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The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. Preparing to rebuild the international economic system as World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference. The delegates deliberated upon and signed the Bretton Woods Agreements during the first three weeks of July 1944. Setting up a system of rules, institutions, and procedures to regulate the international monetary system, the planners at Bretton Woods established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement. The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar and the ability of the IMF to bridge temporary imbalances of payments.
Purpose:
The result of this international meeting, the Bretton Woods Agreement, had the original purpose of rebuilding after World War II through a series of currency stabilization programs and infrastructure loans to war-ravaged nations. By 1946, the system was in full operation through the newly established International Bank for Reconstruction and Development (IBRD, the World Bank) and the International Monetary Fund (IMF). What makes the Bretton Woods Agreement so interesting to us today is the fact that the whole plan for international monetary policy was based on nations agreeing to adhere to a global gold standard. Each country signing the agreement promised to maintain its currency at values within a narrow margin to the value of gold. The IMF was established to facilitate payment imbalances on a temporary basis.
Assumptions:
But it was flawed in its underlying assumptions. By pegging international currency to gold at $35 an ounce, it failed to take into effect the change in gold's actual value since 1934, when the $35 level had been set. The dollar had lost substantial purchasing power during and after World War II, and as European economies built back up, the ever-growing drain on U.S. gold reserves doomed the Bretton Woods Agreement as a permanent, working system. In 1971, experiencing accelerating depletion of its gold reserves, the United States removed its currency from the gold standard, and the Bretton Woods Agreement was no longer workable.
Drawbacks
The Bretton Woods Agreement did not include any provisions for creation of reserves. The presumption was that gold production would be sufficient to continue funding growth and that any short term problems could be resolved through the borrowing regimens. Anticipating a high volume of demand for such lending in reconstruction efforts after World War II, the Bretton Woods attendees formed the IBRD, providing an additional $10 billion to be paid by member nations. As well-intended an idea as it was, the agreements and institutions that grew from Bretton Woods were not adequate for the economic problems of postwar Europe. The United States was experiencing huge trade surplus years while carrying European war debt. U.S. reserves were huge and growing each year. It became increasingly difficult to maintain the peg of the U.S. dollar to $35-per-ounce gold. An open market in gold continued in London, and crises affected the going value of gold. The conflict between the fixed price of gold between central banks at $35 per ounce and open market value depended on the moment. During the Cuban missile crisis, for example, the open market value of gold was $40 per ounce. The mood among U.S. leaders began moving away from belief in the gold standard. During this period, the IMF set up Special Drawing Rights (SDRs) for use as trade between countries. The intention was to create a type of paper gold system, while taking pressure off the United States to continue serving as central banker to the world. However, this did not solve the problem; the depletion of U.S. gold reserves continued until 1971. By that time, the U.S. dollar was overvalued in relation to gold reserves. The United States held only 22 percent gold coverage of foreign reserves by that year. SDRs acted as a basket of key national currencies to facilitate the inevitable trade imbalances.
However, the Bretton Woods Agreement lacked any effective mechanism for checking reserve growth. Only gold and the U.S. asset were considered seriously as reserves, but gold production was lagging. Accordingly, dollar reserves had to expand to make up the difference in lagging gold availability, causing a growing U.S. current account deficit. The solution, it was hoped, would be the SDR. While these instruments continue to exist, this long-term effectiveness can only be the subject of speculation. Today SDRs make up about 1 percent of IMF members' nongold reserves, and when in 1971 the United States went off the gold standard, Bretton Woods ceased to function as an effective centralized monetary body. In theory, SDRs used today on a very limited scale of transactions between the IMF and its members could function as the beginnings of an international currency. But given the widespread use of the U.S. dollar as the peg for so many currencies worldwide, it is unlikely that such a shift to a new direction will occur before circumstances make it the only choice. The Bretton Woods system collapsed, partially due to economic expansion in excess of the gold standard's funding abilities on the part of the United States and other member nations. However, the problems of currency systems not pegged to gold lead to economic problems far worse. On August 15, 1971, the United States unilaterally terminated convertibility of the dollar to gold. As a result, he Bretton Woods system officially ended and the dollar became fully 'fiat currency,' backed by nothing but the promise of the federal government. This action, referred to as the Nixon shock, created the situation in which the United States dollar became a reserve currency used by many states. At the same time, many fixed currencies (such as GBP, for example), also became free floating
End of the Second World War, 1944, international agreement set up world trading community linked by fixed exchange rates with the American Dollar being the main international currency. Countries allowed to adjust value of their exchange rate only after periods of fundamental disequilibrium in balance of payments. Restrictions on international capital flows fair degree of certainty with respect to international economic stransactions. The $US international currency America ran trade deficits provide $US to the world + the expansion of the American economy international engine of growth + export market.
Problems: no mechanism resolved balance of payments problems accentuated OPEC price rises and subsequent crises.
The world underwent profound changes after the Second World War. The experiences of war gave rise to an awareness that international cooperation was crucial to avert further suffering. The United Nations (UN) was thus set up in 1945. In Europe, the first foundations for what would later become the European Union were laid by three Treaties bringing together six signatory States (Germany, Belgium, France, Italy, Luxembourg and the Netherlands):
the Treaty establishing the European Coal and Steel Community (ECSC), signed on 18 April 1951;
the
Rome
Treaties,
i.e.
the
Treaty
establishing
the
European
Economic
Community (EEC) and the Treaty establishing the European Atomic Energy Community (EURATOM), signed in March 1957. Creation of Economic and Monetary Union At the summit in The Hague in December 1969, the Heads of State and Government defined a new objective of European integration: Economic and Monetary Union (EMU). A high-level group chaired by Pierre Werner, Prime Minister of Luxembourg, was thus given the task of drawing up a report on how this goal might be reached by 1980. The Werner group submitted its final report in October 1970. It envisaged the achievement of full economic and monetary union within ten years according to a plan in several stages. The ultimate goal was to achieve full liberalisation of capital movements, the total convertibility of Member States currencies and the irrevocable fixing of exchange rates. The report therefore envisaged the adoption of a single European currency as a possible objective of the process, but did not yet regard it as a goal in itself. Furthermore, the report recommended that the coordination of economic policies be strengthened and guidelines for national budgetary policies drawn up. In March 1971, although being unable to agree on some of the key recommendations of the report, the Six gave their approval in principle to the introduction of EMU in several stages. The first stage, involving the narrowing of currency fluctuation margins, was launched on an experimental basis and did not entail any commitment regarding the continuation of the process.
The collapse of the Bretton Woods system and the decision of the US Government to float the dollar in August 1971 produced a wave of instability on foreign exchanges which called into serious question the parities between the European currencies. The EMU project was brought to an abrupt halt. In March 1972 the Six attempted to impart fresh momentum to monetary integration by creating the "snake in the tunnel": a mechanism for the managed floating of currencies (the "snake") within narrow margins of fluctuation against the dollar (the "tunnel"). Thrown off course by the oil crises, the weakness of the dollar and the differences in economic policy, the "snake" lost most of its members in less than two years and was finally reduced to a "mark" area comprising Germany, the Benelux countries and Denmark. Creation of the European Monetary System (EMS) Efforts to establish an area of monetary stability were renewed in March 1979, at the instigation of France and Germany, with the creation of the European Monetary System (EMS), based on the concept of fixed, but adjustable exchange rates. The currencies of all the Member States, except the United Kingdom, participated in the exchange-rate mechanism. The principle was as follows: exchange rates were based on central rates against the ecu (European Currency Unit), the European unit of account, which was a weighted average of the participating currencies. A grid of bilateral rates was calculated on the basis of these central rates expressed in ecus, and currency fluctuations had to be contained within a margin of 2.25 % either side of the bilateral rates (with the exception of the Italian lira, which was allowed a margin of 6 %). Over a ten-year period, the EMS did much to reduce exchange-rate variability: the flexibility of the system combined with the political resolve to bring about economic convergence, achieved sustainable currency stability. With the adoption of the Single Market Programme in 1985, it became increasingly clear that the potential of the internal market could not be fully exploited as long as relatively high transaction costs linked to currency conversion and the uncertainties linked to exchange-rate fluctuations,
however small, persisted. Moreover, many economists denounced what they called the "impossible triangle": free movement of capital, exchange-rate stability and independent monetary policies were incompatible in the long term. Introduction of the EMU In June 1988 the Hanover European Council set up a committee to study economic and monetary union under the chairmanship of Jacques Delors, the then President of the European Commission. The other members of the committee were the governors of the national central banks, who were therefore closely involved in drawing up the proposals. The committee's report, submitted in April 1989, proposed to strengthen the introduction of the EMU in three stages. In particular, it stressed the need for better coordination of economic policies, rules covering national budget deficits, and a new, completely independent institution which would be responsible for the Union's monetary policy: the European Central Bank (ECB). On the basis of the Delors report, the Madrid European Council decided in June 1989 to launch the first stage of EMU: full liberalisation of capital movements by 1 July 1990. In December 1989 the Strasbourg European Council called for an intergovernmental conference that would identify what amendments needed to be made to the Treaty in order to achieve the EMU. The work of this intergovernmental conference led to the Treaty on European Union, which was formally adopted by the Heads of State and Government at the Maastricht European Council in December 1991 and signed on 7 February 1992. The Treaty provides for the EMU to be introduced in three stages:
stage No 1: (from 1 July 1990 to 31 December 1993): the free movement of capital between Member States;
stage No 2: (from 1 January 1994 to 31 December 1998): convergence of Member States economic policies and strengthening of cooperation between Member States national central banks. The coordination of monetary policies was institutionalised by the establishment of the European Monetary Institute (EMI), whose task was to strengthen
cooperation between the national central banks and to carry out the necessary preparations for the introduction of the single currency. The national central banks were to become independent during this stage;
stage No 3: (underway since 1 January 1999): the gradual introduction of the euro as the single currency of the Member States and the implementation of a common monetary policy under the aegis of the ECB. Transition to the third stage was subject to the achievement of a high degree of durable convergence measured against a number of criteria laid down by the Treaties. The budgetary rules were to become binding and a Member State not complying with them was likely to face penalties. A single monetary policy was introduced and entrusted to the European System of Central Banks (ESCB), made up of the national central banks and the ECB.
The first two stages of EMU have been completed. The third stage is currently underway. In principle, all EU Member States must join this final stage and therefore adopt the euro (Article 119 of the Treaty on the Functioning of the EU). However, some Member States have not yet fulfilled the convergence criteria. These Member States therefore benefit from a provisional derogation until they are able to join the third stage of EMU. Furthermore, the United Kingdom and Denmark gave notification of their intention not to participate in the 3rd stage of EMU and therefore not to adopt the euro. These two States therefore have an exemption with regard to their participation in EMU. The exemption arrangements are detailed in the protocols relating to these two countries annexed to the founding Treaties of the EU. However, the United Kingdom and Denmark reserve the option to end their exemption and submit applications to join the 3rd phase of EMU. Currently, 17 of the 27 Member States have joined the third stage of EMU and therefore have the euro as a single currency
How did the European Monetary System work? The most important part of the EMS was the Exchange Rate Mechanism. This committed all member states' governments to keep their currency exchange rates within bands. This meant that no country's exchange rate could fluctuate more than 2.25% from a central point. This was designed to help create stable commerce without the fear that sudden changes in the values of currencies would dampen trade and encourage the development of trading barriers between member states. It also created a European Currency Unit (ECU) to be used as a unit of account. Although not a real currency, the ECU became the basis for the idea of creating a single currency - an idea that was realised with the launch of the Euro in 1999.
Britain entered the ERM in 1990 at a rate of 2.95 Deutschmarks to one Pound Sterling. Many feel this rate was too high and caused Britain's rapid departure from the system.
Britain dramatically left the ERM on 16 September 1992 (a day that became known as Black Wednesday), because it was no longer possible to keep the pound within the bands of the ERM.
Arguments For
The European Monetary System was important in ensuring currency stability in the European Community at a time when international markets were very volatile.
Without the EMS the completion of the single market project would have been more difficult.
Against
Fixing exchange rates is dangerous because unless the correct rate is set and changed appropriately, a national economy can be forced to pursue policies that are not best suited to domestic conditions simply in order to maintain international stability.
EMS established the principle that one monetary policy can suit all member states. The events of 1992 proved that this was not the case.
Quotes "ERM was a recipe for instability... This instability produced a damaging recession." Professor Patrick Minford, Cardiff Business School, 2002.
Technical Terms Exchange Rates: the ratio in which one country's currency is valued against another.
Monetary policy: the policies employed by Governments or Central Banks to control money supply and interest rates to achieve economic goals.
Fixed or floating exchange rates: in a fixed rate system all rates are set at commonly agreed levels. In a floating system they are allowed to find their own place through market pressure.
Unit of account: an agreed measure for stating the prices of goods and services.