The Bretton-Woods Currency System and Its Collapse 8 comments

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Currency systems have always been one of the cornerstones of world finance; this has become even more apparent in recent years with globalisation and its accompanying trade and financial liberalisation as pushed mainly by the West. With free capital flows into and out of countries, whether local currencies are fixed or freely floating determines the actions that central banks have to take to maintain status quo, as well as the kinds of stress on the system and its stability. Emerging markets suffered badly due to incompatibility of currency systems versus their ability to manage capital flows in 1997-98.

My writeup details the development of the Bretton-Woods currency system after World War 2, and its subsequent collapse more than 20 years later. It gives a perspective on the difficulty of maintaining status quo on the international currency markets.

In the 19th and early 20th centuries gold played a key role in international monetary transactions. The gold standard was used to back currencies; the international value of currency was determined by its fixed relationship to gold; gold was used to settle international accounts. This was the classical gold standard. Supplementing the use of gold in this period was the British pound as a reserve currency. The implication of the gold standard and full convertibility was that exchange rates were fixed, and tended to be self-stabilising: under trade deficits a country's gold reserves would be depleted with corresponding decrease in money supply (since it had to be backed by gold) and importing power would decline, while the lowering of prices would boost exports; thus the deficit would be rectified.

After World War 2, the Bretton Woods conference was convened to structure the international economic framework for the future. One of the key items was the global currency system. Exchange rate stability was a prime goal; however the classical gold standard could no longer be used because gold production was not sufficient to support burgeoning world trade. What emerged was the "pegged rate" currency regime. Members were required to establish a parity of their national currencies in terms of gold (a "peg") and to maintain exchange rates within a "band" by intervening in their foreign exchange markets (ie. buying or selling foreign money). This was somewhere in between pure fixed exchange rates and pure freely-floating rates.

In practice, the world's currencies were pegged to the main reserve currency, now the US dollar, with the latter then pegged to gold at the rate of US$35 per ounce of gold. The US dollar therefore became the key currency of the Bretton Woods system and most international transactions were denominated in dollars from then on. A key reason for this arrangement was that post-WW2, the US dollar was the only currency strong enough fundamentally to meet the rising demands for international liquidity. It was also running a huge balance-of-payments (BOP) surplus; thus, maintaining the Bretton-Woods system necessitated reversal of this BOP flow to meet international dollar shortage. The Bretton-Woods system was highly advantageous to the US which would use the convertible financial system in a system of triangular trade as follows: it would trade (at a tremendous profit) with developing nations, expanding industry and acquiring raw materials. It would use this surplus to send dollars to Europe, which would then be used to rebuild their economies, and make the United States the market for their products. This would allow the other industrialized nations to purchase products from the Third World, which reinforced the American role as the guarantor of stability.

The Bretton-Woods system functioned very well for over 20 years. But it was founded on a contradiction. The system would continue to operate while the mass of US dollars circulating in the rest of the world was backed by gold held in the US. But the very expansion of the international economy tended to increase the need for international liquidity in the form of US dollars. That is, the more the global economy expanded, the shakier became the relationship between the dollar and gold.

In the 1960s, the dollar overhang—the difference between the dollars in international circulation and the value of the gold backing held by the US—began to grow as a result of increased US investment abroad and military spending (eg. the Vietnam war). The growth of the Euro dollar market (please read up yourself) also meant that growing amounts of financial capital were now able to move around the world outside the control of governments; capital controls to maintain incumbent fixed exchange rate regimes (as under the Bretton-Woods system) would not be effective (a tenet of economics is that it is impossible to balance a fixed exchange rate regime with open capital flows).

By 1968, the attempt to defend the dollar at a fixed peg of $35/ounce, the policy of the Eisenhower, Kennedy and Johnson administrations, had become increasingly untenable. Gold outflows from the U.S. accelerated as its balance of payments swung towards zero, a massive reversal from the post-WW2 years. By the early 1970s, as the Vietnam War accelerated inflation, the United States as a whole began running a trade deficit (for the first time in the 20th century). In 1971, as financial assets continued to flee the US and the US economy showed signs of a tailspin, President Nixon finally announced, in August, that the US was unilaterally removing the gold backing from the dollar, effectively spelling the end of the Bretton-Woods fixed-rate system centred on the dollar.

The removal of the gold backing from the US dollar was rapidly followed by the abolition of fixed currency relationships globally and the lifting of restrictions on the movement of capital throughout the 1980s. The demise of the gold standard and global fixed exchange rate regime has been blamed for a series of ensuing currency crises. In 1987, differences between US and German authorities over interest rate policies directly contributed to the October stock market collapse. The decade of the 1990s saw the sterling crisis of 1992, followed by the turbulence in bond markets in 1994 and the Mexican bailout of 1994-95. Then came the Asian crisis of 1997, followed by the Russian default of 1998. Many of these were precipitated by countries managing their own pegs that turned out to be overvalued. Under the Bretton-Woods system, their currencies would have been pegged to the US dollar whose value would be backed by gold; value was assured. But then again, the Bretton-Woods system had also met its demise due to internal instabilities as described above. It just goes to show the dynamism of international finance, and why it is important to evolve one's views, beliefs and positions with time.

References:
(1) When the Bretton Woods system collapsed
(2) Wikipedia: Bretton-Woods System