International Finance: Bretton Woods

System B. Adjustment Mechanism - System must

specify methods to resolve balance of
International Monetary System (IMS) payment (BOP) disequilibria.

What is money? BOP - All payments between a country and

→ Any good that is widely accepted in its trading partners.
exchange of goods and services, as
well as payment of debts. Disequilibria - imbalance

3 Functions of Money C. Confidence - Sound IMS should provide

1. Medium of exchange – money used for confidence in the system.
buying and selling goods and services
2. Unit of account – common standard for History of IMS
measuring relative worth of goods and 1. Era of Specie money
services 2. Era of political money
3. Store of value – convenient way to store 3. Classical Gold Standard
wealth 4. Gold Exchange Standard
5. Bretton Woods System
Why does it matter? 6. System of Flexible Rates
→ Sound IMS is prerequisite for stable
world economy 1. Era of Specie Money - Pre-modern era
→ Requirement for growth of world → Specie money - metal money in
trade and foreign investment circulation.
→ money in the form of coins, precious
Requirement for Stable IMS stones (as opposed to paper money)
1. Liquidity → Example: A roman coin
2. Adjustment Mechanism → Governments had no control over
3. Confidence monetary issues (i.e. money flow)
→ Another problem: chronic specie
A. Liquidity - Amount of assets (e.g., scarcity
money) that can be easily available to
finance trade 2. Era of Political Money - 18th and 19th
century
Market Liquidity - describes how easily an → Financial revolution: introduction of
item can be traded for another item, or into paper money
the common currency within an economy. → Government started printing money
→ Money is the most liquid asset and acquired extensive control over
because it is universally recognized money supply.
and accepted as the common → Example of a paper money is
currency. Chinese paper money during 1200s
→ IMS should provide adequate → Crucial macroeconomic variable:
liquidity to finance international a. Government’s influence over economic
transactions. activities
→ Government could solve
inadequacy of specie money Why did the Classical Gold Standard
a. E.g., Governments could fight against collapse?
deflationary pressure → Rise of warfare states
→ But this can also create inflationary → Major consequence of WWI:
bias nationalization of IMS
a. Too much monetary injection could cause → States safeguarded their gold
inflation (e.g. hyperinflation during Weimar supplies, disengaged from fixed
Republic) exchange rate.
b. May diminish value of currencies
c. Could cause instability in IMS 4. Gold Exchange Standard - Interregnum
period (period between WWI and II)
Dilemma: → Currency tied to gold, but the return
→ States wanted both flexibility in to gold standard was ruled out
domestic economic policies and → Instead of gold, states could use
stability in IMS gold-backed currencies such as British
→ BUT, trade-off between autonomous pound or sterling
domestic economic policies and stable → Gold Exchange only survived a few
monetary order exists. years. Why?
→ The way this dilemma was resolved a. Rise of welfare state
characterizes the subsequent phases b. Advent of Keynesianism: governments
in history of IMS. should fight against frequent recession and
unemployment.
3. The Classical Gold Standard - 1870- → The central belief of Keynesian
1914 economics is that government
→ Essential Feature: intervention can stabilize the
a. Nations fixed the value of their currencies economy. Keynes’ theory was the first
in terms of gold to sharply separate the study of
b. Gold is freely transferable between economic behavior and individual
countries incentives from the study of broad
→ Essentially a fixed rate system aggregate variables and constructs.
a. Suppose the US announces a willingness c. Welfare objectives (e.g., continuous
to buy gold for $200/ per oz and the UK economic growth and full
announces a willingness to buy gold for employment) are more important than
£100 per oz. stable international monetary order ←
b. Then £1=$2 Rise of labor unions.
→ Embodied classical liberal economic → Active intervention in monetary
principles issue
→ Very successful IMS: facilitated → The trade-off:
growth of world trade and global a. Autonomy of domestic economic policies
prosperity over a stable international monetary system.
→ But at the cost of autonomy in b. “Beggar-thy-neighbor policies”,
domestic economic policies competitive depreciation → Great
→ Worked well till World War I Depression → WWII
→ Beggar-thy-neighbor refers to supported it had been damaged by war and
economic and trade policies that a by the Great Depression of the 1930s. The
country enacts that end up adversely second objective was to allow national
affecting its neighbors and/or trading governments the freedom to provide
partners. Protectionist barriers such as generous welfare programmes and to
tariffs, quotas, and sanctions are all intervene in their economies to maintain full
examples of policies that can hurt the employment. This second objective was
economies of other countries. considered to be incompatible with a full
→ Competitive devaluation is a return to the free market system as it had
theoretical scenario in which one existed in the late 19th century—mainly
nation matches an abrupt devaluation because with a free market in international
in another country's currency, often in capital, investors could easily withdraw
a tit-for-tat manner. In other words, money from nations that tried to implement
one nation is matched by a currency interventionist and redistributive policies.
devaluation of another, which in turn → Avoided:
devalues its currency in response. a. Subordination of domestic economic
activities to the stability of the IMS (key
5. Bretton Woods System feature of the Classical Gold Standard).
Two goals of the Bretton Woods System b. The sacrifice of the IMS to the domestic
a. A world in which governments would policy autonomy (key character of the
have considerable leeway to pursue interwar period)
national economic objectives, yet c. Intended to enable governments to
b. The monetary order was based on fixed pursue Keynesian growth policies at home,
exchange rate to prevent competitive without sacrificing international monetary
depreciation stability.
→ In other words, both autonomy and d. Also to achieve a stable international
stability. monetary system, without subordinating
→ Creation of the International autonomy in domestic economic activities.
Monetary Fund (IMF) to supervise the
Bretton Woods System How the dilemma was solved during the
→ The compromise of domestic BWS
autonomy and stability of IMS: 1. If a country is suffering temporary BOP
a. Embedded liberalism - “Unlike the disequilibria, the IMF would provide a
economic nationalism of the thirties, it would medium-term loan to the country.
be liberalistic in character; unlike the 2. If a country is suffering fundamental BOP
liberalism of the gold standard, its liberalism disequilibria, the system would permit a
would be predicated upon domestic country to change its exchange rate.
interventionism.” - John G. Ruggie.
b. Cont. Involving a compromise between The key to the system:
two desirable but partially conflicting 1. American economy → dollar
objectives. The first objective was to revive 2. Other nations pegged their currencies to
free trade. Before World War I, international the dollar (System of fixed XR)
trade formed a large portion of global GDP,
but the classical liberal order which
→ The US pledged to keep the dollar
convertible into gold at $35 per ounce.
→ Dollar was the principal medium of
exchange, store of value, and unit of
account.
→ It was successful. But why did the
system collapse?
Answer: Triffin dilemma

Triffin Dilemma - The soundness of the

Bretton Woods system depended on
liquidity and international confidence
created by the US economy
→ Every state wants dollars to rectify
their BOP problem.
→ But the US can’t print dollars
indefinitely → Inflationary pressure →
devalue the worth of dollars.
→ People will lose confidence in the
dollar and in the system.
→ To provide liquidity, the US would
have to run a BOP deficit.
→ The US BOP deficit in the long run
will undermine confidence in the dollar
and the system.

Two basic asymmetries:

1. Role of dollar as providing liquidity
→ US BOP deficit → decreased
confidence in the system
2. US, not able to devalue the dollar to
improve its BOP position

Collapse of the BWS

August 15, 1971 - Nixon announced that

the US will suspend the convertibility of the
dollar into gold.

6. System of Flexible Rates - Kingston

Conference (1976)
→ The determination of the par value
of a currency is the responsibility of
the country