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BRETTON WOODS MACH II — THE SHAPE OF THINGS TO COME Remarks by BRUCE K. MacLAURY President Federal Reserve Bank of Minneapolis at The School for International Banking Boulder, Colorado July 19, 1972 BRETTON WOODS MACH II -- THE SHAPE OF THINGS TO COME Therefs a certain irony in the fact that President Nixon's announcement last August 15 ending dollar convertibility came as a shock to a world long since accustomed to the idea that the dollar was in practice not convertible into gold. In fact, one is tempted to compare the situation to that of the boy who finally called attention to the fact that the Emperor had no clothes. But the practical consequences of ending the gold illusion were and are - serious. Indeed, during the four month interval between August and the Smithsonian Agreement in December, there were times when it seemed questionable whether a new order would in fact emerge to take the place of the old. This turbulence should not have been particularly surprising, since it had been pretty clear that when the chips were down, and the gold window finally had to be closed, the reaction was not likely to be the neat one of foreign countries holding more inconvertible dollars, or else revaluing their currencies. The risk, rather, was of retaliation through restrictions. Indeed it was to minimize this risk that most of us felt we should avoid taking the ultimate step until it was clear that the United States had no other choice. Even when, in the face of massive outflows of dollars and a rapidly deteriorating trade account, it became clear to nearly everyone last summer that dollar convertibility at existing exchange rates could no longer be sustained, the spectre that most threatened international financial markets was that of spreading protectionism through restrictions and a breakdown in cooperation. - 2 - But if we have successfully avoided a collapse of the working arrangements among nations in support of their international cotmnerce, there's no denying that those arrangements have undergone a profound change in the last few months. The world of Bretton Woods, to which we had become so accustomed, survived as long as it did largely because there was no practical alternative that could be set in its place, even when it became increasingly apparent that the postulates of 1945 were no longer workable. Now, however, the situation is different — the system has already changed in fact, and the task is no longer how to preserve the semblance of past traditions, but how to forge new rules and postulates in keeping with the needs of the future. Perhaps the most difficult aspect of the task is the need to construct a system that will work in a world where the balance of economic power is now more evenly distributed than at any time in the post-war period. For it’s difficult to avoid the feeling that what made Bretton Woods as durable and workable as it was, was the existence of a dominant, and by and large benevolent, center of power in the system — United States. namely, the No amount of negotiation is going to restore that concentration of power, nor provide a ready substitute for it in the near future. Instead, internationally agreed rules must replace dominant sovereign powers as the guardians of peace and order. But as we know from our experience in other areas, the task of fashioning such rules isnft easy. The communique issued at the time of the Smithsonian Agreement last December in effect spelled out an agenda of unfinished business. - 3 - ADJUSTMENTS IN THE EXCHANGE RATE MECHANISM One of the first items, of course, is the consolidation of the present exchange rate relationships. After a bumpy take-off, the new central rates agreed upon last December seemed to be accepted as a reasonable compromise, at least until sterling broke loose last month. Since then, the markets have once again been in turmoil, though calmer the last few days. Floating Rates But whatever the problems about particular rate relationships, there has been a notable absence of calls for a return to floating rates. I would be the first to acknowledge that the four months following August 15 were about the worst possible time to conduct a meaningful experiment with floating exchange rates. Hardly a week went by but what there was some new announcement or rumor as to the eventual rate structure that was likely to emerge. Uncertainty, in other words, was not the product of floating rates as such, but rather of the official poker game that was going on just beneath the surface. But even granting that little light was shed on the viability of a floating rate system by last fall’s "experiment1, the fact remains that 1 few businessmen and even fewer officials have any inclination to weigh anchor again on such seas for some time to come. Indeed, perhaps the best hope for those who remain philosophically wedded to a world of flexible rates is to push for as much flexibility as possible not only in the near term institutional arrangements which govern exchange rates, but more important, in the degree to which such arrangements can themselves be easily modified in the future. Frankly, the arguments pro and con floating rates have long since exhausted both the tellers and the listeners, and only - 4 - practical evidence is likely to advance the cause - one way or the other. Thus if experience with wider bands or more frequent changes in rates turns out to have a salutary effect on trade and commerce, there at least will be a case for pushing the limits somewhat further* Transitional Floats For the time being, however, the main task with respect to exchange rates is to seek agreement on the changes that must be made in the Articles of Agreement of the International Monetary Fund (IMF) to bring existing (or perhaps slightly modified) arrangements back within the bounds of law. of the groundwork in this area has already been laid. Much It’s now two years since the IMF executive directors issued their report on possible means of achieving greater flexibility in exchange rate adjustments. And the areas of common ground have been further solidified by the sanction of experience. For example, the technique of using transitional floats to move from one rate to another has now been used often enough to nearly qualify for common law status. There are any number of details that remain to be settled but at least the principle is no longer very controversial. Wider Bands Likewise, differences of view concerning wider bands have narrowed. From the beginning, it was recognized that there was no magic number for margins either side of parity. Now, however, there is a number that has been accepted as a workable compromise among conflicting views: namely, the 2% percent either side of parity that was agreed in December to replace the previous 1 percent. But what is really needed is some degree of discretion on the part of the IMF to adjust the width of the permitted band in the light of further experience, without having to crank up the - 5 - extremely cumbersome machinery required to change the Articles of Agreement themselves. It goes without saying that a country, or a group of countries, could decide to operate on narrower limits than those set by the IMF. Indeed, that has been the practice throughout much of the post-war period, and we are now witnessing a new variation on the same theme within the European Economic Community (EEC), The implications of this particular experiment, of course, go far beyond the question of appropriate widths of the band around parities. To the extent that the expanded Common Market forges an increasingly closely linked currency system, the greater will be the pressures for harmonization of policies internally, and the greater will be its ability to act as a unit vis-a-vis outside currency blocs, and the dollar in particular. Indeed, even if the EEC adopts an outward- oriented policy stance - which at this point is by no means certain - it is hard to escape the conclusion that progress toward a unified currency within the Common Market will mean a reduced role, relatively at least, for the dollar as an international currency. Diminished International Role of the Dollar It is convenient to divide the international role of the dollar, conceptually, into three aspects; as a reserve currency; as an intervention currency; and as a transactions currency. As and when the arrangements among the Common Market partners provide for some pooling of reserves, it seems reasonable to assume that their need for reserves, and hence for dollars, will be diminished somewhat. And while the pooling of reserves is one of the more sensitive political issues among them, it is worth noting that the first steps along this path have already been taken in the establishment of credit facilities for use within the group. - 6 - Second, the partners have agreed to use each others1 currencies rather than the dollar for official intervention in the exchange market so long as their narrower band is not at the outside limit against the dollar. In this case as well, therefore, reliance on the dollar has been diminished, though by no means eliminated. Finally, a narrower band among Common Market currencies is also likely to diminish the role of the dollar as a transactions currency, at least in trade and financial transactions within the Common Market itself, and perhaps more widely. The argument here is that as the risk of exchange fluctuation is reduced relative to the dollar, Common Market businessmen will find it increasingly convenient to denominate transactions in each others* currencies, and in practice hold those currencies rather than the dollar as working balances. In my own view, the prospect of a diminished role for the dollar as an international currency is not cause for alarm, but rather a fact to be taken into account in assessing the likelihood and timing of exchange market equilibrium for the dollar. As a practical matter, of course, the dollar is not likely to be displaced in any of its international roles very quickly, at least in any absolute sense, so that there should be time to adjust gradually to any decline in relative demand. Smaller, More Frequent Exchange Rate Adjustments Perhaps the toughest question facing those who must translate the present pragmatic compromise on exchange rate mechanisms into precise formal language for amendment of the IMF Articles is how to define the terms that would justify, or even require, a change in parities. There is now fairly widespread agreement that waiting for a Hfundamental dis-equilibrium1 to be * - 7 - documented and certified, at least as practiced in the past under the IMF rules, involves waiting too long. We are now prepared to accept the idea of smaller, more frequent changes as representing an improvement in the system. But this is a very slippery concept, as anyone knows who has tried to come to grips with it in detail, and translate the principle into workable rules. Much of the advice on this issue seems to advocate moving the rate before the case is clear, in order not to be caught holding out too long. In all this discussion of greater flexibility, the basic point must not be lost that changes in exchange rates by definition involve consequences for more than one country, and cannot be allowed to become a tool of, or completely subservient to, domestic policy goals. This implies international surveillance of rate changes, whether or not they are made "more flexible1 . * Again, I would subscribe to a suggestion that the IMF be allowed to establish a limit, say 2 percent, within which countries would be permitted to adjust their parities annually without explicit authorization from the IMF. experience. This limit, in turn, could be adjusted in the light of As you recognize, this is simply a modification of the principle incorporated in the original Articles that permitted countries to adjust their parities unilaterally up to a cumulative change of 10 percent. Exchange Rate Changes for the Dollar: Symmetry? Related to the question of new, and more flexible, rules for exchange rate changes generally is the equally difficult problem of assuring that the dollar, too, will be able to avail itself of the same possibilities for exchange rate changes that are open to other currencies; assuring, in other words, that the system works symmetrically for the dollar. The - 8 - inherent problem, of course, is that even though the dollar is now *more r equal" than in the past, it is still the dominant currency and is likely to remain so for some time. So long as this is the case, it is hard to imagine that the rest of the world will permit us to adjust our rate on the same terms as, say, the Belgian franc or the pound sterling. Yet so long as we do not have the same "rights1 with respect to exchange rate 1 changes, itfs hard to see how we can be expected to accept the same responsibilities on convertibility. DOLLAR CONVERTIBILITY Which brings us right up against the tough issue of dollar converti bility. Again, it’s useful to distinguish the different senses in which this term is used. Dollar convertibility, meaning interchangeability into other currencies, exists now and for the most part has existed throughout the difficult transition period through which we have been passing. (The main qualification is the reduced useability of the dollar resulting from restrictions, both U. S. and foreign, on certain types of exchange trans actions or investment outlets imposed in an effort to limit foreign accumulations of dollars.) Earlier this year, as expectations of a dollar reflow were washed away in a flood of new outflows, the markets began to question whether this interchangeability - at least at then-existing rates would survive. Day-to-day responsibility for defense of the newly established rates fell squarely and solely on the foreign central banks, and the question was posed as to how many more inconvertible dollars they were prepared to swallow. In these circumstances, a number of people argued that the United States had a responsibility to take some initiative in defense of the new - 9 - rates. This issue is still very much under debate within the Administration. Convertibility into Gold and Reserve Assets Dollar convertibility in the pre-August sense, of course, usually implied ultimate convertibility into gold, and far as thatfs concerned, I f afraid we can only speak of the golden past. m tion of convertibility into gold as such. I see no chance of resump The more meaningful question is when, and under what conditions, the dollar should again become convertible into reserve assets generally. You111 note that I didn't say "whether convertibility” , for in a world of more or less fixed parities, I can see no rationale for the dollar remaining inconvertible indefinitely. Convertibility - the Implications 1. But agreeing to the principle of convertibility doesn't take us very far in the real world. The crux of the matter lies in the terms and conditions, a couple of which I've already alluded to. In the first place, we have to have more assurance than we can possibly have at present that the exchange rate relationships agreed to in Washington will in fact bring the U. S. balance of payments back into equilibrium. The science of economic forecasting is hazardous at best, and predicting the results of changes in parities is particularly uncertain. Only time and experience can give us sufficient assurance that U. S. payments equilibrium is in fact a reasonable prospect - without it, convertibility would be a fraud. 2. countries. Symmetry: Dollar vs. other currencies; Surplus vs. Deficit Related to this point is the need for some mechanism that will either permit the United States more easily to change its rate in relation to other currencies, or provide sufficient pressure on surplus countries to induce needed revaluations. Substituting SDR's for gold as the yardstick - 10 - by which the values of all currencies are defined should ease the cosmetics, and hence the politics, of any future changes in dollar parity. But this will do nothing to reduce the f first among equals1 position of the dollar ! 1 that will probably continue to hamper any willingness by the rest of the world to accept a change in dollar parity. This particular bias against the dollar would not be particularly troublesome if a way could be found to provide for symmetry as between surplus and deficit countries. But again I am not very optimistic that major countries will be any more prepared to have the IMF play a strong role in signaling the need for upward rate changes in the future than they have been in the past. As in other areas, some modus operand! may be worked out to overcome these natural biases inherent in the system, but until it is - and no solu tion is immediately apparent - moving to make the dollar convertible would involve risks. 3. The f Overhang™. Then, there is the sticky question of what to y do about the nearly $50 billion already in foreign official hands as a result of past U. S. deficits. As a practical matter, I cannot picture U. S. officials agreeing to any plan that contemplated an amortization schedule for the repayment of these balances. But nor can I imagine any repudiation of responsibility for these balances either. As a sort of middle ground, some have suggested a special "consolidation" issue of SDR!s - a funding into a fiduciary issue without a repayment schedule. But this strikes me as equally difficult to negotiate, primarily because it would appear to be a special concession to the U. S. - U - Faced with these many unacceptable alternatives, I see little choice but to wait until a better balance is achieved between U. S. assets and liabilities, either through a rebuilding of U. S. reserves (through surpluses or regular SDR allocations) or through reductions in liabilities (through basic surpluses or reflows of dollars). 4. The Link between Financial and Trade Arrangements. Finally, there is the very practical question of whether the U. S. should agree to convertibility of the dollar without assurance of progress toward what Administration officials refer to as "fair trading practices.1 Should the 1 U. S. be satisfied, in other words, with arrangements that promised overall equilibrium, but were silent on the composition of the U. S. balance of payments. In the real world, I suspect that most countries, including the U. S., do care about structure - export surpluses, non-discrimination on certain categories of trade, etc. - and that this concern goes far beyond a crude mercantilist approach to economic life. For the United States, for example, the ability to finance aid to Less Developed Countries depends in large measure on our having a current account surplus. Similarly, military burden sharing is something about which we feel strongly, quite apart from balance of payments equilibrium. Thus, I find it quite understandable that the Administration seeks to associate discussions of trade and financial matters, even though this probably implies slower progress toward converti bility. The more troublesome question with respect to trade discussions is whether dismantling of restrictions, however desirable, isn’t going to be as painful for some vested U. S. interests as it is for foreign countries, once all the areas for discussion are out on the table. - 12 - FUTURE RESERVE ASSETS If agreements on exchange rate mechanisms and convertibility are high on the agenda of unfinished business, so too is the question of the nature of future reserve assets. Here, though, I believe a consensus is much closer, and I largely subscribe to the conventional wisdom. There is little doubt in my mind that SDRfs, perhaps somewhat modified, should be the source of future additions to reserves, and hence will fairly soon become the dominant reserve asset. In one sense, it seems a bit odd to describe this view as "conventional wisdom” , since agreement on the creation and issuance of SDR's is so recent. Yet the implications were clear enough: if SDR’s worked, there would no longer be any need for additional gold - or dollars to provide reserve growth. The only question was whether SDR's would work. That question has now been answered in the affirmative, at least to ray satisfaction. If ve already indicated my belief that the role of gold as a monetary metal will continue to diminish, and I accept the diminishing role of the dollar as an international currency as well. The awkward question is whether one takes the logic of this position to its ultimate conclusion and tries to prevent countries from accumulating dollars by requiring periodic encashments into reserve assets. I frankly think that any effort on the part of a few countries or the IMF to push this extreme view would seriously delay agreement on other matters. Indeed, I question whether such a system wouldn't be so fragile, particularly in the absence of strict controls on short-term capital movements, as to represent a step backward in attempts to create a more flexible international financial system. - 13 - One side point that arises in connection with reserve creation through SDR's is whether there should be a link to development assistance through direct allocations primarily to less developed countries. The issue involved is perhaps more easily understood by putting the question in terms of domestic institutions: should the central bank create reserves for the banking system, and hence determine the money supply, by buying the obligations of, say, a regional development bank? The danger, of course, is that political pressures to increase the financing of develop ment efforts may influence inappropriately the decisions of the central bank on the need for monetary growth. Perhaps I am unduly influenced by the gingerly way in which the Federal Reserve has approached the question of purchases of agency issues - which raised some of the same questions but my own view is that, given the many other hurdles that must be cleared in the next couple of years in restructuring the international financial system, the issue of the aid link had best be kept off the agenda at this time. CONCLUSION This survey of some of the issues that must be resolved before we can claim to have revamped Bretton Woods is daunting, even while being incomplete. In the pursuit of the common goal of international monetary reform, I'm not sure that it advances the cause to search for differences of approach within the U. S. administration, amusing though this game may be. For what it is worth, my own impression is that there was really very little difference between the basic positions set forth by Dr. Burns and Treasury Undersecretary Volcker in Montreal last May. It's true that - 14 - their approaches differed: the Chairman emphasized the broad principles that he would expect to find in a new monetary system; Volcker on the other hand, stressed the difficult practical problems that would have to be overcome in reconciling conflicting national interests, agreeing on a set of mutually consistent principles, and finding workable mechanisms to implement those principles once agreed. Similarly, while the Chairman emphasized the necessity to start the rebuilding process promptly, Volcker made it clear that one should not expect that process to be easy or short. Because important national interests are at stake, not just for the U. S., but for the rest of the world; because mens1 conception of reality changes more slowly than reality itself; because we are engaged in building a system that should serve us in changing circumstances for at least another quarter century; and because a false start could be as disillusioning as the British rush to convertibility in 1947, but with far wider repercussions - for all these reasons, we should not expect progress on international monetary reform to be easy or rapid. But because the most important asset along the way will be the good will and continued cooperation of the world’s trading nations, we should get started.
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