A few weeks ago I passed a car displaying a bumpersticker which brought a smile to my face: “This Car Climbed Mt. Everest.” Here was a car owner who was unimpressed with the ubiquitous declaration we see all over New England, “This Car Climbed Mt. Washington.”
Situated a handful of miles west of Mt. Washington is the beautiful little town of Bretton Woods whose name appears in virtually every economics textbook written in the past half century. It was there that more than 700 delegates from all 44 Allied nations met for three weeks in July 1944 to hammer out a new world monetary order.
The system was adopted in 1945 after most of the countries present ratified the proposals. The new monetary order, known as the Bretton Woods Agreement, brought the International Monetary Fund, or IMF, into existence and heralded a fresh approach to world trade and cooperation.
After the disastrous economic performance during the interim world war years, which included the world-wide Great Depression and the collapse of the German economy, the nations of the world were ready for a change.
The goals of a new world order were indeed lofty. A new monetary agreement must promote price stability as well as free trade. It needed to avoid instabilities associated with inappropriate foreign exchange speculation. It should allow for each nation to achieve both external and internal economic balance, in other words, balanced trade (external) and full employment (internal).
How was this supposed to work? The ingredients were gold, the dollar, the IMF, and the International Bank for Reconstruction and Development, which grew into the World Bank.
All international member currencies were to be fixed in value against the dollar. As such, they were to always be convertible into dollars at the set rate. This would insure that the individual countries would not run monetary policies which inflated their currencies.
For example, if a nation were to unwisely pursue an inflationary monetary policy, currency traders would start exchanging that nation’s currency into dollars. That would cause the nation in question to lose its dollar reserves, thereby forcing it to tighten monetary policy to stop the capital exodus and thereby restore price stability.
What would safeguard the value of the dollar? The dollar was fixed to gold at $35 per ounce. The U.S. was to accommodate the unrestricted exchange of dollars for gold. This was believed by the delegates in Bretton Woods to keep the world money “honest.”
As the architects of this system considered the various possible economic scenarios, it was clear more was needed than a dollar fix to gold and a currency fix to the dollar.
For example, what if a country were to experience a temporary recession which resulted in a flow of funds out of that country? Such a country could experience a total depletion of its dollar reserves as it tried to defend against devaluation, and that defense would serve to worsen the recession.
In contrast, what if another country were to experience a sustained long term increase in productivity relative to other countries, which resulted in a perpetual trade surplus? Such a country would experience an external imbalance which would generate a limitless rise in dollar and other foreign reserves as it attempted to “sterilize” or offset the trade surplus by purchasing dollars and other currencies.
In the case of the former dilemma, the IMF was the answer. Each country, at the outset, contributed gold and currency to the IMF who would then lend funds to a country that found itself in a temporary reserve shortage.
In the latter case of a “fundamental disequilibrium” as it was called but not defined, a revaluation or devaluation was allowed under the terms of the system. This was supposed to be a rare occurrence.
This sounds pretty good, or does it? Since we no longer have this system of exchange rates we can safely assume that something went amuck.
As early as 1950, five short years after its adoption, the great economist, Milton Friedman, published a well quoted essay entitled, “The Case for Flexible Exchange Rates.” In essence, Friedman foretold the demise of Bretton Woods 21 years before it completely collapsed.
The first and perhaps most important thing to be wrong with Bretton Woods was the dollar convertibility into gold. As we have examined a few times in the column, fixing a currency to a commodity is a very bad idea. Why?
Simply put, the supply of gold in the world has very little to do with economic performance and price stability, but the amount of money in circulation can have profound effects on both. Wedding the latter to the former causes the supply of money to be determined by the world supply of gold, which may or may not keep pace with economic requirements.
A sudden discovery of new gold deposits in Peru could generate world-wide inflation as the money supply expanded to match the new supply of gold. Conversely, a workers’ union strike in South Africa could generate a world-wide depression as the money supply dropped to match the reduced supply of gold.
However, this was not Friedman’s argument or concern. His analysis was more subtle, but profound and important. His issue had to do with price adjustments. As technologies change, as resources become more scarce or less scarce, as consumers’ preferences change, prices adjust to bring about production changes.
Some prices are flexible and other prices quite inflexible. Workers’ wages are among the most rigid of all prices within a market economy.
As such, if exchange rates are flexible, they can generate the necessary price adjustments that are made difficult by wage rigidities. When exchange rates are fixed, changes in an economy can require long painful years of unemployment before normalcy returns. Friedman was right. His analysis has been observed empirically time and time again.
So how did Bretton Woods collapse? The ultimate demise happened in 1971 with the “Nixon shock” in which the U.S. declared that it would no longer exchange dollars for gold at the fixed rate.
What lead up to this? Murphy’s Law.
Everything that could go wrong, did go wrong. Nations devalued anytime it suited them to capture external trade claiming “fundamental disequilibrium.” World gold supplies failed to keep pace with economic expansion. Inflexibility of the system allowed speculators to profit from currency and gold movements since governments had to react in predictable ways.
Ultimately, the Nixon shock lead to the floating rate system we have today. Interestingly, in setting up a single currency, the eurozone has attempted to bring back the fixed exchange rate regime of Bretton Woods, but with tighter nails and screws and no gold, thank goodness.
The eurozone experience in recent years, with the high unemployment and painfully slow progress toward full employment following the economic shock of 2008 makes Friedman’s 1950 essay all the more profound and prophetic. When prices cannot adjust, the people mourn.
Despite all of this, infants are born, the aged die, families expand, and life goes on. A few years ago I saw another bumpersticker which read, “Maybe it really is all about the Hokey Pokey.”
(Marcus Hutchins, MA, M. Phil, Economics, Columbia University, NYC, is a former economist, treasury bond arbitrage trader and hedge fund manager. He retired to Southport in 1997 where he resides with his wife Andrea and his youngest daughter Abbey. He welcomes feedback at coastaleconomist@me.com.)
