Collapse of the Bretton Woods System and its Subsequent Replacement - Literature review Example

Collapse of the Bretton Woods System and its Subsequent Replacement Introduction The Bretton Woods system is a form of international monetary system developed to guide monetary affairs between global economies. It emanated from the Bretton Woods Agreement that was made at a United Nations Conference on Monetary Policy held from 1st to 22nd July, 1944 at Bretton Woods in New Hampshire, U. S. A. That the establishment of the system was a culmination of years of preparation is evident in its comprehensive approach to managing the monetary affairs of economies of member states. The Second World War and the Great Depression had created a severe and widespread downward spiral in world economies; particularly in European economies. The Bretton Woods Agreement provided an answer to the economic problems resulting from World War II. Its inception was aimed at maintaining long term global peace by creating a stable economic condition through promoting free trade; enabling collaboration in fiscal management and offering short-term help to economies in the event of economic distress. However, this system collapsed in 1973. Since then, new challenges and realities in international economics and trade relations have created the need for new approaches in managing global monetary relations. This paper examines the key characteristics of the initial Bretton Woods System, reasons for its collapse and the current situation in international monetary relations. Features of the Bretton Woods System The Bretton Woods System had three main characteristics: fixed exchange rates, free convertibility between currencies, and freedom from exchange restrictions on current payments for the economies of member countries (De Vries, 1996, p. 128; Griffiths, O'Callaghan & Roach, 2008, p. 24). The establishment of a fixed exchange rate based on a gold standard was meant to avoid the disadvantages associated with the earlier regimes. According to Carbaugh (2011, p. 466), before the adoption of this system, global financial systems had separately and haphazardly experimented with both the fixed and floating exchange rates. Both systems, in spite of having obvious advantages in their ideologies, exhibited inherent failure as a result of weaknesses in their mode of operation and approach to public financial management. For instance, the completely fixed rate of exchange regime bears the inherent advantage of simplifying the target in monetary policy; its implementation brings the disadvantage of possible loss of independent monetary policy as well as the danger of exposing the whole economy to the vulnerability of speculative practices. The overall effects of these two results far outweigh the relative advantage of adopting a completely fixed exchange rate in the economy (King, 2012, p. 133). On the other hand, a floating monetary system bears three important disadvantages in its practice: reckless financial policies by the government, disorderly exchange markets and price inflation (King, 2012, p. 133; Fernandez, Karacadag & Duttagupta, 2006). These effects on the economy are a result of disruptions in the trade and investment patterns which creates an environment that is conducive for price fluctuations. Despite the fact that floating rates have the advantage of not only allowing governments to set independent monetary and financial policies as well as allowing continuous adjustment in the balance of payments with very limited institutions for implementation, all these potential advantages are outweighed by the possibility of disruptions in the trade investment patterns, creation of an environment that encourages speculative activities in the currency market and, more importantly, creating an environment that encourages governments to develop and adapt reckless monetary and financial policies. These would have severe effect in the economies if adopted. The exchange rate regime under the Bretton Woods system was a combination of both the fixed and the floating rates of exchange to develop a quasi-fixed exchange rate called adjustable- pegged exchange rates. This system had various peculiar characteristics which defined its efficacy during the initial period of implementation of the Bretton Woods Agreement. First, the currencies were tied to each other in order to provide stable exchange rates for commercial and financial transactions. Nations had the responsibility of ensuring that their balance of payments do not move away from the established long-term equilibrium level. In the event of fundamental disequilibrium, countries could re-peg their currencies by undertaking revaluation or devaluation policies (Mussa et al., 1994, pp. 4-6). Correction of balance of payments was expected to be done purely by use of fiscal and monetary policies, without necessarily resorting to re-pegging currencies by up to ten percent of the par value (Hossain, 2009). Such a move was treated as a serious economic crisis and was only employed by economies in the event of failure of initial attempts at correcting the imbalances in their accounts. Such a move however required the formal permission of the International Monetary Fund. According to Carbaugh (2011, p. 469), the adjustable pegged rates failed in their aim of maintaining a viable balance of payments adjustment mechanism. Reasons for the failure are varied from operational problems of the entire Bretton Woods system to difficulties in expressing the equilibrium rate upon which a currency could be pegged. Adjustable pegged rates presented the greatest difficulty in their implementations because currency devaluations were considered undesirable by many member countries. Two important institutions were established under the Bretton Woods system: the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development. According to De Vries (1996, pp. 129-130) and Michie and Smith (1999), the IMF was charged with several responsibilities to member countries. First is to be a permanent institution for promoting international monetary cooperation. This was done through creating a common forum for consultation and collaboration on international monetary problems. Second, the IMF was charged with the responsibility of facilitating the expansion of balanced international trade. Growth of international trade was viewed as a necessary precursor to developing growth sectors in local economies, thus contributing to overall development. Third was to maintain stability in exchange transactions by avoiding competitive exchange transactions and, lastly, to avail resources to member countries in the event repeated economic non-performance. The availability of resources to correct maladjustments in the balance of payments accounts of member countries was viewed as a measure to give confidence to member countries and lessen the degree of disequilibrium. The International Bank for Reconstruction and Development, on the other hand, was charged with the sole responsibility of promoting social and economic progress in developing countries (Goddard, et al., 2006 p. 142; Jain, Khanna & Sen, 2009). The institution offers different types of loans to developing countries which are aimed at funding specific projects in order to stimulate productivity and improved utilization of resources. Projects targeted for funding by the bank may be sector-specific, loans for structural adjustment programmes, technical assistance loans and emergency loans for reconstruction. Reasons for collapse of the Bretton Woods system The Bretton Woods system collapsed in 1971 after the United States suspended the convertibility of gold after unprecedented appreciation of major European currencies. The collapse of the system was a culmination of long process of growing strain and global changes in macroeconomic relations. In view of these changes, the fact that the Bretton Woods system survived the turbulent period of the 1950s and 60s following the war was a result of massive international support it received, coupled with good cooperation between governments and central banks (Buckley, 2009, p. 13; Eichengreen, 2008, p. 121). According to Endres (2010), the Bretton Woods system collapsed as a result of three main factors: the inherent rigidity of the system itself, excessive United States spending on the Vietnam War together with domestic social programmes, and the divergence of national responses. The success of the whole system depended on the United States maintaining responsible fiscal and monetary polices. The United States, faced with massive expenditure in the Vietnam War, the Cold War of the 1960s and increasing public expenditure on domestic social programmes, made the real value of gold to increase sharply against the dollar. Major trading partners with the United States were keen on avoiding this pressure, yet the fixed dollar price for gold was pegged at $35 per ounce. The result was that many central banks exchanged dollars for gold. Also, since the United States was seen as being unwilling to contain its large military spending, many member countries stopped supporting the dollar, thus leading to the slow decline of the system. Additionally, several provisions of the Bretton Woods system proved to be not only less practical but also too rigid to accommodate changes in the global economy that occurred after the first two decades of the Bretton Woods Agreement. For instance, although capital controls were allowed under the system, their implementation was made difficult with the rise of multinational corporations. The growing mobility of capital challenged the original rationale of using capital flows as an effective adjustment mechanism. Notably, the provision that nations had a wide array of options for correcting account imbalances was not realistic since many of responses like currency devaluations, restrictions on current accounts, capital controls and reduced trade barriers were not only difficult to implement but also became widely unpopular with governments of member states. Quite on the contrary, many countries in Europe neither increased interest rates nor attempted to curb social spending because this was seen as a trade off against wage demands (Gandolfo, 1994, p. 457). It has further been observed that the collapse of the system was instigated by divergence responses by member economies. The post-colonisation period saw increased membership of the IMF because many former colonies sought funds from the World Bank for local development programmes. The trend of many African and Asian countries seeking to access World Bank resources was contrasted with the situation in Eastern European countries. Many former communist countries, led by Russia with the largest quota, did not join the institution. Some which joined it either left on their own volition or were expelled soon after joining. Contemporary system for international monetary affairs The current international financial system is based on vital lessons learnt after the collapse of the Breton Woods system. Although the Bretton Woods accord that formed the basis of the original system, the current post-Bretton Woods world economic order is based on refinement and fundamental shifts in ideologies from the original thinking. This has been necessitated by the new realities presented by globalisation and increasing changes in international trade and financial affairs (Buckley, 2009, p. 15). The key characteristic of contemporary international financial system is the introduction of floating exchange rates as opposed to the par value rates. This was brought about by an amendment of Article IV of the IMF that allows member countries to adopt any form of exchange rate arrangement that seems appropriate for the local economy (Takagi, 2005, p. 71). The only exception however is that countries cannot peg their currencies to gold or on any other currency. These changes are meant to correct the problems experienced under the regime of pegged exchange rates as experienced in the former system. Further, the role of the IMF has drastically changed under the contemporary system. Currently the role of the institution has changed from being a provider of stabilisation funds to economies to one of being an institution that provides technical support to member countries, crisis management in debtor nations and general surveillance. Although financial assistance is available, its accessibility is based on a raft of conditions to the applying member country (Endres, 2010, p. 167). The IMF also plays an important role in linking developing countries to global capital. The institution offers technical advice to developing countries on the process of opening up their economies to global capital. This is a key role, since the bulk of member countries of the institution comprises developing countries that joined it after the collapse of the Soviet Union (Endres, 2010, p. 167-170). Conclusion In conclusion, the Bretton Woods system collapsed as a result of three major factors: divergent responses by different countries to its requirements, the rigidity of its recommended measures of correcting account imbalances in the face of changing international financial relations and failure of the United States to maintain a responsible fiscal and monetary economic environment by increasing its social expenditure after the Vietnam War. These factors caused an unprecedented appreciation of the value of major European currencies as many countries failed to support the dollar, causing the real value of gold to appreciate against the dollar. Also, many countries were forced to resort to correctional measures, which had been discouraged by the system in the first place, as a trade-off for increased wage bills. The current international monetary relations are shaped with two realities: increased capital flows and globalisation. The contemporary system is shaped to reflect these changes in the management of global financial relations. The choice of an exchange rates regime is now the prerogative of member countries. Additionally, the IMF has shifted its primary responsibility to focusing on offering technical assistance to developing countries as well as advising them on the process of opening up their economies to global capital. References Buckley, R. P. (2009). The international financial system: Policy and regulation. 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