The Bretton Woods Agreement of 1944 - Term Paper Example

Topic: Provide a brief summary and a basic timeline of the international monetary arrangement that came into being with the Bretton Woods agreement of 1944. Why was the agreement instituted? What purpose did it serve? Why did it collapse? The Bretton Woods Agreement came into existence through the United Nations Monetary and Financial Conference held at the Mount Washington Hotel, located in Bretton Woods, New Hampshire to control the world of monetary and financial order after the end of World War II. The conference was attended by 730 delegates from 44 Allied nations from 1 July to 22 July 1944 to sign agreements for the establishment of International Bank for Reconstruction (IBRD, the World Bank), the International Trade Organization (ITO), and the International Monetary Fund (IMF). A system of exchange rate management was deployed, which was working till 1970. Currency conversion was mandatory by the member countries of the agreement, which became functional only in 1959, culminating in the setting of IMF and IBRD. As per the agreement, the member nations needed to consult one anther to reach a unilateral decision on global monetary developments, impacting the economies of all nations. The purpose behind the creation of IBRD was to take quick action for post-war reconstruction, to reach political stability, and promote peace through making of programs for reconstruction and development . Thus, the major industrial nations of the world came closer by framing rules for introducing a system of monetary functions of businesses among the allied powers of the World War II. By 1945, the IBRD an associate of World Bank Group currently and IMF started functioning after the ratification of the agreement by a good number of member countries. As per the agreement, in each member country’s monetary policy it was mandatory to maintain the exchange rate of its currency around a fixed value with the flexibility of 1 percent up or down against gold. It was essential to clear the imbalances in payments by the IMF. The system couldn’t work beyond 1971 due to increasing financial glitches and one-sided termination of conversion of dollar into gold by the United States. This action of the United States created furors in the international economy, and a new situation surfaced making the dollar “reserve currency” for the member nations that signed the agreement . Why was the Agreement instituted? The worldwide depression of the 1930s and the Second World War compelled the governments of leading nations to organize an economic summit. It was a common perception that trade barriers and high costs of the goods had created depression in the world economy, at least to some extent. Nations used to practice currency devaluation to encourage imports by the neighboring countries and adjust their balance of payment issues. As this practice was randomly continued, it produced negative repercussions in the form of deflation, unemployment, and diminishing world trade. Use of currency was not a viable option as was analyzed from the affects of the 1930s depression. The whole economic scenario was well analyzed by Cordell Hull, the U. S. Secretary of State from 1934 to 1944, as he wrote: “Unhampered trade dovetailed with peace; high tariffs, trade barriers, and unfair economic competition, with war... If we could get a freer flow of trade ... so that one country would not be deadly jealous of another and the living standards of all countries might rise, thereby eliminating the economic dissatisfaction that breeds war, we might have a reasonable chance of lasting peace” (Wiggin, 2006). The root cause of any war is always economic, as also remarked by Hull after observing the positions of Germany and Japan in the wake of 1930s depression. The U.S. wanted to put a stop to the economic progress of Japan, which might have been a reason of Japan’s aggressiveness. Otherwise too, countries didn’t share strong economic relations, as is the practice now-a-days (Wiggin, 2006). Before the institution of the agreement, during the 1930s the currency rates of major economies dwindled besides a number of states applied restrictive trade policies. In the 1940’s starting years both America and Britain made proposals for the structuring of a new global financial organization that would help in providing stability in exchange rates and promote trade worldwide. Other than that, need of reorganizing the whole of Europe was identified to face the economic after-effects of First World War. The token of it was a loan of $250 million awarded to France in 1947 by the World Bank – the first act to amend the deteriorating economy of France . According to Griffin (2006), the Bretton Woods Agreement was instituted also because each country knew that war was not the right solution to the economic problems surfacing the countries. So that future wars could be avoided due to economic reasons, reforms have to be made by taking a start on economic issues. The United Sates was the leading nation to host the discussion on the agreement, as it was an economic power least affected by the war. No war was fought on its soil; on the other hand, it solidified its economic strength by selling weapons to the allied forces. What purpose did it serve? The purpose of the Bretton Woods Agreement was to prohibit competition in currencies and develop business cooperation among member states. Supporting member nations of the Bretton Woods Agreement had the view that the stable exchange rate would discourage the “beggar thy neighbor” policies of 1930s and boost international trade. But exchange rates could not remain competitive due to changes in currencies’ rates. Other than that betting over the fixing of exchange rates it resulted in large scale movements of currencies. It was also felt that a fixed exchange rate was a hurdle in the way of pursuing independent monetary and fiscal policies by the member states of the Bretton Woods Agreement. Canada, for example, had been maintaining a per value with the US dollar but in a span of three years the Canadian dollar revalued in 1946 and devalued in 1949. The fixed exchange rate was found unfit for the economy. In 1950, Canada adopted the floating dollar and returned back to the fixed exchange rate after 12 years. It was a lesson to be learnt by other member nations. Everything didn’t happen as per the plan envisaged in the Bretton Woods Agreement. The US Congress withdrew support for the setting of the International Trade Organization; it was created later in 1947 by another name of the General Agreement on Tarrifs and Trade (GATT) to be signed by 23 nations including Canada. It was later known by the name of World Trade Organization . According to Braithwaite and Drahos (2001), a number of related problems that were reason to the birth of the Bretton Woods Agreement included among others deficiency of gold, exchange rate instabilities, the circulation of “hot” money in and out from the system, and the deficiency of a mechanism to fix balance of payment problems. The purpose behind the organization of IMF was to overcome short-term liquidity crises by the new system. The role of the World Bank was economic and industrial rebuilding of Europe and assist developing countries in rapid industrialization. The ITO was created to promote free trade and discourage states to opt the road to protectionism to avoid balance of payment problems by regulating import and devaluing the currency. The formation of ITO never materialized due to US concerns. In stead GATT was instituted to in the post-war period to control taxes but it lacked regulatory mechanism, as coordination of tax policies among member states were never discussed; it was left to the control of the member states. Why did it collapse? It was not (Wiggin, 2006) that the whole system collapsed; some part of it didn’t function as anticipated. It was not adhering to rules of cooperation for converting the dollar into gold and the exchange rate mechanism. The US dollar being the reserve currency, all countries wanted the US dollar to fulfill their trade requirements; the US also showed trade deficit to provide sufficient liquidity in the financial markets. But the problem arose when the US wanted to negate its deficit in balance of payment. It caused shortage of liquidity, creating crisis of the currency. Such a situation had been predicted by the economist Triffin in 1960 in Gold and the Dollar Crisis, New Haven CT. In the case of America maintaining deficit, other nations would lose confidence in dollar as a reserved currency. They would opt for converting their dollars into gold. Due to the Vietnam War, the US had to pay its debt, letting the balance of payment to remain in deficit. The other nations started converting their dollars into gold as the confidence in the credibility of dollar started diminishing. It triggered the US reaction by declaring in August 1971 that it was suspending the arrangement of converting the dollar into gold. Wiggin (2006) has tried to reach the depth on the reasons of the collapse of the Bretton Woods Agreement. The most curious fact of the Bretton Woods Agreement was that all member states agreed to follow the gold as a standard for worldwide acceptance. It was agreed that all member states would adhere to regulating their currency at near about value of gold. The organization of the IMF was to facilitate payment of difference as a short term alternative. The great thing is that the system worked for 25 years but there were some wrong assumptions. It was pegging dollar to gold at $35 an ounce. It didn’t take into account gold’s real value since 1934 when it was fixed to the rate of $35. The purchasing power of the dollar had decreased to a great extent due to the Second World War. With the strengthening of the European economies, the US gold reserves were not sufficient to match the requirement, which proved fatal for the long life of the Bretton Woods Agreement. The issue was also highlighted by a former senior vice president of the Federal Reserve Bank of New York thus: “From the very beginning, gold was the vulnerable point of the Bretton Woods system. Yet the open-ended gold commitment assumed by the United States government under the Bretton Woods legislation is readily understandable in view of the extraordinary circumstances of the time. At the end of the war, our gold stock amounted to $20 billion, roughly 60 percent of the total of official gold reserves. As late as 1957, United States gold reserves exceeded by a ratio of three to one the total dollar reserves of all the foreign central banks. The dollar bestrode the exchange markets like a colossus.” The above statement shows a rosy picture of the gold reserves with the U. S. but in the year 1971, the U.S. faced speedy downfall in its gold reserves and withdrew its currency commitment with gold, resulting in the dead end ahead, as the Bretton Woods Agreement didn’t work anymore. The theme behind the formation of the agreement was economically powerful United Nations (Wiggin, 2006). At the time when the Bretton Woods Agreement came into force, the position of the United States was very strong, as it possessed 80 percent of the gold reserves of the world. It was a win-win situation for the U.S. if gold was used a standard for world currencies and it promoted free trade among nations. Gold proved its mettle by remaining over 100 years its standard by all – the central bank, government, and business groups. It permeated the economic scene by becoming the catalyst of currency exchange. Exchange rate among the nations was fixed. The supply of money revolved around gold reserves. Deficiency of gold was compensated by borrowing money for developing businesses (Wiggin, 2006). Trading whether surplus or deficit reached to zero balance, as accounts were finalized in gold; credit was also negligible. The pegged rates when the values of both currency and gold are in equilibrium helped in running the policy wisely on the basis of a country’s productivity and gold reserves. At the Bretton Woods, the pegged rate was finalized by the major economically powerful nations. In practice, the U.S. dollar acquired the place of gold and the member countries started pegging their currencies with the dollar than the value of gold. Thus, the Bretton Woods Agreement resulted in replacing gold with the U.S. dollar. Because value of gold to dollar was kept at $35 an ounce by the United States, for the time being it functioned perfectly. It was common practice to convert dollar to gold and member countries pegged their currencies to dollar, which degraded the standard of gold by creating a pseudo-gold standard (Wiggin, 2006). John Maynard Keynes, the British economist and the representative of Britain at the Bretton Woods was against any such practice related to pegging of gold. According to Keynes, the purpose of the conference was “to find a common measure, a common standard, a common rule acceptable to each and not irksome to any.” The debate was over preference to economic growth, as proposed by Keynes over price stability, which was the preferred choice of the U.S. as presented by its representative, Harry Dexter White. It left no choice for the third world countries to attain economic growth via the IMF, given the responsibility of checking trade deficit and save currency from further devaluation. Under the agreement, no provision was made for keeping reserves. It was taken for granted that gold production would be enough to fund growth and short term issues would be settled via borrowings. The U.S. reserves were more than sufficient and increasing while institutions like IBRD were unable to solve the post war economic issues. As conditional to joining the IMF, each country was supposed to provide funds to the tune of $8.8 billion, a trade margin to support he global effort. Differences in payments were supposed to be supervised via a number of borrowings. Thus, IMF worked like a centralized bank to fulfill the financial obligations of the member countries. In the meantime the U.S. launched the European Recovery Plan known by the name of the Marshall Plan to provide grant to the countries in need of funds for growth. In the opinion of the American Secretary of State George Marshall, the issues at stake for the western nations, “are so much greater than her present ability to pay that she must have substantial help or face economic, social, and political deterioration of a very grave character" (Wiggin, 2006). The U.S. played its role of leader quite well by giving $17 in help to 16 Western European countries between 1948 and 1954. It was expected by the U.S. that the old enemies Germany and Japan would open their markets for U.S. exports. It formulated new policies as per the new environment encouraging economic growth. Unfortunately, the Cold war between the USSR and the U.S. became hotter than before, as the USSR withdrew from participating in IMF. It resulted in strife between capitalism and communism on the world platform (Wiggin, 2006). Pegging the U.S. dollar to $35-per pound became difficult, as open market of gold in London affected the gold value. A difference of 5 dollar per ounce appeared in the gold value between central banks and open market, which shook the faith of the U.S. leaders in the gold standard. Later on March 17, 1968 the London Gold Pool was shut down due to a run on gold. The need was felt to change the monetary system or to review the gold standard. It was debated by the then President Lyndon B Johnson in 1967 that “The world supply of gold is insufficient to make the present system workable - particularly as the use of the dollar as a reserve currency is essential to create the required international liquidity to sustain world trade and growth" (Wiggin, 2006). The Special Drawing Rights (SDRs) set up with the purpose of trading among nations couldn’t stop the pressure on the U.S. and its gold reserves went on depleting till 1971. At that time, the U.S. dollar got overvalued to gold reserves. One major drawback of the Bretton Woods Agreement was absence of a system to check reserve growth. The production of gold was not up to the needs and SDRs success was doubtful in the long run. The Bretton Woods Agreement collapsed with the U.S. going off the gold standard, reason being the U.S. and other nations couldn’t fund gold standard, which fell short on economic growth needs. Currency systems not pegged to gold collapsed the Bretton Woods Agreement completely. Works Cited Braithwaite, John & Drahos, Peter. “Bretton Woods: birth and breakdown.” Global Business Regulation. April 2009. 25 November 2009. Pp.97-101. . “Bretton Woods system.” 25 November 2009. . “Event 1944 – Bretton Woods Agreement: developing a new international monetary system.” 25 November 2009. . “United Nations monetary and financial conference: Mount Washington Hotel.” 25 November 2009. . Wiggin, Addison. “Bretton Woods Agreement.” The Daily Reckoning. 29 November 2006. 25 November 2009. . Read More