The Collapse of the Bretton Woods Systems - Essay Example

Running head: The Bretton Woods Agreement The Bretton Woods Agreement Name Institution Date The Bretton Woods Agreement Introduction The Bretton Wood Agreement of 1944 features in international monetary policy as a key occurrence whose effects are being felt in the contemporary global economics. It is the precedent for the establishment of the International Monetary Fund (IMF), now a force to reckon with, in respect with international monetary oversight and control. It features as a reaction mechanism to the post World War exchange rate stability concerns. The challenges it sought to address were related to an ailing and eventual collapse of the gold exchange standard of the 1920s-30s. Later on in the 1970s, the system, developed under the agreement collapsed. This collapse is indicated international economies as being the precedent for the haphazard evolution of the current monetary framework. This paper seeks to explore the Bretton Woods Agreement delineating the agreements most important features. It will also feature reasons for its failure and delineates the replacements frameworks. This is with reference to both international economics as well as the impacts on individual national economies. Features of the Bretton Woods Agreement The 1944 US-UK agreement was developed to establish a facsimile of the earlier gold standard of exchange but with a more keen focus on international exchange stability based on the integration of three tenets: capital mobility, free trade and currency convertibility (Landau, 2001). These are the tenets of the main features of the agreement in establishing an economic order. They would be pursued by the IMF, International Trade organization (ITO) and the World Bank, and then called international Bank for Reconstruction and Development. Literature points out that the main feature of the agreement was the development of a system which incorporates fixed but rather adjustable exchange rates. These rates would be based on the dollar whose value was majorly underpinned in the value of gold and would be managed by the IMF (Chowla et al., 2009). In this system, individual country’s currency exchange rates were fixed with narrow limits against the dollar whose rating against gold was fixed. This fixing was run by the country’s central banks which collaborated with the IMF. As such, the national currencies were rated against gold standard, but through the dollar. Signatories who felt either undervaluing or overvaluing of their currency against the standard were enabled to negotiate with the IMF. This system has important implications on central banks. Unlike in the previous gold standard system, the Bretton Woods system obliged them to be directly involved in foreign exchange market. In this involvement, they had a single role maintaining a demand-supply relationship for individual currency at perfect elasticity relative to the par value. This obligation meant that the system withdrew the banks’ role and discretion for reserves accumulation. Accumulation was done, only with respect to balance of payment equilibrium condition. As such, (Montiel, 2009) indicates that the nominal exchange rate was a variable of an exogenous policy, on one hand, while on the other, the banks international reserves stock was endogenous. The agreement was a compromise between Keynes’ and White’s memoranda. However, White was more dominant. The signatories of the compromise committed themselves to maintaining currency inter-convertibility. In this commitment, national economies were required to value their currencies against the dollar or gold. This was a new exchange regime in which rates were to be set at a ±1 percent margin with the par values being expressed relative to US dollars or gold terms. This rate was not permanent, as such, but allowed for devaluations of the currencies occasionally and on needs basis in order to take care of any fundamental disequilibria in signatories’ balance of payments. As such, the regime has been described as an adjustable peg system. The disequilibria and fluctuations not more than 1 percent would be addressed by adjusting the par value (Kevin, 2009). This would be done by national economies through market intervention. Any variation in this excess required the consent of the IMF. A fundamental equilibrium exits when an economy faces balance of payment disequilibria, repeatedly specific to given rate. In the system, rates were controlled in a stepwise way in which their stability and flexibility were combined. In this integrative approach, care was taken to avoid devaluation. In this organization, the US economy was positioned to serve the role of the system’s epicenter with multiple roles. It served to balance of payments deficits, through the IMF, and providing international liquidity. In addition, it was expected to absorb exports from all the other economies as a central market (Hall et al., 2009). This led to undervaluing of economic peripheries in the name European and Asian market. This element features later in the 1970s as a key pressure point against the dollar. The par value system was established to ensure that international markets have stable exchange rates. At the time of the agreement ratification, the economies were focusing on creating an enabling post war rebuilding environment. Each signatory was obligated to ensure maintenance of individual rates for other currencies at disparities in the margin of 1 percent. This was to promote unrestrictive international trade based on fairness of competition. As inducted in a previous section, the observance of the margin was left to market intervention role of individual economies. In this intervention, the dollar was the principle medium apart from being the object for rating. The theme for a non-restrictive market required that signatory national economies make their currencies convertible subject to the allowing of balance of payments. In the non-restrictive market pursuit, the agreement permitted a substantial sense of autonomy for countries to exercise capital mobility. As such the Bretton Woods has been described as being a ‘soft peg’ with capital mobility imperfectness (Montiel, 2009). Capital account flow policies were optional policies leaving portfolio managers in a dilemma with two conflicting trade factors: risk in exchange rate and political implications. In a bid to defend national monetary autonomy and maintain stability of exchange rates, simultaneously, signatories often compromised on capital mobility policies. Reasons for its breakdown The Bretton Woods had its impacts and stands out as a major international economy history event whose effects were handy to post war economies. The IMF played a vital role in these impacts. Through its intervention, economies were helped manage inflation rates and reduce their balance-of-trade deficits. As such, the developed and developing economies did well restructuring after the world wars and addressing unemployment issues. Literature indicates that in the regime of the agreement, the developing countries had the greater gains than industrial economies, when compared relative the economic development levels. However, the system began declining in the 1960s amidst several challenges, especially with regard to the par value. By March 1973, the system had totally collapsed creating space for new systems. There are several reasons that have been indicated as being the precedents for the collapse. Generally, the causes were inherent in the nature of the system. Firstly, the system was expected to stabilize exchange rates and used the US dollar as the main tool for standardization. Additionally, this currency was the intervention item for disequilibria. As such, its success was dependent much upon the confidence on the US current in the national and international market. There was relative stability and marked success of the system until the 1960s when the dollar started facing attacks. There was pressure from critiques who pointed to the over valuing of the dollar. In the system, the US economy was not required to defend the exchange rate of the dollar. This role was in the hands of the IMF and other signatory economies. In the same stride, the US was experiencing heavy capital outflows with regard to meeting increasing demand for the dollar and demands of the Vietnam War. As a result of the war and the dollar glut, the US developed an expansionary policy. This policy came in place amidst a growing world trade. As postulated in the Triffin dilemma, a sequence of events eventually collapsed the par value. In the growing dollar demand, the US was in the first days able to meet the demand by incurring deficits of balance of payments (Levi, 2009). However, this challenged the convertibility of the dollar to gold given that the stock of gold was not commensurate to the needs and the rate at which other central banks grew the dollar reserves. As Triffin indicated, the dilemma was in deciding between increasing international liquidity and disallowing such an increase (Dorrucci & McKay, 2011). This dilemma was met with the fixity of the exchange rate and the need to maintain it amidst normal market fluctuations. This maintenance, as noted before, needed adequate global resources. In these fluctuations, the most rational and economically beneficial undertaking to deal with the disequilibrium was devaluation. However, whilst every other economy could devalue its economy, the United States was the solitary economy which could not. Given that others’ currencies were fixed to the dollar, a devaluation of the dollar could only occur only if the others were revalued (Lal, 2008). The US could therefore not explore options such as domestic expenditure cuttings and devaluation in order to achieve a much needed balance of payments equilibrium and full employment (Herr & Kazandziska, 2011). Given the graveness of the scenario amidst growing pressure, the government of the US announced stoppage of exchanging dollars at an unchanging rate with gold. This ushered an error that stopped the par value system to a scenario in which the dollar would be valued relative to other currencies as in a free market. Lal (2008) further points out the role of quasi-fixed exchange system of rates in relation to capital flows. This system was built on the tenets of the ability of economies to control short-term capital flows. The post World War II provided the Bretton system with ubiquitous exchange controls. These controls were vital in enhancing the ability of the economies and the system in enforcing capital flow control (Levi, 2009). As provided for in this enforcement, the Agreement required that economies differentiate short-term flows from long-term flows and further, that they ban the former. Short-term flows were indicated as being party to speculative attacks on the soft peg system (Lal, 2008). However, the post war era was for economies an era for robust growth. This was so especially for developing economies, hailed as being better beneficiaries of the Agreement tenure. In this robust growth era, there was liberalization of global trade in which short-term capital flows were unpreventable. Trade liberalization was also characterized by a shift from the dollar as the global trade basis. The greatest development was the Euro making the international market a Eurodollar market in which there were no restrictions. As such, economies shifted to floating rate system. They were pushed by the need to change according to international price competitiveness. As Herr & Kazandziska (2011) indicates real time exchanges are beneficial for developing the value of the sectors of an economy that are tradable. Additionally, there were critique of the fixicity as being distortional on markets with respect to inter-country competitiveness. The fixed rates implied that lower inflation economies were at an advantage over higher inflation ones. Thus, the latter experiences decreases in capital outflows and increases in inflows, that are not commensurate to trading partners. The parities between the countries requires increased government support for firms undertaking international trade in view of absorbing the imminent risk. This was a constributing factor to the increased demand for the dollar. The US also needed to support her own in the wake of increasing competition from more export oriented economies such as Germany, Japan and Korea. These factors combined resulted in a liquidity crisis. There is indication in literature citing the role of seigniorage as collapse causative factor. Seignorage refers to the profit a country accrues from minting money (Sandbeck, 2003). It is dependent on the ability of other countries holding a the minter’s reserves or other assets at non-competitive yields (Levi, 2009). The US government was in a favorable position to bank on seignorage as a global legal tender reserves provider by ensuring that other central banks have significant dollar reserves. This was challenged by industrial economics, specifically France, which began to trade dollars for gold in 1962. The French were motivated by political influences as well as the seignorage and challenged the dollar’s future as the international monetary system pivot. The French activity created uncertainty over the sufficiency of the gold in the US custody. This is because of the system’s fractional reserve standard (Schlichter, 2011) in which gold reserves were a fraction of the value of gold held (Levi, 2009). Fractional reserve systems are at risk of bankruptcy and liquidity issues if depositors ask for their reserves. As such, the US economy solvency was dependent on a favorable balance. By 1973, the risk of the economy was imminent and President Nixon Post- Bretton Woods International monetary systems The collapse of the Bretton Woods systems is hailed as having ushered in an era of free market capitalism characterized by a floating exchange rate system or regime. This system did not fully take root in international monetary operations immediately due to ideological strives at the international level. Immediately after the collapse, the Nixon administration developed the Smithsonian Agreement. It was intended to maintain fixed rates but failed to do so owing to its dependence on gold reserves. It was developed on the president’s view that having a totally unstructured international monetary system would be a peril causing competing devaluations. These devaluations were predicted to be precursors of a global economic depression (Lien, 2009). Further intervention followed such as the Plaza Accord seeking to devalue the dollar and later on the Louvre Accord establishing target ranges for major currencies. With time, it was evident that a managed exchange rate was uneconomical and short-lived (Ravenhill, 2008). This changed the role of the IMF and World Bank to purely monetary and development coordination respectively. The free floating exchange system refers to a regime in which exchange rate values are left to the discretion of market forces. This is the face of the contemporary globalized trade characterized with free market capitalism and competition. This is unlike the Bretton regime of par value which allowed no flexibility for rate changes, except for the purposes of correcting disequilibrium. This system relieved governments of the regulatory role. Advocates of the system cited its ability to facilitate economical adjustments to external imbalance is the face of gold-standard defiant national economies (Ravenhill, 2008). This offsetting of imbalances is at an optimum economic level that buffers currencies from either devaluation or overvaluation. As such, it allows economies substantial autonomy. Chowla et al., (2009) however point out that in practice this system is characteristically volatile with often swings presenting economies with underlying differences from their realities. This is characteristic of the current system. In the growth of international economy under the dispensation, international economic order was characterized by increased development of monetary unions. There have been realignments as economies seek more competitive positions in the global economics. These developments include the development of the European Monetary Union whose introduction of the Euro is hailed as ‘marking the largest monetary changeover ever’ (Lien, 2009). There was also the mixed system subsequent to Bretton Woods. This operated on a free float basis that involved 3 currencies: dollar, Yen and Deutsche Mark. Its development was catalyzed by the materialization of a revitalized dollar area as well as advent of the Euro (Dorrucci & McKay, 2011). Over time and international events, the current international monetary system has developed. This is more specific to the Asian crisis of 1997-98 and the Euro’s advent (Dorrucci & McKay, 2011). Chowla et al., (2009) argues that it has haphazardly developing challenging its reference as a system. This was demonstrated in the recent global economic recession whose effects were felt across all economies as well as in various sectors. Firstly, there is limited oversight over the system. The role of the IMF has been curtailed relative to the impacts. Since the collapse of the Bretton system, the institution has not been impactful especially with regard to influencing rich economies. This is mostly to issues of balance of power with the US having a veto and there being skewness towards the rich country. This, in addition to the ideological tenets of IMF operations, challenge its legitimacy. According to Chowla, et al., todays system is one whose rules and norms as well as institutions are based on the Washington model as the guiding ideology and model. The model has emphasis on free markets, total liberalization of the international trade and exports oriented economies. However, these emphasis on exports creates a situation of accumulated large-scale imbalances more so against the US. This was one attribute of the economic crisis in which economies with larger imbalances were more affected than those with less (Dorrucci & McKay, 2011). In this system, the dollar remains the world reserve currency, but in competition with increasingly rising currencies such as the Euro. This has two important ramifications: the US has access to cheap loans and therefore continues to borrow posing an imminent to the rest of economies (Chowla et al., 2009). Additionally, any US economic policy has ripple effects across the globe. The system has made its mark in international monetary issues. However, it creates a weak and volatile business environment especially for poor and developing economies. Such are highly vulnerable to global swings of rates especially with respect to basic market commodities such as oil and foodstuffs. The effects of the recent crisis should be a learning opportunity for economies at national and international levels to develop systems that are consummate to expected challenges inherent to globalization. Conclusions In conclusion, this paper has explored the Bretton Woods Agreement system as operational between 1958 and 1973 when it had its demise. The system was mainly an international monetary control system based in the tenet of fixed rate of exchange based on the convertibility of the currencies to the dollar. The dollar was valued reference to the value of gold. The system also majored on capital flows allowing substantial autonomy on country. As such it was described as the soft peg system. The system made gains until it collapsed amidst a struggling dollar and universalization of trade more so with respect to developing economies. There are various reasons given for the collapse of the par value system. Whatever the explanation, the role of the dollar challenge is inherent in all of them. Additionally, there is one fundamental factor indicated in literature: to base an international monetary system on the fixed par value system is commensurate to an assumption that international economics is an optimum currency arena. On a positive note, Bretton Woods’ collapse is widely appraised as a decisive moment in international monetary systems history upon which contemporary systems are entrenched. This collapse is attributed to globalization trends of the world economy especially as it ushered the development of financial markets and interlocking currency. These were inherent in neo-liberalism. The post-Bretton Woods System international monetary has demonstrated an emphasis on liberalization and free float exchange rates. Notably, there are limited oversights and the dollar remains the universal reserve currency. However, the advent of the Euro and development of monetary unions have continually changed the scenario. As demonstrated by the recession (2008), international monetary systems are still faced with enormous challenges. References Chowla, p., Sennholz, B., & Griffiths, J. (2009). Dollars, devaluations and depressions: how the international monetary system creates crises. London: Bretton Woods Project . Dorrucci, E., & McKay, J. (2011, February ). The International Monetary Systems after the Financial Crisis. Occasional Paper Series No. 123 . Hall, S., Hondroyiannis, G., Swamy, P., & Tavlas, G. (2009). Bretton-Woods Systems, Old and New, and the Rotation of Exchange-rates Regimes. University of Leicester. Herr, H., & Kazandziska. (2011). Macroeconomic Policy Regimes in Western Industrial Countries . Oxon: Routledge . Kevin, S. (2009). Fundamentals of international financial management. New Delhi: Asoke K. Gosh. Lal, D. (2008). 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