Assessment of the Bretton Woods Fixed Exchange Rate System - Essay Example

Money & Banking – an assessment of the Bretton Woods Fixed Exchange Rate System Introduction: Money is omnipresent. Modern society cannot run without it. We cannot think of a society today which can do away with money. Money has changed its form with timekeeping in tune with the different stages of development of the society. Money performs a number of functions and its importance lies in the fact that it acts as a medium of exchange, as a unit of account, as a standard of deferred payments and as a store of value. “Money has been a source of fascination to professionals from numerous fields of learning, and has been written about by anthropologists, philosophers and social historians besides economists. Economists themselves have considered diverse aspects of money such as the reasons for its existence, changes in its form, and its role in the economic prosperity and development of people and nations (ICFAI Center for Management Research (ICMR), 2005).” Money occupies a central place in a modern society. Money provides innumerable benefits in our day-to-day lives. In the classical theory, money played an insignificant role as it had no causative influence on the economy. In the opinion of classical theorists, money was purely confined to medium of exchange and related itself to economic activity. Money was used as a technical instrument to overcome the complexities involved in barter system. There was strong opinion that money was a passive element, which was used to help in the process of exchange. Contrary to this, in modern economics money plays a significant and an active role. Modern economists emphasize that the most important function of money is to regulate the general economic activity and to promote the wealth and welfare of a country’s economy. It further explains how money influences production, consumption and distribution. Thus, the institution of money is considered to be an efficient instrument contributing to economic prosperity of a country. Exchange Rate Mechanism – an overview: Due to the advent of globalization, financial markets are getting integrated with the passage of time, and people and firms are entering into more and more cross-border financial deals. In order to make these transactions feasible, a system for determination of the amount and method of payment of the underlying financial flows is needed. Since the domestic currencies of the parties involved will be different, the flows will take place in some mutually acceptable currency. The parties involved will then need to convert the amount involved into their domestic currencies. The set of rules, regulations, institutions, procedures, practices and mechanisms which determine the rate at which this conversion takes place and this rate of conversion is defined as the Exchange rate and the movements in the exchange rate over a period is called the international monetary system. This system forms the backbone of all cross-border transactions because it makes the settlement of international payments into one another and the transfer of funds across nations, which becomes possible due to the existence of the international monetary system. These transactions may be on account of international trade in goods or service, or due to acquisition or liquidation of financial assets, or because of creation or repayment of international credit. By making all these possible, a smoothly running international monetary system contribute to a more efficient utilization of world resources. The Bretton Woods Fixed Exchange Rate System The Second World War effectively stopped all international economic activity. Global economic growth was severely affected. On one hand, the warning nations suffered huge damages on account of the war, and on the other hand, most of the countries were suffering from hyper-inflation ((ICMR), 2003). The continuing war also made any co-operation on the economic front impossible. In this scenario, the need was felt for an economic system which would again make international trade and investments possible. For this, a system of stable exchange rates was required, which would also ensure that the countries do not get any incentive by following inflationary policies. Also required, was some arrangement which would help countries to tide over their short-term balance of payments problems and help them remain within the system without causing undue turmoil in their economies. Following the First World War, many nations tried to restore the gold standard exchange rate system (U.S. Department of State, 2008). But their attempts were in vain because of the Great Depression that occurred in the 1930s. “According to the view of many economists, following the gold standard system prevented monetary authorities from expanding the money supply (U.S. Department of State, 2008).” In the year 1944, representative of 44 countries met in Bretton Woods, New Hampshire, USA, and signed an agreement to establish a new monetary system which would address all these needs. This system came to be known as the Bretton Woods System. The above mentioned conference that was held at Bretton Woods was the result of two and half years of effort and planning by the Treasuries of both United Kingdom and the United State of America for reconstructing the monetary system after the Second World War (Routledge Encyclopedia of International Political Economy , 2004). The major framework for the evolution of the Bretton woods System was actually designed by two important economists of the time. They were the American minister of state in the U.S. treasury, Harry Dexter White, and the British economist John Maynard Keynes (Dammasch, 2006). Since its evolution, the United States of America has been the dominating power of the Bretton Woods System. The scenario is the same even today. The reason for this kind of dominance was that the United State of America was the country with the biggest economic potential and capability in the post war period. The purchasing power of the US dollar was astoundingly high and also it was the one and only currency which was backed by gold. In addition to this, all the European nations ended up in great debt after the Second World War and as a result they transferred huge amounts of gold to the United States of America. Even this aspect added to the supremacy factor of the United States, which has already stated was a dominant power. The main terms of the agreement arrived at were as follows: Two new institutions were to be established, namely, the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD). IBRD is otherwise called as the World Bank. IMF was supposed to be more important and powerful than the World Bank. It was decided that the member countries would meet under the aegis of this institution and together take a decision on any important thing which might affect the world trade or the world monetary system. Hence, co-operation and mutual consultation was built into the system in order to avoid the universally harming policies being followed by most of the countries before the Second World War. The second most important function of these institutions was to provide funds to member-countries to help them tide over temporary balance-of-payments deficit. The IMF was established to ensure proper working of the international monetary system. One of the important functions of IMF was to provide reserve credit to member countries facing temporary deficit of balance-of-payments. For this purpose, a currency pool was maintained. Each member country was required to contribute to this pool according to its quota, which was fixed on the basis of each country’s importance in world trade. These contributions were to be partly in an international reserve currency and partly in the country’s domestic currency. The World Bank or the IBRD, as its name suggests, was established to help countries in reconstructing their economies in the post World War II period and to help the developing countries increase their economic growth rate. The World Bank generally makes medium and long-term loans for infrastructure projects. Lately, it has started lending to countries having Balance-of-payment problems, if they are willing to adopt growth-oriented policies. It requires a government guarantee for making these loans. For these activities, it raises funds through subscriptions from member countries and by issuing bonds which are generally meant for private subscription. A new system named as the adjustable peg system was established which fixed the exchange rates, with the provision of changing them if the necessity arose. Under the new system, all the members of the newly set up IMF were to fix the par value of their currency either in terms of gold, or in terms of the US dollar. The par value of the US dollar, in turn, was fixed at $35 per ounce. All these values were fixed with the approval of the IMF, and reflected the changed economic and financial scenario in each of the countries and their new positions in international trade. Further, the member countries agreed to maintain the exchange rates for their currency within a band of one percent on either side of the fixed par value. The extreme points of these bands were to be referred to as the Upper and the lower support point, due to the requirement that the countries do not allow the exchange rate to go beyond these points. The monetary authorities were to stand ready to buy or sell their currencies in exchange for the US dollar at these points, and thereby support the exchange rates. For this purpose, a country which would freely buy and sell gold at the aforementioned par value for the settlement of international transactions was deemed to be maintaining its exchange rate within the one percent band. Thus the United States of America, which was the only country fulfilling this condition, did not need to intervene in the foreign exchange markets. Currencies were required to be convertible for trade-related and other current-account transactions, though governments were given the power to regulate capital flows. This was done in the belief that capital flows destabilize economies. For this purpose of such conversion, gold reserves needed to be maintained by the US, and dollar reserves by other countries. As selling the local currency would result in an increase in the dollar reserves and buying it would result in a reduction in the reserves, the countries facing a downward pressure were under more pressure than countries facing an upward pressure on its currency. The additional pressure existed because the deficit country could eventually run out of reserves, and hence needed to follow more prudent economic, monetary and fiscal policies; while the surplus countries would only face an accretion of reserves. This imbalance in the responsibilities imposed on the two sets of countries eventually led to the downfall of the system. Since there was a possibility of such exchange rates being determined as may not be compatible with a country’s balance-of-payments position, the countries were allowed to revise the exchange rate up to 10% of the initially determined rate, within one year of the rates being determined (Wilson, 2000). After that period, a member country could change the original par values up to five percent on either side without referring the matter to IMF that too only if it’s financial and economic condition made it essential. A bigger change could be brought about only with the consent of IMF’s executive board, which would allow it only in case of a “fundamental disequilibrium” in it balance-of-payments. Continuous reduction in reserves was supposed to serve as an indication of a fundamental disequilibrium. All the member countries were required to subscribe to IMF’s capital. The subscription was to be in the form of gold and its own currency. Each country’s quota in IMF’s capital was to be decided in accordance with its position in the world economy. This capital was needed to enable IMF to help the countries in need of reserves for defending their currency. Conclusion: Though, under this system, the member countries had the option of pegging their currencies to either gold or to the dollar, the only reserve asset mentioned in the agreement establishing the system was gold. However, as the gold stocks did not increase substantially in the years following the agreement, this provision acted as an impediment to the growth of international trade. Increase in such trade required a simultaneous increase in the official reserves held by various countries, in order to facilitate the payments for these trades. To get around this problem, countries started holding dollar reserves. They generally held the reserves in the form of interest bearing securities issued by the U.S. government. This was encouraged by the US because of the seigniorage gains involved. While the cost of printing money was almost nil, the benefits were immense as the US could pay for its increased imports just by printing additional money, without suffering a reduction in its reserves. Another problem with the system was that it had become too rigid, despite the aim of the members being otherwise. AS the system provided for realignment of exchange rates in case of a fundamental disequilibrium, predicting exchange rate movements became very easy. This put currencies at the mercy of private speculators. If a country started facing regular deficits of balance-of-payments, people would start expecting a devaluation of its currency. Attempting to profit from such a scenario, private speculators would start selling the currency for gold or some other currency which was expected to remain strong, in the hope of buying it later at a reduced price. As these capital outflows build up, the reserves of the country would go down, eventually forcing it to devaluate its currency. Thus, the expectations prove self-fulfilling. Bibliography (ICMR) ICFAI Center for Management Research Financial Management for Managers [Book]. - Hyderabad : ICFAI Center for Management Research , 2003. Dammasch Sabine The System of Bretton Woods - A lesson from history [Online]. - 2006. - October 23, 2008. - http://www.ww.uni-magdeburg.de/fwwdeka/student/arbeiten/006.pdf. ICFAI Center for Management Research (ICMR) Money and Banking [Book]. - Hyderabad : ICFAI Center for Management Research (ICMR), 2005. Routledge Encyclopedia of International Political Economy Bretton Woods System [Online] // Benjamin J. cohen. - April 4, 2004. - October 23, 2008. - http://www.polsci.ucsb.edu/faculty/cohen/inpress/bretton.html. U.S. Department of State The Bretton Woods System [Online] // About.Com. - About.com, July 13, 2008. - October 23, 2008. - http://economics.about.com/od/foreigntrade/a/bretton_woods.htm. Wilson Theodore A. The Road to Bretton Woods: Winston Churchill and Imperial Finance [Online] // Publications & Resources. - The Churchill Centre, May 21, 2000. - October 23, 2008. - http://www.winstonchurchill.org/i4a/pages/index.cfm?pageid=572. Read More