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The Fall of the Bretton Woods System

In some respects, there are a great many parallels we can draw between the collapse of the Bretton Woods global currency exchange regime and the ongoing crisis with the Euro. Both the Bretton Woods system and the Euro were/are politically motivated projects aimed to both increase trade and promote peace and integration. Yet both projects are arguably beset by fundamental economic problems which were not fully understood at the time of implementation. In this piece I want to explain how the Bretton Woods system ultimately collapsed because of the failure to realise economic realities and the failure to pursue appropriate reforms; perhaps a lesson for policymakers in Europe at this crucial time.

As discussed in previous articles, the Bretton Woods system essentially comprised a series of fixed exchange rates linked to the value of the dollar (which was freely convertible to gold), with the aim of re-kindling international trade and economic growth through eliminating exchange rate uncertainty after the Second World War. For much of the 1950s and 60s, the system seemed to operate relatively successfully as the UK, among other Western nations, experienced somewhat of a Golden Age of prosperity. However, such golden times were inevitably going to end. During the late 1960s, the system began to show increasing signs of vulnerability as global speculators and foreign exchange traders attempted to avoid restrictions on the movement of capital (money). A symptom of this was dramatically displayed in the UK in 1967, when the then Labour government of Harold Wilson was forced to devalue the pound from $2.80 to $2.40.

The demise of the Bretton woods system can be attributed primarily to international price differences which caused deviations from the purchasing power parity (PPP) condition – whereby the price a basket of goods in one country is equal to the price of a basket of goods in a second country. In monetary theory, we assume that traders will seek out all opportunities for ‘arbitrage’ (making a profit by buying good in country X and selling it in country Y for a higher relative price). Price differences arose because monetary and fiscal policies were not consistent in the member countries under restricted capital mobility (i.e. arbitrage was illegal in many instances), and the balance of economic power simply changed too rapidly for the prevailing fixed exchange rates to be continued indefinitely. For example, both the currencies of Germany and Japan became increasingly undervalued at the rate set in 1944, as both countries began to run considerable trade surpluses. In a floating exchange system, the existence of trade surplus would be corrected by a market revaluation (appreciation) of the currencies, which would function through arbitrage activities. However, the national governments of Japan and Germany were unwilling to negotiate a change in the rate, as they benefited from the trade surplus through export lead growth. The flip-side of under-valuation was that the US dollar and UK pound were overvalued. In contrast to the Germans (ever conscious of the damages of hyperinflation) both the successive UK governments and US Presidents promised high growth rates (4-5%) which were to be achieved by expansionary monetary policy. The US, in particular, suffered from this policy as overvalued dollars began to leave the US. This practice was eventually curtailed by stricter capital controls, creating a Euro-dollar market in the rest of the world. The US further debased their currency in war expenditure in Vietnam in the early 1960s.

US gold reserves in Fort Knox experienced a damaging series of runs. Between 1961 and 1971, the total amount of gold shrank from $18 billion to $11 billion at a fixed $35 per ounce. The US ran a chronic balance-of-payments deficit in this period; foreign-held external dollar liabilities exceeded gold reserves as early as 1960 (i.e. if all investors that held dollars across the world asked to exchange for gold, the US treasury would be forced to default!) The gold rushes brought unbearable pressure on the Bretton Woods system, eventually forcing the Nixon administration to suspend convertibility and impose a flat 10% import tax, which was only resolved by the Smithsonian agreement in 1971. The 1971 agreement aimed to change some of the exchange rates to better reflect the competitiveness of national economies linked to the dollar, but this proved too little too late and the Bretton Woods system finally collapsed in 1973. From that period until the present day, no attempt to re-align global currencies into a fixed exchange rate regime has been successful.

The principle lesson to be drawn from the experience of Bretton Woods is that any diplomatic agreement across nation states involving the fixing of economic variables needs to have a degree of flexibility embedded within. This way, changes in economic fundamentals, such as productivity and creditworthiness, can be accounted for without damaging the functionality of the system itself. The fixed dollar exchange rates were based on the relative strength of global economies in 1945, and would rapidly have little relevance when the devastated economies of Germany and Japan, in particular, caught up to the level of development of the US and the UK. A similar situation underpins the economic foundations of the Euro-crisis, which is essentially a problem of weaker economies having a currency stronger than its underlying productivity levels would suggest. The collapse of Bretton Woods would coincide with a further turbulent period in global economic history, marked by the phenomenon of rising inflation and rising unemployment.

Stagflation and the Demise of the Phillips Curve
The Bretton Woods System and the Golden Age of Capitalism