A New System's Big Test

THE international agreement last December that devalued the dollar and established a new set of exchange rates for major currencies was delicately balanced. It stipulated not only what the dollar was worth in terms of other currencies, but how many German marks a Dutch guilder would buy, how many Japanese yen a French franc would equal, and so on. It was inevitable that sooner or later doubts about the value of at least one of these currencies would put the system to a severe test. The test came last week, when an explosion of currency speculation left the whole network of rates badly shaken, and moneymen scurried to shore it up.

The trouble started with the British pound, which had been weakened by rampant inflation. Denis Healey, financial spokesman for the Labor Party, predicted in a speech in Parliament early last week that the Tory government would devalue the pound in July or August. Currency speculators--mostly commercial bankers and treasurers of multinational corporations--took Healey's forecast as confirmation of their worst fears and began to unload pounds. On a single day, Thursday, about $1.2 billion worth of pounds were sold by speculators. In order to keep the pound's price in other currencies from dropping too sharply, European central banks had to pay out some $2.5 billion.

By Friday morning the government of Prime Minister Edward Heath had had enough. Rather than continue using up its foreign currency reserves, it announced that it would let the pound temporarily "float"--that is, trade on international exchanges at any price set by supply and demand. That move in effect devalued the pound, and it quickly sank as low as $2.46 in New York City. The drop canceled two-thirds of the increase in the pound's dollar value, from $2.40 to $2.6057, that was agreed upon in Washington, D.C., in last December's realignment of currencies, called the Smithsonian agreement.

Halting Trading. Far from calming the markets, the British move set off a stampede of speculation that within hours forced currency markets in Europe and Japan to slam shut their exchange windows; they were not scheduled to open again until Tuesday of this week. The dollar, which most money traders consider to be the weakest currency after the pound because of the gigantic U.S. balance of payments deficit, quickly came under attack. The West German Bundesbank had to buy almost $900 million in 90 frenzied minutes Friday morning before officials finally halted trading. In Switzerland, monetary authorities decided not to buy dollars to hold up the price, letting the dollar float down against the Swiss franc. As the situation worsened, French Finance Minister Valery Giscard d'Estaing conferred with President Georges Pompidou and then announced that Common Market central bankers would meet in emergency session in Paris over the weekend to consider what to do.

U.S. officials were stunned by the crisis, and unable to suggest any method of coping with it. The Common Market countries faced two alternatives, neither pleasant for the U.S. The first would be a unified float of all the major European currencies against the dollar, a course favored by officials of Belgium, The Netherlands and Luxembourg. While floating against the dollar, the European currencies' exchange rates against each other would be held steady. That might indeed calm speculation. But it would be a step toward dividing the world into potentially hostile monetary blocs--specifically the U.S. v. Europe--that American Treasury officials have long feared. And since not all European finance ministers want a unified float anyway, that move did not appear likely.

Alternatively, the European governments could clamp tighter controls on currency exchanges and capital movements, mostly in an attempt to keep out dollars, which Common Market countries hold far in excess of their needs. That step is favored by France's Giscard, a vehement opponent of currency flotations. This might quiet the markets, but it would constitute a partial reversal of the post-World War II trend toward freer movement of goods and money across national borders. Some combination of floats and controls is also possible.

In any case, it will take time to restore confidence in the system of exchange rates established by the Smithsonian agreement. For months, serious private discussion in Europe has focused on the pound as the weakest link in the system. There have been widespread predictions that the pound would have to be devalued by the time Britain joined the Common Market on Jan. 1. Such talk spread gasoline on the floor of world currency markets, and Labor's Healey tossed a lighted match on it with his devaluation forecast.

Healey was not just being irresponsible. Britain's currency-weakening inflation pace in April got up to an annual rate of 12%. When Britain enters the Common Market, it will have to worsen its financial position by reducing protective tariffs and contributing hundreds of millions of pounds annually to Common Market programs.

European bankers predict that the pound will float down to somewhere between $2.40 and $2.50, after which the British government will make official that de facto devaluation. Whether that will stabilize the world financial system a while longer remains to be seen. The most discouraging thing about the panic last week was that safety devices built up in the past six months collapsed promptly when put to the test.

The Smithsonian agreement permitted currencies to fluctuate by 2 1/4% above or below their official values, establishing what was supposed to be a "wider band" to help absorb speculation. Yet last week the dollar broke through the lower end of its band within hours after currency traders started dumping large amounts of it on the money exchanges. The European Common Market countries, joined by Britain, recently signed an agreement in order to hold their moneys to very narrow fluctuations against each other. The pact was called the "snake in the tunnel" agreement, because the currencies would have very little room to move. That did not help the pound; in effect the snake got out of the tunnel with its first wiggle. Moneymen may be able to put together measures to hold the Smithsonian system in place a while longer. But last week's crisis underlined once again the urgency of long-term reform of a global financial system that is still quite shaky.

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