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What We’ve Learned in the 50 Years Since Bretton Woods - Global Exchanges

FICC Podcasts August 17, 2021
FICC Podcasts August 17, 2021

 

In this week's episode, we look back at the moment fifty years ago this week when the Bretton Woods System began to crumble because the US suspended the convertibility of the dollar into gold. We discuss key lessons learned over the past fifty years of floating exchange rates with an eye forward to what those lessons might teach us about the future.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:

Hi. Welcome to episode 17 of Global Exchanges, a podcast about foreign exchange markets and related issues. I'm Greg Anderson. In this week's episode, my cohost, Stephen Gallo, and I will be looking back at the moment 50 years ago this week when the Bretton Woods system began to crumble because the U.S. suspended the comfortability of the dollar into gold. We will discuss key lessons learned over the past 50 years of floating exchange rates, with an eye forward what those lessons might teach us about the future. The title for this episode is What. We've Learned in the 50 Years Since Bretton Woods.

Stephen Gallo:

Hi. I'm Stephen Gallo, a London-based FX strategist. Welcome to Global Exchanges, presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's cohost.

Stephen Gallo:

In each weekly podcast, like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets, like commodities.

Greg Anderson:

We strive to make this show as interactive as possible. So don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Stephen Gallo:

Well, Greg, it's the 17th of August, 2021 and this is our 17th podcast. How about that for coincidence? Being the 17th of August, it also means we're just past the 15th of August, and that was the 50 year anniversary of a very important moment in monetary and foreign exchange history. It was the date on which the United States suspended the convert ability of U.S. Dollars into gold by foreign governments.

Greg Anderson:

Wow, Stephen, talk about dredging up ancient history. But let's be honest, we're in the dog days of summer, markets are really boring right now. So actually I like the fact that we're going down this road. I think it will be fun. But we should probably talk a little bit about what the FX marketplace looked like prior to August 15th, 1971. You mentioned the U.S. fixing the dollar to gold, but can you go into a little bit more detail?

Stephen Gallo:

Sure, Greg. Happy to provide a bit more detail. So what I mentioned was the U.S. unilaterally deciding to end the convertibility of U.S. Dollars into gold, which as you suggested, implies that the U.S. would sell gold in exchange for U.S. Dollars at a fixed price. Up until the early 1970s, the official conversion price was $35 an ounce. Although if you go back and look at historical chart of gold, you can pretty clearly see that pressures were starting to build up for a devaluation of the dollar versus gold by the late 1960s, early 1970s.

Stephen Gallo:

But let's just take a step back for the sake of background, the system through which the U.S. Government would redeem dollars for physical gold was known as the Bretton Woods System. And it was established by a large number of world governments in 1944 on the eve of the conclusion of World War II. And I think the term eve of the conclusion of World War II pretty much sums up the rationale here. Governments were aiming for a monetary system that would after years of bloodshed and war promote exchange rates, stability, prevent competitive devaluations and encourage steady economic growth. And so the decision was eventually made for the other major fiat currencies of the time, obviously Germany wasn't on that list, to be pegged to the U.S. Dollar and for the U.S. Dollar to be fixed to the price of gold at $35 an ounce.

Greg Anderson:

I'm actually amazed that any system of fixing exchange rates, like you described with the Bretton Woods System, could last for more than 25 years. I say that just because the relative current economic condition and the relative future prospect of nations change every few months. So for relative prices, i.e. exchange rates, to stay flat for 27 years, it just seems amazing. So what led to the undoing of the Bretton Woods System?

Stephen Gallo:

Well, you know what, Greg, I kind of have two angles on this. The first is economic. With the U.S. Dollar being the global benchmark currency post the second world war and a large supply of dollars required at the global level, in layman's terms, my angle is that the Bretton Woods System simply couldn't ensure U.S. Dollars were adequately supplied to the world economy and be convertible at just $35 per ounce of gold at the same time. The price of gold was just too low. And for its part, the U.S. couldn't keep its external position imbalance with an overvalued exchange rate. But my second angle, Greg, and feel free to comment on this if you want, is purely political. When you've got unemployment rising, as the U.S. did in the early 1970s, and the inflation rate climbing, as it did in the U.S. during the second half of the 1960s, the government is going to want more fiscal leeway and the monetary policy flexibility to support it. And so politics intervened, as is almost always the case.

Greg Anderson:

I think you are right, the politics played their part in the demise of Bretton Woods. Politics are always paramount in foreign exchange. So I guess nothing has changed about that in the last 50 years. However, I would simply point out that politicians are elected to protect the interests of their voters, and voters anywhere and everywhere tend to be nationalistic. They don't like the impression that their country is being taken advantage of by foreigners.

Greg Anderson:

So one thing I would point out about August 15th, 1971 is what was happening with the price of gold. The secondary market price of gold had risen from $36 an ounce in August of 1970, to $41 at the end of July of 1971. So here was the U.S. committed to sell gold for $35 an ounce to foreign central banks, who could then immediately turn around and sell it for $41 in the secondary market. That's $6 worth of arbitrage. And the fed had people knocking at the door asking to facilitate this arbitrage. The U.S. said no to that proposition. In fact, I think any country would do the same in that same situation, and I don't think the type of political system would matter in a moment like that.

Stephen Gallo:

Those are all fair points, Greg. And I think your comment about the arbitrage opportunity in the gold price in the run-up to the end of Bretton Woods is really helpful. Why don't we transition the conversation to the era of floating exchange rates? Give me one thing which you think is a key lesson of the last 50 years or so of floating exchange rates?

Greg Anderson:

My first observation is that markets like a simple, but tried and true numeraire. And by numeraire, I mean, a basic common unit of exchange. Let me point out one fascinating bit of Bretton Woods history. The most dominant economist of the time, John Maynard Keynes, brought to the Bretton Woods Congress of Nations the proposal that a new global currency be created with a new global central bank. And let me just back up and say that by global, I mean on the side of the World War II allies. Anyway, that idea, global currency, got shut down at the Bretton Woods con fab, and the allied world instead opted for something simpler and more tried and true, The U.S. Dollar as the numeraire.

Greg Anderson:

That arrangement survived the U.S's effective devaluation in 1971. It also survived 50 years of ups and downs in the level of the U.S. Dollar and several periods of what I would call not so credible U.S. monetary and fiscal policy. Even today, 50 years after the U.S. de-linked from gold, 90% of global FX volume still runs through the U.S. Dollar. So let me repeat, markets like a simple, but tried and true numeraire. And so with that, I think it would probably take something really big to unseat the U.S. Dollar as the preferred common medium of cross border exchange. Okay. So Stephen, you go next. Give me one lesson we've learned since the end of Bretton Woods that you think is important.

Stephen Gallo:

Well Greg, the first lesson or issued I'd point out is kind of simple and obvious, but it's still worth emphasizing in my opinion, there is not, and probably never will be enough gold above ground to back up the amount of currency in circulation, whether that currency is physical, or digital, or some combination of the two. And that, to me, suggests that the gold price is undervalued. Now, I don't know when or how long it's going to take for that price misalignment to correct, but given the direction things are going in, especially since the start of the pandemic, I think you have to at least conclude that precious metals need to be in a portfolio to some extent. And when you look at the entire stock of global debt outstanding, I mean, we're talking staggering amounts. I think that even before the pandemic, global debt outstanding was something like 20 or 25 times the value of all above ground gold. And when you consider the fact that the amount of gold mined each year only adds about 1 to 2% to above ground gold stocks, it kind of put things into perspective.

Greg Anderson:

It's interesting, you basically said that one lesson of floating exchange rates is to own gold. Gold has increased about 44 fold in price between the $41 an announced price when the U.S. suspended its gold guarantee window, to let's call it $1,780 an ounce now. And while I don't have the data, I suspect that the price of a house in a developed country has probably gone up about that much. But here's something interesting, the U.S.'s CPI Index is only increased about seven fold over that 50 year period. So while we did get the gold price inflation that everyone feared when the Bretton Woods System ended, we got much less overall inflation. And in fact, I would say that probably two thirds of that seven fold increase in the CPI Index occurred during the first 20 years of the 50 year period of floating exchange rates.

Greg Anderson:

Back in 1992, so let's call it 20 years into our 50 year experiment, a tiny central bank, the RBN Zed, started a new fad, it was called inflation targeting. It proved to be highly successful in reigning in inflation in that country, and then in other countries that adopted it in the 1990s. So over the next 15 years, the vast majority of economies adopted it. We have discovered that when inflation targeting is followed in a credible way, it turns out that this institutional arrangement is almost as good as gold, at least in terms of providing an anchor of stability to economies and markets. I have my doubts about it being an effective anchor when central banks lose their independence and, or stray too far away from inflation as their primary mandate, but I'll leave that for another time. So, Stephen, what's another lesson that you draw from our 50 years of floating FX?

Stephen Gallo:

Greg, you mentioned a lot of different points there. I'm going to draw on a few of them. And then what I think going to do is weave my second and third lessons of the 50 years since Bretton Woods ended into one. You alluded to this, but it has taken years for central banks to earn their inflation fighting credibility and become what we know today as independent. But in the last 25 years of floating exchange rates, lesson number two from my perspective is that I think financial markets and investors have generally had faith that central banks will eventually do the right thing when it comes to playing their roles as anchors for inflation rates and preserving the purchasing power of their currencies. And what fascinates me is that investors and market participants have kept the faith in central banks, despite the fact that policy makers have relied on quantitative easing and other unorthodox policy steps for more than decade. It's almost as if we've come to take the issue of central bank independence for granted.

Stephen Gallo:

So that leads me to my third lesson of the last 50 years, which is that global debt, whether you're talking about the notional value of debt outstanding, or as a ratio of global GDP, it seems to have risen exponentially since the end of Bretton Woods. Now, I guess one mitigating factor is that all currencies and all central banks are basically in the same boat, so to speak. But I guess we need to at least be asking the question, will there ever come a time when elevated debt and loose fiscal policy severely constrain the ability of central banks to temper upward pressure on inflation. Now, Greg, I don't want to drag on any longer here, so let me throw it over to you, put the ball in your court. What's your third lesson of the last 50 years of floating exchange rates since the end of Bretton Woods>

Greg Anderson:

So Stephen, my third lesson is to give markets the benefit of the doubt. Going back to the first five years of floating exchange rates, there was a lot of mistrust of the FX market in both academic and official policy circles. The volatility of exchange rates proved to be quite high and that bothered a lot of people. Anyway, in 1976, so-called five years into this grand experiment with floating effects, an academic economist by the name of Rudy Dornbusch wrote a paper that argued that while exchange rates seemingly overshoot small shifts in underlying fundamentals, like interest rates, they do so because FX market participants are trying to rationally price in a long, new future of those fundamentals. Dornbusch won a lot of accolades and fame for his so-called overshoot theory, and he probably also bought the floating FX market another 20 years of patience from the powers that be. Then the FX market wrecked the European exchange rate mechanism in the early 1990s and FX speculators embarrassed the mighty bank of England.

Greg Anderson:

There was a lot of backlash against FX markets and floating exchange rates at that point. But the FX market was entrenched and it survived the criticism. Now looking back at it 30 years later, we can see that market forces probably played a major role in the creation of inflation targeting central banks, and in similarly disciplining fiscal authorities. And where I noted that market forces wrecked the ERM, that brought us something much more stable, the Euro. So with that, like I said, I think we need to give markets the benefit of the doubt. And applying that to today, while I admit that I'm really skeptical about the cryptocurrency craze of the past few years, and I'm deeply distrustful of privately issued, and I'll say it loosely, currencies that have no government and associated tax base underneath them, nevertheless, based on the lessons of the last 50 years, I think we should give the cryptocurrency market a long chance to see what it produces. Maybe the discipline of privately issued currencies competing alongside government issued currencies will make a meaningful contribution to the global economy.

Stephen Gallo:

Greg, I think we can wrap things up here. We've definitely covered a lot of material, which is important in a historical context, and I think we've tried to weave that material into current market themes. And to our listeners, I would just add that if there's anything here we touched on today that has given you food for thought or provoked you into thought, please don't hesitate to reach out to us to deepen the discussion. You can reach us via phone, email, and of course via Bloomberg. We thank you as always for your listenership. Bye for now.

Greg Anderson:

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocm.com/globalexchanges.

Stephen Gallo:

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Incorporated, and BMO Capital Markets Corporation, together, BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts. Notwithstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell, or to buy, or subscribe for any particular product or services, including without limitation, any commodities, securities, or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or suggestion that any investment or strategy reference here in may be suitable for you.

Speaker 3:

It does not take into account to the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this podcast constitutes investment, legal, accounting, or tax advice, or representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures contracts and commodity options, or any other activity which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the U.S. Commodity Exchange Act. BMO is not undertaking to act as a swab advisor to you or in your best interest in you. To the extent applicable, will rely solely on advice from your qualified, independent representative making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment.

Speaker 3:

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Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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