International Econ Exam 3 History

Gold Standard

Fractional reserve system

Currencies rigidly pegged to gold

Fixed exchange rate regime

Price-Specie Flow Mechanism

Ends with beginning of WWI

Fleeting attempt to return to gold standard in

the interwar period – unsuccessful

Why Fall Apart?: Gold standard subordinates

internal balance to external balance

Return to gold after Napoleonic War

• 1717: United Kingdom at £1 to 113 grains (7.32 g) of fine gold.

• 1819: The Bank of England resumed gold purchases and sales

at the pre-war parity (£1 to 113 grains).

• During the war the price of gold had risen due to inflation.

Suppose the official rate/pre-war parity is 1 £ for 1 oz and the

market rate is 2 £ for 1 oz.

• Arbitrageurs could buy gold low from the Bank of England and sell it high on the open market

• Gold drained out of the Bank of England.

• The money supply contracted.

• England went through economic contraction and a deflation

American Civil War

• Both gold and silver were used as a medium of exchange.

• During the war the federal government printed green backs as currency to fund the war effort.

• The green backs were allowed to float on exchange markets in terms of gold and silver.

• Excess printing of green backs led to a general inflation and green backs lost value relative to all goods, including gold.

• 1879 The U.S. government returned to buying and selling green backs for gold.

• The only problem is that the government returned to the pre-war price of gold.

• A deflation occurred. By 1896 the price level had dropped 40% below its 1869 level.

• Farmers were especially hard hit. They wanted a return to the bimetal standard (gold and silver to back currency.)

Britain post-WWI 1918

• 1914 WWI Gold flows suspended

• 1922 Conference in Genoa: Britain, France, Italy

and Japan agreed to try to return to the gold

standard.

• 1925: Britain returned to the gold standard.

• Again, at the pre-war parity.

• Keynes predicted recession.

• Winston Churchill, Chancellor of the Exchequer,

argued that the pre-war parity was necessary to

achieve confidence in the system

• Britain had to go through a deflation in order

to return to the pre-war price level.

• Britain suffered through six years of economic

stagnation as a consequence of the

deflationary policies.

• Eroded confidence in London as the world’s

financial center, England never returned to pre-war parity

Great Depression and Britain

• Stock market collapse transmitted to the banking system.

• Wave of banking failures (US money supply contracts by 75%).

• Governments around the world holding British Sterling feared that the British government would not be able to make good on its commitment to convert sterling for gold at the established price.

• 1931: Britain suspended conversion of sterling for gold.

Competitive devaluations and the end of the gold standard

• 1933 United States suspended conversion of dollars for gold

• 1934 United States resumed conversion of dollars for gold.

• But with a devaluation.

• In 1933: $20.67 per ounce

• In 1934: $35 per ounce

• Investors who had accepted dollars for gold lost 70 percent of their investment.

• Surprise: renege on the gold commitment, change the exchange rate and expand the money supply

Raising the price of gold BLANK the money supply and BLANK the

real exchange rate

expands, changes

Spread of competitive devaluations during the Great Depression

• Other governments followed by raising the price of gold.

• Only correct policy in the early days of the Great Depression.

• At the new higher price of gold, investors brought their gold to the central bank and converted gold to currency.

• This expanded the money supply at a time when the banks and the money supply were collapsing.

In abandoning the gold standard in the 1930s, governments were acknowledging that…

internal balance was more important.

Bretton Woods Fundamental Adjustment Mechanism

Change E (the exchange rate)

Bretton Woods

1944, 44 countries, established IMF and signed the Articles of Agreement

Two plans after WWII

1. Keynes — establish an international currency (bancor) managed by the IMF. Simply: adjustable peg.

2. US/Harry Dexter White — established the gold exchange standard with the U.S. dollar as the reserve currency. Simply: USD as the center of the system.

Gold Exchange Standard

• The U.S. dollar was pegged to gold at $35 per ounce.

• Any country in the world could convert their dollars for gold at $35 an ounce at the Treasury.

• The United States held billions of dollars worth of gold at Fort Knox for purpose of meeting its international commitments.

• Within a country, $/Gold serve as central bank reserves.

• Within a country, national currency serves as bank reserves.

• Money supply is demand deposits and national currency in circulation.

Under Bretton Woods, how does the government fix the exchange rate?

• The government announces that it will buy and sell foreign exchange at the pegged price.

• Suppose the FF is pegged at $1 = 1 FF.

• The Banc de France commits to buy and sell FF in any amount for the price of $1 per 1 FF.

• The money supply becomes the main tool for pegging the exchange rate.

At Bretton Woods, governments agreed that a country with a fundamentally over-valued currency should…

Simply devalue its currency.

Four effects of devaluation

• Equilibrium income increases.

• The current account improves.

• The money supply increases.

• However, eventually inflation will occur, eliminating these short-term benefits.

Achilles Heel of Bretton Woods

Speculators could not lose.

Explain more about how speculators couldn’t lose

Speculator

- Can lose if currency is devalued.

- No effect of there is no change in the exchange rate.

- The only way to win by holding a currency is if it rises in value. But a deficit country will never appreciate their currency because it will make the deficit worse (make exports even more expensive)

- Best speculator option is to sell. Only hold currency of surplus countries.

self-fulfilling crisis: everyone dumps the weak currency at once, which forces the devaluation that speculators were betting on all along.

Frequent speculative attacks in the 1960s

• England, 1964

• Current account in persistent deficit

• Speculators began to believe that the pound was over-valued.

• Speculators began to anticipate a devaluation.

• They sold pounds, drained the Bank of England of reserves and pushed down the English money supply.

• England was eventually forced to devalue the pound in 1967. $2.80/£ to $2.40/£.

The Collapse of Bretton Woods

• 1965-1968 U.S. Policy Errors

• President Johnson pursuing the Vietnam-American War and the War on Poverty.

• Expenditures not matched with an increase in taxes. (Gardner Ackley chair of council of economic advisors)

• The United States developed a federal budget deficit and a trade deficit.

• 1967-68 The Federal Reserve tried to bring interest rates down with a monetary expansion. (William M Martin, Chair of the Board of Governors, Federal Reserve)

• The monetary expansion coupled with the fiscal expansion began to push up prices.

• The rise in prices in the U.S. eroded our international competitiveness. (q for $ falls)

• The U.S. current account went into a deficit.

• US in trouble — currency overvalued, in fundamental disequilibrium

CA deficit caused by fiscal policy undone by

Fiscal contraction

CA deficit caused by inflation…

Is a fundamental disequilibrium. Requires deflation or devaluation.

What did speculators do in 1967-68?

• Speculators began buying gold, thinking that the U.S. might have to raise the price.

• Massive gold sales by the Federal Reserve and European central banks.

How did the US respond to speculators in 1967-68?

• Established a private gold market in which the price would be allowed to fluctuate.

• Only central banks could come to the Federal Reserve and sell dollars for gold at the fixed $35 per ounce.

• One more step away from gold

When Nixon raised taxes in 1969…

• The U.S. economy slid into a recession in early 1970.

• The U.S. economy now had the worst of all worlds: inflation, unemployment, and a current account deficit.

How did the US try to get out of the recession in 1970?

Had to ask all trade partners for devaluation because no control over exchange rate. Germany said no, so US implemented 10% tax on all imports and cut off foreign access to gold.

Smithsonian Agreement, Sec. Treasury John Connally

• December 1971: Dollar devalued 8 percent.

• 10% import surcharge was removed.

• Price of gold is raised to $38 per ounce.

• Hailed as the “most significant monetary agreement in the history of the world,” however dollar was still overvalued

• US monetary expansion in advance of 1972 election because Nixon wanted to win.

• February 1973: speculative attack against the dollar.

• Foreign exchange markets were closed.

• February 12: dollar devalued another 10 percent.

March 1, 1973

• European central banks purchased $3.6 billion defending the fixed exchange rate.

• Market closed again.

• Reopened March 19.

• Interim agreement to allow all currencies to float.

• That agreement became permanent.

Why did European central banks abandon fixed rates?

• Defending the peg required Germany, in particular, to expand its money supply.

• The money expansion raised the fear of inflation.

• Rather than live with the inflation, they chose to move to a float.

Importing inflation/deflation

• Under a peg with a reserve center

• The reserve center can have an expansionary monetary policy

• Interest rates fall

• A capital outflow occurs

• Foreign governments have to expand their money supply too to defend the peg.

• All countries in the system end up with inflation.

Under a floating exchange rate, every country gets to choose

its own rate of inflation

Two ways out of economic contraction

• Keynes Medicine: Devaluation

• Classical/German Medicine: Disinflation

Lesson 1 (think LDC)

Policy makers cannot easily

fix prices, including exchange rates.

• Under a peg, the central bank tries to fix the

price of foreign exchange.

• If that price is not an equilibrium price,

speculators will attack.

• The solution is to allow the market to set the

exchange rate.

LDC Debt Crisis: 1981-1989

• 1979 The U.S. rate of inflation was just under 12%.

• T-bill rate was just under 11%.

• Real interest rate was -1%.

• This is the moment when the US decided to take the

policy remedy prescribed by the German

government.

• Loans lent to Latin America.

• 1979: Monetary contraction in the U.S. (Paul Volker, head of the Federal Reserve.)

• Interest rate rose. Dollar appreciated.

• LDCs could no longer afford debt.

Lesson 2

Policy autonomy under floating exchange rates is an illusion

Mexico: August 1982

• Mexican government informed the U.S. government that it was out of dollar reserves and would not be able to meet its next debt payment.

• U.S. banks immediately attempted to reduce exposure to developing country debt.

• Credit was cut off to Argentina, Brazil, Chile, etc.

• Developing countries were now required to repay their loans.

• The US Treasury provided aid to banks by making contributions to the IMF which then made loans to LA debtors that were used to repay loans to US banks.

• Crisis continued throughout the 1980s

• New democracies established, but destabilized due to debt

• The U.S. government forced Citicorp and Bank of America to forgive some of the loans.

1990-1992 — Legacy of debt crisis: Inflation

• Debt reductions were given to developing countries, no longer able to borrow.

• Funded government expenditures by printing money.

• Left with a legacy of inflation.

Lesson 3

Absence of gold requires competent government policy

Hyperinflation in Bolivia

• The Bolivian government was printing money to fund expenses and using dollar reserves to pay off its debt to American banks.

• Bolivia used a fixed exchange rate to stop the hyper-inflation overnight

• Only worked because of dollarization

• New President Victor Paz Estenssoro’s stabilization plan August 29, 1985.

– Halt to public sector investment

– Public sector wage freeze

– Moratorium on debt payments

– Pegged exchange rate (tightly managed float)

• As people believed that the inflation had stopped, they started holding boliviano again.

• The real demand for money went up.

• Real interest rates in Bolivia went up.

• High interest rates attracted foreign investors.

• A capital inflow started.

• Investors bring $ to the central bank and get boliviano.

• The money supply began to rise but without inflation.

• Slow economic growth, not inflation

What to do during hyperinflation

To preserve the purchasing power of your money:

• Hold your money in the bank all of the time.

• Earn interest to keep from losing value.

• Only remove money from the bank at the moment of a transaction.

• Real demand for money falls almost to zero.

• Businesses quote prices in dollars

Lesson 5

Pegging the currency “borrows” credibility from partners (worked for Bolivia)

1987 Stock market crash

• 19 October 1987 Stock market crash. (Black Monday). Market (globally) lost 20% of value in a single day.

• One of the causes is believed to be program trading.

• Federal Reserve (Alan Greenspan) lowers interest rates, provides easy access to reserves

• Spring 1988 Remove reserves to prevent inflation.

Lesson 6: Protect the money markets from asset market instability

Lesson 7: Short term monetary expansion

1991-94 Swedish banking crisis

Lower interest rates to zero to recapitalize the banks

1992-1993 European Monetary System (EMS) crisis

Disagreement about monetary policy breaks up fixed exchange rate systems.

• German reunification accompanied by monetary expansion. Inflationary pressure.

• Germany conducted a monetary contraction. Triggered a capital inflow.

• Pressure on other countries in the EMS to contract money supply too.

France didn’t want to contract money supply because not in their best interest, so they moved to floating exchange rate.

1997-1998 Asia financial crisis

(1) contagion (Russia and Japan), (2) defending exchange rates in the midst of a speculative attack produces recession. (3) If crisis spreads to the banking system (Indonesia) – conflict between printing money to protect banks and contracting money to protect the exchange rate.

Crisis started with a devaluation of the Thai bhat. Arbitragers expect a

devaluation of the Indonesian Rupiah. Speculative attack against the Rupiah forces Indonesian government to contract M. Inhibits ability of central bank to use the money supply to stabilize the banking system. Russia defaults. Japan falls into a recession. Triggers a bout of contagion.

1998 Long Term Capital Management (LTCM)

• Specialized in the trading of similar assets with slightly different rates of return.

• September 1998: Russia defaulted on its debt

• Investors fled to safety

• Cashed out of LTCM

• LTCM had to repay loans out of capital

• Capital cushion dropped to $600 million

• Fed feared that a collapse of LTCM would trigger a chain reaction of bank failures because it was very intertwined with Wall Street.

• Placing LTCM essentially in receivership gave LTCM time to unwind its illiquid investments.

• LTCM’s creditors were forced to put even more capital into LTCM in order to prevent a disorderly bankruptcy.

• Orderly dissolution: LTCM's positions were slowly sold off over months, not dumped all at once. Controlled exit — LTCM was shut down by early 2000 in a managed way

Set precedent on how to handle future financial crises.

Lesson 10 (LTCM)

Effectively monitor internationally active financial institutions.

Lesson 11 (LTCM)

Orderly dissolution as a monetary policy tool.

Lesson 12 (LTCM)

Economists doing magic sometimes burn down the global economy.

Lesson 13 (07-08)

Protect credit markets from disturbances in asset and equities market.

Six key elements of the 2007-08 crisis

• Giant pool of money coming from retirement savings and Chinese

current account surplus.

• Mortgage-backed securities above normal yield but appeared as if

risk had been diversified away (thought to be safe but high yield)

• Moral Hazard. Mortgage broker had no “skin in the game.”

• Asymmetric information. Credit rating agencies were not carefully

vetting MBS for risk.

• Diversification. Not diversified away from systemic shocks.

• Incomplete contracts. Contracts creating MBS incomplete. Not

clear how to unwind them. No contingencies.

MBS made the probability of an investor losing everything very low.

Central Problem in the 2008 Crisis

Countrywide (mortgage broker) had no incentive to carefully vet a home buyer’s ability to repay the loan.

Some subprime mortgages required no income or credit rating verification.

Teaser rates lured borrowers into loans they couldn’t afford.

Investor willing to buy MBS because they thought risk was diversified and trusted credit rating agencies (though in reality they weren’t being thorough).

Not diversified away from systemic shocks.

Systemic risk: investing in housing great until the bubble burst.

Bubble was driven by speculators who bought houses they couldn’t afford with the intention to sell it later assuming that prices would keep rising so they could sell it at a higher price than they bought it. Eventually, bubble burst so many couldn’t pay back their loans. Banks were in trouble.