The present currency tensions are the result of a complex set of forces arising from the Great Recession. But a look at the break-up of the gold standard and of the fixed-rate dollar regime also sheds light on today’s predicament. On the one hand, a review of the past suggests that consecutive competitive devaluations are less likely today than is commonly feared. At the same time, the review also shows that the forces leading to collapse in the past—a misalignment between domestic priorities and those needed to maintain a fixed exchange rate, concerns about sufficient reserves, and the unique role of confidence in the core economies—remain highly relevant, and policy makers cannot afford to be complacent.
The Present Tensions
The present exchange rate system—though a hodge-podge of variable, managed, and pegged exchange rates—has served the world economy well over the course of a historic crisis. Acting as a safety valve, flexible and semi-flexible exchange rates enabled relatively smooth currency adjustments, and pegged rates generally held. For most of the 40 largest economies, real effective exchange rates remained within reasonable (± 10 percent) bounds, and some of the outliers were consistent with fundamentals.
In addition, today’s currency turmoil appears mild compared to previous episodes. Volatility is less pronounced1 and only five of the 25 major currencies for which comparable data is available are seeing bigger exchange rate shifts than they saw either before the collapse of the fixed exchange rate in 1973 or before the concerted interventions around the Plaza Accord in 1985.
Change in Real Effective Exchange Rate
Nonetheless, this currency turmoil cannot be taken lightly. Currency tensions have a tendency to escalate and have been associated with wars, depressions, and heightened protectionism in the past. In addition, such turmoil is usually a symptom of deeper maladies, particularly in countries at the center of the system.
Today, those maladies include high unemployment and weak safety nets in the United States, excessive reliance on exports in China, a history of deflation in Japan, severe competitive divergence and sovereign debt crises within the euro area, and overheating in emerging markets. Moreover, all of the large advanced countries face a major medium-term fiscal consolidation challenge.
Though fixed exchange rates are less prevalent today than at any time since at least 1870, many countries still have pegged rates. Tensions are building between these countries and those with genuinely flexible exchange rates (including the United States and Japan). Two of the five players at the center of the turmoil—China and several of the other successful emerging markets—have heavily managed exchange rates. In addition, though the euro floats freely, major competitive divergences within the euro area benefit Germany (which sends more than 40 percent of its exports to other euro area countries) and affect several countries in Eastern Europe that have effective pegs or quasi-pegs to the euro, including the Baltics and Bulgaria.
Viewed through this prism, the turmoil that preceded the collapse of history’s two fixed-exchange rate regimes can provide four useful lessons.
Lesson 1: Devaluations Were Not Mainly Competitive
The gold standard’s ultimate collapse in the 1930s provides the fodder for fears of a currency war today. From 1930 to 1938, 20 countries devalued their currencies by more than 10 percent at least once. Some countries—like France, Greece, and Spain—employed this tactic more than five times from 1923 to 1938. By the end of the Great Depression, trade had collapsed by more than one-third.
|Devaluations of More Than 10 Percent, 1929-1938|
|1931||Austria, Italy, Spain|
|1932||Austria, Denmark, Finland, Greece, Japan, Norway, Sweden, Spain, UK|
|1933||Canada, Denmark, Greece, Japan, United States, Yugoslavia|
|1934||Canada, Denmark, Greece, Japan, United States, Yugoslavia|
|1936||Italy, Romania, Spain|
|1937||Czechoslovakia, France, Italy, Spain, Switzerland|
|Source: Who Adjusts? Domestic Sources of Foreign Economic Policy During the Interwar Years. Beth Simmons (1994).|
Though successive devaluations were part of a vicious circle of depression and increased tariffs that account for the collapse in world trade, they are directly responsible for only a small part of the deterioration. Research by Eichengreen and others suggests countries that abandoned the gold standard and devalued their currency were less likely to engage in direct protectionism, while those that stayed on the gold standard suffered deflation and hurt trade through the demand channel.
Most important, it is not clear that competition for export markets provided the main motivation for these devaluations: Studies suggest that the decision of a country’s main trading partners to leave gold and devalue their currency was not a major factor in that country’s own exchange rate choice.2 Trade competition also does not appear to have been a major factor behind the decisions to float currencies after the collapse of the second fixed exchange rate system—the fixed-dollar rate—from 1971 to 1973. In fact, one study suggests that the countries most open to trade were less likely to adopt a floating exchange rate regime.3
Lesson 2: Domestic Priorities Win Out
Domestic concerns played a larger role than trade in breaking both fixed exchange rate regimes. In both cases, domestic objectives called for one monetary policy, while currency objectives called for another. Under the 1930s gold standard, maintaining pre-war gold parity rates—which did not accurately reflect post-war prices—required tight monetary policy and deflation (particularly in Britain). Under the fixed-dollar rate standard, the fixed rates instead required higher inflation—as the United States saw inflation rise from 1.5 percent from 1961 to 1967 to about 3.5 percent in 1968—but many economies, especially Germany, resisted this. In both cases, domestic objectives eventually won out: Britain devalued in 1931, and Germany was one of the first countries to allow appreciation against the dollar.
Today, too, each of the five groups at the center of the tensions sees an inconsistency between its exchange rate and domestic policy objectives. As discussed above, each group is looking to avoid appreciation or favors depreciation. Since they together account for the bulk of global trade, however, this is, by definition, impossible.4 In other words, the solution to their collective problem cannot lie mainly in exchange rate shifts (or for that matter, changes in current accounts, which also sum to zero), but must come from changes in domestic policy.
Lesson 3: Reserves Are Always a Concern
Insufficient reserves were also instrumental to both collapses. Both regimes rested on gold, but were unsustainable as world liquidity needs outpaced the growth of the gold supply.
Concerns about the adequacy of reserves remain an important part of today’s currency tensions. The importance of keeping sufficient reserves is a lesson that developing countries learned from the Southeast Asian financial crisis in 1997–1998. Arguably, however, developing countries have taken this lesson too much to heart, locking themselves into assets with little return and, to some extent, supporting (though not causing) the consumption binge of some advanced countries.
Lesson 4: The Role of Core Countries is Critical
Under both fixed exchange rate regimes, periphery countries often held foreign exchange reserves from the “core”—France, Britain, and the United States under the gold standard, and only the United States under the fixed-dollar rate—to facilitate greater liquidity. But this only worked as long as markets maintained confidence in the foreign reserves of the core countries, and more fundamentally in the policies they pursued.
As the ratio of currency to gold grew, confidence in the core eroded. When Britain finally devalued from gold in 1931, more than two dozen other countries went along with it. After President Nixon broke the dollar’s link with gold in August of 1971, the dollar depreciated by almost 30 percent in real effective terms during the 1970s.
These arrangements were ultimately unsustainable, in part because they were inherently asymmetrical. While all countries depended on the dollar (or franc and British pound) to maintain parity with gold, they had little influence on U.S. (and French and British) policy.
Today, the dollar is no longer the official peg underlying all currencies, but it remains the world’s main reserve currency (it accounts for 62 percent of foreign reserves) and the baseline for half of the world’s currencies. As the outcry over QE2 shows, other countries remain uniquely sensitive to U.S. policy and the dollar’s fluctuations. Similar unorthodox measures by the Bank of England, for example, draw little attention. The euro plays a smaller (but by no means small) role, accounting for 27 percent of reserves, and concerns about its stability clearly contribute to currency tensions today.
In some respects, this thumbnail historical sketch is reassuring. It suggests that, even when currency tensions appear to have degenerated into competitive devaluations in the past, the motives for devaluation lay elsewhere—principally in the need to align the exchange rate with domestic policies. But that is also the bad news, because it suggests that—unless politically thorny domestic reforms are tackled—currency tensions will continue to fester, and may even escalate, especially if the global macroeconomic environment deteriorates.
The attractions of fixed exchange rates are clear, especially for developing countries that are ill-equipped to deal with volatility. However, for all countries with pegged or quasi-pegged exchange rates—and especially those with obviously excessive foreign exchange reserves—the experiences outlined above corroborate the recent consensus: flexible exchange rates provide a better mechanism to deal with shocks, and reduce the likelihood of large macroeconomic imbalances (though they certainly do not eliminate it!).
If China is serious about rebalancing toward domestic consumption and inland regions, a gradual but faster renminbi appreciation is obviously in its interest. As China develops, domestic and foreign pressures to make its currency fully convertible and open its capital account will grow, and so will its need to allow much greater exchange rate flexibility and devote monetary policy to domestic stabilization.
Above all, our historical review underscores the importance of confidence in the core. In this case, the core is the United States and, to a lesser extent, the euro area. Setting these economies’ fiscal and competitive situations on a sound and sustainable path is likely the most necessary requirement for keeping the currency peace.
Uri Dadush is the director of Carnegie’s International Economics Program. Vera Eidelman is the managing editor of the International Economic Bulletin. A previous version of this article was published by VoxEU.
1. The standard deviation of the real effective exchange rate shifts of 25 major currencies from their 2006-2007 average to November 2010 is 11 percent, compared to 13 percent both from their 1979-1980 averages to March 1985 (Plaza Accord) and from their 1969-1970 averages to December 1973 (fixed exchange rate collapse).
2. Wandschneider finds that increased trade with countries on the gold standard made a country only .05 percent more likely to stay on the standard, while Simmons estimates that larger traders were actually less likely to stick with gold.
4. Countries should occasionally remind themselves of the benefits of a strong currency—something they have strived for in the past. In 1968, for example, Germany accepted a higher deutschmark in return for lower inflation. As with undervalued exchange rates, however, overvalued ones can lead to significant problems. In 1925, when Britain agreed to re-adopt gold, it aimed for revaluation but its overvalued rate led to deflation. In 1985, Japan and Germany sacrificed competitiveness to help engineer dollar devaluation and many in Asia today blame the Accord for Japan’s ensuing economic problems (though others argue that Japan’s banking regulations were at fault).