Forex: The Adjustment Mechanism

We should place the adjustment mechanism on thought. After Jamaica, this could be described as a regime of 'managed floating'.

Par values, at least among the major countries, in practice had been abolished.

Exchange rates, in principle, were no longer to be determined by governments but, rather by movements of autonomous demand and supply in the foreign exchange market.

Central banks were expected to intervene in the market whenever necessary, to limit the frequency and amplitude of fluctuations of rates around their long-term trend (clean floating).

But they were not to attempt to influence the long-term trends themselves in mutually inconsistent ways (dirty floating).

This formula reflected a seminal diplomatic compromise between France and the United States at an economic summit meeting of the six largest industrial nations (America, Britain, France, Germany, Italy and Japan) at Rambouillet, France, in November 1975.

Exchange rate movements, the French felt, were much too extreme, indeed even 'irrational', after March 1973; and on this point they were scarcely alone.

Fluctuations between the dollar and other major currencies during 1973-1975 in fact ranged up to 20 percent or more over periods of just a few months.

According to the French, fluctuations of this magnitude--- as in the 1930s--- were bound to discourage trade and investment and encourage destabilizing speculation.

According to the Americans, conversely, a return to pegged rates would only recreate all of the undesirable defects of the Bretton Woods adjustment mechanism.

Until November 1975, this dispute had held up all progress in the deliberations of the Interim Committee. Then, at Rambouillet, the two governments finally agreed to bury their differences, clearing the last obstacles to the Jamaica package two months later.

Henceforth, a distinction would be made between 'disorderly' or 'erratic' exchange rate movements on the one hand, and movements caused by underlying economic and financial conditions on the other.

The appropriate form of the exchange rate regime had occupied much of the time of the Committee of Twenty.

The negotiators had wrestled long and hard over questions like these: what rules and conventions should guide central bank intervention in the foreign exchange market? What should be the respective adjustment obligations of surplus and deficit countries?

What provision, if any, should be made for bringing pressures to bear on countries in persistent payments imbalance?

The Rambouillet compromise--- brilliant diplomatic coup though it may have been--- did little at all to answer any of these fundamental questions-- it left open all difficult problems of actually managing a system of flexible exchange rates.