The Bretton Woods international monetary system: a lesson for today.

Bordo, Michael D.

In fall 1991, the NBER held a conference--"A Retrospective on the Bretton Woods International Monetary System"--at the Mount Washington Hotel in Bretton Woods, New Hampshire. The historic International Monetary Conference of July 1944, creating the Bretton Woods System of adjustable pegged exchange rates, the International Monetary Fund (IMF), and the World Bank, was held at this hotel. The motivation for the NBER conference, organized by Barry J. Eichengreen and me, was to reexamine the Bretton Woods System 20 years after Richard Nixon closed the gold window in August 1971, effectively ending the world's last experiment with pegged exchange rates.

Some scholars' and officials' dissatisfaction with the performance of the present floating exchange rate system, coupled with increased interest in restoring fixed exchange rate arrangements and buoyed by the apparent success of the European Monetary System (EMS), made the conference timely. We assembled a group of young scholars, leading academic authorities on Bretton Woods, former officials from the Bretton Woods era, and one of the participants at the original Bretton Woods conference.

One year after the NBER conference, it seems that our topic was even more timely than we had imagined. The EMS recently has undergone convulsions reminiscent of the currency crises of the Bretton Woods era. Last fall we witnessed a replay of the scenes of 25 years ago: the shunting of anxious officials from one capital to another; their vigorous statements denying that devaluation was imminent; then, after the unthinkable happened, laying the blame on other countries' policies--Germany and the United States, and of course greedy speculators. I will focus here first on the history of the Bretton Woods System: its origins, how it worked in its heyday, its problems, and its collapse. Then I will discuss the conclusions of our conference, and finally the lessons for today.

The History of Bretton Woods

The planning during World War II that led to Bretton Woods aimed to avoid the chaos of the interwar period. The perceived ills to be avoided included: 1) floating exchange rates condemned in the early 1920s as prone to destabilizing speculation; 2) the subsequent gold exchange standard marred in the early 1930s by problems of adjustment, liquidity, and confidence that enforced the international transmission of deflation; and 3) after 1933, the beggar-thy-neighbor devaluations, trade restrictions, exchange controls, and bilateralism. To avoid these ills, John Maynard Keynes, Harry Dexter White, and others made the case for an adjustable peg system. The new system was intended to combine the favorable features of the fixed exchange rate gold standard, particularly exchange rate stability, with flexible rates, that would allow monetary and fiscal independence. Both Keynes, leading the British negotiating team, and White, leading the American team at Bretton Woods, planned an adjustable peg system to be coordinated by an international monetary agency. Considerable differences between the two plans reflected the vastly different circumstances of the two powers at the end of the war: the United Kingdom with a massive outstanding external debt and her resources depleted; the United States the only major power to emerge with her productive capacity unscathed and holding the bulk of the world's gold reserves.

The Articles signed at Bretton Woods represented a compromise between the two plans and between the interests of the United States and the United Kingdom. The system that emerged defined parities in terms of gold and the dollar (the par value system) that could be altered only in the event of a fundamental disequilibrium in the balance of payments (caused, for example, by major technological shocks, changes in preferences, or events such as wars). International reserves and drawings on the IMF (special drawing rights, or SDRs) were to finance adjustment of the balance of payments in ordinary circumstances. In addition, members were supposed to make their currencies convertible for current account transactions, but capital controls were permitted.

The Bretton Woods System took 12 years to achieve full operation. It was not until December 1958 that the western European countries made their currencies convertible for current account transactions. Under the system, each member intervened in the foreign exchange market, either buying or selling dollars, to maintain the parity of its currency within the prescribed 1 percent margins. The U.S. Treasury in turn pegged the dollar at the gold price of $35 per ounce by buying and selling gold freely. Thus, each currency was anchored to the dollar, and indirectly to gold.

The heyday of Bretton Woods was from 1959 to 1967. The dollar emerged as the key reserve currency, reflecting both its use as an intervention currency and a growing demand by the private sector for dollars as money. This growth in dollar demand was a response to stable U.S. monetary policy. In addition, the adjustable peg system evolved into a virtual fixed exchange rate system. Between 1949 and 1967, there were very few changes in parities of the G-10 countries. Because of the devaluation experience of 1949, monetary authorities were unwilling to accept the risk associated with discrete changes in parities: loss of prestige, the impression that others might follow, and the destabilizing speculation that occurred whenever devaluations were rumored.

As the system evolved into a fixed exchange rate, gold dollar standard, three problems that had plagued the interwar gold exchange standard reemerged: adjustment, liquidity, and confidence. They dominated the academic and policy discussions during the period, and were central to the analysis at the NBER conference.

The adjustment issue focused on how to achieve balance-of-payments equilibrium in a world with capital controls, fixed exchange rates, inflexible wages and prices, and domestic policy autonomy. Various policy measures were proposed to aid adjustment. Of particular interest during the period was asymmetry in adjustment between the reserve currency country, the United States, and the rest of the world. For the United States, the persistence of balance-of-payments deficits after 1957 was a source of concern.

The balance-of-payments deficit under Bretton Woods arose because capital outflows exceeded the current account surplus. For the U.S. monetary authorities, the deficit was perceived as a problem because of the threat of a convertibility crisis as outstanding dollar liabilities rose relative to the U.S. monetary gold stock. By 1959, the U.S. monetary gold stock equaled total external dollar liabilities, and was exceeded by the rest of the world's monetary gold stock. By 1964, official dollar liabilities held by foreign monetary authorities exceeded the U.S. monetary gold stock.

U.S. policies to restrict capital flows and discourage convertibility did not solve the problem. The Europeans regarded the U.S. balance-of-payments deficit as a problem because, as the reserve currency country, the United States did not have to adjust her domestic economy to the balance of payments. They resented the asymmetry in adjustment. Before 1965, they also believed mistakenly that the United States was exporting inflation to Europe through its deficits.

However, a number of prominent U.S. economists did not view the persistent U.S. balance-of-payments deficit as requiring adjustment. In their view, it served as the means to satisfy the rest of the world's demand for dollars. All that was required of the United States was to maintain price stability.

The main solution advocated for the adjustment problem was increased liquidity. Exchange rate flexibility was opposed strongly, as was the French proposal to raise the price of gold.

The liquidity problem evolved from a shortfall of monetary gold beginning in the late 1950s. The gap increasingly was made up by dollars. However, as Robert Triffin pointed out in 1960, dollars supplied by the U.S. deficit could not be a permanent solution. As outstanding dollar liabilities increased relative to U.S. gold reserves, the risk of a convertibility crisis grew. In reaction to this risk, it was feared that the United States would adopt policies to stem the dollar outflow. Hence new sources of liquidity were required, answered by the creation of SDRs in 1967. However, by the time SDRs were injected into the system in 1970, they exacerbated worldwide inflation.

The key perceived problem of the gold dollar system was how to maintain confidence. If the growth of the world's monetary gold stock was not sufficient to finance the growth of world real output and to maintain U.S. gold reserves, the system would become dynamically unstable. From 1960 to 1967, the United States developed a number of policies to prevent conversion of dollars into gold. This included formation of the Gold Pool in 1961, swaps, Roosa bonds, and moral suasion. The defense of sterling was viewed as a first line of defense for the dollar. When none of these measures worked, the two-tier arrangement of March 1968 solved the problem temporarily by demonetizing gold at the margin and hence creating a de facto dollar standard.

By 1968, the seeds of destruction of the Bretton Woods System were sown. The world was on an unloved dollar standard. European countries were not happy with the dollar standard but were afraid of the alternatives. Both they and the United States were unwilling to allow their exchange rates to adjust. Moreover, the fixed exchange rate system was under increased pressure because of growing capital mobility. Governance of the system was in a state of flux: the IMF was weak, U.S. power was threatened, and the G-10, the de facto governors, were in discord.

The Bretton Woods System collapsed between 1968 and 1971 in the face of U.S. monetary expansion that exacerbated worldwide inflation. The United States broke the implicit rules of the dollar standard by not maintaining price stability. The rest of the world did not want to absorb additional dollars that would lead to inflation. Surplus countries (especially Germany) were reluctant to revalue. The Americans' hands were forced by British and French decisions in the summer of 1971 to convert dollars into gold. The impasse was ended by President Nixon's closing of the gold window on August 15, 1971.

Another important source of strain on the system was the unworkability of the adjustable peg under increasing capital mobility. Speculation against a fixed parity could not be stopped by either traditional policies or international rescue packages. The breakdown of Bretton Woods marked the end of U.S. financial dominance. The absence of a new center of international management set the stage for a centrifugal international monetary system.

Conclusions of the Conference

The following conclusions emerged from the NBER's Bretton Woods conference:

First, a comparison of the macro performance of the G-7 countries under Bretton Woods with the regimes that preceded and followed it revealed that the convertible period from 1959 to 1971 was the most stable regime for both nominal and real variables, and the most fragile. We still do not know whether Bretton Woods' stability was attributable to the design of the regime or to the absence of significant demand and supply shocks while it lasted. Bretton Woods' fragility, though, was attributed both to flaws in its design and to conflicting policy objectives of the key deficit and surplus countries.

Second, capital controls were important in allowing different countries to follow independent monetary and fiscal policies for significant periods of time, and hence to have divergent inflation rates without having to realign their parities. Yet controls were not effective enough to prevent speculative attacks when the fundamentals dictated a realignment. Reliance on controls in turn impeded efficient international resource allocation. The gradual removal of controls, and the growing integration of world financial markets during the Bretton Woods convertible period, made it increasingly difficult for members to follow divergent policies and hence worsened the strains on the system.

A third issue was whether the Bretton Woods System was rule based, in the sense that adherence by the United States to gold convertibility, and by other member countries to fixed rates with the dollar, constrained monetary authorities to follow stable domestic monetary policies. And, did adherence to the Bretton Woods Articles constrain members from practicing competitive devaluations and encourage them to coordinate their monetary and fiscal policies?

Our conclusion was that the rules of Bretton Woods were not very effective. Gold convertibility did not brake U.S. monetary expansion in the mid-1960s. Competitive devaluations occurred in 1949 and to a lesser extent in 1967, and policy divergence prevailed throughout the period. Moreover, the IMF proved ineffective in enforcing compliance with the Articles by major countries. However, it did play an important role in monitoring the performance of, and assisting in the balance-of-payments adjustment by, developing countries.

Finally, the NBER conference provided new insights on the causes of the collapse of Bretton Woods. Although the United States followed a low inflation policy in the 1950s and early 1960s and hence played by the rules of the game, the cumulation of two decades of even low inflation meant that the fixed price of gold at $35 per ounce eventually would be unsustainable. At that point, which occurred in March 1968, a speculative attack by rational agents could bring it down. Once the regime evolved into a de facto dollar standard, the obligation of the United States was to maintain price stability. Its failure to do so in turn precipitated a speculative attack, since rational currency speculators understood that monetary expansion was inconsistent with maintaining both stable prices and fixed exchange rates.

A Lesson for Today

The experience of Bretton Woods and its collapse provide interesting insights on recent events in the EMS. The exchange rate mechanism of the EMS was designed as an adjustable peg exchange rate system, but its architects hoped to avoid the problems that plagued Bretton Woods.

Like Bretton Woods, it was based on a set of fixed parities called the Exchange Rate Mechanism (ERM). Each country was to establish a central parity of its currency in terms of ECU, the official unit of account. Like Bretton Woods, each currency was bounded by a set of margins of 2.25 percent on either aide of parity (over twice those of Bretton Woods). Unlike Bretton Woods, the monetary authorities of both depreciating and appreciating countries were required to intervene when a currency hit one of the margins. Intervention and adjustment were to be financed under a complicated set of arrangements, designed to overcome the weaknesses of the IMF during Bretton Woods. Also, unlike Bretton Woods, whose members (other than the United States) could in effect decide unilaterally to alter their currencies, EMS changes in central parities were to be decided collectively. Finally, like Bretton Woods, members could (and did) impose capital controls that recently were phased out.

After a shaky start from 1979 to 1985, the EMS was, until recently, successful at stabilizing both nominal and real exchange rates within Europe and at reducing divergences among members' inflation rates. The success of the EMS was attributed in large measure to its evolution as an asymmetrical system, like Bretton Woods, with Germany acting as the center country. The other EMS members adapted their monetary policies to maintain fixed parities with Germany. The Bundesbank has exhibited a strong credible commitment to maintain low inflation. Other members of the EMS, by tying their currencies to the Deutschemark, have used an exchange rate target as a commitment mechanism to successfully reduce their own rates of inflation.

Yet, despite its favorable performance since the mid-1980s, the EMS recently was subjected to the same kinds of stress that plagued Bretton Woods. Like Bretton Woods, the EMS is a pegged exchange rate system that requires that member countries follow similar domestic monetary and fiscal policies and hence have similar inflation rates. This is difficult to do in the face of both differing shocks across countries, and differing national priorities. Under Bretton Woods, capital controls and less integrated international capital markets allowed members to follow divergent policies for considerable periods of time. Under the EMS, the absence of controls and the presence of extremely mobile capital means that any movement of domestic policies away from those consistent with maintaining parity quickly will precipitate a speculative attack. Also, just as under Bretton Woods, the adjustable peg in the face of such capital mobility becomes unworkable. Thus, the difference between the two regimes when faced with asymmetric shocks or differing national priorities was the speed of reaction by world capital markets.

Although the fundamental cause of the crisis was similar in the two regimes, the source of the problem differed. The shock that led to the collapse of Bretton Woods was an acceleration of inflation in the United States, ostensibly to finance the Vietnam War as well as social policies, and to maintain full employment. Under the EMS, the shock was bond-financed German reunification and the Bundesbank's subsequent deflationary policy. In each case, the system broke down because other countries were unwilling to go along with the policies of the center country. Under Bretton Woods, Germany and other western European countries were reluctant to inflate or to revalue, and the United States was reluctant to devalue. Under the EMS, the United Kingdom, Italy, Spain, and Ireland were unwilling to deflate, and Germany was unwilling to revalue. As under Bretton Woods, the EMS had the option for a general realignment, but both improved capital mobility and the Maastricht commitment to a unified currency made it an unrealizable outcome.

Thus the lesson for today is that pegged exchange rate systems do not work for long no matter how well they are designed. Pegged exchange rates, capital mobility, and policy autonomy just do not mix. The case made years ago, during the heyday of Bretton Woods, for floating exchange rates for major countries still holds. This is not to say that European countries could not form a currency union with perfectly fixed exchange rates, if member countries were completely willing to give up domestic policy autonomy. In an uncertain world subject to diverse shocks, the costs for individual countries of doing so apparently are extremely high.