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Currency tensions: What historical parallels teach

Today’s currency tensions are the result of a complex set of forces arising from the Great Recession. This column presents lessons from the break-up of the gold standard and of the fixed-rate dollar standard. While competitive devaluations are less likely today than is commonly feared, there is no room for complacency.

Today’s currency tensions are the result of a complex set of forces arising from the Great Recession (Claessens et al. 2010 and Evenett 2010). Understanding the present, however, is frequently eased by an understanding of the past.

Today’s exchange-rate system, despite being a hodge-podge of variable, managed, and pegged rates, has served the world economy well during the global crisis (Dadush and Eidelman 2010). Acting as a safety valve, flexible and semi-flexible exchange rates have enabled relatively smooth currency adjustments, and pegged rates have generally held. For most of the 40 largest economies, real effective exchange rates have remained within reasonable bounds and, of the 10 that saw real-exchange-rate appreciation exceed 10%, five countries have current-account surpluses and three have seen large resource finds.

Compared with previous episodes, today’s currency turmoil appears mild. Volatility is less pronounced1 and only five of the 25 major currencies for which comparable data is available are seeing exchange rates shift by more than they did either before the collapse of the fixed-exchange-rate system in 1973 or before the concerted interventions around the Plaza Accord in 1985.

Nevertheless, this currency turmoil cannot be taken lightly. Currency tensions have a tendency to escalate and, as we will see, have been associated with heightened protectionism in the past.

Figure 1. Change in real effective exchange rate (Percent change from 2006 to 2007, average to November 2010).

History lessons

While it is true that currency tensions often arise between countries with flexible exchange rates, the potential for conflict is sharper among economies that “manage” their currencies and, perhaps even more so, between these countries and those that let their currencies float (such as the US and Japan). Fixed exchange rates are common; about 50 countries peg (or quasi-peg) their currencies to the dollar and nearly 30 peg to the euro (IMF 2009). Germany, the world’s second largest exporter, shares a currency with about half of its export markets and benefits from major competitiveness divergences with them as well as with Eastern European countries that peg to the euro. Viewed through this prism, the turmoil that preceded the collapse of history’s two fixed-exchange rate regimes – the gold standard in 1936 and the fixed-dollar rate regime in 1973 – provides three useful lessons.

Lesson 1: Most devaluations were not competitive

The gold standard’s collapse in the 1930s provides the fodder for today’s fears of a currency war. From 1930 to 1938, 20 countries devalued their currencies by more than 10% at least once. Some countries – like France, Greece, and Spain – employed this tactic more than five times from 1923 to 1938.

Source: Simmons (1994).

Though successive devaluations were part of a vicious circle of depression and tariff increases that led world trade to collapse by more than one-third, they are directly responsible for only a small part of the deterioration. Research by Eichengreen and others suggests that countries that devalued were less likely to engage in direct protectionism, while those that stayed on the gold standard suffered deflation and hurt trade through the demand channel (see, for example, Eichengreen 1992).


Most importantly, it is not clear that competition for export markets provided the main motivation for these devaluations. Studies suggest that the decision of a country’s main trading partners to devalue their currencies was not a major factor in that country’s own exchange rate choice. For example, Wandschneider (2008) finds that increased trade with countries on the gold standard made a country only 0.05% more likely to stay on the standard, while Simmons (1992) estimates that larger traders were actually less likely to stick with gold.

During the collapse of the fixed dollar rate in the early 1970s, openness to trade seemed to actually discourage countries from floating their currencies. Legernes and Vardal (2000) find that, for every 1% increase in trade openness, countries were 1.29% less likely to adopt a floating rate.

At the same time, the tensions associated with the collapse of that regime also brought with them increased protection – the US imposed a 10% import tax when it suspended gold convertibility, though it eliminated the tariff four months later as part of the Smithsonian Agreement. Still, according to Van der Wee (1984), the dollar devaluation was followed by a decade of “neo-protectionism”, including quotas, subsidies, and non-tariff measures.

Lesson 2: Domestic priorities win out

Domestic worries played a larger role than trade concerns in breaking both fixed-rate regimes. In both cases, domestic objectives called for one monetary policy, while currency objectives called for another. Under the 1930s gold standard, maintaining pre-war gold parity rates required tight monetary policy and deflation, especially in Britain. Under the fixed-dollar rate standard, the fixed rates instead required higher inflation as US inflation accelerated, but many economies, especially Germany, resisted this. In both cases, domestic objectives eventually won out: Britain devalued in 1931, and Germany was one of the first countries to allow appreciation against the dollar.

Lesson 3: Confidence in the core countries is critical

Under both fixed-rate regimes, periphery countries often held foreign exchange reserves in currencies from the “core” – France, Britain, and the US under the gold standard, and only the US under the fixed-dollar rate – to facilitate greater liquidity. But both regimes rested on the core currencies’ parity with gold. This only worked as long as markets maintained confidence in the currencies – and, more fundamentally, the policies – of the core countries.

As the ratio of currency to gold grew, confidence in the core eroded, however, and insufficient reserves were instrumental to both collapses. The asymmetry of these arrangements also made them unsustainable – while all countries depended on the dollar (or franc and British pound) to maintain parity with gold, they had little influence on US (and French and British) policy.

Today, the dollar remains the world’s main reserve currency (it accounts for 62% of foreign reserves) and the reference for half of the world’s currencies (Goldberg 2010). As China’s harping over US fiscal deficits and the outcry over QE2 shows, other countries remain uniquely sensitive to US policy and the dollar’s fluctuations. The euro plays a smaller, but still crucial role, accounting for 27% of reserves, and concerns about its stability also contribute to currency tensions today.

Policy implications

In some respects, this historical sketch is reassuring. It suggests that, even when currency tensions appear to have degenerated into competitive devaluations in the past, the main motive for devaluation lay elsewhere, principally in the need to align the exchange rate with domestic policies. But that is also the bad news. It suggests that, unless politically thorny domestic reforms are tackled, currency tensions will continue to fester, and may escalate. Currency tensions could contribute to inappropriate macroeconomic policy responses, deterioration in international relations, and protectionism (though not necessarily in the form of competitive devaluations), especially if the global macroeconomic environment worsens.

How can we avoid this? The answer takes two forms: encouraging greater exchange-rate flexibility and, more crucially, enacting domestic reforms in the core countries.

The attractions of a fixed exchange rate are clear, especially for small, open, developing countries that are ill-equipped to deal with volatility. Yet, for all countries with managed exchange rates – and especially those with obviously excessive foreign exchange reserves – the experiences outlined above corroborate the current consensus: more flexible exchange rates provide a better mechanism to deal with shocks, and reduce the likelihood of large discontinuities in macroeconomic performance. In addition, they should help allay currency tensions. Nonetheless, the decision to adopt a more flexible exchange rate – and the pace at which it is done – must depend on individual country circumstances as well as the global context.

Above all, our historical review underscores the importance of confidence in the core countries.

The potential for currency instability associated with the European debt crisis is in a class of its own. Even under the best of circumstances, and assuming that the raging debates on the zone’s new institutional arrangements and on how core countries will help are resolved, many years of uncertainty and wrenching adjustment are in store, and this will be reflected in bouts of extreme euro volatility.

For its part, until the US finds the political will to put its fiscal situation on a sound and sustainable path, and to enact reforms that encourage higher household savings, unease about the world’s reserve currency will remain. Unless these problems are dealt with, large US current-account deficits could re-emerge with economic recovery, and again accentuate currency tensions.

As a minimum, policymakers need to develop greater awareness of the deeper reasons behind currency conflicts and work together towards enacting these reforms; it will help them strike compromises, show greater forbearance, and – hopefully – avoid a descent into protectionism.


Claessens, Stijn, Simon J Evenett, Bernard Hoekman (eds.)(2010), Rebalancing the global economy: A primer for policymaking, A VoxEU.org Publication, 23 June.

Dadush, U and V Eidelman (2010), “How to Avoid a Currency War”, International Economic Bulletin, Carnegie Endowment for International Peace, 14 October.

Evenett, Simon J (ed.)(2010), The US-Sino Currency Dispute: New Insights from Economics, Politics, and Law, A VoxEU.org Publication, 15 April.

Eichengreen, B (1992), Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, Oxford University Press.

Goldberg, L (2010), “Is the International Role of the Dollar Changing?”, Current Issues in Economics and Finance, Federal Reserve Bank of New York, January.

IMF (2009), “De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks,” 25 February.

Legernes, L and E Vardal (2000), “From Fixers to Floaters: An Empirical Analysis of the Decline in Fixed Exchange Rate Regimes 1973-1995”, Econometric Society World Congress 2000 Contributed Papers 1754.

Simmons, B (1994), Who Adjusts? Domestic Sources of Foreign Economic Policy During the Inter-war Years, Princeton University Press.

Van der Wee, H (1984), Prosperity and Upheaval: The World Economy 1945-1980, University of California Press.

Wandschneider, K (2008), “The Stability of the Interwar Gold Exchange Standard: Did Politics Matter?”, Journal of Economic History, 68:151-181.

1 The standard deviation of the real effective exchange rate shifts of 25 major currencies from their 2006-2007 average to November 2010 is 11%, compared to 13% both from their 1979-1980 averages to March 1985 (Plaza Accord) and from their 1969-1970 averages to December 1973 (fixed exchange rate collapse).