s through 1970s: the inter-crisis period
The 1950s through 1970s inter-crisis period was the exception rather than the rule, for preventing crisis took a great deal of global coordination and effort that could not be maintained in the face of countries’ individual pursuit of sovereign policies. We first look at the Bretton Woods regime that existed during the 1950s and 1960s, then turn to the post-Bretton Woods oil shocks that caused an economic recession in the 1970s.
BRETTON WOODS: THE 1950S AND 1960S
With the introduction of the Bretton Woods regime, the 1950s and 1960s were a period of relative stability, although one that was difficult to maintain. The Bretton Woods period was in fact the most stable period in terms of most real and nominal macro variables, more so than the gold standard regime, the interwar period, or the floating exchange rate system (Bordo 1992). It can be viewed as an important intermediary step between the gold standard and floating exchange rates, but also a period that required a commitment from the center country, the United States (US), that increasingly came into conflict with domestic economic goals.
Importantly, the US emerged as the world’s largest economic and political superpower after World War II, and the dollar emerged as the dominant currency. The rest of Europe was in a shambles due to the destruction experienced during the war. At the Bretton Woods meeting in 1944, the US and the United Kingdom (UK) laid out the details of the proposed Bretton Woods system before meeting with the other 40 countries (Eichengreen and Kenen 1994). The question to address was how to stabilize the global financial system and rebuild Europe.
One of the main objectives in seeking to stabilize global finance was to fix exchange rates to the dollar, and the dollar to gold, but also to allow countries to pursue policies that promoted full employment. Yet the fixed exchange rate paradoxically ruled out discretionary monetary policy, since in maintaining a fixed exchange rate, countries would have to give up some control over monetary policy to the extent that complete sterilization of foreign exchange inflows could not be managed, and rely more on fiscal policy. This was not understood at the time, and the goals set at Bretton Woods were not easily attained. There was a commitment to pursue trade and current account liberalization, and to assist countries in the maintenance of a stable balance of payments. While free capital movement was at this time discouraged, 15 years later it was promoted and amplified the difficulties associated with maintaining financial stability.
Within the framework of Bretton Woods, the dollar was exchangeable at $35 per ounce of gold, while other currencies were fixed but adjustable within 1 percent of their dollar parities. While this was desirable for some countries, which had experienced great instability during the Great Depression and World War II, many foreign central banks felt uncomfortable holding large dollar stocks, since this was dependent on the US maintaining the value of the dollar (Eichengreen 2007). But this discomfort belied a lack of confidence in the core currency of the Bretton Woods system, which was the dollar and not gold. Countries were nervous about moving from a peg to gold directly to an indirect peg through a fiat currency, since the dollar held no intrinsic value.
During the Bretton Woods negotiations, both British and American architects of the plan (Keynes and White; Figure 3.1) recommended that the agreement include a requirement of capital controls, while New York bankers strongly objected to this type of control. Capital controls would assist nations in their main focus of maintaining a domestic economic policy of full employment rather than an international economic policy of currency parity (Cesarano 2006). Capital controls in Western European nations were accepted, while they were not implemented in the US.1
The end of World War II showed a large increase in per capita income for the United States over European countries, with the US holding a per capita gross domestic product (GDP) 1.7 times that of Western Europe in 1950, and four times that of Southern Europe. It took years for Western Europe to catch up in per capita income to the US, while Southern and Eastern European countries continued to lag behind (Figure 3.2). It is plain to see that at the beginning of the Bretton Woods period, the US had a clear economic hegemony, and its power would have to be tempered with a sense of responsibility in upholding the system.2
The US was a clear “winner,” and this was reinforced by the currency regime that put the dollar at the center of the world economy. New “rules” of the global order established at Bretton Woods were effected in order to maintain the system.
McKinnon (1993) spells out the rules of the game that came into force for the 1950s and 1960s, as follows. Industrial countries other than the United States should:
Figure 3.1 Harry Dexter White and John Maynard Keynes (post-Bretton Woods, in 1946)
- 1. fix a par value for the national currency with the US dollar as the numeraire, and keep exchange rate within one percent of this par value indefinitely;
- 2. use free currency convertibility for current-account payments;
- 3. use capital controls to insulate domestic financial markets, but begin liberalization;
- 4. use the dollar as the intervention currency, and keep active official exchange reserves in US Treasury Bonds;
- 5. subordinate long-run growth in the domestic money supply to the fixed exchange rate and to the prevailing rate of price inflation (in tradable goods) in the United States;
- 6. offset substantial short-run losses in exchange reserves by having the central bank purchase domestic assets to partially restore the liquidity of domestic banks and the money supply (Bagehot’s Rule);
- 7. and limit current account imbalances by adjusting national fiscal policy (government net saving) to offset any divergences between private savings and investment.
Figure 3.2 Per capita income in selected regions, 1950, 1973, and 1992
The United States should:
- 1. remain passive in the foreign exchanges;
- 2. practice free trade with neither a balance-of-payments nor an exchange-rate target[;]
- 3. . . . not hold significant official reserves of foreign exchange;
- 4. keep US capital markets open to foreign governments and private markets as borrowers or depositors;
- 5. maintain position as a net international creditor (in dollar-denominated assets) and limit fiscal deficits;
- 6. and anchor the dollar (world) price level for tradable goods by an independently chosen American monetary policy.
The Bretton Woods system was not something that simply functioned once the “rules of the game” were established; it had to be maintained. The Marshall Plan attempted to support the focus of Bretton Woods. Under the Marshall Plan (1948-52), Western European countries were encouraged by the US to export to the US and restrict imports in order to build up dollar reserves (Meltzer 1991). A portion of the dollar reserves was converted to gold. Thereafter, the US maintained a large current account surplus and invested abroad, which upheld confidence in the US economy (Eichengreen 2007). The Marshall Plan also underscored US hegemony, since the US was able to bypass Bretton Woods institutions in lending aid to European nations, and in doing so, was able to require borrower nations to commit to balance their budgets, engage in trade liberalization, and stabilize their exchange rates (Eichengreen and Kenen 1994).
Just as the system was entering a stable period, convertibility controls were lowered in 1958 as major currencies became convertible on current account transactions (Meltzer 1991), and short-term capital flows and the eurodollar market began their rise. The eurodollar market allowed dollars to be borrowed and lent outside of the US. The large British support for the eurodollar market, resulting from exchange crises, allowed the British to finance trade outside the sterling bloc and resolved the British balance- of-payments imbalances, since dollars became more freely available to relieve the currency asymmetries (Helleiner 1994). American support for the eurodollar market allowed the US to skirt capital controls. The eurodollar market also allowed international lending and trade to occur on a much larger scale (Hirsch 1967). However, these solutions to relieve the binding constraints of Bretton Woods upset the system.
Systemic trouble started in 1959 when the US encountered balance- of-payments problems with mounting trade deficits, allegedly as a result of trade discrimination, and later seen as an outcome of extensive US military expenditures (Meltzer 1991). What is more, the US gold stock had fallen, while major currencies had become convertible for current transactions, threatening the US position as center of the Bretton Woods currency regime. Deficits and dollar accumulation abroad became a cause for concern. US domestic economic policy continued to be a priority despite the burgeoning balance-of-payments problem. Countries abroad were forced to compensate for this by devaluing their currencies relative to the dollar.
A series of balance-of-payments measures were enacted in the United States to reduce net dollar outflows, starting in 1960, with an expansion of Export-Import Bank lending to encourage US exports and also with a reduction in government purchases abroad. The most famous measure implemented by the US was known as “Operation Twist,” and sought to drive up short-term interest rates to keep capital in the country, while keeping long-term interest rates low to maintain economic activity (Best 2004). These measures were not very effective, and were sometimes more onerous on the parties involved than beneficial.
Although the International Monetary Fund (IMF) provided standby funding to countries in need of reserve credit to defend their fixed exchange rate, IMF credit was insufficient to correct exchange rate imbalances (Eichengreen and Kenen 1994). Investors could withdraw capital from a country in anticipation of a devaluation. Other countries were forced to maintain or impose capital controls as a defensive move, as capital flowed more freely.
The threat to the Bretton Woods system intensified with increases in the London gold price as a result of increased demand for gold, due to a lack of confidence in the dollar. There were two prices of gold: that on the London market, and the official American price of $35 per ounce. A divergence favorable to speculators meant that central banks could potentially buy gold from the US and sell it on the London market. This arbitrage reflected the trend in increasing international speculation in the 1960s, which increased capital mobility in search of profit. The London price of gold increased to $40 per ounce in October 1960 upon fears that Kennedy’s possible election to the US presidency would result in inflationary policies that would decrease the real value of the dollar. The London gold price increase forced the US to sell $350 million of gold to the Bank of England to maintain its set price of $35 per ounce.
The general fear of price deviations, as well as the immediate events of 1960, led to the creation of the Gold Pool in 1961, which sought to stabilize the London price of gold so as not to jeopardize the US parity. The Gold Pool allowed foreign governments to intervene in order to stabilize the price of gold (Eichengreen 2007).3 Participants included Belgium, France, Germany, Italy, the Netherlands, Switzerland, the United Kingdom, and the United States (Eichengreen 2007). In addition, European central banks agreed not to buy gold on the London market if the price rose above the official rate. The Gold Pool broke down under growing demand for gold, and the London gold market was shut down for two weeks in March 1968 because of this.4 The problem was that the supply of gold was fixed, and as countries increased dollar reserves, the ratio of dollars to gold increased, which meant that the dollar price of gold would have had to be increased over time in order to maintain the Bretton Woods exchange rate system. Because of this, Group of Ten (G-10) governments stopped trying to control the price of gold for private transactions, and foreign central banks agreed not to sell in the gold market for arbitrage gains.
The political economy that had focused on systemic economic cooperation and control had shifted since the beginning of the Bretton Woods period, with an increasing emphasis on free movement of capital in the US in the 1960s, and with the view that technical solutions, such as short-term capital controls, could resolve global imbalances. Keynesian policy as adapted by the Kennedy Administration allowed for capital flow controls through a mix of fiscal and monetary policies, urging surplus countries with expand?ing economies to increase taxes or decrease government spending while increasing money growth to lower interest rates in order to allow for capital outflows (Meltzer 1991). Deficit countries were encouraged to do the converse. It is doubtful that Keynes would have encouraged the loose policies that were devised in his name, but by this period of turmoil in the Bretton Woods system, Keynes was long gone. As Best (2004) emphasizes, Keynes understood that the economy could not be corrected through technical measures when underlying imbalances were in place.
The Germans insisted that these policy mixes were convoluted, and felt that domestically focused US monetary policy was to blame. Germany was concerned with the specter of inflation, and had worked hard to maintain economic stability through low inflation and large trade surpluses (Brenner 1976). The French were also highly critical of US policies and were opposed to the expansion of the US balance-of-payments deficit financed by foreign countries, particularly as France was subjected to speculative attacks in 1968. Britain, as a deficit country, faced a perpetual sterling crisis by the late 1960s and was in a position similar to that of the US.
Hence the economic powers engaged in talks to increase liquidity in the system. Devaluation of the dollar appeared to be out of the question, since it would erode confidence in the dollar for those holding dollar reserves. By the late 1960s, Western European governments grew less willing to finance expanding US deficits (Helleiner 1994). The US wanted to supplement gold reserves with an additional reserve asset (Meltzer 1991). A version of the US proposal was accepted, and in 1967, the Special Drawing Right (SDR) was created as an asset to supplement gold and dollars.5 However, the SDR could only be held by official institutions such as central banks and international institutions, and was never very effective as a reserve asset. It was too weak to save the system.
Pressures on the dollar and an increasing unwillingness by the US to act as the center currency country resulted in the demise of the Bretton Woods system in 1971, described in the next section. While this demise has been viewed by some economists as inevitable, we do not take that view. The conflicting objectives between providing international liquidity and maintaining confidence in the convertibility of the dollar was dubbed the “Triffin dilemma.” Triffin (1960) believed that the Bretton Woods exchange rate system was unsustainable, since the US would have to run a large current account deficit in order to provide liquidity to the rest of the world, while the same deficit would erode confidence in the dollar’s convertibility into gold. This presumes that a large US current account deficit was beneficial to international liquidity, when it was, in and of itself, clearly not. The main complaint against the US current account deficit was that it pumped excess dollars into economies abroad, which could not be absorbed. A balanced US current account would have better promoted confidence in the dollar. Indeed, the President and other policy makers were increasingly concerned about the impact of the US deficit abroad, while at the same time justifying excessive spending through the necessity of war and domestic economic policy. At the end of the era, US domestic policy trumped its international concerns, and the Bretton Woods period was allowed to crumble.
Despite its ultimate failure, the Bretton Woods period was important in that it focused on maintaining economic stability that prevented large-scale crises. The policies required to maintain the system were extensive, but the effort proved worthwhile in allowing European countries to recover from the destruction of World War II and set up an international economic framework that bridged the gap between the gold standard and freely floating exchange rates. What could have been chaos in the currency and productive arenas was controlled and stabilized as countries played by the international “rules of the game.”