Bretton Woods System and Its Breakdown | Economics

In this article we will discuss about Bretton Woods system and its breakdown.

Bretton Woods System:

After the abandonment of gold standard and chaotic international monetary conditions during the inter-war period, the need was being felt to evolve a more efficient and effective world monetary system. In 1944, the representatives of 44 countries met at Bretton Woods, New Hampshire in the United States for creating the framework of the international monetary system. The conference at Bretton Woods outlined certain principles as the guidelines for operating the world monetary system.

(i) The international monetary system must facilitate unrestricted trade and investment.

(ii) The national currencies would be defined in terms of gold parities and there would be fixed exchange rates. Only in the event of a fundamental disequilibrium in the BOP would a country be expected to change its exchange rates.

(iii) The international liquidity would be made available to the countries for overcoming the temporary BOP deficits.

Thus Bretton Woods meet sought to combine certain features of the old gold standard with a greater degree of flexibility and some measure of control over international liquidity. The expectation and objective at the Bretton Woods was to create a new system that would avoid the undesirable aspects of the old system while retaining its best features.

The things that were to be avoided included rigidity of exchange rates and associated deflationary adjustment mechanism of the gold standard, the instability of the freely floating exchange rates, conflicts of national economic policies, competitive exchange depreciation and the repressive and distorting techniques of exchange controls.

The features, on the other hand, that were to be retained included stability of gold standard, easy adjustment mechanism, market freedom of floating rates, the discretionary control over market forces of the flexible rate system and the selective use of controls. In order to accomplish these objectives, new practices and institutions had to be devised.

The most far-reaching result of the Bretton Woods meet was the creation of International Monetary Fund (IMF). It was a compromise between the British plan put forward by Keynes and the American counter-plan put forward by Dexter and White. While the former was for the creation of an international clearing union, the latter was for a less ambitious stabilisation fund.

The IMF started functioning in March, 1947 with a membership of 30 countries. At present, its membership has gone upto 184. The IMF had two specific objectives of overseeing that the member countries followed a set of agreed rules of conduct in international trade and finance and of providing borrowing facilities for the member countries to tide over their BOP difficulties. Such borrowings were to be repaid within a period of three to four years.

Each member country was assigned a quota on the basis of its economic importance and the volume of its international trade. The member countries’ quota determined their respective voting power and the ability to borrow funds. The total subscription to the Fund was $ 8.8 billion originally. It had grown to $ 205 billion or SDR 145 billion by 1993. The US quota was the largest in 1989 at 21 percent, followed by 7 percent each for the U.K., 6 percent each for Germany and France and 5 percent for Japan.

The member country on joining was to pay 25 percent of its quota in gold and remainder in its own currency. The member country could borrow 25 percent of its quota in one year upto a total of 125 percent of its quota over a period of 5 years. The first 25 percent of its quota, called gold tranche, could be borrowed almost automatically without any restriction or condition.

For further borrowing in the subsequent years, called credit tranche, the higher interest rates are charged and the IMF imposes more supervision and conditions to ensure that the deficit nation was taking appropriate measures to eliminate the BOP deficit.

As regards repayments, these were to be made within a period of 3 to 5 years. It involved the nation’s repurchase of its own currency from the Fund with other convertible currencies approved by the Fund until the IMF once again held no more than 75 percent of the nation’s quota in the nation’s currency.

Under the Bretton Woods System, the gold exchange standard was introduced. The United States was to maintain the price of gold fixed at $ 35 per ounce and to be ready to exchange dollars for gold at that price without restrictions or limitations. Other nations were required to fix the price of their currencies directly in terms of dollars and indirectly in terms of gold. The exchange rate could fluctuate within plus or minus 1 percent around the agreed par value.

The member countries could intervene in the exchange markets to prevent the fluctuation beyond the permissible limit. With the allowed band of fluctuation, the rate of exchange was determined by the forces of demand and supply. However, if a country faced a fundamental disequilibrium in the BOP, the alteration in the exchange rate beyond the permissible limit (± 1 percent) could be affected by it after seeking the consent of the IMF. It is clear that Bretton Woods System ushered in an adjustable peg system of exchange rate that combined the stability of fixed exchange system with greater flexibility than was allowed under the gold standard.

The Bretton Woods System envisaged the removal of all restrictions on the full convertibility of the currencies of member countries into currencies of one another or into dollar. The member countries were expected not to impose additional trade restrictions. The existing trade restrictions were to be removed gradually through multilateral negotiations. The restrictions on the international liquid capital flows were, however, permitted to enable the member countries to protect their currencies against large destabilizing, international money flows.

Since the IMF could provide assistance to the member countries only for tackling the temporary BOP deficit, the amounts obtained from it were to be repaid within a short period of 3 to 5 years. This provision was considered necessary so that the IMF funds should not get tied up for long periods. Under the Bretton Woods System, the long term development assistance was to be provided by the International Bank for Reconstruction and Development (IBRD) also called as the World Bank.

Subsequently, International Development Association (IDA) was established in 1960 to provide concessional development assistance to the poorer countries. Another affiliate of the World Bank— International Finance Corporation was established in 1956 to stimulate private investments in the developing countries from the indigenous and foreign sources.

The Bretton Woods System worked reasonably well in the late 1950’s and early 1960’s. During this period, there were conditions of relatively free trade, a rapid expansion in trade and capital mobility. There was very little inflation or unemployment in the major industrial countries. On the whole, the System served the world community well until the mid 1960’s.

Breakdown of the Bretton Woods System:

No doubt the system worked fairly well until the mid-1960 but the system had some in-built weaknesses and contradictions, under the pressure of which, it eventually broke down on 15th August 1971.

The main factors that led to the collapse of this system were as follows:

(i) The Confidence Problem:

By the end of 1950’s many European countries were having BOP surpluses and the USA was running counterpart deficit. For the continued economic expansion, it was essential for the United States to maintain this deficit as it was the only way through which the growth of international reserves could be sustained in the absence of any other reserve asset including gold.

In the event, the USA continued to run bigger and bigger deficits while its gold assets remained constant. It was just a matter of time when the foreign holders of dollars, including central banks, doubted the ability of the United States to maintain the price of gold at $ 35 per ounce and rushed to convert dollars into gold before the dollar was devalued. This phenomenon was termed as the ‘confidence problem’.

Similar crises of confidence continued to occur during the 1960’s. Britain faced in 1967 a continuing BOP deficit and dwindling official reserves creating the expectations of devaluation of pound. The outflow of funds from England put pressure upon the pound sterling and led eventually to the devaluation of pound sterling in November 1967. A similar episode occurred in 1968-69. The persistent BOP surplus of West Germany led to widespread expectation of upward revaluation of the Mark.

Such an expectation resulted in an almost embarrassing accumulation of reserves due to large scale inflow of foreign funds to that country. France particularly suffered a huge outflow of funds and to protect Franc, the French government imposed stringent exchange controls. But ultimately storm could be weathered only after there was upward readjustment of Mark and downward adjustment of Franc.

(ii) Seigniorage Problem:

It was argued that the Bretton Woods System gave rise to the seigniorage of the United States over other countries, since dollar became the international reserve currency that conferred some undue privilege upon the Americans. The question of seigniorage arose because the United States was the issuing country of dollar. As and when it required dollar, it could issue more dollars.

On the other hand, another country that wanted to increase its holding of dollars could do so only by creating an export surplus i.e., it would have to forego real resources in exchange for the dollars. The central bank of the United States could obtain a much higher rate of return for dollars from the foreigners than what it could obtain in the home country. The existence of seigniorage was the cause of irritation among some of the countries including France. This factor, in the long run, undermined the Bretton Woods System.

(iii) Adjustment Problem:

From the long run point of view, a serious weakness in the Bretton Woods System was the absence of an efficient balance of payments adjustment mechanism. No country can afford to have a persistent BOP deficit. The principal types of adjustment mechanism include adjustment through changes in relative incomes, through relative price changes, through the movements in exchange rates and through the imposition of direct controls over foreign transactions. The Bretton Woods System almost prohibited the use of direct controls.

As regards exchange rate variations, the system prescribed that exchange rate should be held stable with scope only for ±1 percent variation unless a fundamental disequilibrium warranted a greater degree of variation. So the crucial issue was to determine whether the disequilibrium was temporary or fundamental. The operational difficulty had been the timely recognition of the presence of fundamental disequilibrium. There was a general tendency among the member countries of IMF to resist changing the par value of the currency.

Devaluation was often opposed on the ground that it amounted to the acceptance of the failure of government policies and also on account of loss of national prestige. The upward revaluation was frequently opposed by the export industries of the surplus countries. The alternative adjustment mechanism through changes in prices and incomes was found to be in conflict with the domestic goals of full employment and price stability.

The adjustment through quantitative controls was opposed on account of possible distortion of resource allocation and reduction in economic efficiency. In such circumstances the countries adopted wait-and-see policy rather than taking a decisive and speedy action for BOP adjustments. The undue delay led to an aggravation of maladjustment and deepening of the BOP crisis.

(iv) Triffin Dilemma:

A serious inbuilt contradiction in the system was exposed by Triffin as early as 1960. It is often referred as ‘Triffin dilemma’ i.e., either the United States corrected its deficit and created a liquidity shortage or it continued to run the BOP deficit. The latter alternative could only cause the crisis of confidence. The existence of this dilemma clearly showed that the system was inherently unstable and was destined to collapse.

(v) Problem of Symmetry:

There was a general problem of symmetry between deficit and surplus countries or between the USA and the rest of the world. Although the Bretton Woods System intended that both deficit and surplus countries should share the burden of adjustment in payments imbalances, yet the brunt of adjustment fell practically entirely upon the deficit countries.

While the surplus countries could continue to run surpluses so long as they were willing to accumulate reserves, the deficit countries could not run down their reserves indefinitely. This asymmetry between the deficit and surplus countries exposed a serious weakness in this system and became partly responsible for its eclipse.

(vi) The Liquidity Problem:

One of the predominant causes of the breakdown of the Bretton Woods System was the problem of liquidity. Any system of fixed or stable exchange rate could work efficiently only if there were sufficient international reserves. During the 1950’s and 1960’s, the U.S. deficits in BOP continued to increase on account of overseas investments and escalation of Vietnam War. The European countries and Japan at the same time could create surpluses in their BOP.

The U.S. balance of payments deficit could be financed by either the export of gold or through the acquisition of dollars by the foreign surplus countries. In either of the two cases, the United States reserves deteriorated. The rest of the world continued to have large demand for dollars for making the BOP adjustments among themselves as dollar was the key currency. Even for maintaining the exchange rates stable in terms of dollars, countries started keeping a large fraction of their international reserves in the form of dollar balances and the short term dollar securities.

Apart from persistently increasing demand for dollars, this currency also emerged as the principal ‘intervention currency’—a currency which monetary authorities bought or sold in foreign exchange markets to keep exchange rates within ± 1 percent margin round the par values.

This problem of liquidity continued to become grave raising the worldwide expectation of the impending devaluation of dollar. But since other countries were tied to the dollar, that did not permit the United States to make readjustment of the exchange rate of dollar with other principal currencies.

(vii) Speculation and Short Term Capital Movements:

After the development of Euro-dollar market in the late 1950’s, there was rapid growth of highly mobile short term capital. The anticipated changes in par values on account of heavy pressure upon dollar resulted in large scale speculative capital. It led to the speculative capital movements from the United States to other surplus countries such as Germany, Japan and Switzerland. These large scale capital movements were bound to have destabilising effect upon exchange rate as well as the BOP adjustments.

(viii) Conditions of Inflation:

An important factor to cause the collapse of the Bretton Woods System was the domestic inflation in the United States particularly after the escalation of Vietnam War from 1965. Both Johnson and Nixon administrations were unwilling to finance the war efforts by increased taxes. Instead easy money policies were pursued.

These policies intensified inflation in the United States and the balance of current account got weakened. The surplus countries of Europe feared the transmission of inflation to their own countries, when their balance of payments surpluses had been bringing about an increase in their money supplies.

These countries, especially West Germany, attempted to counter inflation through the enforcement of strict monetary policies. The high interest rates further accentuated capital flow from the United States to the countries of Europe and Japan and precipitated in 1970-71 the fall of Bretton Woods System.

All these developments eventually resulted in the United States declaring on August 15, 1971 the inconvertibility of dollar into gold. At the same time, it imposed a temporary 10 percent surcharge on imports and the Bretton Woods System broke down.

The negotiations began almost immediately to bring about proper readjustments in the international monetary system. In December 1971, the representatives of the Group of Ten met at the Smithsonian Institute in Washington. This meeting could hammer out an agreement called as Smithsonian Agreement. It was agreed to increase the dollar price of gold from $ 35 per ounce to $ 38 per ounce. This implied the devaluation of dollar by about 9 percent.

The currencies of the two countries with the largest BOP surplus— Germany and Japan, were revalued. While the German mark was revalued by 17 percent and the Japanese yen was revalued by 14 percent. The band of fluctuation was increased from 1 percent to 2.25 percent on either side of the central rate. The United States withdrew 10 percent surcharge on imports. As the dollar remained inconvertible into gold, the world was essentially on the dollar standard. President Nixon of the United States assured that the dollar would not again be devalued.

It was expected that Smithsonian Agreement would remove the underlying cause of the disequilibrium that led to the crisis of August 1971. These expectations were realised only for a short period. The first break in the pattern of exchange rates established through Smithsonian Agreement occurred in May 1972, when the British pound came under heavy pressure. Britain decided to cease support of the exchange rate and to allow the rate to respond to market forces. Over the next six months, the value of pound dropped 10 percent below the level set in December 1971.

Japan, on the other hand, continued to have a large BOP surplus. The Japanese yen was subject to upward pressure. Throughout the latter half of 1972, the Japanese monetary authority had to buy large amounts of dollar in the foreign exchange market to keep the value of the yen within limits prescribed by the Smithsonian Agreement.

The United States had another huge BOP deficit ($ 10 billion) in 1972. The recognition started dawning that the Smithsonian Agreement was not working and that another devaluation of dollar was required. There was renewed speculation against the dollar and consequent large scale movement of short term capital from the United States to mainly Germany.

During the first seven trading days of February 1973, the German central bank purchased some $ 6 billion in order to prevent the mark from appreciating against the dollar. A second realignment of exchange rates had become unavoidable. On February 12, 1973, the United States was once again forced to devalue dollar by about 10 percent. There was the corresponding appreciation of the EC currencies in terms of dollar.

They decided to let their currencies float jointly. Japan and Italy too joined Britain in rescinding their previous policies of maintaining stable exchange rates and allowed their currencies to float and readjust according to market forces. When the exchange markets reopened on March 19, 1973, all of the World’s major currencies were floating. The Bretton Woods System which had actually died in August 1971 was finally buried. The system of stable and pegged exchange rates gave way to the system of managed floating exchange rates.

Monetary System after the Collapse of Bretton Woods System:

After the crisis of 1971, the Board of Governors of the IMF recognised the necessity of investigating the possible measures for the improvement in the international monetary system. In 1972, it constituted a committee of twenty members, often referred as The “Committee of Twenty” (C20). Three basic weaknesses of the Bretton Woods System, identified by the Committee included liquidity, confidence and adjustment. The outlines of recommendations made by the Committee, therefore, attempted to address to these issues.

Despite prolonged discussion between 1972 and 1974, there could not be any headway towards evolving measures for reforming the system. An agreement was finally reached at a meeting in Jamaica in 1976 concerning some amendments to the Articles of Agreement of the IMF. These were to be enforced from 1978. There was only a limited purpose behind it to make the system of managed float work better.

The principal changes introduced in the International monetary system included:

Firstly, the most significant development since 1978 in the international monetary relations has been the replacement of Special Drawing Rights (SDR’s) in place of gold as a reserve asset system. The official price of gold has been abolished and the restrictions on its sale in the open market have been removed. In fact, the IMF has been itself selling off gold reserves and putting the proceeds in the special funds.

The dominant reserve assets at present are the national currencies, about 75 percent of which are in the U.S. dollar. However, other major currencies have also gained importance. Since SDR is no longer related to gold, it has been linked with a basket of 16 major currencies. The IMF has been engaged in expanding the range of activities for which the SDR’s could be used. In addition, the interest rates on the IMF lendings have been raised closer to the market rate of interest.

Secondly, in order to relieve the problem of shortage of international liquidity, the IMF created several new credit facilities.

These include:

(i) The Compensatory Financing Facility (CFF), which enabled the member countries to draw from the fund upto 100 percent of their quota when they experienced BOP difficulties, caused by temporary shortfalls in the export receipts;

(ii) The Buffer Stock Financing Facility (BSFF) which permitted member countries to draw upto 50 percent of their quota to finance international buffer stock arrangements;

(iii) The Extended Fund Facility (EFF) which allowed the member countries to draw upto 140 percent of their quota extended over a period of three years, when facing serious structural imbalances;

(iv) The Supplementary Financing Facility (SFF) which provided supplementary financing facility when the member countries required the funds over and above those that could be made available under regular and standby arrangements for longer periods; and

(v) The oil facility, under which IMF borrowed funds from some surplus nations to assist those countries that suffered BOP deficits in view of steep rise in petroleum prices in 1973-74. By 1976, the oil facility had been fully utilised and it is now no longer operational. In view of the huge international debt problem faced by several LDC’s, the IMF has also initiated some debt rescheduling and rescue operations.

Thirdly, in the present international monetary system, the member countries are allowed either to float or peg their currencies. In the latter case, the exchange rate of one currency may be pegged to the currency of a particular country, the SDR or a basket of currencies. The exchange rate cannot be fixed in terms of gold. The exchange rate fixation or adjustments are subject to IMF supervision or guidelines. There are no limits on the margins within which these rates are pegged and there are no rules about how these should be altered.

In contrast to the structured arrangements of the gold standard and Bretton Woods System, the present system is more chaotic and reminiscent of the 1930’s.

Some serious shortcomings in the present monetary system are as follows:

(i) There is the existence of a variety of exchange rate regimes with very little effective supervision.

(ii) The reserve asset system depends on the portfolio decisions of central bankers.

(iii) In the present system, there are no accepted rules for sharing the adjustment to payments imbalances.

(iv) The emergence of floating exchange rates has greatly accentuated uncertainty in international trade. Consequently many traders, bankers and economists like to see the return to a more orderly system.