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Bretton woods system

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Bretton woods system

  1. 1. 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.
  2. 2. 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
  3. 3. 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 White. 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.
  4. 4. 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.
  5. 5. 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 ("conditionality"). 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 countries. 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
  6. 6. 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 dollar. 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?
  7. 7. 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 disintegrate. 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.
  8. 8. 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 reserves. 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.

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