Monetary Policy and Free Trade Part II

The 1973 Oil Crisis was a consequence of a series of events that illustrate the downfall of free trade whenever the governments take on expansionary monetary policies to tackle a deficit on the balance of payments, without having a strong monetary reserve to adjust parity purchase power between currencies.

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In the light of the Smithsonian Agreements, the European Economic Community (EEC) decides to self regulate, based on the Werner report of 1970.

Nicknamed by economists as the snake in the tunnel model, basically this meant pegging all EEC currencies to one other, through the coordination of macro-economic policies of the Member States. This trading model proposed a much larger bandwith than Bretton Woods, thus allowing currencies to go up or down 4.5% to the dollar. This allowed that one currency could go up 9% relative to the other.

It was then seen as necessary to improve on the permissive nature of the snake in the tunnel. The Basle Agreements of 1972 take place  on the background negotiations for the Rome Treaty with its 6 Member States.

The new model of the snake in the tunnel limited the bilateral margins between European currencies to 2.5% with a maximum turn over of 4.5% and with all moving together against the dollar. This model killed the sterling pound monetary area, but eventually also collapsed when the U.S. dollar started floating freely. in 1977 the Deutsche Mark led as the reserve currency but only with Benelux and Danemark on its tail.

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The 1973 Oil Crisis had strong effects on the Monetary Policy.

The OAPEC proclaimed an oil embargo to sanction the U.S. support to the Israeli on the Yom Kippur war. Europe and Japan disassociated themselves from the U.S. and Kissinger had to negotiate an Israeli retreat from the Golan Heights and the Sinai Peninsula right after the end of hostilities.

Right after Bretton Woods fall, started the free floating of the U.S. dollar, and most industrialized nations increased their reserves by printing more money , which resulted in a depreciation of the dollar and because oil price was indexed in dollars, oil producers were getting less value for the petro dollars, which made them issue the statement of pegging the oil barrel prices to the gold. OPEC/OAPEC were not ready to make the institutional adjustments from the volatility of the dollar after 1967.

With the Middle East hostilities, the West was increasing their energy bill by 5% per year and selling inflation priced goods back to the oil-producers countries in the Third-World. That led to the declaration of the Shah of Iran in 1973: “You  increased the price of wheat you sell us by 300%, and the same for sugar and cement…; You buy our crude oil and sell it back to us, refined as petrochemicals, at a hundred times the price you’ve paid to us…; It’s only fair that, from now on, you should pay more for oil. Let’s say ten times more.”

With the demise of Bretton Woods, the world financial system fell into a recession of inflationary prices until the 1980s, while the oil prices continued to rise up until 1986.

The 73 oil crisis marked for that same reason the very beginning of  alternative energy sources research, so popular in our days.

The Oil Producers immediately started accumulating a vast wealth and pipe lined some of  those monies in the form of aid to other under developed or developing countries. The International Monetary Fund also created the “Oil Facility” instrument (1974-76) destined to help most affected nations to tackle their balance of payments deficit. The IMF loans were subject to one of two pre-conditions:  a petro-dollar international payment deficit or a general balance of payments deficit.

in 1975 the European Economic Community also joint efforts and approved a regulation (law) on European Community loans.

The International community first instinct was to provide support first to the industrialized countries, those who supported Liberal Capitalism in the form of free trade and financial cooperation. The other support was made available, in the form of a special line of credit, to the Developing countries, whose economies had been caught between higher prices of oil and lower prices for their own export commodities and raw materials amid shrinking Western demand for their goods.

Those Non Alignment countries more often than not, with the exception of a few remarkable cases, ended up appropriating that structural adjustment financial loans and deviating it to their ideological programs, such as rearmament and cosmetic public spending infrastructures.

That meant that the credit institutions loans, like the IMF, The Paris Club of Creditors, the London Club of Creditors,  were never repaid in full, while in debt nations spiraled into consecutive loans, that were granted simply to pay for accumulated interests in the short run, in the long run they could never fully regain international confidence, simultaneously degrading their future access to credit line. A few of the final consequences over this matter were moratoriums over the payments, regime nationalizations of oil wells and even civil wars. On the other side, International Creditors even went as far as forgiving outstanding multi-billion dollars debts just to prevent another collapse of the status quo, but unwillingly legitimizing corrupted regimes in the process and preventing reform.

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in 1979 is born the European Monetary System, in the veils of the II oil shock crisis. Back then, the dollar was floating freely and the Deutsche Mark had limited adhesion from other European currencies. The European Monetary System created a central reserve currency, called the ECU (European Currency Unit). With the ECU it was also created an European Exchange Rate Mechanism (ERM), an extension of European credit facilities and the European Monetary Cooperation Fund (precursor of the European Central Bank: that allocated ECUs to Member States in exchange for Gold and U.S. dollar deposits).

The European Exchange Rate Mechanism created a `Parity Grid` of  bilateral exchange rates based on the fixed currency exchange rate margins of the ECU (a semi pegged system where fluctuations were contained within a margin of 2.25% on either side of the bilateral rates, 6% to Italy and enlarging to 15% in 1993 to sustain speculation against the french franc). The ECU fixed exchange rate was based on a weighted average of the participating currencies.

There were two ECU’s: The Official ECU (mostly an accounting unit for reference, circulating among banking institutions), and the `private` ECU (used in international financial transactions). The ECU was regulated by the European Monetary Cooperation Fund (Brussels Resolution of 1978), that would manage the `snake in the tunnel` trends, issuing currency against the deposit of 20% of gold/dollar reserves of the Central Banks of the Member States, with a trimester review of the divergence indicator.

In the 1980’s most economists began to stand for a nation’s central bank independence from the executive to ensure a smoother monetary policy (avoid its manipulation over party politics and electoral fault moves).

The debate over the European Economic Monetary Union, was again launched by the Delors Committee in 1988 (The Member States Central Banks Governors met around the President of the European Commission). And in 1989 the Delors Report set up a 3 stage plan to roll out the EMU, including the creation of The ESCB (European System of Central Banks):

-Stage 1 (1990-93)- exchange controls were abolished, thus capital movements were completely liberalised in the European Economic Community

-Stage 2 (1994-98)- The European Monetary Institute replaces European Monetary Cooperation Fund and is later baptised European Central Bank, setting up the conversion rate for the 11 participating currencies to the EURO; The Stability Pact gets approved at the European Council of Amsterdam to ensure budgetary discipline after rolling out of the euro, and a new exchange rate mechanism (ERM II) is set up to provide stability above the euro and the national currencies of countries that haven’t yet entered the eurozone.

-Stage 3- (1999)- single monetary policy is introduced under the authority of the ECB. A three-year transition period begins before the introduction of actual EURO cash.

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In the 1990s, central banks started to adopt formal, public inflation targets with the goal of making the outcomes, if not even the process, of monetary policy more transparent. This is to say if a targeted inflation is not achieved then the central bank will typically have to submit an explanation.

The Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998 and adopted an inflation target of 2.5% Retail Prices Index (now 2% of Consumer Prices Index).

The underlying point is about whether monetary policy can soften up business cycles or not. Keynes principle is that the central bank can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded.

Nowadays most economies in the world have an inflation targeting (Conumer Price Index) type of monetary policy. These include the U.S. ( a mix model), the European Union and the single currency (EURO), Australia, Brazil, Canada and India, UK. The great exception is China.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate (ex: EURIBOR) at which banks lend to each other overnight for cash flow purposes.

To achieve inflation targets, Central Banks resort to open market operations (sales and purchases of second hand government debt or changing reserve requirements: If the central bank desires to lower interest rates, it purchases government debt, therefore increasing the amount of cash in circulation; A central bank can only operate a truly independent monetary policy when the exchange rate is floating. If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange).

Changes to the interest rate target are made in reaction to many market indicators in an tentative to forecast economic trends and thus keeping the market on track towards achieving the defined inflation target.

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in 1998 the ECU exchange rates of the Eurozone countries were frozen and the value of the EURO, which then superseded the ECU at site, was therefore established. In 1999 the ERM II replaced the first ERM. A currency in ERM II is allowed to float within a range of plus or minus 15% with respect to a central rate against the euro.

The characteristics of an Economic Monetary Union are free circulation of capitals in a free market area , where member states join in  common commercial policy (competition), adopting a series of convergence criteria in the macro economic sphere (budget, fiscal, monetary). Within the monetary union, there is an assurance of absolute convertibility of the currencies between each other in a fully integrated banking and financial unitarian system. Elimination of fluctuation margins and an irrevocable determination of parities.

Monetary Policy and Free Trade- Part I

After the II World War, monetary policy was quickly addressed by the world leaders who proposed to reaffirm it against the governments regulatory control. They argued that it was not to be used anymore by national governments to artificialy regulate trade deficit.

This international initiative sustained that the market economies should uphold their inherent competitive nature (supply and demand), by discouraging countries to depreciate their currency in order to obtain  commercial bilateral and temporary advantages.

According to the theories of uncovered interest parity (Fisher Hypothesis) and parity purchasing power (Cassel 1918): two currencies have different purchasing power, which differential may be overcome by inflation rates. An example of one measure of PPP is the Big Mac Index made popular by the Economist magazine which looks at the prices of a Big Mac burger in McDonald’s restaurants in different countries.

This pictoresque illustration serves to show that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country.

The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued (The Economist.com).

In other words, both imports and exports would balance one another and exempt governments from imposing strong expansionary monetary measures. There would be market regulation over policy increases in the size of the money supply, or decreases the interest rate, such as expanding currency production and restraining foreign currency exchange.

Global monetary affairs came about after the shock effect of the Great Depression in 1929, when international trade was largely restricted to currency blocs, like the sterling area and the British empire. the US State Secretary Cordell Hull (1933-1944) was a strong believer in a `Economic Security` concept based on the premise that the fundamental cause of the wars lay in economic discrimination and  trade warfare.

The regulatory effect would be introduced to prevent wild fluctuations in exchange rates and sudden currency depreciation, those could disastrously stall international trade from flowing freely (like was happening in the 1930s).

The key note was convertibility of currencies. In Bretton Woods is born the system of `adjustable parities` for international payments, returning to the gold standard as it was before the war, only this time using $U.S. as the world’s new central banks reserve currency. Ongoing only until the world’s gold supply could be reallocated via the international trade ways.

The U.S. dollar became the currency with the most Parity Purchase Power and the only one backed by gold. The other countries would buy and sell dollars to keep market exchange rates within plus or minus 1% of the value.

It was a system of fixed exchange rates regulated by newly created intergovernmental financial authorities: The IMF and World Bank. The debate that ruled the discussion was between UK’s Maynard Keynes, worried about England’s post war deficit defending the deflationary measures of a world `bancor`that could issue money and mediate trade between deficit and superavit countries. While on the other side stood Dexter White for the U.S. concerned about inflationary countries.

The IMF represented a pool of national currencies and gold, subscribed by quotas issued to the member states. This institution was in charge of managing the countries deficit and overview national currency devaluations that could trigger  a decline in imports. Each country’s quota would represent their relative economic power and they would pay a credit deposit of 25% in gold or dollars, that the IMF would use as loans according to size of each country’s quota. This is to say a chance for the country with a structural deficit on their balance of payments to buy their loan in foreign currency or gold, eliminating any PPP differential (maintaining stable currency exchange rates, instead of inducing a cut on the imports).

The Marshall Plan didn’t come about until the IMF reserves proved to be insufficient and only when the funds of the U.N. affiliated World Bank turned out to be over-tightly managed in securities by Wall Street. That left zero margin for European countries with deficits and no guarantees of liquidation to access loans. The GATT also was created later. Both outside the scope of this policy.

For the adjustable parities regime of Bretton Woods to work, gold had to have a fix price, each country had to decide their own parity to the dollar when declaring it to the IMF, and countries could not go over the 1% oscillation in currency exchange rate, except in a long run deficit in the balance of payments, otherwise, if temporary, they had to resort to IMF loans.

The IMF decadence however came about the end of the 50s, when its political goal, of security economics took over its fundamentally sensible and strictly macro economic inspiration. Within the context of Cold War, under pressure of keeping developing countries economies open, The World Bank relaxed its loan policies, supporting unstable regimes in South America and even contributing to what would be called the Green Revolution in the 60s.

The U.S. final attempt to rejuvenate the IMF was to create a system of triangular trade, profiting from raw material trade with under developed nations, using the surplus to sell dollars to Europe that would repay by making the U.S. the market for their products.

The U.S. internal struggle to keep gold at $35 an ounce turned sour when gold was rated higher in the open market in comparison to its fixed quote by the central banks, especially when the U.S. had to force a deficit in its balance of payments to keep the system from loosing its triangular liquidity, while at the same time a long term deficit would erode the systems confidence in the dollar as the reserve currency. European loyalty to U.S. military protection in the Cold War prevented a gold rush and kept the dollar as the reserve currency, until a reform of the system could no longer be postponed.

After the war, the U.S. produced half of the manufactured goods in the world and held half of its monetary reserves. Through the 50’s the U.S. held a balance of payments deficit in order to finance loans and troops abroad. in the 70s, the U.S. already had less than 15% of the world reserves.  The U.S. commitment to fix exchange rates and compromise to convert dollars in gold upon demand was no longer sustainable. in 1967 the IMF replaces the U.S. dollar as reserve currency by the famous special drawing rights in parity with the U.S. dollar exchange rate, but non transferable except between banks and the IMF.

Each Member State would be given SDR in a 1 to 3 proportion of their quotas and these accrued interest of 1.5%.

The SDR were created to stop nations from selling dollar-pegged gold to the open market and keep the dollars instead. The European Nations owed American defense policy protection and took upon them a voluntary loss by holding on to the dollars. The SDR were created as a benchmark to put a value on the allies relationship but with no commodity/equity market to go along with that. With Vietnam war the western loyalty was put to trial against the dollar and in 1970 the U.S. gold  coverage of foreign reserves were depleted down to 22%.

Nixon finally put an end to dollar-gold conversion, except on the open market. Nixon also adopted restrictive measures to American imports. First a more flexible clause was introduced to allow for a 2.25% margin of devaluation on agreed exchange rates, but eventually in 1976 currencies were back to floating and exchange rates were no longer in the center of governments monetary policy.

To rescue the system there were the Smithsonian Agreements in 1971 which devalued the dollar down to $38/ ounce and allowed for trading bands or margins in exchange rates to up or down 2.25% , continuing in exclusive with the special drawing rights. Ultimately the Agreements failed to discipline the pressure of gold against dollar.

in 1972 the gold became a floating asset and during the following ten years all the nations abandoned the currency peged exchange market. in 1973 the market opened one morning as a floating currency regime.