Bretton Woods, 1944-1971; P. Stevens

By 1968, a "two-tier" gold market Mr. Stevens is a freelance. writer who spe cializes in the field of economics. 296 PAUL STEVENS was established in the midst of a gold crisis which, by 1971, cul minated in the suspension of dollar convertibility together with a dol lar devaluation against multilat eral revaluations of most other maj or foreign currencies. Bretton Woods is dead and an autopsy is called for to determine the cause of death. If meaningful international monetary reform is to follow, it is necessary to know what went wrong. Fixed exchange rates, flexible rules. . .. Under the rules established by the Bretton Woads agreement, the gold values of a member nation's currency could be altered "as con1973 BRETTON WOODS: 1944-1971 297 ditions warranted." This distin guishing feature of the Bretton Woods system exposed a drastic ideological departure from the gold standard. Under the gold standard, no natural conditions would ever war rant a change in the gold value of a nation's currency. Under a pure gold standard, all the money in circulation would be either gold or claims to gold. Any paper money would be fully convertible into gold.

There would be no difference be tween claims to gold and gold it..; self, since, if claims to gold cir culated as money, the' gold could not. However, there are government made conditions that could war rant a reduction in the gold value of a nation's currency. If govern ments have the power to artifi cially increase the claims to gold (e.g., dollars) , they have the power to depreciate the value of the na tional monetary unit. Bretton Woods was established with the intention of aiding gov ernments in exercising their pow ers of inflationary finance. Govern ment leaders knew that the gold standard prevented them from fully pursuing domestic goals that depended on deficit spending and prolonged, artificially induced "booms." They detested the gold standard for its fixed rules which brought adverse economic repercussions whenever they refused· to adhere to them, and they detested flexible exchange rates that ex posed the government's policy of currency depreciation.

The political temptations of ar tificially increasing the money sup ply in order to "stimulate the econ omy" prevailed against the gold standard and brought the begin ning of a "new era": fixed ex change rates with flexible rules, the exact opposite of the gold standard. No longer would politicians ad here to the discipline of the gold standard. No longer would they have to restrict their deficits or domestic money supplies. Govern ment leaders would make their own rules and fix the nominal value of money by decree. And if "conditions warranted" a reduc tion in the nominal value of a na tion'smoney, it was agr~ed that a nation could devalue up to ~O per cent after the formality of obtain ing other nations' permission. This was called the "adjustable peg" system. The great ideological distinction between the gold sta,ndard and the Bretton Woods system, then, is that the Bretton Woods system was ostensibly intended to stabil ize exchange rates, but at the same time it anticipated that govern ments would not defend the value of their currencies. Worse, Bretton 298 THE FREEMAN May Woods institutionalized a method which allowed and condoned future currency depreciation.

Export or devalue: institutionalizing the devaluation bias .... Historically (and the Bretton Woods era was no exception) nations have seen fit to pursue a basically mercan tilistic trade policy, i.e., a policy which maintains various regula tions intended to produce more ex ports than imports. The mercantilistic case is not a realistic one. For example, it would be impossible to develop a logical case advocating that all individuals should sell products and services at the same time. Obviously, some individuals must be consumers if there is to be a market for sellers. There is no difference when it comes to nations trading in a world market. This is simply to say that not all nations can run trade surpluses at the same time. An equally difficult case would be to try to convince some indi viduals that most of the money they receive from the sale of goods and services should be saved rather than spent on the consumption of goods. Yet this is the intent un derlying all government policies that aim at increasing exports (sales) and restricting imports (consumption) .

There is no logical reason why individuals should not be allowed to reduce their cash balances by buying goods from other nations if they believe it is to their bene fit; that is what their cash bal ances are for. To penalize men or discourage them from importing by imposing licensing restrictions, capital controls, tariffs, or "import surcharges," only serves to limit the variety of their economic choices. This in turn only serves to reduce their standard of living. A nation's drive for export sur pluses, together with its "protec tionist" policies of restricting im ports, leads to an increase in the domestic money supply. This influx of money, together with the money that governments feel they must artificially create in order to "stimulate the economy," leads to higher domestic wages and prices as more money chases fewer goods. These higher wages and prices create an illusion of prosperity, which explains the popularity of mercantilist-inflationist policies.

But higher domestic wages and prices lead to a dwindling trade surplus as a nation's goods become less competitive in world markets, and a dwindling trade surplus, un less corrected, eventually deterio rates into a trade deficit. This is the dilemma facing all govern ments that pursue the contradic tory and self-defeating policies of mercantilism and inflationary fi nance.

1973 BRETTON WOODS: 1944-1971 299 Under a gold standard there is only one way to resolve this di lemma: stop artificially creating money, stop preventing money from leaving the country. The re sult would be a normal, self-cor recting deflation - Le., a contrac tion of the domestic money sup ply - which would lead to a fall in domestic prices and to equilibrium in that nation's balance of trade position. But because governments hold an unwarranted fear of lower prices and favor higher prices that give the illusion of prosperity, the framers of Bretton Woods adopted a mechanism that would allow gov ernments to inflate their curren cies yet escape the process of a normal self-correcting deflation. By devaluing their currencies, governments could continue to in flate their domestic wages and prices while making their exports less expensive to the world. The device of devaluation was established to allow nations to re gain their competitive edge once their surplus deteriorated into deficit. Devaluation immediiately lowers the price of a nation's ex ports, and in this way nations can more actively strive for export sur pluses. Thus the framers of Bret ton Woods found a way in which nations could continue both their drive for export surpluses and their domestic policies of inflation.

A nation would simply export its goods until its domestic inflation reduced or eliminated its trade ~urplus, then devalue. In this way the Bretton Woods system estab lished an implicit code of con duct: export or devalue. It insti tut,ionalized a devaluation bias within the new international mone tary system, which led to serious imbalances, ultimately resulting in hundreds of devaluations during the Bretton Woods era. IIHot Money Blues. 1I •••Because-de valuations are completely arbitrary (at best mere guesswork), new problems arose in place of old ones. The problems centered around the pre-devaluation exchange rate: na tions were committed to supporting the rate even when it was unreal istic. Bright investors soon began to realize when a particular currency was overvalued and to shift their money from the weak currency to stronger ones. This caused further pressure on exchange rates and re sulted in speculation - Le., selling short on X currency, buying gold, or buying long on Y currency. Gov ernments intervened in foreign ex change markets in order to preserve their unrealistic exchange rates, by accumulating massive amounts of un'Yanted weak currencies. But this could not continue for long.

Finally, when a government was 300 THE FREEMAN May forced to devalue, the action had repercussions on other currencies (particularly if a major currency were involved): it brought all other weak currencies under sus picion. This resulted in further de valuations as investors transferred their money into only the strong est currencies in anticipation of competitive devaluations and ma jor currency realignments. This was called "hot money" and was attributed to speculators - not to currency-depreciating policies of governments. Finally, under the Bretton Woods agreement, national currencies were not allowed to "float" and seek their own levels. The new "par value" of a. currency was ar bitrarily set by the IMF - and these were consistently either too high or too low. Like all forms of government price-fixing, the fixed exchange rate system was in per petual disintegration. This resulted in further "hot money" flurries, further realignments of curren cies,and an inherently unstable exchange rate system - the exact opposite of the goal intended by the framers of monetary reform at Bretton Woods.

The role of the dollar under Bretton Woods .... The role of the dollar under the Bretton Woods system was vastly different from that of other currencies. Because of the United States' economic strength andE urope' S economic weakness after World War II, the dollar was used by other governments as a re serve for their currencies. This meant the dollar was pegged to gold and supposedly committed to stability and convertibility. Thus the dollar was supposed to be "as good as gold," and therefore to be treated as a reserve asset just like gold. There are several implications tied to the concept of a paper re serve currency. (1) Gold, the main reserve asset, was considered too limited in quantity to restore world liquidity or to provide sufficient wealth for rebuilding war-tornna tions. (2) While gold could not be increased, a paper asset (U.S.dol lars) could - consequently the re serves of the western world could be expanded. (3) Inflation could be implemented in a "more equita ble" manner by an ever-increasing paper reserve. (4) A paper reserve currency "should not be devalued"

yet it should be increased "as needed" to meet demand. This ·last blatant contradiction was the ma jor factor in the disintegration of the IMF in later years. Limited gold - unlimited dollars: a formula for disaster .... Since gold was limited, the vast maj ori ty of the assets on which foreign curren cies were based'to finance Europe's 1973 BRETTON WOODS: 1944-1971 301 recovery was not gold but U.S. dol lars - the second primary reserve asset. The demand for dollars came in two forms: (1) demand for foreign exchange to be used for importing goods, and (2) de mand for reserve liquidity and re plenishment. The U.S. satisfied the demand for foreign exchange by inflating its currency and extending loans and .gifts to Europe. These gifts and loans were used almost entirely to import goods from the U.S. Therefore, many of these dollars returned to the U.S. However, the demand for reserve liquidity and replenishment was met by continu ing U.S. deficits that led to Euro pean "stockpiling" of dollars in the form of interest-bearing notes and demand deposit accounts. De mand for dollars between 1950 and 1957 continued and an excess of dollars began to build up in foreign central banks.

After 1957, and to this day, the foreign banks have been obliged to continue to take in dollars that were neither intended for imports nor needed for liquidity. This era has become known as the era of the dollar "glut." Confidence versus liquidity - a two tier tale . ..• During the 1960's the progressive supply andaccumula tion of dollars mounted and world central bankers found themselves confronted with a government made monetary dilemma: the more dollar reserves they acquired, the more likely was the chance that their dollar surplus would depreci ate in value. To state the problem another way, the more liquidity central bankers enjoyed, the less confidence they had in their most liquid asset - the dollar. Gresham's Law prevailed and in 1968 central bankers and private speculators began to convert their dollars into gold. A gold crisis de veloped: the U.S. could not hope to convert the amount of dollars out standing against its gold stock. A "two tier" gold market was set up to avert a dollar devaluation and the break-up of the International Monetary Fund (IMF), i.e., one free market for speculators and industrial users who would buy gold at the free market price, and an official market where govern ments would transact dealings at the pegged price of $35 per ounce.

Finally in 1971, in a wave of "hot money" speculation, the U.S. was forced to devalue the dollar against gold and to suspend its converti bility. Goldls limitations: a blessing in dis guise. . . . The demise of Bretton Wood. can be traced directly to an exce~sive supply of dollars. The anti-gold principles of inflationary finance practiced diligently under 302 THE FREEMAN May the Bretton Woods era, turned into a give-and-take fiasco: the U.S. became a faucet of wealth, supply ing dollars on request to every corner of the world, while over a hundred countries drained the U.S. in the name of world liquidity and "reparations. " The result was a flood of dollars that swept over the world prod uc ing world inflation, numerous re cessions, hundreds of currency re alignments, disruptive trade, a gold crisis, and the final interna tional monetary crisis that has left the world precariously groping for stop-gap measures to resume monetary and trade transactions.

Clearly the Bretton Woods vision of a stable and ever-expanding re serve currency was doomed from the onset. Had the governments limited their reserves to gold, the kind of monetary and credit expan sion under Bretton Woods - and all of its disastrous consequences - could never have occurred. Gold places objective limits on monetary and credit expansion, and this in itself was enough for the framers of Bretton Woods to condemn it. It is no accident that the kinds of limitations gold imposes on the extension of money, credit, and re serves is just what the world is cry ing for today in light of thei'dollar glut." As a reserve currency, the dollar was supposed to be as good as gold. But monetary authorities never stopped to ask "what makes gold so good?" The answer is that gold is limited - the very point for which it was condemned. The refusal of government lead ers to adhere to the rules of the gold standard and th~ir desire to create a monetary system based on their own arbitrary rules of whim and decree, failed as it has always failed. Once again, history has proved that a mixture of govern ment whim with the laws of eco nomics is not a prescription to cure world problems: it has always been and will always be a formula for world chaos.

u.s.balance of payments problems . ... U.S. balance of payments deficits began in the early 1950's and have not ceased to this day. The cause of these incessant deficits can be traced to monetary and trade deci sions made at the inception of Bretton Woods and reinforced throughout its existence. The first straw .... When it was de cided that the U.S. was to act as wor ld banker and benefactor to those countries in need of help after World War II, it is doubtful that anyone really believed the U.S. would profit as world banker. On the contrary, the consensus was that war-torn nations needed more money than they could afford to pay back. It was argued that the 1973 BRETTON WOODS: 1944-1971 303 U.S. could afford to (and therefore should) extend foreign aid (gifts), loans at below market rates of in terest (gifts), and military protec tion (gifts), to those countries in need. What must be remembered is the precedent for this decision: the U.S. was committed to protect and finance the western world by virtue of its great strength and an ever expanding stream of dollars.

It was assumed that this money would return to the U.S. via import demand, and in fact, during the years 1946 to 1949 most of it did, resulting in fantastic U.S. sur pluses. On selling one's cake and wanting it too . ... But during the years 1950 to 1957, a turn of events took place. Europe by design curtailed'its al ready abundant imports and con centrated on replenishing its na tional reserves. With conscious in tent, the U.S. continued to supply the world with dollars through de liberate balance of payments defi cits to accommodate Europe's de mand for reserve replenishment. The refusal of the foreign govern ments to allow their citizens to use their constantly rising dollar sur pluses for U.S. goods (by imposing trade restrictions) led to the dollar glut of the 1960's. The blame for the chronic sur pluses of foreign governments and chronic deficits of the U.S. must be shared. While the U.S. can be blamed for financial irresponsi bility, the surplus countries must be blamed for economic irrespon sibility. The U.S. could have stop ped its deficits, but surplus-ridden countries could have stopped penal izing their citizens and discour aging them from importing. In stead, they decided to increase dollar reserves (dollars that for the most part were given or loaned to them) and to either exchange them for gold or hold them in the form of interest-bearing notes and ac counts.

By accumulating excessive amounts of dollars that they re fused to use, surplus countries helped foster U.S. deficits: some nations' chronic surpluses must mean that other nations are run ning deficits. The irony of the de cision to run an intentional chronic surplus is that the purpose of selling goods is to gain satisfaction as an eventual consumer. The drive for both surplus reserves and sur plus exports, and the refusal to con sume goods with the money re ceived, implies that a nation ex pects to sell a good and somehow derive satisfaction from it after it's gone. The illusion of th.e last straw ..•.The increasing demand for dollars led the U.S. government and the Fed304 THE FREEMAN May eral Reserve System to increase the amount of dollars and thus to de preciate the purchasing power of the dollar. As confidence disap peared in the dollar's ability to continue its role as a reserve cur rency, "hot money" flurries soon appeared. Thus, by the late 60's and early 70's, an enormous amount of dollars accumulated against a dwindling supply of U.S. gold. This caused both "runs" on the U.S. gold stock and "flights" from the dollar into stronger or undervalued cur rencies.

This speculative capital outflow caused the U.S. balance of pay ments deficit to increase in a pyra miding fashion. Finally, the con spicuously low amount of U.S. gold reserves, the disparity between currencies and interest rates, and a dwindling U.S. trade surplus, aroused a well-founded suspicion that the dollar might be devalued - and that other, stronger curren cies might appreciate in value. This justifiable suspicion then caused even greater U.S. capital outflows which led to even greater U.S. deficits. This was the "straw that broke the camel's back." But it was the haystack of straws be fore it, beginning with the first straw - Le., the first U.S. inflation financed gift abroad - that inexo rably led to the progression of U.S. balance of payments deficits, inter national monetary chaos, and the disintegration of the Bretton Woods system. The high price of gifts . ... When the U.S. embarked on a policy of infla tion-financed world loans and gifts, it surrendered all hopes of attain ing a balance of payments equili brium for itself or for the world.

Between the years 1946 and 1969, the U.S. as world banker extended some $83 billion in grants and loans. Since 1958 some $95 billion has left the country. Most of these dollars were nonmarket transac tions motivated by political and military considerations. While many economists believe it is necessary for the U.S. to run trade surpluses to correct its bal ance of payments deficits, to ex pect normal exports to rise to the level of these abnormal capital outflows only makes sense if one stands on one's head - it is not a logical position to take. These grants should never have been given to foreign nations. It was an economically unsound move and the grants were extended at the expense of the American tax payers. Further, any additional loans and gifts made by the U.S. to satisfy nations who demand "free" military protection, such as Europe and Japan have been demanding for years, or "reparations" such as those now being demanded by North and South Vietnam, will 1973 BRETTON WOODS: 1944-1971 305 only lead to further capital out flows ... and this at a time when the world is plagued by deprecia ting dollar reserves and continuing U.S. deficits - the very cause of the international monetary crises which led to the demise of Bretton Woods.

Those who argu~ that the U.S. balance of payments deficits were caused by insufficient trade sur pluses blind themselves to the fact that the U.S. has been running continuous trade surpluses for al most a century. They refuse to place the blame for U.S. balance of payments deficits where it be longs: on the U.S. government's inflationary policies of giveaway finance. On domestic dreams and international nightmares . ...The notion that gov ernments can divorce domestic in flation from international econ omics is fallacious. There is no domestic-international dichotomy in economic theory. There is a causal relationship between alleco nomic activity, thus there can be no international immunity from un sound domestic policies and no do mestic immunity from unsound in ternational policies. To the degree that nations prac tice sound domestic economic and monetary policies, the result will be stable economic progress in both the domestic and international economies. To the degree that do mestic policies are unsound, distor tions will occur that will be de stabilizing and inhibit economic progress both domestically and in ternationally - the results being counter-productive in both areas.

Bretton Woods was set up to ac commodate various nations' domes tic dreams. The dreams of postwar prosperi ty were financed by infla tionary schemes that were incom patible with any sound· interna tional monetary standard. The Bretton Woods agreement estab lished the contradictory system of fixed exchange rates with a built-in devaluation mechanism, in order to avert the monetary repercus sions of not adhering to the ex change rates they fixed. The fram ers of Bretton Woods knew that governments had no intention of preserving the value of their cur rencies, that, in fact, they planned to deficit spend and inflate in order to pay for their domestic economic programs. No international monetary sys tem - not the gold standard nor any form of standardless fiat sys tem, nor any combination thereof - can insure stability given un sound domestic policies. The funda mental economic issue today is not the kind of international monetary system that will replace the Bret ton Woods system, but whether the domestic policies of the nations in306 THE FREEMAN May volved will permit any interna tional monetary system to last. The precondition of any lasting mone tary system is that it has integrity.

A monetary system that has in tegri ty means a monetary system that is protected from government created inflation, Le., arbitrary and artificial increases in the supply of money and credit. It is a moral indictment against today's political leaders and the public at large that the chances for a monetary system that has integ rity are almost nonexistent. For before a nation can have a mone tary system of integrity, it must end all policies of inflationary fi nance. And this means that all those dreams a nation cannot afford must end. The public has bought the politi cian's claim that they can get some thing for nothing; that all a governmentneed do is print up money to pay for programs that satisfy national dreams. But there is no such thing as a free lunch - some one must inevitably pay the price of that lunch. And so it is with domestic dreams. The price for indulging in do mestic dreams .. through govern ment "something for nothing" pro grams is domestic inflation and international monetary crises with all their tragic and disruptive consequences.

If domestic dreams of nations today are pursued by resorting to the insidious schemes of inflation ary finance, they will inevitably become the international night mares of tomorrow. This was the lesson learned from the Bretton Woods system. May it rest in peace! ~ IDEAS ON LIBERTY Unstable Currencies WHEN NATIONS are on a gold standard a fixed rate of exchange is both possible and desirable. When each currency is anchored to gold, all currencies are necessarily anchored to each other. Each currency unit can then be expressed as a precise ratio of another. It can be freely and safely converted into it. But when each country is on its own paper standard its currency can have no fixed value in relation to other currencies. It can be given the appearance of such a fixed value only by making it a crime to buy or sell it at any other rate. But this attempt to maintain by coercion the appearance of stability where no stability exists merely makes the economic consequences incomparably worse.

HENRY HAZLITT, Will Dollar$ Sa'V~ the World?