INTERNATIONAL TRADE

ASSIGNMENT
TOPIC: BRETTON WOODS SYSTEM AND
ITS BREAKDOWN

Introduction
The Bretton Woods system of monetary management established the rules for
commercial and financial relations among the United States, Canada, Western
European countries, Australia, and Japan after the 1944 Bretton Woods
Agreement. The Bretton Woods system was the first example of a
fully negotiated monetary order intended to govern monetary relations among
independent states. The chief features of the Bretton Woods system were an
obligation for each country to adopt a monetary policy that maintained its
external exchange rates within 1 percent by tying its currency to gold and the
ability of the International Monetary Fund (IMF) to bridge temporary imbalances
of payments. Also, there was a need to address the lack of cooperation among
other countries and to prevent competitive devaluation of the currencies as well.
Preparing to rebuild the international economic system while World War II was
still being fought, 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, also known as the Bretton
Woods Conference. The delegates deliberated from 1 to 22 July 1944, and signed
the Bretton Woods agreement on its final day. Setting up a system of rules,
institutions, and procedures to regulate the international monetary system, these
accords established the IMF and the International Bank for Reconstruction and
Development (IBRD), which today is part of the World Bank Group. The United
States, which controlled two-thirds of the world's gold, insisted that the Bretton
Woods system rest on both gold and the US dollar. Soviet representatives
attended the conference but later declined to ratify the final agreements,
charging that the institutions they had created were "branches of Wall
Street".These organizations became operational in 1945 after a sufficient number
of countries had ratified the agreement. According to Barry Eichengreen, the
Bretton Woods system operated successfully due to three factors: "low
international capital mobility, tight financial regulation, and the dominant
economic and financial position of the United States and the dollar."
On 15 August 1971, the United States unilaterally terminated convertibility of the
US dollar to gold, effectively bringing the Bretton Woods system to an end and
rendering the dollar a fiat currency. Shortly thereafter, many fixed currencies also
became free-floating. The Bretton Woods system was over by 1973. The
subsequent era was characterized by floating exchange rates.

Evolution of the Bretton Woods System

Over the years, the Bretton Woods system evolved (until 1971) in several
important directions in response to changing conditions. In 1962, the IMF
negotiated the General Arrangements to Borrow (GAB) up to $6 billion from the
so-called Group of Ten most important industrial nations (the United States, the
United Kingdom, West Germany, Japan, France, Italy, Canada, the Netherlands,
Belgium, and Sweden) and Switzerland to supplement its resources, if needed, to
help nations with balance-of-payments difficulties. This sum of $6 billion was over
and above the periodic increases in the Articles of Agreement that established the
IMF. The GAB was renewed and expanded in subsequent years. Starting in the
early 1960s, member nations began to negotiate standby arrangements. These
refer to advance permission for future borrowings by the nation at the IMF. Once
a standby arrangement was negotiated, the nation paid a small commitment
charge of one-fourth of 1 percent of the amount earmarked and was then able to
borrow up to this additional amount immediately when the need arose at a 5.5
percent charge per year on the amount actually borrowed. Standby arrangements
were usually negotiated by member nations as a first line of defense against
anticipated destabilizing hot money flows. After several increases in quotas, the
total resources of the Fund reached $28.5 billion by 1971 (of which $6.7 billion, or
about 23.5 percent, was the U.S. quota). By the end of 1971, the Fund had lent
about $22 billion (mostly after 1956), of which about $4 billion was outstanding.
The Fund also changed the rules and allowed member nations to borrow up to 50
percent of their quotas in any one year (up from 25 percent). National central
banks also began to negotiate so-called swap arrangements to exchange each
other’s currency to be used to intervene in foreign exchange markets to combat
hot money flows. A central bank facing large liquid capital flows could then sell
the foreign currency forward in order to increase the forward discount or reduce
the forward premium on the foreign currency and discourage destabilizing hot
money flows (see Sections 14.3 to 14.6). Swap arrangements were negotiated for
specific periods of time and with an exchange rate guarantee. When due, they
could either be settled by a reverse transaction or be renegotiated for another
period. The United States and European nations negotiated many such swap
arrangements during the 1960s. The most significant change introduced into the
Bretton Woods system during the 1947–1971 period was the creation of Special
Drawing Rights (SDRs) to supplement the international reserves of gold, foreign
exchange, and reserve position in the IMF. Sometimes called paper gold, SDRs are
accounting entries in the books of the IMF.

Policies to shore up the system

The problems of the Bretton Woods system were dealt with by the IMF, the G10
plus Switzerland, and by US monetary authorities. The remedies that followed
often worked in the short run but not in the long run. The main threat to the
system as a whole was the Triffin problem, which was exacerbated after 1965 by
expansionary US monetary and fiscal policy which led to rising inflation.
After a spike in the London price of gold to $40.50 in October 1960 – based on
fears that John F Kennedy, if elected, would pursue inflationary policies – led the
Treasury to develop policies to discourage Europeans from conversing dollars into
gold. These included:

 Moral suasion on Germany with the threat of pulling out US troops;

 The creation of the Gold Pool in 1961, in which eight central banks pooled
their gold reserves in order to keep the London price of gold close to the $35
per ounce parity price;
 The issue of Roosa bonds (foreign currency denominated bonds);
 The General Arrangements to Borrow in 1961, which was an IMF facility
large enough to offer substantial credit to the US;
 Operation Twist in 1962, in which the US Treasury bought long term debt to
lower long term interest rates and encourage investment, while the Federal
Reserve simultaneously sold short-term Treasury bills to raise short-term
rates and attract capital inflows; and
 The Interest Equalization Tax in 1963, which imposed a tax on capital
outflows.

The US Treasury, aided by the Federal Reserve, also engaged in sterilised

exchange market intervention.

The main instrument used by the Fed to protect the gold stock was the swap
network. It was designed to protect the US gold stock by temporarily providing an
alternative to foreign central bank conversion of their dollar holdings into gold. In
a typical swap transaction, the Federal Reserve and a foreign central bank would
undertake simultaneous and offsetting spot and forward exchange transactions,
typically at the same exchange rate and equal interest rate. The Federal Reserve
swap line increased from $900 million to $11.2 billion between March 1962 and
the closing of the gold window in August 1971.

Breakdown of the Bretton Woods System

The immediate cause of the collapse of the Bretton Woods system was the
expectation in late 1970 and early 1971, in the face of huge balance-of-payments
deficits, that the United States would soon be forced to devalue the dollar. This
led to a massive flight of liquid capital from the United States, which prompted
President Nixon to suspend the convertibility of the dollar into gold on August 15,
1971, and to impose a temporary 10 percent import surcharge. In December
1971, representatives of the Group of Ten nations met at the Smithsonian
Institution in Washington, D.C., and agreed to increase the dollar price of gold
from $35 to $38 an ounce. This implied a devaluation of the dollar of about 9
percent. At the same time, the German mark was revalued by about 17 percent,
the Japanese yen by about 14 percent, and other currencies by smaller amounts
with respect to the dollar. In addition, the band of fluctuation was increased from
1 percent to 2.25 percent on either side of the new central rates, and the United
States removed its 10 percent import surcharge. Since the dollar remained
inconvertible into gold, the world was now essentially on a dollar standard.
President Nixon hailed this Smithsonian Agreement as the “most significant
monetary agreement in the history of the world” and promised that the dollar
“would never again be devalued.” However, with another huge U.S. balance-of-
payments deficit in 1972 it was felt that the Smithsonian Agreement was not
working and that another devaluation of the dollar was required. This expectation
led to renewed speculation against the dollar and became self-fulfilling in
February 1973, when the United States was once again forced to devalue the
dollar, this time by about 10 percent .At the same time, the dollar remained
inconvertible into gold. In March 1972, the original six member nations of the
European Common Market decided to let their currencies float jointly against the
dollar with a total band of fluctuation of only 2.25 percent, instead of the 4.5
percent agreed on in December 1971. This was named the European snake or the
“snake in the tunnel” and lasted until March 1973. When speculation against the
dollar flared up again in March 1973, monetary authorities in the major industrial
nations decided to let their currencies float either independently or jointly. The
present managed floating exchange rate system was born. France abandoned the
snake in 1974, Norway in 1977, and Sweden in 1978.While the immediate cause
of the collapse of the Bretton Woods system was the huge balance-of-payments
deficits of the United States in 1970 and 1971, the fundamental cause is to be
found in the interrelated problems of liquidity, adjustment, and confidence.
Liquidity refers to the amount of international reserves available in relation to the
need for them. International reserves comprise official holdings of gold, foreign
exchange, the reserve position of member nations in the IMF, and SDRs. Table
21.2 shows that most of the increase in liquidity under the Bretton Woods system
resulted from the increase in official holdings of foreign exchange, mostly dollars,
to finance U.S. balance-of-payments deficits.

The main factors that led to the collapse of this

system were as follows:
(i) The Confidence Problem:
By the end of 1950’s many European countries were having BOP
surpluses and the USA was running counterpart deficit. For the
continued economic expansion, it was essential for the United States
to maintain this deficit as it was the only way through which the
growth of international reserves could be sustained in the absence of
any other reserve asset including gold.

In the event, the USA continued to run bigger and bigger deficits while
its gold assets remained constant. It was just a matter of time when
the foreign holders of dollars, including central banks, doubted the
ability of the United States to maintain the price of gold at $ 35 per
ounce and rushed to convert dollars into gold before the dollar was
devalued. This phenomenon was termed as the ‘confidence problem’.

Similar crises of confidence continued to occur during the 1960’s.

Britain faced in 1967 a continuing BOP deficit and dwindling official
reserves creating the expectations of devaluation of pound. The
outflow of funds from England put pressure upon the pound sterling
and led eventually to the devaluation of pound sterling in November
1967. A similar episode occurred in 1968-69. The persistent BOP
surplus of West Germany led to widespread expectation of upward
revaluation of the Mark.

(ii) Seigniorage Problem:

It was argued that the Bretton Woods System gave rise to the
seigniorage of the United States over other countries, since dollar
became the international reserve currency that conferred some undue
privilege upon the Americans. The question of seigniorage arose
because the United States was the issuing country of dollar. As and
when it required dollar, it could issue more dollars.

On the other hand, another country that wanted to increase its holding
of dollars could do so only by creating an export surplus i.e., it would
have to forego real resources in exchange for the dollars. The central
bank of the United States could obtain a much higher rate of return for
dollars from the foreigners than what it could obtain in the home
country. The existence of seigniorage was the cause of irritation among
some of the countries including France. This factor, in the long run,
undermined the Bretton Woods System.

(iii) Adjustment Problem:

From the long run point of view, a serious weakness in the Bretton
Woods System was the absence of an efficient balance of payments
adjustment mechanism. No country can afford to have a persistent
BOP deficit. The principal types of adjustment mechanism include
adjustment through changes in relative incomes, through relative
price changes, through the movements in exchange rates and through
the imposition of direct controls over foreign transactions. The
Bretton Woods System almost prohibited the use of direct controls.

As regards exchange rate variations, the system prescribed that

exchange rate should be held stable with scope only for ±1 percent
variation unless a fundamental disequilibrium warranted a greater
degree of variation. So the crucial issue was to determine whether the
disequilibrium was temporary or fundamental. The operational
difficulty had been the timely recognition of the presence of
fundamental disequilibrium. There was a general tendency among the
member countries of IMF to resist changing the par value of the
currency.

Devaluation was often opposed on the ground that it amounted to the

acceptance of the failure of government policies and also on account of
loss of national prestige. The upward revaluation was frequently
opposed by the export industries of the surplus countries. The
alternative adjustment mechanism through changes in prices and
incomes was found to be in conflict with the domestic goals of full
employment and price stability.

(iv) Triffin Dilemma:

A serious inbuilt contradiction in the system was exposed by Triffin as
early as 1960. It is often referred as ‘Triffin dilemma’ i.e., either the
United States corrected its deficit and created a liquidity shortage or it
continued to run the BOP deficit. The latter alternative could only
cause the crisis of confidence. The existence of this dilemma clearly
showed that the system was inherently unstable and was destined to
collapse.

(v) Problem of Symmetry:

There was a general problem of symmetry between deficit and surplus
countries or between the USA and the rest of the world. Although the
Bretton Woods System intended that both deficit and surplus
countries should share the burden of adjustment in payments
imbalances, yet the brunt of adjustment fell practically entirely upon
the deficit countries.

While the surplus countries could continue to run surpluses so long as

they were willing to accumulate reserves, the deficit countries could
not run down their reserves indefinitely. This asymmetry between the
deficit and surplus countries exposed a serious weakness in this
system and became partly responsible for its eclipse.

Conclusion
The collapse of the Bretton Woods system between 1971 and 1973 led to the
general adoption by advanced countries of a managed floating exchange rate
system, which is still with us. Yet this outcome (at least at the time) was not
inevitable. As was argued by Despres et al. (1966) in contradistinction to Triffin,
the ongoing US balance of payments deficit was not really a problem. The rest of
the world voluntarily held dollar balances because of their valuable service flow –
the deficit was demand-determined. In their view, the Bretton Woods system
could have continued indefinitely. This of course was not the case, but although
the par value system ended in 1973 the dollar standard without gold is still with
us, as McKinnon (1969, 1988, 2014) has long argued.

The dollar standard was resented by the French in the 1960s and referred to as
conferring “the exorbitant privilege” on the US, and the same argument was
made in 2010 by the Governor of the Central Bank of China. However, the
likelihood that the dollar will be replaced as the dominant international currency
in the foreseeable future remains remote. The dollar standard and the legacy of
the Bretton Woods system will be with us for a long time.

REFERENCES
 https://en.wikipedia.org/wiki/Bretton_Woods_system
 https://voxeu.org/article/operation-and-demise-bretton-woods-
system
 https://www.economicsdiscussion.net/money/bretton-woods-
system/bretton-woods-system-and-its-breakdown-
economics/30535
 Dominick-Salvatore-International-Economics.pdf