By Max Harris
Exchange rate management is once again in the headlines. The dollar is strong, inflation is rampant, and policymakers around the world are trying to get a grip. Emerging market economies have spent billions to curb depreciation. Advanced economies are feeling the heat as well. In September, Japan’s finance ministry intervened in foreign exchange markets to bolster the yen, Tokyo’s first support operation in decades. Later that month, the pound sterling fell precipitously in response to the new government’s proposed tax cuts—prompting chatter about whether Britain would intervene too. And the Plaza Accord, a somewhat obscure agreement among the major powers in 1985 to check the dollar’s strength, is back in the news, as pundits wonder whether a revamped pact could be around the corner.
In this environment, one could not ask for a more timely book than Alain Naef’s An Exchange Rate History of the United Kingdom, 1945-1992. Building on meticulous research in the archives, Naef explores sterling’s management from the end of World War II to Britain’s ignominious (and expensive) exit from the Exchange Rate Mechanism (ERM) in 1992. It is a story of a currency in transition, no longer preeminent but still a crucial component of the international monetary system. And it is a story, Naef writes, of the Bank of England (BoE) “progressively los[ing] control” of said currency. The commitment to fixed exchange rates—first under Bretton Woods, then under the ERM—ran up against the growing force of international capital flows. Officials at the BoE intervened to counter these flows and uphold the peg, but time and again the pressure was too much. The result: a succession of crises and a pivot to floating.
Naef skillfully guides the reader through these crises, from Britain’s failed attempt to restore convertibility in 1947 to the pound’s devaluation in 1967, from the humiliation of the IMF loan in 1976 to the disaster of Black Wednesday in 1992. The literature on many of these episodes is deep, but Naef adds to our understanding by shining a light on what officials have long sought to conceal: how did exchange managers actually manage sterling? How much did they intervene? When? Where? Historically, policymakers have treated exchange intervention as a state secret (true, the G7 has become more transparent and called for greater disclosure over the past couple decades, but this shift is no doubt made easier by the fact that the G7 now rarely intervenes). Naef has dug into the archival files, many only recently released, to reconstruct the BoE’s foreign exchange operations and the evolution of Britain’s reserves. Scholars of exchange rate management will value the range of empirical exercises Naef performs on the BoE’s reaction function and the efficacy of intervention, as well as his publication of the underlying data online.
This detailed data, in conjunction with daily reports by the BoE’s dealers on market developments, provide insight into the reality of exchange management: the strategies to outwit speculators, the late-night phone calls to counterparts thousands of miles away, the immense sums at play. Exchange managers had a difficult if not impossible task. They were to maintain the peg through intervention but without recourse to any of the policy levers that fundamentally determine exchange rates. That dealers managed to uphold the various pegs for as long as they did is in retrospect quite remarkable, a testament to their keen feel for the market. Sometimes, however, their skill was not enough, and officials resorted to more underhanded methods. For example, Naef shows in fascinating detail how, with markets closely watching reserves data, the BoE used its swap line with the Federal Reserve in the 1960s to manipulate its published reserves, making them appear more impressive than they were. As Naef concludes, “[t]he reserves of the Bank were literally made up.” But even these experiments in the dark arts could not hold off market forces indefinitely.
Naef grounds his analysis in the little-known day-to-day work of the BoE’s exchange managers rather than the more frequently studied high policy of Treasury officials. Nevertheless, it is a bit surprising that in this exchange rate history there is no mention of the Plaza Accord, Louvre Accord, or indeed much of the 1980s. The book would also have benefitted from deeper engagement with the pre-World War II experience. For instance, Naef claims that the BoE’s decision in 1957 to begin sharing information on intervention “indicates more cooperation than in the interwar years when such exchanges did not occur.” In fact, sharing intervention data was an essential component of the Tripartite Agreement of 1936, whereby Britain, France, and the United States vowed to work together in managing international exchanges. Why there was a lapse in cooperation in the early 1950s is left unclear. But these are quibbles; economists, historians, and policymakers will all find much of value in the book, which will surely become a standard reference.
Today, the world is again enmeshed in monetary turmoil. While foreign exchange intervention will remain a key tool for emerging economies, the G7 is unlikely to intervene except on an ad hoc basis, well aware that markets in these currencies are now so large that they could drain central banks of reserves with barely a change in the ticker. But the experience from the second half of the twentieth century detailed in Naef’s enlightening book remains as relevant as ever. If policymakers want greater exchange rate stability, there needs to be greater alignment of macroeconomic policies: that was true fifty years ago and has only gotten truer since. The yen is weak because the Bank of Japan is continuing its easy monetary policy as others tighten; the pound collapsed because the government’s tax plan was out of line with the need for retrenchment at a time of high inflation. In a world where capital is mobile, exchange rate stability and divergent policies cannot long coexist, even with intervention. To be sure, striking the right balance between the need for independent policies and the desire to prevent excessive swings in exchange rates is no easy task. But as a first step, officials should redouble efforts to consult with one another and share information, reducing the risk of surprise or misinterpretation. In volatile times like these, mutual understanding is more important than ever.
Max Harris is Senior Fellow at the Wharton Initiative on Financial Policy and Regulation.