Important Features of the Bretton Woods Agreement - Assignment Example

Student Name: Student Number: Unit: MM202 International Business Unit Coordinator: Assignment: 02 Topic: Essay Topic No. 2 Describe the most important features of the Bretton Woods Agreement. Why did the Bretton Woods ‘system’ break down and what has replaced it? Due Date: Word Count: 2500 Introduction The topic chosen for analysis is the Bretton Woods System Agreement important features, the reasons for its failure and what replaced the system. The world economy has been developing since early 20th century; many variations had been done previously before and at the beginning of the 20th century. Industrialization and development of world economies were previously very competitive and based on the countries resources. Trade within a regional block and outside the regional block commenced as industrialization geared with the production of new products. Many agreements were made previously before the Bretton Woods System; one of the most known agreements which eventually collapsed was the Classical Gold Standard of 1879-1914. This gave rise to the establishment of Bretton Woods System Agreement after the World War II. The development of Bretton Woods System Agreement had its challenges and successes as well; the reason for the success of the Bretton Woods System Agreement is pegged on its main features identified in this discussion. The reason for its eventual failure are also identified, notably economist still differ on the various causes of the Bretton Woods System Agreement but some main reasons for the failure are known and discussed in this analysis. The post Bretton Woods System Agreement was also another new era in the world economy, how the world coped with the post Bretton Woods System Agreement is also identified, a number of fiscal policies were adapted by IMF in order to suck the effects of the dissolution of the Bretton Woods System Agreement. Thesis statement- The main features of the Bretton Woods System Agreement, the reason for its collapse and the eventuality of the post Bretton Woods System Agreement era. Key words Balance of Payments- means the difference between the countries exports and its imports. A negative means a deficit and a positive means a surplus. Deficit- The negative effect as a result of the balancing of countries exports and imports. Surplus- The positive effect as a result of the difference between exports and imports. Important features of the Bretton Woods Agreement The creation of Bretton Woods System was created in 1944; the goal of the system was to control every country from pursuing selfish policies which could negatively impact on other countries, such policies includes, competitive devaluation and creation of trade blocks which were the result of the world economic crisis in 1930s (Rajan, & Subramanian, 2004). Two countries, Britain and the US played leading role in the creation of the Bretton Woods System. The US however dominated the system because of its relatively stable and superior military and economic muscle (Hondroyiannis, Swamy & Tavlas, 2009, p.150). The leadership was taken away from the UK which was at that time still facing challenges as a result of the war which had significantly reduced its international influence. The contributions of Keynes were rejected by the US and its new policies became the building ground of the new International Monetary Fund (IMF). The central idea US idea was referred to as the revolving fund (Hunt, 2008, p.44). This mandated that each country contribute certain amount “quata” to this new fund system. Roubini (2006, p. 303) asserts that countries with balance of payment challenges could borrow or purchase the currencies from the revolving funds contributed. This essentially meant that countries facing deficits would be responsible for correcting the imbalance. The UK was expected to be among the countries with BOP deficits as a result of the war and the US surplus as a result of its strong economic muscle. There are four main features of the Bretton Woods Agreement as identified below. Firstly, the system was US dollar based system. In essence, this system was gold-based system whereby all the countries were treated symmetrically. The International Monetary Fund (IMF) was responsible for the management of the system (McEachern, 2008, p.422). In the real sense, this system was dominated greatly by the United States as the US dollar played an important role in controlling the world currencies. In fact, the US dollar is still used as the reference point of currency exchange to date. The main reason why the US dominated Bretton Woods System was because the World War II had critically weakened European economy and especially the United Kingdom one of the key founders of the Bretton Woods System through its famous economist, John. M Keynes (Swamy, & Tavlas, 2005, p.1001). The US, represented by Harry D, White of the US Treasury Department took the important role of defining the key functions of the system. As a result of the US dominance, its relationship with other countries was asymmetric (McEachern, 2008, p.422). The US as the dominant member provided domestic price stability, other member countries could only import in this case, the US itself did not engage monetary control, instead the US cared less about the exchange rates, and this was in fact desirable. On the contrary all the member countries were obliged to intervene and fix their exchange rates against the dominant currency, the US dollar. The second feature was its adjustable peg system. This essentially meant that the exchange rates were fixed but allowed to vary under specific conditions. As a result of this, the exchange rates were expected to move in a predictable manner. This was as a result of the provision to combine exchange rate stability and flexibility at the same time avoiding negative currency devaluation. The member countries were allowed to make variations (parities) when fundamental disequilibrium occurred. Notably, fundamental disequilibrium provisions were not clearly articulated. As a result of this, the variations of the exchange rates were done based particularly on the views of the Bretton Woods System developers. Consequently, the UK was forced to devalue once, Germany and France devalued twice while Italy and Japan did not revise their parities are all (Andrews, 2008, p.105). Thirdly, there was a strict capital control. This Bretton Woods System was a major deviation from the Classical Gold Standard of 1879-1914 before the World War I which basically encouraged free capital mobility. Many country members fostered strict exchange controls while the US and Germany imposed less severe capital account regulations (MacDonald, & Burton, 2002, p.108). The fourth main feature was the good performance of macroeconomic. According to Griffiths, O'Callaghan & Roach (2008, p.23) in essence, the global price stability coupled with high growth were attained with intense trade liberalization. As an example, the sustainability of tradable prices (WPI) from 1950s to late 1960s attained an almost ideal situation and common globally. This macroeconomic achievement was one of the Bretton Woods System unparalleled achievement of the century. Why the Bretton Woods System break down According to Duncan, Jancar-Webster & Switky (2008, p.375) Bretton Woods System eventually collapsed despite the unprecedented macroeconomic achievement record. The reason for the Bretton Woods System collapse is still debatable up to this date. However, there are undeniable nominal anchor issues which eventually surfaced and strained the existence of the system. As an example, the Classical Gold Standard collapse was caused by external forces, mainly the outbreak of World War I, on the contrary the Bretton Woods System was as a result of internal inconsistencies (Goldstein, & Lardy, 2004). The US through its currency dominated the control of parities (exchange rates), this was the nominal anchor of the Bretton Woods System. As a result of this, when the US experienced inflation in its economy, the international monetary system suffered as a result and hence compromising systems based on the US dollar. Notably, the variation of the US economy has a direct impact on the world monetary system. As an example, in 1950s, there was a period that the US dollar was in shortage, Europe and Japan desired to increase imports in order to recover from the effects of the war. Since the only internationally accepted money was the US dollar, their import desires were greatly hindered because of the inadequate supply of US dollar dominated foreign reserves (Goldstein & Lardy,2008). Later in 1960s, the contrary happened, dollar oversupply in the world economy. This was as a result of the deficit in the US balance of payments caused by fiscal policy expansion. The spending of the US government during this period was mainly caused by three main reasons, firstly, the need to finance the Vietnam War, secondly due to the space race with the USSR which resulted in man landing in the moon in 1969 and thirdly, increased welfare expenditure (Levi, 2005, p.518). During the 1960s, the US also experienced domestic inflation (measured in WPI) accelerated, this again negatively impacted on the Bretton Woods System. The initial primary role of the US was to offer price stability, when this eventually failed as a result of internal inflation in the US economy; other countries became reluctant to peg their currencies in the unstable dollar (Devetak, Burke, & George, 2007, p.270). According to Sassen (2008, p.153) the linkage of the US dollar with gold was a major weakness, why? Because it did not allow free market ruling of basic economic rule, demand and supply. Instead, this resulted in stagnant market conditions at that time. Perhaps the question of integrity and wise decision making by the central bankers could be raised. If money is tied to gold, then the issue of stability comes into light especially because of the dynamic nature of the market due to changes in demand and supply is considered. This was specifically evident in the 19th century, when gold was discovered in Alaska and California, the supply slightly increased leading to inflation, when the opposite occurred deflation was experienced (Carbaugh, 2011, p.469). Fundamentally, the discovery of gold is not related to the demand of money globally, as evident when Europe wanted more imports and they could not get US dollar based on the gold availability, they were greatly affected. The gold and dollar relationship brought unnecessary strain to the market and hence leading to its obvious failure. In essence, this issue was raised by Keynes. Some speculate that Bretton Woods System could have lasted much longer if the gold to dollar relationship did not exist. The central bank could have tried to manage the supply of money without necessarily referencing it with respect to Gold. In fact, the original function of the gold was to constrain monetary and fiscal authorities or simply, control the economy (Bigman & Teizo, 2002, p.4). In 1968, the dollar and gold linkage was abolished; this led to the depreciation of the US dollar market value. In 1971, the then US President Richard Nixon made it public that the US could no longer sell gold to foreign central banks with reference to the dollar (Frankel, 2005,p.188). This marked the ending of the Bretton Woods System and opened ways for major currencies to start floating. During the same period, the President imposed strict important surcharges and temporary price controls in order to manage the escalation of the US inflation by correcting the balance of payments issues that the country was experiencing. This was referred to as the famous “Nixon shock” (Enders, 2004). What replaced the Bretton Woods System As noted by Bordo, & Eichengreen (2008, p.8) in 1971, the US President Richard Nixon officially ended the convertibility of the dollar into gold and officially ended the Bretton Woods System. After the collapse of the Bretton Woods System, there was an attempt to review the fixed exchange rates, this effort was not fruitful and in 1973, major currencies began to float against each others. More so since the collapse of the Bretton Woods System, the IMF members have been free to select a new platform of exchange arrangement that they wished to establish besides pegging it on another currency (Cohen, 2002, p.45). There were options available, ranging from adapting another country’s currency to participating in a currency bloc or creating a part of monetary union in that case. After the collapse of the Bretton Woods System, many countries feared that this would hinder periods of continual growth. To the surprise of many, the transition to floating exchange rates was smooth and timely as well (Eichengreen, 2004). This is because flexible exchange rates made it relatively easy for economies to adjust to more expensive oil when prices suddenly started to rise in 1973. More so, floating rates have enhanced fine readjustments of external shocks since then. The IMF also responded to the existing challenges by creating an oil price shock of the 1970s by basically adapting lending instruments which helped oil importers to deal effectively with the anticipated deficits in accounts as well as the inflation as a result of high oil prices by setting up the first two oil facilities (Eichengreen, 2007). The IMF also responded to the effects of the 1970s after Bretton Woods System by seeking to correct balance of payments issues through confronting world poorest countries through provision of concessional finances through what was then known as the Trust Fund (Eichengreen, 2008). In March 1986, the IMF established a new concessional loan program referred to as the Structural Adjustment Facility. The program was later succeeded by the Enhanced Structural Adjustment Facility in late 1987 (Dooley, Folkerts-Landau, & Garber, 2004, p.307). Conclusion Bretton Woods System Agreement was one of the milestones in world economics, the successes of this system was pegged mainly on its key features. Firstly, it was US dollar based, this ensured predictability of the currency and smooth import and exports based on the dollar. Secondly adjustable peg also allowed free variations of the local currency with reference to the dollar. Thirdly capital control restricted free capital mobility and finally the unprecedented macroeconomic success as a result of the global price stability coupled with high growth were attained with intense trade liberalization. Despite the successes of the Bretton Woods System, it eventually failed; the core reason for the failure was the linkage of the dollar to gold. This impacted on the stability of the world economy because surplus and deficits were controlled by the availability of gold instead of the cumulative market conditions. The failure of Bretton Woods System in 1971 resulted into a panic that did not materialize as foreign currencies were allowed to float freely in the market and the intervention of the IMF through policies that made the transition even smoother. In essence, the collapse of the Bretton Woods System could have been prevented. This could have been achieved by not pegging gold on the dollar but rather allow the cumulative market conditions to vary exchange rates in different countries. This could have also eased the transitions to other better monetary systems in future. Notwithstanding, the contributions of the Bretton Woods System are essential in the development of better fiscal and monetary policies in future, the recent financial crisis are a good example of how Bretton Wood System set a good example in better fiscal and monetary planning in the world economics. More so, government intervention on free trade has been the genesis of this system government intervention is necessary in correcting economic issues arising from unfair practices. References Andrews, D.M .(2008). Orderly change: international monetary relations since Bretton Woods. Michigan: Cornell University Press. pp. 105-114. Bigman, D.,&  Teizo, T.(2002). Floating exchange rates and the state of world trade and payments. 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