervention inherited from tary authorities. On net, U.S. authorities sold the previous administration. This decision re- $750 million against marks and yen during this flected the view that exchange rates were the period. product of economic policies and that a "conver- Some European monetary authorities who fa- gence" of economic policies was the way to vored more active management of exchange stabilize exchange rates, a view consistent with rates objected to the U.S. policy of "noninter- the Administration's general desire to minimize vention." In this context, the G-7 Economic government interference in markets. Testifying Summit at Versailles in June 1982, agreed to before the Joint Economic Committee of the establish a working group (the Jurgensen Group) U.S. Congress on May 4, 1981, then Undersec- to study the effectiveness of intervention in for- retary of the Treasury Beryl Sprinkel described eign exchange markets.12 the new Administration's exchange market pol- By mid-1984, however, the dollar had risen icy as "a return to fundamentals" by "concen- nearly 60 percent on average against the other trating on strengthening and stabilizing the do- G-10 currencies from its level in the fourth quar- mestic economic factors which have undermined the dollar during the last decade or so." In conjunction with the emphasis on economic fun- 12. Paragraph 38 of the Jurgensen report concludes that damentals, Undersecretary Sprinkel stated that "intervention had been an effective tool in the pursuit of certain exchange rate objectives—notably those oriented the Administration intended to "return to the towards influencing the behavior of the exchange rate in the more limited pre-1978 concept of intervention by short run. There was also broad agreement that sterilized intervening only when necessary to counter con- intervention [intervention that leaves the monetary base unchanged] did not generally have a lasting effect, but that ditions of disorder in the market." He antici- intervention in conjunction with domestic policy changes did pated little need for U.S. intervention in light of have a more durable impact. At the same time it was the President's proposed program of incentive- recognized that attempts to pursue exchange rate objectives which were inconsistent with the fundamentals through in- enhancing tax cuts and deregulation and in light tervention alone tended to be counterproductive."

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U.S. Exchange Rate Policy: Bretton Woods to Present 905

ter of 1980, and its strength concerned some U.S. economic conditions than has been the case. policymakers. Concern was expressed in FOMC They believe that agreed policy actions must be meetings, among other forums, about the impli- implemented and reinforced to improve the fun- damentals further, and that in view of the pre- cations of the strong dollar for the U.S. manu- sent and prospective changes in fundamentals, facturing sector and about the consequences for some further orderly appreciation of the main inflation should the dollar drop precipitously. non-dollar currencies against the dollar is desir- These considerations were among the arguments able. They stand ready to cooperate more leading to an adoption of an easier monetary closely to encourage this when to do so would be helpful. stance in mid-1984. As the dollar continued to rise, the second Reagan Administration began to reverse its pol- This statement that exchange rates were out of icy of nonintervention in currency markets. line with economic fundamentals represented a Group of Five (G-5) officials, meeting on January sharp reversal of the U.S. Administration's pre- 22, 1985, issued a statement reaffirming their vious stance. commitment to promote the convergence of eco- Although intervention in exchange markets nomic policies, to remove structural rigidities, was not explicitly mentioned, the last sentence of and (as agreed at the Williamsburg Economic the G-5 statement quoted above encompassed it. Summit of April 1983) to undertake coordinated During the seven weeks following the Plaza intervention in exchange markets as necessary. Accord, G-5 authorities sold nearly $9 billion, of Subsequently, in coordinated operations with which the United States sold $3.3 billion. other central banks, U.S. authorities sold about With respect to policy intentions, the commu- $650 million between January and March 1985. nique said little that was new. No commitments Although the dollar had started to decline by were made regarding U.S. monetary policy. late February, that decline had not yet had time However, Japanese government officials stated to produce an improvement in the U.S. trade their intention to implement "flexible manage- deficit. So, protectionist sentiment in the United ment of monetary policy with due attention to the States mounted as the trade deficit swelled to an yen [exchange] rate." Since the imbalance in annual rate of $120 billion in the summer of 1985. external positions reflected, to some extent, the In part to deflect protectionist legislation, U.S. misalignment of fiscal policies, specific programs officials arranged a meeting of G-5 officials at the consistent with current policy intentions to re- Plaza Hotel in New York on September 22 with duce fiscal stimulus in the United States and the purpose of ratifying an initiative to bring increase it abroad were included in the state- about an orderly decline in the dollar. In their ments. The United States promised to "imple- statement, G-5 officials drew attention to the ment fully the deficit reduction package for fiscal significant progress that had been made in pro- year 1986" specified in the Gramm-Rudman- moting favorable economic performance along a Hollings act and indicated its intention to imple- path of steady noninflationary growth. Yet, they ment revenue-neutral tax reform. Japan agreed observed, "recent shifts in fundamental eco- to increase investment by local governments, nomic conditions among their countries, together conditional on the circumstances of each region. with policy commitments for the future, have not The West German government stated its inten- been fully reflected in exchange markets." Large tion to continue its tax reform, with tax cuts due imbalances in external positions were noted, to take effect in 1986 and 1988. The United along with the potentially "mutually destruc- Kingdom and France each promised to curb tive" protectionism they might engender. The public expenditure and to reduce tax burdens. statement concluded: In reaction to the G-5 statement and subse- quent intervention, the dollar fell sharply. Mon- etary tightening in Japan in late October provided The Ministers and Governors agreed that ex- further downward impetus for the dollar. By change rates should play a role in adjusting external imbalances. In order to do this, ex- year-end the dollar had fallen 17 percent against change rates should better reflect fundamental the yen and 14 percent against the mark from its

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906 Federal Reserve Bulletin • November 1990

levels just before the Plaza meeting, leaving it 24 interpreted in exchange markets as indicating a and 29 percent respectively below its peaks in lack of concern about the ramifications of a February. further decline in the dollar. In these circum- Throughout this period, the Federal Reserve stances, U.S. monetary authorities at the end of emphasized that, given the dependence of the January intervened on one occasion in support of United States on large capital inflows for the time the dollar. This was the first operation in support being, underlying confidence in the dollar needed of the dollar since mid-1980, except for small to be maintained. Although it believed that a operations when President Reagan was shot in precipitous fall in the dollar was only a remote March 1981 and during the Continental Bank possibility, it was concerned that, should it oc- crisis in May 1984. It was conducted in coordi- cur, it could force sharply higher interest rates nation with the Bank of Japan. and inflationary pressures, thereby threatening On February 22, 1987, officials of the major the financial system and the economy. In light of industrial countries met at the Louvre in . these considerations, the decisions to lower the They concluded that "substantial exchange rate Federal Reserve's discount rate in March and changes since the Plaza Agreement will increas- April 1986 were carefully coordinated with simi- ingly contribute to reducing external imbalances lar moves by other central banks. The March and have now brought their currencies within move coincided with reductions in official rates ranges broadly consistent with underlying eco- in Japan, Germany, France, and the Nether- nomic fundamentals." In addition, they ex- lands. Subsequently, the United Kingdom and pressed concern that "further substantial ex- several other countries in the European Mone- change rate shifts could damage growth and tary System cut their official rates. In April, the adjustment prospects in their countries." There- United States and Japan lowered their discount fore, they agreed to "cooperate closely to foster rates in tandem. stability of exchange rates around current lev- Formal procedures to improve G-7 policy coor- els." In this regard, the G-7 authorities reached dination and strengthen multilateral surveillance certain general understandings about the tolera- were agreed to at the Tokyo Economic Summit in ble range of fluctuations in exchange rates for the May 1986. In particular, a framework for the dollar and about cooperation in exchange market systematic consideration of national policies and operations. performance was adopted, involving the use of No new commitments regarding monetary pol- economic indicators. According to the summit icy were made at the Louvre, although the Bank declaration, the purposes of improved coordina- of Japan announced a reduction of a half percent- tion "should explicitly include . . . fostering age point in its discount rate effective the next greater stability of exchange rates." Although the day. Only two aspects of the agreements on fiscal United States supported improved coordination policy represented new initiatives. Japan prom- of macroeconomic policies to foster increased ised that "a comprehensive economic program stability in exchange rates, U.S. authorities did will be prepared after the approval of the 1987 not intervene in exchange markets in 1986 be- budget by the Diet, so as to stimulate domestic cause the dollar's continued decline was regarded demand, with the prevailing economic situation as orderly and not cause for concern. Japanese duly taken into account." Germany agreed to authorities, however, became quite concerned "propose to increase the size of the tax reduc- about the yen's appreciation, particularly in the tions already enacted for 1988." On the U.S. runup to the national elections in Japan, and the side, the commitment to "policies with a view to Bank of Japan intervened quite heavily in support reducing the fiscal 1988 deficit to 2.3 percent of of the dollar in the spring and summer of 1986. GNP from its estimated level of 3.9 percent in The dollar declined to seven-year lows in early fiscal year 1987" was consistent with the 1987, amid signs that the U.S. economy might be Gramm-Rudman-Hollings target, which in the weakening while the U.S. trade deficit continued event was not reached. to grow. Furthermore, various press statements Despite heavy intervention purchases of dol- attributed to U.S. Administration officials were lars following the Louvre Accord, the dollar

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U.S. Exchange Rate Policy: Bretton Woods to Present 907

continued to decline, particularly against the reached a new set of understandings about fluc- yen. Market participants perceived delays in the tuations in exchange rates and cooperation in implementation of expansionary fiscal measures exchange market operations. They stated that in Japan expected after the Louvre Accord, and "either excessive fluctuation of exchange rates, a talk of trade sanctions on some Japanese prod- further decline of the dollar, or a rise in the dollar ucts heightened concern about a deterioration in to an extent that becomes destabilizing to the U.S.-Japanese trade relations. By the time of the adjustment process, could be counterproductive G-7 meeting in early April, the dollar had fallen by damaging growth prospects in the world econ- more than 5 percent against the yen from its level omy." They also reaffirmed their commitment to at the time of the Louvre Accord. At the April "cooperate closely on exchange markets." In meeting, the G-7 officials "reaffirmed the view addition, the agreements on fiscal policy mea- that around current levels their currencies are sures contained in the Louvre Accord were ex- within ranges broadly consistent with economic tended to include policies for 1988. fundamentals and the basic policy intentions Following the Louvre Accord, the G-7 author- outlined at the Louvre meeting." They urged ities intervened heavily in support of the dollar further measures, however, to "resist rising pro- throughout the episodes of dollar weakness in tectionist pressures, sustain global economic ex- 1987, and sold dollars on several occasions when pansion, and reduce trade imbalances." In this the dollar strengthened significantly. Net official regard, they welcomed newly announced propos- dollar purchases by the G-7 and other major als by Japan for a large supplementary budget to central banks effectively financed more than two- stimulate the economy. thirds of the $144 billion U.S. current account The dollar began to firm in May when monetary deficit in 1987. The U.S. share of these purchases conditions tightened in the United States and was $8.5 billion, and the share of the other G-7 eased abroad. In addition, the passage of the countries was $82 billion. supplementary budget in Japan and more favor- The G-7 authorities continued to make large able U.S. trade data offered some optimism re- purchases of dollars into January 1988, and the garding adjustment of trade imbalances. But the dollar stabilized. Subsequently, the dollar dollar turned down again with the release of strengthened as monetary conditions in the disappointing U.S. trade data in mid-August. Cit- United States were tightened earlier than those ing "the potential for greater inflation, associated abroad and U.S. external accounts improved. As in part with weakness in the dollar," the Federal some foreign authorities began to tighten mone- Reserve raised its discount rate V2 percentage tary conditions and external adjustment stalled point to 6 percent in early September. However, during the second half of 1988, the dollar eased record U.S. trade deficits and market perceptions back somewhat. For the year as a whole, the that the G-7 authorities were pursuing their own dollar appreciated moderately; U.S. authorities domestic objectives soon sparked a further sellofF both bought and sold dollars, so that intervention of the dollar, and equity prices plunged world- was small on balance. When the dollar again wide. The dollar's decline gathered momentum strengthened in the first part of 1989, reaching a once the Federal Reserve moved more aggres- 2!/2-year high against the mark and threatening to sively than its foreign counterparts to supply undermine progress on external adjustment, the liquidity in the aftermath of the stock market U.S. authorities became more active in selling crash. The Federal Reserve's actions in this regard dollars. led market participants to believe that it would In September 1989, G-7 officials issued a com- emphasize domestic objectives, if necessary at the munique stating that they "considered the rise in cost of a further decline in the dollar. By year-end, recent months of the dollar inconsistent with the dollar's value had fallen 21 percent against the longer run fundamentals" and "agreed that a rise yen and 14 percent against the mark from its levels in the dollar above current levels or an excessive at the time of the Louvre Accord. decline could adversely affect prospects for the In these circumstances, G-7 officials recon- world economy. In this context, they agreed to vened by telephone in late December and cooperate closely in exchange markets." The

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908 Federal Reserve Bulletin • November 1990

release of this statement was followed by three uncertainty and concern in exchange markets weeks of coordinated intervention with the initial that monetary policy in Japan was too lax objective of lowering the dollar and the later depressed the yen. Consistent with G-7 under- objective of keeping the dollar lower. For 1989 as standings, U.S. authorities intervened in sup- a whole, U.S. authorities sold $22 billion net, by port of the yen in early 1990, buying more than far the largest U.S. annual operation ever; other $2 billion equivalent of yen. The Bank of Japan G-7 countries made net sales of $43 billion.13 To also bought yen against dollars. As the yen facilitate these operations, the Treasury made continued to weaken nonetheless, G-7 offi- extensive use of the warehousing facility with the cials—meeting in early April—issued a commu- Federal Reserve—its first use since the proceeds nique stating that they had discussed "develop- of the Carter bonds were unwound in 1982. ments in global financial markets, especially the Chiefly as a result of intervention, the combined decline of the yen against other currencies and Federal Reserve and Treasury net position in its undesirable consequences for the global ad- foreign currencies increased to $38 billion equiv- justment process and . . . reaffirmed their alent at the end of 1989 valued at historical cost, commitment to economic policy coordination, as shown in chart 3. including cooperation in the exchange mar- During late 1989 and early 1990, the dollar's kets." In fact, there was little U.S. intervention movements against the major currencies di- in support of the yen after the communique was verged. The opening of the Berlin Wall and released. Concerns about Japanese monetary subsequent steps toward unification of the two policy dissipated, and the yen recovered some- Germanys bolstered the mark, while political what. Between May and July of 1990, in order to adjust balances of foreign currencies and to 13. The scale of U.S. intervention was much larger in 1989 facilitate the retirement of a portion of the than in 1977-79. However, somewhat larger operations prob- amounts of foreign currencies held by the Fed- ably are required to influence exchange rates now, because eral Reserve under its warehousing arrange- the size of the net open position of the private sector ments with the ESF, the Treasury liquidated $2 undoubtedly has increased during this period. Though there are no reliable measures of the latter, according to a survey billion equivalent of DM balances in ways that by the Federal Reserve Bank of New York, the size of the would not significantly influence prevailing ex- U.S. market increased from an estimated average daily change rates. turnover of $18 billion in 1980 to $129 billion in 1989.

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