Definition of Bretton Woods and the International Monetary Fund (IMF)

Of paramount importance to the representatives at the 1944 meeting in Bretton Woods was the prevention of another breakdown of the international financial order, such as the one, which followed the peace after the First World War. From 1918 until well into the 1920s the world had witnessed a rise in protectionism on a grand scale to protect jobs for those returning the war, competitive devaluations designed for the same effect, and massive hyperinflation as the inability to raise conventional taxes led to use of the hidden tax of inflation: inflation shifts buying power from the holders of money, whose holdings buy less to the issuers of money, the central banks. A system was required that would keep countries from changing exchange rates to obtain a trading advantages and to limit inflationary policy. This meant that some sort of control on rate changes was needed, as well as a reserve base for deficit countries. The reserves were to be provided via an institution created for the purpose. The International Monetary Fund (IMF) was established to collect and allocate reserves in order to implement the Articles of Agreement signed in Bretton Woods.

The Articles of Agreement required IMF member countries (of which there were 178 as of March 1994) to:

Promote International Monetary Cooperation

Facilitate the growth of trade

Establish a system of multilateral payments

Create a reserve base

The reserves were contributed by the member countries according to a quota system (since then many times revised) base on the national income and importance of trade in different countries. Of the original contribution, 25 percent was in gold- the so-called gold tranche position- and the remaining 75 percent was in the country’s own currency. A country was allowed to borrow up to its gold-tranche contribution without IMF approval and to borrow an additional 100 percent of its total contribution in four steps, each with additional stringent conditions established by the IMF. These conditions were designed to ensure that corrective macroeconomic policy actions would be taken. The lending facilities have been expanded over the years. Standby arrangements were introduced in 1952, enabling a country to have funds appropriated ahead of the need so that currencies would be less open to attack during the IMF’s deliberation of whether help would be made available. Other extensions of the IMF’s lending ability took the form of:

The Compensating Financing Facility, introduced in 1963 to help countries with temporarily inadequate foreign exchange reserves as a result of events such as crop failures.

The Extended Fund Facility of 1974, providing loans for countries with structural difficulties that take longer to correct.

The Trust Fund from the 1976 Kingston Agreement to allow the sale of goods, which was no longer to have a formal role in the international financial system. The proceeds of gold sales are used for special development loans.

The Supplementary Financing Facility, also known as the Witteveen Facility after the then managing director of the IMF. This gives standby credits and replaced the 1974-1976 Oil Facility, which was established to help countries with temporary difficulties resulting from oil price increases.

The Buffer Stock Facility, which grants loans to enable countries to purchase crucial inventories.

These facilities were supplemented by the 1980 decision allowing the IMF to borrow in the private capital market when necessary and by the extension of borrowing authority in the 1990 General Arrangements to Borrow, Which allows the IMF to lend to nonmembers. The scope of the IMF’s power to lend was further expanded in 1993, when new facilities to assist in exchange-rate stabilization were made available.

As we have seen, the most important feature of the Bretton Woods agreement was the decision to have the U.S. dollar freely convertible into gold and to have the values of other currencies fixed in U.S. dollars. The exchange rates were to be maintained within 1 percent on either side of the official parity, with intervention required as the support points. This required to the United States to maintain a reserve of gold, and other countries to maintain reserve of U.S. dollars. Because the initially selected exchange rates could have been incorrect for balance-of-payments (BoP) equilibrium, each country was allowed a revision of up to 10 percent within a year of the initial selection of the exchange rate. In this basic form the system survived until 1971.

The central place of the U.S. dollar was viewed by John Maynard Keynes as a potential weakness. Keynes preferred an international settlement system based on a new currency unit, the Bancor. However, the idea was rejected, and it was not until the 1960s that the inevitable collapse of the Bretton Woods arrangement was recognized by a Yale economist, Robert Triffin. According to the Triffin Paradox, in order for the stock of world reserves to grow along with world trade, the provider of reserves, the United States, had to run BoP deficits. These deficits were the means by which other countries could accumulate dollar reserves. Although the U.S. deficits were needed, the more they occurred, the more the holders of dollars doubted the ability of the United States to convert dollars into gold at the agreed price. This built-in paradox meant that the system was doomed.

Among the more skeptical holders of dollars was France, which began in 1962 to exchange dollars for gold despite the objection of the United States. Not only were the French doubtful about the future value of the dollar but they also objected to the prominent role of the United States was political, and part was base on the seigniorage gains that France believed accrued to the United States by virtue of the U.S. role as the world’s banker. Seigniorage is the profit from “printing” money and depends on the ability to have people hold your currency or other assets at a noncompetitive yield. Every government which issues legal-tender currency can ensure that it is held by its own citizens, even if it offers no yield at all. For example, U.S. citizens will hold Federal Reserve notes and give up goods or services for them, even though the paper the notes are printed on costs very little to provide.

The United States was in a special position because its role as the leading provider of well as U.S. citizens would hold U.S. dollars. However, most reserves of foreign central banks were and are kept in securities such as treasury bills, which yield interest. If the interest that is paid on the reserve assets is a competitive yield, then the seigniorage gains to the United State from foreign holding U.S. dollar assets is small. Indeed, with sufficient competition from

Alternative reserves of different currencies and

Alternative dollar investments in the United States, seigniorage gains would be competed away.

Nevertheless, the French continued to convert their dollar holdings into gold. This led other countries to worry about whether the United States would have sufficient gold to support the U.S. dollar the French had finished selling their dollars: under a fractional reserve standard, gold reserves are only a fraction of dollars held. By 1968, the run on gold was of such a scale that a March meeting in Washington, D.C., a two-tier gold-pricing system was established. While the official U.S. price of gold was to remain at $35 per ounce, the private-market price of gold was to be allowed to find its own level.

After repeated financial crises, including a devaluation of the pound from $2.80/£ to $2.40/£ in 1967, some relief came in 1970 with the allocation of Special Drawing Rights (SDRs). The SDRs are book entries that are credited to the Accounts of IMF member countries according to their established quotas. They can used to meet payments imbalances, and they provide a net addition to the stock of reserves without the need for any country to run deficits or mine gold. From 1970 to 1972, approximately $9.4 billion worth of the SDRs (or paper gold) was created, and there was no further allocation until January 1, 1979, when SDR 4 billion was created. Similar amounts were created on January 1, 1980, and on January 1, 1981, bringing the total to over SDR 20 billion. No allocations of SDRs have occurred since 1981. A country can draw on its SDRs as long as it maintains an average of more than 30 percent of its cumulative allocation, and a country is required to accept up to 3 times its total allocation. Interest is paid to those who hold SDRs and by those who draw down their SDRs, with the rate based on an average of money-market interest rates in the United States, the United Kingdom, Germany, Japan, and France.

The SDR was originally set equal in value to the gold content of a U.S. dollar in 1969, which was 0.888571 grams, or 1/35 oz. The value was latter revised first being based on a weighted basket of 16 currencies and subsequently being simplified to 5 currencies. The amount of each currency and the U.S. dollar equivalents are the currency basket and the weights are revised every 5 years according to the importance of each country in international trade. The value of the SDR is quoted daily.

If the SDR had arrived earlier, it might have prevented or postponed the collapse of the Bretton Woods system, but by 1971, the fall was imminent. After only two major revisions of exchange rates in the 1950s and 1960s- the floating of the Canadian dollar during the 1950s and the devaluation of sterling in 1967- events suddenly began to unfold rapidly. On August 15, 1971, the United States responded to a huge was placed on imports, and a grogram of wage and price controls was introduced. Many of the major currencies were allowed to float against the dollar, and by the end of 1971 most had appreciated, with the German mark and the Japanese yen both up 12 percent. The dollar had begun a decade of decline.

On August 15, 1971, the United States made it clear that it was no longer content to support a system based on the U.S. dollar. The costs of being a reserve currency were perceived as having begun to exceed any benefit in terms of seigniorage. The 10 largest countries were called together for a meeting at the Smithsonian Institution in Washington in Washington, D.C. As a result of the Smithsonian Agreement, the United States raised the price of gold to $38 per ounce (that is, devalued the dollar). Each of the other countries in return revalued its currency by an amount of up to 10 percent. The band around the new official parity values was increased from 1 percent to 21/₄ on either side, but several European Community countries kept their own exchange rates within a narrow range of each other while jointly allowing the 41/₂ percent band vis-à-vis the dollar. As we have seen, the “snake,” as the European fixed-exchange-rate system was called, became, with some minor revisions, the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) in 1979.

The dollar devaluation was insufficient to restore stability to the system. U.S. inflation had become a serious problem. By 1973 the dollar was under heavy selling pressure even at its devalued or depreciated rates, and in February 1973, the price of gold was raised 11 percent, from $38 to $42.22 per ounce. By the next month most major currencies were floating. This was the unsteady sate of the international financial system as it approached the oil crisis of the fall of 1973.