2.

History of International Monetary Systems, Part 2

(See handout no.2)
The creation of the Bretton Woods system
After World War II, the Bretton Woods system was established. In fact, the agreement to create a new international
monetary system was negotiated among the allied powers een before the end of WW2, leading to the Bretton
Woods Agreement in !"##. Bretton Woods is the name of a small tourist spot in the mountains of $ew %ampshire,
&SA. 'here, the delegates gathered to design a new global economic system. 'heir most important goal was to
preent each country from pursuing selfish policies, such as competitie dealuation, protectionism and forming
trade bloc(s, which damaged the world economy in the !")*s.
'he British delegation was headed by +ohn ,. -eynes, the famous economist, while %arry .. White of the &S
'reasury .epartment represented the American side. 'he contents of the new system were negotiated essentially by
these two countries. As a dominant military and economic power, the &S too( the leadership away from Britain,
which was war torn and losing international influence. 'he -eynes proposal was re/ected and the &S idea became
the foundation of the newly created International ,onetary 0und (I,0).
'he re/ected British proposal was to create a mighty settlement union for all countries. 1ach country was to hae an
official account at this mechanism, and all balance of payments (B23) surpluses and deficits would be recorded and
settled through these accounts. 'his would mean that both surplus and deficit countries bear the responsibility for
correcting the imbalance.
%oweer, the &S plan, which was actually adopted, was a much wea(er revolving fund. 1ach country would
contribute a certain amount (45uota4) to this fund, and member countries with B23 difficulties would borrow (or
4purchase4 hard currencies) from this fund. 'his meant that only deficit countries would bear the responsibility for
correcting the imbalance. ('he &- was e6pected to be a deficit country after the war, while the &S was e6pected to
be a surplus country.) 7ater in the !"8*s, borrowing countries were re5uired to implement macroeconomic policies
to reduce the deficit (4conditionality4).
'he Bretton Woods Agreement also established the World Ban( (International Ban( for 9econstruction and
.eelopment). 'he World Ban(:s initial purpose was to assist the recoery of war;torn 1urope and +apan. But in
reality, +apan:s recoery was assisted by &S bilateral aid and 1urope:s recoery was promoted by the ,arshall 3lan,
a massie &S aid program. 'he World Ban( subse5uently became an organi<ation to assist deeloping countries.
'he I,0 and the World Ban( were called the Bretton Woods sister organi<ations. 2ne more organi<ation
(International 'rade 2rgani<ation) was also planned but not created at that time. Instead, the =eneral Agreement on
'ariffs and 'rade (=A''), a non;organi<ational entity, played the role of promoting free trade for four decades.
=A'' became institutionali<ed as W'2 in !""8. So we now hae three sisters.
The IMF (left) and the World Bank today, in Washinton, !"
Feat#res of the Bretton Woods international dollar standard
0our main features of the Bretton Woods system was as follows.
0irst, it was a US dollar-based system. 2fficially, the Bretton Woods system was a gold;based system which treated
all countries symmetrically, and the I,0 was charged with the responsibility to manage this system. In reality,
howeer, it was a &S;dominated system with the &S dollar playing the role of the (ey currency (the dollar:s
dominance still continues today). 'he relationship between the &S and other countries was highly asymmetric. 'he
&S, as the center country, proided domestic price stability which other countries could 4import,4 but did not itself
engage in currency interention (this is called benign neglect> i.e., the &S did not care about e6change rates, which
was desirable). By contrast, all other countries had the obligation to interene in the currency mar(et to fi6 their
e6change rates against the &S dollar.
Second, it was an adjustable peg system. 'his means that e6change rates were normally fi6ed but permitted to be
ad/usted infre5uently under certain conditions. As a conse5uence, e6change rates were supposed to moe in a
stepwise fashion. 'his was an arrangement to combine e6change rate stability and fle6ibility, while aoiding
mutually destructie dealuation. ,ember countries were allowed to ad/ust 4parities4 (e6change rates) when
4fundamental dise5uilibrium4 e6isted. %oweer, 4fundamental dise5uilibrium4 was not clearly defined anywhere. In
reality, e6change rate ad/ustments were implemented far less often than the builders of the Bretton Woods system
imagined. =ermany realued twice, the &- dealued once, and 0rance dealued twice. +apan and Italy did not
reise their parities.
'hird, capital control was tight. 'his was a big difference from the ?lassical =old Standard of !@A";!"!#, when
there was free capital mobility. Although the &S and =ermany had relatiely less capital;account regulations, other
countries imposed seere e6change controls.
0ourth, macroeconomic performance was good. In particular, global price stability and high growth were
simultaneously achieed under deepening trade liberali<ation. In particular, stability in tradable prices (wholesale
prices or W3I) from the mid !"8*s to the late !"B*s was almost perfect and globally common. 'his macroeconomic
achieement was historically unprecedented.
Ho$ did the Bretton Woods system colla%se&
With such an e6cellent macroeconomic record, why did the Bretton Woods system collapse eentuallyC 1conomists
still debate on this 5uestion, but it is undeniable that there was a nominal anchor problem. 'he collapse of the
?lassical =old Standard was e6ternally forced (i.e., by the outbrea( of WW!), but the collapse of the Bretton Woods
system was due to internal inconsistency. 'he American monetary discipline sered as the nominal anchor for the
Bretton Woods system. But when the &S started to inflate its economy, the international monetary system based on
the &S dollar began to disintegrate.
7et us follow the history of the Bretton Woods system, step by step.
'he !"8*s was a period of dollar shortage. 1urope and +apan wanted to increase imports in the process of recoery
from war damage. But the only internationally acceptable money at that time was the &S dollar. So their capacity to
import was seerely limited by the aailability of foreign reseres denominated in the &S dollar.
%oweer, by the late !"B*s, there was a dollar overhang (oersupply) in the world economy. 'his turnaround was
due to the &S balance of payments deficit, which in turn was caused by e6pansionary fiscal policy. 'he spending of
the &S goernment increased for three reasonsD (i) the war in Eietnam> (ii) welfare e6penditure> and (iii) the space
race with the &SS9 (send humans to the moon by the end of the !"B*s).
In the late !"8*s, the I,0 felt the need to create a new international currency to supplement the dollar. But the
international negotiation too( a long time, and the artificial currency (called the Special .rawing 9ights, or S.9)
was created only in !"B". By that time, there was no longer a dollar shortage> in fact there was a dollar glutF ('oday,
S.9 plays only a minor role, mainly as the I,0:s accounting unit.)
In the mid !"B*s, &S domestic inflation (as measured in W3I) began to accelerate, which strained the Bretton
Woods system. When the &S was proiding price stability, other countries were willing to gie up monetary policy
independence and peg their currencies to the dollar. 'hrough this operation, their price leels were also stabili<ed.
But when the &S began to hae inflation, other countries gradually refused to import it.
'here was a downward pressure on the dollar. In !"B@, the fi6ed lin(age between dollar and gold was abandoned.
'he two-tier pricing of gold was introduced whereby the 4official4 gold;dollar parity was de;lin(ed from the mar(et
price of gold. 'he mar(et price of the dollar immediately depreciated. 'his was similar to the situation of multiple
e6change ratesD an oeralued official rate s. a more depreciated mar(et rate.
0inally, in !"A!, the fi6ed lin(age between dollar and other currencies was gien up. 2n
August !8, !"A!, &S 3resident 9ichard $i6on appeared on 'E and declared that the &S
would no longer sell gold to foreign central ban(s against the dollar. 'his completely
terminated the wor(ing of the Bretton Woods system and ma/or currencies began to float.
At the same time, 3resident $i6on also imposed temporary price controls and stiff import
surcharges. 'hese measures were all supposed to fight inflation and ameliorate the balance
of payments crisis that the &S was facing. 'his was called the 4$i6on Shoc(.4 GIf any
country adopted such a policy pac(age today, it would be seerely critici<ed by the I,0,
W'2 and the international community. It would be told to tighten the budget and money
first.H
President 'i(on $ent on T)
to end the Bretton Woods
system.
0or !! trading days that followed, the Ban( of +apan interened heaily in the currency mar(et to fight off massie
speculatie attac(s, losing # billion dollars of foreign reseres. 'hen, it gae up and let the yen appreciate. 1uropean
central ban(s gae up much sooner before losing a lot of foreign reseres.
Between !"A! and !"A), there was an international effort to re;establish the fi6ed e6change rate system at ad/usted
leels (with a more depreciated dollar). In .ecember !"A!, the monetary authorities of ma/or countries gathered in
Washington, .? to set their mutual e6change rates at new leels (the Smithsonian Agreement). But these rates could
not be maintained ery long. In early !"A), under another bout of heay speculatie attac(s, the Smithsonian rates
were abandoned and ma/or currencies began to float.
Triffin*s dilemma
3rof. 9obert 'riffin offered a famous e6planation as to why the Bretton Woods system had to collapse ineitably. %e
noted that there was a fundamental li5uidity dilemma when some country:s national currency was used as an
international money.
%is argument went something li(e this. As the world economy grew, more international money (Idollar) was
demanded. 'o supply that, the &S had to run a balance;of;payments deficit (how else can the rest of the world get
more dollarsC) But if the &S continued to run a B23 deficit, it would lose credibility as a sound currency country.
'he amount of gold that the &S had would soon be much less than the amount of dollars held by other countries.
'his meant that the &S could not guarantee conersion of international dollars into gold, if all foreign central ban(s
tried to cash in.
'o supply global li5uidity, the &S must run a deficit. But to maintain credibility, the &S must not run a deficit. 'hat
was the fundamental dilemma. In the end, the &S opted to run a B23 deficit, which led to the loss of credibility and
the collapse of the Bretton Woods system.
According to 3rof. 'riffin, the &S should not be blamed for the collapse of the Bretton Woods system, because there
was no way to get out of this impossible situation. But is 3rof. 'riffin rightC
'he issue is controersial. ,y personal iew is that 3rof. 'riffin was not necessarily right, that there was a logical
way out of this 4dilemma.4 0irst, de;lin( dollar from gold so the &S goernment is relieed of the obligation to
e6change gold for dollar. Second, supply /ust the right amount of dollar to the world to aoid global inflation or
deflation (this re5uires ad/ustments in fiscal and monetary policies, /ust as the I,0 would recommend). If these
reisions were adopted, I thin( the Bretton Woods system could hae continued much longer. 2biously, this would
hae re5uired a lot of hard thin(ing, political maneuering, and consensus building. Whether that was possible at
that time was another matter.
+old and money
At this point, we may stop and as( why gold is needed at all for the design of the international monetary system.
Why can:t a wise central ban( (or a group of them) manage money supply without any reference to goldC In fact, this
was e6actly the 5uestion raised by -eynes (7ecture !).
3erhaps the most fundamental answer isD central ban(ers are (were) not so wise. If you tie the alue of money to
gold, it may fluctuate due to the shifting demand and supply conditions of gold. But that would be much better than
hyperinflation or deep dealuation caused by a huge budget deficit or irresponsible monetary policy. =old is needed
to discipline the monetary and fiscal authorities. 1en though macroeconomics has adanced, we cannot trust eery
central ban(er, een to this date.
But at the same time, there are problems associated with the rigid gold;money lin(age.
0irst, short;term price fluctuation is unaoidable. In the !"th century, when a new gold mine was discoered in
?alifornia or Alas(a, the supply of gold increased greatly and the world had an inflation. But when there was no
such big gold discoery, there was a deflation. $o one could ensure that the speed of gold discoery matched the
increase in global money demand.
Second, the more serious problem is long;term shortage of monetary gold. 2er the years, the growth of the rapidly
industriali<ing world economy was faster than the pace of gold discoery. In order to supply the needed money, the
gold standard was gradually transformed so that a small amount of gold could bac( a much greater amount of
money. 'he gold standard eoled in the following steps.
(!) Gold coin standardD only gold coins circulate as money, and no paper money or ban( deposits are used. 'he
amount of monetary gold is e5ual to money supply. All money has intrinsic alue.
(2) Gold bullion standardD as the ban(ing system creates deposit money, people begin to carry paper notes for
conenience. But paper money can be e6changed for gold at any time. ,ost monetary gold is accumulated at ban(
aults in the form of gold bullions (gold bars). 'hrough the money multiplier process, money supply is much greater
than the amount of gold held by ban(s.
()) Gold exchange standardD if gold shortage persists, further saing of gold becomes necessary. =old can be held
only by the center country (&S 0ederal 9eseres) while other central ban(s hold dollar reseres, not gold. 'heir
dollar holdings are guaranteed to be conerted to gold by the &S.
'hese institutional changes proceeded naturally in order to economi<e the use of gold to support an eer greater
amount of money in the world. 'he Bretton Woods system, which collapsed in !"A!, was the last gold;e6change
standard.
2riginally, gold was needed to constrain fiscal and monetary authorities. But if this constraint was too tight for world
economic growth, and if institutional changes were re5uired now and then to loosen it, why continue to be bound by
itC

,-eferences.
Bordo, ,ichael .., and Barry 1ichengreen, eds, A Restrospect on the Bretton oods System! "essons for
#nternational $onetary Reform, $B19 and &niersity of ?hicago 3ress, !"").
+ames, %arold, #nternational $onetary %ooperation since Bretton oods, International ,onetary 0und and 26ford
&niersity 3ress, !""B.
,c-innon, 9onald I., &he Rules of the Game! #nternational $oney and 'xchange Rates, ,I' 3ress, !""B.