The historical experience of the last century provides a testing ground for the hypotheses that cycles in exchange rate regimes may be predicted in terms of the `rules-versus-discretion' theory of monetary policy. The classical gold standard was temporarily disrupted by World War I, and it was later abandoned at a time of unprecedented economic and financial instability. That was followed by beggar-thy-neighbour trade policies and further instability. Fixed exchange rates were re-established after World War II, but they broke down with the Vietnam war and the oil shock. They are now being pursued again in Europe, both within and outside the Community.

In Discussion Paper No. 661, Programme Director Alberto Giovannini considers the establishment and experience of the Bretton Woods regime and compares it with its predecessors, in particular the classical gold standard, to assess the view that countries resort to floating rates as a temporary response to large shocks to the world economy but then revert to fixed rates. According to the rules-versus-discretion theory, fixed exchange rates provide valuable commitments to national monetary authorities, which governments will abandon by invoking `escape clauses' only when large exogenous shocks make `tying the hands' of their monetary authorities too onerous.
Giovannini notes two main difficulties in applying this theory to the history of the international monetary system. First, it may not apply to a fiat currency system such as Bretton Woods, under which banknotes were not convertible into gold and monetary authorities were not required to intervene in the gold market. Second, the historical records of the establishment of the Bretton Woods institutions indicate that policy-makers then sought to substitute more flexible monetary policy coordination for the fixed convertibility rules of the gold standard. This compromise, which probably resulted from the UK's resistance to codification of disciplinary rules, indicates that the return to fixed rates did not re-establish the dominance of rules over discretion.

Giovannini examines the behaviour of interest and exchange rates under the gold standard and Bretton Woods, and he finds that the official parities were not credible at times of large shocks, although the very narrow gold standard bands helped to keep European interest rates within narrow margins for many years. The statistical evidence on the credibility of monetary rules under either regime or whether one was more credible than the other is ambiguous. Credible monetary rules may be valuable, but the post- war return to fixed rates was not inspired by any desire to reinstate them: inter-war experience made the return to gold anachronistic and impractical, but the alternative constructed by the creators of the IMF lacked credibility.

Bretton Woods and its Precursors: Rules versus Discretion in the History of International Monetary Regimes
Alberto Giovannini

Discussion Paper No. 661, June 1992 (IM)