123
Michael TI. Bordo
Michael D. Bordo is a professor of economics at Rutgers University and a research associate of the National Bureau of Economic Research. For excellent research assistance I would like to thank Jakob Koenes. For helpful comments and suggestions I am grateful to Barn,’ Eichengreen, Allan Meltzer, Leslie Presnell, Hugh Rockoft and Anna Schwartz.
• I The Gold Standard, Bretton Woods and Other Monetary Regimes: A Historical Appraisal
INTRODUCTION to the presence of credible commitment mechan- isms, that is, to the incentive compatibility fea- Two Questions tures of the regime. Successful fixed-rate regimes, Which international monetary regmm is h ~5t in addition to being based on simple transparent for economic performance? One based on fixed rules, contained lea tures tim t enconraged a center exchange rates, including the gold standard and country to enforce the rules and other coun- its variants? Adjustable peg regimes such as the tries to comply. Brel ton Woods system and the European Mone- tarv System (EMS)? Or one based on floating The Issues exchange rates? This quest ion has been debated These questions touch on a number of impor- since Nurkse’s classic indictment of flexible rates tant issues raised in economic literature. ‘Ihe and Friedmans classic defense. first is the effect of the exchange rate regime Why have some none tarv regimes been more on welfare. The key advantage of fixed successful than others? Specifically, why did the exchange rates is that they reduce the transac- classical gold standaid last for almost a ceo t urv tions costs of exchange. The key disadvantage is (at least for ( reat Britain) and why did Bret ton that in a world of wage and price stickiness the Woods endure for only 25 years (or less)? Why benefits of reduced transactions costs may he was the EMS successful for only a few years? on tweighed by the costs of more volatile output and employment. This paper attempts to answer these questions Helpman and Razin (1979), Helpinan (1981) lo answer the first question, I examine empiri- and others have raised the welfare issue. This cal evidence on the performance of three mone- theoretical literature concludes that it is difficult ta rv regimes: the classical gold s andard Brett on to provide an unambiguous ranking of exchange Woods, and the current float. As a backdrop, I rate arrangements - examine the mixed regime interwar period. I answer the second question by linking regime success Meltzer 11990) argues the need for empirical 1 See Nurkse (1944) and Friedman (1953). 2 See DeKock and Grilli (1989 and 1992).
MARCH/APRIL 1993 124 measures of the excess burdens associated with flexible rates, coun try-specific shocks can be off- flexible and fixed exchange rates—the costs of set by independent monetary policy.° increased vo)a tilitv on the one hand compared The evidence on this issue is limited. Bavoumi with the output ccsts of sticky pnces on the and Eichengreen (1 992a) applied the Elanchard- other hand. His comparison of EMS and non- Quah appi-oach to show that both supply (per- EMS countries in the postwar period however, manent) and demand (temporary) shocks, for a does not yield clear-cut results. sample of live countries, were considerabh’ greater Earlier literature comparing the macroeco- under the gold standard than under post—World nomic performance of the classical gold stand- War II regimes. However, they found little dif- ard, Bret ton Woods and the current float also ference in the incidence of shocks between yielded mixed results. tIm-do (1981) and Cooper Bretton Woods and the floating exchange rate (1982) showed that the classical gold standard regime. Their results also showed that the dis- was associated with greater price level and real persion of shocks across countries was higher under the gold standard than under the two output vola t ilitv than post—World War II arrange- ments for the United States and United Kingdom. more recent regimes and slightly higher under On the other hand Klein (1975) and Schwartz llretton Woods than under the floating exchange (1986) presented evidence that the gold stand- rate regime. They attributed the ability of the ard provided greater long-term lirice stahilit~’ gold standard to withstand greater shocks to evi- than did the post—World War- It arrangements.3 dence of a faster speed of adjustment of both prices and output, as measured by impulse Bordo (1993) compared the means and stand- response frmctions.~ ai-d deviations of nine variables for the Group A third issue is the case for rules vs. discre- of Seven countries under the three regimes, as 4 tion. A fixed exchange rate max’ he viewed as a well as the interwar period According to these commitment mechanism or rule. It binds the measm’es, the Bretton Woods convertible period hands of polic makers to prevent them from from 1959 to 1971) was the most stable regime following inflationary discretionary policiesi for the majority of countries and variables The monetary authority, in a closed economy or examined. Eichengreen 1 1992a) measured volatil- under flexible rates, might be tempted to engi- ity applying two filters (the first difference of neer an inflation surprise to raise ret-enue.” ‘lie logarithms and a linear trend).~Comp n’ing Bret- outcome is higher inflation because the public, ton Woods and the float for a sample of 10 assuming rational expectations, will anticipate countries, he found no clear-cut connection the policy. Wet-c some credible mechanism, between the volatility of real growth and the such as a monetary rule, in place the expansion- exchange rate regime. He also found no signifi- arv policy would not he implemented. Alterna- cant difference in the correlation of output vola- tivelv, a commitment to a fixed exchange rate tility across countries between the two regimes. through a pledge to maintain gold convertibility, A second issue is whether the exchange rate for example could achie~’ethe same results, hut regime provides insulation from shocks and because it is more transparent, it would possibly monetary policy independence. Under fixed cost less. 10 Such binding commitments may, how- rates, coordinated monetary policy may provide ever, be undesir-ahle in the presence of extreme effective insulation from common supply shocks, emergencies such as major wars, supply shocks but not from country-specific shocks. tinder or financial crises.11 Undet- such circumstances
~Thisresult is disputed by Mettzer and Robinson (1989). apply this methodology to examine the incidence of 4 shocks within Western Europe and within regions of North The Group of Seven countries are Canada, France, Ger- America. many, Italy, Japan, the United Kingdom and the United 8 States. See Kydland and Prescott (1977), Barro and Gordon 5 (1983), and Persson and Tabellini (1990). Eichengreen followed the methodology of Baxter and 9 Stockman (1989). Alternatively the monetary authority may create an inflation t surprise to offset a labor market distortion that raises the Similarty a monetary union such as the proposed Euro- unemployment rate above some desired level. pean Monetary Union could provide effective insulation 10 from common supply shocks for its members. However, 5ee Giavazzi and Pagano (1988). 11 giving up monetary independence imposes additional bur- 5ee Rogoff (1985a) and Fischer (1990). dens in the case of member-specific (regional) shocks, Feldstein (1992). 7 Addressing the issue of the optimum currency area, Bay- oumi and Eichengreen (1992b, 1992c and 1992d) also
FEDERAL RESERVE BANK OF ST. LOUIS 125
a contingent rule, or one with escape clauses tionaty policies. 17 Thus for an international mone- that allow member countries to suspend parity taty arrangement to be effective both between (convertibility) temporarily, may be optimal.12 countries and! within them, a consistent credible com- mitment mechanism is required. Such a mechanism The rule constrains the government to adhere to likely prevailed under the gold standard but the fixed exchange i-ate except in the case of a well- was less evident under Bretton Woods. understood emergency, ~~‘lienit can suspend pal-it)’ (convertibility under the gold standard) A fifth and final issue is the case for international and issue fiat money. Once the emergency has monetary refoi-m. Several, prominent proposals passed, with allowance for a suitable delay, the have been made to reform the present managed authority is expected to return to the rule—that floating exchange rate regime and move it hack is, to the fixed rate at the original parity. If the toward one of greater fixity. These proposals in putilic believes in the government’s commitment part derive from a pet-ception, based on the to return to the rtile, the government will be able historical record, that fixed exchange rates are to raise more revenue than it could with no credi- preferable to the current float. These proposals bility. ‘the inflation rate during the emergency include McKinnon’s case for a gold standard with- would he higher than undet- the rule (when pre- out gold, Mundell’s proposal to target the real sumably it would he zero) hut tess than in the price of gold and the case for target exchange case of put-c discretion. The pattern of alternat- rate zones presented by Williamson and Berg- big fixed and floating exchange rate regimes sten)’ Even more immediate is the move to con- over the past 200 years may he well explained vert the adjustable peg of the EMS to a by adherence to a rule with an escape clause. 13 unified currency area with irrevocably fixed exchange rates. On the other hand, in a regime of floating exchange rates the inflationary bias of discre- ()tTtSftTjp tif tionai-y policy may he overcome by instituting The paper accomplishes a number of tasks. ct-edible monetary rules or other conimitment The next section answers the first question, mechanisms, such as an independent conserva- which international monetary regime is best for tive central hank.’~Such mechanisms may Pre- economic performance, by presenting a compila- vent the perceived disad~-antageof sacrificing Ron of statistical evidence on different aspects national sovereignty to the supernational (lic- of the lierforniance of alternative monetary tates of a fixed exchange rate. regimes. The measures cover the stability of A fourth issue is that of international coopet-a- several macroeconomic variables; the dispersion non and policy coordination. Recent game theory of macroeconomic yariabtes across countries; literature has demonstrated that coordination of the lielsistence of inflation; forecast errors in policies (by fixing exchange rates) can offset spill- inflation and growth; the incidence of supply over effects fi-om uncoordinated policy actions. IS (permanent) and demand (temporary) shocks; Cooperative fixed exchange rate arrangements, the dispersion of shocks between countries; and however, unless enforced by a supernational au- the mean response of prices and output to sup- hot-it)’ whose power exceeds national sovel-eignt\’, ‘ily and demand shocks. The third section tend to break down as individual members de- stresses the importance of adhering to credible value. Cooperation is more likel , without a rules in a historical examination of three inter- supet-nat ional authority, in a world of repeated national monetary regimes: the classical gold! games because the benefits of reputation can standard, Bretton Woods and the EMS. The offset the advantages to each counti-v of cheat- final section answers the question why some ing. “‘ But even in this case, cooperation between regimes endured longer than others. It con- nations may pl-odlucd~tninflationary bias when cludes Ii)’ discussing why even a regional no credible commitment mechanism is present exchange rate arrangement—the EMS—has con- to pt-event governments from following discre- siclerahle difficulty surviving. 2 ‘ See Bordo and Kydland (1992), Flood and Isard (1989a “See Dominguez (1993). and 1989b), and DeKock and Grilli (1989 and 1992). 17 See Rogoff (1985b). “See DeKock and Grilli (1989) and Giovannini (1992). 18 4 5ee McKinnon (1988), Mundelt (1992), Williamson (1985a) ‘ See Rogoff (1985a). and Bergsten (1992). “See Hamada (1979) and Canzoneri and Henderson (1988 and 1991).
MARCHIAPRlL 1993 126
‘the statistical evidence on performance of alter- THE PERFORMANCE OF ALTEW native monetary r-egimes in the next section makes it NATIVE MONETARY REGIMES clear that the performance of regimes in the post— World War II era is superior to that of the regimes ‘to make the case for- one monetary regime in the precedhlg half century. The key exception over another, empirical and historical evidence is the classical gold standard, which exhibits the on their performance is crucial. In this section lowest inflation persistence and a relatively high I present some evidence on different aspects of degree of financial market integration. The l3retton the macroeconomic perfom-mance of alternative Woods convet-titile regime from 1959 to 1970 per- international monetary regimes over the past formed the liestbyfar on virtually all criteria - 110 years. The comparison for the seven hn’gest The greater durability of the gold standard com- (non-Communist) industrialized countries (the pared with llretton Woods cannot he explained Group of Seven countries) is liased on annual by a lower incidence of shocks. The key expla- data for the classical gold standard (1881—4913), nation for its success lies with the credibility of the interwar period (1919—39), Llretton Woods the commitment to the gold standard rule of (1946—70), and the present floating exchange convertibility by England and the other core rates i-egimne (1971—89). The Bretton Woods countries and its near universal acceptance. As a period (1946—70) is divided into two suhperiods: contingent rule, it was flexible enough to with- the preconvertible phase (1946—58) and the con- stand the major shocks that buffeted it. ‘I’he vertilile phase (1959—70).’~ Bretton Woods adjustable peg was in some re- The comparison relates to the theoretical issues spects similar to the gold standard contingent raised by the debate over fixed vs. flexible ex- rule, hut it invited speculative attack hence change rates. According to the traditional view, weakening the escape clause. Unlike England, adherence to a (commodity-based) fixed exchange the leading country before World War I, the rate regime, such as the gold standard, ensured United States, the dominant country under Bret- long-run price stability for the world as a whole ton Woods, maintained a credible commitment because the fixed price of gold provided a mmmi- to a noninflationary policy for (inly a few years. nal anchor to the world money supply. Individ- ‘the world, faced with imported inflation in the ual nations, by pegging their currencies to gold), late 1960s, lost the incentive to follow its leader- fixed) their price levels to that of the world.30 A ship, and the system collapsed in 1971 - fixed-rate system based on fiat money, however, The longevity of general floating exchange may not lirovide a stable nominal anchor unless rate regimes since 1973 suggests that the lessons a cr-edible commitment mechanism constt-ains of Brett ~n Woods have been well learned. Coun- the growth of the world’s money supply.~~The tries are willing to subject their domestic policy disadvantage of fixed rates is that individual autonomy neither to that (if another country nations are exposed to both monetary and real whose commitment they cannot tie sure of in a shocks transmitted from the rest of the world stochastic world, nor to a supernational monetary through the balance of payments and other authority they cannot control. Even the recent channels of transmission.” The advantage of experience of the EMS—a regional exchange rate floating exchange rates is to provide insulation arrangement het\veen countries su1iposediy pur- from foreign shocks. The disadvantage is the suing common goals—revealed differing national atisence of the discipline of the fixed-exchange- priorities in the face of asymmetric shocks that rate rule because monetary authorities night placed intolerable strains on the system. adopt inflationary policies -
1~ lalso examined the period (1946—73) which includes the three years of transition from the Bretton Woods adiusta- ble peg to the present floating regime. The results are similar to those of the 1946—70 period. “The common world price level under the gold standard, however, exhibited secular periods of deflation and infla- tion reflecting shocks to the demand for and supply of gold. See Bordo (1981) and Rockoff (1984). A well- designed monetary rule, it is argued, could have prevented the long-run swings that characterized the price level under the gold standard. See Cagan (1984). 21 See Giovannani (1992). “See Bordo and Schwartz (1989a).
FEDERAL RESERVE BANK OF ST. LOUtS 127
Theoretical developments in recent years have used, for example, Ml vs. M2, was dictated by complicated the simple distinction between fixed the availability of data over the entire period. and floating exchange rates. In the presence of For each variable and each country I present capital mobility, currency substitution, policy two summary statistics: the mean and standard reactions and policy interdependence, floating deviation. For the countries taken as a group, rates no longer necessarily provide insulation I show two summary statistics: the grand mean from either real or monetary shocks.83 Moreover, and a simple measure of convergence defined according to recent real business cycle approaches, as the mean of the absolute differences between there may be no relationship between the inter- each country’s summary statistic and the grand national monetary regime and the transmission means of the group of countries.27 I comment of real shocks.” Nevertheless, the comparison on the statistical results for each variable. - between regimes may shed light on these issues. Inflation. Countries using the classical gold One important caveat is that the historical standard had the lowest rate of inflation and regimes presented here do not represent clear displayed mild deflation during the interwar examples of fixed and floating exchange rate period. The rate of inflation during the Bretton regimes. The interwar period comprises three Woods period was on average and for every regimes: a general floating rate system from country except Japan lower than during the 1919 to 1925, the gold exchange standard from subsequent floating exchange rate period. The 1926 to 1931 and a managed float to 1939.” average rate of inflation in the two Bretton The Bretton Woods regime cannot be character- Woods subperiods was virtually the same. This ized as a fixed exchange rate regime throughout comparison, however, conceals the importance its history: The preconvertibility period was close of two periods of rapid inflation in the 1940s to the adjustable peg envisioned by its architects, and 1950s and in the late 1960s. See figure 1.23 and the convertible period was close to a de facto Thus the evidence based on country and period 2 fixed dollar standard. ’ Finally, although the averages of very low inflation in the gold stand. period since 1973 has been characterized as a ard period and of a lower inflation rate during floating exchange rate regime, at various times it Bretton Woods than the subsequent floating has experienced varying degrees of management. period is consistent with the traditional view on price behavior under fixed (commodity-based) Stability and Convergence and flexible exchange rates. Table 1 presents descriptive statistics on nine In addition, the inflation rates show the highest macroeconomic variables for each Group of degree of convergence betweencountries during Seven country, with the data for each variable the classical gold standard and to a lesser extent converted to a continuous annual series from during the Bretton Woods convertible subperiod 1880 to 1989. The nine variables are the rate of compared with the floating rate period and the inflation; real per capita growth; money growth; mixed interwar regime. This evidence also is short-term nominal interest rates; long-term consistent with the traditional view of the oper. nominal interest rates; short-term real interest ation of the classical price specie flow mechanism rates; long•term real interest rates; and the and commodity arbitrage under fixed rates and absolute rates of change of nominal and real insulation and greater monetary independence exchange rates. The definition of the variable under floating rates?
23See Bordo and Schwartz (1989a). series around the G-7 aggregate. I calculated this Sterna~ 245ee Baxter and Stockman (1989). tive measure of convergence for the data in table 1. The results are very close to those reported here for virtually 2STo be more exact, the United States stayed on the gold every variable. standard until 1933, and France stayed until 1936. For a 2t detailed comparison of the performances of these three The data sources for figure 1 and all subsequent figures regimes In the Interwar period, see Eichengreen (1991 a). are listed in the Data Appendix to Bordo (1993). 29For similar evidence see Bordo (1981), Darby, Lothlan 83Wlthln the sample of seven countries, Canada floated from 1950 to 1961. et.al. (1983) and Datby and Lothian (1989). 2Tfl~j~Is a very crude measure of convergence or diver- gence between the different countries’ summary statistics. Because It Is based on the average for the whole period, It suppresses unusual movements within particular sub- periods. Bayouml and Elchengreen (1992d) presented an aftemative measure of convergence or dispersion—the GDP-welghted standard deviation of the lndMdual country
MARCH/APRIL 1993 128
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LOWS 129 MARCH/APRIL 1993 130 Sa jj~~N~ ~ :ciiN~N:~cNN~ 4 cc ~ ~cjcc’~yj~c’~~ ~ ‘>~ c’~c’c ;‘±~1~~ ‘:t~kisIIIF”~~V” ‘~ “ ‘>,~,, ; ,,,~ :. ‘ I N:, ~~ffJj)JJJ,j~7’~<‘N,, ~ N N~N ~ “ N NN ~ N NNN;N cN’~*’> ‘Js>~3aat >~ ‘~ N ‘‘ , N, ~~ØN “ “>tij~ ~ , , , K~4fl~4~j~N ~& ~N N ~Jc’~fflN~’>c’5c’ ~ Np NP’”” NNC 1f“N’> TN~NN N ~ N,NN N” t ~4!N11caigr”t NNC N~ ‘,~çN ’ > ~cc’>”NNNN’NN,,~’/NN~’N ~ ,>~c N’ cN;N,WNNN >5~flW>~flN~~’N NCIC N N~”N <‘>~‘ cN, N ‘~ N~,,, N ‘c N N’ N”N N N ;:T:NINrnIJtp~y:NN ‘> ~ ~NNNNP ~ IN > ~ ‘ ‘aN,’ N’ ~ ,ç<, I~’NN~ N4c~,: ‘. 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LOUIS 131 ~N ,,‘K~, , N\Nct N< N N N ~ N N jjfJ,,NNN ~NI~T:~c’<~ Tc’N::t~ N *N~N c N ~ N N :~IN ~ N N:a’, N.N N’ NNN~N, NPNNNN ~ ‘>‘NNN N N PP ~ ‘ N~ N ~NN’N ‘ttSi~ ~‘b‘ ‘ ‘~ N’ N N ‘N’ ‘N , N ‘N’, , ‘N N N INN: N :N aN~>,c~ NNC~Ni ~I N ~NN’j>’> ,a, N ‘NN N Nt ‘NNN<~N NN’~:5/3 N ~, NN icc N >tC’~t~~>?tN[~ ,N N Nfl!: IN NCN” NI ~‘~f~J I NeN’ N $~N NN ‘ NNa ~kN~NN NC “~ ~Nj N t ~ N~Nt N’ N’ ‘N ‘ N N NNNNN 2 ‘N’NNC ,: NNNNYNN1IN1NNLNt ~ EN ~N~1C’N’1D ~t&~~t Nut I MARCH/APRIL 1993 132 Figure 1 Inflation Rates, 1880-1989, G7 Countries Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 J — U.S. — U.K. Germany — Canada Percent 1 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 — France Italy = Japan FEDERAL RESERVE BANK OF ST. LOUIS 133 The Bretton Woods convertible subperiod had countries during the fixed-exchange-rate gold the most stable inflation rate of any regime as standard and the convertible Bretton Woods judged by the standard deviation. By contrast, regime, with the greatest divergence in the Ihe preconvertible Bretton Woods period exhibited preconvertible Bretton Woods period and the greater inflation variability than either the gold interwar period. standard period or the recent floating exchange Like inflation and real output variability, money rate period. The evidence of a high degree of growth variability was lowest in the convertible price stability in the convertible phase of Bretton Bretton Woods period. This, however, was not Woods is also consistent with the traditional the case for the preconvertible period, which view that fixed rate (commodity-based) regimes was the most variable of any regime. It also provide a stable nominal anchor; however, the exhibited the greatest divergence in variability remarkable price stability during this period between countries. To the extent that one of niay also reflect the absence of major shocks. the properties of adherence to a fixed-exchange- rate regime is conformity of monetary growth Real per capita GNP. Generally, the Bretton rates between countries, these results are sym- Woods period, especially the convertible period, pathetic to the view that the Bretton Woods exhibited the most rapid output growth of any system really began in 1959. monetary regime, and not surprisingly the inter- war period the lowest (see figure 2). Output Short~ternj and long-terni interest rates, variability was also lowest in the convertible The underlying data for short-term and long- subperiod of Bretton Woods, but because of term interest rates are seen in figures 4 and 5. higher variability in the preconvertible period, As in other nominal series, the degree of con- the Bretton Woods system as a whole was more vergence of mean short-term interest rates is variable than the floating exchange rate period. highest in the convertible Bretton Woods Both pre—World War 11 regimes exhibit higher period. Long-term rates are most closely related variability than their post—World War H coun- in the classical gold standard regime, with the terparts3° The divergence of output variability convertible Bretton Woods period not far behind. between countries was also lowest during the McKinnon (1988) has similar findings, He views Bretton Woods regime, with the interwar regime them as evidence of capital market integration showing the highest divergence.~’The greater under fixed exchange rates. The lack of conver- convergence of output variability under Bretton gence in the preconvertihility Bretton Woods Woods may reflect conformity between countries’ period reflects the presence of pervasive capital business fluctuations, created b the operation controls. Convergence of nominal interest rates of the fixed exchange rate regimea2 would not be expected under floating exchange rates. Convergence of standard deviations is also Money growth (M2). Money grew consider- highest in the gold standard period followed by ably more rapidly across all countries after Bretton Woods. Long-term rates were most stable World War II than before the war (see figure 3). and least divergent under the classical gold stand- There is not much difference between Bretton ard, followed by the two Bretton Woods suhperiods, Woods and the subsequent floating exchange with floating exchange rates the least stable, The rate regime. Within the Bretton Woods regime, evidence that nominal interest rates are more money grew more rapidly in the preconvertibility stable and convergent between countries under period than in the convertibility period. Money fixed exchange rate (commodity-based) regimes growth rates showed the least divergence between is consistent with the traditional view. 30 Baxter and Stockman (1989) and Eichengreen (1992a) use dispersion of real growth and the rise in the dispersion of residuals from a linear trend to the logarithm of real output inflation rates between the Bretton Woods convertible as a detrending filter rather than the logarithmic first ditfer- period and the float have the following explanations: the ence used here. According to their results, real output move to flexible rates allowed countries to stabilize their variability is not greater in the floating than in the fixed relative growth rates in the face of asymmetric supply period. shocks at the expense of their relative inflation rates. They 31 However, using their alternative measure of convergence— also report that, when they apply the linear trend filter of the GDP-weighted standard deviation of the individual Baxter and Stockman (1989), evidence of a rise in the cross country correlation between output movements after country series around the G-7 aggregate—Bayoumi and 1970 is considerably reduced. Eichengreen (1992a) report that the lowest degree of dis- 32 persion of real GDP growth was in the floating rate period, 5ee Bordo and Schwartz (1989a) and Darby and Lothian followed by the Bretton Woods convertible period. Similar (1989). results hold for the real GNP per capita data in table 1. For Bayoumi and Eichengreen (1992a) the decline in the MARCH/APRIL 1993 134 Figure 2 Per Capita Income Growth Rates, 1880-1989, G7 Countries Percent 20 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 — U.S. — ILK. —‘--- Germany — Canada Percent 50 40 30 20 10 0 -10 -20 -30 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 — France — Italy = Japan FEDERAL RESERVE SANK OF ST. LOUIS 135 Figure 3 Money Growth Rates, 1880-1 989, G7 Countries Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 — U.S. — U.K. — Germany — Canada Percent 100 90 80 70 60 50 3040 20 10 0 -10 -20 -30 -40 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 — France — Italy = Japan MARCH/APRIL 1993 136 Figure 4 Short-Term Interest Rates, 1880-1989, G7 Countries Percent 1 17 16 15~ 14 13 12 11 10 9 8 7 6 4 3 2 1 0 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 J — U.S. — U.K. fl—” Germany —“ Canada Percent 17- — 16- 15- 14- 13- 12- 11— 10- 9- 8- 7- 6 4-5 23 1 IIII III 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 — France — Japan FEDERAL RESERVE BANK OF ST. LOUIS 137 Figure 5 Long-Term Interest Rates, 1880-1 989, G7 Countries Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 — U.S. — U.K. —‘--- Germany — Canada Percent 22 21 20- 19-18- 17- 16- 15- 14- 13- 12- 11— 10- 9- 8- 7- 6- 5 4 3- 2- III I III II 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 — France — Italy — Japan MARCH/APRIL 1993 138 Real short-term and real long-term across countries and the least divergence interest rates. For the underlying real short- between countries was in the Bretton Woods term and real long-term interest rate data, see convertible period, with the divergence in gold fIgures 6 and 7. The real interest rates are cx standard period next smallest (see figure 9). The post rates calculated using the rate of change of highest rate of change was in the floating a consumer price index.~~Unlike the nominal exchange rate period. Similarly data from the series, the degree of convergence in means Bretton Woods convertible period had the between real short-term interest rates is lowest lowest standard deviation across countries and in the floating exchange rate period, next lowest the least divergence between standard devia- in the Bretton Woods convertible period and tions, with the gold standard again next in these highest in the preconvertible period. Fot long- rankings. The other t-egimes were characterized term real rates, as in the case of nominal rates, by much greater variability and divergence. convergence is highest under the gold standard These results shed light on the i-elationship followed by the Bretton Woods convertible regime. between the nominal exchange rate regime and It is lowest under preconvertible Bretton Woods. the behavior of real exchange rates. Mussa The real short-term interesl rate is most stable (1986) presented evidence for 16 industrial across countries during the Bretton Woods con- countries in the post—World War IT period vertible period. It also shows the least amount showing the similarity between nonunal and of divergence in standard deviations. The same real exchange rate variability under floating holds fot- real long-term interest rates. rates. His explanation for greater real exchange rate variability under floating rates than under The behavior of real interest rates across fixed rates is nominal price rigidity.~°The expla- regimes is consistent with McKinnon’s explana- nation may, however, be questioned. For exam- ~Heargued that fixed exchange rates ple, a fixed nominal exchange rates may produce encourage capital market integration by elimina- greater trade stability that will be reflected in ting devaluation risk. This reduces variability in short-term real interest rates. Similat-ly, the real exchange rate, as is evident for both the Bretton Woods and gold standard periods. real long-term interest rates ate stabilized by Yet as Eichengreen (1991b) points out and as pooling across niarkets, which reduces capital can be seen in table 4, these results could be market risk. explained by the fact that both periods were Nominal and real exchange rates. The characterized by few shocks.” lowest mean rate of change of the nominal ex- change rate arid the least divergence between Finally, based on monthly data between 1880 rates of change occurred during the Bretton and 1986 for the United Kingdom and the United Woods convertible amid gold standard periods, States, Grilli and Kaminsky show that, with the with the former exhibiting the lowest degree of exception of the post—World War II period, no divergence. Exchange rates during the precon- clear connection exists between the nominal exchange rate regime and the variability of real vertihility Bretton Woods regime changed almost 33 as much as during the floating pet-iod. This exchange rates. My mesults for the Group of mainly reflected the major devaluations of 1949 Seven countries show a clear correlation (see figure 8l.’~Nominal exchange rates were between nominal exchange rate rigidity arid least variable in the gold standard and converti- lower real exchange rate variability for the gold ble Bretton Woods periods and the most varia- standard and Bretton Woods cotivei’tible regime. ble and most divergent in the Bretton Woods For the preconvertibie Bretton Woods period— preconvertible period. de jure a type of fixed exchange rate regime— the correlation is not evident. I do not distin- As with the nominal exchange rate, the lowest guish between fixed and flexible periods in the mean rate of change in the real exchange rate interwar segment as do Grilli and Kaminsky, 33 Define the real interest rate as r, = i~— Alog ~ where i~is in real exchange rates under floating rates than under the nominal interest rate and Alog P~= log P~— log P,_1 fixed rates reflects the response of real exchange rates to is the percentage change in the consumer price index. productivity shocks, with changes in the real exchange 34 See McKinnon (1988). rate producing nominal exchange rate volatility. This vola- 35 tility is offset under fixed rates by exchange market inter- See Bordo (1993) table 2. vention. 3t 38 Also see Dornbusch (1976). See Grilli and Kaminsky (1991). “Stockman (1983 and 1988) argues that greater variability FEDERAL RESERVE BANK OF ST. LOUIS 139 Figure 6 Real Short-Term Interest Rates, 1880-1989, G7 Countries Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 j = U.S. = UK. — Germany — Canada j Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 — Japan — France MARCH/APRIL 1993 140 Figure 7 Real Long-Term Intereét Rates, 1880-1989,07 Countries Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 — U.S. — U.K. —— Germany — Canada Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 — France — Italy = Japan FEDERAL RESERVE BANK OF ST. LOUIS 141 Figure 8 Absolute Change in Nominal Exchange Rates, 1880-1989, G7 Countries Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 I = U.K. — Germany — Canada Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 = France — Italy — Japan MARCH/APRIL 1993 142 Figure 9 Absolute Change in Real Exchange Rates, 1880-1989,07 CountrIes Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 j — U.K. — Germany — Canada Percent 80 70 60 50 40 30 20 10 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 = France — Italy — Japan FEDERAL RESERVE BANK OF ST. LOUIS 143 hence that period cannot be used in the com- gold standard was very nearly a white-noise paiison.3° process, whereas in the post—World War H period, the inflation rate exhibited considerable In summary, the Bretton Woods regime exhibited persistence. Alogoskoufis and Smith (1991) also the best overall macroeconomic performance of show, based on AR(1) regressions of the infla- any regime. ‘this is especially so fot the con- tion rate, that inflation persistence in the two vertible period (1959_70L4tt As the summary coufitmies increased between the classical gold statistics in table 1 show, both nominal and i-eat standamd period and the interwar peiiod and variables were mnost stable in this period. The between the interwar period and the post—World floating exchange rate regime, on most criteria, War II period.41 was not far behind the Bretton Woods converti- ble regime, whereas the classical gold standard Table 2 presents the inflation-rate coefficient exhibited the most stability and the closest con- from the type of Affil) regressions on consumer vergence of financial variables. price index inflation estimated by Alogoskoufis and Smith, for the Group of Seven countries The preconvertible Bretton Woods petiod (1946— over successive regimes since 1880, as well as 58) was considerably less stable fot the average of the standard errors and the Dickey-Fuller tests all countries for both nominal amid real vaiiahles for a unit root.” than other regimes. Also both nominal and i-cal variables did riot vary nearly as closely together. The results, as in Alogoskoufls and Smith, show i’hese differences likely reflect the presence of an increase in inflation persistence fot- most pervasive exchange amid capital controls before countties between the classical gold stanclat-cl 1958 and, related to these, more variable and and the interwar period, and also between the more rapid monetary growth. These data, how- interwar period and the post—World War IT ever, are limited. Although they show excellent period as a whole. Within the post—World War performance for the convettible Bretton Woods II period, inflation persistence is generally lower, regime, they do not tell us why it did well— with the exceptions of France and Japan, in the whethet- it reflected a set of favorable circum- preconvertible l3retton Woods thati the convertible stances, whether it reflected the absence of period. This suggests that though the immediate aggravatimig shocks, whether it reflected stable post—World War Il period was characterized by monetary policy by the key country of the sys- rapid inflation, market agents may have expected tem, the United States, or whether it masked a return to a stable price regime. The higher underlying strains to the system. degree of persistence in the convet-tibte regime suggests that this expectation lost credence. Finally, Inflation Persistence the evidence that persistence was generally highest during the floating exchange rate regime A second piece of evidence is persistent infla- may imply that the public realized that them-c tion. Evidence of persistence in the inflation was no longer a stable nominal anchom’. rate suggests that market agents expect the monetary authorities to continually follow an Forecast Errors in Inflation and inflationary policy; its absence would be consis- Growth tent with the belief that the authorities are fol- lowing a stable momietat-y tule, such as the gold A third piece of evidence relates to the forecast standard’s convertibility rule. Barsky (1987) pre- errors of inflation and real output gt-owth. Accord- sented evidence for the United Kingdom and ing to Mettzer and Robinson (1989), “a welfare United States based on both autocort-elations maximizing muonetary rule would reduce varia- and time set-ies models that inflation under the bility to the niinimum inherent in nature and tt 41 Meltzem (1990) in a comparison of EMS and non-EMS con- Also see Alogoskoufis (1992), who attributes the increase tries in the floating rate period also finds a strong correla- in persistence to the accommodation by the monetary 40tion between changes in nominal and real exchange rates. authorities of shocks. This evidence is also consistent with McKinnon (1992) treats the period 1950 to 1970 as the the results of Klein (1975). 4t de facto dollar standard. He views this period rather than Eichengreen (1992b) also presents these statistics for four 1959 to 1971 as the appropriate one for making the type of the countries. of regime comparisons undertaken here. I made the same calculations as those shown in table I for the period 1950 to 1971. Virtually every variable for each country exhibited greater instability than in the 1959 to 1970 period. This reinforces my choice of dates. MARCH/APRIL 1993 144 FEDERAL RESERVE BANK OF ST. LOUIS 145 institutional arrangements.” They measure varia- absence of shocks to the underlying environment. bility by the mean absolute et-ror (MAE) of a one- One way to shed light on this issue, following period forecast based on the univariate multistate earlier work by Bayoumi and Eichengreen, is to Kalman Filter (MSKF). Following their approach, identify underlying shocks to aggregate supply table 3 presents the MAEs for inflation and real and demand.~~According to them, aggregate growth for the Group of Seven countries over- suc- supply shocks reflect shocks to the environment cessive regimes. the MSKF forecasts incorporate and are independent of the regimne, hut aggregate both transitory and permanent shocks to the rate- demand shocks likely reflect policy actions and of-change series.” are specific to the regime. The smallest forecast errors for inflation on aver- The approach used to calculate aggregate sup- age were for the Bretton Woods convertible period, ply and demand shocks is an extension of the followed by the gold standard amid the floating rate bivariate structural vector autoregression (VAR) periods. The largest errors were for the interwar methodology developed by Blanchard and Quah.~’ period, followed by the preconvemtihle Bretton Following Bayoumi and Eichengreen (1992a), Woods period. The most notable exception to I estimated a two-variable VAR on the rate of the pattern was the United Kingdom, where the change of the price level and output.” Restric- floating rate period exhibited the largest varia- tions on the VAR identify an aggi-egate demand bility. distum-bance, which is assumed to have only a temporary effect on output and a permanent For real growth, as for the inflation rate, the effect on the price level, and an aggregate sup- lowest MAE, on average, occurred in the con- ply disturbance, which is assumed to have a vertible Bretton Woods pem-iod. Another excep- permanent effect on both prices and output.47 tion to this pattern was Japan. ‘I’he highest MAE Overidentifying restrictions, namely, restrictions was again in the interwar and the preconverti- that demand shocks are positively cot-related ble Bretton Woods period. The floating exchange and supply shocks are negatively correlated rate period, though mnore variable than the con- with prices, can be tested by examining the vertible Bietton Woods peiiod, was slightly less impulse response functions to the shocks. variable than the gold standaid regime. ‘The methodology has important limitations ‘These results are quite consistent with those that suggest that the results should be viewed of table 1. The Bretton Woods convertible with caution. ‘I’he key limitation is that one can period was the most stable both in an ey post easily imagine frameworks in which demand and ey ante sense. The performance of the gold shocks have permanent effects on output, where- standard and the float, however, are not much as supply shocks have only temporary effects.” worse, at least for real growth for the float and inflation for the gold standard. I estimated supply (permanent) and demand (temporary) shocks, using annual data for each Demand and Supply Disturbances of the Group of Seven countries,, over alterna- tive regimes in the period 1880—1989. The VARs An important issue is the extent to which the are based on three separate sets of data—1880—1913, performance of atternative monetary regimes, 1919—39 and 1946—89—with the war years omit- as ievealed by the data in the preceeding tables, ted because complete data on them were avail- 49 reflects the operation of the monetary regime in able for only four of the countries. The VARs constraining policy actions or the presence or have two lags. I also did the estimation for 43 Meltzer and Robinson (1989) present their results for supply shocks are orthogonal; the tourth is that demand levels, growth rates, and permanent growth rates of the shocks have only temporary effects on output, that is, that series, I present only growth rates to make the results the cumulative effect of demand shocks on the rate of comparable to those in table 1. change in output must be zero. 44 See Bayoumi and Eichengreen (1992a, 1992b, 1992c and “See Keating and f-Jye (1991). 1 992d). “For results using the complete data set for these four “See Blanchard and Ouah (1989). countries, see appendix table 1 and appendix figure I - ~~Bothvariables were rendered stationary by first differencing. 47 Specifically, four restrictions are placed on the matrix of the shocks: two are simple normalizations, which define the variances of the shocks to aggregate demand and aggregate supply; the third assumes that demand and MARCH/APRIL 1993 SlflOl 15 dO )fNV9 3A~3S3~1V~3O3d 9t7 I. 147 aggregated pm-ice and output data for the Gi-oup of Table 4 shows for the Group of Seven aggre- Seven countries.~° gate that the convertible Bretton Woods regime was the most tranquil of all the regimes—neither The overidentifying restrictions that demand supply nor demand shocks dominated. It was not, shocks be positively correlated and supply shocks however, that much less turbulent than the suc- be negatively correlated with the price level are ceeding float. The interwar period, unsurpris- satisfied for all countries for the two post—World ingly, shows the largest supply and demand War Il regimes. But for’ the period before World shocks.” Sizeable supply and demand shocks War IT, for a number of countries, including the that are two or three times greater than the United States, United Kingdom, and France, they post—World War II period also characterize the are not. Supply shocks were positively correlated classical gold standard.” with prices. This can be seen in the impulse response functions displayed in figure 10. Fig- For individual countries, the Bretton Woods ure 10 shows the impulse responses, to one convertible period was the most stable in four standard deviation shocks in aggregate supply countries and the flexible exchange rate period and aggregate demand, on output and prices for was the most stable in three. The difference the Group of Seven countries aggregateby regime.~’ between the convertible Bretton Woods period and the floating exchange rate period, however, Keating and Nyc (1991) attempted to explain this was not great in any country. The interwar result by possible hysteresis effects. Bayoumi and period as expected was the most volatile. Both Eichengreen (1992a) argued that the perverse types of shocks were the largest in every coun- impulse response patterns for the classical gold try except the United Kingdom. Finally, in the standard amid interwar periods reflected the majority of countries, with the principal excep- interaction of a positive aggregate demand curve tions being the United Kimigdom arid Germany, with a very steep aggregate supply curve. They both supply and demand shocks were consider- explain the positively sloped aggregate demand ably greater in the gold standard period than in curve as reflecting the effects of gold discover- the post—World War IT period. ies induced by the supply shock of agricultural settlements in the United States and Australia. ‘rhe dispersion of demand shocks across coun- These results may also reflect a limitation of the tries, as measured by the GNP-weighted stand- Blanchard-Quah methodology. ard deviation of the individual country shocks around the Group of Seven aggregate, reveals Table 4 presents the standam’d deviations of very little difference between the gold standard supply and demand shocks for the (;roup of and the post—World War It regimes, with the Seven countties and the Group of Seven coun- convertible Bretton Woods regime displaying tries taken as a whole (Group of Seven aggregate) the highest degree of convergence. Dispem’sion by regime. I also show, following Bayoumi and is much greater in the interwar period. The Eichengreen, the weighted average of the indi- dispersion of supply shocks is considerably vidual country shocks.” Figum-es 11 and 12 show greater during the gold standard and the inter- the shocks for the Group of Seven aggregate war periods than in amiy of the post—World and for each of the seven countries. War IT regimes. “The Group of Seven aggregate income growth and infla- 1920s and early 1930s reveal a major negative demand tion rate are a weighted average of the rates in the differ- shock consistent with Friedman and Schwartz’s (1963) ent countries. The weights for each year are the share of attribution of the onset of the Great Depression to each country’s nominal national income in the total income monetary forces. After 1931, negative supply shocks in the Group of Seven countries, where the national predominate, consistent with Bernanke’s (1983) and income data are converted to U.S. dollars using the actual Bernanke and James (1 991) explanation for the severity of exchange rates. the Great Depression that stresses the collapse of the t1 The impulse response functions were calculated from financial system. VARs run for the separate regime periods. Because the “Though the shocks are smaller, the rankings by regime for number of observations was limited, the Bretton Woods the weighted average of individual country shocks are sim- regime could not be split into the two subperiods shown in ilar to the G-7 aggregate. preceding tables, “See Bayoumi and Eichengreen (1992a). “The results for the Group of Seven in the interwar period (figures Ii and 12) as well as those for four countries (appendix figure I) are similar to those reported for the United States by Cecchetti and Karras (1992), who esti- mate a three-variable VAR with monthly data. The late MARCH/APRIL 1993 148 Figure 10 Impulse Response Functions of Demand and Supply Shocks on Prices (Dotted Lines) and Output (Solid Lines), 07 Aggregate by Regimes, Annual Data, 1881-1989 Effects of Aggregate Demand Shocks, 1881-1913 Effects of Aggregate Supply Shocks, 1881-1913 0.16 0.15 014 0.13 0.12 0.11 0.1 0.09 0.08 0.07 0.06 0.05 0.04 FEDERAL RESERVE BANK OF ST. LOUIS 149 Figure 10 (continued) Impulse Response Functions of Demand and Supply Shocks on Prices (Doffed Lines) and Output (Solid Lines), G7 Aggregate by Regimes, Annual Data, 1881-1989 Effects of Aggregate Demand Shocks, 1919-1 939 0.025 S 0.02- I —\ % 1% ~ - 0.015- ‘I 1 / I I—, 0.01 - 0.005 - 0 7 -0005 Effects of Aggregate Supply Shocks, 191 9-1 939 0.09 0.08 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 MARCH/APRIL 1993 150 Figure 10 (continued) Impulse Response Functions of Demand and Supply Shocks on Prices (Dotted Lines) and Output (Solid Lines), 07 Aggregate by Regimes, Annual Data, 1881 -1 989 Effects of Aggregate Demand Shocks, 1946-1 970 Effects of Aggregate Supply Shocks, 1946-1 970 FEDERAL RESERVE BANK OF ST. LOWS 151 Figure 10 (continued) Impulse Response Functions of Demand and Supply Shocks on Prices (Dotted Lines) and Output (Solid Lines), G7 Aggregate by Regimes, Annual Data, 1881 -1989 Effects of Aggregate Demand Shocks, 1946-1989 0.045 0,04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0 -0.005 Effects of Aggregate Supply Shocks, 1946-1989 0.02- 0.01 - ‘I— C -0.01- -0.02- I S -0.03- S S .4 -0.04- .4.4%_S -0.05- -0.06 MARCH/APRIL 1993 152 Figure 10 (continued) Impulse Response Functions of Demand and Supply Shocks on Prices (Doffed Lines) and Output (Solid Lines), 07 Aggregate by Regimes, Annual Data, 1881-1989 Effects of Aggregate Demand Shocks, 1971 -1 989 0.09- 0.08- — — — — 0.07- —— 0.06- ———— 0.05- S. I 0.04- I I 0.03- 0.02- 0.01 - S. - £—.-_~__.__._.-. — ‘I -0.01 Effects of Aggregate Supply Shocks, 1971 -1989 0.02 0 ‘ S -0.02 — S S S ‘4 S -0.04 - S SS S .4 .4 -0.06 — S -0.08 - S_S_S_S —4.-. -0.1- ———4.—--—— -0.12 FEDERAL RESERVE BANK OF ST. LOUIS 153 A ~ A AA A / //7 e/ ‘~t’~ AaV >t*/// A ~..e PA Ir’~ ~L/~27C 7~PA ‘~‘ 7 tr a’ ~%// /P4g ~ *~:rA~ / C, / /// ,//, ~2‘PA “C ‘CC ‘C,,’ / ~ ‘A Al ~“~A s; L~i~tZ ‘~:~ 4: 1~~/~ “C ,s’A ~ ‘Ar ~c~’ ~ ~ tt~ ~ ~‘ ‘C ,C’ / ,, “-CC !~gT~ ‘A fl~C C~, “‘C~ ‘AC, ‘A’: fl*”C ~ ‘A C~, A”C~~~ 4:’ jC’’C’Ar~: ~‘C C’ C’” 2~, ‘ ~ / ‘ :-“‘ / ‘‘‘‘C ~‘ ‘ “-C / ,‘‘C”C’’’’ A ////C/ ‘A’~’,/’~ A ‘‘C ,~C7 / C’ ,( C ‘C ‘C’~~’C C2 ‘C’ / C’ ‘C’ s ‘C ~‘C/ / 2, ,/, / ‘C”’ t~ C, , ‘ a ,~ “ “ “ ‘CC’ ‘/C/C C’ ~‘ C, C~ 7’ : ~CC’C ::C’ t~ ,,‘CAl’ C77’~7’AC ~~ C A7~C, W’O,w*l C’ ‘ ‘C*/,C‘‘C -CA‘ P, C’,,‘AlZ~C/CA”’ C~’CI C/A,,’ U~*t’ ,‘ ,‘ ‘‘ ~a, ,, C -C’~’~//‘C’C ‘A ‘‘C ‘‘C,’,AC7”A> ,CC,1’/ C ‘C I “AC,>, C’~ ,‘~ ‘A’C,C ‘C~’$~,~’C Al Al’ ‘A ‘C a ‘ ~~tC $C’$(~,’ A C7’C’ ‘ —C’ /‘“ ,,“C/“~“~~ A ‘C”C’ St ~ ‘AN v” ~,, ~~‘~lW~ -C ~t ~9, s-/PA ‘C~ 7’, “/4‘ ACr~ tKctA ~~~ , 7rt. C ‘C” A ‘ /‘C~ ‘ C ‘‘/ C’7 , C’C /C’~~’CØC,~~fl C, ‘C”C’C~ fl~~7C ‘C,’ /AC ~, C ~ CC~~’CCC~~’C ‘C CC~”CAMC ,,/ // C ‘CC/CC’C’ ,7’C, ‘‘C p ~‘1C ~ : a ‘-CS~ ‘YS’A ,~ / “-C’ — /~ ~c/ ,r ‘P t’~ “C -C “:~~ ‘C ~ ‘ “/4/C~ :iiiA~ C C’CC C’C’C/~// C : ~ C’At ~ ,‘fl’~’:C~* ~: ~\t C’C:”A C ‘C’ At ,<‘r A ,wé , “ .~ C C C ~,C ‘C C ,, ,, C~‘ t’ fC’ C: ~ ~A’CC\C ,7~’C N ~C I “A‘ 2C’C ~a C/ C/ 7 jf$’C ~CC -CCI -C’ -C ts~t$~~7 ~r C, A ~ ~ CCS~C ~ -C PC/C CO t ~!‘ “~i;f ‘C lT~ ‘C ~ ~1~C ~C, C C : CC’C-C/A’/T~ C’ :: / ‘C”, “C~ CC “Ac Jlr’ C ‘CCC’AC \A’A, LI t~~t,_! ~ AC ,C7~& C,”C7 CECC/p~ C CCC C,//~C C* C:~JC/7,:’C~ ~i ii ~ ~ // ~ ~t,_tC CA Y”~/,Ay/’AC~/‘C,CCCA’~,/,C’C”C ‘‘/‘“‘CCC’ C I~A/C,,‘ ~ ‘C’ ‘A C, 1 MARCH/APRIL 1993 154 Figure 11 Supply and Demand Shocks: 07 Aggregate, 1880-1 989, Annual Data Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 Figure 12 Supply and Demand Shocks: 1880-1989, United States Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 FEDERAL RESERVE BANK OF ST. LOUIS 155 Figure 12 (continued) Supply and Demand Shocks: 1880-1 989, United Kingdom Percent 8- ~‘4 -4 -8- Supply —1 vn- I IIIIIIII 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 Supply and Demand Shocks: 1880-1 989, Germany Percent 1 —1 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 MARCH/APRIL 1993 Figure 12 (continued) Supply and Demand Shocks: 1880-1 989, France Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 Supply and Demand Shocks: 1880-1989, Japan Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 FEDERAL RESERVE BANK OF ST. LOUIS 157 Figure 12 (Continued) Supply and Demand Shocks: 1880-1989, Canada Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 Supply and Demand Shocks: 1880-I 989, Italy Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 MARCH/APRIL 1993 158 In sum, the evidence on supply and demand Bretton Woods than under the floating exchange shocks is quite similar to the measures of vola- rate period. tility drawn from the forecast errors using the Perhaps the gold standard was able to endure MSKF. The gold standard regime, as well as the the greater shocks that it faced because of both interwar period, emerges as a relatively unstable greater price flexibility and greater factor’ mobil- period stressed by widely dispersed supply shocks. ity before World War I. Alternatively, the gold fly contrast, the Bretton Woods convertible period standard was more durable than Bretton Woods is the most stable, with the floating exchange because before World War I, suffrage was limited, rate period not far behind. central banks wem’e often privately owned and, These results raise the interesting question, before Keynes, there was less understanding of why in the past century was the classical gold the link between monetary policy and the level standard so durable in the face of substantial of economic activity. Hence there was less of an shocks, whereas Bretton Woods was so fm-agile incentive for the monetary authorities to pursue in the face of the mildest shocks? full employment policies, which would threaten adherence to convertibility. Responsiveness to Shocks In addition, the Bretton Woods regime was both more stable and seemingly more flexible than The final piece of evidence to be calculated in the floating exchange rate regime and yet more the comparison of regime performance is the fragile. This suggests that its collapse is attribut- response of the price level and output to the able less to outside shocks to the environment aggregate supply (permanent) and aggregate or the structum’e of the Group of Seven economy demand (temporary) shocks. Evidence of a mom-c and more to flaws in the design of the regime. rapid adjustment of prices and output to shocks may help explain why one regime may have been more durable than another. Summary A measure of speed of response can be gleaned The performance of alternative international from the impulse response functions derived monetary regimes suggests that the Bretton from the bivariate \7AR5. In addition, as a crude Woods convertible regime (1959—70) was the measure of response speed, which allowed easy most stable, followed by the floating exchange comparison of all seven countries (luring the rate and the classical gold standard regimes. four regimes, I calculated the mean absolute lag The stability of forecast errors to both inflation of the response functions.” Table 5 presents and growth paralleled that of the ey post data. these measures. Limited inflation persistence—evidence for credibility of the nominal anchor—was lowest The response of output to both demand and during the classical gold standard. Though con- 5upplv shocks for the Group of Seven aggregate siderably higher than under the gold standard, and for most of the individual countries was persistence was less under Bretton Woods than markedly more rapid under the gold standard under the float. Under Bretton Woods the nomi- regime than under the postwar regimes (an ex- nal anchor of the U. S. commitment to peg the ception is the U.S. response to demand shocks) price of its currency to gold was apparently still and within the postwar regimes was slightly effective. Finally, supply shocks were greater more rapid under the Bretton Woods regime and less symmetric, and demand shocks were than the floating exchange rate regime. The greater under the classical gold standard than response of prices to both demand and supply under the post—World War II regimes. A more shccks was considerahl more rapid during the rapid response of both prices and output to these gold standard (and the interwar) regime than shocks also occurm-cd under the gold standard. the postwar regimes for Ihe Group of Seven and most countries?6 Within the postwar The question still remains why some fixed period, it was considerably niot-e rapid under exchange rate regimes endured longer than others “The formula was PC A c~ I PC Ac~ tor 1 to 40, “As mentioned above, according to the overidentifying where i is the year and A c, the impulse response, cal- restrictions of the Bayoumi-Eichengreen-Blanchard-Ouah culating absolute changes because of the presence of approach, supply shocks should have produced a negative both positive and negative responses. This measure is response in prices, not the positive one shown here for the only a rough approximation because it is not possible to pre-World War II periods. calculate the standard errors. FEDERAL RESERVE BANK OF ST. LOUIS £66~.liady/HOUWI ~ r ~. ~~(~ ~4~\ ~ ~~ ~ N~YV~ ~ 7 \~ / ~ ~ \~\>~~v ~~/~r ~ / y/: ~ ~ Jados~s’7 <~ \\ ~ ~Jc~~ ~ ~ y~~/ ~ ;~wfrc~~ ~~c~~ ~ \~ I ~, \ N ~/ / ~( p~ /~ ~ / /~\ // / /~ ~ ~\\ ~>, ~ ~ //~ ~~ ~~ /~ ;i ‘ ~~~~N ~~~~sanóAs ~)me~Stanat ~~ ~ :~ ~~~~:~. // ~~~ ~ : ~ 0~r~ ~ ~~p~~~~ ~ N/ / ~‘ \/ ~~~~~~/ ~ ~ ~ ,~*a~eq4qoi~’~ ~~/~/ ~ // \~ // ~~ ~ ~ ~\ ~ i\ ~se~ ~ ASb4*øt if ;~ ~ ~~\ /\ ~~:~~? ~ ~ t > ~ j/~ ~‘ ~\// iW~~~uo Sa~~ds~0$j ~ / // s~1~c_~ ~ /~ ~ ~ ~ /~/ N~ ~ // \~ \\~ ~~~~ ~~//~,~ ~ ~ N~N~ *‘~ ~ / ~\ / ~ ~2~\ ~N ~ ~ ~~/ /~ ~ ~~/~ / ~~ / ,t ~Sc2 \/2 ~~~N \~ * /~ ~ / e~ aM~ ‘~*k~\t jç/~ ~~ ~~. 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It collapsed both fixed and flexible rates. The durability of the because of fatal flaws in its design (the adjusta- gold standard ma he due to greater prmce flexi- tile peg in the face of improved capital mobility bility and factor mobility before World War I and the confidence problem associated with the that allowed the world economy to respond to gold dollar standard) and the lack of commit- shocks more rapidly. It also mat’ he due to the ment by the United States to the gold standard absence of discm-ctionary monetary policies dedi- convert ihil ty rule. cat ed to maintaining frill employment. But the The Ei~iS,although not based on gold, incor- fragility of the most stable regime, Bretton porated many of the features of the Bretton T~%Toods in the face of mild shocks, suggests that Woods adjustable peg system. Its success in an undet-standing of its demise requires a closer promoting the convergence of inflation rates look at the history, institutions and rules of among its tnemnbers in the 1980s has been behavior of alternative monetary regimes. linked to the presence of an effective commit- ment mechanism—the adherence by the German THE GOLD STANDARD, BRETTON central hank to price stability and the willing- WOODS, AND THE EMS AS ness of other members to tie their currencies to COMMITMENT MECHANISMS the German mark. However, like Bret ton Woods, it suffered serious stress in September 1992 in Perhaps the answer’ to the foregoing questions the face of mnassive shocks because of the basic concerning regime performance and durability incompatibility of pegged exchange rates, capital may be linked to the commitment technology of mobility and policy autonomy. Both the center the regime. Tn this section 1 argue that the gold country and the members were unwilling to standard rule of convertibility was a credible commit to a common policy. commitment mechanism that was crucial to its An overview of the three regimes as embodying success and that the absence of such a mech- the operation of credible monetary rules follows. anism underlies the failure of the l3retton Woods variant. The EMS, though not anchored to gold The Gold Standard as a Commitment convertibility, may have been successful for sev- Mechanism eral years because it embodied a commitment technology reminiscent of the gold standam’d. In the recent literature on the time inconsistency However, like Bretton Woods, it was subject in of optimal government policy, the absence of a September 1992 to intolerable strains because credible comnmitment mechanism leads govern- the commnitment mechanism proved to be not ments, in put-suing stabilization policies, to pro- ct-edible for many of the muembers. duce an inflationary outcome.57 In a closed tinder the classical gold standard, the mnonetarv economy environment, once the monetary authority authorities committed themselves to fix the prices has announced a given rate of monetary growth, which the public expects it to validate, the au- of their currencies in terms of a fixed weight of gold and to buy and sell gold freely in unlimited thority then has an incentive to create a mone- amounts. The pledge to fix the price of a coun- tat-y surprise to either reduce unemployment or try’s currency in terms of gold represents the capture seigniorage revenue. ‘I’he public, with basic rule of the gold standard. The fixed price rational expectations, will come to anticipate the authorities’ perfidy, leading to an inflationary of domestic currency in terms of gold provided a nominal anchor to the international monetary equilibrium. A credible precommnitmnent mech- system. tInder the Bretton Woods system only anism, h preventing the government from the United States fixed the price of its currency cheating, can preserve long-run price stability. in terms of gold. All other convertible currencies The gold standard rule of maintaining a fixed were pegged to the dollar. Also, under llretton price of gold can be viewed as such a mechanism. Woods, free convertibility of gold into dollars was The gold standard i-tile can lie viewed as a form limited. Thus Bretton Woods was a weak variant of contingent rule or a rule with escape clauses.” of the gold standard. Although the Bretton Woods ‘I’he monetary authority maintains the standard— system in its convertible phase (1959—71) was that is, keeps the price of the currency in terms of the most stable monetary regime of the past gold fixed—except in the event of a well-understood 57 8ee Kydland and Prescott (1977) and Barro and Gordon “See Grossman and Van Huyck (1988), DeKock and Grilli (1983). (1989), and Bordo and Kydland (1992). FEDERAL RESERVE BANK OF ST. LOUIS 161 emergency, such as a major war or a financial cmi- historical evolution itself of the gold standard. sis. In wartime it may suspend gold convertibility Gold was accepted as money because of its and issue paper money to finance its expenditures, intrinsic value and desirable propeities. Paper and it can sell debt issues in terms of the nominal claims, developed to economize on the scarce value of its currency on the understanding that debt resources tied up in a commodity money, became will eventually be paid off in gold. The rule is con- acceptable only because they were convertible into tingent in the sense that the public understands that gold. An alter-native commitment mechanism the suspension will last only for the duration of the was to guarantee gold convertibility in the con- wartime emergency plus some period of adjustment. stitution. This was the case for example in It assumes that afteris’ard the government will Sweden before 1914, when laws pertaining to follow the deflationary policies necessary to resume the gold standard could be changed only by two payments at the original parity. Following such identical parliamentary decisions with an elec- a rule will also allow the government to smooth tion in between.” Convertibility was also its revenue from different sources of finance, such enshrined in the laws of a number of gold 5 as taxation, borr’owing and seigniorage. ° standard central banks.63 According to Bordo and Kydland (1992), the The gold standard originally evolved as a domes- gold standard contingent rule worked success- tic commitment mechanism, but its enduring fully for three come countries of the classical fame is as an international rule. The classical gold standard: the United Kingdom, the United gold standard emerged as a true international States, and France. Tn all these countries the standard by 1880 following the switch by the monetary authorities adhered failhfully to the majority of countries from bimetallism, silver fixed price of gold except during major wars. mnonometalism and paper to gold as the basis of During the Napoleonic War and World War I their currencies.” As an international standard, for England, the Civil War for the United States, the key rule was maintenance of gold converti- and the Franco—Prussian War foi France, specie bility at the established par. Maintenance of a payments were suspended, and paper money fixed price of gold by its adherents in turn amid debt were issued. But in each case, after ensured fixed exchange rates. Recent evidence the wartime emergency had passed, policies suggests that, indeed, exchange rates through- leading to resumption were adopted.” Indeed, out the 1880—1914 period were characterized successful adherence to the rule may have ena- by a high degree of fixity in the principal coun- bled the belligerents to obtain access to debt tries. Although exchange rates frequently deviated finance more easily in subsequent wars. Other from par, violations of the gold points amid de- countries, such as Italy, which did not continu- valuations were rare.°5 ously maintain gold convertibility, nevertheless According to game theory literature, for an adopted policies consistent with long-run con- international monetary arrangement to be effec- vertihili ty .°‘ tive both between countries and within them, a The gold standard rule may also have been time-consistent credible commitment mechanism enforced by reputational considlerations. Long- is required. Adherence to the gold convertibility run adherence to the rule was based on the rule provided such a niechanism. In addition to the “See Lucas and Stokey (1983) and Mankiw (1987). who present evidence of expected appreciation of the °°Acase study comparing British and French finances dur- greenback during the American Civil War based on a ing the Napoleonic Wars shows that Britain was able to negative interest differential between bonds that were paid finance its wartime expenditures by a combination of in greenbacks and those paid in gold. Giovannini (1992) finds that the variation of both taxes, debt and paper money issue—to smooth revenue; exchange rates and short-term interest rates varied within whereas France had to rely primarily on taxation. France had to rely on a less efficient mix of finance than Britain the limits set by the gold points in the 1899—1909 period consistent with market agents’ expectations of a credible because she had used up her credibility by defaulting on outstanding debt at the end of the American Revolutionary commitment by the four core’’ countries to the gold standard rule in the sense of this paper. War and by hyperinflating during the Revolution, Napoleon 2 ultimately returned France to the bimetallic standard in ° SeeJonung (1984). 1803 as part of a policy to restore fiscal probity, but because of the previous loss of reputation France was “See Giovannini (1993). unable to take advantage of the contingent aspect of the “See Eichengreen (1985). bimetallic standard rule. See Bordo and White (1991). “See Officer (1986) and Eichengreen (1985). 61The behavior of asset prices (exchange rates and interest rates) suggests that market agents viewed the commitment to gold as credible. See Roll (1972) and Calomiris (1988), MARCHIAPRIL 1993 162 reputation of the domestic gold standard and con- not always changed in the required direction stitutional provisions that ensured domestic com- (or by sufficient amounts) and in the sense that mitment, adherence to the international gold- changes in dotnestic credit were offen nega- standard rule nias’ have been enforced by other tively corm’elated with changes in gold reserves. mechanisms. These include improved access to In addition, a number of countries used gold international capital markets, the operation of devices—practices to prevent gold outflows. the rules of the game, and the hegemonic For the major countries, however (at least power of England. before 1914) such policies were riot used exten- Support for the intertiational gold standat-d sively enough to threaten the convertibility to likely grew because it provided improved access gold—evidence of commitment to fiie l-ule.” to the intet-national capital markets of the core Moreover, as McKinnon (1992) argues, to the countries. Countries were eager to adhere to extent that monetary authorities followed Bage- the standard because thex’ believed that gold hot’s rule and prevented a financial crisis while convertibility would he a signal to credit (fl~sof seemingly violating the rules of the game, the sound government finance and the futut-e ahil- commitment to the gold standard in the long its’ to service debt.”° run may have been strengthened. This was the case both for developing countries An additional enforcement mnechanism for the seeking access to long-term capital, such as in t erna tiomal gold static]at-cl m-ule may have been Austria-I-lungarv and Latin Amet-ica, and fot- the hegenionic power of Englamid, the most countries seeking short-term loans, such as important golml standard countrvi’ A Iiersistent .lapan which financed the Russo-Japanese war 1 heme in t lie literature on the international gold of 1905—06 with foreign loans seven years after stanmlard is that the classical gold standard of joining the gold standard.°~Once on the gold 1880 to 1914 was a British-managed standard.~ standard, these countries feared the consequences Because London was the center for the world’s of suspension.” ‘That England, the most success- principal gold, comnmoclities and capital mam-kets, ful country of the nineteenth century, as well tiecause of the extensive outstanding sterling- as other progressive countries were on the gold denominated assets, and because many countm-ies standard was probably a powerful argument substituted sterling for gold as an international br ~oining.’° reserve currency, some argue that the Batik of The opera tion of the rules of the game, England, by manipula t big its hank rate, could wheretiv the monetary authorities were sup- attract whatever gold it needed and, fm-f her- posed to alter the discount i-ate to speed up the more, that other central banks would adjust adjustment to a change in external halance, may their discount rates accordingly. ‘l’hus the Bank also have heen an important half of the com- of England could exert a powerful influence on mitment mechanism to the international goldl the money supplies and p-ic levels of other standard rule. To the extent the rules were fol- gold standai-d countries. lowed and amljustment facilitated, the commit- The evidence suggests that the Hank did have mnenl to convertibility was strengthened and sonic influence on other European cetitmal hanks.~~ conditions conducive to ahandonment wem-e Lichengreen (1987) treats the Bank of England lessened. as one engaged in a leadership role in a Stackelberg Evidence on the opel-ation of the rules of the strategic game with other central banks as fol- game questions their validity. Bloomfield (1 959) lowers. The other central banks accepted a in a classic study, showed that, with the principal passive role because they benefited from using exception of F.ngland, the rules were frequently stem-Inig as a reserve asset - Acco mcling to tliis violated in the sense that discount rates were interpm-etation, the gold standard rule mas’ SeA case study of Canada during the Great Depression pro- “See Eichengreen (1989a) and Fishtow (1987 and 1989). vides evidence for the importance of the credible commit- “See Friedman (1990) and Gallarotti (1991). ment mechanism of adherence to gold. Canada 70 suspended the gold standard in 1929 but did not allow the See Schwartz (1984). 7m Canadian dollar to depreciate nor the price level to rise for See Eichengreen (1989b). two years. Canada did not take advantage of the suspen- 72 sion to emerge from the depression because of concern See Bordo (1984). for its credibility with foreign lenders. See Bordo and Red- “See Lindert (1969). ish (1990). 67 5ee Yeager (1984), Fishlow (1989) and Hayashi (1989). FEDERAL RESERVE BANK OF ST. LOUIS 163 have been enforced by the Bank of England.7.m key members (England, France and the United ‘thus the monetary authorities of many coun- States), and the unwillingness of its two strongest tries may have been constrained from following members, the United States and France, to fol- indlependent discretionary policies that would low the rules of the game. Instead they exerted have threatened adherence to the gold standlard deflationary pressure on the rest of the world rule. by persistent sterilization of balance-of-payment surpluses. The gold exchange standard collapsed, Indeed according to Giovannini (1989), the gold but according to F’riedmnan arid Schwartz, Temin, standam-dl ivas an asymmetric system. England andl Eichengreen, not before transmitting defla- was the center country. It used its monetary tion and depression across the world.~~ policy (hank t-ate) to maintain gold converti- bility. Other countries accepted the dictates The Bretton Woods International of fixed pam-ities and allowed their money sup- Monetary System plies to respond passively. His regressions suppoi-t tins view—the French and Germnan The planmnng that led to Bretton Woods aimed central banks adapfed their domestic policies to prevent the chaos of the interwar period.” to external conditions, whereas the British The perceived ills to he prevented included (1) did not. floating exchange rates that were condemned as subject to cTestabilizing speculation; (2) a gold The benefits to England as leader of the gold standard—from seigniorage earned on foreign- exchange standard that was vulnem-able to prob- held sterling balances to returns to financial lems of adjustment, liquidity amid confidence, institutions generated b its central position in which enforced the international ti-ansrnissior the goldl standam-d and to access to international of deflation in the early 1 930s; and (3) the capital markets in wartime—were substantial resort to heggar-thv-neighhor devaluations, trade rest rictions, exchange controls and bilater- enough to make the costs of not following the alism after 1933. ‘To lirevent these ills, the case rule ex tt-emely high. for an adjustable peg system was made by ‘The classical gold standard ended in the face Keynes, White, Nurkse and others.” The new of the massive shocks of World War ~ ‘Ihe system would combine the favorable features of gold exchange standard, which prevailed for the fixed exchange rate gold standard—stability only a few years frotii the mid-1920s to the of exchange rates—amid of the flexible exchange Great Depression, was ami attempt to restore the rate standard—monetary and fiscal independtence. beneficial features of the classical gold standard Both Keynes, leading the British negotiating team while allowing a greater iole for domestic stahil- at Bretton Woodls, and White, leading the Amneri- ization policy. This in tum-n cm-eated a growing can team at Bretton Woods, planned tin adjustable conflict between adherence to the rule and dis- cretion. If also attempted to economize on gold peg system to lie coordinated by an international monetary agency. The Keynes plan gave the Inter- reserves by restricting its use to central banks national Cum-rency Union substantially mnome and by encoui-aging the use of foreign exchange reserves amid poii’er than the United Nations Stabili- as a substitute. As is well known, the goldl ex- zation Fund proposedl by White, hut both institu- change standard suffered from a number of tions would have hadl considerable control ovem- the fatal flaws.” These includle the use of two domestic financial policy of the members. reserve currencies (the pound and the dollar), the absence of leadem-ship liv a hegemonic The Ilmitisli plan contained more domestic policy p°~ver,the failure of cooperation between the autonomy than dlid the U.S. plan, whereas the 74 According to Eichengreen (1989a), the Bank of England’s “See Kindleberger (1973), Temin (1989), and Eichengreen ability to ensure convertibility was aided by the coopera- (1992c). tion of other central banks. In addition, as mentioned “See Friedman and Schwartz (1963), Temin (1989) and above, belief based on past performance that England attached highest priority to convertibility encouraged Eichengreen (1 992c). stabilizing private capital movements in times of threats to “This section draws heavily on Bordo (1992). convertibility, such as in 1890 and 1907, “See Bordo (1993). “The standard deviations of both supply and demand shocks during World War I for the countries for which we have continuous data were two to three times as great as during the classical gold standard, See appendix table 1 and figure I - MARCH/APRIL 1993 164 American plan put more emphasis on exchange within 72 hours. Unauthorized changes in the rate stability. Neither architect was in favor of a exchange rate could make members ineligible to 8 rule-based system. °The British were most con- use the fund’s resources, and if a member continued cerned with preventing the deflation of the 1930s, to make unauthorized changes, it could be expelled which they attributed to the constraint of the gold from the fund. A uniform change in par value of standard m’ule and to deflationary U.S. monetary pol- all currencies (in terms of gold) required approval icies. ‘thus they wanted an expansionary system. by a majonity of all voting fund members arid also had to be approved by every member with The American plan was closer to the gold 10 percent or more of the total quota. standard rule in that it stressed the fixity of exchange mates. It did not explicitly mention the importance of rules as a cm-edible commitment Multilateral Payments mechanism, but there were to be strict regula- Members were supposed to make their curren- tions on the linkage between UNITAS (the pro- cies convertible for cut-rent account transactions posed international reserve account) and gold. (Art. VIII), but capital controls were permitted Members, in the event of a fundamnental dis- (Art. VI.3). They were also to avoid discrimina- equilibrium, could change their parities only tory currency and multiple curency arrange- with approval from a three-quarters majom’ity of ments. Countries could avoid declaring their all members of the fund.” currencies convertible, however, by invoking ‘the Articles of Agreement of the International Art. XIV, which allowed a three-year transition Monetary Fund incorporated elements of both the period after establishmnent of the fund. During Keynes and White plans, although in the end, U.S. the transition period, existing exchange controls concerns predominated.” The main points of the could be maintained.” articles were: the creation of the par value system; mnultilateral payments; the use of the fund’s resources; its powers; and its organization. The Fund’s Resources As under the White plan, members could The Par Value System obtain resources fromn the fund to help finance short- or medium-term payments disequilihria. Article TV det’ined the numeraire of the interna- The total fund, contributed by mnembem-s quotas tional monetary system as either gold om the tJ.S. (25 pci-cent in gold amid 75 percent in currencies) dollam of the weight and fineness on July 1, 1944. was set at $8.8 billion. It could he raised every All members were urged to declare a par value five yeams if the mnajoritv of members wanted to and maintain it within a 1 percent margin on do so. The fumid set a number of conditions on either side of parity. Pam-ity could be changed in the use of its resources by deficit countries to the event of a fundamental payments disequili- prevent it fromn accumnulating soft currencies brium at the decision of the member, after con- and froni depleting its holdings of harder cur- 8 sultation with other fund members. ‘F he fund rencies. ” It also established requirements and would not, however, reject the change if it was conditions fom m-epurchase (repayment of a loan), not more than 10 percent; if the change was imicluding giving the fund the right to decide the more than 10 percent, the fund would decide currency in which repurchase would be made. 80 1n the sense of a commitment mechanism to prevent the “Under Art, XIV, three years after March 1, 1947, the IMF time consistency problem. According to Meltzer (1988) and would begin reporting on the countries with existing con- Moggridge (I986), Keynes had a strong preference for trols, two years later it woutd begin consulting with individ- rules over discretion, interpreting rules in the traditional ual members and advising them on policies to restore sense, payments equilibrium and convertibility. Countries that did tm1 See Giovannini (1993). not make satisfactory progress would be censured and ultimately asked to leave the fund, In fact, the fund always 12Am the same time as the Articles of Agreement for the accepted the member’s reason for remaining under Art. International Monetary Fund were signed, the International XIV, Bank for Reconstruction and Development (the World Bank) was established. The Charter of the International ~Members could draw on their quotas without condition. Trade Organization (ITO) was drafted and si9ned in 1947 Beyond that, referred to later as the credit tranches. but never ratified. It was succeeded by the General Agree- although not spelled out in the articles, increasingly more ment for Tariffs and Trade (GATT) originally negotiated in exacting conditions were required. Geneva in 1947 as an interim institution until the ITO came into force, FEDERAL RESERVE BANK OF ST. LOUIS 165 In the case of countries prone to running large the fixed price of gold at $35 per ounce, which surpluses, the scarce currency clause (Art. VII) the U.S. was to maintain, represented the nomi- would come into play. If the fund’s holdings of a nal anchor of the system. Members were required currency wet-c insufficient to satisfy the demand to maintain parity of their exchange rates in for it by other members, it could declare it scarce terms of dollars (or gold). Also, like the gold and then urge members to ration its use by dis- standard, it was a rule with an escape clause. criminatory exchange controls. Members at their initiative could alter their par- ities in the event of a fundamental disequilibrium. The Powers of the Fund The architects never spelled out exactly how the system was supposed to work. Subsequent The fund had considerably less discretionary writers, however, have suggested a number of power over the domestic policies of its members salient features.” First, curm-encies were treated than either of the architects wanted, but it still as equal in the articles. This meant that in theory had power to influence the international mone- each country was required to maintain its par tary system strongly. These powers included its value by intervening in the currency of every authority to approve or reject changes in parity; other country—a practice that would have worked the use of multiple exchange rates and other at cross purposes. In fact, because the United disctiminatory practices; the conditionality implicit States was the only country that pegged its cur- in members’ access to the credit tranches of rency in terms of gold (bought and sold gold), their quotas, which was made explicit by 1952; its all other countries would fix their parities in authomity to declare currencies scat-ce; its authority terms of dollars and would intervene to monitor to declare members ineligible to use its resources their exchange rates within 1 percent of parity (used against France in 1948 following an unap- with the dollar. proved devaluation); and its ultimate authority Second, countries would use their international to expel members.” The fund also had consider- reserves or draw resources from the fund to finance able power as the premier international mone- tary organization in consulting and cooperating payments deficits. In the case of surpluses, coun- with national and other international monetary tries would tempot-arily build up reserves or re- purchase their currencies from the fund. In the authorities. event of medium-tem-ni disequilibria, they would use monetary and fiscal policy to alter aggregate Organization demand. In the event of a fundamental disequil- ibrium, which was never defined but presumably The fund was to be governed by a board of reflected either some permanent structural shock governors appointed by the members. The board or sustained inflation, a member was supposed to would make the major policy decisions, such as alter parity by an amount sufficient to restore exter- approving a change in parity. Operations of the nal equilibrium. fund were to be directed by executive directors appointed by the members arid a managing direc- Third, capital controls wet-c permitted to prevent tor selected by the executive dinectors. Major destabilizing speculation from forcing members to changes such as a uniform change in the par alter their parities prematurely or unintentionally. value of all currencies or the second amend- ment to the articles, which created the special THE HISTORY OF BRETTON drawing right (SDR), would require a majority WOODS: PRE-CONVERTIBILITY vote by the members. The number of votes in turn was tied to the size of each member’s quota) 1946—58 which was determined by its economic size. The international monetary system that began i’hough the articles could not be interpreted after World War TI was far different front the strictly as a retunn to the gold standard rule of system that the architects of Bretton Woods the fixed price of gold with free convertibility, envisioned. ‘The transition period fmom war to “See Diz (1984) for a discussion of conditionality impticit in icies—exchange rates to medium-run external balance, members’ access to the credit tranches of their quotas. monetary and fiscal pohcy to short-run internal batance and international reserves—to provide a buffer to allow “See, for example, Tew (1988), Scammell (1976) and short-run departures from external balance, Veager (1976). For Williamson (I985b) it was a compre- hensive set of rules for assigning macroeconomic pol- MARCH/APRIL 1993 166 peace was much longer and more painful than inflows continued to finance wartime expendi- anticipated. Frill convertibilit of the major tures 1w the allies. At the end of World War II, industrial countries was not achieved until the gold and dollar reserves in Eum-ope and Japan end of 1958, although the system had started were depleted. Europe ran a massive cLtrrent functioning normally hx’ 1955. Two interrelated account deficit, reflecting the demand for essen- problems dominated the fit-st postwar decade: tial imports and the reduced capacity’ of the hilateralismn and the dollar shortage. export industties. The Organization for Euro- pean Economic Cooperation (OEEC) deficit, Bilateralism aggravated by the had winter of 1946—47, reached a high of $9 billion in 1947. The OEEC The legacy of Wot-ld War 11 for virtually every deficit equaled the aniount of the U.S. current country except the United States was one of account surplus, which was large because the pervasive exchange controls and controls on United States) as the only majom’ industrial coun- trade. No mnajor currency except the dollar was try operating at full capacity, supplied the convertible.” Under Art. XIV of the Bretton needed iniports. The dollar shortage was likely Woods agreement, countries could continue to aggravated by overvalued official parities set by use exchange controls for- an indefinite tranisi- the major European industrial countries at the tion period aftem- the establishment of the Inter- end of 1946.88 national Monetary Fund (IME) on March 1, 1947. By the mid—1950s both problems had been In conjunction with exchange controls, every solved. The currencies of western Europe were country negotiated a series of bilateral pay- virtually convertible by 1955 and their current ments agreements with each of its trading part- accounts were generally in surplus. The key tiers. ‘t’he rationale For the continued use of developments in this progmess were the Mar- controls and bilateralism was a shortage of shall Plan and the European Payments Union. international reserves. After the war, the econo- mies of Europe and Asia were devastated. To The Marshall Plan produce the exports needed to generate foreign exchange, industries requiled new and improved The Marshall Plan funneled approximately $13 capital. There was an acute shortage of key billion in aid (grants and loans) to western Europe imports, both foodstuffs to maintain living between 1948 and 1952.” ‘The plan required standards and raw materials and capital equip- the recipients to cooperate in the liberalization ment. Controls allocated the scam-ce reserves. of trade and payments. Consequently, the OEEC was established in April 1948. It presided over The Dollar Shortage the allocation of aid to mnemhers based on the size of their current account deficits. U.S. aid B~the end of World War II, the United States was to pay for essential imports and to provide field two-thirds of the world’s monetary gold international reserves. Each recipient govern- stock (see figure 131. ‘the gold avalanche in the ment provided matching funds in local curt-encv United States in the 1930s was the consequence to be used for investment in the productive of both the dollar devaluation in 1934, when capacity of industry, agriculture and infrastruc- the Roosevelt administration raised the price of ture. Each country also had a delegation of U.S. gold fromn $20.67 per ounce to $35.00, and capi- administrators that advised the host govern- tal flight from Europe. During the war, gold ment on the spending of its counterpart funds. “Under the classical gold standard, convertibility meant the buy and sell foreign exchange (primarily dollars) to keep ability of a private individual to freely convert a unit of any the parity fixed (within the 1 percent margin) and the national currency into gold at the official fixed price. A United States freely buys and sells gold to maintain the suspension of convertibility meant that the exchange rate fixed price of $35 an ounce (within the 1 percent margin). between gold and national currency became flexible but He refers to both market and official convertibility as Bret- the individual could still freely transact in either asset. See ton Woods convertibility. See also McKinnon (1979) and Triffin (1960). By the eve of World War II, convertibility Black (1987). referred to the ability of a private individual to freely make “See Triffin (1957). and receive payments in international transactions in terms of the currency of another country. Under Bretton Woods, “See Milward (1984) and Hoffman and Maier (1984). convertibility meant the freedom for individuals to engage in current account transactions without being subject to exchange controls. Tew (1988) defines this as market con- vertibility and distinguishes it from official convertibility whereby the monetary authorities of each country freely FEDERAL RESERVE BANK OF ST. LOUIS 167 Figure 13 Monetary Gold and Dollar Holdings: the United States and the Rest of the World, 1945-1971 Billions of U.S. dollars — U.S. Monetary Gold Stock 60- — External Dollar Liabilities 50- — External Dollar Liabilities held by Monetary Authorties 40- — Rest of the World Monetary Gold Stock 30- 20— 10— ‘I’, II II III I IT II II m 1945 47 49 51 53 55 57 59 61 53 65 67 69 71 The plan encouraged the liberalization of intra- bank clearinghouse. At the end of each month, European tmade and payments Liv gt-anting aid each member would clear its net debit om cr’edit to countries that extended bilateral credits to position (against all other members) with the other mem’nhers. Finally, the European Payments EPU (the BIS actitig as its agent). The unit of Union (EPU) was established in 1950, under the account for these clearings was the U.S. dollar. auspices of the OEEC, to simplify bilateral clear- The EPU also provided extensive credit lines. ing and pave the tvav to multilateralism - The EPU was highly successful in reducing the volume of pavnients transactions and provided 13v 1952, in part thanks to the Marshall Plan, the background for- the gradual liberalization of the OEEC countries had achieved a 39 percent ~iayments so that by 1953 comniercial banks were increase in industrial prodriction - a doubling of able to engage in multicurrencv arbitrage.” On exports, an increase in imports liv one-third and December 27, 1958, eight countries declared a current account surplus.’”’ their currencies convertible for curm’ent account ramis actions. The European Payments Union and the Return to Convertibility The miiovement to convertibility was aided by the devaluations of 1949. F’ollowing a specula- It took 12 years from the declaration of offi- tive run on the pound in the summer of 1949, cial par values by 32 nations in Deceniher 1 946 the British, 24 hours after informing the IMF’, to achieve convertihilitv for current transactions devalued the pound by 30.5 percent. Shortly liv the major industrial countries, as specified thereafter, 23 countries reduced their parities liv the Btettoti Woods Articles. ‘the Western by similar magnitudes in most cases. Eur-opean miations tried sevem-al schemes to facili- The devaluations of 1949 were important for tate the payments process before estatilishing the Brettomi Woods system for two reasons. First, the EPU in 1950.9! they, along with the Marshall Plan aid, helped The EPU, established Septemnbei- 19, 1950, by move the European countries from a current the OEEC countries, initially was to i-un for two account deficit to a surplus, a movement impor- veam’s, renewable thereafter omi a yearly basis. tant to the eventual restoration of comivem-tibility. It followed the basic prh~cipleof a commercial Second, they revealed a basic weakness of the t “Solomon (1976). ‘ Tew (1988) and Veager (1976). “Kaplan and Schleiminger (1989), MARCH/APRIL 1993 168 adjustable peg arrangement—the one-way option Finally, the fund’s resources were inadequate of speculation against parity. By allowing to solve the emerging liquidity problem of the changes in parity only in the event of a fun- 1960s. The difference between the required damental disequilibrium, the Bretton Woods sys- growth of international reserves (to finance the tem encouraged the monetary authorities to growth of real (iutput and trade and to avoid delay adjustment until they were sure it was deflation) and the growth in the world’s mone- necessary. By that time, speculators also would tary gold stock was met largely by an increase be sure and they would take a position from in official holdings of U.S. dollars resulting fi-om which they could not lose. If the currency is growing U.S. balance-of-payments deficits. By devalued, they win and if it is not, they just lose the time full convertibility was achieved, the the interest (if any) on the speculative funds.” U.S. dollar was serving the buffer function The crisis associated with the 1949 sterling intended by the Bretton Woods Articles for the devaluation in turn created further resistance fund’s resources.” by monetary authorities to changes in parity, which ultimately changed the nature of the international monetary system from the adjusta- THE HISTORY OF BRETTON ble peg intended by the Bretton Woods Articles WOODS: THE HEYDAY OF to a fixed rate megime. BRETTON WOODS 1959-1967 Other developments in the preconvertiblity period included the decline of sterling as a With current account convertibility established reserve asset and the reduced prestige of the by the western European industrial nations at the IMF. The 1MF by intention was not equipped to end of December 1958, the full-blown Bretton deal with the postwar reconstruction problem. Woods system was in operation. Each member Although some limited drawings occurred intervened in the foreign exchange market, before 1952, most of the structural balance of either buying or selling dollars, to maintain its payments assistance in this period was provided parity within the prescribed 1 percent margins. by the Marshall Plan and other U.S. assistance, The U.S. Treasury in turn pegged the price of including the Anglo-American Loan of 1946. The the dollar at $35 per ounce by freely buying consequence of this development is that other and selling gold. Thus each currency was institutions such as the BIS, the agent for the anchored to the dollar and indirectly to gold. EPLJ, emerged as competing sources of interna- Triangular arbitrage kept all cross r-ates within tional monetary authority.’~ a band of 2 percent on either side of parity. Through much of this period, capital controls The fund’s prestige was dealt a severe blow prevailed in most countries except the United by three events in the preconvertibility period. States in one form or another, although by the ‘I’lie first event ivas the French devaluation of mid-1960s their use declined while increasing in January 1948, which created a multiple exchange the United States. rate system. The fund censured France for creating broken cross rates between the dollar The system that operated in the next decade and the poutid. France was denied access to the turned out to be quite different from what the fund’s resout-ces until 1952. France ended the architects had in mind. First, itistead of a system broken cross rates in October 1948 and adopted of equal currencies, it evolved into a variant of a unified rate in the devaluation of 1949. Since the gold exchange standard—the gold-dollar sys- France had access to the Marshall Plan, the fund’s tem. Initially, it was a gold exchange standard actions had little effect. The second event was the with two key currencies, the dollar and the sterling devaluation of September 194~,when pound. But the role of the pound as key cur- the fund, instead of being actively involved in rency declined steadily throughout the 1960s. consultation, was given 24 hours perfunctory Concurrently with the decline of sterling was notice. The third event was the decision by the rise in the dollar as a key currency. Use of Canada to float its currency in September 1950. the dollar as both a private and official interna- T’hough the futid was highly critical of the action, tional money increased dramatically in the it was unable to prevent it. ‘I’he Canadian dollar 1950s amid continued into the 1960s. With full floated successfully until 1961. convertibility, the dollar’s fundamental role as “See Friedman (1953). “See Mundell (1969). “See Mundell (1969). FEDERAL RESERVE BANK OF ST. LOUIS 169 intervention currency led to its use as interna- Of particular interest during the period was tional reserves. This was aidled by stable and asymmetry in adjustment betiveen deficit countries low monetary growth and relatively low infla- like the tjnited Kingdom and surplus countries tion (before 1965). See figure 1 and table 1. like Germany and between the United States as the reserve currency country and rest of the world. ‘the gold exchange standard evolved in the post—World War tt period for the same reasons Both the United Kingdom amid Germany ran it did in the 1920s—to economize on non-interest- the gauntlet between concern over external hearing gold reserves. Ry the late 1950s, the growth convertibility and domestic stability. The United of the world’s monetary gold stock was insuffi- Kingdom alternated between expansionary pol- cient to finance the growth of world real output icy that led to balance-of-payments deficits and and trade.” The other intended source of inter- austerity. Germany alternated between a balance- national liquidity—the resources of the fund— of-payments surplus that led to inflation and was also insufficient. austerity. ‘The second important difference between the The United States had an official settlements convertible Bretton Woods system and the inten- balance-of-payments deficit in 1958 that per- tions of the Bret ton Woods Articles was the evo- sisted, with the notable exception of 1968—69, lution of the adjustable peg system into a virtual until the end of Bm’etton Woods. See figui-e 14. fixed exchange rate system. Between 1949 and With the exception of 1959, however, the 1967, vet-y few changes in parities of the Group United States had a current account surplus of Ten countries occurred.’~The only excep- until 1970. The balance-of-payments deficit tions were the Canadian float in 1950, devalua- under Bretton Woods arose because capital out- tions by France in 1957 and 1958, and minor flows exceeded the current account surplus. In revaluations by Germany and the Netherlands in the early postwar years, the outflow consisted 1961. The adjustable peg system became tess largely of foreign aid. By the end of the 1950s, adjustable because the monetary authorities, private long-term investment abroad (mainly based on the 1949 expeiience, were unwilling direct investment) exceeded military expendi- to accept the risks associated with discrete tures abroad and other official transfers.” changes in parities—loss of prestige, the likeli- The balance-of-payments deficit was perceived hood that others would follow and the pressure as a problem by the U.S. monetary authorities (if speculative capital flows if even a hint of a because of its effect on confidence. As official change in parity were present. dollar liabilities held abroad mounted ivith suc- As the system evolved into a fixed exchange cessive deficits, the likelihood increased that rate gold dollat- standard, the three key prob- these dollars would be converted into gold and lems of the interwar system reemerged: adjust- eventually the U.S. monetary gold stock would ment, liquidity and confidence. These problems reach a point low enough to triggel a run. dominated academic and policy discussions dur- tndeed the U.S. monetary gold stock by 1959 ing the period. equalled total external dollar liabilities and the rest of the world’s monetary gold stock exceeded that of the United States. See figure 13. By 1964 The Adjustment Problem official dollar liabilities held by foreign mone- tary author-ities exceeded the U.S. monetary The adjustment issue focused on how to achieve gold stock. it in a world with capital controls, fixed exchange rates and domestic policy autonomy. Various pol- A second reason the balance-of-payments icy measures were proposed to aid adjustment, deficit was perceived as a problem was the dol- including income policies, rescue packages, capi- lar’s role in providing liquidity to the rest of the tal and trade controls, a mix of monetary and world. Elimination of the U.S. deficit would cre- fiscal policy, and the injection of new liquidity. ate a i-vorldwide liquidity shortage. “See Triffin (1960) and Gilbert (1968). “The Group of Ten countries were Belgium, Canada, France, West Germany, Italy, Japan, the Netherlands, Sweden, United Kingdom, and the United States. Switzer- land was an associate member. “See Eichengreen (1991c). MARCH/APRIL 1993 170 Figure 14 Balance of Payments: United States, 1950-1 971 Millions of U.S. dollars 8,000- 4,000 - 0- ii -4,000- -8,000 - -12,000- Short-Term Capital — Current Account -16,000- Long-Term Capital — Change in Reserves -20,000- —r IIII I IIII III 195051 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 For the Europeans, the U.S. balance-of- the real price of gold had declined since 1934. payments deficit was a problem for different The capital gains earned on the revaluation of reasons. First, as the reserve currency country, the world’s monetary gold reserves would be the United States did not have to adjust its sufficient to retire the outstanding dollar (and domestic economy to the balance of payments. sterling) balances. Once the United States As a matter of routine, the Federal Reserve returned to balance-of-payments equilibrium, automatically sterilized dollar outflows. The the world could return to a fully functioning asymmetry in adjustment was resented. The classical gold standard.’” Germans viewed the situation as the United Some economists argued that the U.S. balance- States exporting inflation to surplus countries of-payments deficit was not really a problem. through its deficits. Their remedy was for the The rest of the world held dollars voluntarily United States (and the United Kingdon) to pur- because of their valuable service flow; the sue contractionary monetary and fiscal policy.” deficit was demand determined.” In fact, U.S. inflation was less (on a GNP- weighted average basis) than that of the rest of The policy response of the U.S. monetary the Group of Seven countries before 1968. See authom-ities was fourfold: to impose controls on figures 1 and 15. The French resented U.S. capital exports; to institute measures to improve financial dominance and the seigniorage they the balance of trade; to alter the monetary fis- believed the United States eained on its out- cal policy mix; and to employ measures to stem standing liabilities. Acting on this perception, the conversion of outstanding dollais into gold. the French in 1965 began to systematically con- vert outstanding dollar liabilities into gold. The During this period, var-ious solutions to the French solution to the dollar problem was to U.S. adjustment problem were proposed: provi- double the price of gold—the amount by which sion of an alternative international reserve “See Emminger (1967). “See Rueff (1967). 1 ”See Despres, Kindleberger and Salant (1966). FEDERAL RESERVE BANK OF ST. LOUIS 171 Figure IS Inflation Rates in the United States, Gland G7 Excluding the United States, 1951 -1 973 Percent 14 12 10 8 6 4 2 0 195152535455565158596061626364656667686970717273 media to increase world liquidity; an increase in The Liquidity Problem the price of gold, either unilaterally, which would devalue the dollar against other currencies, or by The liquidity problem, posed by Rohert ‘I’riffin a uniform change in all parities as under Att. IV; and others, evolved from a shortfall of mone- and increased exchange rate flexibility.b0z tary gold beginning in the late 1950s. The real price of gold had been falling since World War II and would eventually reduce world gold The U.S. balance-of-payments policies were in production. This happened in the early 1950s the main ineffective.” As long as the United hut was offset by new sources of production. States maintained relatively stable prices, as it Gold production declined again in 1966. More- did before 1965, the system could be preserved over, the falling real price would stimulate pri- for a number of years. ‘the real pt-oblem was vate demand for gold and it seemed unlikely that of the gold exchange standard—a convet-ti- that Russian gold sales would make up much of bility crisis was ultimately inevitable. ‘The twin the shotifail. The prospect of the world nione- solutions advocated at the time of an increase in tary gold stock growing enough to finance the the price of gold and an increase in world liquidity growth of world real output and the value of by creation of an artificial reserve asset would trade (without deflation) seemed dim. As can not have permanently eradicated the problem. ‘°~ clearly be seen in figure 16 for the Group of “The official view, which was strongly opposed to increased Bordo and ElIson (1985). Moreover, an increase in world exchange rate flexibility, is in marked contrast to the aca- liquidity by an artificial reserve asset, if convertible into demic view, which by the end of the decade was solidly in gold, would not remove the basic convertibility problem. favor of increased flexibility, as evident at the famous Bur- See McKinnon (1988). Finally as Townsend (1977), Salant genstock Conference. See HaIm (1970) and also Johnson (1983) and Buiter (1989) point out, the gold exchange (1972a). standard as a type of commodity stabilization scheme is bound to collapse in the face of unforeseen shocks, See “See Mettzer (1991). 4 Garber (1993). According to Meltzer (1991), however, a 50 ‘° Evenat a higher gold price, world gold production would percent gold revaluation would have succeeded in preserv- eventually be inadequate to produce long-run price stabil- ing the Bretton Woods system well into the 1970s had the ity. In the long-run, when account is taken of gold as a United States not followed an inflationary policy in the late durable exhaustible resource, deflation is inevitable. See 1960s. MARCH/APR1L 1993 172 Figure 16 The Growth of the Monetary Gold Stock, the Growth in International Reserves and the Growth of the Volume of Real Trade and Real Income, G7, 1951-1973 Percent 50 45 40 35 30 25 20 15 10 5 0 -5 Change in Monetary Gold Stock -10 I III I 195152 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 Seven countries, this was the case. A large gap The Confidence Problem opened in 1958 between the gr-owth of output and the volume of trade and the growth of The perceived key problem of the convertible Bret ton Woods period was the confidence crisis Group of Seven gold reserves. As can he seen in 5 figure 17, the shortfall for the Group of Seven for the dollar.b0 As argued by ‘I’riffin (1960), countries, excluding the United Slates, was made Kenen (1960) and Gilbert (1968), the gold-dollar up by a drain on the U.S. monetary gold system that evolved after 1959 was bound to be reserves until 1966. dynamically unstable if the growth of the world monetary gold stock was insufficient to finance As Triffin (1960) pointed out, dollars supplied the growth of world output and trade and to by the U.S. deficit could not be a permanent prevent the U.S. monetary gold stock from solution to the impending gold shortage because declining relative to outstanding U.S. dollar lia- with continuous deficits, U.S. nionetary gold bilities. ‘I’he pressure on the U.S. tnonetary gold reserves would decline both absolutely and rela- stock would continue, as growth of the world tively to outstanding dollar liabilities until an monetary gold stock declined relative to the eventual convertibility crisis. Should the 1.1.5. growth of world output and trade and as the monetary authorities close the deficit hefot-e world substituted dollars for gold, until it trig- such a crisis, however, it would create a mas- gered a confidence crisis that led to the collapse sive shortage of international liquidity and the of the system, as occurred in 1931. At the same prospect of wot-Id deflation. New sources of time, however, as feat-s over U.S. gold converti- liquidity were required, answered by the crea- hility threatened the dynamic stability of the tion of the special drawing rights in 1967. B)’ Bretton Woods system, gold still served two the tine SDRs were injected into the system in positive roles. 1970, however, they exacerbated workhvide Gold was the numeraire of the system; all inflation - “Although according to Meltzer (1991), there is little evi- rise significantly relative to trade weighted real interest dence in asset markets through the 1960s of a growing rates. Nor did the gold and foreign exchange markets sug- loss of confidence in the dollar. Real interest rates did not gest a flight from the dollar. FEDERAL RESERVE BANK OF ST. LOUIS 173 Figure 17 The Growth of the Monetary Gold Stock, the Growth in International Reserves and the Growth of the Volume of Real Trade and Real Income, G7 Minus the United States, 1951-1973 Percent 80 70 60 50 40 30 20 1951525354555657585960616263646566676869707172 73 currencies were anchored to its fixed price ceeding months, the London Gold Pool, which through the U.S. comniitment to peg its price. agreed to buy or sell gold to peg the price at Until 1968 gold still served as backing to the $35 an ounce, was formed between the United U.S. dollar with a 25 percent gold reserve States and seven other countries. The pool requiremnent against Federal Reserve notes; the became official in November 1961. For the next requirement mnay have served as a brake on six years, it succeeded in stabilizing the price of U.S. monetary expansion. gold but did not prevent a steady decline in the ‘the first glimpse of a confidence crisis was U.S. monetary gold stock. See figure 13. In fact, though the central banks in the seven other the gold rush of October 1960 when speculators pushed the free market price of gold on the countries supplied 40 percent of the gold London market up from $35.20 (the U.S. ‘treas- required to stabilize the price of gold, they ury’s buying price) to $40. See figure 18. This replenished their monetary gold stocks outside first significant runup in gold prices since the the pool by converting outstanding dollar London gold market was reopened in 1954 was balances into gold at the U.S. Treasury.” supposedly triggered by concet-ns over a Democratic During the period 1961—67, the United States victory in the 1960 U.S. Presidential election. niade a series of arrangemnents to protect its U.S. monetary authorities feared that private monetary gold reserves. These included a net- speculation in the gold market might spill into work of swap arrangements with other central official demands fom conversion. Consequently, banks, the issue of Roosa bonds, and moral sua- remedial action was taken quickly. The Tmeas- sion. France, however, did not go along with ury supplied the Bank of England sufficient gold these efforts and began its campaign against the to restore stability, and the monetary authori- dollar in February 1965. ties of the Group of ‘len countries agreed to refrain from buying gold above $35.20. In suc- The period was marked by two sets of under- “See Meltzer (1991). MARCH/APRIL 1993 174 Figure 18 London Gold Price Dollars per ounce 44 43 42 41 40 39 38 37 36 35 34 195455 56 57 58 59 60 61 62 63 64 66 66 67 68 69 70 71 72 lying forces that would undermnine the dollar’s March 1968 the Gold Pool lost $3 billion in gold, relationship to gold—gm-owing gold scarcity and with the U.S. share at $2.2 billion.” The a rise in U.S. inflation. World gold production immediate concerns of the speculators may leveled off in the mid-1960s and even declined have been fears of a dollar devaluation, but in 1966, while at the same time private demand according to Gilbert and Johnson, it reflected soared, precipitating a drop in the world mone- the underlying gold scarcity.” In the face of tary gold stock after 1966. Indeed, beginning in the pressure, the Gold Pool was disbanded on 1966,, the London Gold Pool became a net seller March 17, 1968, and a two-tier arrangement of gold. Also, U.S. money growth accelerated in replaced it. Henceforth, the monetary authori- 1965, in part to finance the Vietnam War, and ties of the Gold Pool agreed neither to sell nor inflation began to rise (figures 1 arid 15). ‘I’he to buy gold from the market. They would trans- current account surplus began to deteriorate in act only among themselves at the official $35 1964 (figure 14), as did U.S. competitiveness, price. In addition, on March 12, 1968, the mirrored in a rise in the ratio of U.S. unit labor United States removed the 25 percent gold costs relative to trade weighted unit labor 7 reserve requirement against Federal Reserve costs.” The balance-of-payments deficit wor- notes. The key consequence of these new sened between 1964 and 1966 but was reversed arrangenients was that gold was demonetized at in 1966 by capital inflows triggered by tight the mat-gin. The link between gold production monetary policy. and other market sources of gold and official After the devaluation of sterling, which the reserves was cut. Moreover, in the following United States tried unsuccessfully to prevent, years, the United States put considerable pres- pressure mnounted against the dollar via the sure on other mnonetary authorities to refrain London Gold mam-ket. From December 1967 to from converting their dollar holdings to gold. “See Meltzer (1991). “See Solomon (1976). “See Gilbert (1968) and Johnson (1968). FEDERAL RESERVE BANK OF ST. LOUIS 175 By 1968 the international monetary system to enforce the par value system. It did not, had evolved very far indeed from the model of however, have sufficient power to prevent the architects of the Articles of Agreemnent. Tn devaluations by major countries and its financial reaction to both developments in financial mar- resources were too limited to provide adequate kets and the confidence problem, the system adjustment assistance for them. The IMF still had evolved into a de facto dollar standard. had an important role as a clearinghouse for Gold convertibility, however, still played a role. different views on monetary reform, as a center Though the major industrial countries tacitly of information, as the principal voice for the agreed not to convert their outstanding dollar countries of the world other than the Group of liabilities into U.S. monetary gold, the threat of Ten countries, as these countries’ primary their doing so was always present. At the same source of adjustment assistance and finally as time, as the countries of continental Europe and an important partner in the major Group of Japan gained economic strength relative to the Ten rescue packages. United States, they became more reluctant to absorb outstanding dollars. They also were In sum, the problems of the interwar system reluctant to adjust theim surpluses by revaluing that Bretton Woods was designed to prevent their currencies, increasingly coming to believe reemerged with a vengeance. ‘the fundamental that adjustment should be undertaken by the difference, however, was that the system was United States. not likely to collapse into deflation as in 1931 but rather explode into inflation. The system had also developed into a de facto fixed exchange rate system. Unlike the classical gold standard, however, where the fixed exchange THE COLLAPSE OF BRETTON rate was the voluntary focal point for both WOODS internal and external equilibrium, in the Bretton Woods system exchange rates became fixed After the establishment of the two-tier arrange- because members feared the consequences of ment, the world monetary system was on a defacto allowing them to change. Nevertheless, because dollar standard. The system became increasingly of increased capital mobility, the pressure for unstable until it collapsed with the closing of altering the parities of countries with persistent the gold window in August 1971. ‘the collapse deficits and surpluses became harder to stop of a system beset by the fatal flaws of the gold through the use of domestic policy tools and the exchange standard and the adjustable peg was aid of international rescue packages. Pressure triggered by an acceleration in world inflation, increased from both academnic and official in large part the consequence of an earlier sources for greater exchange rate flexibility. acceleration of inflation in the United States. Before 1968, the U.S. inflation rate was below that of the GNP weighted inflation rate of the By 1968, the system had also evolved a form Group of Seven countries excluding the United of international governance that was quite dif- States (see figure 15). It began accelerating in ferent fm’om that envisioned at the beginning. 1964, with a pause in 1966—67. The increase in Instead of a community of equal currencies inflation in the United States and the rest of the managed by the TMF, the system was managed world was closely related to an increase in by the United States in cooperation with the money growth and in money growth relative to other members of the Group of Ten countries. the growth of real output. (See figures 19 and In many respects, it was closer to the key cur- 20.) Indeed, a prevalence of excess demand rency system proposed by Williams.” shocks in the mid- and late 1960s is apparent for the United States and other Group of Seven According to Dominguez (1993), the IMF was countries in figures 11 and 12. designed to facilitate international cooperation by serving as a commitment mechanism. It was Darby et al (1983) provided considerable evi- to use its influence and its financial dence on the transmission of inflation in the “See Williams (1936 and 1943) and Johnson (1972b). MARCH/APRIL 1993 176 Figure 19 Money (Ml) Growth Rates in the United States, Gland G7 Excluding the United States, 1951-1913 Percent 26 24 22 20 18 16 14 12 10 8 6 4 2 0 -2 195152535455565758596061626364656661686970717273 Figure 20 Money (Ml) Less Real Output Growth in the United States, Gland G7 Excluding the United States, 1951-1973 Percent 0.25 0.2 0.15 0.1 0.05 0 -0.05 -0.1 195152 53 54 55 56 57 58 59 50 61 62 63 64 65 66 67 68 69 70 71 72 73 FEDERAL RESERVE BANK OF ST. LOUIS 177 Bretton Woods system. Their regression anal- in response to rapid monetary expansion and yses led to a number of important conclusions. Regulation Q was suspended for large certifi- First, U.S. inflation was caused by lagged U.S. cates of deposit, the borrowed funds returned money growth. Second, U.S. money growth was abroad and the deficit grew to $9 billion, independent of changes in international exploding to $30 billion by August 1971 (see fig- reserves.~~?thebalance of payments had no effect ure 14). The dollar flood increased the reserves on the Federal Reserve’s reaction function. of the surplus countries, auguring inflation. Ger- Third, U.S. money growth had strong and sig- man money growth doubled from 6.4 percent nificant effects on money growth in seven to 12 percent in 1971, and the German inflation mnajor countries. These lags were very long— rate increased from 1.8 percent in 1969 to 5.3 up to four years—and reflected the fact that percent in 1971.”~Pressure mounted for a central banks in the seven countries sterilized revaluation of the mark. In April 1971 the dol- reserve flows partially. Finally, money growth lar inflow to Germany reached $3 billion. On in the seven countries explained inflation in May 5, 1971, the German central bank sus- these countries with a significant lag.” pended official operations in the foreign exchange market and allowed the deutsche The key transmission mechanism of intiation mark to float. Similar action by Austria, Bel- was the classical price specie flow mechanism gium, the Netherlands and Switzerland fol- augmented by capital flows. Little evidence for lowed.1~5 other mechanisms including commodity market arbitrage was detected.” According to these In the following months, many began advocat- authors, the Bretton Woods system collapsed ing ending the dollar’s link with gold. In April because of the lagged effects of U.S. expansion- 1971, the U.S. balance of trade turned to deficit ary monetary policy. As the dollar reserves of for the first time and influential voices began Germany, Japan and other countries accumu- urging dollar devaluation. The decision to sus- lated in the late 1960s and early 1970s, it became increasingly more difficult to sterilize pend gold convertibility was triggered by French and British intentions in early August to them. This fostered domestic monetary expan- convert dollars into gold. On August 15 at Camp sion and inflation. In addition, world inflation David, President Nixon announced that he had was aggravated by expansionary monetary and directed Secretary Connolly “to suspend temn- fiscal policies in the rest of the Gmoup of Seven countries, as their governments adopted full- porarily the convem-tibility of the dollar into gold or other reserve assets.” The accompanying pol- employment stabilization policies. The only icy package included a 90-day wage-price alternative to importing U.S. inflation was to freeze, a 10 percent import surcharge and a 10 float—the route taken by all countries in percent investment tax credit.”’ 1973.” The crisis mounted from 1968 to 1971. The ‘I’he U.S. decision to suspend gold convertibil- U.S. current account balance continued to ity ended a key aspect of the Bretton Woods deteriorate in 1968, but the overall balance of system. i’he remaining part of the system—the payments exhibited a surplus in 1968 and 1969 adjustable peg—disappeared 19 months later. thanks to a large short-term capital inflow. The capital inflow was activated by events in the The Bretton Woods system collapsed for three eurodollar market. In the face of tight monetary basic reasons. First, two major flaws under- policy in 1968—69 and Regulation Q ceilings on mined the system. One flaw was the gold time deposits, deposits shifted from U.S. banks exchange standard, which placed the United to the eurodollar market. U.S. banks in turn States under threat of a convertibility crisis. In borrowed in the eurodollar market, repatriating reaction it pursued policies that in the end these funds. In 1970, as U.S. interest rates fell made adjustment more difficult. “See Darby et al (1983) (1987) and Eichengreen (1992b). 4 “See Darby et al (1983). “ See Meltzer (1991). ‘“Except for the case of Japan, there is little evidence for “See Solomon (1976). the leading alternative explanation for the collapse—that it “See Solomon (1976). reflected growing misalignment in real exchange rates between the united States and her principal competitors in the face of differential productivity trends. See Marston MARCH/APRIL 1993 178 The second flaw was the adjustable peg. Because to Giovannini (1993), the Bretton Woods system the costs of discrete changes in parities were was an asymmetric solution to Mundell’s n-i deemed high, in the face of growing capital currency problem.” The United States as the mobility, the system evolved into a reluctant nth country, had to mnaintain the nominal fixed exchange rate system without an effective anchor by following a stable monetary policy. In adjustment mechanism. addition, it had to supply the dollars demanded by the rest of the world as reserves. Finally, U.S. monetary policy was inappropri- ate for a key currency. After 1965, the United The rest of the world had to accept, through States, by inflating, followed an inappropriate its comnmnitment to fixed parities, the price level policy for a key currency country. Though the set by the United States. But because of the ad- acceleration of inflation was low by the stand- justable peg, it had the option to change parities. ards of the following decade, when superim- ‘the rule was defective for the nonreserve cur- posed on the cumulation of low inflation since rencies because the fundamental disequilibrium World War II, it was sufficient to trigger a contingency was never spelled out and no con- speculative attack on the world’s monetary gold straint was placed on the extent to which domestic stock in 1968, leading to the collapse of the financial policy could stray from maintaining ex- Gold Pool.” Once the regime had evolved into ternal balance. In addition, with growing capital a de facto dollar standard, the obligation of the mobility, the option to change parities became United States was to maintain price stability. less viable. Instead, it conducted an inflationary policy, For the United States this rule suffered from which ultimately destroyed the system. a number of fatal flaws. First, because of the fear of a confidence crisis, the gold convertibil- ity requirement may have prevented the United DID THE BRETTON WOODS States in the early 1960s from acting as a center SYSTEM OPERATE AS A SYSTEM country and willingly supplying the reserves BASED ON CREDIBLE RULES? demanded by the rest of the world. Second, as became evident in the later 1960s, this require- One can view the Bretton Woods system as a ment was useless in preventing U.S. monetary set of rules or commitment mechanisms.” For authorities from pursuing an inflationary policy. nonreserve-currency countries the rules were to Finally, although a mechanism was available for maintain fixed parities, except in the contin- the United States to devalue the dollar, mone- gency of a fundamental disequilibrium in the tam-y authorities were loath to use it for fear of balance of payments, and to use fiscal policy to undermining confidence. No effective enforce- smooth out short-run distut-bances. The U.S. ment mechanism existed. Ultimately, the United enforcement mechanism—access to its open cap- States attached greater importance to domestic ital markets—was presumably its dominant economic concerns than to its role as the center power because the IMF had little power. of the international monetary system. For the United States, the center country, the Thus although the Bretton Woods system can rule was to fix the gold pm-ice of the dollar at $35 be interpreted as one based on rules, the system per ounce and to maintain price stability. If a did not provide a credible commitment mech- 20 majority of Bretton Woods members (and every anism.1 The United States was unwilling to member with 10 percent or more of the total quotas) subsume domestic considerations to the respon- agreed, however, the United States could change sibility of maintaining a nominal anchor. At the the dollar price of gold. There was no explicit same time, other Group of Seven countries enforcement mechanism other than reputation and became increasingly unwilling to follow the dic- the commitment to gold convertibility. According tates of the U.S—imposed world inflation rate. “See Garber (1993). ‘18 See Mckinnon (1992) for his version of the rules of the Bretton Woods Articles and the dollar standard. Also see Giovannini (1993) and Obstfeld (1993). “See Mundell (1968). “Giovannini’s (1993) calculations show that during the Bret- ton Woods convertible period credibility bounds on interest rates for the major currencies, in contrast to the classical gold standard, were frequently violated. FEDERAL RESERVE BANK OF ST. LOUIS 179 The failure of the Bretton Woods m-ule sug- renewed gold standard. In this paper I do not gests a number of m-equirements for a well- consider the mci-its or drawbacks of policy designed fixed exchange rate system. These coordination in genem-al, but I examine the EMS include the following: briefly as a monetary regime similar to Bretton Woods.” Of interest is whether lessons for the • that the countries follow similar domes- international monetary system can be derived tic economic goals (underlying inflation from its experience. rates); The EMS, like the Bretton Woods system, • that the rules be transparent; and represents an agreement among countries to set • that some central monetary authority exchange rate parities, to manage intra-European enforce them. Community exchange rates and to finance exc- The recent EMS system was quite successful for hange market intervention. Like Bretton Woods, it is an adjustable peg system. a number of years because it seemed to encom- pass these three elements. Its recent crisis, how- The origins of the EMS date back to the Bretton ever, reflected the emergence of some of the Woods period. The case for stable exchange same problems that led to the breakdown of rates within Europe was made in the context of Bretton Woods. I discuss these issues below in the European Common Market (EEC). In addi- the following subsection. tion to a strong dislike by Europeans for flexible exchange rates—based on their perception of inter- war experience and their belief that exchange POST BREflON WOODS: MANAGED rate volatility reduces trade in highly open FLOATING AND THE EMS economies—the key motivation for extensive policy coordination to stabilize exchange rates As a reaction to the flaws of the Bretton Woods was the common agricultural policy established system, the world turned to generalized floating in 1959.123 exchange rates in March 1973. Though the eatly years of the floating exchange rate were often Food prices in the comnmunity at-c set in terms characterized as a dirty float, whereby mone- of a central unit of account (the ECU) but quoted tary authorities extensively intervened to affect in local currency. Consequently, any changes in both the levels of volatility arid exchange rates, exchange rates lead to changes in local prices. by the end of the 1970s it evolved into a system During the Bretton Woods era, a system of sub- where exchange market intervention occurred sidies and taxes was worked out to insulate the primarily to smooth out fluctuations. Again in local economy from policy realignments. ‘I’his the i980s exchange market intervention was led to an asymnmetm’ic adjustment between hard used by the Group of Seven countries as part of currency countries reluctant to lower their a strategy of policy coordination.” In recent agricultural prices and soft curm’ency countries, years, floating exchange rates have been assailed which allowed their prices to rise. The result from many quarters for excessive volatility in was overproduction of agricultural products both nominal and real exchange rates, which in and an ever-increasing fraction of the EEC turn increase macroeconomic instability and budget allocated to subsidize agriculture. raise the costs of international transactions. Early attempts to stabilize intra-European The attack cites the favorable experience of exchange rates during the Bretton Woods era the EMS from 1987 to 1991 in producing ex- were unsuccessful, as was the Snake in the change rate and price stability as a recommen- Tunnel agreement of the 1970s. The EMS, estab- dation for a return to a global system of fixed lished in 1979, was a formal attempt to overcome exchange rates. It is argued that recent attempts earlier obstacles to exchange rate stabilization. at policy coordination can be formalized and ex- It was designed to prevent the defects of the tended to a more general managed system based Bretton Woods system, including: the asymmetric on either close policy coordination (to keep ex- adjustment mechanism, with the United States change rates within specified target zones) or a as the center, setting the tune fom- the rest of ~2’ See Bordo and Schwartz (1991). 2 “ See Feldstein (1988) and Bordo and Schwartz (1989a). “See Giavazzi and Giovannini (1989). MARCH/APRIL 1993 180 the world; the problems associated with grow- ments disequilibration. The medium termn finan- ing capital mobility; and the dramas of parity cial assistance (MTFA) would provide longer realignments. Instead, the EMS designed a set of term support. intervention rules that would produce a symn- mnetric system of adjustment; create a mechanusm Unlike Bretton Woods, where members (other to finance exchange market interventions; and than the United States) could effectively decide establish a codeof conduct for realigning parities.”4 to unilaterally alter theim parities, changes in central parities were to be decided collectively. Like Bretton Woods, the EMS was based on a Finally, like Bretton Woods, members could (amid set of fixed parities called the exchange rate did) impose capital controls. These have recently mechanism (ERM). Each country was to estab- been phased out. lish a central parity of its currency in terms of The evidence on the performance of the EMS ECU, the official unit of account. The ECU con- indicates that it was successful in the latter half sisted of a basket containing a set number of of the 1980s at stabilizing both nominal and real units of each currency. As the value of curren- exchange rates within Europe, at producing credi- cies varied, the weights of each country in the ble bilateral bands and at reducing divergence basket would change. A parity grid of all between members’ inflation rates.” bilateral rates could then be derived from the ratio of members’ central rates. Again, like Bret- Giavazzi and Pagano (1988), Giavazzi and ton Woods, each currency was bounded by a Giovannini (1989), and Giovannini (1989) make a set of margins of 2.25 percent on either side of strong case that the success of the EMS was parity, creating a total band of 4.5 pet-cent (for largely due to the fact that it was an asymmet- Italy, and later the United Kingdom, when it ric system with Germany acting as the center joined the ERM in 1990, the margin was set at 6 country. The other EMS members adapted their percent on either side of parity). ‘t’he monetary monetary policies to maintain fixed parities with authorities of both the depreciating and appre- Germany. Also, according to the aforementioned ciating countries were required to intervene writers, the Bundesbank exhibited a strong credi- when a currency hit one of the margins. Coun- hle commitment to low inflation and the other tries were also allowed, but not required, to members of the ERM, by tying their currencies undertake intramarginal intervention. The indi- to the deutsche mark, used an exchange rate cator of divergences, which measured each cur- target as a commitment mechanism to success- rency’s average deviation from the central fully reduce their own rates of inflation. Evidence parity, was devised as a signal for the monetary for the asymmetry hypothesis is based on the authorities to take policy actions to strengthen fact that the Bundesbank intervened only when or weaken their currencies. It was supposed to bilateral exchange rates were breached, whereas work smnietrically. the other countries engaged in intra-marginal intervention, and on evidence of asymmetrical Intervention and adjustment was to be behavior of interest rates in Germany and the financed under a complicated set of arrange- other EMS countries. In the period preceding ments. i’hese arrangements were designed to several EMS realignments, non-German EMS overcotne the weaknesses of the IMF’ during interest rates changed drastically, whem-eas no Bretton Woods. ‘the very short-term financing change was observed in their German counter- facility (\T5~’t’F)was to provide credibility to the part. Evidence that the Bundesbank’s reputation bilateral pam-ties by ensuring unlimited financing was responsible for the disinflation of the 1980s for marginal intervention. It provided automatic is based on an out-of-sample simulation of a unlimited lines of ct-edit from the creditor to VAR to pmedict the inflation rate. Downward the debtor members. The short-term monetary shifts in the predicted values of inflation for a support (STMS) was designed to provide short- number of countries after the advent of the term finance for temporary balance of pay- EMS makes the case. That inflation expectations ‘“See Giavazzi and Giovannini (1989). ‘21 At its outset, there was considerable doubt that the EMS would be successful at withstanding the strains of greatly divergent money growth and inflation rates among its members. See Fratianni (1980). See Giavazzi and Giovan- nini (1989); Fratianni and von Hagen (1990 and 1992); and Meltzer (1990). FEDERAL RESERVE BANK OF ST. LOUIS 181 were significantly reduced only in France and The fundamental causes of the crisis, like Italy several years after the advent of the EMS the crises that plagued Bretton Woods, lay in (the argument goes) may reflect slow learning large part with the exchange rate system. The or alternatively that these countries used the EMS, like Bretton Woods, is a pegged exchange EMS to justify following unpopular austerity rate system that requires member countries to policies. follow similar domestic monetary and fiscal policies and hence have sintilar inflation rates. Fratianni and von Flagen (1990 and 1992) dispute This is difficult to do in the face of both differ- both the asymmetry and the imported disinflation ing shocks across countm-ies and differing national hypotheses.” Evidence based on Granger causal- priorities. Under Bretton Woods, capital con- ity tests from a structural VAR suggests that the trols and less integrated international capital German monetary base was not insulated from markets allowed members to follow divergent other EMS base movements nor were non-German policies for considerable periods. Under the EMS monetary bases insulated by the German EMS, the absence of controls (after 1990) and monetary base from external shocks. In this the presence of extremely mobile capital meant interpretation, the EMS is a coordinated mone- that any movement of domestic policies away tary policy system with all members playing from those consistent with maintaining pam’ity a role. would quickly precipitate a speculative attack. Also, just as under Bretton Woods, the adjusta- Finally, Fratianni and von Hagen (1990) pro- vide evidence that the EMS has reduced intra- ble peg in the face of such capital mobility European exchange rate volatility; however, this became unworkable. Thus the difference reduction has been at the expense of increased between the two regimes when faced with volatility of non-EMS currencies. Thus they asymmetric shocks or differing national priori- argue that the EMS is on net balance beneficial ties was the speed of reaction by world capital to welfare because intra-EMS trade exceeds markets. external trade. They also show that although the advent of the EMS has not reduced inflation Though the fundamental cause of the crisis uncertainty relative to non-EMS countries, it has was similar in the two regimes, the source of reduced the effects of fomeign inflation shocks the problem differed. tinder Bretton Woods, the shock that led to its collapse was an accelera- on the mnemnbers. tion of inflation in the United States, ostensibly Despite its favorable performance since the to finance the Vietnam War’, as well as social mid—1980s, the EMS was recently subjected to policies, and to maintain full employment. the same kinds of stress that plagued Bretton Under the EMS, the shock was bond financed Woods. September 1992 and November 1992 German reunification and the Bundesbank’s sub- marked a series of exchange rate crises in sequent deflationary policy. In each case, the Europe that paralleled the events of 1967 to system broke down because other countries 1971. Precipitated by concerns that French vot- were unwillimig to go along with the policies of ers would reject the Maastricht Treaty on Euro- the center coum1try..~l~hecommitments to price stability by both the center country and the 1jean Monetary Union in a referendum on September 20, speculators staged attacks early other members were not shown as credible. in the month on the Nordic curm-encies and then Under Bretton Woods, Germany and other west- later on the Italian lira, the British pound, the ern European countries were reluctant to French franc, and other weaker currencies. The inflate or revalue and the United States was crisis led to the disabling of the ERi~t.Both Italy reluctant to devalue. Under the EMS, the United and the United Kingdom left it while Spain, Kingdom, Italy, Spain, Portugal, Ireland and Portugal and Ireland reimposed or strengthened Sweden were unwilling to deflate amid Germany existing capital controls: in Novemnher Sweden was unwilling to revalue. As under Bretton floated and Portugal and Spain devalued. Woods, although the EMS had the optiomi for a “Also, Collins (1988) and Eichengreen (1992d) present evi- dence that EMS membership may not have been responsi- ble for reducing the inflation rates of EMS countries. Their cross-country regressions show that EMS membership had little effect on inflation performance. Changing public atti- tudes toward inflation within each country represent a more important determinant. See Giavazzi and Collins (1992). MARCH/APRIL 1993 182 general realignment, both imnproverl capital that were a multiple of those facing Bretton mobility and the Maastricht commitment to a Woods. It could also be due to greater flexibility unified currency made it an unrealizable of wages and prices and greater factor mobility outcome. before World War I, which meant that adjust- Thus the lesson from both the EMS and Bret- ing to the greater shocks did not have as serious consequences on real activity and employment ton Woods is that pegged exchange rate systemns do not work for long no matter how well they’ as later in the twentieth century. Alternatively, are designed. Pegged exchange rates, capital political economy factors—such as a more limited suffrage; less concern over the main- mobility and policy autonomy just do not mix. During the heyday of Bretton Woods years ago, tenance of full employment; limited understand- the case made for floating exchange rates for ing of the link between monetary policy and the major countries still holds. This is not to say level of economic activity; and hence loss of an that if Eum-opean countries wet-c completely will- incentive for monetary authorities to pursue ing to give up domestic policy autonomy, they policies that would threaten adherence to could not eventually form a currency union convertibility—could be responsible. These hypotheses clearly need mom-c investigation. with perfectly fixed exchange rates. In an uncertain world subject to diverse shocks, the It also could be due to regime design and costs fom- individual countries of doing so are especially the incentive compatibility features of apparently extremely high. the regime. The classical gold standard may have been so successful because of the credibility of CONCLUSION the commitment to the gold standard rule of convertibility and because of its neam universal This paper examines statistical evidence on acceptance. In turn, the credibility of the gold the performance of alternative monetary standard may stem fm’om the origins of gold as regimes over the past century. It also examines money and the importance of Great Britain, the some aspects of the history of these regitnes. most impom-tant commercial nation of the nine- Both statistical and histom-ical evidence may help teenth century, in enforcing the mules. England’s provide answers to the question why some commitment to convertibility in turn was aided regimes have been more successful than othem’s. by stabilizing private capital flows. They also have implications for current issues The classical gold standard for the core coun- in international monetary reform and the ongo- tmies worked as a contingent rule or a rule with itig debate over rules and discretion. escape clauses. As a consequence, it was flexible ‘the statistical evidence on performance of enough to withstand major shocks, It also ena- alternative monetary regimes in the second sec- bled governments to finance major wars flexi- tion leads to the conclrtsion that the Bretton bly, by allowing them to leave the gold standamcl Woods convertible regime from 1959 to 1970 and temporarily use seigniorage to finance was by far the best on virtually all criteria, but unusual government expenditures. The rule that the recent floating regime is not much may have endured because the requisite defla- worse. Indeed, it is clear that the performance tion required to restore convertibility after the of the regimes in the post—World War II era is emnergency had passed may not have had severe superior to the perlormance of m-egimes in the effects on real variables. This may have been preceding half century. Finally, though the clas- because wages and prices were highly flexible. sical gold standard does relatively poorly in Alternatively the deflation accomnpanying re- terms of the stability of real variables, it per- sumption may have had significant real effects formed best on inflation persistence and financial hut no political constituency strong enough to miiarket integm’ation—evidence for the successful oppose it existed. operation of gold as a nominal anchor. The classical gold standard collapsed under’ This evidence leads to the following question: the unprecedented shocks of World War I. It Why was Bretton Woods so stahle yet so fragile was reinstated as the short-lived gold exchange and the classical gold standard so unstable and standard. Its hrief life reflected the fatal flaws yet so durable? ‘l’he ansiver may he due in part made famous by the ‘t’riffin dilemma. But regard- to the shocks the two regimes faced. This, how- less of the weakmiess of the gold exchange stan- ever, seemns unlikely because the gold standard dard, it suffered from the absence of an effec- was subject to both supply and demand shocks tive comnmnitnient mechanism. ‘there was no cen- FEDERAL RESERVE BANK OF ST. LOUIS 183 ter country to enfom’ce the rule, just three rivals September and November 1992, however, the pulling in different directions. Also, it was the durability of such an arrangement seems doubt- beginning of an era when countries were less ful, as was the case for Bm’etton Woods, in an willing to go along with the gold convertibility uncertain world subject to diverse shocks rule because they attached greater weight to where national priorities can change and com- the objective of domestic economic stability. mitmnents can be broken. Some have amgued that the EMS can be preserved only by precom- The Bm’etton Woods system was set up to pre- mitment to price stability and fixed exchange vent the perceived flaws of the classical gold rates by independent central banks.’” Others standard and the trauma of the interwar argue that the only solution is rapid movement period. The Bretton Woods adjustable peg was to a unified currency enforced by a European in some respects similar to the gold standard central bank.” As Feldstein (1992) points out, contingent rule, but it invited speculative however, full-fledged monetary union com- attacks, hence compromising its role as an pletely precludes the use of domestic monetary escape clause. Bretton Woods evolved into a policy. To the extent that country-specific gold exchange standard fraught with the adjust- shocks dominate common shocks and labor is ment, liquidity and confidence problems of the relatively immobile between European coun- interwar period. Though the problems of the tries, the benefits of permanently fixed gold exchange standard could possibly have been exchange rates may riot outweigh the cost of corrected by raising the price of gold, as it turned increased economic dislocation.” out, it evolved into an asymmetric dollar stand- ard. The United States maintained the credible Finally, proposals for monetary reform, such commitment to a noninflationary policy for only as exchange rate target zones or targeting the a few years. By the mid-1960s it shifted to an real price of gold, though possibly of scientific inflationary policy to further its domestic inter- merit, would work only if nations are willing to ests. The rest of the world, faced with imported give up domestic autonomy and follow credible inflation, soon lost the incemitive to follow U.S. commitments. The history of international leadership and the system collapsed in 1971. monetary regimes casts doubt on the likelihood that the nations of the world will do so in the The advent of the general floating exchange forseeable future. rate system in 1973 and its longevity suggests that the lessons of Bretton Woods have been learned well. Countr’ies are not willing to sub- ject their domestic policy autonomy to that of REFERENCES another country of whose commitment they cannot be sure in a stochastic world nor to a Alogoskoufis, George S. and Ronald Smith. “The Phillips Curve, the Persistence of Inflation, and the Lucas Critique: supernational monetary authority they cannot Evidence from Exchange-Rate Regimes,” American control. 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MARCH/APRIL 1993 188 K ‘P,,. ~ ~ / \//\/~ / \A/ \/\ /~/ It, ~ ~ ~cFc~:’:t ~.< v~::; ~~ ~ ~“ ~ ~~ ~ ~r :~ ~ ~ ~tb~T~~ ~ttK ~ tQ?t~ K - - ~~i; C~-~H~ ,e ‘/ ‘\ -~ KLii. -iKafliI~s / Kr-~~ / e~ ~-3K~ ~ -~ ‘ -~ \,~\ KK9f~4t >K3K, ~ K~ /- -c -‘ 9 4 D<-~ N ~ -~ ~ IP ;~SI’4t~ IF -~ ~ I a-~*~~PS(S~-c ~tc~ -/ -~ ~~7i -c~ ~-KFitt Kcc ~‘ ~ -~ ~ C—- K 5~fl~—’/ k~ /-/ - tNc~\-, / n~eaoaar; -/ - - rn- /- / ,., - —air-- —~aia’ ‘ -~ -~-~ -~I~’-~- — —~--- -c-— — - --c -r—~- - ,- --a ~ / A -~ ~ - Ncfltt -~.-ccs—-c---’— A -r/------— N------N pa -~ ~s- ~-‘ a- —-ar ~vt -. t->t -‘ 1w-cK~ar ~ -N -7~ --4r’--—--Kes---’~-~ K---~ ~-. tn_ i~~~~--<. ~ -p ~ ---p /~ ~ ~ - t±- ~ - -- — --. — —— ~- - -9-c- —. , ~-~-c- 2~ ~ //~ ~ / ‘K ~ z~7~t-~~---- -c-c -N-_ -,- . p < ~ — k—wy a —--- —N ~ -c--c- N / N- s-c -- —,— ~ Ap / £-anv~: -N -cc A ~ -c- N- ~ A ~ 4Lck~a ~ ~ N//__N~7_- -c -N p ~ —~rs ~~- t- N -- /N-NAp~N A~ ~ -p~ /-c// ~~//4/~-~/~/ ~ --:: ~- ~ -- -c—~ - -c_/N ~_c/-p -c-Ks ~ -~4- / ~~~tet~-c ~ , ~ p - PS ~ - -c- ;~~t.4: ~ ~ -c ~ cc:~ ~ I C ~ - ~ ~iIJL ,I Nt 4: -: ~ - — ~ - N— / -- -~ ~- _tse__ /~~4/~cN/N/sA~. /-~ A * K N-p — ~ jfl~~ N- xfr -. - S -V /// / ~, - S ~N- / -N - -N - N--- /-~e-øN- A ~ -c/C ~ {aN-~N — 1 ~-: ~4~1- ~7/%7N ~ -~-c—t~~-/N/p-~-/-c - 1* ~ cb -~ // / - / ~ ~ -N NN 7;/ N/ I- ~~s~— N -- — -- ~-t~-t~--- -N- 4-/4 / ~-. --c~~ - / N - / -& -$~/t~ /t-/ //N / N~-c ~ ~ 7_— /-cc/ —N- -/ —~-% — N / NN N ~: ~ ~f// ij~~~J°4~~:: N-C -- - -~ A --Y<~-~ - ~N-~p - -t-/1- - -~--—:— -- -/- P--- —- -~ / - 4-c - / ~N- - N- N / -- /N-p/ — - - NN-/N-~ / -~—~ -- -/ - -- —1 - N N N7 N - N S - N - N fN N 7 N ~N N~ c’ ~ A -- -- N/ - -w —$~-c. - - - K -- - A ~-p-NN-N N~ N/- NN// -p / - // N a~- N - — - -~ / NC - N-P -cØ N- / N— ~ // - -~ ‘N- )~~/-~ . ~3cCN- ~ N - - -- -— ~-N- - / tC~ N p t~ ~34 N-c N- — -- —- --__.C~ - - —/ NN-/N- -~ N- -N- - -- - /N- N-~ N- - // N- ~t4N~7 - N- ~ t ~ N- 5~ N/~ ~ — / -. p N - ~r c N / N A - / -- K * -%-* N- t~t;~ ~-K /N-Ø.~ N~ - ~ /pN~~ p~ -cq a - --/K- - ~ N-~ N ~N- ~ -- NN- ~ FEDERAL RESERVE BANK OF ST. LOUIS 189 Appendix Figure 1 Supply and Demand Shocks: 1880-1989, Including the War Years, Annual Data, United States Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 Supply and Demand Shocks: 1880-1989, Including the WarYears, Annual Data, United Kingdom Percent 14 12 10 8- 6- 4- 2- -2 -4 -6 -8- -10- -12 -14 -16 -18 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 MARCH/APRIL 1993 190 Appendix Figure 1 (continued) Supply and Demand Shocks: 1880-1989, Including the WarYears, Annual Data, Canada Percent —1 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 Supply and Demand Shocks: l880-1989, Including the WarYears, Annual Data, Italy Percent 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 FEDERAL RESERVE BANK OF ST. LOUIS 191 Appendix Figure 1 (continued) Supply and Demand Shocks: 1880-1989, Including theWarYears, Annual Data, 04 Percent 1 —1 —1 -20- -24 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 MARCH/APRIL 1993