Inadequate mechanism for the creation of liquid reserves

The essential defect of the international monetary system is that, apart from such additions to reserves as result from intermittent increases in monetary stocks of gold, provision is made for the expansion of liquidity mainly through the deficits of key currency countries, whereas those countries may not be running deficits concurrent with an expansion in world demand for liquid reserves. Moreover, the maintenance of confidence in the system depends on the key currencies being strong, and hence on the key currency countries usually being in external balance, if not in surplus. Without provision for an orderly increase in liquidity to permit financing of a growing volume of trade, economic development is inhibited.
Even under the international gold standard, the mining of new gold was not the sole means available for increasing the world's stocks of liquid reserves; since any upward adjustment in the price of gold was ruled out by the basic assumptions of the system, the necessary growth of liquidity depended to a considerable extent on the use of sterling as a reserve currency by many countries. The difficulties faced in the inter-war period in operating the international gold standard reflected, among other things, the dangers to which the international monetary system is exposed when too much reliance is placed on one or more key currencies for providing world liquidity.

More recent experience reiterates this lesson. The fundamental difficulties of the system had been widely recognized before the crisis of 1971. In fact, the very success of the system revealed its basic weaknesses since the increase in world liquidity was made possible by a steady decline in liquidity in the USA and, with it, the key currency of the entire system. As long as the relative shift was interpreted as a transient phenomenon of post-war recovery in western Europe and Japan, it was greeted with satisfaction by all parties concerned. The momentum of the relative shift proved, however, surprisingly enduring. As early as the beginning of the 1960s, signs of the vulnerability of the dollar began to appear even while fears of a post-war dollar shortage lingered on. A foretaste of massive attacks on a reserve currency was provided by the repeated sterling crises of the early 1960s. Here it was evident that the basis of sterling as a reserve currency, inherited from the UK's past pre-eminence in world trade and finance, had changed fundamentally when the size of its Empire was greatly reduced and its overseas investments mostly liquidated. While the relative decline of sterling meant the rise of the dollar as the undisputed reserve currency, an attack on sterling frequently also meant an attack on the dollar. Responses to the strains and stresses of the system and to periodic attacks on the dollar had been largely palliative in nature.

The upsurge in the price of gold, reflecting doubts about the contention that the dollar was as good as gold, was dealt with first by the major central banks which pooled their operations, and subsequently by a two-tier system which severed the gold market from official monetary transactions. As the USA's gold stock fell far below its official liquid liability and USA's deficits continued, the collapse of the system was only postponed by great restraint on the part of the major central banks which refrained from massive conversion of their large dollar holdings into gold. Periodic disquiet in the exchange markets was allayed by such devices as sway agreements, special bond issues to mop up excess official liquidity, and forward exchange operations. Nevertheless, the inability of the central banks to maintain the fixed exchange rate of the dollar finally triggered the crisis of 1971. It began with a massive movement of short-term capital from the USA in 1970 after the reversal of an extremely stringent monetary policy in 1969. As the European countries and Japan continued their restrictive policies at the beginning of 1971, interest differentials between these countries and the USA widened. A total of $12.5 billion left the USA during the first two quarters of 1971, as the effect of the interest differential was magnified by the sharp deterioration in the USA trade balance. Eventually, in May, the pressure on some European currencies became so heavy and the dollar accumulation so large that the Federal Republic of Germany and the Netherlands decided to float, and Austria and Switzerland to appreciate their currencies. These measures and official interventions in the exchange markets by the central banks of western Europe and Japan proved unable to stop the flight from the dollar. On one or two days in August, the outflow reached as high as $1 billion. On 15 August 1971, the USA suspended the convertibility of the dollar into gold or currencies. Other emergency measures included a 10% temporary surcharge on dutiable imports. Since the surcharge fell most heavily on manufactures and exempted many raw materials and products, it affected about 60% of the developed market economies' exports to the USA and about a third of those from the developing countries.

These dramatic measures had important repercussions on the rest of the world. The countries of the EEC were for a time unable to adopt a common policy in response to the new situation. The floating of some currencies posed a threat to the EEC's internal cohesion. In France, the imposition of capital controls and a two-tier exchange system reversed the trend towards liberalization of the European capital markets. In Japan, the initial reluctance to revalue the yen was overcome only when the Bank of Japan, in the course of a single month, accumulated over $4 billion, more than its entire international reserve of a year before. The developing countries whose reserves were mostly in dollars suffered a heavy loss, although their debt burden, also mainly expressed in dollars, was correspondingly reduced in terms of other currencies. Exporters of commodities largely destined for the USA market, such as coffee, wool and tin, were faced with a possible decline in the purchasing power of the proceeds in terms of other currencies. The application of the surcharge to the developing countries was considered unwarranted since the payments deficit of the USA was on the whole unrelated to trade relations with these countries. Moreover, the surcharge was counter to the commitment to introduce a general preferential scheme favouring imports from developing countries.

Despite the slow growth of stocks of monetary gold, world liquidity outside the USA, not including special drawing rights, trebled between 1950 and 1970. Although the increase was especially conspicuous in a few industrial countries, it was general and widespread. This liberal supply of liquidity formed the basis for domestic expansion in most parts of the world and for steady liberalization of exchange controls and trade, which in turn facilitated growth.
(F) Fuzzy exceptional problems