International Financial Architecture
Topic 1: What were the outcomes of the Bretton Woods conference and which factors can account for the agreements reached at that conference? (1200 words) The Bretton woods conference is a United Nations Monetary and Financial Conference that was organized between 1 and 22 July 1944 at Mount Washington Hotel in Bretton woods, New Hampshire, United States. 730 delegates from 44 nations signed an agreement on the final day of the conference.
This agreement went on to become one of the major agreements to govern the monetary relations of independent monetary states. But the obvious question which comes to my mind is why a need for an internationally negotiated monetary order was felt during that period? The reasons were the economic ramifications of the great depression and the concentration of power among a few major economies. Moreover, during the period of the Great depression, the economies engaged in the so called “beggar thy neighbor” policies i. . competitive devaluation of the currencies by various economies in order to substitute imports with domestic goods and increase the competitiveness of the exports in the international markets. In addition, a number of countries also imposed trade barriers, restricting the recovery of international trade. Hence, the representatives from the major nations gathered at Bretton woods to agree upon a unified rules, procedures and institutions to avoid a repetition of a similar prolonged economic crisis.
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The following were the major outcomes of the Bretton woods agreement: Creation of Par value system, emergence of US dollar as reserve currency Convertibility of US dollar to gold at a fixed price Establishment of IMF for international cooperation on monetary matters Determining the power, functions and organization of the Fund Establishment of IBRD to finance the recovery of war inflicted nations The members of the conference believed that stable currency exchange rates were extremely important in order to have a free international trade and a sound recovery from the Great Depression.
Reflecting upon the lessons learnt during the crisis, a free floating exchange rate was deemed unsuitable for the global monetary system. Reverting back to the gold-backed fixed exchange rate system also appeared less feasible to the members not only because the amount of gold reserves were insufficient to meet the rising demand of international trade but also because a large amount of gold reserves were in Soviet Union, which would later appear in a Cold War with the US.
Hence, the members agreed to peg the national currencies to the US dollar, reflecting the reliability of the dollar and the power of the U. S. This means that the governments had the role to intervene in the forex market to keep the exchange rate in the band of plus/minus 1% of the pegged rate and this also led to the emergence of US dollar as a reserve currency. Bordo (1993) argued that the architects of the Bretton Woods system wanted a set of monetary arrangements that would combine the advantage of the classical gold standard (i. . , exchange rate stability) with the advantage of floating rates (i. e. , independence to pursue national full employment policies). Similarly, Cohen argued, in his paper titled Bretton Woods System, that free floating exchange rates encourage destabilizing speculations and competitive depreciation. Nuksee (1944) echoed Cohen’s argument by adding that in a free floating exchange rate regime, a depreciating currency makes speculators and importers to anticipate a further deprecation, resulting in further decline in currency value.
But this explanation is largely contested by Friedman (1953), who argued that every case of destabilizing speculation Nurkse documented involved a prospective change in government policies that would otherwise have changed the exchange rate-that the market just facilitated movement to the new rate. Moreover, Eichengreen and Sachs (1985) contested the prevalence of beggar-thy-neighbor devaluations in the 1930s. They showed that most devaluations were accompanied with expansionary monetary policies.
Besides, the creation of international institutions such as International Monetary Fund (IMF) and International Bank of Reconstruction and Development (IBRD) were the other outcomes of the conference. The members believed that an establishment of an institution such as IMF can prevent the repeat of currency troubles of the interwar years by providing established procedure for inter-governmental consultation. Negotiators believed that future threats to stability are more likely to emerge from private speculation and IMF’s pool of liquidity will be useful in dealing with such situations.
The main function of IMF was to establish international monetary cooperation and to provide a multilateral payment system to ensure a smooth transition period. Cohen highlights administering the rules governing currency values and convertibility, supplying supplementary liquidity, and providing a forum for cooperation among governments as the important functions of IMF. The fund had significant powers to influence international monetary system for eg: to decide upon changes in parity, use of multiple exchange rates and even to declare members ineligible to use its resources or even expel members, if required.
On the other hand, IBRD was created with the purpose of providing financial assistance to the nations suffering in the aftermath of the war. According to the data on the website of the World Bank, the Bank financed projects seeking to dam rivers, generate electricity, and improve access to water and sanitation. Following the reconstruction of Europe, the Bank’s mandate has transitioned to eradicating poverty around the world. Other factors effecting the agreements reached at the conference: 1.
Learning from Depression: Since the conference was held amid the Great Depression, the lessons learnt during and just before the start of depression were fresh in the minds of the member nations. Bordo (1993) highlights the flaw of gold exchange standard, the case against floating exchange rates, and bilateralism as the three major issues dominating the perception of interwar experience. Hudson (2003) argued that the public officials wanted to ensure that the nations are not inclined to isolationism in future, thereby lowering the chances of a similar debacle of the international financial system in the future. . Interests of the US: It is also argued that the interests of the US, being arguably the most powerful member, also shaped the agreements reached at the conference. Cohen argues that in practice the initial scheme, as well as its subsequent development and ultimate demise, were directly dependent on the preferences and policies of the United States. In addition, various economists have highlighted the fact that out of the plans developed by Keynes and White, it is the plan of the latter that appears closer to the compromise that eventually emerged, reflecting the powerful status of the US.
Conclusion: After the agreement on the use of US dollar as a reserve currency, the US, in an attempt to boost the image of the dollar, made it convertible to gold at a fixed rate of $35 per ounce so that the foreign governments can exchange dollars for gold, making dollar even a better commodity than gold as the former earned interest income. This potentially led to the supremacy of the US dollar over the currencies world over as the European nations, engaged in the World War II, exchanged large quantities of gold for dollar. Consequently, US dollar became the currency in which all the major transactions in the world were denominated.
Moreover, since all the currencies were pegged to the US dollar, the demand for the greenback increased exponentially and the U. S hegemony was established. References: Michael Bordo. “The Bretton Woods International Monetary System: A Historical Overview. ” National Bureau of Economic Research working paper number 4033 Benjamin Cohen “The Bretton Woods System. ” Routledge Encyclopedia of International Political Economy Michael Hudson, Super Imperialism: The Origin and Fundamentals of U. S. World Dominance, 2nd ed.
(London and Sterling, VA: Pluto Press, 2003), ch. 5. Prestowitz Clyde (2003) Rogue Nation http://www. worldbank. rg/wb/about/timeline. htm? iframe=true&width=1020&height=620 http://web. worldbank. org/WBSITE/EXTERNAL/EXTABOUTUS/0,,contentMDK:20653660~menuPK:7 2312~pagePK:51123644~piPK:329829~theSitePK:29708,00. html Topic 2: What is meant by the “fall” or “collapse” of the Bretton Woods System and why did it happen? (1192 words) The demise of the agreements (gold exchange standard and par value system) reached at the Bretton Woods conference is referred to as the “fall” or “collapse” of the Bretton Woods System. The collapse occurred during the years 1968-71 leading to consensus on the flexible exchange rate regime among the major nations.
The collapse started with widening of the BOP deficit of the US, resulting in accelerated inflation in U. S and a threat of speculative attack on dollar. This potentially led to a policy dilemma for the US and loss of confidence on the convertibility of the US dollar. This essay tries to analyze the main factors leading to the collapse of the Bretton Woods. These are (i) Rigid exchange rate regime, based on gold standard and the concept of “adjustable peg” (ii) Transmission of inflation through US dollar (iii) Unresolved Triffin dilemma resulting in loss of confidence on US dollar (iv) Reluctance f surplus countries of Europe to initiate corrective measures (the blame game) (v) Divergent monetary policy objectives of U. S and the Europe and Japan (i) Rigid exchange rate regime based on gold standard and the concept of “adjustable peg”: The rigid exchange rate system allowed for limited flexibility in exchange rate to correct the BOP disequilibrium. In 1958, the BOP deficit of US plummeted to $3. 5bn and continued to worsen in the following years. On the other hand, a few European nations and Japan ran a BOP surplus and posed a competitive commercial threat to the U. S.
The weakness in the regime became apparent with the growth in the international capital flow and rising fear of speculative attacks on U. S dollar. Clearly, the consensus reached at Bretton Woods was weakened and Triffen dilemma became more acute as the U. S faced the tradeoff between its role as a global liquidity provider and domestic interests. Triffin (1988) explained that gold exchange standard is flawed by its reliance on the pledge of convertibility of some national currency, such as dollar, into gold. Transmission of inflation through US dollar: During 1957-60, the expansionary monetary policy of U.
S led to widening of the deficit. Bordo (1993) concludes that the changes in the monetary base are closely related to the government’s budget deficit. This, along with the return of European currencies to convertibility, substantially reduced the desire of the European countries to acquire dollars. Meanwhile, the inflation in the U. S accelerated, defeating its responsibilities as the country of the key currency. Since U. S dollar was the reserve currency for the member nations during that period, the stability of the prices in the U. S were linked to the stability of the international monetary system. Although the U.
S government was able to maintain this obligation until mid-1960, the lagged effect of the expansionary monetary policy in the first half of 1960 and the increased spending on social programs and on the escalating war in Vietnam in the latter half (ii) of 1960 had a destabilizing impact on the U. S economy. Despite the increasing strain of inflation on the worsening deficit and on the confidence on dollar, the countries running surpluses continued to buy dollar in order to maintain the peg, eventually resulting in global transmission of inflation. There are various other hypotheses explaining how the U.
S inflation got transmitted to the rest of the world. Genberg and Swoboda (1977) points at the inability of the other nations, unlike that of the U. S, to sterilize reserve flows as the reason behind the import of inflation. Balassa (1964) concludes that the expansionary monetary policy of the U. S further enhanced the inflationary pressures created by rapid growth of the traded goods sector in Germany, Japan and other surplus countries. (iii) Unresolved Triffin dilemma resulting in loss of confidence on US dollar: The Bretton woods system began to rely on the U. S deficit to provide liquidity to the rest of the world.
The fear that the speculators may bet on further devaluation of dollar was a cause of concern for the U. S. Hence, at that point, the U. S was faced with the following two choices: ? Acting in accordance to the commitment made at the Bretton Woods, continue to be the provider of global liquidity at the cost of worsening levels of deficit and a fear of speculative attack on U. S dollar ? Keeping in mind the domestic interests, undertake measures to forestall speculative attack on dollar by correcting the deficit This is what Triffin (1988) called “The Triffin dilemma”.
On the other hand, the governments tried to find an alternative to dollar. Special Drawing Rights, an international reserve asset, were believed to be the choice. But as Cohen noted that they were underprepared for the unanticipated problem of reserve surfeit, which emerged in the late 1960s. He also noted that even attempts such as Swap facilities between central banks as well as IMF proved insufficient the restore the confidence in dollar. (iv) Reluctance of surplus countries of Europe to initiate corrective measures: The expanding monetary base translated into BOP disequilibrium between the U.
S and the surplus countries of Europe and Japan. The Europeans and Japanese believed that U. S should take corrective action to halt its growing deficit as these surplus countries were reluctant to revalue the currencies. Their reluctance stemmed from the facts that the confidence in convertibility of dollar had been weakened and buying dollar implicitly meant importing inflation, resulting in destabilization of other economies. Besides, they argued that the privilege of liability financing created an asymmetry in the regime favorable to the U.
S. On the other hand, U. S argued that these nations should revalue their currencies in order to correct the BOP disequilibrium. Contrary to the belief of the surplus nations, Cohen states that U. S believed that the value of dollar was out of its control as the latter was convertible to gold at a fixed rate and government had no means to influence the rate at which nations bought or sold dollar. This initiated a blame game between the two parties. Bordo (1993) highlights that the difference in the interest rate prevailing in U.
S and Europe reflected the dominance of the latter. This shift in power led to virtual breakdown of the G10 and paved the way for a decentralized system. Conclusion: Besides the aforementioned reasons, Harold (1996) holds divergent monetary policies pursued by the U. S and the European countries and Japan responsible for the debacle of Bretton Woods. He explains that if Germany & Japan had inflation rates similar to that of U. S, the system could have been maintained. Besides, despite the fact that with the breakdown of the Bretton Woods the power of the U.
S got diluted, it still remained the only nation which can change the rules of the game if deemed fit. Cohen notes that President Nixon was determined to force Europeans and Japanese to accept a mutual adjustment of exchange rates. Johnson (1973) elaborates that President Nixon went to the extent of suspending the convertibility of gold to dollar for 4 months beginning from 15 August, 1971, compelling the Europe and Japan to realign the value of their currencies to dollar at a satisfactory rate. Hence, with this the Bretton Woods system collapsed.
Michael Bordo. “The Bretton Woods International Monetary System: A Historical Overview.” National Bureau of Economic Research working paper number 4033 Benjamin Cohen “The Bretton Woods System.” Routledge Encyclopedia of International Political Economy Harold James. International Monetary Cooperation Since Bretton Woods. Oxford University Press. 1996. Chapters 8 only Harry G. Johnson. “The International Monetary Crisis of 1971.” Journal of Business, 1973. Triffin, R. (1988) Gold and the Dollar Crisis, New Haven, CN: Yale University Press. The original statement of the Triffin dilemma.