The Bretton-Woods System 1946-1971

After WWII the international financial system was governed by a formal agreement, the Bretton Woods System, signed by 44 nations in the conference in Bretton Woods 1944. The new international economic order was formally launched with the declaration of fixed exchange rate parities in 1946. Two new international organizations were also created at Bretton Woods, the IMF and the World Bank. The former was designed to promote international monetary cooperation and an orderly exchange rate system and to provide short-term financial assistance to meet temporary balance of payment needs. The World Bank was established to finance economic reconstruction and development.

Under this system the US dollar was placed deliberately as the anchor of the system, with the US government guaranteeing other central banks that they could sell their US dollar reserves at a fixed rate for gold. The world’s need for dollars has allowed the US government as well as Americans to borrow at lower costs, granting them a major advantage. The global financial system would be stabilized – on the basis of gold, and on creditor-oriented rules. By the end of the 1940s the United States held some 75 percent of the world’s monetary gold stock.

That established the US dollar as the world’s reserve currency, freely convertible into gold at the 1933 parity of $35 an ounce. It also implied that once again, as in the 1920s, European balance-of-payments deficits would have to be financed mainly by the United States. Recycling of official government credit was to be filtered via the IMF and World Bank, in which US diplomats alone had veto power to reject policies they found not to be in their national interest. International financial “stability” thus became a global control mechanism – to maintain creditor-oriented rules centered in the US.

In the late 1960s and early 1970s, the system suffered setbacks ostensibly due to problems pointed out by the Triffin dilemma – the conflict of economic interests that arises between short-term domestic objectives and long-term international objectives when a national currency also serves as a world reserve currency. This dilemma was first identified in the 1960s by Belgian-American economist Robert Triffin, who pointed out that the country whose currency, being the global reserve currency, foreign nations wish to hold, must be willing to supply the world with an extra supply of its currency to fulfill world demand for these foreign exchange reserves, thus leading to a trade deficit.

The use of a national currency as global reserve currency leads to tension between its national and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, specifically the current account, as some goals require an outflow of dollars from the US, while others require an overall inflow.

One of original designers of the Bretton Woods system, the British economist John Maynard Keynes, had anticipated this difficulty and had advocated the use of a global reserve currency called “Banco”. The principal mechanism proposed to resolve this dilemma was for the IMF to create a new reserve asset. The formal creation of this asset, the special drawing rights (SDR), came with the approval in May 1968 and legal adoption the next year. The initial allocation of SDRs took place in three stages during 1970-72. Subsequent allocations have been made periodically according the need for reserves.  Currently the IMF’s SDRs are the closest thing to the proposed Bancor but they have not been adopted widely enough to replace the dollar as the global reserve currency.

By 1950 the dollar-based global economic system had become increasingly untenable. Gold continued flowing to the US, strengthening the dollar – until the Korean War reversed matters. From 1951 through 1971 the US ran a deepening balance-of-payments deficit, mainly by expansive war expenditures worldwide and finally in late 60’s enormous flows of speculative funds brought down the system. Through periodic adjustments of exchange rate pegs and a resort to capital controls, the Bretton Woods system survived for a quarter century. The demise came after internationally mobile private capital had grown substantially in both volume and agility, thereby becoming a major force that was difficult to control.