Collapse of Fixed Exchange Rate System
Until the late 1960s, the fixed exchange rates that was formed during the Bretton Woods system worked well. However, it began to show signs of strain during the 1970s. Eventually, the system collapsed in 1973, and we have since had a managed-float system.
In order to understand why the system collapsed, one must consider the unique role played by the US dollar in the system. The dollar played an important role in the system as it was the only currency that was convertible into gold and as a reference point for all others. There were different pressures on the dollar, and those pressures resulted in the devaluation of the dollar.
It is generally believed that the U.S. macroeconomic policy package of 1965-1968 led to the dissolution of the fixed exchange rate system. President Lyndon Johnson supported increases in government spending that were not financed by higher taxes in order to fund both the Vietnam War and his welfare programs. The money supply was instead increased, which was the cause of a rise in price inflation from less than 4 percent in 1966 to close to 9 percent in 1968.While government spending increased, the economy was also stimulated. When people had more money in their pockets, they spent more on imports and the U.S. trade balance began to worsen. Inflation and the deteriorating position of the U.S. foreign trade led to speculation in the foreign exchange market that the dollar would devalue.
For the first time since 1945, US trade figures showed that the US imported more than it exported in the spring of 1971.
Speculators guessed that the mark would be revalued against the dollar and purchased German deutsche marks in the foreign market. The Bundesbank (Germany’s central bank) had to buy $1 billion on May 4, 1971, to hold the dollar/deutsche mark exchange rate at the fixed exchange rate given the high demand for deutsche marks. A Bundesbank representative purchased another $1 billion in foreign exchange during the first hour of trading on May 5. The Bundesbank allowed its currency to float at that point because it faced an inevitable outcome.
The foreign exchange market became increasingly convinced that the dollar was about to go down against the deutsche mark following the decision to float the mark. However, the devaluation of the dollar was not an easy matter.
Under the Bretton Woods exchange rate provisions, other countries could simply fix their dollar rates to a new level in order to adjust their exchange rates. Due to the dollar’s important position in the system, it could only be devalued if all countries concurrently revalued against it.
A lot of countries did not want this, since it would make their products more expensive compared to U.S. products. In August 1971,
- President Nixon announced that the dollar was no longer convertible into gold.
- Furthermore, he announced that the new 10 percent import tax would remain in effect until US trading partners agreed to revalue their currencies against the dollar.
- Trade partners were forced to bargain, and a deal was reached in December 1971 to devalue the dollar 8 percent against foreign currencies.
Afterwards, the import tax was removed. However, the problem remained.
Throughout 1972, the U.S. balance of payments continued to deteriorate, while the money supply continued to grow at an inflationary rate. It was speculated that the dollar was still overvalued and that a second devaluation would be needed. As a result, foreign exchange dealers started converting dollars into deutsche marks and other currencies. Foreign exchange markets were closed in February 1972, after a massive wave of speculation culminated with European central banks spending 53.6 billion on March 1 to prevent their currencies from appreciating against the dollar.
Japan’s yen and most European currencies were floating against the dollar when the market resumed trading on March 19, but many developing countries continued to peg their currencies to the dollar and many do so to this day. It was believed at the time that the switch to a floating system was a temporary solution to unmanageable speculation in the foreign exchange market.
It has been more than 30 years since the Bretton Woods system of fixed exchange rates collapsed, and the temporary solution appears to be permanent. The Bretton Woods system had a significant Achilles’ heel. It couldn’t work if its key currency, the U.S. dollar, was subject to speculation. Bretton Woods could only function if U.S. inflation rates stayed low and there was no balance-of-payments deficit. As soon as these things happened, the system was strained to the breaking point.