Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared at Project Syndicate.
This month marks the 50th anniversary of the date, in March 1973, when the dollar, yen, deutschemark, pound, and other major currencies went untethered, their relative values to be determined thenceforth by foreign exchange markets rather than by governments. The abandonment of the Bretton Woods system of fixed exchange rates was generally viewed as a policy failure. The movement from fixed to flexible exchange rates, however, was probably inevitable, a natural long-term process.
- The Bretton Woods system
The post-war international monetary system that was designed at Bretton Woods, NH, in 1944, was one component of the postwar international order. This order, which also included successive rounds of negotiations to liberalize trade, delivered unprecedented decades of peace and prosperity.
It is tempting to believe that the Bretton Woods system lasted for almost 30 years, coinciding with the period of rapid global economic growth that the French call Les Trente Glorieuses. But, in a sense, the system only reigned for one year.
It did not really get under way until 1958, when Western European countries had grown strong enough that they were able to restore convertibility of their currencies into dollars (by eliminating exchange controls for current account transactions). It was the very next year, 1959, that total dollar liabilities to foreigners surpassed the value of gold reserves held by US authorities. Yale Professor Robert Triffin realized the importance of this signal; correctly diagnosed the problem inherent in the dollar-based system; and foresaw its eventual long-term breakdown. According to the Triffin dilemma, if the rest of the world was to continue to earn enough US dollars, the de facto reserve currency, to keep their economies humming, eventually investors would lose confidence in the dollar. As it happened, the rise in dollar liabilities was accelerated after 1965 by the inflationary US fiscal and monetary expansion of the Vietnam War era.
- The shift to floating
The strains culminated in the tumultuous events of 1971, when US president Richard Nixon suspended the ability of other governments to convert their dollar holdings into gold and devalued the dollar by 11 % (the Smithsonian Agreement), and 1973, when the major pegs were abandoned for good. The new floating system demonstrated its worth later in 1973, when automatic depreciation of the currencies of the most oil-dependent economies, notably Japan’s yen, helped them accommodate to the shocks of the Arab embargo and subsequent quadrupling in the price of oil.
The demise of exchange rate stability wasn’t entirely cliff-like. For one thing, it had been presaged by realignments in 1967, when the pound devalued 14%, and 1969, when the deutsche mark revalued upward by 9%. Also, the worldwide move toward flexibility continued after 1973. Initially most smaller currencies remained pegged. But during the ensuing decades, the trend among the mid-sized Emerging Market and Developing Economies was away from exchange rate targets and toward increased flexibility.
The choice as to exchange rate regime is a trade-off between pluses and minuses. A list of advantages of fixed rates includes: facilitating trade and investment by cutting exchange rate risk and transactions costs; providing a readily monitored nominal anchor for monetary policy; and avoiding two drawbacks that sometimes afflict floating exchange rates — competitive depreciation (“currency wars”) and speculative bubbles. Countervailing advantages of floating exchange rates include the ability to set monetary policy independently of other countries; automatic adjustment to trade shocks; retaining seigniorage for the national government (the privilege of creating money to finance spending); retaining “lender of last resort” protection for the banking system, and avoiding the speculative attacks that sometimes afflict pegged exchange rates.
Gradually over the last 50 years, more and more countries have judged that, for them, the advantages of floating exchange rates outweigh the advantages of fixed rates. A temporary reversal of this trend started in 1985, when some countries, particularly in Latin America, began returning to exchange rate targets as a means of defeating high inflation (the nominal anchor advantage). But the trend toward flexibility resumed after 1994, when Mexico was forced by speculative attack to abandon its exchange rate target, followed by Thailand, Korea, Indonesia, Russia, Brazil, Argentina, Turkey and others. (Another big exception to the overall trend of more flexible exchange rates was the creation of a shared currency, the euro, among 11 European countries in 1999, rising to 20 by now.)
A variety of popular arrangements lie somewhere in between the polar extremes of free floating and giving up one’s currency altogether. They include bands (target zones), baskets, crawling pegs, escape clauses, and systematic managed floats.
Most major currencies (the dollar, euro, yen, pound, Australian and Canadian dollars) have floated almost freely. To some, exchange rates seemed too volatile, and called for intervention in the foreign exchange market. There was a period of occasional concerted intervention — most prominently, a cooperative effort by the G5 that was agreed in the 1985 Plaza Accord to bring the dollar down from its loftiest heights. But intervention became uncommon after 1995.
- Currency wars and reverse currency wars
A proscription against “unfair” currency manipulation carried over to the post-1973 world. Beginning in 2003, US politicians were concerned that China was keeping its currency unfairly undervalued: it intervened frequently, selling renminbi and buying dollars. And Brazilian officials accused the US and Japan of unfair undervaluation in 2010-11, coining the phrase “currency war.”
But among advanced countries, the last major foreign exchange intervention seeking to lower the value of a currency was a cooperative effort to help Japan cope with side-effects of the Tohoku earthquake in 2011. In February 2013, the G7 acted to foreclose currency wars, promising each other to refrain from intentionally driving down the values of their currencies, whether directly via foreign exchange intervention or indirectly via monetary expansion, in a little-known agreement that has held. Even China, in truth, stopped resisting appreciation of its currency in 2014, and switched to fighting depreciation.
These days, currency wars are not in evidence. If anything, the worry is about “reverse currency wars.” At a time when countries are less concerned about trade deficits and more concerned with bringing down inflation, they are competing to raise interest rates and thereby appreciate their currencies, not depreciate them. Some countries are unhappy that the dollar has appreciated by 14 % over the last two years [March 2021-March 2023], reaching its third-highest peak in value since floating began in 1973. (The American public hasn’t even noticed.)
Some have nostalgia for the old post-war monetary system or even yearn for the yet-older gold standard. But the sinking of the ship Bretton Woods in 1973 was not the currency equivalent of the Titanic disaster. Rather, the last half-century has shown that it marked the emergence of a new, better system, which has remained afloat for 50 years despite frequently rough economic seas.
This post written by Jeffrey Frankel.