Let us make an in-depth study of the establishment and essentials of Bretton Woods System.
Establishment of the Bretton Woods System:
The international monetary system, as defined by the ‘rules of the game’, has gone through many changes since the beginning of the 20th century. It may be noted that the international trading environment is largely governed by the exchange rate policy.
An exchange rate connects the price system of trading nations since this (special) price shows the relationship between all domestic prices and all foreign prices. Exchange rate management policy has great implications for macroeconomic environment. There are many types of exchange rate policy options. Important among these are: fixed, flexible, and managed exchange rates. The international monetary system, however, is not in a stable state as the above noted three kinds of exchange rates evolved and prevailed at different times.
The international monetary system before the World War I (1870-1914) comprised the gold standard system. Under this system, government does not intervene in the foreign exchange market and follows a policy of keeping the exchange rate of its currency at a fixed rate. Under this system, currencies of different nations were convertible into gold. With the outbreak of the World War I, the gold standard system failed and the currencies were exchanged at floating rates. However, the United Kingdom went for restoration of the gold standard (1927-31).
But some authors convincingly argued that the re-establishment of the gold standard brought in the Great Depression of the 1930s and the associated financial problems. As a result of these developments, countries one after another went for (competitive) devaluations. All these brought the collapse of the gold standard system and, ultimately, disrupted the international economic order. Most of the countries then adopted nationalistic policies to avoid further disruption. Protectionist measures were undertaken—thereby resulting in a decline in world trade.
It was against this background that plans for a new world trade and monetary order were worked out in the USA during the World War II to prevent the repetition of the 1930s. Two plans were drafted in the early 1940s—one by J. M. Keynes of the U.K. Treasury and another by Harry Dexter White of the US Treasury to provide a permanent and acceptable framework for international transactions. The overriding objectives of the new monetary system to be evolved were the stabilisation in exchange and the promotion of free trade. These objectives were to be achieved through the creation of a permanent international institution.
Ultimately, the White Plan, instead of the Keynes Plan, prevailed as the USA became economically more powerful than the U.K. Anyway, in the spirit of international cooperation, a conference in July 1944 of 44 non-communist nations at Bretton Woods in the state of New Hampshire, U.S.A, led to the creation of the IMF and the International Bank for Reconstruction and Development (now called World Bank).
Together these two form the Bretton Woods institutions. From then, the international monetary system moved into the Bretton Woods pegged exchange rate system (1945-71) under the auspices of the International Monetary Fund (set up in July 1944). These two institutions are, indeed, complementary. The IMF is responsible for short-term balance of payments aid and the World Bank is responsible for long-term project-related development aid.
Essentials of the Bretton Woods System:
Both the IMF and the World Bank were conceived at the Bretton Woods Conference in 1944. The international monetary system is governed by the IMF. The original intention of the Fund was the stabilisation of the world economy providing short-term loans to member countries in case of temporary B OP difficulties. Today, it acts as a development agency as it has shifted its focus of attention to macroeconomic policies so as to lay a basis for sustainable growth and poverty reduction in poor income countries.
The IMF began its operation under its original charter from 1947-71. The founders of the Bretton Woods System wanted to remove the disadvantages of the gold standard system or the ‘fixed’ exchange rate system as well as the ‘instability’ and uncertainty of completely ‘flexible’ exchange rate system. In other words, the System would aim at achieving a stable exchange rate and at lessening the duration and reducing the degree of BOP disequilibrium.
The Bretton Woods System that evolved during 1947-71 came to be known as ‘fixed but adjustable exchange rate’ system. It also came to be known as ‘par value system’ or the’ pegged exchange rate’ system. Under this System, members were required to establish the parity of their currencies in terms of gold or dollar and then to maintain the values of their currencies within 1 p.c. of its par value (±1).
The Articles of Agreement, however, provided an alteration of the par values, subject to the Fund’s approval. Such changes in the parity of the exchange rates (that is, devaluation or revaluation) could be approved if the country could justify its BOP to be in ‘fundamental disequilibrium’.
Thus the Bretton Woods System was indeed a compromise between a short run stability of exchange rates and the long run flexibility. Hence the name ‘stable but adjustable’ exchange rate system.
To fulfil its obligations to maintain the values of currencies within 1 p.c. of par value, the second condition that required to be fulfilled was the creation of a pool of international reserve asset. It involved a system of quotas and drawing rights. SDRs represented a major innovation in 1967 to ease the problem of international liquidity.
The third element of the Bretton Woods System was the prohibition of exchange controls that many nations made frequent use of as a means of dealing with their BOP problems. The Bretton Woods System prohibited the use of exchange controls on current account but allowed exchange controls on capital account transactions.
Between 1945 and 1958 the world economy saw a serious disequilibrium—a surplus in the US BOP vis-a-vis the rest of the world. The result was acute dollar shortage. However, by 1958, a situation of dollar surplus in consequent upon the BOP deficit in the USA emerged. In the process, a classic ‘crisis of confidence’ over the dollar came out. Chronic US BOP deficit caused massive dollar outflows in 1971 when foreign exchange markets were flooded with dollars.
The consequences were far-reaching—foreign exchange markets were closed for brief periods; despite prohibition nations emphasised exchange control mechanisms; countries allowed their currencies to float temporarily. All these brought some embarrassing situations in the world economy.
On the one hand, tremendous enthusiasm by all the nations to dollar sales and, on the other, foreign central banks (except the Federal Reserve Bank of the USA) showed utter disinclination in dollar purchase. By August 1971 the par value system broke down. The United States devalued dollar by 8.6 p.c. in December 1971. This could not prevent BOP deficit from falling. On the contrary, speculation in dollar become so strong that, again, the US currency was devalued in 1973.
Anyway, it was against this background that the Bretton Woods System was abandoned in 1972. By March 1973, the IMF introduced managed floating exchange rate system.