Options for Europe – Part 15

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).

[PRIOR MATERIAL HERE FOR CHAPTER 1]

[THE BASEL ACCORD DIDN’T LAST LONG AND WHEN THE SMITHSONIAN AGREEMENT COLLAPSED THE SNAKE BECAME DISTINCTLY GERMANIC – THE NARRATIVE CONTINUES]

[NEW MATERIAL TODAY FOLLOWS]

The ‘snake’ though wobbly leaves the ‘tunnel’ as Bretton Woods is assigned to history

Hans Tietmeyer (2003: 7), who was part of the German membership on the Werner Committee, described the snake as a “relatively loose exchange-rate arrangement” that “experienced not only a good many tensions, but also withdrawals and re-entries on several occasions, not least by the French Franc”. Howarth and Loedel (2003: xv) referred to the “ill-fated snake”.

The snake started falling apart a few months after the Basel Accord when the British Pound floated on foreign exchange markets in June 1972 eliminating it from participation in the snake. International currency markets had been relatively unstable since February 1972 as speculators bet on what they considered were weak currencies. Despite the December 1971 Smithsonian Agreement, it was generally considered the US dollar remained overvalued even though it has been devalued by 7.9 per cent against gold and other nations had revalued as part of the Agreement. This was especially in the context of its on-going balance of payments deficits and the unwillingness of the US government to drive unemployment up through domestic monetary and fiscal restraint (BIS, 1973: 21).

The speculative activity in early 1972 saw significant fund movements out of the US dollar into Deutsche Marks, the Benelux currencies and the yen (BIS, 1973: 22). In the case of the European currencies, the upward pressure pushed them to the upper limits renegotiated as part of the Smithsonian process and this forced their respective central banks to sell their currencies and buy US dollars to soak up the strong demand.

The speculative attacks reached a peak in June-July 1972, and the British Pound was particularly targetted as a result of Britain’s balance of payments deficit continuing to widen. While so-called ‘sterling crisis’ led to massive Bank of England and Banque de France intervention in an attempt to halt the sale of the Pound in international currency markets, the British government was ultimately forced to float on June 23, 1972. The French central bank, particularly among the Basel Accord signatories, had been trying to assist the Bank of England as part of the Basel Accord to keep within the 2.25 per cent fluctuations agreed in April 1972.

The Basel Accord, in fact, worsened things, because the central bank intervention by France, Belgium and Germany (selling their currencies to buy the Pound) had contained the slide of the pound against the US dollar, but weakened their currencies. As the BIS (1973: 22) noted: “These currencies therefore looked relatively cheap”. And when the dam broke and the Pound floated, there was massive buying of these currencies, which pushed them up to the upper limits against the US dollar. This renewed speculation that the Member State currencies would float against the dollar and forced the Finance Ministers in mid-July 1972 to reaffirm “their determination to adhere to the existing rate structure” (BIS, 1973: 23).

The first fault-line in the Smithsonian Agreement had thus opened. While various measures were taken to ease the currency crisis, it was clear that the balance of payments adjustments envisaged when the nations signed the Agreement were not forthcoming. The US balance of payments deficits, which were undermining confidence in the US dollar were not abating quickly, German and Japanese trade surpluses continued to grow, interest rate differentials (higher in Europe) were persisting, all of which meant that large currency flows were undermining the capacity of the central banks to maintain parities within the agreed limits. There was no doubt that investors were coming to the realisation that the Smithsonian attempt to shore up the failed Bretton Woods fixed-exchange rate system was doomed.

The international currency crisis reemerged in January 1973, when Italy was forced to partially float the lira (segmenting commercial transactions from the rest) to stem the outflow of its currency. A full float was to come on February 14, 1973 but the decision to partially float meant Italy had to quit the ‘snake’. The Swiss franc floated on the same day for similar reasons. In early February, the US published an “enormous trade deficit for 1972” (BIS, 1973: 24) and this prompted a renewed speculative selling of the US dollar of greater volumes than in the previous attacks. The Bundesbank and the Bank of Japan, in particular, were forced to engage in massive US dollar buying to maintain the agreed parities. On February 9, 1972, the foreign exchange markets were closed because “the situation had become untenable” (BIS, 1973: 24). Four days later, after some frenzied discussions between governments, the US dollar was devalued by 10 per cent and 24 hours later, the yen and the lira floated.

The crisis deepened in early March as the US dollar hit its revised lower limits against the other major currencies. On March 1, 1973 the foreign currency markets closed again to give the authorities time to meet and determine the next step. It was obvious that the any attempt to fix exchange rates against the US dollar (even within bands) would fail given the disparities in economic policies and outcomes. The BIS wrote (1973: 24) that “the market was in disarray” and the only course of action was to abandon the fixed exchange rate regime and float the US dollar, which occurred when the currency markets opened again on March 19, 1973. The Bretton Woods system of fixed exchange rates had finally terminated despite the efforts to salvage it.

The remaining Basel Accord partners (Benelux, Denmark, France, Germany and the Netherlands), however, chose to ignore the ‘sword of Damocles’, such was their fear of floating exchange rates, and on March 12, 1973, announced they would jointly float against the US dollar – effectively keeping the ‘snake’ (Basel Accord) but abandoning the ‘tunnel’ (the Smithsonian Agreement). There were a series of ad hoc decisions taken to control capital flows and to realign currencies (for example, the Deutsche Mark was revalued by 3 per cent immediately and then by 5.5 per cent in June 1973) as part of this decision. Norway and Sweden also decided to become part of the joint float.

Despite early optimism, mainly from politicians seeking to give an impression of stability, the trouble was far from over. The underlying economic fundamentals in Europe meant that the currency pressures were unstable. Germany faced continual upward pressure and France the opposite. This meant that the Bundesbank was continually having to purchase the ‘snake’ currencies. Central banks, in general, were continuing to intervene on a significant scale to stabilise currency movements.

Various events later in 1973 further disrupted the world economy and the currency markets. The outbreak of hostilities in the Middle East in October 1973 (the 1973 Arab-Israeli War) was accompanied by the oil embargo imposed by the Organization of the Arab Petroleum Exporting Countries (OAPEC). A few days later on October 16, the Arab nations increased the price of oil by 17 per cent and indicated they would cut production by 25 per cent as part of a leveraged retaliation against the US President’s decision to provide arms to Israel. The price of oil rose by around 3 times within eight months of the action (US Energy Information Administration, 2013). The BIS (1974: 30) assessed at the time that the US “despite the embargo placed on it … was in a better situation than Europe or Japan to withstand both the internal and external effects of the OPEC countries’ actions owing to its lesser dependence on oil imports”. The result, the US dollar appreciated by 17 per cent in the six months to February 1974, basically taking it back to the December 1971 value at the time of the signing of the Smithsonian Agreement.

Further, the European currencies suffered major depreciation as did the Yen. The snake became slimmer on January 19, 1974 when the French government decided to abandon the ‘snake’ and float because it was facing a major strain on its foreign exchange reserves as a result of its dependence on imported oil. The ‘snake’ was looking decidedly Germanic by this stage leading to commentators to refer to the residual ‘snake’ system as a Deutsche Mark-zone.

The confidence in the US dollar didn’t last for long and by February 1974 a major reversal was underway. The BIS (1974: 30) assess that there was an initial overreaction by the foreign exchange markets as the OPEC price hikes and the embargo came into force. It was also clear that while the US was less dependent on oil imports than the European nations, the crude oil price rise impact on the US balance of payments would be very substantial. As a result, the US dollar lost ground in the currency markets. The European story was the opposite. Less energy was required in the mild winter of 1973-74 and the German trade locomotive continued to build even bigger trade surpluses (BIS, 1974).

The world was back to the sort of setup that drove the crisis less than a year earlier in mid-1973.

THIS IS LEADING TO THE CREATION OF THE EMCF, THE FAILURE OF THE SNAKE, AND STAND-OFFS GALORE!

[TO BE CONTINUED]

[THEN MORE TO FOLLOW – ON THE INITIATIVES LATER IN 1970s DEBATES, DELORS REPORT etc COMING]

Additional references

This list will be progressively compiled.
Bank of International Settlements (1973) Forty-Third Annual Report, Basel.

Bank of International Settlements (1974) Forty-Fourth Annual Report, Basel.

US Energy Information Administration (2013) Monthly Energy Review, December, http://www.eia.gov/totalenergy/data/monthly/pdf/sec9_3.pdf