bretton woods system

Case Study:Bretton Woods System

Introduction to International Relations

Why does it matter?

Sound IMS is prerequisite for stable world economy

Requirement for growth of world trade and foreign investment

International Monetary System (IMS)

What is money?◦Any good that is widely accepted in exchange of goods and

services, as well as payment of debts

Three functions of money:1. Medium of exchange – money used for buying and selling

goods and services2. Unit of account – common standard for measuring relative

worth of goods and services3. Store of value – convenient way to store wealth

International Monetary System (IMS)

1. Liquidity2. Adjustment Mechanism3. Confidence

Requirements for Stable IMS

Amount of assets (e.g., money) that can be easily available to finance trade

Market liquidity◦ describes how easily an item can be traded for another item, or into the

common currency within an economy

◦ MONEY is the most liquid asset because it is universally recognized and accepted as the common currency

IMS should provide adequate liquidity to finance international transactions

1. Liquidity

Must specify methods to resolve balance of payment (BOP) disequilibria

BOP◦ All payments between a country and its trading partners

Disequilibria – imbalance

2. Adjustment Mechanism

Sound IMS should provide confidence in the system

3. Confidence

1. Era of specie money – precious stones2. Era of political money – paper money3. Classical Gold Standard◦ Why standard? - money acts as a standard measure

and common denomination of trade4. Gold Exchange Standard5. Bretton Woods System6. System of Flexible Rates

History of IMS

Pre-modern era

Specie money – metal money in circulation◦ coin, money in the form of coins" (as opposed to paper

money or bullion)

Governments had no control over monetary issues (i.e., money flow)

◦ Chronic specie scarcity

1. Era of Specie Money

18th and 19th century

Financial revolution: Paper money; modern banking, credit instruments

Government started printing money◦ Government acquired extensive control over money

supply

2. Era of Political Money

Macro-economic variable:◦ Influence economic activities

Government could solve inadequacy of specie money◦ E.g., Gov’t. could fight against deflationary pressure

But this can also create inflationary bias◦ diminish value of currencies◦ instability in IMS

We want both flexibility in domestic economic policies and stability in IMS

BUT, trade-off between autonomous domestic economic policies and stable monetary order

The way this dilemma was resolved characterizes the subsequent phases in history of IMS

Dilemma:

1870-1914

Features:1. Central bank of a nation bought and sold gold at a fixed

price2. Citizens could freely export and import gold3. Central bank did not interfere with capital flow4. Fixed exchange rate mechanism for adjusting

international BOP

3. The Classical Gold Standard

Embodiment of classical liberal economic principles

Very successful IMS

Facilitated growth of world trade and global prosperity

But at the cost of autonomy in domestic economic policies

Worked well till World War I

Facilitated growth of world trade and global prosperity

Why did the Classical Gold Standard collapse?

◦ Rise of warfare state◦ Major consequence of WWI: nationalization of IMS◦ States safeguarded their gold supplies, disengaged

from fixed XR◦ Advent of Keynesianism: government should fight

against frequent recession and high unemployment

Interregnum period

Currency tied to gold, but the return to gold standard was ruled out

Instead of gold, states could use gold-backed currencies such as British sterling

Basically similar to the Classical Gold Standard

4. Gold Exchange Standard

Only survived a few years. Why?

◦ Rise of welfare state◦ Welfare objectives (e.g., continuous economic growth

and full employment) are more important than stable international monetary order Rise of labor unions

◦ Active intervention in monetary issues

The trade-off…

Autonomy of domestic economic policies over stable international monetary system!

“Beggar-thy-neighbor policies”, competitive depreciation Great Depression WWII

Two goals of the Bretton Woods System

1. A world in which governments would have considerable leeway to pursue national economic objectives, yet

2. The monetary order was based on fixed exchange rate to prevent competitive depreciation

In other words, both autonomy and stability!

5. Bretton Woods System

Creation of the International Monetary Fund (IMF) to supervise the Bretton Woods System

The compromise of domestic autonomy and stability of IMS:

◦ Embedded liberalism

Embedded Liberalism

◦ “Unlike the economic nationalism of the thirties, it would be liberalistic in character; unlike the liberalism of the gold standard, its liberalism would be predicated upon domestic interventionism.” – John G. Ruggie

Avoided

1. Subordination of domestic economic activities to the stability of the IMS (key feature of the Classical Gold Standard)

2. The sacrifice of the IMS to the domestic policy autonomy (key character of the interwar period)

Intended to enable governments to pursue Keynesian growth policies at home, without sacrificing international monetary stability

Also to achieve stable international monetary system, without subordinating autonomy in domestic economic activities

How the dilemma was solved during the BWS

◦ If a country is suffering temporary BOP disequilibria, IMF would provide medium-term loan to the country

◦ If a country is suffering fundamental BOP disequilibria, the system would permit a country to change its exchange rate

The key to the system?

◦ American economy dollar◦ Other nations pegged their currencies to the dollar

(system of fixed XR)◦ The US pledged to keep the dollar convertible into gold

at $35 per ounce◦ Dollar was the principal medium of exchange, store of

value, and unit of account

It was quite successful!

But why did the system collapse?

Triffin dilemma

Triffin dilemma:

◦ soundness of BWS depended on liquidity and international confidence created by the US economy

◦ Every state wants dollar to rectify their BOP problem◦ But the US can’t print dollars indefinitely inflationary

pressure devalue the worth of dollar◦ People will lose confidence in dollar and in the system

Triffin dilemma:

◦ To provide liquidity, the US would have to run BOP deficit

◦ US BOP deficit in the long run will undermine confidence in the dollar and the system

Two basic asymmetries:

1. Role of dollar as providing liquidity US BOP deficit decreased confidence in the system

2. US, not able to devalue the dollar to improve its BOP position

Collapse of the BWS

◦ August 15, 1971 – Nixon announced that the US will suspend the convertibility of the dollar into gold

Kingston Conference (1976)

The determination of the par value of a currency is the responsibility of the country

6. System of Flexible Rates

Briefly discuss:

◦ the importance of international monetary system

◦ trade-off between national autonomy over domestic policies and stability of international monetary system

Activity