The Most Important Features of the Bretton Woods Agreement - Coursework Example

Bretton Woods Agreement xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Instructor xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Introduction In 1944 as the World War II raged on, delegates from 44 allied nations attended a conference in Bretton Woods, New Hampshire. The aim of the conference was to establish means of regulating international monetary trade after the war. The outcome of the conference was the famous Bretton Woods Agreement (Ajami, 2006). The agreement included the formation of the International Bank for Reconstruction and Development and the formation of the International Monetary Fund. The two are part of the World Bank today. It also had the proposal that currencies should be convertible to aid trade and other financial transactions as well as a proposal for the introduction of a pegged and adjustable foreign exchange rate system. Each country would adopt a fiscal policy that would seek to maintain a fixed exchange rate for its currency by tying its currency to the United States dollar. Currencies were pegged to gold and the IMF was given the responsibility and authority of intervening whenever there was an imbalance of payments (Chatterjee, 2010). The Main Features of Bretton Woods Agreement Background Prior to the Bretton Woods Agreement, free trade relied entirely on the convertibility of currencies. From the disastrous floating rates experience of the 1930s, it was evident that the flow of free trade would always stall whenever there were major currency fluctuations. There would be need for intervention but due to the nature of international trade, the lack of a central government meant this could not be possible. The gold standard was used as a result but for the postwar period, this option was not deemed to be feasible (Folsom et al, 2005).The Bretton Woods Agreement architects therefore settled for a fixed exchange rates system that would be managed by international institutions through the use of the U.S. dollar as the reserve currency. These were the main features of the agreement: 1. Fixed Exchange Rates The Bretton Woods Agreement provided for a fixed exchange rates system. The rules of the agreement sought to encourage member states to commit to free trade and the convertibility of their individual currencies into other countries. As a result, a pegged rate currency regime emerged. The member nations were required to set a parity of their individual national currencies with respect to a peg, which was the reserve currency (Allen, 2009). They were also expected to maintain their exchange rates within a range of plus or minus 1 percent of parity through intervention in the foreign exchange markets through the buying or selling of foreign currency. John Keynes suggested that a world currency unit be used as the reserve currency but that was never implemented. Instead, the U.S request of making the U.S. dollar the reserve currency was granted. Essentially, all the other countries would have to peg their currencies to the U.S dollar and on restoring convertibility; they would buy and sell the dollar to keep the exchange rates within the 1 percent range of parity. Basically, the U.S dollar now played the role that gold played under the gold standard regime in the international monetary system (Ghosh & Gulde, 2002). Two main rivals, Britain and the U.S. dominated the conference. Britain was represented by John Keynes and the U.S. by Harry Dexter White. White’s scheme favored a system with incentives designed so as to create price stability throughout the world economies. On the other hand, Keynes preferred a system that would encourage economic growth. Keynes felt that when imbalances in balance of payments occurred, both creditors and debtors should alter their policies since placing too much pressure on the country with a deficit would be deflationary. On the other hand, the U.S. which was eager to become the creditor nation after the war only felt such a problem ought to be dealt with by the deficit country. Due to its dominance, it proposal was accepted (Arner, 2007). The U.S dollar was chosen for a number of reasons. It was he currency with the highest purchasing power and was the only one backed by gold. In addition, the ongoing war had left the rest of the countries in huge debts while the U.S economy was largely unscathed. As such, the dollar was the strongest currency at the time and was easily chosen to be the main currency under the Bretton Woods system. To increase the faith in the U.S dollar, the U.S government linked the dollar to gold at a rate of 35 dollars per ounce of gold. This enabled foreign nations and central banks to exchange their dollars for gold. In other woods, the agreement resulted in a situation where all foreign currencies were valued in relation to the dollar which was convertible into gold and was viewed as being as good as gold. The U.S. dollar became the world currency and the majority of international trade transactions were all denominated in dollars. If any member country desired to change its par value by more than 10 percent, it would need to seek the approval of an international monetary body, the IMF, which was established through the agreement (Chatterjee, 2010). 2. The International Monetary Fund (IMF) The Bretton Woods Agreement led to the establishment of the IMF which remains a powerful international monetary institution to date. The formation of this institution along with the IBRD was due to the need to have an institutional forum for the control of international monetary matters to avoid economic warfare and closed markets as was the case in the 1930s. Keynes asserted that it was important to have a rule-based regime responsible for stabilizing worldwide business expectations. Establishment of rules and structures for worldwide economic regulation, interaction, cooperation and conflict resolution was necessary and formation of an oversight body such as the IMF was the best solution(Arner, 2007). The fund was established in December 1945 and commenced its operations in March 1947. The IMF was tasked with approving exchange rate changes of more than 10 percent and giving advice to governments on policies and matters affecting their monetary systems. The main purpose of the IMF was to promote monetary cooperation all over the globe by supervising, consulting, and collaborating on monetary problems. The body would also facilitate and promote the expansion of international trade. The body was also tasked with eliminating restrictions on foreign exchange and the creation of payment systems for multilateral trade. It would also assist member countries with problems in their balance of payments to solve them (Burton and Brown, 2009). To join the IMF, each country would contribute a sum of money known as a quota subscription. These quotas would be similar to credit deposits and are the largest source of funds at the IMF disposal which it uses to grant loans to member countries. Any country can withdraw up to 25 percent of its quota contribution or more if it has financial problems but repay this money as quickly as possible. A country could borrow from the IMF an amount commensurate to its contribution, which would also determine its voting power. Up to date, the IMF remains a powerful international monetary institution. It lends money to countries and this money is different from conventional loans. Essentially, countries borrow foreign currencies and the dollar is the most commonly borrowed currency (Samuelson & Nordhaus, 2010, p. 723). The IMF does not have control over the national economic policies of its member state. In real sense, its chain of command emanates from member governments and runs upwards. Each country has a member in the highest authority which is the board of governors and this representative is always the head of central bank or the finance minister. An executive board of 24 executive directors manages the day-to-day work of the fund. The US is dominant since it has the highest amount of quotas and consequently the most votes. 3. International Bank for Reconstruction and Development (The World Bank) This is the second body that emerged from the Bretton Woods Agreement. This was meant to promote the growth and development of world trade as well as financing the reconstruction of Europe once the war ceased. The body’s authorized capitalization was $10 billion. It would grant loans using its own funds, issue securities and underwrite private loans to raise more money in order to speed up post-war recovery (Boyes & Melvin, 2013). Clear rules were formed to govern the scope of loans the IBRD would issue. They were primarily meant to aid the recovery of nations after the war. A country had to demonstrate its need for the money and its inability to source for the funds from other sources under the existing market conditions. Additionally, the loans would only finance productive projects except in very special circumstances and the bank had to make arrangements to ensure the loan was used for the original purpose. The nation also had to demonstrate its ability to repay the money back within a stipulated time frame. The borrowing nation may not be a member government but the government of the country where the project is located must guarantee the loan (Burton et al, 2010) Today, the bank provides annual loans totaling about $16 billion to its member countries. Using its vast financial resources, extensive knowledge base and highly trained staff, it helps the developing countries towards the path of sustainable, equitable and steady economic growth. It also contributes in fighting poverty and improving the living standards of millions all over the globe (Burton and Brown, 2009). The bank provides nations with capital for economic investments and also helps them in restructuring their economies. It aims to help countries keep their balance of payments balanced. This is done through cooperation with government agencies, private enterprises and non-governmental institutions. Currently, the bank mainly concentrates on the developing countries and is active in more than 100 countries. The World Bank is an independent body of the UN but is intertwined with the IMF in the sense that any nation wishing to join it must first become a member of the IMF. Its highest authority is the Council of Governors and consists of a single representative from each country. It also has an executive board comprising of 5 directors and a president who is elected by the US and confirmed by the executive board. Again, the U.S. remains the dominant player in the World Bank (Reinert, 2012, p. 416) The Collapse of Bretton Woods System Bretton Woods system and it fixed exchange rates system does not exist anymore in the world economic order. This is in spite of the fact that its other features, the World Bank and the IMF exist to date, with a history of mixed success and failure in playing the role they were meant to play. The system collapsed in 1971. Over the course of its existence, international investment and trade expanded and there was increased macroeconomic performance. Most of the industrialized nations had reduced inflation rates except Japan and interest rates were very low and stable throughout the world. The eventual reasons why it collapsed were fiscal constraints in the U.S as well as inflation fears by Germany (Ghosh & Gulde, 2002). In the late 1960s, the United States experienced higher inflation rates than the rest of the world. Due to the inflation, the dollar became overvalued. The implication was that the exchange rate of the dollar became lower than its gold value. In 1971, for the first time since World War II, the U.S registered negative balance of payments as its imports exceeded its exports (Robinson, 2012). The weaknesses of the system were the restriction of capital movements. In order to control exchange rates, governments were often forced to limit capital flows. Another weakness was that changes in parities were effected out of speculative decisions or financial crises. Additionally, the U.S was not willing to supply the huge amounts of gold demanded by the rest of the world as per the requirement by the system because its gold reserves had diminished and this had eroded confidence in the dollar (Robinson, 2012). Foreigners were exchanging gold for the dollar and the U.S had to curb this. It stopped exchanging gold for dollars but this made the dollar unattractive. A meeting of the ten richest nations convened in Washington later in December 1971 and resolved to devalue the gold by a whopping 8 percent. This was meant to stabilize the dollar and consequently ensure the dollar standard does not collapse but it did not help because ultimately, it was realized it is not possible to fix exchange rates between two currencies as this should be determined by the forces of demand and supply (Suntum, 2005, p.179). Since prices were different all over the globe, the fixed interest rate international monetary system was doomed. In 972, the trade deficit of the U.S tripled. This meant the dollar was still overvalued. In 1972, the dollar was devalued again by 10 percent. By this time, the dollar was too vulnerable in international monetary markets. Speculators started buying the German currency as it was more stable than the dollar. The Bretton Woods system was now collapsing fast and Germany tried to avert this by buying the dollar but its efforts were futile. Soon after the value of the U.S dollar was floated in the market, Bretton Woods system collapsed completely (McEachern, 2011). What has Replaced Bretton Woods System? Currently, the Bretton Woods system has been replaced by a managed float system. The exchange rate of a given currency is determined by the market forces of demand and supply for that currency. The rates are neither fixed nor administered and they move in line with changes in demand and supply (Sharan, 2006, p. 50)The system combines a system of sporadic and targeted interventions by central banks with the general features of freely floating exchange rates. This hybrid managed float system is sued to moderate and regulate fluctuations in monetary exchange rates among the major currencies of the world economy. Most of the developing countries, which are still small economies, still peg their individual currencies to the major currencies such as the dollar or the euro. Alternatively, they peg their currencies to a basket of combined major currencies. In the modern developing world, there is still severe restriction to private international borrowing and even on purchase of foreign exchange, e.g. some governments only allow the purchase of foreign currencies by residents only for specific purposes. In others, there are different exchange rates for the same currency for different transactions (Laurence, 2001) Critics of the current flexible exchange rates that have replaced the Bretton Woods system argue that the rates are inflationary. This owes to the fact that they free the monetary authorities to pursue policies that are expansionary. They also argue that volatility in the exchange rates can sometimes lower the competitiveness of the export sector of a given country. Such a fall in export output leads to unemployment and consequently calls for restrictions on imports (McEachern, 2008) Conclusion World economies are constantly looking for a system that can be netter than the managed float system that is currently in place after the collapse of the Bretton Woods System. Its main weakness is the fluctuations that occur in exchange rates. An ideal system which has always proven to be elusive would be one whereby there would be low inflation and international trade would be fostered. It would also be able to promote a stable world economy with minimal fluctuations. There is need for more stable currency exchange rates in the international markets in order for all nations to benefit from free trade equally. The dominant player in the world economy is the U.S and it is expected to have the greatest input towards the realization of an acceptable and stable world exchange rate system (McEachern, 2011). References Ajami, R. A. (2006). 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International business transactions: a problem-oriented course book (8th ed.). St. Paul, MN: Thomson/West. Ghosh, A. R., & Gulde, A. M. (2002). Exchange rate regimes: choices and consequences. Cambridge, Mass.: MIT Press. Laurence, H. (2001). Globalization and national politics. Money rules: the new politics of finance in Britain and Japan (pp. 57-60). Ithaca: Cornell University Press. McEachern, W. A. (2011). International Economics. Microeconomics (3rd ed., pp. 313-314). Mason, Ohio: South-Western. Reinert, K. A. (2012). An introduction to international economics: new perspectives on the world economy. New York: Cambridge University Press. Robinson, J. (2012). Bankruptcy of our nation your financial survival guide (Rev. and expanded ed.). Green Forest, AR: New Leaf Press. Samuelson, P. A., & Nordhaus, W. D. (2010). Economics. New Delhi: Tata McGraw Hill. Sharan, V. (2006). Development in International Monetary System. International financial management (5th ed., p. 50). New-Delhi: Prentice-Hall of India. Suntum, U. v. (2005). Trade and Changes in the World economy. The invisible hand economic thought yesterday and today (p. 179). Berlin: Springer. Read More