Question

Brief description of the contents, limitations and causes of the collapse of the Bretton Woods system.

Answer 1

After the abandonment of gold standard and chaotic international monetary conditions during the inter-war period, the need was being felt to evolve a more efficient and effective world monetary system. In 1944, the representatives of 44 countries met at Bretton Woods, New Hampshire in the United States for creating the framework of the international monetary system. The conference at Bretton Woods outlined certain principles as the guidelines for operating the world monetary system.

(i) The international monetary system must facilitate unrestricted trade and investment.

(ii) The national currencies would be defined in terms of gold parities and there would be fixed exchange rates. Only in the event of a fundamental disequilibrium in the BOP would a country be expected to change its exchange rates.

(iii) The international liquidity would be made available to the countries for overcoming the temporary BOP deficits.

Thus Bretton Woods meet sought to combine certain features of the old gold standard with a greater degree of flexibility and some measure of control over international liquidity. The expectation and objective at the Bretton Woods was to create a new system that would avoid the undesirable aspects of the old system while retaining its best features.

The things that were to be avoided included rigidity of exchange rates and associated deflationary adjustment mechanism of the gold standard, the instability of the freely floating exchange rates, conflicts of national economic policies, competitive exchange depreciation and the repressive and distorting techniques of exchange controls.

The most far-reaching result of the Bretton Woods meet was the creation of International Monetary Fund (IMF). It was a compromise between the British plan put forward by Keynes and the American counter-plan put forward by Dexter and White. While the former was for the creation of an international clearing union, the latter was for a less ambitious stabilisation fund.

The IMF started functioning in March, 1947 with a membership of 30 countries. At present, its membership has gone upto 184. The IMF had two specific objectives of overseeing that the member countries followed a set of agreed rules of conduct in international trade and finance and of providing borrowing facilities for the member countries to tide over their BOP difficulties. Such borrowings were to be repaid within a period of three to four years.

Each member country was assigned a quota on the basis of its economic importance and the volume of its international trade. The member countries’ quota determined their respective voting power and the ability to borrow funds. The total subscription to the Fund was $ 8.8 billion originally. It had grown to $ 205 billion or SDR 145 billion by 1993. The US quota was the largest in 1989 at 21 percent, followed by 7 percent each for the U.K., 6 percent each for Germany and France and 5 percent for Japan.

Under the Bretton Woods System, the gold exchange standard was introduced. The United States was to maintain the price of gold fixed at $ 35 per ounce and to be ready to exchange dollars for gold at that price without restrictions or limitations. Other nations were required to fix the price of their currencies directly in terms of dollars and indirectly in terms of gold. The exchange rate could fluctuate within plus or minus 1 percent around the agreed par value.

The Bretton Woods System envisaged the removal of all restrictions on the full convertibility of the currencies of member countries into currencies of one another or into dollar. The member countries were expected not to impose additional trade restrictions. The existing trade restrictions were to be removed gradually through multilateral negotiations. The restrictions on the international liquid capital flows were, however, permitted to enable the member countries to protect their currencies against large destabilizing, international money flows.

The main factors that led to the collapse of this system were as follows:

(i) The Confidence Problem:

By the end of 1950’s many European countries were having BOP surpluses and the USA was running counterpart deficit. For the continued economic expansion, it was essential for the United States to maintain this deficit as it was the only way through which the growth of international reserves could be sustained in the absence of any other reserve asset including gold.

(ii) Seigniorage Problem:

It was argued that the Bretton Woods System gave rise to the seigniorage of the United States over other countries, since dollar became the international reserve currency that conferred some undue privilege upon the Americans. The question of seigniorage arose because the United States was the issuing country of dollar. As and when it required dollar, it could issue more dollars.

(iii) Adjustment Problem:

From the long run point of view, a serious weakness in the Bretton Woods System was the absence of an efficient balance of payments adjustment mechanism. No country can afford to have a persistent BOP deficit. The principal types of adjustment mechanism include adjustment through changes in relative incomes, through relative price changes, through the movements in exchange rates and through the imposition of direct controls over foreign transactions. The Bretton Woods System almost prohibited the use of direct controls

(iv) Triffin Dilemma:

A serious inbuilt contradiction in the system was exposed by Triffin as early as 1960. It is often referred as ‘Triffin dilemma’ i.e., either the United States corrected its deficit and created a liquidity shortage or it continued to run the BOP deficit. The latter alternative could only cause the crisis of confidence. The existence of this dilemma clearly showed that the system was inherently unstable and was destined to collapse.

fter the crisis of 1971, the Board of Governors of the IMF recognised the necessity of investigating the possible measures for the improvement in the international monetary system. In 1972, it constituted a committee of twenty members, often referred as The “Committee of Twenty” (C20). Three basic weaknesses of the Bretton Woods System, identified by the Committee included liquidity, confidence and adjustment. The outlines of recommendations made by the Committee, therefore, attempted to address to these issues.

Despite prolonged discussion between 1972 and 1974, there could not be any headway towards evolving measures for reforming the system. An agreement was finally reached at a meeting in Jamaica in 1976 concerning some amendments to the Articles of Agreement of the IMF. These were to be enforced from 1978. There was only a limited purpose behind it to make the system of managed float work better.