Case Study – British IMF loan 1976 – Part 7

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013 (to be ready in draft form for second semester teaching). Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.

Previous parts:

• Case Study – British IMF loan 1976 – Part 1
• Case Study – British IMF loan 1976 – Part 2
• Case Study – British IMF loan 1976 – Part 3
• Case Study – British IMF loan 1976 – Part 4
• Case Study – British IMF loan 1976 – Part 5
• Case Study – British IMF loan 1976 – Part 6

Case Study – The British IMF loan in 1976

The demise of the Bretton Woods system

[SHORT SECTION THAT FOLLOWS REPEATS THE LAST FEW PARAGRAPHS FROM LAST WEEK TO PROVIDE CONTEXT]

The US government was under the same sort of political pressures that all external deficit nations faced. To reduce imports it would have to adopt deflationary fiscal and monetary policies, which drove up unemployment and undermined the popularity of the government in question.

Further, given the fact that the US dollar was at the heart of the Bretton Woods system, the US government was under massive pressure to maintain the official exchange parity of the dollar as a sign that the international monetary system was stable.

This meant that the US government had limited policy room in which to move to reduce the persistent external deficits. The main target became controls on private capital outflow, mostly of a voluntary nature.

It became increasingly clear that the US dollar was overvalued through the 1960s. The persistent external deficits and the rapid build up of reserves by Japan as a result of its strong surpluses was indicative. The rather large decline in the US trade surplus in 1968 provided a clue to this assessment.

By 1971, the persistent US external deficits and other problems in the international monetary system reached the crisis point.

In fact, the Bretton Wood system had been under strain through the 1960s. With the growth in World trade throughout the 1960s, the system required a commensurate growth in reserves to defend the agreed fixed parities and a growth in IMF resources, given its support role to nations with temporary external imbalances.

Further, the growth in reserves had to be proportionality split between gold and US dollars, given the convertibility arrangements. Participating nations had to have certainty that they could always convert their US dollar holdings into gold on demand.

With growing US deficits, the rapid growth in US dollars in the world reserves and a shortage of new gold started to stretch the system as early as 1960. Throughout the 1960s, the US was losing gold as it maintained convertibility in the face of a slower growth in overall World gold production.

[PICKING UP THE DISCUSSION ABOUT THE STRAINS THAT US TRADE DEFICITS WERE PLACING ON THE INTERNATIONAL PAYMENTS SYSTEM … ]

An important issue, that has relevance even today in the Eurozone crisis, is that major trade imbalances developed in the 1950s and 1960s. In the Bretton Woods system and in the context of the international payments system, the sum of the balance of payment deficits has to be equal to the sum of the surpluses, once the injection of new gold (and after 1969, the creation of IMF SDRs) were netted out.

Clearly, an injection of new gold allowed the payments system to be in net surplus without an equal and offsetting deficit somewhere else in the system.

The dominance of the US dollar in that system meant that other nations had to run net surpluses to equal the US external deficit. These imbalances pushed the burden of adjustment onto the deficit nations, especially if the currency was overvalued. These adjustments came in the form of a loss of foreign reserves, a reduction in capacity to borrow in international capital markets, and harsh domestic policies aimed at reducing imports via the creation of unemployment.

Nations with undervalued currencies running persistent large surpluses (the mirror of the deficits) had no particular pressure on them to engage in domestic adjustment. Their citizens might have been aggrieved that their own standard of living could have been higher if the surpluses were not so large because they could either have greater use of their own resources or more imported goods and services in exchange for exporting their real resources.

But that political pressure was minimal compared to the problems a government faced when it cut spending and raised taxes and created unemployment.

During the 1950s, for example, Germany ran huge balance of payment surpluses, which were, in part, promoted by the devaluation of 1949. The Bank of International Settlements wrote (1972 Annual Report, page 14):

… one may say that the German surplus stands out as enormously large and that either the 1949 devaluation of the Deutsche Mark was a mistake or there should have been a subsequent revaluation as the economy recovered. That no revaluation occurred before 1961 is … a reflection on the generally rigid attitude towards fixed official parities that prevailed in this period.

You can see the parallels today with the German export surpluses reflecting the external deficits of the Southern European nations and the German unwillingness to expand domestic demand and reward their own population with real wage increases in line with productivity growth. The result is that the burdens of the imbalances are being forced onto the deficit nations because there is no capacity to change the exchange rate between the nations.

The Bretton Woods system was also strained by movements in the gold price. Remember that the system of convertibility depended on the US dollar being exchanged for gold at a fixed price ($US35 per fine ounce). In the early 1960s, the gold price surged in the wake of higher demand from private buyers and central banks.

The price moved above the level that the US Treasury would convert it at, which was an unsustainable situation. The focus was on the gold shortage and the implications of that shortage for an on-going willingness of the US government to maintain convertibility, which was central to maintaining stability in the international payments system.

Earlier, the US government has sold gold into the market to reduce the excess demand and maintain the US dollar/gold parity. Further, central banks agreed to refrain from adding to gold demand as another way of keeping the market price of gold from separating from the official price.

The coordination of central bank gold trading – where central banks agreed as a group to buy and sell gold in equal amounts as a collective, in order to neutralise the overall impact on the gold price was known as the Gold Pool.

Between 1962 and 1965, the Gold Pool was a net buyer of gold so as to ensure that the gold price was relatively stable and consistent with the official price, taking into account new discoveries (increased supply) and the fact that the USSR was selling large quantities of gold in the market.

After 1965, with the USSR supply ending, the Gold Pool shifted to becoming a net seller of gold to ensure there were adequate supplies to meet the demand.

With the British devaluation in 1967, there was a massive surge in demand for gold as speculators anticipated that the US would also devalue its dollar.

The reserves held in the Gold Pool were significantly drained as the surging demand for gold, driven by the diminished confidence in the capacity of the US dollar to maintain convertibility led to a dislocation between the market price and official price of gold that could no longer be arrested.

As a result, the Gold Pool suspended its activities because it could no longer tame the gold market. It accepted that the gold price would float and a so-called two-tier gold price was established – the free market price and the official US dollar price.

This was one of the final developments that led to the demise of the Bretton Woods system.

The more significant point is that all the new gold supplies were being absorbed by buyers for industrial or saving purposes which squeezed the capacity of nations to add gold to their monetary reserves for use in the international payments system. The Gold Pool filled that need for a time as did the US sales. However, by the end of the 1960s, this capacity was in danger of being exhausted.

The US government engaged in various activities and arrangements (for example, currency swaps with foreign central banks, exchange guarantees, IMF drawings of foreign exchange) to mitigate the loss of gold reserves.

The IMF also created a new reserve asset – the special drawing rights (SDR) in 1969 after several years of discussion and negotiation – to overcome the shortage of gold and the need for the US to reduce its external deficits (and therefore its supply of US dollars to the market).

SDRs were allocated to each member nation in proportion to each nation’s IMF membership quotas. Thus, a nation could draw on its SDR allocation to bolster its international reserves and each participating nation agreed to accept the SDR on an equal basis to the US dollar and gold.

The solution was short-lived.

In 1970 and 1971, the US ran increasingly large external deficits and the state was set for a major speculative attack on the US dollar which would end the Bretton Wood system.

Monetary policy settings were also important. In the late 1960s, the US government hiked interest rates in response to the inflationary surge associated with the prosecution of the Vietnam War.

With an increasingly liquid Euro-dollar market available and the widening US-European interest rate differentials, American banks used their foreign branch network to borrow heavily to overcome the credit squeeze. This led to a significant inflow of funds to the US which helped offset the external deficit.

However, the indebtedness of US banks to their foreign subsidiaries began to reverse in 1970 as the US loosened its monetary policy stance and the funds outflow exacerbated the external deficit. European monetary policy was simultaneously tightening and this also motivated the funds outflow.

The resulting capital flows (mostly out of the US into Germany) led to a further strain on US reserves as the US trade surplus was shrinking rapidly (as the lower interest rates were aiding domestic growth).

In early 1971, the situation came to a head. The massive inflow of funds to Germany put upward pressure on the Deutsche Mark and the Bundesbank engaged in large-scale US dollar purchases.

In the first week of May, the German government suspended the foreign exchange market and was urged to float the Mark by various German economists. The German government did not want to ease monetary policy because they feared that wage pressures would increase the inflation rate.

Several other northern European nations followed suit and suspended their foreign exchange markets.

On May 10, 1971, the German government floated the Mark as did The Netherlands. Other European nations were forced to revalue their parities against the US dollar to halt the inflow of funds.

But a US trade deficit emerged and widened in the period from April as economy activity picked up and the high interest rates in Europe induced a recession, which reduced import demand from the US.

The developing view in the foreign exchange markets was that the US currency would have to devalue further (given it was lower against the Mark and the Dutch currency after their floats).

In August 1971, that sentiment gathered pace and the US dollar was widely sold in international markets for foreign currencies, which added substantially to the official US dollar reserve holdings in many nations.

The subsequent pressure on the US government from various central banks for conversion (via gold or swaps) led to further losses of US reserves.

The situation was unsustainable and on August 15, 1971, the US President suspended convertibility and the Bretton Woods system inevitably collapsed as a result.

Conclusion

NEXT WEEK WE CONSIDER WHAT BRITAIN WAS DOING IN THIS PERIOD IN ADDITION TO THE STRAINS IMPOSED BY THE OPEC CRISIS. THEN WE WILL BE IN A POSITION TO UNDERSTAND WHAT HAPPENED IN 1976.

Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.