Bretton Woods System and world trade in post-war period

Introduction

This reading report is based on two technical papers( The Bretton Woods international monetary system: An historical overview by Michael D. Bordo 148 pages & The post-war rise of world trade: Does the Bretton Woods System deserve credit? By Andrew G. Terborgh 74 pages)on Bretton Wood System as well as the post war international trade system since the U.S has become the most powerful economy after World War II, that US dollar was at that time the dominant currency internationally speaking. The first paper is titled of “The Bretton Woods International Monetary System: An historical overview” by professor Michael D. Bordo who is an economic professor and Director of the center for Monetary and Financial History at Rutger University. His paper has a brief overview of Bretton Woods experience. From its emergence and how it evolved that influence the monetary convertibility and gold dollar standard, until its collapse due to the U.S depression in 1970s. I considered this article to be a very technical one that gives many details on Bretton Wood System in history, but the very interesting part could also be that the author has given the ideas that why Bretton Woods was very stable but lived so short. Meanwhile, the second paper I chose to read is “The Post-War Rise of World Trade: Does the Bretton Wood System Deserve Credit?” . This one is more of an analyzing paper written by Andrew G. Terborgh, economic professor in London School of Economics. That I found his paper is more critical, that he has compared traditional explanations of the fast growing global economy after World War II which focused much on policies such as tariff reduction or technology development such as improvement of transportation and communication. In his paper, he argued that the traditional analysis may ignored the role of Bretton Wood system of giving a stable trade environment that stimulate the rapid growth. So that the author has strongly concluded that the monetary union is an important driver to reach exchange rate stability and general credibility , convertibility at the period 1950s -1960s when we witness a huge growth of bilateral trade.

These two papers are both very impressive, and both gives points on how does Bretton Wood System matter on the international trade system construction, both articles give detailed example and research on the gold dollar system. After my reading on these papers, I decided to give my reading report into two parts, the first part would be a historical overview of Bretton wood system, and second part will be effectiveness and weakness of the system regarding to the two papers’ points as well as my opinions on the question.

Basically, my reading report will be surrounding the problematic: how does Bretton Wood System matter in the global trade structure?

At the end of the report, I will be concluding on comparing the opinions that two papers have offered us and raise some questions that could be further concerned.

Part I Historical overview of Bretton Wood System

A. Post-war global trade and origins of Bretton Wood

Both authors have pointed out that the period after second world war was a new era of global economy, that is to say, international trade grew rapidly and consistently compared to the years before or even compare to the first globalization period before 1914. If summarize what Andrew G. has mentioned in his second part of work, first of all, world trade has outpaced world output since 1950s to 1970s. (from 1953 to 1963, trade in manufactured products increased by 83 percent, while manufacturing output rose by only 54 percent.). secondly, global trade growth was largely within the industrialized countries, because those countries were more productive, that there was a sharp increase in the similar final goods, components of productions exchange, that 54% of world trade were within those industrialized countries.

What is interesting to know is that in Professor Andrew’s work, he has firstly reminded us the very frequent traditional explanations of such an economic boom in western countries. Those are tariff reduction with liberalization of trade, development of transportation and communication, and he also mentioned the Heckscher-Ohlin style model of income growth and convergence. Before we start to analyze the contribution of Bretton Wood system, we have to think whether those traditional explanations weighted more than the unified money union system that has stimulate the world trades. Andrew argued that there were not sufficient proves for traditional reasons. For example refers to GATT, it is true that it’s a giant organ to involve 23 nations on reducing tariffs covering many trades, however, statistics showed (appendix 1) what GATT has contributed was not quite efficient from 1950 to 1960, that was why the European Economic Community was then created to further solve the trade issues, after 1960s we see a more obvious trend of reducing tariffs, however, international trades have already started busily after 1950. Andrew has quote what Irwin (Irwin 1995) has concluded “ there is considerable uncertainty about the effects of tariff cuts on trade, because quantitative restraints and foreign exchange restrictions continued to be in place, it is not clear that the tariff reductions translated into more open market access for Europe.” That might describe the US situation in post war period was very protectionist. (Krugman 1995)

Other conditions affect world trade is transportation and communication within countries. Communication could help world market to have a better allocation of resources, countries import the goods and materials they need to produce the goods and export them to the countries who need. Post war period the communication between economies were much intensive and effective thanks to the use of computers or other communication technologies to offset geographical constraints. So does we could explain the development of transportation, for example faster shipping of goods, this improvement was after world war two which reduced transport cost of goods, especially when goods were produced in stages across different countries, an efficient and low cost transportation would facilitate the cross boundaries trades. We believe those improving factors accelerate the pace of international trade, but as krugman(1995) has stated in his works that their contribution is marginal, because those improvement have already showed and sufficient before the world war, but why do little empirical evaluations have supported what economic historians have found to account for the economic boom in 1950s and 1960s.

Except for those external effects that would affect international trade, we should also have a research on a more financial or monetary perspective, which is to see what could hinder or help inside of trades themselves. For example the payment standard, the exchange rate stability, external financial risks. Those are the core value we should carefully look at in terms of evaluating international trade situation. In Andrew’s paper, he has mentioned the payment obstacles in terms of whether monetary regimes could have an influence on that to reduce payment friction.

Industrialization and globalization give chance to a more intensive cross countries business, but in the trading system one of the important element is the payment section. Different countries have different currencies, any market stability change will lead to the exchange rate volatility, then the benefit you get from the international trade may not worth the value to what you expect. Thus, exchange rate is a risk for international traders, because the rate change is often unpredictable and could come in a sudden, which McCallum conclude a phenomenon as “home-bias” to illustrate the example study on Canadian trade in 1988, its trade within country provinces are 20 times more than the trades with U.S. which is to avoid foreign exchange rate risk. Andrew has in his paper addressed that a currency union with an international accepted payment standard will reduce the problems of payment frictions and thus increase the trade. He imported two empirical statistical example, one from Rose to analyze impact of currency unions on bilateral trade, from his dataset, result shows countries sharing a currency trade over three times more with each other than similar countries but use different currencies. Another example is carried out by Persson(2001) proved 66% increase in trade from a currency union. Even though there are many critics on the study result, but other economic experts Estevadeordal, Frantz and Taylor(2001) also given studies to prove that previous gold standard regime has an effective impact on the growth of international trade from 1870 to 1914 as an common accepted currency union. When gold standard was abandoned after 1914, international trade destabilized for a period. (Ashworth 1987) Lopez-Cordova using the econometric model to suggest that two countries using the gold standard traded 60% more with each other than countries using different monetary regime.

From the empirical studies, we noticed that an effective monetary union or payment standard could have a positive impact on bilateral trade. Andrew has described in his paper that from 1950s to 1960s nearly 70 percent of global exports came from developed countries where they comprised the core of Bretton Woods system. Both researchers have made assumptions from this simple relationship and suggest that Bretton Wood System had an important role in world trade growth especially in 1960s during the peak ear of the System.

From the interwar experience, countries observed many monetary problems such as wildly fluctuating exchange rates, collapse of Gold exchange standard, liquidity problem, confidence problem, etc to be avoid in the post war period of international trade. Those flaws of interwar monetary system lead to the creation of Bretton Wood System. Britain and U.S are the major players in the negotiation of the system. They both wanted a peaceful international trade which Michael described (p 16) as beliefs included multilateral payments system, stable exchange rates and full employment. Two wartime negotiations, august 14, 1941 and February 23, 1942 led to the creation of settings of Bretton Woods plan. British treasury team Keynes Plan and American team White Plan had reached the compromise in 1943 regarding international payment, terms on lending, postwar recovery, employment… which concluded as a joint statement as a draft for the Bretton Woods Conference and led to the articles of IMF in 1944. The joint statement was a compromise of the interests between two countries, however, U.S still remained the controlling power of the agreement because it was obviously the strongest economy in the world. What I appreciate Michael has concluded that the creation of Bretton Woods System is also a result that the winners of the war feel like they have the obligation of creating the peace and a regulated international trading system when the war is finished, and they have shared the same perspective that full employment and liberal multilateral payment system is important. As far as I am concerning that the creation of a new international monetary order should be under the guidance and the implementation with supervision of powerful economies, U.S and Britain are the case, even though it is idealism that they think they are the one to save democracy, but we couldn’t neglect that they made contribution on the negotiation of creating a mutual agreed joint statement and give the start of new international order which did result in the fast growth of international trade between 1950s to 1960s.

B. Operation and evolvement of Bretton Woods System

The concluded articles of Fund are based on the creation of par value system, multilateral payments and use of fund’s resources power and organization. I just want to quote the objectives of the Fund “ to promote international monetary co-operation, to facilitate the maintenance of full employment and rapid growth, to maintain stable exchange rates and avoid competitive devaluations to provide a multilateral payments system and eliminate exchange restrictions, to provide resources to meet balance of payments disequilibria without resort to drastic measures and to shorten the duration and lessen the degree of payments disequilibria. “

Thus it gives the Fund power and authority to influence the international monetary system, which included as determining parity changes, multiple exchange rates or other discriminatory actions, conditionality of access to credit, or to declare currencies scarce, or whether countries membership could be held or whether they are accessible to use fund’s resources. The Fund’s as a supra international monetary supervisor aims of recovering post-war world economy and encourage peaceful operation of trade, it has decisive power over, precisely par value system , multilateral payment system , its resources .

The Fund is the major part of the Bretton Woods System. The system was supposed to work firstly to maintain the parity between member countries currencies and dollar , (U.S would then fix the parity with gold). Moreover, members could ask Fund’s financial help to pay deficits to prevent any fiscal crisis or unintentional alter of currency parity. Michael questioned whether the system has processed as the funders Keynes and White has architected.

By looking at the first period of Bretton Woods System, before it has started functioning effectively, the period from 1946 to 1958 was not smoothly as anticipated, that is to say the full convertibility was not well achieved before 1958, major reasons are the legacy of bilateralism of WWII and the dollar shortage as U.S dollar became the dominant currency after the war. After 1950 it is when the system has really being in a good development with the progress of Marshall plan and the European payments union, when British sterling’s leading position has been replaced by the U.S dollar as the major currency in international trade.

Most of the European countries who have participated in the war has suffered great financial deficit and monetary problems after the war. However, in early 1950s, those countries have achieved 39% increase in industrial production, and expand of exports as well as current account surplus . Marshall plan contributes a part of the recovery of European economics, that it was created in 1948 to restore European countries in deficit with 13 billion dollars, but it requires the liberalization and cooperation of trade and payments and potentially allied European countries economically. Then, the Organization for European Economic Cooperation OEEC was established in 1948 aimed at dealing with allocation of aid by Marshall plan, later on the European payments union was established in 1950. Those institutions were plant to stimulate industry , agriculture investment, gave confidence to investors, as well as infrastructure construction, which also linked with expansion of liberalization of trade. Productive activities in European countries were promoted through the plan, that Eichengreen and Uzan given Marshall Plan permanently raised the growth rates of recipients. (1991)

The Bretton Woods System has started early when 32 countries have signed declaration of parity values in 1946, but it started functioning as a scheme which facilitate much of the payments process within world trade process after 10 years approaching, especially after the establishment of European Payments Union to reduce payments transactions and give settlement of international multilateral trade. The Bretton Woods System has also marked the end of british sterling’s key position which U.S dollar has later on became dominant, due to U.K’s current account deficits after the war and devaluation of sterling in 1949, when demand of U.K’s productions were reduced due to the financial recession after WWII. The devaluation gives the chance to the deficit European countries to restore convertibility. In 1950s, dollars raised its position with U.S emerging market, it has played the role as a unit of account to define member countries’ parities within IMF, which is to say, countries regard dollar as a exchange standard, they buy and sell dollar with a fixed rate.

The evolvement of Bretton Woods System is very characteristic, we witness, U.S has gradually become the key player, U.S dollar became prominent, from a supposed to be adjustable parity system but changed to a fix exchange rate with dollar system. The Bretton woods reached its peak period in 1958 and the later few years with the establishment of current account convertibility, by maintaining exchange rate with dollars, on the other hand, dollar pegged a price with buying gold, so, all the currencies were indirectly stably linked with gold trade. Thus, they system has kind of evolved into a gold dollar system like before. Which also gives dollar the role as an intervention medium currency. After 1968, the system was almost managed by U.S and the G-10 countries out of the IMF. Briefly, the system become a dollar gold exchange system, but with the financial crisis of U.S as well as the huge inflation which pushed U.S into a convertibility crisis, and it lacked of mechanism to adjust the fixed exchange rate with the growing capital mobility, as dollar played the role as gold in the gold exchange system, but dollar is still a currency, when it faces price instability, the crisis will extend to the whole system, and U.S in this period has conducted an inflationary policy which in result triggered the crisis. Especially, when industrial countries had recovered from the deficit problem, they would no longer regard U.S power as that important as before, the system was collapsed in the end and U.S has ended its dominant position in the global financial market.

Part II Effectiveness and weakness of the system

A. Contribution to a stable international market

Bretton Woods System reached its best performance during the early 1960s, what it has achieved is a true multilateral payment system, a free market, a real and confident current account convertibility, exchange rate stability, and a full credibility, which from 1950 to 1960 support the growth of international trades across countries. We should also emphasize the role of Marshall plan as well as OEEC and EPU, that they were functioning to assure multilateral trade payment, liberalization of trade and account convertibility.

From the reading materials, Andrew spoke to support the view that it is an effective currency union and certainly increased the trade by analyzing the features of the system: current account convertibility; exchange rate Volatility; credibility of the system.

He has explained the problem during 1950s when problems occurred like US dollar shortage and large dependence of bilateral trades, which hinder the multinational intra Europe trades, and restriction of Bretton Woods System. IMF didn’t solve the problem because it didn’t have enough sources. However, he praised Marshall plan facilitate the situation, it has loaned 13 billion dollars to Western Europe to overcome their deficit and this is an important step towards full convertibility. By introducing Marshall Plan, profited countries have had an increase of productivity, gain current account surplus and convertibility that wins investors’ trust. In terms of solving shortage of dollar, devaluation of British sterling made a contribution. With the emergence of European payment union, member countries all made their currencies convertible, which facilitate the intra EPU trade. As a result, when trades increased, more investors were coming and confident with the market. In 1958, European countries have reached full convertibility. After 1958, the system maintained convertibility of main currencies in the market.

However, both authors have stated that during 1960s, Bretton Woods System was operated not as the drafters have planed, especially in terms of exchange rate volatility. It was supposed to have an adjustable pegs in case disequilibrium happened and avoid the problem occurred in the war period of floating exchange rate, countries could adjust their exchange rate with consultant of IMF in case it is necessary. However, during 1960s, statistics showed that countries adopted Bretton Woods System had a relative stable nominal and real exchange rate than other period in before 1960s, especially after the devaluations of major currencies like sterling, franc. Thus, Bretton Woods System was actually developed into a fixed exchange rate system. fixed exchange rate is crucial for the stablility of global financial market, reduce risk of free movement of capital and trade, encourage liberalization of multilateral trade.

Michael in his paper also confirmed that the system was stable during period between 1950s to 1960s, because United States as the most powerful country after the war had become the center of the system, and it introduced stable financial policies to keep the stable operation of the system.

Except for the stability of the system, another important thing is that to give credibility to the system, just as we experienced in the classical gold standard regime, monetary authorities protect gold parities which wins confidence of the market, leads to the positive impact of international trade. As the case of Bretton Woods System, in the early 1960s, it was when full convertibility had achieved and exchange rate stayed fixed, those became a good indicator of credibility of the system. however, this didn’t last long, after 1960s,capial mobility was imperfect (suggested by Obstfeld), the market needed more adjustment and realignment, but the system lacked of adjustment mechanism. Thus, credibility of the system only lasted in the period when it operated effectively.

The very interesting thing in Andrew’s paper is that he has used econometric models to explain the effectiveness of Bretton Wood System on international trade. For example, the variable of exchange rate gives that, exchange rate volatility reduce bilateral trade, he gives model on Bretton woods system, two countries which completely eliminate exchange rate variability will result in 2.5 percent increase in trade. Statistical result showed, in the early 1960s, the peak of Bretton Wood, zero volatility of exchange rate raised 9 percent of bilateral trade. The conclusion of this model gives participation of Bretton Woods System increased trade. he has transferred his data set into the historical context, “ country pairs that made their currencies fully convertible traded about 40 percent more than pairs in which at least one country restricted current account payments”. The time period on the result also showed that Bretton Wood was much more successful in 1960s than in 1950s.

I would also like to speak about the legacies of Bretton Wood system, even though the system crashed down after no more than 30 years, but this was a great experience of world economic order construction. The related international monetary institutions are playing crucial role in the international trade order nowadays. The system not only achieved convertibility of currency and exchange rate stability, but also expand the trades, increase liberal cross country trade. It was an important step towards recovery from WWII, productivities have increased as well, much more gains come from trade and export, thus generates a better condition for welfare contribution, like per cappita income of people.

B. Weakness and failure of the system

During the second world war, countries have suffered the financial disaster brought by the war, except for America, from 1940 to 1944, it’s industrial sector growth has reached 15%. When the war has come to an end, U.S has already had 60% of gold stock. Dollar became a major currency, with the Bretton Woods System, U.S has reinforced its economic dominant position in the world. As the most powerful country in the world after the war, it started Marshall plan to give loan to other western European countries, when those countries started to recover, their productions also come into the global market to compete with Amercian productions. Afterwards, U.S started wars in Asia, large military spend gave itself financial pressure, Japanese economy has also recovered during that period and had also competitive market share of productions in global market. In the late 1960s, crisis of U.S dollar burst out, in 1960, U.S only had 17.8 billion dollar of gold storage, however, it had already 21 billion indebt, accompanied with the later Vietnam war, the deficit became more serious, a huge dollar inflation appeared which produce incredibility of dollar by other countries who participated in the Bretton Wood System. Finally, the inflation crisis marked the end of the system when president Nikson has announced new economic policy to stop exchange gold with dollar, at the end of 1971, government has announced the devaluation of dollar of 7.89% and a second time in 1973, a devaluation of 10%, however, it didn’t save the worsen situation. Countries gave up the fixed exchange rate of dollar, restart to use flexible exchange rate, Bretton Wood System came to the end after 27 years.

Combining with what the two papers have analyzed about the weakness of the system as well as my opinions from reading other materials. Several points I may agree on the problem of the system is the liquidity problem, the confidence problem, as well as whether this system was designed to a large extent protect the political and economic power of U.S in the world market, such as take dollar as the unique standard to fix exchange rate and the rate of exchange gold.

By looking at the liquidity problem, in the middle 1950s, IMF has declared it has adequate reserves however, it was not the case with its later report that reserve is insufficient after 1960s. Triffin has argued that the inadequacy of liquidity was due to the reduction of gold production. Gold stock was inadequate to finance the growth of world real output and trade volume. Other currencies were not convertible towards gold, but to dollars, countries have to have dollar asset stock, which required U.S ‘s trade deficit. Due to the deficit, U.S monetary gold reserves would decline. Moreover, countries would prefer to have gold asset rather than dollar asset. Insufficient liquidity and reserve assets didn’t meet the requirement of world economy growth.

Linked with the liquidity problem, there was also a confidence crisis of Dollar when the world gold stock was insufficient to meet the output world wide. U.S had a great pressure on lack of gold stock. The problem was potentially started when creating the Bretton Wood System to define dollar as an stock asset substitute the gold. This might cause big instability. To keep countries have the supply of U.S dollar, it depends on trade deficit of U.S, so could dollar be allocated to other countries. but this would triggered dollar crisis. But if U.S keep the balance of dollar trade, the supply of international monetary reserves would not be enough, moreover, if it keeps surplus in the trade, there would be shortage of dollar in the financial market. The consequence is that trade deficit of U.S lead to the reduction of gold stock in U.S, thus, international confidence of dollar would be affected. (Triffin’s Dilemma, gold and dollar crisis)

From late 1960s to the early 1970s, U.S dollar has experienced several crisis. For example, in 1973, western Europe has started another trend of undersell dollar to buy gold, London gold market has reached the gold price to even 96 dollar an ounce (compare to before 1970, 35 dollar per ounce), member countries have gave up the flexible rate to dollar. Nikson’s policy has marked an end of gold dollar system.

Further more, even though the two research papers have not mentioned directly, the capitalism interest of U.S, but they both some how emphasize that even though we could admit that the system has contributed to the economic recovery, but on the other side, this also reveal state interest that the U.S wanted to consolidate its dominant position in the world, by giving dollar the primary importance, expand American capital market and external investment, which is what I considered as “ dollar prerogative”, for example, it could devaluate dollar by printing more money when facing trade deficit, however it is at the rate of reducing dollar confidence, as a result to the collapse of the system.

Conclusion

The two papers have showed the rise and down of Bretton Wood system. We could divide the system into two period, from before 1958 and after 1958, before 1958, due to problems left by the war, like inconvertible currencies as obstacle of international trade, destruction of infrastructure and physical capital limit Europe’s production, they have no better means to have dollar if trade of production were lack behind. The system thus did not achieve full convertibility of current account and full liberalization of international trade. The plan of this system was to avoid problems and chaos like what in the interwar time thus the adjustable peg system was designed, and international monetary institution will be in charge of that. However, the system evolved not as it has designed at the beginning, in 1960s, the system achieved full convertibility, and the system had become gold dollar standard a fixed exchange rate to dollar is maintained, and dollar was the major currency. However, dollar crisis started when U.S has experienced deflation of dollar, as well as lose confidence on dollar, gold stock in U.S become less and less, much more financial income were spent to support military war in Asia. The system collapsed in the 8th dollar crisis with the new economic poicy introduced by president Nikson, dollar was no longer the fixed currency to exchange for gold.

Form the how evaluation of the system, by answering the question whether Bretton Woods System matters in the post war global economic order, I agreed with authors that it has been effective between 1950 to 1960 that it has previously encouraged the recovery of western countries from the depression of the war, then it has increased multilateral trade and open trade liberalization during that period, by reducing exchange rate volatility. However, there are still many flaws of the system, for example, within one monetary system, if we keep one country’s currency as the dominant reserve asset, it would be risky if the country would later on going into economic crisis. Market with a monetary system also requires strong credibility to maintain stable. Thus, I agree with Andrew suggested at the end, designing a monetary regime needs an supervisor institution to assure the credibility, within the regime, all the countries must be benefit from it, rather than keeping one country’s dominant position. At last, what I’ve learnt from the historical document was that, designing a international order regime was always under the support of the most powerful country like the UK before the war and U.S after the war.

However, I would still have further questions to research for. Like why did UK Germany France had agreed to participate into the system? How did the IMF’s role evolved from the start of the system to nowadays? Are those problems lEd to collapse could be avoided during the operation of the system?

Reference:
The Post-War rise of world trade: Dose the Bretton Woods System deserve credit? Andrew G. Terborgh London School of Economics 2003

The Bretton Woods international monetary system: An historical overview
Michael D. Bordo National Bureau of Economic Research Cambridge 1992

http://www2.econ.iastate.edu/classes/econ355/choi/bre.htm http://www.indiastudychannel.com/forum/28128-Conclusion-bretton-woods-system.aspx http://www.time.com/time/business/article/0,8599,1852254,00.html