The Bank of France's losses were notable but not unique, Belgium and the Netherlands being other cases in point. They underscored the perils of foreign exchange markets. Gone now were the dull days of the 19th century when the bulk of Western foreign exchange transactions took place within the narrow margins of the gold points. Even then there had been some excitement in markets for so-called "peripheral" currencies, such as the Austro-Hungarian florin in the 1870s or Argentine pesos in the early 1890s. But these problems were essentially limited to the local market (Vienna and Buenos Aires respectively). In addition, the forward market had been developed to provide hedging instruments that investors could use to protect themselves (Flandreau and Komlos 2006).
But now the markets developed further. Atkin (2005) argues that the expansion of trading on the foreign exchange market in financial centres like London was the proximate source of the rise of exchange rate volatility. Large numbers of traders would periodically line up on one or the other side of the market. Variations over short intervals could be substantial. These variations increased the value of immediate settlement services, providing the basis for the growth of the telegraphic transfers that dominated exchange rate quotations. This transformation also enabled commercial banks, with their networks of foreign branches, to participate in this market previously dominated by investment banks which had the means to draw instruments with the highest liquidity. This evolution also increased the demand for hedging (already substantial, in the past, for Austria and Russia) and generalised the availability of forward exchange instruments (Einzig 1937) and foreign exchange options (Mixon 2009). A consequence was that shorting a currency become easier.
This was something that central banks ignored at their peril. Foreign exchange market intervention was frequent in the 1920s (Chlepner 1927, Van der Vee and Tavernier 1975, Blancheton and Maveyraud 2009). Interventions were undertaken to prepare the market for major loans, to counter speculation, and to push the exchange rate toward some target. They took a variety of forms, including standing orders in the spot market and intervention in the forward market. There were also "currency repos," a combination of spot sales and forward repurchases, or vice versa, between the central bank and its counterparties in the foreign exchange market, as in the case of Austria's "Kostdevisen" (Einzig 1935, Eichengreen and Flandreau 2009, p. 409). Bank of France Governor Emile Moreau's memoirs describe how in 1926 foreign exchange trader Léon Verdier was loaned to the Bank of France by a leading commercial bank so that he could put together a foreign exchange department to handle these operations (Moreau 1954, p. 103).
FISCAL IMPLICATIONS: A complication was the interaction of treasuries and central banks over the foreign exchange policy. During World War I, treasuries increased their control of foreign exchange markets. Although the long-run goal was in principle a "retreat" of political supervision, governments in practice remained reluctant to surrender all authority to the central bank, which was in the overwhelming majority of cases still a private institution. Exchange controls had become part of the standard weaponry of economic policy. At a very minimum, treasuries continued to monitor developments in this area.
Until de facto stabilisation of the franc in 1926, which led to the creation of a foreign exchange department, as noted above, the Bank of France needed the agreement of the treasury in order to intervene in the foreign exchange market and was in practice regularly prevented from doing so. Interventions took a hybrid form involving the Bank of France, the Treasury (which was a large owner of foreign exchange through foreign loans), and banking intermediaries which undertook the actual interventions. It was only in 1926 that a framework was established enabling the Bank to purchase foreign exchange, and even then the Treasury retained the power of authorisation.
One reason the Treasury was reluctant to surrender authority was that it shared the profits accruing from investment in foreign securities (Mouré 2002). The same mechanism came into play in reverse when the Bank of France suffered losses from the sterling crisis in 1931 and had to be recapitalised by the taxpayers' money (Accominotti 2008). The conflicts of responsibility and authority on foreign exchange also help to explain the subsequent creation of "Exchange Equalisation Accounts" in Great Britain, United States, Switzerland, Netherlands, Belgium, France and other countries, whereby the bulk of the responsibility of dealing with exchange rate uncertainty was transferred to fiscal authorities. Contemporaries discussed the transfer of leadership from the "banks of issue" to "treasuries". Governments used technical pretexts to motivate the changeover (they invoked valuation rules for foreign exchange and gold reserves constrained their use, governments could easily endow their fund with money raising capabilities by letting them issue treasury bills). Contemporary economists emphasised instead that the exchange rate being a general interest matter, had to be dealt with by the government. Others outlined that treasuries were less subjected to public scrutiny and disclosure than central banks and thus possibly superior instruments to outsmart the market.
The modern debate on the fiscal effects of asset purchases thus has a 19th and 20th century precedent in the dispute over the management of foreign exchange reserves. The lesson policy-makers derived from the 1930s was that reserve and exchange rate management was too important - or too dangerous - to be delegated to central bankers. Thus, we see here the roots of modern practice in countries like the United States where monetary policy is the domain of the central bank but foreign exchange policy is the responsibility of the treasury - with all the resulting tensions and contradictions.
THE STERLING AREA: The 1920s saw growing rivalry between sterling and dollar. While previous authors argued that it was not until after World War II that the retreat of sterling occurred, more recent research, including our own (Eichengreen and Flandreau), has argued that the dollar had already challenged sterling as a reserve currency in the 1920s. The newly created Federal Reserve System actively worked to create a stable and liquid market in internationally accepted dollar credits (Eichengreen and Flandreau 2012). U.S. commercial banks were authorised for the first time to branch abroad under the provisions of the Federal Reserve Act and worked to develop a market in dollar-denominated bonds (Eichengreen and Flandreau 2012). Investment banks like J.P. Morgan were enlisted to sell the U.S. tranche of stabilisation loans under, inter alia, the Dawes Plan to retail investors in the United States. London was by no means prepared to abandon this market, although current account problems led the Treasury and Bank of England place embargos on foreign capital calls at various points during the 1920s, forcing borrowers to look elsewhere.
The sterling crisis then was a defining moment. It conferred big losses on holders of sterling (official as well as private) and cooled attitudes toward holding foreign exchange reserves. Yet the effects of the crisis on the international status of sterling were paradoxical. The resulting depreciation of sterling, after the sharp initial drop, was not disorderly. There was a notably absence of bank failures and liquidity problems in London. Following the sharp initial drop, investors began betting on sterling's appreciation. Another casualty of the sterling crisis was the credibility of the dollar's peg to gold, which was damaged by sterling's collapse (Accominotti 2009). Given the clouds over other currencies, both the dollar and the currencies of the gold bloc, it became attractive to peg to sterling, which in turn strengthened the incentive to hold sterling balances. Amidst the general retreat from foreign exchange reserves, sterling actually managed to expand its position in central bank reserves, now principally in the Dominions and Sterling Area.
The Sterling Area provided a relatively favourable combination of stability and flexibility. Channeling the age-sanctioned views of the banking school, the British financial system remained biased towards expansion, while at the same time offering facilities to back-stop the currency and deal with crises, along with a dose of monetary orthodoxy that meant monetary policy would remain reasonably expansionary and mostly geared towards recovery. This was an attractive package which, unsurprisingly was embraced where there were powerful banking constituencies with vested interests in the prosperity of the City (as in the Dominions) and in places where the lessons of the interwar period were already digested, leading to the understanding that there were other, better focal points for central bankers than simply tracking the price of gold (Jonung 1979).
Jamaluddin Ahmed, PhD FCA is the General Secretary of Bangladesh Economic Association and a member of Board of Directors of Bangladesh Bank.
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