All Commentary
Tuesday, May 1, 1973

Bretton Woods: 1944-1971

Mr. Stevens is a free-lance writer who specializes in the field of economics.

In 1944, as the world was recovering from the effects of World War II, the heads of state from over 100 countries met in Bretton Woods to create an international monetary system that would unite the western world, insure monetary stability, and facilitate international trade. Over the years since then the system has been plagued by dollar shortages and dollar “gluts”; chronic deficits and chronic surpluses; perpetual parity disequilibria, “hot money” capital flows, and currency depreciation. By 1968, a “two-tier” gold market was established in the midst of a gold crisis which, by 1971, culminated in the suspension of dollar convertibility together with a dollar devaluation against multilateral revaluations of most other major foreign currencies.

Bretton Woods is dead and an autopsy is called for to determine the cause of death. If meaningful international monetary reform is to follow, it is necessary to know what went wrong.

Fixed exchange rates, flexible rules…. Under the rules established by the Bretton Woods agreement, the gold values of a member nation’s currency could be altered “as conditions warranted.” This distinguishing feature of the Bretton Woods system exposed a drastic ideological departure from the gold standard.

Under the gold standard, no natural conditions would ever warrant a change in the gold value of a nation’s currency. Under a pure gold standard, all the money in circulation would be either gold or claims to gold. Any paper money would be fully convertible into gold. There would be no difference between claims to gold and gold itself, since, if claims to gold circulated as money, the gold could not.

However, there are government-made conditions that could warrant a reduction in the gold value of a nation’s currency. If governments have the power to artificially increase the claims to gold (e.g., dollars), they have the power to depreciate the value of the national monetary unit.

Bretton Woods was established with the intention of aiding governments in exercising their powers of inflationary finance. Government leaders knew that the gold standard prevented them from fully pursuing domestic goals that depended on deficit spending and prolonged, artificially induced “booms.” They detested the gold standard for its fixed rules which brought adverse economic repercussions whenever they refused to adhere to them, and they detested flexible exchange rates that exposed the government’s policy of currency depreciation.

The political temptations of artificially increasing the money supply in order to “stimulate the economy” prevailed against the gold standard and brought the beginning of a “new era”: fixed exchange rates with flexible rules, the exact opposite of the gold standard.

No longer would politicians adhere to the discipline of the gold standard. No longer would they have to restrict their deficits or domestic money supplies. Government leaders would make their own rules and fix the nominal value of money by decree. And if “conditions warranted” a reduction in the nominal value of a nation’s money, it was agreed that a nation could devalue up to 10 per cent after the formality of obtaining other nations’ permission. This was called the “adjustable peg” system.

The great ideological distinction between the gold standard and the Bretton Woods system, then, is that the Bretton Woods system was ostensibly intended to stabilize exchange rates, but at the same time it anticipated that governments would not defend the value of their currencies. Worse, Bretton Woods institutionalized a method which allowed and condoned future currency depreciation.

Export or devalue: institutionalizing the devaluation bias….

Historically (and the Bretton Woods era was no exception) nations have seen fit to pursue a basically mercantilistic trade policy, i.e., a policy which maintains various regulations intended to produce more exports than imports.

The mercantilistic case is not a realistic one. For example, it would be impossible to develop a logical case advocating that all individuals should sell products and services at the same time. Obviously, some individuals must be consumers if there is to be a market for sellers.

There is no difference when it comes to nations trading in a world market. This is simply to say that not all nations can run trade surpluses at the same time.

An equally difficult case would be to try to convince some individuals that most of the money they receive from the sale of goods and services should be saved rather than spent on the consumption of goods. Yet this is the intent underlying all government policies that aim at increasing exports (sales) and restricting imports (consumption).

There is no logical reason why individuals should not be allowed to reduce their cash balances by buying goods from other nations if they believe it is to their benefit; that is what their cash balances are for. To penalize men or discourage them from importing by imposing licensing restrictions, capital controls, tariffs, or “import surcharges,” only serves to limit the variety of their economic choices. This in turn only serves to reduce their standard of living. A nation’s drive for export surpluses, together with its “protectionist” policies of restricting imports, leads to an increase in the domestic money supply. This influx of money, together with the money that governments feel they must artificially create in order to “stimulate the economy,” leads to higher domestic wages and prices as more money chases fewer goods. These higher wages and prices create an illusion of prosperity, which explains the popularity of mercantilist-inflationist policies.

But higher domestic wages and prices lead to a dwindling trade surplus as a nation’s goods become less competitive in world markets, and a dwindling trade surplus, unless corrected, eventually deteriorates into a trade deficit. This is the dilemma facing all governments that pursue the contradictory and self-defeating policies of mercantilism and inflationary finance.

Under a gold standard there is only one way to resolve this dilemma: stop artificially creating money, stop preventing money from leaving the country. The result would be a normal, self-correcting deflation — i.e., a contraction of the domestic money supply — which would lead to a fall in domestic prices and to equilibrium in that nation’s balance of trade position.

But because governments hold an unwarranted fear of lower prices and favor higher prices that give the illusion of prosperity, the framers of Bretton Woods adopted a mechanism that would allow governments to inflate their currencies yet escape the process of a normal self-correcting deflation. By devaluing their currencies, governments could continue to inflate their domestic wages and prices while making their exports less expensive to the world.

The device of devaluation was established to allow nations to regain their competitive edge once their surplus deteriorated into deficit. Devaluation immediately lowers the price of a nation’s exports, and in this way nations can more actively strive for export surpluses. Thus the framers of Bretton Woods found a way in which nations could continue both their drive for export surpluses and their domestic policies of inflation.

A nation would simply export its goods until its domestic inflation reduced or eliminated its trade surplus, then devalue. In this way the Bretton Woods system established an implicit code of conduct: export or devalue. It institutionalized a devaluation bias within the new international monetary system, which led to serious imbalances, ultimately resulting in hundreds of devaluations during the Bretton Woods era.

“Hot Money Blues.”…

Because devaluations are completely arbitrary (at best mere guesswork), new problems arose in place of old ones. The problems centered around the pre-devaluation exchange rate: nations were committed to supporting the rate even when it was unrealistic.

Bright investors soon began to realize when a particular currency was overvalued and to shift their money from the weak currency to stronger ones. This caused further pressure on exchange rates and resulted in speculation — i.e., selling short on X currency, buying gold, or buying long on Y currency. Governments intervened in foreign exchange markets in order to preserve their unrealistic exchange rates, by accumulating massive amounts of unwanted weak currencies. But this could not continue for long.

Finally, when a government was forced to devalue, the action had repercussions on other currencies (particularly if a major currency were involved): it brought all other weak currencies under suspicion. This resulted in further devaluations as investors transferred their money into only the strongest currencies in anticipation of competitive devaluations and major currency realignments. This was called “hot money” and was attributed to speculators — not to currency-depreciating policies of governments.

Finally, under the Bretton Woods agreement, national currencies were not allowed to “float” and seek their own levels. The new “par value” of a currency was arbitrarily set by the IMF — and these were consistently either too high or too low. Like all forms of government price-fixing, the fixed exchange rate system was in perpetual disintegration. This resulted in further “hot money” flurries, further realignments of currencies, and an inherently unstable exchange rate system — the exact opposite of the goal intended by the framers of monetary reform at Bretton Woods.

The role of the dollar under Bretton Woods….

The role of the dollar under the Bretton Woods system was vastly different from that of other currencies. Because of the

United States’ economic strength and Europe’s economic weakness after World War II, the dollar was used by other governments as a reserve for their currencies. This meant the dollar was pegged to gold and supposedly committed to stability and convertibility. Thus the dollar was supposed to be “as good as gold,” and therefore to be treated as a reserve asset just like gold.

There are several implications tied to the concept of a paper reserve currency. (1) Gold, the main reserve asset, was considered too limited in quantity to restore world liquidity or to provide sufficient wealth for rebuilding war-torn nations. (2) While gold could not be increased, a paper asset (U.S. dollars) could — consequently the reserves of the western world could be expanded. (3) Inflation could be implemented in a “more equitable” manner by an ever-increasing paper reserve. (4) A paper reserve currency “should not be devalued” yet it should be increased “as needed” to meet demand. This last blatant contradiction was the major factor in the disintegration of the IMF in later years.

Limited gold — unlimited dollars: a formula for disaster….

Since gold was limited, the vast majority of the assets on which foreign currencies were based to finance Europe’s recovery was not gold but U.S. dollars — the second primary reserve asset. The demand for dollars came in two forms: (1) demand for foreign exchange to be used for importing goods, and (2) demand for reserve liquidity and replenishment.

The U.S. satisfied the demand for foreign exchange by inflating its currency and extending loans and gifts to Europe. These gifts and loans were used almost entirely to import goods from the U.S. Therefore, many of these dollars returned to the U.S. However, the demand for reserve liquidity and replenishment was met by continuing U.S. deficits that led to European “stockpiling” of dollars in the form of interest-bearing notes and demand deposit accounts. Demand for dollars between 1950 and 1957 continued and an excess of dollars began to build up in foreign central banks.

After 1957, and to this day, the foreign banks have been obliged to continue to take in dollars that were neither intended for imports nor needed for liquidity. This era has become known as the era of the dollar “glut.”

Confidence versus liquidity — a two-tier tale….

During the 1960′s the progressive supply and accumulation of dollars mounted and world central bankers found themselves confronted with a government-made monetary dilemma: the more dollar reserves they acquired, the more likely was the chance that their dollar surplus would depreciate in value. To state the problem another way, the more liquidity central bankers enjoyed, the less confidence they had in their most liquid asset — the dollar.

Gresham’s Law prevailed and in 1968 central bankers and private speculators began to convert their dollars into gold. A gold crisis developed: the U.S. could not hope to convert the amount of dollars outstanding against its gold stock. A “two tier” gold market was set up to avert a dollar devaluation and the break-up of the International Monetary Fund (IMF), i.e., one free market for speculators and industrial users who would buy gold at the free market price, and an official market where governments would transact dealings at the pegged price of $35 per ounce. Finally in 1971, in a wave of “hot money” speculation, the U.S. was forced to devalue the dollar against gold and to suspend its convertibility.

Gold’s limitations: a blessing in disguise….

The demise of Bretton Woods can be traced directly to an excessive supply of dollars. The anti-gold principles of inflationary finance practiced diligently under the Bretton Woods era, turned into a give-and-take fiasco: the U.S. became a faucet of wealth, supplying dollars on request to every corner of the world, while over a hundred countries drained the U.S. in the name of world liquidity and “reparations.”

The result was a flood of dollars that swept over the world producing world inflation, numerous recessions, hundreds of currency realignments, disruptive trade, a gold crisis, and the final international monetary crisis that has left the world precariously groping for stop-gap measures to resume monetary and trade transactions.

Clearly the Bretton Woods vision of a stable and ever-expanding reserve currency was doomed from the onset. Had the governments limited their reserves to gold, the kind of monetary and credit expansion under Bretton Woods — and all of its disastrous consequences — could never have occurred. Gold places objective limits on monetary and credit expansion, and this in itself was enough for the framers of Bretton Woods to condemn it.

It is no accident that the kinds of limitations gold imposes on the extension of money, credit, and reserves is just what the world is crying for today in light of the “dollar glut.” As a reserve currency, the dollar was supposed to be as good as gold. But monetary authorities never stopped to ask “what makes gold so good?” The answer is that gold is limited — the very point for which it was condemned.

The refusal of government leaders to adhere to the rules of the gold standard and their desire to create a monetary system based on their own arbitrary rules of whim and decree, failed as it has always failed. Once again, history has proved that a mixture of government whim with the laws of economics is not a prescription to cure world problems: it has always been and will always be a formula for world chaos.

U.S. balance of payments problems….

U.S. balance of payments deficits began in the early 1950′s and have not ceased to this day. The cause of these incessant deficits can be traced to monetary and trade decisions made at the inception of Bretton Woods and reinforced throughout its existence.

The first straw….

When it was decided that the U.S. was to act as world banker and benefactor to those countries in need of help after World War II, it is doubtful that anyone really believed the U.S. would profit as world banker. On the contrary, the consensus was that war-torn nations needed more money than they could afford to pay back. It was argued that the

U.S. could afford to (and therefore should) extend foreign aid (gifts), loans at below market rates of interest (gifts), and military protection (gifts), to those countries in need.

What must be remembered is the precedent for this decision: the U.S. was committed to protect and finance the western world by virtue of its great strength and an ever-expanding stream of dollars.

It was assumed that this money would return to the U.S. via import demand, and in fact, during the years 1946 to 1949 most of it did, resulting in fantastic U.S. surpluses.

On selling one’s cake and wanting it too….

But during the years 1950 to 1957, a turn of events took place. Europe by design curtailed its already abundant imports and concentrated on replenishing its national reserves. With conscious intent, the U.S. continued to supply the world with dollars through deliberate balance of payments deficits to accommodate Europe’s demand for reserve replenishment. The refusal of the foreign governments to allow their citizens to use their constantly rising dollar surpluses for U.S. goods (by imposing trade restrictions) led to the dollar glut of the 1960′s.

The blame for the chronic surpluses of foreign governments and chronic deficits of the U.S. must be shared. While the U.S. can be blamed for financial irresponsibility, the surplus countries must be blamed for economic irresponsibility. The U.S. could have stopped its deficits, but surplus-ridden countries could have stopped penalizing their citizens and discouraging them from importing. Instead, they decided to increase dollar reserves (dollars that for the most part were given or loaned to them) and to either exchange them for gold or hold them in the form of interest-bearing notes and accounts.

By accumulating excessive amounts of dollars that they refused to use, surplus countries helped foster U.S. deficits: some nations’ chronic surpluses must mean that other nations are running deficits. The irony of the decision to run an intentional chronic surplus is that the purpose of selling goods is to gain satisfaction as an eventual consumer. The drive for both surplus reserves and surplus exports, and the refusal to consume goods with the money received, implies that a nation expects to sell a good and somehow derive satisfaction from it after it’s gone.

The illusion of the last straw….

The increasing demand for dollars led the U.S. government and the Federal Reserve System to increase the amount of dollars and thus to depreciate the purchasing power of the dollar. As confidence disappeared in the dollar’s ability to continue its role as a reserve currency, “hot money” flurries soon appeared. Thus, by the late 60′s and early 70′s, an enormous amount of dollars accumulated against a dwindling supply of U.S. gold. This caused both “runs” on the U.S. gold stock and “flights” from the dollar into stronger or undervalued currencies.

This speculative capital outflow caused the U.S. balance of payments deficit to increase in a pyramiding fashion. Finally, the conspicuously low amount of U.S. gold reserves, the disparity between currencies and interest rates, and a dwindling U.S. trade surplus, aroused a well-founded suspicion that the dollar might be devalued — and that other, stronger currencies might appreciate in value.

This justifiable suspicion then caused even greater U.S. capital outflows which led to even greater U.S. deficits. This was the “straw that broke the camel’s back.” But it was the haystack of straws before it, beginning with the first straw — i.e., the first U.S. inflation-financed gift abroad — that inexorably led to the progression of U.S. balance of payments deficits, international monetary chaos, and the disintegration of the Bretton Woods system.

The high price of gifts….

When the U.S. embarked on a policy of inflation-financed world loans and gifts, it surrendered all hopes of attaining a balance of payments equilibrium for itself or for the world. Between the years 1946 and 1969, the U.S. as world banker extended some $83 billion in grants and loans. Since 1958 some $95 billion has left the country. Most of these dollars were non-market transactions motivated by political and military considerations.

While many economists believe it is necessary for the U.S. to run trade surpluses to correct its balance of payments deficits, to expect normal exports to rise to the level of these abnormal capital outflows only makes sense if one stands on one’s head — it is not a logical position to take.

These grants should never have been given to foreign nations. It was an economically unsound move and the grants were extended at the expense of the American taxpayers. Further, any additional loans and gifts made by the U.S. to satisfy nations who demand “free” military protection, such as Europe and Japan have been demanding for years, or “reparations” such as those now being demanded by North and South Vietnam, will only lead to further capital outflows… and this at a time when the world is plagued by depreciating dollar reserves and continuing U.S. deficits — the very cause of the international monetary crises which led to the demise of Bretton Woods.

Those who argue that the U.S. balance of payments deficits were caused by insufficient trade surpluses blind themselves to the fact that the U.S. has been running continuous trade surpluses for almost a century. They refuse to place the blame for U.S. balance of payments deficits where it belongs: on the U.S. government’s inflationary policies of give-away finance.

On domestic dreams and international nightmares….

The notion that governments can divorce domestic inflation from international economics is fallacious. There is no domestic-international dichotomy in economic theory. There is a causal relationship between all economic activity, thus there can be no international immunity from unsound domestic policies and no domestic immunity from unsound international policies.

To the degree that nations practice sound domestic economic and monetary policies, the result will be stable economic progress in both the domestic and international economies. To the degree that domestic policies are unsound, distortions will occur that will be destabilizing and inhibit economic progress both domestically and internationally — the results being counter-productive in both areas. Bretton Woods was set up to accommodate various nations’ domestic dreams. The dreams of post-war prosperity were financed by inflationary schemes that were incompatible with any sound international monetary standard. The Bretton Woods agreement established the contradictory system of fixed exchange rates with a built-in devaluation mechanism, in order to avert the monetary repercussions of not adhering to the exchange rates they fixed. The framers of Bretton Woods knew that governments had no intention of preserving the value of their currencies, that, in fact, they planned to deficit spend and inflate in order to pay for their domestic economic programs.

No international monetary system — not the gold standard nor any form of standard less fiat system, nor any combination thereof — can insure stability given unsound domestic policies. The fundamental economic issue today is not the kind of international monetary system that will replace the Bretton Woods system, but whether the domestic policies of the nations involved will permit any international monetary system to last. The pre-condition of any lasting monetary system is that it has integrity.

A monetary system that has integrity means a monetary system that is protected from government-created inflation, i.e., arbitrary and artificial increases in the supply of money and credit.

It is a moral indictment against today’s political leaders and the public at large that the chances for a monetary system that has integrity are almost non-existent. For before a nation can have a monetary system of integrity, it must end all policies of inflationary finance. And this means that all those dreams a nation cannot afford must end.

The public has bought the politician’s claim that they can get something for nothing; that all a government need do is print up money to pay for programs that satisfy national dreams. But there is no such thing as a free lunch — someone must inevitably pay the price of that lunch.

And so it is with domestic dreams.

The price for indulging in domestic dreams through government “something for nothing” programs is domestic inflation and international monetary crises with all their tragic and disruptive consequences.

If domestic dreams of nations today are pursued by resorting to the insidious schemes of inflationary finance, they will inevitably become the international nightmares of tomorrow.

This was the lesson learned from the Bretton Woods system. May it rest in peace!



Unstable Currencies

WHEN NATIONS are on a gold standard a fixed rate of exchange is both possible and desirable. When each currency is anchored to gold, all currencies are necessarily anchored to each other. Each currency unit can then be expressed as a precise ratio of another. It can be freely and safely converted into it. But when each country is on its own paper standard its currency can have no fixed value in relation to other currencies. It can be given the appearance of such a fixed value only by making it a crime to buy or sell it at any other rate. But this attempt to maintain by coercion the appearance of stability where no stability exists merely makes the economic consequences incomparably worse.

HENRY HAZLITT, Will Dollars Save the World?