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Shane Payne

Professor Roman Studer

EH 206

19 November 2010

Bretton Woods: A Plan Set to Fail

Just as a building requires a solid foundation to ensure structural stability,

economic policy must adhere to basic fundamentals and guidelines in order to be

sustainable and avoid collapse. When examining the breakdown of Bretton Woods, this

concept is clearly evident, and flaws in the initial framework of Bretton Woods doomed

the system from its origination. Criticism of the Bretton Woods system was present well

before symptoms of its demise were apparent, headed by economist Robert Triffin who

testified before Congress in 1960 that the system was at risk of failure (IMF Exhibit). In

response to the warnings, many innovations and institutional facilities were introduced to

the original policy in hopes of rectifying the perceived weaknesses in the system.

However, these measures ultimately served only to delay the inevitable collapse of the

Bretton Woods system.

In this paper, I will first present an outline of the Bretton Woods system and

review its major pillars. By examining the original framework of the Bretton Woods plan,

major conflicts of interests will then be highlighted and potential problems will be

identified. Afterwards, a summary and discussion of the steps employed in attempts to

overcome these obstacles will be then be undertaken. Finally, when all of the events

inclusive of the final collapse and abandonment of the system have been accounted for, I

will make an argument that reasons the collapse of the Bretton Woods system began with
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faulty policy structure which eventually led to an erosion of confidence in the dollar, the

trigger that caused the collapse of Bretton Woods.

Starting with the initial design of Bretton Woods, its main feature was based on a

system of fixed exchange rates predicated on the dollar. The U.S. dollar was established

as the reserve currency for central banks around the world, and its value was derived

from the United States’ own gold reserve. Countries then pegged their currencies to the

dollar and were expected to stay within a band of +/- 1%, thus creating a fixed exchange

rate. This was a desired system as it limited uncertainty and facilitated smooth

convertibility between currencies (Krugman 575-576). Also, in the case of payment

imbalances, exchange rates could be adjusted conditional on international agreement

allowing for more flexibility than past systems. These qualities seemed to strike a balance

between the chaos associated with a floating exchange rate system which was subject to

independent tactics such as competitive devaluations, and the strict rules of the Gold

Standard that led to vicious and debilitating business cycles.

Other key characteristics of the Bretton Woods system include the incorporation

of the International Monetary Fund (IMF), the provision for domestic control over

monetary and fiscal policy, and the International Bank for Reconstruction and

Development (IBRD) was launched. The IMF was placed in charge of short-term

stabilization and was given the authority to provide distressed countries with liquidity in

times of need. Allowing countries to have control over their own domestic issues was

another critical point of the Bretton Woods plan, which contrasted policy under the Gold

Standard. With power in the hands of individual nations, actions and policy could be

executed that was in the best interests of each country. Lastly, to help promote
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international growth the IBRD was created which granted loans to support reconstruction

efforts and economic development projects.

Moving on from the basic layout of Bretton Woods, there were many flaws in the

proposal despite the positive intentions of its creators. The greatest transgression of the

policy was its heavy reliance on the dollar as a dependable international reserve asset. As

stated by the U.S. Secretary of the Treasury Henry Fowler, “Providing reserves and

exchanges for the whole world is too much for one country and one currency to bear

(Kemp)." When a single currency is used as a global reserve currency, it creates a conflict

of interest between national monetary policy and global monetary policy. The United

States would be presented with the dilemma of either fulfilling its obligation as an

international facilitator by running large deficits that eventually would result in negative

domestic consequences, or prioritizing domestic goals by reducing its deficit which

would lead to a liquidity crisis for countries holding reserves of dollars. Both objectives

could not be achieved simultaneously and this attribute played a major role in the

eventual collapse of the Bretton Woods system.

Another critical flaw of Bretton Woods was the participating countries’ inability

to properly control cross-border capital movements. According to fundamental

macroeconomic theory there is a set of three potential economic targets which only two

can be pursued concurrently: free capital movement; an independent monetary policy;

and a fixed exchange rate (Mansur 4). Bretton Woods clearly established a regime that

was based on running a fixed exchange system and maintaining domestic control over

policy. Therefore, for Bretton Woods to survive and uphold its tenets, strict control would

have to be maintained over trans-national cash flows. Yet the trade liberalization
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encouraged under the policy’s framework led to elevated levels of capital market

liberalization. This movement made it increasingly difficult to control parties involved

with cross-border transactions due to their creative methods used to bypass regulatory

efforts. Investors aiming to gain maximum returns on their principal are also driven

towards financial innovation in pursuit of a higher yield. With cross-border capital

movements being relatively unhindered, the macroeconomic trilemma is in violation and

immense pressure is exerted on the Bretton Woods framework.

Now shifting the focus towards measures aimed at preserving Bretton Woods, the

formation of the London Gold Pool in 1961 was the first major step taken to patch an

apparent blemish in the system. In order to protect the price of gold from rising above the

fixed peg of $35/oz, a group of eight central banks consisting of seven European

countries and the United States pooled their gold reserves together and coordinated

intervention efforts in the London gold market. The United States had the most exposure

as it provided 50% of the gold being sold off with the remainder being split among the

European central banks. While the Gold Pool was successful in keeping the price of gold

in check during the majority of its tenure, it caused a huge drain on United States gold

reserves and the pool folded in 1968 after a large deficit was amassed. When the program

began the U.S. gold reserves totaled $17.4 billion; by its end roughly six years later it had

fallen to $10.7 billion (almost a 40% decline) with about $2.2 billion being directly

related to participation in the Gold Pool (Garber 466). This lack of gold reserves backing

up the dollar only mounted further pressures upon the anointed reserve currency.

Additional attempts at improving upon the original framework of the Bretton

Woods system were also made. The General Agreements to Borrow (GAB) and special
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drawing rights (SDRs) were some of the innovations aimed at providing extra sources of

liquidity to the system. The IMF held authority over both the GAB and SDRs. The GAB

enables the IMF to borrow specified amounts of currencies from participating central

banks at attractive rates of interest which it can then lend to participating countries in

need of short-term liquidity. On the other hand, SDRs were a new international reserve

asset created in response to the growing inadequacy of the dollar and gold (IMF

Factsheet). These new credit lines ended up achieving their goal of creating higher levels

of liquidity but it also led to a decrease in demand for liquid dollar claims. Couple this

with the U.S. expansionary policy, and the process of monetary crisis was in fact

accelerated.

As pressure on the international monetary system continues to build, cracks begin

to emerge which snowball into the first collapse of Bretton Woods. In 1967 the United

Kingdom has to devalue the pound sterling, a currency of great importance secondary

only to the dollar. The Gold Pool’s collapse in 1968 gives way to a two-tiered market for

gold which separated the private market from the official market for the precious metal.

With confidence in the currency reserve of the dollar eroding quickly, the private market

for gold rose above the fixed official valuation leaving room for exploitation between

markets. In a short succession, many other currencies are suddenly devalued while gold

continues to rise and in 1971 the breaking point is reached. Known as the Nixon Shock,

President Nixon announces unilaterally that the dollar to gold convertibility will be halted

and imposed other restrictions in an effort to reverse the speculative run on the dollar.

However, the Bretton Woods system though seemingly dead, would be resurrected and

make one final stand in its futile battle against market forces.
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The resurrection effort was carried out in Washington, D.C., where a G10 summit

formed the Smithsonian Agreement which made sweeping changes to the Bretton Woods

scheme. The base currency, the dollar, was devalued to $38/oz and periphery currencies

were given wider bands of valuation of +/- 2.25%. Despite the large scale restructuring of

Bretton Woods, the Smithsonian Agreement was largely ineffective as it barely sustained

the system for a year. Investors and speculators were not convinced there were sufficient

levels of gold to support the dollar. The U.S. continued to print money and pump it into

its escalating war efforts in Vietnam leading to further deterioration of confidence in the

dollar. Finally, in March 1973, with gold prices surging and the dollar flailing, the system

of fixed exchange rates collapsed into generalized floating, and the era of Bretton Woods

was over (Garber 465-466).

In conclusion, Bretton Woods was on a crash course to fail due to its flawed

structuring, and this setup contributed to the continued devaluation of the dollar which

acted as the trigger that set off the collapse of the Bretton Woods system. The framework

of Bretton Woods established the dollar as the reserve currency for the international

monetary system, and this created a conflict of interests with the United States’ own

domestic affairs which was never effectively resolved. Drains on the U.S. gold system

through efforts such as the Gold Pool further exacerbated problems. On top of all of this,

the United States continued to increase the supply of dollars and many lost faith in its

value as a reserve asset. This erosion of confidence in the dollar was the cause of the

speculative attacks against the dollar which ultimately forced the Bretton Woods system

into collapse.
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Works Cited

Factsheet. The International Monetary Fund, 29 Sep. 2008.

<http://www.imf.org/external/np/exr/facts/sdr.htm>

Garber, Peter M., “The Collapse of the Bretton Woods Fixed Exchange Rate System”, A

Retrospective on the Bretton Woods System: Lessons From International

Monetary Reform (Chicago, 1993), ch. 9.

An IMF Exhibit. The International Monetary Fund, 2008.

<http://www.imf.org/external/np/exr/center/mm/eng/mm_sc_03.htm>

Kemp, John. A Cabal Plotting Against the Dollar? Reuters. 6 Oct. 2009

< http://blogs.reuters.com/columns/2009/10/06/a-cabal-plotting-against-the-

dollar/>

Krugman, Paul and Maurice Obstfeld, International Economics: Theory and Policy, 8th

edition (Boston, 2008), ch. 19.

Mansur, A. “Macroeconomic Policy Trilemma in Open Economies: Which Policy Option

is Ideally Suited to the Malaysian Context?” Jurnal Pengurusan. 3.26 (2005): 4.