From the End of the Bretton Woods System to the Creation and Crisis of the European Monetary System

An issue debated among economists for many decades is whether a fixed- exchange-rate system would be preferable to a flexible one. The advantages of a fixed-rate regime include the encouragement of international trade thanks to less uncertainty (about exchange rates), the ruling out of excessive fluctuations in exchange rates (which do not always reflect the market fundamentals and are subject to speculative movements) and the limitation of opportunistic behaviour by policymakers (including central banks). The main costs of fixed rates are the exclusion, for a given time span, of exchange-rate adjustments and the related demise of autonomous monetary policies at the national level; as we shall see, this cost is exacerbated in monetary unions. once a country has chosen between the two systems, it must stick to the regime selected in order to preserve the credibility of economic policies (Krugman et al. 2016).

Historically, it is well known that at the end of the nineteenth century and the beginning of the twentieth there was a fixed-exchange-rate regime in the world: the Gold standard. This regime guaranteed the growth of international trade and also of capital flows (foreign direct investments), i.e. the spurs of the ‘First Globalization’. After the Great Depression in the 1930s, protectionism spread to many countries, comprising competitive devaluations, exchange-rate instability and huge falls in international trade.

The Bretton Woods Agreements (1944) sought to reintroduce a regime of fixed exchange rates, called the ‘gold-exchange standard’, anchored to the Us dollar. The new regime was fundamental in securing the effectiveness of the international payments system and the growth of international trade (thanks also to the liberalizations carried out within the General Agreement on Tariffs and Trade); in fact, the 1950s and 1960s are cited as the ‘golden age of capitalism’, especially in the Western developed countries. However, the ‘Washington consensus’ (the International Monetary Fund and the World Bank are based in Washington, DC) has been criticized because of its extreme adoption of the free market ideology: for example, by requiring the countries assisted to undertake drastic liberalizations, privatizations, structural reforms, financial deregulation, etc. - in some cases, by means of ‘shock therapies’ disregarding economic and social conditions (Stiglitz 2006).

From a technical point of view, the Bretton Woods regime was an asymmetric system and crucially depended on the credibility of the leading country. When the credibility of the United States’ fiscal and monetary policies slowly vanished at the end of the 1960s, new instability and crises occurred.¹ In 1971, President Nixon declared the end of the dollar’s convertibility into gold. The dollar was devalued and 2 years later the Bretton Woods regime collapsed. Thus, after 1973, flexible exchange rates characterized the relations among the dominant currencies in the world. The new instability, together with supply-side shocks (in particular the oil shocks that began in 1973), affected macroeconomic developments in the 1970s, with recessions and rising inflation - the so-called ‘stagflation’. The Keynesian concept of the Phillips Curve - i.e. an inverse relationship between inflation and the unemployment rate - came under attack. Monetary policies in many countries began to follow the prescriptions of the monetary school (M. Friedman) and new classical macroeconomics (the ‘rational expectation paradigm’ popularized by R. Lucas).

The exchange-rate and macroeconomic instability was particularly deleterious for trade areas like the European Community, which, as we have seen (Chap. 1), had established a customs union already in the 1960s. This union could not survive in the long run, with unstable exchange rates. Moreover, the European economies are comparatively ‘open’, and exchange-rate movements produce large macroeconomic effects. Finally, also the Common Agricultural Policy cannot properly function with frequent exchange-rate movements. Consequently, after the collapse of the Bretton Woods regime, in 1972-1973, an attempt was made to fix the exchange-rate of some European currencies: the so-called ‘snake’; but this experiment also failed.

A more successful agreement was reached in 1978: the European Monetary System (EMS), which entered into force in March 1979. It comprised an ‘exchange-rate mechanism’ (whereby the exchange rates of the participating currencies had a fixed ‘central parity’ with the new virtual currency, the ECU²), rules regarding the intervention of central banks in support of their currencies, and provisions concerning financial support for individual participating countries (when needed). The EMS was called a ‘quasi-fixed’ exchange-rate system because there were two flexibility features: (i) a floating band of ±2.25% around the central parity (±6% for the weaker currencies); (ii) the possibility of realignments, i.e. changes of the central parities decided by the European Council, when the intervention of central banks (in support of weaker currencies) was insufficient.

As a matter of fact, from 1979 to 1987 there were 10 realignments.³ There followed a period of 5 years, called the ‘strong EMS period’, without any realignment and with a consequent real appreciation of the currencies in the countries with higher inflation, leading to competitiveness losses.

The EMS suffered from the same problem as the Bretton Woods system: its asymmetry. The monetary policy was substantially decided by the leading country, i.e. Germany.⁴ There was a risk that possible conflicts in the conduct of monetary policy could cause crises. In fact, in 1992 interest rates were raised in Germany (as a consequence of expansionary fiscal policy after Germany’s reunification accompanied by restrictive monetary policy). The other countries in the EMS had the option of following Germany in raising interest rates (with negative consequences in terms of recession and higher debt burden) or not changing them, thus abandoning the fixed exchange-rate system. Speculative forces considered the second option more likely. They consequently started selling the weaker currencies and - also through ‘self-fulfilling expectation’ mechanisms - caused a major crisis in the EMS. Some other causes included the political instability generated by the rejection of the Maastricht Treaty in Denmark’s referendum (June 1992); the competitiveness gaps generated in the long ‘strong EMS’ period (a last correction of exchange rates would have been necessary before the start of the monetary union); the economic situation in individual countries (e.g. the huge public debt in Italy).

The intervention of central banks in support of weak currencies was important but not unlimited (as required by the EMS agreement). Eventually, in September 1992 the Italian lira and the British pound were ousted from the EMS (the lira re-entered in 1996); many other currencies were compelled to devalue; finally, in 1993 the speculative attacks turned against the French franc. Then, in August 1993 the European Council adopted a drastic measure: a much wider floating interval (±15%) was allowed to all EMS currencies. This was apparently a success, since speculative forces subsided in the following years.