Therefore, in an attempt to reverse this situation and to rebuild the international economic order with a stronger foundation, “730 delegates from 44 Allied nations gathered in Bretton Woods, New Hampshire, U.S. to sign the Bretton Woods Agreements in the first three weeks of July 1944.”
(http://en.wikipedia.org/wiki/Bretton_Woods_system)
The Bretton Woods Agreement, in essence, fundamentally departed from the direction of the gold exchange standard in many distinct paths. The first striking feature of this agreement that differed from the gold standard was the establishment of two international credit lending institutions:
In July 1944, representatives from 45 countries convened at the Mount Washington Hotel in New Hampshire, United States to sign an agreement that would lead to the creation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD).
In hopes of devising a constructive international monetary system, the purpose of creation of the IMF was (i) to regulate the macroeconomic policies of its member countries, (ii) help countries that were having a fundamental disequilibrium in their balance of payments by receiving deposit from surplus countries and giving out those loans to deficit countries (mainly poor countries) with varying degrees conditionality, and (iii) to ensure price stability in financial markets without imposing any tariffs or restrictions on trade and (iiii) to contribute to the overall development of emerging economies through its lending policies. On the other hand, the purpose of creation for the IBRD was to have a focus on the reconstruction of nations devastated by WWII.
The price stability component of the IMF’s responsibilities was to be ensured by what is called “the fixed exchange rate system” (also known as the pegged exchange rate system or the adjustable peg). This system offered multiple benefits; (I) first, maintaining of fixed exchange rates would facilitate the cross border transaction of goods and services, (II) second, it would ease political tensions and would bring about economic stability, (III) and third, it would also aid in the removal of tariffs and barriers and help governments ensure equilibrium in their balance of payments. In a sense, the newly established rules of the Bretton Woods system resembled those of the pre-war gold standard era only with the exception of the U.S. dollar, which was accepted as the worldwide currency in lieu of gold with the consent of the member countries.
The pegged exchange rate was a system whereby countries would first and foremost peg their national currencies to the key currency, vis-à-vis to the U.S. dollar. Each country was obligated to declare a “par value” rate for their national currency by intervening in their foreign exchange markets while the exchange rate for each currency was allowed to move by 1% above or below parity. While nations that were willing to convert their gold reserves or assets into paper currency would do so through this anchor currency. After the U.S. dollar became the only currency convertible to gold, then the price of gold was also decided to be fixed at $35 per an ounce of gold. This was because of the following reason: “For the Bretton Woods system to remain workable, it would either have to alter the peg of the dollar to gold, or it would have to maintain the free market price for gold near the $35 per ounce official price.”
(http://en.wikipedia.org/wiki/Bretton_Woods_system)
The application of this rule meant that the U.S. dollar would take over the role of gold and assume the responsibilities of that which it had played during the gold standard system. Once the U.S. dollar had become the only currency exchangeable in terms of gold with the greatest purchasing power, all the indebted European countries who had been involved in WWII decided to transfer massive amounts of their gold reserves to the U.S. contributing to the appreciation of the dollar and to the economic leadership of the U.S. in the world.
Furthermore, in accordance with the conditions listed in the agreement, poor countries also had the right to alter their par value rate to correct the fundamental disequilibrium in their balance of payments. But this decision was contingent upon the IMF which would first have to determine if the country’s balance of payments was in a serious fundamental disequilibrium.
The IMF was also provided support with a special fund that largely comprised of each member country’s contributions of gold and their own national currencies to the fund. A member country experiencing a trade deficit in its current account would be able to borrow foreign currency from the Fund in amounts that would be determined by the size of its contribution (also known as quota). Meaning, the greater the contribution was, the higher the amount of funds that a member could borrow from the IMF. Once the money was borrowed, the member state was required to repay its debts within a time limit of 18 months to 5 years depending on the magnitude of the balance of payments disequilibrium in that country.
Even though there was a belief that as long as the Bretton Woods agreements were strictly observed and adhered to by the member countries, the balance of payments issue would resolve itself with the support of the national monetary reserves backed by loans and credits given by the IMF. However, it turned out over time that the IMF’s credits would prove unworkable in tackling Western Europe’s enormous balance of payments deficits. This was because in the era following WWII, there was a huge dollar shortage as countries were imposing tariffs and barriers to each other which caused a heavy demand for the U.S. dollar.
Under the Bretton Woods System, no other currency was convertible to gold other than the U.S. dollar which also added greater emphasis on the demand for the U.S. dollar. In order to satisfy this demand, the U.S. Federal Reserve started increasing the dollar supply. However, as the dollar supply increased on other currencies (i.e. the exchange rates of other currencies), the value of dollar started depreciating as other country’s currencies started appreciating. As a result, other countries were forced to gradually increase their money supply.
By the 1960s, many European countries did not want to increase their domestic money supplies but the system compelled them to do so. Among those countries that reluctantly increased their money supply were Germany, Switzerland, and France. These countries have faced the most severe hyperinflation rates in their economies in the periods preceding the Great Depression. By 1971, the European countries wanted to form the “European Common Market” and decided to abandon the Bretton Woods System.
From 1971-1973, the Bretton Woods System became inoperable. In 1973, President Nixon cut the dollar system which allowed for the collapse and the disappearance of the link between the U.S. dollar and gold. The demise of this system has concretely taught us four important lessons: (I) the lack of operational adjustment mechanisms, (II) the great adversity of running a system of fixed exchange rates (or adjustable peg) in the presence of highly mobile international capital, (III) that there was strong international cooperation and close coordination among participating governments and central banks around the world which was very easily distinguishable from the last quarter of the nineteenth century since the possibility of international economic coordination or collaboration was virtually non-existent during the gold standard era. (IV) Even though there were strenuous efforts being made by the member countries to defend the parity, sustainability of this system turned out to be impossible as keeping the parity at a stable rate would require unparalleled foreign exchange market intervention as well as international support at all levels.