The Bretton Woods Agreement - Term Paper Example

 «International Business» 2010 INTRODUCTION The construction and implementation of the Bretton Woods monetary system represented the most comprehensive attempt in history to establish stability in what would become, by design, an evermore integrated world economy. Although efforts to design the system started as early as 1940, it was not until July of 1944 that representatives from forty-four countries converged on the pristine hills of New Hampshire to hammer out the agreement (Scammel, 1975:iii). Though the visions of the participants may have differed, perhaps significantly, each sought to lay the foundation for a system which would provide exchange rate stability, facilitate full currency convertibility, provide the means for smooth balance of payments adjustment, and foster the opening of world markets. In what was, arguably, an unprecedented level of cooperation and coordination, delegates from participating countries constructed and ratified a set of agreements which would define postwar monetary and trade agreements , thus shaping the course of world economic history for decades to come. This paper aims to provide an analytical review of the Bretton Woods system, its consequences and how world monetary system has been transformed after its dissolution. BRETTON WOODS SYSTEM AND NEOLIBERAL REGIME Bretton Woods system can be characterized as the international monetary regime based on stable and adjustable exchange rates, which were not permanent but allowed the application of occasional devaluations of individual currencies in order to correct fundamental disequilibria in the balance of payments (Burnham, 2003). On a global scale, countries-participants of this regime – which included the United States, Japan, Great Britain, Italy, France, Germany, Spain, Belgium, Greece, Switzerland, Denmark, Finland, and the Netherlands, - were submitting their exchange rated to international disciplines, in this manner surrendering their national sovereignties to international organizations (Burnham, 2003). Practically, Bretton Woods regime effectively replace an obsolete gold exchange standard, its deflationary impact and chronic balance of payments deficits, resolving in this manner the problems of the states. Neoliberal economic regime, that eventually replaced Bretton Woods system, emphasized that markets react to individual needs through price mechanisms and therefore fulfill individual needs better than the public sector (Harney, 2007). The tools of the neoliberal regime consist of mechanisms like liberalizing markets, privatization of public institutions, outsourcing and contract bidding, stricter expectations on returns, tax cuts benefiting the wealthy, cutting back public expenses, international free trade, strengthening and expanding private ownership with international treaties and acceptance of the rule of the global money markets (Harney, 2007). Basically the idea is to reduce the size and the strength of the public sector while increasing the sphere of the markets. Ideologically, private ownership is at the core of liberalism as advocated by both John Locke and Adam Smith. “The works of a number of scholars, many associated with the economics department at the University of Chicago, with their strong preference for the market over the dictates of the state, can be seen as providing the intellectual basis and inspiration for the privatization movement,” explains Suleiman (2003:97). The idea is to first, reduce the size of the public sector, and secondly make the remnants of “public sector operate more like the private sector” Suleiman, 2003:124). These ideas originated within the international context, “in the international community of think tanks, experts, and academics in disciplines such as economics, accounting, business, management, and administration” that “has played an important role in transmitting and informing about ideas and practices” (Suleiman, 2003:53). Organizations such as the OECD and the World Bank have held a key role in advocating these ideas around the world. As a result, “it is probably fair to say that never before have governments and administrations across the world been so intensely aware of the way new governments and administrations function (Suleiman, 2003:153). BRETTON WOODS AGREEMENT: EXCHANGE RATES AND EXCHANGE RATE SYSTEM The Bretton Woods Conference began three decades of extraordinary growth and prosperity, giving birth to an “economic miracle” in Europe and Japan and impressive, if slightly lower, rates of growth in North America (Hunt, 2002). Bretton Woods was more than simply the launching pad for a postwar boom, however. As one economist described it: “What was Bretton Woods about if it was not the creation of a world in which countries did not close their eyes to the repercussions of their actions on others?” (Solomon, 1982:13) There was more to it than that. Bretton Woods meant more than recognition of the effects of policy on others. Louis Rasminsky, Governor of the Bank of Canada, comes closer to the mark: "Something very important happened at Bretton Woods in 1944, and that was that the world consciously took control of the international monetary system" (Solomon, 1982:13). The Bretton Woods Conference realised an elusive goal: orchestrating and formalising cooperation among the world’s economic powers (Hunt, 2002). That, ultimately, is Bretton Woods’ legacy. The agreements signed in 1944 created the world’s first fully-negotiated system of laws and institutions for governing the international economy (Van Dormael, 1978:16). Though they may have been flawed, their vision of mutual responsibility and emphasis on cooperative management of the international economy not only lasted, but also continues to shape international economics. However, the Bretton Woods system - good intentions, high ideals, and all - did not last. In order to understand the postwar international monetary system, its function, and ultimate demise, one must start with its origins and examine the currents of economic and political thought that gave rise to Bretton Woods. Characteristics of Bretton Woods Regime The financial system created during Anglo-American wartime negotiations and ratified at Bretton Woods represented a departure from both the “classical” 19th century gold standard and that of the interwar period in three fundamental ways (Eichengreen, 1996). It was clear that gold would have a role in the postwar international monetary system. Indeed, the structure of the IMF reflected this in that twenty-five percent of a country’s subscription to the Fund was to be in gold. The role of gold, through its ties with the dollar, though, turned out to be much more. Although not stipulated in the Bretton Woods Agreement Act, the U.S. Treasury pegged the price of the dollar at $35.00 per ounce and actively supported this by freely buying and selling gold on the open market. Because of the decline of sterling as the key currency and the concomitant rise of the dollar, each currency was directly tied to the dollar and indirectly tied to gold (Wild et al, 2010; Bordo, 1992:31). Thus the gold-dollar exchange standard tied the system to gold because of the willingness of the United States to defend the dollar price of gold and the fact that countries pegged their currencies to the dollar. The switch from an adjustable peg to a de facto fixed exchange rate regime can be attributed to several determinants. On December 18, 1946, the Fund announced the official par values of the thirty-two countries who had signed the Bretton Woods Agreement (Scammel, 1975:29). This was significant not only because this represented the first time countries had jointly announced their exchange rates but also because the Fund essentially accepted any par value the countries suggested. This allowed countries to declare a par value higher than what they expected to be durable, thus allowing them to enter the transition with increased purchasing power from their export earnings and existing reserves (Eckes, 1975:226). The inability of Britain to defend its par value resulted in a 30% devaluation in 1949, which prompted thirty-one other countries to devalue their currencies shortly after Britain did (Van Dormael, 1978:26). This in turn prompted the United States to actively promote European convertibility through the establishment of the European Payments Union. With realigned, and arguably more realistic, par values, the stage was set for the establishment of de facto fixed rates. The first departure of “classical” 19th century gold standard was an allowance for changes in exchange rates during periods of “fundamental disequilibrium,” and from the critical standpoint it was the least novel and, arguably, the least important departure. Though exchange rates could be altered, Bretton Woods ultimately functioned as a fixed-rate system (Wild et al, 2010, Scammel, 1975). Countries were required to declare a par value for their currencies and hold their exchange rate within 1 percent on either side of par. Margins were even narrower in practice. The majority of European nations and Japan held their rates within a range of three-quarters of one percent on either side of par (Scammel, 1975:31). Devaluation and re-valuation were extreme measures, available only in periods of duress - as “fundamental disequilibrium” suggests. Understanding Why Bretton Woods Was Implemented: Pre and inter-War economic period From the critical perspective, that the Bretton Woods system was designed to operate using fixed rates is little surprise. Fixed rates were never seriously challenged in the minds of either Bretton Woods’ architects or their contemporaries (Eichengreen, 1996; Wasserman, 2010). They represented simply the best and most stable foundation on which to construct a monetary and trading system. The world’s experience with “free floating,” the franc’s float between 1924 and 1926, provided a damning indictment of unpegged currencies. To quote one interwar economist: The post-war history of the French franc up to the end of 1926 affords an instructive example of completely free and uncontrolled exchange rate variations. ... The dangers of...cumulative and self-aggravating movements under a regime of freely fluctuating exchanges are clearly demonstrated by the French experience. ... Self-aggravating movements, instead of promoting adjustment in the balance of payments, are apt to intensify any initial disequilibrium and to produce what may be termed “explosive” conditions of instability (Eichengreen, 1996, p.51). In the minds of economists who lived through and studied the 1920s, floating rates were forever associated with “explosive” instability (Eichengreen, 1996). The managed floats of the 1930s did little to assuage economists' fears regarding floating rate systems. Indeed, they created new ones as managed parities evolved into competitive devaluations. To quote one economic historian, “In the discussions preceding Bretton Woods, the fear had been that countries would repeat the experience of the 1930s and engage in competitive devaluation for price advantage in export markets” (James, 1996, p.99). The lesson was evident: even controlled exchange rates were liable to manipulation and thus conducive to disorder. Interwar experience with floating and freely adjustable exchange rates thus served to reinforce the desire to return to fixed rates. For many, the interwar years proved not only the wisdom of fixed rates, but also of the importance of gold as an anchor for those rates. According to Eichengreen (1996), “A ‘sound’ currency and domestic gold convertibility were indistinguishable and formed the basis of public opinion regarding currency matters” (Eichengreen, 1996, pp.57-58). Even as interwar currency instability drove the architects of the Bretton Woods system to seek security in the stability of fixed exchange rates based on gold, their experience with the economic dislocations of the interwar period taught them the importance of adjustment mechanisms. During the 1920s and 1930s, European economies suffered terrible deflationary spirals caused by rises in their central bank discount rates designed to preserve fixed currency values (Scammel, 1975). The political and economic costs of the dislocations that resulted were enough to convince planners of the need for a mechanism that would allow the international monetary system to survive shocks without compromising economic performance. The adjustable peg was to be that mechanism. By limiting changes in pegged exchange rates to periods of “fundamental disequilibrium,” Bretton Woods’ architects believed they had found a compromise between the destabilising effects of freely-floating (or frequently altered) exchange rates and the creation of a system whose rule-bound rigidity prevented it from effectively responding to financial crises (Hunt, 2002). States would be allowed to alter their exchange rates only during times of trouble, thereby providing them a way to eliminate their payments deficits without burdening their domestic economies (Wild et al, 2010). Though the nature of “fundamental disequilibrium” was never clearly defined - or “never defined in fewer than ten pages” (Eichengreen, 1996) - the ability to change par values was a nevertheless a significant concession to interwar economic and political thought. Bretton Woods’ second departure from the classical gold standard was related to the first. The Articles of Agreement permitted states to employ capital controls in order to maintain their balance of payments without central bank intervention (Van Dormael, 1978). This, too, was a product of interwar experience, as economists came to see volatile capital flows as a threat to both national economies and the international monetary system in the 1930s and 1940s (Van Dormael, 1978). The League of Nations took the lead in researching the effects of capital flows on the international economy as part of its effort to better understand the Great Depression (Scammel, 1975). The “favorite villains” of 1930s economic literature - an uneven distribution of gold, the gold sterilising policies of the Federal Reserve and Bank of France, excessive inflation, and structural weaknesses in the major industrial centers - were, they believed, secondary actors (Van Dormael, 1978). Volatile short-term capital flows were the primary cause of the collapse. League economists argued that “hot” money flows destabilised the system by making it impossible for states to pursue stable monetary policies and continually threatening the stability of fixed exchange rates, making governmental attempts at fiscal stabilisation highly hazardous. In his analysis, Ragnar Nurske (1944) epitomised this view: “In the absence of international reserves large enough to meet such speculative and often self-perpetuating capital movements many countries had to resort to exchange control and other less insidious means of correcting the balance of payments. ... But, if owing to anticipated exchange adjustments, political unrest or similar causes, closer control of hot money movements is inevitable, the sum of its difficulties and dangers might be overcome by international understanding” (220, 222). If “hot money,” volatile (some said “irresponsible,” others “wasteful”) flows of capital were the cause of interwar instability, any successful future system would need a means of controlling them. To quote Keynes: “There is no country which can, in future, safely allow the flight of funds for political reasons to evade domestic taxation or in anticipation of the owner turning refugee. Equally, there is no country that can safely receive fugitive funds, which constitute an unwanted import of capital, yet cannot safely be used for fixed investment” (Keynes quoted in Moggridge, 1992, p.673). The solution was simple and uncontroversial. Capital controls were to be permitted and even encouraged in the new international monetary system. INSTITUTIONAL CHANGES OF THE BRETTON WOODS SYSTEM Bretton Woods’ third, and final, departure from the gold standard was both the most radical and the most promising. It was nothing less than the creation of a supranational authority, the International Monetary Fund (IMF), designed to monitor national economic policies, sanction governments whose policies destabilised the system, and extend financing to countries experiencing balance-of-payments difficulties (Wild et al, 2010). The belief in a tenable international organisation that would watch over and even direct the international economy was a direct result of both the very public failure of economic cooperation during the interwar years and the tremendous success of Allied wartime collaboration. The primary purpose of IMF was to secure international monetary stability among its member countries. Another institution created by the Bretton Woods agreement was the World Bank, the function of which was to to provide long-term loans for postwar reconstruction in Europe and through its division, International Bank for Reconstruction and Development (IBRD) support economic development in the rest of the world. The creation of these two fundamental institutions have been further enhanced with the General Agreement on Trade and Tariffs, the primary purpose of which was to promote world trade integration through the continuous reduction of tariffs. IMF, the World Bank and GATT replaced by the WTO eventually played significant role in economic and political globalisation of the world (Sterling-Folker, 2002). From the critical perspective, at least in principle, the Bretton Woods system’s three departures from the classical gold standards were designed as complements to one another (Van Dormael, 1978; Wasserman, 2010). Pegged rates were intended to prevent competitive currency devaluations designed to improve a country’s trade position (Wasserman, 2010). Capital controls, in turn, were incorporated in order to protect pegged rates against disequilibrating capital flows, while the IMF’s resources were to be used as a supplement to capital controls in the fight to maintain currency values (Van Dormael, 1978). IMF surveillance completed the triangle, providing objective information on and allowing members to act against the unfair monetary policies of others (Wasserman, 2010). In sum, it was a system designed to satisfy both the economic and political visions of the period in which it was constructed. Bretton Woods sought not only to prevent another Great Depression, but also to avoid the sacrifice of national economic goals to external demands (Burnham, 2003). In attempting to fashion a compromise between these goals - between national autonomy and a monetary system that operated automatically Bretton Woods’ architects would undermine the system’s mechanism of adjustment, creating a flaw in the system's character that would help bring about its demise (Sterling-Folker, 2002). THE BREAKDOWN OF THE BRETTON WOODS AGREEMENT Economic analysts and historians suggest that despite the plethora of determinants of the Bretton Wood system collapse, the loss of confidence in the United States’ ability to maintain dollar-gold convertibility is considered one of the main contributory factors (Wild, 2010). The pound crises occurred in the 1960s, specifically in 1964 and 1967, had a substantial influence of the US dollar. Investors believed that once the exchange rate stability was broken by a British devaluation, other countries – especially the US – would be tempted to follow the example. When the US trade balance deteriorated in the last quarter of 1967 in the face of a continued deficit in the capital account, traders and investors moved out of the dollar and into gold in anticipation of devaluation (Johnson, 1982). Government rallied to support the dollar. To curb the gold rush, they coordinated their sales of gold and purchases of dollars and temporarily stablised the exchange rate. Gold purchases declined briefly in early 1968, when President Johnson had introduced a set of capital controls to curb outflows of capital by businesses and financial institutions (Stein, 1994). Higher interest rates helped that the capital account countered the deterioration in the current account. However, imports into the US continued to increase and the trade balance deteriorated, leading to a dollar crisis in early March in 1968. Investors and speculators continued to pressure the US, and gold purchases were made of up to $1.6 billion (Kane, 1983:17). The gold-pool members reduced their gold-holdings by $3.6 billion between September 1967 and March 1968. US holdings fell by $2.4 and those of Britain by $340 million. Reforms of the gold market had been discussed since 1967 (fueling gold rush). The enormous loss of total reserves in the US (the other countries only had a change rather than decline in the composition of their reserves) in early 1968 hastened the agreement on the establishment of a two-tier gold market (Solomon, 1982:114). In the summer of 1971, the US trade balance moved from a surplus of $160 million in March in to a deficit of $165 in June (Johnson, 1982:115). In August, France announced that it planned to purchase $191 million of gold from the US to pay back an IMF loan. At the same time a US Congressional Subcommittee came out with the Reuss report, which argued that nothing but a realignment could improve the US balance-of-payments position (Solomon, 1982:181-184). This resulted in a flight from the dollar. During the following week, international dollar reserves increased by $3.7 billion while the US international reserves declined by $1.2 billion (Kane, 1983:19). By August 15th, it was evident that the dollar could not be stabilised. US President Nixon announced the suspension of the dollar’s convertibility into gold and imposed a 10 percent surcharge on imports (Stein, 1994). The Bretton Woods regime had collapsed. The next dollar crisis was twelve months after the Smithsonian Agreement came in force. The crisis began in early 1973 when the Swiss franc allowed its currency to float after it had hit its upper intervention point against the US dollar and intervention in the foreign exchange markets could not reverse capital inflows. With more and more countries floating their currencies, foreign exchange traders saw the Smithsonian Agreement weakening. When it was announced in February 1973, that the US current account deficit had increased more than expected to $9.7 billion, a flight from the dollar set in. In the beginning of February 1973 the G10 countries purchased $10-12 billion dollars to stabilise the dollar and it was without success (Johnson, 1982:122). On February 12th the US President asked Congress to authorise a 10 percent devaluation of the dollar. This did not stop the capital outflows. Because of the dollar flight and governments’ unsuccessful attempt to stabilise its peg with billions of dollars, the foreign exchange markets were closed, and when they opened again the major currencies were floating against the dollar. CONCLUSION The dilemma facing the G-10 countries in 1971 was the Bretton Woods system had grown obsolete. Absent a working mechanism for the adjustment of exchange rates, Bretton Woods as it was practiced could not function in a world in which the asymmetries that shaped its growth no longer existed. A more symmetrical system was needed as Europe and Japan enjoyed ever-greater economic and political strength. Bretton Woods system has been gradually replaced with neo-liberal international economic regime that favored symmetrical development of the world, fostered internationalization and finally led to globalisation of the world economies. Nevertheless, Bretton Woods had left a significant legacy. While the system was “officially” dissolved in 1973 when the dollar was allowed to float, the two institutions created in the Bretton Woods Agreement Act - the International Monetary Fund and the World Bank - survived and remain a vital part of international trade and monetary arrangements to this day. Scarcely any country experiencing balance of payments problems, financial crisis, or development problems can escape the prescriptive strings attached to funds disbursed by these institutions. It is no secret to world leaders, and indeed potential borrowers, that the IMF “seal of approval” is a veritable prerequisite for the flow of both public and private funds. REFERENCES Bordo, M. D. 1992, The Bretton Woods International Monetary System: An Historical Overview. National Bureau of Economic Research, Inc. Working Paper No. 4033, Cambridge MA Burnham, P. 2003. Remaking the Postwar World Economy: Robot and British Policy in the 1950s, Palgrave Macmillan Eckes, A. E. 1975. A Search for Solvency: Bretton Woods and the International Monetary System. 1941-1971. Austin and London, University of Texas Press. Eichengreen, B. 1996. Globalizing Capital: A History of the International Monetary System. Princeton: Princeton University Press. Hunt, E. K. 2002. History of Economic Thought: A Critical Perspective. Armonk, NY: M.E. Sharpe. Harney, D. 2007. A Brief History of Neoliberalism. Oxford University Press Johnson, R.B. 1982. The Economics of the Euro-Market. History, Theory and Policy. New York: St. Martin’s Press James, H. 1996. International Monetary Cooperation Since Bretton Woods. New York: Oxford University Press. Kane, D.R. 1983. The Eurodollar Market and the Years of Crisis. New York: St. Martin’s Press Moggridge, D.E. 1992. Maynard Keynes: An Economist’s Biography. New York: Routledge. Nurske, R. 1944. International Currency Experience: Lessons of the Inter-War Period. New York: League of Nations. Scammel, W. M. 1975. International Monetary Policy: Bretton Woods and After. New York: John Wiley and Sons. Stein, H. 1994. Presidential Economics: The Making of Economic Policy from Roosevelt to Clinton, 3rd Revised Edition. Washington, D.C.: American Enterprise Institute for Public Policy Research. Sterling-Folker, J. 2002.Theories of International Cooperation and the Primacy of Anarchy: Explaining U.S. International Monetary Policy-Making After Bretton Woods. Albany, New York: State University of New York Press. Solomon, R. 1977. The International Monetary System, 1945-1976. New York: Harper & Row. Ezra Suleiman. (2003). Dismantling Democratic States, Princeton: Princeton University Press Van Dormael, A. 1978. Bretton Woods: Birth of a Monetary System. New York: Holmes & Meier Publishers, Inc.. Wasserman, A. 2010. Two Sides to the Coin: A History of Gold. CreateSpace Wild, J., Wild, K., and Han, J. 2010. International Business: the Challenges of Globalization, fifth edition, Pearson, New Jersey Read More