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Summary of week 6 the course International Money and Finance.
- Instelling
- Universiteit Van Amsterdam (UvA)
Summary of the course International Money and Finance. Including chapters: 11, 14, 15.
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Chapter 11: The International Monetary SystemThe Bretton Woods System
There were several important features to the system: a fixed butt adjustable exchange rate and the
setting up of two new international organizations. These were the International Monetary Fund
(IMF), with the duty of monitoring and supervising the system, and the International Bank for
Reconstruction and Development (IBRD), commonly known as the World Bank, charged initially with
the role of assisting the reconstruction of Europe’s devastated economies. In fat the World Bank is a
pair of institutions – the IBRD and the International Development Association, which obtains money
from developed nations and lends out the funds to the poorest less-developed countries (LDCs) at
concessional terms. A third institution, the International Finance Corporation, is affiliated to the
World Bank and provides risk capital direct to the private sector of LDCs. Under the Articles of
Agreement of the IMF, each currency was assigned a central parity against the US dollar and was
allowed to fluctuate by plus or minus 1% either side of this parity. The dollar itself was fixed to the
price of gold at $35 per ounce. The idea of fixing the dollar to the price of gold was to provide
confidence in the system. It was reasoned that foreign central banks would be more willing to hold
dollars in their reserves if they knew that they could be converted into gold. That the dollar was fixed
to the price of gold, making the dollar ‘as good as gold’. A country was expected to perverse the par
value of its currency vis-à-vis the dollar, but, in case of a ‘fundamental disequilibrium’ in its balance
of payments, it could devalue or revalue its currency. Providing the proposed change was less than
10% the IMF could not object, but larger realignments required the permission of the Fund. The
ability of a country to alter its par rate as a last resort was seen as an essential part of the system: it
offered countries an ultimate alternative to deflation or import controls as a means of correcting
persistent balance of payments imbalances. Under the Articles of Agreement of the Fund, the
member governments committed themselves to making their currencies convertible for current
account transactions as soon as was feasible. Convertibility for current account transactions meant
that, while governments could still employ capital controls, they could not prevent their residents or
residents of other countries form buying or selling their currency for current account transactions. It
is notable, however, that such a commitment to convertibility was not required with respect to
capital account transactions. This omission reflected the widespread suspicion that capital
movements were potentially highly destabilizing.
The IMF was set up with its general objective being to oversee and promote international monetary
cooperation and the growth of world trade. To these ends, one of the principal tasks of the Fund was
to ensure the smooth functioning of the fixed exchange rate system. In particular, minimizing the
need for countries to devalue and revalue their currencies by providing them with credit facilities
with which to finance temporary balance of payments deficits. One of the major problems envisaged
with the fixed exchange rate system was that countries facing a temporary balance of payments
deficit would be forced to deflate their economies if they wished to maintain their exchange rate
parity. As most governments had committed themselves to the maintenance of full employment,
such a scenario was not particularly appealing. To avert this, a credit mechanism was set up to
provide support for countries facing transitory balance of payments problems. Avoidance of
deflationary policies was viewed as helpful in maintaining the volume of world trade. Under the
credit facility, each member of the IMF was allocated a quota, the size of the quota being related to
its economic importance as reflected in the size of its subscription to the Fund. A country had to
place one-quarter of its quota in reserve assets and the remaining three-quarters in its own currency
with the Fund. This gave the IMF a stock of funds which could be lent to countries facing balance of
payments difficulties. In total a country could draw a maximum of 125% of its quota. As a rule any
borrowing from the Fund has to be repaid over a period of three to five years. When repaying the
Fund a country buys back its currency with foreign reserves.
The adoption of floating exchange rates stood in marked contrast to the setting-up of the Bretton
Woods system. There was no general agreement to adopt floating exchange rates or what rules
,should govern the conduct of future exchange rate policies. Rather, the move to floating rates was a
somewhat disorderly and haphazard product of the breakdown of the fixed exchange rate system.
The Bretton Woods System operated with reasonable success and only occasional realignments from
1947 to 1971. Explanations of its breakdown generally concentrate on the problems of liquidity and
the lack of an adequate adjustment mechanism.
The Liquidity Problem: Well before the eventual demise of Bretton Woods, Rober Triffin had
predicted an eventual loss of confidence in the system. Triffin argued that there was an inherent
contradiction in the gold-dollar standard. For the Bretton Woods system to function successfully it
was essential that confidence was maintained in the US dollar; so long as central banks knew that
dollars could be converted into gold at $35 per ounce they would willingly hold dollars in their
reserves. Triffin pointed out that as international trade grew, so would th demand for international
reserves, namely US dollars. To meet the demand for these reserves the Bretton Woods system
depended on the US running deficits, with the other countries running surpluses and purchasing
dollars to prevent their currencies appreciating. Hence, over time,, the stock of US dollar liabilities to
the rest of the world would increase and this rate of increase would be higher than the annual
addition to the US gold reserves resulting from gold-mining activities. As a result, the ratio of US
dollar liabilities to gold held by the US Federal Reserve would deteriorate until eventually the
convertibility of dollars into gold at $35 per ounce would become de facto impossible. As it became
apparent that the US authorities would not be able to fulfil their convertibility commitment, Triffin
predicted that central banks would begin to anticipate a devaluation of the dollar rate against gold.
In anticipation of this, central banks would start to convert their reserves into dollars and stop
pegging their currencies against the dollar, leading to an inevitable breakdown of the system. The
‘Triffin dilemma’ was that continued US deficits would undermine the Bretton Woods system, yet if
the US took measures to curb its deficits this would lead to a shortage of world reserves which would
undermine the growth of world trade and exert deflationary pressures on the world economy.
Alternative interpretation of the demise of Bretton Woods: Thomas Gresham argued that when there
is a discrepancy between the official rate of exchange between two assets and their private market
rate of exchange, the asset that is undervalued at the official rate will disappear from circulation,
while the asset that is overvalued will continue in circulation. When applied to the monetary field
this means that ‘bad money drives out good money’. The two assets to be considered are gold and
the dollar. Under the Bretton Woods system the official rate of exchange of these two assets was set
at $35 per troy ounce. The US authorities were committed to buy and sell gold with foreign monetary
authorities at this price. With U|A prices increasing by some 40% between 1959 and 1969, the price
of gold should, ceteris paribus, have risen by a similar amount. Indeed, as we have seen in the private
market, there was a persistent upward pressure on the price of gold, leading to the setting-up of the
gold pool. However, these gold sales became so significant that the loss of gold led central banks to
disband the gold pool in 1968. A two-tier market for gold led to the private market price of gold rising
above the official rate. Once the official price of gold became undervalued compared to the private
rate, central banks could easily have caused a major run on the dollar by converting their dollar
reserves into gold and then selling it on the private market at a profit. In a bid to preserve the fixed
exchange rate system in 1967, the USA secured an agreement from foreign central banks not convert
their dollar reserves into gold nor sell it on private markets. In effect, the dollar was de facto no
longer convertible into gold. In the end, following a further deterioration of the Us balance of
payments in 1970 and 1971, President Nixon announced the de jure suspension of the dollar
convertibility into gold. Dollars had driven out gold in accordance with Gresham’s Law.
The Bretton Woods system permitted a realignment of exchange rate parities as a last resort in case
of ‘fundamentals disequilibrium’ of a member’s balance of payments. In practice, however, countries
proved extremely reluctant to either devalue or revalue their currencies or undertake other
, economic policy measures required to ensure sustainable balance of payments positions. The fact
that ‘fundamental disequilibrium’ was not defined did not help. The USA could not devalue the dollar
in terms of gold since this would undermine confidence in the whole system. In addition, a dollar
devaluation against gold did not improve US competitiveness if other countries maintained their
exchange rate parities against the dollar. The expansionary US monetary policy inevitably resulted in
higher US inflation and significant widening of its balance of payments deficits. In practice, deficit
countries proved extremely reluctant to devalue their currencies because such action was viewed as
a sign of governmental and national weakness. The surplus countries were not prepared to reflate
their economies as a means of reducing their surpluses because they feared the inflationary
consequences. And revalue their currencies would risk ending export growth and lead to
unemployment in their economies as their tradables industries would be forced to contract. The
recognition that in a fixed exchange rate regime the pressure was normally on debtors to undertake
economic adjustment, because of the fall in their reserves required to defend the exchange rate, had
led to the inclusion of a ‘scarce currency clause’ in the IMF articles. This permitted debtor countries
to adopt penal measures against persistent surplus countries, but it was never invoked. With neither
deficit nor surplus countries being prepared to adjust their economies of exchange rates the question
of how to maintain fixed exchange rate parities in the face of persistent imbalances in the balance
payments required an answer. In a bid to prevent exchange rate realignments, the surplus countries
supplied the deficit countries’ central banks with reserves on a credit basis to enable them to prevent
devaluations of their currencies.
The Pivotal role of the dollar meant that the USA was the major source of international liquidity
under the Bretton Woods system. To acquire reserves the rest of the world had to run balance of
payments surpluses while the USA ran deficits. This meant that the rest of the world had to consume
less than it was producing, while the USA had the privilege of being able to consume more than it
was producing. President Charles the Gaulle of France argued that the system conferred an
‘exorbitant privilege’ on the US, which was able to gain productive long-term assets from its
overseas investments in exchange for short-term dollar liabilities. Dollar treasury bonds accumulated
by the rest of the world yielded relatively low rates of interest and their purchasing power was
eroded by US inflation. In effect, the USA was able to borrow at very low real rates of interest. The
actual methodology to calculate the value of such ‘seigniorage’ benefits has been an area of
controversy. There was resentment on the part of some deficit countries that they had to adopt
deflationary policies to correct their balance of payments deficits, while, because of the reserve
currency status of the dollar, the USA was under no corresponding pressure to correct its deficits.
The perceived seigniorage benefits conferred to the UAA, while not one of the major reasons for the
breakdown of the Bretton Woods scheme, did, however, when the system was under strain, weaken
the resolve to save the system.
The Post-Bretton Woods Era
The first oil shock and its aftermath: The return to floating exchange rates was initially regarded by
central bankers as only a temporary development until a new monetary order could be established.
In the event, any hopes of a return to fixed parities were overtaken by events. As a result of the Arab-
Israeli conflict at the end of 1973, the Oil Petroleum Exporting Countries (OPEC) quadrupled the price
of oil which had a huge impact on the world economy and effectively ended any hopes of restoring a
fixed exchange rate system. The huge oil price rise meant a significant deterioration of the oil
importing countries’ terms of trade with the OPEC countries. Non-oil exporting LDCs were
particularly had hit both by the rise in the price of their oil imports and by the recession in the
industrialized countries which reduced their export earnings. As a result the LDCs as a group
experienced massive current account deficits. In order to assist them, the IMF set up an ‘oil facility’
which borrowed funds from the surplus OPEC countries for lending to the LDCs. The impact of the oil
shock was far from uniform, as some countries were more dependent than others on oil imports.
Due to its differential impact and the different policy responses adopted by governments to deal with
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