FX International Payments
By Frances Coppola
This piece, the first in our series, describes how the so-called “Bretton Woods” system was created – and how it ultimately failed. Subsequent posts will look at the evolution of monetary policy since the failure of Bretton Woods, as central banks gradually abandoned exchange rate management in favor of inflation targeting.
In 1944, as World War II was drawing to a close, representatives of forty-four countries met at Bretton Woods in the U.S.’s White Mountain National Forest, in New Hampshire. Led by the British economist John Maynard Keynes and Harry Dexter White from the U.S. Treasury, they hammered out an agreement they hoped would form the basis of a new financial world order. The “Bretton Woods” system of internationally fixed exchange rates was born out of the conference, as was the International Monetary Fund (IMF) and the World Bank.
In the Great Depression that preceded World War II, most countries had abandoned the gold standard. Few countries desired a return to the pre-war standard, but the group designed a system anchored to gold. Keynes’ idea was to create a world central bank that would issue a politically independent international settlement currency backed by gold – which he light-heartedly dubbed “bancor.” But White said that a politically independent currency would lack international credibility, and argued for the dollar to become the gold-backed currency anchoring the new system.
White’s argument seemed practical: at that time, the Federal Reserve held approximately half of the world’s gold reserves, and the major powers of Europe and Japan were nearly destitute after what many consider the most destructive war in history. No one could imagine that the U.S. might run out of gold, or that European and Far Eastern countries might in future challenge the U.S.’s economic dominance.
So, the new system was built around the U.S. dollar. The dollar’s value in gold was fixed at 1/35th of an ounce. The major currencies were to be fully convertible to dollars at a fixed exchange rate, though with fluctuation permitted within a 1 percent band.1 Countries participating in the scheme would settle their international obligations in dollars: but the U.S. would settle its own international obligations in gold.
When a country’s international obligations must be settled in a foreign currency, running persistent balance of payment deficits creates a risk of insolvency. Under the Bretton Woods system, therefore, it was possible for a country literally to run out of money2
It quickly became apparent that fixed-dollar exchange rates and narrow fluctuation bands were unsuitable for war-torn Europe. The war had destroyed much of the productive capacity of the European powers and their colonies, leaving them dependent on imports from the U.S. Making their currencies convertible to dollars at a fixed exchange rate rendered them desperately short of dollars. In 1947, Washington, concerned that European countries might resort to protectionism, devised the Marshall plan to provide aid to the devastated European economies.3
The U.K., at that time the second-most-important global financial power after the U.S., initially maintained the pound-dollar exchange rate at $4.03 (where it had been since 1940) but with strict exchange controls to prevent other European powers from relieving their own dollar shortages by converting sterling reserves to dollars. In 1947, under pressure from the U.S., it removed exchange controls, allowing overseas holders of pounds to convert them to dollars. After only six weeks the U.K. re-imposed exchange controls to protect what remained of its dollar and gold reserves.
Thereafter, maintaining adequate reserves became a preoccupation of successive U.K. governments.4
The pound was eventually devalued by 30 percent in 1949.5 But the Bretton Woods system did not become fully operational until 1958, when fourteen countries made their currencies convertible to the dollar at fixed exchange rates.
As Europe and Japan recovered from the war, international demand for dollars soared, putting pressure on the U.S. balance of payments. In 1960, the economist Frederic Triffin warned that international demand for dollars would mean either the U.S. losing all its gold or severe deflation in the rest of the world.6 The accuracy of his prediction quickly became apparent. Kersi Doodha, writing in The Economic Weekly in March 1961, observed:
“Currently, the dollar is under severe international economic pressure. Countries holding a large stock of dollars as currency reserves are gradually converting them into gold. Consequently, the United States balance of payments reflects a steady flow of gold out of the country. The gold stock has declined to very near the ''safe limit" of $17 billions. Even in the London Gold Market which supplies practically 80 percent of the world's total requirements, the price of gold has for some time now shown a consistent premium over the officially fixed dollar/gold parity of 8.15.00 per ounce of fine gold.7”
Over the next few years, the U.S., U.K. and European countries cooperated to maintain international dollar liquidity while limiting gold outflows from the U.S. But by 1967, foreign claims on gold exceeded the U.S.’s gold reserves.8 In response, the U.S. resorted to capital controls, creating an international dollar shortage. The U.K., already struggling to maintain its dollar exchange rate due to persistent FX crises, and having several times received short-term assistance from the IMF9 , devalued the pound in November 1967.10
By the end of March 1968, U.S. gold reserves had fallen to $10.7 billion. To ward off a foreign exchange crisis, the U.S. restricted gold sales to central banks only, at the official price: all private sector gold purchases were thereafter made through the London Gold Pool at a higher (market) price. But the outflows continued, culminating in a speculative run on the London Gold Pool in November 1968 in which central banks participated.11 The following year, Germany and France devalued their currencies, putting further pressure on the U.S.’s gold reserves. In May 1971, following sustained speculative attacks, Germany and the Netherlands floated their currencies, effectively leaving the Bretton Woods System.12
The end came in August 1971, when President Nixon unilaterally suspended the dollar’s convertibility to gold and introduced a 10 percent import tax to compensate American businesses for “unfair exchange rates.”13 In December 1971, a meeting of the world’s leading monetary authorities at the Smithsonian Institution in Washington, DC, agreed to reset the Bretton Woods system: the U.S. would devalue versus gold, and other countries would revalue versus the dollar, creating an effective dollar devaluation of about 10.7 percent.14 But relief was short-lived. During 1972, repeated speculative attacks pushed European currencies to the top of their new, wider fluctuation bands, and both the gold price and inflation soared. In March 1973, the U.S. government devalued the dollar by a further 10 percent, fueling inflation still further: but speculators continued their attacks, forcing governments to abandon their currency exchange rate pegs to the dollar. Within a month, nearly all currencies were floating. The Bretton Woods experiment with internationally fixed exchange rates had failed.
The Bretton Woods international fixed exchange rate system was short-lived, lasting only 15 years from its effective start in 1958 to its abandonment in 1973. But it took much longer for the world’s major monetary authorities to complete the transition to today’s system of mainly floating exchange rates and inflation targeting. The next piece in the series discusses the next phase of that transition: the turbulent monetary history of the 1970s and 1980s.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Establishment of the Bretton Woods System,” Federal Reserve Bank of Atlanta;http://www.federalreservehistory.org/Events/DetailView/28
2.“The Mirage of Fixed Exchange Rates,” Obstfeld & Rogoff; http://scholar.harvard.edu/files/rogoff/files/51_jep95.pdf 3.“Overview of Bretton Woods,” Federal Reserve Bank of Richmond;http://www.federalreservehistory.org/Events/DetailView/32
4.“The Sterling Crisis of 1947 and the British response to the Marshall Plan,” Newton; http://www.jstor.org/stable/2597288?seq=6%23page_scan_tab_contents
5.“Pound devalued 30 percent,” The Guardian;https://www.theguardian.com/century/1940-1949/Story/0,,105127,00.html
6.“The Dollar Glut,” International Monetary Fund; https://www.imf.org/external/np/exr/center/mm/eng/mm_sc_03.htm
7. “The Keynes-Triffin Plan on International Liquidity,” Doodha; http://www.epw.in/system/files/pdf/1961_13/9/the_keynestriffin_plan_on_international_liquidity.pdf
8.“The Collapse Of The Bretton Woods Fixed Exchange Rate System,” Peter Garber; http://people.stern.nyu.edu/igiddy/options.htm
9.“Negotiating Credibility: Britain and the International Monetary Fund 1956-76,” Clift & Tomlinson; http://www.nber.org/chapters/c6876.pdf
10. “Wilson defends ‘pound in your pocket’,” BBC; http://news.bbc.co.uk/onthisday/hi/dates/stories/november/19/newsid_3208000/3208396.stm
11.“The Collapse Of The Bretton Woods Fixed Exchange Rate System,” Peter Garber; http://www.nber.org/chapters/c6876.pdf
13.Address to the Nation Outlining a New Economic Policy: “The Challenge of Peace,” Richard Nixon; http://www.presidency.ucsb.edu/ws/index.php?pid=3115%23axzz1UZnES7PMon
14.“Smithsonian Agreement,” Federal Reserve Bank of Cleveland; http://www.federalreservehistory.org/Events/DetailView/34