The History of Bretton Woods System by Kau Wing Jian and Lim Wooi Choon

The History of Bretton Woods System

by Kau Wing Jian and Lim Wooi Choon

In July 1944, an international monetary system known as the Bretton Woods system was created in the United Nations Monetary and Financial Conference was held at the Mount Washington Hotel in Bretton Woods, New Hampshire, where delegates from 44 nations. During the interwar period, the classic gold standard had been abandoned, meanwhile governments not only undertook competitive devaluations, but also set up restrictive trade policies that worsened the Great Depression. As a result, these countries saw the opportunity for a new international system that provide for post-war reconstruction after World War II. Afterward, they created this system that would not only avoid the stiffness of previous international monetary systems, but would also to improve the cooperation among the countries which participated in this systems. Thus, the Bretton Woods system was an unprecedented cooperative effort for nations that had been setting up barriers between their economies for more than a decade during war period. The aims of the Bretton Woods system was to ensure exchange rate stability, prevent competitive devaluations and promote economic growth.

The primary designer of the Bretton Woods system was John Maynard Keynes, served as an adviser to the British Treasury. However, Harry Dexter White served as the chief international economist at the Treasury Department in the United States. Keynes was one of the most influential economists of the time, planned for the creation of a large institution with the resources and authority to step in when imbalances occur. At the same time, this approach was consistent with his belief that public institutions should be able to intervene in times of crises. The Keynes plan to established a global central bank called the “Clearing Union”. This bank would issue a new international currency, the “bancor” which would be used to settle international imbalances. Keynes proposed raising funds of $26 million for the “Clearing Union”. Each nation would receive a limited credit that would prevent it from running a balance of payments deficit, but each country would also be discouraged from running surpluses by having to remit excess “bancor” to the Clearing Union. The plan reflected Keynes’s concerns about the global post-war economy.

In contrast, White’s plan for a new institution was one of more limited powers and resources. It reflected a problem that much of the financial resources of the “Clearing Union” envisioned by Keynes would be used to buy American goods, resulting in the United States holding the majority of bancor. White worried that America would end up being paid for its exports in “funny money”. Keynes lost the argument in his plan. Therefore, White proposed a new monetary institution called the “Stabilization Fund”. Rather than issue a new currency, it would be funded with a finite pool of national currencies and gold of $5 million that would effectively limit the supply of reserve credit. To summarize, the plan adopted at Bretton Woods which resembled the White plan with some concessions in response to Keynes’s concerns. A clause was added in case a country ran a balance of payments surplus and its currency became scarce in world trade. The fund could ration that currency and authorize limited imports from the surplus country. In addition, the total resources for the fund were raised from $5 million to $8.5 million.

The 730 delegates at Bretton Woods agreed to establish two new institutions. The International Monetary Fund (IMF) would monitor exchange rates and lend reserve currencies to nations with balance-of-payments deficits. The International Bank for Reconstruction and Development, now known as the World Bank Group, was responsible for providing financial assistance for the reconstruction after World War II and the economic development of less developed countries. Both the IMF and World Bank still survived and play important roles today, but each has fierce critics. The IMF has been criticised for the conditions it attaches to loans, which have been seen as too focused on austerity and the rights of creditors and too little concerned with the welfare of the poor. However, World Bank has mainly focused on loans to developing countries, has been criticised for failing to pay sufficient attention to the social and environmental consequences or negative externalities of the projects it funds.

The IMF came into formal existence in December 1945, when its first 29 member countries signed its Articles of Agreement. The countries agreed to keep their currencies fixed but adjustable (within a 1 percent band) to the dollar, and the dollar was fixed to gold at $35 an ounce. The Bretton Woods exchange-rate system saw all currencies linked to the dollar, and the dollar linked to gold. To prevent speculation against currency pegs, capital flows were severely restricted. To this day, when a country joins the IMF, it receives a quota based on its relative position in the world economy, which determines how much it contributes to the fund. In 1958, the Bretton Woods system became fully functional as currencies became convertible. Countries settled international balances in dollars, and US dollars were convertible to gold at a fixed exchange rate of $35 an ounce. The United States had the responsibility of keeping the price of gold fixed and had to adjust the supply of dollars to maintain confidence in future gold convertibility.

In 1971, President Richard Nixon ended the dollar’s convertibility to gold. The Bretton Woods system was in place until persistent US balance-of-payments deficits led to foreign-held dollars exceeding the US gold stock, implying that the United States could not fulfil its obligation to redeem dollars for gold at the official price. This is because a sizable increase in domestic spending on President Lyndon Johnson's Great Society programs and a rise in military spending caused by the Vietnam War gradually worsened the overvaluation of the dollar. By March 1973 the major currencies began to float against each other. Since the collapse of the Bretton Woods system, IMF members have been free to choose any form of exchange arrangement they wish (except pegging their currency to gold) allowing the currency to float freely, pegging it to another currency or a basket of currencies, adopting the currency of another country, participating in a currency bloc, or forming part of a monetary union.

With the end of Bretton Woods in 1970s, money has no tie to gold or any anchor anymore, it formed variety of exchange rate regime and capital control. In this situation, most rich country’s currencies float more which means less freely, whereas emerging country’s currencies more freer in capital flow because of globalization and removal of restriction. Due to freer flow, countries can control their currencies to avoid currency sudden soar. When capital pours in, central bank buy the currencies to control their currency. In current decade, many countries especially the emerging countries have learnt the lesson from the economic crisis in 1998 and 2008, they found that keeping extremely high quantity reserve is the key to survive during economic crisis. The reserve is mainly use to cover emergency imports and short-term debt payments. The best example is China, China did managed to limit their capital flow to make sure the Yuan is cheap without causing consumer inflation. In the other hand, they kept a large fraction of the global built up reserves. This large fraction of global built up reserve make an large impact on international monetary market. This causes many emerging countries are not willing to risk their currencies to rise to stay competitive in market. As a result many of the world's most vibrant economies in effect shadow the dollar, in an arrangement that has been dubbed “Bretton Woods 2”.