Finance

Why So Much Talk Around Bretton Woods Right Now

bretton woods financial system

With economic collapse slowly gaining pace, threatening with new depression, world economists started to analyze the possible reasons and outcomes. One of the most popular theory is based on the contradiction found in the Bretton Woods Agreement of 1944.

The History of Bretton Woods Monetary System

Let’s recall the history. It’s 1944. The Second World War is still going on, but its outcome has already been predetermined. The defeated countries are ruined as are the European victors to significant extent.

The war was relatively beneficial only to the USA, but they had to take emergency measures and support militarized economy. They were also losing people in the lines (though the losses were out of proportion to the main countries at war). That’s why the USA were deeply concerned with restoring Europe and maintaining sustainable growth for the post-war European countries. The USA didn’t want big wars in Europe any more (two world wars where the USA were compelled to take part were enough).

Furthermore, by 1944 the USA had accumulated more than 90% of the world reserves of gold which was the main currency for global trade. All the other victors virtually ran out of money. The defeated countries didn’t have any money left at all.

At that moment, the conference that had to establish the post-war world monetary system was convoked. The task of the new system was to provide for sustainable and free global trade and to exclude tough competition between the countries that could cause another big war. That’s why those who created the Bretton Woods system tried to take into account the lessons taught by the history as much as possible.

The Lessons of the 19th and the Beginning of the 20th Century

At this point, let us go back a little and take a look at what was happening to monetary systems and international trade in the 19th and the beginning of the 20th century.

The truth is that the “gold standard” idolized by supporters of the “physical gold” has virtually never existed in reality. Indeed physical gold and silver (notably the latter one was mainly used) had been money before the mid 19th century. But this is not the “gold standard” at all.

At the same time paper money existed as well. It was mainly represented by public bonds, but they were continuously devaluating (let’s remember Dostoyevsky’s Russia where settlements were carried out “using silver or paper money”). However, for international settlements mainly physical gold (in the West) and silver (in trade with the East) were used.

By the end of the 19th century all the developed countries had put money circulation to order by introducing firm paper money (because it was obviously inconvenient to use physical gold). This is how the “gold standard” was introduced in these countries. England was the first country to do that (1821), Russia was the last one (Vitte’s reform, 1893–1895).

Global trade, foreign investments etc. began flourishing because it became possible to trade in national currencies and forecast return on investments.

But the “golden century” didn’t last long. It lasted till the end of the 19th century. By that time, especially after the Depression of the 1870s, it had become clear that the gold standard was hampering the development, because there was not enough gold to provide for the money that growing global economy needed.

Refusing the Gold Standard

That’s why the very end of the 19th century and the beginning of the 20th century marked the total refusal of the gold standard (do you remember what O. Henry’s characters say about bimetallism?). Most national currencies devaluated. The established system was crumbling. Countries started protecting their markets from neighbors who gained advantages due to the currency devaluation. Custom barriers were introduced everywhere.

The Great Britain turned out to be in the most advantageous situation, because it managed to preserve large market thanks to its vast amount of the colonies. France went the same way. It was the beginning of the 20th century when it conquered Morocco, the Algerian Sahara and a number of other territories expanding the French empire. Italy invaded Abyssinia. Japan was actively expanding into China where it collided with Russia. And so on.

In other words colonies are needed for other purposes contrary to what many think. Their value is not really in the resources, but in the control over markets.

Rapidly developing Germany almost didn’t get any colonies (except a few small ones in Africa), so the only way to expand the market for Germany was to struggle for the division of the Ottoman Empire, which led to the First World War.

Essentially, the war didn’t solve anything. The defeated countries lost some of their territories, the old empires collapsed (Austria-Hungary, the Ottoman Empire), the victors heaved the sigh of relief. But the currency turmoil didn’t end. And the global trade couldn’t be restored by any means. England as the “queen of the seas” and the main beneficiary of global trade introduced the gold standard again but couldn’t afford it and asked the FRS to help. The FRS raised the rate but it had a disastrous impact on the overheated American economy (at that time it already was the strongest economy in the world).

That led to the Great Depression and made all countries completely refuse of the gold standard. As a result, the Dawes Plan intended to settle the economic situation in Europe didn’t work. Isolationist policy prevailed in Europe again, and Germany which was locked within its boundaries, deprived of markets and encumbered by enormous debts unleashed the Second World War.

Bretton Woods Framework

With this picture in mind, the Bretton Woods system creators set the goal to establish a monetary system in which national currencies could exist (as an important attribute of national sovereignty) without being pegged to gold. But it necessitated the introduction of an anchor currency, i. e. the reference currency that could be used alone or as a currency peg to carry out the international trade without limitations.

The isolationism always leads to wars. This is a very important point that everyone should realize. “When goods don’t cross borders, soldiers will”

And such framework was suggested by the USA and accepted by the other conference participants (including the USSR). It was imposed on the defeated countries as a matter of fact.

That was bundled with the other measures, such as opening the markets of the colonies, helping restore Europe and Japan (the Marshall Plan) etc. intended to create a free market and prevent the isolationism in the post-war world.

By the way, here’s an interesting fact. It’s known that Europe and Japan received approximately 40 billion dollars aid (if converted to today’s money, it’s more than a trillion) according to the Marshall Plan. But there is still no accurate information about who was given this money and what were the conditions of this aid.

So, what is the Bretton Woods monetary system?

  • All member countries are given the right to independently emit their currency. But the currencies should be pegged to the US dollar. It means national currency exchange rates publicly declared by central banks should exist and the central banks should actually buy and sell using these rates (+-1%). With that in mind, countries can independently devaluate and revaluate their currencies (change the declared exchange rate).
  • The US dollar is pegged to gold. It means the fixed value of gold in the dollars is declared, which is 35 dollars per troy ounce. And FRS shall buy and sell gold by this price.
  • The agreement member countries shall establish the International Monetary Fund. The IMF shall provide loans to cover imbalance of payments.

Therefore the issue where the member countries didn’t have backing (gold) was solved and prerequisites for transparent and efficient international trade were set.

This implied that a national currency exchange rate is determined by foreign trade balance. If it’s positive, the currency revaluates (it was a popular belief that it’s good to have strong currency), if it’s negative, the currency devaluates. If the balance turned negative but the country thought it was temporary and didn’t want to devaluate its currency it could receive an IMF loan.

Actually this was the bomb put under the Bretton Woods system.

Bretton Woods Outcomes and Lessons

This system really enabled unprecedented growth of the world economy that had the monetary barriers (lack of money/gold) removed.

Germany, France, England and Japan raised from the ruins and reclaimed their status of industrially developed countries. The USA experienced the consumer boom. The aggregate global GDP hit the max for the entire previous history of mankind.

But by the end of the 60s, problems had begun to emerge.

The reason was that essentially this feast was at the expense of the USA.

The USA became the main buyer on the global market because all the members of the Bretton Woods (except the USSR which was building its own system) were developing by exporting their cheap products to the USA. And they quickly realized the benefits of the positive payment balance and didn’t hurry to revaluate their currencies accumulating foreign exchange reserves instead.

And whereas the USA had 50% of global industrial production and the foreign exchange reserve exceeded 22 thousand tonnes in 1944, the US industry had decreased to 20% and the foreign exchange reserve had dropped to 9 thousand tonnes by 1970.

Furthermore, the industry was declining not only relatively, but absolutely too, because it couldn’t stand the competition against cheap European and Japanese products. Unemployment increased in the USA, and as a response the service sector dramatically grew.

And what about the consumer boom in the USA? In fact, the USA launched an extensive emission to fund the military production during the war. But it didn’t get to the consumer market because the significant share of salaries was suspended, and the population voluntary-compulsory bought public bonds.

After the war, this deferred demand started getting gradually released by paying off the bonds. That’s why even those who lost a job when businesses closed still had a quite decent financial cushion. The US government also allocated large amounts for social payments such as unemployment payments, veteran’s pensions etc. With the US market being flooded with cheap goods from Europe and Japan it was possible to keep the quality of living increasing till the 60s end (the consumption level reached by that time in the USA hasn’t been exceeded afterwards).

But then the situation in the USA started deteriorating rapidly. By 1971, the US leaders had realized it shouldn’t be that way any more. The seemingly infinite financial resource turned out to be quite finite. Furthermore, the former allies went ahead and began asking for industrial amounts of gold in exchange of the earned dollars (famous de Gaulle’s demarche).  And the USA couldn’t emit to protect their economy because the dollar was pegged to gold.

But it should be considered that the development of the entire Western world at the expense of the USA wasn’t pure parasitism. Cumulatively, the global economy growth exceeded the decline of the US economy. Therefore the Bretton Woods system worked as a driver for the development of the global economy. As a result, the USA canceled the pegging of the dollar to gold in 1971. It allowed them to deflate the dollar. And that was the end of the Bretton Woods system.

It may come as a surprise to many, but when the Bretton Woods system still existed the dollar wasn’t used as the international trade currency at all, the most of the trade was carried out in national currencies, because cross rates were absolutely transparent and stable, and devaluations and revaluations were rare.

Chaos ensued, the international trade declined. It had its foundation removed, so it became absolutely unclear what rates should be applied when trading.  Previously cross rates had been calculated using the dollar, so countries could comfortably trade in national currencies, but it became risky afterwards. Cross rates for currency pairs became floating, and it wasn’t clear how to align them. A number of devaluations of the dollar and revaluations of other currencies occurred. In fact, it was apparently the moment when massive international trade turned to the dollars.

A reasonable question: didn’t the creators of the Bretton Woods system, the best economists of the world, think about such scenario? Apparently yes, they didn’t.  Because it’s been always thought that countries should strengthen their currencies if possible, and there has never been the situation when almost all countries has worked for an external market (the US market) rather than for internal ones.

Jamaica Monetary System

jamaica agreementThe chaos lasted approximately for 2 years. The Jamaica Conference took place in 1976, where in fact the modern monetary system was established.

The purpose of the Jamaica system was to introduce market mechanisms for defining currency exchange rates. Exchange markets were created in the Jamaica Agreement countries. In those markets, the country’s central bank was an important player, but it wasn’t the only one.

Also, gold lost its sacred meaning and became one of exchange market goods. Central banks were given a right to sell and buy it by market prices.

By the way, it should be noted that there was an attempt to establish a global anchor currency within the Jamaica system. That was infamous IMF’s SDR (Special Drawing Rights). Cross rates between this currency and world currencies were calculated using some quite complicated principles. Then they were simplified, and SDR was calculated using the reserve currency basket, but that didn’t work out too. SDR didn’t obtain wide circulation in the international trade. However, some countries are still keeping their foreign exchange reserves in SDR.

Thus, the golden age for the global financial sector began as it got a new source of revenue in form of currency trade and related activities (hedging, international arbitration etc.).

Another consequence of the Jamaica Agreement was that the dollar became the international trade currency. The dollar got this role as a matter of fact. Just because the currency pair liquidity to the dollar was largest and the margin was smallest. It means that for countries like France and Germany it was easier and more cost-efficient to trade in the dollars than in the franks or deutsche marks because transactors lost less on exchanges and hedging of exchange risks.

Essentially the Jamaica system didn’t change anything in the trade between the main Western countries. The financial sector just began earning a larger interest.

It was advantageous to the USA because the devaluation of the dollar helped them restore the competitiveness of their economy to a large extent. The USA got an additional advantage due to the development of the global financial sector that was based mainly in the USA and had to incur expenses there. That also brought an additional wave of demand in the domestic American market.

The other Bretton Woods countries lost. Their economic growth dramatically slowed down. But those countries that managed to develop during that period had stayed developed.

Development After Jamaica Agreement

The Jamaica system entailed one very important consequence – the system made it much easier for a wide range of emerging countries to join the global system using an investment model. The market mechanism used to form a currency exchange rate was much more transparent than arbitrary decisions of the central banks of emerging countries, and that was the reason why it was sensible to invest in those countries. Investors could forecast their expenses and profits with no dependence on the arbitrary treatment of a local central bank.

And this is how the Jamaica system prepared the ground for the next important step in the development of the global system which was the transition of production facilities to emerging countries. This exact step became a driver for the whole global economy and financial sector in the entire subsequent period (since the 70s till now).

Yet there were some additional exchange regulation requirements for the joining countries. The main requirement was “No devaluations”. This body of requirements became known as the “Washington Consensus”.

And the IMF, established to provide countries loans to stabilize national currency, was given a new life. The IMF obtained a lot of emerging country customers who were trying to comply with the Consensus. That ended well for some countries, but the most countries weren’t just as lucky. However, it is a whole different story…

Consequences And Conlusions

What’s in it for us? Shortly:

  • we are living under Jamaica system, not Bretton Woods – and that’s the main difference;
  • the USA were not beneficiary of Bretton Woods, but on the contrary, became the system’s donor. This happened due to miscalculation of the project makers (may be);
  • global currency is nothing new. There were other attempts for its introduction, but all have failed so far;
  • dollar was established as a world currency not because it was declared as such,  or not because the USA screwed everybody up, but only due to the simple fact that it was the most convenient choice of the time.

Now when the world is looking for a good recipe to renew the global growth, our monetary system history may provide some interesting details which may help to avoid certain mistakes in the future. We’ll see.

 

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