Case Study – British IMF loan 1976 – Part 1

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013 (to be ready in draft form for second semester teaching). Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.

Case Study – The British IMF loan in 1976

It was called the 1976 Pound Sterling crisis and it represented a defining moment in the struggle between the existing Keynesian macroeconomic orthodoxy and the emerging Monetarist rival. It has been considered the point at which the paradigm shift in macroeconomic theory and policy-making was consolidated and marked the end of the full employment era that had been maintained since World War II.

To understand what happened in 1976, we have to take a step back in time and trace the evolution of the currency arrangements in the 50 or so years before the British government approached the IMF for a loan.

Prior to World War II, many nations operated monetary arrangements based on the gold standard, where paper money issued by a central bank was backed by gold and the currency’s value was expressed in terms of a specified unit of gold. At the heart of the gold standard was currency convertibility, whereby a person could swap paper currency for the relevant amount of gold on demand.

By fixing the value of currencies in terms of a fixed amount of gold, the system thus defined all exchange rates. So, if for example, the Australian Pound was worth 15 grains of gold and the US dollar was worth 30 grains of gold, then the each US dollar could buy 2 Australian pounds in trading exchanges.

The monetary authority agreed to maintain the “mint price” of gold fixed by standing ready to buy or sell gold to meet any supply or demand imbalance. Further, the central bank (or equivalent in those days) had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate

Gold was also considered to be the principle method of making international payments. Accordingly, when imbalances in trade between nations arose, gold had to be transferred between nations to fund these imbalances at the agreed parities. For surplus nations in receipt of gold, their money supply would rise because they now had more gold backing.

The rising money supply would push aggregate demand up against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline.

The loss of gold reserves to surplus nations forced the governments of the trade deficit nations to withdraw paper currency, which led to rising unemployment and falling output and prices. The falling prices improved the nation’s competitiveness, which also helped resolve the trade imbalance.

The proponents of the gold standard argued that the monetary constraints prevented the government from issuing paper currency as a means of stimulating their economies and this discipline led to price levels in different trading countries, which were consistent with trade balance.

The problem was that the price adjustments required to resolve the trade imbalances were slow to work and in the meantime, deficit nations had to endure long domestic recessions and entrenched unemployment. The governments in the deficit nations were unable to pursue domestic policies that might deliver sustained full empoyment.

The onset of World War I interrupted the operation of the gold standard and currencies fluctuated at will. Once war ended, there was considerable instability in exchange rates and attempts by some nations to return to the gold standard proved very costly in terms of gold losses and rising unemployment.

This was particularly the result of the creditor nations demanding unrealistic war reparations be paid, which crippled the debtor nations. Countries tried to devalue to restore growth but this led to a competing set of such parity changes – the so-called “Beggar Thy Neighbour” policy period, where one nation could only improve its standing by undermining that of others.

The net result was a severely disrupted international trade system that ultimately contributed to the onset of the collapse of the financial system in the early 1930s and the Great Depression.

The UK, which had been on the gold standard since 1844 with interruptions for war, finally abandoned the gold standard in 1931 as it was facing massive gold losses during the Great Depression. It had tried to maintain the value of the Pound in terms the pre-World War I parity with gold but the war severely weakened its economy and so the pound was massively over-valued in this period and trade competitiveness undermined as a consequence.

World War II effectively ended any hope of a return to a pure gold standard. As World War II was in its last days, delegates from 44 Allied nations met in Bretton Woods, a resort in New Hampshire, United States. The conference was called the United Nations Monetary and Financial Conference and ran between July 1-22, 1944.

Here is Keynes between the Soviet and Yugoslavian delegates.

The Bretton Woods agreement, reached on the last day of the Conference, set the rules for the international monetary system which would run from 1945 and 1971.

The system of fixed exchange rates set the prices that currencies would exchange against each other and established two multilateral institutions, the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (later named the World Bank).

The Bretton Woods agreement created the so-called gold exchange standard whereby convertibility to gold was abandoned and replaced by convertibility into the US dollar, reflecting the dominance of the Unted States in world trade.

There were two basic principles that governed the new monetary order. First, all currencies were fixed in value against the US and the US government agreed to convert US dollars held by official holders (which were central banks and the IMF) into gold at $USD35 per ounce of gold. This provided the nominal anchor for the exchange rate system and certainty among trading nations.

Second, if a nation was in recession and faced an over-valued currency with chronic trade deficits it could devalue to restore balance of trade. Similarly, a nation faced with inflation and an under-valued currency could revalue its currency to reduce net exports.

Central banks now maintained stocks of US dollars as reserves, which they would buy and sell to ensure their currencies stayed within plus or minus one percent of the agreed parity.

Nations runnning trade surpluses were thus able to build up significant US dollar reserves. Deficit nations, facing downward pressure on their exchange rates had to sell US dollars and buy their own currencies on foreign exchange markets to maintain the parity.

When a central bank was forced to buy its own currency and sell US dollars to defend the agreed exchange rate, the reduction in the domestic money supply would cause the domestic economy to contract and unemployment to rise.

While central banks could sell gold to the United States treasury at the convertible price to build reserves this capacity was clearly limited by its gold reserves.

Ultimately, a nation with chronic trade deficits would exhaust their US dollar reserves and be forced to adopt harsh contractionary policies to reduce imports and stimulate exports via the deflation.

Further, the stock of $USD reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities.

Just like the pure gold standard, the Bretton Woods system was politically difficult to maintain because of the social instability arising from unemployment.

The capacity of fiscal policy was thus highly restricted under this system because it could not undermine the central bank’s responsibility to maintain the currency value.

So if expansionary fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels.

Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities.

When a nation faced chronic imbalances they were permitted to revalue or devalue their currencies. These were considered to be once off realignments and generally frowned upon.

As noted above, the Bretton Woods agreement established two new multilateral institutions, which were designed to play separate roles within a global system of exchange rate stability and economic development.

The International Bank for Reconstruction and Development was designed to provide development capital to poor nations.





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    6 Responses to Case Study – British IMF loan 1976 – Part 1

    1. Andy says:

      Very interesting chapter. Sorry if it’s obvious but, under the gold standard, how were the initial exchange rates fixed ? Did it depend on the physical amount of Gold held by each country and, if so were these then periodically reviewed ?

    2. larry says:

      I think the period between the end of WW2 and 1971/2 should be referred to as the quasi-Keynes orthodoxy. Samuelson knew his position was not quite Keynesian and Joan Robinson referred to the policies as bastard Keynesianism. At least, that is how I read that history.

      You left out the important role played by Harry Dexter White, the primary author of the Bretton Woods agreement, which effectively made the US dollar the reserve currency, thereby undercutting Britain’s decaying global empire ambitions further. Keynes’ inept diplomatic efforts gained Britain little other than complaints about how much noise Mrs Keynes made in the early hours of the night dancing. The result was certainly not Keynesian, as the IMF and World bank were American oriented and did not truly represent global interests as Keynes has organized his to do.

      It is of some interest that the Russian delegates were told not to say anything and to act only as observers.

      By 1976, Ralph Miliband, a Marxist oriented political scientist, considered that the Labour Party had effectively sold out its primary constituents. That is still true today, though there appears to be some little movement to recover this ‘lost’ ground.

    3. Larry, the irony being that Miliband’s son is now in charge…

    4. larry says:

      Phil, yes, very. Even more ironic if his brother were in charge.

    5. Roger Erickson says:

      Amazing. In case you thought the Brits weren’t stupid too.

      Can someone explain to me why a fiat currency issuer would EVER borrow fiat, from an institution partially funded with their own fiat? … words fail me

      Just who is colonizing whom here? The Hudson Bay and East India Corp got tired of the travel involved in looting foreigners … and decided to cut out the middleman?

    6. Andy says:

      “Can someone explain to me why a fiat currency issuer would EVER borrow fiat, from an institution partially funded with their own fiat? …”

      To maintain their exchange rate ? The loan was in dollars and they were short on reserves.

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