The Bretton Woods Agreement - Case Study Example

There has probably no other event that has greatly affected and influenced the economic thought of the 20th century more than the signing of the Bretton Woods Agreement. From the gloomy experiences that the United States and the Great Britain during the onslaught of the Great Depression representative economists of these two nations, Harry Dexter White and John Maynard Keynes, respectively led the gathering of economists at the Mount Washington Hotel in Bretton Woods, New Hampshire to formulate a system that will prevent the recurrence of this traumatic experience. It was in this in this meeting gathering that the Bretton Woods system was born. Initially, this has initiated an acceleration of global activity. However as the system progresses, its flaws surfaced out so intensely that the former United States President Richard Nixon sentenced it to its demise on August 1971. Though the International Monetary Fund and the World Bank, two financing institutions that were born because of the system are still existent, the initial system that they adopted were substantially altered by Nixon’s cessation of gold standard. Gold Standard Adam Smith, the father of economics, and his contemporary thinkers, has started recognizing and studying on the benefits from international trade and capital mobility. Though overseas trading has already been practiced centuries earlier before their era, there was no formal academic and scientific study for this. Smith, in his pioneering investigation on the British economy, has plotted out a fertile condition for nations to maximize their gains: the presence of a sufficiently functioning international monetary system that promotes and facilitates trade and efficient allocation of capital (Ferderer, 2002, p.1). The 18th century admired the prospects for mutual gain that they get from free trade between nations (Understanding economics, 2006). In the past 200 years, capital mobility in large quantities and allocation of these to lucrative and promising investments became a tool that altered the standard of living. Effectiveness of financial institutions should then be measured by the contributions that they give to this process and eventually to a country’s growth and employment (Eatwell & Taylor, 1999). They should then adapt a financial system that will facilitate the flow of capital and investment. In 1717 Sir Isaac Newton ‘accidentally’ adopted a de facto gold standard that later became the monetary regime in those times. The renowned scientist, a master of the mint, set the gold price for silver at a level lower than that of the market, thus causing the disappearance of silver coins from the circulation. Because of this, gold standard has become popular in other countries as their monetary regime. Entering into the ‘gold club’ simplified their transactions and thus economizes trading and transaction costs. According to McKinnon (as cited in Ferderer, 2002, p.2) the classical gold standard follows certain rules. From these rules he elaborated the following qualities of the classical gold standard: 1. It assures the convertibility of domestic currency to gold at a fixed price. In cases where this practice in not feasible, banks could buy domestic assets and can issue notes against them. A coverage ratio, the ratio of gold to notes often set at 40% delimits this practice. This partial backing of notes allows flexibility to solve liquidity problems within a disciplined structure. 2. It assures that “triangular arbitrage would retain the market exchange rates between the domestic currency and foreign currencies at an official (gold price determined) parities. 3. It considers central banks are lenders of last resort. 4. It makes gold as the “nominal anchor” that deters countries from exerting any lengthy influence over the common price level. The Birth of the Bretton Woods System World Wars 1 & 2 and the Great Depression stressed out the importance of creating a new system that will respond to these global financial shocks. International finance authorities concurred to plot a new financial architecture that would provide economic stability and would gear the economy towards full employment. This was the start of the onset of the Bretton Wood Agreement. The conference was actually the result of approximately two and a half years of post-war monetary reconstruction initiated by United Kingdom and United States Treasuries. Though attended by forty-four allied nations and one neutral nation (Argentina), the ‘rival plans’ of Harry Dexter White of the US Treasury and the renowned economist John Maynard Keynes of the UK dominated the assembly. The discussion finally resulted into a compromise that was closer to White’s plan. This reflects the intensified power of the United States at the waning of the World War II. Four major points were highlighted in the new system. First of these is the agreement of the negotiators that the interwar period exposed the disadvantages of “unrestrained flexibility of exchange rates.” During the 1930’s the floating rates were pointed out as inhibitors of trade and investment and as encouragers of destabilizing speculation and competitive depreciations. However, instead of entirely reviving the “classical gold standard of the nineteenth century,” pressures from advocates for more activist administrative right of governments to occasionally revise currency values made the attending governments reluctant for the past regime’s total revitalisation. Thus the ‘pegged’ or the ‘adjustable peg’ a compromise of free floating and irrevocable fixed rates became the monetary regime. The assurance that the participating states would have adequate supply of monetary reserves in times of financial constraints gave birth to the International Monetary Fund, the second key point in the Bretton Woods System. In cases when reserves were depleted, IMF will act as a supplementary source of liquidity for countries with reserves deficit. Again two contending parties in the persons of White and Keynes emerged. White proposed for a more limited borrowing mechanism, while Keynes opted for liberal institution similar to a world central bank, capable of creating fresh reserves if needed. White’s suggestion was preferred over Keynes. `The third point was the necessity to avoid recurrence of the1930’s economic warfare. There was a consensus among all the participants of the removal of exchange control limiting currency convertibility and return of free multilateral payments system that would discourage in engaging in discriminatory currency practices or exchange regulation. The last point is about the existence of an international forum for international cooperation on financial matters. The financial problems in the interwar period, as these negotiators agree, were exacerbated because of the absence of any established procedure or machinery for inter-governmental consultation. While the leaders’ focus is on their war campaigns, economic policies became their least priority thus making their national treasury susceptible to major economic setbacks. The task of this international financial agency was to provide consultative assistance to economic managers of countries. This was another task assigned to the Fund. The US Influence in the Conference What was noticeable the United States received the most benefits and preferences in these four points. The US preponderance in terms their of economic and military might gave it the power to influence the proceedings of the convention. This was first highlighted as the proposals of White were given more weight than those of Keynes. In the second point above, the prospect of White on the limited role of IMF in lending is one good example of this. Another important political advantage the US had was its influence on the IMF. Since the decision power of a country in IMF depends on the By obtaining the majority of the seats in IMF’s board of decision makers, US had the right to obtain veto power in future decisions. Having this power ensures the superpower to actively participate in the international monetary activities regulatory, lending, and consultative role of the agency. The status of the US dollar as the only currency that has the capability to be exchanged for gold again showed the homogeny of the American government in those times. Majority of gold reserves, about one third of the entire global gold supply, were found in the United States treasury (The Bretton Woods System, n.d.). So while there exist a gold standard, the green back’s value against gold, in practice, became the standard of other currency rates and the nearly perfect substitute for the expensive metal. Problems on Implementing the Bretton Woods System The ensuing years exposed the flaws of the Bretton Woods system. The optimism that this convention has generated turned out to be merely an illusion. The first few years after the onset of the new system monetary relations became unstable, the transitional period was short, and the IMF had very limited resources to lend. This dismal outcome of the talks provided the reason to shift the burden of overseeing the implementation of the monetary regime from IMF to the United States. To keep its position as the international financial leader, the United States should weaken its dollar supply. A surplus in the supply of dollars would result into inflation of its value, making the currency unattractive. This would, in turn, will cause the dollar to lose its leadership position. To preserve its dominance, the American government should intervene by keeping its dollar supply low. However despite employing ways to fix the problem US experienced a persistent deficit in its balance of payments between the years 1958 and 1971. Initially, economists considered these annual deficits as temporary. However, its persistence made American economic managers realized that it has no signs of disappearance. Among the causes of chronic deficits three stood out prominently. The first one was its capital outflow. Another reason is its military commitments during those times. Curbing the Communist expansion in Europe and Asia forces the US to release huge amount of dollars. The Vietnam War stood out as the most destructive of all in US economy as inflation ensued. Economists prescribed five ways to correct the American Balance of Payment deficit. The US administration should decide to deflate their economy, to devalue the dollar, to impose exchange controls on current account, to deplete gold stock, and to increase liabilities. It was clear that the solutions to stop the overheating of US dollar circulation caused the curbing of the economic activity of the nation. This placed the United States to a financial dilemma. America should decide whether it will strengthen its financial position by devaluing the dollar or to give up its campaign to halt communism. Because of the exacerbating situation in the American economy and continuous and escalating problems that America was facing, on August 1971, President Richard Nixon declared that the United States would no longer implement the Bretton Woods system. Summary and Conclusion From the start the United States took over the most essential role in the progress of the Bretton Woods agreement. Being the economic and military superpower, it used its influence in ensuring that they would actively participate in the global economic sphere as a major player. It has deftly yet successfully used its political might to influence the outcome of the convention. In the process however, its plan of becoming a key player soon plagued its economy. Powerful as it may be, the United States submitted itself to economic forces. Its military campaigns overseas and its mission of halting the advance of communism throughout the globe posed a problem in its drive to solve the recurring balance of payments deficit. Thus on August 1971 President Richard Nixon finally gave up America’ insistence on preserving the Bretton Woods system, the financial policy that it lobbied for and influenced to maintain its monetary hegemony. References Beams, N. (2001) When the Bretton Woods system collapsed. Retrieved February 27, 2007, from http://www.wsws.org/articles/2001/aug2001/bw-a16.shtml Bordo. M.D. The Bretton Woods International Monetary: a lesson for today. Retrieved February 27, 2007, from http://www.mattdorn.com/content/understanding-economics-international-finance-liberalization-etc/ Bretton Woods System (2007) Retrieved February 27, 2007, from http://en.wikipedia.org/wiki/Bretton_Woods_system Cohen, B. (n.d.) Bretton Woods System Retrieved February 27, 2007, from http://www.polsci.ucsb.edu/faculty/cohen/inpress/bretton.html Eatwell. J. & Taylor, L. (1999) Towards an Effective Regulation of International Capital Markets Retrieved February 27, 2007, from http://www.fes.de/ipg/ipg3_99/arteatwell.html Ferderer, P. (2002) The Evolution of the international Financial System: 1879-1971. Saint Paul: Macalester College. Flandreau, M, Holtfrerich, C., James, H. (2003). International Financial History in the Twentieth Century. London: Cambridge University Press. Germain, R.D. (n.d.) Reforming the International Financial Architecture: The New Political Agenda. PhD Dissertation. Wales: University of Wales . The Bretton Woods System (n.d.) Retrieved February 27, 2007, from http://www.econ.iastate.edu/classes/econ355/choi/bre.htm Understanding economics: International finance, liberalization, etc. (2006). Retrieved February 27, 2007, from http://www.mattdorn.com/content/understanding-economics-international-finance-liberalization-etc/ Read More