GEP Policy

Introduction

The Bretton Woods System refers to the dominant monetary system introduced in the middle of 1940s. It was largely affected by the Keynesian economic theory. The advocates of the system tried to present the optimal monetary policy that could help address the main challenges present at that historical period. At that period, all nation states aimed at determining the system that could allow adequately substituting the classical gold standard.

Current paper examines the key principles and characteristics of the Bretton Woods System. The reasons of its failure will be discussed. It will also be explained why it was an inevitable outcome. The paper will also present and discuss the conclusions made from the experience of the Bretton Woods System.

Main Characteristics of the Bretton Woods System

Current monetary system was a response to the main challenges and monetary instability of that period. During the 19th century, the classical gold standard was a dominant monetary system. It was comparatively efficient and allowed maximizing the rates of economic growth, as well as international trade. All national currencies referred to a certain weight of gold. The pound sterling was slightly less than 1/4 of a gold ounce, and the US dollar was equal to 1/20 of a gold ounce. Under such system, all exchange rates between all currencies based on the fixed gold standards. It means that they did not change until they were backed by the same amount of gold. However, such stability of exchange rates was not caused by any government interventions or control in the sphere.

However, the global conditions changed after World War I. During the war, all national governments began inflating their currencies. They needed to increase their aggregate spending, but it was almost impossible under the classical gold standard. As a result, numerous exchange controls, quotas and tariffs emerged. During 1920s, the gold-exchange standard was introduced. At that period, the US maintained the classical gold standard, while other capitalist countries, including the Great Britain, used other principles. They formally declared their adherence to the gold standard, but they did not have the necessary amount of gold.

Fluctuating fiat currencies were introduced during 1930s. However, they were also inefficient as all national governments began to inflate their currencies. The main characteristics of the Bretton Woods System were as follows. The US dollar displaced the British pound as the only reserve currencies. The dollar was defined as a 1/35 of a gold ounce. However, significant restrictions were introduced. Ordinary citizens could not redeem it in gold. Such option was formally granted only to foreign governments. The available stock of gold in the US at that period was equal to around $25 billion.

At the international level, several financial institutions were introduced. The first one was the International Monetary Fund (IMF). According to Keynes, IMF should help reorganize the global financial system in the post-war period. The second one was the International Bank for Reconstruction and Development (IBRD). The majority of developed and developing countries began to coordinate their efforts through such institutions. Current system contained the majority of the same problems as the gold-exchange system. The main disadvantage is its inherently inflationary character. The real convertibility of the US dollar to gold was not maintained and it was de jure admitted in 1971.

 

Reasons of Failure

The Bretton Woods System was inflationary and could not meet its stated objectives even from a theoretical point of view. It was not sustainable in the long run. The system led to inflationary temptations of the US government. Although the US dollar was formally redeemed in gold, the US could inflate its money supply and obtain additional benefits. Other national governments usually did not convert the US dollars in gold but used dollars to increase the supply of their monetary supply. In this way, they also could increase their revenues and cover their deficits. The only exception was the strategy of the French government that realized the financial opportunities of converting the US dollars in gold. Such strategy was widely used during 1960s.

As the US government realized the threats of such policies of foreign governments, such possibility was abolished in 1971. The US dollar became both de facto and de jure irredeemable in gold. Thus, other national governments could only use the US dollar as a reserve currency and increase their money supply on such basis. The collapse of the system was a necessary outcome of the principles that were introduced at the beginning of its operations.

Another problem with the Bretton Woods System is the existence of two markets of gold. The first one was a formal market where the price for gold was fixed at $35 per ounce. The second one was the free market. Although the majority of economists predicted that gold prices would substantially decline to its "industrial" price ($10) or even below, the real situation was opposite. The price for gold did not decline but tended to increase at a high rate. It was dangerous for the US monetary system for several reasons. First, the constant outflow of gold emerged and the US reserves diminished. Second, other national governments received an opportunity to use the disparity between the formal and real prices for gold to increase their reserves and improve financial state. France successfully utilized such opportunities. Therefore, the US government had to eliminate them and make the US dollar irredeemable in gold.

The Bretton Woods System also demonstrates a number of flaws in the general Keynesian economic theory. First, it neglects the long-run monetary effects of its monetary policy. In the short run, the Bretton Woods System was comparatively efficient, at least in comparison to the previous system of 1930s. However, the US government had both incentives and mechanism for inflating the country's money supply. Other national governments used the US dollar as a reserve currency to increase the supply of their national currencies. Consequently, the overall rates of inflation in the world increased dramatically.

Second, Keynesianism does not realize the potential threats of high government involvement into the financial sphere. When all national governments acquire the absolute control over the money supply under the fiat money regime, they tend to become irresponsible in their spending programs. Consequently, budget deficits increase and one of the ways of financing such deficits is through inflation. Third, inflation is not neutral in relation to the economy. As Keynesians believe that inflation is always inversely related to unemployment, they propose to stimulate production through government spending and higher inflation. However, in the long run, such relationship is absent and inflation may create substantial problems for the economic development of any country.

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Lessons for a Modern Financial System

The Bretton Woods System seems to be extremely helpful for the current monetary system. In particular, the recent financial crisis of 2007/08 outlined the same basic problems as the collapse of the Bretton Woods System. First of all, it is reasonable to present some advantages and disadvantages of the Bretton Woods System. The main advantages include the maintenance of the practice of reserve currencies and the coordination of international monetary policies through several global financial institutions. The system that is based on the principle of reserve currencies (or the only reserve currency) demonstrates better results in the sphere of financial stability in comparison to the completely unregulated fiat system of 1930s. The country that controls the money supply of the reserve currency has a temptation to increase the supply of its currency, but it has to control the overall rate of such increase. Otherwise, the rates of global inflation may be extremely high, and other countries may select another (more reliable) reserve currency. Therefore, the existence of reserve currencies restricts the government expansionist policies to some extent. The coordination of monetary policies of different countries with the help of IMF and IBRD is also positive. Such institutions help examine the existing monetary tendencies in the economies of various countries. Corresponding preventive and consulting services may also be provided.

Moreover, if some national governments experience substantial financial difficulties, the institutions may provide a corresponding financial assistance and support. Therefore, the governments may receive an opportunity to use borrowed funds for solving the problems of budget deficit and national debt. However, the Bretton Woods System has a large number of disadvantages, as well. The main disadvantage is high inflation experiencing by the majority of economies. During the 19th century, the prices tended to decline and it was beneficial for the expansion of savings, investments and innovations. Since the introduction of the fiat monetary system, deflation became viewed as a threat to economic progress and national governments try to avoid it. When the inflation rates become high, unemployment does not decline and countries experience stagflation.

Another disadvantage is Keynes' arbitrary definitions of "excessive" and "persistent" account surpluses. In this way, IMF and other financial institutions acquire an opportunity to control almost all policies of central banks and tax some operations. Thus, central banks cannot provide independent monetary policies and address their current needs. In the long run, the monetary policies of all countries tend to become close but the level of inflation is high. The following lessons for the present system may be formulated. First, it is unreasonable to create two or more markets for any goods or commodities. In particular, gold should have only one price and it should be based on the market supply and demand. The role of gold in the 21st century is still significant, but it differs from the functions fulfilled at the beginning or in the middle of the 20th century. Gold is a strategic reserve that helps increase the financial stability of various national governments. In case there exist other equal things, it may lead to the introduction of more conservative monetary policies with a closer control over the money supply. Second, international coordination through global financial institutions should be used as a tool for solving financial difficulties and minimizing key risks rather than allowing national governments to increase the money supply at a mutually agreed way. The latter strategy will lead to higher inflation rates in the world and new economic recessions. Third, international financial institutions offer loans to national governments at very low interest rates. Consequently, governments obtain additional incentives to implement irresponsible financial policies and increase their indebtedness. Such tendency constitutes substantial threats. Therefore, it is reasonable to make such loans closer to the dominant market rates. In this way, national governments may allocate their resources more efficiently. Finally, the role of SDRs should be increased. Developing countries should be free to convert some of their reserves in SDRs and be less dependent on the monetary policy of other countries, as well as on the reserve currency only. Such option may also be beneficial for China as one of the dominant global economies. If China is interested in converting some of its reserved in SDRs, it may allow minimizing the current misbalances between the US and China. If the conflict of interests between global economies is resolved, it will also create an attractive environment for other economies.

Conclusion

The Bretton Woods System was an attempt to reorganize the global monetary system in accordance with the changing conditions of the world economy. Fluctuating fiat currencies during 1930s proved their inefficiency and the Keynesian experts proposed to introduce a new monetary system. Although it was comparatively efficient in the short run, it was highly inflationary and was not actually supported by real gold reserves. As two markets of gold emerged, the US government had to abolish the convertibility of US dollars in gold in order to maintain its financial stability and minimize the outflow of gold.

As the monetary system was based on inflationary incentives, its ultimate collapse was inevitable. The introduction of free exchange rates was the only possible solution to the existing problems. It is possible to formulate a large number of lessons from such experience. In particular, gold should be viewed as a strategic reserve that may be effectively used to increase stability of the national monetary systems. The main international institutions should also provide better coordination. Interest rates in the inter-government loans should be close to market rates in order to encourage the effective allocation of scarce resources. Higher reliance on SDRs may help balance the interests of China and the US and contribute to the global macroeconomic balance.

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Nov 15, 2018 in Research
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