Bretton Woods system

Overview

The Bretton Woods system of monetary management established the rules for commercial relations among 44 countries, including the United Kingdom, United States, Canada, European countries, and Australia, after the 1944 Bretton Woods Agreement until the Jamaica Accords in 1976. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent states. The Bretton Woods system required countries to guarantee convertibility of their currencies into U.S. dollars with the dollar convertible to gold bullion for foreign governments and central banks. It envisioned greater cooperation among countries to prevent future competitive devaluations, and thus established the International Monetary Fund (IMF) to monitor exchange rates and lend reserve currencies to countries with balance of payments deficits. According to Barry Eichengreen, the Bretton Woods system operated successfully due to three factors: "low international capital mobility, tight financial regulation, and the dominant economic and financial position of the United States and the dollar". Preparing to rebuild the international economic system while World War II was still being fought, delegates from 44 Allied countries gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference, also known as the Bretton Woods Conference. The delegates deliberated from 1 to 22 July 1944, and signed the Bretton Woods agreement on its final day. Setting up a system of rules, institutions, and procedures to regulate the international monetary system, these accords established the IMF and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. The United States, which controlled two-thirds of the world's gold, insisted that the Bretton Woods system rest on both gold and the US dollar. Soviet representatives attended the conference but later declined to ratify the final agreements, charging that the institutions they had created were "branches of Wall Street". These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement.

Eurodollar growth increased capital flows, challenging regulation of capital movements. On 15 August 1971, the United States ended the convertibility of the US dollar to gold, effectively bringing the Bretton Woods system to an end and rendering the dollar a fiat currency. Shortly thereafter, many fixed currencies (such as the pound sterling) also became free-floating, and the subsequent era has been characterized by floating exchange rates. The end of Bretton Woods was formally ratified by the Jamaica Accords in 1976. Critics argue that the system's reliance on the U.S. dollar allowed the United States to operate with fewer constraints than other nations, while fixed exchange rates limited countries such as the major European economies and Japan in their ability to adjust monetary policy in response to rising inflation and shifting trade conditions. They also note that the IMF and World Bank often imposed policy conditions that placed significant strain on developing countries and restricted the flexibility of local economies.

Origins

The planners at Bretton Woods hoped to avoid a repetition of the Treaty of Versailles after World War I, which had created enough economic and political tension to lead to WWII. After World War I, Britain owed the U.S. substantial sums, which Britain could not repay because it had used the funds to support allies such as France during the War; the Allies could not pay back Britain, so Britain could not pay back the U.S. The solution at Versailles for the French, British, and Americans seemed to entail ultimately charging Germany for the debts. If the demands on Germany were unrealistic, then it was unrealistic for France to pay back Britain, and for Britain to pay back the US. Thus, many "assets" on bank balance sheets internationally were actually unrecoverable loans, which culminated in the 1931 banking crisis. Intransigence by creditor countries for the repayment of Allied war debts and reparations, combined with an inclination to isolationism, led to a breakdown of the international financial system and a worldwide economic depression. The beggar thy neighbour policies that emerged as the crisis continued saw some trading countries using currency devaluations in an attempt to increase their competitiveness (i.e. raise exports and lower imports), though recent research suggests this de facto inflationary policy probably offset some of the contractionary forces in world price levels. In the 1920s, international flows of speculative financial capital increased, leading to extremes in balance of payments situations in various European countries and the US. In the 1930s, world markets never broke through the barriers and restrictions on international trade and investment volume – barriers haphazardly constructed, nationally motivated and imposed. The various anarchic and often autarkic protectionist and neo-mercantilist national policies – often mutually inconsistent – that emerged over the first half of the decade worked inconsistently and self-defeatingly to promote national import substitution, increase national exports, divert foreign investment and trade flows, and even prevent certain categories of cross-border trade and investment outright. Global central bankers attempted to manage the situation by meeting with each other, but their understanding of the situation as well as difficulties in communicating internationally, hindered their abilities. The lesson was that simply having responsible, hard-working central bankers was not enough. Britain in the 1930s had an exclusionary trade bloc with countries and territories of the British Empire known as the Sterling Area. If Britain imported more than it exported to such trading partners, recipients of pounds sterling within these countries tended to put them into London banks. This meant that though Britain was running a trade deficit, it had a financial account surplus, and payments balanced. Increasingly, Britain's positive balance of payments required keeping the wealth from across its Empire in British banks. One incentive for, say, South African holders of rand to park their wealth in London and to keep the money in Sterling, was a strongly valued pound sterling. In the 1920s, imports from the US threatened certain parts of the British domestic market for manufactured goods and the way out of the trade deficit was to devalue the currency. But Britain could not devalue, or the Empire surplus would leave its banking system. Nazi Germany also worked with a bloc of controlled countries by 1940. Germany forced trading partners with a surplus to spend that surplus importing products from Germany. Thus, Britain survived by keeping Sterling-using countries' surpluses in its banking system, and Germany survived by forcing trading partners to purchase its own products. The U.S. was concerned that a sudden drop-off in war spending might return its population to the unemployment levels of the 1930s, and so wanted Sterling-using countries and everyone in Europe to be able to import from the US, hence the U.S. supported free trade and international convertibility of currencies into gold or dollars.

Post-war negotiations

When many of the same experts who observed the 1930s became the architects of a new, unified, post-war system at Bretton Woods, their guiding principles became "no more beggar thy neighbor" and "control flows of speculative financial capital". Preventing a repetition of this process of competitive devaluations was desired, but in a way that would not force debtor countries to contract their industrial bases by keeping interest rates at a level high enough to attract foreign bank deposits. John Maynard Keynes, wary of repeating the Great Depression, was behind Britain's proposal that surplus countries be forced by a "use-it-or-lose-it" mechanism, to either import from debtor states, build factories in debtor states or donate to debtor states. The U.S. opposed Keynes' plan, and a senior official at the U.S. Treasury, Harry Dexter White, rejected Keynes' proposals, in favor of an International Monetary Fund with enough resources to counteract destabilizing flows of speculative finance. However, unlike the modern IMF, White's proposed fund would have counteracted dangerous speculative flows automatically, with no political strings attached—i.e., no IMF conditionality. Economic historian Brad Delong writes that on almost every point where he was overruled by the Americans, Keynes was later proved correct by events. Today these key 1930s events look different to scholars of the era (see the work of Barry Eichengreen Golden Fetters: The Gold Standard and the Great Depression, 1919–1939 and How to Prevent a Currency War); in particular, devaluations today are viewed with more nuance. Ben Bernanke's opinion on the subject follows:

... [T]he proximate cause of the world depression was a structurally flawed and poorly managed international gold standard. ... For a variety of reasons, including a desire of the Federal Reserve to curb the U.S. stock market boom, monetary policy in several major countries turned contractionary in the late 1920s—a contraction that was transmitted worldwide by the gold standard. What was initially a mild deflationary process began to snowball when the banking and currency crises of 1931 instigated an international "scramble for gold". Sterilization of gold inflows by surplus countries [the U.S. and France], substitution of gold for foreign exchange reserves, and runs on commercial banks all led to increases in the gold backing of money, and consequently to sharp unintended declines in national money supplies. Monetary contractions in turn were strongly associated with falling prices, output and employment. Effective international cooperation could in principle have permitted a worldwide monetary expansion despite gold standard constraints, but disputes over World War I reparations and war debts, and the insularity and inexperience of the Federal Reserve, among other factors, prevented this outcome. As a result, individual countries were able to escape the deflationary vortex only by unilaterally abandoning the gold standard and re-establishing domestic monetary stability, a process that dragged on in a halting and uncoordinated manner until France and the other Gold Bloc countries finally left gold in 1936. —Great Depression, B. Bernanke In 1944 at Bretton Woods, as a result of the collective conventional wisdom of the time, representatives from all the leading allied states collectively favored a regulated system of fixed exchange rates, indirectly disciplined by a US dollar tied to gold—a system that relied on a regulated market economy with tight controls on the values of currencies. Flows of speculative international finance were curtailed by shunting them through and limiting them via central banks. This meant that international flows of investment went into foreign direct investment (FDI)—i.e., construction of factories overseas, rather than international currency manipulation or bond markets. Although the national experts disagreed to some degree on the specific implementation of this system, all agreed on the need for tight controls.

Economic security

Also based on experience of the inter-war years, U.S. planners developed a concept of economic security—that a liberal international economic system would enhance the possibilities of postwar peace. One of those who saw such a security link was Cordell Hull, the United States Secretary of State from 1933 to 1944. Hull believed that the fundamental causes of the two world wars lay in economic discrimination and trade warfare. Hull argued

[U]nhampered trade dovetailed with peace; high tariffs, trade barriers, and unfair economic competition, with war … if we could get a freer flow of trade…freer in the sense of fewer discriminations and obstructions…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.

Rise of governmental intervention

The developed countries also agreed that the liberal international economic system required governmental intervention. In the aftermath of the Great Depression, public management of the economy had emerged as a primary activity of governments in the developed states. Employment, stability, and growth were now important subjects of public policy. In turn, the role of government in the national economy had become associated with the assumption by the state of the responsibility for assuring its citizens of a degree of economic well-being. The system of economic protection for at-risk citizens sometimes called the welfare state grew out of the Great Depression, which created a popular demand for governmental intervention in the economy, and out of the theoretical contributions of the Keynesian school of economics, which asserted the need for governmental intervention to counter market imperfections. However, increased government intervention in domestic economy brought with it isolationist sentiment that had a profoundly negative effect on international economics. The priority of national goals, independent national action in the interwar period, and the failure to perceive that those national goals could not be realized without some form of international collaboration—all resulted in "beggar-thy-neighbor" policies such as high tariffs, competitive devaluations that contributed to the breakdown of the gold-based international monetary system, domestic political instability, and international war. The lesson learned was, as the principal architect of the Bretton Woods system New Dealer Harry Dexter White put it:

the absence of a high degree of economic collaboration among the leading nations will … inevitably result in economic warfare that will be but the prelude and instigator of military warfare on an even vaster scale. To ensure economic stability and political peace, states agreed to cooperate to closely regulate the production of their currencies to maintain fixed exchange rates between countries with the aim of more easily facilitating international trade. This was the foundation of the U.S. vision of postwar world free trade, which also involved lowering tariffs and, among other things, maintaining a balance of trade via fixed exchange rates that would be favorable to the capitalist system. Thus, the more developed market economies agreed with the U.S. vision of post-war international economic management, which intended to create and maintain an effective international monetary system and foster the reduction of barriers to trade and capital flows. In a sense, the new international monetary system was a return to a system similar to the pre-war gold standard, only using U.S. dollars as the world's new reserve currency until international trade reallocated the world's gold supply. Thus, the new system would be devoid (initially) of governments meddling with their currency supply as they had during the years of economic turmoil preceding WWII. Instead, governments would closely police the production of their currencies and ensure that they would not artificially manipulate their price levels. If anything, Bretton Woods was a return to a time devoid of increased governmental intervention in economies and currency systems.

Atlantic Charter

The Atlantic Charter, drafted during U.S. President Franklin D. Roosevelt's August 1941 meeting with British Prime Minister Winston Churchill on a ship in the North Atlantic, was the most notable precursor to the Bretton Woods Conference. Like Woodrow Wilson before him, whose "Fourteen Points" had outlined U.S. aims in the aftermath of the First World War, Roosevelt set forth a range of ambitious goals for the postwar world even before the U.S. had entered the Second World War. The Atlantic Charter affirmed the right of all states to equal access to trade and raw materials. Moreover, the charter called for freedom of the seas (a principal U.S. foreign policy aim since France and Britain had first threatened U.S. shipping in the 1790s), the disarmament of aggressors, and the "establishment of a wider and more permanent system of general security". As the war drew to a close, the Bretton Woods conference was the culmination of some two and a half years of planning for postwar reconstruction by the Treasuries of the U.S. and the UK. U.S. representatives studied with their British counterparts the reconstitution of what had been lacking between the two world wars: a system of international payments that would let countries trade without fear of sudden currency depreciation or wild exchange rate fluctuations—ailments that had nearly paralyzed world capitalism during the Great Depression. Without a strong European market for U.S. goods and services, most policymakers believed, the U.S. economy would be unable to sustain the prosperity it had achieved during the war. In addition, U.S. unions had only grudgingly accepted government-imposed restraints on their demands during the war, but they were willing to wait no longer, particularly as inflation cut into the existing wage scales with painful force (by the end of 1945, there had already been major strikes in the automobile, electrical, and steel industries). In early 1945, Bernard Baruch described the spirit of Bretton Woods as: if we can "stop subsidization of labor and sweated competition in the export markets", as well as prevent rebuilding of war machines, "oh boy, oh boy, what long term prosperity we will have." The United States could therefore use its position of influence to reopen and control the rules of the world economy, so as to give unhindered access to all countries' markets and materials.

Wartime devastation of Europe and East Asia

United States allies—economically exhausted by the war—needed U.S. assistance to rebuild their domestic production and to finance their international trade; indeed, they needed it to survive. Before the war, the French and the British realized that they could no longer compete with U.S. industries in an open marketplace. During the 1930s, the British created their own economic bloc to shut out U.S. goods. Churchill did not believe that he could surrender that protection after the war, so he watered down the Atlantic Charter's "free access" clause before agreeing to it. Yet U.S. officials were determined to open their access to the British empire. The combined value of British and U.S. trade was well over half of all the world's trade in goods. For the U.S. to open global markets, it first had to split the British (trade) empire. While Britain had economically dominated the 19th century, U.S. officials intended the second half of the 20th to be under U.S. hegemony. A senior official of the Bank of England commented:

One of the reasons Bretton Woods worked was that the U.S. was clearly the most powerful country at the table and so ultimately was able to impose its will on the others, including an often-dismayed Britain. At the time, one senior official at the Bank of England described the deal reached at Bretton Woods as "the greatest blow to Britain next to the war", largely because it underlined the way financial power had moved from the UK to the US. A devastated Britain had little choice. Two world wars had destroyed the country's principal industries that paid for the importation of half of the nation's food and nearly all its raw materials except coal. The British had no choice but to ask for aid. Not until the United States signed an agreement on 6 December 1945 to grant Britain aid of $4.4 billion did the British Parliament ratify the Bretton Woods Agreements (which occurred later in December 1945).

Design of the financial system

Free trade relied on the free convertibility of currencies. Negotiators at the Bretton Woods conference, fresh from what they perceived as a disastrous experience with floating rates in the 1930s, concluded that major monetary fluctuations could stall the free flow of trade. The new economic system required an accepted vehicle for investment, trade, and payments. Unlike national economies, however, the international economy lacks a central government that can issue currency and manage its use. In the past this problem had been solved through the gold standard, but the architects of Bretton Woods did not consider this option feasible for the postwar political economy. Instead, they set up a system of fixed exchange rates managed by a series of newly created international institutions using the U.S. dollar (which was a gold standard currency for central banks) as a reserve currency.

Previous regimes

In the 19th and early 20th centuries gold played a key role in international monetary transactions. The gold standard was used to back currencies; the international value of currency was determined by its fixed relationship to gold; gold was used to settle international accounts. The gold standard maintained fixed exchange rates that were seen as desirable because they reduced the risk when trading with other countries. Imbalances in international trade were theoretically rectified automatically by the gold standard. A country with a deficit would have depleted gold reserves and would thus have to reduce its money supply. The resulting fall in demand would reduce imports and the lowering of prices would boost exports; thus, the deficit would be rectified. Any country experiencing inflation would lose gold and therefore would have a decrease in the amount of money available to spend. This decrease in the amount of money would act to reduce the inflationary pressure. Supplementing the use of gold in this period was the British pound. Based on the dominant British economy, the pound became a reserve, transaction, and intervention currency. But the pound was not up to the challenge of serving as the primary world currency, given the weakness of the British economy after the Second World War. The architects of Bretton Woods had conceived of a system wherein exchange rate stability was a prime goal. Yet, in an era of more activist economic policy, governments did not seriously consider permanently fixed rates on the model of the classical gold standard of the 19th century. Gold production was not even sufficient to meet the demands of growing international trade and investment. Further, a sizable share of the world's known gold reserves was located in the Soviet Union, which would later emerge as a Cold War rival to the United States and Western Europe. The only currency strong enough to meet the rising demands for international currency transactions was the U.S. dollar. The strength of the U.S. economy, the fixed relationship of the dollar to gold ($35 an ounce), and the commitment of the U.S. government to convert dollars into gold at that price made the dollar as good as gold. In fact, the dollar was even better than gold: it earned interest and it was more flexible than gold.

Fixed exchange rates

The rules of Bretton Woods, set forth in the articles of agreement of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), provided for a system of fixed exchange rates. The rules further sought to encourage an open system by committing members to the convertibility of their respective currencies into other currencies and to free trade. What emerged was the "pegged rate" currency regime. Members were required to establish a parity of their national currencies in terms of the reserve currency (a "peg") and to maintain exchange rates within plus or minus 1% of parity (a "band") by intervening in their foreign exchange markets (that is, buying or selling foreign money). In theory, the reserve currency would be the bancor (a World Currency Unit that was never implemented), proposed by John Maynard Keynes; however, the United States objected, and their request was granted, making the "reserve currency" the U.S. dollar. This meant that other countries would peg their currencies to the U.S. dollar, and—once convertibility was restored—would buy and sell U.S. dollars to keep market exchange rates within plus or minus 1% of parity. Thus, the U.S. dollar took over the role that gold had played under the gold standard in the international financial system. Meanwhile, to bolster confidence in the dollar, the U.S. agreed separately to link the dollar to gold at the rate of $35 per ounce (making $1 equal to 13+5⁄7 grains or 888.67 milligrams). At this rate, foreign governments and central banks could exchange dollars for gold. Bretton Woods established a system of payments based on the dollar, which defined all currencies in relation to the dollar, itself convertible into gold, and above all, "as good as gold" for trade. U.S. currency was now effectively the world currency, the standard to which every other currency was pegged. The U.S. dollar was the currency with the most purchasing power and it was the only currency that was backed by gold. Additionally, all European states that had been involved in World War II were highly in debt and transferred large amounts of gold into the United States, a fact that contributed to the supremacy of the United States. Thus, the U.S. dollar was strongly appreciated in the rest of the world and therefore became the key currency of the Bretton Woods system. Member countries could only change their par value by more than 10% with IMF approval, which was contingent on IMF determination that its balance of payments was in a "fundamental disequilibrium". The formal definition of fundamental disequilibrium was never determined, leading to uncertainty of approvals and attempts to repeatedly devalue by less than 10% instead. Any country that changed without approval or after being denied approval was denied access to the IMF. Maintaining the fixed exchange system required countries to maintain sufficient foreign exchange reserves to intervene in markets and prevent fluctuations away from the pegged rate. This also meant that international movement of capital could not be too large (because that might lead to large fluctuations in the exchange rate and necessitate costly market interventions that risked depleting a country's foreign exchange reserves).

Formal regimes

The Bretton Woods Conference led to the establishment of the IMF and the IBRD (now the World Bank), which remain powerful forces in the world economy as of the 2020s. A major point of common ground at the Conference was the goal to avoid a recurrence of the closed markets and economic warfare that had characterized the 1930s. Thus, negotiators at Bretton Woods also agreed that there was a need for an institutional forum for international cooperation on monetary matters. Already in 1944, the British economist John Maynard Keynes emphasized "the importance of rule-based regimes to stabilize business expectations"—something he accepted in the Bretton Woods system of fixed exchange rates. Currency troubles in the interwar years, it was felt, had been greatly exacerbated by the absence of any established procedure or machinery for intergovernmental consultation. As a result of the establishment of agreed upon structures and rules of international economic interaction, conflict over economic issues was minimized, and the significance of the economic aspect of international relations seemed to recede.

International Monetary Fund

Officially established on 27 December 1945, when the 29 participating countries at the conference of Bretton Woods signed its Articles of Agreement, the IMF was to be the keeper of the rules and the main instrument of public international management. The Fund commenced its financial operations on 1 March 1947. IMF approval was necessary for any change in exchange rates in excess of 10%. It advised countries on policies affecting the monetary system and lent reserve currencies to countries that had incurred balance of payment debts.