The Collapse of Bretton Woods System (EN)

In July of 1944, the Secretary of U.S Treasury, Henry Morgenthau Jr. gathered representatives of 44 nations in Bretton Woods, New Hampshire. To answer the question “What kind of economic system we are going to have after WW2?” They had already believed that the U.S. was going to win the war. And there were two perspectives; American view and British view.

American view was defended by Harry Dexter White as he was saying after the war there should be an economic structure based around international institutes and those are IMF and World Bank. The U.S. Dollar should be the key currency, fixed to gold. $35 = Ounce of gold

On the other side there was British view defended by John Maynard Keynes. He agreed that there should be an international arrangement around organizations like IMF and World Bank but he did not like the idea of American dollar being the key currency instead he said there should be one universal money and that money as an unit of account should be Bancor and there should be one global Central Bank issuing bancors. According to Keynes, if there was bancor, there would not be interest rate volatility, no price rate volatility and no exchange risk.

As far as money concerned, Bretton Woods is an important point in the history. It’s bringing the money into the centre of economy. These were two views represented in Bretton Woods and American view was accepted. As a result of it, IMF and WB were formed and American currency became the key currency.

By looking at this IMF decides the healthiness of an economy. If the international trade is in deficit. -There are two types of deficit; temporary and permanent deficit- IMF studies international trade, determines whether there is a temporary or permanent current account deficit. And according to that, comes up with a policy prescription for domestic economy.

If there is a temporary current account deficit, IMF allows countries to do devaluation. Devaluation improves current account deficit by making exports goods. The price of domestic goods go down and the demand for those goods will increase in international market. People will be able to export more, as export increases then this current account deficit will disappear as a result of devaluation.

If there is permanent current account deficit, then IMF comes up with standby agreement that requires structural change of the domestic economy. Structural change is either reforming financial sector or reforming public sector. Reforming public sector means reducing public sector borrowing requirement through privatizations. IMF gives money to countries to do that.

IMF gives tranches to countries when they face with a current account deficit. Tranches are money given to IMF by member countries. Member countries contribute to IMF by giving gold, foreign exchange, hard currency and their own currency. When they need to improve their current account deficit through structural adjustment, that structural change will be financed by their own money at the IMF. This is how it works. Member countries contributes to IMF budget by the size of their own GDP. When they are in need, they will go and draw money from IMF that they have already contributed. And IMF will tell you what to do about finance and public sector reforms.

For IMF to approve this, 88% of the votes must say “okay, you need to do this” or whatever IMF is going to offer to the world must be approved by 88% of the members. Now, because the U.S.; as the largest contributor in the world to IMF budget, the U.S. already has 14% of the votes. The U.S. actually dominates how the world economy is going to be shaped under IMF/Bretton Woods system. By contributing certain percentage of their GDP to IMF budget, they got 14% of voting rights and that means the U.S can block everything that IMF says against the U.S. S basically the world economic system under Bretton Woods has been dominated by the U.S. And it still continues.

After WW2, the U.S; largest surplus economy will have to send its surplus to the world and it passes one thing; a legal system regulating AID flows around the world that is known as Marshall AID. Bretton Woods system goes functional under Marshall AID. Almost every country receives Marshall AID, they still do. Marshall AID is the largest AID organization in the world.

So the U.S. Hegemony works like this; the U.S. Dollar being key currency and Marshall AID. Everything fixed to the U.S. Dollars but with one exception; countries could devalue or revalue their currency within a band that is “Snake in the Tunnel”. This is a band that countries allowed to devalue without asking IMF permission.

Under this system, interest rate volatility has not being very volatied. Prices did not move because they were suppressed, suppressed by the U.S. hegemony. If hegemony cannot suppress any longer then the system doesn’t work and it collapses. There are certain reasons why it collapses.

Petrodollars: In, 1967, Israel responded an attack from Egypt and defeated them and their neighbors. It was known as “6 Days War”. Then OPEC countries came together and decided to increase oil prices. Most of the developing countries in need of industrialization, their demand of oil had increased that also increased their import will. They had to borrow money from IMF but IMF was not ready to lend everyone that much money because the demand was too much. Then in 1967, IMF introduced SDR(Special Drawing Rights) and once this is introduced, Bretton Woods system was finished. SDR are rights by individual countries to use currency even there is no currency. Basically these are like Keynes’ bancor. Somehow if they were to listen to Keynes and introduce bancor instead of the U.S. Dollars and so on, the world would not go down like that. So IMF finds the solution to introduce SDR just like the universal currency. This was one thing that happened; the increase in oil prices. The second thing is Vietnam War.

Vietnam war: The U.S. sent so many troops to Vietnam. It was very expensive. Vietnam was a very small country but they took super power down, defeated the U.S. As a result of it the U.S. ended it up with big budget deficit. Now this big budget deficit prevented the U.S. to contribute their share to IMF. The U.S. was no longer hegemony in the system. The third reason was Soviet Union.

Euro dollars: After WW2, there was an eastern block led by Soviet Union and they were gold producers. With the sell of golds, they received too much U.S dollars. But those dollars were not deposited in the U.S. banks because Soviet Union was afraid that the U.S. could block their money in the banks. Instead they deposited their gold money in France. Why France? Because France had the biggest communist party in Europe. They thought their money would be safe there. And the banks in France converted those dollars into Euro dollars. Euro dollars created a system and French did not put a reserve requirement on this. And Euro dollars started to multiply infinitely. The number of euro dollars in circulation has increased so much that the U.S. cannot reach it. In the U.S. there are U.S. dollars and around the world there are Petrodollars and Euro dollars.

Money were deposited in Western banks. If western banks are collecting domestic funds they would pay lower and they charge higher domestic rate. Euro dollars have relatively smaller deposit rate. They land out in Euro dollars, their credit rate is lower than domestic credit rate. They make profit but the profit is lower. They are low risk positive return instruments. So by taking less lower risk. Western banks were able to make profits. So Euro dollar credit market expands so much that it causes an international debt market. Basically this positive return lending goes to developing countries’ governments. And their international debt increases. The reason why it continues to developing countries’ government credit is because these governments are perceived to be risk free. That international debt increases so much that developing countries cannot pay back.

One thing to take into consideration is this, Euro dollar market starts speculation in that snake in the tunnel. Big amounts of money being speculated with this margin of 2.5%. Basically that kind of speculation undermines government authority. Governments become helpless with the coming and speculating of private companies.

So the system has collapsed and corrupted from within the system itself and it’s no longer sustainable and the U.S. is no longer continue to controlling the system. And that is the end of Bretton Woods . What comes after this, is highly risky, highly competitive financial and economic environment in which our interest rate started going volatiled.