the gold standard, bretton woods and other monetary regimes: a

123

Michael TI. Bordo

Michael D. Bordo is a professor of economics at RutgersUniversity and a research associate of the National Bureau ofEconomic Research. For excellent research assistance Iwould like to thank Jakob Koenes. For helpful comments andsuggestions I am grateful to Barn,’ Eichengreen, Allan Meltzer,Leslie Presnell, Hugh Rockoft and Anna Schwartz.

• I The Gold Standard, BrettonWoods and Other MonetaryRegimes: A HistoricalAppraisal

INTRODUCTION

Two Questions

Which international monetary regmm is h ~5tfor economic performance? One based on fixedexchange rates, including the gold standard andits variants? Adjustable peg regimes such as theBrel ton Woods system and the European Mone-tarv System (EMS)? Or one based on floatingexchange rates? This quest ion has been debatedsince Nurkse’s classic indictment of flexible ratesand Friedmans classic defense.

Why have some none tarv regimes been moresuccessful than others? Specifically, why did theclassical gold standaid last for almost a ceo t urv(at least for ( reat Britain) and why did Bret tonWoods endure for only 25 years (or less)? Whywas the EMS successful for only a few years?

This paper attempts to answer these questionslo answer the first question, I examine empiri-cal evidence on the performance of three mone-ta rv regimes: the classical gold s andard Brett onWoods, and the current float. As a backdrop, Iexamine the mixed regime interwar period. I answerthe second question by linking regime success

1See Nurkse (1944) and Friedman (1953).2See DeKock and Grilli (1989 and 1992).

to the presence of credible commitment mechan-isms, that is, to the incentive compatibility fea-tures of the regime. Successful fixed-rate regimes,in addition to being based on simple transparentrules, contained lea tures tim t enconraged a centercountry to enforce the rules and other coun-tries to comply.

The Issues

These questions touch on a number of impor-tant issues raised in economic literature. ‘Ihefirst is the effect of the exchange rate regimeon welfare. The key advantage of fixedexchange rates is that they reduce the transac-tions costs of exchange. The key disadvantage isthat in a world of wage and price stickiness thebenefits of reduced transactions costs may heon tweighed by the costs of more volatile outputand employment.

Helpman and Razin (1979), Helpinan (1981)and others have raised the welfare issue. Thistheoretical literature concludes that it is difficultto provide an unambiguous ranking of exchangerate arrangements -

Meltzer 11990) argues the need for empirical

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measures of the excess burdens associated withflexible and fixed exchange rates—the costs ofincreased vo)a tili tv on the one hand comparedwith the output ccsts of sticky pnces on theother hand. His comparison of EMS and non-EMS countries in the postwar period however,does not yield clear-cut results.

Earlier literature comparing the macroeco-nomic performance of the classical gold stand-ard, Bret ton Woods and the current float alsoyielded mixed results. tIm-do (1981) and Cooper(1982) showed that the classical gold standardwas associated with greater price level and realoutput vola t ilitv than post—World War II arrange-ments for the United States and United Kingdom.On the other hand Klein (1975) and Schwartz(1986) presented evidence that the gold stand-ard provided greater long-term lirice stahilit~’than did the post—World War- It arrangements.3

Bordo (1993) compared the means and stand-ai-d deviations of nine variables for the Groupof Seven countries under the three regimes, aswell as the interwar period4 According to thesemeasm’es, the Bretton Woods convertible periodfrom 1959 to 1971) was the most stable regimefor the majority of countries and variablesexamined. Eichengreen 1 1992a) measured volatil-ity applying two filters (the first difference oflogarithms and a linear trend).~Comp n’ing Bret-ton Woods and the float for a sample of 10countries, he found no clear-cut connectionbetween the volatility of real growth and theexchange rate regime. He also found no signifi-cant difference in the correlation of output vola-tility across countries between the two regimes.

A second issue is whether the exchange rateregime provides insulation from shocks andmonetary policy independence. Under fixedrates, coordinated monetary policy may provideeffective insulation from common supply shocks,but not from country-specific shocks. tinder

flexible rates, coun try-specific shocks can be off-set by independent monetary policy.°

The evidence on this issue is limited. Bavoumiand Eichengreen (1 992a) applied the Elanchard-Quah appi-oach to show that both supply (per-manent) and demand (temporary) shocks, for asample of live countries, were considerabh’ greaterunder the gold standard than under post—WorldWar II regimes. However, they found little dif-ference in the incidence of shocks betweenBretton Woods and the floating exchange rateregime. Their results also showed that the dis-persion of shocks across countries was higherunder the gold standard than under the twomore recent regimes and slightly higher underllretton Woods than under the floating exchangerate regime. They attributed the ability of thegold standard to withstand greater shocks to evi-dence of a faster speed of adjustment of both

prices and output, as measured by impulseresponse frmctions.~

A third issue is the case for rules vs. discre-tion. A fixed exchange rate max’ he viewed as acommitment mechanism or rule. It binds thehands of polic makers to prevent them fromfollowing inflationary discretionary policiesiThe monetary authority, in a closed economy orunder flexible rates, might be tempted to engi-neer an inflation surprise to raise ret-enue.” ‘lieoutcome is higher inflation because the public,assuming rational expectations, will anticipatethe policy. Wet-c some credible mechanism,such as a monetary rule, in place the expansion-arv policy would not he implemented. Alterna-tivelv, a commitment to a fixed exchange ratethrough a pledge to maintain gold convertibility,for example could achie~’ethe same results, hutbecause it is more transparent, it would possiblycost less. 10 Such binding commitments may, how-ever, be undesir-ahle in the presence of extremeemergencies such as major wars, supply shocksor financial crises.11 Undet- such circumstances

~Thisresult is disputed by Mettzer and Robinson (1989).4The Group of Seven countries are Canada, France, Ger-many, Italy, Japan, the United Kingdom and the UnitedStates.

5Eichengreen followed the methodology of Baxter andStockman (1989).

tSimilarty a monetary union such as the proposed Euro-pean Monetary Union could provide effective insulationfrom common supply shocks for its members. However,giving up monetary independence imposes additional bur-dens in the case of member-specific (regional) shocks,Feldstein (1992).

7Addressing the issue of the optimum currency area, Bay-oumi and Eichengreen (1992b, 1992c and 1992d) also

apply this methodology to examine the incidence ofshocks within Western Europe and within regions of NorthAmerica.

8See Kydland and Prescott (1977), Barro and Gordon(1983), and Persson and Tabellini (1990).

9Alternatively the monetary authority may create an inflationsurprise to offset a labor market distortion that raises theunemployment rate above some desired level.

105ee Giavazzi and Pagano (1988).115ee Rogoff (1985a) and Fischer (1990).

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a contingent rule, or one with escape clausesthat allow member countries to suspend parity(convertibility) temporarily, may be optimal.12

The rule constrains the government to adhere tothe fixed exchange i-ate except in the case of a well-understood emergency, ~~‘lienit can suspend

pal-it)’ (convertibility under the gold standard)and issue fiat money. Once the emergency has

passed, with allowance for a suitable delay, theauthority is expected to return to the rule—thatis, to the fixed rate at the original parity. If the

putilic believes in the government’s commitmentto return to the rtile, the government will be ableto raise more revenue than it could with no credi-bility. ‘the inflation rate during the emergencywould he higher than undet- the rule (when pre-sumably it would he zero) hut tess than in thecase of put-c discretion. The pattern of alternat-big fixed and floating exchange rate regimesover the past 200 years may he well explainedby adherence to a rule with an escape clause. 13

On the other hand, in a regime of floatingexchange rates the inflationary bias of discre-tionai-y policy may he overcome by institutingct-edible monetary rules or other conimitmentmechanisms, such as an independent conserva-tive central hank.’~Such mechanisms may Pre-vent the perceived disad~-antageof sacrificingnational sovereignty to the supernational (lic-tates of a fixed exchange rate.

A fourth issue is that of international coopet-a-non and policy coordination. Recent game theoryliterature has demonstrated that coordination of

policies (by fixing exchange rates) can offset spill-over effects fi-om uncoordinated policy actions. IS

Cooperative fixed exchange rate arrangements,however, unless enforced by a supernational au-hot-it)’ whose power exceeds national sovel-eignt\’,

tend to break down as individual members de-value. Cooperation is more likel , without asupet-nat ional authority, in a world of repeatedgames because the benefits of reputation canoffset the advantages to each count i-v of cheat-

ing. “‘ But even in this case, cooperation betweennations may pl-odlucd~tninflationary bias whenno credible commitment mechanism is presentto pt-event governments from following discre-

tionaty policies. 17 Thus for an international mone-taty arrangement to be effective both betweencountries and! within them, a consistent credible com-mitment mechanism is required. Such a mechanismlikely prevailed under the gold standard butwas less evident under Bretton Woods.

A fifth and final issue is the case for internationalmonetary refoi-m. Several, prominent proposalshave been made to reform the present managedfloating exchange rate regime and move it hacktoward one of greater fixity. These proposals in

part derive from a pet-ception, based on thehistorical record, that fixed exchange rates are

preferable to the current float. These proposalsinclude McKinnon’s case for a gold standard with-out gold, Mundell’s proposal to target the realprice of gold and the case for target exchangerate zones presented by Williamson and Berg-sten)’ Even more immediate is the move to con-vert the adjustable peg of the EMS to aunified currency area with irrevocably fixedexchange rates.

()tTtSftTjp tif

The paper accomplishes a number of tasks.The next section answers the first question,which international monetary regime is best foreconomic performance, by presenting a compila-Ron of statistical evidence on different aspectsof the lierforniance of alternative monetaryregimes. The measures cover the stability ofseveral macroeconomic variables; the dispersionof macroeconomic yariabtes across countries;the lielsistence of inflation; forecast errors ininflation and growth; the incidence of supply(permanent) and demand (temporary) shocks;the dispersion of shocks between countries; andthe mean response of prices and output to sup-

‘ily and demand shocks. The third sectionstresses the importance of adhering to crediblerules in a historical examination of three inter-national monetary regimes: the classical gold!standard, Bretton Woods and the EMS. Thefinal section answers the question why someregimes endured longer than others. It con-cludes Ii)’ discussing why even a regionalexchange rate arrangement—the EMS—has con-siclerahle difficulty surviving.

‘2See Bordo and Kydland (1992), Flood and Isard (1989a

and 1989b), and DeKock and Grilli (1989 and 1992).

“See DeKock and Grilli (1989) and Giovannini (1992).

‘4See Rogoff (1985a).

“See Hamada (1979) and Canzoneri and Henderson (1988and 1991).

“See Dominguez (1993).17

See Rogoff (1985b).18

5ee McKinnon (1988), Mundelt (1992), Williamson (1985a)and Bergsten (1992).

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‘the statistical evidence on performance of alter-native monetary r-egimes in the next section makes itclear that the performance of regimes in the post—World War II era is superior to that of the regimesin the precedhlg half century. The key exceptionis the classical gold standard, which exhibits thelowest inflation persistence and a relatively highdegree of financial market integration. The l3rettonWoods convet-titile regime from 1959 to 1970 per-formed the liest by far on virtually all criteria -

The greater durability of the gold standard com-pared with llretton Woods cannot he explainedby a lower incidence of shocks. The key expla-nation for its success lies with the credibility ofthe commitment to the gold standard rule ofconvertibility by England and the other corecountries and its near universal acceptance. As acontingent rule, it was flexible enough to with-stand the major shocks that buffeted it. ‘I’heBretton Woods adjustable peg was in some re-spects similar to the gold standard contingentrule, hut it invited speculative attack henceweakening the escape clause. Unlike England,the leading country before World War I, theUnited States, the dominant country under Bret-ton Woods, maintained a credible commitmentto a noninflationary policy for (inly a few years.‘the world, faced with imported inflation in thelate 1960s, lost the incentive to follow its leader-ship, and the system collapsed in 1971 -

The longevity of general floating exchangerate regimes since 1973 suggests that the lessonsof Brett ~n Woods have been well learned. Coun-tries are willing to subject their domestic policyautonomy neither to that (if another countrywhose commitment they cannot tie sure of in astochastic world, nor to a supernational monetaryauthority they cannot control. Even the recentexperience of the EMS—a regional exchange ratearrangement het\veen countries su1iposediy pur-suing common goals—revealed differing nationalpriorities in the face of asymmetric shocks thatplaced intolerable strains on the system.

THE PERFORMANCE OF ALTEW

NATIVE MONETARY REGIMES

‘to make the case for- one monetary regimeover another, empirical and historical evidenceon their performance is crucial. In this sectionI present some evidence on different aspects ofthe macroeconomic perfom-mance of alternativeinternational monetary regimes over the past110 years. The comparison for the seven hn’gest(non-Communist) industrialized countries (theGroup of Seven countries) is liased on annualdata for the classical gold standard (1881—4913),the interwar period (1919—39), Llretton Woods(1946—70), and the present floating exchangerates i-egimne (1971—89). The Bretton Woodsperiod (1946—70) is divided into two suhperiods:the preconvertible phase (1946—58) and the con-vertilile phase (1959—70).’~

The comparison relates to the theoretical issuesraised by the debate over fixed vs. flexible ex-change rates. According to the traditional view,adherence to a (commodity-based) fixed exchangerate regime, such as the gold standard, ensuredlong-run price stability for the world as a wholebecause the fixed price of gold provided a mmmi-nal anchor to the world money supply. Individ-ual nations, by pegging their currencies to gold),fixed) their price levels to that of the world.30 Afixed-rate system based on fiat money, however,may not lirovide a stable nominal anchor unlessa cr-edible commitment mechanism constt-ainsthe growth of the world’s money supply.~~Thedisadvantage of fixed rates is that individualnations are exposed to both monetary and realshocks transmitted from the rest of the worldthrough the balance of payments and otherchannels of transmission.” The advantage offloating exchange rates is to provide insulationfrom foreign shocks. The disadvantage is theatisence of the discipline of the fixed-exchange-rate rule because monetary authorities nightadopt 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 aresimilar 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 ofgold. See Bordo (1981) and Rockoff (1984). A well-designed monetary rule, it is argued, could have preventedthe long-run swings that characterized the price levelunder the gold standard. See Cagan (1984).

21See Giovannani (1992).“See Bordo and Schwartz (1989a).

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Theoretical developments in recent years havecomplicated the simple distinction between fixedand floating exchange rates. In the presence ofcapital mobility, currency substitution, policyreactions and policy interdependence, floatingrates no longer necessarily provide insulationfrom either real or monetary shocks.83 Moreover,according to recent real business cycle approaches,there may be no relationship between the inter-national monetary regime and the transmissionof real shocks.” Nevertheless, the comparisonbetween regimes may shed light on these issues.

One important caveat is that the historicalregimes presented here do not represent clearexamples of fixed and floating exchange rateregimes. The interwar period comprises threeregimes: a general floating rate system from1919 to 1925, the gold exchange standard from1926 to 1931 and a managed float to 1939.”The Bretton Woods regime cannot be character-ized as a fixed exchange rate regime throughoutits history: The preconvertibility period was closeto the adjustable peg envisioned by its architects,and the convertible period was close to a de factofixed dollar standard.2’ Finally, although theperiod since 1973 has been characterized as afloating exchange rate regime, at various times ithas experienced varying degrees of management.

Stability and Convergence

Table 1 presents descriptive statistics on ninemacroeconomic variables for each Group ofSeven country, with the data for each variableconverted to a continuous annual series from1880 to 1989. The nine variables are the rate ofinflation; real per capita growth; money growth;short-term nominal interest rates; long-termnominal interest rates; short-term real interestrates; long•term real interest rates; and theabsolute rates of change of nominal and realexchange rates. The definition of the variable

used, for example, Ml vs. M2, was dictated bythe availability of data over the entire period.For each variable and each country I presenttwo summary statistics: the mean and standarddeviation. For the countries taken as a group,I show two summary statistics: the grand meanand a simple measure of convergence definedas the mean of the absolute differences betweeneach country’s summary statistic and the grandmeans of the group of countries.27 I commenton the statistical results for each variable. -

Inflation. Countries using the classical goldstandard had the lowest rate of inflation anddisplayed mild deflation during the interwarperiod. The rate of inflation during the BrettonWoods period was on average and for everycountry except Japan lower than during thesubsequent floating exchange rate period. Theaverage rate of inflation in the two BrettonWoods subperiods was virtually the same. Thiscomparison, however, conceals the importanceof two periods of rapid inflation in the 1940sand 1950s and in the late 1960s. See figure 1.23Thus the evidence based on country and periodaverages of very low inflation in the gold stand.ard period and of a lower inflation rate duringBretton Woods than the subsequent floatingperiod is consistent with the traditional view onprice behavior under fixed (commodity-based)and flexible exchange rates.

In addition, the inflation rates show the highestdegree of convergence betweencountries duringthe classical gold standard and to a lesser extentduring the Bretton Woods convertible subperiodcompared with the floating rate period and themixed interwar regime. This evidence also isconsistent with the traditional view of the oper.ation of the classical price specie flow mechanismand commodity arbitrage under fixed rates andinsulation and greater monetary independenceunder floating rates?

23See Bordo and Schwartz (1989a).245ee Baxter and Stockman (1989).2STo be more exact, the United States stayed on the gold

standard until 1933, and France stayed until 1936. For adetailed comparison of the performances of these threeregimes In the Interwar period, see Eichengreen (1991 a).

83Wlthln the sample of seven countries, Canada floated from1950 to 1961.

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, Itsuppresses unusual movements within particular sub-periods. Bayouml and Elchengreen (1992d) presented anaftemative measure of convergence or dispersion—theGDP-welghted standard deviation of the lndMdual country

series around the G-7 aggregate. I calculated this Sterna~tive measure of convergence for the data in table 1. Theresults are veryclose to those reported here for virtuallyevery variable.

2tThe data sources for figure 1 and all subsequent figuresare listed in the Data Appendix to Bordo (1993).

29For similar evidence see Bordo (1981), Darby, Lothlanet.al. (1983) and Datby and Lothian (1989).

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Nut IMARCH/APRIL 1993

132

Figure 1Inflation Rates, 1880-1989, G7 Countries

Percent

J — U.S. — U.K. Germany — Canada

— France Italy = Japan

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

Percent

1

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990


133

The Bretton Woods convertible subperiod hadthe most stable inflation rate of any regime asjudged by the standard deviation. By contrast,Ihe preconvertible Bretton Woods period exhibitedgreater inflation variability than either the goldstandard period or the recent floating exchangerate period. The evidence of a high degree ofprice stability in the convertible phase of BrettonWoods is also consistent with the traditionalview that fixed rate (commodity-based) regimesprovide a stable nominal anchor; however, theremarkable price stability during this periodniay also reflect the absence of major shocks.

Real per capita GNP. Generally, the BrettonWoods period, especially the convertible period,exhibited the most rapid output growth of anymonetary regime, and not surprisingly the inter-war period the lowest (see figure 2). Outputvariability was also lowest in the convertiblesubperiod of Bretton Woods, but because ofhigher variability in the preconvertible period,the Bretton Woods system as a whole was morevariable than the floating exchange rate period.Both pre—World War 11 regimes exhibit highervariability than their post—World War H coun-terparts3° The divergence of output variabilitybetween countries was also lowest during theBretton Woods regime, with the interwar regimeshowing the highest divergence.~’The greaterconvergence of output variability under BrettonWoods may reflect conformity between countries’business fluctuations, created b the operationof the fixed exchange rate regimea2

Money growth (M2). Money grew consider-ably more rapidly across all countries afterWorld War II than before the war (see figure 3).There is not much difference between BrettonWoods and the subsequent floating exchangerate regime. Within the Bretton Woods regime,money grew more rapidly in the preconvertibilityperiod than in the convertibility period. Moneygrowth rates showed the least divergence between

countries during the fixed-exchange-rate goldstandard and the convertible Bretton Woodsregime, with the greatest divergence in thepreconvertible Bretton Woods period and theinterwar period.

Like inflation and real output variability, moneygrowth variability was lowest in the convertibleBretton Woods period. This, however, was notthe case for the preconvertible period, whichwas the most variable of any regime. It alsoexhibited the greatest divergence in variabilitybetween countries. To the extent that one ofthe properties of adherence to a fixed-exchange-rate regime is conformity of monetary growthrates between countries, these results are sym-pathetic to the view that the Bretton Woodssystem really began in 1959.

Short~ternj and long-terni interest rates,The underlying data for short-term and long-term interest rates are seen in figures 4 and 5.As in other nominal series, the degree of con-vergence of mean short-term interest rates ishighest in the convertible Bretton Woodsperiod. Long-term rates are most closely relatedin the classical gold standard regime, with theconvertible Bretton Woods period not far behind.McKinnon (1988) has similar findings, He viewsthem as evidence of capital market integrationunder fixed exchange rates. The lack of conver-gence in the preconvertihility Bretton Woodsperiod reflects the presence of pervasive capitalcontrols. Convergence of nominal interest rateswould not be expected under floating exchangerates. Convergence of standard deviations is alsohighest in the gold standard period followed byBretton Woods. Long-term rates were most stableand least divergent under the classical gold stand-ard, followed by the two Bretton Woods suhperiods,with floating exchange rates the least stable, Theevidence that nominal interest rates are morestable and convergent between countries underfixed exchange rate (commodity-based) regimesis consistent with the traditional view.

30Baxter and Stockman (1989) and Eichengreen (1992a) useresiduals from a linear trend to the logarithm of real outputas a detrending filter rather than the logarithmic first ditfer-ence used here. According to their results, real outputvariability is not greater in the floating than in the fixedperiod.

31However, using their alternative measure of convergence—the GDP-weighted standard deviation of the individualcountry series around the G-7 aggregate—Bayoumi andEichengreen (1992a) report that the lowest degree of dis-persion of real GDP growth was in the floating rate period,followed by the Bretton Woods convertible period. Similarresults hold for the real GNP per capita data in table 1.For Bayoumi and Eichengreen (1992a) the decline in the

dispersion of real growth and the rise in the dispersion ofinflation rates between the Bretton Woods convertibleperiod and the float have the following explanations: themove to flexible rates allowed countries to stabilize theirrelative growth rates in the face of asymmetric supplyshocks at the expense of their relative inflation rates. Theyalso report that, when they apply the linear trend filter ofBaxter and Stockman (1989), evidence of a rise in thecross country correlation between output movements after1970 is considerably reduced.

325ee Bordo and Schwartz (1989a) and Darby and Lothian(1989).

MARCH/APRIL 1993

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Figure 2Per Capita Income Growth Rates, 1880-1989, G7 Countries

Percent

20

— U.S. — ILK. —‘--- Germany — Canada

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

— France — Italy = Japan

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

Percent

50

40

30

20

100

-10

-20

-30

FEDERAL RESERVE SANK OF ST. LOUIS

135

Figure 3

Money Growth Rates, 1880-1 989, G7 Countries

Percent

1009080706050403020100

-10-20-30-40

— U.S. — U.K. — Germany — Canada

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990


1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

Percent

MARCH/APRIL 1993

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Figure 4

Short-Term Interest Rates, 1880-1989, G7 Countries

Percent

1171615~1413121110987

6

432101880 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—10-9-8-7-654-321 I I I I I I I

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

— France — Japan


Figure 5

137

Long-Term Interest Rates, 1880-1 989, G7 Countries

Percent

20-19-18-17-16-15-14-13-12-11—10-9-8-7-6-543-

— U.S. — U.K. —‘--- Germany — Canada

2- I I I I I I I I I

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

Percent

2221

— France — Italy — Japan

MARCH/APRIL 1993

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Real short-term and real long-terminterest rates. For the underlying real short-term and real long-term interest rate data, seefIgures 6 and 7. The real interest rates are cxpost rates calculated using the rate of change ofa consumer price index.~~Unlike the nominalseries, the degree of convergence in meansbetween real short-term interest rates is lowestin the floating exchange rate period, next lowestin the Bretton Woods convertible period andhighest in the preconvertible period. Fot long-term real rates, as in the case of nominal rates,convergence is highest under the gold standardfollowed by the Bretton Woods convertible regime.It is lowest under preconvertible Bretton Woods.The real short-term interesl rate is most stableacross countries during the Bretton Woods con-vertible period. It also shows the least amountof divergence in standard deviations. The sameholds fot- real long-term interest rates.

The behavior of real interest rates acrossregimes is consistent with McKinnon’s explana-

~ He argued that fixed exchange ratesencourage capital market integration by elimina-ting devaluation risk. This reduces variabilityin short-term real interest rates. Similat-ly,real long-term interest rates ate stabilized bypooling across niarkets, which reduces capitalmarket risk.

Nominal and real exchange rates. Thelowest mean rate of change of the nominal ex-change rate arid the least divergence betweenrates of change occurred during the BrettonWoods convertible amid gold standard periods,with the former exhibiting the lowest degree ofdivergence. Exchange rates during the precon-vertihility Bretton Woods regime changed almostas much as during the floating pet-iod. Thismainly reflected the major devaluations of 1949(see figure 8l.’~Nominal exchange rates wereleast variable in the gold standard and converti-ble Bretton Woods periods and the most varia-ble and most divergent in the Bretton Woodspreconvertible period.

As with the nominal exchange rate, the lowestmean rate of change in the real exchange rate

across countries and the least divergencebetween countries was in the Bretton Woodsconvertible period, with the divergence in goldstandard period next smallest (see figure 9). Thehighest rate of change was in the floatingexchange rate period. Similarly data from theBretton Woods convertible period had thelowest standard deviation across countries andthe least divergence between standard devia-tions, with the gold standard again next in theserankings. The other t-egimes were characterizedby much greater variability and divergence.These results shed light on the i-elationshipbetween the nominal exchange rate regime andthe behavior of real exchange rates. Mussa(1986) presented evidence for 16 industrialcountries in the post—World War IT periodshowing the similarity between nonunal andreal exchange rate variability under floatingrates. His explanation for greater real exchangerate variability under floating rates than underfixed rates is nominal price rigidity.~°The expla-nation may, however, be questioned. For exam-ple, a fixed nominal exchange rates may producegreater trade stability that will be reflected inthe real exchange rate, as is evident for boththe Bretton Woods and gold standard periods.Yet as Eichengreen (1991b) points out and ascan be seen in table 4, these results could beexplained by the fact that both periods werecharacterized by few shocks.”

Finally, based on monthly data between 1880and 1986 for the United Kingdom and the UnitedStates, Grilli and Kaminsky show that, with theexception of the post—World War II period, noclear connection exists between the nominalexchange rate regime and the variability of realexchange rates.33 My mesults for the Group ofSeven countries show a clear correlationbetween nominal exchange rate rigidity aridlower real exchange rate variability for the goldstandard and Bretton Woods cotivei’tible regime.For the preconvertibie Bretton Woods period—de jure a type of fixed exchange rate regime—the correlation is not evident. I do not distin-guish between fixed and flexible periods in theinterwar segment as do Grilli and Kaminsky,

33Define the real interest rate as r, = i~— Alog ~ where i~isthe nominal interest rate and Alog P~= log P~— log P,_1is the percentage change in the consumer price index.

34See McKinnon (1988).35See Bordo (1993) table 2.3tAlso see Dornbusch (1976).“Stockman (1983 and 1988) argues that greater variability

in real exchange rates under floating rates than underfixed rates reflects the response of real exchange rates toproductivity shocks, with changes in the real exchangerate producing nominal exchange rate volatility. This vola-tility is offset under fixed rates by exchange market inter-vention.

38See Grilli and Kaminsky (1991).


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



Figure 8

141

Absolute Change in Nominal Exchange Rates, 1880-1989, G7 Countries

Percent

I = U.K. — Germany — Canada

= France — Italy — Japan

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

Percent

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

MARCH/APRIL 1993

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Figure 9

Absolute Change in Real Exchange Rates, 1880-1989,07 CountrIes

Percent

j — U.K. — Germany — Canada

Percent

70

60

50

40

30

20

10

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

80

= France — Italy — Japan


143

hence that period cannot be used in the com-

paiison.3°

In summary, the Bretton Woods regime exhibitedthe best overall macroeconomic performance ofany regime. ‘this is especially so fot the con-vertible period (1959_70L4tt As the summarystatistics in table 1 show, both nominal and i-eatvariables were mnost stable in this period. Thefloating exchange rate regime, on most criteria,was not far behind the Bretton Woods converti-ble regime, whereas the classical gold standardexhibited the most stability and the closest con-vergence of financial variables.

The preconvertible Bretton Woods petiod (1946—58) was considerably less stable fot the average ofall countries for both nominal amid real vaiiahlesthan other regimes. Also both nominal and i-calvariables did riot vary nearly as closely together.i’hese differences likely reflect the presence ofpervasive exchange amid capital controls before1958 and, related to these, more variable andmore rapid monetary growth. These data, how-ever, are limited. Although they show excellentperformance for the convettible Bretton Woodsregime, they do not tell us why it did well—whethet- it reflected a set of favorable circum-stances, whether it reflected the absence ofaggravatimig shocks, whether it reflected stablemonetary policy by the key country of the sys-tem, the United States, or whether it maskedunderlying strains to the system.

Inflation Persistence

A second piece of evidence is persistent infla-tion. Evidence of persistence in the inflationrate suggests that market agents expect themonetary authorities to continually follow aninflationary policy; its absence would be consis-tent with the belief that the authorities are fol-lowing a stable momietat-y tule, such as the goldstandard’s convertibility rule. Barsky (1987) pre-sented evidence for the United Kingdom andUnited States based on both autocort-elationsand time set-ies models that inflation under the

gold standard was very nearly a white-noiseprocess, whereas in the post—World War Hperiod, the inflation rate exhibited considerablepersistence. Alogoskoufis and Smith (1991) alsoshow, based on AR(1) regressions of the infla-tion rate, that inflation persistence in the twocoufitmies increased between the classical goldstandamd period and the interwar peiiod andbetween the interwar period and the post—WorldWar II period.41

Table 2 presents the inflation-rate coefficientfrom the type of Affil) regressions on consumerprice index inflation estimated by Alogoskoufisand Smith, for the Group of Seven countriesover successive regimes since 1880, as well asthe standard errors and the Dickey-Fuller testsfor a unit root.”

The results, as in Alogoskoufls and Smith, showan increase in inflation persistence fot- mostcountties between the classical gold stanclat-cland the interwar period, and also between theinterwar period and the post—World War ITperiod as a whole. Within the post—World WarII period, inflation persistence is generally lower,with the exceptions of France and Japan, in thepreconvertible l3retton Woods thati the convertibleperiod. This suggests that though the immediatepost—World War Il period was characterized byrapid inflation, market agents may have expecteda return to a stable price regime. The higherdegree of persistence in the convet-tibte regimesuggests that this expectation lost credence. Finally,the evidence that persistence was generallyhighest during the floating exchange rate regimemay imply that the public realized that them-cwas no longer a stable nominal anchom’.

Forecast Errors in Inflation andGrowth

A third piece of evidence relates to the forecasterrors of inflation and real output gt-owth. Accord-ing to Mettzer and Robinson (1989), “a welfaremaximizing muonetary rule would reduce varia-bility to the niinimum inherent in nature and

ttMeltzem (1990) in a comparison of EMS and non-EMS con-tries in the floating rate period also finds a strong correla-tion between changes in nominal and real exchange rates.40McKinnon (1992) treats the period 1950 to 1970 as thede facto dollar standard. He views this period rather than1959 to 1971 as the appropriate one for making the typeof regime comparisons undertaken here. I made the samecalculations as those shown in table I for the period 1950to 1971. Virtually every variable for each country exhibitedgreater instability than in the 1959 to 1970 period. Thisreinforces my choice of dates.

41Also see Alogoskoufis (1992), who attributes the increasein persistence to the accommodation by the monetaryauthorities of shocks. This evidence is also consistent withthe results of Klein (1975).

4tEichengreen (1992b) also presents these statistics for fourof the countries.

MARCH/APRIL 1993

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145

institutional arrangements.” They measure varia-bility by the mean absolute et-ror (MAE) of a one-period forecast based on the univariate multistateKalman Filter (MSKF). Following their approach,table 3 presents the MAEs for inflation and realgrowth for the Group of Seven countries over- suc-cessive regimes. the MSKF forecasts incorporateboth transitory and permanent shocks to the rate-of-change series.”

The smallest forecast errors for inflation on aver-age were for the Bretton Woods convertible period,followed by the gold standard amid the floating rateperiods. The largest errors were for the interwarperiod, followed by the preconvemtihle BrettonWoods period. The most notable exception tothe pattern was the United Kingdom, where thefloating rate period exhibited the largest varia-bility.

For real growth, as for the inflation rate, thelowest MAE, on average, occurred in the con-vertible Bretton Woods pem-iod. Another excep-tion to this pattern was Japan. ‘I’he highest MAEwas again in the interwar and the preconverti-ble Bretton Woods period. The floating exchangerate period, though mnore variable than the con-vertible Bietton Woods peiiod, was slightly lessvariable than the gold standaid regime.

‘These results are quite consistent with thoseof table 1. The Bretton Woods convertibleperiod was the most stable both in an ey postand ey ante sense. The performance of the goldstandard and the float, however, are not muchworse, at least for real growth for the float andinflation for the gold standard.

Demand and Supply Disturbances

An important issue is the extent to which theperformance of atternative monetary regimes,as ievealed by the data in the preceeding tables,reflects the operation of the monetary regime inconstraining policy actions or the presence or

43Meltzer and Robinson (1989) present their results forlevels, growth rates, and permanent growth rates of theseries, I present only growth rates to make the resultscomparable to those in table 1.

44See Bayoumi and Eichengreen (1992a, 1992b, 1992c and1 992d).

“See Blanchard and Ouah (1989).~~Bothvariables were rendered stationary by first differencing.47Specifically, four restrictions are placed on the matrix of

the shocks: two are simple normalizations, which definethe variances of the shocks to aggregate demand andaggregate supply; the third assumes that demand and

absence of shocks to the underlying environment.One way to shed light on this issue, followingearlier work by Bayoumi and Eichengreen, is toidentify underlying shocks to aggregate supplyand demand.~~According to them, aggregatesupply shocks reflect shocks to the environmentand are independent of the regimne, hut aggregatedemand shocks likely reflect policy actions andare specific to the regime.

The approach used to calculate aggregate sup-ply and demand shocks is an extension of thebivariate structural vector autoregression (VAR)methodology developed by Blanchard and Quah.~’Following Bayoumi and Eichengreen (1992a),I estimated a two-variable VAR on the rate ofchange of the price level and output.” Restric-tions on the VAR identify an aggi-egate demanddistum-bance, which is assumed to have only atemporary effect on output and a permanenteffect on the price level, and an aggregate sup-ply disturbance, which is assumed to have apermanent effect on both prices and output.47

Overidentifying restrictions, namely, restrictionsthat demand shocks are positively cot-relatedand supply shocks are negatively correlatedwith prices, can be tested by examining theimpulse response functions to the shocks.

‘The methodology has important limitationsthat suggest that the results should be viewedwith caution. ‘I’he key limitation is that one caneasily imagine frameworks in which demandshocks have permanent effects on output, where-as supply shocks have only temporary effects.”

I estimated supply (permanent) and demand(temporary) shocks, using annual data for eachof the Group of Seven countries,, over alterna-tive regimes in the period 1880—1989. The VARsare based on three separate sets of data—1880—1913,1919—39 and 1946—89—with the war years omit-ted because complete data on them were avail-able for only four of the countries.49 The VARshave two lags. I also did the estimation for

supply shocks are orthogonal; the tourth is that demandshocks have only temporary effects on output, that is, thatthe cumulative effect of demand shocks on the rate ofchange in output must be zero.

“See Keating and f-Jye (1991).“For results using the complete data set for these four

countries, see appendix table 1 and appendix figure I -

MARCH/APRIL 1993

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9t7 I.

147

aggregated pm-ice and output data for the Gi-oup ofSeven countries.~°

The overidentifying restrictions that demandshocks be positively correlated and supply shocksbe negatively correlated with the price level aresatisfied for all countries for the two post—WorldWar Il regimes. But for’ the period before WorldWar IT, for a number of countries, including theUnited States, United Kingdom, and France, theyare not. Supply shocks were positively correlatedwith prices. This can be seen in the impulseresponse functions displayed in figure 10. Fig-ure 10 shows the impulse responses, to onestandard deviation shocks in aggregate supplyand aggregate demand, on output and prices forthe Group of Seven countries aggregateby regime.~’

Keating and Nyc (1991) attempted to explain thisresult by possible hysteresis effects. Bayoumi andEichengreen (1992a) argued that the perverseimpulse response patterns for the classical goldstandard amid interwar periods reflected theinteraction of a positive aggregate demand curvewith a very steep aggregate supply curve. Theyexplain the positively sloped aggregate demandcurve as reflecting the effects of gold discover-ies induced by the supply shock of agriculturalsettlements in the United States and Australia.These results may also reflect a limitation of theBlanchard-Quah methodology.

Table 4 presents the standam’d deviations ofsupply and demand shocks for the (;roup ofSeven countties and the Group of Seven coun-tries taken as a whole (Group of Seven aggregate)by regime. I also show, following Bayoumi andEichengreen, the weighted average of the indi-vidual country shocks.” Figum-es 11 and 12 showthe shocks for the Group of Seven aggregateand for each of the seven countries.

Table 4 shows for the Group of Seven aggre-gate that the convertible Bretton Woods regimewas the most tranquil of all the regimes—neithersupply nor demand shocks dominated. It was not,however, that much less turbulent than the suc-ceeding float. The interwar period, unsurpris-ingly, shows the largest supply and demandshocks.” Sizeable supply and demand shocksthat are two or three times greater than thepost—World War II period also characterize theclassical gold standard.”

For individual countries, the Bretton Woodsconvertible period was the most stable in fourcountries and the flexible exchange rate periodwas the most stable in three. The differencebetween the convertible Bretton Woods periodand the floating exchange rate period, however,was not great in any country. The interwarperiod as expected was the most volatile. Bothtypes of shocks were the largest in every coun-try except the United Kingdom. Finally, in themajority of countries, with the principal excep-tions being the United Kimigdom arid Germany,both supply and demand shocks were consider-ably greater in the gold standard period than inthe post—World War IT period.

‘rhe dispersion of demand shocks across coun-tries, as measured by the GNP-weighted stand-ard deviation of the individual country shocksaround the Group of Seven aggregate, revealsvery little difference between the gold standardand the post—World War It regimes, with theconvertible Bretton Woods regime displayingthe highest degree of convergence. Dispem’sionis much greater in the interwar period. Thedispersion of supply shocks is considerablygreater during the gold standard and the inter-war periods than in amiy of the post—WorldWar IT regimes.

“The Group of Seven aggregate income growth and infla-tion rate are a weighted average of the rates in the differ-ent countries. The weights for each year are the share ofeach country’s nominal national income in the total incomein the Group of Seven countries, where the nationalincome data are converted to U.S. dollars using the actualexchange rates.

t1The impulse response functions were calculated fromVARs run for the separate regime periods. Because thenumber of observations was limited, the Bretton Woodsregime could not be split into the two subperiods shown inpreceding 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 theUnited States by Cecchetti and Karras (1992), who esti-mate a three-variable VAR with monthly data. The late

1920s and early 1930s reveal a major negative demandshock consistent with Friedman and Schwartz’s (1963)attribution of the onset of the Great Depression tomonetary forces. After 1931, negative supply shockspredominate, consistent with Bernanke’s (1983) andBernanke and James (1 991) explanation for the severity ofthe Great Depression that stresses the collapse of thefinancial system.

“Though the shocks are smaller, the rankings by regime forthe weighted average of individual country shocks are sim-ilar to the G-7 aggregate.

MARCH/APRIL 1993

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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

0.120.11

0.10.09

0.08

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0.06

0.05

0.04


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

0.025

Effects of Aggregate Demand Shocks, 1919-1 939

0.02-S

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Effects of Aggregate Supply Shocks, 191 9-1 939

MARCH/APRIL 1993

150


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


Impulse Response Functions of Demand and Supply Shocks on Prices (Dotted Lines)and Output (Solid Lines), G7 Aggregate by Regimes, Annual Data, 1881 -1989

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Effects of Aggregate Demand Shocks, 1946-1989

Effects of Aggregate Supply Shocks, 1946-1989

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MARCH/APRIL 1993


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

S. - £—.-_~__.__._.-. —‘I

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Effects of Aggregate Supply Shocks, 1971 -1989

152

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Figure 11

Supply and Demand Shocks: 07 Aggregate, 1880-1 989, Annual Data

Percent

Figure 12Supply and Demand Shocks: 1880-1989, United States

Percent

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155


Supply and Demand Shocks: 1880-1 989, United Kingdom

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MARCH/APRIL 1993


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157

Figure 12 (Continued)

Supply and Demand Shocks: 1880-1989, Canada

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MARCH/APRIL 1993

158

In sum, the evidence on supply and demandshocks is quite similar to the measures of vola-tility drawn from the forecast errors using theMSKF. The gold standard regime, as well as theinterwar period, emerges as a relatively unstableperiod stressed by widely dispersed supply shocks.fly contrast, the Bretton Woods convertible periodis the most stable, with the floating exchangerate period not far behind.

These results raise the interesting question,why in the past century was the classical goldstandard so durable in the face of substantialshocks, whereas Bretton Woods was so fm-agilein the face of the mildest shocks?

Responsiveness to Shocks

The final piece of evidence to be calculated inthe comparison of regime performance is theresponse of the price level and output to theaggregate supply (permanent) and aggregatedemand (temporary) shocks. Evidence of a mom-crapid adjustment of prices and output to shocksmay help explain why one regime may havebeen more durable than another.

A measure of speed of response can be gleanedfrom the impulse response functions derivedfrom the bivariate \7AR5. In addition, as a crudemeasure of response speed, which allowed easycomparison of all seven countries (luring thefour regimes, I calculated the mean absolute lagof the response functions.” Table 5 presentsthese measures.

The response of output to both demand and5upplv shocks for the Group of Seven aggregateand for most of the individual countries wasmarkedly more rapid under the gold standardregime than under the postwar regimes (an ex-ception is the U.S. response to demand shocks)and within the postwar regimes was slightlymore rapid under the Bretton Woods regimethan the floating exchange rate regime. Theresponse of prices to both demand and supplyshccks was considerahl more rapid during thegold standard (and the interwar) regime thanthe postwar regimes for Ihe Group of Sevenand most countries?6 Within the postwarperiod, it was considerably niot-e rapid under

Bretton Woods than under the floating exchangerate period.

Perhaps the gold standard was able to endurethe greater shocks that it faced because of both

greater price flexibility and greater factor’ mobil-ity before World War I. Alternatively, the goldstandard was more durable than Bretton Woodsbecause before World War I, suffrage was limited,central banks wem’e often privately owned and,before Keynes, there was less understanding ofthe link between monetary policy and the levelof economic activity. Hence there was less of anincentive for the monetary authorities to pursuefull employment policies, which would threatenadherence to convertibility.

In addition, the Bretton Woods regime was bothmore stable and seemingly more flexible thanthe floating exchange rate regime and yet morefragile. This suggests that its collapse is attribut-able less to outside shocks to the environmentor the structum’e of the Group of Seven economyand more to flaws in the design of the regime.

Summary

The performance of alternative internationalmonetary regimes suggests that the BrettonWoods convertible regime (1959—70) was themost stable, followed by the floating exchangerate and the classical gold standard regimes.The stability of forecast errors to both inflationand growth paralleled that of the ey post data.Limited inflation persistence—evidence forcredibility of the nominal anchor—was lowestduring the classical gold standard. Though con-siderably higher than under the gold standard,persistence was less under Bretton Woods thanunder the float. Under Bretton Woods the nomi-nal anchor of the U. S. commitment to peg theprice of its currency to gold was apparently stilleffective. Finally, supply shocks were greaterand less symmetric, and demand shocks weregreater under the classical gold standard thanunder the post—World War II regimes. A morerapid response of both prices and output to theseshocks also occurm-cd under the gold standard.

The question still remains why some fixedexchange rate regimes endured longer than others

“The formula was PC A c~ I PC Ac~ tor 1 to 40,where i is the year and A c, the impulse response, cal-culating absolute changes because of the presence ofboth positive and negative responses. This measure isonly a rough approximation because it is not possible tocalculate the standard errors.

“As mentioned above, according to the overidentifyingrestrictions of the Bayoumi-Eichengreen-Blanchard-Ouahapproach, supply shocks should have produced a negativeresponse in prices, not the positive one shown here for thepre-World War II periods.


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or why the world periodically shifted betweenfixed and flexible rates. The durability of thegold standard ma he due to greater prmce flexi-bility and factor mobility before World War Ithat allowed the world economy to respond toshocks more rapidly. It also mat’ he due to theabsence of discm-ctionary monetary policies dedi-cat ed to maintaining frill employment. But thefragility of the most stable regime, BrettonT~%Toods in the face of mild shocks, suggests thatan undet-standing of its demise requires a closerlook at the history, institutions and rules ofbehavior of alternative monetary regimes.

THE GOLD STANDARD, BRETTON

WOODS, AND THE EMS AS

COMMITMENT MECHANISMS

Perhaps the answer’ to the foregoing questionsconcerning regime performance and durabilitymay be linked to the commitment technology ofthe regime. Tn this section 1 argue that the goldstandard rule of convertibility was a crediblecommitment mechanism that was crucial to itssuccess and that the absence of such a mech-anism underlies the failure of the l3retton Woodsvariant. The EMS, though not anchored to goldconvertibility, may have been successful for sev-eral years because it embodied a commitmenttechnology reminiscent of the gold standam’d.However, like Bretton Woods, it was subject inSeptember 1992 to intolerable strains becausethe commnitment mechanism proved to be notct-edible for many of the muembers.

tinder the classical gold standard, the mnonetarvauthorities committed themselves to fix the pricesof their currencies in terms of a fixed weight ofgold and to buy and sell gold freely in unlimitedamounts. The pledge to fix the price of a coun-try’s currency in terms of gold represents thebasic rule of the gold standard. The fixed priceof domestic currency in terms of gold provideda nominal anchor to the international monetarysystem. tInder the Bretton Woods system onlythe United States fixed the price of its currencyin terms of gold. All other convertible currencieswere pegged to the dollar. Also, under llrettonWoods, free convertibility of gold into dollars waslimited. Thus Bretton Woods was a weak variantof the gold standard. Although the Bretton Woodssystem in its convertible phase (1959—71) wasthe most stable monetary regime of the past

century, it was short lived. It collapsed bothbecause of fatal flaws in its design (the adjusta-tile peg in the face of improved capital mobilityand the confidence problem associated with thegold dollar standard) and the lack of commit-ment by the United States to the gold standardconvert ihil ty rule.

The Ei~iS,although not based on gold, incor-porated many of the features of the BrettonWoods adjustable peg system. Its success inpromoting the convergence of inflation ratesamong its tnemnbers in the 1980s has beenlinked to the presence of an effective commit-ment mechanism—the adherence by the Germancentral hank to price stability and the willing-ness of other members to tie their currencies tothe German mark. However, like Bret ton Woods,it suffered serious stress in September 1992 inthe face of mnassive shocks because of the basicincompatibility of pegged exchange rates, capitalmobility and policy autonomy. Both the centercountry and the members were unwilling tocommit to a common policy.

An overview of the three regimes as embodyingthe operation of credible monetary rules follows.

The Gold Standard as a CommitmentMechanism

In the recent literature on the time inconsistencyof optimal government policy, the absence of acredible comnmitment mechanism leads govern-ments, in put-suing stabilization policies, to pro-duce an inflationary outcome.57 In a closedeconomy environment, once the monetary authorityhas announced a given rate of monetary growth,which the public expects it to validate, the au-thority then has an incentive to create a mone-tat-y surprise to either reduce unemployment orcapture seigniorage revenue. ‘I’he public, withrational expectations, will come to anticipate theauthorities’ perfidy, leading to an inflationaryequilibrium. A credible precommnitmnent mech-anism, h preventing the government fromcheating, can preserve long-run price stability.The gold standard rule of maintaining a fixedprice of gold can be viewed as such a mechanism.

The gold standard i-tile can lie viewed as a formof contingent rule or a rule with escape clauses.”‘I’he monetary authority maintains the standard—that is, keeps the price of the currency in terms ofgold fixed—except in the event of a well-understood

578ee Kydland and Prescott (1977) and Barro and Gordon(1983).

“See Grossman and Van Huyck (1988), DeKock and Grilli(1989), and Bordo and Kydland (1992).


161

emergency, such as a major war or a financial cmi-sis. In wartime it may suspend gold convertibilityand issue paper money to finance its expenditures,and it can sell debt issues in terms of the nominalvalue of its currency on the understanding that debtwill eventually be paid off in gold. The rule is con-tingent in the sense that the public understands thatthe suspension will last only for the duration of thewartime emergency plus some period of adjustment.It assumes that afteris’ard the government willfollow the deflationary policies necessary to resumepayments at the original parity. Following sucha rule will also allow the government to smoothits revenue from different sources of finance, suchas taxation, borr’owing and seigniorage.5°

According to Bordo and Kydland (1992), thegold standard contingent rule worked success-fully for three come countries of the classicalgold standard: the United Kingdom, the UnitedStates, and France. Tn all these countries themonetary authorities adhered failhfully to thefixed price of gold except during major wars.During the Napoleonic War and World War Ifor England, the Civil War for the United States,and the Franco—Prussian War foi France, speciepayments were suspended, and paper moneyamid debt were issued. But in each case, afterthe wartime emergency had passed, policiesleading to resumption were adopted.” Indeed,successful adherence to the rule may have ena-bled the belligerents to obtain access to debtfinance more easily in subsequent wars. Othercountries, such as Italy, which did not continu-ously maintain gold convertibility, neverthelessadopted policies consistent with long-run con-vertihili ty .°‘

The gold standard rule may also have beenenforced by reputational considlerations. Long-run adherence to the rule was based on the

historical evolution itself of the gold standard.Gold was accepted as money because of itsintrinsic value and desirable propeities. Paperclaims, developed to economize on the scarceresources tied up in a commodity money, becameacceptable only because they were convertible intogold. An alter-native commitment mechanismwas to guarantee gold convertibility in the con-stitution. This was the case for example inSweden before 1914, when laws pertaining tothe gold standard could be changed only by twoidentical parliamentary decisions with an elec-tion in between.” Convertibility was alsoenshrined in the laws of a number of goldstandard central banks.63

The gold standard originally evolved as a domes-tic commitment mechanism, but its enduringfame is as an international rule. The classicalgold standard emerged as a true internationalstandard by 1880 following the switch by themajority of countries from bimetallism, silvermnonometalism and paper to gold as the basis oftheir currencies.” As an international standard,the key rule was maintenance of gold converti-bility at the established par. Maintenance of afixed price of gold by its adherents in turnensured fixed exchange rates. Recent evidencesuggests that, indeed, exchange rates through-out the 1880—1914 period were characterizedby a high degree of fixity in the principal coun-tries. Although exchange rates frequently deviatedfrom par, violations of the gold points amid de-valuations were rare.°5

According to game theory literature, for aninternational monetary arrangement to be effec-tive both between countries and within them, atime-consistent credible commitment mechanismis required. Adherence to the gold convertibilityrule provided such a niechanism. In addition to the

“See Lucas and Stokey (1983) and Mankiw (1987).°°Acase study comparing British and French finances dur-

ing the Napoleonic Wars shows that Britain was able tofinance its wartime expenditures by a combination oftaxes, debt and paper money issue—to smooth revenue;whereas France had to rely primarily on taxation. Francehad to rely on a less efficient mix of finance than Britainbecause she had used up her credibility by defaulting onoutstanding debt at the end of the American RevolutionaryWar and by hyperinflating during the Revolution, Napoleonultimately returned France to the bimetallic standard in

1803 as part of a policy to restore fiscal probity, butbecause of the previous loss of reputation France wasunable to take advantage of the contingent aspect of thebimetallic standard rule. See Bordo and White (1991).

61The behavior of asset prices (exchange rates and interestrates) suggests that market agents viewed the commitmentto gold as credible. See Roll (1972) and Calomiris (1988),

who present evidence of expected appreciation of thegreenback during the American Civil War based on anegative interest differential between bonds that were paidin greenbacks and those paid in gold.

Giovannini (1992) finds that the variation of bothexchange rates and short-term interest rates varied withinthe limits set by the gold points in the 1899—1909 periodconsistent with market agents’ expectations of a crediblecommitment by the four core’’ countries to the goldstandard rule in the sense of this paper.

°2SeeJonung (1984).

“See Giovannini (1993).“See Eichengreen (1985).

“See Officer (1986) and Eichengreen (1985).

MARCHIAPRIL 1993

162

reputation of the domestic gold standard and con-stitutional provisions that ensured domestic com-mitment, adherence to the international gold-standard rule nias’ have been enforced by othermechanisms. These include improved access tointernational capital markets, the operation ofthe rules of the game, and the hegemonicpower of England.

Support for the intertiational gold standat-dlikely grew because it provided improved accessto the intet-national capital markets of the corecountries. Countries were eager to adhere tothe standard because thex’ believed that goldconvertibility would he a signal to credit (fl~sofsound government finance and the futut-e ahil-its’ to service debt.”°

This was the case both for developing countriesseeking access to long-term capital, such asAustria-I-lungarv and Latin Amet-ica, and fot-countries seeking short-term loans, such as.lapan which financed the Russo-Japanese warof 1905—06 with foreign loans seven years afterjoining the gold standard.°~Once on the goldstandard, these countries feared the consequencesof suspension.” ‘That England, the most success-ful country of the nineteenth century, as wellas other progressive countries were on the goldstandard was probably a powerful argumentbr ~oining.’°

The opera tion of the rules of the game,wheretiv the monetary authorities were sup-

posed to alter the discount i-ate to speed up theadjustment to a change in external halance, mayalso have heen an important half of the com-mitment mechanism to the international goldlstandard rule. To the extent the rules were fol-lowed and amljustment facilitated, the commit-

mnenl to convertibility was strengthened andconditions conducive to ahandonment wem-elessened.

Evidence on the opel-ation of the rules of thegame questions their validity. Bloomfield (1 959)

in a classic study, showed that, with the principalexception of F.ngland, the rules were frequentlyviolated in the sense that discount rates were

SeA case study of Canada during the Great Depression pro-vides evidence for the importance of the credible commit-ment mechanism of adherence to gold. Canadasuspended the gold standard in 1929 but did not allow theCanadian dollar to depreciate nor the price level to rise fortwo years. Canada did not take advantage of the suspen-sion to emerge from the depression because of concernfor its credibility with foreign lenders. See Bordo and Red-ish (1990).

675ee Yeager (1984), Fishlow (1989) and Hayashi (1989).

not always changed in the required direction(or by sufficient amounts) and in the sense thatchanges in dotnestic credit were offen nega-tively corm’elated with changes in gold reserves.In addition, a number of countries used golddevices—practices to prevent gold outflows.

For the major countries, however (at leastbefore 1914) such policies were riot used exten-sively enough to threaten the convertibility togold—evidence of commitment to fiie l-ule.”Moreover, as McKinnon (1992) argues, to theextent that monetary authorities followed Bage-hot’s rule and prevented a financial crisis whileseemingly violating the rules of the game, thecommitment to the gold standard in the longrun may have been strengthened.

An additional enforcement mnechanism for thein t erna tiomal gold static]at-cl m-ule may have beenthe hegenionic power of Englamid, the mostimportant golml standard countrvi’ A Iiersistent1 heme in t lie literature on the international goldstanmlard is that the classical gold standard of1880 to 1914 was a British-managed standard.~Because London was the center for the world’s

principal gold, comnmoclities and capital mam-kets,tiecause of the extensive outstanding sterling-denominated assets, and because many countm-iessubstituted sterling for gold as an internationalreserve currency, some argue that the Batik ofEngland, by manipula t big its hank rate, couldattract whatever gold it needed and, fm-f her-more, that other central banks would adjusttheir discount rates accordingly. ‘l’hus the Bankof England could exert a powerful influence onthe money supplies and p-ic levels of othergold standai-d countries.

The evidence suggests that the Hank did havesonic influence on other European cetitmal hanks.~~Lichengreen (1987) treats the Bank of Englandas one engaged in a leadership role in a Stackelbergstrategic game with other central banks as fol-lowers. The other central banks accepted a

passive role because they benefited from usingstem-Inig as a reserve asset - Acco mcling to tliisinterpm-etation, the gold standard rule mas’

“See Eichengreen (1989a) and Fishtow (1987 and 1989).

“See Friedman (1990) and Gallarotti (1991).70See Schwartz (1984).7mSee Eichengreen (1989b).72See Bordo (1984).

“See Lindert (1969).


163

have been enforced by the Bank of England.7.m

‘thus the monetary authorities of many coun-tries may have been constrained from followingindlependent discretionary policies that wouldhave threatened adherence to the gold standlardrule.

Indeed according to Giovannini (1989), the goldstandam-dl ivas an asymmetric system. Englandwas the center country. It used its monetarypolicy (hank t-ate) to maintain gold converti-bility. Other countries accepted the dictatesof fixed pam-ities and allowed their money sup-plies to respond passively. His regressionssuppoi-t tins view—the French and Germnancentral banks adapfed their domestic policiesto external conditions, whereas the Britishdid not.

The benefits to England as leader of the goldstandard—from seigniorage earned on foreign-held sterling balances to returns to financialinstitutions generated b its central position inthe goldl standam-d and to access to internationalcapital markets in wartime—were substantialenough to make the costs of not following therule ex tt-emely high.

‘The classical gold standard ended in the faceof the massive shocks of World War ~ ‘Ihegold exchange standard, which prevailed foronly a few years frotii the mid-1920s to theGreat Depression, was ami attempt to restore thebeneficial features of the classical gold standardwhile allowing a greater iole for domestic stahil-ization policy. This in tum-n cm-eated a growingconflict between adherence to the rule and dis-cretion. If also attempted to economize on goldreserves by restricting its use to central banksand by encoui-aging the use of foreign exchangeas a substitute. As is well known, the goldl ex-change standard suffered from a number offatal flaws.” These includle the use of tworeserve currencies (the pound and the dollar),the absence of leadem-ship liv a hegemonic

p°~ver,the failure of cooperation between the

key members (England, France and the UnitedStates), and the unwillingness of its two strongestmembers, the United States and France, to fol-low the rules of the game. Instead they exerteddeflationary pressure on the rest of the worldby persistent sterilization of balance-of-paymentsurpluses. The gold exchange standard collapsed,but according to F’riedmnan arid Schwartz, Temin,andl Eichengreen, not before transmitting defla-tion and depression across the world.~~

The Bretton Woods InternationalMonetary System

The planmnng that led to Bretton Woods aimedto prevent the chaos of the interwar period.”The perceived ills to he prevented included (1)floating exchange rates that were condemned assubject to cTestabilizing speculation; (2) a goldexchange standard that was vulnem-able to prob-lems of adjustment, liquidity amid confidence,which enforced the international ti-ansrnissiorof deflation in the early 1 930s; and (3) theresort to heggar-thv-neighhor devaluations,trade rest rictions, exchange controls and bilater-alism after 1933. ‘To lirevent these ills, the casefor an adjustable peg system was made byKeynes, White, Nurkse and others.” The newsystem would combine the favorable features ofthe fixed exchange rate gold standard—stabilityof exchange rates—amid of the flexible exchangerate standard—monetary and fiscal independtence.

Both Keynes, leading the British negotiating teamat Bretton Woodls, and White, leading the Amneri-can team at Bretton Woods, planned tin adjustable

peg system to lie coordinated by an internationalmonetary agency. The Keynes plan gave the Inter-national Cum-rency Union substantially mnomereserves amid poii’er than the United Nations Stabili-zation Fund proposedl by White, hut both institu-tions would have hadl considerable control ovem- thedomestic financial policy of the members.

The Ilmitisli plan contained more domestic policyautonomy than dlid the U.S. plan, whereas the

74According to Eichengreen (1989a), the Bank of England’sability to ensure convertibility was aided by the coopera-tion of other central banks. In addition, as mentionedabove, belief based on past performance that Englandattached highest priority to convertibility encouragedstabilizing private capital movements in times of threats toconvertibility, such as in 1890 and 1907,

“The standard deviations of both supply and demandshocks during World War I for the countries for which wehave continuous data were two to three times as great asduring the classical gold standard, See appendix table 1and figure I -

“See Kindleberger (1973), Temin (1989), and Eichengreen

(1992c).“See Friedman and Schwartz (1963), Temin (1989) and

Eichengreen (1 992c).

“This section draws heavily on Bordo (1992).

“See Bordo (1993).

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American plan put more emphasis on exchangerate stability. Neither architect was in favor of arule-based system.8°The British were most con-cerned with preventing the deflation of the 1930s,

which they attributed to the constraint of the goldstandard m’ule and to deflationary U.S. monetary pol-icies. ‘thus they wanted an expansionary system.

The American plan was closer to the goldstandard rule in that it stressed the fixity ofexchange mates. It did not explicitly mention theimportance of rules as a cm-edible commitmentmechanism, but there were to be strict regula-

tions on the linkage between UNITAS (the pro-posed international reserve account) and gold.Members, in the event of a fundamnental dis-equilibrium, could change their parities onlywith approval from a three-quarters majom’ity ofall members of the fund.”

‘the Articles of Agreement of the InternationalMonetary Fund incorporated elements of both theKeynes and White plans, although in the end, U.S.concerns predominated.” The main points of thearticles were: the creation of the par value system;mnultilateral payments; the use of the fund’sresources; its powers; and its organization.

The Par Value System

Article TV det’ined the numeraire of the interna-tional monetary system as either gold om the tJ.S.dollam of the weight and fineness on July 1, 1944.All members were urged to declare a par value

and maintain it within a 1 percent margin oneither side of parity. Pam-ity could be changed inthe event of a fundamental payments disequili-brium at the decision of the member, after con-

sultation with other fund members. ‘Fhe fundwould not, however, reject the change if it wasnot more than 10 percent; if the change wasmore than 10 percent, the fund would decide

within 72 hours. Unauthorized changes in the

exchange rate could make members ineligible touse the fund’s resources, and if a member continuedto make unauthorized changes, it could be expelledfrom the fund. A uniform change in par value ofall currencies (in terms of gold) required approvalby a majonity of all voting fund members aridalso had to be approved by every member with10 percent or more of the total quota.

Multilateral Payments

Members were supposed to make their curren-cies convertible for cut-rent account transactions(Art. VIII), but capital controls were permitted(Art. VI.3). They were also to avoid discrimina-tory currency and multiple curency arrange-ments. Countries could avoid declaring theircurrencies convertible, however, by invokingArt. XIV, which allowed a three-year transitionperiod after establishmnent of the fund. Duringthe transition period, existing exchange controlscould be maintained.”

The Fund’s Resources

As under the White plan, members couldobtain resources fromn the fund to help financeshort- or medium-term payments disequilihria.The total fund, contributed by mnembem-s quotas(25 pci-cent in gold amid 75 percent in currencies)

was set at $8.8 billion. It could he raised everyfive yeams if the mnajoritv of members wanted todo so. The fumid set a number of conditions onthe use of its resources by deficit countries toprevent it fromn accumnulating soft currenciesand froni depleting its holdings of harder cur-rencies.8” It also established requirements andconditions fom m-epurchase (repayment of a loan),imicluding giving the fund the right to decide thecurrency in which repurchase would be made.

801n the sense of a commitment mechanism to prevent thetime consistency problem. According to Meltzer (1988) andMoggridge (I986), Keynes had a strong preference forrules over discretion, interpreting rules in the traditionalsense,

tm1See Giovannini (1993).12Am the same time as the Articles of Agreement for the

International Monetary Fund were signed, the InternationalBank for Reconstruction and Development (the WorldBank) was established. The Charter of the InternationalTrade Organization (ITO) was drafted and si9ned in 1947but never ratified. It was succeeded by the General Agree-ment for Tariffs and Trade (GATT) originally negotiated in

Geneva in 1947 as an interim institution until the ITOcame into force,

“Under Art, XIV, three years after March 1, 1947, the IMFwould begin reporting on the countries with existing con-trols, two years later it woutd begin consulting with individ-ual members and advising them on policies to restorepayments equilibrium and convertibility. Countries that didnot make satisfactory progress would be censured andultimately asked to leave the fund, In fact, the fund alwaysaccepted the member’s reason for remaining under Art.XIV,

~Members could draw on their quotas without condition.Beyond that, referred to later as the credit tranches.although not spelled out in the articles, increasingly moreexacting conditions were required.


165

In the case of countries prone to running largesurpluses, the scarce currency clause (Art. VII)would come into play. If the fund’s holdings of acurrency wet-c insufficient to satisfy the demandfor it by other members, it could declare it scarceand then urge members to ration its use by dis-criminatory exchange controls.

The Powers of the Fund

The fund had considerably less discretionarypower over the domestic policies of its membersthan either of the architects wanted, but it stillhad power to influence the international mone-tary system strongly. These powers included itsauthority to approve or reject changes in parity;the use of multiple exchange rates and otherdisctiminatory practices; the conditionality implicitin members’ access to the credit tranches oftheir quotas, which was made explicit by 1952; itsauthomity to declare currencies scat-ce; its authorityto declare members ineligible to use its resources(used against France in 1948 following an unap-proved devaluation); and its ultimate authorityto expel members.” The fund also had consider-able power as the premier international mone-tary organization in consulting and cooperatingwith national and other international monetaryauthorities.

Organization

The fund was to be governed by a board ofgovernors appointed by the members. The boardwould make the major policy decisions, such asapproving a change in parity. Operations of thefund were to be directed by executive directorsappointed by the members arid a managing direc-tor selected by the executive dinectors. Majorchanges such as a uniform change in the parvalue of all currencies or the second amend-ment to the articles, which created the specialdrawing right (SDR), would require a majorityvote by the members. The number of votes inturn was tied to the size of each member’s quota)which was determined by its economic size.

i’hough the articles could not be interpretedstrictly as a retunn to the gold standard rule ofthe fixed price of gold with free convertibility,

the fixed price of gold at $35 per ounce, whichthe U.S. was to maintain, represented the nomi-nal anchor of the system. Members were requiredto maintain parity of their exchange rates interms of dollars (or gold). Also, like the goldstandard, it was a rule with an escape clause.Members at their initiative could alter their par-ities in the event of a fundamental disequilibrium.

The architects never spelled out exactly howthe system was supposed to work. Subsequentwriters, however, have suggested a number ofsalient features.” First, curm-encies were treatedas equal in the articles. This meant that in theoryeach country was required to maintain its parvalue by intervening in the currency of everyother country—a practice that would have workedat cross purposes. In fact, because the UnitedStates was the only country that pegged its cur-rency in terms of gold (bought and sold gold),all other countries would fix their parities interms of dollars and would intervene to monitortheir exchange rates within 1 percent of paritywith the dollar.

Second, countries would use their internationalreserves or draw resources from the fund to financepayments deficits. In the case of surpluses, coun-tries would tempot-arily build up reserves or re-purchase their currencies from the fund. In theevent of medium-tem-ni disequilibria, they would usemonetary and fiscal policy to alter aggregatedemand. In the event of a fundamental disequil-ibrium, which was never defined but presumablyreflected either some permanent structural shockor sustained inflation, a member was supposed toalter parity by an amount sufficient to restore exter-nal equilibrium.

Third, capital controls wet-c permitted to preventdestabilizing speculation from forcing members toalter their parities prematurely or unintentionally.

THE HISTORY OF BRETTONWOODS: PRE-CONVERTIBILITY

1946—58

The international monetary system that beganafter World War TI was far different front thesystem that the architects of Bretton Woodsenvisioned. ‘The transition period fmom war to

“See Diz (1984) for a discussion of conditionality impticit inmembers’ access to the credit tranches of their quotas.

“See, for example, Tew (1988), Scammell (1976) andVeager (1976). For Williamson (I985b) it was a compre-hensive set of rules for assigning macroeconomic pol-

icies—exchange rates to medium-run external balance,monetary and fiscal pohcy to short-run internal batanceand international reserves—to provide a buffer to allowshort-run departures from external balance,

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peace was much longer and more painful thananticipated. Frill convertibilit of the majorindustrial countries was not achieved until theend of 1958, although the system had startedfunctioning normally hx’ 1955. Two interrelatedproblems dominated the fit-st postwar decade:hilateralismn and the dollar shortage.

Bilateralism

The legacy of Wot-ld War 11 for virtually everycountry except the United States was one ofpervasive exchange controls and controls ontrade. No mnajor currency except the dollar wasconvertible.” Under Art. XIV of the BrettonWoods agreement, countries could continue touse exchange controls for- an indefinite tranisi-tion period aftem- the establishment of the Inter-national Monetary Fund (IME) on March 1, 1947.In conjunction with exchange controls, everycountry negotiated a series of bilateral pay-ments agreements with each of its trading part-tiers. ‘t’he rationale For the continued use ofcontrols and bilateralism was a shortage ofinternational reserves. After the war, the econo-mies of Europe and Asia were devastated. Toproduce the exports needed to generate foreignexchange, industries requiled new and improvedcapital. There was an acute shortage of keyimports, both foodstuffs to maintain livingstandards and raw materials and capital equip-ment. Controls allocated the scam-ce reserves.

The Dollar Shortage

B~the end of World War II, the United Statesfield two-thirds of the world’s monetary goldstock (see figure 131. ‘the gold avalanche in theUnited States in the 1930s was the consequenceof both the dollar devaluation in 1934, whenthe Roosevelt administration raised the price ofgold fromn $20.67 per ounce to $35.00, and capi-tal flight from Europe. During the war, gold

inflows continued to finance wartime expendi-tures 1w the allies. At the end of World War II,gold and dollar reserves in Eum-ope and Japanwere depleted. Europe ran a massive cLtrrentaccount deficit, reflecting the demand for essen-tial imports and the reduced capacity’ of theexport industties. The Organization for Euro-pean Economic Cooperation (OEEC) deficit,aggravated by the had winter of 1946—47,reached a high of $9 billion in 1947. The OEECdeficit equaled the aniount of the U.S. currentaccount surplus, which was large because theUnited States) as the only majom’ industrial coun-try operating at full capacity, supplied theneeded iniports. The dollar shortage was likelyaggravated by overvalued official parities set bythe major European industrial countries at theend of 1946.88

By the mid—1950s both problems had beensolved. The currencies of western Europe werevirtually convertible by 1955 and their currentaccounts were generally in surplus. The keydevelopments in this progmess were the Mar-shall Plan and the European Payments Union.

The Marshall Plan

The Marshall Plan funneled approximately $13billion in aid (grants and loans) to western Europebetween 1948 and 1952.” ‘The plan requiredthe recipients to cooperate in the liberalizationof trade and payments. Consequently, the OEECwas established in April 1948. It presided overthe allocation of aid to mnemhers based on thesize of their current account deficits. U.S. aidwas to pay for essential imports and to provideinternational reserves. Each recipient govern-ment provided matching funds in local curt-encvto be used for investment in the productivecapacity of industry, agriculture and infrastruc-ture. Each country also had a delegation of U.S.administrators that advised the host govern-ment on the spending of its counterpart funds.

“Under the classical gold standard, convertibility meant theability of a private individual to freely convert a unit of anynational currency into gold at the official fixed price. Asuspension of convertibility meant that the exchange ratebetween gold and national currency became flexible butthe individual could still freely transact in either asset. SeeTriffin (1960). By the eve of World War II, convertibilityreferred to the ability of a private individual to freely makeand receive payments in international transactions in termsof the currency of another country. Under Bretton Woods,convertibility meant the freedom for individuals to engagein current account transactions without being subject toexchange controls. Tew (1988) defines this as market con-vertibility and distinguishes it from official convertibilitywhereby the monetary authorities of each country freely

buy and sell foreign exchange (primarily dollars) to keepthe parity fixed (within the 1 percent margin) and theUnited States freely buys and sells gold to maintain thefixed price of $35 an ounce (within the 1 percent margin).He refers to both market and official convertibility as Bret-ton Woods convertibility. See also McKinnon (1979) andBlack (1987).

“See Triffin (1957).

“See Milward (1984) and Hoffman and Maier (1984).


167

Figure 13

Monetary Gold and Dollar Holdings: the UnitedStates and the Rest of the World,1945-1971 Billions of U.S. dollars

‘I’, I I I I I I I

1945 47 49 51 53 55 57I I T I I I I m

59 61 53 65 67 69

The plan encouraged the liberalization of intra-European tmade and payments Liv gt-anting aidto countries that extended bilateral credits toother mem’nhers. Finally, the European PaymentsUnion (EPU) was established in 1950, under theauspices of the OEEC, to simplify bilateral clear-ing and pave the tvav to multilateralism -

13v 1952, in part thanks to the Marshall Plan,the OEEC countries had achieved a 39 percentincrease in industrial prodriction - a doubling ofexports, an increase in imports liv one-third anda current account surplus.’”’

The European Payments Unionand the Return to Convertibility

It took 12 years from the declaration of offi-cial par values by 32 nations in Deceniher 1 946to achieve convertihilitv for current transactionsliv the major industrial countries, as specifiedliv the Btettoti Woods Articles. ‘the WesternEur-opean miations tried sevem-al schemes to facili-tate the payments process before estatilishingthe EPU in 1950.9!

The EPU, established Septemnbei- 19, 1950, bythe OEEC countries, initially was to i-un for twoveam’s, renewable thereafter omi a yearly basis.It followed the basic prh~cipleof a commercial

bank clearinghouse. At the end of each month,each member would clear its net debit om cr’editposition (against all other members) with theEPU (the BIS actitig as its agent). The unit ofaccount for these clearings was the U.S. dollar.The EPU also provided extensive credit lines.The EPU was highly successful in reducing thevolume of pavnients transactions and providedthe background for- the gradual liberalization of

~iayments so that by 1953 comniercial banks wereable to engage in multicurrencv arbitrage.” OnDecember 27, 1958, eight countries declaredtheir currencies convertible for curm’ent accountramis actions.

The miiovement to convertibility was aided bythe devaluations of 1949. F’ollowing a specula-tive run on the pound in the summer of 1949,the British, 24 hours after informing the IMF’,devalued the pound by 30.5 percent. Shortlythereafter, 23 countries reduced their paritiesby similar magnitudes in most cases.

The devaluations of 1949 were important forthe Brettomi Woods system for two reasons. First,they, along with the Marshall Plan aid, helpedmove the European countries from a currentaccount deficit to a surplus, a movement impor-tant to the eventual restoration of comivem-tibility.Second, they revealed a basic weakness of the

“Solomon (1976).

“Kaplan and Schleiminger (1989),

‘tTew (1988) and Veager (1976).

— U.S. Monetary Gold Stock

— External Dollar Liabilities

— External Dollar Liabilities held by Monetary Authorties

— Rest of the World Monetary Gold Stock

60-

50-

40-

30-

20—

10—

71

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adjustable peg arrangement—the one-way optionof speculation against parity. By allowingchanges in parity only in the event of a fun-damental disequilibrium, the Bretton Woods sys-tem encouraged the monetary authorities todelay adjustment until they were sure it wasnecessary. By that time, speculators also wouldbe sure and they would take a position fromwhich they could not lose. If the currency isdevalued, they win and if it is not, they just losethe interest (if any) on the speculative funds.”The crisis associated with the 1949 sterlingdevaluation in turn created further resistanceby monetary authorities to changes in parity,which ultimately changed the nature of theinternational monetary system from the adjusta-ble peg intended by the Bretton Woods Articlesto a fixed rate megime.

Other developments in the preconvertiblityperiod included the decline of sterling as areserve asset and the reduced prestige of theIMF. The 1MF by intention was not equipped todeal with the postwar reconstruction problem.Although some limited drawings occurredbefore 1952, most of the structural balance ofpayments assistance in this period was providedby the Marshall Plan and other U.S. assistance,including the Anglo-American Loan of 1946. Theconsequence of this development is that otherinstitutions such as the BIS, the agent for theEPLJ, emerged as competing sources of interna-tional monetary authority.’~

The fund’s prestige was dealt a severe blowby three events in the preconvertibility period.‘I’lie first event ivas the French devaluation ofJanuary 1948, which created a multiple exchangerate system. The fund censured France forcreating broken cross rates between the dollarand the poutid. France was denied access to thefund’s resout-ces until 1952. France ended thebroken cross rates in October 1948 and adopteda unified rate in the devaluation of 1949. SinceFrance had access to the Marshall Plan, the fund’sactions had little effect. The second event was thesterling devaluation of September 194~,whenthe fund, instead of being actively involved inconsultation, was given 24 hours perfunctorynotice. The third event was the decision byCanada to float its currency in September 1950.T’hough the futid was highly critical of the action,it was unable to prevent it. ‘I’he Canadian dollarfloated successfully until 1961.

Finally, the fund’s resources were inadequateto solve the emerging liquidity problem of the1960s. The difference between the requiredgrowth of international reserves (to finance thegrowth of real (iutput and trade and to avoiddeflation) and the growth in the world’s mone-tary gold stock was met largely by an increasein official holdings of U.S. dollars resulting fi-omgrowing U.S. balance-of-payments deficits. Bythe time full convertibility was achieved, theU.S. dollar was serving the buffer functionintended by the Bretton Woods Articles for thefund’s resources.”

THE HISTORY OF BRETTONWOODS: THE HEYDAY OFBRETTON WOODS 1959-1967

With current account convertibility establishedby the western European industrial nations at theend of December 1958, the full-blown BrettonWoods system was in operation. Each memberintervened in the foreign exchange market,either buying or selling dollars, to maintain itsparity within the prescribed 1 percent margins.The U.S. Treasury in turn pegged the price ofthe dollar at $35 per ounce by freely buyingand selling gold. Thus each currency wasanchored to the dollar and indirectly to gold.Triangular arbitrage kept all cross r-ates withina band of 2 percent on either side of parity.Through much of this period, capital controlsprevailed in most countries except the UnitedStates in one form or another, although by themid-1960s their use declined while increasing inthe United States.

The system that operated in the next decadeturned out to be quite different from what thearchitects had in mind. First, itistead of a systemof equal currencies, it evolved into a variant ofthe gold exchange standard—the gold-dollar sys-tem. Initially, it was a gold exchange standardwith two key currencies, the dollar and thepound. But the role of the pound as key cur-rency declined steadily throughout the 1960s.Concurrently with the decline of sterling wasthe rise in the dollar as a key currency. Use ofthe dollar as both a private and official interna-tional money increased dramatically in the1950s amid continued into the 1960s. With fullconvertibility, the dollar’s fundamental role as

“See Friedman (1953).

“See Mundell (1969).



169

intervention currency led to its use as interna-tional reserves. This was aidled by stable andlow monetary growth and relatively low infla-tion (before 1965). See figure 1 and table 1.

‘the gold exchange standard evolved in thepost—World War tt period for the same reasonsit did in the 1920s—to economize on non-interest-hearing gold reserves. Ry the late 1950s, the growthof the world’s monetary gold stock was insuffi-cient to finance the growth of world real outputand trade.” The other intended source of inter-national liquidity—the resources of the fund—was also insufficient.

‘The second important difference between theconvertible Bretton Woods system and the inten-tions of the Bret ton Woods Articles was the evo-lution of the adjustable peg system into a virtualfixed exchange rate system. Between 1949 and1967, vet-y few changes in parities of the Groupof Ten countries occurred.’~The only excep-tions were the Canadian float in 1950, devalua-tions by France in 1957 and 1958, and minorrevaluations by Germany and the Netherlands in1961. The adjustable peg system became tessadjustable because the monetary authorities,based on the 1949 expeiience, were unwillingto accept the risks associated with discretechanges in parities—loss of prestige, the likeli-hood that others would follow and the pressure(if speculative capital flows if even a hint of achange in parity were present.

As the system evolved into a fixed exchangerate gold dollat- standard, the three key prob-lems of the interwar system reemerged: adjust-ment, liquidity and confidence. These problemsdominated academic and policy discussions dur-ing the period.

The Adjustment Problem

The adjustment issue focused on how to achieveit in a world with capital controls, fixed exchangerates and domestic policy autonomy. Various pol-icy measures were proposed to aid adjustment,including income policies, rescue packages, capi-tal and trade controls, a mix of monetary andfiscal policy, and the injection of new liquidity.

Of particular interest during the period wasasymmetry in adjustment betiveen deficit countrieslike the tjnited Kingdom and surplus countrieslike Germany and between the United States asthe reserve currency country and rest of the world.

Both the United Kingdom amid Germany ranthe gauntlet between concern over externalconvertibility and domestic stability. The UnitedKingdom alternated between expansionary pol-icy that led to balance-of-payments deficits andausterity. Germany alternated between a balance-of-payments surplus that led to inflation andausterity.

The United States had an official settlementsbalance-of-payments deficit in 1958 that per-sisted, with the notable exception of 1968—69,until the end of Bm’etton Woods. See figui-e 14.With the exception of 1959, however, theUnited States had a current account surplusuntil 1970. The balance-of-payments deficitunder Bretton Woods arose because capital out-flows exceeded the current account surplus. Inthe early postwar years, the outflow consistedlargely of foreign aid. By the end of the 1950s,private long-term investment abroad (mainlydirect investment) exceeded military expendi-tures abroad and other official transfers.”

The balance-of-payments deficit was perceivedas a problem by the U.S. monetary authoritiesbecause of its effect on confidence. As officialdollar liabilities held abroad mounted ivith suc-cessive deficits, the likelihood increased thatthese dollars would be converted into gold andeventually the U.S. monetary gold stock wouldreach a point low enough to triggel a run.tndeed the U.S. monetary gold stock by 1959equalled total external dollar liabilities and therest of the world’s monetary gold stock exceededthat of the United States. See figure 13. By 1964official dollar liabilities held by foreign mone-tary author-ities exceeded the U.S. monetarygold stock.

A second reason the balance-of-paymentsdeficit was perceived as a problem was the dol-lar’s role in providing liquidity to the rest of theworld. Elimination of the U.S. deficit would cre-ate a i-vorldwide liquidity shortage.

“See Triff in (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).

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Figure 14

Balance of Payments: United States, 1950-1 971 Millions of U.S. dollars

8,000-

4,000 -

0-

-4,000-

-8,000 -

-12,000-

-16,000-Short-Term Capital — Current Account

Long-Term Capital — Change in Reserves

I I I I I52 53 54 55 56 57 58 59

I I I I I I I

60 61 62 63 64 65 66 67 68 69 70 71

For the Europeans,payments deficit wasreasons. First, as thethe United States diddomestic economy to

the U.S. balance-of-a problem for differentreserve currency country,not have to adjust itsthe balance of payments.

As a matter of routine, the Federal Reserveautomatically sterilized dollar outflows. Theasymmetry in adjustment was resented. TheGermans viewed the situation as the UnitedStates exporting inflation to surplus countriesthrough its deficits. Their remedy was for theUnited States (and the United Kingdon) to pur-sue contractionary monetary and fiscal policy.”In fact, U.S. inflation was less (on a GNP-weighted average basis) than that of the rest ofthe Group of Seven countries before 1968. Seefigures 1 and 15. The French resented U.S.financial dominance and the seigniorage theybelieved the United States eained on its out-standing liabilities. Acting on this perception,the French in 1965 began to systematically con-vert outstanding dollar liabilities into gold. TheFrench solution to the dollar problem was todouble the price of gold—the amount by which

the real price of gold had declined since 1934.The capital gains earned on the revaluation ofthe world’s monetary gold reserves would besufficient to retire the outstanding dollar (andsterling) balances. Once the United Statesreturned to balance-of-payments equilibrium,the world could return to a fully functioningclassical gold standard.’”

Some economists argued that the U.S. balance-of-payments deficit was not really a problem.The rest of the world held dollars voluntarilybecause of their valuable service flow; thedeficit was demand determined.”

The policy response of the U.S. monetaryauthom-ities was fourfold: to impose controls oncapital exports; to institute measures to improvethe balance of trade; to alter the monetary fis-cal policy mix; and to employ measures to stemthe conversion of outstanding dollais into gold.

During this period, var-ious solutions to theU.S. adjustment problem were proposed: provi-sion of an alternative international reserve

“See Emminger (1967).“See Rueff (1967).1”See Despres, Kindleberger and Salant (1966).

ii

-20,000- —r195051


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

media to increase world liquidity; an increase inthe price of gold, either unilaterally, which woulddevalue the dollar against other currencies, or bya uniform change in all parities as under Att. IV;and increased exchange rate flexibility.b0z

The U.S. balance-of-payments policies were in

the main ineffective.” As long as the United

States maintained relatively stable prices, as itdid before 1965, the system could be preservedfor a number of years. ‘the real pt-oblem wasthat of the gold exchange standard—a convet-ti-

bility crisis was ultimately inevitable. ‘The twinsolutions advocated at the time of an increase in

the price of gold and an increase in world liquidity

by creation of an artificial reserve asset wouldnot have permanently eradicated the problem. ‘°~

“The official view, which was strongly opposed to increasedexchange rate flexibility, is in marked contrast to the aca-demic view, which by the end of the decade was solidly infavor of increased flexibility, as evident at the famous Bur-genstock Conference. See HaIm (1970) and also Johnson(1972a).

“See Mettzer (1991).

‘°4Evenat a higher gold price, world gold production wouldeventually be inadequate to produce long-run price stabil-ity. In the long-run, when account is taken of gold as adurable exhaustible resource, deflation is inevitable. See

The Liquidity Problem

The liquidity problem, posed by Rohert ‘I’riffinand others, evolved from a shortfall of mone-

tary gold beginning in the late 1950s. The realprice of gold had been falling since World War

II and would eventually reduce world goldproduction. This happened in the early 1950shut was offset by new sources of production.Gold production declined again in 1966. More-over, the falling real price would stimulate pri-vate demand for gold and it seemed unlikelythat Russian gold sales would make up much ofthe shotifail. The prospect of the world nione-tary gold stock growing enough to finance thegrowth of world real output and the value oftrade (without deflation) seemed dim. As canclearly be seen in figure 16 for the Group of

Bordo and ElIson (1985). Moreover, an increase in worldliquidity by an artificial reserve asset, if convertible intogold, would not remove the basic convertibility problem.See McKinnon (1988). Finally as Townsend (1977), Salant(1983) and Buiter (1989) point out, the gold exchangestandard as a type of commodity stabilization scheme isbound to collapse in the face of unforeseen shocks, SeeGarber (1993). According to Meltzer (1991), however, a 50percent gold revaluation would have succeeded in preserv-ing the Bretton Woods system well into the 1970s had theUnited States not followed an inflationary policy in the late1960s.

195152535455565158596061626364656667686970717273

MARCH/APR1L 1993

172

Figure 16The 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

3025

2015

10

5

0

-5

-10195152

Seven countries, this was the case. A large gapopened in 1958 between the gr-owth of outputand the volume of trade and the growth ofGroup of Seven gold reserves. As can he seen infigure 17, the shortfall for the Group of Sevencountries, excluding the United Slates, was madeup by a drain on the U.S. monetary goldreserves until 1966.

As Triffin (1960) pointed out, dollars suppliedby the U.S. deficit could not be a permanentsolution to the impending gold shortage becausewith continuous deficits, U.S. nionetary goldreserves would decline both absolutely and rela-tively to outstanding dollar liabilities until aneventual convertibility crisis. Should the 1.1.5.monetary authorities close the deficit hefot-esuch a crisis, however, it would create a mas-sive shortage of international liquidity and theprospect of wot-Id deflation. New sources ofliquidity were required, answered by the crea-

tion of the special drawing rights in 1967. B)’the tine SDRs were injected into the system in1970, however, they exacerbated workhvideinflation -

The Confidence Problem

The perceived key problem of the convertibleBret ton Woods period was the confidence crisisfor the dollar.b05 As argued by ‘I’riffin (1960),Kenen (1960) and Gilbert (1968), the gold-dollarsystem that evolved after 1959 was bound to bedynamically unstable if the growth of the worldmonetary gold stock was insufficient to financethe growth of world output and trade and toprevent the U.S. monetary gold stock fromdeclining relative to outstanding U.S. dollar lia-bilities. ‘I’he pressure on the U.S. tnonetary goldstock would continue, as growth of the worldmonetary gold stock declined relative to thegrowth of world output and trade and as theworld substituted dollars for gold, until it trig-gered a confidence crisis that led to the collapseof the system, as occurred in 1931. At the sametime, however, as feat-s over U.S. gold converti-hility threatened the dynamic stability of theBretton Woods system, gold still served twopositive roles.

Gold was the numeraire of the system; all

“Although according to Meltzer (1991), there is little evi-dence in asset markets through the 1960s of a growingloss of confidence in the dollar. Real interest rates did not

rise significantly relative to trade weighted real interestrates. Nor did the gold and foreign exchange markets sug-gest a flight from the dollar.

Change in Monetary Gold StockI I I I I

53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73


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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

73

currencies were anchored to its fixed pricethrough the U.S. comniitment to peg its price.Until 1968 gold still served as backing to theU.S. dollar with a 25 percent gold reserverequiremnent against Federal Reserve notes; therequirement mnay have served as a brake on

U.S. monetary expansion.

‘the first glimpse of a confidence crisis was

the gold rush of October 1960 when speculatorspushed the free market price of gold on theLondon market up from $35.20 (the U.S. ‘treas-ury’s buying price) to $40. See figure 18. Thisfirst significant runup in gold prices since theLondon gold market was reopened in 1954 wassupposedly triggered by concet-ns over a Democraticvictory in the 1960 U.S. Presidential election.

U.S. monetary authorities feared that privatespeculation in the gold market might spill intoofficial demands fom conversion. Consequently,remedial action was taken quickly. The Tmeas-ury supplied the Bank of England sufficient goldto restore stability, and the monetary authori-ties of the Group of ‘len countries agreed torefrain from buying gold above $35.20. In suc-

ceeding months, the London Gold Pool, whichagreed to buy or sell gold to peg the price at$35 an ounce, was formed between the UnitedStates and seven other countries. The poolbecame official in November 1961. For the nextsix years, it succeeded in stabilizing the price ofgold but did not prevent a steady decline in theU.S. monetary gold stock. See figure 13. In fact,though the central banks in the seven othercountries supplied 40 percent of the goldrequired to stabilize the price of gold, theyreplenished their monetary gold stocks outsidethe pool by converting outstanding dollarbalances into gold at the U.S. Treasury.”

During the period 1961—67, the United Statesniade a series of arrangemnents to protect itsmonetary gold reserves. These included a net-

work of swap arrangements with other centralbanks, the issue of Roosa bonds, and moral sua-sion. France, however, did not go along withthese efforts and began its campaign against thedollar in February 1965.

The period was marked by two sets of under-

“See Meltzer (1991).

80

70

60

50

40

30

20

1951525354555657585960616263646566676869707172

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Figure 18London Gold Price

Dollars per ounce

44

43

42

41

40

39

38

37

36

35

34

lying forces that would undermnine the dollar’srelationship to gold—gm-owing gold scarcity anda rise in U.S. inflation. World gold productionleveled off in the mid-1960s and even declinedin 1966, while at the same time private demandsoared, precipitating a drop in the world mone-tary gold stock after 1966. Indeed, beginning in1966,, the London Gold Pool became a net sellerof gold. Also, U.S. money growth accelerated in1965, in part to finance the Vietnam War, andinflation began to rise (figures 1 arid 15). ‘I’hecurrent account surplus began to deteriorate in1964 (figure 14), as did U.S. competitiveness,mirrored in a rise in the ratio of U.S. unit laborcosts relative to trade weighted unit laborcosts.”7 The balance-of-payments deficit wor-sened between 1964 and 1966 but was reversedin 1966 by capital inflows triggered by tightmonetary policy.

After the devaluation of sterling, which theUnited States tried unsuccessfully to prevent,pressure mnounted against the dollar via theLondon Gold mam-ket. From December 1967 to

March 1968 the Gold Pool lost $3 billion in gold,with the U.S. share at $2.2 billion.” Theimmediate concerns of the speculators mayhave been fears of a dollar devaluation, butaccording to Gilbert and Johnson, it reflectedthe underlying gold scarcity.” In the face ofthe pressure, the Gold Pool was disbanded onMarch 17, 1968, and a two-tier arrangementreplaced it. Henceforth, the monetary authori-ties of the Gold Pool agreed neither to sell norto buy gold from the market. They would trans-act only among themselves at the official $35price. In addition, on March 12, 1968, theUnited States removed the 25 percent goldreserve requirement against Federal Reservenotes. The key consequence of these new

arrangenients was that gold was demonetized atthe mat-gin. The link between gold productionand other market sources of gold and officialreserves was cut. Moreover, in the followingyears, the United States put considerable pres-sure on other mnonetary authorities to refrainfrom converting their dollar holdings to gold.

“See Meltzer (1991).

“See Solomon (1976).“See Gilbert (1968) and Johnson (1968).

195455 56 57 58 59 60 61 62 63 64 66 66 67 68 69 70 71 72


175

By 1968 the international monetary systemhad evolved very far indeed from the model ofthe architects of the Articles of Agreemnent. Tnreaction to both developments in financial mar-kets and the confidence problem, the systemhad evolved into a de facto dollar standard.Gold convertibility, however, still played a role.Though the major industrial countries tacitlyagreed not to convert their outstanding dollarliabilities into U.S. monetary gold, the threat oftheir doing so was always present. At the sametime, as the countries of continental Europe andJapan gained economic strength relative to theUnited States, they became more reluctant toabsorb outstanding dollars. They also werereluctant to adjust theim surpluses by revaluingtheir currencies, increasingly coming to believethat adjustment should be undertaken by theUnited States.

The system had also developed into a de factofixed exchange rate system. Unlike the classicalgold standard, however, where the fixed exchangerate was the voluntary focal point for bothinternal and external equilibrium, in the BrettonWoods system exchange rates became fixedbecause members feared the consequences ofallowing them to change. Nevertheless, becauseof increased capital mobility, the pressure foraltering the parities of countries with persistentdeficits and surpluses became harder to stopthrough the use of domestic policy tools and theaid of international rescue packages. Pressureincreased from both academnic and officialsources for greater exchange rate flexibility.

By 1968, the system had also evolved a formof international governance that was quite dif-ferent fm’om that envisioned at the beginning.Instead of a community of equal currenciesmanaged by the TMF, the system was managedby the United States in cooperation with theother members of the Group of Ten countries.In many respects, it was closer to the key cur-rency system proposed by Williams.”

According to Dominguez (1993), the IMF wasdesigned to facilitate international cooperationby serving as a commitment mechanism. It wasto use its influence and its financial

to enforce the par value system. It did not,however, have sufficient power to preventdevaluations by major countries and its financialresources were too limited to provide adequateadjustment assistance for them. The IMF stillhad an important role as a clearinghouse fordifferent views on monetary reform, as a centerof information, as the principal voice for thecountries of the world other than the Group ofTen countries, as these countries’ primarysource of adjustment assistance and finally asan important partner in the major Group ofTen rescue packages.

In sum, the problems of the interwar systemthat Bretton Woods was designed to preventreemerged with a vengeance. ‘the fundamentaldifference, however, was that the system wasnot likely to collapse into deflation as in 1931but rather explode into inflation.

THE COLLAPSE OF BRETTON

WOODS

After the establishment of the two-tier arrange-ment, the world monetary system was on a defactodollar standard. The system became increasinglyunstable until it collapsed with the closing ofthe gold window in August 1971. ‘the collapseof a system beset by the fatal flaws of the goldexchange standard and the adjustable peg wastriggered by an acceleration in world inflation,in large part the consequence of an earlieracceleration of inflation in the United States.Before 1968, the U.S. inflation rate was belowthat of the GNP weighted inflation rate of theGroup of Seven countries excluding the UnitedStates (see figure 15). It began accelerating in1964, with a pause in 1966—67. The increase ininflation in the United States and the rest of theworld was closely related to an increase inmoney growth and in money growth relative tothe growth of real output. (See figures 19 and20.) Indeed, a prevalence of excess demandshocks in the mid- and late 1960s is apparentfor the United States and other Group of Sevencountries in figures 11 and 12.

Darby et al (1983) provided considerable evi-dence on the transmission of inflation in the

“See Williams (1936 and 1943) and Johnson (1972b).

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Figure 19

Money (Ml) Growth Rates in the United States, Gland G7 Excluding the United States,1951-1913

Percent

262422

2018

161412

108

6420-2195152535455565758596061626364656661686970717273

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

-0.1195152 53 54 55 56 57 58 59 50 61 62 63 64 65 66 67 68 69 70 71 72 73


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Bretton Woods system. Their regression anal-yses led to a number of important conclusions.First, U.S. inflation was caused by lagged U.S.money growth. Second, U.S. money growth wasindependent of changes in internationalreserves.~~?thebalance of payments had no effecton the Federal Reserve’s reaction function.Third, U.S. money growth had strong and sig-nificant effects on money growth in sevenmnajor countries. These lags were very long—up to four years—and reflected the fact thatcentral banks in the seven countries sterilizedreserve flows partially. Finally, money growthin the seven countries explained inflation inthese countries with a significant lag.”

The key transmission mechanism of intiationwas the classical price specie flow mechanismaugmented by capital flows. Little evidence forother mechanisms including commodity marketarbitrage was detected.” According to theseauthors, the Bretton Woods system collapsedbecause of the lagged effects of U.S. expansion-ary monetary policy. As the dollar reserves ofGermany, Japan and other countries accumu-lated in the late 1960s and early 1970s, itbecame increasingly more difficult to sterilizethem. This fostered domestic monetary expan-sion and inflation. In addition, world inflationwas aggravated by expansionary monetary andfiscal policies in the rest of the Gmoup of Sevencountries, as their governments adopted full-employment stabilization policies. The onlyalternative to importing U.S. inflation was tofloat—the route taken by all countries in1973.”

The crisis mounted from 1968 to 1971. TheU.S. current account balance continued todeteriorate in 1968, but the overall balance ofpayments exhibited a surplus in 1968 and 1969thanks to a large short-term capital inflow. Thecapital inflow was activated by events in theeurodollar market. In the face of tight monetarypolicy in 1968—69 and Regulation Q ceilings ontime deposits, deposits shifted from U.S. banksto the eurodollar market. U.S. banks in turnborrowed in the eurodollar market, repatriatingthese funds. In 1970, as U.S. interest rates fell

in response to rapid monetary expansion andRegulation Q was suspended for large certifi-cates of deposit, the borrowed funds returnedabroad and the deficit grew to $9 billion,exploding to $30 billion by August 1971 (see fig-ure 14). The dollar flood increased the reservesof the surplus countries, auguring inflation. Ger-man money growth doubled from 6.4 percentto 12 percent in 1971, and the German inflationrate increased from 1.8 percent in 1969 to 5.3percent in 1971.”~Pressure mounted for arevaluation of the mark. In April 1971 the dol-lar inflow to Germany reached $3 billion. OnMay 5, 1971, the German central bank sus-pended official operations in the foreignexchange market and allowed the deutschemark to float. Similar action by Austria, Bel-gium, the Netherlands and Switzerland fol-lowed.1~5

In the following months, many began advocat-ing ending the dollar’s link with gold. In April1971, the U.S. balance of trade turned to deficitfor the first time and influential voices beganurging dollar devaluation. The decision to sus-pend gold convertibility was triggered byFrench and British intentions in early August toconvert dollars into gold. On August 15 at CampDavid, President Nixon announced that he haddirected Secretary Connolly “to suspend temn-porarily the convem-tibility of the dollar into goldor other reserve assets.” The accompanying pol-icy package included a 90-day wage-pricefreeze, a 10 percent import surcharge and a 10percent investment tax credit.”’

‘I’he U.S. decision to suspend gold convertibil-ity ended a key aspect of the Bretton Woodssystem. i’he remaining part of the system—theadjustable peg—disappeared 19 months later.

The Bretton Woods system collapsed for threebasic reasons. First, two major flaws under-mined the system. One flaw was the goldexchange standard, which placed the UnitedStates under threat of a convertibility crisis. Inreaction it pursued policies that in the endmade adjustment more difficult.

“See Darby et al (1983)

“See Darby et al (1983).

‘“Except for the case of Japan, there is little evidence forthe leading alternative explanation for the collapse—that itreflected growing misalignment in real exchange ratesbetween the united States and her principal competitors inthe face of differential productivity trends. See Marston

(1987) and Eichengreen (1992b).

“4See Meltzer (1991).

“See Solomon (1976).

“See Solomon (1976).

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The second flaw was the adjustable peg. Becausethe costs of discrete changes in parities weredeemed high, in the face of growing capitalmobility, the system evolved into a reluctantfixed exchange rate system without an effectiveadjustment mechanism.

Finally, U.S. monetary policy was inappropri-ate for a key currency. After 1965, the UnitedStates, by inflating, followed an inappropriatepolicy for a key currency country. Though theacceleration of inflation was low by the stand-ards of the following decade, when superim-posed on the cumulation of low inflation sinceWorld War II, it was sufficient to trigger aspeculative attack on the world’s monetary goldstock in 1968, leading to the collapse of theGold Pool.” Once the regime had evolved intoa de facto dollar standard, the obligation of theUnited States was to maintain price stability.Instead, it conducted an inflationary policy,which ultimately destroyed the system.

DID THE BRETTON WOODSSYSTEM OPERATE AS A SYSTEMBASED ON CREDIBLE RULES?

One can view the Bretton Woods system as aset of rules or commitment mechanisms.” Fornonreserve-currency countries the rules were tomaintain fixed parities, except in the contin-gency of a fundamental disequilibrium in thebalance of payments, and to use fiscal policy tosmooth out short-run distut-bances. The U.S.enforcement mechanism—access to its open cap-ital markets—was presumably its dominantpower because the IMF had little power.

For the United States, the center country, therule was to fix the gold pm-ice of the dollar at $35per ounce and to maintain price stability. If amajority of Bretton Woods members (and everymember with 10 percent or more of the total quotas)agreed, however, the United States could changethe dollar price of gold. There was no explicitenforcement mechanism other than reputation andthe commitment to gold convertibility. According

to Giovannini (1993), the Bretton Woods systemwas an asymmetric solution to Mundell’s n-icurrency problem.” The United States as thenth country, had to mnaintain the nominalanchor by following a stable monetary policy. Inaddition, it had to supply the dollars demandedby the rest of the world as reserves.

The rest of the world had to accept, throughits comnmnitment to fixed parities, the price levelset by the United States. But because of the ad-justable peg, it had the option to change parities.‘the rule was defective for the nonreserve cur-rencies because the fundamental disequilibriumcontingency was never spelled out and no con-straint was placed on the extent to which domesticfinancial policy could stray from maintaining ex-ternal balance. In addition, with growing capitalmobility, the option to change parities becameless viable.

For the United States this rule suffered froma number of fatal flaws. First, because of thefear of a confidence crisis, the gold convertibil-ity requirement may have prevented the UnitedStates in the early 1960s from acting as a centercountry and willingly supplying the reservesdemanded by the rest of the world. Second, asbecame evident in the later 1960s, this require-ment was useless in preventing U.S. monetaryauthorities from pursuing an inflationary policy.Finally, although a mechanism was available forthe United States to devalue the dollar, mone-tam-y authorities were loath to use it for fear ofundermining confidence. No effective enforce-ment mechanism existed. Ultimately, the UnitedStates attached greater importance to domesticeconomic concerns than to its role as the centerof the international monetary system.

Thus although the Bretton Woods system canbe interpreted as one based on rules, the systemdid not provide a credible commitment mech-anism.1

20 The United States was unwilling tosubsume domestic considerations to the respon-sibility of maintaining a nominal anchor. At thesame time, other Group of Seven countriesbecame increasingly unwilling to follow the dic-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 seeGiovannini (1993) and Obstfeld (1993).


“Giovannini’s (1993) calculations show that during the Bret-ton Woods convertible period credibility bounds on interestrates for the major currencies, in contrast to the classicalgold standard, were frequently violated.


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The failure of the Bretton Woods m-ule sug-gests a number of m-equirements for a well-designed fixed exchange rate system. Theseinclude the following:

• that the countries follow similar domes-tic economic goals (underlying inflationrates);

• that the rules be transparent; and

• that some central monetary authorityenforce them.

The recent EMS system was quite successful fora number of years because it seemed to encom-pass these three elements. Its recent crisis, how-ever, reflected the emergence of some of thesame problems that led to the breakdown ofBretton Woods. I discuss these issues below inthe following subsection.

POST BREflON WOODS: MANAGEDFLOATING AND THE EMS

As a reaction to the flaws of the Bretton Woodssystem, the world turned to generalized floatingexchange rates in March 1973. Though the eatlyyears of the floating exchange rate were oftencharacterized as a dirty float, whereby mone-tary authorities extensively intervened to affectboth the levels of volatility arid exchange rates,by the end of the 1970s it evolved into a systemwhere exchange market intervention occurredprimarily to smooth out fluctuations. Again inthe i980s exchange market intervention wasused by the Group of Seven countries as part ofa strategy of policy coordination.” In recentyears, floating exchange rates have been assailedfrom many quarters for excessive volatility inboth nominal and real exchange rates, which inturn increase macroeconomic instability andraise the costs of international transactions.

The attack cites the favorable experience ofthe EMS from 1987 to 1991 in producing ex-change rate and price stability as a recommen-dation for a return to a global system of fixedexchange rates. It is argued that recent attemptsat policy coordination can be formalized and ex-tended to a more general managed system basedon either close policy coordination (to keep ex-change rates within specified target zones) or a

renewed gold standard. In this paper I do notconsider the mci-its or drawbacks of policycoordination in genem-al, but I examine the EMSbriefly as a monetary regime similar to BrettonWoods.” Of interest is whether lessons for theinternational monetary system can be derivedfrom its experience.

The EMS, like the Bretton Woods system,represents an agreement among countries to setexchange rate parities, to manage intra-EuropeanCommunity exchange rates and to finance exc-hange market intervention. Like Bretton Woods,it is an adjustable peg system.

The origins of the EMS date back to the BrettonWoods period. The case for stable exchangerates within Europe was made in the context ofthe European Common Market (EEC). In addi-tion to a strong dislike by Europeans for flexibleexchange rates—based on their perception of inter-war experience and their belief that exchangerate volatility reduces trade in highly openeconomies—the key motivation for extensivepolicy coordination to stabilize exchange rateswas the common agricultural policy establishedin 1959.123

Food prices in the comnmunity at-c set in termsof a central unit of account (the ECU) but quotedin local currency. Consequently, any changes inexchange rates lead to changes in local prices.During the Bretton Woods era, a system of sub-sidies and taxes was worked out to insulate thelocal economy from policy realignments. ‘I’hisled to an asymnmetm’ic adjustment between hardcurrency countries reluctant to lower theiragricultural prices and soft curm’ency countries,which allowed their prices to rise. The resultwas overproduction of agricultural productsand an ever-increasing fraction of the EECbudget allocated to subsidize agriculture.

Early attempts to stabilize intra-Europeanexchange rates during the Bretton Woods erawere unsuccessful, as was the Snake in theTunnel agreement of the 1970s. The EMS, estab-lished in 1979, was a formal attempt to overcomeearlier obstacles to exchange rate stabilization.It was designed to prevent the defects of theBretton Woods system, including: the asymmetricadjustment mechanism, with the United Statesas the center, setting the tune fom- the rest of

~2’ See Bordo and Schwartz (1991).“2See Feldstein (1988) and Bordo and Schwartz (1989a).

“See Giavazzi and Giovannini (1989).

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the world; the problems associated with grow-ing capital mobility; and the dramas of parityrealignments. Instead, the EMS designed a set ofintervention rules that would produce a symn-mnetric system of adjustment; create a mechanusmto finance exchange market interventions; andestablish a codeof conduct for realigning parities.”4

Like Bretton Woods, the EMS was based on aset of fixed parities called the exchange ratemechanism (ERM). Each country was to estab-lish a central parity of its currency in terms ofECU, the official unit of account. The ECU con-sisted of a basket containing a set number ofunits of each currency. As the value of curren-cies varied, the weights of each country in thebasket would change. A parity grid of allbilateral rates could then be derived from theratio of members’ central rates. Again, like Bret-ton Woods, each currency was bounded by aset of margins of 2.25 percent on either side ofparity, creating a total band of 4.5 pet-cent (forItaly, and later the United Kingdom, when itjoined the ERM in 1990, the margin was set at 6percent on either side of parity). ‘t’he monetaryauthorities of both the depreciating and appre-ciating countries were required to intervenewhen a currency hit one of the margins. Coun-tries were also allowed, but not required, toundertake intramarginal intervention. The indi-cator of divergences, which measured each cur-rency’s average deviation from the centralparity, was devised as a signal for the monetaryauthorities to take policy actions to strengthenor weaken their currencies. It was supposed towork smnietrically.

Intervention and adjustment was to befinanced under a complicated set of arrange-ments. i’hese arrangements were designed toovercotne the weaknesses of the IMF’ duringBretton Woods. ‘the very short-term financingfacility (\T5~’t’F)was to provide credibility to thebilateral pam-ties by ensuring unlimited financingfor marginal intervention. It provided automaticunlimited lines of ct-edit from the creditor tothe debtor members. The short-term monetarysupport (STMS) was designed to provide short-term finance for temporary balance of pay-

ments disequilibration. The medium termn finan-cial assistance (MTFA) would provide longerterm support.

Unlike Bretton Woods, where members (otherthan the United States) could effectively decideto unilaterally alter theim parities, changes incentral parities were to be decided collectively.Finally, like Bretton Woods, members could (amiddid) impose capital controls. These have recentlybeen phased out.

The evidence on the performance of the EMSindicates that it was successful in the latter halfof the 1980s at stabilizing both nominal and realexchange rates within Europe, at producing credi-ble bilateral bands and at reducing divergencebetween members’ inflation rates.”

Giavazzi and Pagano (1988), Giavazzi andGiovannini (1989), and Giovannini (1989) make astrong case that the success of the EMS waslargely due to the fact that it was an asymmet-ric system with Germany acting as the centercountry. The other EMS members adapted theirmonetary policies to maintain fixed parities withGermany. Also, according to the aforementionedwriters, the Bundesbank exhibited a strong credi-hle commitment to low inflation and the othermembers of the ERM, by tying their currenciesto the deutsche mark, used an exchange ratetarget as a commitment mechanism to success-fully reduce their own rates of inflation. Evidencefor the asymmetry hypothesis is based on thefact that the Bundesbank intervened only whenbilateral exchange rates were breached, whereasthe other countries engaged in intra-marginalintervention, and on evidence of asymmetricalbehavior of interest rates in Germany and theother EMS countries. In the period precedingseveral EMS realignments, non-German EMSinterest rates changed drastically, whem-eas nochange was observed in their German counter-part. Evidence that the Bundesbank’s reputationwas responsible for the disinflation of the 1980sis based on an out-of-sample simulation of aVAR to pmedict the inflation rate. Downwardshifts in the predicted values of inflation for anumber of countries after the advent of theEMS 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 greatlydivergent money growth and inflation rates among itsmembers. See Fratianni (1980). See Giavazzi and Giovan-nini (1989); Fratianni and von Hagen (1990 and 1992); andMeltzer (1990).


181

were significantly reduced only in France andItaly several years after the advent of the EMS(the argument goes) may reflect slow learningor alternatively that these countries used theEMS to justify following unpopular austeritypolicies.

Fratianni and von Flagen (1990 and 1992) disputeboth the asymmetry and the imported disinflationhypotheses.” Evidence based on Granger causal-ity tests from a structural VAR suggests that theGerman monetary base was not insulated fromother EMS base movements nor were non-GermanEMS monetary bases insulated by the Germanmonetary base from external shocks. In thisinterpretation, the EMS is a coordinated mone-tary policy system with all members playinga role.

Finally, Fratianni and von Hagen (1990) pro-vide evidence that the EMS has reduced intra-European exchange rate volatility; however, thisreduction has been at the expense of increasedvolatility of non-EMS currencies. Thus theyargue that the EMS is on net balance beneficialto welfare because intra-EMS trade exceedsexternal trade. They also show that althoughthe advent of the EMS has not reduced inflationuncertainty relative to non-EMS countries, it hasreduced the effects of fomeign inflation shockson the mnemnbers.

Despite its favorable performance since themid—1980s, the EMS was recently subjected tothe same kinds of stress that plagued BrettonWoods. September 1992 and November 1992marked a series of exchange rate crises inEurope that paralleled the events of 1967 to1971. Precipitated by concerns that French vot-ers would reject the Maastricht Treaty on Euro-

1jean Monetary Union in a referendum onSeptember 20, speculators staged attacks earlyin the month on the Nordic curm-encies and thenlater on the Italian lira, the British pound, theFrench franc, and other weaker currencies. Thecrisis led to the disabling of the ERi~t.Both Italyand the United Kingdom left it while Spain,Portugal and Ireland reimposed or strengthenedexisting capital controls: in Novemnher Swedenfloated and Portugal and Spain devalued.

The fundamental causes of the crisis, likethe crises that plagued Bretton Woods, lay inlarge part with the exchange rate system. TheEMS, like Bretton Woods, is a pegged exchangerate system that requires member countries tofollow similar domestic monetary and fiscalpolicies and hence have sintilar inflation rates.This is difficult to do in the face of both differ-ing shocks across countm-ies and differing nationalpriorities. Under Bretton Woods, capital con-trols and less integrated international capitalmarkets allowed members to follow divergentpolicies for considerable periods. Under theEMS, the absence of controls (after 1990) andthe presence of extremely mobile capital meantthat any movement of domestic policies awayfrom those consistent with maintaining pam’itywould quickly precipitate a speculative attack.Also, just as under Bretton Woods, the adjusta-ble peg in the face of such capital mobilitybecame unworkable. Thus the differencebetween the two regimes when faced withasymmetric shocks or differing national priori-ties was the speed of reaction by world capitalmarkets.

Though the fundamental cause of the crisiswas similar in the two regimes, the source ofthe problem differed. tinder Bretton Woods, theshock that led to its collapse was an accelera-tion of inflation in the United States, ostensiblyto finance the Vietnam War’, as well as socialpolicies, and to maintain full employment.Under the EMS, the shock was bond financedGerman reunification and the Bundesbank’s sub-sequent deflationary policy. In each case, thesystem broke down because other countrieswere unwillimig to go along with the policies ofthe center coum1try..~l~hecommitments to pricestability by both the center country and theother members were not shown as credible.Under Bretton Woods, Germany and other west-ern European countries were reluctant toinflate or revalue and the United States wasreluctant to devalue. Under the EMS, the UnitedKingdom, Italy, Spain, Portugal, Ireland andSweden were unwilling to deflate amid Germanywas unwilling to revalue. As under BrettonWoods, 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. Theircross-country regressions show that EMS membership hadlittle effect on inflation performance. Changing public atti-tudes toward inflation within each country represent amore important determinant. See Giavazzi and Collins (1992).

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general realignment, both imnproverl capitalmobility and the Maastricht commitment to aunified currency made it an unrealizableoutcome.

Thus the lesson from both the EMS and Bret-ton Woods is that pegged exchange rate systemnsdo not work for long no matter how well they’are designed. Pegged exchange rates, capitalmobility and policy autonomy just do not mix.During the heyday of Bretton Woods years ago,the case made for floating exchange rates formajor countries still holds. This is not to saythat if Eum-opean countries wet-c completely will-ing to give up domestic policy autonomy, theycould not eventually form a currency unionwith perfectly fixed exchange rates. In anuncertain world subject to diverse shocks, thecosts fom- individual countries of doing so areapparently extremely high.

CONCLUSION

This paper examines statistical evidence onthe performance of alternative monetaryregimes over the past century. It also examinessome aspects of the history of these regitnes.Both statistical and histom-ical evidence may helpprovide answers to the question why someregimes have been more successful than othem’s.They also have implications for current issuesin international monetary reform and the ongo-itig debate over rules and discretion.

‘the statistical evidence on performance ofalternative monetary regimes in the second sec-tion leads to the conclrtsion that the BrettonWoods convertible regime from 1959 to 1970was by far the best on virtually all criteria, butthat the recent floating regime is not muchworse. Indeed, it is clear that the performanceof the regimes in the post—World War II era issuperior to the perlormance of m-egimes in thepreceding half century. Finally, though the clas-sical gold standard does relatively poorly interms of the stability of real variables, it per-formed best on inflation persistence and financialmiiarket integm’ation—evidence for the successfuloperation of gold as a nominal anchor.

This evidence leads to the following question:Why was Bretton Woods so stahle yet so fragileand the classical gold standard so unstable andyet so durable? ‘l’he ansiver may he due in partto the shocks the two regimes faced. This, how-ever, seemns unlikely because the gold standardwas subject to both supply and demand shocks

that were a multiple of those facing BrettonWoods. It could also be due to greater flexibilityof wages and prices and greater factor mobilitybefore World War I, which meant that adjust-ing to the greater shocks did not have as seriousconsequences on real activity and employmentas later in the twentieth century. Alternatively,political economy factors—such as a morelimited suffrage; less concern over the main-tenance of full employment; limited understand-ing of the link between monetary policy and thelevel of economic activity; and hence loss of anincentive for monetary authorities to pursuepolicies that would threaten adherence toconvertibility—could be responsible. Thesehypotheses clearly need mom-c investigation.

It also could be due to regime design andespecially the incentive compatibility features ofthe regime. The classical gold standard may havebeen so successful because of the credibility ofthe commitment to the gold standard rule ofconvertibility and because of its neam universalacceptance. In turn, the credibility of the goldstandard may stem fm’om the origins of gold asmoney and the importance of Great Britain, themost impom-tant commercial nation of the nine-teenth century, in enforcing the mules. England’scommitment to convertibility in turn was aidedby stabilizing private capital flows.

The classical gold standard for the core coun-tmies worked as a contingent rule or a rule withescape clauses. As a consequence, it was flexibleenough to withstand major shocks, It also ena-bled governments to finance major wars flexi-bly, by allowing them to leave the gold standamcland temporarily use seigniorage to financeunusual government expenditures. The rulemay have endured because the requisite defla-tion required to restore convertibility after theemnergency had passed may not have had severeeffects on real variables. This may have beenbecause wages and prices were highly flexible.Alternatively the deflation accomnpanying re-sumption may have had significant real effectshut no political constituency strong enough tooppose it existed.

The classical gold standard collapsed under’the unprecedented shocks of World War I. Itwas reinstated as the short-lived gold exchangestandard. Its hrief life reflected the fatal flawsmade famous by the ‘t’riffin dilemma. But regard-less of the weakmiess of the gold exchange stan-dard, it suffered from the absence of an effec-tive comnmnitnient mechanism. ‘there was no cen-


183

ter country to enfom’ce the rule, just three rivalspulling in different directions. Also, it was thebeginning of an era when countries were lesswilling to go along with the gold convertibilityrule because they attached greater weight tothe objective of domestic economic stability.

The Bm’etton Woods system was set up to pre-vent the perceived flaws of the classical goldstandard and the trauma of the interwarperiod. The Bretton Woods adjustable peg wasin some respects similar to the gold standardcontingent rule, but it invited speculativeattacks, hence compromising its role as anescape clause. Bretton Woods evolved into agold exchange standard fraught with the adjust-ment, liquidity and confidence problems of theinterwar period. Though the problems of thegold exchange standard could possibly have beencorrected by raising the price of gold, as it turnedout, it evolved into an asymmetric dollar stand-ard. The United States maintained the crediblecommitment to a noninflationary policy for onlya few years. By the mid-1960s it shifted to aninflationary policy to further its domestic inter-ests. The rest of the world, faced with importedinflation, soon lost the incemitive to follow U.S.leadership and the system collapsed in 1971.

The advent of the general floating exchangerate system in 1973 and its longevity suggeststhat the lessons of Bretton Woods have beenlearned well. Countr’ies are not willing to sub-ject their domestic policy autonomy to that ofanother country of whose commitment theycannot be sure in a stochastic world nor to asupernational monetary authority they cannotcontrol. The key advantage of floating exchangerates stressed a generation ago by Milton Fried-man and Harry Johnson—the freedom to pursuean independent monetary policy—still holds today.Major countries can design domestic monetamypolicy rules to achieve domestic pt-ice stabilitywithout the costs of giving up their policyautonomy -

The experience of the EMS reveals that coun-tmies that have similar goals and face similarshocks can establish a regional exchange rateregime. This m-egime requires both a crediblecommitmemit mechanism and the willingness ofmember countries to give up sovereignty fom’ ahigher purpose. As attested to by the events of

‘“See Neumann (1991).

“See Delors (1989).“See Eichengreen (1992d).

September and November 1992, however, thedurability of such an arrangement seems doubt-ful, as was the case for Bm’etton Woods, in anuncertain world subject to diverse shockswhere national priorities can change and com-mitmnents can be broken. Some have amguedthat the EMS can be preserved only by precom-mitment to price stability and fixed exchangerates by independent central banks.’” Othersargue that the only solution is rapid movementto a unified currency enforced by a Europeancentral bank.” As Feldstein (1992) points out,however, full-fledged monetary union com-pletely precludes the use of domestic monetarypolicy. To the extent that country-specificshocks dominate common shocks and labor isrelatively immobile between European coun-tries, the benefits of permanently fixedexchange rates may riot outweigh the cost ofincreased economic dislocation.”

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189

Appendix Figure 1

Supply and Demand Shocks: 1880-1989, Including the War Years, Annual Data,

United States

Percent

Supply and Demand Shocks: 1880-1989, Including the WarYears,

United Kingdom

Percent

-2

-4

-6-8-

-10--12-14-16-18

Annual Data,

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980

1412

108-

6-

4-2-

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

Supply and Demand Shocks: l880-1989, Including the WarYears, Annual Data, Italy

Percent

—1

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980


191

Appendix Figure 1 (continued)Supply and Demand Shocks: 1880-1989, Including theWarYears, Annual Data, 04

Percent

—1

—1

-20-

-24

1

1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980

MARCH/APRIL 1993