The History of FX: Part 3
Life after Bretton Woods
Negotiations to define a new monetary system in 1973 and 1974 proved unsuccessful due to the impossibility to achieve simultaneously monetary policy independence, fixed exchange rates and free capital flows. Therefore, each of the world’s economic powers decided to cope with the fall of Bretton Woods in a different way.
In the case of the U.S. policymakers decided to continue with the fiscal and monetary expansion in an attempt to achieve higher economic growth. The Federal Reserve continued to finance a large part of the fiscal deficit. One of its consequences was to weaken even more the role of USD as a valid international currency.
The countries of Western Europe, for whom cross border trade was exceptionally important and who’s Common Agricultural Policy could be seriously disrupted by exchange rate swings, wanted to peg their currencies to one another. Therefore Europeans defined a new regional monetary agreement, which began with the “snake” (a band that EEC countries’ currencies exchange rates could fluctuate against each other) from 1972 to 1978 and then to the European Monetary System (EMS) in 1979.
Deutsche Mark the new USD?
Economies of scale determined that the EMS became a reduced form of the Bretton Woods System with the deutsche mark at its centre. The selection of Germany as the central country was not political, but economical due to its very strong commitment against inflation. The rules of this new European system were the same as Bretton Woods, with Germany now providing a nominal anchor to the price level. Its weaknesses were also the same. Periphery countries faced a trade-off between domestic policies and exchange rate stability. For other economies that were unable to find a new monetary host they were forced to let their currencies “float”. Notable is JPY who saw a huge appreciation against USD from 360 Yen to USD in 1970 to less than 220 Yen to USD in 1979!
Exchange Rate Mechanism (ERM)
In 1979 the ERM was established. It was a fixed (but somewhat) adjustable, exchange rate system for the countries of the European Union (EU). The ERM was similar to the Bretton Woods system, except that it was not based on any currency or gold. The currencies were pegged to a monetary host known as the European Currency Unit (ECU) that was based on a weighted average of the participating countries in 1979. As with the Bretton Woods system, currencies were allowed to fluctuate around their entry rate (±2¼%) and realignments were allowed if the entry rate was obviously not right. This happened quite often to start with, but after the first few years the currencies had found their correct levels.
The Bank of England brought to its knees
GBP joined the ERM in October 1990. In hindsight it was the wrong time (as the UK was entering a recession) and at the wrong rate (£1 = 2.95 Deutsche Marks) which was too high. GBP was allowed larger band’s (plus or minus 6%), but by the summer of 1992 GBP was already hovering around the bottom of its band (£1 = 2.78 Deutsche Marks).
The rules of the ERM stated “that all members had to help struggling currencies stay within the permitted bands”. This meant buying GBP or cutting a countries interest rates to make GBP more attractive to investors and speculators. However, there was no point buying GBP when the effect would be small compared with the might of the global economy. It was because Germany’s interest rates were relatively high over the period 1990-92 that the UK had to keep their interest rates higher than they would have liked given that the UK was in the depths of a recession.
Get ready for the band to break!! The pressure was too much. Speculators continually sold GBP throughout early September 1992 and the only buyer was the UK government! On the 16th September 1992, the UK government lost over £7 billion buying GBP. One of the main “benefactors was the American investor George Soros whose Quantum Fund made in excess of 1 Billion USD selling GBP!!!They UK government even raised interest rates by 5% in one day (from 10% to 15%!) to halt the slide. Taken as a sign of desperation speculators kept selling GBP. They knew GBP was only going one way. The UK Chancellor announced the UK’s suspension of their membership of the ERM that evening. GBP fell by 15% instantly and has been floating ever since.
Another System Failure?
Other countries suffered as well. The bands were widened (to plus or minus 15%). These bands were so wide that the ERM was barely an exchange rate system any more. Sounds eerily the same as the downfall of Bretton Woods yes? Whilst frequent realignments would disrupt the stability on which the system was based, too little realignment puts pressure on countries not to realign however bad the problems are. There were no realignments between 1987 and 1992. The pound should probably have been realigned earlier in 1992, but membership of the ERM was the foundation around which the rest of the UK’s government economic policy was built.