Monetary regimes: Gold Standard, Bretton Woods and ERM A comparison with EMU

Enrique Garcia 11111151

Summary

Introduction Gold standard Interwar system Bretton Woods EMR A comparison with the EMU Conclusion

Introduction Gold standard, Bretton Woods and ERM, three monetary systems which ended up collapsing in the last century. This story can teach us many lessons about exchange rates regimes, the strong and weak points and how a monetary regime can collapse. The history of monetary regimes rotate around three items: fixed exchange rates, free movement of capital and autonomous monetary policy. It is impossible for the three elements to work in unison, and the failure of monetary regimes is usually based on this paradox. Gold Standard The classic gold standard regime was based on a set of rules which ensured the maintenance of purchasing power of money and freedom for international trade. The mechanisms to achieve these goals are the convertibility of currency and a group of rules relating the quantity of money in circulation to that country's gold stock. In this point, the convertibility of paper money into gold established a limit to expand the money supply, only through increasing the production of gold or expanding the credit or other means of payment it was possible. And this exception could explain the business cycle during 1870-1914. Jess Huerta del Soto explains how the expansion of credit financing long run investment projects backed by simple deposits causes the deterioration of banks balances, of booms and depressions (Money, Bank Credit and Economic Cycles). The main mechanism to correct imbalances or asymmetric shocks under this system is the flow-specie-mechanism which operates through the balance of payments. If a country has a commercial surplus, new quantities of gold are entering and the direct consequence is the rise of prices. This increase of prices fosters the rise of exports and the decrease of imports balancing the commercial surplus. This mechanism works with imbalances between countries, but what about a general boom or broad depression in the gold standard countries? In the case of trade cycle, gold standard meant a limit to the expansion of credit. However, R.G Hawtrey thought that this correction was so slow since the flow of currency is very gradual. The mechanism of adjustment to stop the expansion of credit lags far behind the expansion of credit because authorities controlling credit were guided by the adequacy of their stock of gold. The process is described: An expansion of credit, with the consequent increase in incomes and prices, leads eventually to more currency passing in circulation. If this currency has to be either gold coin or paper money wholly or partly backed by gold, the effect is to encroach on the available supplies of gold in the gold standard countries, till last the expansion of credit has to be stopped. In this process, a country which imports gold is in a credit expansion. The export of gold could mean a credit contraction. The evidence tells us that this general process was globalised in all gold standard countries. In this regard, any shortage of gold could break a financial crisis as the monetary expansion had to stop. Thus, we can consider the function of gold a limit for the liquidity expansion slowing the credit expansion. The end of gold standard was in 1914 when the most of countries finished the convertibility of their currencies in order to finance the WWI through debt and inflation. The system needed discipline and commitment, specifically to ensure the convertibility of the currency into gold and allow prices adjust. The peg was a problem to issue more

paper money and debt and this is the most important cause for the end of gold standard: countries abandoned discipline and rules. Interwar system After WWI, some countries tried to come back to the gold standard. However, it was a failed attempt as the Great Depression brought an end to the classic gold standard. In the second half of the 1920s convertibility was restored in the main countries of Europe. We are talking about 5 or 6 years of the duration of the system, so the question is why the second attempt to establish the gold standard failed. Barry Eichengreen (1990) described some aspects of this period which allow us understand some keys of the failure of the interwar gold standard system: The failure of central banks to play by the rules of game: The adjustment mechanism seemed inadequate as there were persistent imbalances between the countries which the price-specie mechanism should correct. Britain had continuously deficit on the balance of payments and France and US were in persistent surplus. The restoration of external balances did not seem to operate. We can talk about central banks were sterilizing the exchange rate in order to pursue other objectives (against the commitment of gold standard). Kindleberger (1973) remarks the failure of the leading participant, the US, to accept the function of lender of last resort providing liquidity to the system in the financial crisis, role which was played by Britain in the first era of gold standard (Bank of England). In this point, when the crisis arose in 1931 there was no one to play the role of liquidity supplier for the system. One characteristic of this system was the practice of backing money by foreign assets. This practice consisted in diversifying the reserve portfolios with foreign assets. In this way, it was not a pure gold standard, but a gold exchange standard which allowed central banks to provide domestic assets to foreign central bankers avoiding to adjust to reserve losses. Then, Bank of England owned assets in foreign currencies in countries like Austria or Germany, and the same for the rest of central banks. The system depended on the confidence of the rest of the currencies since a end of convertibility of a currency could destabilize the whole system. Austria and Germany suspended the convertibility of their currencies, and the system collapsed.

Bretton Woods The monetary regime of Bretton Woods was established after WWII and based on the fixed but adjustable exchange rates, the adjustable peg. All the currencies had a fixed exchange rate or a parity in terms of gold or dollars, and the dollar was pegged to gold. Exchange rates could only vary within the support or intervention points (1 per cent). The main problem of this system was the lack of an adjustment mechanism which corrected automatically imbalances between currencies. To adjust the exchange rate of a currency, a disequilibrium had to be demonstrated. The absence of flexibility (free floating) or other mechanisms (through prices) had, as consequence, problems of speculation. The possibility of parity changes fostered the speculative tensions buying

strong currencies and selling weak currencies. Some episodes of devaluations took place: 1949 (Europe), 1957-1958 (France). The other weak point was the credibility of the dollar. As the reserve currency was used to provide liquidity to the financial markets in the financial crisis, the dollar lost credibility like a currency backed by gold. This is the Triffin Dilemma which consisted in the impossibility of carrying out two objectives at the same time. On one hand, maintaining the convertibility and credibility of the dollar and on the other hand, providing liquidity to the financial markets. In 1962 France takes gold from USA converting dollars into gold. The next fact was the protest of US. The worry about the confidence of dollar and his future value grew in Europe. From 1958 to 1971 the balance of payments of USA was deteriorating seriously till 1971 when the convertibility of the dollar was suspended while many agents tried to convert dollars into gold. Again, the impossibility of two objectives simultaneously appeared. The convertibility of the currency needs discipline and adjustment through prices. Expanding liquidity to the financial system is expanding the monetary base, something that the peg to gold should avoid. Convertibility into gold and a flexible monetary system are incompatible. ERM Other monetary regime to analyse is the Exchange Rate Mechanism (ERM) inside the European Monetary System (EMS). The system was based on fixed but adjustable exchange rates relative to the ECU (European currency unit). Then, European currencies were expressed in terms of the ECU and the available margin to float was 2.25%, if the exchange rate deviated from this band, the intervention of central bank was compulsory. Adjustments had to be made by monetary policy, specifically by adjusting interest rates. It implied a need to renounce monetary policy in order to fulfil the commitment. Capital controls could be a tool to monitor the exchange rate, but this mean has serious limits and non desirable consequences. The system was unstable, from 1979 1987 there were 11 realignments. From 1987 1992 tranquility prevailed. However, 1992 was the start of a sequence of events which lead to the end of the ERM. The main cause is the spirit of 1992 and the elimination of capital controls by European members. Without capital controls, maintaining the ERM was difficult as government had to renounce monetary policy (fixed exchange rates and no capital controls). The depression of 1992 finished ERM as central banks decided to adapt the monetary policy to the depression. The chain of facts was as follows: German reunification put upward pressure on German interest rates because of the increase of demand of credit to finance reunification. The German mark began to appreciate, while other currencies could not increase interest rates because of recession. Bank of England tried to maintain the pound within the band established by the ERM. It was ineffective, causing massive speculation on the pound. Currencies left the ERM since exchange rates could not be maintained within the prescribed limits.

The system ended because monetary policy and fixed exchange rates are incompatible without capital controls. Fighting against the depression and maintaining the fixed exchange rates were not possible.

A comparison with the EMU EMU is based on two points: fixed exchange rates between Euro members and free movement of capital. So all the Euro members renounced their monetary policy, leaving this task to the European Central Bank. We can consider the similarities between classic gold standard and EMU, taking into account that autonomous monetary policy is not available. Another resemblance is the existence of a leadership with capacity and power to guarantee the purchasing power of the currency, Germany (Britain before 1914). However, we have to remark some disparities such the peg to gold which it is not established in the EMU (more flexible to provide liquidity to commercial banks) and the existence of one currency instead many currencies pegged to gold. This aspect could be positive from the point of view of commitment with the monetary system, there is no chance to central banks carry out their own monetary policy such 1920s. In fact, the development of EMU cannot be understood without the problems of ERM which allowed central banks leave the commitment, being a second attempt to set an efficient monetary system in Europe. The current crisis has surprised many policy makers in Europe as they cannot devaluate their currency, usual practice in the second half of the 20th century, remembering an old age such gold standard period. Adjustments have to be done by prices and balances of payments, something that can be painful in the short run. Conclusion The analysis of monetary regimes show us the incompatibility of some goals in the economy policy. All the systems collapsed when authorities broke the basis of the regimes. The gold standard sacrificed autonomous monetary policy in order to guarantee free movement of capital and fixed exchange rates (and also limit the monetary expansion). When central banks decided to change monetary policy to achieve local goals the system collapsed (1914, 1931). Bretton Woods was a mix of fixed and flexible exchange rates with free circulation of capital (and the peg to gold). But the system collapsed because countries were not willing to adjust imbalances through balances of payments, expanding the money supply (dollars) which is incompatible with convertility. Authorities didn't fulfil the basis of the game. The operation of ERM was not good (11 realignments in 8 years) but the system survived with the tool of capital controls. Authorities established fixed exchange rates and some autonomy in the monetary policy. In 1992, capital controls disappeared and countries had to choose between maintaining the system or pursuing their own goals with the monetary policy. Again, central banks left the system. The question is analyse what properties are more desirable for a monetary system and if those properties compensate the costs of achieve it. But the incompatibility of some goals is clear since the appearance of imbalances need a system to adjust it, and sometimes these adjustments are painful. References A. Moosa, 2005. Exchange Rate Regimes: fixed, flexible or something in between. Palgrave Macmilian. Barry Eichengreen, 1992. Monetary regime transformations Barry Eichengreen, 2002. Still feterred after all these years.

R.G. Hawtrey, 1933. The Gold Standard from 1717 to 1914, in The Gold Standard in Theory and Practice, London, 77-106. Jess Huerta del Soto, 2005. Money, Bank Credit and Economic Cycles. Harry S. Johnson, 1973. The international monetary crisis of 1971. The Journal of Bussiness.