Destination of Bretton Woods System - Essay Example

Britton Woods System Introduction Economic environment has changed over time. There is increasing capital movements and is increasingly becoming uncontrollable. This requires stabilising systems. Such a system was developed at the Britton woods conference some years ago (Lavelle, 2011). The system that evolved from the 1944 UN monetary and financial conference became to be known as the Britton Woods System (Palicki, 2009). The Britton Woods agreement was signed during the conference and was aimed to create Britton Woods System that had fixed exchange rates (Cherunilam, 2007). The system delayed in its implementation until late 1950s and collapsed in 1971 due to various factors (Froyen, 2008). In recent years, the leading industrial countries have been advocating for the revival of the reason and role as well as the spirit of the Britton, system to withstand the mounting size of capital flows and the global trade. Prior to 1944, many countries tried to resuscitate the gold standard following the First World War. However, this collapsed completely over the great depression of the 1930s (Larry, & Dan, 2008). The main cause of the failure was attributed to inability of the system to allow rapid expansion monetary system to necessitate economic activity (Lavelle, 2011). This resulted in the convention of the representatives of the world’s leading industrialised nations held a meeting in New Hampshire to create a new international monetary system in the year 1944 (Adrews, 2008). This is because the US as at that time was responsible for more than half of the globe’s capacity to manufacture (Fangerau, 2005). In addition, it also held most of the gold from the universe. The leaders therefore concluded that they needed to tie the currencies from the world to the dollar (Herr & Kazandziska, 2011). This essay will discuss the main features of the Britton Woods System. It will also discuss the main causes of the collapse of the system and what replaced the system. Important features of the Britton Woods Agreement The Britton Woods Agreement was signed in 1944 during a United Nations conference on monetary and finance. The conference was held in Britton Woods. The plans for agreement were an amalgamation of the American White memorandum and the British Keynes memorandum. The Keynes plan was based on the idea that a new international financial institution, International Clearing Union, would be created that play a role similar to that of a bank (Lien, 2008). The International Clearing Union (ICU) was to provide an international currency whose value would be fixed in terms of gold (Gray, 2007). Other countries would then set par values in terms of this currency and open accounts with ICU that would be utilized for settling trade (Lavelle, 2011). The ICU would extend interest to countries with surplus and overdraft to countries with deficit. Countries receiving overdraft were to pay an interest on such arrangement (Hagele, 2010). The Keynes memorandum also allowed countries to alter exchange rates and to apply exchange and trade controls. This was aimed at reconciling full employment with payments balance (Palicki, 2009). the memorandum also suggested creation of liquidity that would allow smooth running of the international monetary system (Hagele, 2010). On the other hand, the American plan foresaw a world without trade restrictions and of currencies that were pegged. These were to be overseen by an international institution that could veto parity changes. The memorandum focused on creation of an institution known as the United Nations Stabilization Fund (UNSF). The plan suggested that each nation contribute a specified quota of their domestic currency and gold to UNSF. The value of each country’s currency was to have a fixed value. The plan proposed that deficit countries would sell their own currency for foreign currency. This would in turn result in an increase in the balances of deficit countries and a decrease in the balances of surplus countries (Palicki, 2009). A country was expected to defend its par values and any changes in parity were to be done in consultation with UNSF (Lavelle, 2011). The plan opposed provision of liquidity as proposed by Keynes plan. Due to conflicting views of the two plans, the resulting Britton Woods Agreement was amalgamation of the two plans. However, the American white memorandum dominated the agreement. The Keynes’ proposal to have International Clearing Union was dropped and suggestion to have large liquidity was cut from $23 billion to $8.8 billion, which was closer to $5 billion proposed by the white memorandum (Lavelle, 2011). In spite this; the American draft conceded having countries have greater control over exchange rates. Under the agreement, parity changes could only be done by newly created International monetary Fund (IMF). IMF was charged with the responsibility of maintaining stable exchange rates, allowing for a multilateral payment system, allowing full employment and faster economic growth in addition to promoting international monetary cooperation (Palicki, 2009). Due to fear of United States running huge surplus as it had done during the inter war period that had it force deflationary pressures on other nations, British had a scarce currency clause introduced in the agreement. This clause gave IMF power to ration the use any currency that was declared scarce. This was to be done via exchange controls. However, evidence suggests that this clause was not used when it was expected to have been used. The Britton Woods agreement expected its members to make their currencies convertible into either the dollar or gold. Each member of the system was expected to declare parity with either dollar or gold and maintain this parity within plus or minus 1%. Any country that changed its parity without authorization risked being denied use of the funds resources (Lavelle, 2011). This threat was however not enacted as exemplified by the case of France (Palicki, 2009). In 1948, France adopted multiple exchange rates that caused IMF to withdraw the country’s drawing rights until 1952. France got dollar from USA in form of Marshal Aid and as such, it was able to operate its current account without any help from IMF. Why the Britton Woods System broke down The Britton Woods system had various weaknesses that resulted in its break down. One of these weaknesses was liquidity problem. The liquidity that was set in the agreement, $8.8 billion was not sufficient to support world trade growth (Palicki, 2009). Moreover, the system evolved over time into gold dollar standard owing to huge US deficit resulting from the Vietnam War and the war on poverty. Many nations held more stock of dollars and this resulted in an increased fear that there would be enough liquidity to convert dollars into gold. This in turn resulted in the confidence problem. Thus, another weakness of the Britton Woods System was the problem of confidence. During the inter war crisis, the dollar was subject to a confidence crisis. This crisis resulted from lack of liquidity within the IMF system (Lavelle, 2011). Although formal arrangements were undertaken to increase liquidity through special drawing rights, the confidence was not increased. As the dollar balances grew due to Vietnam War, convertibility confidence fell faster. This resulted in confidence crisis. Another issue that probably resulted in the breakdown of Britton Woods System was the problem of adjustment. There was an automatic adjustment of the price specie flow mechanism when the agreement came into place. Even though the automatic response of the mechanism was criticized during the gold exchange standard, this was seen as its strength. The Britton Woods System lacked an automatic mechanism (Palicki, 2009). Issues related to unemployment concerns resulted in a delay in the deflationary adjustment as required. Consequently, there were asymmetries between surplus and deficit countries similar to what was experienced during the gold exchange standard. The collapse of the system is also attributed to structural problems. Due to growing world economy at unprecedented rate, there was need for more liquidity or reserve assets. This could not be attained because liquidity was fixed at $8.8 billions. Moreover, the quantity of gold was fixed at 4 billion ounces and as such, other countries had to hold US dollar and gold as reserve (Lavelle, 2011). Owing to stable growth in world economy, there was increased demand for dollar as reserve assets. This forced US to maintain increasing trade deficits. However, the US was not able to devalue the dollar since it was the numerary of the system (Palicki, 2009). Moreover, the US did not have powers of setting exchange rate between the dollar and other currencies. Another issue that culminated in the break down of the system was the rigidity exchange rates. The par value system was characterized by the notion of fundamental disequilibrium. Governments were unable to change their exchange rates because they could not tell when a fundamental disequilibrium existed. Moreover, they were unable to maintain international payment equilibrium since they were inhibited from repegging. Consequently, many governments began to go to enormous lengths of avoiding the defeat of altered par value (Lavelle, 2011). The system also created irresistible incentives for speculative currency shifts that greatly contributed to the confidence problem that existed at that time. The dollar glut that took place after 1958 had devastating effects on exchange rate (Palicki, 2009). This resulted in persistent payments imbalance between the US and the surplus countries of Europe and Japan. This culminated in blame game between the two opposing sides for the disequilibrium (Baumol & Blinder, 2011). America argued that its allies could do more by revaluing or inflating their currencies to reduce the surpluses. On the other hand, European countries and Japan argued that the US needed to take the first steps to correct the situation. Therefore, each side felt discriminated against. What replaced Britton Woods System? The Britton Woods system was replaced by flexible exchange rate regime. After the Britton Woods system collapsed, the US adopted an essentially flexible exchange rate as its official policy. Flexible exchange rate regime has various advantages over fixed exchange rate that was used by the Britton Woods system. First, the flexible exchange regime can use monetary policy. After the collapse of the Britton Woods system, countries were able to use whatever monetary policy they deemed suitable for its domestic objectives without worrying on whether such a move would deplete its official reserves of foreign exchange (Lavelle, 2011). Countries are now able to utilise monetary policy for combating the effects of adverse shocks that could otherwise lower their output below full employment (Spero & Hart, 2009). Another advantage of flexible exchange regime is that its exchange rate adjustment offers an automatic way to adjust to adverse shocks. Such adjustments do not require conscious policy action (Palicki, 2009). The flexible exchange regime also plays automatic stabilization function of flexible exchange rates. When the Britton Woods system collapsed, the world was hit by the first oil shock that induced recession and a fall in output. The countries had the freedom to use expansionary monetary and fiscal policies to raise output. As such, many countries took advantage of the flexible rates. This was initially seen as a temporary measure but with time many countries begun to view a flexible exchange rate regime as a permanent condition. Due to increased use of flexible exchange rate regime, there was large exchange rate swings in 1980s. There was an increased appreciation of the dollar in the first half of 1980s and a big dollar depreciation in the second half of the decade (Lavelle, 2011). The tight monetary policy implemented in the US by the federal reserve due to 1979 oil crisis partly explained the appreciation of the dollar in the first half of 1980s (Berg, 2010). This was also precipitated by pursuance of supply side policies, which cut taxes. There was also increased expenditure on defence in the US. All these raised the value of the dollar and lowered the current account balance. The fluctuating value of the dollar in 1980s had devastating effects around the globe. During the first half of the 1980s, many people in the US lost their jobs in the export sector due fall in the foreign demand for US goods (Dooley and Garber 2003). This resulted in dissatisfaction with the flexible exchange rate regime. This made some countries in developed world to start managing the exchange rate to some degree (Lavelle, 2011). This was accomplished by having the central banks intervene in foreign exchange markets. This regime was referred to as managed float and not a fixed regime. However, managed regime required that countries coordinate their macroeconomic policies (Palicki, 2009). This was attempted during periodic summit meetings. In 1985, industrialised countries met and decided that the dollar value was too high and decided to intervene in the foreign exchange market (Weaver, 2011). This move was not aimed at introducing a fixed exchange rate but rather to influence the market somewhat to bring the dollar down (Cherunilam, 2008). This resulted in the depreciation of the dollar to its initial value at the beginning of 1980s. By 1987, the value of the dollar had depreciated enough and as such, industrialized countries agreed to stabilise it. The dollar stabilised in early 1990s but appreciated in the later years of 1990s. The dollar significantly depreciated in 2002 falling by over 30% relative to euro in 2-year period (Lavelle, 2011). The managed float regime is the main exchange rate regime that is currently used in many countries. Conclusion Britton Woods System was established after the signing of the Britton Woods Agreement in the UN monetary and financial conference held in New Hampshire to create a new international monetary system in the year 1944. The adoption of the system delayed until the end of 1950s and by the time it was implemented it had evolved greatly. The agreement signed at the meeting was an amalgamation of the American White memorandum and the British Keynes memorandum. The two drafts had conflicting ideas and had to be amalgamated to be signed. The amalgamation of the two drafts resulted in the creation of the International Monetary Fund. IMF was charged with the responsibility of maintaining stable exchange rates, allowing for a multilateral payment system, allowing full employment and faster economic growth in addition to promoting international monetary cooperation. A scarce currency clause was also introduced in the agreement. This clause gave IMF power to ration the use any currency that was declared scarce. This was to be done via exchange controls. The Britton Woods agreement expected its members to make their currencies convertible into either the dollar or gold. The Britton Woods system had various weaknesses that resulted in its break down. One of these weaknesses was liquidity problem. Another issue that probably resulted in the breakdown of Britton Woods System was the problem of adjustment. The collapse of the system is also attributed to structural problems. Another issue that culminated in the break down of the system was the rigidity exchange rates. The Britton Woods system was replaced by flexible exchange rate regime. The flexible exchange regime allowed countries to use monetary policy. This enabled them to combat the effects of adverse shocks that could otherwise lower their output below full employment. Moreover, countries were able to adjust exchange rate allowing them an automatic way to adjust to adverse shocks. The fluctuating value of the dollar in 1980s due to flexible exchange rate regime had devastating effects around the globe. This resulted in the adoption of the float management regime that helped to stabilise the exchange rate. This system is still widely used in many countries. References Adrews, D. (2008). Orderly Change: International Monetary Relations since Bretton Woods. Cornell: Cornell University Press Baumol, W., & Blinder, A. (2011). Economics: Principles & Policy, 12th Ed. London: Cengage Learning Berg, H. (2010). International Finance and Open-Economy Macroeconomics: Theory, History, and Policy. London: World Scientific Cherunilam, F. (2007). International Business: Text and Cases, 4th Ed. New York: PHI Learning Pvt. Ltd. Cherunilam, F. (2008). International Economics. Jakarta: Tata McGraw-Hill Education Dooley, F., and Garber. (2003). 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London: Taylor & Francis Larry Elliott , Dan Atkinson (2008). The Gods That Failed: How Blind Faith in Markets Has Cost Us Our Future. The Bodley Head Ltd. pp. 6–15, 72–81 Lavelle, K. (2011). Legislating International Organization: The Us Congress, the IMF, and the World Bank. Oxford: Oxford University Press Lien, K. (2008). Day Trading And Swing Trading The Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, 2nd Ed. New York: John Wiley & Sons Palicki, B. (2009). A Capitalist Manifesto. New York: Xlibris Corporation Spero, J., & Hart, J. (2009). The Politics of International Economic Relations, 7th Ed. London: Cengage Learning Weaver, F. (2011). The United States and the Global Economy: From Bretton Woods to the Current Crisis. London: Rowman & Littlefield Read More