Stable currency exchange rates are a necessary incentive for expanding world trade, rising productivity, and improved standards of living. The Bretton Woods system of international institutions, such as the International Monetary Fund, the World Bank and World Trade Organization, was created to encourage stable monetary policies and discourage trade “war” via protectionist tariffs, currency devaluations and unilateral, artificial restrictions on capital flow.
Prior to World War I, international cooperation in maintaining stable exchange rates was achieved by pegging the value of a nation’s money to gold. The government which backed the currency would promise to produce a given amount of gold upon demand. Ideally, the “gold standard” was a self-regulating system:
If ever a central bank or a Treasury printed "too many" banknotes under a gold standard, the first thing that would happen would be that those excess bank notes would be returned to the Treasury by individuals demanding gold in exchange. Thus each country's domestic supply of money was linked directly to its domestic reserves of gold.
Suppose a country under the gold standard ran a trade deficit in excess of foreigners' desired investments. It, too, would find those who had sold goods to its citizens lining up outside the Treasury looking to exchange banknotes for gold. And these foreign suppliers of imports would then ship the gold back to their countries. The money stock at home would fall as gold reserves fell. And with a falling money stock would come falling prices, falling production, and falling demand for imports.
So balance of payments equilibrium would be restored, and countries' price levels kept in roughly appropriate competitive alignment, by the gold standard as sources of disequilibrium were removed by shipments of gold, or threatened shipments of gold, that raised and lowered nations' reserves. Monetary authorities would find themselves restrained from pursuing over-inflationary policies by fears of the gold drains that would result. DeLong (1997)
At least, that is the way it was supposed to work. Prior to World War I, the “gold standard”, supported by the hegemonic control exercised by the City of London, (the UK's financial sector) over the world financial system, did function more or less like the ideal. The war changed that. World War I had been costly in terms of military spending, loss of human life and labor, and particularly in France, in terms of property damage and economic dislocation. None of the Western powers who participated in the war, however, had been willing to finance it with higher taxes. Nor were the civilian populations willing to restrict imports in proportion to the export capacity lost by the war.
To make matters worse for the losers, the winners insisted on enormous payments (denominated in gold) to defray the winners losses, called “reparations”. Germany and Austria were in no position to pay these off, and in the long run, had to be bailed out with loans from the United States. In fact, the total loans to Germany between the wars exceeded the total reparations paid. In 1923, reparations, along with the above described structural problems, triggered “hyperinflation” in Germany.
All the European countries, however, not just the losers, had balance-of-payment problems. Importing more than you export lowers foreign demand for your currency. This increases the exchange rate and results in higher prices for imports, which in turn leads to wage and price inflation. One method for dealing with balance-of-payment problems is to devalue your currency. Then imports are cheaper and everyone else will have a tougher time exporting to your country. The problem is, everyone else wants to do it, too, and increase tariffs. In 1931, faced with the loss of investor confidence in central banks around the world, the industrialized nations all implemented mutually-destructive protectionist “solutions”. In the United States, for example, the infamous Smoot-Hawley Act was passed, raising tariffs.
By cutting demand in this way, they were exporting unemployment. Competitive devaluation proliferated as countries sought to gain advantage by lowering the price of their exports, and increasing the price of imports. Trade collapsed, and countries drifted towards autarchy, increasing the political tensions that culminated in war.
Bretton Woods Project (2002)
As World War II drew to a close, economists in the Allied nations came to the conclusion that future Great Depressions could be avoided by international cooperation, and the United States was in a position to command this cooperation.
In July, 1944, representatives of 43 countries gathered at Mount Washington Hotel in New Hampshire, for what became known as the Bretton Woods Conference.The conference chairman remarked:
All of us have seen the great economic tragedy of our time. We saw the worldwide depression of the 1930s. We saw currency disorders develop and spread from land to land, destroying the basis for international trade and international investment, and even an international future. In their wake, we saw unemployment and wretchedness -idle tools and wasted wealth ... We saw bewilderment and bitterness become the breeders of fascism and finally of war.
Henry Morgenthau Jr. (US Treasury Secretary); Opening Remarks to the Bretton Woods Conference, Mount Washington Hotel, New Hampshire, July 12, 1944.
At Bretton Woods, treaties were signed creating the International Monetary Fund, and the International Bank for Reconstruction and Development, which is now one of the five (5) components of the World Bank. An organization to govern tariffs, the International Trade Organization or “ITO”, never materialized. Instead, countries worked within the General Agreement on Tariffs and Trade GATT for decades, until finally the World Trade Organization was created.
As originally conceived, the IMF would:
- oversee a system of fixed but adjustable exchange rates,
- promote the currency convertibility needed to develop trade, and
- act as a lender of last resort for countries facing balance of payments crises.
Countries facing deep balance of payments problems could still devalue, but only with IMF authorization. The fixed exchange rate was not pegged directly to gold, but to the United States dollar, and the dollar, in turn, was freely convertible to gold. At that time, the world’s gold reserves were concentrated in the United States. Finally, the IMF was intended to play a role, along with the World Bank, in the reconstruction effort after the war. In fact, however, direct assistance from the United States under the “Marshall Plan” completely overshadowed the redevelopment role of Bretton Woods institutions in the reconstruction of Europe. Instead, the IMF and World Bank evolved into development agencies for the Third World.
By 1971, the United States developed its own macroeconomic problems, and President Nixon announced that the dollar would no longer be freely convertible to gold. This effectively ended the IMF regime of fixed exchange rates. However, the IMF’s role as a regulator of monetary policy remains, and its role in international intervention in monetary crises has expanded.
Critics of the IMF note that control of the organization is directly tied to a nation’s financial contribution to the Fund, and thus completely dominated by the United States and other wealthy nations. Debtor nations have virtually no representation in setting IMF policy, but in order to obtain IMF assistance, must conform their policies to IMF policy, sometimes with disastrous results, politically. The IMF is also criticized for maintaining an air of secrecy and impenetrable bureaucracy.
The International Monetary Fund: http://www.imf.org/external/about.htm
The IMF’s Critics: http://www.brettonwoodsproject.org/about/basics.html
J. Bradford DeLong, “Sloughing Toward Utopia? : Economic History of the Twentieth Century” (1997), Chapter VII. (http://econ161.berkeley.edu/TCEH/Slouch_Gold8.html)