Bretton Woods system

United Kingdom and United States started negotiations towards the reconstruction of the international monetary system in 1941. The objective of the system which emerged was to avoid the breakdown in international monetary relations. In 1944 at Bretton Woods, New Hampshire an international monetary conference was held to put the basis of the Bretton Woods system, the leading negotiators were Harry Dexter White representing US and John Maynard Keynes for United Kingdom. Bretton Woods aimed to bring full employment, price stability and external balance without any restrictions on international trade (P. R. Krugman et. all. 2012).

Rules and Institutions

According to Keith Pilbeam (1992) Bretton Woods system created multiple institutions which are going to be discussed in the following section. Two of the key institutions were the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD). IMF was the managing body, it responsibility was to monitor and supervise the new system while IBRD also known as the World Bank had to assist the reconstruction of the Europe’s economies. Another institution developed with this new international monetary system was the International Finance Corporation (IFC) which provided risk capital to less developed countries. BrettonWoods Project (2005) argues that the original agreement included plans for the International Trade Organization (ITO) but these were first put into action in 1990 when the World Trade Organisation (WTO) was created.

One of the most important features of this system was the fixed but adjustable exchange rate. A parity against the dollar was assigned to each currency, this was left to fluctuate positive or negative by only one percentage (Keith Pilbeam, 1992). The dollar then was fixed to gold at a price of $35 per ounce. The objective behind this feature was to spread confidence towards the new system, making the dollars ‘as good as gold’, thus the foreign central banks would be more willing to hold dollar reserves (Keith Pilbeam, 1992). According to Keith Pilbeam (1992) the participating countries had to maintain their exchange rates and only in the case of a fundamental disequilibrium they were allowed to readjust their currencies to correct the balance of payments imbalances. The Bretton Woods system aimed to incorporate the advantages of the fixed exchange rate while giving more flexibility than under the normal gold standard system. The IMF objective was to minimise the amount of revaluations of currencies needed in the world. It had to provide credit for those countries which had a balance of payment deficit because a policy to deflate the economy will increase the unemployment level and will affect the volume of trade (Keith Pilbeam, 1992). Each country had to keep an assigned quota (gold and own currency) with the IMF, from this fund the members facing high balance of payments difficulties could borrow in tranches, but with each tranche the conditions placed by the IMF would become more severe.

Bretton Woods system success / failure

This section will focus on the issues that Bretton Woods system had and which led to its failure but also on its successes.

Keith Pilbeam (1992) argues that one of the issues was the liquidity problem, Robert Triffin (1960) pointed out that the bond between the dollar and the gold will ultimately result in a loss of confidence in the system. Confidence in the U.S. dollar was essential for the success of this monetary system, banks will hold dollar reserves only if they are confident that the dollars can easily be changed into gold at the constant rate of $35 per ounce. As the international trade grew so did the demand for dollars, but the gold reserves did not increase proportionally with the demand, hence it became clear that the US authorities will not be able to maintain the $35 rate. Triffin (1960) predicted that this will make the foreign central banks to change dollars for gold and eventually the system will break. Another issue with this system as Keith Pilbeam (1992) sustains is related to the Gresham’s Law. This law implies that if there is a difference between the official rate of exchange rate and the private market rate of exchange between two assets, only the overvalued asset will continue in circulation. In the case of Bretton Woods the two assets are gold and the dollar. As the inflation in USA increased, the authorities struggled to maintain the rate of change at $35, the private markets pressured the price of the gold to go up and this resulted in a gold pool (Keith Pilbeam, 1992). Because the official price of the gold was under valuated banks could cause a run on the dollar, converting dollars into gold and then sell the gold in the private markets to make profit. President Nixon announced the termination of the dollar-gold convertibility in 1971 and the Gresham’s Law proved to be right. Furthermore, another key issue of this system is the lack of an adjustment mechanism (Keith Pilbeam, 1992). In case of an acute fundamental disequilibrium of a country’s balance of payments a realignment of the exchange rate was permitted but these members were reluctant to do so because this was seen as a weakness. Also according to Keith Pilbeam (1992) the “fundamental disequilibrium” was not defined. Another solution to this problem apart from the realignment of those currencies was for the US government to devalue the dollar in terms of gold but this action will not only make USA less competitive but will also harm the confidence in the system. Keith Pilbeam (1992) argues that there were two ways of getting out of this crisis, either countries with deficit would have to deflate their economy or countries with surplus would have to revalue their currencies. Countries with deficit would not pursue a deflationary policy because this will cause unemployment and those with surplus were reluctant to revalue their currency because this will reduce their export growth and eventually will increase unemployment. Paul De Grauwe (1996) argues that another issue of the Bretton Woods system was the (n-1) problem or seigniorage problem. The system had an in-built mechanism to correct US if they engaged in an excess money creation, hence inflation. All the members could convert their dollar reserves into gold if USA started this fiscal and monetary expansion which was not backed by a strong economic growth. Paul De Grauwe (1996) sustain that all the members which pegged their currency to the dollar started to import inflation when USA began this process. The confidence problem arose, speculators understood that the German, Swiss and Japanese authorities were concerned with the

inflation, thus they started massive speculative transactions of their currencies putting more pressure on the system. According to the “in-built” mechanism the Germans, the Swiss and the Japanese should have converted their dollars into gold to stop this process but they did not. P. D. Grauwe (1996) argues that Germany and Japan were too dependent on USA to try to force such a disciplinary action, thus they did not act. In 1973 the Bretton Woods system collapsed when the major members Germany, Japan and UK stopped maintaining a fixed exchange rate with the dollar. Despite its drawbacks the Bretton Woods system had made it possible for the international trade to flourish in the period 1950-1960, it removed the uncertainty of businesses that their currency will not be accepted as a mean of payment. By pledging to keep the dollar-gold rate fixed USA provided confidence to the global trade environment but this also was a weakness, when the USA had issues holding this fixed rate it went back on its word for the national interest of the country.

EMU

After the Bretton Woods system EU looked for a new monetary system to achieve economic and monetary union. The economic union already started according to Mark Baimbridge et. all (2000) between 1960-1970 when members dismantled tariff barriers and quotas, thus the only objective was to achieve a monetary union. In 1991 the “Maastricht Treaty” has been signed setting the start for EMU in January 1999. Peter B. Kenen and Ellen E. Meade (2008) argue that this project was the most ambitious project of its type, it involved that the member states would give up their currency in favour for the new currency called euro and also to subordinate their central banks to the European Central Bank. Giving up their own currency for euro is seen by B. Kenen and Ellen E. Meade (2008) as a commitment from the members that they will not abandon the system.

European Central Bank ECB

Mark Baimbridge et. all. (2000) argue that the ECB was constructed and organized as the Bundesbank to bring confidence and credibility that the monetary objectives will be achieved. The key features of the ECB were: independence of national governments which will further consolidate the confidence in it and the pursuit of price stability.

EMU RULES

The convergence criteria from the Maastricht Treaty together with The Stability and Growth Pact represent the rules of EMU. According to Europa (2006) there are four major convergence criteria: Price stability, Government finances which covers annual government deficit and debt, exchange rates and long-term interest rates. Europa (2006) argues that the inflation rate of the future member is allowed to be over the average inflation rate of the three best countries from EMS in terms of price stability by only 1.5%. In terms of government finances the annual budget deficit must not be over 3% of GDP, although in cases of temporary or exceptional nature it can be higher. The national debt must not exceed 60% of GDP, the only case where a member with higher national debt than the previous figure can be accepted is when the trend of the national debt shows that it is declining at a

convenient rate (Europa, 2006). Another criterion for a member to be accepted in the final step (EMU) is that during the prior two years from the assessment the member had to participate in the exchange-rate mechanism without any severe tensions. Lastly, the nominal long-term interest rate must not go over the value from the three best performing members in terms of price stability by more than 2% (Europa, 2006). P. B. Kenen and E. Meade (2008) argue that Theo Waigel, the German finance minister proposed additional protection mechanisms in the form of the Stability and Growth Pact. The first point from this pact was that the EU governments would have to aim at close to balance or surplus budgets and if not financial sanctions listed in the treaty will be applied. The second mechanism of defence proposed in this pact was that every member state had to prepare a stability program on how will they keep their budged close to balance and it will have to be updated annually. The Council of Ministers was in charge of analyzing these programmes (P. B. Kenen and E. E. Meade, 2008). Finally, they adopted the legislation on excessive deficit procedures and financial sanctions.

Lessons have / have not been learnt

EMU is a centralized monetary union and according to Lars Jonung (2002) this form is stronger when facing economic shocks than decentralized monetary unions. He also argues that political union is acting as glue for monetary unions. One important lesson which has been learnt from the Bretton Woods system is the creation of the ECB, because of its independence ECB can follow price stability and politicians cannot intervene. The monetary policies now are taken in the interest of the EU and not in the interest of a particular country (i.e. USA in the BW system). Issues like Gresham’s Law and Triffin dilemma are now avoided because the euro is not pegged to a specific asset like in the case of the dollar-gold. Speculators can no long benefit from the pegged mechanism. Strict controls have been applied to the members of the EMU through the Maastricht Treaty and The Stability and Growth Pact. Inflation, national debt and annual deficit are now closely monitored and were causes which lead to the dissolution of the BW system. Mark Baimbridge et. all. (2000) argue that because of the differences between the economies of the EMU members economic shocks might cause different reactions, hence the ECB will not be able to correct all and this might lead to the fall of the EMU. The reduction in policy instruments caused by EMU might reduce the chance of success of achieving certain objectives. Although some aspects of the BW system have been corrected with EMU, the adjustment mechanism is still weak as discussed above. The problem of confidence has been addressed through the creation of the ECB as a copy of the Bundesbank which has a history of maintaining price stability.

To conclude, the success of the EMU is not only a matter of economics but also of politics, thus the future of this monetary union hinges on the political and economical relationships of the members.

Reference list:

Baimbridge M. (2000). The impact of the Euro: Debating Britain’s Future. Houndmills: Palgrave Macmillan

Kenen P. B. (2008). Regional Monetary Integration. Cambridge New York: Cambridge University Press.

Krugman, P. (2012). International Economics. 9th Ed. Boston London: Pearson Education Limited.

K. Pilbeam (1992). International Finance. Basingstoke: Macmillan Grauwe P. (1996). International money: postwar trends and theories. Oxford: Oxford

University Press. Foreman-Peck, James (1995). A history of the world economy: international economic

relations since 1850. New York; London: Harvester Wheatsheaf. European Commission (2014). EMU and the euro – the first 10 years. Available at:

http://ec.europa.eu/economy_finance/publications/publication1932_en.pdf [Accessed: 23.03.2014]

Michael D. Bordo (1993). The Bretton Woods International Monetary System: A Historical Overview. Available at: http://www.nber.org/chapters/c6867.pdf [Accessed: 23.03.2014]

Michael W. Klein (1998). European Monetary Union. Available at: http://www.bostonfed.org/economic/neer/neer1998/neer298a.pdf [Accessed: 23.03.2014]

BrettonWoods Project (2005). What are the Bretton Woods Institutions. Available at: http://www.brettonwoodsproject.org/2005/08/art-320747/ [Accessed: 23.03.2014]