The Point of Creating The Bretton Woods System - Case Study Example

1. Introduction The Bretton Woods system was a precedent entirely negotiated monetary system conceived with the intention of regulating commercial and financial interactions on a global scale. It aimed to establish the obligatory terms and conditions that were to be followed in all sorts of monetary transactions and relationships between the major economic powers of the world. It was created to bring order amidst the global economic turmoil that was born during the days of the great depression and aggravated through the course of the Second World War which set the backdrop for the birth of the system. In fact although not recognized back then the effects of globalization in its nascent stages was also leading to uncomfortably unprecedented changes in the economy in nations that were within the reach of integration and these effects also led to the need being felt for some sort of control (Salvatore, 2001). All these culminated to the creation of the system at the Mount Washington Hotel in Bretton Woods, New Hampshire where 730 delegates from all 44 allied nations had come to participate in the United Nations Monetary and Financial Conference and they debated upon and signed the Bretton Woods agreement during the course of the initial three weeks in the month of July, 1944. The objective of the present endeavour is to bring out the rationale behind the creation of the system and to look at its various performances and then to finally examine the causes behind its breaking down as a system. In what follows, we first look at economic and political conditions the prevalence of which created the need for such a system to explore the rationale. We then look at the significant contributions and failures of the system and finally concluding with pointing out the main causes that led to a break down in the Bretton woods system. 2. The Political Economy Backdrop In the post First World War period most of the affected economies sought the security and the stability provided by the previous system referred to as the Gold standard and by 1926, most of them returned to it. However sub-optimal valuations of a significant number of currencies coupled with a seriously hurt and still recovering England having to assume leadership as well as certain other flaws in adoption of the system led to degradations in global economic relations and financial interactions. This drop hit its trough with the great depression that spread through open channels of trade from its origin of Great Britain to all the major economies of the World. As a direct consequence economies the world over saw ‘a race to the bottom’ of sorts, each trying to lower its currency value than the other in pursuit of reducing the mounting balance of payment deficits. This international currency devaluation competition led to aggravated mass unemployment, huge number of bankruptcies and failures of many major financial intermediaries and for perhaps the first time the need for regulations on actions like devaluations on a global scale was felt. A large number of conferences held during the 1930s that dealt with treating the effects of the depression failed to bring any promising result. But with the end of the Second World War being sighted in the mid 1940s it became apparent that some sort of innovative regulatory monetary system that prevented the previous mistakes was needed to stabilize and govern international financial interactions and initiate the much needed monetary reforms globally. So, the primary rationale behind forming the Bretton Woods system was essentially that of creating a new monetary system that provided the stability and the security that the re-adoption of the gold standard previously had failed to provide and establishing an institution that regulated international economic relations under this new system. The primary negotiations began as mentioned before, in 1944 even before the War was officially over so strongly was the need for such an institution felt. 3. The Inception of the System and its Operations The conference, held with the objectives of strict restructuring of international economic and currency relations led to the conception of the International Monetary Fund (known better as the IMF) and the International Bank for Reconstruction and Development (IBRD), and the implementation of fixed exchange rates against the U.S. Dollar was agreed upon by the participating nations. This center stage acquisition of the U.S. Dollar was due to the following reason: the USA in the post war situation emerged to be the strongest economic power and given the debt struck situations of most of the war stricken European economies which led them to transfer large amounts of gold to the USA, it obtained dominant status and the Dollar attained supremacy and was the only currency to be backed by gold. U.S.A. set the value of $35 as equal to one ounce of gold and all the other participating nations had to define the value of their currencies in terms of Gold or Dollars. A system of adjustable peg was adopted which was referred to as the par value system. Although the exchange rates were to be pegged at their respective par values, the allowance for adjustments in the face of ‘fundamental disequilibrium’ was accorded (Salvatore, 2001). 3.1 The IMF and its operations The institution that was to become the IMF was conceived to back the lack of foreign exchange reserves, a problem that started looming large once non-floating exchange rates were adopted. Adequate supply of foreign exchange reserves would be necessary to wipe out the deficits that resulted from maintaining pegged exchange rates. It was also introduced to ensure fast dismantling of the currency and trade regulations that were adopted on a large scale during the War time emergencies. The IMF was essentially to be a pool of funds that was to be financed through the subscription payments made by the members that thereby entitled them to a certain quota (determined in accordance to the respective nation’s relative economic importance) of Foreign Exchange in times of need. 25 per cent of the subscription had to be paid in gold or currency that was convertible into gold which effectively implied the dollar as that was the only directly gold convertible currency for central banks at that time, and 75 per cent of it had to be paid in the respective members home currency (Moggridge, 1980). This was the first attempt at institutional permanent monetary cooperation at the international scale. The magnitude of contributions by the members not only determined their respective quotas, it also determined the extent to which a member country’s representatives could vote. So it was an asymmetric voting system with the weightage of a nations vote being dependent upon its contribution to the fund, and this structure essentially implied that the U.S. leadership would have the major dominance over workings of the system as it enjoyed the maximum quota. The U.S.A held one third of all IMF quotas and the resulting power in terms of potential votes allowed them to bring about changes in the IMF even if every other vote was cast against them. The fact of the IMF headquarters being based in Washington D.C. and employing mostly U.S.A. economists led to further U.S. influences on the IMF. 3.2 IBRD It was agreed upon in the conference that the devastated Europe would need heavy reconstructing in the post war period to be able to participate in the international platform competitively. So the new system could be adopted only after this reconstruction had been achieved. Thus, with the primary objectives of financing such post war reformations and promotion of healthy international trading relations the planners at the Bretton Woods seminar conceived the International Bank for Reconstruction and Development which is presently the most important of the agencies of the World Bank. The IBRD had a capital base of $10 Billion and was to forward loans to the worst hit nations to allow them to recover quickly from the Wartime devastations and facilitate development. Issuing securities was an important way of raising funds for the IBRD. 3.3 Incorporation of Developing Nations After the decolonization phase of the 1950s, to incorporate the developing countries into the new global environment and to help them deal with the extreme mass poverty illiteracy and other social problems associated with less developed countries new organizations were founded. In 1956 the International Finance Corporation (IFC) was formed to provide loan support to private concerns that lacked capital in the developing world. The International Development Association was formed in 1961 with the objectives of providing loans to poor nations at very easy terms. These additions to the World Bank have made it the U.N. institution for foreign aid. 3.4 SDRs The system faced a significant threat in the early 1960s when most European War hit nations had recovered unexpectedly fast and started growing economically at a significant pace leading to a sudden weakened relative position of the U.S. and gradually the already large U.S. B.O.P deficits became larger and visibly their was a decline in confidence for the Dollar1. The notion of the present reserve status being inadequate and the looming international liquidity being potentially growth and development hindering led to the IMF issuing Special Drawing Rights (SDRs) which member countries had the option of adding to their present stock of foreign currency holdings and gold. SDRs were not backed by gold and they were actual international reserves issued by the IMF in the form of accounting entries and often referred to as ‘paper gold’. An interest of 1.5% was levied on the deficit or surplus holdings of SDRs of member nations to make them correct B.O.P. disequilibrium (Salvatore, 2001). 4. The U.S B.O.P deficits and the Collapse of the system Up to 1949, since the inception of the system, the U.S. observed huge B.O.P. surpluses. But with the European recovery being completed more or less by 1950, the chronology of the subsequent history of the system can be divided into the period of the ‘dollar shortage’2 which refers to the small deficits3 that lasted up to 1958 since when the deficits jumped up sharply4 and hence led to the period of the ‘dollar glut’ that followed and finally led to the collapse of the system (Salvatore, 2001). Post 1958, large increases in capital outflows5 coupled with mounting inflation rates6 in the U.S. economy added to the increasing deficits and finally led to withering away of the traditional U.S trade surplus in 1968. The financing of the deficits mostly with Dollars led to foreign official dollar holdings to rise to around $40 billion in 1970 from around $13 billion in 1949. Foreign private holdings of dollars were even larger and the point to note here is that all these were potential claims on the U.S. gold reserves (Salvatore, 2001). By this time U.S. gold reserves had also shrunk considerably7 which added considerably to the mounting pressure. The U.S. sought unsuccessfully to persuade a revaluation by surplus nations with particular insistence to West Germany and Japan in 1970 and subsequently in 1971 but this only had the effect of creating an expectation that the U.S would eventually devalue the dollar. This in turn caused a frenzy of destabilizing capital movements out of dollars to stronger currencies8. Finally on August 15, 1971, President Nixon was forced to suspend the convertibility of the dollar into gold which finally marked the ‘death’, impending for quite sometime, of the Bretton Woods system (Triffin, 1988). References: Moggridge, D., (1980) Activities 1941 - 1946 : shaping the post-war world, Bretton Woods and reparations. London: Macmillan Salvatore, D., (2001) International Economics, 7th ed, New-York, John Wiley & Sons Triffin, R. (1988) Gold and the Dollar Crisis, New Haven, CN: Yale University Press. Read More