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Bretton Woods System

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After the First World War many countries were left in unstable conditions. Infrastructures were in flux, economies were in isolation, and exchange rates were volatile especially in the 1930’s. Alongside these prevailing conditions, an increasing number of governments enforced restrictive trade policies. As a result, the United States in conjunction with Great Britain in the 1940’s created proposals for the design of a new financial institution that would control exchange rates and strengthen international trade. It was also hoped that such action would aid in the recovery of the Europe and curb the effects of the WW1 (Carbaugh, 2002).

During the year 1944, representatives of 45 countries gathered at the United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire. Throughout this meeting, they discussed a variety of financial issues including exchange rates and protectionist trade, along with the European recovery from the war.

The culmination of this meeting resulted in the Bretton Woods Agreement. Its function was to create an international monetary system of convertible currencies, fixed exchange rates along with free trade. As a catalyst to these functions, the agreement created two international institutions: the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (the World Bank). The goal was to provide economic aid for reconstruction of postwar Europe (Hawtrey, 1946).

While the International Trade Organization that was proposed in the Bretton Woods Agreement was not endorsed by the United States, it was later backed in 1947 but in the form of the General Agreement on Tariffs and Trade (GATT). This new agreement was also ratified by 23 other countries, and would grow to become the World Trade Organization that we are familiar with today. In recent decades the World Bank and IMF have been responsible in aiding numerous countries regain stable economies.

The Bretton Woods Agreement was also designed to manage competition between foreign currencies and promote monetary co operation for trading nations. As a signatory to the Bretton Woods Agreement, IMF members agreed to exchange rates that could be controlled within predetermined parities surrounding the US dollar, or with the agreement of the IMF, altered to correct a fundamental imbalance in the balance of payments. This system remained in use from 1946 until the early 1970s (Bordo, 1992).

The main pillars of the Bretton Woods systemGold has always played a role in international transactions, never more so than in the nineteenth and twentieth centuries. This precious metal was contributing factor in foreign monetary transactions, with many countries using the “gold standard” to back their currencies, with international value of their currency being calculated by its fixed relationship to gold. Gold was also used as a medium to settle international accounts, and maintained exchange rates; highly beneficial to nations because it reduced the risk of foreign trade.

When shifts in balance occurred in international trade, the gold standard was used to determine levels and rectify the disequilibrium. In isolating this problem, when a country showed a deficit it would relate to a reduced amount in gold reserves and consequently they would need to reduce its monetary supply. The resultant decrease in demand would limit their imports and reduced prices would strengthen exports; thereby correcting the deficit. Likewise, when a country encountered inflation, it would lose some of its gold reserves, and would have decreased amounts capital to spend. This reduction in monetary funds would act to minimize inflationary pressure. During this initial time Great Britain had a dominant economy and used their currency; the pound sterling, to support gold as a reserve, transaction and intervention currency. But the pound was not up to the challenge of serving as the primary world currency, particular following World War 2 when the British economy was at its weakest (Kenen, 1994).

The designers of Bretton Woods imagined a system with the cornerstone being exchange rate stability. But during the early part of the 1900’s governments focused on progressive economic policies, and overlooked permanently fixed rates. Notwithstanding, a considerable amount of the worlds known gold reserves were located in Russia, nor was the production of gold was not sufficient enough to meet the increasing demands of foreign trade and investment (Mikesell, 1994).

With the growing demand for international liquidity, only the US dollar was strong enough to accommodate the increasing foreign trade that was taking place. With its versatile economy, and the fixed relationship of gold to the dollar; about $35 an ounce, combined with a determined U.S. government to convert dollars to gold at that price made the dollar comparable with gold. In fact, the dollar was even better than gold: it earned interest and it was more flexible than gold (Acheson, Chant & Prachowny, 1969).

The International Monetary FundIn an age of comparative, and absolute advantage, nations the world over have substantial interest in the success of international trade. Foreign trade greatly impacts currency exchange and the system which controls its working. As international trade involves exchanges; be it financial or product, the parties involved must conform to the basic rules which outline the exchanges for an impartial system.

With disputes, or countries attempting to engage their trading partner with an unfavorable agreement, the result is instability, a reduced foreign trade volume, and a negative impact to national economies. This course of action is likely to lead to economic warfare and could even threaten international peace (World Bank Publications, 1984).

Therefore, the conference proposed that a broad international agency was needed to maintain an international monetary system which will promote international trade. Countries could discuss and agree on international monetary changes which affect each other. They could also ban practices deemed to be harmful to world prosperity, and they could assist each other to overcome temporary exchange difficulties (Dormael, 1978).

The nations agreed, for these purposes, on a permanent supranational body; The International Monetary Fund, with resources and powers to perform its delegated tasks.

Post-war stability and prosperityThe conclusion of World War 2 marked the beginning of a new era for the global economy. Governments embraced foreign trade, and actively adopted policies, and strategies to increase the presence of foreign investment. National leaders and economists identified international trade as paramount for economic growth, a drastic shift away from the isolationist policies during the war. With an open economic policy, and a new stance on cooperation, international trade grew consistently and quickly during the1950’s and 60’s (See Chart 1). During the second half of last century, the absolute value of product exports from democratic countries grew from $53 billion to $112.3 billion, with an annual rate of increase of 6 percent. This accelerated to 8 percent in the 1960’s (Kenwood & Lougheed, 1992, Ashworth, 1987). Such increases were even greater than those had in the half century preceding 1914, and since 1973 such annual growth rates had slowed to an erratic 4 percent.

The results of the Bretton Woods system were most noted during the 1950’s and 1960’s were the increases in world trade steadily outgrew world output. From 1953 to 1963 for example, trade in manufactured goods grew by 83 percent, conversely, manufacturing output increased by only 54 percent (Ashworth, 1987). Chart 2 illustrates the rapid growth of trade in relation to output during the two decades. The increase of this ratio endured until the 1970’s.

Newly industrialized, and developed countries particularly benefited from Bretton Woods, as they experienced growth through trade. By 1973 inter-trade between developed countries was responsible for more than 54 percent of world trade (Kenwood & Lougheed, 1992). This growth in intra-trade was parallel with the movement toward manufactured goods. Industrial economies increasingly engaged in trade of similar end-products and subsequently traded components from various stages of production (Krugman 1995).

As the commencement of the Second World War saw many governments adopt a closed, albeit protectionist trade policy, these barriers were gradually lifted as peace was restored. Through political negotiations; concessions and allowances, nations were able to reestablish trade agreements and apply new liberal policies which would be seen as the major cause of the post-war trade boom.

The General Agreement on Trade and Tariffs is recognized as the pinnacle of these negotiations. At the Geneva conference, over 123 proposals were discussed, encompassing over 50,000 articles. This agreement was ratified in 1947 by 23 nations, and highlighted by the United States which had effectively reduced its import duties by more than 50 percent by the mid-1950’s (Irwin, 1995).

Regardless of the initiative taken by the United States, the remaining original parties made only superficial concessions. In an analysis of the post-war trade recovery, Irwin (1995) concludes: “The formation of GATT does not appear to have stimulated a rapid liberalization of world trade in the decade after 1947. . ..” As GATT did not have the capacity to resolve European trading issues, it led to the formation of the European Economic Community (EEC) in the 1960’s, which later produced a uniform external tariff among six nations. Only in the late 1960s, following the Kennedy Round negotiations did the signatories effectively reduce tariffs. Chart 3 illustrates the failure of countries to decrease tariffs in the 1950s and 1960s. As a result, free trade was not immediately felt, but rather through gradual and continual negotiations.

The effect of tariff reductions on post-war trade has raised much debate. Many feel that the Bretton Woods system was the initial step in trade recovery, while Krugman (1995) discusses Germany and the United States; the largest economies at the time, having highly protectionist trade policies. In any case, growth in world trade before the first war took place in an environment of relatively high tariffs. Furthermore, during the 1950’s in an equal time of high restrictions, there was still a relatively high rate of global trade, particularly in Europe. Rose (1991) evaluated the impact of tariffs the trade ratio using a scattered cross-section sample from 1951 to 1980. After identifying control variables for traditional determinants of trade, Rose concluded there was no statistically significant relationship between the tariff rate and trade ratio for developed countries.

And as Irwin (1995) asserts: “. . . there is considerable uncertainty about the effects of tariff cuts on trade. Because quantitative restraints and foreign exchange restrictions continued to be in place, it is not clear that the tariff reductions translated into more open market access for Europe.” Therefore, although the gradual reduction of tariff rates during the post-war period contributed to increased trade, it was by no means the sole factor.

ConclusionThe Bretton Woods system represented a new era in the global economy. The architects created this monetary order primarily to govern economic relations in the international arena. This agreement of international economic control laid the rules for commercial and financial relations amongst the world’s major trading states.

Bretton Woods was also the catalyst for the International Bank for Reconstruction and Development (later divided into the World Bank and Bank for International Settlements) and the International Monetary Fund. These organizations became operational in 1946 after members signed the agreement (Mercado, Welford & Prescott, 2001).

The chief features of Bretton Woods was the decision and commitment each country made to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value. Secondly, the financial provision of the IMF, and to bridge temporary payments imbalances.

Without the Bretton Woods System, world trade and other economic activities could not have grown so dramatically following the Second World War and the following decades. Despite its success, embedded in its design was its own downfall, as the world economic conditions changed, the system did not. The failure of fixed rate system to reflect the reality in currency status, coupled the United States’ economic problems were major factors in ending the system. In the end, the global economic environment of the 1970s could not be governed by economic relations that existed in the 1940s (Baylis & Smith, 2001).

References:

AppendixChart 1Total Merchandise Export Growth, % Change from 1952-1970Source: World Trade OrganizationChart 2World Trade/ Output Growth 1950-1995Source: Hummels, 1999Chart 3Unweighted World Average Own Trade, 35 Countries (percentages)Source: Clemens & Williamson, 2001BibliographyAcheson, A.L.K., Chant, J.F. & Prachowny, M.F.J. 1969, Bretton Woods revisited : evaluations of the International Monetary Fund and the International Bank for Reconstruction and Development , Queens Univeristy Press, Kingston, p. 34-42Ashworth, W. 1987, A Short History of the International Economy Since 1850. Longman, London, p. 45-48Baylis, J. & Smith, S. 2001, The Globalization of World Politics; An Introduction to International Relations, 2nd edn., Oxford University Press, New York, p. 278-280, 293, 533, 563Bordo, M.D. 1992, The Bretton Woods International Monetary System; An Historical Overview, Cambridge University Press, Massuchusettes, p. 55-62Carbaugh, R.J. 2002, International Economics, 8th edn., South Western, Ohio, p. 484Clemens, M. & Williamson, J. 2001, “A Tariff-Growth Paradox? Protection’s Impact the World Around 1875-1997,” NBER Working Paper 8459, p. 124Dormael, A. 1978, Bretton Woods; A Birth of a Monetary System, Macmillan, London, p. 210-220Hawtrey, R.G. 1946, Bretton Woods; For Better of Worse, Longmans, London, p. 122-128Hummels, D. 1999, “Have International Transportation Costs Declined?” unpublished manuscript, Purdue University Press, Purdue, p. 63Irwin, D. 1995, “The GATT’s Contribution to Economic Recovery in Post-War Western Europe,” in Barry Eichengreen (ed.), Europe’s Postwar Recovery, Cambridge University Press, Cambridge, p. 5, 12, 17Kenen, P.B. 1994, Ways to Reform Exchange-Rate Arrangements, Princeton, New Jersey, p. 112-114Kenwood, G. & Lougheed, A. 1992, The Growth of the International Economy, 1820-2000. 4th edn., Routledge, London, p. 135, 139Krugman, P. 1995, “Growing World Trade: Causes and Consequences,” Brookings Papers on Economic Activity, 1: 327-362.

Mercado, S., Welford, R. & Prescott, K. 2001, European Business, 4th edn., Prentice Hall, London, p. 80, 85, 155Rose, Andrew K. (1991). “Why Has Trade Grown Faster Than Income?” The Canadian Journal of Economics, 24: 417-427.

Mikesell, R.F. 1994, The Bretton Woods debates; A Memoir, Princeton, New Jersey, p. 66-68World Bank Publications, 1984, Bretton Woods at forty, 1944-84, World Bank Press, Washington DC, p. 23-38

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