Features of the Bretton Woods Agreement - Case Study Example

Introduction Bretton Woods System is a term used to refer to the 20th century system of monetary management. This system consisted of rules that defined commercial and financial relationships among member countries; that were mostly industrial countries of the time. The Bretton woods system is a classical example of an agreed monetary relations order governing countries. Background When the First World War came to an end, countries tried to stabilize their economies to the way they were before the war. Nations needed to go back to the old financial order as soon as possible. Leading economies across Europe got together to discuss possible solutions, and one of their proposals for getting back to financial security was the gold system. Under this system, a country was to have gold reserves, in addition to the foreign currency, and monies in circulation. The gold system, however, collapsed in 1929 because of the great depression, which led to overvaluation or undervaluation of the participating currencies (Bordo, Michael D. & Eichengreen, Barry, 1993: 124). Existing financial relations were affected, and countries worked individually by increasing their exports so as to reduce their deficits. Nations that managed to deflate their currencies quickly while maintaining their strength in the market succeeded greatly. The result of the deflation competition was the failure of credit institutions due to bankruptcy, high unemployment and high inflation rates. Conferences were held to address the economic failures that caused the great depression, but none yielded a solution. It was not until final times of the Second World War that considerable steps were made towards addressing the economic failures. Negotiations towards the formation of a reliable monetary system were initiated; together with a supervisory institution to monitor it once it was in place (Onkvisit, Sak & Shaw, John, 1997: 63). In July 1944, an international conference with delegates from 44 countries met in the United States in the district of Bretton Woods in New Hampshire. Delegates attending the conference discussed the course to recovery after the Second World War. The previous period had been market by unstable exchange rates and unfavorable trade rules among other monetary troubles. The American and British government explored the possibility of attaining stable exchange rates through multilateral payment systems. The two governments drew plans of how the new monetary order should operate. Maynard Keynes, a renowned economist and advisor to the British government treasury drew up the plan proposed by the British government. The American government’s draft was written by a panel of experts led by the then deputy secretary of the American treasury, Harry Dexter White. Features of the Bretton Woods Agreement Maynard Keynes Proposal His plan advocated for the formation of an international financial institution which would work as a central bank to all the member countries. This institution was to facilitate an international currency called Bancor, whose value was to be fixed to the value of gold. The member countries would then set their currencies to function under a par value system using their account at the International Clearing Union so as to facilitate the settlement of trade (Moggridge, 1980: 207). Countries that attain a trade surplus will be eligible to receive interest while those with trade deficits will be able to overdraft with an interest. Keynes plan allowed countries to change exchange and trade controls so as to enable reconciliation of full employment with the payment balance. He suggested a certain degree of flexibility by the clearing union on the exchange rates. He also wanted to address the problem of imported unemployment by limiting foreign deflationary policies affecting member countries. Keynes wanted the international monetary system to have substantial liquidity of around $23 billion to allow for its smooth running (Onkvisit, Sak & Shaw, John J, 1997:80). Keynes draft was against going back to the gold standard which had failed in the 1920’s. The White Draft White proposed trade free of restrictions. He wanted currencies to be pegged and be overseen by an international institution that will have total power over changes in parity. The institution that White proposed was called the United Nations Stabilization Fund. Every country would contribute a given quota of their domestic currency and a certain amount of gold to the UNSF. Countries with trade deficits would draw resources from the UNSF by selling their currency in exchange for foreign currency thus increasing their balance. White was opposed to a high amount of liquidity for the International Monetary System; he wanted countries to have $5 billion dollars in drawing rights and the United States obligation to be limited to $2 billion (Onkvisit, Sak & Shaw, John J, 1997:82). . The plan that was finally adopted was a merger of ideas from the two drafts with most of it borrowing from White’s ideologies. The British gave up the International Clearing Unit and their proposed high liquidity of the International Monetary System. The agreed value of liquidity was $8.8 billion, and this was closer to White’s value of $5 billion (Moggridge, 1980: 218). The Americans, on the other hand, gave up their capital control centered approach for a national control centered approach. Par value changes cannot be made without authorization by the IMF. The British expressed concern over the US running a large surplus as it was during the warring period, therefore, forcing deflation on other countries. The scarce currency clause was introduced to address this concern. The clause gave the IMF power to ration currency in times if scarcity by introducing exchange controls. The Bretton Woods agreement wanted members to have their currencies convertible to gold or to the US dollar within a plus or minus one per cent parity. Countries changing their parity without authorization would be denied access to resources. The international monetary fund (IMF) together with the international bank for reconstruction and development (IBRD) were created by members who attended the conference, and the main aim was to set fixed currency change with the US dollar being the key currency (Kenen, Peter B, 1994: 16). The International Monetary Fund and the World Bank The International Monetary Fund (IMF) It was established on December 27th 1945 through the signing of articles by 29 participating countries. Its operations began in March 1947. The IMF is an international organization that currently hosts 183 countries of the world. Its core duty is to bring good international monetary relations and cooperation. This cooperation is enhanced by its global monitoring agency which consults with other monetary organizations for updates on economic trends for its planning. The global agency also supervises monetary spending by borrowers and also collaborates with other domestic and international monetary organizations to address monetary and development issues. The IMF has played a key role in promoting trade expansion in the world. Expanding trade has resulted in increased job opportunities because of a lot of money circulating thus leading to development and better living standards. The International Monetary Fund is critical in controlling foreign exchange restrictions which may affect world trade. It provides a number of payment systems used to transfer money in multilateral trade and also, it provides a platform through which payment issues arising from deficits are solved by availing resources, which can be used to cover the deficit value (Moggridge, 1980: 271). There were rules that a country had to adhere to before joining the international monetary fund. A country had to contribute a given portion of their money labeled a quota to form part of the liquid money available at the IMF. This money is given out to countries with monetary problem so that they can boost development projects, which will result in economic development, so that countries can repay the loan and also be economically independent. When a country joins the IMF, it is allowed to withdraw money adding up to 25% of its quota value. The IMF also allows borrowing beyond the 25% in cases of extreme need and the money has to be paid back to the IMF upon recovery by the country. However, a country must demonstrate the capability of payment of the loan before allocation so as to avoid leading the IMF to bankruptcy. Countries that contribute more in their quota are allowed to borrow more while those that contribute less can only borrow less. The size of the quota has a relation to the level of influence that a country has on decisions made. Countries that have a large quota share have more influence on decisions made than countries with lesser quotas. This is evident in the case of the two proposals, one by White and the other by Keynes. White’s proposal was chosen because the United States had the largest quota among all the participating countries of the Bretton Woods Agreement. The US had more influence than Britain thus it influenced decisions more (Onkvisit, Sak & Shaw, John J, 1997: 48). Loans granted by the IMF to individual countries do not have the same rules as those of other credit institution. IMF loans are considered more of an application for foreign currency which have to be paid back either through gold of the same value as the loan or a country's national currency. The loan is supposed to be paid back within 3 to 5 years of a 20 year circa. The World Bank The World Bank is an organization of the United Nations. It is considered the chief source of financial aid and every country joining it must be a member of the international monetary fund. The total amount of money given out to client countries by the World Bank in the form of loans adds up to almost $16 billion annually. The bank aims to counter the worst forms of poverty and improve living standards of people through financing development projects, and helping governments through the restructuring process in cases of massive destruction. It also solicits for partnerships from investors thus encouraging foreign direct investments (Kenen, Peter B, 1994: 38). The World Bank is capable of doing its work because of the financial resources it has and also its highly qualified staff. The World Bank conducts research, which guides it in providing resourceful knowledge to developing countries, on how they can achieve and maintain economic stability and thus ensure growth. Why did the Bretton Woods System Breakdown? The Bretton Woods Agreement was very successful in bringing about the much needed economic revival in the participating countries, after the great depression experienced at the end of the Second World War. The late 1950’s saw many countries get back most of their gold reserve because of the increased stability of their local currencies. However, in the 1960’s the economic boom got even bigger and the United States’ control weakened making the dollar suffer because of the devaluation. The United States reserves were unable to sustain the trade expansion of the other countries. This led to slower economic growth (Bordo, Michael D. & Eichengreen, Barry, 1993:141). The International Monetary Fund introduced a new policy called special drawing rights so as to counter the reserve shortage. Special drawing rights were arrived at by assigning a net worth average of the world’s leading currencies. The currencies used in coming up with the value includes the sterling pound, the Japanese yen, the German mark, the US dollar and the French franc. The special drawing rights did not give a lasting solution to the reserve problem experienced earlier. Instead, there were imbalances on the payments made between the industrialized countries and this destroyed the Bretton Woods System completely. Another problem that led to the failure of the Bretton Woods system is that of liquidity. Initially, the provision of liquidity was estimated at $8.8 billion but this value turned out to be insufficient to finance the rising trade needs of all the participating countries (Bordo, Michael D. & Eichengreen, Barry, 1993: 144). The Bretton system had progressively grown to a dollar gold standard because the US had a large deficit. The deficit was bound to get worse because the US used a lot of money to finance their war in Vietnam and the war against poverty. The other member countries were in possession of many dollar notes, and this made the other nations think that the Federal Reserve may not have enough money to facilitate the conversion of dollars to gold. These fears led to lack of confidence in the system. A confidence crisis was tagged to the dollar just as it was the case during the warring period. Lack of liquidity in the IMF made countries lose confidence in its future. Although interim measures to address the liquidity problem were made through the introduction of special drawing rights, this did not bring confidence in the Bretton Wood System. SDRs eventually led to the same problems of over and undervaluation and those of imbalances in payments which it was supposed to solve (Onkvisit, Sak & Shaw, John J, 1997:92). At this point, all hope was lost in the capability of the Bretton Woods System; it had proved incapable of fostering free and fair economic development to the participating countries as it had previously done. In addition, there were adjustment problems in the Bretton Woods Agreement. Contrary to the 1920s to 1930s gold systems which had the price Vs species mechanism of automatic adjustment in place, the bretton system had no such mechanism. This led to asymmetries in deficit and surplus countries as was the case during the previous gold system thus leading to numerous consequences. Adjusting parity levels would also have resulted in the failure of the whole system because it would have led to mistrust and speculations. The US dollar had dual roles as a national currency and a reserve currency. This made monetary policies in the US to be free of external forces while they influenced other countries policies (Kenen, Peter B, 1994: 17). What has replaced the Bretton Woods System? The Bretton Woods Agreement collapsed in 1971. This was because of the overvaluation of the dollar and the depletion of the gold reserves which controlled trade under the Bretton Wood Agreement. It was replaced by the Smithsonian agreement in December 1971 (Council on Foreign Relations, 1972:1). President Nixon, the then president of the USA hailed this agreement as the greatest monetary step taken in world history. Countries once again agreed to maintain a fixed exchange rate but not pegging it to gold and with no currency top up. Under this agreement, negotiations on the currency rate were first conducted and currency was allowed to fluctuate within a wider range. The Smithsonian agreement devaluated the US dollar by 8% leading to a change in the price of gold from $35 to $38. In 1972, European countries began getting rid of the dollar binding circumstances. The Smithsonian agreement collapsed the year 1973. This marked the beginning of a free floating exchange rate. Conclusion The Bretton woods system had noble intentions of ending the post war destruction and bringing economic development to member countries. The Bretton Woods system characterized by its fixed exchange rates and the Smithsonian agreement of 1971 with its fluctuating currency values do not exist anymore today. Their policies had to change so as to fit the changing market needs but their lessons are still relevant to modern day economists (Council on Foreign Relations, 1972:5). The Bretton Woods system has contributed towards a considerable increase in trade among nations of the world. Te system has also improved investments through increased foreign domestic investments and better macroeconomic performance. The inflation rate at the time of the system was very low especially in industrial countries except Japan. The Bretton Woods system brought about the highest real income per capita rates ever witnessed since the 1879 monetary era. The interest rates of this time were low yet very stable (Bordo, Michael D. & Eichengreen, Barry, 1993:110). The Bretton Woods system has led to expansion of trade relations because of the formation of the International Monetary and the World Bank which acts as the lending institution for countries. The founders of the Bretton system had tried to promote free trade through ending unfavorable policies. They did not want the continuation of the 1920-1930 situation of ‘beggar-thy-neighbor’. World trade opened up leading to massive economic growth in countries. Although the objectives of the system were achieved, their achievement led to the fall of the system. If there had been adequate liquidity to support the system, then the system would have survived the confidence problems it faced when the dollar was overvalued. The conflicting asymmetries between deficits and surplus also contributed to the end of the Bretton woods system. The Bretton system and the Smithsonian agreement provide invaluable lessons for modern day economists. Bibliography Bordo, Michael D. & Eichengreen, Barry (1993). A Retrospective on the Bretton Woods System. Chicago and London: The University of Chicago Press Council on Foreign Relations. (1972). Smithsonian Agreement and its Aftermath: several views. Kenen, Peter B. (1994). Managing the world economy: fifty years after Bretton Woods. Washington DC: Institute for International Economics Moggridge, Donald (1980). Activities 1941 - 1946: shaping the post-war world, Bretton Woods and reparations. London: Macmillan Onkvisit, Sak & Shaw, John J. (1997). International Marketing: Analysis and Strategy. New Jersey: Prentice Hall Read More