Money Matters: An IMF Exhibit -- The Importance of Global Cooperation. Reinventing the System (1972-1981)

Would Floating Rates Sink the System?

In spite of the surprising U.S. decision in 1971 to take the dollar off the gold standard, the world still clung to the old system. In attempts to set more realistic exchange rates, the U.S. dollar was devalued and stronger currencies, like the German mark and the Japanese yen, were revalued. But even after two devaluations, the flight from the U.S. dollar continued. No new set of exchange rates could be sustained. Finally, in early 1973, fixed exchange rates based on gold were abandoned altogether and currencies were left to float. Although governments continued to intervene, market forces now determined exchange rates.

Could an international monetary system based on floating rates actually work?

Monetary Revolution

For thousands of years, "money" had been based on a tangible, valuable commodity such as gold or silver. In the early 1970s, the international community abandoned the security and discipline of a fixed-rate metal standard. In its place, the world adopted a system of "floating" exchange rates: each currency’s value moved up or down depending on international demand and the amount of confidence in its country’s economy.

Floating Rate Systems

Free Floating Exchange Rate

The currency's value is determined solely by supply and demand in the market, rather than official policy. Countries generally permit a free float only as a temporary solution, because it could result in excessive fluctuations. Such fluctuations disrupt international transactions by constantly altering the cost of goods and value of payments between companies in different countries.

Managed Floating Exchange Rate

This type is similar to a free floating exchange rate, but a government intervenes by buying or selling its own currency to minimize fluctuations. Australia, Canada, Jamaica, Japan, the Philippines, the United States, and others adopted this type of exchange rate.

Currency Peg

The currency's value is pegged to a basket of currencies or to another country's currency. Many developing countries pegged their exchange rates to the SDR or to the currency of an industrial country with which they traded heavily.

The European Snake

Beginning in mid-1972, the EEC stabilized its own currencies in relation to one another. This system was dubbed the "European Snake." Each country agreed not to allow its currency to fluctuate more than 1 1/8% up or down from an agreed central exchange rate. The EEC currencies floated jointly against the dollar. The Snake was the forerunner of the European Monetary System, which went into effect in 1979.

With the collapse of the Bretton Woods system, had the IMF outlived its usefulness?

Critics argued that the world no longer needed an organization designed to monitor a system that was now obsolete.

But the IMF adapted to the new circumstances and actually began to take an even more influential role in the world’s monetary system.

• Instead of monitoring fixed exchange rates, the IMF took on the responsibility of exercising firm surveillance over its members' exchange-rate policies.
• To help countries with balance of payments deficits, the IMF increased its lending activities.

OPEC Takes Center Stage

The fourth Arab-Israeli conflict broke out in October 1973. Over the next three months, the price of crude oil shot up 300%! Global energy and financial crises ensued.

Did the war cause the oil crisis? The answer is yes, and no:

• Because of the war, the Organization of Arab Petroleum Exporting Countries (OAPEC) declared an oil embargo against the United States and the Netherlands - countries judged too friendly to Israel. The embargo caused severe energy shortages over the winter of 1973-74.
• At the same time, the Organization of Petroleum Exporting Countries (OPEC) sharply raised the price of crude oil. Although OPEC acted mainly for economic reasons, the war did serve as a catalyst. (OPEC includes the OAPEC countries, plus other non-Arab oil exporters such as Indonesia, Ecuador, and Venezuela.)

Ultimately, it was the steep oil-price increases of the 1970s, not the politically motivated 1973 embargo that intensified high inflation, caused a global recession, and drastically altered most countries' balance of payments.

OPEC's Point of View

• The U.S. dollars OPEC received for oil fell in value during the early 1970s, because of devaluations and depreciation.
• Oil prices had not kept up with other commodities. Between 1960 and 1973, the price of oil increased a mere 25% - far less than other commodities.
• Underpricing had caused oil to be wasted. OPEC price increases and production cuts were necessary, to protect resources from depletion.

Dealing with the Energy Crisis

• In December 1973, a large part of the British work force began to work a three-day week to conserve electricity.
• In the United States, year-round daylight saving time went into effect in 1974, and the national speed limit was lowered to 55.
• In Europe, stores could not keep up with a high demand for bicycles.
• India's prime minister, Indira Gandhi, set an example in November 1973 by riding to and from work in a horse-drawn cart.
• The oil embargo caused serious gasoline shortages in the winter of 1973-74.

Petrodollar Problem

While oil importers accumulated huge bills they could not pay, oil exporters accumulated large amounts of U.S. dollars - more than they knew how to use. These dollars were known as "petrodollars."

Is there such a thing as TOO MUCH money?

Oil-exporting countries found themselves with so much money, they could not spend it fast enough. Some had small populations; many were still at early stages of industrialization. They could not import enough from the countries that bought their oil to keep from piling up enormous dollar surpluses.

The world economy would contract if all that money was taken out of circulation (i.e., not spent or loaned to someone else to spend). Oil exporters needed investment outlets for their petrodollars.


Recycling Petrodollars

Borrowers' Market

The solution to one problem created another. Recycling petrodollars through the banking system slowed economic contraction, but did not alleviate massive payment imbalances. As a result the debts of oil-importing countries - especially developing countries - continued to pile up:

• The foreign debts of 100 developing countries (excluding oil exporters) increased 150% between 1973 and 1977.

Could the economies of the debtors withstand the inflationary pressure of the sudden, enormous oil-price increase?

Without the discipline of a fixed standard, could the new floating-rate system cope with such massive trade and monetary imbalances?

"The international monetary system is facing its most difficult period since the 1930s."

H. Johannes Witteveen
Managing Director of the IMF
January 15, 1974

Stagflation

The 1970s ushered in many firsts: the first handheld calculator, the birth of the first test-tube baby, and the first personal computer. And, for the first time in history, high inflation joined a stagnant economy for a prolonged period of time. By 1979, this unprecedented combination had a new name: stagflation.

Inflation Unchecked

Inflation was already underway in the early 1970s because of increased commodity prices, as well as excess liquidity created by countries no longer disciplined by the gold standard. Inflationary pressures increased when the dramatic rise in oil prices raised the price of manufactured goods and food. The resulting decrease in demand and production led to fewer jobs and a stagnant economy.


Rush from the Dollar

The value of the U.S. dollar kept sinking, despite attempts by the U.S., German, Japanese, and even OPEC governments to halt its fall.

Why did the rest of the world care?

The U.S. dollar was still the primary reserve currency of the world. Countries holding dollars, instead of gold, as a reserve asset did not want to see the value of their assets fall.

Gold Rush

In 1979, investors, including Saudi Arabia and other oil-producing nations, backed away from holding U.S. dollars as reserves, since they could no longer count on them to retain their value. They sold their surplus dollars for alternative reserve assets, like German marks, Japanese yen, and Swiss francs. In addition, dollar holders increasingly wanted non-monetary assets such as gold and silver, as well as art and real estate. This pushed gold prices from $200 per ounce in early 1979 to $875 less than a year later.

Silver Rush

How Much Silver Does Your Money Buy?

The price of silver shot up, doubling in both 1979 and 1980. The cost of silver flatware followed suit. The money that bought an entire place setting in 1978 purchased only one utensil in 1980.


War on Inflation

Desperate times called for desperate measures. Governments around the world fought inflation in 1979 and the early 1980s by raising interest rates to record highs in order to tighten the money supply and reduce pressure on prices.

How Do Higher Interest Rates Reduce Inflation?

Central banks control interest rates on funds that they lend to individual banks and on funds loaned between banks. If the central bank raises these interest rates, individual banks are forced in turn to raise the rates they charge their customers. Borrowing money becomes more expensive, so less is borrowed. Economic activity slows, less money is earned, and less money is spent. Demand for goods and services falls. To revive shrinking demand, providers of goods and services lower their prices, and inflation slows.

Cost of the War on Inflation

Stopping inflation came at great cost. In addition to decreasing the money supply, high interest rates reduced spending, output, and employment. The world economy was pulled into the deepest recession since the 1930s. World Trade fell in 1981 for the first time since World War II.

Stabilizing the Dollar

To slow inflation and stop the fall of the dollar, the U.S. government adopted a dramatic anti-inflationary policy in October 1979. It made borrowing money more difficult and more expensive. The policy worked, interest rates soared. By the end of 1981, inflation had been brought under control and the value of the dollar had stabilized. But the anti-inflationary policy also plunged the U.S. economy into recession.

Chain Reaction

Since capital now flowed across borders with ease, higher interest rates in one country attracted capital away from others. U.S. anti-inflationary policies pushed interest rates to record levels. As the high U.S. rates attracted capital, other countries were forced to raise their interest rates to compete. High interest rates around the world caused spending to contract sharply, throwing the global economy into recession.

By International Monetary Fund

Source: International Monetary Fund

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