Following the collapse of Bretton Woods, countries were completely free to control the supply of their own currencies. They could increase their money supplies without the backing of any precious metal required for that increase in the money supply. Governments also realized the fact that there was a profit to be made just by
However, by the late 1970s, some countries have gotten too greedy for seigniorage, meaning that they allowed changes in their domestic currency largely. It was during this time when many countries have fixed their exchange rate systems.
Some of the benefits of this system included: (i) the minimization of uncertainty for the future exchange rates (ii) the assumption of a supervisory role by the monetary policy which would be responsible for keeping the money supply under control (i.e. self-imposed discipline on monetary policy (iii) The occurrence of a change in a country’s balance of payments is more likely under the fixed exchange rate system. However, it can be controlled by devaluation (one-time change).
Conversely, some of the costs that were associated with the system of fixed exchange rates included the following deficiencies: (a) First, under this system, monetary policy would not completely be independent. For instance, in the event of a severe recession, when a large increase in money supply is needed, fixed exchange rate regime would not allow it. (b) Second, monetary policy is most tempted to break the rule of not allowing the money supply to grow excessively. An example would be the “systemic risk” of irresponsible monetary policy. It is better to have a flexible exchange rate system, which would show the consequences of changes in the money supply on a daily basis.
On the other hand, those countries that were running independent monetary policies with floating exchange rates have selected to use some key currencies such the U.S. dollar ($), Euro (€), Japanese Yen (¥) and also what is called the Special Drawing Rights (SDRs).
The SDRs were created during the Bretton Woods system in 1969 as an alternative to the strongest currencies to support the fixed exchange rates regime (only to be issued by the IMF). The SDRs are basically an international reserve asset that was put to use under the guidance of the IMF when two of the major currencies: the gold and the U.S. dollar, fell short of achieving their intended objectives of underpinning the expansion of international trade and encouraging financial flows between the member countries.
The SDRs are generally allocated in proportion to the contributions of the members to the IMF. If a member country wants to contribute more than the required amount, then the IMF would issue SDRs to this member. The value of SDR is currently expressed in a basket of four currencies as opposed to the past where it was represented solely by the U.S. dollar. Today these are: the U.S. dollar, the Japanese Yen, pound sterling and the Euro. The use of the SDRs may vary depending on the need trading arrangements. For instance, if the U.S. government had a desire to export certain goods or a service from Japan and was reluctant to make a payment in U.S. dollars, the transaction can be made with the usage of SDRs since both countries are participating members of the IMF.
In brief, it is possible to argue that the post-1973 period was largely marked by three crucial turning points, which have shaped much of the historical structure of the international monetary system. The first significant event was the advent of the “European Currency Snake” (also referred to as the snake in the tunnel), the second was the eruption of the “Great Debate” between fixed exchange rates and floating exchange rates, and the third event encompasses the dynamic changes in the monetary policies of the U.S. Federal Reserve.
By the mid-1970s, a globalization trend emerged that simultaneously promoted free trade and the elimination of capital controls (i.e. reduction of barriers to trade). This trend, in essence, came into being with the ongoing development in the areas of telecommunications, information technologies, as well as with the rapid structural improvements in the financial markets.
The liberalization of exchange rates during this period has revived unpleasant memories of the post-WWI era where floating exchange rates have largely caused massive hyperinflation. “Europe, not the United States or Japan, was where floating currencies had been associated with hyperinflation in the 1920s. Europe was where the devaluations of the 1930 had most corroded good economic relations.” (Eichengreen, 2008, pg. 150)
Many European countries with the breakdown of the Bretton Woods system were reluctant to go back to a system of floating exchange rates. Therefore, in an attempt to devise a single currency band among European countries, the concept of the “snake in the tunnel” was introduced. This monetary policy was supposed to limit fluctuations among various European currencies and peg all the European Economic Community (EEC) currency bands to one another. The so-called
In 1979, after the failure of the snake in the tunnel system, a new system was introduced called the “European Monetary System” (EMS) where the European Currency Unit (ECU) would be defined. Some of the key terms of the agreement were: (1) The ECU, which is composed of a basket of currencies, would prevent any fluctuations above 2.25% in bilateral exchange rates among member countries. (2) A new system called the Exchange Rate System (ERS) would be established which would limit exchange rate variability and prepare grounds for monetary stability in Europe. (3) Credit would be extended to all the members in need.
In the outcome of negotiations, even though no currency was declared the key/anchor currency, the German
By the mid-1990s, the EMS had suffered a series of turbulences: (I) primarily with the escalating tension over which member country’s currency would be the anchor currency, (II) the implementation of incompatible economic policies among member countries followed by an increase in violation of the rule of 2.25% in bilateral exchange rates have caused the system to lose its elementary functions. “The European Monetary System was no longer a functional arrangement in May 1998 as the member countries fixed their mutual exchange rates when participating in the Euro.”
(http://en.wikipedia.org/wiki/European_Monetary_System)
This situation has gradually led to the foundation of a single European currency called the “
(http://en.wikipedia.org/wiki/Maastricht_Treaty)
The purpose of the imposition of the Maastricht criteria was to bring about exchange rate stability to the Euro zone (also known as Optimum Currency Area), which is an economic union of member states that use the Euro as their currency. The benefits of joining the Optimum Currency Area included: (1) A higher economic integration, (2) free-movement of goods and services and factors of production, (3) Common tariff structures on non-members, (4) Economic symmetry and stability, and finally (5) more self-control on monetary policy. In 1998, 11 countries announced the adoption of Euro as their currency and in the following year, Euro was introduced and the European Central Bank was established.
Conclusion
The key foundation stone of the pre-war gold standard era required strict adherence to the rules of the game as currency convertibility was the crucial component for maintaining this regime. The emergence of the classical gold standard system prior to the WWI was accidental. This can be partially attributed to the fact that this regime evolved out in an era where a variety of commodities such as; cattle, wine, jewelry and diamonds were being used and traded for daily transactions instead of paper currency. A further contributing factor to the development of this regime came about with Britain’s accidental acceptance of a
Prior to the collapse of the Bretton Woods System in the early 1970s, there was a widespread belief in the international community that the high levels of volatility of capital flows were the root cause of the problem. The reason for this was the lack of tight regulation in international capital flows, which gave rise to a destabilization of national currencies.
In return, this international predicament forced governments to take drastic measures to protect their domestic economies whether by raising tariffs or by increasing import quotas, which is very similar to what they have done during the inter-war period. As a counterattack strategy, those countries that chose to devaluate their currencies would witness their immediate neighbors impose the same strategy of currency devaluation which then would trigger a reactionary war of tariffs and quotas.
In essence, the lessons extracted from the unfortunate economic circumstances of the 1930s have demonstrated that currency instability was the least desired strategy for the establishment of a free international trade. Therefore, it was understood that the restoration of global economic growth presupposed a system that would favor limited international capital flows and a sustainable regime for currency stability.
As for the grand monetary experiment conducted by the members of the European Union, there needs to be an increased level of willingness to forego a certain degree national sovereignty to create and further advance the dream of a full-fledged European Economic Integration. The initial steps for the formation of a complete monetary union were taken with the creation of a single common currency called the Euro. However, what is now a feasible economic goal for Europe stands as a difficult objective to be achieved for other regional monetary unions around the world such Latin America, the Middle East, Africa and East Asia as there is less willingness to comprise national sovereignty instead of a stronger monetary union.
WORKS CITED
Braga de Macedo, Jorge, Eichengreen Barry, & Reis Haime. (1996).
Eichengreen, Barry. (2008). “
Keynes, J.M. (1980). “
Kindleberger, P. Charles, (1993). “
University Press, Inc., 200 Madioson Avenue, New York, New York. (Second Edition)
Simmons, C. Edward. (1936). “
Polanyi, P. Karl. (1944). “
By the Ferris Printing Company, New York.
(http://en.wikipedia.org/wiki/Bretton_Woods_system)
(http://en.wikipedia.org/wiki/European_Monetary_System)
(http://en.wikipedia.org/wiki/Maastricht_Treaty)
BIBLIOGRAPHY
Barry Eichengreen: is John L. Simpson Professor of Economics and Professor of Political Science, University of California at Berkeley, Research Associate of the National Bureau of Economic Research, and Research Fellow of the Center for Economic Policy Research.
Charles Poor Kindleberger: was a historical economist and author of over 30 books. His 1978 book
Edward C Simmons: was an Assistant Professor of Economics at the University Michigan who later became a Professor of Economics at Duke University.
Jaime Reis: is Professor of Economic History at the European University Institute in Florence on leave as Senior Research Fellow at the Institute of Social Sciences of the University of Lisbon.
John Maynard Keynes: was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments. He greatly refined earlier work on the causes of business cycles, and advocated the use of fiscal and monetary measures to mitigate the adverse effects of economic recessions and depressions. His ideas are the basis for the school of thought known as Keynesian economics, as well as its various offshoots. Keynes was also a civil servant, a director of the Bank of England, a patron of the arts and an art collector, a part of the Bloomsbury Group of intellectuals, an advisor to several charitable trusts, a writer, a private investor, and a farmer.
Jorge Braga de Macedo: Professor of Economics, at the Nova University in Lisbon, Research Associate of the National Bureau of Economic Research and Research Associate of the National Bureau of Economic Research and Research Fellow of the Center for Economic Policy Research. As Portugal’s Minister of Finance, he was a signatory of the Maastricht Treaty and chaired ECOFIN Council from January to June 1992. After leaving the Cabinet in December 1993 he chaired the Committee for European Affairs of the Portuguese Parliament until October 1995.
Karl Paul Polanyi: was a Hungarian intellectual known for his opposition to traditional economic thought and his influential book