For 25 years after WWII, 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.

Territorial waters = 12 nautical miles. US navy ships patrolled near Spratly archipelago on international waters (outside 12 nm).

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 (backed by gold within limits), 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." The world economy tripled in size during the two decades, but gold supply did not change much.

A bank run occurs when a large number of customers flock to the bank to withdraw money simultaneously. Bretton Woods system fell apart when major nations began to demand payments in gold.

Structural problems: (i) Over time the world economy grew and needed more liquidity or reserve assets. ⇒ Marshall Plan Aid.

Gate of Honor, Versaille Palace
"Wir wollen Kohle, Wir wollen Brot" (We want coal, We want bread). (former) President Herbert Hoover (1947): The whole economy of Europe is interlinked with German economy through the exchange of raw materials and manufactured goods.)

(ii) Given the fixed quantity of gold (192,000 tons or 6.2 billion ounces, annual production of gold = 80 million ounces = $100 billion), other countries had to hold US dollar and gold as reserve. Keynes had proposed that a world reserve currency be created and managed by a central bank. (Today IMF manages SDR.)

(iii) As the world economy grew, the increased world demand for dollar as reserve assets meant that US had to incur increasing trade deficits. (1945: US = 50%, 1960: US = 40%)

(iv) Other countries resorted to devaluation to reduce trade deficits. But the US was not able to devalue the dollar. (Raising the price of USD did not affect the dollar pegs of other currencies.)

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 parities 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)

Invasion of Normandy (June 6, 1944)
International Monetary Fund and World Bank meeting was held in July 1944 in Bretton Woods, New Hampshire, one month after the invasion of Normandy.

This meeting to establish United Nations was held in San Francisco and the charter was signed in June 1945 (after Germany's surrender).

UN came into existence in October 1945. The Articles of Agreement of the IMF was signed in December 1945. The next year, the By-laws were adopted at a meeting in Savanna, Georgia (March 8-18, 1946).

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.

Initial quota: $8 billion (worth about $80 billion today)
(Total Quota = 238 billion SDR as of 2010, 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

Changing 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 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.

During the Bretton Woods era (1948-73), world trade volume increased six-fold while GWP tripled (from $7 trillion in 1950 to $21 trillion) . ⇒ Transctions demand for foreign currencies increased 6 times but the gold supply did not increase much. Per capita US GDP doubled ($2,700 in 1950 to $5,400 in 1973 at the end of the Bretton Woods.)

But the total international reserve increased only by 3% during the same period. So there developed an acute shortage of international reserve assets. The US had acquired the bulk of the world's gold. In 1946, the US held $26 billion worth of gold (740 million ounces, world total = 6 billion oz). Today, Treasury owns 260 million ounces of gold (mostly in Fort Knox, Denver, and West Point and a little bit at FRB NY).

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). Today, this must be paid in SDR or major currencies ($, £, € and yen).

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. (Today, this amount is worth roughly $100 billion) 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 2011, quota increased to SDR 477 billion (about $677 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)

e.g., US = 17.75% ($65 billion), total = $366 billion (as of 2009)

Total: 2.5 million votes (and growing).

US gold holdings: currently, about 8,000 tons ($160 billion at $40 per oz), or about 5% of the world's total gold stock. (the world has about 190,000 tons in 2019, World Gold Council)

Jewelry: 90,000 tons, Investors: 40,000 tons, governments: 33,000 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. Purpose: to avoid exchange control. At maturity, both parties re-exchange the original amounts.

The total quota is small, not sufficient to deal with the European crisis.

In 2008, Japan lent $100 billion to the IMF. US also extended $100 billion line of credit.

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

During the 1950s the USD increasingly took over the function of gold as the major international reserve asset.

No one planned this development. The US was the dominant world power. (US share of output: 50% in 1950, 40% in 1960, but has been stable at 25% since the 1980s.) Well over half of all international money transactions were financed in terms of dollar. The US also owned about two thirds of the official gold reserve in the world in 1940.

The dollar became the dominant invoice currency. (The US profits as the banker.) Most exporters invoiced the importers in dollars. When the European countries had reserve surpluses in the 1950s and early 1960s, 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 had halted the 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. Over time, US dollar became increasingly more important.

In 1945, Korean won was pegged to USD. In 1949, yen was pegged at 360 yen per USD.

US: $18 trillion
EU: $14
UK: $7
Japan: $3

use contractionary Monetary policy (raise interest rate) or Fiscal policy (cut federal spending) to reduce aggregate demand. This is a painful option because the government will become less popular. (e.g., Great Britain after WWI)

A permanent but painful solution.

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

(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.

Instead of importing American goods, China buys dollar assets. As China holds more dollar assets, their value in RMB declines when RMB appreciates (Chinese investors lose money: buy high, sell low)

China buys properties in the middle east, and central Asia (Kazakhstan) (Silkroad Economic Belt, 2013)

China's trade/GDP ratio = 41% in 2015
US = 30%)

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 are:

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

(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. International reserve in other countries 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 mainly of gold.

Some of the fundamentals are wrong (p, w, r, Y, e). The first best policy is a devaluation of USD. All other policies such as lowering interest rates are second best.

= Gold held by the Fed/Liabilities to Foreign Central Banks (Reginald Howe, copy)

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

To lesson the outflow of private capital, the US imposed an interest equalization tax in 1963. This was effective to curb temporarily the outflow of portfolio investment. However, because r* > r, it was more than offset by a big jump in US bank loans to foreign borrowers and a further growth in US direct investment.

(a) Voluntary Foreign Credit Restraint program was adopted in 1965 (Canada and developing countries were exempted). This was replaced by Mandatory Investment Controls in 1968, lifted in 1975.

(b)Federal Reserve System entered into a series of currency swap agreements with central banks of Western Europe, Canada, and Japan. Under these bilateral agreements, a foreign central bank provided standby credit (in foreign currency) to the Federal Reserve System in return for an equal amount of standby credit (in dollar).

None of these measures reduced US basic deficit but lessened the gold drain and dampened the speculative capital outflows. President Nixon once raised the value of dollar, to penalize the speculators. (It did not work).

President Richard Nixon

The crisis of 1971 was caused by a gradual loss of confidence in dollar. In 1970, funds began to move at an enormous rate from the US dollar to financial centers in Europe and Japan.

In May 1971, West Germany left the Bretton woods system. Switzerland redeemed $50 million for gold. In early August 1971, France sent a battleship to New York harbor and took delivery of $191 million in gold (Huffington Post). Then on August 11, the British ambassador requested to redeem $3 billion for gold (1/3 of US gold reserve, Tyler Durden) President Nixon (copy) announced on August 15, 1971:

(i) a 90-day freeze on wages and prices

(ii)10% import surcharge on dutiable imports

(iii) suspension of dollar's convertibility into gold.

After the Yom Kippur war (October 6-25, 1973), in July 1974, Kissinger sent his deputy William Simon to the Middle East. Kissinger and Saudi royal family agreed:

(i) All of oil sales will be priced in USD (Saudi's will not accept other currencies), and invest surplus oil revenues in US securities,

(ii) in return, US will protect Saudi's oil fields and guarantee protection from Israel.