Battle of the exchange funds

Max Harris

This post contributes to our occasional series of guest posts by external researchers who have used the Bank of England’s archives for their work on subjects outside traditional central banking topics.

When Britain created the Exchange Equalisation Account (EEA) in 1932, its designers had little sense of the controversy that would ensue. The previous year, Britain had suspended gold convertibility, and the volatile capital flows that followed convinced officials that they needed a tool for managing the exchange rate. The EEA – originally a fund solely for foreign exchange interventions (its remit is broader now) – seemed not only necessary but eminently reasonable. To a world in the throes of depression, however, it looked like a means to weaken sterling and reap a competitive advantage. America responded by establishing the Exchange Stabilization Fund (ESF) in what many viewed as another escalation in the conflict that was tearing the international monetary system apart.

As I discuss in ‘Monetary War and Peace: London, Washington, Paris, and the Tripartite Agreement of 1936‘, the standoff between the two funds did much to worsen Anglo-American relations in particular and international monetary relations generally. Building on research conducted at the Bank of England’s (BoE) archives, as well as records from other central banks and finance ministries, I show that the massive funds and the secrecy with which they were managed submerged both sides of the Atlantic in a thick fog of suspicion. Each country assumed the other was up to no good. This mistrust would not dissipate until London and Washington, joined by Paris, came together in the Tripartite Agreement of 1936. Under this Agreement, the three powers promised to end their monetary conflict and work toward a co-operative peace. They foreswore competitive depreciation and sought greater exchange stability, with exchange funds now considered essential to achieving such stability. So swift was the Agreement’s impact that, almost overnight, the world went from viewing the funds as weapons of monetary war to instruments of peace. In this post, I provide a brief history of the funds during the Great Depression and the shift brought about by the Tripartite Agreement.

Though the EEA, as the first fund of its kind, was novel, British exchange intervention was not. London had operated in markets during the First World War to peg the pound-dollar rate, and the BoE intervened to buttress the pound’s parity after the restoration of the gold standard in 1925. As explained in Moggridge (1972), the BoE put a premium on secrecy, concerned that the market, if aware of its actions, would counteract its moves.

With Britain’s departure from the gold standard in September 1931, the pound suddenly lost its anchor and large swings in the exchange rate became common. Officials went from viewing exchange intervention as merely useful to indispensable, and in 1932, Parliament established the EEA, to be controlled by the Treasury and operated by the BoE; endowed it with £150 million; and gave it the mandate of ‘checking undue fluctuations in the exchange value of sterling’ (see Howson (1980) for a history of the EEA). The EEA’s purpose is very different today. At the time of its introduction, officials could use pounds from the fund to purchase dollars in the market if they felt sterling was too strong, and they could sell dollars from the EEA to purchase pounds if they felt sterling was too weak. In line with earlier practice, exchange managers continued to operate behind the scenes, revealing almost nothing of their work.

Across the Atlantic, policymakers were not pleased. One American financier testified before Congress that the EEA was ‘a manipulative fund in the hands of an economic general, and is operated solely in the interests of England. I regard it as dangerous as military airplanes crossing our borders without any aircraft guns to meet them’. After all, the EEA’s seemingly anodyne mandate gave exchange managers immense discretion. The concern was that Britain would use the EEA’s resources to buy dollars, pushing the value of the pound down and that of the dollar up. There was some justification to these fears: officials in Whitehall privately admitted that the EEA was needed to ‘keep down the pound’. Indeed, the EEA did often work to prevent the pound’s appreciation and to accumulate dollar reserves (as well as French francs and gold). But at times the British also expended those reserves to soften depreciation. The secrecy surrounding the EEA – in particular, the decision not to inform the Americans about interventions – made the fund appear more threatening than it was.

Anglo-American relations further deteriorated in 1933 with Franklin Roosevelt’s decision to devalue the dollar. The following year, Roosevelt secured Congressional approval for America’s own exchange fund, the ESF. The EEA was clearly the motivating factor. As the House Majority Report stated, the ESF was needed ‘to defend the American dollar and our gold stocks against the invasion of similar funds operated by competitor nations’. Convinced that imitation would bring protection, US officials gave the ESF a broad mandate and allowed it to operate in secrecy with no requirement for public disclosure.

The ESF, and indeed all of Roosevelt’s monetary machinations, strained already fraught Anglo-American relations. It did not help that the ESF’s operations were ‘shrouded in complete secrecy’, according to Britain’s financial attaché, so that it was not clear when the fund was buying what (Bewley to Leith-Ross, March 29, 1935, National Archives T 188/116). Attempts to get the two countries to share intervention data as a gesture of goodwill failed to gain traction, with each side guarding what it considered highly sensitive information. As a result, monetary authorities knew little of each other’s intentions. From late 1933 to the spring of 1936, distrust was so pervasive that, rather than discuss their concerns, they rarely even talked. And when they did talk, the tension was palpable. In May 1936, U.S. Secretary of the Treasury Henry Morgenthau Jr. berated the British financial attaché, ‘if we were at war with each other we could not be acting any differently’.

This scolding, however, actually marked the inflection point, and détente soon followed. Morgenthau was angry because, while he had recently decided to come to terms with Britain, the initial response from London had been lukewarm. Morgenthau’s new desire for rapprochement reflected his concern that the worsening economic situation in France, fuelled by the franc’s overvaluation, would play into Germany’s hands. The growing threat posed by Hitler convinced Morgenthau that the democracies needed to stick together, and in his domain, that meant cooperating on monetary matters.

Though London was hesitant to parley at first, Morgenthau’s outburst drove home the gravity of the moment and the two sides finally opened a dialogue. Paris soon joined the conversations, and in September 1936, after months of negotiations, the three powers announced the Tripartite Agreement. This informal accord marked the first triumph for monetary multilateralism after years of destructive unilateralism. The New York Times cheered that ‘the three great democracies have given evidence of their ability to work together in behalf of economic peace, recovery and order’.

Beyond paving the way for France’s much needed devaluation, the Agreement – a watershed in monetary history – set forth a new framework predicated on cooperation. The parties sought nothing less than the ‘restoration of order in international economic relations’. They vowed to work toward a more liberal international system and promised not to engage in competitive depreciation. They would not fix exchange rates, but they would seek greater stability and use exchange funds to this end. They created new facilities with one another to encourage stabilizing intervention.

Critically, the Agreement called for ‘consultation’. Monetary authorities started talking regularly, discussing their daily interventions as a matter of routine, conversing on financial developments, and even coordinating public statements. Morgenthau soon exclaimed that ‘this kind of information (on exchange intervention) we never received and never gave’ prior to the Agreement, but now ‘the ice is broken, and they (the British) give us enough to work with and we give them enough to work with, so we can work together’. Much of the suspicion that had accumulated over the years dissolved in an instant. Each side not only knew what the other was doing but, with this foundation, could collaborate more generally. In this way, the Agreement became, in the words of the BoE’s Montagu Norman, ‘a declaration of international solidarity on which the world now counts’ (‘Introductory Remarks’, May 26, 1937, BoE Archives C43/25). Another BoE official recalled that, after many dark years, it was ‘the first sign of monetary sanity’, which, ‘like a candle in a window, threw a flickering light on the gloomy scene of international monetary and political convulsions’ (‘Memoirs’, BoE Archives C160/179).

As I detail in Harris (2021), the Tripartite Agreement served as the basis for international monetary policy among the democracies during the three years preceding the Second World War. There were many twists and turns as the parties figured out how to operate during these tumultuous years, that twilight time of near-war, with the world headed toward catastrophe but desperately holding onto peace. What is clear is that, for the democracies, the monetary war ended not in 1944 with Bretton Woods, nor in 1939 with the battle against fascism, but in 1936, and the shift from opacity to transparency played a key role.

Max Harris is is the author of ‘Monetary War and Peace: London, Washington, Paris, and the Tripartite Agreement of 1936’ and received his PhD in Economics from Harvard University.

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