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United Kingdom and United States started negotiations towards the reconstruction of the
international monetary system in 1941. The objective of the system which emerged was to
avoid the breakdown in international monetary relations. In 1944 at Bretton Woods, New
Hampshire an international monetary conference was held to put the basis of the Bretton
Woods system, the leading negotiators were Harry Dexter White representing US and John
Maynard Keynes for United Kingdom. Bretton Woods aimed to bring full employment, price
stability and external balance without any restrictions on international trade (P. R. Krugman
et. all. 2012).
This section will focus on the issues that Bretton Woods system had and which led to its
failure but also on its successes.
Keith Pilbeam (1992) argues that one of the issues was the liquidity problem, Robert Triffin
(1960) pointed out that the bond between the dollar and the gold will ultimately result in a
loss of confidence in the system. Confidence in the U.S. dollar was essential for the success
of this monetary system, banks will hold dollar reserves only if they are confident that the
dollars can easily be changed into gold at the constant rate of $35 per ounce. As the
international trade grew so did the demand for dollars, but the gold reserves did not increase
proportionally with the demand, hence it became clear that the US authorities will not be able
to maintain the $35 rate. Triffin (1960) predicted that this will make the foreign central banks
to change dollars for gold and eventually the system will break. Another issue with this
system as Keith Pilbeam (1992) sustains is related to the Greshams Law. This law implies
that if there is a difference between the official rate of exchange rate and the private market
rate of exchange between two assets, only the overvalued asset will continue in circulation. In
the case of Bretton Woods the two assets are gold and the dollar. As the inflation in USA
increased, the authorities struggled to maintain the rate of change at $35, the private markets
pressured the price of the gold to go up and this resulted in a gold pool (Keith Pilbeam,
1992). Because the official price of the gold was under valuated banks could cause a run on
the dollar, converting dollars into gold and then sell the gold in the private markets to make
profit. President Nixon announced the termination of the dollar-gold convertibility in 1971
and the Greshams Law proved to be right. Furthermore, another key issue of this system is
the lack of an adjustment mechanism (Keith Pilbeam, 1992). In case of an acute
fundamental disequilibrium of a countrys balance of payments a realignment of the exchange
rate was permitted but these members were reluctant to do so because this was seen as a
weakness. Also according to Keith Pilbeam (1992) the fundamental disequilibrium was not
defined. Another solution to this problem apart from the realignment of those currencies was
for the US government to devalue the dollar in terms of gold but this action will not only
make USA less competitive but will also harm the confidence in the system. Keith Pilbeam
(1992) argues that there were two ways of getting out of this crisis, either countries with
deficit would have to deflate their economy or countries with surplus would have to revalue
their currencies. Countries with deficit would not pursue a deflationary policy because this
will cause unemployment and those with surplus were reluctant to revalue their currency
because this will reduce their export growth and eventually will increase unemployment. Paul
De Grauwe (1996) argues that another issue of the Bretton Woods system was the (n-1)
problem or seigniorage problem. The system had an in-built mechanism to correct US if
they engaged in an excess money creation, hence inflation. All the members could convert
their dollar reserves into gold if USA started this fiscal and monetary expansion which was
not backed by a strong economic growth. Paul De Grauwe (1996) sustain that all the
members which pegged their currency to the dollar started to import inflation when USA
began this process. The confidence problem arose, speculators understood that the German,
Swiss and Japanese authorities were concerned with the inflation, thus they started massive
speculative transactions of their currencies putting more pressure on the system. According to
the in-built mechanism the Germans, the Swiss and the Japanese should have converted
their dollars into gold to stop this process but they did not. P. D. Grauwe (1996) argues that
Germany and Japan were too dependent on USA to try to force such a disciplinary action,
thus they did not act. In 1973 the Bretton Woods system collapsed when the major members
Germany, Japan and UK stopped maintaining a fixed exchange rate with the dollar. Despite
its drawbacks the Bretton Woods system had made it possible for the international trade to
flourish in the period 1950-1960, it removed the uncertainty of businesses that their currency
will not be accepted as a mean of payment. By pledging to keep the dollar-gold rate fixed
USA provided confidence to the global trade environment but this also was a weakness, when
the USA had issues holding this fixed rate it went back on its word for the national interest of
the country.
EMU
After the Bretton Woods system EU looked for a new monetary system to achieve economic
and monetary union. The economic union already started according to Mark Baimbridge et.
all (2000) between 1960-1970 when members dismantled tariff barriers and quotas, thus the
only objective was to achieve a monetary union. In 1991 the Maastricht Treaty has been
signed setting the start for EMU in January 1999. Peter B. Kenen and Ellen E. Meade (2008)
argue that this project was the most ambitious project of its type, it involved that the member
states would give up their currency in favour for the new currency called euro and also to
subordinate their central banks to the European Central Bank. Giving up their own currency
for euro is seen by B. Kenen and Ellen E. Meade (2008) as a commitment from the members
that they will not abandon the system.
EMU RULES
The convergence criteria from the Maastricht Treaty together with The Stability and
Growth Pact represent the rules of EMU. According to Europa (2006) there are four major
convergence criteria: Price stability, Government finances which covers annual
government deficit and debt, exchange rates and long-term interest rates. Europa (2006)
argues that the inflation rate of the future member is allowed to be over the average inflation
rate of the three best countries from EMS in terms of price stability by only 1.5%. In terms of
government finances the annual budget deficit must not be over 3% of GDP, although in
cases of temporary or exceptional nature it can be higher. The national debt must not exceed
60% of GDP, the only case where a member with higher national debt than the previous
figure can be accepted is when the trend of the national debt shows that it is declining at a
convenient rate (Europa, 2006). Another criterion for a member to be accepted in the final
step (EMU) is that during the prior two years from the assessment the member had to
participate in the exchange-rate mechanism without any severe tensions. Lastly, the nominal
long-term interest rate must not go over the value from the three best performing members in
terms of price stability by more than 2% (Europa, 2006). P. B. Kenen and E. Meade (2008)
argue that Theo Waigel, the German finance minister proposed additional protection
mechanisms in the form of the Stability and Growth Pact. The first point from this pact was
that the EU governments would have to aim at close to balance or surplus budgets and if not
financial sanctions listed in the treaty will be applied. The second mechanism of defence
proposed in this pact was that every member state had to prepare a stability program on how
will they keep their budged close to balance and it will have to be updated annually. The
Council of Ministers was in charge of analyzing these programmes (P. B. Kenen and E. E.
Meade, 2008). Finally, they adopted the legislation on excessive deficit procedures and
financial sanctions.
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