Bretton Woods Agreement - Thesis Example

RUNNING HEAD: THE BRETTON WOODS AGREEMENT The Bretton Woods Agreement Names Institution Date Introduction During the Second World War, there were concerns about instability in the exchange rate and disorders in international trade and the monetary system. These challenges therefore influenced the need for change in the existing international monetary system. Consequently, in despite of the fact that the Second World War was not complete, a conference was held in Mount Washington Hotel in Bretton Woods in order to develop a fresh monitory structure that was to govern the commercial and financial relations among the leading economies of the world (Hastedt, 2009). The Bretton Woods Agreement was an international monetary system that was initiated in 1994 with the objective reconstructing the economic order after the war. This particular paper seeks to evaluate the most important features of the Bretton Woods Agreement. The scope of the analysis will also be grounded on evaluating why the Bretton Woods ‘system’ broke down and what has replaced it. One of the substantial features of the Bretton Woods agreement was the adoption of a semi-fixed exchange rate system that was referred to as the adjustable pegged exchange rate. Carbaugh, (2011) discloses that the main feature of the adjustable peg system was that the currencies used by the members of the agreement were tied to each other in order to ascertain a stable exchange rate for financial and commercial transactions. Nevertheless, when the balance of payment shifted from its long term equilibrium position, a nation was allowed to repeg its exchange rate through revaluation or devolution policies. The member nations made a principle agreement to protect the existing par value even in the event of disequilibrium in the balance of payment. Furthermore, under the adjustable pegged exchange rate, the member states were expected to utilize the monetary and fiscal policies in order to correct the existing payment imbalances. However, if reversing a persistent payment imbalance resulted to a severe interruption to the domestic economy, in terms of unemployment and inflation, then the member nations were obligated to correct the disequilibrium through reppegging their currencies up to 10% without getting permission from the IMF and by greater than 10% with the funds permission (Carbaugh, 2011). Another significant feature of the Bretton Woods agreement was the adoption of an exchange standard that was based on gold and the dollar. Goddard (2006) highlights that; this particular proposal was advanced by the U.S delegation that was led by Harry Dexter White. According to the delegation, the integration of the gold exchange standard arose from the logic that there was need to revive the use of gold into the international monitory system. This is because as Bordo and Eichengreen,(2007) disclose, the gold standard had the lowest rate of inflation. Although during the First World War, many nations found it difficult to convert their currencies into gold and thus leading to the collapse of the gold standard, which further disrupted international trade. The Second World War however ignited the need for an integrated monetary system which encompassed the use of gold and the dollar. McEachern, (2008) highlights that the dollar was selected as a major reserve currency based on the fact that the US had an economy that was stronger and was not affected by the war. Consequently, all the exchange rates were then fixed in terms of the dollar and the US which had the most of the reserves of gold, stood the opportunity to convert foreign dollar holdings into gold at a rate of $ 35 per ounce. The Bretton Woods agreement also instigated the formation of international financial institutions such as the International monitory fund (McEachern, 2008). Shamah, (2003) highlights that; one of the objectives of the establishment of the international monitory fund was to loan foreign currencies to members who needed assistance according to their size and resources. The institution was also to ensure that the exchange rate was stable and effective monitory cooperation existed among member states. Another function of the IMF that was propagated during the Bretton Woods agreement was to act as insurance company by monitoring the actions. In addition the IMF gave warnings to members whose activities increased the probability of a crisis. The member countries were required to implement corrective polices before the approval of the fund (Eichengreen, 1994). According to Mikesell, (2000) another significant feature of the Bretton Woods agreement was that governments were to were to provide a guarantee of an efficient monetary reserve supply, based on the fact that the exchange rate was pegged. The newly established IMF was therefore charged with the role of supervising the fixed pool of money /funds that composed of gold and national currencies that were underwritten by every member state. Every nation was therefore required to contribute into the fund a particular amount which consisted of 75% of the state currency and 25% of the gold. In addition, members were allocated a quota, which permitted them to borrow from the fund when their reserves were declining. Cohen, (2002) further discloses that the magnitude of the quota gave an indication of the reflective individual contribution and the economic significance of every nation. The new system was grounded on various binding legitimate obligations. In addition the members had to depend on multilateral decision making that were undertaken by the International Monitory Fund. Also a distinctive feature of the Bretton Woods agreement was the aspect of restrictions on capital movements. The restrictions were viewed as necessary in order to protect the interests of the entire economy and the ordinary people (Orlin, 1996). Feinstein and Harioka (1980) conducted a study that involved the use of correlations of saving investments across nations in order to measure mobility during the classical gold years. Bay-oumi (1990) also conducted a similar study and both studies revealed that the correlations were much lesser. Bordo and Eichengreen (2007) performed a re-ran of a similar saving- investment regression for the entire Bretton Woods years which was between; 1946-1970. The findings revealed that the saving coefficient is utility. The coefficient remained unchanged or unaltered when distinct regressions were run for a convertible and pre-convertible Bretton Woods sub- periods. The findings therefore gave an indication of the fact that capital movements during the Bretton Woods agreement years were restricted. Why the Bretton Woods ‘system’ broke down The collapse of the Bretton Woods system was one of the most controversial debates. Various discussions therefore emerged to try and explain why the system collapsed. Levi, (2009) highlights that the Bretton Woods system collapsed as a result of two major flaws that existed in the system. One of the flaws was the gold exchange standard. According to Levi, (2009) this particular standard placed the U.S under the danger of a convertible crisis. In the long –run the U.S pursued polices that were unsuitable and thus making adjustments more difficult. The second flaw resulted from the adjustable peg. Based on the fact that the existing costs of discrete changes among members were high, the system then become a hesitant fixed exchange system that did not posses an effective mechanism for adjustment. Finally the U.S policy was unsuitable for a major currency. Bardo (1993) discloses that after 1965, by taking the approach of inflating, the U.S adopted a policy that was very inappropriate. This is because the approach triggered a speculative attack on the stock of gold that existed in the world and thus leading to the downfall of the gold pool. Bardo (1993) therefore argues that conducting an inflationary policy finally destroyed the Bretton Woods system. On the other hand Agry, (1981) discloses that apart from the existing flaws in the system as highlighted by Levi, (2009) and Bardo (1993), the system was also very vulnerable to attacks arising from the Dollar and gold crisis. The crisis would majorly be characterized by the U.S dollar exceeding the existing gold reserves. Agry, (1981) highlights that; in 1960, Robert Triffin warned concerning the vulnerability of this particular system. Years later, the crisis occurred in 1963 whereby the external liabilities of the U.S went beyond the monetary reserves of gold. According to Agry, (1981) external liabilities were basically a significant measure of the dollars versus inerability. Based on this principle, the domestic liabilities of the government could also be prepared for speculative attack. By 1964, the external liabilities of the U.S amounted to 29 billion, U.S. M1, which was basically of a magnitude that was greater than $409 billion. Cherunilam, (2008) further discloses that the depletion of gold reserves and the increased buildup of liquidity liabilities that were held by foreigners further increased the magnitude of the crisis. By 1971, the liabilities had increased to approximately $68 billion. For instance Germany alone had a large pool of dollars that was able to exhaust the whole stock of gold in the U.S at $35 an ounce. The implication of this was that there were barriers in converting the internally held dollars into foreign exchange. This therefore resulted to the collapse of the Bretton Woods system. The domestic problems in America also greatly contributed to the collapse of the Bretton Woods system. Wang, (2008) highlights that during the 1960s; the economy of the US experienced increased unemployment, inflation and lower growth relative to nations such as Germany and Japan. Furthermore, the US dollar seemed to be overvalued and assumptions concerning the devaluation of the US dollar persisted. Nevertheless, the devaluation of the US dollar was not that significant based on the fact that the dollar remained inconvertible (Wang, 2008). Wills, (2005) also discloses the fact that another domestic problem that resulted to the collapse of the system was the behaviour of the United States. Wills, (2005) highlights that in second quarter of the 1960 the behaviour of the United States was greatly destabilizing. Some of the behaviours adopted by U.S include increased spending by the government majorly on social program, involvement in the Vietnam War which required a huge amount of spending and also the rising rate of inflation. Lack of cooperation among member states was another factor that influenced the collapse of the Bretton Woods system. De Vries, (1966) highlights that the years that followed after the establishment of the agreement were merged with lack of cooperation amongst member states essentially towards the requirements of the IMF. De Vries, (1966) further reveals that the IMF was constantly tolerant with member states that declined to play by the system of per value rule. A case is Canada, who made the IMF aware of her decision to permit her currency to float due to the heavy inflow of capital. After an intense debate, the IMF did not make any official declaration on the matter. Canada on the other hand went ahead to float its exchange rate. What replaced the Bretton Woods System The Bretton Woods system collapsed in 1971 resulting to the adoption of the Smithsonian Agreement. Cherunilam, (2008) highlights that after the US president Nixon suspended the conversion gold into the dollar, foreign governments were left with no alternative but to go on with the existing exchange rates by accruing more dollars without convertibility or revaluing the unfair exchange rate. The immediate response of the U.S was to establish a free floating system whereby major currencies were left to float vis-a –vis the dollar, with an exception of the French currency. This particular move was however opposed by the Japanese and European governments because they had anticipated that the US would devalue their currency. In order to put an end to the crisis, ministers of finance from the ten major IMF trading nations, met at Smithsonian Institution in 1971 and formulated the Smithsonian Agreement. Under the Smithsonian Agreement, currencies were permitted to fluctuate within a larger range of 2.5 % on a newly fixed rate referred to as the central rates. In addition similar to the Bretton Woods system, the agreement also required the efforts of stabilization by the central bank. Furthermore, an additional fluctuation at a rate of 2% against 1% was allowed. The Smithsonian Agreement did not exist for long it only lasted for fourteen months and was replaced by the floating exchange rate system (Gandolfo, 1995). Conclusion The discussion above has presented the main features of the Bretton Woods system. Some of the highlighted aspects include; adoption of a semi-fixed exchange rate system, the use of an exchange standard that was based on gold and the dollar, the provision of a guarantee of an efficient monetary reserve supply by governments, the formation of the IMF AND restrictions on capital movements. The paper has also highlighted the reasons that contributed to the collapse of the Bretton Woods system. From the above analysis it can be concluded that the Bretton Woods system was significant in dealing with the challenges that arose out of the Second World War. Nevertheless, the system mainly failed due to the adoption of unsuitable polices. References Agry, V. (1981). The postwar International Monetary Crisis. London: Allen & Unwin. ABC.(2004). The American Economy. Amazon.com. Bordo,M and Eichengreen, E.(2007). A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform NBER-Project Report. University of Chicago Press. Bardo, M.(1993). ‘’The Gold standard, Bretton Woods and other monetary regimes. A historical Appraisal, Review, Federal Reserve Bank of St. Louis, p175-178. Cherunilam, F.(2008). International Economics 5E. Tata McGraw-Hill Education Carbaugh,J.(2011). International Economics. Cengage Learning. Cohen , B. J.(2002). Bretoon Woods system , in R.J.B Jones (ed). Routledge Encyclopedia of International political economy , New York: Routledge. De Vries, M. G. (1966). Fund Members’ Adherence to the Par Value Regime: Empirical Evidence. IMF StafPapers 13(November):504-31. Eichengreen, B.(1994). International Monetary Arrangements for the Twenty First Century. Brookings Institution Press. Goddard,J.(2006). International Business: Theory and Practice. M.E. Sharpe. Gandolfo, G. 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