The Bretton Woods Conference was remarkably successful. In three weeks the delegates agreed on the establishment of two permanent institutions for international cooperation on monetary and financial problems. This was possible because of the thorough preparation in the three preceding years. It is particularly noteworthy that these countries agreed on how to deal with the postwar problems they expected, although they did not agree on what the problems would be.
All countries were concerned about a recurrence of the economic devastation that followed the end of World War I – the Great Depression, the sharp contraction of world trade, the disorderly exchange conditions, and the problems associated with reparations, interallied debts, and defaults on government loans. A number of conferences were held in the 1920s and l930s without achieving agreement on how to deal with these problems. Even at the height of the depression in July 1933, the World Economic and Monetary Conference in London could not agree on such a basic question as the appropriate exchange rate for the dollar. It was not until 1936 that the United States, the United Kingdom, and France agreed in the Tripartite Declaration on a common policy to support orderly exchange arrangements. This experience showed that plans for dealing with postwar economic problems should be made before rather than after the end of World War II.
In the view of the United Kingdom, the Great Depression was mainly due to a chronic inadequacy of demand in the United States. The depression was transmitted to other countries through the U.S. balance-of-payments surplus, which drained other countries of their reserves and compelled them to follow deflationary monetary policies.
To deal with these problems and the exchange and trade disorders they generated, Lord Keynes proposed the establishment of an International Clearing Union. Members would be required to fix a par value for their currencies, which could be changed after consultation with the Clearing Union, and in some cases only with its approval. Surplus countries would share with deficit countries the responsibility for balance-of-payments adjustment. They would have to provide generous credits to the deficit countries through the Clearing Union and they would pay interest on these credits at the same rate as the deficit countries. »The necessity of some such plan as the above.« Keynes wrote in a letter in April 1941, »arises from the unbalanced creditor position of the United States.«
The United States Treasury had a quite different view of the problems of the 1920s and 1930s. It believed that the Great Depression resulted from the interaction of wartime inflation and the gold standard. The inflation exhausted the free gold reserves of central banks. and reduced gold production after the war and the amount of newly mined gold available for the growth of the money supply. The deflation this caused was aggravated by the restoration of the gold standard in a number of countries at inappropriate parities, particularly an overvalued rate for sterling. The United States did not agree that its balance-of-payments surplus spread the depression to other countries. Actually, the United States‹ surplus on current account fell considerably in the 1930s. The large overall surplus in 1938-40 was due to European imports for rearmament and the capital outflow from Europe just before World War II. The depression was intensified and spread, however, by competitive devaluations and restrictive trade and exchange practices.
In the opinion of the U.S. Treasury, a similar depression would not occur after World War II because very few countries would attempt to restore the gold standard. The greater danger was that the large outlays necessary for reconstruction would create huge balance-of-payments deficits that might lead to a renewal of competitive devaluations and trade and exchange restrictions. To avoid such disorders, Harry D. White proposed the establishment of an International Stabilization Fund and an International Bank for Reconstruction and Development (IBRD). The Stabilization Fund would have responsibility for maintaining stable exchange rates and orderly exchange arrangements. It would help finance current account deficits to enable members to adjust the balance-of-payments without resorting to measures destructive of national or international prosperity. The International Bank for Reconstruction and Development would provide credits for reconstruction immediately after the war, and later it would assure the availability of long-term loans for development.
Apart from the financial provisions, the differences between the U.S. plan for an International Stabilization Fund and the U.K. plan for an International Clearing Union were not great. Both plans provided for international responsibility on changes in the par value of members` currencies and the elimination of exchange restrictions on current transactions. Both agreed that balance-of-payments adjustment had to be made by surplus as well as deficit countries. The major differences were on the degree of responsibility that surplus countries had for adjustment and on the amount and conditions for financial assistance to deficit countries.
The Keynes plan did not deal with the problem of reconstruction. The White plan called for the establishment of an international bank to help finance postwar reconstruction and the development of the low-income countries. There was little discussion with the United Kingdom of the plan for the World Bank, although the U.S. Treasury provided written answers to the questions submitted by the British economists on the Bank as well as the Fund.
The discussions between the United States and the United Kingdom went on for two years. During that period, the United States also held discussions with the Soviet Union, the free French, China, Canada, and a number of developing countries. The United Kingdom held discussions with the Commonwealth countries and the London-based governments of the occupied countries. France wanted a larger role for gold to give greater assurance of stability of exchange rates. Canada emphasized the importance of convertibility and multilateral settlements. The European governments in exile thought that prompt reconstruction was essential for social and political reasons as well as economic reasons. The Latin American countries stressed the need for stable and remunerative prices for basic commodities and for long-term credits for development.
In April 1944, the United States and the United Kingdom agreed on a Joint Statement of Experts on the Establishment of an International Monetary Fund. The exchange rate provisions were much the same as in the White and Keynes plans. The Fund would have larger resources than proposed in the White plan but much less than proposed in the Keynes plan. Provision was made for the possibility of a large and persistent surplus in the United States balance of payments. If the International Monetary Fund were to find that this had occurred, members would be authorized to impose restrictions on dollar payments. In any case, members could continue wartime restrictions on current transactions during a transition period.
After the joint statement was published, President Roosevelt invited the Allied and associated countries to a United Nations Monetary and Financial Conference at Bretton Woods to establish an International Monetary Fund »and possibly an International Bank for Reconstruction and Development.« To prepare for the conference, the U.S. Treasury invited a smaller group of countries to send representatives to a preliminary drafting meeting in Atlantic City in mid-June. About thirty economists from thirteen other countries joined the U.S. economists in Atlantic City. They agreed that the Bretton Woods Conference should establish the World Bank as well as the Monetary Fund. They prepared a working paper for the conference that offered alternative wording for the provisions in draft agreements on the Fund and Bank. In addition, the U.S. Treasury issued a document entitled »Questions and Answers on the International Monetary Fund« and »Questions and Answers on the International Bank for Reconstruction and Development,« which explained how these institutions were expected to work.
The conference convened on July 1, 1944, with Henry Morgenthau Jr., the secretary of the Treasury and head of the U.S. delegation, presiding. The conference was organized to deal. with the Monetary Fund and the World Bank in two commissions presided over by White on the Fund and Keynes on the Bank. Most provisions were adopted unanimously on the basis of committee reports written by the technical advisers. A few difficult issues on the Monetary Fund were referred to a Committee on Unsettled Questions. An able and imaginative drafting committee, chained by Louis Rasminsky of Canada, smoothed out remaining differences by a judicious choice of words.
Neither the World Bank nor the Monetary Fund provided much financial assistance to Europe in the early postwar years. The World Bank made a few reconstruction loans immediately after the war. The supplementary resources that Europe needed for reconstruction came mainly from the Marshall Plan, The Monetary Fund engaged in a few transactions with Europe before the Marshall Plan but none while the plan was in effect.
The world economy evolved quite differently after the war from what had been expected. Instead of a deep depression, as was widely feared, there was a remarkable growth of output in the United States, the other industrial countries, and many of the developing countries. Instead of large surpluses, the United States developed a persistent deficit in its overall balance of payments. Ultimately, this made it necessary to amend the Articles of Agreement.
The Fund agreement adopted at Bretton Woods reflected the preference of its members for an exchange-rate system based on par values without the rigidity of the gold standard. It was assumed that, if the United States were to maintain a high level of output with stable prices, other countries would follow policies that would enable them to have an appropriate balance of payments and to keep the dollar exchange rates for their currencies within the 1 percent margin above and below parity prescribed at Bretton Woods.
The Great Depression caused a radical change in the objectives of economic policy. The gold standard endured for nearly a hundred years in the United Kingdom and for more than fifty years in the United States without a change in the par value of the pound and the dollar. That was possible, despite protracted periods of deflation and depression marked by occasional monetary crises, because the maintenance of the gold value of the currency was the primary objective of economic policy. In the 1930s, after years of deflation and depression, every country abandoned the gold parity of its currency. The gold standard came to be regarded as having a deflationary bias.
The members of the International Monetary Fund accepted the obligation to maintain stable exchange rates based on par values, but not as a primary objective of economic policy. Article I (ii) of the Fund Agreement states that one of its purposes is to »facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic policy.«
The par value system required all members to give the same importance to price stability and to the level of output and employment, and to follow compatible fiscal, monetary, and wage policies. At times, some members of the Monetary Fund, including the United States, were unable to follow such policies. More recently, even the European countries with similar social and economic objectives were unable to maintain the exchange rates for their currencies within the wider margins from the central rates permitted by the exchange-rate arrangements of the European Monetary Union.
The U.S. balance-of-payments deficit on an official reserve basis fell into deficit in the 1960s because of the large increase in foreign investment. The current account remained in surplus until 1970. The United States tried to restrain the capital outflow by a tax on purchases of foreign securities and by restrictions on the transfer of funds for direct investment in the industrial countries. Investment in the United States by the European surplus countries in the 1960s was relatively small. Instead, they accumulated large reserves, much of which was in dollars and converted into gold.
It was thought that one reason for the persistent U.S. deficit on an official reserve basis was the unavailability of sufficient reserves other than dollars derived from the U.S. balance-of-payments deficit. It was hoped that if adequate reserves were available in another way, the U.S. deficit on an official reserve basis, and the drain on U.S. gold reserves, would be eliminated. The Fund agreement was amended to authorize it to create reserve assets, designated as special drawing rights (SDR), initially equal in value to one gold dollar. The Fund distributed SDRs to members on the basis of their quotas. This increased their reserves, but it did not halt the U.S. deficit or the converting of dollars into gold.
In August 1971, when the payments situation became critical because of a flight from the dollar, the United States notified the Monetary Fund that it would no longer convert foreign official dollar holdings into gold. It also placed a tariff surcharge on most imports. In order to retain the central role of the dollar in the international monetary system and to secure the withdrawal of the tariff surcharge, the industrial countries and the Monetary Fund agreed in December 1971 on a realignment of par values. The dollar was to be devalued and the strong European currencies and the yen were revalued. Moreover, the other industrial countries undertook to support the foreign exchange value of the dollar, although it was no longer convertible.
In spite of the realignment of par values, the U.S. deficit increased and the dollar fell in the exchange market. In February 1973, the dollar was devalued again, but the pressure on the dollar continued. The other industrial countries stopped supporting the dollar because the accumulation of dollars in their reserves was causing inflation. In March 1973, the twice-reduced par value was abandoned and the dollar became a floating currency, convertible into other currencies through the exchange market.
The floating of the dollar effectively ended the system of fixed but adjustable par values. The second amendment to the Fund agreement provides a new basis for international responsibility on exchange rates. Members are required to cooperate with the Monetary Fund in maintaining orderly exchange conditions. They are allowed to have any exchange-rate system they want, provided they do not manipulate the exchange rate to obtain an unfair advantage in international trade or to prevent balance-of-payments adjustment. Thus, a member can have a floating rate, or base its exchange rate on another currency, or on the SDR, or on a basket of currencies, but not on gold. A number of European countries decided to link the exchange rates for their currencies within a wider margin around the par value or central rate. The United States and most other members chose to have a floating exchange rate. The SDR has been redefined to consist of a fixed amount of dollars, yen, deutsche marks, French francs, and sterling. It has replaced the dollar as the accounting unit of the Monetary Fund.
The financial operations of the Bretton Woods institutions have been broadened to meet new problems. The World Bank was originally designed to guarantee loans of members made through bond issues and to make loans directly to members out of its capital and funds it raises in the market. The World Bank found that such operations gave too much emphasis to government projects and too little encouragement to private investment. To facilitate the development of the private sector, it established the International Finance Corporation, which invests in private companies in developing countries. And to encourage foreign direct investment in developing countries, the World Bank provided means for arbitrating disputes between foreign direct investors and the host country.
As some members are too poor to finance their development by loans at market rates of interest, the World Bank established the International Development Association (IDA) to make loans to them on concessionary terms. It is able to do this because the funds for the IDA come from contributions of the high-income countries rather than from borrowing in the market. When the IDA needs additional funds. they come from further contributions (replenishment).
The Monetary Fund was originally intended to help finance current account deficits, mainly of a cyclical character, that could be corrected within two or three years. For this purpose, annual drawings of 25 percent of the quota were thought to be adequate. Where adjustment of the balance of payments required a change in the par value of the currency and changes in fiscal and monetary policies, the annual quota drawings would not be sufficient to finance the deficits until the balance of payments was restored. The Monetary Fund devised a method of assuring members of financial assistance in excess of the quota limits through waivers and standby agreements for larger drawings.
Experience showed that a balance-of-payments deficit could arise from causes beyond a member`s control. The sharp increase in the cost of oil imports, for example, caused a difficult payments problem for many members. The Monetary Fund created special facilities to provide credits, outside the quota limits, for dealing with such problems. More recently, the Monetary Fund and the World Bank have acquired new members from Central and Eastern Europe, some of them former constituents of the Soviet Union. These members need technical and financial assistance in converting from a state-managed economy to a market-oriented economy. For this purpose, the Monetary Fund has created the systemic transformation facility. The financing of the credit operations of the Monetary Fund comes primarily from the quota subscriptions of its members (capital), now amounting to SDR 145 billion, equivalent to more than $200 billion. The Monetary Fund can also borrow from its members, which it has done on occasion.
As the broadening of the operations of the Monetary Fund and the World Bank indicate, they have been indispensable for dealing with some of the critical financial problems that have arisen in recent years. They can provide financial assistance promptly, without the delay inevitable in parliamentary proceedings for granting aid. And they can offer technical assistance to their members that would be politically unacceptable if it were to seem imposed by other countries.
The inability of the United States to restore its balance of payments after two devaluations of the dollar led to the second amendment to the Fund agreement, which authorized floating exchange rates. One reason for adopting floating rates was the belief that it would result in automatic balance-of-payments adjustment.
The appropriate balance of payments for a country is the same under a system of floating rates as under a system of par values. A high-income country that would normally generate more savings than can be profitably invested at home should have a surplus on current account offset by net foreign investment. The function of the exchange rate is to enable a country to maintain an appropriate balance of payments with policies directed forward stability of prices and a high level of output and employment. Under a system of par values, such an exchange rate is presumed to reflect relative prices and costs – purchasing power parity.
This is expected to result in an appropriate balance on trade in goods and services. Monetary policy should be able to bring about an offsetting balance on capital flows.
With floating exchange rates, the supply of and demand for a currency are equated in the foreign exchange market. That does not assure an appropriate balance of payments. It may merely mean that an inappropriate surplus or deficit on current account is matched by an offsetting, but inappropriate, balance on capital account. And with floating rates, capital flows may be greatly distorted because of inappropriate differences in interest rates and speculation on changes in exchange rates. In fact, with floating exchange rates, capital flows may make it more difficult to achieve an appropriate balance on current account.
That happened in the United States in the 1980s. A huge inflow of foreign capital for direct investment and for the purchase of American securities, augmented by speculative funds, resulted in an enormous increase in the foreign exchange value of the dollar. Between mid-1980 and mid-1985, the dollar rose by over 100 percent against the deutsche mark, even more against most other European currencies, but less against the yen and the Canadian dollar. This was one of the major causes of the large and persistent U.S. deficit on current account. In 1980, the United States had a current account surplus of $7 billion. Since then, the current account has been constantly in deficit, reaching a peak of $167 billion in 1987. Although the dollar has fallen well below its 1980 level, the current account deficit was still $109 billion in 1993 and will probably be much larger this year. The anomalous appreciation of the dollar in the 1980s is not the only reason for the persistence of the U.S. current account deficit, but it created conditions that have made it much more difficult to adjust the U.S. balance of payments.
When the exchange rate for a currency rises and falls considerably in a short period, it must be either overvalued or undervalued, measured by relative prices and costs, at some time during the period. This not only distorts the pattern of international trade but has adverse effects on the economy. An overvalued currency is like a too-tight monetary policy. It restrains the rise of prices, but it also holds down the growth of output and employment. An undervalued currency, on the other hand, is like a too-easy monetary policy. It stimulates the expansion of output and employment, but it also facilitates a rise of prices.
For this reason, the exchange rate is an inherent aspect of monetary policy; and the monetary authorities cannot ignore large changes in the foreign exchange value of the currency. With floating rates, the foreign exchange market needs guidance by the monetary authorities, not only through the usual instruments of monetary policy, but at times also directly through intervention. The problem is what the objective of intervention should be and how it should be integrated with other aspects of monetary policy.
The experience with the Exchange Rate Arrangements (ERA) of the European Monetary Union may be helpful on this. The countries that participated in the ERA undertook to maintain their exchange rates with the currencies of the other participants within 21/4 percent of the central rate, although Italy and Spain were allowed to have a margin of 6 percent above and below the central rate. From the end of June 1979 to the end of June 1989, in the first ten years of these arrangements, the French franc, a key currency in the ERA, fell by 32 percent against the deutsche mark, the standard currency in the ERA, while the British pound fell by 24 percent, although the United Kingdom was not in the ERA in this period. Nevertheless, the franc fluctuated much less than the pound. In this ten-year period, the average change in the rate for the deutsche mark, at six-month intervals, was 2.1 percent for the franc and 5.6 percent for the pound. Apparently the monetary authorities were able to reduce the volatility even when they could not maintain the stability of exchange rates. The objective of intervention, under a system of floating rates, should be to minimize the volatility of exchange rates.
It has been suggested that, with floating rates, the monetary authorities should establish a target zone with a wide band, within which they would maintain the exchange rate. In the ERA of the European Monetary Union, Italy and Spain were allowed a 6 percent margin from the central rate – in effect, a target zone with a 12 percent band. That did not prevent large fluctuations in the exchange rates for the lira and the peseta, and it increased the volatility of the rates for these currencies. If the policy is to intervene only at the top and bottom of the band, the target zone may encourage volatility. When the exchange rate begins to fall, speculators may quickly drive it to the bottom of the target zone, as the monetary authorities are not expected to intervene before then.
A better policy would be for the monetary authorities to intervene at any point in the target zone, whenever there is a large and rapid change in the exchange rate. As intervention in the exchange market affects other countries, it should be undertaken only after consultation with the Monetary Fund and in cooperation with the countries whose currencies are used for intervention. A fall in the foreign exchange rate may be a signal that the exchange market believes that a change in monetary policy is necessary. Therefore, when the monetary authorities intervene in the exchange market, they should consider whether the intervention should be accompanied by a change in policy.
Intervention itself changes the monetary situation as it affects the money supply and the reserves of the banking system. Thus, selling foreign exchange to support the exchange rate has the same effect as selling Treasury bills in order to tighten the monetary situation. In the 1930s, some countries established exchange equalization accounts to insulate the money supply and bank reserves from transactions in gold and foreign exchange reserves. When the monetary authorities intervene in the exchange market, they must consider whether the magnitude of the consequent monetary changes is consistent with the broader objectives of economic policy. The amount of intervention is not a proper measure of the change in the monetary aggregates that is appropriate for the economy. If the intervention causes too large a change in the money supply and bank reserves, the monetary authorities may have to undertake open market operations to offset the excess. The behavior of the exchange rate is only one, and not the most important, indication that a change in monetary policy is necessary. As the U.S. Treasury stated in the »Questions and Answers on the International Monetary Fund« submitted to the Bretton Woods Conference: »It would be a complete inversion of objectives if a high level of business activity were to be sacrificed to maintain any given structure of exchange rates.«