International Finance

Assignment
Submitted by:-
Syeda Maham Waseem (170156)

Submitted to:-
Sir Shoaib

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Bretton Woods and the Financial Crisis
of 1971
1) What motivated John Maynard Keynes and Harry Dexter White to design the
Bretton Woods system? How would that system helps to address the problems
they saw? 

Background:
Let’s first discuss the times of 1940’s and closer and what were the critical issues of that
time. If we generally discuss, before the World War I the classical gold standard was the
system that was followed and it had many advantages and disadvantaged both. With the
outbreak of World War I, many countries suspended this system and prohibited gold
exports. The problems with system were that it may not provide enough flexibility in the
supply of money, because the supply of newly mined gold is not closely related to the
growing needs of the world economy for a matching supply of money.

Then in the period of World War I and after that, the period of the Great Depression (1931-
1939) many countries suffered from hyperinflation. It was a period of open economic
warfare through competitive devaluation and there was shortage of gold too. So there must
be a system that could address some of these problems.

Before that inter war period there were some rules that most of the countries were
following for example that the import and export of gold would be practiced. But countries
started breaking the rules. It is price flow mechanism that:

Exports increase Gold increase Increase money or currency

value) Currency appreciate Less exports and more imports
G Gold decrease

But countries didn’t follow that mechanism and ruled out. In fact when their exports
increased, they didn’t appreciate their currency correspondingly so that their currency
would stay in the country and their exports still increase. Countries didn’t follow the rule of
the game, because of the concern about economic stability.

Goal:
The world order up to 1939 failed to provide national security, economic stability, growth,
democracy etc. So, they wanted to establish new multilateral organizations that would bind
nations together in a web of interdependence to prevent conflicts related to security and
work more on relief and reconstruction and reform .One primary focus was to come up with

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a currency system less rigid than the Gold Standard while providing similar stability.
Secondly, it focuses to reconstruct the damages because of the wars and the Great
Depression. And thirdly, to provide a system that would again make the countries to follow
the rule of the game and countries again follow smooth international trade.

Bretton Woods System:

The resolution of the Bretton Woods meeting was to arrange a new system of rules,
regulations, and procedures for the main economies of the world, to ensure their economic
stability and restore economic growth and reconstruction. John Maynard Keynes and Harry
Dexter White wanted to address these five problems:

i. Trade Warfare: Tariffs and other barriers prevented the free flow of goods from one
country to other. Imperial preferences restricted trade, especially Britain promoted
trade within its imperial system, to boost Britain’s reserves of gold and to not let any
other country be monetary capital of the World.
 IMF was supposed to motivate the reduction of trade barriers by offering
attractive monetary credits, if free trade would create monetary imbalances.
ii. Unstable currencies: Countries were hesitant to international flow of capital because
of uncertainties created by unstable currencies. E.g. devaluation would place a
country’s exporters at a price advantage compared to other nations.
iii. Destabilizing flows of speculative finance: Unstable currencies and geopolitical
conflicts cause the outflow of cash or gold reserves from the country, that negatively
affects their economy or income, employment and the banking sector.
iv. Inflexible monetary standard: At that time, almost all countries aimed at gathering
maximum gold reserves rather than to gain international prestige, or economic
security or sound currency. It was causing a mentality of one country profit at the
expense of others, and was ignoring that mutual gains could also be achieved by
trade. Secondly, gold was inelastic; its global stock did not grow with the pace of
global economy. And thirdly, gold standard was also inflexible, as it was difficult to
shift gold reserves to countries and banks.
v. Gold imbalances: US had almost two- thirds of the world’s gold reserves, and also it
was leading creditor as well as dominant exporter, that helped to finance the Allies
during war .It was causing dependence of other countries on US to finance
reconstruction.

How to address the problems:

To address these problems, Bretton Woods established the International Monetary

Fund (IMF) and the World Bank.

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The IMF's primary purpose was to:

 Raise global monetary cooperation

 Achieve  financial stability
 Facilitate the international trade
 Reduce unemployment and poverty
 Promote sustainable economic growth

The World Bank’s primary purpose was to:

 Eliminate extreme poverty

 Promote means of sharing prosperity

The Bretton Woods Agreement wanted to address all those problems mentioned above by
establishing a rule of fixed exchange rates, supported with intervention or support of IMF.

i. Countries would join the IMF and they will contribute to its capital base. Each
country share would be determined by the size of the economy and the gold
reserves.
ii. Countries could get loans from IMF to offset the temporary imbalances of payments.
And with the interest amount to be determined, IMF would also impose policies
necessary to correct the trade balances.
iii. Every country will peg its currency with USD and gold, as the reserve currency and
the currency would fluctuate within +/- 1% of the target. Bretton woods declared the
US dollar to be the world’s reserve currency.
iv. If there would be fundamental disequilibrium in its balance of payments, countries
could devalue its currency by more than 10%, only with IMF approval.

2) How would the IMF function?

The International Monetary Fund (IMF) formation was greatly influenced by the worldwide
financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation
in Germany and elsewhere, and the general economic breakdown that happened between
the two world wars and the Great Depression. In the Bretton Woods system, there was
creation of IMF, which was delegated with the supervision of the new international
monetary system and with granting loans to deal with the balance of payment difficulties.

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IMF was created to check on monetary system, by ensuring the maintenance of the fixed-
exchange rate. And IMF’s creation another motive was to provide international monetary
cooperation and to facilitate the growth of international trade. Another aim or motive of
IMF was to try to avoid repetition of disorder, through a blend of discipline and flexibility.

Functioning of IMF:

The IMF’s main mission is to safeguard or ensure the stability of the international monetary
system. It ensures so in these ways:

Economic Surveillance

IMF keeps track of the global economy and the economies of member countries. It monitors
the economic and financial policies of its 189 member countries. IMF highlights probable
risks to stability and directs or advises on needed policy adjustments.

Lending

IMF provides loans to member countries with balance of payments problems, to help them
remake or reconstruct their international reserves, and to stabilize their currencies, to
continue paying for imports, and re-establish conditions for strong economic growth, while
correcting underlying or primary problems.

Capacity Development

IMF works with governments around the world, to update their economic policies and
institutions, and train their people. This helps countries to strengthen their economy,
improve growth and create jobs or increase employment.

IMF: Main duties today

 Surveillance of exchange rate policies (No longer fixed rate exchange)
 Financial assistance (including credits and loans)
 Technical assistance (expertise in fiscal/monetary policy)

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 3) Please examine case Exhibits 6 and 7 for trends in federal government receipts
and outlays that show the impact of President Lyndon Johnson’s policies. What
was the impact of those policies on net borrowing by the government? How
did this affect the US balance of payments given in case Exhibit 10? Why was
the United States unable to hold to the dollar-gold peg?

In exhibit 7, we can see increase of income taxes from $US 68,762 Million in 1968 to $US
87,249 Million in 1969 .This pattern was only due to the increase in taxes, and we can see
that in 1969 the US receipts ($US 187,784 Million), were much higher than expenditures
($US 184,548 Million). The result of that surplus was that balance of payment became
positive, because of the positive current account balance in 1970 that was previously
negative. Emerging economies affected United States GDP share in world from 35% to 27% .
And also the lowers the gold reserves for US. United States was unable to hold the dollar
gold peg because foreign countries had more US holdings than US itself. Foreign countries
had $US 14 Billion of holding while United States had only $US 3.2 Billion of gold reserves.

4) Why did Nixon add the other features to his New Economic Policy? Why didn’t he
just close the gold window?

Foreign countries were converting US dollars into the gold which were eventually worsening
US Balance of Payments. Major reasons for US monetary position disequilibrium were firstly
it was unable to finance its commitments on trade, foreign aid, capital mobility and security
etc. We can see that US balance on current account went from $3.3 Billion (1960-64
average) to $-1.3 Billion (EXHIBIT 10) and we can also see foreign investment in US are also
declining very fast. If we check the US net liquidity balance, it goes from $-2.8 Billion to $-
23.4 Billion in 1971, such a big change it was. Like official transaction balance was also
becoming more negative. Whether it was goods and services, productivity or US interest
rates everything was declining and was affecting US balance of payment somehow.

Nixon added policies like import taxes to hold foreign countries to convert dollars into gold
and he wanted other countries to do the same. In (EXHIBIT 14) we can see that major
countries gold reserves were increasing because they were converting dollars to gold. Japan
gold reserves were $2.9 Billion and in Sept 1971, they were $13.4 Billion. So US has to take
some actions to refrain countries from doing that so. So he added other features too to his
new economic policy. He wanted other countries to allow their currencies to revalue; just
closing gold window might cause major international depression. That’s why he

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recommended closing the gold window and implementing 10% import tax surcharge.
Because just closing gold window would demotivate countries to allow their currencies to
revalue. So tax surcharges were also imposed for the attention of foreign governments, to
revalue their currencies. US would make it more difficult for their products to compete in US
markets.

5) What should Nixon do next?

The only way out is to abandon Bretton woods system, so that the currency could be
devalued in order to maintain a favourable balance of payments and to reduce trade
deficits. As the foreign governments are converting dollar into gold, abandoning Bretton
woods would restrict Governments to do that, and that’s how the US can control their
capital outflow and maintain their current and trade account deficit. The fixed exchange rate
system should became a floating exchange rate system. 

COMPREHENSIVE:

This case describes the Bretton Woods system, the dollar run, and Nixon's policy. In August
1971, President Richard Nixon needed to decide how to deal with the growing run on the US
dollar. The decline in dollar confidence has led some of the country's trading partners to
exchange dollars in gold in the US Treasury window. For the Bretton Woods system, the
American dollar was the currency for World’s reserves. To provide enough money to grow
the global economy, the United States would eventually fall short of its balance of payments
- which would force it to hold back its money and devalue the currency. The Bretton Woods
plan seemed to be designed to fail. Nixon's two outstanding policy options are (a)
ineffective; and (b) devalue dollar by rejecting the commitment under the Bretton Woods
Agreement to convert dollars into gold by $ 35 / ounce.

President Richard Nixon introduced a New Economic Policy that would dramatically change
the stance of the United States in international monetary affairs. This policy would impose a
special import tax surcharge and suspend the convertibility of dollars for gold. These actions
would abandon the Bretton Woods agreement that had underpinned global finance since
1945.

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Kennedy and the Balance of Payments

1) What is the relationship between interest rate and short term capital flows?

Capital flows means the flow of funds or capital from one country to another country, in
order to earn a short-term profit on interest rate differences or the expected exchange rate
moves. Interest rates do affect the short term capital flows. Higher interest rates attract
the foreign investors to deposit or invest their money in your country because of high
returns or you can say capital inflows.

Local public or investors and consumers also deposit in the banks for higher return and
then got less amount of money left to buy foreign products. So, imports would reduce
and it will also positively impact the BOP, as capital outflows would reduce. If interest
rate is lower, then affect would be vice versa.

In the late 1957 and first few months of 1958, interest rates remained at their high level
(from internet source), and then fall abruptly and from exhibit 4, we have these values:

T-bill or call money rates (% per annum) :

 1.74 % in 1955
 3.26 % in 1957
 1.84% in 1958
 2.94 % in 1960

From these values, we can deduce that interest rates and short term capital flows have
direct relation.

2) What account reflects increased US investment in EEC?

Six countries (Belgium the federal republic Germany, France, Italy, Luxemburg, and
Netherlands) signed this EEC treaty. The purpose of it was free trade (elimination of tariffs,
freely movement of goods, services and capital) among those countries. So that the
dependency on US would be less and they could trade more among their selves and would
have less trade with United States.

Trade account reflects increased US investment in EEC. An increase in US foreign investment

in Europe and growing dollar reserve overseas reduced the motivation or encouragement
for foreign governments to hold US currency.

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In another case we can see that for the recovery of Japan right after World War 2, US did
not take apart trade barriers that restricted US imports .In fact US took an active part in
encouraging protectionism in Japan and Europe. Therefore US left its borders open for
Japan exports and insisted other countries too to buy more goods from Japan. Hence the
trade account reflects US high investment in EEC and for the free trade agreements too.

3) What is the role of US capital market in the global economy?

Capital market of US has very much and huge impacts on global economy because of its
size and interconnections with other countries. So we can say that developments in the
US economy are bound to have important effects around the world for the following
reasons.

i. The US has the world’s single largest economy, accounting for almost a quarter of
global GDP (at market exchange rates)
ii. One-fifth of global FDI.
iii. Ranked third in stock market capitalisation.
iv. It is the most important export destination for one-fifth of countries around the
world.
v. The US dollar is the most widely used currency around the globe
vi. Trade and financial transactions, and changes in US monetary policy and investor
sentiment play a major role in driving global financing conditions.
vii. US heavy industry is matured and its branches are in many developing and
developed countries.
viii. Their financial institutes are very much stronger; in order to get evidence we can
review financial crises of 2007-8 that proves that few US giants can collapse the
whole world within less than one year period.

America's commitment to unrestricted capital flows further enhanced the dollar's

international role. Since the United States was the world’s largest and freest capital market,
and American interest rates were generally favorable (see Exhibit 4), foreign governments
found it attractive to issue bonds in the United States. America's political stability and
economic strength also led many foreigners to deposit their dollars in U.S. banks or buy T-
bills. In addition, American multinationals and to some extent banks were an important
source of funds for Europe and the developing world.

As long as foreigners were content to hold and use dollars, and as long as the United States
had adequate gold stocks to back its foreign liabilities, a net outflow of U.S. dollars was
viewed positively by foreign governments. Since dollars were being used to finance world

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trade, U.S. deficits were critical for maintaining international liquidity. But as the 1950s wore
to a close, the outflow of dollars and gold from the United States began to reach crisis
proportions (see Exhibits 1, 2, and 3). The American government first became sensitive to
this problem around 1958. Concerned with domestic inflation President Eisenhower
introduced austerity measures that caused a recession. But for the first time in the post war
period, a recession in the United States did not produce a strong reduction in imports of
foreign goods and services. The increasing quality of imports and the growing
competitiveness of America's trading partners kept the demand for imports high. The result
was that the U.S. current account surplus, which had been strongly positive in 1956 and
1957.

4) What expenditures are necessary to sustain the US leadership? What is the

impact of these expenditures on BOP?

American foreign policy promoted global security. The United States was making large
military expenditures and maintaining substantial forces abroad to counter Soviet
assertiveness. Reducing those expenditures might have been viewed as capitulation to the
U.S.S.R. The United States was also fostering European cooperation and integration in the
interest of political stability and economic growth. Since rapid economic development was
viewed as the best defense against the spread of communism, it was not desirable to
restrict capital outflow to American allies or to erect trade barriers.

If the United States sustained an active foreign policy with a worldwide political, economic,
and military role, the balance of payments might continue to deteriorate. But a weak U.S.
balance of payments could jeopardize America's ability to pursue post war objectives.
Hence, each of Kennedy's standard options appeared to be constrained: adopting deflation,
devaluation, retrenchment, capital controls or trade controls implied sacrificing important
objectives.

For correcting balance of payment deficit, US had to decrease international commitments

and place controls on the outflow of capital or the inflow of foreign goods.
By raising import barriers, restricting US investment abroad, bringing American troops back
home could have reversed the process of growing deficits.

We can see in exhibit 1, that Government spending on military actions is becoming more
and more with passing years that is negatively impacting its BOP, as Government
transactions (mostly comprised of military expenditures) went from -542 USD Million in
1950 to -2609 USD Million in 1960.

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COMPREHENSIVE:

In this case Kennedy and the officials were trying to take measures to safeguard the US
economy and work on its BOP deficits. In the late 1960’s US were facing trade balance
deficit and some critical balance of payment deficit. US currency was under spell, most of
the gold was taken out of US that caused high trade deficits and BOP deficits. Such issues in
the balance of payment if exist for a long time can be a threat to the whole economy
because balance of payment closely interacts with key macroeconomic variables such as
GDP, exchange rates, interest rates and inflation rates. 

It can be said that the U.S. issue of the payment crisis is a cost that it has to pay to get more
political and economic influence from its counterparts. The issue stemmed from the post
war American effort to liberalize global trade freedom even though it required the sacrifice
of specific American economic goals. However, the process of free trade barriers took
longer than expected; and as a result, the costs associated with it were growing out of
control. All advanced accounts for U.S. payroll balance, the current account, particularly the
trade deficit balance, contributed a large part to the decline in US pay balance. There were
several reasons for the trade deficit balance. When the U.S. imposed terms to release trade
barriers, imports increased. However, these policies did not help boost exports because U.S.
counterparts still work.

Following were three of the traditional approaches to address the issue of balance of
payment:

i. To change the exchange rate, or to devalue the dollar, it would make American
exports cheaper and foreign imports relatively more expensive. This would cause
higher demand of American products and the rise in American exports, but due to
Bretton wood system it was not an easy way to adopt.
ii. They could adopt deflation; it is used for reducing the outflow of a nation’s currency.
If Kennedy employee restrictive policies, most consumers would be unable to buy
imports and high interest rates would attract investors to invest in the US economy.
iii. To reduce international commitments and place controls on the outflow of capital or
the inflow of foreign goods.

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