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NBER WORKING PAPER SERIES WHY CLASHES BETWEEN INTERNAL AND EXTERNAL STABILITY GOALS END IN CURRENCY CRISES, 1797-1994 Michael D. Bordo Anna J, Schwartz NBER Working Paper5710 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 August 1996 This paper is part of NBER’s research programs in Monetary Economics and International Finance and Macroeconomics. Any opinions expressed are those of the authors and not those of the National Bureau of Economic Research. @ 1996 by Michael D. Bordo and Anna J. Schwartz. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including O notice, is given to the source. NBER Working Paper5710 August 1996 WHY CLASHES BETWEEN INTERNAL AND EXTERNAL STABILITY GOALS END IN CURRENCY CRISES, 1797-1994 ABST RACT We argue that recent currency crises reflect clashes between fundamentals and pegged exchange rates, just as did crises in the past. We reject the view that crises reflect self-fulfilling prophecies that are not closely related to measured fundamentals. Doubts about the timing of a market attack on a currency are less important than the fact that it is bound to happen if a government’s policies are inconsistent with pegged exchange rates. We base these conclusions on a review of currency crises in the historical record under metallic monetary regimes and of crises post-World War II under Bretton Woods, and since, in European and Latin American pegged exchange rate regimes. Michael D. Bordo Department of Economics Rutgers University New Jersey Hall New Brunswick, NJ 08904 and NBER mbordo @phoenix .princeton.edu Anna J. Schwartz National Bureau of Economic Research 50 East 42nd Street, 17th Floor New York, NY 10017-5405 aschwar [email protected] WHY CLASHES BETWEEN INTERNAL AND EXTERNAL STABILITY GOALS END IN CURRENCY CRISES, 1797-1994 1. Introduction The Mexican crisis of December 1994 and the European Monetary System (EMS) crisis of September 1992 have aroused interest in the subject of currency crises. Academics seek to understand their causes and propagation mechanisms, Policy makers debate the need for new mechanisms to prevent them. In the traditional view, a country faces a currency crisis when inconsistencies arise between preserving pegged exchange rates, whether fixed or crawling pegs, and protecting domestic monetary and fiscal policy -- the fundamentals -- for the sake of internal stability and competitiveness. For countries that are part of a pegged exchange rate system, such as Bretton Woods or the EMS, crises are an endemic part of the system. They arise because of unexpected shocks that may make unsustainable policies that were previously compatible with existing exchange rate arrangements. Market participants understand this tension and precipitate an attack on a currency by selling it short when destabilizing shocks occur. Recently, the traditional view and its modern extension, speculative attack models based on rational expectations, have been challenged by the view that currency crises reflect self-fulfilling prophecies that are not closely related to measured fundamentals. Crises instead can happen under conditions of multiple equilibria in the foreign exchange market. In this paper we argue that recent crises reflect fundamentals, just as did crises in the past. The trick is to identify the fundamentals. We define a currency crisis as a market-based attack on the exchange value of a currency. It involves a break with earlier market judgment about 2 the exchange value of a currency. If a devaluation, which also involves a change in the peg, does not occur because of market pressure, it does not qualify as a currency crisis. In both cases, however, it is imperative to sort out the inconsistency between fundamentals and the pegged rate. 1 A currency crisis is also different from a banking panic, which sharply increases the demand for currency, but the two types of crises may feed upon one another (Krugman, 1991; Bordo, Mizrach, and Schwartz, 1996). We report in section 2 the discussion in the literature of the two competing theories of currency crises: the classical view based on fundamentals , and the recent view based on self-fulfilling prophecies. judgment on For a the validity of the competing theories we believe the crises of experience offer guidance. In section 3 we examine famous historical examples of crises from 1797 to World War II. In section 4 we examine post-World War II crises . In section 5 we offer lessons from history. 2. The Literature on Currency Crises In the traditional view on currency crises, pegged exchange rates are durable only as long as monetary authorities are credibly committed to maintaining them. This requires that domestic policy always is subordinated to the objective of maintaining the fixed exchange rate. Under the classical gold standard, the commitment to the fixed price of gold was credible for the core countries of Western Europe and the United States. Speculative attacks on 1 Frankel and Rose (1996) define a currency crash in emerging markets as a nominal depreciation of at least 25% that is also at least a 10% increase in the rate of depreciation. Eichengreen, Rose, and Wyplosz (1995) distinguish between a devaluation and a currency crisis. Both are preceded by monetary and fiscal expansion and the deterioration of other fundamentals, but in a devaluation inconsistent policies are reversed with a change in parity, whereas in a currency crisis inconsistent policies continue after the parity change. 3 their currencies that forced abandonment or alteration of the parity rarely occurred.z Under special circumstances, such as wartime emergencies or financial exigency, the commitment might be temporarily suspended, but the market understood that the original parity would be restored once the emergency had passed. These events, moreover, were rarely characterized by the type of duress crises today are subject to. For peripheral countries, such as the Latin American countries, however, the pattern set by the core countries is not observed. They suspended convertibility and altered parities when subordinating domestic needs to the dictates of external balance proved onerous (Bordo and Schwartz, 1996) . Of two recent interpretations of currency crises, both based on the postulate of rational expectations, one extends the traditional view, maintaining that speculative attacks on a currency are driven by the incompatibility of the pegged exchange rate and expansionary domestic financial policy, the other, maintaining that currency crises are not necessarily driven by a conflict between deteriorating fundamentals and the pegged exchange rate, but reflect self-fulfilling prophecies. The innovation of the first interpretation is that the timing of the attack is predictable, It occurs before the monetary authority has exhausted its reserves, In the second interpretation, the timing is not predictable. Crises may be self- fulfilling prophecies of market participants. Because their expectations are that the monetary authority’s policies will be inconsistent with the peg, they 2 Incipient attacks on the Bank of England and other central banks were countered on several occasions by central bank cooperation and, more important, stabilizing short-term capital flows by market participants confident of the credibility of the commitment to gold parity (Bordo and Kydland, 1996; Eichengreen, 1992). 4 take actions to force the authority to abandon the peg and thereby ratify their expectations. Crises occur in circumstances of multiple equilibria indeterminacy -- -- in foreign exchange markets, in which random shocks called sunspots can trigger an attack. 2.1. Classical Currency Crises Two seminal articles by Krugman (1979) and Floyd and Garber (1984a) argue that, in a world of perfect foresight, a speculative attack on a currency with a fixed exchange rate will occur when a monetary the inconsistency a budget deficit. exogenous. the point currency maintaining The path Unlike abandonment eince with the peg, of domestic the traditional of the peg and adoption at which short reserves would in anticipation international reserves expands credit view, authority, domestic a speculative have been are declining attack exchange exhausted. of the depreciation pari to finance that rate, forces occurs before Speculators sell is bound to occur, that passu credit of is assumed to be expansion of a floating in disregard with the domestic credit when shadow expansion. In this literature, exchange rate floated, determined demand zero, determined attack, money -- the exchange -- equals the nominal by the rate by the growth the decline is determined by the The prevail the attack and nominal supply size of the decline semi-elasticity of demand the if exchange of money occurs, supply rates freely and money fall to rise, At the equals depreciation rates reserves demand. supply of expected place interest and money and the money a reflection rates. takes of the growth When depreciates of money attack that would peg. in reserves in turn interest rate interaction the existing exchange demand, a speculative on a path time a decline of the in real incorporated in money demand for money. Thus in and reserves the money 5 market is always in equilibrium. The equilibrium determined. This exhau~ted, attack opposite pegged taking were rate occurs fundamentals, the ratio the can be driven fueled an expansion of a depreciation of a trading 1976 Mexican Argentina’s postmortem crises, has been exchange citing applied (Gerlach peg on Mexico’s 1994 and the Finnish strand 1992 in the rate, with Chile Chilean exchange in the rate of domestic increase equals profits of ways. arise. In one credit a jump when the 1992) . In addition, other the deficit, current in 1982, authorities account deteriorate argues the up to the collapse, with the extension, currency (Blanco that and before currency by bailing and actual that 1994; out crises insolvent 1986); as the (Dornbusch, the and Rose, the attack 1989); 1996); on the and Mexican and Valdes, of the case competitiveness 1982 Chilean Goldfajn, is a critique crises: the and Van Wijnbergen, as well literature damages Eichengreen and Garber, (Cumby crisis alternatively, for arbitrage to hypothetical crisis, for arbitrage currency; steadily are credit. and Smets, in 1981 shadow to rise rates reserves for arbitrage the path and Flood, of domestic devaluation crawling Another rates until in a number over interest crises. the extended of one country’s partner when ia precisely opportunities opportunities consistent (1987), by banking The model the to GDP, providing opportunities interest real delayed in the domestic Only Bhandari, as the Velasco too soon, model, (Agenor, of debt crisis. banks nominal such jump, positions has been of the attack the attack uncertainty in the original collapse would do no further model permits were arise. incorporating expansion whereas short would The original extension, rate staged direction exchange and the timing is so because, the exchange by Bpeculators if the is unique classical 1995]. model of 6 crises currency by a number 1992 EMS exchange Obatfeld, 1995; rate appear money differentials financial Krugman 1992 variable The subject domestic This and self-fulfilling credit approach low, and interest the until environment. choices becomes crisis has been between are influenced expansion budget of the of the policymaking opens speculative 1992 is exogenous, that did not adequate, assumption making in most of credibility September The basic agents, to constraints attacked -- a measure 1995; critique, were credit account as optimizing expectations, 1992 EMS crisis occurrence is cited to the behavior by market an endogenous up the possibility of multiple attacks. can be triggered by Flood the classical equilibria. of multiple by random events and Garber currency In Obstfeld as an example of fundamentals. is the presence from articles that of domestic were 1993, the Currency Crises Reflecting Self-Fulfilling Speculative Attacks unrelated that 1994). explain reserves were and Germany to take are viewed 1995). rates, rates to the currencies -- did not predict it fails (Obstfeld, equilibria EMS members the growth objectives, participants’ inflation it cannot and Wyplosz, According their exchange (Rose and Svennson, that governments and find that Rose, 1995). before pegged monitored because competing 2.2. between model, challenged When growth markets late August and Rogoff, with who (Eichengreen, fundamentals inconsistent deficits, crigis Obstfeld of the countries, of authors, crisis (1986), of a currency The explanation equilibria model and Obstfeld could The on the assumption for exchange approach (1986), accommodate seemingly offered in foreign like sunspots. (1984b) crisis its markets derives which showed multiple that domestic credit growth in normal circumstances is consistent with the currency peg, there are two possible equilibria, which depend upon the expectations of market participants 7 about monetary authority an attack never an attack happens, the Diamond will comes, the of rational Ozkan based on unemployment peg. decide to abandon expansionary cost of maintaining participants of the central potential the peg, against Market the cost loss of credibility, scenario If unemployment is low and the likelihood that the peg will low. Hence there sluggish, external will likelihood shock is high. that Hence such it can and an a shock, weighg the a loss of credibility. in light of their of the economy assessment relative of multiple is sound, to a then equilibria. the of an external is high be abandoned are likely in an attack. in the event If unemployment speculators to it, i.e., of the economy the peg will the and a rise the possibility be abandoned the expected to output, rate in function mechanism exchange or may not provoke state a loss of abandoning shock given analysis and Rogoff, from potential, cost to in output and, state creates be no attack. the choice of the may that (Obstfeld of a large bank, decision bank minimizes of a floating this judgment model peg as a commitment of abandoning extends a run on a bank by a cost-benefit of output i.e. , a decline understand bank’s It is this the central The central (2) if approach authority’s of the credibility in favor the (1) If expectations. In a typical in the event attack: indefinitely; -- whether the monetary the currency policy. runs is determined 1994), but the peg monetary unemployment, models, survives Essentially of bank or the deviation low inflation, rate collapse. peg or float adopts of a speculative on depositors’ and some measure The authority maintain may depends and Sutherland, rate, exchange expectations. 1996; inflation in the event (1982) model equilibria the currency a world fixed system not occur In multiple maintain the and Dybvig or will actions shock is and the economy is in the event to attack the of an currency. 8 The attack may be triggered an increase in interest temporarily repulsing weakening effect likelihood affect likelihood to the peg under could economy were The interest rates with situation that competes makes of a speculative As noted the rates, thereby debt, Similarly, interest above, the rate response succeed 1992, increase, may be path (Kenen, future bank which is in but the heightens the dependent, 1996) . Past attacks had high (Davies if the can adherence and Vines, credibility on its currency and Masson, in the state of the 1994) . is not the only speculative system factor attack. debt, (Obstfeld, the commitment attacks. that could Another mortgage 1994). create factor interest Concern to maintain is rising rates, for each a peg, and of and creates the peg prohibitive caused of the September Obstfeld of the the government’s the devaluation, on the Swedish on unemployment (1994) 16 September, a devaluation threatening the attacks events Wednesday, expecting which rates it may in September which forestall on government with If the in the event attack. lira on Black participants, bank, cost of maintaining of self-fulfilling Italian term (Drazen of the banking did interest to an attack effects heights, of an attack a central of the economy objectives model help for a self-fulfilling stability these success be exposed bad enough state conditions the still hand, event. attack. central the gun may 1995) . On the other past and as Sweden of the successful of the trivial to astronomical on the economy credibility the rates the attack, of a later The by a seemingly and the 1992 EMS crisis explains the in this lira, ability reflected stability attack to roll their the on the Market bid up domestic and validated krona way. spawned over interest its short- expectations. the effects of the banking of high system. The a 9 rise in German triggered interest ~elf-fulfilling Sutherland, fulfilling attacks that what occasioned would therefore The would news race (Buiter, other strategy. evidence the outcome. Dornbusch, money that and and debt 1993). would patterns become was “rules more preceded refused attacks. collapse is arrangements reunification to reflate, moderate there and the devaluation of the EMS, market suggest were (Krugman, that all the EMS 1996; the market the exchange by surprise crises, of augured of unemployment, for virtually shock is no dearth as in earlier deterioration rapid and the the peripheral of German of the game” explanation, ratios policies. members. in the EMS crisis to GDP shock a coordinated on individual reunification These crisis of the includes and among The Germans to adopt self-fulfilling fundamentals, the rate is (EMU) and led to the the cooperative countries 1996). unwilling attacks EMS Union in June September that argument devalued, conservative for the EMS exchange perceptions The if members Monetary to adopt in early for self- 1993). on the referendum following the breakdown the German the down that, to the European “no” vote to market The evidence growth Moreover, factor (Ozkhan responsible and Wyplosz, an incentive and Pesenti, were competitiveness, following was the currencies held the belief explanation broke to the that was and the peripheral staged Contrary have systemic Sensing participants attacks on the referendum themselves countries (Eichengreen of the Danish Corsetti, has been for admission a response Germany countries the in France it was between reunification on EMS member itself on the EMS no longer A different that attacks Treaty not qualify adverse tight following 1994). The Maastricht they rates political Branson, devaluers, 1993; anticipated rate that unpegged. developments (the 10 results of the Danish marketa assessed the For Krugman distinguishes that they do not his model, will that on a more that would a predictable and that produces deteriorate loss function speculative deteriorate attack of fundamentals is uncertain, but the range speculators attempt even rate. fact that The markets it is bound logical important about to happen context arises equilibria the Historical The examples expectations case in which then, they just in as in if the evaluation Moreover, will limit the historians That approach Examples we briefly policy objectives equilibria events task involves function is a useful of Currency describe way important inconsistent in foreign not mean have is to uncover and a pegged is less pursue does crises occur currency that been can also be explained and the preference classical that if governments the events for economic process 3. Famous that and the equilibrium be narrow. of the attack of multiple In every lead to inconsistency. political domestic the timing of rational prophecies, task between possibility occurred. fulfilling that Doubt in a world actually from multiple time, follow, will but is not If the parameters over equilibria it is incontrovertible of inconsistency exchange to profit will that more. In our opinion, because the way equilibria, function predictably. of multiple range altered models multiple objective A possibility who have of the new crisis sophisticated fundamentals authority’s be unique. the key aspect from his own, are based the monetary referenda) fundamentals. (1996), them assume and French they world an understanding to study exchange have as self- fundamentals. the real The forces of the authorities. currency In this crises. Crises in this section were the policies. explained by of monetary than crises affecting 11 currencies linked metallic) epecie to standard. The case was typical. money creation maintaining restraining features of only in order those that might be the correct fiscal occurred policy High collection optimal printing could if monetary accounted case the common crucial create tax behaved element objective. must be retired taxes (Vegh, varied. failing to or capturee French crises the franc as well. be distinguished from of convertibility to pursue The should an optimal classical finance in peacetime in wartime No standard rates, a suspension government theory wartime (Barre, might also of 1979) . make it 1989). were financed taxation, borrowing, stability. Moreover, wartime of specie reserves, even arrangements (the or external prudently. or adventitious for reserve to other the authorities for currency internal Treasury) authorities or external would loss deficits 1923-26 (or a loss of authority interest and seigniorage. expenditures authorities Independent The inflation was In wartime, of conventional how wartime press) exigencies mutiny) costs in wartime a rational which reserve budget - the in some respects that was to the commodity crises borrowing, the government adhering to allow crisis of the monetary individual policy, debt, to use the Thus, Us. with produced or raising in peacetime. postulates when occurred of taxation, tax smoothing expenditures that that growth it applies a link to) a gold of an impending to finance monetary crises of restoring portrayal rates, one of the -- although Currency symptom stylized low interest required crisis The usual The circumstances reserves. ltiit (or in the process drains Sometimes events legal (enemy invasion; the military losses. in the individual episodes confronted the dilemma Giving up the external we review of choosing objective between is that the in each internal -- convertibility of 12 the currency into the weight of specie specified by the fixed exchange rate -- constituted the currency crisis. Besides descriptions that follow each show, the common episode element, had unique as the features. 3.1. John Law’s Operations, 1716-20 John economic Law in 1705 theorized project that would employ raising support by establishing a note-issuing to take over on trade conglomerate right with company to collect He also bought refund all French it at an interest a major economic shares 1720 share holders converted above of the bank, terminated below debt, Law’s trade ones at market a company the tobacco Europe. new coinage, and then prices by the state while The and the direct below the conglomerate theory, the Regent’s outside to issue indirect with adding a major real wealth and organizing then right that paid in the company, their 100 made began gains livres. of the led the bank shares into banknotes. note had disappeared. the bank into specie. price to peg the price The pegging circulation At the 10,000 taxes. par, to collecting never Law countered for payments by note creation. at 9,000 operation and price same time Law its note livres 1720 the company legal tender stock increased to fall below In February its notes support tender national Despite prices decline legal first in France all French the finance undertook project. January payments taxes, rate service. To sell stock in 1719 purchased could and expand in 1716, Louisiana, and finally up the French the government the Africa, to work bank with creation resources He put the theory a monopoly trade currency unused without monopoly, prices. that livres, ended level per share, as by prohibiting took above over 100 livres, intervening 1720, had doubled steps specie management The ensuing in May in several By issue. and price to convert by which and the devalued time specie specie 13 in terms of livre that Richard Cantillon, incompatibility banknotes specie domestic to buy Dutch proved reserves forced Law to reverse and a quick collapse occurred to December 1720. price declined level the share as in May even The note 1719. who recognized and the exchange by evading rate, the sold the exchange controls A run on the Banque Royale’s his policy, precipitating Law presided from its peak. reappeared (Garber, over a massive a deflation fell by 56% by October fell to 500 livres of 1720 is evidence loss of his operations. circulation Specie There and economist, right. though by one-third price had at the beginning Cantillon collapse controls. operations guilder Events The price Law’s exchange financier 1987). of confidence, power, the French between and managed (Murphy, and imposed tournois, Following in September and was his 1721, revalued 1720, fall about from May and the from the same to the definition it 1990). 3.2. England, 1797 The Bank when the of England its bullion start O’Brien between gold reserves external drain to a metallic internal drain landed suspension Finally, France, of war finance by a premium in February a handful of men (because after to finance. in the in France assignat suspension, to increased from face of a massive inflation), the at its (marking scare the government 1793, The tension convertibility of an invasion in Ireland), Soon war 1797, According in response collapse on gold the disastrous 1797 of convertibility. and specie 27, In February at E4 million. by the Bank the Bank’s on February El million. the government’s to prevent after standard it had stood actions hindered occasioned currency the gold fell to just above contractionary the exigencies 1793 to 1797. frigate reserve of the war with (1967), dwindling suspended its return and of when a French authorized Bank an the was prepared to 14 resume payment, renewed year but the government after year until and the demurred, 1803, when act of suspension it was extended until was six months after a definitive peace treaty had been ratified. 3,3. The United States, 1861 War broke out in April 1861. When Treasury Secretary Salmon The Civil Chase took office in March, and Boston, who government. Immediately coin, the issue 3-year national large agreed remainder Treasury in coin. This secretary In New net government, fall which a priority City the banks weekly. By 2 September charged them interest loan certificates. exchanged began some banks daily. To escape the the banks to from the the government to the Independent the proceeds to subtreasuries 1861, needed, of to permit but the he accorded of the banks’. to keep House subtreasury had a deficiency interest loan certificates a specie tried $35 million On 19 September the until agreed in for other operated, on 5 August to the Treasurers had to be transferred had agreed to pay the and According the banks On 19 August each secretary to give notes payments. and the Clearing short. and banks treasury ahead The intended act was repealed Philadelphia, to the Assistant the Treasury with York, and to reimburse was to by banks of New of $50 million as needed. notes specie the proceeds liabilities, would deficiency under of the needs York in coin maturing subscribed much advances arrangement to redeem to leave the Treasury’s The the banks $5 million or Treasury and to maintain loans three paid to be paid Act of 1846 government specie they subscription. disbursements, against to make 7.30 bonds sums needed he met with P. was to assure credited for gold. no bank’s to the in specie and the Clearing House the banks of 25% that $3.5 million the Clearing charge, reserve House began with On 1 October to issue the the second 15 $35 million November, of treasury another registered loan of the bonds. certificates (These specie specie credit) of the that The premium (Myers paper. would demand notes followed suit. of an overissue in international of the secretary. have of specie that and on 16 half value (greenbacks), in the loan the banks of paper reserves. Given further It is important Independent suspended to note money It occurred the magnitude that (domestic Treasury, a suspension eventually payments Resumption bonds, to 90% of their At the end of the month, it is likely crisis suspension over issued peculiarities followed, in coupon banks, issued. ) because of the treasury a currency amount, collateralized House a decline institutional issues half and the Treasury forced inflexibility same secretary did not occur that to the New York from the banks. payments, suspension with the was allotted issues the Clearing In December draining notes because and the of the greenback of payments associated occurred. in 1861 of payments immediately did not occur put gold until at a 1 January 1879 I, 1931). 3.4. U.S. Currency Weakness, 1894-96 legal In the context tender Treasury Silver Purchase the U.S. finance tenders. dollar of a U.S. budget for redemption of 1890, surged, in legal threatened attempted offering for public the the Treasury increase Treasury despite to restore repeal tenders subscription and the about that its stock outstanding, reserve $50 million however, in 1893. and and November 5% bonds. of To legal when to at a minimum 10-year of the Sherman Act of gold In January creation the convertibility of the Sherman reserve. its gold 1890 in coin, uncertainty ran down the gold after redeemable Act of 1890 mandated, the deficit, The Notes deficit presented 1894, the $100 million The by subscribers 16 used legal to obtain gold to pay for the bonds with no increment to tenders the gold reserve. In January reduced the reserve Stymied, coin banking on terms Treaaury restore the gold syndicate to redeem legal London in gold to sell syndicate withdrawn exports the the bonds five months campaign resumed in response reservea declined. dollar eased, The crisis speculative as only 6% advantage devaluation (Grilli, of $68.8 the contract in 1896, rose, domestic strength the of gold gold exchange. delivered a month. withdrawala and borrowed paid exchange the exchange in market. The million. was signed 1895, syndicate no gold when was agricultural was dissolved. During of gold and gold of the pro-silver forces, and gold won out an additional accumulation the Republicans the to ounces It delivered controlling for a total credit 300,000 against the and provide gold ounces with the election, pressure exports on the time permanently. gold standard and the probability 1990). of obtaining (Garber 3,500,000 for legal tenders, imports of the U.S. attack, tendera him to purchase issue intereat-free the Treasury after authorized 4% bond At the end of August gold to the Once this for legal contracted not exceeding effectively from the Treasury. the electoral of the or sold to obtain in exchange and associated a 30-year at a rate to protect in New York, marketed During One-half secretary a law which to market from Europe tenders under line of short-term reserve. agreed $25 million syndicate, a 6-month waa to be shipped The 1895 the Treasury he negotiated, with in exchange to $45 million. in February Belmont-Morgan 1895 a run on gold The episode a line of credit and Grilli, 1986). in 1894-96 of the timing has been haa been modeled of the interpreted in foreign currency attack as a eatimated as displaying to avoid a the 17 3.5. Crisis of 1914 What was distinctive about the 1914 crisis, on the outbreak of war, unlike earlier gold standard wartime crises, was the breakdown of international clearance through London that followed. Indeed, it was a crisis in the sense of a disruption of the foreign exchange market but different from others in not being external balance. worldwide gold Under ready Moreover, standard, these for panic demands balances. been Foreigners were established in the as a result to replace down. Stock worldwide their Exchange new sterling Fearing a securities, in any event remittance, of a continued sterling. to liquidate in gold to be deprived by refusing and obtain Payment was not replenish the London international market loans and gold would embargoes worldwide. By 1 August the houses letter of indemnity limits of Peel’s Bank of England and the Stock had raised Exchange from the Chancellor Act. from banks at Bank closed the entire short-term responded could and in isolation. their houses face of an attempt everywhere inadequate rate. acceptance internal affecting discount securities have Bank The London to sell exchanges acceptors for cash. contracted it was possible stock discount just one country banks between crisis, While collapse withdrawals a systemic ceased. price to discount an inconsistency credits Long-term to operate, and not The London credits. with it was conditions, flow of new bills. acceptance associated rate postponement The Treasury bills of payment On 5 September Currency On 13 August occurred. approved to replace to permit issued the Bank Bank accepted on maturity announced rate call issue before loans, beyond although 4 August it would loans and gotten of England on condition that 10%, made of notes Notes, the Bank to a the no panic undertook to and granted of paying have funds 2% above for 18 repayment of all pre-moratorium acceptances, thus enabling acceptors to meet their obligations at maturity, and the banks agreed to finance discount of new bills. The reopening of the London the end of the transactions In New York drain gold relieved lack of sterling. however, New York falling demanded September sterling gold. pool international rate strong in terms of the belligerent dollar exchange rate During the of the year melting was pegged of gold sell gold of gold note~ reached was Defense coin, and against was on 1 arranged obtained of goods par. complete knowledge of dollar- by remittance the exchange the gold 7/16, export was rate would free international movement the dollar in January it illegal In the United 1919. of gold States. 1916, 1916, market, a key States, of the war. prohibited to buy or feature of the export Interconvertibility were was sterling- for the rest 1918, made 1917 to June sterling- to the United but of the bullion the 1914, Act on 5 December suspended. from September over, in 1915 the point it was held of the Realm The operation Early depreciated, where took By December currencies. and the Act of 18 May standard, licensed and gold for the London, from day to day what sterling at $4.76 the gold They Act banknote6 needed York to of exchange. had to be settled and passed fell below at a premium. a functioning of $100 million movement exchange In Britain, in New was banks shipped. dollar sterling led interior rates marked had created. a solution credits New York. knew of war 1915, The Aldrich-Vreeland but provided that The banks wartime rest banks. on 4 January market at provisional A gold indebtedness gold was When banks in and outside exchange. be. Little of the money for currency, due abroad by banks of international demand Exchange the outbreak correspondent the domestic obligations impasse the breakdown from their Stock suspended of in both 19 countries (Brown I, 1940). 3.6. French Franc Crisis, 1923-26 When the franc was unpegged in March 1919, its exchange value declined eharply ae the government seemed 1920, signaled however, repayment of Bank a shift of France limit on the government’s franc reflected cente over this the next The national reputation. latter from Germany readinese advances borrowing on an annual in fiscal was divided reconstruction after hyperinflation of France under reaction to which the fell to 3.49 which reserves of foreign to 6.71 increased. balanced, epecial was defused at the Bank rose government debt loans 8.99 cente it required imposed the a legal rate from under expenditure issue there. of the 6.27 to 8.99 cente The credits assured the Dawes turned in October and a special expected budget, Germany’s value By December of the 1922, the was E4 million used few weeke, that 1925 brought short. The the unable 1920, in a pledge franc, would be on to finance failure down and exchange budget counted the franc franc month against foreign the ordinary that were out to fall that to support and franc, 1924. of new taxee and the to be recoverable concerning in March were Plan franc’e of the Law of 31 December imposition the next for the In 1923 the government the terms The new taxes problem on the exchange of $100 million during were Doubte in April. by the of France. but payments budget franc that developed the Bank of gold and rising affaire, had an effect to repay negotiation in that The exchange a special Treaty. to 5.25 cents crieis law of 31 December basis, into an ordinary expenses the Versailles from posed declined The policy from the Bank. however, to pay reparations especially The five quarters. budget, under on inflation. to deflationary improvement The budget detailing bent from of a 4.7 cents in 20 September to 2.05 in July 1926. Only with as premier in office to 3.95 and minister, had proposed, cents exchange finance by the rate was who opposed financial appointment a capital stability end of the year. at that the of Raymond levy his predecessors restored. The Bank of Franc level. The de facto stabilization of the French gyrations Poincare The franc then pegged became rebounded the de jure in June 1928. Interpretations aspects of the experience: government excessive debt to honor importance its debts, spending, to rise the the as they fiscal failure should have, not restored, political unsettled Frenchmen foreigners Krugman, 1991; Eichengreen of these interpretations, causes related disappointment (Brown Rather we are willing between then rates the to settle taxes parity left and right giving pride of or on government prewar Makinen different ability to inadequate that I, 1940; emphasized in the interest infighting 1992). have of confidence of short-term franc was and franc of the that and Woodwardr of place 1989; to any one for all of the above. 3.7. Sterling, 1931 A succession to gold. In the of political first half from depression-increased trade balance shrank from shipping trade. and Reserve E150 million, holiday, observers crisis next month rates in May banking deposits with the gold as a critical capital budget The in Germany contraction reserves and the in Vienna made link resulted invisible fell, minimum. flight of E5 million difficulties sterling’s investments 1930 brought regarded fiscal insurance. on foreign declined unhinged in the on unemployment precipitated British shocks a deficit services starting a level of a banking The outlays as interest losses banking frozen. of 1931, financial the Austrian and economic and income of foreign down In May to under 1931 announcement were thereby E70 million of 21 German debts investors to British repatriated bank in July fall in sterling rate was raised below twice was On 1 Augustr Labour tough replaced achieve budget investor in July the May balance decisions suspended convertibility German of Germany’s Committee against forecast large taxes the budget largest Report major led to a currencies. changed Bank again The among before With crowning reserves that and Paris personnel that over The on 23 August, on 10 September event would expenditures. resigned New York navy deficits and reduce problem, Though did not halt. budget Its attempt coalition. was unsuccessful. to provided disturbed pay cuts that the Government dwindling, on 19 September. of analysis of the events devaluation themselves do not explain invocation also and Hsieh 1995). Britain’s reserves came investors’ of international It is hard up to Britain’s devaluation political to believe to the point leading as a surprise, of devaluation. 3 That large as well that did not were seems departure fundamentals expectations, investors investors as by fundamentals and that and economic of exhaustion the probability and small point to raise to solve as a mutiny. described is that export was disaffection the press from gold closing of the Macmillan Committee run on sterling One vein The funds. same time from 2.5% to 4.5% but not by a multiparty confidence and at the suspended. unable Government, the London the gold political and was loans, their uncollectible, and the publication convertibility require banks events requiring (Eichengreen who were running associate that influenced by down loss with by events to us uncontroversial. The 3 Violations of credibility bands (bands within which uncovered interest arbitrage prevails consistent with gold point arbitrage efficiency) for the dollar/sterling rate, estimated for the interwar period, begin after June 1931 (Officer, 1996), 22 other vein of analysis that emphasizes self-fulfilling balance-of-payments speculative attacks does not fit the facts of sterling devaluation in 1931. 3.8. The Dollar Crisis, February 1933 From was well taking the date known the of Roosevelt’s that dollar he and his advisers off the gold position to attack the dollar. earmark in New York or moved claim. Fears States held more moreover, year gold amounted in surplus;, holdings U.S. that foreign bankers were British bought amount of gold. was to 40% of total gold held were not deposited reserves; three times by foreigners of in a they unfounded. The at the beginning. it under all the gold had proved investments way. there Private gold selling could United U.S. the trade gold, balance was as great as its gold amounted to one-fifth of withdrawals of exchange The enormous zoomed, legally required Federal Reserve 40% of gold Bank short, buying of Federal to outstanding holiday. exporting with lacked to offset Reserve notes. the notes explains gold. Private The a corresponding expertise speculation as the reserve Panic they the proceeds. and earmarked the System’s at the end of February for a banking began unfortunately serve reduced domestic by the threat sterling staff that would issue alarmed for sterling, Reserve temporarily lay in possible represented, offered The Federal ratio was, investors, policy dollars the dollars deposit the demand had already drain 1932, the possibility countries own countries world securities flight. in foreign under foreign if danger Roosevelt’s dealings to their considering Foreign In 1932 they in November investments. or capital perceived were standard. of a European merican The danger, gold at the polls at the end of 1932 than and U.S. were. victory that currency- ratio at the New its eagerness in below York to join the 23 Disconnecting the dollar from gold on the depression-racked U.S. United to take, States currency was crises 3.9. Gold Bloc, forced in other Poland, and Switzerland) into gold represented an ever and resistance parities need flows ability of the bloc foreign trade, situation remaining Belgium firm Poland and experienced the only major For them barrier adherence followed for domestic the austerity first standard to surmount. controls itself Their sterling in many of maintaining countries, their Holland because France, In April governments Agreement In September with dependent France the pressures trade was mainly Front to combine 1936 France the British on was in while that with its deteriorated. and Switzerland Popular it tried in the credit had markedly Holland, 1936, the had done, and failed. bloc 1935. domestic escaped its foreign of the gold heavily in March to expand expenditures. of confidence Belgium, the bloc but tried controls. the Tripartite parities. commitment. losses. of its parity, Holland, freely by rearmament of the erosion their condition exchange defense still from the depreciated was undermined to abandon experienced As previous ones policies effects as Belgium, gold Belgium, to the gold to the deflationary to sustain France. negotiating the 1992). By 1936 the imposed influence an action that (France, exchange in its gold and France colonies. were was one manifestation was countries States, for fiscal flight Bloc to the United at home Capital same in no way the devaluations in face of competition (Eichengreen, The the in 1935. higher mounted bloc , capital unlike it was a stabilizing countries. of the Gold convertible difficulties but have been 1935-36 The currencies Italy, economy, may came did to power reflation devalued and Americans not, and after not to in 24 engage in competitive devalued devaluations. and joined the Agreement The other Gold (Eichengreen, Bloc 1990). countries when countries Again, found internal policies incompatible with external commitments, had to choose between 4. Post-World War each rate member era the country within 1% of its parity were It was conditions of currency cases crises crises that that declared or gold. required proved followed internal attempts to maintain Currency with float Under for its currency the dollar. incompatible the Bretton post-1973. to intervene in the managed of failed punctuated a par value with favored they finally stability.d Crises from those dollar economic and the choice II Currency We distinguish exchange them, also crises the chosen period to peg exchange after Woods pegged Bretton in terms Woods, of the its exchange arose when parity. Bretton rate domestic The examples Woods collapsed rates. A. Bretton Woods 4.1. Sterling in Crisis, 1947-49 Britain, World War as was the II with case with a massive other European balance-of-payments belligerents, deficit in gold emerged from and dollars. To ensure that she would ratify the Bretton Woods Articles and quickly restore current account convertibility, the United States and Canada extended a $5 billion loan. The ensuing a month. Britain restored run on sterling Convertibility was current depleted suspended account convertibility the U.K. ‘s reserves on 11 July by $1 billion 1947. within on 20 August 1947. The return to the pre-World War II parity of S4.03 without accounting for 4 Political factors, such as the ascendancy of a left-wing government and a politically dependent central bank, according to Simmons (1994), led governments in the interwar period to abandon their external commitments. 25 the change in competitiveness for the crisis. confidence setting These conditions in the official the stage Sterling that had occurred did not disappear. exchange for a speculative was created In the rate of sterling the condition6 summer weakened of 1949 markedly, attack. an international protect its inconvertibility since currency, with exchange controls to into dollars. Nonresident holders of inconvertible sterling, however, had an incentive to get around British exchange controls, for example, by selling sterling for dollars at a rate of exchange that was lower than the official rate, then using the proceeds to buy dollar goods that could be sold at a profit. The buyer could goods cheaply. sterling Speculating was devalued on devaluation was a sure bet. purchase sterling On 18 September, to $2.80. 4.2. Sterling in Crisis, 1967 Internal and external objectives were on a collision in Britain. produced Expansionary inflation, international Government instead fiscal adopted under pressure. payments assumed was evidently price to promote in the current account, and declining in October on imports, in the spring not possible. incomes leaving loan, and followed. growth in July of 1966, policy was enacted. strike was and unchanged. contractionary temporarily and improving A seamen’s The Labour policies 1965 improved sterling was the balance in May announced, Foreign 1964 on employment devaluation, internal outflow and summer monetary policy sterling 1964 opposed on capital faster Deflationary and against IMF and G-10 Reconciling a run on sterling. compulsory policies and restrictions but from fiscal office a surcharge situation, and Speculation a $4 billion measures external a deficit reserves. that In November monetary course again of and June and a central the banks led to 26 provided loans this time. From May 1967 onwards Talk of a possible and the balance November British devaluation of payments preceded deteriorated. by one day devaluation 4.3. French Franc in Crisis, In May throughout became 1968, student the country. widespread An enormous in sterling as unemployment run on sterling of the pound ebbed. to rose on 17 $2.40. 1968-69 riots The confidence in France settlement touched raised off hourly strikes wage rates and lockouts by 11%, shortened the work week, and provoked a flight of capital into D-marks and gold . France tightened price controls, restricted imports and some external payments, Credit from introduced restrictions francs markets subsidies replaced to D-marks for exports, these and measures intensified, imposed exchange in September. and on 20 November controls. In November major European a flight exchange shut down. Between exchange April reserves. and November France France cut public lost $2.9 billion spending, increased of its foreign indirect taxes, imposed ceilings on corrunercialbank lending, and raised interest rates. Yet these measures did not suffice to reduce the growing deficits in the French current account during tightened restrictions purchase, and France in July incurred reserves, first on bank froze short-term however, was devalued the funds raised for public minimum The again TO resist The drain French French requirements investment. of $2.3 billion. On 10 August continued. of 1969. resistance for hire devaluation on French ended. The franc by 11.11%. Successful banks credit, debts 4.4. U.S. Dollar in Crisis, central two quarters operation intervening 1960 of the with Bretton their Woods system own currencies depended against on foreign the dollar to 27 maintain par values, at $35 an ounce balance in transactions of payments parities and the United other countries that added weakening U.S. balance of the U.S. of the gold system declined holders that the A focu8 1960 was the first of its total denominated account about A portent year liquid in which U.S. liabilities gold to all Bank of England Bank Bank’s the internal getting victory over capital payments, outstanding when intervene. agreed foreign to move at the controls, to alter dollars ahead. 1960 triggered Gold the monetary-fiscal given with Bank, concerns sold and gold of gold to to occurred the price reaching reserving for the after measures and to enlist the election of the to improve mix, to stem the Federal it would rhetoric administration’s The response policy that his campaign losses in the price. to institute into gold, to the banks not willing in the price On 27 October, objectives, fixed a rise was central in the market. in November external initially to sell gold of a lack of confidence convertibility to adopt Hencer did not The Treasury on intervention the economy an expression for dollars. but the U.S. the Treasury the decision favor gold holdings. Bank Kennedy’s gold bought the price, $40 an ounce, reserves pressure on the U.S. dollar was the London gold market. In of investors in October, future in dollars. private the sustainability of the troubled as European restore a steadily the March 1960, the price rose above $35 an ounce, stabilize The U.S. of other to produce doubts gold by the exchange surpluses tended and growing to buy or sell authorities. largely reserves commitment. ready monetary Current dollar of payments level of assets foreign established. to their standing was determined convertibility was below with accordingly countries States about were seen commitment to administration the balance conversion Reserve as of of in foreign was 28 exchange market intervention. describe in the currency these crisis a decade of the Bretton later Woods underscores the system that failure we of stratagems. The dollar-based expansionary middle rate The collapse monetary of the 1960s. stability imposing international Other policies countries at the cost on the rest sake of their and fiscal monetary own domestic price the United faced the of a level of the world, system fated States choice of inflation or giving was the up fixed to succumb adopted by the of maintaining United exchange States exchange to was rates for the stability. 4.5. Bretton Wood’s Collapse, 1971-73 Once from the French a $1.7 billion franc was devalued deficit on current account overall balance-of-payments billion in 1971. Its official reserves was owing to increased U.S. monetary change of-payments expansionary was undervalued closed before the exchange The policy in relation A few days to float France to a small of $2 billion rose 1969, in that surplus year correspondingly. growth rapidly moved in 1970, an and of $3.4 Part and a higher of this U.S. balance- deficit. Us. Germany. surplus in August spot the German against and official was thereby of 1969, reserves eventually In March 1971, election the dollar increased 1969, to the government the D-mark and on 26 October, there was large inflows substantially. the D-mark it, permitted appreciated, were that a flow of funds in October reopening Although by 1970 there perception stimulating and a day after revaluat: on of 9.29% was announced. the last quarter a market to the dollar, market, rate fostered a capital Domestic outflow of foreign inflation a in funds, in Germany worsened. several European countries requested conversion of their 29 dollar regerves quotas. into gold The payout reduced to enable them to pay for an increase in their IMF the U.S. gold stock to the lowest level since 1936. A persistent dollar outflow thereafter accelerated in the first few days of May 1971, overwhelming foreign exchange markets. On 5 May seven European countries closed their foreign exchange markets, and five others on several continents withdrew their support for the dollar. Dealings in D-marks, guilders, and Swiss francs were suspended. On 9 May both Germany and Holland announced that their currencies would float, since they could not maintain exchange rates within the established margins. The devaluation of the dollar vis-a-vis the D-mark as the result of the float left unsolved the dollar’s exchange rate vis-a-vis the yen. Japan’s capital controls were proof against the dollar flows that inundated European foreign exchange markets but not against the large deficit in U.S. trade with Japan. That bilateral trade imbalance was a provocation, over and above the imbalance between U.S. gold reserves and outstanding dollar liabilities, for the changes the United States introduced on 15 August 1971 to achieve a dollar devaluation. The convertibility of the dollar was formally suspended, as was the use of the swap network through which dollars could be exchanged with central banks for other currencies. The effect was to oblige other countries to hold dollars or to trade them for a price determined in the market and so to revalue their currencies. Foreign exchange markets abroad, except in Japan, shut down. The Japanese initial attempt to maintain purchase $4 billion to float upwards; on 23 August. the pegged in the two weeks other Restoration currencies rate after floated of a repegged of the yen 15 August. when system compelled them The yen was then exchange markets of exchange rates, were to freed reopened however, 30 remained the goal After much at a meeting December that central rates official negotiation, at the dollar were revalued of fluctuation of gold The would appreciation of the dollar of other central credibility, revealed. The London of trade Capital followed suit. and suspended above and below with the agreement be $38 an ounce, currencies. the so-called specified rather arranged on 17-18 percentages, of the dollar that the implying than a an The dollar, continued and the surge pounds, and Swiss raised (this time currencies. imposed although all to $42.22 the floated. rose in the United however, crisis in Holland central lira, yen, rates erupted discontinued States, the official unchanged did not staunch in March pegging 1973. their soared, were Canadian leaving and both European rates This exchange markets few reversals. its foreign New Again, with and Japan, closed lacked exchange deficit of the major an ounce), The new central countries of gold 1973 Japan of the dollar. franc and a further industrial were holdings meeting and foreign U.S. balance-of-payments On 10 February support price to rise in dollar controls at the Smithsonian in the gold free market of negotiations, abroad, established as the participants corresponding other rates and inflation balance round D.C. was inconvertible. The Japan. in Washington, henceforth value growth parities Smithsonian of 7.9% of the gold value of currency at varying depreciation remained its partners. Institution permissible. price and a readjustment 2 1/4% margins were States Smithsonian Currencies 1971. proviso of the United the with countries a and and Germany exchange set price U.K. flow rates and of gold the gold time market in a hurried dollar, the Money value Irish was of of dollars the major to the dollar. 31 B. Managed Float Regime 4.6. European Economic Community Snake The notion di~cussion in June of a European for year~. 1971, but Implementing the the Bretton Woods monetary turbulence system weak dollar on European main targets the notion had been scheduled markets activation of the The D-mark inflows. not reflect country fundamentals revaluation of its currency contributed to its low economic occasioned with exchange disturbances. The snake was collapse April the effects rates by the dollar’s growth. until of for a start the and the Swiss European but dollar subject during snake was dissatisfaction currencies. of the capital had been in exchange delayed The impetus for the initiative the union franc of 1972. of the were the as a result Germany problems supposed did believed the had to provide a zone of stability. The technical fluctuation agreement parities motivation of EEC currencies by a convergence among them Operationallyr discount amount permitted from EEC currency, strong-currency settlement currency was rate of another the weak stipulated, acquired premium set by the policies from floor the weak-currency for a desired creditor reserve which but as much currency so the over EEC currency agreement, to the dollar, country. and monetary the margin of Smithsonian so that exchange be fixed. if one rose to floor), to narrow the 2 1/4% margins of economic by the Smithsonian in relation ceiling below snake was if an EEC currency on the central and ceiling another would of the its central reached was and the asset or by both. could and obtain floor to other either fell by the A monthly exchange repayment the (half the 4 1/2% between was to be bought country 2 1/4% as 9% in relation to ceiling country, rate plus the weak for its 32 short-term credit facility if it had lent its currency to the debtor. Debtors were to make settlement in a prescribed mix of reserve assets. Six countries (France, Germany, Italy, Belgium, Luxembourg, Holland) originally joined the snake; three others joined in May 1972 but left in June (U.K., Denmark, Denmark Eire). rejoined in October 1972. Italy left in December 1972. France left in January 1974, rejoined in June 1975, and left again in March 1976. Sweden Sweden left in August Many occasiong the changes between system. Countries subsequently several March rates within 1973 and October joined snake made. in May 1972. the 1978, were the D-mark was On four revalued within and the Norwegian krone each was revalued once. Germany devalued feasibility the national to seek devalued in October again, as was the Danish of the snake was doubtful governments convergence to yield of economic up for a replacement remedy countries, 1976 The krone, Swedish krona and the Norwegian was krone times. The drawn in exchange than non-EEC 1977. The guilder other and Norway, the perceived formally to the union policies. of the snake shortcomings in the absence direct of consensus monetary In December autonomy, 1978 proposals by the European of its forerunner. Monetary In March and were System 1979 by to it was established. 4.7. Chile’s Currency Crisis, 1982 Chile maintained Pegging fixed its exchange it unchanged the exchange expectations 35% in 1979. and the until rate at 39 pesos the peso was rate to the dollar actual rate to the dollar devalued by 18% in June was a strategy of inflation, which in June to lower was 1979 and 1982, inflationary at an annual rate of 33 If capital anchor approach country The would rate commitment bank in creating expectations, rate established the exchange strategy would exchange 1976 to 6.6% roughly in 1981 nominal in the U.S. until experience tightening than Tradable goods if its commitment prices, prices to a fixed goods, however, wage in Chile exchange indexation in 1979. rise rate in part that was had adopted Producer was the 5% in prices rose in 1980, one that from risen anchor. in 1981-82 followed A second U.S. averaged 13.3%, value by a 29% appreciation How did these and exchange in 1980-81, rates apparently not abandoned until in affect Prices because of fluctuations as would had credibility. at set of in the exchange in 1980-82 rates, Chile policy 1979 to combat A decline declined of an inflation country. a nominal rates central in inflation continued history in real terms. interest rose, prices with interest 1979 was reversed anchor in late in 1980. and 28% appreciation country U.S. price government higher anchor backward-looking Chile’s to monetary late This the exchange of the country’s at the time 12.7% that commitment. had a low-inflation 1979 rate of price 1982. long-term of the consumer and is a firm to the achievement country U.S. second, to the decline to fact in 1978, The and points terms nontradable to that contrary 9.0% affecting 2 percentage equal and two objectives: on the part credibility the anchor was rates. set was the shift the dollar that in 1977, circumstances inflation. about country to deliver contributing link to the dollar. similar by declines give record, anchor restraint thereby it would established rate link to the enforce goods low-inflation be expected money, and for traded firmly rate then The assumption was two assumptions must be true, one, that the anchor to succeed, has a firmly adopting do not complicate the strategy, for the nominal inflows Chile? be expected of of a system the peso of waB 34 devalued. As we next As a result rate, which inflow note, monetary of financial were generally of short-term applauded, capital, with in 1981 providing Chilean surged, instead price of dollars rate, the peso authorities not appreciating terms when the seemingly fixed external would intervened. have exchange but Monetary from depreciating, in real terms consequences 1979, 10% in 1981, adjusting balances bought to the in foreign balances, initial credit to rise more growth accelerated. Trying tradable goods of the bank. foreign rose by a third their have fallen to keep sectors inflow The base currencies in demand level foreign the exchange By not declined because importers. unless While foreign By permitting their from exchange before meant than Chilean the peso in 1982, fully in 1980 sterilizing from changing the nominal and benefited in 1981, fully In 1982, of dollars Keeping to prevent spurted. lost competitiveness, price higher assets, in real importers. the base in 1982. changed growth rate but was two-thirds for Chilean balances importers, off than increased (dollars) in 1979. money better doubled in 1980, barely domestic than were exchange had the from exporters in for fixed rate the peso 6.7% demand in 1980-81, not intervened. hurt from at the and benefited faltered, of a large rising exchange a part. of the exchange external and hurt exporters than rates While the nominal exporters fixing to the dollar seemingly and more increase 1982 below yield. pesos also played was the recipient exporters hurt and the interest had the authorities by the central authorities would Keeping rate sterilized fell real of 39 pesos for Chilean increased, rate importers, demand Chile a high benefited exchange apparently liberalization, 1979 to 59.2% peso~ expansion falling the in increase domestic domestic money that, when prices rose in 35 relative the to foreign nominal current anchor. account no problem ceased, goods The trade deficit, but terms deficit. The banking and in pesos, however, sold found almost from the middle 30%, the trade rose. Inflation rate would not an attractive U.S. real capital last. itself interest experiment that the peso account abroad in dollars Output declined The unemployment reserves fell, ended the United spread not only investors but rate rose to and domestic that because also States because credit the peso-dollar Chile the a successful Chile price relates had a choice stability inflows to protect failed. The other ceased to be steep rise competitor for between or letting we draw Goldfajn, the the supply exchange is that, was supply of pesos rate. in the main and Valdes, that exchange priority 1995) . we stress. of an exchange of pesos grow capital to do both chooses rate to protect with By The of the real It tried if a country anchor. 73.43. experience consequences limiting a nominal inflation of the Chilean to the monetary the peso-dollar lesson of overvaluation (Dornbusch, dimensions with the dollar and that making is a mistake overlooks experiment rate with as a case to collapse, strategy One dimension Chile’s exchange assessed was bound assessment internal 1982. foreign inflows made into recession. and expectations for foreign rates has been of economic target. again in 1982 ended the end of 1982, This once posed inflow~ the current had borrowed the continued, capital to distress. was plunged grew, to settle which in dire When commitment Financing inflows steadily. reserves by their inflows. Devaluation rate 10% of GDP. of 1981 to June Capital economy by 1981 was meanwhile, deficit soared stuck as long as capital foreign system, authorities deteriorated At the end of 1981 Chile sharply the deficit of trade the authorities lent prices, and to adopt a 36 nominal anchor, it would be wige to avoid an anchor monetary 1976, 1982, 1994 A.1976. of devaluation Three different episodes macroeconomic incompatibility describe with each one settings the fixed policies. Fiscal financed base foreign financing, rose 20% per annum rose account mounted 2.5% regime were generated in in terms that in of their prevailed. We base exchange and they from of GNP in 1971 to 10% in 1975, rate As a result debt as the main to grow in dollar Accordingly, flight while growth source From of 1974 of deficit Inflation the real the real the deficit price in the rose $5.3 billion price of of current in 1971 to $4.4 billion of approximately rate declined. per dollar, value demand in 1975. strongly. investment of 12.5 pesos ,$1 billion the in 1971 to 33.8% and private stagnated. Capital by expansionary continued surged less than fueled bank. 19.6% domestic in 1973-74, and they 5.5% of GNP. from replaced At the nominal exports similar rate began, from accelerated but the monetary declined in Mexico were exchange from the central debt imports that recovery deficits by borrowing the monetary about swings in turn. In 1972 a cyclical above wide growth. 4.8. Mexican Devaluations, to 1976 undergoing in 1975, was a feature of 1974-76. The Echeverria world prices, and the administration slow growth attributed of exports domestic to world inflation recession, to higher justifying continuing expansionary demand policies. Import controls were imposed, but the exhaustion of foreign exchange reserves compelled the decision allow the peso devalued to float. Inflation to 23 per dollar. Mexico rose to 27%. then entered In October on 31 August the peso into negotiations was for medium- to 37 term financing B. 1982. The Lopez supported target~. was tripled adopted, but combined introduction The deficits. real of government increase large Trade price of imports, quotas were imposed import volume substantially, rose 1978-81, proven IMF oil reserves to the estimate in 1975. IMF program set aside restraints public exchange of the initially was on foreign sector rate fiscal borrowing. spending, (crawling deficit in was at the with rate the (CETES). deficits leading on many still flexible 1977-81 expenditures liberalization the by higher monetization bonds fiscal compared 1977-82, in line with of Mexico’s and weakened a more sector the economy in 1980, in the economy in public The barrels provided and reduced improvement increases. policy with in office the estimate per barrel stimulus, annum), to stabilize 16 billion at $31.25 demand of 9% per huge to 1990). administration, of 1977, of an expansionary more (Buffie program course oil prices favor Once In the IMF Portillo an austerity nearly With from the were was bought that was matched at the expense not matched by balance and real exchange rate to rising account consumer by 15.2%. but nonoil current and capital Dollar exports earnings were by revenue of payments appreciation goods lowered deficits. imports the In 1981 but overall exports rose exchange rate from petroleum hampered of a by real appreciation. The foreign used increase in current indebtedness to finance to some capital private sector debt, service including account income. account $80-odd flight. mostly short-term deficits billion Public in the sector was financed by 1981, debt amortization of which was two form of commercial represented by growth 50% to 83% was and a half loans. in times In 1981 debt an 80% claim on current 38 By mid-1981 reetraint increase was exerted at premiums depreciation wage increase. resort to a dual system was net rose to foreign rate had not previously expansion system and private sectors economy sharply increased prices output and the inflation rate doubled. productive it faced. Instead consumption, C.1994. continued demanded. to A 40% followed by a 30% and the consolidated On 1 Septefier exchange devaluation finance no controls quickly came the banking were introduced. to a halt, as did lending. By the end of 1982 the Mexican fell debt 1982 was continued, in August. and comprehensive by the public and foreign but Massive capital flight was not halted by the of GNP. exchange unavoidable, on 17 February and monetary nationalized, service banks announced 17.6% appeared expenditures, commercial Fiscal debt of the peso on fiscal of the peso public Debt devaluation investment, the debt public sector The dominant the end of 1994 is that view in a vast on the peso by foreign instability in a basically was investors sound would having been literature an innocent frightened economy. foreign not have flight contraction. imported Had the capital investment Mexico in a deep of intermediate Mexico financed was debt been had to endure and public wasteful victim Real used to the plight sector (Buffie on the Mexican 1990). peso crisis of a speculative by manifestations From inputs. The at attack of political 1988 on Mexico certainly had corrected many of the ruinous policies it favored that led to the 1982 debacle and the subsequent period of stagnation. One feature of the economy that had concerned presaged a need also merited some observers to devalue was the peso. a growing Other current features account in 1993-94 deficit of the economy, that however, concern. The condition of the banks at the very least was problematical, with the 39 percent of nonperforming currency denominated loans rising year by year loans firms borrowed from sound currency do not choose liabilities. close more have The Mexican the gap between than one rate were those local varied survived and real that and U.S. rates, the price the collapse after loans. been of output, We next with There was in as good 1994, inflation and the thus exchange it ought rate to a shape as to and nominal stupendous review a not enough dollar/peso in late in the Mexican dollar 1988 but of a fixed its fate it in fact experienced. with performance. economy jumps of total liabilities the underpinnings without 1990 on. Foreign- Borrowers in a country declined it did not deserve devaluation interest unemployment that rate to 27.1% peso had the Mexican Moreover, who believe to replace inflation that 18.5% in dollara. the Mexican indicator ehaky. banks from from rise the origins in of the crisis. Monetary growth was highly quadrupled 1990-92 from 25.3 average introduced billion growth erratic pesos from 1988 on. The in 1989 to 96 billion of Ml was more than level pesos 100% per year. in 1991. The New In Peso, in January 1993, was equal to 1,000 Ml and M3 in 1993-94, which was 20% per annum, was hardly restrictive. about old pesos. of Ml The growth rate of During the 1980s and early 1990s Mexico brought the public deficit under control and reduced outstanding debts. In 1982 domestic and external public debt was 51% of GDP. BY 1992 the ratio was 27%. In 1992 the budget was in balance. Fiscal easing in 1993-94, however, unbalanced the budget position somewhat, but it was nevertheless among the best performers among OECD countries. The government Treasury bills until of less than 1994 financed its short-term one year maturity. When the needs with interest Cetes, rate it had 40 to pay on Cetea laxity, term rose in 1994, as had occurred dollar-indexed government in previous Tesobonos to interest During reflecting 1982-88 rate decades, that paid average annual 1.9% per year. December 1987 opted for an ambitious open the Mexico latter mechanism balance objective, was an incomes a nominal On 1 March its 29 February policy for the next then per day In November in 1990, 1991 at the daily rater fluctuation band from a narrower would band was maintain. to 40 centavos offset the The permitted the end of 1993. Over appreciated, current owing account from that took that down a role capita office would in deliver enterprises, inflation. To achieve but the primary the peso/dollar months that and then peg of 1 new peso of bands in 1991, was exchange extended limit the 4% annually, between annual but this Mexico inflation capital of the inflow that revised per real day limit early 1993 intervention in October was not enough then the The From and the United rate was inflows. the capital was lower constant. range at introduced, and 20 centavos held trading rate it until per day was announced, rate of depreciation 1988 on the trend to growing deficit fixed for the day’s differential The Mexican the period the 86% and per 1.1% to 15% by the end of 1994. day or around inflation was program and bring and the upper established per to short- exposing government-owned 40 per day a system depreciated widened fiscal shifted rate, government was given three In 1989 a crawling in 1992. over anchor. end of the year. 80 centavos interest in Mexico privatize 1988 the government level government stabilization the budget, concern risk. The Salinas to free markets, to trade, rate inflation contracted reforms the a lower and exchange real GDP structural the market’s 1992 to States until 10%. exchange rate The result was a widening financed. The interest sharply rate 41 hikes in the Mexico United and other investment. candidate close vulnerability with would exacerbate fixed until once did not stem peso policy to float would exchange to convince restrict problems again rate. (OECD attraction fluctuation capital band, exchange of portfolio assassination precipitated Foreign the for foreign and the rate, of the outflows signaling reserves the central the market economic for the banks that growth sinking that that drove the were between confronted authorities that out of peso assets, 1995; 1996). Meigs would was under of choosing Mexico bank it would The dilemma On 20 December, shifts diminished drawn down the end of the year. the peso loans. exchange 1994 rate. however, objectives unrest of the exchange monetary nonperforming political in March however, as an outlet of the To defend tighten, markets to the bottom no remission tighten in 1994, emerging In addition, presidential the peso States a weight internal To subpar, and of and external a commitment the peso and on 22 December had to not devalue. already had made devalued have to a by 15%, but that Mexico freed the 4.9. Crisis in the European Exchange Rate Mechanism, 1992-93 In the European Monetary System, Germany was the nominal anchor. Other EMS countries pegged their currencies to the DM in order inflation would this reunification had disruptive event, effects it is claimed, have continued is a realistic autonomy its low- credibility. German that to import and their in 1990 on the European the period until of exchange European projection. exchange is commonly rate The cited Monetary rate System. stability monetary union conflict between commitments would as the external was But that attained. EMS for that began in 1987 We doubt countries’ not have been event that monetary absent, even 42 had German reunification been accomplished without undesirable side effectO. The conjunction of many forces ensured that the slightest shock that could derail the path to monetary union would lead to severe stress on the system (Eichengreen and Wyplosz, 1993). The forces included the elimination of capital controls in 1989, the discouragement of adjustments in parities after 1987, the supposition of credible commitment by member countries to policies consistent with fixed rates, and the unwarranted belief of unlimited intervention on a member to by the Bundesbank in the event of pressure realign. To contain the inflation generated by government budget deficits that financed reunification, the Bundesbank adopted a restrictive policy. It made no allowances for the blow to its domestic real economy its European partners interest rates, Germany. Hence nominal exchange have their devalue, but Italy, currencies. U.S. exchange began dollar, rate rates The other countries enforced There incorrectly Italian participants were thus priced lira was the that quarter many drew first were High capital of German inflows to For the existing other EMS the German countries inflation reluctant would rate to deflate or or to devaluations. of Spain, members, Portugal, from the a realignment that exchange currency the UK, second and half was predictable. of 1992 worsened currencies in foreign inflicted. appreciated. below non-EMS in the first hikes to be plausible, inflation and Finland, to market countries. The rate of loss of competitiveness that were real in the end the market indicated believe a weak arrangements their and of Sweden recession these rate its interest with the German Evidence 1991 coupled had to reduce realign that or to the economies the traders of A situation of had reason to markets. exposed to market distrust of 43 its parity. Italian foreign reserves began to decrease in February 1992 and losses became heavy in June, Lira bond prices then declined futures wealth In July and spot markets. tax on deposits foreign liabilities and the government of a bankrupt downgraded Italian the bottom of the currency of Italy raised but did defend the existing equivalent The Swedish next krona. peg by raising markka. A week rate later, when company. to defend imposed thereupon lira was quoted its parity, the at Bank to 15%. pound was quoted parity, on 3 September slightly intervention. the above To signal Bank its ERM floor, its commitment of England to borrowed $14.5 of DM from the market. to be sold off were had been forced of its trade having short-term rates former Soviet by about bands level and the rates as much to defend floated that of other as three 1991 On 8 of 14%, 13% implied the pegged fluctuation Union. and unwilling the existing of the markka with the markka by 12% in November its reserves, above between the Finnish to devalue with exhausted deviation evaluations, there the the was ERM currencies times the size of ERM bands. Sweden, rate charged borrowed Because Britain, unlike by the a for the Moody’s the the Italy responsibility On 28 August heavy The depreciation and market band. British Finland a substantial holding from AAI to AA3. currencies Finland, state accelerated declined despite to the collapse September also the not recover billion owing debt the discount On 25 August the outflow in both Finland, central to counter bank for overnight DM to add to its reserves. home mortgages the authorities bore floating were the attack Sterling rather constrained bank and than on the regerves lira were fixed in their krona, to 75%, also interest response. raised the and under attack. rates in For the market, 44 this made the British commitment suspect. The Italians responded by intervening on their own and with others, billion in Frankfurt September, next Italy capitulated, day the Bundesbank interest devaluing for the a day the sterling. That reserves. Another below On currency withdrawn Sterling markets. in five years at 24 On 13 lira by 7% against Sweden marginal lending that had survived ending Ireland, Greece, rate were the D-mark. decreased two The key to have was lost and so was $15 billion the peseta that in fell near increase its ERM floor, the minimum lending to 15% which and that rate was never evening put it was on 19 September. Italy and the peseta was devalued by 5% within the ERM. central bank raised under attack to give up. The Swedish On 20 September their ERM its overnight that controls, The Bank of England it to 9% on 21 September. rate had not in September. all currencies floors. 10%, and lowered capital raised indefinitely ready an EC country tightened pressure of its band, then, to 500%. raised on the drachma a further temporarily not yet rate to however, was thought of England fell below from the ERM was at the bottom that was under the Bank from the ERM, also withdrew market, exchange estimated ERM rate. 16 September, into effect. again of England 10% to 12% and announced attack the first time lira was day the Bank its central minimum in other D-marks, rates. Within from and 60 million using its restored its The of Bank to 300%. joined The Bank the ERM, of Greece and raised also suffered intervened the official an in the lending rate from 30% to 40% When de France the French and the franc Bundesbank came under intervened attack on 23 September, heavily. That attack both was the Banque repulsed. 45 On 4 January 1993, banks stated firmly the their when In November, the Riksbank interest ended rate franc was again readiness the krona its ERN to defend again its resistance. to 12.5%. near came The Norwegian krone but both central it. under It floated floor attack, the krona was allowed after and a few hours, lowered to float it8 key on 10 December. On 22 November The Bank of Ireland 2 December again, Spain raised to defend 13 May, since however, the Portuguese escudo was followed under began, suit. There their central by 6%. 26 November the overnight rate was and raised by 10%. in the first pressure, and it was devalued, was parities to 100% between January to subside again attacks rate was devalued appeared the peseta 1992 currency In early the punt of attacks devalued its overnight the punt. but on 30 January The wave and Portugal another months of 1993. for the third this time On time by 5%. The In mid-July, interlude. however, the French franc was only a little above its ERM floor. The increase in French interest convinced market rates traders its link to the DM. This above that was already France not, high German was willing however, ones seems to have to pay the price an unalloyed triumph to preserve for a fixed rate. On 30 July all EM currencies were at the bottom of their bands vis-a- vis the D-mark. On 1 August the ERM was altered, making it closer to a free float than a pegged but adjustable exchange rate system. The bands were widened to 15% above and below the existing central parities. Only the DM and guilder exchange 5. Lessons rates were unaltered (Buiter et al., 1996). from History Our survey of the historical episodes of currency crises in the past two 46 centuries suggests a number of lessons. First, currency crises occur when internal economic conditions for the currency. Institutions and the circumstances in which occurred widely the countries surveyed. across differed all these Second, the crises within standard currency apparent usually short-lived, commitment time practices; in order associated cases with before standard. instability. would the war effort. banking parity before instability. What Under War War Bet crises was common II always a commodity a government of war, when were the it became to suspend In peacetime These following affecting be driven was restored. World conditions currency World Crises on the outbreak the government to pursue to convertibility currency usually For developed crises very countries II was paramount, a norm the that eroded. The experience upon that and the original has since suspended occurred external incompatibility. for two reasons; or banking usually agents arise the we have of a commodity could with basic in the historical crises to market incompatible was this context countries convertibility were the financial developed among experiences occurred unsound are of developing convertibility the market’s under realization peripheral the pressure that countries was different. of speculative the governments were attack pursuing They consequent lax financial policies. Third, exposed to currency individual rate, face crises. countries. incompatible also in the post-World with currency requiring Some They II period occurred countries a commitment crises War an adjustment under followed to the peg. if competitive the Bretton two fiscal Virtuous trends of the nominal Woods was sets of circumstances and monetary countries, had changed parity. system Although policies however, the for real Bretton could exchange Woods 47 wag designed reluctant adverse to voluntarily capital revaluation occurred, but was movements even Bretton unwillingness affairs could they only a hint when delayed was possible because not avert countries were that punished by devaluation adjustment of capital an attack were or finally controls, on the peg that precipitated. Woods itself of the United spillovers because were Consequently, controls from was States, in a noninflationary the dollar in practice, parities if there Delay set of circumstances system, their in the offing. end capital Fourth, pegged alter it was traumatic. in the either as an adjustable subject to a systemic the reserve manner, center country, and of the nonreserve U.S. balance-of-payments crisis. to conduct countries deficits The doomed its to absorb the system. Fifth, that the experience of Bretton Bretton Woods A lesson mobile Woods. capital more parities under and deep international parities. 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