Bretton Woods System and the IMF

Implementation of Bretton Woods

• Postwar monetary arrangements were planned, leading to the Joint Statement developed by Keynes and White in 1944.
• The Joint Statement was made at the Bretton Woods Conference, attended by 44 countries.
• A system of fixed exchange traits was established to avoid governments losing domestic autonomy.
• Four innovations were introduced, including greater exchange-rate flexibility, capital controls, a stabilization fund, and the IMF.

Greater Exchange-Rate Flexibility

• Exchange rates were fixed but adjustable with central parity against gold.
• These rates could be adjusted if faced with a fundamental disequilibrium, imbalances leading to domestic adjustments.

Capital Controls

• Governments could limit international capital flows, preventing destabilizing speculative movements.

Stabilization Fund

• Member countries contributed to a pool of currencies to help manage balance of payments deficits.

IMF Role

• The IMF monitored macroeconomic policies and balance-of-payments, deciding to devalue or manage the stabilization fund.

American Dollar as Primary Reserve

• The US became the largest economy after World War II, holding 60-70% of the world’s gold supply.
• Bretton Woods fixed the dollar at $35 per ounce of gold, meaning the dollar was "as good as gold," due to the fixed exchange rate system.
• The Marshall Plan and military expenditures facilitated US aid to European countries, enabling them to accumulate dollar reserves.
• European countries converted dollar reserves into gold, solidifying the dollar’s position as the primary reserve currency.

Collapse of Bretton Woods

• Persistent US current-account deficits stemmed from military expenditures in the Vietnam War and domestic welfare programs.
• Johnson and Nixon were unwilling to fund these expenses through fiscal tightening (increased taxes).
• Expansionary policies increased US imports, further contributing to the deficits.
• Dollar Overhang occurred as foreign governments claimed US gold reserves with claims exceeding the amount of gold the US possessed.
• Confidence in the American dollar decreased, threatening the stability of Bretton Woods.
• The $35 dollar per ounce of gold was eroded, leading to speculative attacks in anticipation of devaluation.
• Nixon devalued the dollar and suspended its convertibility into gold, ending the Bretton Woods system by removing the fixed-exchange-rate system.
• Most currencies moved to floating exchange rates after abandoning the fixed exchange rate.

Current Account Deficits and Surpluses (1st)

• The US consistently had large current-account deficits due to military spending during the Reagan administration.
• Japan and Germany had large current-account surpluses in the 1980s through fiscal tightening.
• Germany and Japan financed US deficits.
• The US attracted surplus countries to finance their deficits by ensuring high investment returns.
• The dollar strengthened and appreciated by 50% in 1985 as capital flowed.
• The Plaza Accord was an agreement by the G5 (US, Germany, Japan, Britain, and France) to reduce the dollar's value against the yen and mark by 10-12%.
• The Louvre Accord met in 1987 where the G5 agreed to stabilize exchange rates after the dollar fell again.
• Domestic policies in Japan and Germany hindered this implementation.
• Japan was reluctant to adjust its fiscal policy.
• US reluctance arose from disagreements between Democrats and Republicans; Democrats wanted higher taxes and reduced military expenditures, while Republicans wanted to cut social programs.
• Germany's reluctance blocked efforts to jeopardize price stability.

Current Account Deficits and Surpluses (2nd)

• The US experienced renewed deficits in the 1990s, larger than those in the 1980s.
• Large tax cuts by the Bush administration in 2001 widened the deficit.
• Japan, Germany, and China (due to the East Asian Financial Crisis) had large surpluses, with China becoming the single largest supplier of credit to the US.
• Strengthened capital flows appreciated the dollar again in 2002.
• Protectionist ideas emerged from the United States.
• The Bush administration pressured China to boost consumption and allow the RMB to appreciate against the dollar.

Global Financial Crisis (2006-2008)

• Plentiful, cheap credit from surplus countries to the US created borrowing conditions that led to the housing bubble.
• Banks and mortgage lenders offered loans to almost anyone because they could sell those loans as mortgage-backed securities (MBS).
• Bundled risky loans became complex financial instruments, like MBS and collateralized debt obligations (CDOs), which were sold to investors who believed they were safe.
• People took advantage of low interest rates to buy expensive homes.
• Increased demand caused home prices to climb.
• Prices became unsustainable, and people could not afford their mortgage payments.
• Many were owing more on their mortgage than their home was worth as home prices fell.
• The MBS and CDOs plummeted which led to huge losses for banks and investors.
• The issue spread globally to countries like the US, Great Britain, Ireland, and Spain.
• Governments injected liquidity to prevent the total collapse.
• The G20 held summits offering fiscal stimulus and expanded IMF lending capacity.
• Global payment imbalances and the US persistence deficits contributed to the financial crisis due to capital flows from surplus countries like China, Japan and Germany
• The system created excessive borrowing and cheap credit leading to the housing bubble resulting in financial vulnerabilities from risky loans in the real-estate market and the global financial crises
• This financial instability affected other countries besides the US.