Flexible forex exchange rate regimes: 1973–present
Although the exchange rate stability sustained by the Bretton Woods system facilitated
expanding international trade, this early success masked its underlying design flaw, wherein
there existed no mechanism for increasing the supply of international reserves to support
continued growth in trade.[24]: 22 The system began experiencing insurmountable market pressures
and deteriorating cohesion among its key participants in the late 1950s and early 1960s. Central
banks needed more U.S. dollars to hold as reserves, but were unable to expand their money
supplies if doing so meant exceeding their dollar reserves and threatening their exchange rate
pegs. To accommodate these needs, the Bretton Woods system depended on the United States to
run dollar deficits. As a consequence, the dollar's value began exceeding its gold backing. During
the early 1960s, investors could sell gold for a greater dollar exchange rate in London than in the
United States, signaling to market participants that the dollar was overvalued. Belgian-American
economist Robert Triffin defined this problem now known as the Triffin dilemma, in which a
country's national economic interests conflict with its international objectives as the custodian of
the world's reserve currency.[21]: 34–35
France voiced concerns over the artificially low price of gold in 1968 and called for returns
to the former gold standard. Meanwhile, excess dollars flowed into international markets as the
United States expanded its money supply to accommodate the costs of its military campaign in
the Vietnam War. Its gold reserves were assaulted by speculative investors following its first
current account deficit since the 19th century. In August 1971, President Richard Nixon
suspended the exchange of U.S. dollars for gold as part of the Nixon Shock. The closure of the
gold window effectively shifted the adjustment burdens of a devalued dollar to other nations.
Speculative traders chased other currencies and began selling dollars in anticipation of these
currencies being revalued against the dollar. These influxes of capital presented difficulties to
foreign central banks, which then faced choosing among inflationary money supplies, largely
ineffective capital controls, or floating exchange rates.[21]: 34–35 [36]: 14–15 Following these woes
surrounding the U.S. dollar, the dollar price of gold was raised to US$38 per ounce and the
Bretton Woods system was modified to allow fluctuations within an augmented band of 2.25%
as part of the Smithsonian Agreement signed by the G-10 members in December 1971. The
agreement delayed the system's demise for a further two years.[23]: 6–7 The system's erosion was
expedited not only by the dollar devaluations that occurred, but also by the oil crises of the 1970s
which emphasized the importance of international financial markets in petrodollar recycling and
balance of payments financing. Once the world's reserve currency began to float, other nations
began adopting floating exchange rate regimes.[16]: 5–7
Post-Bretton Woods financial order: 1976
As part of the first amendment to its articles of agreement in 1969, the IMF developed a
new reserve instrument called special drawing rights (SDRs), which could be held by central
banks and exchanged among themselves and the Fund as an alternative to gold. SDRs entered
service in 1970 originally as units of a market basket of sixteen major vehicle currencies of
countries whose share of total world exports exceeded 1%. The basket's composition changed
over time and presently consists of the U.S. dollar, euro, Japanese yen, Chinese yuan, and British
pound. Beyond holding them as reserves, nations can denominate transactions among themselves
and the Fund in SDRs, although the instrument is not a vehicle for trade. In international
transactions, the currency basket's portfolio characteristic affords greater stability against the
uncertainties inherent with free floating exchange rates.[20]: 34–35 [26]: 50–51 [27]: 117 [29]: 10 Special drawing
rights were originally equivalent to a specified amount of gold, but were not directly redeemable
for gold and instead served as a surrogate in obtaining other currencies that could be exchanged
for gold. The Fund initially issued 9.5 billion XDR from 1970 to 1972.[31]: 182–183
IMF members signed the Jamaica Agreement in January 1976, which ratified the end of the
Bretton Woods system and reoriented the Fund's role in supporting the international monetary
system. The agreement officially embraced the flexible exchange rate regimes that emerged after
the failure of the Smithsonian Agreement measures. In tandem with floating exchange rates, the
agreement endorsed central bank interventions aimed at clearing excessive volatility. The
agreement retroactively formalized the abandonment of gold as a reserve instrument and the
Fund subsequently demonetized its gold reserves, returning gold to members or selling it to
provide poorer nations with relief funding. Developing countries and countries not endowed with
oil export resources enjoyed greater access to IMF lending programs as a result. The Fund
continued assisting nations experiencing balance of payments deficits and currency crises, but
began imposing conditionality on its funding that required countries to adopt policies aimed at
reducing deficits through spending cuts and tax increases, reducing protective trade barriers, and
contractionary monetary policy.[20]: 36 [30]: 47–48 [37]: 12–13
The second amendment to the articles of agreement was signed in 1978. It legally
formalized the free-floating acceptance and gold demonetization achieved by the Jamaica
Agreement, and required members to support stable exchange rates through macroeconomic
policy. The post-Bretton Woods system was decentralized in that member states retained
autonomy in selecting an exchange rate regime. The amendment also expanded the institution's
capacity for oversight and charged members with supporting monetary sustainability by
cooperating with the Fund on regime implementation.[26]: 62–63 [27]: 138 This role is called IMF
surveillance and is recognized as a pivotal point in the evolution of the Fund's mandate, which
was extended beyond balance of payments issues to broader concern with internal and external
stresses on countries' overall economic policies.[27]: 148 [32]: 10–11
Under the dominance of flexible exchange rate regimes, the foreign exchange markets
became significantly more volatile. In 1980, newly elected U.S. President Ronald Reagan's
administration brought about increasing balance of payments deficits and budget deficits. To
finance these deficits, the United States offered artificially high real interest rates to attract large
inflows of foreign capital. As foreign investors' demand for U.S. dollars grew, the dollar's value
appreciated substantially until reaching its peak in February 1985. The U.S. trade deficit grew to
$160 billion in 1985 ($341 billion in 2012 dollars[11]) as a result of the dollar's strong
appreciation. The G5 met in September 1985 at the Plaza Hotel in New York City and agreed
that the dollar should depreciate against the major currencies to resolve the United States' trade
deficit and pledged to support this goal with concerted foreign exchange market interventions, in
what became known as the Plaza Accord. The U.S. dollar continued to depreciate, but
industrialized nations became increasingly concerned that it would decline too heavily and that
exchange rate volatility would increase. To address these concerns, the G7 (now G8) held a
summit in Paris in 1987, where they agreed to pursue improved exchange rate stability and better
coordinate their macroeconomic policies, in what became known as the Louvre Accord. This
accord became the provenance of the managed float regime by which central banks jointly
intervene to resolve under- and overvaluations in the foreign exchange market to stabilize
otherwise freely floating currencies. Exchange rates stabilized following the embrace of
managed floating during the 1990s, with a strong U.S. economic performance from 1997 to 2000
during the Dot-com bubble. After the 2000 stock market correction of the Dot-com bubble the
country's trade deficit grew, the September 11 attacks increased political uncertainties, and the
dollar began to depreciate in 2001.[16]: 175 [20]: 36–37 [21]: 37 [27]: 147 [38]: 16–17
European Monetary System: 1979
Following the Smithsonian Agreement, member states of the European Economic
Community adopted a narrower currency band of 1.125% for exchange rates among their own
currencies, creating a smaller scale fixed exchange rate system known as the snake in the tunnel.
The snake proved unsustainable as it did not compel EEC countries to coordinate
macroeconomic policies. In 1979, the European Monetary System (EMS) phased out the
currency snake. The EMS featured two key components: the European Currency Unit (ECU), an
artificial weighted average market basket of European Union members' currencies, and the
Exchange Rate Mechanism (ERM), a procedure for managing exchange rate fluctuations in
keeping with a calculated parity grid of currencies' par values.[13]: 130 [20]: 42–44 [39]: 185
The parity grid was derived from parities each participating country established for its
currency with all other currencies in the system, denominated in terms of ECUs. The weights
within the ECU changed in response to variances in the values of each currency in its basket.
Under the ERM, if an exchange rate reached its upper or lower limit (within a 2.25% band), both
nations in that currency pair were obligated to intervene collectively in the foreign exchange
market and buy or sell the under- or overvalued currency as necessary to return the exchange rate
to its par value according to the parity matrix. The requirement of cooperative market
intervention marked a key difference from the Bretton Woods system. Similarly to Bretton
Woods however, EMS members could impose capital controls and other monetary policy shifts
on countries responsible for exchange rates approaching their bounds, as identified by a
divergence indicator which measured deviations from the ECU's value.[15]: 496–497 [24]: 29–30 The
central exchange rates of the parity grid could be adjusted in exceptional circumstances, and
were modified every eight months on average during the systems' initial four years of operation.
[27]: 160 During its twenty-year lifespan, these central rates were adjusted over 50 times.[23]: 7
Birth of the World Trade Organization: 1994
The Uruguay Round of GATT multilateral trade negotiations took place from 1986 to
1994, with 123 nations becoming party to agreements achieved throughout the negotiations.
Among the achievements were trade liberalization in agricultural goods and textiles, the General
Agreement on Trade in Services, and agreements on intellectual property rights issues. The key
manifestation of this round was the Marrakech Agreement signed in April 1994, which
established the World Trade Organization (WTO). The WTO is a chartered multilateral trade
organization, charged with continuing the GATT mandate to promote trade, govern trade
relations, and prevent damaging trade practices or policies. It became operational in January
1995. Compared with its GATT secretariat predecessor, the WTO features an improved
mechanism for settling trade disputes since the organization is membership-based and not
dependent on consensus as in traditional trade negotiations. This function was designed to
address prior weaknesses, whereby parties in dispute would invoke delays, obstruct negotiations,
or fall back on weak enforcement.[10]: 181 [15]: 459–460 [18]: 47 In 1997, WTO members reached an
agreement which committed to softer restrictions on commercial financial services, including
banking services, securities trading, and insurance services. These commitments entered into
force in March 1999, consisting of 70 governments accounting for approximately 95% of
worldwide financial services.[41]
