The establishment of the US dollar as the global vehicle currency in 1944 during the Bretton Woods Conference influenced the global economy after World War II. This economic system created a resilient platform for the stabilization of global economic performance in the 1950s and 1960s. However, this system was short-lived and it would collapse due to inherent flaws in its structure and the failure by key sovereign member states to adhere to the set rules. In a bid to understand what changed to cause the collapse of the Bretton Woods monetary system, it is important to explain why it was created. According to Bordo, this system was established to “design a new international monetary order for the post-war, and to avoid the perceived problems of the interwar period: protectionism, beggar-thy-neighbor devaluations, hot money flows, and unstable exchange rates.” Additionally, the system was meant to create a framework of monetary and financial stability to spur worldwide economic growth and international trade. The fixed exchange rate was based on gold standards established a favorable environment for global trade and finance by offering the much-needed flexibility that nations had adopted in the 1930s for the restoration and maintenance of domestic financial and economic stability.
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However, as the Bretton Woods system continued to evolve into a gold dollar standard, issues hitherto associated with the inter-war gold exchange standard reappeared, including liquidity, confidence, and adjustment. Bordo notes that the adjustment problem in Bretton Woods “reflected downward rigidity in wages and prices which prevented the normal price adjustment of the gold standard price specie flow mechanism to operate.” Therefore, payment deficits created other related problems such as the ever-increasing unemployment rates and unprecedented recessions. For instance, the United Kingdom had to deal with this problem as the country tinkered between fiscal and expansionary monetary policy. Soon, the country had to adopt austerity measures in the wake of a currency crisis. For countries in surplus, the problem of inflation arose, and it had to be dealt with through capital controls and sterilization. Another problem associated with adjustment was the asymmetric adjustment between other countries around the world and the US. Given that the fixed exchange system was pegged on the US dollar, the US became the central reserve state by default and thus it was not required to adjust to deficits in its balance of payments, and the Europeans resented this imbalance of adjustment. European countries, especially France, Germany, and the UK argued that the US was having an unwarranted advantage over them in terms of conducting international trade.
Consequently, the monetary bodies in the US were concerned about the deficits in the balance of payments as it raised the question of whether trade partners around the world would have confidence in the dollar. Specifically, this fear was hinged on the knowledge that with every deficit, the official dollar liabilities in foreign countries would increase, and such dollars would be changed into gold. Eventually, the US monetary gold stock would be pushed downwards to the point that it would initiate a run. This fear was substantiated by 1964 when the official dollar liabilities in the hands of foreign monetary authorities were more than the US gold stock (Bordo). The last problem was that of liquidity based on the concern that Bretton Woods had undervalued gold prices in the post-war era, and thus the rate at which gold would be produced would not be enough to finance the growth and development of international trade. In response, “the shortfall would be met by capital outflows from the US, manifest in its balance of payments deficit” (Bordo). The US would then be forced to tighten its monetary policies and cause international deflationary pressure. Therefore, the Bretton Woods problem had to be fixed through policy.
The G10 plus Switzerland together with the International Monetary Fund (IMF) stepped in to work with the US monetary authorities and create a pathway out of the issues facing the Bretton Woods system. The objective was to discourage foreign countries, especially Europeans, from changing dollars into gold. In addition, the US Treasury together with the Federal Reserve took the appropriate measures to sterilize the exchange market as part of the intervention efforts. The Federal Reserve mainly used the swap network to ensure that the gold stock was sufficiently protected by offering foreign central banks an alternative to the conversion of dollars into gold. In a normal swap transaction, “the Federal Reserve and a foreign central bank would undertake simultaneous and offsetting spot and forward exchange transactions, typically at the same exchange rate and equal interest rate” (Bordo). Ultimately, on August 15, 1971, President Nixon suspended gold convertibility, thus marking the collapse of the Bretton Woods monetary system to usher in a new era of international monetary system. International financial markets adapted by abandoning the fixed exchange rate regime introduced under Bretton Woods and adopting a managed floating exchange rate system. This system is still in place up to date and even though it has its weaknesses, it has been resilient over the years.
General Agreement on Tariff and Trade
Twenty-three (23) countries signed The General Agreement on Tariff and Trade (GATT) on October 30, 1947, as a legal agreement to minimize barriers to international trade. The main approach toward the achievement of this goal was by reducing or eliminating subsidies, tariffs, and quotas while reserving some important regulations at the same time. The initial tariff negotiations and reductions in 1947 were between 32 percent and 34 percent according to the World Bank (134). The GATT was replaced by the World Trade Organization (WTO) on January 1, 1995, which then oversaw the 1999 Uruguay Round of negotiations that placed the average tariff level at 5 percent (Goldstein et al. 38), and these are still the current tariffs. These tariff cuts have contributed significantly to the liberalization of international trade with the aim of improving access to the global markets among other objectives.
In 1944 as the Second World War neared its end, there was a need to steer international trade into the right direction of growth and stability. During the Great Depression, which has shaken all world economies before World War II, most countries had abandoned the gold standard. Therefore, in a bid to fix the many financial problems at the time, a fixed exchange rate was introduced following the Bretton Woods Conference. The reasoning behind the adoption of fixed exchange rates was that this system would have numerous advantages to the international monetary systems. First, fixed exchange rates would help in the stabilization of the exchange rate by avoiding currency fluctuations (O’Connell 275). The problem with currency fluctuations is that it causes trade problems for the involved firms or countries. For instance, if a country is exporting its goods, a quick appreciation of the currency used in the target market would make such exports uncompetitive leading to huge losses for the country in question. However, with a fixed exchange rate regime, the problem of the rapid appreciation of currency would not be encountered. Therefore, fixed exchange rates would create stability of currencies and markets thus spurring economic growth through encouraging investment. Investors would be willing to invest in a stable market environment because they can predict market trends in both the short-term and long-term. Finally, fixed exchange rates were envisioned as the best way of keeping inflation low because the currency value is backed by the value of another currency or another measure of value, such as gold. These were the main reasons why fixed exchange rates were adopted in the first place.
Tariffs are some of the international trade barriers that affect trading negatively. Therefore, the reasoning behind lower tariffs, especially through the GATT was to encourage international trade by moving away from protectionist policies to an open trading system. With lower tariffs, countries could import and export their goods easily. As such, competition in the local markets increases, which leads to a reduction in prices. Low prices in local markets mean that domestic consumers can afford goods and this aspect raises consumption. Therefore, lower tariffs were preferred as a way of removing international trade barriers to encourage countries to trade with each other in a liberalized trade model. Ultimately, this approach would advance international trade and spur economic growth in the long-term.
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Bordo, Michael. “The Operation and Demise of the Bretton Woods System: 1958 to 1971.” VoxEU, 2017.
Goldstein, Judith, et al. “Institutions in International Relations: Understanding the Effects of the GATT and the WTO on World Trade.” International Organization, vol. 61, no. 1, 2007, pp. 37-67.
O’Connell, Joan. “An International Adjustment Mechanism with Fixed Exchange Rates.” Economica, vol. 35, no. 139, 1968, pp. 274-282.
World Bank. World Development Report, 1987. World Bank Press, 1987.