How do you explain the rise and fall of the Bretton Woods system? Essay Sample
How far the emergence of the Euro can be seen against the background of the need for exchange rate stability and the creation of an optimal currency area?
1) The rise and fall of the Bretton Woods system:
The origins of the Bretton Woods system are to be found in the convergence of several key conditions: the shared experiences of the Great Depression, the concentration of power in a small number of states, and the presence of a dominant power willing and able to assume a leading role.
The depression of the 1930s, followed by the war, had vastly diminished commercial trade, the international exchange of currencies, and cross-border lending and borrowing. The creators of the Bretton Woods hoped to avoid a repeat of the disaster of the 1930s, when exchange controls undermined the international payments system that was the basis for world trade. Some of the primary policies to increase competitiveness in 1930’s were currency devaluations and protectionist measures. Reduction in the real value of a currencies made export products relatively cheaper, which in its turn in most cases reduced balance of payments deficits. However, currency devaluations also worsened national deflationary spirals, which resulted in plummeting national incomes, shrinking demand, mass unemployment, and a overall decline in the world trade.
Whereas, trade protection policies only led to the greater alienation of the world community and the consequent retaliation measures by affected countries. Although these strategies tended to increase government revenues in the short-run, they dramatically undermined the dynamic efficiency of the medium and longer-term. Trade in the 1930s became largely restricted to currency blocs, such as British Empire. These blocs according to the opinion of many prominent economic thinkers reduced possibility for international flow of capital, which resulted in reduction of foreign investment opportunities.
Also based on experience of interwar years, the concept of “economic security” was developed. The main idea of that concept was that a liberal international economic system would enhance the possibilities of the postwar peace. One of those who saw such a security link was Cordell Hull, the U.S. secretary of state from 1933 to 1944. Hull believed that the fundamental causes of the two world wars lay in economic discrimination and trade warfare. Specifically, he had in mind the trade and exchange controls of Nazi Germany and the imperial trade preference system practiced by Britain. Hull argued that:
“…unhampered trade dovetailed with peace; high tariffs, trade barriers, and unfair economic competition, with war… if we could get a freer flow of trade… freer in the sense of fewer discriminations and obstructions… 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”.
Whereas, the principal architect of the Bretton Woods system Harry Dexter White, argued that:
“The absence of a high degree of economic collaboration among the leading nations will… inevitably result in economic warfare that will be but the prelude and instigator of military warfare on an even vaster scale”.
Another factor which proved extremely influential in the creation of such international system as the Bretton Woods was the fact that there was a country which was willing to take on itself the role of a facilitator. International economic management relied on the dominant power to lead the system. The concentration of power facilitated management by confining the number of actors whose agreement was necessary to establish rules, institutions, and procedures and to carry out management. The obvious candidate for the role was the United States. The relative advantages of the U.S. economy were undeniable and overwhelming. The U.S. held a majority of world investment capital, manufacturing production and exports.
As the world’s greatest industrial power, and one of the few nations undamaged by the war, the U.S. stood to gain more than any other country from the opening of the entire world to unfettered trade. The United States would have a global market for its exports, and it would have unrestricted access to vital raw materials. Without a strong European market for U.S. goods and services, most policymakers believed, the U.S. economy would be unable to sustain the prosperity it had achieved during the war.
Although the system was near perfect on paper, the real monetary relations after the war were anything but stable. After a short burst of activity IMF lending reduced in size to an extremely small scale, its pool of liquidity was clearly insufficient. The reserves of most countries were near exhaustion, there was a scarcity of gold held by Central Banks outside the US and hardly any prospects for the new gold production. As the consequence, America became the last source of the global liquidity growth with the rest of the world more than willing to increase their dollar holdings.
Initially, a relatively open market was maintained for imports of foreign goods. In effect, an unspoken agreement was struck. America’s allies accepted its dominance that accorded the United States special privileges, such as to act abroad unilaterally to promote U.S. or collective interests. However, in the latter years of the Bretton Woods system these special privileges of the US came under increased criticisms. The United States, in turn, condoned its allies’ use of the system to promote their own prosperity at the short term expense of the United States.
After 1958, America’s persistent deficits, by which international liquidity was financed, began to widen. Following a brief surplus in 1957, the U.S. balance of payments plunged to a $3.5 billion gap in 1958 and to even larger deficits in 1959 and 1960. Subsequently, the former enthusiasm of European governments to obtain dollar reserves was transformed into an equally keen desire to avoid surplus dollar accumulations. During the 1960’s, almost two thirds of America’s cumulative deficit was transferred in the form of gold, mostly to Europe (B. Cohen, 1999).The Bretton Woods system was clearly coming under strain.
Another source of strain on the system was inherent in the structure of the par value system: the ambiguity of the key notion of fundamental disequilibrium. The inflexibility of exchange rates not only increased fears of a potential world liquidity shortage. It also created irresistible incentives for speculative currency shifts. The pegged rate system was incapable of coping with even greater widening payments imbalances and the confidence problem was worsening as speculators were encouraged to bet on devaluation of the dollar or revaluations of the currencies of Europe or Japan (B. Cohen).
According to Robert Mundell one of the primary reasons for failure of the Bretton Woods system was the fact that the price of gold which was set by President Roosevelt in 1934 became very quickly obsolete. Because the price of gold was undervalued, there was a very strong incentives for speculation which led to enormous withdrawals by the central banks of participating countries. Another reason which according to Mundell could play a fatal role in the failure of the system, was the rapidly accelerating rate of inflation in the US, which was partially caused by the need of the war spending (I refer to the war in Vietnam). Because the rate of inflation in the US was much higher than the optimal rate of Europe, the political confrontations became imminent (eg. Charles de Gaulle’s protests against the US hegemony).
On the other hand, Milton Friedman argues that the Bretton Woods system had failed because of its natural flaw. The countries in the system had incentive to behave negatively in respect to each other, at least in the short-run. Under a fixed exchange rate system, the country which over expands can benefit, by imposing costs on other members.
The above factors combined with another political controversy, which was largely based on the US concern with the growing competitiveness of Europe and Japan, eventually led to the suspension of convertibility of the US dollar to gold (15 August 1971), which can be marked as the fall of the Bretton Wood’s original agreement.
2) Emergence of the Euro.
At the launch of the Bretton Woods system in 1944, major economies chose an adjustable fixed exchange rate to the dollar backed by the gold reserve in the United States. During the operation of the Bretton Woods system, two distinct views that became the foundations of the analysis of exchange rate regimes appeared. Friedman (1953) expressively stated the possible merits of a floating exchange rate for the sake of absorbing external shocks. Mundell (1961) and McKinnon (1963) responded that, depending on the economic conditions, some economies would be better off if they retained a fixed exchange rate. Their contributions are well known as the theory of “optimum currency areas”. They also stressed that the economically desirable extent of common currency areas might not coincide with national borders.
After the collapse of the Bretton Woods system, European economies moved to develop their own arrangements for exchange rate stability, which culminated with the launch of the euro on January 1, 1999 and the circulation of euro-denominated banknotes and coins in January 2002. These two important events demonstrated that the European economies have finally completed the formation of a single currency. However, the arguments about sustainability of such a system and justifications for its existence at all are still an ‘ad-hoc’ topic of the modern scientific debates. Quite possibly the most powerful arguments on the topic, at least in the field of economics, were produced by the two long-term academic rivals: Mundell and Friedman. In the following passages of my work I would like to concentrate on the issues of exchange rate stability and the idea of the optimal currency area.
In his earlier works Mundell have developed the idea of the optimum currency area (1961). He presumed that agents in the private sector did not try to anticipate future movements in the price level, interest rates, the exchange rate, or in government policy itself. In addition to stationary expectations, Mundell posited that labor mobility was restricted to fairly small national, or even regional, domains, as in Western Europe or across developing countries. And these smallish domains could well experience macroeconomic shocks differentially, i.e. “asymmetrically”. According to the common textbooks interpretation of Mundell’ arguments existing nation states are the natural currency areas. Therefore the one-size-fits-all monetary policy as practiced in the European monetary union can’t be right. Because the labour markets are somewhat segmented internationally, and the composition of output varies from one country to the next–leading them to experience terms-of-trade shocks differentially. Thus, as the earlier Mundell had been commonly (and still is) interpreted, having an independent national monetary policy with exchange rate flexibility is the most efficient way to deal with asymmetric shocks.
However in his latter years, starting from the beginning of 1970’s, Robert Mundell had dramatically altered his view on the subject and argued that expansion of monetary union will in effect provide greater stimulus for economic stability than concentration on monetary policy adjustments within individual member states. According to his revised opinion the exchange rate is not an effective “cushion” against real external shocks, such as changes in the price of oil. “…the loss of export markets or a technological change cannot be offset by exchange rate changes” (Mudell, 2001). He argues that the common currency areas, such as the Euro, result in common rates of inflation (if measured by the EU basket of goods). And although one or another area can occasionally experience exceptional growth, the consequent rises in wages or the housing market prices should not be identified as inflation. Even more so adoption of the common currency should reduce existing inflationary pressures.
He also argues that a large currency area with a single monetary policy provides a better protection against exogenous shocks. And that the Euro will be a much more stable currency than any of its components. Partially the reason for this stability is the idea that adjustment between different regions of the area is effortless because its starts to take place as soon as a problem arises (in his work Mundell compares adjustments within EMU with adjustments within different states in the US). As well some economists pointed out that when a country firmly fixes its currency to a large and stable monetary leader it gets rudder for its monetary policy, a stable rate of inflation, and discipline for its fiscal policy.
The emergence of the Euro can also be considered as beneficial for the terms of trade. Mundell compares effects derived from uncertainty caused by fluctuations in individual exchange rates to tariffs. Hence, creation of the Euro leads to reduction in costs associated with exchanges in goods and services and have a potentially boosting effect for the economies of 11 country members. According to Mundell the inefficiencies of the volatility of exchange rates, which are so detrimental for the international trade, are underlined by the amount of the currency speculation. Daily speculation on currency markets exceeds $1.5 trillion. For this reason, he argues that the creation of the European monetary union is extremely beneficial as it completely eliminates speculative activity within the area.
In contrast, Milton Friedman argues that hard-fixing currencies to each other, like in the case of the Euro, is favourable in terms of reduction in transaction costs, which lead to increase in international trade and foreign direct investment. However, from his point of view the country which fixes the exchange will also have to bear the economic cost of adjusting to external forces that affect it differently than the other country or countries (in the case of Euro) whose currency it shares. Adjusting to such external forces with a fixed exchange rate requires adjustments in many individual prices and wages that could be avoided if it could change the exchange rate. What he argues is that having independent monetary policy, hence a relatively unstable exchange rate policy, is actually beneficial because it is a more efficient system of adjustments to exogenous shocks. A flexible exchange rate would allow each member country of the EMU to have the appropriate monetary policy, which can lead to a healthier economic growth.
Coming to a conclusion, I would like to state that there are undeniable advantages of having hard-fixed exchange rate policy, some of the most important of which are increase in foreign direct investment, reduction in transaction costs and to some extent reduction in speculative movements. However, there are also quite powerful arguments against these type of systems, which are put forward by some of the brightest minds in the world of academia. One does not need to look far in the modern European history to find vivid examples of failure of such arrangements, eg. the fall of the Bretton Woods and the ERM (1992). For this reason, I tend to support Milton Friedman’s view, which states that for deep political reasons, individual countries cannot be counted on to stick to proper internal market policies, and so need flexible exchange rates to absorb the shocks of economic change.
1) J. Orlin Grabbe, 1996, “International Financial Markets”, 3rd edition, Prentica Hall.
2) www.polsci.ucsb.edu, Benjamin J. Cohen.
3) www.ecb.int, 1998 (EMI / ECB).
4) Eichengreen B., 1993, “European Monetary Unification”, Journal of Economic Literature (pp.1321-57).
5) Huhne C., Forder J., 2001, “Both sides of the coin”, Profile Books Ltd.
6) Mundell R.A., Friedman M., 2001, “One world, one money”?, Options Politiques.
7) Mundell R.A., 1961, “A theory of optimum currency areas”, American Economic Review.