Bretton Woods system
Critically evaluate the rules and institutions of the Bretton Woods system and the lessons
learnt by other Economic and monetary policy makers
Abstract
In advanced economies, the prospects of sustained inflationary pressure and the continued risks
of debt-deflation that calls for effective monetary policy is always a real threat to successful
economic growth and expansion program particularly where there is high prevalence of
unemployment rate and economic stagnation. Fiscal restraint, strong medium and long term
consolidation measures, entitlement reform, structural reform and restructuring financial sectors
are some of the measures IMF recommends for financial stability. This paper critically evaluates
the policies of the IMF and the Bretton woods institution.
Introduction
The Bretton Woods came into being in July 1944 in New Hampshire in a US city known as the
Bretton Woods hence the name. The new economic order followed the Second World War and
the following three institutions were created to implement its policies.
a) The International bank for Reconstruction and Development. (IBRD)
The rules and institutions of the Bretton Woods system 2
IBRD was charged with the responsibility of ensuring the availability of long-term funds to
finance investments and to speed up the recovery process during the post war period in Europe.
b) International Monetary Fund (IMF)
Its responsibility was mainly to supervise the monetary arrangements in member countries.
c) International trade Organization (ITO)
Its major objective was to remove or reduce protectionism in the new world economic block that
had developed during the war.
The Bretton Wood also acted also acted as currency converter (restoration of confidence) not just
the restoration of economic systems. The economic systems created allowed more flexibility in
its built in systems than its predecessor that was referred to as the gold standard. It provided not
just the exchange rate guidance but also the policies and rules to be followed when settling the
payment imbalances in a way that was acceptable to all the member countries and which
promoted the international trade.
The IBRD evolved and became the World Bank and the Marshall plan was rolled out that
transformed its role in the global financial market to a multilateral development agency and it
was specifically mandated to assist the third world countries attain economic stability but its
functions were commercialize and concessional.
In 1945, the articles of ITO were not formally ratified instead the General Agreement on Trade
and Tarrifs that was a temporary creation for the ITO became operational and it acted as a global
framework of rules that targeted the reduction of protectionism and also provided a forum for
countries to negotiate the reduction of tariffs.
The rules and institutions of the Bretton Woods system 3
The IMF policies were partly developed from the Keynes recommendations to the International
Clearing Union which was advanced by the British while the International Stabilization Fund
that was forwarded by the US was also utilized in its policy development. (Keynes, 1964)
(Keynes, 1979)
The Keynesian approach of the demand oriented growth that emphasize the theory of balance of
balance of payments constrained growth that was also referred to as the Thirlwall’s Law
(Thirlwall’s, 1979, 1983, 1986 and 1981). In later years however the empirical generalization
was preferred than the law itself. (Thirlwall’s, 1997, 1991) Many countries in the third world
could utilize the domestic resources available in their countries if they were given adequate
foreign exchange as the importance of exports is to pay for the other import component of
demand to satisfy consumption and also investment. (Thirlwall’s, 1997) The only way to find a
long term solution towards improving a countries economic growth rate that’s consistent with its
equilibrium in its balance of payments is through structural changes that target the increase of its
income elasticity particularly of its exports and the general reduction of its imports income
elasticity. (Thirlwall’s, 2002, p. 78) The demand oriented theories developed by Keynes were
supplemented by the structural economic dynamics that were developed by Pasinetti (1981,
1993)
The major policies of the Bretton Woods aimed at a) Financing temporary balance of payments
imbalances from the respective country’s reserves or from borrowed funds mostly from the IMF.
The other persistent imbalances could be controlled by applying the fiscal and the monetary
policies. The rate of exchange could be changed by 1% and only after exhausting other control
procedures and also if the domestic adjustments would be ineffective and inconveniencing. The
exchange controls were only to be utilized to check the destabilizing capital movements.
The rules and institutions of the Bretton Woods system 4
The IMF acted as a short term source of assistance to relieve the BOP crisis and also as an arbiter
of the exchange rates adjustments. The Bretton Woods was very successful due to the rapid
expansion of trade and also the capital mobility which facilitated high economic growth in
respective countries but it lasted until the mid 1960’s when its own inbuilt contradictions
gradually started emerging.
The major features of the Bretton Woods initially were to act or take up a position as a reserve
asset that linked the United States dollar to a gold standard rate of 35 dollars per each ounce of
gold. Gold was the reserve asset. Other countries however were obliged to defend their own
home countries by trading in dollars. The US dollar was tied to gold will other currencies were
tied to the dollar. Most countries preferred to hold their general reserves in the form of the US
dollar as they had confidence in the dollar as it was convertible to gold. Gold was largely viewed
as a reserve asset and not as an international currency.
Each member of the IMF was given a quota that was based on a formula that considered such
factors as the size of the country’s income or importance in the global trade. These quotas
determined the countries contribution to the fund and the limits of its borrowings and also its
voting rights within the general decision making body of the IMF. Countries in deficit received
foreign exchange from the IMF in exchange of their own currencies which they were allowed to
buy them again when their economies improved.
B) The major lessons to be learnt by Economic and Monetary policy makers can be clearly
understood after evaluating the reasons that contributed to the failure of the Bretton Woods
institution.
The rules and institutions of the Bretton Woods system 5
The major reason that led to the failure of the Bretton wood was the liquidity problem. The
expansion of the international trade could only be matched with an equivalent international
liquidity. The persistent balance of payments deficits by the USA government led to the problem
of confidence in dollar conversion commitment by the US into gold at the existing rate which
was $35 per ounce of gold at the time. The ability of the US government to guarantee the
maintenance of the gold price was put into focus was questioned and if its continued deficit
would create liquidity shortage. Foreign central banks would convert their dollar holdings into
dollars if the loss of confidence in US dollars persisted. These signals pre-empted Bretton
Wood’s problems that led to its collapse and it was known as the Triffin dilemma. Triffin argued
that IMF should be converted into a deposit bank and the foreign countries central banks should
maintain a specified amount of reserve at the bank. These would facilitate the banks effort to
increase its own international reserves by providing loans and also purchasing securities in the
international markets. These proposals led to the Special Drawings Rights (SDRs) which were
introduced in 1967.
When there is discrepancy between two rates of exchange, private and official market rate, the
asset that’s undervalued, at the rate which is official, will certainly disappear from the market or
from the circulation while the overvalued will remain in circulation according to the Gresham’s
law. Gold and the US dollar were the two assets; each ounce of gold was valued at $35. Between
the years 1959 and 1969, inflation in the US rose by 40% but the price of the gold was not
affected as the Bretton Wood’s policy was the fixed rate of exchange. These meant that foreign
countries would have made a profit over the conversion of dollar into gold and later reselling the
gold at higher rate due to the inflation rates. The US made an agreement with foreign banks not
to convert their dollars and from the year 1967 the US dollar was not convertible to gold. The
The rules and institutions of the Bretton Woods system 6
high inflation rate in the US during the early years of 1970s was mostly caused by the Vietnam
war.
The limitations of the adjustment mechanism were;
The member countries of the Bretton Wood were very reluctant to either devalue o revalue their
currencies or even to implement policies that would provide a sustainable external balance. As
the cornerstone of the system, the US could not devalue its currency but only implemented
deflationary policies to control its spiraling inflation or the deficit of its balance of payments.
Other countries like the UK also avoided devaluation. Full employment and other political
reasons were cited as the causes of the reluctance to devalue the currencies. These meant that the
fixed exchange rate system could not operate effectively.
The role of the dollar in the Bretton Woods circles was meant to provide the required
international liquidity. To acquire the foreign reserves, the member nations were actually
required to maintain surpluses in their balance of payments while the US had deficits. The US
government utilized the dollars to fund its deficits. The US was literally borrowing at very low
interest rates from the rest of the world. These caused a lot of strain in the member countries
confidence with the US government.
The eventual end of the Bretton Wood began with the UK devaluation of the sterling in 1967
which affected the US ability to protect and defend the dollar’s gold price. In1971 the US
severed the links between the gold and the dollar after trying unsuccessfully to raise taxes to
finance the Vietnam war while the inflation was at an all time high. Attempts to devalue the US
dollar never succeeded and member countries were compelled to float their own currencies. The
The rules and institutions of the Bretton Woods system 7
Bretton Woods collapsed after its members became unwilling to act that would have sustained its
existence.
The political economy of the UK insist that the ideational level must be met and due weight
afforded to it in order to understand why and how the rate of balance of payments issues changes
over time. (Rosamond, 2002) (Hall, 1993) Contemporary social constructivist in UK,
international and also comparative political economy has received and shared this conclusive
recognition of the independent, constitutive and the causal role of concepts and ideational in
shaping the political, economic outcomes and practices. (Blyth, 1997, 2002, Ruggie, 1998, 1982,
Hay, 2004 and Sinclair, 2005)
The lessons to be learnt by the Economics and policy makers are; a) Concerning the lending
policies new measures have to be introduced to supplement the measures that Bretton Woods
implemented. The oil facility, the extended facility and the supplementary facility. These were
introduced in 1974 to finance the cost of direct imports that followed the oil price increment in
- The second facility was designed to assist the LDC by availing the long term funding to
assist in streamlining the structural problems. The supplementary financing facility was for
countries that were struggling with serious balance of payments problems.
Countries should also choose or custom their own exchange rates or they could choose any of the
existing exchange rates. (Lawson, 1988)
The most important experience was the replacement of the gold with the Special Drawing Rights
(SDR) as reserve assets. This was an attempt to solve or address the Triffin dilemma. These
included the complete abolition of the gold price and other restrictions on the open market sale of
gold.
The rules and institutions of the Bretton Woods system 8
To conclude, the lessons learnt on the Bretton Woods case may apply to the current EMU
policies but the economic conditions that prevailed in the late 1940s and the early years of 1960s
when the Bretton Woods prosperity was at its peak are quite different now. The global market
has turned into a small commercial world where trading activities are initiated and concluded
within hours. The advanced forms of communication techniques have revolutionized most of the
economic activities that depended so much on the global EMU concessions. The fixed and
floating exchange rates regimes should be shared among all the participating nations.
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