The Evolution of the Exchange Rate from "Sacrosanct" Parity to Flexible Monetary Policy Instrument

The Evolution of the Exchange Rate from "Sacrosanct" Parity to Flexible Monetary Policy Instrument (1)

Otmar Emminger, German Yearbook on Business History 1987, pp.1-16

1. The Three Evolutionary Phases of the Exchange Rate System After the War

Deutsche Bundesbank's refusal to continue supporting the dollar at a fixed rate

after the dollar nose-dived on March 1, 1973 triggered off an avalanche in the

international monetary landscape. It resulted in the collapse of the Bretton-

Woods-system of fixed parities and in the introduction of the mixed system of free floating and the European "snake".

Even if the dollar crisis of spring 1973 had been resolved in some other way,

sooner or later the system of fixed parities would have had to capitulate in the face of other world economic shocks, e.g. the oil shock at the end of 1973 and its

repercussions on the international balance of payments structure and inflation. No less a figure than the Managing Director of the International Monetary Fund, Mr. J. Witteveen, attested to this when in a programmatic address held in London in January 1974 he declared: "Given the new circumstances, a considerable measure of floating is not only unavoidable but even desirable".

The evolution of the exchange rate system over the last 40 years can be broken

down into three phases. In the first phase after the Second World War, currency

parities were still regarded as almost taboo or "sacrosanct", more so than would

have been necessary or advisable under the Bretton-Woods-system. This was

followed, particularly under the pressure of the currency tensions and crises of the sixties and the initial years of the seventies, by a period of ad hoc parity adjustments which were always overdue and often inadequate. This phase was, in turn, replaced in 1973 by the new system of group floating against the dollar which, on the one hand, meant flexibility versus a number of major currencies and, on the other, a system of fixed but adjustable parities within a regional group in Europe. This mixed system has, in turn, undergone several evolutionary phases since 1973.

All this was of such decisive importance for both the world economy and

German stability policy that it justifies a brief review of the entire postwar period.

One motivating factor for me here is the fact that I lived through all these

developments and changes since 1949, often playing an active role. Besides, it is my impression that the essence of, and the reasons behind, the present mixed system of free floating and a regional monetary system can only be understood properly if its emergence is shown in greater detail.

2. Exchange Rate Parity as "Taboo" - a Look to the Distant Past

In looking back to the evolution of the exchange rate system, I should like to go

back to the pre-war period because of my personal experiences. I was probably one of the first people in Germany to show an active interest in the phenomenon of floating. My doctoral thesis, the bulk of which was conceived during my stay in England in 1932/33, was entitled "Discount policy or currency-floating as a means of squaring payments balances". In it, I treated both the abortive sterling

revaluation of 1925 and England's abandonment of the gold standard as well as its transition to floating in September 1931. My assessment of this transition to

floating was on the whole positive. In the main, I saw in it an effective defensive

measure against the deflationist tendencies emanating at the time predominantly

from the U.S.A. (2)

The section of my doctoral thesis published in the "Weltwirtschaftliches

Archiv" caused a fair bit of commotion at the time. It was discussed in seminars at various universities. Immediately after its publication, I received an invitation

from Ministerialdirektor Lautenbach, the acknowledged currency expert, to a

lengthy discussion with him and his staff at the Reich Economics Ministry.

Lautenbach was very much taken by my pladoyer for exchange rate adjustment

and greater exchange rate flexibility, but he could not prevail over Schacht. The

publication of my thesis also resulted in an invitation to join the international

section of the Berlin Institute for Business Research, which I did in spring of 1935.

In 1936, the President of the Institute, Professor Wagemann, instructed me to write an opinion opposing the then prevailing 'Schacht' system. This consisted of a vastly overvalued official Reichsmark rate, but de facto of a number of different

exchange rates (types of blocked Marks etc.) which varied depending on the type of transaction and often on the country involved, the whole thing coupled with

numerous payments and trading restrictions. The Reichsmark had been the sole

currency to maintain gold parity, even when the dollar was devalued by roughly

40% at the beginning of 1934. By 1937, the Reichsmark was overvalued by no less than 51 % compared with the average of other major currencies.

At the time, I proposed a strong devaluation of the official Reichsmark parity (I also estimated how much it would have to be devalued) and the abolition of the many exchange rates. I do not believe that my opinion ever reached the addressee Wagemann had in mind, the then President of the Reichsbank Hjalmar Schacht; but, in view of the well-known attitude not only of Schacht but of practically the entire Reichsbank, it probably would not have achieved much even if it had. I should like to add here that I met with Schacht on several occasions in the fifties and on one occasion crossed swords with him in front of a larger circle when he criticized the central bank's monetary policy with a highly impertinent line of argument (something he also did in a number of articles in obscure publications). The main reason for Schacht's fury at the Bank deutscher Lander and later the Bundesbank was our decision from the outset never to publish comments made by him (as one of the men behind Hitler) in our press extracts. (3) Nor could he ever understand how it was that we had such high foreign exchange surpluses while he, as head of the Reichsbank, was always facing the trauma of a lack of foreign exchange.

Some of today's economic historians share the view - rightly or wrongly - that

Bruning and Luther had no other course of action open to them in 1931 and 1932, above all because of the conditions imposed on Germany in the Young Plan, other than to stick to the excessively high Reichsmark parity and to pursue a

corresponding deflation policy. In my view, these conditions did not justify the

disastrous policy adopted at the time. Besides, it certainly did not apply to Schacht, who took over the helm of the Reichsbank in 1933. (4)

I should like to show just how deeply rooted the ideological dogma of exchange

rate immutability was with the help of another example. From 1930 to 1932 there was a triumvirate of experts in Berlin known to be the main ideological supports for Bruning and Luther's deflation course, namely Gustav Stolper, Moritz Julius Bonn and Melchior Palyi. Bonn emigrated to England in 1933, Stolper and Palyi to America (where Palyi later became professor in Chicago). Both Bonn and Palyi visited us on several occasions in the fifties at the Bundesbank or Bank deutscher Lander, as it was then called. Both still shared the view that Bruning and Luther's politically disastrous deflation policy was the only correct one. A quotation from an opinion Professor Palyi wrote for the Institut für Bankwirtschaft und Bankrecht in Cologne in 1961 will perhaps provide an impression of the way both regarded the fixed parity as sacrosanct. At one point he writes: "Before the era of the World Wars ... economists, irrespective of their school of thought, were unanimous that the fixed parity vis-a-vis gold was valid for all time ... even the 'Staatliche Theorie des Geldes' by G. F. Knapp (1905), the standard work of the anti-metallists (opponents of the gold standard) culminated in the sentence that 'a fixed exchange rate was the ultimate goal of monetary policy' .... To throw overboard a principle accepted by all noteworthy economists of the last centuries denotes a lack of scientific tradition".

Professor Bonn had a similar attitude towards currency parity. So it is little wonder that in a speech we organized for him in Frankfurt he condemned England's abandonment of the gold standard in 1931 most categorically as a great mistake. That contrasts most sharply with the assessment in my doctoral thesis published in 1934 where - among other things - I wrote: "The point of the English experiment in 1931 was to avoid the compulsion to deflate .... The

whole difference between England and America during the crisis was in a nutshell that America was an active deflation site, while England was compelled to deflate from without .... Certainly, the success would have been more secure and greater, had England distanced itself from the deflation of the gold countries earlier, say at the end of 1930 .... At any event, the payments balance crisis was solved by this step, the independence of English credit policy restored" etc.

Although I considered England's transition to floating in 1931 as the right

decision under the given circumstances, and although I was in the thirties one of the small circle of younger economists who criticized the enormous overvaluation of the Reichsmark, I was not one of the dogmatists who regarded floating at any price and in every situation as the sole valid panacea. On the contrary, I was always a pragmatist in external monetary policy. In the postwar period I, of course, followed the academic discussion on flexible exchange rates very closely from the outset, from Professor Milton Friedman to the well-known German proponent of floating, Professor Egon Sohmen. In the sixties we invited Professor Sohmen, who was then teaching in Heidelberg, to discussions at the Bundesbank on various occasions.

3. Exchange Rate Adjustments on an Ad Hoc Basis (1961-1973)

In the fifties and sixties I did not speak out in favour of floating the D-Mark, except that at the end of 1956 in an internal paper on a possible D-Mark revaluation one option I did propose was to greatly increase the fluctuation band and to allow the D-Mark to float up to a possible upper limit. But at the time it still looked as though the inflation differential which kept opening up between the Federal Republic and other major European countries could be compensated by ad hoc parity adjustments, thus safeguarding the external stability of the D-Mark. From 1956 I pleaded passionately on several occasions for timely adjustment of the D-Mark exchange rate. I can probably say that I was one of the first monetary pragmatists to defend the view that our stability policy would only have a chance in the long run if it was protected on the external flank. At the end of 1956 my ideas on a possible D-Mark revaluation were thrown out by the central bank directorate by seven votes to one (mine).

I simply accepted it as inevitable that my 1956/57 proposals were doomed to

failure with the central bank president at the time, Vocke. Vocke used to hold

marvellous speeches against inflation, but he was incapable of comprehending this new external threat to the stability of the D-Mark. He was too greatly influenced by his pre-war experience characterized by the trauma of a constant shortage of foreign exchange while we, since the mid-fifties, had been suffering from an undesired influx of foreign exchange. To the end he denied the very existence of a currency dilemma as the result of our stability policy in the midst of an inflation-stricken Europe. Towards the end of his term, he frequently repeated - the last time in a speech in May 1957 - the contradictory statement: "We do not want to revalue the D-Mark, nor do we want to adopt the inflationary line taken by some other countries". He simply could not accept that the creeping inflation of the early sixties was the very result of the long delay in revaluing. He revealed just how entrenched he was in his pre-war ideology in a 1972 essay in which he made a passionate plea - as a cure for the currency dilemma - for a general return to gold convertibility, proposing a large international "gold bond" issue to the U.S.A. (a bond issued in real gold!). (5) Vocke resented my early lobbying for a D-Mark revaluation and other clashes to the end of his life (which bothered me little).

A source of true regret, however, was that between 1959 and 1961 I also had

differences of opinion on the exchange rate question with the revered and very

likable president Blessing. He, together with a majority of votes on the central bank council, over which he had great influence, was responsible for the D-Mark

revaluation which would have been due at the beginning of 1960 at the latest to

avert imported inflation being postponed to March 1961. The Bonn Government

was divided, and the view adopted by the Bundesbank often tipped the scales.

Two convictions determined Blessing's negative stance: on the one hand, he had firmly believed - not least under the influence of Per Jacobsson, at the time Managing Director of the IMF - that the inflationary danger had been overcome in the world economy and that a new era of stability had dawned, with the result that an inflationary danger from without no longer existed. On the other hand, he had, like Vocke, taken over from his pre-war activity at the Reichsbank the ideological belief of the inviolability of the exchange rate parity into the postwar period. At the press conference held on March 5, 1961 to mark the announcement of the delayed and insufficient 5% revaluation of the D-Mark, Blessing said: "The Bundesbank has long resisted an exchange rate adjustment. For any central bank, currency parity is simply sacrosanct and may only be changed when all other means have failed".

The postponement of the revaluation was one reason for the inflationary wage-

cost spiral the Federal Republic found itself in from 1960 to 1962 and which was

difficult to get under control again. Some critics of the 1961 D-Mark revaluation

pointed out ironically afterwards that the inflation rate after the revaluation was

for a time higher than before the revaluation, and from that they deduced the

inefficacity of using the exchange rate to protect the external flank. These critics

included Vocke, Abs, Klasen, Strauss and others. Apart from the fact that the 5%

revaluation in March 1961 was naturally totally inadequate, these critics overlooked above all the fact that, once under way, wage inflation was a phenomenon that could continue for years, particularly if monetary policy was fettered by the exchange rate.

Blessing and I were very close friends, so I know how difficult it was for him in

February 1961 to come around to the D-Mark revaluation; at the time, he had even openly toyed with the idea of resigning. All the more credit to him then that he learned the right lesson from the experience in 1960/61, and that in autumn 1968, when domestic stability was again being threatened from without, he immediately and with all his energy joined the camp of those in favour of a quick D-Mark revaluation and that he advocated this viewpoint in the face of criticism from the Federal Government. In 1960/61, Blessing had long hesitated before agreeing to a 5% change in the D-Mark parity, but in October 1969 in a speech on the occasion of the 300th meeting of the central bank council he said: "I hope that in future exchange rates will no longer be treated like sacred cows .... After 12 years I have come to the conclusion that if we wish to maintain some degree of stability in our own house, we must adjust exchange rates from time to time, or we shall have to join the rest of the world on the inflationary roller coaster".

Moreover, in the period prior to the transition to floating, I myself often had to

face the problem that I had to deny any intention of a change in the D-Mark rate-

often very much against my own convictions and intentions - to avoid greater

damage that would have been caused by the inflow of undesirable speculative

money.

But there were also occasions when I spoke out publicly against exchange rate

adjustments and more flexible exchange rates, not out of consideration for any

tense monetary situation but because the situation did not demand any parity

measure. This was, for example, the case when in its first annual report at the end of 1964 and in the ensuing period the "Board of Experts for the Assessment of Overall Economic Trends" spoke out in favour of somewhat more flexible exchange rates, underpinning this view with an attached opinion by Professors F. A. Lutz and E. Sohmen. I rejected these and similar proposals at the time in interviews and lectures. I cited the usual counterarguments, not least of which being that we should not unduly hamper the cooperation that was just getting under way on the currency front within the European Community. But for me a much. more important reason was that in those years there was exceptionally no necessity to protect the foreign trade and payments side via parity measures. From mid-1964 to mid-1966 we had, for the time, a high current account deficit (over DM 9 bn.) which was also not fully offset by capital inflows, with the result that the overall balance was in deficit and that there had to be a net outflow of foreign exchange.

Our import prices fell by 3 % between mid-1965 and mid-1968. All this meant that this was one of the few longer periods prior to the transition to floating in 1973 when Bundesbank monetary policy was free of the nightmare of imported

inflation. At the beginning of 1965 we then also stated in our annual report for 1964 (page 23) that imported inflation was over, at least for the time being. So the proposals of the Board of Experts and the other professors were wide of the mark and outdated.

My stance on the D-Mark parity at the time did not, however, mean that I now

regarded fixed parities as taboo. I was always clear on the fact that there would

always be situations where the exchange rate would have to be adjusted in as

flexible a way as possible.

Even at the time when we remained pretty well untroubled by the dilemma

between the fixed exchange rate and domestic monetary stability, my support of

the system of fixed exchange rates, above all against the dollar, was only

conditional. I stated as much in the mid-sixties in several speeches and essays. I did so in very basic terms in a paper I delivered at the annual meeting of the Verein fur Socialpolitik in September 1964. (6) In it, I outlined that a system of fixed but adjustable exchange rates could only work if

- "through its domestic stability, i.e. monetary and economic stability, the key

currency country makes it easier for the other member countries to maintain

fixed parities without causing too great tensions with respect to their own

domestic stability;

- any possible tensions between fixed exchange rates and domestic economic

objectives are lessened successfully through close cooperation and common

rules for balance of payments policy;

- adequate (but again not excessive) elasticity in the financial bridging of

temporary imbalances is ensured, whereby of course abuses of such elasticity

must also be prevented".

These key statements, dating from 1964, do not yet, of course, contain the

reservation indispensable on the basis of later experience that vis-a.-vis the dollar erratic capital movements can be a particularly disruptive element in a class of their own, making fixed rates impossible.

4. Change in the Nature of Currency Crises

Up to and including 1968, the currency crises we had to face were caused mainly by European tensions. This is particularly true of the sterling and franc crises in the sixties. The last step in this European theatre of crises was the D-Mark crisis in September/October 1969. It was in the main a crisis of omission. What had been left undone in November 1968, despite the strong urging of the Bundesbank, now had to be done by means of a more general and stronger D-Mark revaluation. But the D-Mark crisis of October 1969, unlike that of November 1968, was no longer an entirely European crisis. Dollar tensions now also played a role, primarily as a result of disruptive short-term capital movements between the D-Mark and the dollar in both directions. From the end of 1969 there was then a fundamental change in the nature of currency crises in two aspects:

- Firstly, the dollar replaced inner-European currency tensions as the main crisis

factor.

- Secondly, destabilizing capital movements now came to the fore as the cause of

the crisis, relegating price and demand differentials to the second rank.

The Bretton-Woods Agreement had not been very kind towards capital movements. When payments business was liberalized, it was to come after goods and services business. Now the tables almost seemed to be turned. Today, there is at times the danger that the capital flows triggered off by distorted interest rate relations or other disruptions will distort payments balances and exchange rates to such an extent that goods and services business must suffer. Capital movements have not only become a driving force for the world economy since the seventies, but also a potential disruptive factor of the first order. At any rate, the superiority of international capital movements over goods and services has radically changed the nature of our currency system.

It was not by chance that from the beginning of the seventies the interest rate

differential and speculative financial flows increasingly dominated the monetary

policy stage. It was at the beginning of the seventies that international financial

flows and the mutual interdependence of the financial markets increased

enormously, with the dollar at the centre of attention. The continuing liberalization of international capital flows as well as the greater mobility of capital as a result of modern communications technology were instrumental in the increasing importance of capital movements.

Naturally, loss of confidence in the dollar, which had repeatedly resulted in

destabilizing capital movements from the end of the sixties, was not uninfluenced

by the deterioration in the U.S. trade and current account balances, particularly in 1971 and 1972; confidence in the dollar was also undermined by lax U.S. budgetary policy and burgeoning inflation - in part a consequence of the Vietnam War. But if we look at the orders of magnitude for the crisis period from 1970 to spring 1973, the U.S. current account deficits were more than overshadowed by the disequilibria in the U.S. balance on capital account. Over these 3 1/ 4 years in question, the U.S. foreign exchange balance (official reserve transactions) showed a deficit of roughly $ 62 bn. The current and capital accounts made up roughly $ 25 bn. of this total, the rest was short-term capital movements (including unclassifiable residual items).

The situation elsewhere was even more one-sided. From 1969 at the latest, the D-Mark had - most unwillingly - become the main counterpart to the dollar. Of the huge foreign exchange surpluses from the beginning of 1970 to March 1973 (DM 74 bn.), only one-seventh (DM 10.7 bn.) came from surpluses on the German current account, the other six-sevenths from monetary and capital inflows due to interest rates and confidence; and that despite the fact that out of pure desperation the German side had in those years repeatedly tried to stem capital inflows through administrative or price restrictions (including cash deposits). The extent to which the world was inundated with dollars at the time can be seen at least approximately from the inflation of global foreign exchange reserves. Between the beginning of 1970 and March 1973 they trebled from $ 33 bn. to $ 103 bn.

This meant that aggregate currency reserves almost doubled. In the same period, the foreign exchange reserves of Deutsche Bundesbank climbed more than sixfold (from DM 11.7 bn. to DM 73.4 bn.), which resulted in overall reserves more than trebling.

The change in the nature of currency risks from the sixties to the seventies was

recognized early on. I myself said in an interview (7) in November 1969, i.e. shortly after the overdue D-Mark revaluation of October 1969 that, with the sterling, franc and D-Mark parity adjustments behind us, we were now facing a dollar problem which would impose a strain on the world monetary system in future.

In this context, I of course cited in the main the deficit on the U.S. "basic balance", the deficit on current account, plus the balance of longer-term capital movements. It was only in 1970/71 that it became apparent what huge disruptive potential was also harboured in the to and fro of all types of short-term funds (vagrant dollars). I repeatedly drew attention to this in lectures and essays.

In one lecture delivered to an Italian banking conference in June 1971 entitled

"Short-Term Capital Movements as the Cause of Crisis" (8) I said: "Whether we like it or not, we need greater exchange rate flexibility for our own protection. A broader exchange rate fluctuation band will not be of much help in such cases .... For special emergencies, the International Monetary Fund should therefore under all  circumstances be given the possibility of permitting a country whose monetary situation is seriously threatened to let its exchange rate float".

5. Greater Exchange Rate Flexibility Becomes International Topic

The currency crises of 1967 to 1969 had demonstrated how ad hoc adjustments of individual parities encountered political and psychological barriers, and how large the damage could be if adjustment were postponed. These new insights resulted in ever greater discussion worldwide of how to improve the monetary system through greater exchange rate flexibility. Nor was such discussion merely limited to academic circles anymore. From 1969 at the latest, the IMF, the EEC and the OECD also tackled the problems connected with greater flexibility of the exchange rate system. As a rule, consideration was given to extensively widening the fluctuation band around a fixed parity and to promoting timely parity adjustments by relaxing the rules or even by introducing a system of continuous minor adjustments ("sliding parities").

I myself was involved in such deliberations, but not only on various official and

unofficial international bodies of which I was a member. Our own experience in

Germany in November 1968 and May 1969 had made it clear to me just how much timely adjustment had been prevented by political and ideological prejudice as well as by lobby groups, so I made a number of sallies in favour of greater exchange rate flexibility in Germany too. Even though my proposals did not yet advocate freely floating exchange rates but merely that the IMF should grant a country greater flexibility in special cases, in Germany I was nevertheless regarded more and more often as a pioneer of exchange rate flexibility. (9)

I went one step further in an interview I gave the Handelsblatt in September

1970. I predicted, not at once but in a not-too-distant future: "We shall decouple

from the dollar, and if possible together with other EC currencies". The first

practical opportunity to do so would have been the dollar crisis in May 1971. The

block float Minister Schiller and I wanted to introduce against the dollar did not,

however, materialize because France and Italy could not be convinced to join in.

This was half a defeat for me, too, as in May 1971 I had - in opposition to Klasen's

view and the majority of the central bank council- been an energetic proponent of

block floating. The May 1971 crisis also provided an object lesson that floating

made it possible to bridge a fairly long period, namely in this case May to

December 1971, and even to withstand the "Nixon shock" of August 1971

relatively unscathed. During this period of floating we were able to get rid of

several billion dollars we had previously been compelled to take up through

intervention, whereas those countries which in the summer of 1971 initially

maintained their fixed parity against the dollar (e.g. Japan and France) had to take up substantial dollar amounts at excessively high rates.

The Washington exchange rate realignment of December 1971 did not, as

Nixon had claimed at the time, turn out to be a lasting monument but merely an

intermediate stage on the way to floating the dollar. Britain threw in the towel as

early as June 1972 and let the pound float downwards - and since then it has been floating in isolation to this very day.

When in spring 1972 I saw that the December 1971 realignment kept running

aground because of a lack of U.S. cooperation and that the only way we could

maintain it was by instigating a monetary policy geared one-sidedly to the

payments balance in conjunction with renewed capital import restrictions, it

became pretty clear to me that sooner rather than later the switch to floating

against the dollar would have to come.

I had an interesting and amusing experience around that time during a meeting

with the later Nobel Prize winner Milton Friedman. We were both members of a

panel discussion at an international banking conference in Montreal in May 1972.

During the panel discussion there were no noteworthy points on which we

disagreed. During the ensuing press conference Professor Friedman was asked by a reporter: "Professor Friedman, you have been in favour of a general floating of currencies for some time now. When do you think it will come about?". Friedman replied: "It will probably never come about for one simple reason. It would put the world's central banks out of business. Fixed exchange rates always result in renewed currency crises and crisis meetings where central bank chiefs can make themselves important and show off'. Just under a year later, it was none other than some central banks - specifically the Swiss and German - which gave the impulse to floating (and block floating). By chance, or perhaps not by chance, it was in both cases the deputy chairmen then in office - Leutwiler in Switzerland and myself in the Federal Republic - who in February and March 1973 took the decisive step.

The end of the fixed-rate system was heralded in by the Bundesbank ceasing to buy dollars, thus forcing the Council of Ministers of the EEC to resort to block floating against the dollar. To describe the details of this dramatic development would go beyond the scope of this paper. The result was that we decoupled ourselves from the international inflation convoy - a revolutionary step for our stability policy.

6. The Long Road to the Legalization of Floating

It took quite some time for the new system of floating to be finally accepted and

legalized, namely until January 1976. (10) When we sounded the alarm on March 1, 1973 by no longer buying dollars at the fixed rate and when, ten days later, at

German insistence the EC Council of Ministers passed its resolution to block float with the majority of members against the dollar, many thought that it was only a transitional phase, a temporary emergency solution. The reason was that, at the time discussion on the future exchange rate system was in full swing in the IMF's reform group, the so-called Committee of Twenty, and they were not yet considering a longer-term transition to floating.

On March 23, 1973, I had to report to the Group of Deputies (11) of the reform

committee on the preceding monetary crisis and our transition to floating. I

emphasized that destabilizing capital movements had been the villain of the piece, and that the massive influx of foreign exchange into the D-Mark (within four weeks over $ 7.6 bn., i.e. almost DM 24 bn.) had virtually nothing to do with a German current account surplus. I also stated that interest rate differentials had been of scant significance, since at the height of the crisis penal interest had even had to be paid on short-term D-Mark deposits. I came to the conclusion that as long as the combination of a weak dollar and huge liquid dollar holdings persisted, greater exchange rate flexibility would probably be unavoidable, not only temporarily but also over the longer term. This was not contested, but too little notice was taken of it in the committee's further deliberations. To begin with, even the Committee of Twenty treated the dollar/D-Mark crisis of spring 1973 as a gust of wind, which - although strong - would nevertheless die down. The preferred formula for the future reformed system which was accepted by the ministers and central bank governors at the end of March 1973 was as follows: "The exchange rate system should remain based on stable but adjustable par values. It was also recognized that floating rates could provide a useful technique in particular situations".

There were signs as early as late autumn 1973 that the work of the reform

committee would come to a dead end on all major points. The centrepiece of the

reform, "fixed but adjustable parities", had been slipping further and further away since March 1973. This became even clearer when towards the end of 1973 the first oil crisis erupted. Then - as already mentioned - even the Managing Director of the IMF stated that under the new circumstances extensive floating was not only unavoidable, but even desirable. But other parts of the planned general reform had also been too ambitious or far fetched from the outset. Even under more favourable conditions it would have been almost impossible to implement them.

All these theoretical projects never left the drawing board; in the end, the reality of the inevitability of exchange rate flexibility caught up on and overtook them.

What remained was a small piecemeal programme including, for example, the

appointment of the Interim Committee of the IMF as ministerial advisory and

steering group. Or the guidelines promulgated in the summer of 1974 on how to

deal with floating exchange rates. Some of these were taken over into the revised

IMF Articles of Agreement.

The Reform Committee of the IMF was dissolved after presentation of its last

report in June 1974. But that by no means saw an end to discussion of the future

world monetary system, because the system of extensive floating had not yet been accepted by everyone as being final. Even the Germans and the Americans, who had almost always adopted the same position on the exchange rate question since March 1973, still disagreed on the nuances. One example of this is the discussion which took place at an international banking conference in Williamsburg in July 1974. (12)

In my address (13) , I had stated that floating, or at least much greater exchange

rate flexibility, would probably remain the dominant element in any exchange rate system for the foreseeable future. This address was my farewell to the Reform Committee of the IMF (which was in the process of being dissolved). My friend Paul Volcker stated at a press conference at the same meeting that he was "more optimistic than Dr. Emminger about the possibility of making progress towards the stated aim of the reform, namely to fixed but adjustable parities", and perhaps even of achieving a certain degree of convertibility of major currencies into reserve assets, particularly special drawing rights. Certainly, that would not be possible without a reduction in global inflation and "sensible inner stability" in the major countries. Even Jeremy Morse, Chairman of the Group of Deputies of the Committee of Twenty, still fostered certain illusions about monetary reform.

At the same conference he said: "If world inflation abates and the oil price problem is gradually resolved, we can then achieve a measure of cooperative control over floating from which we could then advance to stable but adjustable parities".

Nor did the completion of the work of the Committee of Twenty put an end to

the differences of opinion on the future exchange rate system. Discussions

continued in the various bodies, because the Articles of Agreement of the

International Monetary Fund still had to be adapted to the new situation. In the

process, the situation escalated to seemingly irreconcilable differences between the American and French viewpoints. The Americans wanted an exchange rate system which was as liberal as possible. The new U.S. Treasury Secretary, William Simon, was an out and out advocate of free exchange rates. The French, on the other hand, insisted on a gradual return to a system of fixed but adjustable parities, at least as the ultimate goal. Their view at the time was that the European "snake" should only be a transition to a general system of parities. But the future treatment of gold within the IMF was also a source of long-running disagreements with the French.

7. Rambouillet Summit and Jamaica Conference

In summer 1975, it was finally decided to tackle both questions at the conference of the Interim Committee of the IMF planned for January 1976 in Jamaica. The aim was to achieve final agreement on the long overdue revision of the IMF Articles of Agreement. We had endless discussions on this, be it in the Monetary Committee of the EC or in the OECD or at the IMF. Again and again, the American and French viewpoints clashed irreconcilably. Some compared the inflexible stance of the French to the "Maginot Doctrine".

I had the opportunity to get the difficult decision-making process really rolling.

At the beginning of November 1975 I was chairing a meeting of the Monetary

Committee (Working Group III) of the OECD in Paris. (14) I had established the firm tradition that during the meeting the delegation heads would get together for an intimate dinner to discuss all pressing problems as freely and as openly as possible.

At this dinner I deliberately played "agent provocateur" by raising the question of how we were going to handle the impending problems at the upcoming IMF

conference in Jamaica if an end could not be put to the irreconcilable differences

that still existed between the Americans and the French. I concluded by saying: "If the two of you cannot agree on a joint course of action soon, then there is

absolutely no point in our going to Jamaica simply to hear the same old song

again". I added: "If, however, the two of you were to reach a compromise, then we promise you that we will also adopt that compromise as the basis for further

action". This plea, which found the support of other members, had astonishing

results. The two committee members involved, Jacques de Larosiere, at the time

Directeur du Tresor at the French Ministry of Finance, and the American,

Ed Yeo III, at the time Under-Secretary for monetary questions at the U.S. Trea-

sury, then decided to meet as often and for as long as it took in the coming weeks to hammer out an agreement. After several bilateral talks they finally agreed on a joint memorandum ("Memorandum of Understanding") on November 15, 1975.

The Franco-American agreement came just in time for the beginning of the

summit conference held in Rambouillet from November 15 to 17, 1975. This

summit had been agreed on at the invitation of French President Giscard d'Estaing at the end of August 1975. However, the assertion (15) sometimes made that the Rambouillet summit was convened only or mainly to settle unresolved exchange rate questions is false. Quite the contrary. From the outset, the agenda contained a host of general questions about the economic recession at the time and how it could be overcome etc. The communique of the Rambouillet summit makes this clear. Monetary problems came 12th on a list of, in all, 17 points.

Above all, however, the monetary problems were not dealt with in any detail at

the summit. Approving notice was merely taken of the Franco-American

Memorandum of Understanding hammered out by de Larosiere and Yeo.

According to reports of those present, this is supposed to have taken less than an

hour.

In any event, the proposal remained a strictly bilateral Franco-American

document and was treated as such until final agreement was reached in December 1975. The final wording was not even available for discussion at Rambouillet. It was only worked out later by the two partners and then circulated to the other countries concerned for further deliberation. Directly after the Rambouillet summit, Yeo and de Larosiere visited the most important other countries concerned (including the Federal Republic) to acquaint them with the details of their memorandum. Understandably, some countries objected that the agreement had come about as a result of purely bilateral negotiations between the Americans and the French. But de Larosiere and Yeo said they had received a "mandate" to do so from other countries, obviously referring to our talks in Paris on the fringe of the OECD meeting.

The summit communique is also quite clear on the fact that - at least with

respect to the future exchange rate system - what was presented in Rambouillet was not an agreement reached by all concerned, but merely a Franco-American

compromise presented at the conference. Point 12 of the communique states: "We welcome the rapprochement, reached at the request of many other countries, between the views of the United States and France on the need for stability that the reform of the international monetary system must promote. This rapprochement will facilitate agreement through the IMF at the next session of the Interim Committee in Jamaica on the outstanding issues of international monetary reform". And it did so. In Jamaica, agreement was reached swiftly in January 1976 on the future Article IV of the IMF Articles of Agreement concerning the international exchange rate system. Agreement was also reached on the gold question (which had been hardly touched on at the Rambouillet summit and had not been mentioned in the communique).

What form did the Franco-American agreement take? It consisted of two parts.

The first part dealt with the principles governing the future exchange rate system, which - reformulated somewhat by the EC Monetary Committee, the Group of Ten and the IMF - were then reflected in the revised Article IV of the IMF Articles of Agreement. The main point was that every country could select its exchange rate system freely; they must, however, notify the IMF of the selection made and allow the IMF to monitor their exchange rate policy. Furthermore, Article IV of the IMF Articles of Agreement (like the Rambouillet communique) clearly states that the stability of any exchange rate system depends on the member countries pursuing a sound domestic policy. To this end, each member country was to "endeavour to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability".

That is, by the way, the standard formulation to be found to this very day in all international monetary communiques (sound, non-inflationary economic growth), like the communique of the recent economic summit in Tokyo. Finally, Article IV of the new IMF Articles of Agreement calls on the member countries to "avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members". All of this, and above all the free choice of exchange rate system, was completely in line with our German viewpoint. It also looked very much like a "victory" of the American position on the exchange rate system over the French.

In return, the Americans accommodated the French somewhat in the other

part of the agreement dealing with the measures to prevent "erratic fluctuations in exchange rates". The same Point 12 of the Rambouillet communique stated here:

"With regard to monetary problems, we affirm our intention to work for greater

stability. '" At the same time, our monetary authorities will act to counter

disorderly market conditions or erratic fluctuations in exchange rates".

Specifically, the daily consultations which already existed between the central banks concerned were to be improved, and there was to be regular consultations between the finance ministers of the major countries. This, too, was taken up eleven years later in Tokyo.

Immediately after Rambouillet the Americans and the French, as was to be

expected, gave varying interpretations of the compromise reached. It was no

different seven years later after the second summit in France, the Versailles

Conference. The French Finance Minister saw in the Franco-American agreement a three-stage plan for the establishment of fixed exchange rates; he believed that at the end of the road, "when conditions are right", the 85 % majority provided for in the agreement (and later in Article IV of the IMF Articles of Agreement) would be achieved, allowing the creation of a general system of fixed but adjustable parities.

As for intervention in the foreign exchange markets, the French hoped the

Americans would always help support the dollar, at least in the event of "erratic"

exchange rate fluctuations; the Americans were, they argued, now committed to do so, just as they were committed to constant consultation on foreign exchange

market developments (which has existed for a long time anyway between central

banks, including the Fed). The Americans, on the other hand, stressed the general freedom to select an exchange rate system; on the subject of intervention they stated their goodwill, but that the decision whether to intervene or not was theirs and theirs alone.

One aspect of some importance here was the definition of "erratic exchange rate
fluctuations" mentioned in the Franco-American agreement and in the summit

communique. This definition was understood as an extension of the expression

"disorderly markets" used until then. When at the end of November 1975 Under-

Secretary Ed Yeo III explained the Franco-American compromise to us in greater

detail, he defined "erratic" exchange rate fluctuations as "such movements for which no explanation can be found in the underlying economic situation". This is

reminiscent of a similar passage in the Agreement of the Group of Five of

September 22, 1985. Ten years later, the Americans realized that they could not

simply stand by, exercising "benign neglect", and watch the dollar deviate

substantially and persistently from the underlying economic fundamentals. In fact, they had already come very close to realizing this during the 1978/79 dollar crisis when - to use the words of an American spokesman - they went over to a "very activist definition of the fight against disorderly markets" and even wanted to win support for a sort of "target zone system" for the dollar. At the time, of course, U.S. exchange rate policy was activated to counter excessive dollar weakness. The latest bout of activity since 1985, on the other hand, was triggered off by an excessively strong dollar and its repercussions. In a nutshell: activity only in extreme situations.

Experience has taught us in the meantime that persistent upward distortions in

the dollar rate - for years welcomed by the Americans as a "strong dollar" - can

have unpleasant side effects: distortions in foreign trade structures and in the

domestic economic structure, the accumulation of high foreign debt, protectionist dangers etc. But people have now also learned that such longer-term exchange rate distortions are not simply a result of floating, but reflect in reality structural faults in the economic and financial policies of major countries. An attempt is now being made to rectify the consequences of exchange rate distortion, in particular the huge disequilibria in world trade, through greater cooperation between the leading countries and through better "compatibility" of their economic and financial policies. The exchange rate, above all that of the dollar as the key currency, has become a "signal for economic policy" to be ignored at one's peril.

Notes:

1) The present article corresponds in large parts to chapter 9 of Otmar Emminger: D-Mark, Dollar, Wiihrungskrisen. Erinnerungen eines ehemaligen Bundesbankpriisidenten, Deutsche Verlags-Anstalt GmbH, Stuttgart 1986.

2) For reasons too complex to discuss here, the theoretical part of my doctoral thesis was never published, and the manuscript was lost in the confusion of war. The practical section, my analysis of English monetary policy from 1919 to 1933, was published in two essays in the "Weltwirtschaftliches Archiv" in September and November 1934.

3) One of the ways Schacht had his revenge was to accuse the President of the Bundesbank at the time, Blessing - whom Schacht himself had recalled from the BIS in Basle to the Reichsbank in 1933 and who was considered his "right hand" for quite some time - at the end of the fifties in a most unfair way of being a Nazi sympathizer, something which - being totally unfounded - wounded Blessing deeply.

4) The other argument that official devaluation would result in a corresponding increase in the Reichsmark value of German external debt most of which was denominated in dollars was untenable, at least after the dollar devaluation in 1934.

5) Wilhelm Vocke, "Bemerkungen zur Wlihrungskrise" (Comments on the Currency Crisis), Neue ZUrcher Zeitung dated September 22, 1972.

6) Otmar Emminger, "Grundprobleme der internationalen Wahrungsordnung" (Basic Problems of the International Monetary System), address delivered at the 1964 annual meeting of the "Verein fur Socialpolitik" in Travemunde.

7) Industriekurier dated November 15, 1969.

8) Otmar Emminger, "Kurzfristige Kapitalbewegungen als Krisenursache" (Short-Term Capital Movements as the Cause of Crisis), address delivered to an Italian banking symposium at the invitation of the Italian central bank, June 1971.

9) Cr., for example, Industriekurier dated November 15, 1969, page 13: "Asked about his favourite topic, limited flexibility of exchange rates, Dr. Emminger said ... ".

10) If the day the revised IMF Articles of Agreement came into effect is taken as the date of legalization, then it took until April 1978.

11) This Group of Deputies, under the chairmanship of the Englishman Jeremy Morse (at the time still Bank of England), did the real work; meetings of the Committee of Ministers were only seldom.

12) cr. New York Times dated July 2, 1974.

13) Otmar Emminger, "The Evolving International Monetary System", June 1974.

14) I was chairman of this not unimportant OECD committee from 1969 until 1977.

15) For example, by Reiner Hellmann in VWD Finanz- und Wirtschaftsspiegel" dated May 6, 1985.