Question

7. Explain the pillars of the Bretton Woods financial system, and how they were designed to resolve the financial instability of previous decades.

Answer 1

In 1944 several countries sat together to find out a suitable curency system after abandoning classical gold standard (1875-1914) .
The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. Preparing to rebuild the international economic system as World War Two was still raging, 730 delegates from all 44 World War Two Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire for the United Nations Monetary and Financial Conference. The delegates signed the Bretton Woods Agreements during the first three weeks of July 1944. It replaced the gold standard with the U.S. dollar as the global currency. It established America as the dominant power in the world economy. After the agreement was signed, America was the only country with the ability to print dollars.

According to this Bretton - Woods conference major steps were atken towards the stabilization of world economy by setting up of the the Iternatuional Monetory Fund (IMF) & IBRD (which later came to be known as World Bank). These organizations became operational in 1946 after a sufficient number of countries had ratified the agreement.

The Bretton Woods system had the following features:-

• Dollar was pegged to gold at 35 per oz. Other currencies were pegged to dollar par value.
• Only in USA gold was fully convertible to currency & vice versa.
• Under the agreement, countries promised that their central banks would maintain fixed exchange rates between their currencies and the dollar.
• If a country's currency value became too weak relative to the dollar, the bank would buy up its currency in foreign exchange markets.
• Each country participating in the BWS were asked to maintain a dollar reserve with the International Monetory Authority.
• The BWS had allowed +/- 1% change in the par value of the currency of the individual countries if required with respect to what was fixed at BWS.
• Members of the Bretton Woods system agreed to avoid trade wars. For example, they wouldn't lower their currencies strictly to increase trade. But they could regulate their currencies under certain conditions. Like for instance, they could take action if foreign direct investment began to destabilize their economies. They could also adjust their currency values to rebuild after a war.
• An example of the concept of BWS :- Gold & Dollar was convertible in bothways, however, other nation currencies like, Pound fixed with USD, FRANC fixed with USD etc.

Advantages of Bretton Woods System

• Dependence on Gold was heavily reduced as dollars also became the means of international transaction.
• A stable exchange rate had facilitated a stable economic environment
• A major depletion in a countries dollar stock could be easilty offset by drawing from reserves.
• The dollar reserve earned interest.
• Countries were required to monitor and maintain their currency pegs which they achieved primarily by using their currency to buy or sell U.S. dollars as needed. The Bretton Woods System, therefore, minimized international currency exchange rate volatility which again helped international trade.
• More stability in Forex was also a factor for the successful support of loans and grants internationally from the World Bank.

Why the Agreement Was Needed

Before Bretton Woods, most countries followed the gold standard. That meant each country guaranteed that it would redeem its currency for its value in gold. After Bretton Woods, each member agreed to redeem its currency for U.S. dollars, not gold. The dollar was chosen because the United States held three-fourths of the world's supply of gold. No other currency had enough gold to back it as a replacement. Hence, Bretton Woods allowed the world to slowly transition from a gold standard to a U.S. dollar standard. This again created more demand for dollars, even though its worth in gold remained the same. This discrepancy in value however led to the collapse of the Bretton Woods system three decades later.

Until World War I, most countries were on the gold standard. However, they abandoned gold so they could print the currency needed to pay for their war costs. This caused hyperinflation, as the supply of money overwhelmed the demand. After the war, countries again returned to the gold standard which was considered to be safer. However, in 1929, Great Depression came which resulted in stock market crash, investors switched to commodities trading. It drove up the price of gold, resulting in people redeeming their dollars for gold. The Federal Reserve made things worse by defending the nation's gold reserve by raising interest rates. The fall of the gold standard led countries to raise trade barriers, devalue their currencies to compete against one another for export markets and curtail usage of foreign exchange by their citizens. All these factors led to declining world trade, high unemployment, and plummeting living standards in many countries.

The Bretton Woods system gave nations more flexibility than strict adherence to the gold standard. It also provided less volatility than a currency system with no standard at all. A member country still retained the ability to alter its currency's value, if needed, to correct a fundamental disequilibrium in its current account balance. Although, the Bretton Woods System collapsed in the 1970s but it created a long lasting influence on international currency exchange and trade through its development of the IMF and World Bank.

The Bretton Woods system led to the development of 3 international organisations of largest importance for International Economic Law & Order. These are also considered to be the pillars of BWS :-

1. The World Trade Organization (WTO) (the successor of the General Agreement on Tariffs and Trade)
2. The International Monetary Fund (IMF)
3. The World Bank Group

While the International Trade Organization that was proposed in the Bretton Woods Agreement was not endorsed by the United States, it was later backed in 1947 but in the form of the General Agreement on Tariffs and Trade (GATT). This new agreement was also ratified by 23 other countries, and later on became the World Trade Organization.

• GATT supported free international trade. GATT is multilateral instead of bilateral.
• Advocated Nondiscrimination via MFN (most-favored-nation) clause. MFN generalizes benefits of any bilateral bargain to all GATT members.
• Tariffs on manufactured goods drop from around 40% to less than 4%. Growth of world trade outpaced world economic growth.
• GATT was very robust. It succeeded despite Cold War, Vietnam war & many other wars of independence, de-colonization, creation of European Council, etc.

IMF was established by the BWS with the vision of an institution that would oversee the international monetary system, exchange rates, and international payments to enable countries and their citizens to buy goods and services from each other. They expected that this new global entity would ensure exchange rate stability and encourage its member countries to eliminate the exchange restrictions that hindered trade. Officially, the IMF came into existence in December 1945 with twenty-nine member countries (the Soviets, who were at Bretton Woods, refused to join the IMF).

The Bretton Woods system could not have worked without the IMF. Member countries needed it to bail them out if their currency values got too low. They'd need a kind of global central bank they could borrow from in case they needed to adjust their currency's value and didn't have the funds themselves.  In 1947, the French became the first nation to borrow from the IMF.

The Bretton Woods countries, however, did'nt make IMF a global central bank. Instead, they agreed to contribute to a fixed pool of national currencies and gold to be held by the IMF. Each member country of the Bretton Woods system was then entitled to borrow what it needed, within the limits of its contributions. The IMF was also responsible for enforcing the Bretton Woods agreement.

In the later period of BWS when dollar started depreciating, the IMF designed and introduced a Special Drwaing Rights (SDR) to replace US dollars in the BWS. A Special Drawing Right (SDR) is basically an international monetary reserve asset. Today the value of an SDR consists of the value of four of the IMF’s biggest members’ currencies - the U.S. dollar, the British pound, the Japanese yen, and the euro - but the currencies do not hold equal weight. SDRs are quoted in terms of U.S. dollars. The basket, or group of currencies, is reviewed every five years by the IMF executive board and is based on the currency’s role in international trade and finance.
The purpose of the IMF was to monitor exchange rates and identify nations that needed global monetary support. In the 21st century, the IMF has 189 member countries and still continues to support global monetary cooperation.

The World Bank, initially called the International Bank for Reconstruction and Development, was established to manage funds available for providing assistance to countries that had been physically and financially devastated by World War II. At present, the World Bank helps to promote these efforts through its loans and grants to governments.
The World Bank’s first loans were extended during the late 1940s to finance the reconstruction of the war-ravaged economies of Western Europe. When these nations recovered & attained economic self-sufficiency, the World Bank started assisting the world’s poorer nations. The World Bank has one central purpose :- to promote economic and social progress in developing countries by helping raise productivity & improve the standard of living of the people.