The Bretton Woods System and the gold standard

2.5.1 Introduction

Most of the countries tried to reestablish the gold standard after World War I, but it had been totally collapsed during the Great Depression in 1930s. Some economists said comply with the gold standard had prohibited monetary authorities from increasing the money supply rapidly enough to recover the economies. Therefore, the representatives of most of the world’s leading nations met at Bretton Woods, New Hampshire, in 1944 to create a new international monetary system. The representatives had decided to link the world currencies to the dollar since the United States accounted for over half of the world’s manufacturing capacity and held most of the world’s gold during that time. At the final, they agreed should be convertible into gold at $35 per ounce.

What is Bretton Woods System? The Bretton Woods system is often refer to the international monetary standard that being used from the end of World War II until 1971. The origin of the name is taken from the venue of the conference in 1944 that had established the International Monetary Fund (IMF) and World Bank. According to the history, the Bretton Woods system was the first instance of monetary standard that had been fully negotiated in order to control currency relations among fully independent states. The standard was created to combine binding legal obligations with multilateral decision-making conducted through an international organization — the IMF, endowed with limited supranational authority. During the running of the scheme, it was highly depended on the United States’ preferences and policies.

The International Monetary Fund was officially established on 27th December 1945, when the 29 nations who had participated in the conference of Bretton Woods signed the Articles of Agreement. It commenced its financial operations on 1st March 1947. The IMF is an international organization, which consists of 183 member countries nowadays. The objectives of the IMF are to promote international monetary cooperation by establishing a global monitoring agency that supervises, consults, and collaborates on monetary problems. It facilitates world trade expansion and thereby contributes to the promotion and maintenance of high levels of employment and real income. Furthermore, the IMF ensures exchange rate stability to avoid competitive exchange depreciation. It eliminates foreign exchange restrictions and assists in creating systems of payment for multilateral trade. Moreover, member countries with disequilibrium in their balance of payments are provided with the opportunity to correct their problems by making the financial resources of the IMF available for them.

On the other hand, World Bank is the most significant source of financial aid for developing nations in the world. It provides approximately $16 billion of loans to its client countries per year. It utilizes its financial resources, highly trained staff, and extensive knowledge base to help each developing country to move towards the path of stable, sustainable, and equitable growth in the order to fight against poverty. Its goals are to eliminate the worst forms of poverty and to improve living standards. It supports the restructuring process of economies and provides capital for productive investments. Furthermore, it encourages foreign direct investment by making guarantees or accepting partnerships with investors. The World Bank’s aims are to keep payments in developing countries balanced and to foster international trade. It is active in more than 100 developing economies. It forms assistance strategies by cooperating with government agencies, non-governmental institutions and private enterprises. It offers financial services, analytical, advisory, and capacity building.

The conference was organized in the American resort village of Bretton Woods, New Hampshire. Treasuries of the United Kingdom and the United States had been culminated the monetary standard for two and a half years. Even though the conference was attended by all 44 allied nations, plus one neutral government — Argentina, the conference discussion was dominated by two rival plans developed — Harry Dexter White of the U.S. Treasury and John Maynard Keynes of Britain respectively. The ultimate compromise was much closer to White’s plan than to that of Keynes, which reflected the overwhelming power of the United States although World War II was nearly came to the end.

Although the differences between the White and Keynes plans was quite large during that time, especially with regarding 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 International Monetary Fund.

There were four points being stand out which are listed as below:

Negotiators generally agreed that, to them, conclusively proved that the exchange rate during the two world wars and the fundamental shortcomings of unrestrained flexibility. 30 years of the 20th century is considered a floating exchange rate system has to stop trade and investment, encouraging the destabilizing speculation and competitive devaluations. However, a more radical economic policies, the government at the same time to go back to the 19th century, the classical gold standard model of a permanent fixed rate. Policy makers understand the wish to retain the right to require the revision of the occasion as a monetary value. Therefore a compromise between, either freely floating or irrevocably fixed rates polarity selection – some arrangements may be given against any of the shortcomings of both worlds.

What emerged is a ‘link rate’ or ‘adjustable peg currency system, also known as the par value system. Members of the obligation to declare par value (1 ‘hanging’) is the national currency, and to intervene in currency markets to limit exchange rate fluctuations in the maximum profit (a ‘band’) 1% above or below parity, but they also keep rights and, where necessary, in accordance with agreed procedures, to change their face value to correct the fundamental imbalance ‘in its balance of payments equilibrium. Unfortunately, the basic concepts of imbalance, but the key of the par value system of operation, has never explained in any detail – a notorious omission, will eventually come back in subsequent years plagued the system.

All the Governments that, if there is no free floating exchange rate, countries need a sufficient guarantee of currency reserves. Negotiators do not consider it necessary to change in any fundamental system of the gold exchange standard had been inherited from the interwar years. International mobility is still mainly gold or convertible currency countries share, directly or indirectly, for gold, (‘Gold Exchange’). In particular, they are unwilling to change, whether in dollars or its gold reserves, which at the time equivalent of three quarters of the world, all of the value of the central role of central bank gold. Negotiators also agreed, but a deficit of liquidity in some countries the desirability of additional sources. The biggest problem is whether the source should be made as Keynes, is the same one world central bank will be able to create new reserves (according to Keynes, this may be the so-called Bancor), or more limited borrowing mechanism, white preferred.

A reflection of what concessions the United States occur: 1 subscription and the IMF, which is embedded in the quota system itself is only a national currency and each signed a fixed pool of more of the gold. Member is assigned a quota, broadly reflect each country’s relative economic importance and the obligation to pay the same amount of subscription funds. Subscription is to pay 25 percent of gold or currency convertible into gold (effectively U.S. dollar, which was the only currency the central bank is still directly gold convertible) and members of its own funds accounted for 75 percent. Each member was entitled to a short period of reserve required by the size of quotas by its decision to the amount of foreign currency.

All the Government has agreed that the need to avoid the kind of economic war 30 years specific to the 10-year recurrence. Some of the rules binding framework needs to ensure that countries will abolish the existing restrictions on foreign exchange control, currency convertibility, return to a multilateral payments system free. Therefore, in principle, members engaged in prohibited conduct or discriminatory currency exchange controls, only two real exceptions. First of all, convertible obligations extend to current international transactions only. Governments do not regulate money to buy and sell goods or services trade. But they have no obligation, to avoid the regulatory capital account transactions. In fact, to encourage them to make a formal capital controls to maintain external balance facing a potential instability ‘hot money’ inflows. Second, the obligation can be deferred exchange, if a member so in a post-war ‘chosen transitional period. Members deferred their obligation to be known as the convertibility of Article XIV of the State; members accepted their so-called Article VIII status. One of the functions assigned to the IMF to oversee the management of currency exchange code of law.

Negotiators agreed that there is a problem of international cooperation on the monetary system of the need for the Forum. Currency in the trouble between the world wars, it was felt, has been greatly affected by any given process or governmental consultation mechanism between the cases, increased. In the post-war era, the fund itself will provide such a forum – in fact, a truly historic achievement. No more break the path of a country’s decision to allocate voting rights among the government, one vote basis, but a considerable proportion of the quota. One third of all the IMF quota, first of all, the United States is in itself a guarantee of future decision-making and effective veto power.

With these four points, we can conclude that the definition of the Bretton Woods system is a monetary standard is the combination of an unchanged gold exchange, a centralized pool of gold and national currencies, and an exchange rate system of adjustable pegs. IMF was the center of the regime and it had to carry out three essentual functions as stated as below:

Regulatory – administer the rules governing currency values and convertibility,

Financial – supply supplementary liquidity

Consultative – provide a forum for cooperation among governments.

Under the Bretton Woods system, central banks of countries other than the United States had to perform the task of maintaining fixed exchange rates between their currencies and the dollar by intervening in foreign exchange markets. If a country’s currency was too high relative to the dollar, its central bank would sell its currency in exchange for dollars in order to reduce the value of its currency. Conversely, if the value of a country’s money was too low, the country would buy its own currency in order to raise the price.

The Bretton Woods system had been lasted until 1971. The inflation in the United States and a growing American trade deficit of that time were depreciating the value of the dollar. Americans urged both Germany and Japan which had favorable payments balances to appreciate their currencies. But those nations were reluctant to do so, since raising the value of their currencies would raise the prices for their goods and hurt their exports. Finally, the United States abandoned the fixed value of the dollar and allowed it to “float”, that is to fluctuate against other currencies. This caused the dollar fell dramatically. World leaders sought to revive the Bretton Woods system with the so-called Smithsonian Agreement in 1971, but failed. By 1973, the United States and other nations agreed to allow exchange rates to float.

Economists named the resulting system as “managed float regime”, which means that even though exchange rates for most currencies float, central banks still can intervene to prevent sharp changes. As in 1971, countries with large trade surpluses often sell their own currencies in an effort to prevent them from appreciating and prevent them from hurting exports. Conversely, countries with large trade deficits often buy their own currencies in order to prevent depreciation, which could increase domestic prices. But there are limits to what can be accomplished through intervention, especially for countries with large trade deficits. Eventually, a country that intervenes to support its currency may deplete its international reserves, making it unable to continue buttressing the currency and potentially leaving it unable to meet its international obligations.

2.5.2 Advantage and Disadvantage of Bretton Woods System

The benefits of the Bretton Woods system were a significant expansion of international trade and investment as well as a notable macroeconomic performance: the rate of inflation was lower on average for every industrialized country except Japan than during the period of floating exchange rates that followed, the real per capita income growth was higher than in any monetary regime since 1879 and the interest rates were low and stable. It has to be noted that leading economists nowadays argue “whether macroeconomic performance stability was responsible for the successes of Bretton Woods, or the controversy.”

Under the gold exchange standard, a country has to address the problem by deflating the domestic economy when faced with chronic Balance Payment deficits. Before World War II, European nations often used this policy, in particular the Great Britain. Even though few currencies were convertible into gold, policy makers thought that currencies should be backed by gold and willingly adopted deflationary policies after World War I. Deflationary policy is not the only option when faced with BP deficits. Devaluation is accepted in Bretton Woods. The adjustable peg was viewed as a vast improvement over the gold exchange standard with fixed parity. Currencies were convertible into gold, but unlike the gold exchange standard, countries had the ability to change par values. For this reason, Keynes described the Bretton Woods system as “the exact opposite of the gold standard.”

On the contrary, weaknesses of the system were capital movement restrictions throughout the Bretton Woods years (governments needed to limit capital flows in order to have a certain extent of control) as well as the fact that parities were only adjusted after speculative and financial crises. Another negative aspect was the pressure Bretton Woods put on the United States, which was not willing to supply the amount of gold the rest of the world demanded, because the gold reserves declined and eroded the confidence in the dollar.

In the post-World War II scenario, countries devastated by the war needed enormous resources for reconstruction. Imports went up and their deficits were financed by drawing down their reserves. At that time, the US dollar was the main component in the currency reserves of the rest of the world, and those reserves had been expanding as a consequence of the US running a continued balance of payments deficit; other countries were willing to hold those dollars as a reserve asset because they were committed to maintain convertibility between their currency and the dollar.

The problem was that if the short-run dollar liabilities of the US continued to increase in relation to its holdings of gold, then the belief in the credibility of the US commitment to convert dollars into gold at the fixed price would be eroded. The central banks would thus have an overwhelming incentive to convert the existing dollar holdings into gold, and that would, in turn, force the US to give up its commitment. This was the Triffin Dilemma after Robert Triffin, the main critic of the Bretton Woods system. Triffin suggested that the IMF should be turned into a ‘deposit bank’ for central banks and a new ‘reserve asset’ be created under the control of the IMF. In 1967, gold was displaced by creating the Special Drawing Rights (SDRs), also known as ‘paper gold’, in the IMF with the intention of increasing the stock of international reserves. Originally defined in terms of gold, with 35 SDRs being equal to one ounce of gold (the dollar-gold rate of the Bretton Woods system), it has been redefined several times since 1974. At present, it is calculated daily as the weighted sum of the values in dollars of four currencies (euro, dollar, Japanese yen, and pound sterling) of the five countries (France, Germany, Japan, the UK and the US). It derives its strength from IMF members being willing to use it as a reserve currency and use it as a means of payment between central banks to exchange for national currencies. The original installments of SDRs were distributed to member countries according to their quota in the Fund (the quota was broadly related to the country’s economic importance as indicated by the value of its international trade).

Structural problem also exist in this system. Over time the world economy grew and needed more liquidity, which meant that US had to maintain increasing trade deficits. But the US was not able to devalue the dollar. The dollar was the numeraire of the system, for instance, it was the standard by letting other currencies to peg with. Accordingly, the U.S. did not have the power to set the exchange rate between the dollar and any other currency. Changing the value of dollar in terms of gold has no real effect, because the values of other currencies were pegged to the dollar. This problem would not have existed if most of other currencies were pegged to gold. However, none of these currencies were pegged to gold because they were not convertible into gold with the limited supply of gold.

The breakdown of the Bretton Woods system was preceded by many events, such as the devaluation of the pound in 1967, flight from dollars to gold in 1968 leading to the creation of a two-tiered gold market (with the official rate at $35 per ounce and the private rate market determined) and finally in August 1971, the British demand that US guarantee the gold value of its dollar holdings. This led to the US decision to give up the link between the dollar and gold.

2.5.3 Crisis of Bretton Woods System

The enduring imbalances of payments between the Western industrialized countriesIn the 1960s and 1970s had weakened the Bretton Woods System. The main problem was that one national currency which is the U.S. dollar had to be an international reserve currency at the same time. This made the national monetary and fiscal policy of the United States free from external economic pressures, while seriously affecting those external economies. The U.S. was forced to run deficits in their balance of payments in order to ensure international liquidity which had been caused world inflation. In the 1960s, there was a run of very inflationary policy which limited the convertibility of the U.S. dollar since the reserves were insufficient to meet the demand for their currency. Yet, the other member countries were not willing to accept the high inflation rates that the par value system would have caused and “the dollar ended up being weak and unwanted, just as predicted by Gresham’s law: Bad money drives out good money.” The Bretton Woods System had collapsed. Another fundamental problem was the delayed adjustment of the parities to changes in the economic environment of the countries. It was always a great political risk for a government to adjust the parity and “each change in the par value of a major currency tended to become a crisis for the whole system.” This led to a lack of trust and destabilizing speculations.

Collapse of Bretton Woods System was dissolved between 1968 and 1973. U.S. President Richard Nixon announced to suspend the dollar’s convertibility into gold temporarily in August of 1971. The dollar had struggled throughout 1960s within the parity established at Bretton Woods which showed the symptom of the end of the system. There was an attempt to reestablish the fixed exchange rates but it was failed. The major currencies began to float against each other in the March of 1973. At the same time, the par value system was abandoned and the member countries agreed on permitting different kinds of ways for determining the exchange value of a nation’s money. Started from the breakdown of the Bretton Woods System, IMF members have the freedom to select any form of exchange arrangement as they wish except pegging their currency to gold.

Most of the nations afraid of the breakdown of the Bretton Woods System would cause the end of the rapid growth period. But the transformation of the monetary standard to floating exchange rates made it easier for economies to adjust to more expensive oil especially during October of 1973 — the price suddenly started rising. The IMF adapted its lending instruments in order to respond to the challenges created by the oil price shocks of the 1970s. It also set up the first of two oil facilities in order to aid oil importers to overcome the anticipated current account deficits and inflation in the face of higher oil prices.

IMF sought to respond to the balance of payments deficits faced by many poorest countries by providing concessional financing called the Trust Fund since the mid of 1970s. IMF created a new concessional loan program called the Structural Adjustment Facility in March of 1986. In December of 1987, the Structural Adjustment Facility was taken over by the Enhanced Structural Adjustment Facility.

As a conclusion, even though the Bretton Woods System of 1944 with its fixed exchange rates had been collapsed, its goals are still as valid today as they have been in the past. Most of the large developed nations allow their currencies to float freely nowadays and only supply and demand are the determinants of its worth. The value of the currencies can be influenced by buying and selling their own currency besides to peg the value of the money to one of the main currencies.

What are the implications of the Bretton Woods experience for future international monetary relations? The most important implication is that simply stabilizing exchange rates is not sufficient to automatically deliver the benefits trumpeted by the proponents of such an initiative. It is crucial that national economic policies, for instant, budget deficits, and economic outcomes, for instant, inflation, converge to a certain extent before countries decide to fix exchange rates. However, a short term divergence of policies is not detrimental for the functioning of such a system; it is rather a credible commitment to fixed exchange rates that ensures its stability. It can be concluded that ambitious international monetary reforms like the Bretton Woods System can only work if they are integrated into wider economic and political convergence. With this fact in mind it is easy to understand how far the world with its various countries and living standards, policies, and economies is from a “new system of Bretton Woods”, that can overcome its previous weaknesses.