By Patrick Corby
This essay will focus on the stability of the international monetary framework that was set-up in Bretton Woods, New Hampshire in 1944 by 29 nations. Specifically whether the fixed exchange rate that was the pillar of this framework provided the stability that lead to what is commonly called the ‘golden age of capitalism’.
In reference to the ‘golden age’ of capitalism, a note. The period refers to the end of World War II in 1945, until the United States of America severed the convertibility of the US dollar into gold in 1971; roughly one generation.
The period is often misrepresented as more far reaching in scope and prosperity than it actually was. For instance within the period occurred two revolutions, in Cuba and China; the Vietnam, Korean and Cold Wars; the de-colonisation of Africa and Asia and the fact that the period saw general political and market volatility.
Instead the ‘golden age’ period refers narrowly to a political integration of the 29 Western participants of the Bretton Woods system, the rise of state interventionism in market roles, such as the Welfare State and the economical accumulation of capital towards pre – World War II standards. As we shall see the ‘golden age’ became more of a political hope than an economic reality.
The Bretton Woods system was developed due to monetary instability and the political upheaval that occurred through WWII. The instability stemmed from rapid expansionary monetary policies always the accomplice to the financing of war and the economic recovery afterwards1.
The expansion of credit will always lead to a loss in purchasing power and therefore inflation in prices2. This effect is due to the nominal increase in the medium of exchange not mirrored by a real increase in reserve assets.
The expansion of credit and loss of reserves in a war environment produces large discrepancies in the real and nominal values of currencies. Therefore exchange rates, reflecting the relative purchasing power of currencies, are significantly altered.
Towards the end and the period afterwards in WWII most currencies were in fact overvalued due to this effect and required devaluation or a deflationary period.
This was politically undesirable; devaluation would lead to larger current account deficits and a shrinking of the economy short-term. A deflation would also shrink the economy and produce domestic tightening while the market adjusted. Therefore a political solution was sought as a compromise3.
The Articles of Agreement drawn up at Bretton Woods formed the first internationally negotiated monetary policy governing sovereign international relations.
Since the nations did not want the rigidity of the gold asset standard, and knew that the flexibility of floating exchanges would be too volatile in this atmosphere, a compromise was found. The system developed by Keynes and Harry Dexter White allowed purchasing power confidence while offering the expansionary flexibility nations needed to recover quickly, avoid deflation and secure devaluations.
The solution was an international reserve currency that could be held as an asset alongside gold. This was seen to secure market confidence and exchange rate parity and at the same time providing the liquidity and flexibility that an asset like gold could not4.
Post – WWII the USA had gold reserves totalling around 20,000 metric tonnes, or 705, 479, 239 ounces, around 60% of the world gold supply at the time5.
The financial confidence that this held meant that the USD could boast a full purchasing conversion rate of $35 per gold ounce – each dollar paid out around .03 ounces of gold, or 0.888671 grams – making the USD the most stable currency in the world after the war and the perfect candidate for international reserve status.
Thus the agreement was to use the hard backed USD as an international reserve currency – literally a ‘new’ asset backed by its own assets. Allowing those overvalued currencies to increase their reserves and snuff devaluation. The USA was willing to expand its currency for this for the benefit of running the current account deficit necessary to provide the liquidity – “able to settle their deficits in dollars [instead of traded assets]”6.
This enabled a more flexible political situation for those countries that had downward pressure on their exchange rates and a more flexible situation for the USA which could now basically finance itself.
The fixed exchange rates pegged the dependent currencies within + (or) – 1% of 1.00 USDs purchasing power. Roughly 4.00 German marks, 360.00 Japanese yen, 625.00 Italian lira and 0.357 British pounds. This was all ultimately founded on the confidence that $35 could be converted into 1.00 ounce of gold bullion.
These exchange rates could fluctuate in the + (or) – 1.00 band against the USD. Though the system was set up – through the IMF – to give revaluation if great diversions occurred. This mechanism, that would have given far more security to the market in a fixed exchange policy environment, was never exercised. Occurring mainly due to continued expansion of the USD making it unnecessary7.
The theorised advantages of the fixed exchange system are firstly a release of political pressure arising through conflicts in exchange rate devaluation and deflation. Allowing instead for a unified political market.
Secondly pegging to a low inflation currency, like the USD at the time, restrains domestic inflation by restricting expansionary policies to its reserves of USDs. This was largely a success from 1946 till 1970 when the mean inflation rate was 3.6% for the participating countries with a standard deviation of 4.6%. Compared to the inter-war period where the mean inflation was -1.1% with a standard deviation of 7.7%.
In this sense the Bretton Woods framework did therefore realise short-term tightening of domestic credit policy and a lowering of inflation deviations8.
Thirdly, which is linked to the second point, the inflation that accompanies monetary expansion becomes more predictable on an international level when controlled by one factor – The USD – granting lower volatility in the market which could only increase activity9.
What the framework did not ultimately solve was the restrictions on credit expansion that led to the original problem of loss in purchasing power. Instead it set up an environment that relied solely on the confidence of the USDs purchasing power, while in a sharp contradiction relying solely on the USA to provide asset liquidity by expanding credit through current account deficits. Thus Robert Triffen’s Dilemma or Triffen’s paradox
The inherent economic contradiction in international reserve currency set out by Triffen predicted that eventually the Bretton Woods system of providing liquidity would avalanche into loss of confidence in the purchasing power and not only effect the domestic economy but all those economies holding the ‘overvalued’ asset.
This has been summed up nicely by Financial Times’ John Plender:
“To supply the world’s risk-free asset, the country at the heart of the international monetary system has to run a current account deficit. In doing so, it becomes more indebted to foreigners until the risk-free asset ceases to be risk-free.”10
This occurred exactly how Robert Triffen, who worked at the IMF and World Bank, described it would to congress in 1960. “By 1965, nearly 60 per cent of world reserves were denominated in US dollars” with a total of 72 currencies throughout the world linked to the USD11.
The USA experienced net reserve losses of $25 billion between 1949 and 1969, shown in exhibit 17, by increasing its reserve liabilities by $16 billion and losing $9 billion in gross reserve assets shown in the appendix, Graph A12.
Compared to the inter-war period which had a mean monetary expansion of 2% per annum the Bretton Woods era had a monetary expansion of 10.1% per annum mostly lead by the USD13.
This “reserve creation on net reserves”14 was able to be sustained only until the market felt that the confidence in the USDs purchasing convertibility had been lost.
“The build-up in dollar-denominated liabilities that occurred from running high current account deficits for liquidity caused foreigners to doubt whether the United States could maintain gold convertibility at $35 or might be forced to devalue”15.
From 1949 to 1969 the accumulation of USD was in total $40 billion which was the turning point for the unquestioning support of the convertibility of the USD into gold.
“By the beginning of the 1970s, the policy of chronic “‘mild” inflation was running into serious difficulties. Of the more than $300 billion of new money created between 1960 and 1972, at least $60 billion (some estimates run as high as $80 billion) flowed abroad in payment of goods, services, and assets which the American economy had failed to produce. These billions in due course formed the basis of the huge and volatile Eurodollar market. Gold reserves declined from $17.8 to $11 billion between 1960 and 1970, while short-term foreign obligations, still supposedly payable on demand in gold, rose from $21 to $47 billion. The dollar was manifestly no longer “‘as good as gold,” and the stage was set for a major crisis.”16
By 1961 not only the market but nations were increasingly concerned that the market for USDs was overvalued and being kept artificially high through its $35/1 political policy.
The problem was that “between 1945 and 1972, the American dollar lost almost three fourths of its domestic purchasing power”17 also reflected in the Bloomberg screenshot below. “This occurred because of the mismatch between the amount of gold held by the US Federal Reserve and the outstanding dollars held by the rest of the world”18
With Marshall Aid, the American foreign aid packages to Europe; growing military expenditure overseas (Vietnam and the Cold War); corporate investment outflows and big society programs all being financed by the USAs current account deficit privilege the expansionary system was increasingly seen as having no deceleration in sight.
On top of this gold had been increasing in value to 4 or 5 times the value of 1934 when the USD was fixed through the ‘golden age’ period. Although kept at $35/1 in the USA the London market price was $34.71 in 1950 and $58.16 in 197219.
Both of these factors: the accumulation of USD reserves decreasing the USD nominal value, plus the rising price of gold in outside markets, pushed European nations to use their USD redemption clause and convert their USD holdings into US gold. Since now gold in the USA was cheap due to the USDs $35/1 overvalued status – you could get more for your dollar – the US had essentially been trapped into a corner. Unable to devalue and lose confidence itself it became prey to those dependent upon it.
1958 marks the first year that national central banks started using their right and converting their dollars into gold. US gold reserves fell 10% from 20,312 metric tons to 18,290 that year, 5% in 1959 and 9% in 196020. As seen from the first diagram from 1958 till 1971 gold reserves in the USA dropped from 20,000 metric tons to 9,000 metric tons, more than 50% of America’s gold reserves were wiped out in little over a decade.
“Net U.S. reserves fell dramatically from + $23 billion at the end of 1949 to – $24 billion at the end of June 1971, and the convertibility of the dollar, at a fixed price or exchange rate, into gold or any foreign currency was “temporarily” suspended on August 15, 1971.”21
“The growing overvaluation of a stable dollar rate finally led to its depreciation, and even over depreciation, over the following years, its rate vis-fi-vis the German mark, for instance, falling by 57 per cent (from 4.00 to 1.7315 marks per $) between the inception of floating rates in September 1969 and the end of 1979.”22
To conclude the Bretton Woods system although provided a sort of stability from 1949 till 1969 it was in no way sustainable and in fact only put the USA at a disadvantage. The golden age was the period where the confidence lost in European currencies got a political helping hand by pegging themselves to the USD asset. Making the USA the world financier until the inherent contradiction took hold and the market lost confidence in the USDs purchasing power just as other currencies.
The golden age really refers to the political intervention to halt devaluations after war-time monetary expansion. The political integration of Bretton Woods using the USD as the shoulders that artificial European currency values over consumed off. The result, a siphoning off of the USAs gold reserves cheaply as its role as liquidity financier weighed down on its market purchasing power.
The process spread gold from its 60% concentration in its US home to the depleted central banks of the European states. The fixed exchange rate and the confidence in the USD were at odds and actually created a foundation of economic instability that was tracked through the golden age.
“Neither exchange rate stability nor purchasing power stability guarantees the other”23
1 Kindleberger, Manics, Panics and Crashes, P. 53
2 Kindleberger, Manics, Panics and Crashes, P. 62
3 The Post-war rise of world trade: does the Bretton Woods system deserve credit?, Andrew G. Terborgh, P. 18
4 Reform of the International Monetary System, Justin Yifu Lin, Shahrokh Fardoust, David Rosenblatt, World Bank Paper, P. 8
5 Jim Reid, A Journey into the Unknown, Deutsche Bank, exhibit 17
6 European Monetary System, Robert Triffen, P. 141
7 Maurice Obstfeld and Kenneth Rogoff, The Mirage of Fixed Exchange Rates, Journal of Economic Perspectives, P. 2
8A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform, Michael D. Bordo and Barry Eichengreen, Graph P. 6
9 Maurice Obstfeld and Kenneth Rogoff, The Mirage of Fixed Exchange Rates, Journal of Economic Perspectives, P. 5
11 Reform of the International Monetary System, Justin Yifu Lin, Shahrokh Fardoust, David Rosenblatt, World Bank Paper, P. 19
12 Robert Triffen, The European Monetary System, Tombstone or Conerstone, P. 142
13 A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform, Michael D. Bordo and Barry Eichengreen, Graph P. 7)
14 Robert Triffen, The European Monetary System, Tombstone or Conerstone, P. 140 Triffen Paper
15 Source: John Kemp, Reuters, January 13, 2009
16 G. C. Wiengand, Contributions in Economics and Economic History No 12, 1975, P. 12
17G. C. Wiengand, Contributions in Economics and Economic History No 12, 1975, P. 12
18Reform of the International Monetary System, Justin Yifu Lin, Shahrokh Fardoust, David Rosenblatt, World Bank Paper, P. 37
20 John Paul Koning, The losing battle to fix gold at $35, 2009
21 Robert Triffen, European Monetary System, P. 146)
22 Robert Triffen, European Monetary System, P. 146
23 Domestic stability verses exchange stability, Leland B. Yeager, P. 2