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Bretton Woods System

1. What is Bretton Woods system
A brief World War II Timeline
Recall that the representatives of the US and its
Allies worked out three post-war arrangments:
(i) ITO (still-born), replaced by GATT and WTO
(ii) IBRD (which became the World Bank), and
(iii) IMF, immediately after the Normandy invasion in
June 1944.
For 25 years after WWII (see the timeline), the
international monetary system known as the Bretton
Woods system, was based on stable and adjustable
exchange rates.
Stable and
adjustable
exchange
rates

lose national
sovereignty

Exchange rates were not permanently fixed, but

occasional devaluations of individual currencies were
allowed to correct fundamental disequilibria in the
balance of payments (BP). Ever-increasing attack on
the dollar in the 1960s culminated in the collapse of
the Bretton Woods system in 1971, and it was
reluctantly replaced with a regime of floating
exchange rates.
By signing the agreement, nations were submitting
their exchange rates to international disciplines.
This amounted to a significant surrender of national
sovereignty to an international organization.

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Deflationary policy: Under the gold exchange

standard, a country has to resort to the classical
medicine of deflating the domestic economy when
faced with chronic BP deficits.
Before World War II, European nations often used
this policy, in particular the Great Britain. Even
though few currencies were convertible into gold,
policy makers thought that currencies should be
backed by gold and willingly adopted deflationary
policies after WWI.
Advantages
over the gold
exchange
standard

Deflationary policy is not the only option when faced

with BP deficits. Devaluation is accepted in Bretton
Woods.
The adjustable peg was viewed as a vast
improvement over the gold exchange standard with
fixed parity.

Currencies were convertible into gold, but

unlike the gold exchange standard, countries had the
ability to change par values of their currencies. For
this reason, Keynes described the Bretton Woods
system as "the exact opposite of the gold standard."
Structural problem: (i) Over time the world economy
grew and needed more liquidity or reserve assets.

Marshall Plan Aid.

"Wir wollen Kohle, Wir wollen Brot" (We want coal,
We want bread). (former) President Herbert Hoover
(1947): The whole economy of Europe is interlinked
with German economy through the exchange of raw
materials and manufactured goods.)
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(ii) Given the fixed quantity of gold (165,000 tons or

4 billion ounces, annual production of gold = 80
million ounces) , other countries had to hold US
dollar and gold as reserve.
(iii) As the world economy grows, the increased
world demand for dollar as reserve assets meant that
Unanticipated US had to maintain increasing trade deficits.
Problem
(iv) Other countries resorted to devaluation. But the
US was not able to devalue the dollar.
The dollar was the numraire of the system, i.e., it
was the standard to which every other currency was
pegged. Accordingly, the U.S. did not have the power
to set the exchange rate between the dollar and any
other currency.

Changing the value of dollar in terms of gold

has no real effect, because the values of other
currencies were pegged to the dollar. This is the n-th
currency problem.This problem would not have
existed if most of other currencies were pegged to
gold. However, none of these currencies were pegged
to gold because they were not convertible into gold.
(limited supply of gold)
Invasion of Normandy (June 6, 1944)
International Monetary Fund and World Bank
meeting was held in July 1944 in Bretton Woods,
New Hampshire, one month after the invasion of
Normandy.
The political complement of this meeting to establish
United Nations was held in San Francisco and the
charter was signed in June 1945 (after Germany's
surrender).
UN came into existence in October 1945. The
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Articles of Agreement was signed in December 1945.

The next year, the By-laws were adopted at a
meeting in Savanna, Georgia (March 8-18, 1946).

2. Contents of the Articles of Agreement (copy)

IMF was established to provide member countries with
the necessary funds to cover short term balance of
payments problems. The Fund in turn received
resources from members who were allotted quotas.
Initial quota: $8 billion (about $80 billion today)
(Total Quota = 238 billion SDR as of 2010, doubled,
reaching 476 billion SDR in 2011).

Par value
and 1%
band

Upon entering the Fund, a country submitted a par

value of its currency expressed in terms of gold or in
terms of the US dollar using the weight of gold in effect
on July 1, 1944 ($35 per troy oz).
All exchange transactions between member countries
were to be effected at a rate that fluctuated within 1%
band (which approximates gold import/export points)
around the par values of the respective currencies.
Article IV: A member could change the par value of its
currency only to correct a fundamental
disequilibrium in its balance of payments, and only
after consulting with the Fund.

Article IV
Change par
value

(However, speculators correctly anticipate such weak

currencies, making it more difficult for the monetary
authorities to defend them.)
In case the Fund objects a change, but the member
devalues its currency, then that member is ineligible to
use Fund's resources.

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The Fund cannot formally propose a change of the par

value of a currency.
No objection to a change if the cumulative change is
less than 10% of the par value.
Article VI

Article VI: allows members to control capital

movements.
Article VII: The Fund may declare a currency to be
scarce. If so, member countries are authorized to
impose exchange control over the scarce currency.

Article VII:
scarce
currency

Remark: A problem that appeared during the interwar

period was that unlike deficit countries, surplus
countries were not under any pressure to adjust their
BP. A deficit country was compelled to take some kind
of action to restore equilibrium, but a surplus country
can accumulate reserves indefinitely. (This is still true
even today. IMF monitors currency practices of deficit
countries that receive loans.)
Britain adopted deflationary policy in the 1920s, but
the surplus countries (US + France) did not participate
in the adjustment process.

Article VIII

Article VIII forbids restrictions on current account

balances. Members are obligated to maintain the
convertibility of foreign held current account balances
(to facilitate trade).

Exceptions: Article VII + XIV

Article XIV allows a member country to retain
exchange control restrictions in effect when that
country entered the Fund. Once a member country
abolishes its exchange control over the current
payments and accepted the obligations of Article VIII,
then it cannot reimpose exchange control without the
approval of the Fund.
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Article XIV

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Remark: Most major countries in Europe accepted the

obligations of Article VIII by 1961. Japan came under
this article in 1964.
The remaining Article XIV countries are obligated to
consult annually with the Fund on exchange controls,
but the Fund has no power to abolish the exchange
control unilaterally. No scarce currency declaration has
been made.
Most nations outside the Communist bloc became
members of the IMF.

3. How a Country Finances its Trade Deficits

During the Bretton Woods era (1948-73), world trade increased sixfold while GWP tripled (from $7 trillion in 1950 to $21 trillion) Per
capita GDP doubled ($2,700 trillion in 1950 to $5,400 in 1973 at the
end of the Bretton Woods.)
But the total international reserve increased only by 3% during the
same period. So lack of international reserve became acute. The US
had acquired the bulk of the world's gold. In 1946, the US held $26
billion worth of gold (740 million ounces, world total = 800 million oz)
when the estimated world total was $33 billion. Today, Treasury
owned gold is 260 million ounces (mostly in Fort Knox, Denver, and
West Point and a little bit in FRB NY).
If the U.S. had exported Treasury bills, it would have provided
additional reserves for the US. However, nations became increasingly
reluctant to hold $. Gradually, the US stock of gold was depleted.
The Fund was the source of financing for a member country
experiencing a temporary disequilibrium in its balance of payments.
These resources come from gold and currency subscriptions of its
members.
Upon entering the Fund, each country was allotted a quota in
Reserve/Gold

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Reserve/Gold accordance with its relative economic size.

tranche
Reserve (gold) tranche: 25% of quota was paid to the Fund in gold
Credit
(1944 US dollar). Today, this must be paid in SDR or major currencies
tranche
($, , and yen).
Credit tranche: 75% of quota was paid in the currency's own currency.

In 1946, the Fund started with aggregate quotas of $8 billion, 20% of

world reserves. (Today, this amount is worth roughly $100 billion) The
quota was raised in 1971. The largest quota was US: $6.7 billion
(21.9%): U.K. $2.8 billion (9.2%), Germany, France 5%, Japan 4%.
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The quota was increased several times.

Quota

In 1990 the quota was increased to $135 billion, still equal to about
20% of world reserves.
In 2011, quota increased to SDR 476 billion. There have been no
increases thereafter.
The quota determines the voting power of a member's executive
director. (250 votes + 1 vote for SDR100,000)
e.g., US = 17.75% ($65 billion) total = $366 billion (as of 2009)
Total: 2.5 million votes (and growing).
US holding of gold: currently, about 8,000 tons ($160 billion at $40 per
oz), or about 5% of the world's total gold stock. (the world has about
165,000 tons)

The size of a country's quota determines the borrowing limit of that

country.
(i) Basic Facility: gold tranche + 4 credit tranche = 125%
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(ii) Extended Facility: 140%

Borrowing

(iii) Standby Agreements: Short term borrowing member countries

negotiate to receive the Fund's guarantee. usually borrowing is for 3-5
years.
(iv) General Agreements to Borrow (GAB): was negotiated in 1962 by
the Group of Ten: France, Italy, Germany, Belgium, Netherlands,
Sweden, Japan, UK, US, Canada. Switzerland joined in 1964. The fund
could borrow up to $5.9 billion from the Group of Ten to provide more
short term assistance.
(v) Currency Swap Arrangements: made in 1962. bilateral
arrangements between central banks.
The total quota is small, not sufficient to deal with the European crisis.
In 2008, Japan lent $100 billion to the IMF. US also extended $100
billion line of credit.

4. SPECIAL DRAWING RIGHTS (copy)

In a certain sense, SDR allocations were like the credit
limits on a person's credit card or line of credit. SDRs
can be used to make payments to settle debts between
central banks.
In addition, each member country agreed to accept
three times its own SDR quota from other central banks.

when

value of

An agreement was reached at the IMF annual meeting

in Rio de Janeiro in 1967 to issue SDRs to be allocated
to 104 participants. The first allocation was made in
1970 (3.4 billion), then 1971 (2.95 billion), 1972 (2.95
billion)
Originally, the value of an SDR was set at one US dollar,
both having the same weight in gold in 1970. However,
dollar was devalued a couple of times, and there was a
general move to end the key role of $ in the

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SDR

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general move to end the key role of $ in the

international monetary system.
After July 1, 1974, the value of SDR was determined in
terms of "basket" of 16 main currencies. Weights: USD
= 33%, mark = 12.5%, pound = 9%, FF = 7.5%, yen =
7.5%, CND = 6%, lira = 6%. From April 1980, only 5
major currencies.
$ = 42%, DM = 19%, yen = 13%, FF = 13%, pound =
13% The value of SDR is calculated daily by IMF.
Currently, it includes $, euro, pound and yen. 1 SDR =
$1.50 as of 2013
From October 1, 2016, USD, , Renminbi, yen,
(GBP). Renminbi is "freely usable" in international
transactions.
Codes: USD, EUR, GBP, CNY, JPY, XDR
SDRs are merely bookkeeping entries. It becomes a
reserve asset because of the commitment of
participating countries to accept SDRs up to an amount
equal to 3 times their own SDR allocations.
A decision to create SDRs require the approval of a
majority of member countries holding 85% of the
weighted voting power of the Fund. Once created, SDRs
are distributed to participants in proportion to Fund
quotas. As of 2009, the total allocation reached SDR
204 billion.

between
central
banks

Unlike dollar and other currencies, SDRs are not usable

for private international transactions.
SDRs represent a net addition to international reserve
that are as useful as gold or dollars, unlike international
borrowing (which does not change reserves). Since it
costs nothing to create SDRs, the world saves resources

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that would otherwise be wasted to mine and refine gold.

For this reasons, SDRs are sometimes called paper gold.
However, they should be called "e-Gold" (electronic
gold) since no paper notes are issued.
SDR plays a limited role as an international reserve
asset due to its small quantity relative to the daily
transactions volume (about $5 trillion dollars) in the
foreign exchange market. Its main function is the unit of
account of transactions of international organizations
importance
and central banks.
SDR is not tied to any single currency, and hence there
is no need to worry about the trade deficit of any single
country.
SDRs can be created as needed to insure stable growth
of international reserves. If SDRs replace $ as reserve
assets in central banks, the US does not have to be a
world banker. SDR makes the IMF an international
central bank.

interest
rate

Once every year, the IMF charges every country

interest on allotment, and credits every country with
interest on the average SDR holdings during the past
year. The interest rate was 1.5% per year originally, but
raised to 5% in 1975. Now it is calculated weekly based
on a weighted average of short term interest rates in the
basket currencies (Euro, Yen, Pound Sterling, USD).
about $1.5 in April 2014.

Problems

Developing countries are reluctant to use SDR.

5. The Role of the US Dollar

The international monetary system evolved in a way that was
not foreseen in the Articles of Agreement of IMF.
During the 1950s the US emerged as the leading reserve
country, and the dollar increasingly taking over the function of
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gold as a major international reserve asset.

Why
hold
dollar,
not
gold?

No one planned this development. The US was the dominant

world power. Well over half of all international money
transactions were financed in terms of dollar; the US produced
more than half of the world output. The US also owned about
two thirds of the official gold reserve in the world in 1940.
Dollar became the dominant invoice currency. Most exporters
invoiced the importers in dollars. When the European
countries had reserve surpluses, they converted the surpluses
into dollar reserves rather than gold because
(i) interest could be earned on dollar assets, and
(ii)dollar reserves can always be converted into gold at $35
per ounce whenever it became necessary.
All of the non-Communist countries maintained a stable
relationship between their currencies and the dollar either
directly or indirectly through the British pound. The US dollar
was at the center of this system. Since the Great Britain had
halted the gold convertibility of its currency, US dollar was the
only currency directly convertible into gold for official
purposes. Before WWI, the pound sterling performed a similar
function, but the sterling area had shrunken to a small number
of countries.
As the Bretton Woods system evolved, the reserves of most
countries became a mixture of gold and dollars. US dollar
became increasingly more important.

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central
role of $

The US balance of payments was more important than those

of other countries, because other countries were holding US
dollar as dollar as the principal reserve asset. Moreover, the US was
unable to eliminate ever-increasing trade deficits, which
principal
undermined the Bretton Woods system.
reserve
asset
In particular, President of France, De Gaulle, complained that
the US had an exorbitant privilege: unlimited financing
because other countries were willing to hold dollar assets.

6. Five ways to correct BP deficits

(1) deflate the

economy

use contractionary Monetary policy (raise

interest rate) or Fiscal policy (cut federal
spending) to reduce aggregate demand. This
is a painful option because the government
will become less popular. (e.g., Great
Britain after WWI)
A permanent but painful solution.
As the price of the foreign currency (e)

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(2) devalue own

currency

As the price of the foreign currency (e)

rises, net exports = X(e) - M(e) declines,
which reduces trade deficit.
A permanent and effective solution (under
fixed exchange rates).

(3) impose exchange

control on current
account

An exchange control limits imports. A

temporary solution.
A temporary remedy.

(4) deplete gold stock

(5) increase liabilities

to foreign central
banks.
The surplus country
(e.g., China) holds
more dollar assets.

Since the stock of gold is limited, it will

soon run out.
This means the US is unwilling to devalue
$, or the surplus country (e.g., China) is
unwilling to let RMB appreciate. A
temporary solution, and eventually the
latter country gives up.
As China holds more dollar assets, their
value in RMB declines when RMB
appreciates (Chinese investors lose money),
which eventually happens.
Only speculators gain.

7. US Payments Deficit in the 1960s

In the 1960s the international monetary system was shaken
by a series of disturbances in the foreign exchange and gold
markets. Since the US dollar was used as the principal
reserve asset by our trading partners, the weakness of
dollar raised doubts about the viability of the entire system.

Persistent
US BP
deficits in

During the period 1958-1971, the US experienced a

persistent deficit in its balance of payments. At first,
economists viewed these annual deficits as temporary.
However, it gradually dawned to policy makers that the US

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deficits were not disappearing. The causes of these chronic

deficits are:
(a) a higher rate of return r* > r, which results in a capital
outflow.
(b) military commitments in Europe and Asia.
(c) The Vietnam war also caused inflation in the US.
During the years 1958-1971, the US experienced a
cumulative reserve deficit of $56 billion. International
reserve in other countries mainly consisted of US dollar and
gold, although the currencies of other major countries were
reserve assets but they played a minor role.

International
reserve
US reserve assets included foreign currencies such as Yen,
assets of the DM and British pound at first. However, by the end of the
US
1960s, the US international reserve consisted of mainly
gold.

Some of the fundamentals are wrong (p, w, r, Y, e). The

best policy is a devaluation of USD. All other policies such
as lowering interest rates are second best.
click the image below

Increasing

During this period (from 1958 to 1971), the US not only

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liabilities to
foreign
central
banks
Gold
Coverage of
a currency

Bretton Woods

witnessed a gradual depletion of its international reserve

assets but also a dramatic increase in liabilities to foreign
central banks.

= Gold held by the Fed/Liabilities to Foreign Central Banks

(Reginald Howe, copy)

Gold
coverage in
1963

(a few months after Nixon's declaration of dollar's gold

inconvertibility)

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Gold
coverage in
1971

By 1963, the US gold reserve at FRB New York

(Manhattan) barely covered liabilities to foreign central
banks, and by 1970 the gold coverage had fallen to 55%,
by 1971 22%. Thus, from 1963, had the foreign central
banks tried to convert their dollar reserves into gold, the US
would have been forced to abandon dollar's gold

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would have been forced to abandon dollar's gold

convertibility.

International
gold bar,
World Gold
Council

8. Collapse of the Bretton Woods

To lesson the outflow of private capital, the US imposed
an interest equalization tax in 1963. This was effective
to curb temporarily the outflow of portfolio investment.
However, because r* > r, it was more than offset by a big
jump in US bank loans to foreign borrowers and a further
growth in US direct investment.
(a) Voluntary Foreign Credit Restraint program was
adopted in 1965 (Canada and developing countries were
exempted). This was replaced by Mandatory Investment
Controls in 1968, lifted in 1975.
temporary
measures (b)Federal Reserve System entered into a series of
currency swap agreements with central banks of
Western Europe, Canada, and Japan. Under these
bilateral agreements, a foreign central bank provided
standby credit (in foreign currency) to the Federal
Reserve System in return for an equal amount of standby
credit (in dollar).
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None of these measures reduced US basic deficit but

lessened the gold drain and dampened the speculative
capital outflows. President Nixon once raised the value of
dollar, to penalize the speculators. (It did not work).
The crisis of 1971 was caused by a gradual loss of
confidence in dollar. In 1970, funds began to move at an
enormous rate from the US dollar to financial centers in
Europe and Japan.
In May 1971, West Germany left the Bretton woods
system. Switzerland redeemed $50 million for gold.
Collapse
of Bretton France sent a warship to New York harbor to withdraw
$190 million in gold. President Nixon (copy) announced
Woods
on August 15, 1971:
(i) a 90-day freeze on wages and prices
(ii)10% import surcharge on dutiable imports
(iii) suspension of dollar's convertibility into gold.

9. SMITHSONIAN AGREEMENT (copy)

International monetary negotiations were
undertaken within the framework of the Group of
Ten. Details were worked out by the Group of Ten
in a meeting at the Smithsonian Institution in
Washington DC in December 1971. The agreement
was then formalized by the IMF.
temporary
regime

currency

It was a temporary regime. The agreement allowed

member countries to vary their exchange rates
within margins of 2 % on either side of the central
rates after currency realignment.
Currency realignment: Yen appreciated 17%,
Mark 13.5 %, pound 9%, FF 9%. Par value of other
minor currencies were also changed. In return for
the revaluation of other currencies, the U.S. agreed

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realignment to raise the price of gold from $35 to $38 an ounce.

This was equivalent to a dollar devaluation of
8.57%.
This devaluation of dollar has no significance
because the dollar remains inconvertible. 10%
import surcharge was suppressed.
The collapse of the Bretton Woods system did not
generate a chaos as did the collapse of the
international gold standard in the 1930s.
Importance

The Smithsonian Agreement was a useless attempt

to perpetuate the adjustable peg system with new
currency alignment.

End

Par Value Modification Act, 1973 (amended) (copy)

With the second devaluation of the dollar in March
1973 by 11% (the price of gold rose from $38.00 to
$42.22 per ounce), the Smithsonian agreement fell
apart and other currencies were left to float against
the dollar. Bank of Japan absorbed a few billion
dollars in one week, but eventually quit.

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