Bretton Woods System of Controlling the Exchange Rates - Example

Running head: Bretton Woods Agreement The Bretton Woods Agreement Name Institution Date Bretton Woods Agreement Introduction Bretton Woods Agreement was formed as a reaction to deterioration in the finance market after the first world war in 1944 as countries sought to restructure currency and international finance relationships (Eichengreen, 2007, p.34). The agreement was formulated to respond to the collapsed the gold-exchange standard error that collapsed in the 1930s and preceded the Internationally Monetary Fund system. To begin with, the establishment of the Bretton Woods System was aimed at stabilizing the exchange rate hence ensuring reconstruction and growth and avoiding devaluation of currency due to competition experiences in the 1930s. Secondly, the system was created so as to prevent the repetition of ‘beggar-thy-neighbour’ policies which existed in interwar gold-exchange standards latter stages whereby countries experienced deterioration of the exchange rates and economic instability (Kenen, 1994, p.45). Bretton Woods System architects sought to combine the gold-standard rule’s nominal stability with policy maker’s freedom and flexibility over the floating system. Though John Maynard Keynes was the main negotiator, the agreed system was not completely coherent with his initial plans and those of hi core architect Harry Dexter White (Levi, 2009, p.145). This regime was characterized by fixed but adjustable exchange rates rather than the rigid exchange rates which characterized the gold-exchange standard error in mid 1920s. The architects of the Bretton Woods System intended to develop a system where all currencies were equal. However, the adopted system was different in that the U.S. dollar became the center of the system as it played a pivotal role against which other currencies were to measured. The Bretton Woods System can be described as having been asymmetric since the U.S. pursued its domestic objectives freely while other countries had to forego their domestic targets in order to ensure that they achieved and maintained foreign-reserve flows stability (in this regard, a reserve of the U.S. dollar) (Hall et al, 2009, p.79). The main features of the Bretton Woods System One of the main features of the Bretton Woods Agreement was the existence of fixed exchange rates pegged on the US dollar which was accepted as the key currency. Eichengreen (2007, p.32) argues that there did not exist a major currency which would have replaced the U.S. dollar between the 1950s and 1960s. As a result, there was no option but to adopt the U.S. dollar as the reserve currency. Other currencies’ exchange rates were pegged on the U.S. dollar meaning that any domestic policies formulated in U.S. transferred their impact on the dollar on other currencies. In this regard, the Bretton Woods System did not have any effective means of enforcing adjustment on the weak currencies and the very strong currency (U.S. dollar) equitably. The strong currency continued strengthening and exchange rates worked to its favor especially due to its scarcity driven by the reliance on it as the sole reserve currency. However, these exchange rates were adjustable and IMF was in charge of managing it. The system was relatively stable between 1959 to 1971. The US currency was defined in terms of gold such that $35 was equal to one ounce of gold. The United States which acted as the nominal anchor provider and central reserve country had the capacity of pegging its currency on gold. In this regard, each country’s currency rates were fixed and the national central banks with the support of IMF prevented any speculative attacks. The rates were only adjustable when fundamental disequilibrium occurred (Bordo & Eichengreen, 1993, p.77). Since the system was pegged on the US dollar, each currency was convertible to the dollar. The fact that Bretton Woods System was pegged on the US dollar clearly brings out the dominating power of the USA over the system. This can be explained by the fact that the U.S. dollar played a pivotal role in the sustainability of the system and without which the system was bound to fail. Selection of the U.S. dollar as the reserve currency and the backbone of the system was based on the fact that the US had the biggest economic potential after the II World War and its dollar had the greatest purchasing power (Levi, 2009, p.111). Moreover, most of the European countries transferred their gold to the US after the II World War as a settlement of their huge debts thereby making USA the supreme economic power. Negotiations for the rates were allowed in cases where a country found that its currency was over or undervalued with the IMF. As a result, fluctuations of the exchange rates were addressed. This in turn resulted to standardization and stabilization of inflation, increased trade growth and prevention of financial crises (Chowla et al, 2009, p.23). The U.S. currency was not subject to standardization due to its position and the fact that other currencies did not impact pressure on it. The only requirement for the U.S. government was a commitment to convertibility of the currency to gold and maintaining the strong reputation. As long as this commitment was maintained (convertibility to gold and hence price stability), the Bretton Woods System of exchange rates control succeeded. To enhance this, the country was encouraged to apply domestic policies aimed at standardization of its currency so as to offset any disturbances which would occur temporarily. Another main feature of the system was that any arising market pressures were under the system were contained through capital control. Exchange rates were under this system maintained on any side of the official parity at 1% (Herr & Kazandziska, 2011, p.45) . While other countries were expected to store the U.S. dollar as their reserve currency, the U.S. was required to maintain gold reserves. Every country had a chance to revise its initial selected exchange rates to up to 10% within the selection year since the initial selection had the possibility of being incorrect with regard to balance-of-payments. During the Bretton Woods system’s sub-periods, inflation ranged at an average level in every country apart from Japan. However, this behavior was in consistent with traditional view that flexible exchange rates and commodity based (fixed) exchange rates result to a floating period (Bordo & Eichengreen, 1993, p.34.). Prior to the Bretton Woods System, the existing classical gold standards recorded the lowest inflation rates as indicated in the tables below. ( Bordo & Eichengreen, 1993, p.34) (Bordo & Eichengreen, 1993, p.34) Reasons for the breakdown of Bretton Woods system’ and its replacement According to Bordo & Schwartz (1989, p. 33), Bretton Woods System could not be sustained since it was pegged on a national currency (i.e. the US dollar). These authors maintain that fixed rates have the disadvantage of exposure of individual countries to real and monetary shocks from other parts of the world as transmitted through payments balance. In addition, the gold demand and supply difference resulted in periods of inflation and deflation thereby impacting on individual country’s economies. As the U.S. economy destabilized, the country moved to being the major debtor in the world from its previous financial position of being the major creditor (Bordo & Eichengreen, 1993, p.101). The destabilization of the U.S. economy is attributed to impacts resulting from the U.S. financing the Vietnam war experienced in the early 1970s (Kevin, 2009, p.45). U.S. commitment to financing the Vietnam War resulted to adoption of highly expansionary and fiscal policies. This resulted to a shift in commitment as domestic concerns became of a greater importance to U.S. as compared to its role in the international monetary system maintenance. It’s commitment to convertibility of its currency to gold diminished as this became of less concern to the government hence weakening the Bretton Woods System. This affected its reputation and the stability of its currency. As speculators put pressure on the dollar in the thought that the currency was overvalued, Richard Nixon who was the US president then announced that the currency would no longer be valued against gold. This clearly brought out the diminished commitment of the U.S. government on sustainability of Bretton Woods System. Domestic issues were perceived to be more important to the government as compared to the stability of the financial market. As a result of the announcement, the Bretton Woods System could not be sustained. The overall reliance of the Bretton Woods System on the U.S. dollar convertibility to gold meant that the system could only exist if the convertibility persisted (Eichengreen, 2008, p.98). Since this could not be the case after the announcement by Richard Nixon, the Bretton Woods System was abandoned. This proved John Maynard Keynes point of the central position of the U.S. dollar in the Bretton Woods System as its weakness point correct (Kenen, 1994, p.65). The system would have continued only if the U.S which was the provider of the reserve currency run balance-of—payments through which other countries would access and accumulate dollar reserves. Despite the importance of US deficits, frequent reoccurrence resulted to loss of trust on U.S. dollar convertibility to gold and maintenance of the agreed price by speculators such as France. France reacted to its speculations by objecting the idea of other currencies having to peg their currencies on the U.S. dollar as doubt on the sustainability of the value of the U.S. dollar heightened. This stand was influenced by the believe held by France that the U.S. accrued huge benefits by having other countries depend on its currency as the reserve currency. In addition, France decision was politically influence and thus aimed at objecting the perceived powerful United States. The position held by the U.S. meant that its citizens as well as the foreign central banks could hold the U.S. dollar which was the reserve currency. This resulted to France opting to convert the dollars it held into gold rather than converting its currency to the U.S. dollar. Other countries reacted to this in fear that the U.S. run out of gold reserves to support its currency after French sold its last dollar reserves (Levi, 2009, p.38). As a result, the system continued weakening and finally collapsed. Several reasons have been attributed to declined rates at which major currencies adjusted their exchange rated. To begin with, countries were concerned that the devaluation of their currencies would negatively impact on their reputation thereby resulting to a decline in their national prestige (Eichengreen, 2008, p.46). Secondly, speculation on the lowering value of the U.S. dollar raised concerns that this would ultimately trigger capital flows which were self fulfilling. As Japan and other European countries maintained undervalued real exchange rates through capital controls, the U.S. ran deficits in the balance-of-payments. The deficits in balance-of-payments which had cumulated over time were then financed from the gold reserves resulting to a further concern on the stability of U.S. dollar value against gold. Another factor that contributed to the collapse of the Bretton Woods System was the imbalances of payments that were enduring between the Western industrialized countries. Since the U.S. dollar was the only currency accepted as the international currency then, monetary and fiscal policy of the country had a heavy influence on the other economies while it remained free from external economic pressures (Landau, 2001, p.56). In order to avoid a world inflation and ensure international liquidity, deficits in balance of payments were run by USA. This did not last due to limited reserves to meet the world’s demand for the U.S. dollar. As a result, the U.S. ran an inflationary policy by limiting conversion of U.S. dollar. However, these action faced opposition as other member countries shunned the high inflation rates resulting from the par value system. In addition, other countries saw the position of the U.S. dollar as the pivot of the Bretton Woods System as a major threat to maintaining exchange rates. The currency was perceived as weakening and thus not in a position to maintain the initial agreed gold convertibility value. The ultimate result was weakening and rejection of the U.S. dollar causing the collapse of Bretton Woods System (Kenen, 1994, p.76). The Bretton Woods System was replaced by the current international monetary system. This system is based on ‘freely floating’ exchange rates which according to proponents prevent overvaluation and undervaluation thereby resulting to greater stability as country gain control over the development of own monetary control policies (Keynes, 2010, p.45). This is due to the fact that exchange rates do not go beyond or lower that the optimum economic level. Major industrialized countries have been key in intervening on exchange rates so as to protect own currencies. Every currency is however subject to the international market’s opinion. The replacement of Bretton Woods System by the International Monetary System is attributed to growth in democratic rights and globalization (Keynes, 2010, p.67). Despite the replacement of Bretton Woods System, some countries such as United Arab Emirates still peg their exchange rates on the dollar and other hard currencies such as euro. In addition, the dollar has retained its world’s reserve currency position even though this may be short lived. Its position means that US has the capacity to continue borrowing indefinitely and cheaply, a factor that negatively affects the rest of the world. This has been evident as the world experienced an economic turmoil catalyzed by US government’s large scale borrowing from other countries as such countries sought to build reserves of US securities (Hall et al, 2009, p.47). In this regard, increased demand for the dollar resulted to maintained low interest rates by the US government and as a result a disastrous private-sector borrowing bubble. Secondly, any decision on American fiscal and monetary policy automatically has an impact on the other parts of the world and the such impacts are not thought of by the US administration if it makes the decisions. Conclusion As indicated above, the Bretton Woods Agreement resulted to the formation of the Bretton Woods System of controlling the exchange rates. This system was based on maintenance of fixed but adjustable rates aimed at addressing the financial instability experienced after the first World War. It is clear that the main point of weakness of the system was the used of the U.S. dollar as the pivot of the system. The weakening of the U.S. dollar, diminished gold reserves and the ultimate announcement by the U.S. president resulted to failure of the Bretton Woods Agreement and replacement by the International Monetary Fund system. From the analysis, the U.S. was the main beneficially of the Bretton Woods System as its currency remained free from outside pressures. Sociologists perceive the collapse of the Bretton Woods System as having resulted from globalization and growing democracy whereby U.S. supremacy in the market could be controlled. Though the dollar has retained its dominancy as a reserve currency even in the new system, much emphasis has been placed on the existence of free float exchange rates where countries are free to make their own domestic policies to control the value of their currencies. References Bordo, M. & Eichengreen, B. (1993). Aretrospective on the Bretton Woods System: lessons for the International Monetary Reform. Chicago: The University of Chicago press. Chowla, p., Sennholz, B., & Griffiths, J. (2009). Dollars, devaluations and depressions: how the international monetary system creates crises. London: Bretton Woods Project . Eichengreen, B. (2007). Global Imbalances and the Lessons of Bretton Woods. National Bureau of Economic Research, Cambridge, MA. Eichengreen, B. (2008). Globalising Capital: A History of the International Monetary System, 2nd edition. Princeton, N.J.: Princeton University Press. Hall, S., Hondroyiannis, G., Swamy, P. & Tavlas, G. (2009). Bretton-Woods systems, old and new, and the rotation of exchange-rates regimes. University of Leicester, department of economics: Working paper No. 09/15 Herr, H., & Kazandziska. (2011). Macroeconomic Policy Regimes in Western Industrial Countries . Oxon: Routledge . Kenen, Peter B. (1994). Managing the world economy: fifty years after Bretton Woods. Washington DC.: Institute for International Economics Kevin, S. (2009). Fundamentals of international financial management. New Delhi: Asoke K. Gosh. Keynes, J. (2010). The economic consequences of the peace. Los Angeles: Indo-European publishing. Landau, A. (2001). Redrawing the global economy : elements of integration and fragmentation. Basingstoke: Palgrave. Levi, M. (2009). International finance, 5th ed. New Yolk: Routledge. Read More