President Nixon's letter to a kid in a California school.

Three points:

1. By signing the agreement, nations were submitting their exchange rates to international disciplines. This amounted to a significant surrender of national sovereignty to an international organization.
2. A nation does not have to resort to the classical medicine of deflating the domestic economy when faced with chronic BP deficits. Before World War II, European nations often resorted to this policy, in particular the Great Britain. Because of this ability to change par values, Keynes described the Bretton Woods system as "the exact opposite of the gold standard."
3. The dollar was the numeraire of the system, i.e., it was the standard to which every other currency was pegged. Accordingly, the U.S. did not have the power to set the exchange rate between the dollar and any other currency. Changing the value of dollar in terms of gold has no real effect, because the values of other currencies were pegged to the dollar. This is the n-th currency problem.This problem would not have existed if most of other currencies were pegged to gold or other currencies. However, none of these currencies pegged to gold because they were not convertible to into gold.

A brief World War II Timeline

See World War II Timeline for more details.

Yale University museum

I. Contents of the Articles of Agreement

1. Upon entering the Fund, a country submitted a par value of its currency expressed in terms of gold or in terms of the US dollar using the weight of gold in effect on July 1, 1944 ($35 per troy oz). All exchange transactions between member countries were to be effected at a rate that diverged not more than 1% (which approximates gold import/export points) from the par values of the respective currencies.

2. Article IV: A member could change the par value of its currency only to correct a fundamental disequilibrium in its balance of payments, and only after consulting with the Fund.

   (However, speculators correctly anticipate such weak currencies, making it more difficult for the monetary authorities to defend them.)

   • In case when the Fund objects a change, but the member devalues its currency, then that member is ineligible to use Fund's resources.
   • The Fund cannot formally propose a change of the par value of a currency.
   • No objection to a change if the cumulative change is less than 10% of the par value.
3. Article VI: allows members to control capital movements.

4. Article VII: The Fund may declare a currency to be scarce. If so, member countries are authorized to impose exchange control over the scarce currency.

   Remark: A problem that appeared during the interwar period was that surplus countries were not as much under pressure to adjust their BP as deficit countries did. A deficit country was compelled to take some kind of action to restore equilibrium, but a surplus country can accumulate reserves indefinitely.

   Britain adopted deflationary policy in the 1920s, but the surplus countries (US + France) did not participate in the adjustment process.

5. Article VIII: forbids members to restrict current account balances. Members are obligated to maintain the convertibility of foreign held current account balances (to facilitate trade).

   Exceptions: Article VII + XIV

6. Article XIV allows a member country to retain exchange control restrictions in effect when that country entered the Fund. Once a member country abolishes its exchange control over the current payments and accepted the obligations of Article VIII, then it cannot reimpose exchange control without the approval of the Fund.

   Remark: Most major countries in Europe accepted the obligations of Article VIII by 1961. Japan came under this article in 1964. The remaining Article XIV countries are obligated to consult annually with the Fund on exchange controls, but the Fund has no power to abolish the exchange control unilaterally. No scarce currency declaration has been made.

   Most nations outside the Communist bloc became members of the IMF.

II. Financing Trade Deficits

World trade increased six-fold between 1948-1973. But the total international reserve increased only by 3%. So lack of international reserve became acute. The US had acquired the bulk of world's gold. In 1946, the US held $26 billion when the estimated world total was $33 billion.

If the U.S. had exported Treasury bills, it would have provided additional reserves for the US. However, nations became increasingly reluctant to hold $. Gradually, the US stock of gold was depleted.

The Fund was the source of financing for a member country experiencing a temporary disequilibrium in its balance of payments. These resources come from gold and currency subscriptions of its members.

1. Upon entering the Fund, each country was allotted a quota in accordance with its relative economic size.
   • Reserve (gold) tranche: 25% of quota was paid to the Fund in gold (1944 US dollar)

   • Credit tranche: 75% of quota was paid in the currency's own currency.

   Figure 1. Gold tranche vs credit tranche.
   
   In 1946, the Fund started with aggregate quotas of $8 billion, 20% of world reserves. The quota was raised in 1971. The largest quota was US: $6.7 billion (21.9%): U.K. $2.8 billion (9.2%), Germany, France 5%, Japan 4%. The quota was increased several times.

   In 1990 the quota was increased to $135 billion, still equal to about 20% of world reserves.

   The quota determines the voting power of a member's executive director.

2. The size of a country's quota determines the borrowing limit of that country.
   • Basic Facility: gold tranche + 4 credit tranche = 125%
   • Extended Facility: 140%
   • Standby Agreements: Short term borrowing member countries negotiate to receive the Fund's guarantee. usually borrowing is for 3-5 years.

   • General Agreements to Borrow (GAB): was negotiated in 1962 by the Group of Ten: France, Italy, Germany, Belgium, Netherlands, Sweden, Japan, UK, US, Canada. Switzerland joined in 1964. The fund could borrow up to $5.9 billion from the Group of Ten to provide more short term assistance.

   • Currency Swap Arrangements: made in 1962. bilateral arrangements between central banks.

SPECIAL DRAWING RIGHTS

1. An agreement was reached at the IMF annual meeting in Rio de Janeiro in 1967 to issue SDRs to be allocated to 104 participants. The first allocation was made in 1970 (3.4 billion), then 1971 (2.95 billion), 1972 (2.95 billion)

2. Originally, the value of an SDR was set at one US dollar, both having the same weight in gold in 1970. However, dollar was devalued a couple of times, and there was a general move to end the key role of $ in the international monetary system.

   After July 1, 1974, the value of SDR was determined in terms of "basket" of 16 main currencies. Weights: USD = 33%, mark = 12.5%, pound = 9%, FF = 7.5%, yen = 7.5%, CND = 6%, lira = 6%. From April 1980, only 5 major currencies.

   $ = 42%, DM = 19%, yen = 13%, FF = 13%, pound = 13% The value of SDR is calculated daily by IMF.

3. SDRs are merely bookkeeping entries. It becomes a reserve asset because of the commitment of participating countries to accept SDRs up to an amount equal to 3 times their own SDR allocations.

4. A decision to create SDRs require the approval of a majority of member countries holding 85% of the weighted voting power of the Fund. Once created, SDRs are distributed to participants in proportion to Fund quotas.

5. Unlike dollar and other currencies, SDRs are not usable for private international transactions.

6. SDRs represent a net addition to international reserve that are as useful as gold or dollars, unlike international borrowing (which does not change reserves). Since it costs nothing to create SDRs, the world saves resources that would otherwise be wasted to mine and refine gold. For this reasons, SDRs are sometimes called paper gold.

7. SDRs can be created as needed to insure stable growth of international reserves. If SDRs replace $ as reserve assets in central banks, the US does not have to be a world banker. SDR makes the IMF an international central bank.
8. Once every year, the IMF charges every country interest on allotment, and credits every country with interest on the average SDR holdings during the past year. The interest rate was 1.5% per year originally, but raised to 5% in 1975.

The Role of the US Dollar

1. No one planned this development. The US was the dominant world power. Well over half of all international money transactions were financed in terms of dollar; the US produced more than half the world output.

   When the European countries had reserve surpluses, they converted the surpluses into dollar reserves rather than gold because

   • interest could be earned on dollar assets, and
   • they can always be converted into gold at $35 per ounce whenever it became necessary.
2. All of the non-Communist countries maintained a stable relationship between their currencies and the dollar either directly or indirectly through the British pound. The US dollar was at the center of this system. Since the Great Britain halted gold convertibility of its currency, US dollar was the only currency directly convertible into gold for official purposes. Before WWI, the pound sterling performed a similar function, but the sterling area had shrunken to a small number of countries.

   As the Bretton Woods system evolved, the reserves of most countries became a mixture of gold and dollars. US dollar became increasingly more important.

   Figure 2. Central role of dollar.
   
   

3. The US balance of payments were more important than those of other countries, because other countries were holding US dollar as the principal reserve asset. Moreover, the US was unable to eliminate ever-increasing trade deficits, which undermined the Bretton Woods system.

   In particular, President of France, De Gaulle, complained that the US had exorbitant privilege: unlimited financing because other countries were willing to hold dollar assets.

"This is a great day for France!" President Richard Nixon while attending Charles De Gaulle's funeral.

-from The 776 Stupidest Things Ever Said

US PAYMENTS DEFICIT

During the period 1958-1971, the US experienced a persistent deficit in its balance of payments. At first, economists viewed these annual deficits as temporary. However, it became obvious that the US deficits were not disappearing. The causes of this deficit include:

• a higher rate of return r* > r, which results in capital outflow.
• military commitments.
• The Vietnam war also caused inflation in the US.

• deflate the economy: use M and F
• devalue currency
• impose exchange control on current account
• deplete gold stock
• increase liability to foreign central banks

The US Deficit

During the years 1958-1971, the US experienced a cumulative reserve deficit of $56 billion. In other countries, the international reserve mainly consisted of US dollar and gold, although the currencies of other major countries were reserve assets but they played a minor role. US reserve assets included foreign currencies such as Yen, DM and British pound at first. However, by the end of the 1960s, the US international reserve consisted of mainly of gold.

Move your mouse to Figure 2a.

During this period (from 1958 to 1971), the US not only witnessed a gradual depletion of its international reserve assets but also a dramatic increase in liabilities to foreign central banks.

Gold Coverage = Gold/Liability to Foreign Central Banks

Figure 3a. Gold Coverage in 1963 and 1972.

By 1963, the US gold reserve at Manhattan barely covered liabilities to foreign central banks, and by 1970 the gold coverage hadfallen to 55%, by 1971 22%. Thus, from 1963, had the foreign central banks tried to convert their dollar reserves into gold, the US would have been forced to abandon gold convertibility. As a matter of fact, in response to a massive flight from the dollar persuaded President Richard Nixon to halt gold convertibility on August 15, 1971.

International gold bar, World Gold Council

What the US did

1. To lesson the outflow of private capital, the US imposed an interest equalization tax in 1963. This was effective to curb temporarily the outflow of portfolio investment. However, because r* > r, it was more than offset by a big jump in US bank loans to foreign borrowers and a further growth in US direct investment.

2. Voluntary Foreign Credit Restraint program was adopted in 1965 (Canada and developing countries were exempted). This was replaced by Mandatory Investment Controls in 1968, lifted in 1975.

3. Federal Reserve System entered into a series of currency swap agreements with central banks of Western Europe, Canada, and Japan. Under these bilateral agreements, a foreign central bank provided standby credit (in foreign currency) to the Federal Reserve System in return for an equal amount of standby credit (in dollar).

   None of these measures reduced US basic deficit but lessened the gold drain and dampened the speculative capital outflows. President Nixon once raised the value of dollar, to penalize the speculators. (It did not work). Nixon:

   The crisis of 1971 was inspired by a loss of confidence in dollar. In 1970, funds began to move at an enormous rate from the US dollar to financial centers in Europe and Japan. From Jan-August 1971, $20 billion in assets fled to other countries. President Nixon announced:

   • a 90-day freeze on wages and prices
   • 10% import surcharge on dutiable imports
   • suspension of dollar's convertibility into gold.

SMITHSONIAN AGREEMENT

1. It was a temporary regime. The agreement allowed member countries to vary their exchange rates within margins of 2 ¼% on either side of the central rates after currency realignment.

2. Currency realignment: Yen appreciated 17%, Mark 13.5 %, pound 9%, FF 9%. In return for the revaluation of other currencies, the U.S. agreed to raise the price of gold from $35 to $38 an ounce. This was equivalent to a dollar devaluation of 8.57%.

3. This devaluation of dollar has no significance because the dollar remains inconvertible. 10% import surcharge was suppressed.

   The collapse of the Bretton Woods system did not generate a chaos as did the collapse of the international gold standard in the 1930s.

4. The Smithsonian Agreement was a useless attempt to perpetuate the adjustable peg system with new currency alignment.

5. With the second devaluation of the dollar in February 1973 by 11% (the price of gold rose from $35.00 to $42.22 per ounce), the Smithsonian agreement fell apart and other currencies were left to float against the dollar. Bank of Japan absorbed a few billion dollars in one week, but eventually quit.