How we arrived at the exchange rate system we have today
The story of the Bretton Woods Agreement
It’s funny how going down rabbit holes searching for a particular topic often leads to learning about something else. And that something else could be even more fascinating.
One such rabbit hole is how I learnt about the Bretton Woods Agreement. I started off wanting to learn about the International Monetary Fund, but one Wikipedia link led to another, and I was soon at the article about the Bretton Woods agreement.
The agreement’s story is one of early success and eventual failure leading to the global financial system we have today. I find it interesting because we arrived at the system through trial and error. We first had to realise what didn’t work to find out what did. I find that analogy similar to my career path where I’ve figured out what I want to do by eliminating what I surely did not want to do.
So why was the Bretton Woods agreement needed?
Post-World War 2, the Allied leaders believed that the lack of a global monetary system aided Hitler’s rise to power.
In 1944, representatives from 44 Allied nations met in Bretton Woods, USA. To prevent history from repeating itself, they set up a system of rules, institutions, and procedures to regulate the international monetary system called the Bretton Woods Agreement.
These accords established the IMF and the International Bank for Reconstruction and Development, which today is part of the World Bank Group.
What were the mistakes made that the agreement sought to solve?
Allied Leaders believed that a failure to establish a stable system to determine exchange rates post World War 1 had increased tensions around the globe.
Exchange rate instability -
Post-World War 1, the UK pegged the £ to gold at the same rate which existed prior to the world war. But the excessive money printing done during the war had increased inflation. The currency was overvalued.
Market forces sold £’s and converted it into physical gold leading to a dangerous drop in gold reserves. Eventually, the Bank of England was forced to stop converting £’s to gold to preserve their gold reserves.
The bank was coerced by market pressure to devalue its currency to stop the outflow of gold. There was no system of international co-operation which could pause such speculation.
After the devaluation, the UK experienced an extended period of recession.
Hyper-inflation -
Germany faced hyper-inflation post- World War 1. To aid in its war efforts, it printed money without the backing of economic resources. Berlin was counting on the prize money once it won the war. Plus, Berlin had to pay repatriations to Allied nations once it lost.
To honour its obligations, Germany sold its own currency to buy foreign currency. This made foreign currency expensive to buy and the German currency quickly lost its value. Leading to a vicious cycle wherein Germany would print more money to pay repatriations, thereby increasing inflation.
This was one of the drivers of World War 2 and no monetary system existed to stop this from happening again in the future.
Economic growth was at a standstill -
Post-World War 1, the USA was supplying most of the goods around the world. Importing countries ran heavy deficits as imports exceeded exports.
To curtail payments in precious foreign exchange, partner countries would devalue their own currency to boost exports rather than take on more debt.
Protectionist practises such as tariffs, trade barriers and import substitution were obstacles in global trade.
To deepen trade, fair rules were needed to be followed by all parties.
Furthermore, central banks and governments did not have flexibility in combating recession. The impact of these issues was amplified because of the prevalence of the gold standard that existed across the global economy.
Post the agreement however dawned the golden age of capitalism.
The golden age of capitalism
Post 1944, policy coordination under the Bretton Woods agreement led to a stable economic system wherein the world experienced low unemployment, no major economic collapse and reduction in the wealth gap.
How did this happen?
During the Second World War, USA had lent the equivalent of $575 bn in today’s terms, to the allied nations for war expenses. Post the war, American exports dominated global trade. The combined effects meant that the Americans dictated terms of global trade.
International currencies such as pounds, yen, franc etc were pegged to the US Dollar. USD was in turn pegged to gold; at a fixed exchange rate of $35 an ounce. Along with the option to convert their dollar reserves into gold at any time. This established stable exchange rates.
This system of keeping currencies fixed but adjustable to the dollar gave central banks flexibility over monetary policy and exchange rate stability.
But, how do nations get their hands on dollars?
Partner countries lacked the dollars required to import food and energy necessary to prevent the collapse of their war-ravaged economies.
To overcome the dollar shortages, USA provided aid to the tune of $114bn in today’s terms to Europe under the Marshall plan. The aid along with lowering the international currencies value relative to the dollar, allowed partner countries to boost their net exports.
In the late 1950’s, pro-business policies along with globalization helped countries to grow rapidly and restore their competitiveness vis-à-vis the U.S.
But the system was unsustainable for a myriad of reasons. The system eventually collapsed in 1971.
The collapse of Bretton Woods
In economics there is a concept called the impossible trinity, which states that it is impossible to have all three of the following things at the same time:
Fixed exchange rate
Free movement of capital
An independent monetary policy
The agreement sought to provide all three.
By 1965, USA’s expenses had increased due to the Vietnam War and Lyndon Johnson’s Great Society. This led to a widening balance of payment deficit. To fund the country’s expenses, it started borrowing.
As official dollar liabilities held abroad mounted with successive deficits, the likelihood increased that these dollars would be converted into gold and that the US monetary gold stock would eventually reach a point low enough to trigger a run.
By 1964, official dollar liabilities held by foreign monetary authorities exceeded that of the US monetary gold stock.
Essentially the USA had exported inflation, by increasing the supply of dollars in the system and not allowing the dollar to depreciate against gold.
European allies were unhappy as they did not have control over the inflationary pressures in their countries. They felt that USA had too much power and they set the monetary policy keeping their own interests in mind.
In 1971, the French and British convinced the dollar was overvalued, sought to convert their massive holdings of dollar reserves to gold. Seeking to protect its gold reserves President Richard Nixon decided to suspend the conversion of dollars into gold. This dissolved the Bretton Woods Agreement and the start of free-floating exchange rates.
It is the system that exists today and is the basis of the modern economy.
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This is so well done! Bookmarked for sounding intelligent at your expense. Saw your substack thanks to your intro email on the group and here to doff my imaginary tin foil hat to you for being so consistent and keeping the writing exciting. Loved loved this!