Bretton Woods

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The year was
1944. For the first time in modern history, an international agreement
was reached to govern monetary policy among nations. It was, significantly,
a chance to create a stabilizing international currency and ensure
monetary stability once and for all. In total, 730 delegates from
44 nations met for three weeks in July that year at a hotel resort
in Bretton Woods, New Hampshire.

It was a significant
opportunity. But it fell short of what could have been achieved.
It was a turning point in monetary history, however.

The result
of this international meeting, the Bretton Woods Agreement, had
the original purpose of rebuilding after World War II through a
series of currency stabilization programs and infrastructure loans
to war-ravaged nations. By 1946, the system was in full operation
through the newly established International Bank for Reconstruction
and Development (IBRD, the World Bank) and the International Monetary
Fund (IMF).

What makes
the Bretton Woods accords so interesting to us today is the fact
that the whole plan for international monetary policy was based
on nations agreeing to adhere to a global gold standard. Each country
signing the agreement promised to maintain its currency at values
within a narrow margin to the value of gold. The IMF was established
to facilitate payment imbalances on a temporary basis.

This system
worked for 25 years. But it was flawed in its underlying assumptions.
By pegging international currency to gold at $35 an ounce, it failed
to take into effect the change in gold’s actual value since 1934,
when the $35 level had been set. The dollar had lost substantial
purchasing power during and after World War II, and as European
economies built back up, the ever-growing drain on U.S. gold reserves
doomed the Bretton Woods Agreement as a permanent, working system.

This problem
was described by a former senior vice president of the Federal Reserve
Bank of New York:

“From the
very beginning, gold was the vulnerable point of the Bretton Woods
system. Yet the open-ended gold commitment assumed by the United
States government under the Bretton Woods legislation is readily
understandable in view of the extraordinary circumstances of the
time. At the end of the war, our gold stock amounted to $20 billion,
roughly 60 percent of the total of official gold reserves. As
late as 1957, United States gold reserves exceeded by a ratio
of three to one the total dollar reserves of all the foreign central
banks. The dollar bestrode the exchange markets like a colossus.”

In 1971, experiencing
accelerating depletion of its gold reserves, the United States removed
its currency from the gold standard, and Bretton Woods was no longer

In some respects,
the ideas behind Bretton Woods were much like an economic United
Nations. The combination of the worldwide depression of the 1930s
and the Second World War were key in leading so many nations to
an economic summit of such magnitude. The opinion of the day was
that trade barriers and high costs had caused the worldwide depression,
at least in part. Also, during that time it was common practice
to use currency devaluation as a means for affecting neighboring
countries’ imports and reducing payment deficits. Unfortunately,
the practice led to chronic deflation, unemployment, and a reduction
in international trade. The lessons learned in the 1930s (but subsequently
forgotten by many nations) included a realization that the use of
currency as a tactical economic tool invariably causes more problems
than it solves.

The situation
was summed up well by Cordell Hull, U.S. secretary of state from
1933 through 1944, who wrote:

trade dovetailed with peace; high tariffs, trade barriers, and
unfair economic competition, with war… If we could get a freer
flow of trade … so that one country would not be deadly jealous
of another and the living standards of all countries might rise,
thereby eliminating the economic dissatisfaction that breeds war,
we might have a reasonable chance of lasting peace.”

Hull’s suggestion
that war often has an economic root is reasonable given the position
of both Germany and Japan in the 1930s. The trade embargo imposed
by the United States against Japan, specifically intended to curtail
Japanese expansion, may have been a leading cause for Japan’s militaristic

Another observer
agreed, saying that poor economic relations among nations “inevitably
result in economic warfare that will be but a prelude and instigator
of military warfare on an even vaster scale.”

Bretton Woods
had the original intention of smoothing out economic conflict, in
recognition of the problems that economic disparity causes. The
nations at the meeting knew that these economic problems were at
least partly to blame for the war itself, and that economic reform
would help to prevent future wars. At that time, the United States
was without any doubt the most powerful nation in the world, both
militarily and economically. Because the fighting did not take place
on U.S. soil, the country built up its industrial might during the
war, selling weapons to its allies while developing its own economic
strength. Manufacturing by 1945 was twice the annual rate of 1935–1939.

Due to its
economic dominance, the United States held the leadership role at
Bretton Woods. It is also important to note that the United States
owned 80 percent of the world’s gold reserves at the time. So the
United States had every motive to agree to the use of the gold standard
to organize world currencies and to create and encourage free trade.
The gold standard evolved over a period of hundreds of years, planned
by a central bank, government, or committee of business leaders.

most of the nineteenth century, the gold standard dominated currency
exchange. Gold created a fixed exchange rate between nations. Money
supply was limited to gold reserves, so nations lacking gold were
required to borrow money to finance their production and investment.

When the gold
standard was in force, it was true that the net sum of trade surplus
and deficit came out to zero overall, because accounts were eventually
settled in gold – and credit was limited as well. In comparison,
in today’s fiat money system, it is not gold but credit that determines
how much money a country can spend. So instead of economic might
being dictated by gold reserves, it is dictated by a country’s borrowing
power. The trade deficit and the trade surplus are only “in balance”
in theory, because the disparity between the two sides is funded
with debt.

The pegged
rates – the value of currency to the value of gold – maintained
sensible economic policy based on a nation’s productivity and gold
reserves. Following Bretton Woods, the pegged rate was formalized
by agreement among the leading economic powers of the world.

The concept
was a good one. However, in practice the international currency
naturally became the U.S. dollar and other nations pegged their
currencies to the dollar rather than to the value of gold. The actual
outcome of Bretton Woods was to replace the gold standard with the
dollar standard. Once the United States linked the dollar to gold
at a value of $35 per ounce, the whole system fell into place, at
least for a while. Since the dollar was convertible to gold and
other nations pegged their currencies to the dollar, it created
a pseudo-gold standard.

The British
economist John Maynard Keynes represented Great Britain at Bretton
Woods. Keynes preferred establishing a system that would have encouraged
economic growth rather than a gold-pegged system. He favored creation
of an international central bank and possibly even a world currency.
He proposed that the goal of the conference was “to find a common
measure, a common standard, a common rule acceptable to each and
not irksome to any.”

Keynes’ ideas
were not accepted. The United States, in its leading economic position,
preferred the plan offered by its representative, Harry Dexter White.
The U.S. position was intended to create and maintain price stability
rather than outright economic growth. As a consequence, Third World
progress would be achieved through lending and infrastructure investment
through the IMF, which was charged with managing trade deficits
to avoid currency devaluation.

In joining
the IMF, each country was assigned a trade quota to fund the international
effort, budgeted originally at $8.8 billion. Disparity among countries
was to be managed through a series of borrowings. A country could
borrow from the IMF, which would be acting in fact like a central

The Bretton
Woods agreement did not include any provisions for creation of reserves.
The presumption was that gold production would be sufficient to
continue funding growth and that any short term problems could be
resolved through the borrowing regimens.

a high volume of demand for such lending in reconstruction efforts
after World War II, the Bretton Woods attendees formed the IBRD,
providing an additional $10 billion to be paid by member nations.
As well-intended an idea as it was, the agreements and institutions
that grew from Bretton Woods were not adequate for the economic
problems of postwar Europe. The United States was experiencing huge
trade surplus years while carrying European war debt. U.S. reserves
were huge and growing each year.

By 1947, it
became clear that the IMF and IBRD were not going to fix the problems
of European postwar economic woes. To help address the issue, the
United States set up a system to help finance recovery among European
countries. The European Recovery Program (better known as the Marshall
Plan) was organized to give grants to countries to rebuild. The
problems of European nations, according to Secretary of State George
Marshall, “are so much greater than her present ability to pay that
she must have substantial help or face economic, social, and political
deterioration of a very grave character.”

Between 1948
and 1954, the United States gave 16 Western European nations $17
billion in grants. Believing that former enemies Japan and Germany
would provide markets for future U.S. exports, policies were enacted
to encourage economic growth. During this period, the Cold War became
increasingly worse as the arms race continued. The USSR had signed
the Bretton Woods agreement, but it refused to join or participate
in the IMF.

Thus, the proposed
economic reforms turned into part of the struggle between capitalism
and Communism on the world stage.

It became increasingly
difficult to maintain the peg of the U.S. dollar to $35-per-ounce
gold. An open market in gold continued in London, and crises affected
the going value of gold. The conflict between the fixed price of
gold between central banks at $35 per ounce and open market value
depended on the moment. During the Cuban missile crisis, for example,
the open market value of gold was $40 per ounce. The mood among
U.S. leaders began moving away from belief in the gold standard.

President Lyndon
B. Johnson argued in 1967 that:

“The world
supply of gold is insufficient to make the present system workable
– particularly as the use of the dollar as a reserve currency
is essential to create the required international liquidity to
sustain world trade and growth.”

By 1968, Johnson
had enacted a series of measures designed to curtail the outflow
of U.S. gold. Even so, on March 17, 1968, a run on gold closed the
London Gold Pool permanently. By this time, it had become clear
that maintaining the gold standard under the Bretton Woods configuration
was no longer practical. Either the monetary system had to change
or the gold standard itself would need to be revised.

this period, the IMF set up Special Drawing Rights (SDRs) for use
as trade between countries. The intention was to create a type of
paper gold system, while taking pressure off the United States to
continue serving as central banker to the world. However, this did
not solve the problem; the depletion of U.S. gold reserves continued
until 1971. By that time, the U.S. dollar was overvalued in relation
to gold reserves. The United States held only 22 percent gold coverage
of foreign reserves by that year. SDRs acted as a basket of key
national currencies to facilitate the inevitable trade imbalances.

However, Bretton
Woods lacked any effective mechanism for checking reserve growth.
Only gold and the U.S. asset were considered seriously as reserves,
but gold production was lagging. Accordingly, dollar reserves had
to expand to make up the difference in lagging gold availability,
causing a growing U.S. current account deficit. The solution, it
was hoped, would be the SDR.

these instruments continue to exist, this long-term effectiveness
can only be the subject of speculation. Today SDRs make up about
1 percent of IMF members’ nongold reserves, and when in 1971 the
United States went off the gold standard, Bretton Woods ceased to
function as an effective centralized monetary body. In theory, SDRs
– used today on a very limited scale of transactions between
the IMF and its members – could function as the beginnings
of an international currency. But given the widespread use of the
U.S. dollar as the peg for so many currencies worldwide, it is unlikely
that such a shift to a new direction will occur before circumstances
make it the only choice.

Bretton Woods system collapsed, partially due to economic expansion
in excess of the gold standard’s funding abilities on the part of
the United States and other member nations. However, the problems
of currency systems not pegged to gold lead to economic problems
far worse.

29, 2006

Wiggin [send
him mail
] is the editorial director and publisher of The
Daily Reckoning. He is the author, with Bill Bonner, of Financial
Reckoning Day: Surviving The Soft Depression of The 21st
and the upcoming Empire
of Debt
. This
article is taken from his soon-to-be released new book, The
Demise of the Dollar…and Why It’s Great for Your Investments

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