History of Exchange Rate System – Bretton Woods Exchange Rate System
The Bretton Wood Exchange Rate System is frequently referred to the international monetary standard that was used from the end of the Second World War till 1971. It was mostly the product of aspiring Anglo-American planning during World War II. The architects who were behind the attempt to plan a new and liberal international economic order in context to the broad fluctuation, aggressive depreciation, decrease in trade and uncertainty of the world’s economy in the 1930s were John Maynard Keynes in Britain and Harry Dexter White in the United States. The product of their in depth discussion were included in the draft Articles of Agreement of the International Monetary Fund (IMF), which were, in the course of time being submitted to the historic conference called together at Bretton Woods, New Hampshire, in July 1994 (Henrique 1999). While preparing to reconstruct the international economic system during the Second World War, 730 representatives from all Allied nations saw the opportunity for a new international system that will make use of the lessons of the previous gold standards and the event of the Great Depression were gathered for the Bretton Woods Conference also known as the United Nations Monetary and Financial Conference was held at Bretton Woods, New Hampshire, United States. The representatives were engage in depth and long discussion from the 1-22 July 1994 and signed the Bretton Woods agreement on the 22nd July 1994.
The aim of the Bretton Woods System was to create a sound monetary policy that will maintain the exchange rates among each country . In the conference, two institutions which is International Monetary Funds (IMF) and the International Bank for Reconstruction and Development (IBRD) are set up in order to create rules and regulations and procedures to supervise the international monetary system. The adoption of the International Monetary Funds (IMF) articles in the conference did not only create the legal structure for a new international institution, but also mold the international monetary system for the next quarter of the century (Henrique 1999). The Bretton Woods Exchange Rate System of monetary management formed the regulations for financial relations among the U.S. , Japan, Western Europe, Australia and Canada in the mid-20th century. This system was an example of a wholly negotiated monetary order aimed to regulate monetary relations among free nation-states.
The primary features of the Bretton Woods Exchange Rate System was that each country was obligated to practice a monetary policy that maintained the exchange rate by maximum 1 percent difference by binding its currency to gold and the capability of the IMF to bond temporary imbalances of payments. Besides that, those at Bretton Woods envisage an international monetary system that would prevent competitive denigration and promote economic expansion (Federal Reserve History 2016)
The advantages of Bretton Woods system include the elimination of uncertainty and risk. It had contributed to an steady and rapid growth of trade demands stability in FOREX markets. The uncertainty on income and cost of both importers and exporters has eliminated by the fixed exchange rate method and hence promote stronger economic growth. Besides, speculation in the FOREX market will be eliminated because of the fixed exchange rate. Speculative investors cannot take advantage of the floating exchange rate to earn an profit which will in turn manipulate the exchange rate. With a fixed exchange rate, traders will have confidence to make international payments without the fear of losses. It also encourage foreign investment for a country since the exchange rate is stable which in turn leads the country to a higher economic growth. With these advantages, the Bretton Woods system has temporary ended the financial and monetary war in the world and lead to a positive world economic recovery after World War II.
The disadvantages of Bretton Woods system include the adequacy of foreign exchange reserves. A relatively poor country will have a higher difficulty in order to maintain a sufficient level of foreign exchange reserves in order to keep the exchange rate fixed. In addition, the Bretton Woods agreement has restrict the capital movement of government. Goverments are needed to limit their capital flows in order to keep the exchange rate fixed. The structural deficiency in the Bretton Woods also put the pressure on U.S. The convertibility of dollar-gold has forced U.S. to supply their gold reserve to the rest of world. Below we will discuss how the Bretton Woods system has eventually collapsed because of the structural deficiency.
The abandoning of the Bretton Wood to the era of floating exchange rate system
The Bretton Woods system performs reasonably well and smooth until middle year of 1960 when some critical issues and problems arise. In the Bretton Woods agreements, U.S. has guaranteed to all the participating central banks that U.S. stood ready to exchange gold at $35 per ounce upon demand, which refers to the gold standard. This feature is one of the crucial discussion that lead to the end of the Bretton Wood system. Below we will discuss how this feature has an important effect in abandoning of the Bretton Wood.
In fact, U.S. inflation has been rising since 1960s when President Lyndon Johnson introduced the “Great Society” programs and a heavy military spending in Vietnam War. Instead of increasing tax to cover budget deficit, U.S. choose to finance the spending by monetizing the debt. In which, U.S. government issues bonds to cover its spending and the central bank print money and purchase the debt, which in turn increase the money supply of U.S. market and lead to an rapid inflation. An increase in money supply has an immediate financial impact on lowering of U.S. interest rates. Speculative investors take this advantages to borrow from U.S. and invest in foreign countries that have a higher relative rate of return. This eventually lead to an excessive supply of U.S. dollars in exchange for other currencies. Under normal circumstances, this will lead to an depreciation on U.S. dollar and an appreciation on non-reserve currencies. However, member countries are required to maintain the fixed exchange rate by intervening on the FOREX markets as stated in the Bretton Woods agreement. Hence, all the participating central banks are required to buy the excess dollars and sell their home currency to balance the demand and supply of dollars. (International Finance Theory and Policy, 2005).
In order to continue maintaining the fixed exchange rate, non U.S. central banks will eventually print money and held U.S. dollar as their reserves. The continual practice of printing money and buy U.S. dollar to maintain the fixed exchange rate by non U.S. central banks has bring an irreparable effect on the global financial system. In the event of dollar devaluation, the dollar-denominated assets holdings by inverstors would fall in value. In this case, investors will suffer a huge lose if dollar valuation really did occur.
Furthermore, the inflationary consequences in all the member countries has weakening the sustainability of Bretton Woods system. Private investors has recognised the problems and expect a dollar devaluation. This had lead to a divestment of dollar-denominated assets and investors convert their dollar to pounds or other currency. Eventually, this had added a downward pressure on the dollar value. However, U.S. central banks could not stop purchasing dollar or could not simply convert dollars to pounds or other currency because it will eventually lead to dollar devaluation.
As a result, the dollar reserves held by the other central banks had been increasing at a rapid and substantial rate and started to exceed the size of U.S. official gold stock. This has eventually lead to an issue called “dollar overhang”, in which the amount of U.S. dollars outside the U.S. exceed the U.S. gold reserves. If all other central banks intended to convert their dollars into gold at the same time, the U.S. is impossible to complete the conversion because there were insufficient gold reserves to meet all the demands. The liquidity problem arises when some countries discovered the deficiency of the system and start to lose confidence in dollars as it has revealed the overvaluation of U.S. dollar. Non U.S. central banks has recognize this problem and expect a dollar devaluation will eventually happen. They gradually convert their dollars for gold at the gold standard, which is $35 per ounce. U.S. gold reserves was around 20,000 tonnes in 1950s and nearly fall below 8,000 tonnes in early 1970s. (Refers to Appendix) The imbalances in the Bretton Woods system has reached its crisis proportions in 1971.
The Bretton Woods Exchange System has begun to collapse and dissolve when President Richard M.Nixon (37th U.S. President) announced his New Economic Policy to create a new prosperity without war, which is also known as the “Nixon shock. In the policy, U.S. has imposed a 10% import surcharge, a 90-days wage and price freeze in U.S and U.S. has closed the “gold window” that terminate the convertibility of dollar-gold in order to protect the dollar from attacks of international money speculators (Investopedia, 2009). This policy has eventually lead Bretton Woods exchange system to an end after achieving fixed exchange rate among its members for almost 30years, leaving the world with a floating exchange rate system.
Other Issues related to Bretton Woods system
In 1968, a lot of investors and privatize corporation also trade gold at the commodity market. The intervention of investors and speculators had affected the Bretton Woods system since gold price in market are fluctuating while gold price with U.S. central banks is fixed. On 1st November 1961, London Gold Pool was formed with intention to intervene in the London gold market and keep the price of gold at $35 per ounce. However, the pool collapsed due to a gold crisis. Subsequently, seven remaining members of the London Gold Pool, which includes United States, West Germany, Switzerland, the Netherlands, Belgium, Italy and Great Britain, agreed to create a “two tier gold system”. The central banks agreed to settle international debts with their gold only and not to sell the gold in the private market. While the private market gold price would remain freely fluctuate and determine by supply and demand in the market.
Furthermore, adjustment problem is also the main and vital concern in the system. In the operations of Bretton Woods system, this problem arises when individual countries had delayed their payments imbalances. The contraction in the money supply that should exist in a deficit country and the expansion in money supply in surplus country did not exist.
In fact, British pound has officially devalued in 1967 due to the declining of U.K. foreign exchange reserves. Although the government had tried to maintain the exchange rate, however it was forced to the devaluation because of numerous economic problems. U.K. has facing trade deficit throughout the 1950s and 60s. In order to finance the deficit on account balance of payments, U.K. is forced to use the foreign exchange reserves. Besides, U.K. borrowed funds from IMF to maintain the value of pound. However, increasingly pressure from creditors has led to the government suffer from a large loss on foreign currency reserves in order to repay the debt. The U.K. economy is also facing a relatively decline in productivity compared to other competitors which leads to a trade deficit. When the supply for pound is larger than demand of pound, the pound will eventually devalue. This devaluation was important as it is the key currency in Bretton Woods system.
The era of floating exchange rate system
After the collapse of Bretton Woods Exchange system, the major currencies began to float against each other. U.K. began floating the pound in June 1972, while U.S. dollar was devalued against gold in February 1973 and all the other currencies began floating. After years of discussion and negotiations, the Jamaica Accords has formed in 1976 and it is considered as one of the most monetary agreements in history. In Jamaica Accords, every member country was free to choose its own preferred exchange rate arrangements, for example, allowing the currency to float freely or participating in a currency bloc.
The government with a floating exchange rate has freedom with choose their internal policy constraints and domestic policy. They can freely make a choice with internal policy objectives that is most effective for the domestic economy. Furthermore, if there is any disequilibrium balance payment from internal policy implantation, it will be naturally redressed by the function of self- correcting with an adjustment in the external currency price. The floating exchange rate is merely controlled by the demand and supply forces. However, the dollar is no longer backed by gold. The floating exchange rate system is functioning well until now.