Bretton Woods system
The Bretton Woods system of international economic management established the rules for commercial and financial relations among the world's major industrial states. The Bretton Woods system was the first example of a fully negotiated monetary order in world history intended to govern monetary relations among independent nation-states.
Preparing to rebuild global capitalism as World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel, situated in the New Hampshire resort town of Bretton Woods, for the United Nations Monetary and Financial Conference. The delegates deliberated upon and finally signed the Bretton Woods Agreement during the first three weeks of July 1944.
Setting up a system of rules, institutions, and procedures to regulate the international political economy, the planners at Bretton Woods established the International Bank for Reconstruction and Development (later divided into the World Bank and Bank for International Settlements) and the International Monetary Fund. These organizations became operational in 1946 after a sufficient number of countries had ratified the agreement.
The chief features of the Bretton Woods system were, first, an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold; and, secondly, the provision by the IMF of finance to bridge temporary payments imbalances. In face of increasing strain, the system eventually collapsed in 1971, following the United States' suspension of convertibility from dollars to gold.
The origins of the Bretton Woods system
The political bases for the Bretton Woods system are to be found in the confluence of several key conditions: the shared experiences of the Great Depression, the concentration of power in a small number of states, and the presence of a dominant power willing and able to assume a leadership role.
The experiences of the Great Depression
A high level of agreement among the powerful on the goals and means of international economic management facilitated the decisions reached by the Bretton Woods Conference. The foundation of that agreement was a shared belief in capitalism. Although the developed countries differed somewhat in the type of capitalism they preferred for their national economies (France, for example, preferred greater planning and state intervention, whereas the United States favored relatively limited state intervention); all nevertheless relied primarily on market mechanisms and on private ownership.
Thus, it is their similarities rather than their differences that appear most striking. All the participating governments at Bretton Woods agreed that the monetary chaos of the interwar period had yielded several valuable lessons.
The experience of the Great Depression, when proliferation of exchange controls and trade barriers led to economic disaster, was fresh on the minds of public officials. The planners at Bretton Woods hoped to avoid a repeat of the debacle of the 1930s, when exchange controls undermined the international payments system that was the basis for world trade. The "beggar thy neighbor" policies of 1930s governments—using currency devaluations to increase the competitiveness of a country's export products in order to reduce balance of payments deficits—worsened national deflationary spirals, which resulted in plummeting national incomes, shrinking demand, mass unemployment, and an overall decline in world trade. Trade in the 1930s became largely restricted to currency blocs (groups of nations that use an equivalent currency, such as the "Pound Sterling Bloc" of the British Empire). These blocs retarded the international flow of capital and foreign investment opportunities. Although this strategy tended to increase government revenues in the short-run, it dramatically worsened the situation in the medium and longer-run.
Thus, for the international economy, planners at Bretton Woods all favored a liberal system, one that relied primarily on the market with the minimum of barriers to the flow of private trade and capital. Although they disagreed on the specific implementation of this liberal system, all agreed on an open system.
Also based on experience of interwar years, U.S. planners developed a concept of economic security—that a liberal international economic system would enhance the possibilities of postwar peace. One of those who saw such a security link was Cordell Hull, the U.S. secretary of state from 1933 to 1944.1 Hull believed that the fundamental causes of the two world wars lay in economic discrimination and trade warfare. Specifically, he had in mind the trade and exchange controls (bilateral arrangements) of Nazi Germany and the imperial preference system practiced by Britain (by which members or former members of the British Empire were accorded special trade status). Hull argued that
unhampered trade dovetailed with peace; high tariffs, trade barriers, and unfair economic competition, with war... if we could get a freer flow of trade... freer in the sense of fewer discriminations and obstructions... so that one country would not be deadly jealous of another and the living standards of all countries might rise, thereby eliminating the economic dissatisfaction that breeds war, we might have a reasonable chance of lasting peace.2
The rise of governmental intervention
The developed countries also agreed that the liberal international economic system required governmental intervention. In the aftermath of the Great Depression, public management of the economy had emerged as a primary activity of governments in the developed states. Employment, stability, and growth were now important subjects of public policy. In turn, the role of government in the national economy had become associated with the assumption by the state of the responsibility for assuring of its citizens a degree of economic well-being. The welfare state grew out of the Great Depression, which created a popular demand for governmental intervention in the economy, and out of the theoretical contributions of the Keynesian school of economics, which asserted the need for governmental intervention to maintain adequate levels of employment.
At the international level, these ideas also evolved from the experience of the 1930s. The priority of national goals, independent national action in the interwar period, and the failure to perceive that those national goals could not be realized without some form of international collaboration resulted in "beggar-thy-neighbor" policies such as high tariffs and competitive devaluations contributed to economic breakdown, domestic political instability, and international war. The lesson learned was that, as New Dealer Harry Dexter White, the principal architect of the Bretton Woods system, put it:
the absence of a high degree of economic collaboration among the leading nations will... inevitably result in economic warfare that will be but the prelude and instigator of military warfare on an even vaster scale.3
To ensure economic stability and political peace, states agreed to cooperate to regulate the international economic system. The pillar of the U.S. vision of the postwar world was free trade. Free trade involved lowering tariffs and among other things a balance of trade favorable to the capitalist system.
Thus, the more developed market economies agreed to the U.S. vision of postwar international economic management, which was to be designed to create and maintain an effective international monetary system and foster the reduction of barriers to trade and capital flows.
The rise of U.S. hegemony
International economic management relied on the dominant power to lead the system. The concentration of power facilitated management by confining the number of actors whose agreement was necessary to establish rules, institutions, and procedures and to carry out management within the agreed system. That leader was, of course, the United States. As the world's foremost economic and political power, the United States was clearly in a position to assume the responsibility of leadership.
The United States had emerged from the Second World War as the strongest economy in the world, experiencing rapid industrial growth and capital accumulation. The U.S. had remained untouched by the ravages of World War II and had built a thriving manufacturing industry and grown wealthy selling weapons and lending money to the other combatants; in fact, U.S. industrial production in 1945 was more than double that of annual production between the prewar years of 1935 and 1939. In contrast, Europe and Japan were militarily and economically shattered.
As the Bretton Woods Conference convened, the relative advantages of the U.S. economy were undeniable and overwhelming. The U.S. held a majority of world investment capital, manufacturing production and exports. In 1945, the U.S. produced half the world's coal, two-thirds of the oil, and more than half of the electricity. The U.S. was able to produce great quantities of ships, airplanes, land vehicles, armaments, machine tools, chemical products, and so on. Reinforcing the initial advantage—and assuring the U.S. unmistakable leadership in the capitalist world—the U.S. held 80 percent of the world's gold reserves and had not only a powerful army but also the atomic bomb.
As the world's greatest industrial power, and one of the few nations unravaged by the war, the U.S. stood to gain more than any other country from the opening of the entire world to unfettered trade. The United States would have a global market for its exports, and it would have unrestricted access to vital raw materials.
The United States was not only able, it was also willing, to assume this leadership role. Although the U.S. had more gold, more manufacturing capacity and more military power than the rest of the world put together, U.S. capitalism could not survive without markets and allies. William Clayton, the assistant secretary of state for economic affairs, was among myriad U.S. policymakers who summed up this point: "We need markets—big markets—around the world in which to buy and sell."
There had been many predictions that peace would bring a return of depression and unemployment, as war production ceased and returning soldiers flooded the labor market. Compounding the economic difficulties was a sharp rise in labor unrest. Determined to avoid another economic catastrophe like that of the 1930s, U.S. President Franklin D. Roosevelt saw the creation of the postwar order as a way to ensure continuing U.S. prosperity.
The Atlantic Charter
Throughout the war, the United States envisaged a postwar economic order in which the U.S. could penetrate markets that had been previously closed to other currency trading blocs, as well as to open up opportunities for foreign investments for U.S. corporations by removing restrictions on the international flow of capital.
The Atlantic Charter, drafted during President Roosevelt's August 1941 meeting with British Prime Minister Winston Churchill on a ship in the North Atlantic was the most notable precursor to the Bretton Woods Conference. Like Woodrow Wilson before him, whose "Fourteen Points" had outlined U.S. aims in the aftermath of the First World War, Roosevelt set forth a range of ambitious goals for the postwar world even before the U.S. had entered the Second World War. The Atlantic Charter affirmed the right of all nations to equal access to trade and raw materials. Moreover, the charter called for freedom of the seas (a principal U.S. foreign policy aim since France and Britain had first threatened U.S. shipping in the 1790s), the disarmament of aggressors, and the "establishment of a wider and permanent system of general security."
As the war drew to a close, the Bretton Woods Conference was the culmination of some two and a half years of planning for postwar reconstruction by the Treasuries of the U.S. and the UK. U.S. representatives studied with their British counterparts the reconstitution of what had been lacking between the two world wars: a system of international payments that would allow trade to be conducted without fear of sudden currency depreciation or wild fluctuations in exchange rates—ailments that had nearly paralyzed world capitalism during the Great Depression.
Without a strong European market for U.S. goods and services, most policymakers believed, the U.S. economy would be unable to sustain the prosperity it had achieved during the war. In addition, U.S. unions had only grudgingly accepted government-imposed restraints on their demand during the war, but they were willing to wait no longer, particularly as inflation cut into the existing wage scales with painful force. (By the end of 1945, there had already been major strikes in the automobile, electrical, and steel industries.)
Financier and self-appointed adviser to presidents and congressmen, Bernard Baruch, summed up the spirit of Bretton Wood in early 1945: if we can "stop subsidization of labor and sweated competition in the export markets," as well as prevent rebuilding of war machines, "oh boy, oh boy, what long term prosperity we will have."4 Thus, the United States would use its predominant position to restore an open world economy, unified under U.S. control, which gave the U.S. unhindered access to markets and raw materials.
Wartime devastation of Europe and Japan
Furthermore, U.S. allies—economically exhausted by the war—accepted this leadership. They needed U.S. assistance to rebuild their domestic production and to finance their international trade; indeed, they needed it to survive.
Before the war, the French and the British were realizing that they could no longer compete with U.S. industry in an open marketplace. During the 1930s, the British had created their own economic bloc to shut out U.S. goods. Churchill did not believe that he could surrender that protection after the war, so he watered down the Atlantic Charter's "free access" clause before agreeing to it.
Yet, U.S. officials were determined to break open the empire. Combined, British and U.S. trade accounted for well over half the world's exchange of goods. If the British bloc could be split apart, the U.S. would be well on its way to opening the entire global marketplace. But as the nineteenth century had been economically dominated by Britain, the second half of the twentieth was to be one of U.S. hegemony.
A devastated Britain had little choice. Two world wars had destroyed the country's principal industries that paid for the importation of half the nation's food and nearly all its raw materials except coal. The British had no choice but to ask for aid. In 1945, the U.S. agreed to a loan of 3.8 billion. In return, weary British officials promised to negotiate the agreement.
For nearly two centuries, French and U.S. interests had clashed in both the Old World and the New World. During the war, French mistrust of the United States was embodied by General Charles de Gaulle, president of the French provisional government. De Gaulle bitterly fought U.S. officials as he tried to maintain his country's colonies and diplomatic freedom of action. In turn, U.S. officials saw de Gaulle as a political extremist.
But in 1945 de Gaulle—the leading voice of French nationalism—was forced to grudgingly ask the U.S. for a billion dollar loan. Most of the request was granted; in return France promised to curtail government subsidies and currency manipulation that had given its exporters advantages in the world market.
On a far more profound level, as the Bretton Woods conference was convening, the greater part of the Third World remained politically and economically subordinate. Linked to the developed countries of the West economically and politically—formally and informally—these states had little choice but to acquiesce to the international economic system established for them. In the East, Soviet hegemony in Eastern Europe provided the foundation for a separate and stable international economic system.
In short, the confluence of these three favorable political conditions—the concentration of power, the cluster of shared interests and ideas, and the hegemony of the United States—provided the political capability to equal the tasks of managing the international economy.
The design of the Bretton Woods system
Free trade relied on the free convertibility of currencies. Negotiators at the Bretton Woods Conference, fresh from what they perceived as a disastrous experience with floating rates in the 1930s, concluded that major monetary fluctuations could stall the free flow of trade.
The liberal economic system required an accepted vehicle for investment, trade, and payments. Unlike national economies, however, the international economy lacks a central government that can issue currency and manage its use. In the past this problem had been solved through the gold standard, but the architects of Bretton Woods did not consider this option feasible for the postwar political economy. Instead, they set up a system of fixed exchange rates managed by a series of newly created international institutions using the U.S. dollar as a reserve currency.
In the nineteenth and twentieth centuries gold played a key role in international monetary transactions. The gold standard was used to back currencies; the international value of currency was determined by its fixed relationship to gold; gold was used to settle international accounts. The gold standard maintained fixed exchange rates that were seen as desirable because they reduced the risk of trading with other countries.
Imbalances in international trade were theoretically rectified automatically by the gold standard. A country with a deficit would have depleted gold reserves and would thus have to reduce its money supply. The resulting fall in demand would reduce imports and the lowering of prices would boost exports; thus the deficit would be rectified. Any country experiencing inflation would lose gold and therefore would have a decrease in the amount of money available to spend. This decrease in the amount of money would act to reduce the inflationary pressure. Supplementing the use of gold in this period was the British pound. Based on the dominant British economy, the pound became a reserve, transaction, and intervention currency. But the pound was not up to the challenge of serving as the primary world currency, given the weakness of the British economy after the Second World War.
The architects of Bretton Woods had conceived of a system wherein exchange rate stability was a prime goal. Yet, in an era of more activist economic policy, governments did not seriously consider permanently fixed rates on the model of the classical gold standard of the nineteenth century. Gold production was not even sufficient to meet the demands of growing international trade and investment. And a sizable share of the world's known gold reserves were located in the Soviet Union, which would later emerge as a Cold War rival of the United States and Western Europe.
The only currency strong enough to meet the rising demands for international liquidity was the US dollar. The strength of the U.S. economy, the fixed relationship of the dollar to gold ($35 an ounce), and the commitment of the U.S. government to convert dollars into gold at that price made the dollar as good as gold. In fact, the dollar was even better than gold: it earned interest and it was more flexible than gold.
The Bretton Woods system of fixed exchange rates
The Bretton Woods system sought to secure the advantages of the gold standard without its disadvantages. Thus, a compromise was sought between the polar alternatives of either freely floating or irrevocably fixed rates—an arrangement that might gain the advantages of both without suffering the disadvantages of either while retaining the right to revise currency values on occasion as circumstances warranted.
The rules of Bretton Woods, set forth in the articles of agreement of the IMF and the International Bank for Reconstruction and Development, provided for a system of fixed exchange rates. The rules further sought to encourage an open system by committing members to the convertibility of their respective currencies into other currencies and to free trade.
The "pegged rate" or "par value" currency regime
What emerged was the "pegged rate" currency regime. Members were obligated to establish a parity of their national currencies in terms of gold (a "peg") and to maintain exchange rates within 1 percent, plus or minus, of parity (a "band") by intervening in their foreign exchange markets (that is, buying or selling foreign money).
The "reserve currency"
In practice, however, since the principal "reserve currency" would be the U.S. dollar, this meant that other countries would peg their currencies to the U.S. dollar, and—once convertibility was restored—would buy and sell U.S. dollars to keep market exchange rates within 1 percent, plus or minus, of parity. Thus, the U.S. dollar took over the role that gold had played under the gold standard in the international financial system.
Meanwhile, in order to bolster faith in the dollar, the U.S. agreed separately to link the dollar to gold at the rate of $35 per ounce of gold. At this rate, foreign governments and central banks were able to exchange dollars for gold. Bretton Woods established a system of payments based on the dollar, in which all currencies were defined in relation to the dollar, itself convertible into gold, and above all, "as good as gold." The U.S. currency was now effectively the world currency, the standard to which every other currency was pegged. As the world's key currency, most international transactions were denominated in dollars.
The U.S. dollar was the currency with the most purchasing power and it was the only currency that was backed by gold. Additionally, all European nations that had been involved in World War II were highly in debt and transferred large amounts of gold into the United States, a fact that contributed to the supremacy of the United States. Thus, the U.S. dollar was strongly appreciated in the rest of the world and therefore became the key currency of the Bretton Woods system.
Member countries could only change their par value with IMF approval, which was contingent on IMF determination that its balance of payments was in a "fundamental disequilibrium."
The Bretton Woods Conference led to the establishment of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (now known as the World Bank), which still remain powerful forces in the world economy.
As mentioned, a major point of common ground at the Conference was the goal to avoid a recurrence of the closed markets and economic warfare that had characterized the 1930s. Thus, negotiators at Bretton Woods also agreed that there was a need for an institutional forum for international cooperation on monetary matters. Already in 1944 the British economist John Maynard Keynes emphasized "the importance of rule-based regimes to stabilize business expectations"—something he accepted in the Bretton Woods system of fixed exchanged rates. Currency troubles in the interwar years, it was felt, had been greatly exacerbated by the absence of any established procedure or machinery for inter-governmental consultation.
As a result of the establishment of agreed upon structures and rules of international economic interaction, conflict over economic issues was minimized, and the significance of the economic aspect of international relations seemed to recede.
The International Monetary Fund
Officially established on December 27, 1945, when the 29 participating countries at the conference of Bretton Woods signed its Articles of Agreement, the IMF was to be the keeper of the rules and the main instrument of public international management. The Fund commenced its financial operations on March 1, 1947. IMF approval was necessary for any change in exchange rates. It advised countries on policies affecting the monetary system.
Designing the IMF
The big question at the Bretton Woods Conference with respect to the institution that would emerge as the IMF was the issue of future access to international liquidity and whether that source should be akin to a world central bank able to create new reserves at will or a more limited borrowing mechanism.
Although attended by 44 nations, discussions at the conference were dominated by two rival plans developed by the U.S. and Britain. As the chief international economist at the U.S. Treasury in 1942–44, Harry Dexter White drafted the U.S. blueprint for international access to liquidity, which competed with the plan drafted for the British Treasury by the eminent British economist John Maynard Keynes. Overall, White's scheme tended to favor incentives designed to create price stability within the world's economies, while Keynes' wanted a system that encouraged economic growth.
At the time, gaps between the White and Keynes plans seemed enormous. Outlining the difficulty of creating a system that every nation could accept in his speech at the closing plenary session of the Bretton Woods Conference on July 22, 1944, Keynes stated:
We, the delegates of this Conference, Mr. President, have been trying to accomplish something very difficult to accomplish.[...] It has been our task to find a common measure, a common standard, a common rule acceptable to each and not irksome to any.5
Keynes' proposals would have established a world reserve currency administered by a central bank (which he thought might be called "bancor") vested with the possibility of creating money and with the authority to take actions on a much larger scale (understandable considering deflationary problems in Britain at the time).
In case of balance of payments imbalances, Keynes recommended that both debtors and creditors should change their policies. As outlined by Keynes, countries with payment surpluses should increase their imports from the deficit countries and thereby create a foreign trade equilibrium. Thus, Keynes was sensitive to the problem that placing too much of the burden on the deficit country would be deflationary.
But the U.S., as a likely creditor nation, and eager to take on the role of the world's economic powerhouse, balked at Keynes' plan and did not pay serious attention to it. The U.S. contingent was too concerned about inflationary pressures in the postwar economy, and White saw an imbalance as a problem only of the deficit country.
Although compromise was reached on some points, because of the overwhelming economic and military power of the U.S., the participants at Bretton Woods largely agreed on White's plan. As a result, the IMF was born with an economic approach and political ideology that stressed controlling inflation and introducing austerity plans over fighting poverty. This left the IMF severely detached from the realities of Third World countries struggling with underdevelopment from the onset.
Subscriptions and quotas
What emerged largely reflected U.S. preferences: a system of subscriptions and quotas embedded in the IMF, which itself was to be no more than a fixed pool of national currencies and gold subscribed by each country as opposed to a world central bank capable of creating money. The Fund was charged with managing various nations' trade deficits so that they would not produce currency devaluations that would trigger a decline in imports.
The IMF was provided with a fund, composed of contributions of member countries in gold and their own currencies. The original quotas planned were to total $8.8 billion. When joining the IMF, members were assigned "quotas" reflecting their relative economic power, and, as a sort of credit deposit, were obliged to pay a "subscription" of an amount commensurate to the quota. The subscription was to be paid 25 percent in gold or currency convertible into gold (effectively the dollar, which was the only currency then still directly gold convertible for central banks) and 75 percent in the member's own money.
Quota subscriptions were to form the largest source of money at the IMF's disposal. The IMF set out to use this money to grant loans to member countries with financial difficulties. Each member was then entitled to be able to immediately withdraw 25 percent of its quota in case of payment problems. If this sum was insufficient, each nation that had the system was also able to request loans for foreign currency.
Financing trade deficits
In the event of a deficit in the current account, Fund members, when short of reserves, would be able to borrow needed foreign currency from this fund in amounts determined by the size of its quota. In other words, the higher the country's contribution was, the higher the sum of money it could borrow from the IMF.
Members were obliged to pay back debts within a period of eighteen months to five years. In turn, the IMF embarked on setting up rules and procedures to keep a country from going too deeply into debt, year after year. The Fund would exercise "surveillance" over other economies for the U.S. Treasury, in return for its loans to prop up national currencies.
IMF loans were not comparable to loans issued by a conventional credit institution. Instead, it was effectively a chance to purchase a foreign currency with gold or the member's national currency.
The U.S.-backed IMF plan sought to end restrictions on the transfer of goods and services from one country to another, eliminate currency blocs and lift currency exchange controls.
The IMF was designed to advance credits to countries with balance of payments deficits. Short-run balance of payment difficulties would be overcome by IMF loans, which would facilitate stable currency exchange rates. This flexibility meant that member states would not have to induce a depression automatically in order to cut its national income down to such a low level that its imports will finally fall within its means. Thus, countries were to be spared the need to resort to the classical medicine of deflating themselves into drastic unemployment when faced with chronic balance of payments deficits. Before the Second World War, European nations often resorted to this, particularly Britain.
Moreover, the planners at Bretton Woods hoped that this would reduce the temptation of cash-poor nations to reduce capital outflow by restricting imports. In effect, the IMF extended Keynesian measures—government intervention to prop up demand and avoid recession—to protect the U.S. and the stronger economies from disruptions of international trade and growth.
Changing the par value
The IMF sought to provide for occasional discontinuous exchange-rate adjustments (changing a member's par value) by international agreement with the IMF. Member nations were permitted first to depreciate (or appreciate in opposite situations) their currencies by 10 percent. This tends to restore equilibrium in its trade by expanding its exports and contracting imports. This would be allowed only if there was what was called a "fundamental disequilibrium." A decrease in the value of the country's money was called a "devaluation" while an increase in the value of the country's money was called a "revaluation."
It was envisioned that these changes in exchange rates would be quite rare. Regrettably the notion of fundamental disequilibrium, though key to the operation of the par value system, was never spelled out in any detail—an omission that would eventually come back to haunt the regime in later years.
Never before had international monetary cooperation been attempted on a permanent institutional basis. Even more groundbreaking was the decision to allocate voting rights among governments not on a one-state, one-vote basis but rather in proportion to quotas. Since the U.S. was contributing the most, U.S. leadership was the key implication. Under the system of weighted voting the U.S. was able to exert a preponderant influence on the IMF. With one-third of all IMF quotas at the outset, enough to veto all changes to the IMF Charter on its own.
In addition, the IMF was based in Washington, D.C., and staffed mainly by its economists. It regularly exchanged personnel with the U.S. Treasury. When the IMF began operations in 1946, President Harry S. Truman named White as its first U.S. Executive Director. Since no Deputy Managing Director post had yet been created, White served occasionally as Acting Managing Director and generally played a highly influential role during the IMF's first year.
The International Bank for Reconstruction and Development
No provision was made for international creation of reserves. New gold production was assumed sufficient. In the event of structural disequilibria, it was expected that there would be national solutions—a change in the value of the currency or an improvement by other means of a country's competitive position. Few means were given to the IMF, however, to encourage such national solutions.
It had been recognized in 1944 that the new system could come into being only after a return to normalcy following the disruption of World War II. It was expected that after a brief transition period—expected to be no more than five years—the international economy would recover and the system would enter into operation.
To promote the growth of world trade and to finance the postwar reconstruction of Europe, the planners at Bretton Woods created another institution, the International Bank for Reconstruction and Development (IBRD)—now known as the World Bank. The IBRD had an authorized capitalization of $10 billion and was expected to make loans of its own funds to underwrite private loans and to issue securities to raise new funds to make possible a speedy postwar recovery. The IBRD (World Bank) was to be a specialized agency of the United Nations charged with making loans for economic development purposes.
Readjusting the Bretton Woods system
The dollar shortages and the Marshall Plan
The Bretton Wood arrangements were largely adhered to and ratified by the participating governments. It was expected that national monetary reserves, supplemented with necessary IMF credits, would finance any temporary balance of payments disequilibria. But this did not however prove sufficient to get Europe out of the doldrums.
Postwar world capitalism suffered from a huge dollar shortage. The United States was running huge balance of trade surpluses, and the U.S. reserves were immense and growing. It was necessary to reverse this flow. Dollars had to leave the United States and become available for international use. In other words, the United States would have to reverse the natural economic processes and run a balance of payments deficit.
The modest credit facilities of the IMF were clearly insufficient to deal with Western Europe's huge balance of payments deficits. The problem was further aggravated by the reaffirmation IMF Board of Governors in the provision in the Bretton Woods Articles of Agreement that the IMF could make loans only for current account deficits and not for capital and reconstruction purposes. Only the United States contribution of $570 million was actually available for IBRD lending. In addition, because the only available market for IBRD bonds was the conservative Wall Street banking market, the IBRD was forced to adopt a conservative lending policy, granting loans only when repayment was assured. Given these problems, by 1947 the IMF and the IBRD themselves were admitting that they could not deal with the international monetary system's economic problems.6
Thus, the much looser Marshall Plan—the European Recovery Program—was set up to provide U.S. finance to rebuild Europe largely through grants rather than loans. The Marshall Plan was the program of massive economic aid given by the United States to favored countries in Western Europe for the rebuilding of capitalism. In a speech to Congress on June 5, 1946, U.S. Secretary of State George Marshall stated:
The breakdown of the business structure of Europe during the war was complete. ... Europe's requirements for the next three or four years of foreign food and other essential products... principally from the United States... are so much greater than her present ability to pay that she must have substantial help or face economic, social and political deterioration of a very grave character.7
From 1947 until 1958, the United States deliberately encouraged an outflow of dollars, and, from 1950 on, the United States ran a balance of payments deficit with the intent of providing liquidity for the international economy. Dollars flowed out through various U.S. aid programs: the Truman Doctrine entailing aid to the pro-U.S. Greek and Turkish regimes, which were struggling to suppress socialist revolution, aid to various pro-U.S. regimes in the Third World, and most important, the Marshall Plan. From 1948 to 1954 the United States gave sixteen Western European countries $17 billion in outright grants.
To encourage long-term adjustment, the United States promoted European and Japanese trade competitiveness. Policies for economic controls on the defeated former Axis countries were scrapped. Aid to Europe and Japan was designed to rebuild productive and export capacity. In the long run it was expected that such European and Japanese recovery would benefit the United States by widening markets for U.S. exports, and providing locations for U.S. capital expansion.
In 1958, the World Bank created the International Finance Corporation and the International Development Agency. Both have been controversial. Critics of the IDA argue that it was designed to head off a broader based system headed by the United Nations, and that the IDA lends without consideration for the effectiveness of the program. Critics also point out that the pressure to keep developing economies "open" has lead to their having difficulties obtaining funds through ordinary channels, and a continual cycle of asset buy up by foreign investors and capital flight by locals. Defenders of the IDA pointed to its ability to make large loans for agricultural programs which aided the "Green Revolution" of the 1960s, and its functioning to stabilize and occasionally subsidize Third World governments, particularly in Latin America.
Bretton Woods then, created a system of triangular trade: the United States would use the convertible financial system to trade at a tremendous profit with developing nations, expanding industry and acquiring raw materials. It would use this surplus to send dollars to Europe, which would then be used to rebuild their economies, and make the United States the market for their products. This would allow the other industrialized nations to purchase products from the Third World, which reinforced the American role as the guarantor of stability. When this triangle became destabilized, Bretton Woods entered a period of crisis which lead ultimately to its collapse.
Bretton Woods and the Cold War
In 1945, Roosevelt and Churchill prepared the postwar era by negotiating with Joseph Stalin at Yalta about respective zones of influence; this same year U.S. and Soviet troops divided Germany into occupation zones and confronted one another in Korea.
Harry Dexter White succeeded in getting the Soviet Union to participate in the Bretton Woods conference in 1944, but his goal was frustrated when the Soviet Union would not join the IMF. In the past, the reasons why the Soviet Union chose not to subscribe to the articles by December 1945 have been the subject of speculation. But since the release of relevant Soviet archives, it is now clear that the Soviet calculation was based on the behavior of the parties that had actually expressed their assent to the Bretton Woods Agreements. The extended debates about ratification that had taken place both in the UK and the U.S. were read in Moscow as evidence of the quick disintegration of the wartime alliance.
Facing the Soviet Union, whose power had also strengthened and whose territorial influence had expanded, the United States assumed the role of leader of the capitalist camp. The rise of the postwar United States as the world's leading industrial, monetary, and military power was rooted in the impact of the U.S. military victory, in the instability of the national states in postwar Europe, and the wartime devastation of the Soviet economy.
Thus, American power had to be used to rebuild U.S.-friendly regimes and free market capitalism, especially in Europe, and prevent Soviet-backed regimes from spreading across the war-torn countries of Europe. The conflict, however, was that European nations, which still nominally held large colonial possessions overseas, could not simultaneously rebuild their own economies, and hold on to their colonial empires. The fiscal discipline imposed by Bretton Woods made the U.S. the only nation that could afford large-scale foreign deployments within the Western alliance. Over the course of the late 1940s and early 1950s, the United Kingdom and France were gradually forced to accept abandoning colonial outposts, which would in the late 1950s and early 1960s, lead to revolt and finally independence for most of their empires.
The price paid for this position—especially in the Cold War climate—was the militarization of the U.S. economy, what U.S. President Dwight D. Eisenhower called the "armament industry" and "the military-industrial complex," and the related notion that the U.S. should assume a protective role in what was referred to as "the free world." Looking back at the origins of the Cold War, in a paper that Harry Dexter White was writing at the time of his death, he lamented the "tensions between certain of the major powers" that had brought "almost catastrophic" consequences, including an "acute lack of confidence in continued political stability and the crippling fear of war on a scale unprecedented and almost unimaginable in its destructive potentialities." 
Despite the economic effort imposed by such a policy, being at the center of the international market gave the U.S. unprecedented freedom of action in pursuing its foreign affairs goals. A trade surplus made it easier to keep armies abroad and to invest outside the United States. Because other nations could not sustain foreign deployments, U.S. power to decide why, when and how to intervene in global crisis increased. The dollar continued to function as a compass to guide the health of the world economy, and exporting to the U.S. became the primary economic goal of developing or redeveloping economies. This arrangement came to be referred to as the Pax Americana, in analogy to the Pax Britannica of the late nineteenth century and the Pax Romana of the first. (See Globalism)
The Late Bretton Woods System
The U.S. balance of payments crisis (1958–1968)
After the end of World War II, the U.S. held $26 billion in gold reserves, of an estimated total of $40 billion (approx 60%). As world trade increased rapidly through the 1950s, the size of the gold base increased by only a few percent. In 1958, the U.S. trade deficit swung negative. The first U.S. response to the crisis was in the late 1950s when the Eisenhower administration placed import quotas on oil and other restrictions on trade outflows. More drastic measures were proposed, but not acted on. However, with a mounting recession that began in 1959, this response alone was not sustainable. In 1960 with Kennedy's election a decade long effort to maintain the Bretton Woods at the $35/ounce price was begun.
The design of the Bretton Woods System was that only nations could enforce gold convertibility on the anchor currency – the United States. Gold convertibility enforcement was not required, but instead, allowed. Nations could forgo converting dollars to gold, and instead hold dollars. Rather than full convertibility, it provided a fixed price for sales between central banks. However, there was still an open gold market, 80% of which was traded through London, which issued a morning "gold fix," which was the price of gold on the open market. For the Bretton Woods system to remain workable, it would either have to alter the peg of the dollar to gold, or it would have to maintain the free market price for gold near the $35 per ounce official price. The greater the gap between free market gold prices and central bank gold prices, the greater the temptation to deal with internal economic issues by buying gold at the Bretton Woods price and selling it on the open market.
The first effort was the creation of the "London Gold Pool." The theory of the pool was that spikes in the free market price of gold, set by the "morning gold fix" in London, could be controlled by having a pool of gold to sell on the open market, which would then be recovered when the price of gold dropped. Gold price spiked in response to events such as the Cuban Missile Crisis, and other smaller events, to as high as $40/ounce. The Kennedy administration began drafting a radical change of the tax system in order to spur more productive capacity, and thus encourage exports. This would culminate with his tax cut program of 1963, designed to maintain the $35 peg.
In 1967 there was an attack on the pound, and a run on gold in the "sterling area," and on November 17, 1967, the British government was forced to devalue the pound. U.S. President Lyndon Baines Johnson was faced with a brutal choice, either he could institute protectionist measures, including travel taxes, export subsidies and slashing the budget – or he could accept the risk of a "run on gold" and the dollar. From Johnson's perspective: "The world supply of gold is insufficient to make the present system workable—particularly as the use of the dollar as a reserve currency is essential to create the required international liquidity to sustain world trade and growth." He believed that the priorities of the United States were correct, and that, while there were internal tensions in the Western alliance, that turning away from open trade would be more costly, economically and politically, than it was worth: "Our role of world leadership in a political and military sense is the only reason for our current embarrassment in an economic sense on the one hand and on the other the correction of the economic embarrassment under present monetary systems will result in an untenable position economically for our allies."
While West Germany agreed not to purchase gold from the U.S., and agreed to hold dollars instead, the pressure on both the Dollar and the Pound Sterling continued. In January 1968 Johnson imposed a series of measures designed to end gold outflow, and to increase American exports. However, to no avail: on March 17, 1968, there was a run on gold, the London Gold Pool was dissolved, and a series of meetings began to rescue or reform the system as it existed. However, as long as the U.S. commitments to foreign deployment continued, particularly to Western Europe, there was little that could be done to maintain the gold peg.
The attempt to maintain that peg collapsed in November 1968, and a new policy program was attempted: to convert Bretton Woods to a system where the enforcement mechanism floated by some means, which would be set by either fiat, or by a restriction to honor foreign accounts.
Structural changes underpinning the decline of international monetary management
Return to convertibility
In the 1960 and the 1970s important structural changes eventually led to the breakdown of international monetary management. One change was the development of a high level of monetary interdependence. The stage was set for monetary interdependence by the return to convertibility of the Western European currencies at the end of 1958 and of the Japanese yen in 1964. Convertibility facilitated the vast expansion of international financial transactions, which deepened monetary interdependence.
The growth of international currency markets
Another aspect of the internationalization of banking has been the emergence of international banking consortia. Since 1964 various banks had formed international syndicates, and by 1971 over three-fourths of the world's largest banks had become shareholders in such syndicates. Multinational banks can and do make huge international transfers of capital not only for investment purposes but also for hedging and speculating against exchange rate changes.
These new forms of monetary interdependence made possible huge capital flows. During the Bretton Woods era countries were reluctant to alter exchange rates formally even in cases of structural disequilibria. Because such changes had a direct impact on certain domestic economic groups, they came to be seen as political risks for leaders. As a result official exchange rates often became unrealistic in market terms, providing a virtually risk-free temptation for speculators. They could move from a weak to a strong currency hoping to reap profits when a revaluation occurred. If, however, monetary authorities managed to avoid revaluation, they could return to other currencies with no loss. The combination of risk-free speculation with the availability of huge sums was highly destabilizing.
The decline of U.S. hegemony
A second structural change that undermined monetary management was the decline of U.S. hegemony. The U.S. was no longer the dominant economic power it had been for almost two decades. By the mid-1960s Europe and Japan had become international economic powers in their own right. With total reserves exceeding those of the U.S., with higher levels of growth and trade, and with per capita income approaching that of the U.S., Europe and Japan were narrowing the gap between themselves and the United States.
The shift toward a more pluralistic distribution of economic power led to increasing dissatisfaction with the privileged role of the U.S. dollar as the international currency. As in effect the world's central banker, the U.S., through its deficit, determined the level of international liquidity. In an increasingly interdependent world, U.S. policy greatly influenced economic conditions in Europe and Japan. In addition, as long as other countries were willing to hold dollars, the U.S. could carry out massive foreign expenditures for political purposes—military activities and foreign aid—without the threat of balance-of-payments constraints.
Dissatisfaction with the political implications of the dollar system was increased by détente between the United States and the Soviet Union. The Soviet "threat" had been an important force in cementing the Western capitalist monetary system. The U.S. political and security umbrella helped make American economic domination palatable for Europe and Japan, which had been economically exhausted by the war. As gross domestic production grew in European countries, trade grew. When common security tensions lessened, this loosened the transatlantic dependence on defence concerns, and allowed latent economic tensions to surface.
The decline of the dollar
Reinforcing the relative decline in U.S. power and the dissatisfaction of Europe and Japan with the system was the continuing decline of the dollar—the foundation that had underpinned the post-1945 global trading system. The Vietnam War and the refusal of the administration of U.S. President Lyndon B. Johnson to pay for it and its Great Society programs through taxation resulted in an increased dollar outflow to pay for the military expenditures and rampant inflation, which led to the deterioration of the U.S. balance of trade position. In the late 1960s, the dollar was overvalued with its current trading position, while the deutschmark and the yen were undervalued; and, naturally, the Germans and the Japanese had no desire to revalue and thereby make their exports more expensive, whereas the U.S. sought to maintain its international credibility by avoiding devaluation. Meanwhile, the pressure on government reserves was intensified by the new international currency markets, with their vast pools of speculative capital moving around in search of quick profits.
In contrast, upon the creation of Bretton Woods, with the U.S. producing half of the world's manufactured goods and holding half its reserves, the twin burdens of international management and the Cold War were possible to meet at first. Throughout the 1950s Washington sustained a balance of payments deficit in order to finance loans, aid, and troops for allied regimes. But during the 1960s the costs of doing so became less tolerable. By 1970 the United States held under 16 percent of international reserves. Adjustment to these changed realities was impeded by the U.S. commitment to fixed exchange rates and by the U.S. obligation to convert dollars into gold on demand.
In sum, monetary interdependence was increasing at a faster pace than international management in the 1960s, leading up to the collapse of the Bretton Woods system. New problems created by interdependence, including huge capital flows, placed stresses on the fixed exchange rate system and impeded national economic management. Amid these problems, economic cooperation decreased, and U.S. leadership declined, and eventually broke down.
The paralysis of international monetary management
"Floating" Bretton Woods (1968–1972)
By 1968, the attempt to defend the dollar at a fixed peg of $35/ounce, the policy of the Eisenhower, Kennedy and Johnson administrations, had become increasingly perishable. Gold outflows from the United States accelerated, and despite gaining assurances from Germany and other nations to hold gold, the "dollar shortage" of the 1940s and 1950s had become a dollar glut. In 1967, the IMF agreed in Rio de Janeiro to replace the tranche division set up in 1946. Special Drawing Rights were set as equal to one U.S. dollar, but were not usable for transactions other than between banks and the IMF. Nations were required to accept holding SDRs equal to three times their allotment, and interest would be charged, or credited, to each nation based on their SDR holding. The original interest rate was set at 1.5%.
The intent of the SDR system was to prevent nations from buying pegged dollars and selling them at the higher free market price, and give nations a reason to hold dollars, by crediting interest, at the same time, set a clear limit to the amount of dollars which could be held. The essential conflict was that the American role as military defender of the capitalist world's economic system was recognized, but not given a specific monetary value. In effect, other nations "purchased" American defense policy by taking a loss in holding dollars. They were only willing to do this as long as they supported U.S. military policy, because of the Vietnam war and other unpopular actions, the pro-U.S. consensus began to evaporate. The SDR agreement, in effect, monetized the value of this relationship, but did not create a market for it.
The use of SDRs as "paper gold" seemed to offer a way to balance the system, turning the IMF, rather than the U.S., into the world's central banker. The US tightened controls over foreign investment and currency, including mandatory investment controls in 1968. In 1970, U.S. President Richard Nixon lifted import quotas on oil in an attempt to reduce energy costs; instead, however, this exacerbated dollar flight, and created pressure from petro-dollars. Still, the United States continued to draw down reserves. In 1971 it had a reserve deficit of $56 Billion dollars; as well, it had depleted most of its non-gold reserves and had only 22% gold coverage of foreign reserves. In short, the dollar was tremendously overvalued with respect to gold.
"Closing the gold window"
By the early 1970s, as the Vietnam War accelerated inflation, the United States was running not just a balance of payments deficit but also a trade deficit (for the first time in the twentieth century). The crucial turning point was 1970, which saw U.S. gold coverage deteriorate from 55% to 22%. This, in the view of neoclassical economists, represented the point where holders of the dollar had lost faith in the U.S. ability to cut its budget and trade deficits.
In 1971 more and more dollars were being printed in Washington, then being pumped overseas, to pay for the nation's military expenditures and private investments. In the first six months of 1971, assets for $22 billion fled the United States. In response, on August 15, 1971, without consulting members of the international monetary system or his own State Department, Nixon unilaterally imposed 90 day wage and price controls, a 10 % import surcharge, and most importantly "closed(ing) the gold window," making the dollar inconvertible to gold directly, except on the open market.
The surcharge was dropped in December 1971 as part of a general revaluation of major currencies, which were henceforth allowed 2.25 percent devaluations from the agreed exchange rate. But even the more flexible official rates could not be defended against the speculators. By March 1976, all the world's major currencies were floating—in other words, their exchange rates were not set by governments but depended on demand across the international currency markets.
The Smithsonian Agreement
The shock of August 15 was followed by efforts under U.S. leadership to develop a new system of international monetary management. Throughout the fall of 1971, there was a series of multilateral and bilateral negotiations of the Group of Ten seeking to develop a new multilateral monetary system.
In December of 1971, on the 17th and 18th, the Group of Ten, meeting in the Smithsonian Institute in Washington, created the Smithsonian Agreement which devalued the dollar to $38 dollars an ounce, with 2.25% trading bands, and attempted to balance the world financial system using SDRs alone. It was criticized at the time, and was by design a "temporary" agreement. It failed to impose discipline on the US government, and with no other credibility mechanism in place, the pressure against the dollar in gold continued.
This resulted in gold becoming a floating asset, and in 1971 it reached $44.20/ounce, in 1972 $70.30/ounce and still climbing. By 1972, currencies began abandoning even this devalued peg against the dollar, though it would take a decade for all of the industrialized nations to do so. In February of 1973, the Bretton Woods currency exchange markets would close, after a last gasp devaluation of the dollar to $44/ounce, and only would reopen in March in a floating currency regime.
The collapse of the Bretton Woods system is a subject of intense debate, there are a variety of theories as to why it did so, ranging from the budget deficit problems, to blaming the Vietnam War, to marginal tax rates. The fundamental point of agreement is that the United States ran an increasing balance of trade deficit, and that, in the end, it could not establish credibility on reigning this deficit in. This would lead to the study in economics of credibility as a separate field, and to the prominence of "open" macro-economic models, such as the Mundell-Fleming model.
Notes and references
1For discussions of how liberal ideas motivated U.S. foreign economic policy after World War II, see, e.g., Kenneth Waltz, Man, the State and War (New York: Columbia University Press, 1969) and David P. Calleo and Benjamin M. Rowland, American and World Political Economy (Bloomington, Indiana: University of Indiana Press, 1973).
2Cordell Hull, The Memoirs of Cordell Hull, vol. 1 (New York: Macmillan, 1948), p. 81.
3Quoted in Robert A. Pollard, Economic Security and the Origins of the Cold War, 1945–1950 (New York: Columbia University Press, 1985), p.8.
4Baruch to E. Coblentz, March 23, 1945, Papers of Bernard Baruch, Princeton University Library, Princeton, N.J quoted in Walter LaFeber, Russia, America, and the Cold War (New York, 2002), p.12.
5Comments by John Maynard Keynes in his speech at the closing plenary session of the Bretton Woods Conference on July 22, 1944 in Donald Moggeridge (ed.), The Collected Writings of John Maynard Keynes (London: Cambridge University Press, 1980), vol. 26, p. 101. This comment also can be found quoted online at 
6Edward S. Mason and Robert E. Asher, The World Bank Since Bretton Woods (Washington, D.C.: The Brookings Institution, 1973), pp. 105–107, 124–135.
7Comments by U.S. Secretary of State George Marshall in his June 1947 speech "Against Hunger, Poverty, Desperation and Chaos" at a Harvard University commencement ceremony. A full transcript of his speech can be read online at