Currency Convertibility

Barry Eichengreen, Jaime Reis, Jorge Braga de Macedo

• Publisher: Routledge
• Year: 2005
• ISBN:
  9781134825684
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The spread of currency convertibility is one of the most dramatic trends of the late twentieth century. It reflects the desire of policymakers to integrate their economies into the global trading system and to attract financial capital and direct investment from abroad.In this book a team of leading international economists and economic historians look at parallel situations in the history of the international monetary system, focusing in particular on the gold standard. The concluding chapter uses a case study of modern Portugal to draw out implications for modern international monetary relations in Europe and for the rest of the world.

Part I: OVERVIEW

1: INTRODUCTION: Currency convertibility in historical perspective—the gold standard and beyond

Jorge Braga de Macedo, Barry Eichengreen and Jaime Reis

One of the most pronounced international economic trends of the late twentieth century is the adoption of convertible currencies. For many years after World War II, countries maintained restrictions on the freedom of residents to convert domestic currency into foreign exchange, Until the end of the 1950s the industrial economies, aside from the United States and Canada, controlled purchases and sales of foreign currency for purposes related to current account transactions (that is, purchases and sales of goods and services abroad). Developing countries were slower still to restore convertibility on current account. The centrally planned economies, for whom restrictions on convertibility were a corollary of their strategy of suppressing the market economy, never began the process.

In recent years this situation has been transformed. Current account convertibility is now an economic fact of life throughout the industrial world. An increasing number of developing countries have relaxed exchange restrictions. Many of the previously-planned economies of Central and Eastern Europe, including several of the successor states of the former Soviet Union, have opted for convertibility after debating its merits relative to those of a payments union. The spread of convertibility reflects the desire of national policy-makers to integrate their economies into the global trading system. It is driven by the effort to attract financial capital and direct investment from abroad. It signals that governments have made significant progress in implementing a stable and sustainable macroeconomic strategy.

Many countries have followed the establishment of current account convertibility by relaxing restrictions on international capital flows (by establishing convertibility on capital account, in other words). While the removal of controls on capital account transactions has been selective, in significant parts of the world—Western Europe for example—controls have all but disappeared. Members of the European Union participating in the Exchange Rate Mechanism of the European Monetary System peg their currencies to one another within multilateral bands without any restrictions on international capital flows. An increasing number of developing and transition countries, seeking to encourage the growth of their financial markets and to attract funds from abroad, have relaxed or removed controls on capital inflows and outflows.¹

This trend toward currency convertibility raises a host of questions for economists and policy-makers. Can developing and transition economies rely on foreign capital to meet their financial needs, or will international financial markets prove fickle, as they have in earlier periods? Can the volatility of capital inflows and outflows be managed? Can central banks successfully peg their currencies to those of major trading partners, as countries like Estonia and Argentina are attempting to do, or will they suffer unmanageable speculative pressures, like those experienced by some members of the European Monetary System in 1992–93 and Mexico in 1994?² Is there a compromise between the extremes of floating exchange rates on the one hand and monetary unification on the other?

While the countries and circumstances differ, the questions are not new. In a sense, the current situation represents a return to an earlier era, when countries were on commodity standards, legal tender was convertible on demand, and individuals were free to import and export specie. In the cases of Estonia, Argentina and the small, open EU member states seeking to peg their currencies within the EMS, it resembles nothing so much as the gold standard of the late nineteenth century. The parallel encourages the attempt to seek lessons in the history of the international monetary system.

This book attempts to do just that. It seeks to draw out the implications of gold standard history for modern international financial relations, focusing on the small, open economies at the fringes of the gold standard system whose experience resembles that of small, open economies in Southern Europe and other parts of the world today. The contributors are international economists and economic historians. They draw evidence from cross-country comparisons and national case studies. Much of the case study material is taken from the experience of one country, Portugal, with a particularly rich and informative—yet relatively neglected—international monetary history.

Often controversy over the advisability of instituting convertibility and pegging the currency revolves around whether these policies can buttress the credibility of policy-makers’ commitment to price stability. Michael Bordo and Anna Schwartz, in Chapter 2, ask whether the gold standard can be understood as a credibility-enhancing rule. They present evidence, from 21 countries between 1880 and 1990, consistent with the notion that the gold standard can be understood as a contingent rule that enhanced the credibility of the commitment to price stability. The rule was contingent in the sense that it was binding under normal circumstances but could be relaxed in times of crisis. It worked smoothly, Bordo and Schwartz conclude, in the industrial countries that were at the core of the gold standard, but not in developing countries at the periphery of the system. But the authors caution that an exchange rate rule was not sufficient for credibility, although it could enhance a domestic commitment to stable policies.³ They emphasize that the effects and effectiveness of the gold standard rule depended on the economic and political context in which it operated. It was credibility-enhancing only when specific political and economic conditions were in place. Of such conditions, Bordo and Schwartz single out economic maturation and development, which cultivated support for the gold standard by creating a constituency of industrial and commercial interests that stood to benefit from monetary stability.

This theme is taken up in Alan Milward's chapter, which stresses the association of the gold standard with economic development and the constitutional rule of the middle class. The gold standards displacement of alternative monetary arrangements in the second half of the nineteenth century reflected the growing influence of the industrial and commercial classes, in Milward's view. To assume that the movement to the gold standard reflected efficiency considerations alone is to ignore the over-arching role of politics.

Political considerations are prominent also in Marcello de Cecco's analysis of central banks and international capital flows. De Cecco shows how the success of an exchange rate policy under the gold standard hinged on the elusive factor of market confidence. He underscores the limitations of standard prescriptions of the steps the authorities could take to gain credibility in the markets. He dismisses as simplistic the view that monetary authorities who were officially independent in fact enjoyed freedom from political constraints. Central bank policies under the gold standard, he insists, were shaped from the start by the politics of banking and diplomacy.⁴

There is an analogy here with recent work in economics emphasizing the political prerequisites for maintenance of an exchange rate peg. Early models of speculative attacks on pegged currencies assumed that instability erupted when a government's foreign exchange reserves fell to some arbitrary lower level.⁵ Currency instability in these models was driven by the economic determinants of the balance of payments (relative national inflation rates, budget deficits, productivity growth rates, etc.). Recent models, in contrast, acknowledge that countries can borrow from abroad, rendering the level of reserves irrelevant, and argue that speculative instability is likely to arise when the political costs of defending a currency peg become prohibitive (because, for example, overvaluation aggravates domestic unemployment, fanning opposition to the government's policies).⁶

Under the gold standard these politics played themselves out in different ways in countries situated differently in the international system. The standard view, echoed in Bordo and Schwartz, is that the political conditions for a sustainable currency peg were in place in the industrial countries at the core of the gold standard system but not in the developing countries of the periphery. Barry Eichengreen and Marc Flandreau object that the geography of the gold standard is not adequately captured by this core-periphery distinction. They show that the international monetary system of the second half of the nineteenth century is more accurately described in terms of currency blocs. There existed several such blocs, each with a center and periphery, rather than a unified world system with a single core. Monetary arrangements in each bloc depended not just on factors common to countries at comparable stages of economic development but also on the particular history and economic characteristics of the countries comprising the bloc.

Many readers will detect echoes here of the current European debate over variable geometry. In that context the question is whether the members of the European Union should attempt to construct an evenly integrated economic, financial and political area, adopting a procedure in which the slowest ship is allowed to govern the speed of the entire convoy, or whether different member states should be allowed to proceed at different speeds, forming a series of (perhaps overlapping) commercial and financial blocs. Increasingly, the consensus view is that some form of variable geometry is inevitable because not all countries are prepared to proceed with further integration initiatives, particularly in the monetary domain. But if variable geometry is the answer, it is also a source of questions. For example, should variable geometry be ‘positive’ in the sense that any country that wishes to participate in a particular integration initiative should be entitled to do so, or ‘negative’ in that only countries which satisfy specific preconditions will be allowed to proceed?

The gold standard can be seen as precisely a form of positive variable geometry. Not all countries participated. Those which joined, upon satisfying the minimal conditions for currency convertibility, did not have to seek the approval of the incumbent members of the gold standard club. All countries that wished to participate were permitted to do so. There is no evidence that countries which experienced financial difficulties subsequently—the Latin American countries, considered by Bordo and Schwartz, or the Southern European countries like Italy, considered by de Cecco—destabilized the common monetary standard. Positive variable geometry seems to have delivered tolerable results under the gold standard, in other words.

Portugal was the first nation to join the United Kingdom on the gold standard in 1854, and the last to restore gold convertibility in 1931. She was the penultimate member state of the European Community to join the EMS in 1992. The papers by Jaime Reis, Fernando Santos and Jorge Braga de Macedo analyze the 1854, 1931 and 1992 decisions. In 1854 Portugal's decision was a reflexive response to the monetary crisis of the 1840s. In 1931 the decision to join the gold standard had been in place for the better part of a decade; it was part of a grand policy design and was taken despite, not because of, the economic crisis of the 1930s. In both cases the timing of Portugal's adoption of the gold standard differed from that of other European countries. And in both cases historical contingencies had important implications for the country's subsequent international monetary experience. In 1854 Portugal adopted gold convertibility on the eve of a period when one country after another joined the gold standard club, reinforcing the advantages of membership and minimizing the strains of adopting the requisite policies. In 1931, when Portugal again joined the gold standard, the international monetary system was about to enter a period of crisis. It is no surprise that Portugal's subsequent gold standard experience was tumultuous and abbreviated.

The parallel with the 1990s is obvious. In 1992, when Portugal joined the EMS, German unification was placing upward pressure on European interest rates and subjecting the EMS to strains. It follows that Portugal's experience was stormy and that the escudo naturally attracted the attention of speculators.⁷

Portugal's monetary policy decisions were more than financial froth on the surface of deeper economic currents, however; they could themselves shape fundamental economic developments. Eugénia Mata and Nuno Valério, in their overview of 150 years of Portuguese currency experience, highlight the importance of international monetary policy decisions for the country's economic development. Portugal ‘s suspension of convertibility in 1891, they observe, was costly in that subsequent lack of access to international capital markets implied policies of fiscal austerity and slow growth. The suspension of convertibility in 1931 again discouraged inward foreign investment, although it left a heritage of monetary stability that lasted for more than 40 years.⁸

As Jorge Braga de Macedo observes in his chapter, Portugal's entry into the EMS in 1992 was in effect a third attempt to cement the escudo's convertibility.⁹ The 1992 decision resembles that of 1854 in that it was designed to deal with specific problems of inflation and adjustment. It resembles that of 1931 insofar as it was part of an over-arching strategy to integrate Portugal into the European economy.

The pay-off to that strategy will depend on the success with which the member states of the European Union navigate the final stages of their integration process. A key question for the 1996 Intergovernmental Conference is which member states will participate in the monetary union when Stage III of the Maastricht process commences, presumably at the beginning of 1999, and how the criteria determining whether countries qualify for participation will be applied. It is all but certain that monetary arrangements in Stage III will involve variable geo...

Table of contents

• COVER PAGE
• CURRENCY CONVERTIBILITY
• ROUTLEDGE EXPLORATIONS IN ECONOMIC HISTORY
• TITLE PAGE
• COPYRIGHT PAGE
• FIGURES
• TABLES
• CONTRIBUTORS
• PREFACE
• PART I: OVERVIEW
• PART II: MYTHS AND REALITIES OF THE GOLD STANDARD
• PART III: PORTUGUESE CURRENCY EXPERIENCE
• PART IV: IMPLICATIONS FOR EUROPE IN THE 1990S