World Payments System After World War II

Situation after WWII

The Great Depression and the war caused world trade to shrink tremendously.

The international gold standard was no longer functioning. So, a new system was necessary.

Bretton Woods

Before the war came to an end, an international conference was held in Bretton Woods, New Hampshire in 1944.

From this conference two major institutions emerged: IMF and World Bank (IBRD).

Three institutions of world economic order

IMF: smooth functioning of world payments system

World Bank: provide long term loans to rebuild Europe (the focus shifted later on to developing countries)

GATT: establish free international trading system (evolved into WTO)

Elements of an international monetary system

1. Supply of international liquidity

2. Exchange rate determination system

3. Balance of payments adjustment mechanism

International gold standard (1880-1914) , (1930’s)

International liquidity: gold and convertible currencies

Exchange rate system: Fixed, the anchor of the system is gold

Adjustment mechanism for balance payments disequilibrium: interest rates, capital mobility

International gold standard

Adjustment mechanism: interest rates were raised in deficit

countries, lowered in surplus countries capital mobility gold did not move much between

deficit and surplus countries.

Gold standard

Was functioning smoothly during 1880-1914.

The system is considered to have contributed to the worsening of depression.

Bretton Woods System

There were two rival plans prepared for the BW conference:

Keynes Plan White Plan The White Plan was accepted, parallel

to the rising dominance of the US.

Bretton Woods System

International liquidity: dollar and gold Exchange rate system: adjustable peg

system Balance of payments adjustment

mechanism: unlike gold standard, domestic policy concerns take priority over international adjustment.

International liquidity

1 $=1/35 ounces of gold US is the issuer of international

liquidity Convertability between the US dollar

and gold

Exchange rate system

Fixed exchange rate system (adjustable peg)

The US dollar is the anchor of the system.

1 $=1/35 ounces of gold All other currencies adjust vis a vis the

$

Exchange rate system

Fixed parities are set with a 1% margin in both directions.

If the exchange rate was outside this “band”, then the central bank intervened in the foreign exchnge market.

German surplus

Germany intervenes:

Sell DM, buy $ Shift SDM tothe

right German dollar

reserves and money supply increase

SDM

DDM

$/DM

UK deficit

UK intervenes: Buy £, sell $ Shift D£ to the right UK dollar reserves

and money supply decrease

S£

D£

$/£

BP disequilibrium

If the deficit or surplus is chronic, then the exchange rate (peg) needs to be changed. Hence the name “adjustable peg”.

This is “devaluation” or “revaluation”.

IMF’s role in the system

Provide stable and relatively fixed exchange rates.

Provide financing facility in case of balance of payments disequilibrium (deficit).

In the gold standard this required capial inflows and higher interest rates.

IMF’s role in the system

IMF enabled the member countries to borrow from each other.

The resources were the gold and domestic currencies of all the members paid at the time of the establishment of the fund.

US in the BW system

US was running trade deficits. Trade deficits were financed by the

creation of dollars. If the creation of dollars caused

exchange rate disturbances, the other party intervened in the forex market.

US in the BW system

US deficits were not a problem during the 1950’s because it solved the liquidity problem.

World trade grew at a rate of 7% per year, but gold supply grew at a rate of 1 to 1.5%.

Dollars substituted for gold.

US in the BW system

But starting with the 1960’s, a the solution to the liquidity problem created another problem: confidence problem.

The value of the dollar was set against gold, and the parity could not be maintained.

This is Triffin’s dilemma.

Triffin’s Dilemma

Robert Triffin Gold and the Dollar Crisis: The Future of Convertibility (1960).

Under the Bretton Woods system in which the U.S. dollar was the world’s principal reserve currency (instead of gold, for example), the United States had to create large trade deficits in order to provide the rest of the world with the liquidity required for functioning of the global trading system.

Triffin’s Dilemma

Triffin wrote, U.S. trade deficits eventually would undermine the foreign exchange value of the dollar because foreign accounts would hold an increasing quantity of dollars.

Triffin’s Dilemma

Issuing the reserve currency gives domestic policy makers an advantage by making it easier to finance either domestic budget deficits or foreign trade deficits because there always is a ready bidders' market for any financing instruments from that issuer.

Problems of the BW system:

1. Liquidity problem

2. Confidence problem

3. Adjustment problem The first two are related to the Triffin

Dilemma. The third problem led to the collapse

of the system.

Major events in the BW system

1967 devaluation of the pound: suspicion that the fixed exchange rates between key currencies may not be sustained.

1968: major central banks announced that they were not making transaction in gold with private individuals and firms:two tier gold market

Major events in the BW system

1970: IMF created a new international resereve asset called SDR (paper gold). 1SDR=1/35 oz gold. IMF created 3.5 billion SDR’s in all member countries accounts.

1971: breaking of the $-gold link. The system collapsed.

Adjustment problem

Most prominent imbalance in the system was US deficits and German surpluses.

Automatic forces were not removing the imbalance. Macro policiy instruments were directed toward internal targets (growth in US, inflation in Germany) rather than external.