Bretton Woods System and 1944 Agreement

How Bretton Woods Introduced a New World Order

Bretton Woods
US delegates attending the United Nations Monetary and Financial Conference, also known as the Bretton Woods Conference, in Bretton Woods, New Hampshire. The 10 delegates are (l-r, standing): Assistant Secretary of Treasury Harry Dexter White, Fred M. Vinson, Dean Acheson, Edward E. Brown, Marriner S. Eccles, and Michigan Congressman Jesse P. Wolcott. Front row, seated: Senator Robert F. Wagner, Kentucky Congressman Brent Spence, Secretary of Treasury Henry Morgenthau Jr., and New Hampshire Senator Charles W. Tobey. The conference, which included delegates from 34 nations, resulted in the creation of the International Monetary Fund and the World Bank. Photo: Bettmann/Getty Images

The Bretton Woods system was a remarkable achievement of global coordination. It established the U.S. dollar as the global currency, taking the world off of the gold standard. It created the World Bank and the International Monetary Fund (IMF). These two global organizations would monitor the new system. It established America as the dominant power behind these two organizations and the world economy.

That's because the United States was the only country with the ability to print dollars,

The Bretton Woods Agreement

Under the Bretton Woods agreement, countries promised that their central banks would maintain fixed exchange rates between their currencies and the dollar. How exactly would they do this? If a country's currency value became too weak relative to the dollar, the bank would buy up its currency in foreign exchange markets. That would decrease the supply, which would automatically raise the price. If its currency became too high, the bank would print more. That would increase the supply and automatically lower its price.

Members of the Bretton Woods system agreed to avoid any trade warfare. For example, they wouldn't lower their currencies strictly to increase trade. But they could regulate their currencies under certain conditions. For example, they could take action if foreign direct investment began to destabilize their economies.

They could also adjust their currency values to rebuild after a war.

How It Replaced the Gold Standard

Before Bretton Woods, most countries followed the gold standard. That meant each country guaranteed that it would redeem its currency for its value in gold. After Bretton Woods, each member agreed to redeem its currency for U.S. dollars, not gold.

Why dollars? The U.S. held three-fourths of the world's supply of gold. The dollar's value was 1/35 of an ounce of gold. In a way, the world was still on somewhat of a gold standard.

The dollar had now become a substitute for gold. As a result, the value of the dollar began to increase relative to other currencies. Now, there was more demand for it, even though its worth in gold remained the same. This discrepancy in value planted the seed for the collapse of the Bretton Woods system three decades later.

Why It Was Needed

Until World War I, most countries were on the gold standard. However, they went off so they could print the currency needed to pay for their war costs. It caused hyperinflation, as the supply of money overwhelmed the demand. The value of money fell so dramatically that, in some cases, people needed wheelbarrows full of cash just to buy a loaf of bread. After the war, countries returned to the safety of the gold standard.

All went well until the Great Depression. After the 1929 stock market crash, investors switched to forex trading and commodities.

It drove up the price of gold, resulting in people redeeming their dollars for gold. The Federal Reserve made things worse by defending the nation's gold reserve by raising interest rates. It's no wonder that, as World War II wound down, countries were ready to abandon a pure gold standard.

The Bretton Woods system gave nations more flexibility than a strict adherence to the gold standard, but less volatility than no standard at all. A member country still retained the ability to alter its currency's value if needed to correct a "fundamental disequilibrium" in its current account balance. (Source: Benjamin Cohen, Bretton Woods; Time A Brief History of Bretton Woods)

Role of the IMF and World Bank

The Bretton Woods system could not have worked without the IMF. That's because member countries needed a mechanism to bail them out if their currency values got too low. They'd need a kind of global central bank they could borrow from in case they needed to adjust their currency's value, and didn't have the funds themselves. Otherwise, they would just slap on trade barriers or raise interest rates.

The Bretton Woods countries decided against giving the IMF the power of a global central bank, to print money as needed. Instead, they agreed to contribute to a fixed pool of national currencies and gold to be held by the IMF. Each member of the Bretton Woods system was then entitled to borrow what it needed, within the limits of its contributions. The IMF was also responsible for enforcing the Bretton Woods agreement.

The World Bank, despite its name, was not the world's central bank. At the time of the Bretton Woods agreement, the World Bank was set up to lend to the European countries devastated by World War II. Now the purpose of the World Bank is to loan money to economic development projects in emerging market countries.

The Collapse of the Bretton Woods System

In 1971, the U.S. was suffering from massive stagflation. That's a deadly combination of inflation and recession. It was partly a result of the dollar's role as a global currency. In response, President Nixon started to deflate the dollar's value in gold. Nixon revalued the dollar to 1/38 of an ounce of gold, then 1/42 of an ounce.

But the plan backfired. It created a run on the U.S. gold reserves at Fort Knox as people redeemed their quickly devaluing dollars for gold. In 1973, Nixon unhooked the value of gold from altogether. Without price controls, gold quickly shot up to $120 per ounce in the free market. The Bretton Woods system was over. (Source: Time, Fuss Over Dollar Devaluation, October 4, 1971) 

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