With all the recent talk of a Bretton Woods II international monetary system, perhaps it is time to take a look back at the end of the original Bretton Woods system and see if it provides any lessons for the management of the current system.
The closing of the “gold window” on August 15, 1971 by President Nixon ended the convertibility of the US dollar into gold and triggered the collapse of the Bretton Woods international monetary regime. The crisis was caused by a persistent US balance of payments deficit, which was the result of inflationary US fiscal and monetary policies.
The US dollar was the sole reserve currency in the Bretton Woods international monetary system and the only currency to be pegged to gold. Other currencies set a par value to the dollar, which remained “passive” in the exchange markets and let other currencies determine parity rates. The dollar, in turn, could be exchanged for gold at the fixed rate of $35 per ounce. This last institutional feature would prove to be an important one, for it explicitly took away US policy autonomy in the sphere of setting exchange rates. Other countries could change and/or manipulate their exchange rates against the dollar, but the US was unable to effect a devaluation (or a revaluation) of its currency against others.
As the only reserve currency in the Bretton Woods system, the US was obliged to maintain price stability as the primary goal of its monetary policy. Over the course of the previous decade, US officials had become increasingly unwilling to pursue price stability as they grappled with the problems of financing the Vietnam War and domestic Great Society programs. US deficits put severe pressures on the dollar, requiring US policy makers to jack up interest rates and/or decrease the money supply in order to restore market confidence in the strength of the dollar.
Tying the dollar to gold resulted in persistent liquidity shortfalls as worldwide economic growth required an expansion of the monetary base that outstripped increases in the reserve holdings of gold. This, of course, worsened the reserve to liability ratio. Indeed, by 1971 the amount of US dollars outstanding dwarfed the gold reserves held by the US. This hurt market confidence in the ability of the US to maintain the gold exchange rate, and threatened to exhaust US gold holdings through a run on the dollar.
As long as the US dollar, and only the US dollar, remained pegged to gold, foreign holders of dollars could demand the conversion of their dollars into gold by the US Treasury. As US dollar liabilities began to exceed the supply of US gold holdings (as they did due to rising US government spending), the risk of a “run” on gold increased.
In 1968, inflation began to pick up in the US, due to the massive government spending programs associated with the Vietnam War and the Great Society social programs. Initially, the response of the Federal Reserve and its new, Nixon-appointed chairman – William Burns, was to try and clamp down on liquidity in the US banking system. But the existence of the Eurodollar markets allowed big US banks to circumvent the Fed’s restrictions on the money supply by borrowing abroad and increasing their liabilities to their foreign branches. Eurodollar borrowing also worsened the official US balance of payments deficit and, by extension, its gold liabilities.
With brief exceptions, US fiscal and monetary policy remained (and became increasingly so) expansionary over the course of the 1960’s. As the reserve currency, the US simply had to maintain price stability to protect the stability of the international monetary system. Ultimately, it was merely confidence that the US would be able to honor its dollar commitments that kept the Bretton Woods regime functioning smoothly. As international holdings of dollars began to outstrip US holdings of gold, that confidence began to disappear.
But the day of reckoning was still some way off. A further breathing space was afforded the US by the German decision to revalue the deutschemark by 9.3% on September 29, 1969. This move was taken in response to massive increases in Bundesbank reserve holdings, driven both by its strong macroeconomic performance (low inflation rates and real GDP growth), and by the expansionary fiscal policies of the French (their response to the student riots of 1968), which resulted in significant capital flows from France to Germany and a concomitant French devaluation (against the dollar) of 11.1%. Large increases in the reserve holdings of European central banks were becoming increasingly hard for them to handle, however, without sparking domestic inflation.
Normally, reserve increases are “sterilized” by central banks – as central banks buy dollars and sell their own currencies on the markets to support their exchange rates, they mop up this increase in the domestic money supply by selling government bonds, thereby converting the cash into debt and forestalling the inflationary effects of an increase in the money supply. But as dollar reserves grew, the ability of the domestic capital markets to absorb new debt issues decreased, to the point that new issues of government securities became untenable and an increase in the money supply unavoidable. German money supply growth rose from 6.4% to 12.1% during 1971, the height of the crisis (these and other numbers in this post are drawn from Bordo - NBER Working Paper #4033). In this way, the combined effects of expansionary US fiscal policies and the rigidities of the Bretton Woods system forced other countries to “import” US inflation into their own economies.
Still, the institutional design of Bretton Woods left the US with few options for devaluing its currency. As the reserve currency, other countries pegged to the dollar and manipulated their exchange rates accordingly due to current account imbalances or other variables. It is true that a rise in the dollar price of gold would have effectively amounted to devaluation, but politically this possibility never gained much traction. Devaluations are politically embarrassing. Furthermore the US President, even if he had wished to alter the gold to dollar parity, was unable to act on his own because a change would have required Congressional approval.
Neither President Nixon nor his main economic policy advisors ever seriously considered restraining domestic spending or seeking price stability as a matter of national policy. At the same time, they were not contemplating any preemptive US attack on the Bretton Woods regime, or for that matter any fundamental changes in its structure. Only when the overhang of US dollar liabilities relative to its gold stock threatened a run on the dollar did the Nixon administration act (by May 1971, official dollar holdings stood at $18.5 billion, while US gold reserves had fallen to under $10 billion at the $35 per ounce rate). In other words, only when international commitments threatened domestic economic policies did the President decide to act unilaterally and close the gold window.
Push finally came to shove in early August 1971 when the British and French began converting some of their dollars into gold at the US Treasury. Some $800 million were exchanged over the course of a couple of days and further conversions seemed inevitable. Confidence in the ability of the US to uphold the convertibility of the dollar into gold had deteriorated to the point of no return. When the British asked the US on August 13 to guarantee their dollar holdings at the prevailing dollar-sterling parity the implication was clear: a run on the dollar was imminent.
But the Nixon administration, facing rising unemployment and an upcoming election, was unwilling to devote monetary policy to a defense of the peg. So dollar convertibility into gold was suspended. The immediate effect of the change was to prevent the exhaustion of US gold stocks. But the underlying goal was a massive devaluation of the dollar by forcing foreign holders of dollars to sell their holdings at whatever the market would bear, rather than being able to convert them into gold.
While revaluations of the European and Japanese currencies were modest at first (they rose on average by roughly 8% in the first four months after the end of convertibility, due largely to massive central bank intervention buying dollars in the exchange markets). Extended negotiations between the US and the major industrial powers yielded no new agreements on a new international monetary regime, and by early 1973, most major economies had bit the bullet and floated their currencies. The Bretton Woods regime was dead.
Obviously the current international monetary system faces a different set of problems and challenges than those faced by the original Bretton Woods regime. But the parallels are striking: massive US current account deficits; the inability of other countries to sterilize their dollar reserves and maintain their dollar pegs; the preeminence of domestic political factors in setting monetary policies; the role of international financial markets in forcing the hands of policy makers etc. Those who do not remember their history are doomed to repeat it.
Economics
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