the european monetary system 50 years after bretton woods

7/30/2019 The European Monetary System 50 Years After Bretton Woods

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The European Monetary System 50 Years after Bretton Woods:A Comparison Between Two Systems

R. A. MundellColumbia University

Paper presented at Project Europe 1985-95, the tenth edition of the "Incontri di

Rocca Salimbeni" meetings, in Siena, 25 November 1994.


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This paper evaluates key features of the international monetary system that emergedin the post-war period and contrasts it with the European Monetary System thatoriginated in the late 1990s and which came to be regarded as the prelude to EuropeanMonetary Union.

1. Fifty Years Ago

A half century ago, when the conference at Bretton Woods was held, the internationalsituation was very different from today. The world war was still raging but itsinitiative had passed to the Allies. Allied troops had landed in Normandy and wereadvancing across France; German forces were being pushed up the Italian spine; andthe Japanese Empire was in full retreat. Thoughts had already turned to the task ofreconstructing the post-war international economic system.

Haunting the deliberations were the four horsemen of the 1930s: economic

isolationism, depression, nationalism and instability. The specific challenge was theneed to set up institutional machinery to temper the business cycle, avoid currencychaos, protectionism, trade restrictions, exchange control, dried-up lending anddiscrimination. It was generally agreed that management of interdependence wouldrequire some surrender of national sovereignty in exchange for a voice insupranational power.

The challenges came to be divided into two categories. One was thefinancialproblemconcerning the balance of payments, exchange rates, and international lending; theother was the commercialproblem involving protectionism, discrimination and the

growth of trade and employment.

The main initiatives came from the United States and Great Britain. In the UnitedStates, the financial problems came to be centered in the Treasury, under HenryMoregenthau Jr., Harry Dexter White and others; and the commercial problem atState, under Will Clayton and others. A companion division of labor developed acrossthe Atlantic with Lord Keynes, involved in his Clearing Union Plan, James Meadewith his plan for a Commercial Union, and Lionel Robbins as head of the EconomicSection of the War Cabinet Secretariat.

The financial negotiations gave birth to the Bretton Woods twins. The IMF was givenresponsibility over exchange rates, liquidity, and short-term balance-of-paymentsfinance; and the IBRD (World Bank) over long-term lending and development policy.Both institutions were handicapped in the early years by resources inadequate inrelation to their task. More important, however, was that their functions in the earlyyears were preempted by Marshall Plan aid; the recipients of that bilateral aid could


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not double-dip by drawing on the Fund. The first decade served as a formative periodthat prepared the two institutions for more important work in the 1960s.

The other half of the grand design, however, was less lucky in its institutionalpromise. It fell afoul of complicated negotiations, bad compromises, and finally, the

United States Congress. The ITO Charter, signed in Havana in March 1948, cameunder attack in both countries: In Britain, which wanted commercial rules to becontingent on full employment, and in the United States, because of its escape clauses,

lack of provision for investor protection and failure to rule out discrimination andexchange control; it was charged that only the United States and Switzerland wouldadhere to its provisions.(1) Fortunately, the less controversial commercial provisions ofthe Havana Charter (which was rejected by the U.S. Congress in 1950) had earlier

been incorporated into the GATT.(2)

The failure of the Havana Charter meant that the post-war airplane had to limp along

on three engines, the IMF, the IBRD and the GATT. There was no explicitarrangements for ensuring price stability or full employment at the international level.Global macroeconomic stability had to rest on the stability of the international

monetary system.

2. Order vs System

Twenty five years ago, at an earlier Bretton Woods retrospect, I made a distinctionbetween a monetarysystem and a monetary order: A system is an aggregation ofdiverse entities united by regular interaction according to some form of control. When

we speak of the international monetary system we are concerned with the mechanismsgoverning the interaction between trading nations, and in particular between themoney and credit instruments of national communities in foreign exchange, capital,and commodity markets. The control is exerted through policies at the national levelinteracting with one another in that loose form of supervision that we call co-operation.

An order, as distinct from a system, represent the framework and setting in which thesystem operates. It is a framework of laws, conventions, regulations, and mores thatestablish the setting of the system and the understanding of the environment by the

participants in it. A monetary order is to a monetary system somewhat like aconstitution is to a political or electoral system. We can think of the monetary systemas the modus operandi of the monetary order.

We are accustomed to thinking in terms of a given monetary system. In what follows Ishall have to treat as variables what are usually, in economic analysis, regarded asconstants. But the system may be undergoing change without our noticing it. The


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"monetary order" may be rigid and unable to cope with the problems of the newsystem. If we fail to distinguish between system problems and orderproblems we maywrongly discard ideas about the system that no longer appear to work, or blame theorder because it was created to house a system that had grown beyond it. In the lattercase we have to ask whether it would be better to strengthen the order and suppress

changes in the system, or modify the order to accommodate change in the system.

3. The Post-War System

The IMF Articles of Agreement signed at Bretton Woods, New Hampshire did notcreate a new international monetary system. On the contrary, it almost made itimpossible for the existing international monetary system to function.(3) According tothe agreement, countries were required to maintain exchange rates within one percentof the par value. This clause would have forced a revolutionary change in operating

procedures in the United States which did not, as a rule, intervene in the foreign

exchange market. As the system had operated since the devaluation of the franc in1936 and the Tripartite Agreement in the same year, the United States bought and soldgold within narrow margins of its fixed parity. Most of the other countries fixed theircurrencies to the dollar, directly or indirectly through the pound sterling or one of theother reserve currencies. The exchange rate rule would have required the UnitedStates to support all the foreign currencies in the New York market or else close it.

To negate this obligation--almost as an afterthought--the United States had a crucialsub-clause, Article IV-4(b) inserted into the articles. This subclause enabled a memberto fix the price of gold in lieu of adhering to its exchange rate obligations. When the

United States notified the Fund that it was buying and selling gold freely (to foreignmonetary authorities for official monetary purposes) it was relieved of its exchangerate obligations.(4)

This sub-clause established the legal basis for the asymmetrical post-war internationalmonetary system, a system that been in existence since the late 1930s. (5) It was adollar standard, anchored to gold.

Was the anchored dollar standard a "system"? A system is an aggregation of diverseentities united by regular interaction according to a form of control. The anchored

dollar standard can be identified as a system if we can perceive the order in theinteraction of its components and outline the form of control.

In a presentation before the Subcommittee on International Exchange and Paymentsof the U.S. Congress, I presented, in a paper entitled "Rules of the Gold ExchangeStandard," the first complete analysis of the gold exchange standard as coherentsystem:


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"The size of the deficit of a key currency "inner" country is a measure of the extent to which it is supplementingincreases in world gold holdings by currency reserves. The composition of the deficit provides a measure of theextent to which non-reserve "outer" countries judge, in their interests, its size to be excessive or deficient.

The outer countries peg (directly or, through other currencies, indirectly) their currencies to the inner country'scurrency (the U.S. dollar) and thus act as residualpurchasers or sellers ofdollars, while the inner country (the

United States) pegs the currency to the ultimate asset (gold), and thus acts as the residualbuyer or seller ofgold.This means that thesize of the U.S. deficit determines the increase in reserves of the rest of the world, while itscomposition determines the change in reserves of the United States, given the rate of increase of monetary goldholdings in the world.

When U.S. monetary policy is very expansive the outer countries have to buy up large amounts of dollars and thishas direct and indirect inflationary consequences for the outer countries; similar, when U.S. monetary policy isrestrictive there is a scarcity of dollars and this has deflationary consequences for the rest of the world.

The outer countries' protection against an excessive or deficit excess of dollars is to alter the composition of the U.S.deficit and thus affect the reserve position of the United States. When U.S. monetary policy is excessively expansivethe outer countries can convert dollars into gold; this leaves the aggregate level of their own reserves unchanged, but

it destroys world reserves because it reduces U.S. reserves. And similarly, when U.S. policy is unduly restrictive, theouter countries can convert gold into dollars, leaving their own reserves unchanged, but improvingthe reserveposition of the United States. The composition of the U.S. deficit, which is under the control of the outer countries,

is the mechanism by which the outer countries in their role as governors of the gold exchange standard cast theirvotes with respect to the appropriateness or inappropriateness of the aggregate size of the U.S. deficit.

The vigorwith which the votes are cast, however, is circumscribed by the attachment of the inner and outercountries alike to the existing system. The outer countries can warn the United States by gold conversions, but they

cannot lower the U.S. gold stock below the point at which it no longer pays the United States to continue running it;overly aggressive conversions would reinforce the "go-it-alone" forces in the United States...On the other hand, theU.S. freedom of action is also circumscribed in the sense that U.S. monetary policy must not be so inimical to the

interests of the rest of the world that the outer countries decide, in their own protection, to opt out of the system byabandoning the dollar for gold.

This is the system as it is supposed to operate. But within these constraints monetary and fiscal policies have to becarefully coordinated as both the U.S. and the outer countries try to preserve internal balance and externalequilibrium..."

The rules of the game of the system constitute a combination of laws, commitments,conventions and gentlemen's agreements by which the inner country (the UnitedStates) pegs its currency (the dollar) to gold and the outer countries (Let us call themEurope) peg their currencies to the dollar, either directly or indirectly through anothercurrency (such as the pound sterling or the franc). This means that the United Statesacts as the residualbuyer or seller of gold, whereas Europe acts as the residualbuyer

or seller of dollars. The U.S. has to buy up any excess supply of gold on worldmarkets and satisfy any excess demand out of its own reserves; failure to do so wouldresult in the dollar price of gold moving away from the dollar parity. Europe, on its

part, has to take up any excess of dollars offered to it or supply any excess of dollarsdemanded; failure to do so would result in the exchange rate moving away from itsdollar parity. (6)


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The boundary conditions are given by the U.S. stock of gold and Europe's stock ofdollars; the United States cannot supply gold, nor Europe dollars, they lack. But thereis an asymmetry in these conditions because, as long as gold and dollars can besupplied at the U.S. Treasury, Europe has access to additional dollars in exchange forgold. The total reserves (dollars and gold) of Europe therefore constitutes Europe's

boundary condition, whereas the gold reserve of the United States represents the U.S.constraint.

Control of the system rests on U.S. monetary policy, on the one hand, and Europe'sgold-dollar portfolio on the other. When the United States expands the dollar supply it

puts upward pressure on world incomes and prices--directly, because of interest rateeffects and spending changes in the United States, and indirectly because of increasesin European reserves. Similarly, when the United States contracts the dollar supply, it

puts downward pressure on world prices.

Europe's gold-dollar portfolio is the other control variable. When Europe convertsdollars into gold it weakens the U.S. reserve position and stimulates or compels amonetary contraction(7) and when it converts gold into dollars it strengthens the

reserve position and permits or compels a monetary expansion. Europe's gold-purchase policy thus influences U.S. monetary policy, while the latter "determines"world prices and incomes. When U.S. monetary policy is forcing inflation on the restof the world, Europe can stimulate or compel a contraction by gold purchases; andwhen U.S. monetary policy is deflationary, Europe can entice an expansion by goldsales.

We may thus express the control mechanism of the system as follows: The UnitedStates expands or contracts its monetary policy according to whether its gold position

is excessive or deficient, and Europe buys or sells gold from the United Statesaccording to whether U.S. policy is causing inflation or deflation. The gold exchangestandard therefore constitutes a "system" and it is with its implications that we mustnow be concerned.

4. The Mechanism of Adjustment

The system can be formulated in precise mathematical terms.(8) The purpose of doing

so, of course, is not to lend an impression of spurious precision to central bankbehavior.(9) It is rather to be explicit about the possibilities inherent in the mechanism,and to see what help the formulation is in uncovering possibilities easily missed byunaided intuition.(10)

Figure 1 plots Europe gold holdings (G) on the abscissa and U.S. dollar liabilities (D)on the ordinate. Given the stock of gold in the worlds as a whole, the line RS plots the


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relation between Europe's gold holdings (and therefore U.S. gold holdings as theresidual) and U.S. dollar liabilities, which preserves the U.S. gold-reserve ratio at itsdesired level. Thus if Europe holds OR of gold, none is left over for the United Statesand dollar liabilities must be zero, whereas if Europe holds no gold (so that the UnitedStates holds it all), U.S. dollar liabilities are ORS. (Given one dollar's worth of gold as

the unit in which gold is measured, the slope of RS with a negative sign, is thereciprocal of the U.S. reserve ratio, which is assumed to be less than 1. (11))

The line PQ plots the relation between Europe's gold holdings and U.S. dollarliabilities that preserves a given money supply (composed of dollars and gold) in theworld as a whole, and therefore (supposing no lags) a given level of prices orincomes. Thus a dollar supply OQ would be exactly sufficient to maintain a givenlevel of prices so Europe's gold holdings would have to be zero to preserve that pricelevel; and, similarly, if the dollar supply were nil, gold holdings in Europe would haveto be OP. The slope of PQ (with negative sign) is the reciprocal of the dollar price ofgold, which, as already noted, it taken to be unity.

The two lines represent targets of policy. When the U.S. reserve ratio is below (above)

the desired ratio, which is the case whenever D is above (below) RS, U.S. authoritieswill reduce (increase) D; and when the world money supply is

Figure 1. The Adjustment Mechanism

above (below) that which preserves the price level implied by PQ, which is the casewhenever G is right (left) of PQ, Europe will purchase (sell) gold to encouragerestraint of expansion in the U.S. We thus get "direction forces" at each point in thediagram indicated, in each quadrant, by arrows.

It may be seen at once that the system may be stable or unstable, depending on theintensity of the forces acting on the control variables. Let be the rate of dollarexpansion in the United States expressed as a proportion of excess gold reserves; let

be the rate of gold purchases in Europe expressed as a proportion of the excess of theworld money supply over its equilibrium level; and let be the gold-dollarequilibrium reserve ratio in the United States. Then, assuming , and are constant, thesystem is stable or unstable according to whether / is greater or less than 1/. (In the

borderline case, the system, from an initial point in the graph such as Z, would


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oscillate hopelessly (and elliptically) around the equilibrium Q.) Thus if = 25 percent, U.S. monetary contraction must be more than four times European gold

purchases; if this were not the case the world money supply would increase (decrease)when the price level was too high and the dollar supply overexpanded(underexpanded).

The potential for instability arises from the fact that the policy mix violates theprincipal of effective market classification.(12) The United States adjusts the dollar

supply to protect its gold reserve position, while Europe adjusts its gold holdings toinduce the United States to changes its monetary policy. Target variables are notmatched to the targets they affect most strongly..

The system might break down even in the event that it is otherwise stable. Boundaryconstraints are given by the axes and by a vertical line from R1. Hitting the latter

boundary would imply a suspension of gold payments in the United States--structural

collapse--or a cessation of the rules of the game. Thus it is entirely possible that, givena sufficiently large disequilibrium such as that indicated by the point Z', the systemcould break down because it hits the barrier from R to the right, flattening both RRS

and PQ.

5. The Mounting Crisis

At the end of 1950 the United States had 652.0 million ounces of gold and sevenEuropean countries had 95 million. By 1971, the United States stock had dropped to291.6 million ounces, while Europe's seven countries held 481.7 million ounces. The

seven countries were the original six countries that signed the Treaty of Rome andSwitzerland. The bulk of this enormous shift of gold from the United States to Europeoccurred in the late 1950s and early 1960s.

It is clear from the analysis of the system that the anchored dollar standard had crisis-laden potential if it is run in such a way that the United States policy is governed byits reserve ratio while Europe tries to control the world rate of inflation by pressureexerted on the composition of the US balance of payments. In the 1960s the UnitedStates and Europe were on a collision course with respect to the internationalmonetary system--what Prime Minister Harold Wilson of the U.K. called a "monetary

war."

The risk lies that the variables would hit the boundary conditions determined by thestock and price of gold, bringing on a convertibility crisis. A higher price of gold--tomake up for World War II and post-war inflation--would have provided more roomfor adjustment within the parameters of the system. But, in the 1960s, an increase inthe price of gold was ruled out--mainly for political reasons.


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The system problem was exacerbated in the late 1960s by the war in Viet-Nam which,in conjunction with the war on poverty, made U.S. financial policy overlyexpansionist, not just from Europe's point of view but from that of the United Statesas well. The fixed exchange rate system imposed correspondingly high inflation rates

on Europe or the alternative of accumulating reserves and massive speculation.Especially in Germany, the system was criticized for producing "importedinflation"(13) into the surplus countries.

Given the basic disequilibrium of the system--both because of the undervaluation ofgold and the excessively expansionary monetary policies in the United States--it is

perhaps surprising that it could last as long as it did. Beneath the threat-counterthreatstruggle between the two continents, lay a powerful undercurrent of bluff. Neither--and least of all Europe--wanted the system to collapse. Rather than bring on a collapseof the system, countries changed their mode of operation.

First, palliatives kept the system in operation for some years. Indeed, it was widelyhoped that if the system could be kept in place for some years, efforts to modify itthrough the creation of SDRs--a kind of paper gold insofar as it was intended to be agold substitute--would create a sounder basis for equilibrium.

The palliatives were, first, mechanisms for reducing the excess demand for gold byeconomizing on it. The United States removed the 25% gold reserve requirement

behind member bank deposits at the Federal Reserve in 1965, and behind FederalReserve currency in 1968. These measures removed the internal gold reserve

requirement and freed what was left of the US gold stock for the requirements ofexternal convertibility.(14)

More important were the changes in the mode of operation as manifested in the dynamics of both

parties. First, the elimination of the gold reserve requirements freed US monetary policy formore expansionary policies, and, as it turned out, reduced the pressure on the United States topreserve price stability; The US inflation rate, which had averaged less than 2% before 1965,

rose to 4.4% in 1968, 5.4% in 1969 and 5.9% in 1970.(15)

Second, Europe was now worried that, with US gold stocks now comparatively low, the UnitedStates would react to gold conversions by changing the system, scrapping convertibility; flexible

exchange rates were anathema in Europe. Under the old mechanism, faced with the increasedinflation rate in the United States, Europe would have pounced on the US gold stock. But to eventhreaten to do so in the late 1960s would have brought down the system. It had become an

oligopoly in which countries could not act in their short-run self interest without taking intoaccount the reactions of their partners. Another factor was the belief, as already mentioned, that

the production of gold-guaranteed SDRs would save the system from destruction if it could bemaintained for a few more years.


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The system did break down, however, in the summer of 1971 after an earlier mark crisis in thespring. In August 1971 the United States rejected demands for conversions of dollars into gold

by the U.K. and other countries. The gold window was declared closed and the dollar becameofficially inconvertible. This posed a problem for the other countries--whether to continue to peg

to an inconvertible dollar, to let their currencies float jointly against the dollar, or to let their

currencies float independently against the dollar and each other.

6. The Smithsonian System

Already in the events leading up to the August crisis, a joint float had been considered. In the

crisis of May 1971, when the mark (and guilder and Belgian franc) floated, Germany proposed ajoint float with her other partners. At that time France and the European Commission proposedinstead fixed parities and controls on capital movements. No agreement resulted.

After the system crisis of August 15, 1971, Germany again proposed a joint float, again rejected

by France. Exchange rates now floated, to the discomfort of most countries in Europe and small

countries all over the world. Four months after the crisis, the major countries met at theSmithsonian Institution to reconstruct the international monetary system.

The new system had some similarities to the old system. There was a modest realignment ofexchange rates. Currencies were in effect pegged to the dollar. The main difference was in theU.S. commitment to covertibility. Although the official price of gold was maintained--it had

been raised to $38 an ounce--the United States was not buying or selling any. The internationalmonetary system was therefore no longer an anchored dollar standard. For all practical purposes

it was a dollar standard.(16)

How does the mode of operation of an unanchored dollar standard differ from an anchored dollar

standard? It will be recalled that in an anchored dollar standard there are two targets(convertibility of the dollar and a stable price level) and two instruments (the supply of dollars

and the U.S. gold reserve). The United States adjusts its policies to maintain convertibility andEurope controls the composition fo the US deficit to achieve inflation targets.

Under the unanchored dollar standard the situation is different. Europe adheres to a monetary

policy to achieve balance of payments equilibrium while the United States follows a monetarypolicy that achieves its inflation target. The adjustment process is reversed.

Under these reversed assignments, the system does not exhibit the instability inherent in the

anchored dollar standard. This is because it conforms to the principle of effective marketclassification. US monetary policy is matched to the price level which it affects most directly;and European monetary policy is matched to its balance of payments, which it affects most

directly.

International reserves are created as a result of the U.S. balance of payments deficit, which mustequal, in equilibrium, both the excess supply of dollars in the United States and the excess

demand for dollars in the rest of the world. In a growing world economy the equilibrium balanceof payments deficit of the United States will be equal to the increase in dollar reserves desired in


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the rest of the world. Given fixed exchange rates, U.S. monetary policy essentially determinesthe rate of monetary expansion in the world as a whole.

These relationships can be expressed in terms of a model. Let R = k*Y* be the demand for

reserves on the part of the rest of the world (ROW), where Y* is the GDP of ROW and k* is the

fraction of Y* that ROW wants to hold in the form of dollar balances. Under a pure dollarstandard, the US payments deficit P is equal to the growth of foreign exchange reserves so thatdR/dt = P = n*k*Y*, where n is the rate of growth of nominal GDP in ROW. If in, say 1970, n*= .06, Y* = $4 trillion, and k* = .01, then P would equal $2.4 billion, not far from the average

annual magnitude of the persistent balance of payments deficit of the period. Alternatively, if weexpress the US payments deficit as a fraction of US GDP, i.e., b = P/Y, we have b = n*k*, where

is the ratio of the shares in world product of the rest of the world and the United States.

The stability of the unanchored dollar standard, however, does not mean that it is an effectiveinternational monetary system. The United States has the ability to use monetary policy to

achieve price stability, but it may not choose to do so. In the absence of the convertibility

requirement, there is no mechanism (apart from moral suasion) by which Europe can induce theUnited States to change its monetary policy. The United States has complete freedom to impose

its own inflation preferences on the rest of the world.(17) In short, it is a dominated system, the"Roman solution."

In retrospect, as we look again at the post-war international monetary system, it is possible to see

that features of the unanchored dollar standard had already crept into the post-war system in thelate 1960s, especially after the elimination of the gold reserve requirements behind deposits andnotes, and when the UN gold stock had dwindled to crisis levels.(18)

To conclude, therefore, the unanchored dollar standard has the merit that it is free from the

destabilizing possibilities of the anchored dollar standard; but the demerit that it is a dominatedsystem which makes no provision for an accountability mechanism such as convertibility.

By contrast, the anchored dollar standard has the possible demerit that its stability depends on

careful timing of central banking policies, but the merit that it makes the reserve currencycountry accountable for its policies through the convertibility discipline.

The merits of the unanchored dollar system, formed at the Smithsonian Institution in December1971, soon outlived their usefulness. The rules of the game required Europe to maintain balanceof payments equilibrium and the United States to maintain price stability. But fulfillment of the

two targets were not entirely independent. The United States, in the presidential election year of1972, was following a monetary policy that was much too expansionary for Europe. The

consequent aggravation of the European surpluses led to additional imported inflation in Europe,an inflation which many of the European countries tried to avoid by sterilization policies.

Sterilization policies, however, cannot work in the long run. The surpluses, which automaticallyexpand the money supply, can be temporarily offset by central bank sales of securities or

changes in reserve requirements. However, these actions tend to raise interest rates and aggravate


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capital inflows. With reserves rising rapidly, bullish speculation is aggravated and the centralbank eventually has to abandon its exchange rate peg. This is indeed what occurred in the mark

crisis of May 1971 when the Bundesbank had to buy up dollars at the rate exceeding $150million an hour. A similar phenomenon occurred early in 1973.

In February of 1973, Dr. George Schultz, a disciple of Milton Friedman and the new Secretary ofthe Treasury, sought a solution in devaluing the dollar.(19) The official price (at which the UnitedStates was neither buying nor selling) was raised $42.22, and some exchange rates werechanged. But, in the absence of a more restrained monetary policy, devaluation only served to

whet the appetites of speculators. Speculative capital outflows forced massive quantities of dollarbalances on the rest of the world. In Japan, foreign exchange reserves (mainly dollar balances)

soared from $2.6 billion at the end of 1969 to $15.2 billion at the end of 1972; and in Germany,foreign exchange reserves (again mainly dollar balances) had soared from $2.7 billion to $15.8billion over the same period. By the spring of 1973, the unanchored dollar system was in the

throes of a major system crisis.

European countries were skeptical that the United States would take measures to tighten itsmonetary policy and reduce its deficit and the consequent flood of reserves to the rest of the

world. Professor H.W.J.Bosman, in discussing the problem from the German point of view,wrote:

"Among these measures I do not include a substantial reduction of the U.S. balance of payments deficit. Of course,we would wish that such a reduction would take place, but we may not base ourselves on such a development as it isimprobable that it will occur. It is for the U.S.A. from a technical point of view very difficult to use the instruments

of the economic policy to improve the balance of payments position; it is furthermore politically still more difficultto do so, as imports and exports only play a minor role in producing and spending national income, and last butperhaps most important the polit ical will does not exist to solve the problem. All statements concerning an

improvement of the balance of payments position have not be taken too seriously. The recent devaluation of thedollar may improve somewhat the balance of payments posit ion but it will not change it fundamentally, unless theU.S. are going to change fundamentally their commitments toward the world outside...

Sticking to the dollar system...means that the dollar reserves of the other countries and especially of Europe will

continue to grow and that there will be always a tendency to assume that the existing parities will not be the rightones, so that it can only pay to continue speculation against the dollar and in favor of the D.M. If nothing would bedone against that speculative flow of dollars strengthening the already existing "normal" flow, the European andespecially the German authorities would be faced with a continued creation of money.

Without maintaining that this can be regarded as the main cause of inflation, it makes the struggle against inflationstill more difficult than it is already. Of course something can be done against the influence of large-scale dollar

inflow on the banking system, e.g., by requiring a reserve of 100 per cent against foreign deposits. Experience tellsus that this does not prevent outside funds continuing to flow into the country waiting for the currency to berevalued or to rise when left free. Moreover, the foreign funds can be invested in securities and then a measure likethe 100 per cent reserve cannot be applied..." (20)

In June, the system was disbanded and the period of flexible exchange rates began.


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7. Formation of the ERM

It will be recalled that Germany had proposed a joint float of the European currencies

against the dollar both before and after the crisis that followed August 15, 1971,proposals that were rejected by the other countries. In the Spring of 1973, before thebreakup of the unanchored dollar standard set up at the Smithsonian Institution,Germany again proposed a joint float of the European currencies, again rejected. Onereason is not far to seek: A joint float would by no means have been a symmetricaloutcome. Whenever the dollar weakened, a joint float would have had to rally around

the mark. Neither France nor Britain were ready yet to acknowledge the mark as thenatural center of the system.

Nevertheless, the European countries had earlier indicated an interest in, if not

consensus on, European monetary integration. Proposals for monetary integration goback to the late 1950s. The Treaty of Rome had called for individual policies forachieving equilibrium in overall balance of payments, maintaining confidence incurrencies, and coordinating policies through collaborations of governments andcentral banks.

Four years later, in October 1962, the European Commission submitted to the Councilof Ministers a set of proposals for coordination of monetary and economic policieswithin the Community, leading to the eventual establishment of a monetary andeconomic union. In 1964, the Committee of governors of the Central Banks of the

Member States was set up, along with budgetary and economic policy committees. InFebruary 1968, the commission proposed that members commit themselves to adjusttheir exchange rate parities only by common agreement and to consider theelimination of margins on each others' currencies around the established parities. Thenext year, on February 12, 1969, the "Barre Report" called for concerted economic

policies to ensure the attainment of agreed medium-term objectives. The Councilagreed with many features on the Barre Report and committed members to priorconsultation before a member altered its economic policies in such a way as to havean important impact on other members.

The Community Summit conference at the Hague, on December 1 and 2, 1969,requested the Council to draw up a plan, based on the Barre Report, to establish bystages an economic and monetary union in the Community. On March 6, 1970, theCouncil authorized the creation of a committee, headed by Pierre Werner ofLuxembourg, to draw up a plan for economic and monetary union. Along the lines of

the Barre Report, central banks established a fund for balance of payments support bywhich members could draw up to $1 billion for a period of three, extendable to six


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months. The Werner Report of October 8, 1970 recommended a program for theestablishment by stages of an economic and monetary union by 1980.

In its final form, the union was to have the following features: (1) a single Communitycurrency (or else rigid and irrevocable fixing of exchange rates with zero margins and

total interconvertibility); (2) complete liberalization of capital movements; (3) acommon central banking system, organized along the lines of the Federal ReserveSystem; and (4) centralized responsibility in a Community "center of decision for

economic policy" politically responsible to a European Parliament. These provisionswere later watered down at French insistence, leaving undecided the exact division of

powers between the Community and member states. The substance of the amendedWerner Report was adopted by the Council of Ministers of February 9, 1971.Subsequent progress, however, was overtaken by the turmoil in the exchange marketsin the spring and summer of 1971.(21)

The impulse for European monetary integration fluctuates with the dollar cycle: it isstrongest when the dollar is weak, as in the early and late 1960s and the early and late1970s. After the implementation of the Snake under the Werner Plan, the next great

thrust forward came in the wake of the weak dollar depreciation in the late 1970s.Following the Bremen summit in 1978, President Giscard d'Estaing and ChancellorHelmut Schmidt made the agreement to create the European Monetary System, whichcame into existence in March 1979.

8. Crisis of the ERM

The EMS was viewed as a prelude to monetary unification:

"The purpose of the European Monetary System is to establish a greater measure of monetary stability in theCommunity. It should be seen as a fundamental component of a more comprehensive strategy aimed at lastinggrowth with stability, a progressive return to full employment, the harmonization of living standards and the

lessening of regional disparities within the Community. The Monetary System will facilitate the convergence ofeconomic development and give fresh impetus to the process of European Union." (22)

The EMS went beyond the Snake in that it created an institution, the EuropeanMonetary Cooperation Fund, and introduced a kind of pre-money, the ecu, defined asa basket of the currencies of the EC countries, weighted by a formula that tookaccount of both trade and GDP. The ecu was to serve as numeraire for the EMS


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exchange rate mechanism; as a basis for indicating divergence; as the numeraire forcentral bank operations; and as a means of settlement between monetary authorities ofthe European Community. The Fund was to provide a source of ecus for settlement ofcentral bank transactions against a deposit of 20% of gold and 20% of foreignexchange reserves.

The exchange rate mechanism (ERM) within the EMS in theory was symmetrical withrespect to its member countries, but in practice the DM became the "inflation anchor"

of the system. The Bundesbank has been able to pursue monetary policies dictated bythe requirements of internal balance (as its constitution requires). When a conflictexists--such as an appreciating mark (or a payments surplus) combined withinflationary pressure-- Germany has opted for tight money to prevent inflation ratherthan easy money to relieve the external pressure on itself or its partners in the EMS.By contrast, the other countries in the ERM have had to give priority to external

balance, tightening or easing monetary policy according to whether their currencies arat their upper or lower limit. In short, the ERM has all the hallmarks of a currencyareas anchored to the mark and German monetary policy.

The analogy with the dollar standard is apparent. But it should not be carried too far.The dollar standard was global, the mark standard, regional. As already noted, the sizeof a country's transactions domain plays a large role in determining its ability tocushion shocks in the system as a whole; the burden of international adjustment isdistributed inversely in proportion to the size of country. With a country one-third thesize of the US economy, Germany, qua anchor, is only one-third as stable. Theturnaround in German fiscal policy due to unification brought about a reduction in theGerman current account from a surplus of $46 billion in 1990 to a deficit of $20.7

billion, a turnaround of $66.7 billion. This corresponded to an adjustment of 4.4% ofGerman GDP, but the same absolute disturbance would have involved a turnaround ofonly 1.1% of US GDP.(23)

The effect of the enormous inward transfer to (or reverse outward transfer from)Germany put pressure on the German price level, forcing the Bundesbank to reactwith higher interest rates--and the highest interest differentials (relative to the UnitedStates) favoring the mark--in years. Left alone with a neutral monetary policy (say afixed rate of monetary expansion) the mark would temporarily have appreciatedstrongly in the spot market against all currencies, but going to a substantial discount in

the forward market to reflect both the interest differential and a future weakness of themark. Equilibrium would have been served by a substantial realignment involving atemporary appreciation of the mark or a downward realignment of the currencies ofGermany's partners in the ERM. It should be emphasized, however, that had Germany

been a larger country, the needed scale of real exchange rate adjustment would havebeen proportionately smaller.


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Most economic events are spread across countries. The German unificationdisturbance was unique, a shock unparalleled since the oil price increases of the1970s, but concentrated in a single country. One approach to the shock would have

been for Germany to appreciate its currency against the dollar and against its partnersin the Community. But this would have undermined its usefulness as an anchor and

would have overvalued German labor (especially in the Eastern provinces) in the longrun. In any case, France at this time would have resisted such a general appreciation

of the mark and insisted on a proportional appreciation of the franc.

The best policy--given the ERM--might have been for the Bundesbank to follow amonetary policy that would be neutral for Europe as a whole. Abstracting fromordinary economic growth, there are two candidates for a "neutral" monetary policy.One is that the growth of the money supply in Europe is kept unchanged. Under thesecircumstances, an increase in German government spending, financed by an increasein debt, would lead to somewhat higher interest rates in Europe and a somewhathigher ecu. The price of domestic goods would rise somewhat in Germany, and fallsomewhat in the rest of Europe with international goods prices remaining constant. A

Europe-wide monetary policy would have cushioned the impact of the Germanunification shock over the EMS part of the continent. It would have led to moreinflation than the Bundesbank wanted, and more deflation than her partners wanted,

but a more balanced equilibrium for the fixed exchange rate mechanism. It wouldhave been the equilibrium imposed by an independent Board of Directors of theEuropean Central Bank with power distributed among the Board in proportion to theeconomic sizes of its member countries.(24)

The ERM crisis of September 1992 illustrates a basic defect of the EMS system. The

mark anchor works as long as disturbances are not too large and arise from outsideGermany. But disturbances in Germany would be neutralized only if Germanyadopted a policy appropriate for Europe as a whole, not Germany alone. (25) The role ofleader implies responsibility to the group not the individual. Self-centered behavior onthe part of the leader undermines the whole system. European Monetary Union wouldeliminate much of that defect of the EMS. (26)

9.The Mechanism of Adjustment

A number of writers have identified the mechanism of adjustment in the ERM withthe post-war or "Bretton Woods system." or even the gold standard. Thus De Ceccoand Giovannini write:

"Indeed, the functioning of the EMS in its first ten years strikingly resembles the functioning of other fixedexchange rates regimes: the gold standard and the Bretton Woods regime. Like the earlier experiences, the conductof monetary policy was under the control of a 'centre' country--West Germany. The other countries either largely

accommodated Germany's monetary policy, as did Ireland, at an allegedly high price in terms of domestic


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employment and welfare, or achieved temporary monetary independence with the use of capital controls, as didFrance and Italy. This pattern also characterizes also earlier experiences: monetary policy wad dominated by the

United Kingdom during the gold standard and--at least to some extent the U.S. during the Bretton Woods years.Capital controls were also used by countries other than Britain during the gold standard, and by the Europeancountries, including West Germany, during the Bretton Woods years."(27)

It should be clear by now that this view is incorrect. The ERM system was not like thegold standard or even the "Bretton Woods regime." First of all, let us consider theanalogy to the gold standard. It is true that London was the center of the world'scapital market, that sterling was widely used as an invoice currency, and that thesterling bill served as a secondary substitute means of payment. But the majordeterminant of the world price level was the stock of monetary gold, not Britishmonetary policy. Decades before World War I the United States had become thelargest economy in the world and the largest holder of gold. The British stock of goldwas incredibly small relative to the other major holders and British interest ratesfollowed, not determined, the world cycle. News about economic events originated in

London, the world's main financial center, but they were not principally determined inLondon. The gold standard was anchored to gold, not the pound. It is also true that thegold exchange standard of the 1920s was anchored to gold, and it was the abortiverestoration of gold that aggravated demand for it and brought about the deflation ofthe 1930s.

After the Tripartite Agreement of 1936, the United States was the only country onsome semblance of a gold standard (although private citizens could not hold gold andthe dollar was not redeemable). The dollar had a key-currency role in the post-war

period. But the gold-reserve and convertibility requirements imposed a discipline on

US monetary policy. In the absence of these requirements US monetary policy wouldhave been more inflationary than it was. This is suggested by the more expansionary

policy after the gold reserve requirements were abolished in the late 1960s; and by theeven more inflationary policy in the United States when the convertibility requirementwas scrapped.

The correct analogy for the ERM is the unanchored dollar system set up at theSmithsonian Institution. As the Bundesbank report for 1971 correctly claimed, thesystem had become a dollar standard. The United States pursued its own inflation

preferences in its monetary policy and that determined the inflation rate for the

currency area as a whole. The monetary policies of the outer countries weredisciplined by their balance of payments, but the United States policy rested on itsself-discipline, without the accountability of convertibility. When these inflation

preferences clashed with those of Europe, a crisis emerged that ended in the partialbreakup of the dollar standard system.(28)


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The ERM had gravitated to a mark standard in the 1980s. The mark standard of 1980-92 had the same type of adjustment mechanism as the dollar standard of the early1970s. Under the ERM system, the Bundesbank pursued its own inflation preferences.The other countries pursued policies to stabilize their exchange rates and preserve

balance of payments equilibrium. The ERM crisis occurred because Germany's

monetary policy was too tight for its neighbors.(29)

10. Conclusion

My task in this paper was to contrast two systems: (1) the International MonetarySystem that came into being after the signing of the Bretton Woods Agreements fiftyyear ago, and which broke down in steps in the late 1960s and early 1970s; and (2) theEuropean Monetary System which came into being after an agreement signed inBremen between France and Germany in 1978 and which threatened to break down invarious steps during 1992 and 1993.

Despite superficial similarities, there was a fundamental difference between the twosystem. Consider first the earlier system. This was an anchored reserve-currencysystem. Under the Bretton Woods arrangements, most of the other currencies were

pegged to the dollar, whereas the US dollar was pegged to gold. US monetary policywas disciplined by its internal gold reserve ratio and by its commitment to externalconvertibility of the dollar (for foreign monetary authorities). European countrieswere constrained by the discipline of balance of payments equilibrium, but had anadditional weapon--conversion of dollar balances--with which they could put pressureon the United States to contract or encourage it to expand. Although the system was

asymmetrical in the sense that the dollar had a special role, there was an exchange ofcommitments that distributed control between the United States and the outercountries.

The ERM system was basically different. Under the ERM system as it came tooperate after the Plaza Accord, the outer countries were disciplined by the balance of

payments under fixed exchange rates while the center country, Germany, could pursuean independent monetary policy geared to its version of price stability. Germanycould pursue its own inflation preferences without any accountability mechanism; theother countries had no instruments to alter German monetary policy. It was a

dominated system, a mark standard, the Roman solution.

The correct analogy to the ERM is not the gold standard or the post-war system; it isthe regime set up at the Smithsonian Institution in December 1971 and that lasted

(albeit with a second devaluation of the dollar) until June 1973. This system was anunanchored dollar standard in which the United States could pursue its own inflation


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preferences, without any accountability mechanism; the other countries had noinstruments to alter US monetary policy. It was a dominated system, a dollar standard,the Roman solution.

Both the dollar and mark standards threatened to break down when the center countrypursued monetary policies that were at variance with the needs of the outer countries.The dollar standard broke down in 1973 because US monetary policy, taken inconjunction with the explosion of the Eurodollar market, flooded surplus countrieswith reserves. Rather than accept the inflationary consequences of expansion, orrevalue the currencies in fundamental disequilibrium, the system was allowed to breakup.(30)

Similarly, the mark standard threatened to break down when German monetary

policy, over-reacting to the unification shock, followed a money policy that was tootight for the rest of the ERM. Rather than import deflation (or less disinflation thanwas politically acceptable), several countries devalued or left the ERM. The markstandard broke up--or, more correctly, was transformed, because Germany monetary

policy in the wake of the unification shock was too contractionary for the rest of theERM. When, in the summer of 1992, the mark was soaring against the dollar--reaching a dollar low of DM1.385--the Bundesbank should have reacted to the errorsignal and moderated its policies.

The defect of both the dollar and mark standards was that the monetary policies of the

anchor countries were out of line with the interests of their partners. In the case of theUnited States, monetary policy was too inflationary. In the case of Germany,monetary policy was too deflationary. There is an inherent defect in any unanchoredcurrency standard that lacks a mechanism by which the partner countries can havesome influence over the monetary policy of the leader and therefore the currency areaas a whole.

1. I have discussed some aspects of these issues in "Multilateral Commercial Diplomacy," The

National Banking Review 3, No. 2 December 1965): 193-199.

2. Aware that negotiations for the charter would last a long time, interim agreements had beenmade soon after the war ended. The U.S. tariff, despite reductions since the Smoot-Hawley Tariff

under the Reciprocal Trade Agreements Act, was still a main barrier to trade. Crucially, theAdministration got authority from Congress to reduce tariffs to 50 percent of the 1945 level,


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giving effect to a crucially important U.S. proposal at the 1946 London Conference to embodynew commercial treaty rules, including those expected to be incorporated later in the ITO, in a

General Agreement on Tariffs and Trade. It was out of this ad hoc memorandum that GATT--theonly living remnant of the Havana Charter--was born.

3. I have discussed this issue in greater depth in "Tales from the Bretton Woods," inRetrospective on the Bretton Woods System (M. Bordo and B. Eichengreen, eds.) Cambridge,MA: National Bureau of Economic Research, 1991.

4. There were two other problems with the Articles of Agreement for the other countries: (1)

Literally, Article IV required each country--unless it adopted, like the United States, Article IV-4(b)--to keep the currencies ofallmember countries within one percent of parity, clearly aridiculously wasteful arrangement; subsequently it was established that a country that was fixing

its currency to one convertible currency would be deemed to be satisfying its obligations. (2) Acountry in, say, the sterling area that kept its currency fixed to the pound within 1 per cent of

parity, whereas the pound was fixed within margins on the dollar, could experience exchange

margins of 2 percent of parity or more against the dollar; arrangements of this type weresubsequently condoned as a "multiple-currency practice."

5. Why did countries shift from intervention in the gold market to intervention in the dollar

market? My conjecture is that the shift occurred after the "gold scare" of 1937 when a change inthe U.S. commitment to gold was widely discussed. Transactions costs were much lower under

the dollar standard than under gold.

6. Under the Bretton Woods arrangements, parities for currencies were specified in terms of thenumber of grams of gold or number (or fraction thereof) of 1944 U.S. gold dollars equivalent toone currency unit. Market exchange rates, however, were determined directly by the foreign

exchange market including intervention by the exchange authorities.

7. I shall speak throughout of "expansion" and "contraction" and rising and falling prices ratherthan increases or decreases in the rate of expansion or contraction of money and prices, but the

reader should have no difficulty in making his own translation into a growing economy.

8. See my paper, "The Crisis Problem," inMonetary Problems of the International Economy (R.A. Mundell and A. K. Swoboda, eds.) Chicago: University of Chicago Press 1969: 343-349;

reprinted in R.A.Mundell,International Economics New York: Macmillan 1968: 282-288..

9. I know of no central banker who wold like to think that his actions can be expressed in asystem of differential equations.

10. For a mathematical formulation of the system and formal proofs about its behavior see mypaper "The Crisis Problem" inMonetary Problems in the International Economy (eds. R.A.

Mundell and A. K. Swoboda) Chicago: University of Chicago Press, 1968:343-349, reprinted inR.A. Mundell,International Economics, New York: Macmillan, 1968..


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11. D may be taken t o represent the aggregate supply of non-gold money in the world as awhole, rather than simply the foreign central bank holdings of dollars, since we are not

concerned here with exchange margins, imperfect substitutability of one currency for the other,or more than one currency areas, while the gold stock, equal to OR1, can readily be adjusted to

take into account private gold hoarding.

12. The principle of effective market classification was first discussed in my paper, "TheMonetary Dynamics of International Adjustment Under Fixed and Flexible Exchange Rates,"Quarterly Journal of Economics 74 (May 1960): 227-257(reprinted inInternational Economics,

loc. cit., 152-176); and developed further in "The Appropriate Use of Monetary and Fiscal Policyfor External and Interna l Stability,"IMF Staff Papers (March 1962): 70-79 (reprinted in

International Economics, loc. cit.,233-239). In the latter article the principle was formulated asfollows: "...Policies should be paired with the objectives on which they have they most influence.If this principle is not followed, there will develop a tendency either for a cyclical approach to

equilibrium or for instability...On a still more general level, we have the principle that Tinbergenmade famous--that to attain a given number of independent targets there must be at least an equal

number of instruments. Tinbergen's principle is concerned with the existence and location of asolution to the system. It does not assert that any given set of policy responses will, in fact, leadto that solution. To assert this, it is necessary to investigate the stability properties of a dynamic

system. In this respect, the principle of effective market classification is a necessary companionto Tinbergen's Principle."

13. The term "imported inflation" was invented by Professor Wilhelm Rpke of the Graduate

Institute of International Studies in Geneva.

14. By 1968 the private market demand for gold had caught up with market supply and the goldpool--composed of the few countries that were major gold holders--was disbanded. In March of

that year, the central banks made the decision to withdrew from the private market, allowing theprivate market price to rise above the official price. This measure prevented any further drain ofgold from official to private stocks.

15. Although the rate of increase of US money held by domestic residents (except in 1968) did

not appear to surge--it was 4.6% in 1967, 7.2% in 1968, 5.8% in 1969 and 3.6% in 1970--exported money in the Eurodollar market was soaring, a phenomenon the Federal Reserve

studiously ignored. See my article, "World Inflation and the Eurodollar," Economic Notes 1,No.2, 1971.

16. In its report for 1971 the German Bundesbank declared that the gold exchange standard hadfor the time being been replaced by a dollar standard.

17. A reserve currency country has, moreover, an incentive to inflate above what wouldotherwise be national inflation preferences. This arises because of the additional seigniorageprovided by the inflation tax. I analyzed this issue in "The Optimum Balance of Payments

Deficit," in Stabilization Policies in Interdependent Economies (Pascal Salin and Emil Claassen,eds.) Amsterdam: North-Holland Press 1972: 69-86.


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18. In one year, 1969, the United States actually acquired 27 million ounces of gold, aconsequence of the events of May 1969 in France. Nevertheless, gold conversions continued so

that the United States lost about 60 million ounces between 1969 and the end of 1971.

19. It should be remembered that many economists--Keynesians and Monetarists alike--

misdiagnosed the disequilibrium of the 1950s and 1960s as a national problem of correcting theU.S. balance of payments rather than a problem inherent in the structure of the internationalmonetary system. The major problem of the 1950s and 1960s was the undervaluation andscarcity of gold, which could not be corrected by a small change in exchange rates.

20. H.W.JBosman, "Exchange Rate Policies," inEuropean Economic Integration and MonetaryUnification Brussels: European Communities Commission Directorate-General for Economicand Financial Affairs (October 1973): 25-26.

21. Arthur Bloomfield has provided a detailed discussion of the early developments toward

monetary integration in the community. See A. Bloomfield, "The Historical Setting," in

L.B.Krause and W.S.Salant,European Monetary Integration and its Meaning for the UnitedStates, Washington, D.C.: The Brookings Institution, 1973: 1-19.

22. Statement in the conclusion of the Presidency of the European Council of 4 December 1978,quoted in M. De Cecco and A. Giovannini, "Does Europe Need a Central Bank," in M. De Ceccoand A. Giovannini (eds.),A European Central Bank? Perspectives on Monetary Unification after

Ten Years of the EMS. Cambridge: Cambridge University Press 1989: 2.

23. On this argument see my paper, "The Proper Distribution of the Burden of InternationalAdjustment,"National Banking Review 3(September 1965): 81-87; reprinted in myInternational

Economics (Ch. 13); see also my "Uncommon Arguments for Common Currencies," in The

Economics of Common Currencies (H.G.Johnson and A.K.Swoboda, eds) London: Allen &Unwin, 1973: 114-132.

24. The Maastricht Treaty, however, assumes an independent central bank with one director fromeach country; this solution may, however, prove to be a mistake.

25. The best defense for the Bundesbank's policy is that there is a critical rate of inflation atwhich expectations of inflation lead to a crack in the bond market and compensatory wage

demands, that threaten to set in motion a wage-price spiral (the correction of which, later on,would entail a higher cost in terms of excess unemployment). To the extent that this argument is

valid, it seems to be an argument for an appreciation of the mark within the ERM.

26. Critics may argue, however, that flexible exchange rates would have resulted in a bettersolution in the case of a shock of the size experienced by Germany. In the same view someadvocates of flexible exchange rates have argued that flexible exchange rates between the North-

East and South-West regions of the United States would have cushioned those regions againstthe oil shocks of the 1970s and 1980s; and, similarly, that a separate currency for New York City

during its debt crisis of the mid-1970s would have allowed it to pay off its debt in depreciatedcurrency. These arguments, however, seem to be short-run in nature; a flexible exchange rate


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regime has the defect that it sets in motion expectations of future changes that nullify theeffectiveness of the adjustment features of flexible exchange rates. The best solution, signalled

by the sharp appreciation of the DEM against the dollar, would have been a more expansionarymonetary policy in Germany.

27. De Cecco and Giovannini, loc. cit.,.3.

28. The breakup was only partial because, while the surplus European countries floated, most of

the Fund members in the rest of the world that had fixed their currencies to the dollar stayedthere. Whereas the inflation preferences of the United States were higher than that in the surplus

European countries (or at least Germany and Holland), they were substantially lower than mostother countries.

29. Differences in "inflation preferences" are not always easy to measure. For example, in ahighly integrated currency area, there is a single inflation rate for the area as a whole and it is

not, in general, possible to distinguish between inflation rates in the center and outer countries.

During the late 1960s and early 1970s, for example, US inflation rates did not differ much frommost of the European countries; and German inflation rates were not much if any lower than herneighbors. Even differential rates of monetary expansion (relative to output) may not correctlyreflect inflation preferences where part of the money supply is held abroad. For example, US

monetary expansion was not exceptionally rapid in the 1960s and 1970s (although it did increasesubstantially in the latter decade) when measured by domestic monetary aggregates, making no

allowance for the inflationary effect of soaring dollar balances abroad both in official hands andfor use as reserves in the Eurodollar market.

30. It would be a mistake to claim that the Committee of Twenty was in any sense forced todisband the system. Without denying the US blame for an excessively expansionary monetary

policy, the Committee's decision to scrap the dollar standard for flexible exchange rates was anunwise one. A better alternative would have been for Germany, the main country in fundamental

disequilibrium, to revalue the mark. German foreign exchange reserves had almost doubled,rising from $11.5 billion at the end of 1971 to $20.8 billion at the end of 1973. The othercountries, including Japan, were not in fundamental disequilibrium; Japan's reserves, for

example, fell from $12.6 billion to $8.5 billion over the same period. Rather than destroying thesystem because the exchange rate of a country comprising (then) 6% of world GDP was

inappropriate, it would have been better for Germany alone to leave the system temporarily andthen refix at a higher parity. (Germany could argue in defense, however, that because of worldinflationary pressures it would be better for the rest of the world to adapt to Germany rather than

the other way around even if Germany were only 6% of world GDP.) However, whatever thedefects of the dollar standard, including the correct charge that it was too inflationary, its

maintenance would have resulted in less inflation in most countries than actually occurred. Onlya handful of countries have had less inflationary pressure, and depreciated against the dollar,since 1973.

the european monetary system 50 years after bretton woods

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