The Bretton Woods Agreement - Case Study Example

STUDENT NAME: PROFESSOR: COURSE: SEMESTER: DATE: The Bretton Woods Agreement Introduction After the end of the world war, the world economic power houses led by the US came together in Bretton New Hampshire to establish new monetary system to replace the Gold standard system which had collapsed during the great depression of the 1930s. The driving idea behind the revising the monetary system was the need to enable expansion in money supply through international trade and to revive the world economies that had been devastated by the war. The United States accounted for more than half of the global economic output and had accumulated most of the world’s gold. It was therefore logical for other world currencies to be tied to the dollar which was also to be pegged at $35 per ounce. This led to the creation of an adjustable pegged foreign exchange rate system (Triffin, 1957, Bordo, 1993). The new state of the monetary system meant that some readjustments have to be made. The major outcome of the Bretton woods agreement was the creation of the international monetary fund to monitor exchange rates for all the countries and lend reserve currencies to nations experiencing trade deficits due to imbalance between exports and imports. There was also the creation of the international bank for reconstruction and development now known as the World Bank. The bank was to provide the struggling and underdeveloped world nations with capital for reconstruction and development (Bordo, 1993, Eichengreen, 2008). The system worked quite well with Germany rising again from war time destruction. With time though, the US economy had started to suffer negatively from the Bretton woods monetary system. Inflation was very high in the US economy and the trade deficits had stated to grow. The US could no longer allow the dollar to be trading on a fixed rate pegged to the dollar and so it had to abandon the system and allow its currency to freely float in the currency market. This marked the end of the Bretton woods system and assured in the floating system where countries let their currencies float freely against the dollar. The dollar started being used as a reserve currency for many world economies (Meltzer, 1991). This paper will seek to discus the salient feature of the Bretton woods agreement, why the system was abandoned and what replaced it. This will be achieved under the appropriate subheadings. Important features of the Bretton Woods agreements After intense negotiation mainly between the US and Britain concerning the new world monetary system to be adopted, they finally reached a compromise between the overriding interests of the two victors of the world war. The compromise led to the drafting of the core articles of agreement of the Bretton woods agreement (Hall, Hondroyiannis, & Tavlas, 2009). The main objectives of the new system to be adopted were to; Promote international monetary cooperation Creation of employment and rapid growth Maintenance of a stable exchange rate to ensure peace To provide needed funding to correct disequilibria in payments With this objectives in consideration then the main articles of agreement which make up the main features of the Bretton woods agreements had to be implemented. The features are: A par value system Article 4 of the agreement required all members to declare a par value of their currencies and maintain it within 1% margin of either side against either gold or the dollar. The dollar in turn was to be convertible to gold at $35 dollars per ounce (Bordo, 1993). Incase of substantial fluctuation from the set margin, it could be corrected after consultation with the fund. Any unauthorized changes in the exchange rate could lead to members being refused access to the funds resources. If any unilateral agreement on the exchange rate was to be made, it had to be supported by a majority of the voting power and also approved by members with not less than 10% of the total quota (McKinnon, R. 1993, Hall, Hondroyiannis & Tavlas, 2009). The International Monetary Fund An international monetary fund institution was to be established to help meet the objectives of the Bretton woods agreement (Bordo, 1993).. As noted by McKinnon (1993) and Triffin (1957) the institution was intended to: foster collaboration amongst members on international monetary issues ensure the maintenance of full employment in member states maintain stable exchange rates in the international currency exchange market provide a multilateral payments system and removing exchange restrictions in order to allow for monetary liquidity in international trade Provide financial assistance to member nations who are faced with deficits in balance of payments. This was to help ease external disequilibria The international bank for reconstruction and development The architects of the Bretton woods agreement also created another important institution that is the international bank for reconstruction and development (Bordo, 1993). This bank was to offer loans to members for the purposes of reconstruction and development of their economies. The main idea was to help economically disadvantaged members due to war and other factors to increase the productivity of their economies. In addition to issuing loans, the bank was also allowed to raise funds through issuing securities in efforts to get the world economy recover from the effects of the World War 2. The institution is now known as the World Bank (Solomon, 1977, Eichengreen, 1989). Why the Bretton woods system failed The adjustment problem Bretton woods agreement was made with the intention of eventually getting all the member currencies being equal with no dominant currency. The United State’s dollar was to act as the center of the system. However this was not to happen due to a multiplicity of economic factors and actions by member states which directly undermined the initial agreement. In 1949, 24 member nations devalued their currencies against the dollar in order to enable massive exportation of their trade commodities (Bordo, 1993). According to Hall et al (2009) major world currencies were however less adjusted over time due to reasons such as; Reputation-concern that devaluing a currency will result in decline in national prestige among the citizens of a country Speculation- a concern that an intention of parity change may influence selfish capital flows Expenditure reduction- devaluation was viewed as possible factor to increasing inflationary effects in the domestic economy if compression of domestic absorption is not realized thereby incurring political and policy costs to implement the devaluation The fact that most of the currencies in west Europe countries and Japan remained devalued against the dollar all through to the late 60s meant that the countries’ economies thrived under export led growth. On the other hand the united states run into balance of payments deficits by supplying the dollar liquidity to the rest of the world as an alternative to the previously used gold which was less liquid and thus would have slowed economic recovery (Hirsch, 1967). The United States towards the end of 1960s had started to experience a slow economy and trade deficits and it was beginning to rethink its action of sacrificing the dollar to the rest of the world who were benefiting a lot from the united state being the center of the system and them acting as the periphery. Desperes & Kindleberger (1966) argued that the balance of payment in the US rose because of massive capital outflows out of the country which exceeded the current account surplus. The rising deficit was viewed by policy makers and politicians in the us as a major problem due to the negative impact it had on the confidence of people on the dollar as a currency to peg all the other world currencies. By 1959, the monetary gold reserve in the US equaled total external dollar liabilities and the rest of the worlds gold stock had exceed the gold reserves in the US which was previously three quarters of the gold in the world (Eichengreen, 2004). To the rest of the world the dollar was playing a vital role of providing liquidity to the rest of the world. If the US tried to fix its deficit then it would lead to a shortage of liquidity to the rest of the world and thereby stifling world economies. As noted by (Johnson, 1973) countries such as Germany and France which had over time reconstructed their economies viewed the us as transporting inflation to surplus countries through its deficits and would go ahead to convert dollar liabilities into gold stock in an effort to return the value of gold to its initial value and return the world monetary system to the gold standard. The US responded to its trade balance deficits by controlling capital flows to reduce capital outflow and initiating a new gold conversion policy whereby the Federal Reserve would borrow to buy dollars held abroad instead of paying for them with the diminishing gold reserve. These efforts were all designed to ensure that the US retained enough gold reserves as it did before the 1950s (Johnson, 1973). The surplus nations on the other hand played a big role in the collapse of the Bretton woods system. The nations were not willing to revalue their currencies and absorb the dollar balances. Countries such a Germany which were newly industrialized refused to raise the value of its currency in order to sustain its export led growth. The system was then to be decentralized due to the growing gap between the sovereignty of the US and that of the newly industrialized countries (Johnson, 1973). The liquidity problem Towards late 1950s there was a shortage of liquidity caused by inadequacy in gold production. The real price of gold was far less than what it was since the World War 2 and this was threatening to eventually reduce world production of gold. This liquidity problem meant that gold stock will not be adequate enough to facilitate of the real output of the world in terms of trade volumes (Bordo, 1993). The main solution that could bring matters to normalcy was to convert all the existing reserves into international money and have the IMF giving generous liquidity as the world’s central bank. However this was not to happen due to overriding interests of member states particularly the US, Britain and France. The fact that the system enjoyed a relatively short heyday duration from 1959 to 1967 in which it was sustained by a raft of controls on current account and capital account by the us government, and also its effect of generating unsustainable dollar liquidity increases meant that the system was not functional to satisfy each and every member state and maintain stable state of liquidity in the monetary sense for the rest of the world to realize its production capacity (Hirsch, 1967). These problems associated with the fixed exchange rate by the Bretton woods agreement build a case for the abandonment of the system consequently leading to a de-facto dollar standard and even after the dollar acquired this status, the united sates did not play its role of maintenance of price stability and instead pursued an inflationary policy that finally crumbled the monetary system The confidence problem As the world economies continued getting strong after the sustained reconstruction efforts, the US had started experiencing rising trade deficits (Bordo, 1993,). The major concern that was getting much attention was the confidence crisis for the dollar. During the period preceding 1966, the growing gold scarcity and the rising inflation in the US market was demeaning the confidence in the dollar (Johnson, 1965, Mundell, 1969). World production of gold was reducing dramatically. This coupled with the soaring of private demand further worsened the problem that resulted in reduction in world monetary gold stock. The US engaged in a spirited effort to force other monetary authorities all over the world to refrain from converting dollar reserves into gold. This meant that the dollar was becoming as de-facto standard for the rest of the world. As a result, the US was committed to convertibility in order to maintain the Bretton woods system but the threat of the confidence crisis would curtail the ability of the dollar to the dollars required by the rest of the world for liquidity purposes. Tow major factors towards 1970 meant that the Bretton woods system was not sustainable occurred. First it was the collapse of the gold-pool agreement in 1968 (Yeager, 1976). The price of gold remained at $35 per ounce in official transactions but members did not engage in private trading. The US Federal Reserve removed the 25 percent gold requirement against the issuance of Federal Reserve notes. The resultant effect was the demonetization of gold to let the dollar trade freely without a fixed value against the gold in order to ease the pressure on the dollar. Towards the end of 1971 it had become increasingly impossible to maintain economic stability in the US under the Bretton woods agreement. The US announced a temporary suspension of the convertibility of the dollar to gold. This marked the start of the demise of the Bretton woods system. My the year 1974 all efforts by the world economies to maintain the fixed exchange rate system were not successful due to pressure from the respective domestic economies’ interests. Major currencies would eventually start to float against each other (Eichengreen, 1989, McKinnon, 1993). Conclusion The Bretton woods agreement was a response by the major world economies after the world war to prevent countries from intentionally devaluing their currencies in order to stimulate exports and transfer unemployment to other nations. It was also an effort to increase liquidity in the international trade to ensure faster recovery from war. The fixed exchange rate that was based on the value of gold facilitated by the liquidity of the US dollar which was in turn pegged on the gold at $ 35 dollars per ounce, failed due to liquidity problems, lack of confidence in the dollar and adjustment problems by the major world economies. The result was a system that is decentralized with world currencies free to float against each other. References Bordo, M.(1993). The Bretton Woods International monetary system: A historical overview, University of Chicago Press, available online at http://www.nber.org/books/bord93-1 Desperes, E., Kindleberger, C. (February 5 1966). The dollar and world liquidity: A minority view, The Economist Eichengreen, B. (1989). How do fixed exchange rate rigimes work? Evidence from the Gold Standard, Bretton Woods, and the EMS, London, Center for Economic Policy Research Eichengreen, B. (2004). Global imbalances and the lessons of Bretton woods, NBER Working paper 10497 Eichengreen, B. (2008). Globalising capital: A history of the international monetary system, 2nd edition, Princeton University Press Hall, S., Hondroyiannis, G., & Tavlas,G. (2009). Bretton-Woods systems,Old and new, and the rotation of exchange rate regimes, working paper #9/15, University of Leicester Hirsch, F.(1967). Money International .London: Penguin. Johnson, H. (1965). The world economy at crossroads, Oxford: oxford University Press Johnson, H. (1973). The international monetary crisis of 1971. Journal of business, vol46, pp. 11-23 McKinnon, R. (1993). The Rules of the Game: International Money in Historical Perspective. Journal of Economic Literature, Vol.22, pp. 1-44 Meltzer, A. (1991). U.S Policy in the Bretton woods era, Federal Reserve Bank of St. Louis Review, Vol 73, pp. 54-83 Mundell, R. Ed. (1969). Monetary problems of the international economy, Chicago: University of Chicago Press Solomon, R. (1977). The international monetary system: An insyder’s view, New York: Harper and row Triffin, R. (1957). Europe and the money muddle. New Haven, Yale University Press Yeager, L. Ed. (1976). International monetary relations: theory, history, and policy, Harper and Row Read More