The International Monetary Fund

The embodiment of the Bretton Woods system was an institution known as the IMF. In July 1944, forty-four countries signed the Articles of Agreement of the International Monetary Fund. The IMF began operations in 1945, and its headquarters is in Washington, D.C. The IMF’s initial function was to oversee the reconstruction of the world’s international payments system. However, the Articles of Agreement also provided for the creation of a pool of international reserves that countries with temporary payments imbalances could draw on. Each country in the IMF was assigned a quota of money to contribute to the pool of funds. The size of this quota is related to a number of variables related to the country’s importance in the world economy. One-quarter of this quota was contributed in gold, and the country’s own currency comprised the remaining three-quarters of its quota. The size of the quota was also tied to a country’s ability to borrow from the IMF. A country could borrow up to a fourth of its quota at any time without any conditions. As a country attempted to borrow more reserves from the IMF to finance an imbalance in its balance of payments, the institution would begin to impose “conditions” on this borrowing. Essentially the conditions the IMF imposed were that the borrowing government would have to pursue monetary and fiscal policies that were consistent with long-run external balance. Because most borrowing countries had external deficits, this invariably meant tighter monetary and/or fiscal policies. Thus, once a country had exhausted its own reserves, there was a limit to its ability to pursue inconsistent policies indefinitely. IMF loans are short-run loans that are designed to be repaid in three to five years.

In practice, these loans have proven to be troublesome because many of the countries borrowing from the IMF have serious imbalances in their balance of payments that may be difficult to correct in the short run. IMF-mandated conditions that will correct these problems in a short period of time might call for a combination of fiscal and/or monetary policy measures that can create a severe short-run economic contraction. The balance of payments problem may well be cured but the costs in terms of lost output may be high. Such lending also puts the IMF in the unenviable position of determining a sovereign country’s macroeconomic policies. As one might imagine, this can make the IMF an unpopular institution. It is frequently forgotten that it was not the IMF that created the macroeconomic policies that led to the payments imbalance in the first place. However, the IMF is frequently involved in the solution to a macroeconomic problem at a time when the country’s economy is not performing well. As a result, the IMF is a deeply unpopular institution in many developing countries.’

The demise of the Bretton Woods System

During the 1950s and 1960s, the Bretton Woods system functioned fairly well. However, there were a couple of problems that developed over time. The first problem with the system was that it was not symmetrical. The IMF would force a country with a chronic balance of payments deficit to pursue more restrictive monetary and fiscal policies that would eventually correct the problem. However, what would happen to a country with a chronic balance of payments surplus? As designed, the system allowed countries with a balance of payments surplus to accumulate reserves through intervention and then sterilize the effect of this intervention on the domestic economy. However, the result was that the Bretton Woods system had no real way to deal with chronic surpluses. Since the country would not be borrowing from the IMF, there was no way to force it to pursue policies that would correct this type of imbalance. In a gold-standard world, the system was symmetric in this regard. The system would correct both deficits and surpluses. In the Bretton Woods system, the deficits might get corrected but there was no effective way to deal with countries with persistent surpluses.

A second and more serious problem with the system developed over time. In the Bretton Woods system, all currencies were fixed to the dollar and the U.S. government was obligated to exchange dollars for gold at a fixed price. Thus, the system would function so long as the U.S. balance of payments was balanced in the long run. However, beginning in the mid-1960s, the U.S. developed a persistent balance of payments deficit. The U.S. dollar was the world’s dominant reserve currency and was the heart of the system. All other countries wanted to hold dollars to use for intervention, and the U.S. was not obligated to correct this imbalance. Thus, the U.S. did not see the need to adjust domestic monetary and/or fiscal policy to reduce the external imbalance. Over time, this led to foreign central banks holding an increasing number of dollars. Surplus countries had to buy dollars and sell their domestic currencies to prevent their currencies from appreciating. By the end of the 1960s, an obvious problem had emerged. Foreign central banks were holding an amount of dollars that was larger than the U.S. stock of gold at the official price of $35 per ounce. Unless the U.S. was willing to change its economic policies, the situation increasingly was untenable.

In many respects, the end of the Bretton Woods system was fairly predictable. The U.S. was faced with a choice. It could:

• 1 change its macroeconomic policies to reduce or eliminate its external deficit,
• 2 have foreign central banks demand gold in exchange for the dollars that they were holding, or
• 3 devalue the dollar and let it float against gold and the other currencies.

The U.S. chose the latter option. The announcement by the U.S. in August of 1971 that it would no longer redeem dollars for gold effectively ended the Bretton Woods system. Over the next two years, there were periodic efforts by the member countries to reconstruct the system. However, since the U.S. was unwilling to change the policies that led to the problem in the first place, little was accomplished. The generalized global turbulence associated with the first oil shock in 1973 effectively ended any willingness by IMF members to reconstruct the system. For the last thirty years the world has been without a formal international monetary system. In the next section we will consider how the current system, or lack thereof, works.