Bretton Woods system

The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states.

Preparing to rebuild the international economic system as World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference. The delegates deliberated upon and signed the Bretton Woods Agreements during the first three weeks of July 1944.

Setting up a system of rules, institutions, and procedures to regulate the international monetary system, the planners at Bretton Woods established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement.

The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold and the ability of the IMF to bridge temporary imbalances of payments. Then, on August 15, 1971 the United States unilaterally terminated convertibility of the dollar to gold. This action created the situation, referred to as the Nixon shock, whereby the United States dollar became the sole backing of currencies and a reserve currency for the member states.

Origins

The political basis for the Bretton Woods system was in the confluence of several key conditions: the shared experiences of the Great Depression, the concentration of power in a small number of states (further enhanced by the exclusion of a number of important nations because of the war), and the presence of a dominant power willing and able to assume a leadership role in global monetary affairs.

Great Depression

A high level of agreement among the powerful on the goals and means of international economic management facilitated the decisions reached by the Bretton Woods Conference. Its foundation was based on a shared belief in capitalism. Although the developed countries' governments differed in the type of capitalism they preferred for their national economies (France, for example, preferred greater planning and state intervention, whereas the United States favored relatively limited state intervention), all relied primarily on market mechanisms and on private ownership.

Thus, it is their similarities rather than their differences that appear most striking. All the participating governments at Bretton Woods agreed that the monetary chaos of the interwar period had yielded several valuable lessons.

The experience of the Great Depression was fresh on the minds of public officials. The planners at Bretton Woods hoped to avoid a repeat of the debacle of the 1930s, when intransigent American insistence as a creditor nation on the repayment of Allied war debts, combined with an inclination to isolationism, led to a breakdown of the international financial system and a worldwide economic depression.^[1] The "beggar thy neighbor" policies of 1930s governments—using currency devaluations to increase the competitiveness of a country's export products to reduce balance of payments deficits—worsened national deflationary spirals, which resulted in plummeting national incomes, shrinking demand, mass unemployment, and an overall decline in world trade. Trade in the 1930s became largely restricted to currency blocs (groups of nations that use an equivalent currency, such as the "Sterling Area" of the British Empire). These blocs retarded the international flow of capital and foreign investment opportunities. Although this strategy tended to increase government revenues in the short run, it dramatically worsened the situation in the medium and longer run.

Thus, for the international economy, planners at Bretton Woods all favored a regulated system, one that relied on a regulated market with tight controls on the value of currencies. Although they disagreed on the specific implementation of this system, all agreed on the need for tight controls.

The idea of economic security

Cordell Hull

Also based on experience of inter-war years, U.S. planners developed a concept of economic security—that a liberal international economic system would enhance the possibilities of postwar peace. One of those who saw such a security link was Cordell Hull, the United States Secretary of State from 1933 to 1944.^{[Notes 1]} Hull believed that the fundamental causes of the two world wars lay in economic discrimination and trade warfare. Specifically, he had in mind the trade and exchange controls (bilateral arrangements) ^[2] of Nazi Germany and the imperial preference system practiced by Britain, by which members or former members of the British Empire were accorded special trade status, itself provoked by German, French, and American protectionist policies. Hull argued

[U]nhampered trade dovetailed with peace; high tariffs, trade barriers, and unfair economic competition, with war…if we could get a freer flow of trade…freer in the sense of fewer discriminations and obstructions…so that one country would not be deadly jealous of another and the living standards of all countries might rise, thereby eliminating the economic dissatisfaction that breeds war, we might have a reasonable chance of lasting peace.

—^[3]

Rise of governmental intervention

The developed countries also agreed that the liberal international economic system required governmental intervention. In the aftermath of the Great Depression, public management of the economy had emerged as a primary activity of governments in the developed states. Employment, stability, and growth were now important subjects of public policy. In turn, the role of government in the national economy had become associated with the assumption by the state of the responsibility for assuring its citizens of a degree of economic well-being. The welfare state grew out of the Great Depression, which created a popular demand for governmental intervention in the economy, and out of the theoretical contributions of the Keynesian school of economics, which asserted the need for governmental intervention to maintain an adequate level of employment.

However, increased government intervention in domestic economy brought with it isolationist sentiment that had a profoundly negative effect on international economics. The priority of national goals, independent national action in the interwar period, and the failure to perceive that those national goals could not be realized without some form of international collaboration—which resulted in “beggar-thy-neighbor” policies such as high tariffs, competitive devaluations that contributed to the breakdown of the gold-based international monetary system, domestic political instability, and international war. The lesson learned was, as the principal architect of the Bretton Woods system New Dealer Harry Dexter White put it:

the absence of a high degree of economic collaboration among the leading nations will…inevitably result in economic warfare that will be but the prelude and instigator of military warfare on an even vaster scale.

—^{[Notes 2]}

To ensure economic stability and political peace, states agreed to cooperate to closely regulate the production of their individual currencies to maintain fixed exchange rates between countries with the aim of more easily facilitating international trade. This was the foundation of the U.S. vision of postwar world free trade, which also involved lowering tariffs and among other things maintaining a balance of trade via fixed exchange rates that would be favorable to the capitalist system.

Thus, the more developed market economies agreed with the U.S. vision of post-war international economic management, which was to be designed to create and maintain an effective international monetary system and foster the reduction of barriers to trade and capital flows. In a sense, the new international monetary system was in fact a return to a system similar to the pre-war gold standard, only using US dollars as the world's new reserve currency until the world's gold supply could be reallocated via international trade. Thus, the new system would be devoid (initially) of governments meddling with their currency supply as they had during the years of economic turmoil preceding WWII. Instead, governments would closely police the production of their currencies and ensure that they would not artificially manipulate their price levels. If anything, Bretton Woods was in fact a return to a time devoid of increased governmental intervention in economies and currency systems.

Atlantic Charter

Roosevelt and Churchill during their secret meeting of August 9 – 12, 1941, in Newfoundland that resulted in the Atlantic Charter, which the U.S. and Britain officially announced two days later.

The Atlantic Charter, drafted during U.S. President Franklin D. Roosevelt's August 1941 meeting with British Prime Minister Winston Churchill on a ship in the North Atlantic, was the most notable precursor to the Bretton Woods Conference. Like Woodrow Wilson before him, whose "Fourteen Points" had outlined U.S. aims in the aftermath of the First World War, Roosevelt set forth a range of ambitious goals for the postwar world even before the U.S. had entered the Second World War. The Atlantic Charter affirmed the right of all nations to equal access to trade and raw materials. Moreover, the charter called for freedom of the seas (a principal U.S. foreign policy aim since France and Britain had first threatened U.S. shipping in the 1790s), the disarmament of aggressors, and the "establishment of a wider and permanent system of general security."

As the war drew to a close, the Bretton Woods conference was the culmination of some two and a half years of planning for postwar reconstruction by the Treasuries of the U.S. and the UK. U.S. representatives studied with their British counterparts the reconstitution of what had been lacking between the two world wars: a system of international payments that would allow trade to be conducted without fear of sudden currency depreciation or wild fluctuations in exchange rates—ailments that had nearly paralyzed world capitalism during the Great Depression.

Without a strong European market for U.S. goods and services, most policymakers believed, the U.S. economy would be unable to sustain the prosperity it had achieved during the war. In addition, U.S. unions had only grudgingly accepted government-imposed restraints on their demand during the war, but they were willing to wait no longer, particularly as inflation cut into the existing wage scales with painful force. (By the end of 1945, there had already been major strikes in the automobile, electrical, and steel industries.)

In early 1945 Bernard Baruch described the spirit of Bretton Woods as: if we can "stop subsidization of labor and sweated competition in the export markets," as well as prevent rebuilding of war machines, "oh boy, oh boy, what long term prosperity we will have."^[4] The United States [c]ould therefore use its position of influence to reopen and control the [rules of the] world economy, so as to give unhindered access to all nations' markets and materials.

Wartime devastation of Europe and East Asia

Besides that, U.S. allies—economically exhausted by the war—accepted this leadership. They needed U.S. assistance to rebuild their domestic production and to finance their international trade; indeed, they needed it to survive.

Before the war, the French and the British were realizing that they could no longer compete with U.S. industry in an open marketplace. During the 1930s, the British had created their own economic bloc to shut out U.S. goods. Churchill did not believe that he could surrender that protection after the war, so he watered down the Atlantic Charter's "free access" clause before agreeing to it.

Yet, the U.S. officials were determined to open their access to the British empire. The combined value of British and U.S. trade was well over half of all the world's trade in goods. For the U.S. to open global markets, it first had to split the British (trade) empire. While Britain had economically dominated the 19th century, the U.S. officials intended the second half of the 20th to be under U.S. hegemony^[5].

According to one commentator,

One of the reasons Bretton Woods worked was that the US was clearly the most powerful country at the table and so ultimately was able to impose its will on the others, including an often-dismayed Britain. At the time, one senior official at the Bank of England described the deal reached at Bretton Woods as “the greatest blow to Britain next to the war”, largely because it underlined the way in which financial power had moved from the UK to the US.

—Business Spectator^[6]

A devastated Britain had little choice. Two world wars had destroyed the country's principal industries that paid for the importation of half the nation's food and nearly all its raw materials except coal. The British had no choice but to ask for aid. Not until the United States signed an agreement on December 6, 1945 to grant Britain aid of $4.4 billion did the British Parliament ratify the Bretton Woods Agreements (which occurred later in December 1945).^[7]

For nearly two centuries, French and U.S. interests had clashed in both the Old World and the New World. During the war, French mistrust of the United States was embodied by General Charles de Gaulle, president of the French provisional government. De Gaulle bitterly fought U.S. officials as he tried to maintain his country's colonies and diplomatic freedom of action. In turn, U.S. officials saw de Gaulle as a political extremist.

But in 1945 de Gaulle—at that point the leading voice of French nationalism—was forced to grudgingly ask the U.S. for a billion-dollar loan. Most of the request was granted; in return France promised to curtail government subsidies and currency manipulation that had given its exporters advantages in the world market.

On a far more profound level, as the Bretton Woods conference was convening, the greater part of the Third World remained politically and economically subordinate. Linked to the developed countries of the West economically and politically—formally and informally—these states had little choice but to acquiesce in the international economic system established for them. In the East, Soviet hegemony in Eastern Europe provided the foundation for a separate international economic system.

Design

Free trade relied on the free convertibility of currencies. Negotiators at the Bretton Woods conference, fresh from what they perceived as a disastrous experience with floating rates in the 1930s, concluded that major monetary fluctuations could stall the free flow of trade.

The liberal economic system required an accepted vehicle for investment, trade, and payments. Unlike national economies, however, the international economy lacks a central government that can issue currency and manage its use. In the past this problem had been solved through the gold standard, but the architects of Bretton Woods did not consider this option feasible for the postwar political economy. Instead, they set up a system of fixed exchange rates managed by a series of newly created international institutions using the U.S. dollar (which was a gold standard currency for central banks) as a reserve currency.

Informal

Previous regimes

In the 19th and early 20th centuries gold played a key role in international monetary transactions. The gold standard was used to back currencies; the international value of currency was determined by its fixed relationship to gold; gold was used to settle international accounts. The gold standard maintained fixed exchange rates that were seen as desirable because they reduced the risk of trading with other countries.

Imbalances in international trade were theoretically rectified automatically by the gold standard. A country with a deficit would have depleted gold reserves and would thus have to reduce its money supply. The resulting fall in demand would reduce imports and the lowering of prices would boost exports; thus the deficit would be rectified. Any country experiencing inflation would lose gold and therefore would have a decrease in the amount of money available to spend. This decrease in the amount of money would act to reduce the inflationary pressure. Supplementing the use of gold in this period was the British pound. Based on the dominant British economy, the pound became a reserve, transaction, and intervention currency. But the pound was not up to the challenge of serving as the primary world currency, given the weakness of the British economy after the Second World War.

The architects of Bretton Woods had conceived of a system wherein exchange rate stability was a prime goal. Yet, in an era of more activist economic policy, governments did not seriously consider permanently fixed rates on the model of the classical gold standard of the nineteenth century. Gold production was not even sufficient to meet the demands of growing international trade and investment. And a sizeable share of the world's known gold reserves were located in the Soviet Union, which would later emerge as a Cold War rival to the United States and Western Europe.

The only currency strong enough to meet the rising demands for international currency transactions was the U.S. dollar. The strength of the U.S. economy, the fixed relationship of the dollar to gold ($35 an ounce), and the commitment of the U.S. government to convert dollars into gold at that price made the dollar as good as gold. In fact, the dollar was even better than gold: it earned interest and it was more flexible than gold.

Another view is that in the time of discount banks, discount was the interest earned on gold, and that the only way to repay interest on government bonds is by printing more dollars, thus raising the price of gold. If gold is fixed at $35 then other countries will demand gold and not accept dollars. The closing of the gold window in 1971 was the result.

Fixed exchange rates

The rules of Bretton Woods, set forth in the articles of agreement of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), provided for a system of fixed exchange rates. The rules further sought to encourage an open system by committing members to the convertibility of their respective currencies into other currencies and to free trade.

What emerged was the "pegged rate" currency regime. Members were required to establish a parity of their national currencies in terms of gold (a "peg") and to maintain exchange rates within plus or minus 1% of parity (a "band") by intervening in their foreign exchange markets (that is, buying or selling foreign money).

In theory the reserve currency would be the bancor (a World Currency Unit that was never implemented), suggested by John Maynard Keynes; however, the United States objected and their request was granted, making the "reserve currency" the U.S. dollar. This meant that other countries would peg their currencies to the U.S. dollar, and—once convertibility was restored—would buy and sell U.S. dollars to keep market exchange rates within plus or minus 1% of parity. Thus, the U.S. dollar took over the role that gold had played under the gold standard in the international financial system. (Rogue Nation, 2003, Clyde Prestowitz)

Meanwhile, to bolster faith in the dollar, the U.S. agreed separately to link the dollar to gold at the rate of $35 per ounce of gold. At this rate, foreign governments and central banks were able to exchange dollars for gold. Bretton Woods established a system of payments based on the dollar, in which all currencies were defined in relation to the dollar, itself convertible into gold, and above all, "as good as gold". The U.S. currency was now effectively the world currency, the standard to which every other currency was pegged. As the world's key currency, most international transactions were denominated in US dollars.

The U.S. dollar was the currency with the most purchasing power and it was the only currency that was backed by gold. Additionally, all European nations that had been involved in World War II were highly in debt and transferred large amounts of gold into the United States, a fact that contributed to the supremacy of the United States . Thus, the U.S. dollar was strongly appreciated in the rest of the world and therefore became the key currency of the Bretton Woods system.

Member countries could only change their par value with IMF approval, which was contingent on IMF determination that its balance of payments was in a "fundamental disequilibrium".

Formal regimes

The Bretton Woods Conference led to the establishment of the IMF and the IBRD (now the World Bank), which still remain powerful forces in the world economy.

As mentioned, a major point of common ground at the Conference was the goal to avoid a recurrence of the closed markets and economic warfare that had characterized the 1930s. Thus, negotiators at Bretton Woods also agreed that there was a need for an institutional forum for international cooperation on monetary matters. Already in 1944 the British economist John Maynard Keynes emphasized "the importance of rule-based regimes to stabilize business expectations"—something he accepted in the Bretton Woods system of fixed exchange rates. Currency troubles in the interwar years, it was felt, had been greatly exacerbated by the absence of any established procedure or machinery for intergovernmental consultation.

As a result of the establishment of agreed upon structures and rules of international economic interaction, conflict over economic issues was minimized, and the significance of the economic aspect of international relations seemed to recede.

International Monetary Fund

Officially established on December 27, 1945, when the 29 participating countries at the conference of Bretton Woods signed its Articles of Agreement, the IMF was to be the keeper of the rules and the main instrument of public international management. The Fund commenced its financial operations on March 1, 1947. IMF approval was necessary for any change in exchange rates in excess of 1%. It advised countries on policies affecting the monetary system.

Designing the IMF

The big question at the Bretton Woods conference with respect to the institution that would emerge as the IMF was the issue of future access to international liquidity and whether that source should be akin to a world central bank able to create new reserves at will or a more limited borrowing mechanism.

John Maynard Keynes (right) and Harry Dexter White at the inaugural meeting of the International Monetary Fund's Board of Governors in Savannah, Georgia, U.S., March 8, 1946

Although attended by 44 nations, discussions at the conference were dominated by two rival plans developed by the United States and Britain. As the chief international economist at the U.S. Treasury in 1942–44, Harry Dexter White drafted the U.S. blueprint for international access to liquidity, which competed with the plan drafted for the British Treasury by Keynes. Overall, White's scheme tended to favor incentives designed to create price stability within the world's economies, while Keynes' wanted a system that encouraged economic growth.

At the time, gaps between the White and Keynes plans seemed enormous. Outlining the difficulty of creating a system that every nation could accept in his speech at the closing plenary session of the Bretton Woods conference on July 22, 1944, Keynes stated:

We, the delegates of this Conference, Mr. President, have been trying to accomplish something very difficult to accomplish.[...] It has been our task to find a common measure, a common standard, a common rule acceptable to each and not irksome to any.

—^{[Notes 3]}

Keynes' proposals would have established a world reserve currency (which he thought might be called "bancor") administered by a central bank vested with the possibility of creating money and with the authority to take actions on a much larger scale (understandable considering deflationary problems in Britain at the time).

In case of balance of payments imbalances, Keynes recommended that both debtors and creditors should change their policies. As outlined by Keynes, countries with payment surpluses should increase their imports from the deficit countries and thereby create a foreign trade equilibrium. Thus, Keynes was sensitive to the problem that placing too much of the burden on the deficit country would be deflationary.

But the United States, as a likely creditor nation, and eager to take on the role of the world's economic powerhouse, balked at Keynes' plan and did not pay serious attention to it. The U.S. contingent was too concerned about inflationary pressures in the postwar economy, and White saw an imbalance as a problem only of the deficit country.

Although compromise was reached on some points, because of the overwhelming economic and military power of the United States, the participants at Bretton Woods largely agreed on White's plan.

Subscriptions and quotas

What emerged largely reflected U.S. preferences: a system of subscriptions and quotas embedded in the IMF, which itself was to be no more than a fixed pool of national currencies and gold subscribed by each country as opposed to a world central bank capable of creating money. The Fund was charged with managing various nations' trade deficits so that they would not produce currency devaluations that would trigger a decline in imports.

The IMF is provided with a fund, composed of contributions of member countries in gold and their own currencies. The original quotas were to total $8.8 billion. When joining the IMF, members are assigned "quotas" reflecting their relative economic power, and, it is as a sort of credit deposit, were obliged are to pay a "subscription" of an amount commensurate to the quota. The subscription is to be paid 25% in gold or currency convertible into gold (effectively the dollar, which was the only currency then still directly gold convertible for central banks) and 75% in the member's own currency.

Quota subscriptions are to form the largest source of money at the IMF's disposal. The IMF set out to use this money to grant loans to member countries with financial difficulties. Each member is then entitled to withdraw 25% of its quota immediately in case of payment problems. If this sum should be insufficient, each nation in the system is also able to request loans for foreign currency.

Financing trade deficits

In the event of a deficit in the current account, Fund members, when short of reserves, would be able to borrow foreign currency in amounts determined by the size of its quota. In other words, the higher the country's contribution was, the higher the sum of money it could borrow from the IMF.

Members were required to pay back debts within a period of 18 months to five years. In turn, the IMF embarked on setting up rules and procedures to keep a country from going too deeply into debt year after year. The Fund would exercise "surveillance" over other economies for the U.S. Treasury in return for its loans to prop up national currencies.

IMF loans were not comparable to loans issued by a conventional credit institution. Instead, they were effectively a chance to purchase a foreign currency with gold or the member's national currency.

The U.S.-backed IMF plan sought to end restrictions on the transfer of goods and services from one country to another, eliminate currency blocs, and lift currency exchange controls.

The IMF was designed to advance credits to countries with balance of payments deficits. Short-run balance of payment difficulties would be overcome by IMF loans, which would facilitate stable currency exchange rates. This flexibility meant a member state would not have to induce a depression to cut its national income down to such a low level that its imports would finally fall within its means. Thus, countries were to be spared the need to resort to the classical medicine of deflating themselves into drastic unemployment when faced with chronic balance of payments deficits. Before the Second World War, European nations—particularly Britain—often resorted to this.

Changing the par value

The IMF sought to provide for occasional discontinuous exchange-rate adjustments (changing a member's par value) by international agreement. Member nations were permitted to adjust their currency exchange rate by 10%. This tended to restore equilibrium in their trade by expanding their exports and contracting imports. This would be allowed only if there was a fundamental disequilibrium. A decrease in the value of a country's money was called a devaluation, while an increase in the value of the country's money was called a revaluation.

It was envisioned that these changes in exchange rates would be quite rare. However, the concept of fundamental disequilibrium, though key to the operation of the par value system, was never defined in detail.

IMF operations

Never before had international monetary cooperation been attempted on a permanent institutional basis. Even more groundbreaking was the decision to allocate voting rights among governments, not on a one-state one-vote basis, but rather in proportion to quotas. Since the United States was contributing the most, U.S. leadership was the key. Under the system of weighted voting, the United States exerted a preponderant influence on the IMF. The United States held one-third of all IMF quotas at the outset, enough on its own to veto all changes to the IMF Charter.

In addition, the IMF was based in Washington, D.C., and staffed mainly by U.S. economists. It regularly exchanged personnel with the U.S. Treasury. When the IMF began operations in 1946, President Harry S. Truman named White as its first U.S. Executive Director. Since no Deputy Managing Director post had yet been created, White served occasionally as Acting Managing Director and generally played a highly influential role during the IMF's first year.

International Bank for Reconstruction and Development

The agreement made no provisions for international creation of reserves. New gold production was assumed to be sufficient. In the event of structural disequilibria, it was expected that there would be national solutions, for example, an adjustment in the value of the currency or an improvement by other means of a country's competitive position. The IMF was left with few means, however, to encourage such national solutions.

It had been recognized in 1944 that the new system could only commence after a return to normalcy following the disruption of World War II. It was expected that after a brief transition period of no more than five years, the international economy would recover and the system would enter into operation.

To promote the growth of world trade and to finance the postwar reconstruction of Europe, the planners at Bretton Woods created another institution, the International Bank for Reconstruction and Development (IBRD), now the most important agency of the World Bank Group. The IBRD had an authorized capitalization of $10 billion and was expected to make loans of its own funds to underwrite private loans and to issue securities to raise new funds to make possible a speedy postwar recovery. The IBRD was to be a specialized agency of the United Nations charged with making loans for economic development purposes.

Readjustment

Dollar shortages and the Marshall Plan

The Bretton Wood arrangements were largely adhered to and ratified by the participating governments. It was expected that national monetary reserves, supplemented with necessary IMF credits, would finance any temporary balance of payments disequilibria. But this did not prove sufficient to get Europe out of its doldrums.

Postwar world capitalism suffered from a huge dollar shortage. The United States was running huge balance of trade surpluses, and the U.S. reserves were immense and growing. It was necessary to reverse this flow. Dollars had to leave the United States and become available for international use. In other words, the United States would have to reverse the natural economic processes and run a balance of payments deficit.

The modest credit facilities of the IMF were clearly insufficient to deal with Western Europe's huge balance of payments deficits. The problem was further aggravated by the reaffirmation by the IMF Board of Governors in the provision in the Bretton Woods Articles of Agreement that the IMF could make loans only for current account deficits and not for capital and reconstruction purposes. Only the United States contribution of $570 million was actually available for IBRD lending. In addition, because the only available market for IBRD bonds was the conservative Wall Street banking market, the IBRD was forced to adopt a conservative lending policy, granting loans only when repayment was assured. Given these problems, by 1947 the IMF and the IBRD themselves were admitting that they could not deal with the international monetary system's economic problems.^[8]

The United States set up the European Recovery Program (Marshall Plan) to provide large-scale financial and economic aid for rebuilding Europe largely through grants rather than loans. This included countries belonging to the Soviet bloc, e.g., Poland. In a speech at Harvard University on June 5, 1947, U.S. Secretary of State George Marshall stated:

The breakdown of the business structure of Europe during the war was complete. …Europe's requirements for the next three or four years of foreign food and other essential products… principally from the United States… are so much greater than her present ability to pay that she must have substantial help or face economic, social and political deterioration of a very grave character.

—^{[Notes 4]}

From 1947 until 1958, the U.S. deliberately encouraged an outflow of dollars, and, from 1950 on, the United States ran a balance of payments deficit with the intent of providing liquidity for the international economy. Dollars flowed out through various U.S. aid programs: the Truman Doctrine entailing aid to the pro-U.S. Greek and Turkish regimes, which were struggling to suppress communist revolution, aid to various pro-U.S. regimes in the Third World, and most important, the Marshall Plan. From 1948 to 1954 the United States provided 16 Western European countries $17 billion in grants.

To encourage long-term adjustment, the United States promoted European and Japanese trade competitiveness. Policies for economic controls on the defeated former Axis countries were scrapped. Aid to Europe and Japan was designed to rebuild productivity and export capacity. In the long run it was expected that such European and Japanese recovery would benefit the United States by widening markets for U.S. exports, and providing locations for U.S. capital expansion.

In 1956, the World Bank created the International Finance Corporation and in 1960 it created the International Development Association (IDA). Both have been controversial. Critics of the IDA argue that it was designed to head off a broader based system headed by the United Nations, and that the IDA lends without consideration for the effectiveness of the program. Critics also point out that the pressure to keep developing economies "open" has led to their having difficulties obtaining funds through ordinary channels, and a continual cycle of asset buy up by foreign investors and capital flight by locals. Defenders of the IDA pointed to its ability to make large loans for agricultural programs which aided the "Green Revolution" of the 1960s, and its functioning to stabilize and occasionally subsidize Third World governments, particularly in Latin America.

Bretton Woods, then, created a system of triangular trade: the United States would use the convertible financial system to trade at a tremendous profit with developing nations, expanding industry and acquiring raw materials. It would use this surplus to send dollars to Europe, which would then be used to rebuild their economies, and make the United States the market for their products. This would allow the other industrialized nations to purchase products from the Third World, which reinforced the American role as the guarantor of stability. When this triangle became destabilized, Bretton Woods entered a period of crisis that ultimately led to its collapse.

Cold War

In 1945, Roosevelt and Churchill prepared the postwar era by negotiating with Joseph Stalin at Yalta about respective zones of influence; this same year Germany was divided into four occupation zones (Soviet, American, British, and French).

Harry Dexter White succeeded in getting the Soviet Union to participate in the Bretton Woods conference in 1944, but his goal was frustrated when the Soviet Union would not join the IMF. In the past, the reasons why the Soviet Union chose not to subscribe to the articles by December 1945 have been the subject of speculation. But since the release of relevant Soviet archives, it is now clear that the Soviet calculation was based on the behavior of the parties that had actually expressed their assent to the Bretton Woods Agreements. The extended debates about ratification that had taken place both in the UK and the U.S. were read in Moscow as evidence of the quick disintegration of the wartime alliance.

Facing the Soviet Union, whose power had also strengthened and whose territorial influence had expanded, the U.S. assumed the role of leader of the capitalist camp. The rise of the postwar U.S. as the world's leading industrial, monetary, and military power was rooted in the fact that the mainland U.S. was untouched by the war, in the instability of the national states in postwar Europe, and the wartime devastation of the Soviet and European economies.

Despite the economic effort imposed by such a policy, being at the center of the international market gave the U.S. unprecedented freedom of action in pursuing its foreign affairs goals. A trade surplus made it easier to keep armies abroad and to invest outside the U.S., and because other nations could not sustain foreign deployments, the U.S. had the power to decide why, when and how to intervene in global crises. The dollar continued to function as a compass to guide the health of the world economy, and exporting to the U.S. became the primary economic goal of developing or redeveloping economies. This arrangement came to be referred to as the Pax Americana, in analogy to the Pax Britannica of the late 19th century and the Pax Romana of the first. (See Globalism)

Late Bretton Woods System

U.S. balance of payments crisis

After the end of World War II, the U.S. held $26 billion in gold reserves, of an estimated total of $40 billion (approx 60%). As world trade increased rapidly through the 1950s, the size of the gold base increased by only a few percent. In 1950, the U.S. balance of payments swung negative. The first U.S. response to the crisis was in the late 1950s when the Eisenhower administration placed import quotas on oil and other restrictions on trade outflows. More drastic measures were proposed, but not acted upon. However, with a mounting recession that began in 1958, this response alone was not sustainable. In 1960, with Kennedy's election, a decade-long effort to maintain the Bretton Woods System at the $35/ounce price was begun.

The design of the Bretton Woods System was that nations could only enforce gold convertibility on the anchor currency—the United States’ dollar. Gold convertibility enforcement was not required, but instead, allowed. Nations could forgo converting dollars to gold, and instead hold dollars. Rather than full convertibility, it provided a fixed price for sales between central banks. However, there was still an open gold market. For the Bretton Woods system to remain workable, it would either have to alter the peg of the dollar to gold, or it would have to maintain the free market price for gold near the $35 per ounce official price. The greater the gap between free market gold prices and central bank gold prices, the greater the temptation to deal with internal economic issues by buying gold at the Bretton Woods price and selling it on the open market.

In 1960 Robert Triffin noticed that holding dollars was more valuable than gold because constant U.S. balance of payments deficits helped to keep the system liquid and fuel economic growth. What would later come to be known as Triffin's Dilemma was predicted when Triffin noted that if the U.S. failed to keep running deficits the system would lose its liquidity, not be able to keep up with the world's economic growth, and, thus, bring the system to a halt. But incurring such payment deficits also meant that, over time, the deficits would erode confidence in the dollar as the reserve currency created instability.^[9]

The first effort was the creation of the London Gold Pool on November 1 of 1961 between eight nations. The theory behind the pool was that spikes in the free market price of gold, set by the morning gold fix in London, could be controlled by having a pool of gold to sell on the open market, that would then be recovered when the price of gold dropped. Gold's price spiked in response to events such as the Cuban Missile Crisis, and other smaller events, to as high as $40/ounce. The Kennedy administration drafted a radical change of the tax system to spur more production capacity and thus encourage exports. This culminated with the 1963 tax cut program, designed to maintain the $35 peg.

In 1967, there was an attack on the pound and a run on gold in the sterling area, and on November 18, 1967, the British government was forced to devalue the pound.^[10] U.S. President Lyndon Baines Johnson was faced with a brutal choice, either institute protectionist measures, including travel taxes, export subsidies and slashing the budget—or accept the risk of a "run on gold" and the dollar. From Johnson's perspective: "The world supply of gold is insufficient to make the present system workable—particularly as the use of the dollar as a reserve currency is essential to create the required international liquidity to sustain world trade and growth."^[11] He believed that the priorities of the United States were correct, and, although there were internal tensions in the Western alliance, that turning away from open trade would be more costly, economically and politically, than it was worth: "Our role of world leadership in a political and military sense is the only reason for our current embarrassment in an economic sense on the one hand and on the other the correction of the economic embarrassment under present monetary systems will result in an untenable position economically for our allies."

While West Germany agreed not to purchase gold from the U.S., and agreed to hold dollars instead, the pressure on both the dollar and the pound sterling continued. In January 1968 Johnson imposed a series of measures designed to end gold outflow, and to increase U.S. exports. This was unsuccessful, however, as in mid-March 1968 a run on gold ensued, the London Gold Pool was dissolved, and a series of meetings attempted to rescue or reform the existing system.^[12] But, as long as the U.S. commitments to foreign deployment continued, particularly to Western Europe, there was little that could be done to maintain the gold peg.

All attempts to maintain the peg collapsed in November 1968, and a new policy program attempted to convert the Bretton Woods system into an enforcement mechanism of floating the gold peg, which would be set by either fiat policy or by a restriction to honor foreign accounts. The collapse of the gold pool and the refusal of the pool members to trade gold with private entities—on March 18, 1968 the Congress of the United States repealed the 25% requirement of gold backing of the dollar^[13]—as well as the US pledge to suspend gold sales to governments that trade in the private markets,^[14] led to the expansion of the private markets for international gold trade, in which the price of gold rose much higher than the official dollar price.^{[15] [16]} The US gold reserves continued to be depleted due to the actions of some nations, notably France,^[16] who continued to build up their gold reserves.

Structural changes underpinning the decline of international monetary management

Return to convertibility

In the 1960s and 70s, important structural changes eventually led to the breakdown of international monetary management. One change was the development of a high level of monetary interdependence. The stage was set for monetary interdependence by the return to convertibility of the Western European currencies at the end of 1958 and of the Japanese yen in 1964. Convertibility facilitated the vast expansion of international financial transactions, which deepened monetary interdependence.

Growth of international currency markets

Another aspect of the internationalization of banking has been the emergence of international banking consortia. Since 1964 various banks had formed international syndicates, and by 1971 over three quarters of the world's largest banks had become shareholders in such syndicates. Multinational banks can and do make huge international transfers of capital not only for investment purposes but also for hedging and speculating against exchange rate fluctuations.

These new forms of monetary interdependence made possible huge capital flows. During the Bretton Woods era countries were reluctant to alter exchange rates formally even in cases of structural disequilibria. Because such changes had a direct impact on certain domestic economic groups, they came to be seen as political risks for leaders. As a result official exchange rates often became unrealistic in market terms, providing a virtually risk-free temptation for speculators. They could move from a weak to a strong currency hoping to reap profits when a revaluation occurred. If, however, monetary authorities managed to avoid revaluation, they could return to other currencies with no loss. The combination of risk-free speculation with the availability of huge sums was highly destabilizing.

Decline

U.S. monetary influence

A second structural change that undermined monetary management was the decline of U.S. hegemony. The U.S. was no longer the dominant economic power it had been for more than two decades. By the mid-1960s, the E.E.C. and Japan had become international economic powers in their own right. With total reserves exceeding those of the U.S., with higher levels of growth and trade, and with per capita income approaching that of the U.S., Europe and Japan were narrowing the gap between themselves and the United States.

The shift toward a more pluralistic distribution of economic power led to increasing dissatisfaction with the privileged role of the U.S. dollar as the international currency. As in effect the world's central banker, the U.S., through its deficit, determined the level of international liquidity. In an increasingly interdependent world, U.S. policy greatly influenced economic conditions in Europe and Japan. In addition, as long as other countries were willing to hold dollars, the U.S. could carry out massive foreign expenditures for political purposes—military activities and foreign aid—without the threat of balance-of-payments constraints.

Dissatisfaction with the political implications of the dollar system was increased by détente between the U.S. and the Soviet Union. The Soviet threat had been an important force in cementing the Western capitalist monetary system. The U.S. political and security umbrella helped make American economic domination palatable for Europe and Japan, which had been economically exhausted by the war. As gross domestic production grew in European countries, trade grew. When common security tensions lessened, this loosened the transatlantic dependence on defence concerns, and allowed latent economic tensions to surface.

Dollar

Reinforcing the relative decline in U.S. power and the dissatisfaction of Europe and Japan with the system was the continuing decline of the dollar—the foundation that had underpinned the post-1945 global trading system. The Vietnam War and the refusal of the administration of U.S. President Lyndon B. Johnson to pay for it and its Great Society programs through taxation resulted in an increased dollar outflow to pay for the military expenditures and rampant inflation, which led to the deterioration of the U.S. balance of trade position. In the late 1960s, the dollar was overvalued with its current trading position, while the Deutsche Mark and the yen were undervalued; and, naturally, the Germans and the Japanese had no desire to revalue and thereby make their exports more expensive, whereas the U.S. sought to maintain its international credibility by avoiding devaluation.^[17] Meanwhile, the pressure on government reserves was intensified by the new international currency markets, with their vast pools of speculative capital moving around in search of quick profits.^[16]

In contrast, upon the creation of Bretton Woods, with the U.S. producing half of the world's manufactured goods and holding half its reserves, the twin burdens of international management and the Cold War were possible to meet at first. Throughout the 1950s Washington sustained a balance of payments deficit to finance loans, aid, and troops for allied regimes. But during the 1960s the costs of doing so became less tolerable. By 1970 the U.S. held under 16% of international reserves. Adjustment to these changed realities was impeded by the U.S. commitment to fixed exchange rates and by the U.S. obligation to convert dollars into gold on demand.

Paralysis of international monetary management

Floating-rate Bretton Woods system 1968–1972

By 1968, the attempt to defend the dollar at a fixed peg of $35/ounce, the policy of the Eisenhower, Kennedy and Johnson administrations, had become increasingly untenable. Gold outflows from the U.S. accelerated, and despite gaining assurances from Germany and other nations to hold gold, the unbalanced fiscal spending of the Johnson administration had transformed the dollar shortage of the 1940s and 1950s into a dollar glut by the 1960s. In 1967, the IMF agreed in Rio de Janeiro to replace the tranche division set up in 1946. Special Drawing Rights were set as equal to one U.S. dollar, but were not usable for transactions other than between banks and the IMF. Nations were required to accept holding Special Drawing Rights (SDRs) equal to three times their allotment, and interest would be charged, or credited, to each nation based on their SDR holding. The original interest rate was 1.5%.

The intent of the SDR system was to prevent nations from buying pegged gold and selling it at the higher free market price, and give nations a reason to hold dollars by crediting interest, at the same time setting a clear limit to the amount of dollars that could be held. The essential conflict was that the American role as military defender of the capitalist world's economic system was recognized, but not given a specific monetary value. In effect, other nations "purchased" American defense policy by taking a loss in holding dollars. They were only willing to do this as long as they supported U.S. military policy. Because of the Vietnam War and other unpopular actions, the pro-U.S. consensus began to evaporate. The SDR agreement, in effect, monetized the value of this relationship, but did not create a market for it.

The use of SDRs as paper gold seemed to offer a way to balance the system, turning the IMF, rather than the U.S., into the world's central banker. The U.S. tightened controls over foreign investment and currency, including mandatory investment controls in 1968. In 1970, U.S. President Richard Nixon lifted import quotas on oil in an attempt to reduce energy costs; instead, however, this exacerbated dollar flight, and created pressure from petro-dollars. Still, the U.S. continued to draw down reserves. In 1971 it had a reserve deficit of $56 billion; as well, it had depleted most of its non-gold reserves and had only 22% gold coverage of foreign reserves. In short, the dollar was tremendously overvalued with respect to gold.

Nixon Shock

By the early 1970s, as the Vietnam War accelerated inflation, the United States as a whole began running a trade deficit. The crucial turning point was 1970, which saw U.S. gold coverage deteriorate from 55% to 22%. This, in the view of neoclassical economists, represented the point where holders of the dollar had lost faith in the ability of the U.S. to cut budget and trade deficits.

In 1971 more and more dollars were being printed in Washington, then being pumped overseas, to pay for government expenditure on the military and social programs. In the first six months of 1971, assets for $22 billion fled the U.S. In response, on August 15, 1971, Nixon unilaterally imposed 90-day wage and price controls, a 10% import surcharge, and most importantly "closed the gold window", making the dollar inconvertible to gold directly, except on the open market. Unusually, this decision was made without consulting members of the international monetary system or even his own State Department, and was soon dubbed the "Nixon Shock".

The surcharge was dropped in December 1971 as part of a general revaluation of major currencies, which were henceforth allowed 2.25% devaluations from the agreed exchange rate. But even the more flexible official rates could not be defended against the speculators. By March 1976, all the major currencies were floating—in other words, exchange rates were no longer the principal method used by governments to administer monetary policy.

Smithsonian Agreement

The shock of August 15 was followed by efforts under U.S. leadership to develop a new system of international monetary management. Throughout the fall of 1971, there was a series of multilateral and bilateral negotiations of the Group of Ten seeking to develop a new multilateral monetary system.

On December 17 and 18, 1971, the Group of Ten, meeting in the Smithsonian Institution in Washington, created the Smithsonian Agreement, which devalued the dollar to $38/ounce, with 2.25% trading bands, and attempted to balance the world financial system using SDRs alone. It was criticized at the time, and was by design a "temporary" agreement. It failed to impose discipline on the U.S. government, and with no other credibility mechanism in place, the pressure against the dollar in gold continued.

This resulted in gold becoming a floating asset, and in 1971 it reached $44.20/ounce, in 1972 $70.30/ounce and still climbing. By 1972, currencies began abandoning even this devalued peg against the dollar, though it took a decade for all of the industrialized nations to do so. In February 1973 the Bretton Woods currency exchange markets closed, after a last-gasp devaluation of the dollar to $44/ounce, and reopened in March in a floating currency regime.

Bretton Woods II

Dooley, Folkerts-Landau and Garber have referred to the monetary system of today as Bretton Woods II. They argue that today, like 40 years ago, the international system is composed of a core issuing the dominant international currency, and a periphery. The periphery is committed to export-led growth based on the maintenance of an undervalued exchange rate. In the 1960s, the core was the United States and the periphery was Europe and Japan. This old periphery has since 'graduated', and the new periphery is Asia. The core remains the same, the United States. The argument is that a system of pegged currencies, in which the periphery export capital to the core that provides a financial intermediary role is both stable and desirable, although this notion is controversial.^[18]

This meaning of "Bretton Woods II" has been somewhat superseded in the wake of the Global financial crisis of 2008, as policymakers and others have called for a new international monetary system that some of them dub Bretton Woods II. On the other side this crisis has revived the debate about Bretton Woods II.^{[Notes 5]}

The term dollar hegemony is coined by Henry C.K. Liu to describe the hegemonic role of the US dollar in the globalized economy.

On September 26, 2008, French president, Nicolas Sarkozy, said, "we must rethink the financial system from scratch, as at Bretton Woods.”^[19]

On September 24–25, 2009 US President Obama hosted the G20 in Pittsburgh at the David L. Lawrence Convention Center. A realignment of currency exchange rates was proposed. This meeting's policy outcome could be known as the Pittsburgh Agreement of 2009, where deficit nations may devalue their currencies and surplus nations may revalue theirs upward.

In March 2010, Prime Minister Papandreou of Greece wrote an op-ed in the International Herald Tribune, in which he said: "Democratic governments worldwide must establish a new global financial architecture, as bold in its own way as Bretton Woods, as bold as the creation of the European Community and European Monetary Union. And we need it fast." In interviews coinciding with his meeting with President Obama, he indicated that Obama would raise the issue of new regulations for the international financial markets at the next G20 meetings in June and November 2010.

Academic legacy

The collapse of the Bretton Woods system led to the study in economics of credibility as a distinct field, and to the prominence of "open" macroeconomic models, such as the Mundell-Fleming model.

Pegged rates

Dates shown are those on which the rate was introduced; "*" indicates floating rate supplied by IMF^[20]

Japanese yen

Note: GDP for 2007 is $4.272 trillion US Dollars

Deutsche Mark

Note: GDP for 2007 is $2.807 trillion US Dollars

Pound sterling

Note: GDP for 2007 is $2.1 trillion US Dollars

French franc

Note: GDP for 2007 is $2.075 trillion US Dollars

Italian lira

Note: GDP for 2007 is $1.8 trillion US Dollars

Spanish peseta

Note: GDP for 2007 is $1.361 trillion US Dollars

Dutch gulden

Note: GDP for 2007 is $0.645 trillion US Dollars

Belgian franc

Note: GDP for 2007 is $0.376 trillion US Dollars

Greek drachma

Note: GDP for 2007 is $0.327 trillion US Dollars

Swiss franc

Note: GDP for 2007 is $0.303 trillion US Dollars

Danish krone

Note: GDP for 2007 is $0.203 trillion US Dollars

Finnish markka

Note: GDP for 2007 is $0.188 trillion US Dollars

See also

Notes

References

Further reading

• Van Dormael, A.; Bretton Woods : birth of a monetary system; London MacMillan 1978
• Michael D. Bordo and Barry Eichengreen; A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform; 1993
• Harold James; International Monetary Cooperation Since Bretton Woods; Oxford University Press, USA 1996

External links

• Donald Markwell, John Maynard Keynes and International Relations: Economic Paths to War and Peace, Oxford University Press, 2006
• The Gold Battles Within the Cold War (PDF) by Francis J. Gavin (2002)
• International Financial Stability (PDF) by Michael Dooley, PhD, David Folkerts-Landau and Peter Garber, Deutsche Bank (October 2005)
• "Bretton Woods System", prepared for the Routledge Encyclopedia of International Political Economy by Dr. B. Cohen
• Bretton Woods Agreement by Addison Wiggin, co-author of Empire of Debt
• Dollar Hegemony by Henry C.K. Liu