Exchange Rate Regimes: The Bretton Woods System

Bretton Woods is the name of the town in the state of New Hampshire, USA, where the delegations from over forty five countries met in 1944 to deliberate on proposals for a post-war international monetary system. The two main contending proposals were “the White plan” named after Harry Dexter White of the US Treasury and the “Keynes plan” whose architect was Lord Keynes of the UK. Following the Second World War, policy makers from victorious allied powers, principally the US and UK, took up the task of thoroughly revamping the world monetary system for the non-communist world. The outcome was the so called “Bretton Woods System” and the birth of new supra-national institutions, the International Monetary Fund (the IMF or simply the “Fund”) and the World Bank.

Under this system US Dollar was the only currency that was fully convertible to gold; where other countries currencies were not directly convertible to gold. Countries held US dollars, as well as gold, for use as an international means of payment.

The system proposed an international clearing union that would create an international reserve asset called “bancor”. Countries would accept payment in bancor to settle international transactions without limit. They would also be allowed to acquire bancor by using overdraft facilities with the clearing union.

In return for undertaking this obligation, the member countries were entitled to have access to credit facilities from the IMF to carry out their intervention in the currency markets.

The novel feature of regime which makes it an adjustable peg system rather than a fixed rate system like the gold standard was that the parity of a currency against the dollar could be changed in the face of a fundamental equilibrium. A fundamental equilibrium is said to exist when at the given exchange rate, the country repeatedly faces balance of payment disequilibria, and has to constantly intervene and sell foreign exchange (persistent deficits) or buy foreign exchange (persistent surpluses) against its own currency. The situation of persistent deficits is much more difficult to deal with and calls for a devaluation of the home currency. Changes of upto 10% in either direction could be made without the consent of the Fund and obtaining their approval.

Under the Bretton Wood System, the US dollar in effect became international money. Other countries accumulated and held dollar balances with which they could settle their international payments; the US could in principal buy goods and services from other countries simply by paying with its own money. This system could work as long as other countries had confidence in the stability of the US dollar and in the ability of the US treasury to convert dollars into gold on demand at the specified conversion rate.

Professor Robert Triffin warned that gold exchange system was programmed to collapse in the long run. To satisfy the growing needs of reserves, the US had to run BOP deficits continuously which would eventually impair the public confidence in the dollar, triggering a run on the dollar. If reserve currency country runs BOP deficits to supply reserves, they can lead to a crisis of confidence in the reserve currency itself causing the down fall of the system. This dilemma is known as Triffin Paradox.

The system came under pressure and ultimately broke down when this confidence was shaken due to various political and some economic factors starting in mid-1960s. On August 15, 1971, the US government abandoned its commitment to convert dollars into gold at the fixed price of $35 per ounce and the major currencies went on a float. An attempt was made to resurrect the system by increasing the price of gold and widening the bands of permissible variation around the central parity. This was the so called Smithsonian Agreement. That too failed to hold the system together, and by early 1973, the world moved to a system of floating rates.

After a period of wild fluctuation in exchange rates — accentuated by real shock such as the oil price crises in 1973 — policy makers in various countries started experimenting with exchange rate regimes which were hybrids between fixed and floating rates. A group of countries in Europe entered into Bretton Woods like engagement of adjustable pegs within themselves. This was the European monetary system. Other countries tried various mixed versions.

Features of the Bretton Woods System

Four main features of the Bretton Woods system was as follows.

  1. First, it was a US dollar-based system. Officially, the Bretton Woods system was a gold-based system which treated all countries symmetrically, and the IMF was charged with the responsibility to manage this system. In reality, however, it was a US-dominated system with the US dollar playing the role of the key currency (the dollar’s dominance still continues today). The relationship between the US and other countries was highly asymmetric. The US, as the center country, provided domestic price stability which other countries could “import,” but did not itself engage in currency intervention (this is called benign neglect; i.e., the US did not care about exchange rates, which was desirable). By contrast, all other countries had the obligation to intervene in the currency market to fix their exchange rates against the US dollar.
  2. Second, it was an adjustable peg system. This means that exchange rates were normally fixed but permitted to be adjusted infrequently under certain conditions. As a consequence, exchange rates were supposed to move in a stepwise fashion. This was an arrangement to combine exchange rate stability and flexibility, while avoiding mutually destructive devaluation. Member countries were allowed to adjust “parities” (exchange rates) when “fundamental disequilibrium” existed. However, “fundamental disequilibrium” was not clearly defined anywhere. In reality, exchange rate adjustments were implemented far less often than the builders of the Bretton Woods system imagined. Germany revalued twice, the UK devalued once, and France devalued twice. Japan and Italy did not revise their parities.
  3. Third, capital control was tight. This was a big difference from the Classical Gold Standard of 1879-1914, when there was free capital mobility. Although the US and Germany had relatively less capital-account regulations, other countries imposed severe exchange controls.
  4. Fourth, macroeconomic performance was good. In particular, global price stability and high growth were simultaneously achieved under deepening trade liberalization. In particular, stability in tradable prices (wholesale prices or WPI) from the mid 1950s to the late 1960s was almost perfect and globally common. This macroeconomic achievement was historically unprecedented.

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