The relatively short-lived “Bretton Woods” fixed exchange rate system once tied currency to the U.S. dollar and its value in gold. Here’s a look at what the Bretton Woods System is, how it was created, and what led to its eventual failure. A major point of common ground at the Conference was the goal to avoid a recurrence of the closed markets and economic warfare that had characterized the 1930s. Thus, negotiators at Bretton Woods also agreed that there was a need for an institutional forum for international cooperation on monetary matters. Already in 1944, the British economist John Maynard Keynes emphasized “the importance of rule-based regimes to stabilize business expectations”—something he accepted in the Bretton Woods system of fixed exchange rates. Currency troubles in the interwar years, it was felt, had been greatly exacerbated by the absence of any established procedure or machinery for intergovernmental consultation.

This meant that international flows of investment went into foreign direct investment (FDI)—i.e., construction of factories overseas, rather than international currency manipulation or bond markets. Although the national experts disagreed to some degree on the specific implementation of this system, all agreed on the need for tight controls. During the 1960 and early 1970s the amount of U.S. dollar reserves held by nonreserve central banks grew significantly, which led to what became known as the Triffin what is meant by the bretton woods agreement class 10 dilemmaThe problem of excessive U.S. dollar holdings by foreign central banks. Robert Triffin was a Belgian economist and Yale University professor who highlighted the problems related to dollar overhang. Dollar overhang occurred when the amount of U.S. dollar assets held by nonreserve central banks exceeded the total supply of gold in the U.S.

1. Each member country was required to maintain a quota of reserves with the IMF that would then be available to lend to those countries experiencing balance of payments difficulties.
2. Further, there was no definitive timeline for implementing the new rules, so it would be close to 15 years before the Bretton Woods system was actually in full operation.
3. Today, the U.S. dollar isn’t backed by anything, other than the U.S. government’s own ability to generate revenue.
4. Also, since U.S. gold holdings had fallen to very low levels by the early 1970s and since the dollar overhang was substantial, the devaluation would have had to be extremely large to prevent the depletion of U.S. gold reserves.
5. What they feared, however, was the U.S. devaluing the dollar, thus making their dollar assets less valuable.
6. The IMF, based on the principle of a credit union, whereby members could withdraw more than their original gold quotas, was established to provide relief for temporary current account shortfalls.

Ratification of Bretton Woods Final Act and Savannah Conference

1. Unusually, this decision was made without consulting members of the international monetary system or even his own State Department and was soon dubbed the “Nixon Shock”.
2. The primary designers of the Bretton Woods system were the famous British economist John Maynard Keynes and chief international economist of the U.S.
3. Formally introduced in December 1945, both institutions have withstood the test of time, globally serving as important pillars for international capital financing and trade activities.
4. Those at Bretton Woods envisioned an international monetary system that would ensure exchange rate stability, prevent competitive devaluations, and promote economic growth.
5. The conference, formally known as the United Nations Monetary and Financial Conference, convened on July 1, 1944, and was attended by 730 delegates.
6. The Marshall Plan and more competitively-aligned exchange rates relieved much of the pressure on European nations trying to revive their war-torn economies, allowing them to experience rapid growth and restore their competitiveness vis-à-vis the U.S.

Even more groundbreaking was the decision to allocate voting rights among governments, not on a one-state one-vote basis, but rather in proportion to quotas. Since the United States was contributing the most, U.S. leadership was the key. Under the system of weighted voting, the United States exerted a preponderant influence on the IMF. The United States held one-third of all IMF quotas at the outset, enough on its own to veto all changes to the IMF Charter.

Rise of governmental intervention

Countries were required to monitor and maintain their currency pegs which they achieved primarily by using their currency to buy or sell U.S. dollars as needed. The Bretton Woods system, therefore, minimized international currency exchange rate volatility which helped international trade relations. More stability in foreign currency exchange was also a factor in the successful support of loans and grants internationally from the World Bank. Under the Bretton Woods system, foreign central banks were allowed to exchange their dollars for gold at the rate of $35 per ounce. Once the dollar overhang problem arose, it became conceivable that the United States could run out of its reserve asset—gold.

In turn, the IMF embarked on setting up rules and procedures to keep a country from going too deeply into debt year after year. The IMF set out to use this money to grant loans to member countries with financial difficulties. Each member is then entitled to withdraw 25% of its quota immediately in case of payment problems.

Bretton Woods Agreement and the Institutions It Created Explained

Elimination of the US balance of payments deficits (as the French and Germans were urging) could create a global liquidity shortage. Within this context, the U.S. administered $13 billion of financing to Europe through the Marshall Plan in 1948, and some two dozen countries, following Britain’s lead, were permitted to devalue their currencies against the dollar in 1949. These moves helped alleviate the shortage of dollars and restored competitive balance by reducing the U.S. trade surplus. The BIS, formed in 1930, was originally primarily intended to facilitate settling financial obligations arising from the peace treaties that concluded the First World War.

Growth of international currency markets

The Bretton Woods system of exchange rates was set up as a gold exchange standard, a cross between a pure gold standard and a reserve currency standard. In a gold exchange standard, one country is singled out to be the reserve currency. The U.S. dollar was fixed to a weight in gold, originally set at $35 per ounce. The U.S. central bank agreed to exchange dollars for gold on demand, but only with foreign central banks. In a pure gold standard, the central bank would exchange gold for dollars with the general public as well. In July 1944, delegates from forty-five of the allied powers engaged in World War II met in Bretton Woods, New Hampshire, in the United States to plan for the economic institutions believed necessary to assist in the reconstruction, development, and growth of the postwar economy.

One of the problems that typically arises with a reserve currency standard is the persistence of balance of payments (BoP) deficits. BoP deficits require a country to sell its dollar reserves on the Forex market. When these deficits are recurring and large, a country will eventually run out of reserves. When that happens, it will no longer be able to defend its fixed currency value.

Policies to shore up the system

Today, the U.S. dollar isn’t backed by anything, other than the U.S. government’s own ability to generate revenue. In the end, the Smithsonian Agreement extended the life of Bretton Woods for just over a year. By March 1973, a repeat of the severe dollar outflows in 1971 led to a suspension of Forex trading for almost three weeks.

In the event of a deficit in the current account, Fund members, when short of reserves, would be able to borrow foreign currency in amounts determined by the size of its quota. In other words, the higher the country’s contribution was, the higher the sum of money it could borrow from the IMF. The Bretton Woods system—which required a currency peg to the U.S. dollar and linked the value of the dollar to gold—is no longer in effect. In the 1960s, the dollar had struggled within the system set up under the Bretton Woods agreement. The Bretton Woods agreement created two institutions, the IMF and the World Bank.