Chapter 10 Outline

The Collapse of the Fixed Exchange Rate System

The system of fixed exchange rates established at Bretton Woods worked well until the late 1960s, when it began to show signs of strain. The system finally collapsed in 1973, and since then we have had a managed-float system. To understand why the system collapsed, one must appreciate the special role of the US dollar in the system. As the only currency that could be converted into gold, and as the currency that served as the reference point for all others, the dollar occupied a central place in the system. Any pressure on the dollar to devalue could wreak havoc with the system, and that is what occurred.

Most economists trace the breakup of the fixed exchange rate system to the US macroeconomic policy package of 1965 - 1968.³ To finance both the Vietnam conflict and his welfare programs, President Johnson backed an increase in US government spending that was not financed by an increase in taxes. Instead, it was financed by an increase in the money supply, which led to a rise in price inflation from less than 4 percent in 1966 to close to 9 percent by 1968. At the same time, the rise in government spending had stimulated the economy. With more money in their pockets, people spent more--particularly on imports--and the US trade balance began to deteriorate.

The increase in inflation and the worsening of the US foreign trade position gave rise to speculation in the foreign exchange market that the dollar would be devalued. Things came to a head in the spring of 1971 when US trade figures showed that for the first time since 1945, the United States was importing more than it was exporting. This set off massive purchases of deutsche marks in the foreign exchange market by speculators who guessed that the mark would be revalued against the dollar. On a single day, May 4, 1971, the Bundesbank (Germany's central bank) had to buy $1 billion to hold the dollar/deutsche mark exchange rate at its fixed exchange rate given the great demand for deutsche marks. On the morning of May 5, the Bundesbank purchased another $1 billion during the first hour of foreign exchange trading! At that point, the Bundesbank faced the inevitable and allowed its currency to float.

In the weeks following the decision to float the deutsche mark, the foreign exchange market became increasingly convinced that the dollar would have to be devalued. However, devaluation of the dollar was no easy matter. Under the Bretton Woods provisions, any other country could change its exchange rates against all currencies simply by fixing its dollar rate at a new level. But as the key currency in the system, the dollar could be devalued only if all countries agreed to simultaneously revalue against the dollar. And many countries did not want this, because it would make their products more expensive relative to US products.

To force the issue, President Nixon announced in August 1971 that the dollar was no longer convertible into gold. He also announced that a new 10 percent tax on imports would remain in effect until US trading partners agreed to revalue their currencies against the dollar. This brought the trading partners to the bargaining table, and in December 1971 an agreement was reached to devalue the dollar by about 8 percent against foreign currencies. The import tax was then removed.

The problem was not solved, however. The US balance-of-payments position continued to deteriorate throughout 1972, while the US money supply continued to expand at an inflationary rate. Speculation continued to grow that the dollar was still overvalued and that a second devaluation would be necessary. In anticipation, foreign exchange dealers began converting dollars to deutsche marks and other currencies. After a massive wave of speculation in February 1972, which culminated with European central banks spending $3.6 billion on March 1 to try to prevent their currencies from appreciating against the dollar, the foreign exchange market was closed. When the foreign exchange market reopened March 19, the currencies of Japan and most European countries were floating against the dollar, although many developing countries continued to peg their currency to the dollar, and many do to this day. At that time, the switch to a floating system was viewed as a temporary response to unmanageable speculation in the foreign exchange market. But it is now almost 30 years since the Bretton Woods system of fixed exchange rates collapsed, and the temporary solution looks permanent.

The Bretton Woods system had an Achilles' heel: The system could not work if its key currency, the US dollar, was under speculative attack. The Bretton Woods system could work only as long as the US inflation rate remained low and the United States did not run a balance-of-payments deficit. Once these things occurred, the system soon became strained to the breaking point.