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Bretton Woods System
The Bretton Woods system is commonly understood to refer to the
international monetary regime that prevailed from the end of World
War II until the early 1970s. Taking its name from the site of the 1944
conference that created the *International Monetary Fund (IMF) and
*World Bank, the Bretton Woods system was history's first example of a
fully negotiated monetary order intended to govern currency relations
among sovereign states. In principle, the regime was designed to
combine binding legal obligations with multilateral decision-making
conducted through an international organization, the IMF, endowed
with limited supranational authority. In practice the initial scheme, as
well as its subsequent development and ultimate demise, were directly
dependent on the preferences and policies of its most powerful
member, the United States.
Design of the Bretton Woods system
The conference that gave birth to the system, held in the Amrican resort
village of Bretton Woods, New Hampshire, was the culmination of some
two and a half years of planning for postwar monetary reconstruction
by the Treasuries of the United Kingdom and the United States.
Although attended by all forty four allied nations, plus one neutral
government (Argentina), conference discussion was dominated by two
rival plans developed, respectively, by Harry Dexter White of the U.S.
Treasury and by *John Maynard Keynes of Britain. The compromise that
ultimately emerged was much closer to White's plan than to that of
Keynes, reflecting the overwhelming *power of the United States as
World War II was drawing to a close.
Athough, at the time, gaps between the White and Keynes plans seemed
enormous - especially with respect to the issue of future access to
international *liquidity - in retrospect it is their similarities rather than
their differences that appear most striking. In fact, there was much
common ground among all the participating governments at Bretton
Woods. All agreed that the monetary chaos of the interwar period had
yielded several valuable lessons. All were determined to avoid repeating
what they perceived to be the errors of the past. Their consensus of
judgment was reflected directly in the Articles of Agreement of the IMF.
Four points in particular stand out. First, negotiators generally agreed
that as far as they were concerned, the interwar period had conclusively
demonstrated the fundamental disadvantages of unrestrained flexibility
of *exchange rates. The floating rates of the 1930s were seen as having
discouraged trade and investment and to have encouraged destabilizing
speculation and competitive depreciations. Yet in an era of more activist
economic policy, governments were at the same time reluctant to return
to permanently fixed rates on the model of the classical *gold standard
of the nineteenth century. Policy-makers understandably wished to
retain the right to revise currency values on occasion as circumstances
warranted. Hence a compromise was sought between the polar
alternatives of either freely floating or irrevocably fixed rates - some
arrangement that might gain the advantages of both without suffering
the disadvantages of either.
What emerged was the 'pegged rate' or 'adjustable peg' currency
regime, also known as the par value system. Members were obligated to
declare a par value (a 'peg') for their national money and to intervene in
currency markets to limit exchange rate fluctuations within maximum
margins (a 'band') one per cent above or below parity; but they also
retained the right, whenever necessary and in accordance with agreed
procedures, to alter their par value to correct a 'fundamental
disequilibrium' in their *balance of payments. Regrettably the notion of
fundamental disequilibrium, though key to the operation of the par
value system, was never spelled out in any detail - a notorious omission
that would eventually come back to haunt the regime in later years.
Second, all governments generally agreed that if exchange rates were
not to float freely, states would also require assurance of an adequate
supply of monetary reserves. Negotiators did not think it necessary to
alter in any fundamental way the *gold exchange standard that had
been inherited from the interwar years. International liquidity would
still consist primarily of national stocks of gold or currencies
convertible, directly or indirectly, into gold ('gold exchange'). The
United States, in particular, was loth to alter either the central role of
the dollar or the value of its gold reserves, which at the time amounted
to three quarters of all central bank gold in the world. Negotiators, did
concur, however, on the desirability of some supplementary source of
liquidity for deficit countries. The big question was whether that source
should, as proposed by Keynes, be akin to a world central bank able to
create new reserves at will (which Keynes thought might be called
*bancor); or a more limited borrowing mechanism, as preferred by
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. Members were assigned quotas, roughly reflecting each
state's relative economic importance, and were obligated to pay into the
Fund a subscription of equal amount. The subscription was to be paid
25 per cent 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 per cent in the member's own money. Each
member was then entitled, when short of reserves, to borrow needed
foreign currency in amounts determined by the size of its quota.
A third point on which all governments agreed was that it was
necessary to avoid recurrence of the kind of economic warfare that had
characterized the decade of the 1930s. Some binding framework of
rules was needed to ensure that states would remove existing
*exchange controls limiting *currency convertibility and return to a
system of free multilateral payments. Hence members were in principle
forbidden to engage in discriminatory currency practices or exchange
regulation, with only two practical exceptions. First, convertibility
obligations were extended to current international transactions only.
Governments were to refrain from regulating purchases and sales of
currency for trade in goods or services. But they were not obligated to
refrain from regulation of capital-account transactions. Indeed, they
were formally encouraged to make use of *capital controls to maintain
external balance in the face of potentially destabilizing 'hot money'
flows. Second, convertibility obligations could be deferred if a member
so chose during a postwar 'transitional period.' Members deferring their
convertibility obligations were known as Article XIV countries;
members accepting them had so-called Article VIII status. One of the
responsibilities assigned to the IMF was to oversee this legal code
governing currency convertibility.
Finally, negotiators agreed that there was a need for an institutional
forum for international cooperation on monetary matters. Currency
troubles in the interwar years, it was felt, had been greatly exacerbated
by the absence of any established procedure or machinery for inter-
governmental consultation. In the postwar era, the Fund itself would
provide such a forum - in fact, an achievement of truly historic
proportions. Never before had international monetary cooperation been
attempted on a permanent institutional basis. Even more pathbreaking
was the decision to allocate voting rights among governments not on a
one-state, one-vote basis but rather in proportion to quotas. With one-
third of all IMF quotas at the outset, the United States assured itself an
effective veto over future decision-making.
Together these four points defined the Bretton Woods system - a
monetary regime joining an essentially unchanged gold exchange
standard, supplemented only by a centralized pool of gold and national
currencies, with an entirely new exchange rate system of adjustable
pegs. At the center of the regime was to be the IMF, which was expected
to perform three important functions: regulatory (administering the
rules governing currency values and convertibility), financial (supplying
supplementary liquidity), and consultative (providing a forum for
cooperation among governments). Structurally, the regime combined a
respect for the traditional principle of national *sovereignty - especially,
of course, that of the United States - with a new commitment to
collective responsibility for management of monetary relations,
expressed both in mutually agreed rules and in the powers of the Fund.
The creation of the Bretton Woods system
After World War II, the Bretton Woods system was established. In fact, the
agreement to create a new international monetary system was negotiated
among the allied powers even before the end of WW2, leading to the Bretton
Woods Agreement in 1944. Bretton Woods is the name of a small tourist spot
in the mountains of New Hampshire, USA. There, the delegates gathered to
design a new global economic system. Their most important goal was to
prevent each country from pursuing selfish policies, such as competitive
devaluation, protectionism and forming trade blocks, which damaged the
world economy in the 1930s.
The British delegation was headed by John M. Keynes, the famous economist,
while Harry D. White of the US Treasury Department represented the
American side. The contents of the new system were negotiated essentially by
these two countries. As a dominant military and economic power, the US took
the leadership away from Britain, which was war torn and losing international
influence. The Keynes proposal was rejected and the US idea became the
foundation of the newly created International Monetary Fund (IMF).
The rejected British proposal was to create a mighty settlement union for all
countries. Each country was to have an official account at this mechanism, and
all balance of payments (BOP) surpluses and deficits would be recorded and
settled through these accounts. This would mean that both surplus and deficit
countries bear the responsibility for correcting the imbalance.
However, the US plan, which was actually adopted, was a much
weaker revolving fund. Each country would contribute a certain amount
("quota") to this fund, and member countries with BOP difficulties would
borrow (or "purchase" hard currencies) from this fund. This meant that only
deficit countries would bear the responsibility for correcting the imbalance.
(The UK was expected to be a deficit country after the war, while the US was
expected to be a surplus country.) Later in the 1950s, borrowing countries
were required to implement macroeconomic policies to reduce the deficit
The Bretton Woods Agreement also established the World Bank
(International Bank for Reconstruction and Development). The World Bank's
initial purpose was to assist the recovery of war-torn Europe and Japan. But in
reality, Japan's recovery was assisted by US bilateral aid and Europe's
recovery was promoted by the Marshall Plan, a massive US aid program. The
World Bank subsequently became an organization to assist developing
The IMF and the World Bank were called the Bretton Woods sister
organizations. One more organization (International Trade Organization) was
also planned but not created at that time. Instead, the General Agreement on
Tariffs and Trade (GATT), a non-organizational entity, played the role of
promoting free trade for four decades. GATT became institutionalized as WTO
in 1995. So we now have three sisters.
Features of the Bretton Woods international dollar standard
Four main features of the Bretton Woods system was as follows.
First, it was a US dollar-based system. Officially, the Bretton Woods system was
a gold-based system which treated all countries symmetrically, and the IMF
was charged with the responsibility to manage this system. In reality,
however, it was a US-dominated system with the US dollar playing the role of
the key currency (the dollar's dominance still continues today). The
relationship between the US and other countries was highly asymmetric. The
US, as the center country, provided domestic price stability which other
countries could "import," but did not itself engage in currency intervention
(this is called benign neglect; i.e., the US did not care about exchange rates,
which was desirable). By contrast, all other countries had the obligation to
intervene in the currency market to fix their exchange rates against the US
Second, it was an adjustable peg system. This means that exchange rates were
normally fixed but permitted to be adjusted infrequently under certain
conditions. As a consequence, exchange rates were supposed to move in a
stepwise fashion. This was an arrangement to combine exchange rate stability
and flexibility, while avoiding mutually destructive devaluation. Member
countries were allowed to adjust "parities" (exchange rates) when
"fundamental disequilibrium" existed. However, "fundamental
disequilibrium" was not clearly defined anywhere. In reality, exchange rate
adjustments were implemented far less often than the builders of the Bretton
Woods system imagined. Germany revalued twice, the UK devalued once, and
France devalued twice. Japan and Italy did not revise their parities.
Third, capital control was tight. This was a big difference from the Classical
Gold Standard of 1879-1914, when there was free capital mobility. Although
the US and Germany had relatively less capital-account regulations, other
countries imposed severe exchange controls.
Fourth, macroeconomic performance was good. In particular, global price
stability and high growth were simultaneously achieved under deepening
trade liberalization. In particular, stability in tradable prices (wholesale prices
or WPI) from the mid 1950s to the late 1960s was almost perfect and globally
common. This macroeconomic achievement was historically unprecedented.
How did the Bretton Woods system collapse?
With such an excellent macroeconomic record, why did the Bretton Woods
system collapse eventually? Economists still debate on this question, but it is
undeniable that there was a nominal anchor problem. The collapse of the
Classical Gold Standard was externally forced (i.e., by the outbreak of WW1),
but the collapse of the Bretton Woods system was due to internal
inconsistency. The American monetary discipline served as the nominal
anchor for the Bretton Woods system. But when the US started to inflate its
economy, the international monetary system based on the US dollar began to
Let us follow the history of the Bretton Woods system, step by step.
The 1950s was a period of dollar shortage. Europe and Japan wanted to
increase imports in the process of recovery from war damage. But the only
internationally acceptable money at that time was the US dollar. So their
capacity to import was severely limited by the availability of foreign reserves
denominated in the US dollar.
However, by the late 1960s, there was a dollar overhang (oversupply) in the
world economy. This turnaround was due to the US balance of payments
deficit, which in turn was caused by expansionary fiscal policy. The spending
of the US government increased for three reasons: (i) the war in Vietnam; (ii)
welfare expenditure; and (iii) the space race with the USSR (send humans to
the moon by the end of the 1960s).
In the late 1950s, the IMF felt the need to create a new international currency
to supplement the dollar. But the international negotiation took a long time,
and the artificial currency (called the Special Drawing Rights, or SDR) was
created only in 1969. By that time, there was no longer a dollar shortage; in
fact there was a dollar glut! (Today, SDR plays only a minor role, mainly as the
IMF's accounting unit.)
In the mid 1960s, US domestic inflation (as measured in WPI) began to
accelerate, which strained the Bretton Woods system. When the US was
providing price stability, other countries were willing to give up monetary
policy independence and peg their currencies to the dollar. Through this
operation, their price levels were also stabilized. But when the US began to
have inflation, other countries gradually refused to import it.
There was a downward pressure on the dollar. In 1968, the fixed linkage
between dollar and gold was abandoned. The two-tier pricing of gold was
introduced whereby the "official" gold-dollar parity was de-linked from the
market price of gold. The market price of the dollar immediately depreciated.
This was similar to the situation of multiple exchange rates: an overvalued
official rate vs. a more depreciated market rate.
Finally, in 1971, the fixed linkage between dollar and other currencies was
given up. On August 15, 1971, US President Richard Nixon appeared on TV
and declared that the US would no longer sell gold to foreign central banks
against the dollar. This completely terminated the working of the Bretton
Woods system and major currencies began to float. At the same time,
President Nixon also imposed temporary price controls and stiff import
surcharges. These measures were all supposed to fight inflation and
ameliorate the balance of payments crisis that the US was facing. This was
called the "Nixon Shock." [If any country adopted such a policy package today,
it would be severely criticized by the IMF, WTO and the international
community. It would be told to tighten the budget and money first.]
For 11 trading days that followed, the Bank of Japan intervened heavily in the
currency market to fight off massive speculative attacks, losing 4 billion
dollars of foreign reserves. Then, it gave up and let the yen appreciate.
European central banks gave up much sooner before losing a lot of foreign
Between 1971 and 1973, there was an international effort to re-establish the
fixed exchange rate system at adjusted levels (with a more depreciated
dollar). In December 1971, the monetary authorities of major countries
gathered in Washington, DC to set their mutual exchange rates at new levels
(the Smithsonian Agreement). But these rates could not be maintained very
long. In early 1973, under another bout of heavy speculative attacks, the
Smithsonian rates were abandoned and major currencies began to float.