Events that led to the Collapse of the Bretton Woods System

With recent negotiations of currency wars and dissension over policy of quantitative easing proposed by the U.S. Federal Reserve, leaders of 20 largest economic systems, known as G-20, will be run intoing in Seoul on November 11-12th, 2010 to discourse issues related to the planetary economic recovery and edifice of a new model, which can prolong more balanced planetary growing. Recently, some economic experts, political leaders, and media observers argued in favour of a new international pecuniary government capable of replacing bing Bretton Woods II system established in the early 1970s ( Economist, 2010 ; Emsden, 2010 ) . Some argue that new system should use gold as a mention point for indexs such as rising prices, deflation, and currency values ( Zoellick, 2010 ) . With this involvement toward creative activity of a new pecuniary order, it is of import to understand the chief factors and events that led to the prostration of original Bretton Woods system as this will assist to avoid past errors. Therefore, the intent of this paper is to supply a instead general overview of the cardinal elements of the Bretton Woods system and to document the most of import facets that led to its death.

Introduction

On August 15, 1971, in a televised reference to the state President Nixon announced that the United States was shuting “ gold window ” and taking gold backup from the dollar. This meant that the foreign authoritiess could no longer turn in dollars and change over them for gold. The proclamation, competently named Nixon Shock, has been made without anterior audience with the leaders of the other major capitalist states. Thus the committedness by the U.S. to deliver international dollar retentions at the rate of $ 35 per ounce, which basically had formed the anchor of the post-war international fiscal system set in topographic point at the Bretton Woods conference in 1944, had been wholly broken. Nixon ‘s one-sided determination dealt it a fatal blow and in fact ended the Bretton Woods system of international exchange ( Cohen, 2002 ) .

What are the factors that caused the prostration of the Bretton Woods System? To to the full understand the determination made by the President Nixon and the importance of what followed it is necessary to see the historical background of the Bretton Woods system every bit good as cardinal design elements of this system.

Background

The Bretton Woods system refers to the international pecuniary system that existed from the terminal of World War II until the early 1970s. In 1944 leaders of major states met in the Bretton Woods, New Hampshire in the U.S. to discourse programs and necessary actions that must be taken to assist states to reconstruct their post-war economic systems. The conference resulted in the creative activity of a to the full negotiated pecuniary government intended to regulate currency dealingss among autonomous provinces. Several of import facets should be noted ( Suranovic, 2010 ) .

First, the government was based on the system of fixed exchange rates between currencies and the web of fiscal support for states that could run into balance of payments troubles. This was done to forestall hyperinflation and instability of international system. The memories of Great Depression, hyperinflation in Germany, and general economic instability in the universe that lead to the installing of totalitarian governments in many states, were still fresh and graphic. So the system of fixed exchange rates was thought to forestall rising prices and extinguish uncertainnesss in international minutess, therefore advancing the enlargement of international trade and investing. Generally, what came out of the conference was the ‘pegged rate ‘ or ‘adjustable nog ‘ currency mechanism, besides known as the par value system. Members were obligated to declare a par value ( a ‘peg ‘ ) for national currency and could step in in currency markets to restrict exchange rate fluctuations within upper limit borders ( a ‘band ‘ ) of one per centum above or below para. State had the right, whenever necessary and in conformity with in agreement processs, to alter their par value to rectify a ‘fundamental disequilibrium ‘ in their balance of payments. A really of import facet of this mechanism is the inquiry of the modesty currency and gilded criterion. Under the Bretton-Woods system, the United States had assumed the function of so chief banker with dollar functioning as a modesty currency. Foreign cardinal Bankss could therefore easy exchange dollars for gold. Originally, the exchange rate was set at $ 35 per ounce. National currencies of non-reserve members were fixed to the U.S. dollar or to gold. However, these states did non hold any duties to interchange their ain currencies for gold. Merely the modesty state i.e. the U.S. had such duty ( Cohen, 2002 ; Suranovic, 2010 ) .

Second, all national authoritiess by and large agreed that since exchange rates were pegged, authoritiess must necessitate some sort of confidence of an equal supply of pecuniary militias. What emerged was the International Monetary Fund ( IMF ) , a new establishment, which managed a fixed pool of financess dwelling of national currencies and gold contributed by each member. Each state was therefore obligated to pay into the Fund a certain sum which included 25 per centum of gold and 75 per centum of national currency. Furthermore, members were assigned a quota, which entitled them, when short of militias, to borrow needful sums of financess. The size of the quota reflected single part and comparative economic importance of each state. The new mechanism was based on the series of binding legal duties along with many-sided decision-making conducted by IMF, which had assumed really wide regulation duties ( Mikesell, 2000 ; Cohen, 2002 ) .

Third, members were by and large forbidden from prosecuting in any sort of prejudiced currency patterns or exchange ordinances. The thought was to forestall any return of economic warfare between states that had characterized the decennary of the 1930s. Finally, all states agreed that any type of currency problems should be solved through an unfastened forum that is through the IMF. This has established a formal protocol and set of processs of inter-governmental audience, which each state was obligated to follow ( Cohen, 2002 ; Mikesell, 2000 ) .

Together these cardinal facets defined the kernel of Bretton Woods system, a pecuniary system based on the fixed exchange rate supplemented by the system of adjustable nogs along with the pool of gold and a basket of national currencies.

The timeline of Bretton Woods system can be notionally divided into two typical periods. The first period is frequently called ‘dollar deficit ‘ , which lasted until about 1958 and the 2nd one, the “ dollar oversupply ” lasted until the prostration of the system. During the first period United States intentionally ran a balance of payment shortages to promote an escape of financess. This was done chiefly to supply liquidness to other states and assist states to get the better of post-war fiscal distraught nevertheless geopolitical factors should non be excluded wholly. Dollars were fluxing to the Western Europe, Japan and other pro-American states through a assortment of different assistance plans. During the dollar-shortage period, the United States emerged as the lone state in the universe capable of back uping and prolonging a long-run economic recovery of international economic system ( Cohen, 2002 ) .

The Collapse of the Bretton Woods

The state of affairs, nevertheless, began to alter shortly after 1958. The U.S. balance of trade plunged drastically doing a 3.5 billion shortage in 1958. By the terminal of 1960 shortages become even larger. To many economic historiographers this marked a turning point. Alternatively of ‘dollar deficit ‘ everyone talked about ‘dollar oversupply ‘ as many foreign authoritiess tried to acquire rid of inordinate dollar accretions ( Cohen, 2002 ) . But what did really made the U.S. dollar so unwanted? One possible beginning of job was caused by the alleged the Triffin quandary. The phenomenon foremost described by the economic expert Robert Triffin posits that if the U.S. dollar serves as an international modesty currency, so the United States must be willing to run trade shortages to supply adequate liquidness to the remainder of the universe to fulfill demand for foreign exchange militias. So in order to avoid liquidness jobs other states had to trust on the United States, or more exactly on the shortages in the balance of payments of the United States, specifically on the current history. Triffin farther argued that the trust on the convertibility of dollar into gold represented an indispensable defect of the Bretton Woods system. Indeed, by so terminal of 1960 the ‘dollar overhang ‘ – a state of affairs when the value of dollar denominated assets held by foreign cardinal Bankss exceeded the entire supply of gold in the U.S. – became rather obvious. The hazard that the United States could merely run out of gold did non look so impossible any more ( Suranovic, 2010 ; Cohen, 2002 ) . So to avoid possible guess against dollar, the trade shortages would hold to halt but that would make a liquidness job. But how can the liquidness job be solved? To work out it, the state would hold to accept current history shortage on the balance of payment. But that would take back to the job discussed above, viz. to the depletion of gold militias and the ability of the dollar to be converted into gold. Indeed, it is a true quandary or instead the Triffin quandary ( Cohen, 2002 ; McKinnon, 2007 ) .

Now, one possible solution to the quandary could be devaluation of the dollar. This attack seemed easy in theory yet it was difficult to implement since the U.S. dollar was non fixed to other national currencies. In fact, it was other manner around. In add-on, foreign authoritiess argued that was non their mistake, therefore they should n’t worry about it ( Suranovic, 2010 ) .

Another possible solution to the Triffin quandary was to devaluate the dollar with regard to the gold. This was even harder to implement. The devaluation would hold to be instead big otherwise the United States risked a depletion of gold militias. But if implemented, this attack would non hold solved cardinal conditions. Alternatively, it would hold merely reduced the exchange rate ( Suranovic, 2010 ) .

Another option unfastened to the United States was to alter its pecuniary policy and merely cut down the supply of dollars in circulation by cutting the current history shortage and raising involvement rates in order to pull dollars back into the state. This nevertheless could take to the economic recession since the growing of the money supply is limited. The authorities would hold to finance the budget through higher revenue enhancements or cutting public disbursement or combination of both. In the terminal, both are politically unpopular steps ( Suranovic, 2010 ) .

As it can be seen, none of possible solutions really resolves the job, the quandary still exists. Finally, what the United States ended up making was a following a series of smaller steps, instead defensive in nature, targeted chiefly against bad onslaughts on the dollar. These included a system of short-run recognition barters among cardinal Bankss and supplying much bigger authorization to the IMF particularly its loaning ability ( Cohen, 2002 ) .

The Triffin quandary was non the lone beginning of strain. The other job was the very nature and construction of the par value system itself. As mentioned earlier, foreign authoritiess were allowed to rectify a ‘fundamental disequilibrium ‘ . However, this was really difficult to make since authoritiess could n’t even state when such disequilibrium existed. So even though authoritiess could alter their exchange rates, the nature of the par value system inhibited the re-pegging of the rates, which made international payment equilibrium really hard to keep. As one would anticipate, this necessarily leads to the rigidness of exchange rates and frights of the possible liquidness deficit, which in return merely increases inducements for currency guesss ( Cohen, 2002 ) .

The dealingss between the United States and the European states and Japan deserve particular attending here. As mentioned before, each side blamed the other. The United States thought its spouses could make much more by appreciating their currencies. The Europeans and Nipponese expected the U.S. to take the first measure in the undertaking the shortages. Both parties thought that their involvements were threatened by the other side. In the terminal, everyone argued that the opposite side created an dissymmetry in the exchange rate government favourable merely to them. The arguments over what side benefits more from bing status masked a much deeper political job. The political circles in the United States were coming to the realisation that Europe and Japan could show a competitory job to the commercial and concern involvement of the U.S. It was going really hard to accommodate protection of domestic involvements on the one manus, with the aid to foreign Alliess on the other manus. Conversely, Europe and Japan were going more and more concerned about America ‘s privileged ability to finance its shortages. The “ extortionate privilege ” , a term coined by the France ‘s president Charles De Gaulle sums up the kernel of job perceived by the foreign states. Simply put, the United States could publish any sum of excess dollars to cover shortages in balance of payment because dollar served as modesty currency. Such sole ability belonged merely to the America. Other states could non make that as they had to keep the equilibrium in their balances of payments. The Europeans and Japanese could seek to restrict the America ‘s ability by the demanding transition of dollars into gold. However, as the ‘dollar overhang ‘ continued its growing, doing the Triffin dilemma even more marked, foreign authoritiess were going loath to prosecute this way ( Cohen, 2002 ; Suranovic, 2010 ) .

As it can be seen, the Bretton Woods systems relied merely on one simple but of import premise: the United States economic policies must hold stabilising consequence for the whole system to work swimmingly. Equally long as the U.S. behaves good, the system can work. Before 1965 this premise by and large held true and the Bretton Woods ran without major jobs, largely due to the disciplinary steps adopted earlier. During the 2nd half of the sixtiess, the U.S. behaviour was going progressively destabilizing. Increased authorities disbursement on societal plans, unpopular war in Vietnam, and turning domestic rising prices caused shortages to go larger exposing all concealed jobs of the Bretton Woods system ( Wills, 2005 ) . However, no ameliorating steps were undertaken during this clip. The job was acquiring worse, therefore sabotaging planetary assurance. It was going obvious that the pegged exchange rate system was non capable of managing turning shortages in the balance of payments. The bad onslaughts were increasing and the dollar devaluation or major reappraisal of European and Nipponese currencies was at hand ( Cohen, 2002 ) .

The play reached its extremum, when the United States, the individual most of import member of the Bretton Woods system brought it to the terminal. Worried about an intensifying disequilibrium in the balance of payment and turning national protectionism sentiments in the Congress, President Nixon decided to coerce new accommodations to interchange rates between the U.S. , Europe and Japan. On 15 August 1971, the dollar could no longer be exchanged into gold. The U.S. besides imposed a ten-percent duty on all imports and introduced monetary value and pay controls to suppress rising prices. This set of steps led to a new renegotiated understanding known as Smithsonian Agreement but in the terminal, this understanding merely temporarily extended the life of the system. In February of 1973, 18 months after the “ Nixon daze ” , currencies of all major industrial states were set free as they established drifting exchange rates. With its two cardinal elements of system – par value and gilded criterion – terminated, the Bretton Woods system was officially gone. From now on, the exchange rate of the U.S. dollar and other major currencies was determined merely by the market ( McKinnon, 2007 ; Cohen, 2002 ; Suranovic, 2010 ) .

Decision

The death of the Bretton Woods system demonstrates the failing of fixed exchange rate systems. States must give up certain grade of independency over their pecuniary policies therefore disregarding domestic economic conditions, which are dominated by the international involvements. It can be really difficult and dearly-won to make, necessitating a batch of coordination at both national and international degrees. The prostration of the Bretton Wood system besides ushered in a new epoch: many limitations were removed leting capital move freely between states. This basically represented the beginning of the new phase characterized by the interconnection of planetary economic system and increased function of international fiscal markets. The hereafter of the new pecuniary system is non clear at this point. Recent fiscal crisis clearly indicates that new set of international pecuniary ordinances is likely to be adopted in the close hereafter. To what widen they will alter international fiscal landscape remains to be seen.

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