Since the beginning of the 19th century, globalization, international trade and free trade between countries became the new economic order and several attempts have been made since then to develop policies and schemes to ensure the stability of the international monetary system. It is safe to say that in truth, the world economy has never been in a state of utopia, but nevertheless, we have never stopped trying to attain such.
The Bretton Woods era of 1944 to 1977, one of the few fairly successful schemes the world powers created in trying to achieve economic utopia, though existed for a short period, has been accredited as being one of the most successful international monetary systems, so impressive was the economic stability and growth of the era that there have been ongoing talks for a comeback of the system.
In this paper we attempt to shed some light on the defunct Bretton Woods system and the possibility of its comeback. In the first section, we discuss its history, design and objectives. Second section, we discuss the reasons for its demise. Third section, we discuss the reasoning behind the calls for a new Bretton Woods. Fourth section, we discuss the obstacles that could prevent the establishment of a new Bretton Woods and lessons from its past experience. Section five will contain the conclusion and some recommendations.
THE OVERALL DESIGN AND INTENDED OBJECTIVE OF THE BRETTON WOODS SYSTEM
Background and Intended Objectives of the Bretton Woods system
At the end of the World War II, 44 allied countries and Argentina came together in Mount Washington Hotel in the area of Bretton Woods, New Hampshire, United States, with a major motive of correcting the ills of the post-war I era which was characterized by International economic disorder, ‘beggar-thy-neighbor’ policies- where countries trying to come out of their depressed states do so, but at the expense of other countries.
The overall intended objective was therefore stable exchange rate and possible promotion of world peace. There was the recognized need for an institutional forum for International cooperation on monetary matters, so that in the advent of a world-wide crisis, such as world wars, there would be an internationally agreeable solution, rather than individual countries adopting selfish policies.
Build-up of the System
This recognized need had prior to the conference in 1944, instigated discussions amongst the British and American governments, and their economic experts, who had come up with different plans; Harry Dexter White of the U.S treasury on one hand, and Lord Keynes of Britain on the other, and the conference was seen as merely formalizing, and finalizing the agreements made. The final decisions which were agreed to at the Bretton woods conference were influenced majorly by the U.S plans. This is evident of the economic and military prowess of the United States at that time.
The concentration of power in the hands of few countries, the like-mindedness of the overall goal (not necessarily the policies in achieving these goals) and the willingness and ability of one country-the U.S to takeover leadership, allowed for the success of the Bretton Woods conference.
The system was designed to incorporate the advantages of both a fixed rate system, such as the gold standard (stable exchange rate), and that of a flexible exchange rate system (flexibility), and the resultant system was the adjustable peg rate system.
The Peg and Exchange Convertibility: The U.S dollar was pegged to gold at the fixed rate of $35 per ounce, and every other country’s currency was then pegged to the dollar at a par value which had to be maintained or defended by buying and selling the dollar in the foreign currency market. Though there was no International Central Bank to produce an International currency, and control its supply, the U.S dollar became in effect, the world currency. With the fixed peg of $35 per ounce of gold, the rate at which countries could exchange their dollar for gold and vice-versa, the U.S dollar became as good as gold, and this boosted faith in the U.S dollar.
This system afforded an opportunity for exchange rates amongst countries to be fixed in the short run, within a 1% band around the pegged rate. A country could change the rate at which it was pegged to gold, outside the 1% band, only if its balance of payment was in ‘fundamental disequilibrium’.
Why The U.S Dollars: The U.S was still the only currency being backed by gold, and at that time held three-quarter of the world’s monetary gold (Gold had been transferred to U.S by European nations during the war), leaving the $ the most appreciated currency to the rest of the world. It was also the strongest economy after the World War II, and was considered liquid enough to meet the demand of increasing Internationalization, and global trade.
Addressing Liquidity: To satisfy International liquidity, and to prevent the repeat of the gold shortage of the 1920s, and the fallout of the fixed rate of the 1930s, another major decision to be made was as regards adequate supply of official monetary reserves; This was very fundamental to the effective running of an adjustable peg rate. The conference agreed to a system of subscriptions and quotas which reflected each country’s economic strength. The quota of each member country was made up of 25% of gold and the remaining 75% in the country’s domestic currency. The quotas were important also because they determined the voting right, and the amount of foreign currency each member country could borrow from the fund.
The Commissions: Three commissions were set up at the conference to achieve its intended objectives.
The first Commission headed by Harry D, White of the U.S treasury was designed to formulate the Articles of Agreement of the International Monetary Fund, which was at the very heart of the system.
The second commission was also introduced to formulate the Articles of Agreement for the International Bank for Reconstruction and Development. This was chaired by Lord Keynes of the United Kingdom. It then had the duty of financing post-war international reconstruction and development. Now known as the World Bank, it remains a very influential global body with a broader capacity.
The third commission, was chaired by Dr. Eduardo Suarez of Mexico, and it was charged with coming up with other means of International financial cooperation.
THE REASONS FOR THE EVENTUAL DEMISE
According to economic historians, the Bretton Woods system came to a halt in the 1970s leading to a switch from a state-led to a market-led system of monetary control. Crucial events leading to its demise being the suspension of the dollar’s convertibility into gold in 1971, the United states abandonment of Capital Controls in 1974, and Great Britain’s ending of capital controls in 1979 which was swiftly copied by most other major contries, amongst other reasons enumerated below:
Balance of Payment: A major cause for the demise of the Bretton Woods system was its dependence on the United States economy. The system was designed to remain strong as long as the U.S economy remained strong. However, an excessive supply of US dollars on FOREX markets in exchange for other currencies led to the US dollar depreciation and appreciation of non-reserve currencies. To maintain the fixed exchange rate, non-reserve countries were required to intervene on the private FOREX. For example, the British central bank was required to run a balance of payments surplus, buy the excess dollars and sell pounds on the private FOREX market.
This Balance of payment surplus had inflationary problems because of the excess supply of the non-reserve country’s currency. The U.S. economy also faced inflationary pressure from operating a balance of payment deficit, the federal government expenditure rose from financing the Vietnam War and social programs. The U.S used expansionary monetary policies, printing more money, in order to finance those huge expenses. This increased money supply, which led to U.S goods becoming more expensive than foreign goods due the rise in prices and caused a large demand for foreign currency.
The Triffin Dilemma: Another reason for the collapse of the system was the Triffin dilemma. Robert Triffin was a Belgian economist and Yale University professor who highlighted the problems related to dollar overhang. Dollar overhang occurred when the amount of U.S dollar assets held by non-reserve central banks exceeded the total supply of gold in the U.S treasury at the exchange rate of $35 per ounce. Dollar overhang occurred in the system by 1960 and continued to worsen throughout the decade of the 1960s. By 1971, foreign holdings of U.S dollars stood at $50 billion while U.S gold reserves were valued at only $15 billion. This led to speculation on the U.S dollar, devaluing the dollar and holding gold became the safe route. In a gold exchange standard this linkage between gold and the reserve currency is believed to provide the constraint that prevents the reserve currency country from disproportionate monetary expansion and its ensuing inflationary effects.
In the face of balance of payment deficits leading to a severe depletion of gold reserves, the U.S had several adjustment options open. One option was a devaluation of the dollar. However, this was not an option easy to implement. The only way to realize the dollar devaluation was for other countries to revalue their currencies with respect to the dollar, as the currencies were fixed to the dollar. The other devaluation option open to the US was devaluation with respect to gold. In other words, the U.S could raise the price of gold to $40 or $50 per ounce or more. However, this change would not change the fundamental conditions that led to the excess supply of dollars. At most, this devaluation would only reduce the rate at which gold flowed out to foreign central banks. Also, since the U.S gold holdings had fallen to very low levels by the early 1970s and since the dollar overhang was substantial, the devaluation would have had to be extremely large to prevent the depletion of U.S gold reserves.
The other option open to the U.S was a change in domestic monetary policy to reduce the excess supply of dollars on the FOREX. Recall, that money supply increases were high to help finance rising federal deficit spending. A reversal of this policy would mean a substantial reduction in the growth of the money supply. If money supply increases were not available to finance the budget deficit the government would have to resort to a much more unpopular method of financing; namely raising taxes or reducing spending. The unpopularity and internal difficulty of such fiscal and monetary prudence led the U.S to resort to other options.
Suspension of the Dollars Convertibility: The final blow on the Bretton Woods system came on August 15, 1971 when the then U.S president Richard Nixon announced measures to stem the excessive flight of dollars on foreign demand and reduce the balance of trade deficit as well as cause non-reserve countries to revalue their currencies against the dollar. The measures were a 10 percent surcharge on imports, a 90 day wage and price control, and the suspension of convertibility of dollar to gold. The 10 percent surcharge on imports was to force countries, such as Japan, to revalue their currency by 10 percent and the 90 day wage and price control was to prevent foreign exporters from transferring the burden of the 10 percent import tax through increased price on the American people as well as reduce inflation. The suspension of convertibility of dollar to gold ultimately ended the gold exchange standard of the Bretton Woods system and changed the system to a reserve currency system. This prompted the Smithsonian agreement of December 1971 where non-reserve countries agreed to revalue their currencies against the dollar for the 10 percent import charge to be dropped, and the eventual devaluation of the dollar. The price of gold rose from $38 per ounce to $44.20 per ounce in 1971 and even higher to $70.30 per ounce causing an increase in flight of dollar abroad and prompting non-reserve countries to abandon the pegging of their currency to the dollar and moving into a floating exchange rate regime.
THE REASONING BEHIND ONGOING DISCUSSIONS TO INTRODUCE A NEW SYSTEM
The last 10 years have been followed by many public discussions about Bretton Woods’s system with different controversial opinions. According to S.Dammasch (2000, p.11-12) “Human rights activists argue that the programmes for the structural adjustment (SAP) of the developing countries initiated by the World Bank and the IMF has led to increase poverty of the East-bloc states. In contrast, however, major industrialized nations have begun to worry about the implications of the growing size and the speculative nature of financial movements in times of increasing globalization trends. Thus, calls for a “new system of Bretton Woods” have been heard in almost every industrialized country”.
Several calls have been made over the years for a refurbished international system to tackle the problem of uncontrolled capital flows amongst nations. Several Financial journalists have also noted that Financial crises since 1971 have been preceded by large capital inflows into affected regions. It wasn’t until late 2008 that this idea began to receive substantial support from leading politicians.
There has been a call by French President Nicolas Sarkozy during the World Economic Forum in Davos in 2010, for the reinvention of the Bretton Woods system of currency valuations in order to remove volatility and monetary manipulation by some nations to enhance their export successes. (Diane Francis, 2010)
On October 13, 2008, British Prime Minister Gordon Brown (APT Team, 2008) said “world leaders must meet to agree to a new economic system: ‘We must have a new Bretton Woods, building a new international financial architecture for the years ahead.’”
Generally the industrial nations experienced much slower growth and higher unemployment in the post Bretton Woods era, and according to Professor Gordon Fletcher in retrospect the 1950s and 60s when the Bretton Woods system was operating came to be seen as a golden age. (Fletcher.G,1989). Financial crises are seen to have been more extreme and have increased in frequency with the emerging economies bearing the brunt of it before the most recent global financial crisis which started in 2007.
Chief amongst these strengths of the old Bretton Woods as noted by Anna J. Schwartz (2000) was that there were low and stable inflation rates on the average for most Industrialised countries except for Japan during the Bretton woods era. More so, considerable expansion of international trade and investment and the real per capita income growth was higher than in any monetary regime since 1879.
CHALLENGES TO A NEW BRETTON WOODS SYSTEM
Various factors have been identified as clogs in the wheel of the advancement of a new Bretton Woods system, some of them are:
Evolution of the World Economy: One of the major reasons why a new Bretton Woods system might not work is because of how evolved the global economy has become in terms of international trade and monetary management. After the demise of the old Bretton Woods system, the following structural changes have taken place in world economies:
Growth of international currency markets: due to the instability and lack of certainty in the financial world, having a fixed exchange rate became difficult and thus rational expectations and predictions were fuelled with uncertainty. Thus, for countries to make well informed decisions based on prevailing economic conditions, they adopted a floating exchange rate system, so that the true value of the economy could be revealed at all times.
A major reason the Bretton Woods system was successful was because of its fixed exchange rate system. Thus, with the current increase in trade and volatility of the monetary system, a fixed rate system might be difficult to implement.
Lack of Dominant Currency: During the Bretton woods era the U.S. dollar was the most stable and powerful currency. It was also the only currency strong enough to be exchanged for gold. Since it was the strongest currency, countries traded mostly in the dollar.
Although currently, due to the prevailing economic conditions, the dollar and other currencies like the Chinese RMB, euro, yen are unstable and not strong enough to be dominant currencies.
The Old Bretton Woods was successful because it only had one currency to measure by. The lack of a dominant currency would therefore pose challenges to the development of a new system and multiple currencies will only be more destabilizing.
Derivative trading: with the emergence of the international currency markets, derivative trading has been a popular favourite of the financial market traders. Speculation, hedging, derivatives and arbitrage trading in the financial system have significant impact on the level of international prices and exchange rates, that it cannot be ignored. Integrating these in a new monetary system would involve complex controls which might be difficult to implement.
Conflicts of Interest: Different nations have different levels of growth, different objectives, and different currency policies. For some countries adopting a fixed exchange rate is more convenient, while for others, especially developing countries having a flexible exchange is more profitable. Due to the varying preferences and objectives of each nation, being cooperative and following a particular policy could be quite inconvenient and disadvantageous for most.
Floating Exchange Rate System: The fixed exchange rate system of the old Bretton Woods was advantageous but had limitations. Though it encouraged price stability and was anti-inflationary, its restrictive nature prevented necessary adjustments to economic disequilibrium. Presently, the exchange rates worldwide for most countries are flexible. This flexibility makes trade between developing and developed countries bearable and profitable. When fixed, trade is expensive for most developing countries. And with the current economic recession, flexibility is what the economy needs to make profitable trade.
The Original vs. A Sequel: According to G. Rachman (2008, Financial times), a new bretton woods will flop. Reason being that;
Like most sequels, Bretton Woods II is not going to be nearly as good as the original. The first conference gave birth to the World Bank and the International Monetary Fund. Its successor will be duller and less consequential.
The first reason for this is that the global financial crisis, bad as it is, is not as bad as the Second World War. The war destroyed the established order and so the world leaders who drew up the postwar institutions on a blank slate.
Second, there isn’t enough time. The original Bretton Woods conference benefited from two years of preparation, and not a few weeks. Finally, there are conflicts of interest and U.S has neither the power nor the inclination to impose a new set of arrangements on the rest of the world.
Of course his opinion is subjective, but in truth, given an ill prepared plan and conflicts of interests, a new Bretton Woods is most likely to fail.
Inefficient Governance: Creating a Bretton Woods system that takes account of the complex intrinsic and extrinsic framework of the global economy is quite difficult. The economy has evolved a lot since the 1944 when the first Bretton woods system was made. There are more world leaders now, and the more the world leaders are, the higher the differences in preferences. Creating a Bretton Woods that could possibly integrate the objectives of all nations is not only difficult but if created will require high maintenance.
LESSONS FROM THE OLD BRETTON WOODS
U.S Deficit budget: During the Bretton woods era, the U.S ran deficit budget. Due to the nation’s constant lending to other nations, they experienced a severe deficit in their balance of payments which strongly affected their international financial position and status negatively. This deficit made the dollar weak and undependable.
Due to the large scale of economic activities globally, the exchange rate is always adjusting to reflect the real value of the economy. Thus having just one currency pegged to gold in this present time is no longer reasonable. Currencies need to be flexible against each other, so that when a nation runs a deficit, and its currency looses value, the whole economy will not lose at the same time.
Bretton Woods Policies: When the policy of a fixed exchange rate system was established, the financial strength of developing countries was not adequately taken into consideration. In the short run, the fixed exchange rate worked well for the developed countries, but as the developing countries claimed independence and began to evolve into the global economy, trade with the developed economies at a fixed rate was definitely too expensive for them.
Moreover, polices imposed by the World Bank and IMF on developing countries like SAP i.e. structural adjustment program didn’t work out well on the developing countries, it has been argued that it worsened their level of poverty, S.Dammasch (2000, p.11).
The Slide to breakdown: The breakdown of the Bretton Woods system occurred via the failure of the dollar as the dominant currency, the rules of cooperation for its convertibility into gold and the exchange rates regime. The lack of a backup currency to resolve the issue or at least minimize the losses incurred contributed to the demise of the system.
Thus the Bretton Woods dependence on the dollar been the only currency that could be convertibility to gold was too risky.
Short run vs. Long run functions: Another problem with the Old Bretton Woods was that the same plan was made for the short run and long run. Right after World War II, the international monetary system was only concerned with their present predicament of how to get the economy back on track. Given the destruction caused by the war, addressing the pressing need of the economy was appropriate but during evaluations in the short run, proper schemes and policies should have been arranged to counter what could go wrong in the long run.
The undoing of the Bretton woods system was that the plans for the short run were allowed to run indefinitely into the long run until they could no longer hold. Thus the system defaulted.
RECOMMENDATIONS AND CONCLUSION
The worst banking crisis since the Great Depression strongly suggests that a global rules-based system is necessary to oversee financial markets and coordinate economic management. Hence, this has led to the ongoing discussions to reintroduce the Bretton woods system. As discussed in the earlier part of this paper, this is not going to be an easy task as the world’s market economy has drastically changed and thus cannot be compared to mid 90’s. This has led us to suggest some recommendations which should be helpful if this vision of reintroducing the Bretton Woods system is to be realized.
A new Bretton woods system is plausible as long as it can adapt to varying economic conditions as the global economy evolves. Thus the following:
Stronger monetary policy: Given the current system of floating exchange rates, the World Bank should advise the governments of each country to implement monetary policies that ensure that their currency is not undervalued or overvalued.
Inflation targeting: Plans to prevent the occurrence of repetitive financial crises should be made; one defect that is common in all financial crises is inflation. Inflation is good for the economy, but when this inflation is excessive, the growth is one-sided. Thus as economic growth occurs for some sectors of the economy, other sectors are worse off accumulating loss and debt. There is a huge case of inequality in the economy and no real economic development ever occurs. Thus a new Bretton Woods system should take considerate account of the inequality caused by inflation.
Regulation for derivatives: From the recent financial crisis, derivative trading has been seen to have played a huge role in increasing the negative impact of the crisis. If possible, a special regulation body or committee should be tasked with responsibility of monitoring and regulating the derivatives market. Because most derivatives are OTC, there is no public information as to their transactions, but since it has proven through the recent crisis that it has a strong hold in the market. Such activities should be divulged to the government. So, that to a certain extent an adequate regulatory framework can be established and financial loss minimized.