Bretton Woods System

Recall that the representatives of the US and its Allies worked out three post-war arrangments: (i) ITO (still-born), replaced by GATT and WTO (ii) IBRD (which became the World Bank) and (iii) IMF.

For 25 years after WWII (see the timeline), the international monetary system known as the Bretton Woods system, was based on stable and adjustable exchange rates.

Exchange rates were not permanently fixed, but occasional devaluations of individual currencies were allowed to correct fundamental disequilibria in the balance of payments (BP). Ever-increasing attack on the dollar in the 1960s culminated in the collapse of the Bretton Woods system in 1971, and it was reluctantly replaced with a regime of floating exchange rates.

By signing the agreement, nations were submitting their exchange rates to international disciplines.

This amounted to a significant surrender of national sovereignty to an international organization.

Deflationary policy: Under the gold exchange standard, a country has to resort to the classical medicine of deflating the domestic economy when faced with chronic BP deficits.

Before World War II, European nations often used this policy, in particular the Great Britain. Even though few currencies were convertible into gold, policy makers thought that currencies should be backed by gold and willingly adopted deflationary policies after WWI.

Currencies were convertible into gold, but unlike the gold exchange standard, countries had the ability to change par values of their currencies. For this reason, Keynes described the Bretton Woods system as "the exact opposite of the gold standard."

Structural problem: Over time the world economy grew and needed more liquidity or reserve assets. Given the fixed quantity of gold (165,000 tons or 4 billion ounces) , the increased world demand for dollar as reserve assets meant that US had to maintain increasing trade deficits. But the US was not able to devalue the dollar.

The dollar was the numéraire of the system, i.e., it was the standard to which every other currency was pegged. Accordingly, the U.S. did not have the power to set the exchange rate between the dollar and any other currency.

Changing the value of dollar in terms of gold has no real effect, because the values of other currencies were pegged to the dollar. This is the n-th currency problem.This problem would not have existed if most of other currencies were pegged to gold. However, none of these currencies were pegged to gold because they were not convertible into gold. (limited supply of gold)

IMF was established to provide member countries with the necessary funds to cover short term balance of payments problems. The Fund in turn received resources from members who were allotted quotas.

(Total Quota = 238 billion SDR as of 2010, to be doubled, reaching 476 billion SDR in 2011).

Upon entering the Fund, a country submitted a par value of its currency expressed in terms of gold or in terms of the US dollar using the weight of gold in effect on July 1, 1944 ($35 per troy oz).

All exchange transactions between member countries were to be effected at a rate that fluctuated within 1% band (which approximates gold import/export points) around the par values of the respective currencies.

Article IV

Change par value

Article IV: A member could change the par value of its currency only to correct a fundamental disequilibrium in its balance of payments, and only after consulting with the Fund.

(However, speculators correctly anticipate such weak currencies, making it more difficult for the monetary authorities to defend them.)

In case when the Fund objects a change, but the member devalues its currency, then that member is ineligible to use Fund's resources.

The Fund cannot formally propose a change of the par value of a currency.

No objection to a change if the cumulative change is less than 10% of the par value.

Britain adopted deflationary policy in the 1920s, but the surplus countries (US + France) did not participate in the adjustment process.

Exceptions: Article VII + XIV

Most nations outside the Communist bloc became members of the IMF.

World trade increased six-fold between 1948-1973. But the total international reserve increased only by 3% during the same period. So lack of international reserve became acute. The US had acquired the bulk of the world's gold. In 1946, the US held $26 billion worth of gold when the estimated world total was $33 billion.

If the U.S. had exported Treasury bills, it would have provided additional reserves for the US. However, nations became increasingly reluctant to hold $. Gradually, the US stock of gold was depleted.

The Fund was the source of financing for a member country experiencing a temporary disequilibrium in its balance of payments. These resources come from gold and currency subscriptions of its members.

Reserve/Gold tranche

Credit tranche

Reserve (gold) tranche: 25% of quota was paid to the Fund in gold (1944 US dollar)

Credit tranche: 75% of quota was paid in the currency's own currency.

In 1946, the Fund started with aggregate quotas of $8 billion, 20% of world reserves. The quota was raised in 1971. The largest quota was US: $6.7 billion (21.9%): U.K. $2.8 billion (9.2%), Germany, France 5%, Japan 4%. The quota was increased several times.

In 1990 the quota was increased to $135 billion, still equal to about 20% of world reserves.
In 1998, the quota was again increased to SDR 212 billion (about $288 billion). There have been no increases thereafter.

The quota determines the voting power of a member's executive director. (250 votes + 1 vote for SDR100,000)

US holding of gold: currently, about 8,000 tons ($160 billion at $40 per oz), or about 5% of the world holding. (the world has about 145,000 tons)

(i) Basic Facility: gold tranche + 4 credit tranche = 125%

(ii) Extended Facility: 140%

(iii) Standby Agreements: Short term borrowing member countries negotiate to receive the Fund's guarantee. usually borrowing is for 3-5 years.

(iv) General Agreements to Borrow (GAB): was negotiated in 1962 by the Group of Ten: France, Italy, Germany, Belgium, Netherlands, Sweden, Japan, UK, US, Canada. Switzerland joined in 1964. The fund could borrow up to $5.9 billion from the Group of Ten to provide more short term assistance.

(v) Currency Swap Arrangements: made in 1962. bilateral arrangements between central banks.

The international monetary system evolved in a way that was not foreseen in the Articles of Agreement of IMF.

During the 1950s the US emerged as the leading reserve country, and the dollar increasingly taking over the function of gold as a major international reserve asset.

No one planned this development. The US was the dominant world power. Well over half of all international money transactions were financed in terms of dollar; the US produced more than half of the world output. The US also owned about two thirds of the official gold reserve in the world in 1940.  

Dollar became the dominant invoice currency. Most exporters invoiced the importers in dollars. When the European countries had reserve surpluses, they converted the surpluses into dollar reserves rather than gold because

(i) interest could be earned on dollar assets, and

(ii) dollar reserves can always be converted into gold at $35 per ounce whenever it became necessary.

All of the non-Communist countries maintained a stable relationship between their currencies and the dollar either directly or indirectly through the British pound. The US dollar was at the center of this system. Since the Great Britain halted gold convertibility of its currency, US dollar was the only currency directly convertible into gold for official purposes. Before WWI, the pound sterling performed a similar function, but the sterling area had shrunken to a small number of countries.

As the Bretton Woods system evolved, the reserves of most countries became a mixture of gold and dollars. US dollar became increasingly more important.

In particular, President of France, De Gaulle, complained that the US had an exorbitant privilege: unlimited financing because other countries were willing to hold dollar assets.

As the price of the foreign currency (e) rises, net exports = X(e) - M(e) declines, which reduces the trade deficit.

A permanent and effective solution (under fixed exchange rates).

A temporary remedy.

Since the stock of gold is limited, it will soon run out.

(5) increase liabilities to foreign central banks. (5) = (6) below

(6) The surplus country (e.g., China) holds more dollar assets.

This means the US is unwilling to devalue $, or the surplus country (e.g., China) is unwilling to let RMB appreciate. A temporary solution, and eventually the latter country gives up.

As China holds more dollar assets, their value in RMB declines when RMB appreciates (Chinese investors lose money), which eventually happens.

Only speculators gain.

During the period 1958-1971, the US experienced a persistent deficit in its balance of payments. At first, economists viewed these annual deficits as temporary. However, it gradually dawned to policy makers that the US deficits were not disappearing. The causes of these chronic deficits include:

(a) a higher rate of return r* > r, which results in a capital outflow.

(b) military commitments in Europe and Asia.

(c)The Vietnam war also caused inflation in the US.

During the years 1958-1971, the US experienced a cumulative reserve deficit of $56 billion. In other countries, the international reserve mainly consisted of US dollar and gold, although the currencies of other major countries were reserve assets but they played a minor role.

US reserve assets included foreign currencies such as Yen, DM and British pound at first. However, by the end of the 1960s, the US international reserve consisted of mainly gold.

(a few months after Nixon's declaration of dollar's gold inconvertibility)