The Daily Reckoning PRESENTS: 1944’s Bretton Woods Agreement had the original intention of smoothing out economic conflict after World War II. However, the actual outcome – replacing of the gold standard with the dollar standard – ended up causing far more problems throughout the years, as today’s falling dollar will show. Addison Wiggin explores…
The year was 1944. For the first time in modern history, an international agreement was reached to govern monetary policy among nations. It was, significantly, a chance to create a stabilizing international currency and ensure monetary stability once and for all. In total, 730 delegates from 44 nations met for three weeks in July that year at a hotel resort in Bretton Woods, New Hampshire.
It was a significant opportunity. But it fell short of what could have been achieved. It was a turning point in monetary history, however.
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 accords 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.
This system worked for 25 years. 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.
This problem was described by a former senior vice president of the Federal Reserve Bank of New York:
“From the very beginning, gold was the vulnerable point of the Bretton Woods system. Yet the open-ended gold commitment assumed by the United States government under the Bretton Woods legislation is readily understandable in view of the extraordinary circumstances of the time. At the end of the war, our gold stock amounted to $20 billion, roughly 60 percent of the total of official gold reserves. As late as 1957, United States gold reserves exceeded by a ratio of three to one the total dollar reserves of all the foreign central banks. The dollar bestrode the exchange markets like a colossus.”
In 1971, experiencing accelerating depletion of its gold reserves, the United States removed its currency from the gold standard, and Bretton Woods was no longer workable.
In some respects, the ideas behind Bretton Woods were much like an economic United Nations. The combination of the worldwide depression of the 1930s and the Second World War were key in leading so many nations to an economic summit of such magnitude. The opinion of the day was that trade barriers and high costs had caused the worldwide depression, at least in part. Also, during that time it was common practice to use currency devaluation as a means for affecting neighboring countries’ imports and reducing payment deficits. Unfortunately, the practice led to chronic deflation, unemployment, and a reduction in international trade. The lessons learned in the 1930s (but subsequently forgotten by many nations) included a realization that the use of currency as a tactical economic tool invariably causes more problems than it solves.
The situation was summed up well by Cordell Hull, U.S. secretary of state from 1933 through 1944, who wrote:
“Unhampered trade dovetailed with peace; high tariffs, trade barriers, and unfair economic competition, with war… If we could get a freer flow of trade … so that one country would not be deadly jealous of another and the living standards of all countries might rise, thereby eliminating the economic dissatisfaction that breeds war, we might have a reasonable chance of lasting peace.”
Hull’s suggestion that war often has an economic root is reasonable given the position of both Germany and Japan in the 1930s. The trade embargo imposed by the United States against Japan, specifically intended to curtail Japanese expansion, may have been a leading cause for Japan’s militaristic stance.
Another observer agreed, saying that poor economic relations among nations “inevitably result in economic warfare that will be but a prelude and instigator of military warfare on an even vaster scale.”
Bretton Woods had the original intention of smoothing out economic conflict, in recognition of the problems that economic disparity causes. The nations at the meeting knew that these economic problems were at least partly to blame for the war itself, and that economic reform would help to prevent future wars. At that time, the United States was without any doubt the most powerful nation in the world, both militarily and economically. Because the fighting did not take place on U.S. soil, the country built up its industrial might during the war, selling weapons to its allies while developing its own economic strength. Manufacturing by 1945 was twice the annual rate of 1935-1939.
Due to its economic dominance, the United States held the leadership role at Bretton Woods. It is also important to note that the United States owned 80 percent of the world’s gold reserves at the time. So the United States had every motive to agree to the use of the gold standard to organize world currencies and to create and encourage free trade. The gold standard evolved over a period of hundreds of years, planned by a central bank, government, or committee of business leaders.
Throughout most of the nineteenth century, the gold standard dominated currency exchange. Gold created a fixed exchange rate between nations. Money supply was limited to gold reserves, so nations lacking gold were required to borrow money to finance their production and investment.
When the gold standard was in force, it was true that the net sum of trade surplus and deficit came out to zero overall, because accounts were eventually settled in gold – and credit was limited as well. In comparison, in today’s fiat money system, it is not gold but credit that determines how much money a country can spend. So instead of economic might being dictated by gold reserves, it is dictated by a country’s borrowing power. The trade deficit and the trade surplus are only “in balance” in theory, because the disparity between the two sides is funded with debt.
The pegged rates – the value of currency to the value of gold – maintained sensible economic policy based on a nation’s productivity and gold reserves. Following Bretton Woods, the pegged rate was formalized by agreement among the leading economic powers of the world.
The concept was a good one. However, in practice the international currency naturally became the U.S. dollar and other nations pegged their currencies to the dollar rather than to the value of gold. The actual outcome of Bretton Woods was to replace the gold standard with the dollar standard. Once the United States linked the dollar to gold at a value of $35 per ounce, the whole system fell into place, at least for a while. Since the dollar was convertible to gold and other nations pegged their currencies to the dollar, it created a pseudo-gold standard.
The British economist John Maynard Keynes represented Great Britain at Bretton Woods. Keynes preferred establishing a system that would have encouraged economic growth rather than a gold-pegged system. He favored creation of an international central bank and possibly even a world currency. He proposed that the goal of the conference was “to find a common measure, a common standard, a common rule acceptable to each and not irksome to any.”
Keynes’ ideas were not accepted. The United States, in its leading economic position, preferred the plan offered by its representative, Harry Dexter White. The U.S. position was intended to create and maintain price stability rather than outright economic growth. As a consequence, Third World progress would be achieved through lending and infrastructure investment through the IMF, which was charged with managing trade deficits to avoid currency devaluation.
In joining the IMF, each country was assigned a trade quota to fund the international effort, budgeted originally at $8.8 billion. Disparity among countries was to be managed through a series of borrowings. A country could borrow from the IMF, which would be acting in fact like a central bank.
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.
By 1947, it became clear that the IMF and IBRD were not going to fix the problems of European postwar economic woes. To help address the issue, the United States set up a system to help finance recovery among European countries. The European Recovery Program (better known as the Marshall Plan) was organized to give grants to countries to rebuild. The problems of European nations, according to Secretary of State George Marshall, “are so much greater than her present ability to pay that she must have substantial help or face economic, social, and political deterioration of a very grave character.”
Between 1948 and 1954, the United States gave 16 Western European nations $17 billion in grants. Believing that former enemies Japan and Germany would provide markets for future U.S. exports, policies were enacted to encourage economic growth. During this period, the Cold War became increasingly worse as the arms race continued. The USSR had signed the Bretton Woods agreement, but it refused to join or participate in the IMF.
Thus, the proposed economic reforms turned into part of the struggle between capitalism and Communism on the world stage.
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.
President Lyndon B. Johnson argued in 1967 that:
“The world supply of gold is insufficient to make the present system workable – particularly as the use of the dollar as a reserve currency is essential to create the required international liquidity to sustain world trade and growth.”
By 1968, Johnson had enacted a series of measures designed to curtail the outflow of U.S. gold. Even so, on March 17, 1968, a run on gold closed the London Gold Pool permanently. By this time, it had become clear that maintaining the gold standard under the Bretton Woods configuration was no longer practical. Either the monetary system had to change or the gold standard itself would need to be revised.
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, Bretton Woods 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.
November 28, 2006
The Daily Reckoning
Editor’s Note: Addison Wiggin is the editorial director and publisher of The Daily Reckoning. Mr. Wiggin is also the author, with Bill Bonner, of the international bestseller Financial Reckoning Day and the upcoming thriller Empire of Debt. Mr. Wiggin is frequent guest on national radio and television programs.
The above essay was taken from Mr. Wiggin’s newly-released book, The Demise of the Dollar…and Why It’s Great for Your Investments. To order your copy, please see here:
Watch the dollar!
We watched yesterday, but nothing much happened to the dollar. Instead, stocks fell. “Stocks mark worst drop in months,” reported Reuters.
Still, it wasn’t much of a drop – just 150 points. We’ve seen much worse. In fact, we think we will see worse. Booms are followed by busts; that’s just the way it works.
But as the boom goes on, more and more people think the bust will never come – that’s just the way it works too. And they begin to develop ideas, theories, and illusions that support their perpetual boom longings.
Here, a commentator explains why, although things may look bad for the dollar now, they won’t get worse:
“There is still enormous demand for dollars for purposes of financial speculation, ” writes our old friend Rick Ackerman.
“This fact is indisputable when you consider that there are $370 trillion of derivatives in play in a world [that] produces only about $55 trillion in real goods and services…[and] we can discount fears that China and Japan, the dollar’s main supporters, are about to diversify out of dollars in any meaningful way, as they’ve long threatened to do. The simple fact is that, to keep their export-based economies running smoothly, they will do whatever it takes to keep their respective currencies from appreciating. In the case of China, the tactic is more than merely expedient, since any slowing of the country’s manufacturing economy risks idling millions of workers who have migrated from rural China to urban manufacturing centers and huge factory towns.
“Meanwhile, although the dollar may look sickly at the moment, I doubt that its collapse is imminent. If I am right, we should expect the stock market to rebound with the dollar in the days and weeks ahead.”
But then, he covers himself to “However, I am not married to this scenario,” he adds.
To Rick’s analysis we add another:
“Fallacy of U.S. as a debtor nation” is the headline of a research paper from Deutsche Bank.
“We believe the prevailing view of the [United States] as a net debtor nation is no longer appropriate and instead regard the [United States] as the world’s most powerful financial hegemon,” says the report, with unblushing ardor.
Okay…the gauntlet has been thrown down. We must pick it up. We’re not afraid of opposing views here at the Daily Reckoning. Just so long as they’re expressed clearly and stupidly enough for us to laugh at them. But the Deutsche Bank team disappoints us. It makes a powerful claim:
“Not only is the dollar not in decline but it is actually getting stronger and the international currency system remains exceptionally stable. In fact, we believe a global economic empire – meaning a cycling of funds that guarantees global prosperity – is not in place and that the global economy is thus entering a period of long term prosperity.”
But then, reading on for proof, we can’t seem to find it.
“The dollar’s dispersion on the back of the U.S. trade deficit and direct U.S. investment abroad has functioned to supply the world with growth currency and sharply boost global economic growth. This is nothing less than global Keynesianism. In short, the supply of currency from the [United States] has turned dormant resources and labor overseas into effective economic resources, driving a sharp increase in the global economy’s growth potential.”
All right so far…we agree. This is just what has happened. The U.S. dollar has worked its magic on the whole world – misleading practically everyone. As the supply of dollars increased, people took it as an increase in real demand. They started digging holes in Chile so they could bring up copper out of the ground. They began setting up tables in China where young women from the country could sit down and put gadgets together. They hooked up telephone systems in India and taught the locals to speak with midwestern accents so they could take orders for new gizmos.
Inflation of the worldwide money supply – with dollars – has produced a boom. No doubt about it. Our disagreement is not about the past, but about the future. The Deutsche Bank team sees a boom…followed by another boom. When we see a boom, on the other hand, we get suspicious.
Both they and we wonder marvel at how stable the world economy…and the dollar…have been.
“This stability appears to make little sense given the [United States’] massive current-account deficit,” they comment.
At $800 billion, the world has never seen anything like it. Normally, it would mean an increase in U.S. net debt, with which would come an obligation to pay interest. This year’s deficit equals 7% of GDP. Ten years at this rate would put the accumulated debt at 70% of GDP. At 5% interest, this would mean that the United States was paying out 3.5% of its GDP in interest to foreigners – an amount equal to all its GDP growth, and then some…forever.
Not good. But don’t worry; the system will blow up long before that happens. Team Deutsche Bank figures there must be a reason it hasn’t blown up already; their analysts come to the conclusion that the system is not unstable at all. Maybe it will never blow up!
What the researchers think they see is a “new global imperial cycle.” It is based, they say, on low-cost Asian labor, superior management and skills of U.S. companies, different rates of return from United States vs. foreign investments, high profits in the financial sector, high leverage, and the profit that the United States makes from issuing its own currency to the rest of the world. All of these factors, they say, give the United States an advantage that doesn’t show up in the world’s flow of funds statistics.
It is a kind of ‘dark matter,’ they seem to be saying. But it is so dark we cannot see it at all. Every one of the factors listed above could be taken as a negative as much as a positive. Low cost Asian labor allows American companies to cut labor costs…and increases their profits. But what happens to the displaced American laborers? How will they afford to buy the imported products, unless by going into debt (and thereby creating more profits in the financial sector)?
When they finally realize what is happening to them, shouldn’t we expect them to cut back a little? Maybe that is why auto sales are falling. House sales are falling, too. According to the Financial Times, sellers in Las Vegas are so desperate they throw in a free swimming pool and a vacation in Florida when you buy a new house. Cancellation on new house contracts are said to be running as high as 42 percent. And here comes Wal-Mart with the news that its same store sales have just suffered their first decline ever.
And at some point won’t all that leverage turn out to be not so great after all? Leverage is great when prices are rising. But when prices fall, it magnifies your losses.
And then, mightn’t foreigners decide to cut back too? Mightn’t they get a little weary of so much liquidity provided by the U.S. dollar and decide to hold a little more of their wealth in other brands? Isn’t that why the dollar is falling – even while U.S. interest rates are above those of Europe and Japan?
Yes…the system is stable. But it is only stable as long as it is stable. All it takes is something to destabilize it – and then the whole thing begins to wobble, and could fall apart.
We can’t look into the future any better than Deutsche Bank. Looking at the past, we see what they see; the dollar system has been a great success. The easy money it has provided the world has set off a global boom unlike anything in history. But also looking at history, we’ve never read of a Keynesian boom that didn’t end…or a paper-money system that didn’t eventually collapse.
But heck…there’s always a first time.
Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…
“The pound sterling still stands on its own, but the United Kingdom is still a member of the European Union…and a very large part of their trade goes to the Eurozone. If sterling is out on the rallying currencies limb by itself, trade goes to the dogs.”
And more views:
*** GoldMoney.com’s James Turk hasn’t been mislead by the “stability” of the U.S. dollar…
“There is never any certainty when it comes to markets. We can only make investment decisions based on probabilities,” says he. “Importantly, we can increase the odds in our favor by following two basic rules. Buy assets that are undervalued, and follow the trend.
“We are following both of these rules when buying gold.
“Gold is rising against all of the world’s currencies. The rates of increase are of course different as some currencies are weaker than others. But regardless, it is clear that gold’s long-term trend is rising.
“What’s more, gold is still undervalued. There is any number of ways to make this point, but perhaps the simplest is to look at the price of gold in inflation-adjusted dollars. In 1980 inflation-adjusted dollars, gold today is only $250 per ounce, which is not even one-third of the $850 record high reached that year.
“Gold is breaking out around the world. People are fleeing national currencies. They are moving their wealth into the safety and security of gold, which is not too surprising. All national currencies are being debased by inflation and/or other monetary disorders. So what would you rather hold? Gold, or some national currency?”
[Ed. Note: More to follow from James Turk, later this week…]
*** Michael Kinsley seems to have just woken up. “Free Market Free-for-All: Proof that the stock market is irrational,” he writes. The poor man has no clue what he is talking about. He notes that prices go up and down…and that different people in different situations put different prices on the things they buy.
This is deeply disturbing to the man, as if he had just discovered that his favorite pet preferred his neighbor’s dog chow. He seems to be saying that there is something faithless about it.
What he is chiefly concerned about is that private investors may be getting away with something…buying a company for more than the public paid for it…and then reselling it for even more than that. “Either the stock market is a fraud on the public, or these deals that dominate the business pages are a fraud on the public. Which is it?” he wants to know.
What beer does Michael Kinsley drink? We don’t know…but we suggest he switch brands.
*** And a letter from a dear reader:
“Dear Editors (I love that third person talk),
“I have been a long time reader and yes, past and present subscriber to some of your publications. You write great stuff and give me a laugh every day. Thank you.
“Anyway, the reason why I’m writing is to inquire if you (my editors), or any of your readers are noticing a change in our mainstream-minded peers, for lack of a better word? I have. I move in many different circles of influence as most people do and I’m sensing a change across the board, be it conservative or liberal in politics or investing.
“Over the last three or four years when I would be having an open and honest exchange of ideas about finances, (usually there are two different groups, housing or equities) I was always the crackpot out in left field standing with my back against the wall and on the foul line, crying the sky is falling, which I must admit I enjoyed and excepted. They would politely listen, smirk, humor me, and most times good naturally blow me off.
“However, over the last three months or so the tenors of the conversations are starting to become more harsh, and strained to stay amiable. Again, this is across most or all circles. Where my comments were once a source of levity, they are now becoming a source of aggravation and personal offense. Facts and figures are important to get the big picture into prospective, but I think that it is people’s sentiments and emotions that truly move the markets.
“I really think people are starting to sense though not understanding, that our way of life, how we have conducted business personally, and professionally, is about to change…”