The Bretton Woods System - Essay Example

THE BRETTON WOODS SYSTEM Introduction The Bretton Woods system of foreign exchange controls has the distinction of being the first fully negotiated monetary management principles that were formulated to control financial and commercial relationships between the world’s nations. The Bretton Woods Agreement was signed in 1944 against the backdrop of the still raging World War II. A total of 730 representatives from 44 nations (only from the “Allies” group of nations that eventually won World War II, not the “Axis” group that was defeated) attended a 3 week-long United Nations Monetary & Financial Conference at the Mount Washington Hotel in Bretton Woods, New Hampshire, England, at the end of which the Bretton Woods Agreement was officially signed during the 4th week of July 1944 (Wikipedia, 2006). Background There were several reasons why the Bretton Woods Agreement was signed. 1) The Great Depression The Great Depression of 1930 represents the biggest economic calamity the world has ever experienced. Although its epicentre was in Europe and North America, its crippling economic effects were felt all over the world, especially in industralised countries. This massive economic downturn was caused by countries putting up trade barriers and indulging in proliferation of foreign exchange controls to undermine the international payments system. Some countries devalued their currencies to rectify their balance of payments deficits and make their national exports more attractive in the world market. Other countries that used the same currency formed blocs (such as the British Empire Sterling Area), and placed unreasonable restrictions on foreign investment chances and the international flow of capital. These crude and unethical tactics (dubbed “beggar thy neighbour” policies {Wikipedia, 2006}) led to steep falls in national income, mass unemployment, and an overall decrease in international trade. The sudden lack of demand meant that construction projects, mining and logging operations ground to a halt, agricultural produce prices plummeted by more than 50% (Wikipedia, 2006), and social ills like unemployment and homelessness hit unprecedented peaks. The Bretton Woods Agreement’s primary target was to ensure that a disaster of such magnitude as the Great Depression would never be repeated. 2) World Peace The international community badly needed a liberal international economic system to increase the prospects of a lasting peace after the devastating World War II. This view was strongly propagated especially by the United States, which was convinced that the basic causes of World War II were economic prejudice and trade warfare. Cordell Hull, the U.S. Secretary of State (1933 to 1944) put his country’s viewpoint succinctly when he said: “Unhampered trade dovetailed with peace; a freer flow of trade with fewer discriminations and obstructions would eliminate the economic dissatisfaction that breeds war, and we might have a reasonable chance of lasting peace” (Wikipedia, 2006). 3) Popular Demand for Governmental Intervention After the chaotic situation that led to the Great Depression, employment, stability and growth needed to be the primary components of public policy. The makers of the Bretton Woods Agreement were convinced that governments should take over public management of the economy as this would create a feeling of well being among citizens, reassuring them that a responsible body was in charge of their economic future. This idea of a Welfare State was an important offshoot of the Great Depression (Wikipedia, 2006). 4) Economic Security Economic discrimination, one of the main causes of World War II, was in urgent need of being addressed. The Bretton Woods conveners agreed that the international economic system needed to be regulated. In order to do this, it was agreed that there should be free trade. Free trade involved minimising barriers to trade and capital movement and creating a balance of trade favourable to the capitalist system (Wikipedia, 2006). 5) The Rise of U.S. Influence Unlike Europe and East Asia that were economically and militarily shattered by the events of World War II, the U.S. remained unaffected by it. On the contrary, it achieved rapid industrial growth and capital accumulation, producing half the world’s coal and electricity, and holding 80% of global gold reserves (Wikipedia, 2006). There was the need of a dominant country to don the mantle of leadership in the international economic management system, and the U.S. took on that role. Moreover, the opening up of the world to free trade would benefit the U.S. most of all, allowing it to import raw materials from other countries and channel its exports to the world. Determined to prevent another 1930-like disaster, U.S. President Franklin D. Roosevelt was convinced that creation of a postwar order was the only way to guarantee continuing U.S. prospects. His view was strongly supported by U.S. policymakers who claimed: “We need markets – big markets – around the world in which to buy and sell” (Wikipedia, 2006). 6) The Atlantic Charter The Atlantic Charter is said to be the forerunner of the Bretton Woods Agreement. U.S. President Franklin Roosevelt and British Prime Minister Winston Churchill drafted it during a meeting in August 1941 while onboard a ship in the Northern Atlantic. The Charter contained Fourteen Points that confirmed freedom of the seas and unhindered access to markets and raw materials to all countries of the world. The Atlantic Charter is seen as representing U.S. plans to set up a liberal global economy unified under U.S. control in its role as the predominant power of the world (Wikipedia, 2006). 7) Wartime Destruction of Europe and East Asia Europe and East Asia suffered huge setbacks both militarily as well as economically as a result of World War II. They desperately needed to rebuild their infrastructures and their economies. Britain, which had created its own economic bloc to keep out U.S. goods in the 1930s, now had no choice but to split the bloc. It also needed finance badly to start the rebuilding process. The U.S. gave it a loan of $ 3.8 billion, and in return Britain signed the Atlantic Charter that effectively opened up the complete global market place and gave the U.S. full access to it. France too followed in Britain’s footsteps; the U.S. granted it a loan of $ 4 billion, and in return France agreed to stop government subsidies and currency manipulations that had made French exports attractive in the world market. The countries of the Third World were bound to developed countries by economic and political ties; they had no choice but to agree to the international economic system set up for them (Wikipedia, 2006). Design and Working of the Bretton Woods System Free trade depended on free convertibility of currencies. The liberal international economic system required an accepted carrier for investment, trade and payments. At the time the Bretton Woods Conference was convened, the gold standard was used to back world currencies. It involved calculating a currency’s value by its fixed relationship to gold; the British Pound was the primary world currency. But the ravages of World War II greatly weakened the British economy, and this repercussion was felt by the gold standard. The architects of the Bretton Woods Agreement recognised this deficiency and came up with a system of fixed exchange rates. The new fixed exchange rates system allowed member countries to convert their currencies into other currencies by the “pegged rate” rule. This rule required member nations to fix a parity of their national currencies in terms of gold (a ‘peg’), and to continue keeping exchange rates within a ‘band’ (plus or minus 1% of parity) in the course of foreign exchange transactions (Wikipedia, 2006). The system used the U.S. dollar as a reserve currency. All nations were required to ensure convertibility by pegging their currencies to the U.S. dollar; the country could then buy and sell U.S. dollars to maintain market exchange rates within the ‘band’. The U.S. dollar thus became a gold standard currency for central banks. The preference for the U.S. dollar was due to its backing by a strong U.S. economy, its committed relation to gold ($ 35 an ounce {Wikipedia, 2006}), and the confirmation by the U.S. government to covert U.S. dollars into gold at that same price. The Bretton Woods Conference created the International Monetary Fund (IMF) and the International Bank for Reconstruction & Development (IBRD) as the keepers of the rules, and controllers of international monetary matters. This represented the first time in world history that international monetary cooperation was tried on permanent institutional basis. The IMF was officially set up on December 27, 1945 with its base in Washington D.C. and with Harry Dexter White as its first U.S. Executive Director. Member countries needed IMF approval for any change in its par value originally set up by the IMF. Member nations could borrow foreign currency from the IMF to finance trade deficits. The IMF also issued advisories to member nations on their programmes that could have repercussions on the monetary system. Like the IMF, the IBRD was also formed on December 27, 1945. It had an initial capital of $ 10 billion (Wikipedia, 2006). It was required to provide loans to member countries to finance reconstruction projects in the wake of devastation caused by World War II, as well as to facilitate the growth of international trade. Such loans could be given directly to member nation governments or to public entities that had proper governmental backing for repayment. The Fall of the Bretton Woods System The fixed exchange rates of the Bretton Woods System started coming under pressure during the 1960s. Belgian-American economist Robert Tiffin exposed the first basic imbalance of the system in 1960. He noticed that one ounce of gold fetched $ 40 when exchanged in London, although the price was $ 35 in the U.S.(Wikipedia, 2006). Tiffin concluded that the number of U.S. dollars in valid use as money was more than the amount of gold that backed them up. This signified that the dollar was overvalued. The only way to rectify this was for the U.S. to adopt a dual pronged tactic: increase interest rates with the aim of luring dollars back into the U.S., and reducing the number of dollars in valid use by cutting the deficit. Both these rectification steps would however cause the U.S. economy to go into recession – a situation not acceptable to U.S. President John F. Kennedy and U.S. policy makers. A temporary solution, called the “London Gold Pool” (Wikipedia, 2006) was created whereby fluctuations in gold price could be countered by selling gold from the pool in the open market. This solution, however, did not prove to be very effective. The Cuban Missile Crisis of 1962 which involved a hostile standoff between the U.S. and the Soviet Union over the latter’s deployment of nuclear missiles in Cuba, sparked off the second setback to the Bretton Woods System. The event caused the price of gold to jump to $ 40 an ounce (Wikipedia, 2006). The U.S. administration, under the leadership of President Kennedy, was forced to put in place a tax cut programme in 1963 to encourage national production and exports with the ultimate aim of maintaining the $ 35 peg. The third blow to the Bretton Woods system came in 1967 when the British pound was devalued in response to a run on gold in the “sterling area”. The U.S. chose not to take protection measures (like budget slashing, introducing export subsidies and travel taxes), instead opting to accept the risk of a ‘run of gold’. In spite of the U.S. administration’s (then led by President Lyndon Johnson) policies in January 1968 aimed at increasing exports and stopping gold outflow, the intense pressure on the dollar and pound sterling continued. On March 17, 1968 there was a run on gold that resulted in the dissolution of the London Gold Pool. The collapse of the gold peg followed in November 1968 (Wikipedia, 2006). Efforts were made to restore the authority of the Bretton Woods System by incorporating a partial floating mechanism, but to no avail. The final, crippling blow to the Bretton Woods System came in 1970. As a result of inflation caused by the Vietnam War, the U.S. economy registered a trade deficit for the first time in the 20th century. The U.S. gold coverage fell from 55% to 22%. In the first half of 1971, assets worth $ 22 billion were pulled out of the U.S.(Wikipedia, 2006). In response, U.S. President Richard Nixon delivered the ‘Nixon Shock’ on August 15, 1971, announcing the imposition of a 10% import surcharge, 90 day wage and price controls, and most significantly, officially closing the ‘gold window’, declaring that the U.S. had stopped allowing the U.S. dollar to be exchanged for gold. The U.S. withdrew the 10% import surcharge in December 1971. Following this move and a general revaluation of currencies, the fluctuating ‘band’ (plus or minus 1% of parity) grew in size, to become plus or minus 2.25% of parity (Wikipedia, 2006). This measure could not weather attacks by speculators, and member nations started exiting one by one from the Bretton Woods System, preferring to adopt a floating exchange rate system vis-à-vis the U.S. dollar. By March 1976, every major world currency was floating. The Bretton Woods System had finally, totally, and irreparably collapsed. (Wikipedia, 2006). Reference used: Anon. (29 November 2006). “Bretton Woods System.” Retrieved 2 December 2006 from Wikipedia Web site: http://en.wikipedia.org/wiki/Bretton_Woods_System Read More