The Bretton Woods System
The purpose of the Bretton Woods system was twofold. First, countries had a strong desire to return to some form of international monetary system that featured fixed exchange rates. The period after the gold standard from 1914 up to World War II was characterized by exchange rates that were extremely unstable. Given that both business and governments had become used to stable exchange rates, this period of instability was very unsettling. Thus, the first objective of a new international monetary system was to develop some form of fixed exchange rates. The second purpose of the Bretton Woods system was to develop some method that would decouple the link between a balance of payments imbalance and the supply of money. In order to accomplish this objective, it was necessary to reduce the role that gold played in determining a country’s money supply. It became necessary to link currencies to something other than gold. Both of these objectives were satisfied in a rather unique manner.
First, the price of gold was defined in terms of the U.S. dollar. The U.S. was to maintain the price of gold fixed at $35 per ounce. In addition, the U.S. would stand ready to exchange dollars for gold, or vice versa, at the stated price without restrictions or limitations. This requirement allowed the system to retain at least a small part of the old link to gold. Second, all other currencies were fixed in terms of the U.S. dollar. The Bretton Woods system was essentially a U.S. dollar standard, with the dollar linked to gold. Because all currencies were fixed to the dollar, they also were fixed in relation to one another. The international monetary system seemed ideal in that exchange rates were fixed and governments were now free to pursue a monetary policy consistent with internal balance—in other words, intervention coupled with sterilization. Thus, a country would no longer have to sacrifice internal balance considerations to maintain its external balance.
However, the Bretton Woods system was far from perfect. The inherent problem in what the system tried to accomplish is that it is logically impossible for all countries to have a balance of payments that balances in both the short and the long run. At best, one would hope that countries would have a balance of payments deficit over some period of time and surpluses over another, so that a country’s balance of payments would “balance” in the long run. This long-run balancing was quite important for sustaining this type of international monetary system. In order to maintain fixed exchange rates in this system, it was necessary for governments to actively intervene in the foreign exchange market. In some cases, the governments would have to buy their own currency or sell foreign exchange (dollars) to prevent the domestic currency from depreciating. In other cases, they would have to buy foreign exchange (dollars) or sell their own currency in order to prevent the domestic currency from appreciating. In order to sell foreign exchange, it is necessary for the government to have a readily available supply. This selling of foreign exchange would occur when the country had a balance of payments deficit. Thus, the necessary reserves of foreign exchange to sell needed to be created in a previous period when the country had a balance of payments surplus and was accumulating foreign exchange. As such, it was important for countries to pursue internal policies that would ensure that the balance of payments “balanced” in the long run.
To more fully examine how the gold-exchange standard functioned, consider the following situation. Suppose that a country was currently in a recession and at the same time also had a current account deficit. In this case, the macroeconomic policies the government would need to pursue to obtain both an internal and external balance are inconsistent with one another. Internal balance considerations would suggest that the government should pursue expansionary monetary and/or fiscal policies. However, such policies would exacerbate the external deficit. In this case, the government might still prefer to fight the recession and keep the exchange rate fixed by selling previously accumulated foreign exchange. Once the domestic economy had recovered sufficiently, it might be possible to slow economic activity enough to re-establish external balance. If a country had sufficient international reserves in the short run, it might be able to deal with internal balance issues and temporarily ignore external balance considerations.
As outlined, the system could function over time if the balance of payments imbalances were short-run in nature. However, if the imbalances were persistent it would be difficult for the country to “finance” the balance of payments deficit using previously accumulated reserves. If the country kept pursuing policies that were inconsistent with internal and external balance, at some point the country might have no choice but to change the value of its currency and its relation to the U.S. dollar. If this situation occurred in enough countries, the devaluations would be so frequent that exchange rates would no longer be fixed. In other words, there needed to be some mechanism built into the international monetary system to encourage countries to maintain policies that would produce external balance and a stable exchange rate in the long run. In a gold-standard world, the enforcement mechanism was obvious. Balance of payments imbalances were by the nature of the system self-liquidating. In the Bretton Woods system, the mechanism was less obvious.