A fixed point peg can be defended from speculation, so long as the side under pressure to devalue is defended by the other central bank ... because the other currency is under upward pressure, and that central bank can create its own currency to defend against upward pressure.

When the pound was forced out of the ERM, the Bundesbank did not want to defend the ERM exchange rate of the pound, AFAIR because it was faced with the inflationary impact of the integration of East and West Germany, and the side effect of pushing down against that upward pressure is an increase in supply of reserves, pushing down the floor inter-bank reserve lending rate.

And the Bank of England AFAIR did not want to defend the pound by increasing interest rates, AFAIR because the UK was coming out of a recession, so as it defended the FXR with purchases of pounds using foreign exchange reserves, at the same time it issued pounds as reserves domestically to keep the interest rate down.

To be able to defend a system of pegged exchange rates, you either need the central banks on either side of the peg to put first priority on defending the exchange rates, or regulatory controls on flows of financial capital across international boundaries, or both. The EU eliminated the capital controls in transactions between ERM members, and as it turned out when push came to shove, the priority on defending the ERM was not there.

The break-down of Bretton Woods was similar ... in the original Bretton Woods system, all currency pegs were to gold, and net clearances were in gold. The use of US$ for clearances was a convention that developed, to avoid the inconvenience of net clearances between reserve banks in gold.

When France refused to accept that the US$ in the early 70's was at the correct peg to gold, and demanded clearances in gold, the US was faced with either an ongoing series of devaluations by the USG, a radical change in economic policy to reduce the downward pressure on the dollar which showed up in the requirement to pay net clearances, or else an abandonment of the Bretton Woods system. In the end, though it took a little while to play out, the last course was taken.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.