The Most Important Features of the Bretton Woods Agreement - Case Study Example

Running header: Bretton Woods Student’s Name: Name of Institution: Instructor’s Name: Course Code: Date of Submission: Describe the most important features of the Bretton Woods Agreement. Why did the Bretton Woods ‘system’ break down and what has replaced it? Introduction During the summer of 1944, World War II (WWII) was still ongoing. The same summer delegates from a total of 44 countries met in Bretton Woods, a rural area in the New Hampshire, to lay down the foundation for a new international financial system. The meeting was the result of the determination of President Franklin D Roosevelt of the US and Winston Churchill, the UK Prime Minister, to see a post-war prosperity based on economic cooperation and avoiding the 1930s economic conflicts and tensions between countries, which they believed fanned the drift to the war (Schifferes, 2008). During the meeting President Roosevelt (quoted in Schifferes, 2008) said, “The economic health of every country is a proper matter of concern to all its neighbors, near and distant.” But largely, it can be said that the conference was part of the US’s plan to create and lead a new world order that would rest upon the rule of law, and which also facilitated and enhanced the creation of the United Nations, as well as strengthening other international organization (Schifferes, 2008; Wiggin, 2006). By the 1970s, however, the US dollar was under much pressure from many factors, including the heavy cost of the Vietnam War as well as the growing trade deficit. President Nixon of the US unilaterally abandoned the gold standard and devalued the US currency, the dollar, in 1971. This move would only be ratified later in the year by another meeting dubbed the Smithsonian Agreement. This marked the beginning of the end for the Brent Woods system as some of its key aspects began to lose favor. For instance, fixed exchange rates were abandoned for floating rates, which meant that the value of major currencies would now be determined by market trading. Attempts to put in place a new Bretton Woods deal on currencies failed. Eventually, Bretton Woods system broke down (Cohen, 2002; Wiggin, 2006; Iozzo & Mosconi, 2006). The purpose of this paper is to take a closer look at the key features that the Bretton Woods Agreement set to champion, the reasons that led to the breakdown of the BWs system and what economic world order has since taken over from that vacuum left. The important features of Bretton Woods System As already mention above, the BW system was meant as a strategy for a postwar reconstruction of the world monetary space. The conference was dominated by two key approaches to the postwar plan led by Harry Dexter White from the US treasury on one hand and John Maynard Keynes from Britain on the other. The ultimate plan was a compromise between the two approaches, but with a notable inclination toward White’s plan than Keynes’. This reflected even further the overwhelming power of the US even as the WWII approached its denouement (Lago et al., 2009; Terborgh, 2003). At the time, there seemed to be a big difference between the plans of White and Keynes, especially regarding ‘future access to international liquidity’ (Cohen, 2002), the similarities were more notable. In fact, most attending countries agreed on many of the BW proposals. For instance, all of them agreed on the lessons that the interwar monetary chaos had presented, and were therefore determined to avoid the recurrence of such troubles. This overall agreement was directly reflected in the IMF Articles of Agreement. In these articles, four key issues are distinctly clear. One, the negotiators shared the idea that the war had exposed the limitations of ungoverned flexibility of monetary exchange rates (Clark & Polak, 2004; Ocampo, 2010). They saw the 1930s floating rates as having discouraged or limited trade and investments in one respect, but also encouraging competitive depreciation and destabilizing speculation in another. But even then, governments did not see the need for returning to the classical 19th C gold standard model (Eichengreen, 2007) of permanently fixed exchange rates. Cohen (2002) attributes this reluctance the-then reigning sense of activist economic policy in which policy makers hoped to retain their right to- where necessary by circumstances- revise the value of currencies. As such a compromise lying between the option of freely floating rates and fixed rate was arrived at. In other words, this was a way of winning the advantages of both without risking the limitations of either. The resultant deal is what came to be referred to as ‘adjustable peg’ or ‘pegged rate’ or par value system (Cohen, 2002; Iozzo & Mosconi, 2006). This can be illustrated by the signatory member countries were required to declare a ‘peg’ (par value) for their domestic currency, and granted the permission to intervene and govern currency markets so as to limit fluctuation of exchange rates within a maximum range of 1 percent above or below the par value (Cohen, 2002). At the same time, they were also permitted to alter the par value where necessary and within the directives of the agreement so as to correct what was termed as ‘fundamental disequilibrium’ in the domestic ‘payments balance’ (Cecarano, 2003). Unfortunately, despite being key to the operation of the par value, the scope or/and constitution of the ‘fundamental disequilibrium’ were not clearly defined. Two, the signatory governments also agreed that in the case that the exchange rates would not float freely, they (the states) would need assurance(s) that there would be an adequate source of monetary reserves. The attending states did not see the need to alter the basic premise of the inherited elements of the gold exchange standards. Thus, international liquidity still primarily consisted of currencies- directly or indirectly- convertible into gold, i.e. gold exchange (Terborgh, 2003; Clark & Polak, 2004; Ocampo, 2010). Most particularly, the US did not like the idea of altering either the dollar’s central role or its gold reserves value, which was worth three quarters of all gold in the central banks of the world (Cohen, 2002). Ultimately, the countries did agree on the need for other supplementary source(s) of liquidity, especially for deficit countries. However, the main question that remained was whether this supplementary source, as proposed by Keynes, was to be in the frame of world central bank with the capacity to put up other reserves at will, or would it champion a more limited mechanism for borrowing, as White preferred. In the end, the preferences adopted basically stuck with the preferences of the US, i.e. the system of quotas and subscription would be embedded within the IMF (Blanchard & Milesi-Ferretti, 2009), itself a fixed collection of national currencies as well as gold subscribed by all member countries. In line with this, each member country was assigned quotas generally based on and reflecting the economic importance of each country, and which obligated them to pay equal subscription amount. As dictated in the agreement, the subscription would be 25 percent gold or currency- in dollars- convertible into gold, and 75 percent in each country’s own currency (Ocampo, 2010). Thus, each member country short of reserves was permitted to borrow on the basis of the value of its quota. The third element on which the government agreed was the need to avoid the same economic disagreements and conflicts of the 1930s, which were partly the reason for the war. The governments recognized the need to find a binding framework that would ensure the states would do away with existing factors limiting exchange controls, convertibility of currencies, and provide for a free multilateral payment system (Iozzo & Mosconi, 2006). On principle, the governments were forbidden from conducting discriminatory practices of currency and regulation of exchange. However, there were to be two so-termed ‘practical’ exceptions: one, the convertibility obligations would only be valid within current international transactions, i.e. governments would not regulate purchases and currency sales meant for the purpose of trade in goods and/or services (Iozzo & Mosconi, 2006). However, they were not obligated to avoid regulating capital-account transactions. Infact, they were encouraged to utilize the capital control as a tool to maintain external balance in cases of ‘hot money’ flows with the potential to destabilize its economy; and two, the obligations for convertibility could be removed if a member so-wished in the transitional period after the war (Cohen, 2002). Such members were termed as Article XIV countries, while those that stayed were called Article VIII countries. The IMF was mandated with the task of overseeing the practice of this legal aspect of currency convertibility (Cohen, 2002). Finally, the negotiating government felt that the currency troubles experienced during the interwar years had been made even fiercer by the absence of a system or framework of procedures for intergovernmental collusion and consultations. The governments therefore agreed on the need for an institutional platform for international monetary cooperation. Until then, such an attempt had not been made. Even most remarkable was the decision to offer member states voting rights on the basis of quota proportions. Notably, with the US owning a third of the IMF quota, it had the upper veto hand in the future processes of decision-making. These four points are the main ones that defined the Bretton Woods agreement/system. Its structural mechanism was a combination the respect for conventional sovereignty principles and new order in which sovereign countries committed themselves to a collective responsibility for the sound management of international monetary relations on the basis of both mutual agreement and the powers of the IMF. Why the Bretton Woods System Broke Down One of the reasons for the breakdown of the Bretton Woods was what has come to be known as Triffin Dilemma is inherent within the structure of the gold exchange standards in the aftermath of the WWII (Cohen, 2002; Lago, et al., 2009). By relying mainly on the convertibility of the national currency, e.g. the dollar, into gold, the gold exchange standard is essentially flawed (Triffin, 1988, cited in Cohen, 2002). Indeed, it can be said that the Bretton Woods system over-relied on the US deficits as a tool for averting a shortage of world liquidity. Unfortunately, by 1988, the US dollar overhang (Cohen, 2002; Wiggin, 2006) was already exceeding its gold stock. This erosion of the US net reserve standing was expected to eventually kill confidence in the capacity of the dollar’s convertibility. This situation caused a great dilemma. For instance, on one end, forestalling speculation against the US dollar would force the US deficits to cease. Unfortunately, the system would face a liquidity problem as a result. On the other hand, to forestall the problem of liquidity would mean that the US deficits continue (Clark & Polak, 2004). Unfortunately, the system would face a confidence problem. Either way, there was no easy way out, not that they had not tried to find a solution. Negotiations to put in place an alternative source of liquidity growth so as to reduce the reliance of the system on the US deficits begun in mid-1960s. These agreements led to the creation of Special Drawing Right (SDR) (Cohen, 2002; Mosconi, 2010) to deal with potential liquidity shortage in the future. However, as Cohen (2002) notes, the SDR did not anticipate the opposite threat of ‘reserve surfeit’ (Cohen, 2002; Mosconi, 2010; Clark & Polak, 2004) that emerged in the last years of the 1960s. Even a number of other defensive measures were initiated in the early 1960s to contain the increasing speculative pressures upon the dollar, e.g. network of reciprocal facilities for short-term credits [swaps] (Cohen, 2002) among the national central banks and an expanded IMF lending authority. In the end, all these proved insufficient in averting a loss of confidence in the US dollar. The second reason is attributed to the nature of the par value system, especially the vagueness and even ambiguity that accompanied the central notion of ‘fundamental disequilibrium’ (Cohen, 2002; Cesarano, 2003). Since ‘fundamental disequilibrium’ was not clearly defined, governments could not at any time tell whether it existed or not. Equally surrounding this question was how international equilibrium of payments would be maintained when governments were stopped from repegging rates (Cohen, 2002). As a result, governments adopted even extreme measures just so as to avoid being defeated by an altered par value. This then caused the exchange rates to become even more rigid, thereby aggravating fears of a possible shortage of world liquidity. In addition, this provided the suitable ingredients for shifts in the speculative currency, further adding to confidence problem. Ultimately, the failure of the Bretton Woods was the result of a post-war political conflict and the struggle in the global balance of power (Chomsky, 2008; Obstfeld & Kenneth, 2010; Broz & Frieden, 2001; Eichengreen, 2007). As the time after the war grew longer, the initial commitments to the BWs began to fade. The cost strengthening foreign friends and allies at the expense of domestic interest was increasingly becoming intolerable (Eichengreen, 2007). As a result, the US worried about the commercial competition and threat arising in Japan and Europe, while the two sides also worried about how the US used its liability financing privileges- what France’s President Charles de Gaulle called ‘exorbitant privilege’. In order to curb this US’s policy autonomy, these powers used their powers as well, demanding that the accumulated dollar balances be converted into gold. Nevertheless, with a rising dollar overhang, this right grew less appealing for most governments (Cohen, 2002). Meanwhile, the governments assumed the US economy would stabilize. But with increased expenditure of the US government on domestic social programs and the Vietnam war, its economy grew more unstable, i.e. inflation grew causing deficits to widen more. Even then the US still refused to undertake new actions in accordance with the policy of ‘benign neglect’. The US inflation began to infect other countries in the world. Unfortunately, the pegged rate system could not cope up with the increasing imbalances of payments. Concerned about the US’s fast-deteriorating payment standings, President Nixon of the US suspended the dollar’s convertibility of to gold on 15 August 1971 (Cohen, 2002; Eichengreen, 2007). The Smithsonian Agreement of 1973 (Cohen, 2002; Obstfeld & Kenneth, 2010; Beams, 2001) set monies of the industrial countries free, and float independently. As a result, the gold exchange rate, the par value system and the two key postwar monetary policies were terminated. Conclusion: A New Global Financial Order Although the world does not have an explicitly named economic order as was the Bretton Woods system, the failures of the Bretton Woods agreement and its eventual breakdown have since had certain key implications and consequences. For instance, the formation of the G7 (now the G8) the group of the leading world economies was created, and which then helped coordinate adjustment of currency through the 1980s Plaza and Louvre Accords. Equally, European nations began to consider seriously an even closer monetary co-operation, which eventually gave birth to the Euro in 1999 (Schifferes, 2008). These are essential elements of growing inclination towards financial globalization, boosted by the deregulation of both currency markets and the rules of banking and investment. However, in recent times, there have been increasingly explicit calls for a new global financial system. In an October 2008 G8 summit, the President of European Commission, Jose Manuel Barosso (quoted in Simpkins, 2008) called for a “new global financial order”. In attempts to define the basic elements of this ‘new’ order, President Sarkozy of France has also been quoted calling for government regulation on financial institutions. And in line with this, the European Union has seconded this calling for more tough regulations on hedge funds, limiting executive pay, putting in place new rules for agencies that rate credit (Simpkins, 2008). Nevertheless, these are merely propositions and suggestions. Otherwise, while the 2007 global financial crisis has seen the US adopt some of these regulations, it still cannot be said that there is a new global financial order in place. But then again, it may only not be here in name. Otherwise, elements of it are already on. References Beams, N. 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