From Bretton Woods to Bipolarity: The Evolution of Thought on Exchange Rate Regimes, 1971-2001

The author is indebted to William Branson for comments on a previous draft.

Introduction

The Bretton Woods system was still in operation when the Monetary Authority of Singapore (MAS) opened for business at the beginning of 1971. Since then the international monetary system has evolved through many exchange market crises to the point where the policy that countries with open capital accounts are most strongly advised to avoid is that which was enshrined in the Bretton Woods agreement, namely the adjustable peg. Conventional wisdom has instead embraced the bipolarity thesis: that countries with open capital accounts should either fix their exchange rate firmly (with a currency board or a single currency) or else allow it to float. This paper sketches the steps along that intellectual road, as background for consideration of the evolution of Singapore's own policy and what is implied for the options open to the countries of East Asia.

The Breakdown of Bretton Woods

The Bretton Woods system was based on the policy consensus founded on Keynesian economics that prevailed in the first quarter century after the Second World War. Each country was expected to use its monetary and fiscal policy primarily to keep the economy at "internal balance", interpreted as non-inflationary full employment. The exchange rate was supposed to be such as to make this policy broadly consistent with the maintenance of "external balance", meaning a current account balance that would be financed by capital flows, with the aid of reserve movements to even out short-run discrepancies and with some shading of macro policies to help. This might involve either a more deflationary overall macro policy or a shift in the fiscal/monetary mix, toward tighter money and easier fiscal policy, to combat a payments deficit. (This may be thought of as using fiscal policy to target internal balance and monetary policy to target the exchange rate.) But if the exchange rate was significantly inconsistent with the simultaneous achievement of medium-term internal and external balance, then the exchange rate was said to be in "fundamental disequilibrium", and should be changed to re-establish such consistency. The presumption at the time of Bretton Woods was that this could be done by administrative fiat without undue problems in terms of anticipatory capital flows, but this assumption became increasingly untenable as capital mobility reemerged from the 1950s onwards.

Reserves consisted of gold and dollars, with the dollar's value pegged in terms of gold at $35 an ounce. A US payments deficit was supposed to drain the United States of gold reserves, and thus exert pressures for more cautious macro policies. But it was not clear that there was a fallback possibility of devaluation if this did not suffice, as there was with other currencies. Many people argued that, since other currencies were pegged to the dollar, a dollar devaluation might simply alter the dollar price of gold rather than the exchange rate between the dollar and other currencies. In principle this was not supposed to happen because the dollar in which pegs were expressed was 1/35 of an ounce of gold, but there was sufficient doubt that other countries would leave their currencies unchanged in terms of gold in the event of a US devaluation to pose the possibility that the end result might be a large increase in the gold price. This meant that a US payments deficit created an incentive to run into gold, draining the United States of gold and threatening the breakdown of the system, a threat that was intensified after the 1967 devaluation of the pound sterling removed what had been regarded as the dollar's front line of defense. The danger of a private run into gold was eliminated when the gold pool was suspended in 1968, which resulted in the creation of a two-tier gold market: an official market where gold was in principle traded among monetary authorities at the official price, and a private market where the gold price floated. But this increased the pressure on other countries to ward off a breakdown of the system by having them accumulate dollars in their reserves rather than convert their dollars into gold.

De facto elimination of dollar convertibility also removed the ability of the system to restrain the United States, and ensured that the inflationary pressures resulting from financing the Vietnam War without a tax increase were transmitted to other countries. Every expectation of an exchange rate change led to a speculative rush into a currency that the market expected to be revalued, or out of one thought to be at risk of devaluation. By May of 1971 Germany, a prime candidate for revaluation, found the inflationary pressures intolerable and set the deutschemark free to float, as the Canadian dollar already was. When the IMF was asked to ratify this decision, the Canadian Executive Director in the Fund is reported to have quipped: "You'll have to build a bigger dog-house now!" There was not long to wait before further massive dollar purchases in Europe led to American fears that several European countries were on the brink of making large gold purchases while they still had the legal right to do so. On August 15, 1971 the United States decided to make that impossible by closing the gold window to foreign official purchasers. The Bretton Woods system was formally dead. (See Solomon 1977 for an account of the breakdown of Bretton Woods.)

The Emergence of Generalized Floating

The other major developed countries reluctantly decided that this left them no option but to float. This decision was not reached lightly: the prime minister of one major European country is reputed to have instructed his central bank that they must neither buy any more of those wretched dollars nor allow the country's currency to appreciate. It was only as political leaders were convinced that this was not a technically feasible option that floating was accepted, but almost everyone insisted that this must be a strictly temporary state of affairs to be corrected by a multilateral agreement to restore a par value system as quickly as possible. Negotiations at the Smithsonian Institution in Washington finally achieved such an agreement in December 1971. After countries had fought bitterly about every last 1% change in their official exchange rates, the United States ended up with an effective devaluation of the dollar of about 7%, which it regarded as too small but agreed to accept in the interest of international harmony.

Since nothing was done to restore any form of dollar convertibility, the effect of the Smithsonian Agreement was to place the world on a dollar standard. This would have been somewhat similar to the currency board systems that have become popular in the last decade, in that all countries other than the United States would normally have been under pressure to import the monetary policy set in the United States. They could have avoided doing this in the short run only to the extent that they maintained effective capital controls, and in the long run even that would not have been effective. Monetary independence could have been achieved only by periodic devaluations or revaluations, acts that would have subjected the countries involved to massive losses to speculators as capital mobility progressively mounted. Since other countries rejected both the prospect of becoming a monetary satellite of the United States and that of becoming a milk-cow for speculators, they were emphatic that the Smithsonian was to be merely the first step in a comprehensive reform of the international monetary system.

The negotiations intended to achieve such a reconstruction of the international monetary system were initiated in the Committee of Twenty (C-20) in 1972. Rather remarkably, the negotiators never engaged in any substantive discussion of the exchange rate regime that should be embodied in the reformed system: it was accepted by all that this should be a restoration of the Bretton Woods regime of "stable but adjustable exchange rates". This formula was not changed even when another tidal wave of speculative pressures blew away the Smithsonian Agreement in March 1973, and forced adoption of generalized floating by the industrial countries. Instead, the big focus of the negotiations was on how to achieve symmetry in international monetary obligations. This meant quite different things to the two main parties to the negotiations, the USA and the Europeans. To the United States, the asymmetry that had come to seem alarming was that between deficit and surplus countries, with all the pressures for adjustment supposedly resting on deficit countries. To the Europeans (with the Japanese concurring, though they were not major actors in the negotiations), the big asymmetry was that between the reserve center (i.e. the United States) and the rest, with all the pressures for adjustment resting on the non-reserve centers. About the only thing on which both parties agreed, other than the restoration of an exchange rate regime that had become unworkable because of capital mobility, was that the SDR should be made the principal reserve asset. This provided the backdrop to the third big contentious issue in the negotiations, the proposal to create a link between the issue of SDRs and the provision of development assistance, e.g. by allocating SDRs wholly or disproportionately to developing countries. This would have amounted to development assistance because in those days the interest rate on the SDR was only 1.5% per annum.

The United States proposed a complicated system of reserve indicators as a way of pressuring surplus countries into adjustment. Each country would have accepted a norm for its reserve level, and would then have been expected to initiate adjustment action if its reserves rose a given distance above, or fell the same distance below, that norm. Exactly what form adjustment actions should take was not spelled out, but the presumption was that it would have included exchange rate changes, which would have meant that the system would have provided information to help speculators profit at the expense of central banks. The Europeans proposed a system of asset settlement, which would have obliged the reserve center to settle its payments imbalances by transferring reserve assets (gold or SDRs) rather than building up dollar liabilities, at least beyond some strictly defined limits. The obvious reconciliation of these two proposals, to combine them rather than choose between them, never really got considered, perhaps because the negotiators recognized what they could not admit publicly: that their chosen exchange rate regime was going to prevent such fine tuning of when and who should adjust. Neither was there agreement on the link, with Germany and the United States leading the opposition to what critics feared was an attempt to turn the SDR into funny money. Eventually the negotiations fizzled out, using the oil price increase of late 1973 as an alibi to explain why it was not possible to secure an agreement at that time.

Formally, the two principal achievements of the C-20 negotiations were to endorse the return of the adjustable peg and to declare the SDR the principal reserve asset, but neither had any impact on subsequent events. Two other achievements, both of which were actually negotiated in the IMF Executive Board and then merely endorsed by the C-20, might have amounted to something, though in the end they too fell by the wayside. One was to redefine the value of the SDR as equal to a basket of currencies, in place of its previous definition in terms of gold. The other was the design of a quite substantive set of guidelines for the management of floating exchange rates. These encouraged countries to intervene to moderate sharp short-term fluctuations, permitted them to lean against the wind, and, most interestingly, specified procedures for an embryonic target zone system (IMF 1974, p.35):

(3)(a) If a member with a floating rate should desire…to bring its exchange rate within, or closer to, some target zone of rates, it should consult with the Fund about this target and its adaptation to changing circumstances. If the Fund considers the target to be within the range of reasonable estimates of the medium-term norm for the exchange rate…it would be free…to act aggressively to move its rate toward the target zone…

(b) If the exchange rate of a member with a floating rate has moved outside what the Fund considers to be the range of reasonable estimates of the medium-term norm for that exchange rate to an extent the Fund considers likely to be harmful to the interests of members, the Fund will consult with the member, and…may encourage the member…(i) not to act to moderate movements toward this range, or (ii) to take action to moderate further divergence…

When the reform negotiations were abandoned, the world found itself with a system of generalized floating among the industrial countries but continued general pegging among the developing countries. Even among the industrial countries, floating was in many cases accepted only reluctantly. In particular, a number of the European countries had already arranged to limit their exchange rate fluctuations more closely than the margins of +/- 2¼ % sanctioned by the Smithsonian Agreement, and to that end had created what was known as "the snake in the tunnel" before the collapse of the Smithsonian par values in March 1973. At that time the snake continued even though it broke out of its tunnel; that is, several European countries, mainly members of the European Community, essentially came to peg to the deutschemark. But with that exception all the main industrial countries had moved to floating exchange rates by 1974. (See Williamson 1976 for an account of the C-20 negotiations.)

Developing Countries in a World of Generalized Floating

While the industrial countries started to let their currencies float in 1973, almost all the developing countries continued to peg. The majority of them pegged to the US dollar, while a group of former French colonies in Africa used the CFA franc, which was pegged to the French franc. A dwindling group of former British colonies pegged to the pound sterling, while a few other countries pegged to neighboring countries' currencies, e.g. Lesotho and Swaziland pegged to the South African rand. As time passed, an increasing number of countries moved away from a peg to a single currency and began to peg either to the basket SDR or to a tailor-made currency basket. Most developing countries continued to use the adjustable peg, i.e. they sought to maintain the value of their peg constant over time but occasionally made adjustments, usually fairly substantial, when forced to do so by circumstances. But a few countries, mainly in Latin America, allowed their currencies to crawl, generally with a view to neutralizing their high rate of inflation.

It was not long before developing countries realized that pegging to the dollar in a world where all the major currencies were floating was a very different proposition to pegging to it in a world of stable exchange rates, even if those rates had occasionally been adjusted. A stable dollar exchange rate no longer guaranteed a stable effective exchange rate. A country with a stable rate against the dollar could now suffer a major loss of competitiveness, or (conversely) import serious inflationary pressures, as a result of events that were totally extraneous to it, namely depreciation or appreciation of other major currencies against the dollar. This meant that a country's decisions on exchange rate policy were not ended by deciding that it would peg; it also had to decide to what to peg. Before long this spawned a new literature on what became known as the "optimal peg".

This literature postulated that the choice of a unit to which to peg should be made with a view to stabilizing some variable, rather than with a view to optimizing some variable. This reflects the view that fluctuations between third currencies are disturbances that threaten to alter an exchange rate that has presumptively been set at an optimal level. Picking a peg is viewed as a problem of minimizing the instability imposed by movements between third currencies that are noise so far as the domestic economy is concerned.

Most authors on this issue took the position that the sensible objective in choosing a peg was to try and stabilize the macroeconomy. As under Bretton Woods, this should be interpreted as aiming to secure continuous internal balance and medium-term external balance. The reason for the asymmetry is that departures from internal balance always involve a welfare cost (today's unemployed cannot compensate by working overtime tomorrow, and deflation tomorrow compounds rather than negates the distributive injustice done by today's inflation), whereas variations in reserves allow short-run departures from external balance with negligible welfare costs. Variations in third-currency exchange rates constitute short-run shocks that one wants to prevent disrupting short-run internal balance or medium-run external balance, but one does not seek to have the current account adjust to every short-run shock so as to preserve continuous external balance. This approach leads to the policy recommendation to peg to a basket of currencies that will stabilize the effective exchange rate. Of course, it has to be recognized that this means destabilizing all bilateral exchange rates. Most of these will inevitably fluctuate in a world of generalized floating: one can at most stabilize one bilateral rate, plus any others that are stable in terms of the currency chosen as a peg. Countries whose trade is dominated by a single country (or currency area) can sensibly peg to that country's currency, because there is no acute conflict between the objective of stabilizing the effective exchange rate and thus the macroeconomy and the microeconomic convenience of a constant rate in terms of a major trading currency, but others have to choose, and the gist of the argument was that macroeconomic considerations should dominate.

Subsidiary issues concern the choice of weights to calculate the effective exchange rate. Most authors favored the use of total trade weights rather than export or import weights. Most would have preferred using elasticity weights rather than simple trade weights if they were confident that good estimates of the trade elasticities were available, but in practice most practitioners have settled for simple trade weights. Most authors have favored basing trade weights on the direction of trade rather than the currency of denomination of trade, on the ground that it is currently quoted prices for future delivery, rather than prices agreed in past contracts for current delivery, that influence resource allocation. And most authors have taken the view that the weights should be based on trade, or at least current account transactions, and not capital flows. (See Williamson 1982 for a survey of the literature on this issue.)

This literature provided the intellectual foundation for the movement toward basket pegging that became quite widespread among developing countries as the 1970s progressed. For a time quite a number of countries pegged to the SDR rather than a tailor-made basket. For example, in April 1979 the IMF recorded 33 countries pegging to a basket (13 of them to the SDR) as against 60 to single currencies (40 of them to the dollar). Calculations suggested that for a country with diversified trade the loss of precision in stabilizing in terms of the SDR rather than in terms of a tailor-made basket would typically be rather small. One advantage of widespread adoption of this practice among developing countries would have been to stabilize their exchange rates against each other, which could have encouraged the growth of South-South trade and reassured countries that they were not going to suffer competitive devaluations by their competitors as a result of extraneous events. But in practice the SDR was never adopted widely enough to make this a major attraction.

The Rise of Monetarism

As late as 1971 President Nixon could proclaim "We are all Keynesians now!" without being ridiculed. But among economists it had ceased to be true by then, and in the following decade monetarism became the new orthodoxy. Undoubtedly the major factor undermining the Keynesian consensus was the outburst of inflation that started in the late 1960s, raged almost unchecked through most of the 1970s, and was tamed only in the 1980s in industrial countries and as late as the 1990s in a number of developing countries. This was blamed, quite plausibly, on the U.S. policy of targeting "internal balance", interpreted as a particular level of unemployment that history had suggested to be compatible with low inflation. But when shocks increased the "natural rate of unemployment", as they presumably did in the late 1960s (although economists still do not have a handle on the nature of those shocks), a policy of continuing to target the same level of unemployment translated not just into faster inflation but into accelerating inflation. The Friedman-Phelps theory of how adaptive inflation expectations make the long-run Phillips curve vertical provided a convincing explanation of the phenomenon of accelerating inflation that became painfully evident shortly after the theory was first adumbrated (Friedman 1968, Phelps 1967). And a policy of pegging to the dollar then generalized this inflation worldwide.

The monetarists offered a solution: provide the economy with a nominal anchor, which would ensure that any tendency for inflation to accelerate would provoke a stabilizing deflationary response. Friedman's candidate was a constant rate of growth of the money supply, while Robert Mundell was the leading advocate of the view that a fixed nominal exchange rate with a stable currency was a preferable candidate for most countries, particularly the smaller ones. One of the problems perceived by many countries in the early 1970s was that, because of the high inflation and loss of fiscal discipline in the United States, the dollar no longer provided a stable currency that made a good nominal anchor. This drove countries like Germany to embrace floating exchange rates. Together with greater fiscal discipline and its policy of targeting a non-inflationary rate of growth of the monetary base, this enabled Germany to restore price stability relatively rapidly, which then made the deutschemark an attractive alternative nominal anchor for its neighbors, hence the European snake.

The other area of the world that proved relatively immune to the inflation of the early 1970s was East Asia. Most countries in the region decided to adjust to the oil price shock by increasing exports and decreasing imports, rather than by borrowing and avoiding deflationary policies as was the common response elsewhere, particularly in Latin America. This required a combination of relatively deflationary policies and competitive exchange rates. The deflationary policies came at just the right time to avoid a buildup of inflationary momentum such as occurred in most of the rest of the world. Aggressive devaluation was not needed to secure competitive exchange rates, given the inflation prevailing elsewhere (including in most industrial countries). The cautious macroeconomic policies of this period provided one of the foundations for the "economic miracle", since it avoided most of the countries (the exceptions being Korea and the Philippines) encountering subsequent debt problems.

Much of the rest of the developing world showed much less dedication to macroeconomic stability, at least until well into the 1980s or even until the 1990s. Rather than adjust in response to the oil shock of 1973, they borrowed to finance increased current account deficits while aiming to maintain growth. This policy led to rapidly increasing levels of debt, which proved unsustainable after the United States pushed interest rates sky-high in 1979 to bring inflation under control. US policy simultaneously increased the burden of debt service, appreciated the dollar in terms of which most debt service had to be paid, and depressed the commodity prices that most countries still largely relied on to finance debt service. The result was that the debt crisis started in 1982 and enveloped much of the developing world for most of the 1980s. The debt crisis required devaluations, which increased fiscal deficits as countries had to find the resources for servicing an increased domestic-currency burden of foreign debt that could no longer be financed by increased foreign borrowing, and this further accelerated inflation.

Once countries did begin to acknowledge the cost of high inflation and seek to bring it down, at least they found that the US dollar once again provided a stable unit that they could use as a nominal anchor. The standard stabilization program tended to start off by declaring a fixed exchange rate against the dollar. (A variant sometimes used was to preannounce a slowly decelerating downward crawl against the dollar, a "tablita".) These programs proved quite popular, perhaps in part because it was discovered, to general surprise, that such programs were often expansionary in their early phase (Kiguel and Liviatan 1991). The common explanation was that what looked like a high nominal interest rate to foreigners (if the program was credible) translated into a low real interest rate to nationals as inertial inflation was still being ground out of the system.¹ This was consistent with large capital inflows that financed a domestic boom. It turned out that there was often a price to be paid, but that is a story of the 1990s.

The European Monetary System

The European Community had talked about launching a program to achieve European monetary union in the early 1970s, but this was swept away in the monetary hurricane that demolished the Bretton Woods system. All that survived was the European snake, as described above. But by 1978 the Europeans were getting tired of the stresses to which they were subjected as a result of the dollar's roller-coaster-weak after the collapse of Bretton Woods in 1973, strengthening in 1975, weak again in 1978. The European currencies did not float up and down in parallel, but the internationally active ones, notably the deutschemark, tended to strengthen and weaken the most. It was primarily to mitigate the fluctuations this produced in their effective exchange rate that the Germans were interested in building a "zone of monetary stability" in Europe.

The European Monetary System (EMS) was launched in early 1979, with a first phase that in practice consisted mainly of the exchange rate mechanism (ERM), although there was also a European Monetary Cooperation Fund that centralized a part of the reserves and facilitated short-term intervention in defense of the exchange rate obligations. The ERM was an adjustable peg with margins of +/- 2¼%, but in its early years (until 1987) it operated more like a crawling peg, with relatively frequent parity changes that were undertaken promptly enough to make individual changes mostly small enough to avoid forced discrete changes in market exchange rates. That served to limit the speculative pressures that developed in anticipation of parity changes. But in 1987 an understanding was reached that in future an attempt would be made to avoid parity changes, as a prelude to stage 2 of the EMS in which all intra-European exchange controls would be abolished. That second stage duly started in 1990, when France and Italy completed the liberalization of their capital accounts, and for a few months all appeared to be going well.

But that was to change as a result of the tensions produced by German reunification. When West Germany absorbed East Germany in 1990, East Germans were given deutschemarks in return for their East-marks and wages were translated into deutschemarks at a generous 1:1, and the German budget went into big deficit as massive fiscal transfers to modernize East Germany were started. The Bundesbank attempted to avoid this being translated into higher inflation by raising German interest rates. The textbook corollary would have been a real appreciation of the deutschemark, to facilitate a real resource transfer into Germany as a counterpart to the increased fiscal deficit. This would have enabled Germany to import capital from (or export less capital to) the rest of the world, i.e. to share the burden of reconstructing East Germany with other countries. But this channel was blocked, at least vis-à-vis other ERM member countries, by the unswerving devotion of the Bundesbank to price stability and the obligation to keep intra-ERM exchange rates constant. Suggestions for a deutschemark appreciation within the ERM, or for an asymmetrical upside widening of the deutschemark band, were brusquely rejected by Germany's ERM partners. This was foolish since it made economic policy extremely problematic for the other members of the ERM. Tensions were further increased by exchange market crises in the Nordic countries and Danish rejection in a referendum of the Maastricht Treaty for moving on to European monetary union (EMU). In September 1992 there was a run on the pound and the lira, whereupon they both withdrew from the ERM and resumed floating. More runs followed in the succeeding months, with devaluations of Irish punt, Spanish peseta and Portuguese escudo. In the summer of 1993 even the French franc was subjected to a major speculative run. Rather than devalue, it was decided to widen intra-ERM margins to +/- 15%.

To general surprise, this worked like a dream. Within a few weeks currencies were back within their old narrow margins, without the central banks having to push them there. When the margins were first widened it was generally assumed that this would put paid to the project for pushing on to EMU by 1999, but the authorities soon announced that they had no intention of being deterred from continuing on the planned timetable. And that they did. The currencies of 11 EU members, more than had been expected to qualify for EMU membership, were irrevocably locked on 1 January 1999, as had been planned. A twelfth EU member, Greece, joined two years later, leaving only Denmark, Sweden, and the UK outside the euro.

Misalignments Among the G3/G7 Currencies

While the European countries were engaged on their venture to first limit and then eliminate exchange rate variations, the relationships among the major industrial country currencies were regarded as progressively less amenable to government control. One is thinking here especially of the exchange rates between the US dollar and the deutschemark and Japanese yen, the G3 relationship, but the Canadian dollar also floated the whole time, the pound sterling did for most of the time, and the Italian lira did for a short time; out of the G7 currencies, it was only the French franc that was tied to the deutschemark for the whole period after 1979.

Apart from the intra-European relationship, G7 exchange rates had started to float in the early 1970s, as recounted above. It was not long before alarm bells were ringing about the extent of the dollar's depreciation in the course of 1973, a depreciation that the United States decided to view with what became known as "benign neglect". From then on the dollar was on a roller coaster: strong in 1975, weak in 1978-79, progressively stronger in 1981-85, weakening in 1985-87, weaker still in the mid-1990s, then strengthening until the present day. In 1978-79 US policy actively sought to combat the dollar's weakness, but any concern with the dollar exchange rate was abandoned when the Reagan administration took office in 1981. Sterilized intervention in the exchange market was terminated, and an official study of the effectiveness of official intervention in the foreign exchange market (the Jurgensen Report, 1984) rationalized this decision by concluding that it was not an effective tool for exchange rate management. The official view became that exchange rates could be managed by the authorities only where they were prepared to use monetary policy for that purpose, which precluded the use of monetary policy for domestic stabilization. While use of the exchange rate as a nominal anchor might make sense for small open economies, it was inappropriate for the large G3/G7 economies. Other G7 currencies also experienced large misalignments at times, sometimes as the counterpart to the dollar's position, at other times (as with sterling's strength in 1980-82) independent of the dollar.

Not everyone thought it good policy to remain passive in the face of the dollar's growing overvaluation in the years 1981-85. In fact, this was the immediate stimulus for the development of the target zone proposal for exchange rate management at the Institute for International Economics (Bergsten and Williamson 1983, Williamson 1985). The basic idea was that the major countries should announce estimates of medium-term equilibrium exchange rates, and then undertake to maintain market exchange rates within a wide zone, say of +/- 10%, around the estimated equilibrium. We argued that the first weapon to be used in defense of the edge of the target zone should be sterilized intervention, but that if necessary a country should be prepared to adjust monetary policy to defend the zone. We argued, based on our understanding of European experience in the ERM, that most of the time monetary policy would be able to pursue internal objectives, but that occasionally it would be necessary to divert interest rates to exchange rate management. Paul Krugman (1991) subsequently provided a theoretical basis for this intuition, with his demonstration that a credible commitment to intervene at the margin would generate a "honeymoon effect" which would mean that for most of the time stabilizing speculators would keep the rate within the band. A later version of our proposal, the "blueprint for policy coordination" developed by Marcus Miller and me (Williamson and Miller 1987), envisaged offsetting any undesired impact on domestic demand from exchange rate oriented monetary policy by an adjustment in fiscal policy. That is, fiscal policy should be directed to domestic stabilization so that monetary policy could be freed to manage the exchange rate-a proposal that ran afoul the strong political sentiment against using fiscal policy to "fine tune" domestic demand.

The target zone proposal was first developed when most of us assumed that the extant theory of exchange rate determination, which essentially says that the market exchange rate will deviate from its long run equilibrium value by the integral of expected future short-term interest differentials between now and the long run (modified by portfolio positions), was basically correct. But as time progressed it became increasingly difficult to make sense of most exchange rate movements in terms of what this theory identified as "the fundamentals": relative inflation rates, interest rate differentials, portfolio changes, and balance of payments positions. Indeed, it turned out that econometric attempts to explain exchange rate behavior on the basis of the standard theory were singularly unsuccessful at time horizons of less than a year (Meese and Rogoff 1984). One alternative view is that bandwagon effects play a significant role in driving exchange rates. If true, this would seem to strengthen the case for trying to manage exchange rates, and for thinking that sterilized intervention can sometimes play a useful role in reversing a disequilibrating fad.

An abrupt change in US exchange rate policy was announced at the Plaza Hotel in 1985, when the Reagan administration finally acknowledged that the overvalued dollar was causing an acute protectionist backlash. For the next 18 months the Baker Treasury actively sought to push the dollar down (of course, the aim was described as an orderly appreciation of other currencies). When it decided that the dollar had fallen enough, the G7 adopted an unannounced target zone at the Louvre meeting in early 1987. That lasted until the stock market correction of October 1987 ("Black Monday"), when the US administration made it clear that expansionary policies would not be risked by exchange rate objectives. From then on G7 intervention became ever more episodic, with the Clinton administration embracing a strong dollar rhetoric that rejected any systematic attempt to limit currency misalignments.

The important development in industrial country macro policy in the 1990s did not concern exchange rate policy per se, but consisted of the development of inflation targeting as a new form of nominal anchor to replace the money-supply targeting that convincingly failed in the 1980s. So far this appears to be a vast improvement over the money supply rules inspired by monetarist thinking, while still providing an escape from both the danger that inflation will explode in response to a negative supply shock and the anomaly of having a large country use the exchange rate as a nominal anchor. Many economists have come to conceptualize the exchange rate question as focused exclusively on the choice of nominal anchor, so that they find it incongruous to hear anyone argue in favor of both exchange rate targeting and inflation targeting. But the implication of the empirical finding that exchange rates are not driven by what economists regard as "the fundamentals" is that this is perfectly reasonable. Think of inflation targeting as providing a modern version of internal balance, one that is proof against a progressive acceleration of inflation such as occurred in the 1970s. One can certainly operate that regime without any exchange rate target, as the main industrial countries are doing today. But one could also adopt an exchange rate target, if one believed that would do any good, with the aim of using policies like sterilized intervention and jawboning to limit the extent to which the exchange rate is driven away from its equilibrium level by fads and bandwagon effects. Provided that the target is indeed reasonably close to equilibrium (and one reason for favoring wide zones is to make the system invulnerable to likely errors in estimating the equilibrium rate), it is difficult to see what harm this could do, and it might do some good. There is no reason for dismissing such a regime as inherently infeasible.

The Emerging Market Crises of the 1990s

While the G7 were becoming ever more committed to floating and the Europeans were driving toward monetary union, the situation among emerging markets displayed far more diversity. Some countries pegged to a single currency and others to a basket; some used the adjustable peg and some crawled. Quite a number had used a currency peg to provide a nominal anchor to bring inflation under control. Many of them had experienced the same progressive increase in capital mobility that the industrial countries had been through a couple of decades earlier, although some of the less developed were still effectively isolated from the international capital market by capital controls. And there were two policy innovations in the 1980s and early 1990s.

The first was the revival of currency boards. This is a currency arrangement that had been virtually eliminated as the British Empire was liquidated in the 1960s. An aspect of the transition from colony to nationhood was replacement of its currency board-an arrangement where local currency was issued only in exchange for the currency of the metropole, to which the local currency was firmly pegged-by a central bank, which allowed a country to create money also in exchange for local assets. The advantages this was supposed to confer were in terms of being able to reap seigniorage and gaining the ability to pursue a local anticyclical policy. While there was Singapore's outstanding example of growing out of its currency board arrangement in strength and achieving a superior system, most countries that replaced currency boards by central banks promptly abused their new freedom to indulge in inflationary financing. As this became more widely understood, so a move to revive currency boards gradually gathered strength.

The first off the mark was Hong Kong, still formally a colony at the time though one that ran its own affairs more independently than many nominally independent countries, which in 1983 chose to resolve an excessive depreciation of the floating Hong Kong dollar caused by a loss of political confidence by establishing a fixed rate with the US dollar and backing it up with a currency board. It was followed in 1991 by Argentina and in 1992 by Estonia, and since then several other countries have chosen the same route. A new tendency is to regard a currency board as a half way measure and to go instead for dollarization (as Ecuador has done) or euroization (as is already being discussed in places in the Balkans).

The logic of a currency board is to provide an institutional guarantee that monetary policy will be operated in a way that provides a stabilizing feedback from the standpoint of maintaining a fixed exchange rate. Any reserve loss (gain) will be translated into a tighter (easier) monetary policy, without any discretionary policy decisions that might prevent that outcome materializing. In association with the guarantee that reserves will always be at least 100% of the monetary base, this is expected to generate confidence that the exchange rate peg will be maintained indefinitely, which will in turn build confidence that will make capital movements stabilizing. Dollarization makes it even more difficult and costly to abandon the pledge to maintain the exchange rate fixed, and removes the very concept of an independent monetary policy, thus further buttressing confidence in the permanence of the monetary regime. The downside is, of course, the loss of the ability to allow the exchange rate to change when this could facilitate adjustment (as manifest in Argentina today).

The other innovation among developing countries in the 1990s was to experiment with arrangements similar to the target zones that Fred Bergsten and I had advocated for the main industrial countries in the 1980s. There were three elements to a "crawling band" regime, as Jacob Frenkel termed it in 1992 when he added a crawl to the wide band that Israel had already worked its way to, so as to avoid the periodic crises that had been erupting whenever a parity change was anticipated. The first was use of a basket of currencies as the unit in terms of which to define the country's exchange rate target, and therefore band. (Of course, a country whose trade is heavily concentrated on one particular country or currency area can perfectly well adopt a single-currency basket, but for the majority of countries it is important to stabilize in terms of a basket rather than a single currency so as to avoid major shocks coming from movements in third-currency exchange rates.) The second element was the wide band, of something like +/- 10%. This was intended to allow for inaccuracies in estimation of the equilibrium exchange rate, to give some scope for small parity adjustments without precipitating crises, to allow room for an element of anti-cyclical monetary policy at variance with that in the peg country or countries, and to avoid the need to have every minor blip in capital flows show up in money supply changes. The third element was the crawl of the parity, which was envisaged as allowing the authorities to keep the band realistic in the face of real shocks, differential inflation, and Balassa-Samuelson productivity bias. The extent to which the future crawl was pre-determined and pre-announced varied a lot, with some countries announcing a virtual tablita, others announcing a formula (usually based on the outcome for differential inflation), others (like Singapore) predetermining but not announcing, and others following a more discretionary policy. Dornbusch and Park (1999) termed this the BBC regime, where BBC stands for basket, band, and crawl.

For a time a number of developing countries used this regime: Chile from the early 1990s to 1998, Colombia over almost as long a period, Singapore from 1975 to the present, Israel from 1992 more or less to the present, Hungary from the mid 1990s to the present, Poland from 1995 more or less to the present, Ecuador for a time, plus Brazil, Mexico and Russia with a somewhat different twist until they were overwhelmed by crises, and Indonesia for a while until contagion hit it in 1997. The crawling band's peak popularity was in the year or so before the East Asian crisis started, which was when I published a fairly up-beat study of how the regime had been operating in the three countries where the parameters were public that had accumulated the most experience with it, namely Chile, Colombia, and Israel (Williamson 1996). But that crisis nurtured profound skepticism about the whole idea of pegging, or even managing, exchange rates.

The first of the big emerging market crises of the 1990s was that in Mexico, which started at the end of 1994. Mexico had a crawling band system, but it was one that had used the exchange rate as a hard nominal anchor, i.e. in which the crawl was predetermined and pre-announced, rather than determining the rate of crawl primarily by the need to maintain a competitive exchange rate. It had therefore run into the problem that afflicted many countries that chose to use the exchange rate as a nominal anchor in disinflating: it had become overvalued in the process, as inertial inflation was slow to decline. For a while this was not a problem because big capital inflows willingly financed the large current account deficit, and indeed Mexican officials used to explain how their current account deficit was a sign of success rather than a policy problem (just like officials of the Bush administration do today). But the shocks of Chiapas and the Colosio assassination undermined the confidence that had sustained the Mexican economy despite its large current account deficit and slow growth, and after a few months of trying to get by with a shortening of maturities in the foreign-held debt, a serious run on the peso set in. After a failed attempt at a discrete devaluation, the authorities allowed the peso to float. Interest rates had to be raised very high and recession was sharp, but, with the help of massive bailout loans, recovery was swift. Aided by NAFTA, Mexico has since then begun to look much more secure and achieve a respectable rate of growth.

The East Asian crisis started in a very similar way, with speculative pressures on the Thai baht, the currency of a country whose modestly excessive inflation had contributed to a persistent current account deficit that had built up a big external debt that was largely financed short-term. The baht was supposedly pegged to a currency basket, but since the basket seemed to consist overwhelmingly (about 88%) of the US dollar, this did not do much to blunt the problem of having the effective exchange rate appreciate as a result of the strength of the dollar. The dollar's weakness in 1995 had temporarily concealed the secular deterioration in Thailand's position, but this became all too clear as the dollar recovered in 1996. The short maturity of much of the foreign borrowing and the weak financial position of many of those who had borrowed abroad made it at the same time essential and perilous to raise domestic interest rates to defend the currency. By July 1997 the reserves ran out, and the baht had to be floated. Since it promptly depreciated drastically, there were widespread bankruptcies among those who had borrowed foreign currencies and were unable to service the inflated baht value of their foreign debts.

Given that other East Asian countries were now highly integrated in the international capital market, the Thai crisis quickly had repercussions in other countries that the market placed in a similar category. These were primarily Thailand's neighbors in South East Asia: countries that had benefited from the "miracle" growth rates of the preceding decades, and that the market had enthusiastically financed as long as things were going well following their rapid liberalization of the capital account in the 1990s. All the ASEAN countries except perhaps Singapore had de facto pegged to the dollar (McKinnon 2000), and had therefore suffered from effective appreciation as the dollar appreciated in 1995-97. Again with the exception of Singapore, all had experienced pervasive "cronyism", although the harmful results of this were not widely apparent until the crisis broke. Perhaps most important, most of them had built up large stocks of short-term, foreign currency denominated debts. As foreign investors worried whether other countries might be vulnerable to the same disease that had afflicted Thailand, they quickly fixed on Malaysia and Indonesia as the most similar. So, even though both had enjoyed rather good macroeconomic management over the years, they found their currencies suffering speculative runs. It was difficult to doubt the reality of contagion; it still seems highly unlikely that either economy would have run into trouble had Thailand not suffered a crisis and been forced to devalue.

In October problems spread north, first to Hong Kong and then to Korea. Hong Kong's currency board prevented a devaluation, but not a recession. And in a subsequent attack in 1998, the Hong Kong Monetary Authority utilized a highly unorthodox (and highly profitable) intervention in the equity market in order to ward off a speculative attack. Korea had not built up the massive reserves that Hong Kong had done, and it had its own problems that were already manifest in the bankruptcy of several of the chaebols, so it proved unable to avoid being forced to float the won. Once again, devaluation proved to be highly contractionary, although the concerted restructuring of Korea's short-term bank debts facilitated a relatively rapid recovery.

In 1998 it was Russia's turn to be forced to allow its exchange rate to float. Russia was another country that had become chronically overvalued as a consequence of the decision to use the exchange rate as a nominal anchor in stabilizing inflation. The exchange rate had again been sustained for a time by capital inflows, but market doubts developed as it became clear that the fiscal deficit was on an explosive path (Kharas, Pinto, and Ulatov 2001). A new IMF agreement just seemed to make matters worse, as the debt swap it embodied served to increase the volume of debt that was senior to the ruble debt outstanding. Once again, a pegged currency was forced to float.

The unilateral debt reconstruction that accompanied Russia's forced float precipitated a flight to safety which brought the Brazilian real under new pressure and upset LTCM's gamble that the regressions of the preceding n years could be safely extrapolated into the future. For a few weeks the situation looked genuinely dangerous. Yet the crisis quickly blew over, with Brazil being shored up by a new IMF package that lasted just long enough to get President Cardoso reelected and allow Brazil to abandon its currency peg under safer circumstances. Like so many other countries, Brazil failed to secure an orderly devaluation and was forced to float. The results were in this case agreeably untraumatic: growth slowed but Brazil avoided a recession, and its new regime of inflation targeting appeared to be operating well.

Although the Brazilian float is usually treated as the end of the world economic crisis that started with Thailand in July 1997, it did not mark the end of countries being forced to float. Turkey has to be added to that list as of 2001.

Will the Bipolarity Thesis Endure?

Review of the emerging market crises of the 1990s suggests that, under the conditions of high capital mobility now characteristic of emerging markets as well as industrial countries, there is an association between proneness to crisis and the presence of a pegged exchange rate. No country with a currency board was forced to devalue. And the countries that escaped contagion were those with floating currencies, like South Africa and (in the last round) Mexico. Ergo, countries should go to one or other of the two extreme regimes, either a currency board or a floating exchange rate. Intermediate regimes should be avoided (Eichengreen 1999, Fischer 2001).

It would be fatuous to deny that there is an element of truth in this diagnosis. Nevertheless, there are several reasons for doubting whether it represents the end of intellectual history on exchange rate policy.

First, currency boards do not exempt countries from crises, as both Argentina and Hong Kong have illustrated. They have so far avoided a country being forced to devalue, but they have not avoided countries being subjected to intense and prolonged deflationary pressures, and one can debate whether that is less problematic than a forced devaluation.

Second, a side-benefit of the collapse of LTCM and the rush to safety was that a series of attacks on floating currencies (Australia, New Zealand, South Africa) got called off as the hedge funds and their ilk were forced to pull back (Financial Stability Forum 2000). One may wonder whether there would be as much enthusiasm for floating if those countries had been forced into savage deflationary actions to prevent their currencies being weakened even further, or had encountered severe stagflationary effects as such a weakening occurred.

Third, there is still one well-managed country that says quite explicitly that it has a BBC regime and seems to think it is well served by it. Admittedly Singapore does not publish the parameters of basket, band, or crawl, as I have always advocated and still favor, although the MAS has recently moved to increase the transparency of its regime by publishing regular Monetary Policy Statements and the latest one states explicitly that the crawl has been reduced to zero for the time being. The fact that Singapore uses such a regime despite the high capital mobility that is said to preclude intermediate regimes ought to give the bipolarity advocates occasion for thought.

Fourth, it has been claimed that a number of countries in East Asia that describe their exchange rates as floating are continuing to intervene heavily (McKinnon 2000). While McCauley (2001) has shown that the exchange rates of Korea, the Philippines, and Thailand, as well as Indonesia, are significantly more volatile than they were before the crisis, it remains true that reserve changes, at least in Indonesia and Korea, have been heavier than would seem consistent with comfort with a floating regime. If currencies are not to be allowed to float reasonably freely, then there is a strong case for concerting exchange rate policies, so as to avoid the actuality or fear of competitive devaluation from countries that are important bilateral traders and competitors in third markets. This will require articulating some principles that guide their actions, and thus take them directly back to the subject of intermediate exchange rate regimes.

For these reasons I am doubtful that the bipolarity thesis will end the debate on choice of exchange rate regime.

Possibilities in East Asia

Perhaps the part of the world that is most likely to deviate from the current conventional wisdom is East Asia. Of course it is possible that the region will come to acquiesce in the current Anglo-Saxon norm of unmanaged floating, as others have done, but there seem to be other possibilities as well. One of those possibilities is that the region reverts to the dollar standard, but this is a system that, given the diversified trade of East Asia, would clearly be inferior to a BBC regime. Another possibility is that the region moves permanently to some form of BBC regime. A third is that it uses a BBC regime as a transition mechanism toward an ultimate monetary union. Note that short-run adoption of a BBC regime need neither imply nor preclude a subsequent move to monetary union, but it is difficult to imagine a move straight to monetary union without some such intermediate regime.

A possible variant on the BBC regime would be a system of mutual pegging among the East Asian currencies similar to the European snake and ERM prior to evolution of the euro, instead of common pegging to a basket. There would seem to be several obstacles to East Asia taking that alternative route. Perhaps the most important is that the region contains no dominant economic power that could fulfill the role of anchoring the system as Germany did in Europe (unless Japan were to participate, but that would create its own problems of pulling the other countries around in the wake of the vagaries of the yen). Another problem is that it would impose a far more drastic change on Hong Kong than a BBC regime would, since Hong Kong would have to revert to (circumscribed) floating rather than simply changing the currency unit to which its currency board is keyed. A third is that China and Taiwan would have to defend their bilateral exchange rate (assuming both participated), something that might be politically problematic given their reluctance to acknowledge reality. For these reasons it seems to me that East Asia would be well advised to focus on the BBC regime rather than creating an Asian snake.

How might the region move toward a BBC regime if that were desired? A natural first step would be to negotiate the creation of an Asian currency unit (ACU) with composition suitable for a common basket peg. (This use of the term ACU is not to be confused with the Singapore banking ACU, which is a term for the offshore banking book, and has existed since 1968. This is discussed later in Chapter 7.) The direction of the region's external trade would suggest that this should consist of something in the range of 35% to 40% US dollar, 30% to 35% Japanese yen, and about 30% euro. The governments of the region might start issuing some of their debt in the form of ACUs, in order to create a market in the unit. This would facilitate private sector trade once countries shifted to pegging to the ACU, since forward markets could quickly be established between the ACU and each of the main world currencies. In some cases, where regional currencies seemed likely to fluctuate a lot in terms of the ACU, forward markets might also be established between the regional currencies and the ACU. A functioning ACU market would eliminate the most obvious reason that governments have at the moment for seeking stability in terms of the dollar rather than their effective exchange rates, which is the microeconomic inconvenience to traders of not being able to use the peg currency for their transactions without excessive risk.

Once a market in ACUs was functioning, one would look for an agreement to use the ACU as the common reference point for all countries of the region. Countries with pegged exchange rates (China, Hong Kong, Malaysia, Myanmar, and Vietnam) would shift their parity from dollars (or any currency composite they may currently be using) to the ACU. Countries with managed exchange rates that have been using an undisclosed basket as a basis for managing their exchange rates (Singapore, and perhaps Cambodia and Laos) would use the ACU instead. Countries with floating currencies could announce a reference rate in terms of the ACU.

This operation presents four potential problems. One would be to persuade all the countries of the region that they would be better off using an ACU peg rather than a dollar peg. One is sometimes told that a basket would be too complicated to carry credibility: the argument has never struck me as very persuasive (most people quickly master far more complex concepts when it is in their financial interest to do so), but hopefully prior familiarity with the ACU would relieve any such anxieties.

The second is that countries with pegged exchange rates could find themselves locking in a misaligned exchange rate if they shifted from dollar to ACU peg on a day when the dollar was on average overvalued relative to the yen and euro, assuming that the shift is to be made without imposing a discontinuous change in the market exchange rate. It is highly desirable to avoid any market suspicions that there may be discontinuous changes in market rates, so as to avoid provoking speculative pressures. This problem will be more acute the narrower are the margins. Probably the best way to resolve this problem would be to wait to make the shift until a time when the dollar is not in obvious disequilibrium.

The third problem is that it would require all countries to disclose the content of their basket and the central value at which they peg to it. These are among the parameters of its managed float that Singapore has heretofore kept secret. Certainly the content of the basket would be public knowledge. Conceivably knowledge of the parity could be kept confidential among the monetary authorities that were party to the agreement, although it seems somewhat improbable that secrecy would in practice be maintained. My own view is that such public knowledge would be a thoroughly good thing; a secret parity cannot play much of a role in helping to focus expectations and thus stabilize exchange rates. But my view is not shared universally.

The fourth problem is that the countries that have been floating would need to agree on reference rates for their currencies. It is central to the whole concept of cooperative exchange rate management that these should be mutually agreed values rather than unilateral declarations. This would mean not only that the countries themselves should have a clear concept of what macroeconomic strategy they wish to pursue (in particular, in terms of balance of payments objectives), but that these should be objectives that their partners regard as acceptable. It would of course ease matters to pose the initial task as one of agreeing reference rates, since these do not imply specific intervention obligations.

The principle of multilateral agreement of parities is one that should be maintained even after the initial set of parities had been agreed. This would imply continual consultation on each country's crawl relative to the ACU. Those countries that started off with fixed exchange rates might start to allow their rates to crawl, based on the same principles as were being developed to govern changes in reference rates. This should enable these countries to solve the "exit problem" that otherwise sooner or later confronts any country with a fixed exchange rate that is not prepared to subjugate its domestic policies to the priority of maintaining a fixed exchange rate.

In due course one might see those countries with reference rates start to act with a view to limiting deviations from their announced parities. One would hope that this process would gradually build up credibility for the monetary authorities. Only when substantial credibility had been accumulated would it seem wise to announce bands (limits on the deviations from parity). At that point it would be possible to begin considering whether there is a desire to proceed further and pursue a goal of eventual monetary integration, but that is a topic for the more distant future.

References

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Dornbusch, Rudi, and Yung Chul Park (1999), "Flexibility or Nominal Anchors?", in S.Collignon, J. Pisani-Ferry, and Y.C.Park, eds., Exchange Rate Policies in Emerging Asian Countries (London and New York: Routledge).

Eichengreen, Barry (1999), Toward a New International Financial Architecture. (Washington: Institute for International Economics).

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Notes

1. A complementary explanation of why they were expansionary is that the costs of stabilization were prepaid as inflation eroded real money balances and curbed output, which ground the distributive inconsistency underlying the inflation out of the system.