A Brief History of Time Part 1: The Beginning of Floating Exchange Rates

Our history begins in 1968 during the Tet Offensive. The rising US government expenditures for the Vietnam war was placing strain on the international monetary system, which at the time was based off of the Gold Standard (hereinafter referred to as GS) and the Bretton Woods Agreement. Under the GS and Bretton Woods, national currencies were either convertible at a fixed rate into gold, or "pegged" to the US dollar. A pegged currency would be actively manipulated by the government to maintain the exchange rate to within +/- 1% of parity with the dollar. The dollar, while still based off its convertibility into gold, became the default reserve currency of the world.

The benefit of the GS was that it was self-correcting. If a country maintained a current account deficit, gold would flow out of the country to those with surpluses. This would contract the domestic money supply, decreasing lending, and pushing the country into recession. This led to a decline in domestic consumption thereby reducing the deficit. An add on effect came from the resulting devaluation in the deficit currency, which made their goods more competitive and helped reverse the current account deficit. Likewise if a country experienced prolonged surpluses, its money supply would increase, leading to increased inflation and a strengthening currency as international money would flow into the surplus currency to take advantage of rising asset prices. This led to a decline in export competitiveness and a reduction in the surplus.

The downsides all stemmed from the fact that it was ultimately the supply of gold which determined the money supply. Unlike today's system, money could not be created at will. Keeping the supply of gold constant, an economic boom would cause demand to outstrip the money supply. The prolonged boom after the end of WWII created what was known as a dollar shortage, because convertibility ensured that the supply of dollars was constrained by the relatively constant supply of gold.

Back to vietnam: by 1968 there began to be widespread concern that increased levels of US military spending was creating a currency crisis and a run on US gold reserves. The US had been maintaining a current account deficit for several years, and as dollars were flowing out to pay for the war, so was gold. Since other major world currencies were pegged to the dollar, the decline in gold reserves began to jeopardize the stability of the fixed exchange rates. As we mentioned earlier, under the GS, a deficit creates negative pressure on the currency of the net importing nation. Normally this would adjust itself naturally by the self-correction mechanism: the dollar should decline and other currencies rise against it. But we were under the Bretton Woods pegging system, which meant that other governments had to spend large amounts of money to maintain the lower exchange rate in the face of a gold run in the US.

Some revaluations were enacted in a piecemeal fashion: the German mark was formally appreciated by 9.29% on September 20, 1969. But the manipulation that governments had to engage in as the US balance of payments deteriorated represented a dead weight loss of productive capacity; the money spent could have been productively employed elsewhere. Moreover government budgets experienced strain as the money flowed into manipulating exchange rates. Since governments have always been huge participants in debt markets, the distortions created by increased government borrowing were transferred to the real economy, and crisis ensued. As Vietnam dragged on, non-governmental actors anticipating devaluation placed extreme pressure on the monetary system.

Finally, during the summer of 1971, the Nixon administration formally suspended the convertibility of the dollar into gold. Thus began the rapid advance of the floating exchange rate mechanism. Under this new system, currencies would float freely against one another. Exchange rates would be determined primarily through market forces, with some government intervention during crises. Most importantly, the supply of dollars would not be constrained by the amount of gold in the world, allowing the government to regulate the money supply as needed.

Stay Tuned for Part II, "Exponential Expansion of Reserve Currencies Under Floating Exchange Rates"

-RiskAffine