2. History of International Monetary Systems, Part 2

(See handout no.2)

The creation of the Bretton Woods system

After World War II, the Bretton Woods system was established. In fact, the agreement to create a new international monetary system was negotiated among the allied powers even before the end of WW2, leading to the Bretton Woods Agreement in 1944. Bretton Woods is the name of a small tourist spot in the mountains of New Hampshire, USA. There, the delegates gathered to design a new global economic system. Their most important goal was to prevent each country from pursuing selfish policies, such as competitive devaluation, protectionism and forming trade blocks, which damaged the world economy in the 1930s.

The British delegation was headed by John M. Keynes, the famous economist, while Harry D. White  of the US Treasury Department represented the American side. The contents of the new system were negotiated essentially by these two countries. As a dominant military and economic power, the US took the leadership away from Britain, which was war torn and losing international influence. The Keynes proposal was rejected and the US idea became the foundation of the newly created International Monetary Fund (IMF).

The rejected British proposal was to create a mighty settlement union for all countries. Each country was to have an official account at this mechanism, and all balance of payments (BOP) surpluses and deficits would be recorded and settled through these accounts. This would mean that both surplus and deficit countries bear the responsibility for correcting the imbalance.

However, the US plan, which was actually adopted, was a much weaker revolving fund. Each country would contribute a certain amount ("quota") to this fund, and member countries with BOP difficulties would borrow (or "purchase" hard currencies) from this fund. This meant that only deficit countries would bear the responsibility for correcting the imbalance. (The UK was expected to be a deficit country after the war, while the US was expected to be a surplus country.) Later in the 1950s, borrowing countries were required to implement macroeconomic policies to reduce the deficit ("conditionality").

The Bretton Woods Agreement also established the World Bank (International Bank for Reconstruction and Development). The World Bank's initial purpose was to assist the recovery of war-torn Europe and Japan. But in reality, Japan's recovery was assisted by US bilateral aid and Europe's recovery was promoted by the Marshall Plan, a massive US aid program. The World Bank subsequently became an organization to assist developing countries.

The IMF and the World Bank were called the Bretton Woods sister organizations. One more organization (International Trade Organization) was also planned but not created at that time. Instead, the General Agreement on Tariffs and Trade (GATT), a non-organizational entity, played the role of promoting free trade for four decades. GATT became institutionalized as WTO in 1995. So we now have three sisters.

The IMF (left) and the World Bank today, in Washington, DC

Features of the Bretton Woods international dollar standard

Four main features of the Bretton Woods system was as follows.

First, it was a US dollar-based system. Officially, the Bretton Woods system was a gold-based system which treated all countries symmetrically, and the IMF was charged with the responsibility to manage this system. In reality, however, it was a US-dominated system with the US dollar playing the role of the key currency (the dollar's dominance still continues today). The relationship between the US and other countries was highly asymmetric. The US, as the center country, provided domestic price stability which other countries could "import," but did not itself engage in currency intervention (this is called benign neglect; i.e., the US did not care about exchange rates, which was desirable). By contrast, all other countries had the obligation to intervene in the currency market to fix their exchange rates against the US dollar.

Second, it was an adjustable peg system. This means that exchange rates were normally fixed but permitted to be adjusted infrequently under certain conditions. As a consequence, exchange rates were supposed to move in a stepwise fashion. This was an arrangement to combine exchange rate stability and flexibility, while avoiding mutually destructive devaluation. Member countries were allowed to adjust "parities" (exchange rates) when "fundamental disequilibrium" existed. However,  "fundamental disequilibrium" was not clearly defined anywhere. In reality, exchange rate adjustments were implemented far less often than the builders of the Bretton Woods system imagined. Germany revalued twice, the UK devalued once, and France devalued twice. Japan and Italy did not revise their parities.

Third, capital control was tight. This was a big difference from the Classical Gold Standard of 1879-1914, when there was free capital mobility. Although the US and Germany had relatively less capital-account regulations, other countries imposed severe exchange controls.

Fourth, macroeconomic performance was good. In particular, global price stability and high growth were simultaneously achieved under deepening trade liberalization. In particular, stability in tradable prices (wholesale prices or WPI) from the mid 1950s to the late 1960s was almost perfect and globally common. This macroeconomic achievement was historically unprecedented.

How did the Bretton Woods system collapse?

With such an excellent macroeconomic record, why did the Bretton Woods system collapse eventually? Economists still debate on this question, but it is undeniable that there was a nominal anchor problem. The collapse of the Classical Gold Standard was externally forced (i.e., by the outbreak of WW1), but the collapse of the Bretton Woods system was due to internal inconsistency. The American monetary discipline served as the nominal anchor for the Bretton Woods system. But when the US started to inflate its economy, the international monetary system based on the US dollar began to disintegrate.

Let us follow the history of the Bretton Woods system, step by step.

The 1950s was a period of dollar shortage. Europe and Japan wanted to increase imports in the process of recovery from war damage. But the only internationally acceptable money at that time was the US dollar. So their capacity to import was severely limited by the availability of foreign reserves denominated in the US dollar.

However, by the late 1960s, there was a dollar overhang (oversupply) in the world economy. This turnaround was due to the US balance of payments deficit, which in turn was caused by expansionary fiscal policy. The spending of the US government increased for three reasons: (i) the war in Vietnam; (ii) welfare expenditure; and (iii) the space race with the USSR (send humans to the moon by the end of the 1960s).

In the late 1950s, the IMF felt the need to create a new international currency to supplement the dollar. But the international negotiation took a long time, and the artificial currency (called the Special Drawing Rights, or SDR) was created only in 1969. By that time, there was no longer a dollar shortage; in fact there was a dollar glut! (Today, SDR plays only a minor role, mainly as the IMF's accounting unit.)

In the mid 1960s, US domestic inflation (as measured in WPI) began to accelerate, which strained the Bretton Woods system. When the US was providing price stability, other countries were willing to give up monetary policy independence and peg their currencies to the dollar. Through this operation, their price levels were also stabilized. But when the US began to have inflation, other countries gradually refused to import it.

There was a downward pressure on the dollar. In 1968, the fixed linkage between dollar and gold was abandoned. The two-tier pricing of gold was introduced whereby the "official" gold-dollar parity was de-linked from the market price of gold. The market price of the dollar immediately depreciated. This was similar to the situation of multiple exchange rates: an overvalued official rate vs. a more depreciated market rate.

President Nixon went on TV to end the Bretton Woods system.

Finally, in 1971, the fixed linkage between dollar and other currencies was given up. On August 15, 1971, US President Richard Nixon appeared on TV and declared that the US would no longer sell gold to foreign central banks against the dollar. This completely terminated the working of the Bretton Woods system and major currencies began to float. At the same time, President Nixon also imposed temporary price controls and stiff import surcharges. These measures were all supposed to fight inflation and ameliorate the balance of payments crisis that the US was facing. This was called the "Nixon Shock." [If any country adopted such a policy package today, it would be severely criticized by the IMF, WTO and the international community. It would be told to tighten the budget and money first.]

For 11 trading days that followed, the Bank of Japan intervened heavily in the currency market to fight off massive speculative attacks, losing 4 billion dollars of foreign reserves. Then, it gave up and let the yen appreciate. European central banks gave up much sooner before losing a lot of foreign reserves.

Between 1971 and 1973, there was an international effort to re-establish the fixed exchange rate system at adjusted levels (with a more depreciated dollar). In December 1971, the monetary authorities of major countries gathered in Washington, DC to set their mutual exchange rates at new levels (the Smithsonian Agreement). But these rates could not be maintained very long. In early 1973, under another bout of heavy speculative attacks, the Smithsonian rates were abandoned and major currencies began to float.

Triffin's dilemma

Prof. Robert Triffin offered a famous explanation as to why the Bretton Woods system had to collapse inevitably. He noted that there was a fundamental liquidity dilemma when some country's national currency was used as an international money.

His argument went something like this. As the world economy grew, more international money (=dollar) was demanded. To supply that, the US had to run a balance-of-payments deficit (how else can the rest of the world get more dollars?) But if the US continued to run a BOP deficit, it would lose credibility as a sound currency country. The amount of gold that the US had would soon be much less than the amount of dollars held by other countries. This meant that the US could not guarantee conversion of international dollars into gold, if all foreign central banks tried to cash in.

To supply global liquidity, the US must run a deficit. But to maintain credibility, the US must not run a deficit. That was the fundamental dilemma. In the end, the US opted to run a BOP deficit, which led to the loss of credibility and the collapse of the Bretton Woods system.

According to Prof. Triffin, the US should not be blamed for the collapse of the Bretton Woods system, because there was no way to get out of this impossible situation. But is Prof. Triffin right?

The issue is controversial. My personal view is that Prof. Triffin was not necessarily right, that there was a logical way out of this "dilemma." First, de-link dollar from gold so the US government is relieved of the obligation to exchange gold for dollar. Second, supply just the right amount of dollar to the world to avoid global inflation or deflation (this requires adjustments in fiscal and monetary policies, just as the IMF would recommend). If these revisions were adopted, I think the Bretton Woods system could have continued much longer. Obviously, this would have required a lot of hard thinking, political maneuvering, and consensus building. Whether that was possible at that time was another matter.

Gold and money

At this point, we may stop and ask why gold is needed at all for the design of the international monetary system. Why can't a wise central bank (or a group of them) manage money supply without any reference to gold? In fact, this was exactly the question raised by Keynes (Lecture 1).

Perhaps the most fundamental answer is: central bankers are (were) not so wise. If you tie the value of money to gold, it may fluctuate due to the shifting demand and supply conditions of gold. But that would be much better than hyperinflation or deep devaluation caused by a huge budget deficit or irresponsible monetary policy. Gold is needed to discipline the monetary and fiscal authorities. Even though macroeconomics has advanced, we cannot trust every central banker, even to this date.

But at the same time, there are problems associated with the rigid gold-money linkage.

First, short-term price fluctuation is unavoidable. In the 19th century, when a new gold mine was discovered in California or Alaska, the supply of gold increased greatly and the world had an inflation. But when there was no such big gold discovery, there was a deflation. No one could ensure that the speed of gold discovery matched the increase in global money demand.

Second, the more serious problem is long-term shortage of monetary gold. Over the years, the growth of the rapidly industrializing world economy was faster than the pace of gold discovery. In order to supply the needed money, the gold standard was gradually transformed so that a small amount of gold could back a much greater amount of money. The gold standard evolved in the following steps.

(1) Gold coin standard: only gold coins circulate as money, and no paper money or bank deposits are used. The amount of monetary gold is equal to money supply. All money has intrinsic value.

(2) Gold bullion standard: as the banking system creates deposit money, people begin to carry paper notes for convenience. But paper money can be exchanged for gold at any time. Most monetary gold is accumulated at bank vaults in the form of gold bullions (gold bars). Through the money multiplier process, money supply is much greater than the amount of gold held by banks.

(3) Gold exchange standard: if gold shortage persists, further saving of gold becomes necessary. Gold can be held only by the center country (US Federal Reserves) while other central banks hold dollar reserves, not gold. Their dollar holdings are guaranteed to be converted to gold by the US.

These institutional changes proceeded naturally in order to economize the use of gold to support an ever greater amount of money in the world. The Bretton Woods system, which collapsed in 1971, was the last gold-exchange standard.

Originally, gold was needed to constrain fiscal and monetary authorities. But if this constraint was too tight for world economic growth, and if institutional changes were required now and then to loosen it, why continue to be bound by it?



Bordo, Michael D., and Barry Eichengreen, eds, A Restrospect on the Bretton Woods System: Lessons for International Monetary Reform, NBER and University of Chicago Press, 1993.

James, Harold, International Monetary Cooperation since Bretton Woods, International Monetary Fund and Oxford University Press, 1996.

McKinnon, Ronald I., The Rules of the Game: International Money and Exchange Rates, MIT Press, 1996.