Why did the Nixon administration finally pull the plug on the IMF Bretton Woods system on 15 August 1971, after two decades of monetary chaos and instability? In fact the decision was to a large degree inevitable. In its final form the Bretton Woods Monetary Agreement that created the IMF was unworkable because it lacked a mechanism to adjust persistent payments imbalances between countries. Exchange-rate stability could only be maintained by providing ever-increasing amounts of "liquidity," a process that created enormous political difficulties and ultimately undermined confidence in the IMF system.
Why were the fixed exchange rates unstable? The IMF plan, unlike a pure gold standard, affirmed the primacy of domestic economic goals, which included the maintenance of full-employment economies over strict balance-of-payments concerns. But exchange-rate stability can only be sustained when there is comparable price stability between countries, a near impossibility. If prices change markedly because of inflation or deflation in a given domestic economy, then currency exchange rates must shift accordingly or else their initial par rates will quickly be rendered obsolete. When exchange rates are not changed to reflect price shifts, balance-of-payments deficits and surpluses quickly emerge. Such a situation would be especially problematic if the initial par values were already out of line, which was often the case under the IMF Bretton Woods system, because nations were given wide discretion to establish their own rates.
The ensuing balance-of-payments disequilibria were a constant source of monetary instability in the IMF Bretton Woods system. For example, if Great Britain's domestic economic goals produced a yearly inflation rate of 6 percent, and the United States pursued policies that resulted in 4 percent inflation, then the exchange rate would have to be adjusted if balance-of-payments disequilibrium was to be avoided. But this obviously contradicted the IMF's goal of exchange-rate stability, and without market-determined rates there was no easy mechanism to adjust the exchange rate without creating havoc. Deflating the domestic economy to bring the balance-of-payments into balance was not politically realistic or desirable after World War II. Furthermore, the IMF system actually rewarded speculators, who knew the direction of any revaluation and could simply put pressure on a vulnerable currency until a nation exhausted its reserves or its will defending the old exchange rate. Speculators made a fortune forcing the devaluation of sterling in 1949 and 1967. The only option to avoid damaging devaluations was capital and trade controls. Every major country, including the United States, had to install capital controls in one form or another during the early years of the IMF Bretton Woods system in order to maintain their exchange rate, despite the fact they were forbidden (except in extreme cases) by the IMF.
A second flaw, less well recognized but equally serious, was the method of providing "liquidity" in the IMF Bretton Woods system. Liquidity is simply another word used to describe reserve assets that are transferred from debtor to surplus countries to cover their payments gap. In order to offset a negative payments balance and maintain a fixed exchange rate, governments had to supply some universally accepted asset over which they had no issuing control to cover. Until 1914 this asset was, at least in theory, gold. Because the IMF Bretton Woods planners believed that there was not enough gold to supply world liquidity (reserve) needs, key currencies, such as the dollar and sterling, should be used to supplement or replace gold to settle international transactions.
The failure to make sterling fully convertible in 1947 meant that the dollar alone would serve the reserve asset, or "liquidity," function. As a result the dollar was demanded by foreign nations both as a reserve asset and to finance much of the world's trade. These factors, in conjunction with the economic recovery of Europe, helped produce a sizable American balance-of-payments deficit. But it was not like the payments deficit of any other nation. Some of these excess dollars were actually desired by the rest of the world, not to purchase American goods and services but for reserve and international settlement purposes. In other words, the dollar's unique role in world trade and reserve creation meant that a certain level of American balance-of-payments deficit was desirable and in fact necessary for the international economy. But how much of a payments deficit was needed to supply global liquidity was difficult, if not impossible, to determine. Initially most foreign central banks preferred to hold dollars because they earned interest and had lower transaction costs than gold. But as American dollar liabilities—created by the yearly payments deficits—increased, confidence in the gold convertibility of the dollar fell. After convertibility was established by the major economies of western Europe at the end of 1958, central banks began to buy increasing amounts of gold from the United States with their excess dollars.
This brought up a larger question: how stable and cooperative could the IMF Bretton Woods system be if it only worked when the world's largest economy, the United States, ran yearly balance-of-payments deficits? Much has been made of the advantages and disadvantages this system conferred on the American economy. When foreign central banks held dollars for reserve and transaction purposes, it enabled American consumers to receive foreign goods and services without having to give anything other than a promise to pay in return. It was like automatic credit, or, if the reserves built up indefinitely, like getting things for almost nothing. This arrangement, which is the benefit of seigniorage, could be maintained as long as the dollar was "as good as gold," when holding dollars in the form of short-term interest-bearing securities was probably preferable to buying gold, which earned no interest income and had high transaction costs. The danger came when overseas holders of dollars worried that the dollar was not as good as gold or for noneconomic reasons preferred holding gold to dollars. This sentiment emerged in the late 1950s and 1960s.
Under the IMF Bretton Woods system, overseas central bankers could turn in their excess dollars for gold at any time. But at some point the ratio of dollar liabilities to American gold would increase to a level that might cause a loss of foreign confidence in the dollar and a run to the U.S. Treasury gold window. American policymakers saw this as a threat to the economic well-being and foreign policy of the United States. The loss of American gold was also seen as a threat to the world economy, because it was believed that a worldwide preference for gold over dollars would decrease the amount of liquidity needed to finance and balance ever-expanding world trade. A mass conversion to gold would force the United States to suspend convertibility, which would wipe out the dollar's value as a reserve and transaction currency. It was feared that competition between central banks for scarce gold could subject the international economy to paralyzing deflation. Another fear was that the resulting collapse of liquidity would freeze world trade and investment, restoring the disastrous conditions that paralyzed the world during the 1930s and created depression and world war.
The IMF Bretton Woods monetary system did have certain disadvantages for the United States. The fact that overseas central bankers held dollars in their reserves meant that the United States could be pressured for political reasons by the countries within the IMF Bretton Woods system. While the United States accrued benefits from the system, its pledge to convert dollars into gold made it vulnerable in ways other countries were not, especially as the ratio of gold to dollars decreased over time. To some extent Great Britain ran a similar gold-exchange standard before 1914 with a very low gold to sterling ratio, but international monetary relations were far less politicized before World War I. If France held a large supply of dollars as reserves and wanted to express dissatisfaction with some aspect of American foreign or economic policy, it could convert those dollars into gold. Converting dollars into gold gave surplus countries an important source of political leverage. It was this scenario that caused President John F. Kennedy to exclaim that "the two things which scared him most were nuclear weapons and the payments deficit."
The IMF Bretton Woods system trapped reserve countries in another way. If a nonreserve country ran a persistent balance-of-payments deficit, it had the option of devaluing its currency to improve the terms of trade of its exports. The dollar was priced in terms of gold, so if it was devalued, other currencies could simply shift the value of their currencies so that no real devaluation could take place. The only true devaluation option that the United States had was to suspend the convertibility of the dollar into gold. The rest of the world would be left with a choice. Overseas central bankers could support the exchange rate of the dollar by using their own reserves to maintain their exchange rates with the dollar. Or they could "float" their currencies in all the foreign-exchange markets to determine their true value. Suspending dollar-gold convertibility was an option few American policymakers wanted to consider during the 1950s and 1960s. For their part, most European surplus countries dreaded either option.
Why was there such a fear—both in the United States and abroad—of abandoning the IMF Bretton Woods fixed exchange rates and moving to a market-determined, free-floating exchange-rate regime? It is hard to underestimate the powerful influence of the received wisdom concerning the history of monetary relations between the wars. In the postwar period it was a widely held belief that the economic collapse of the 1930s was caused by a failure of international monetary cooperation. In the minds of most postwar economists and policymakers, capital flight, which had its roots in free-market speculation, had ruined the gold exchange standard, which destroyed international liquidity and froze international trade and financial transactions. The collapse of the rules of the game unleashed a vicious competition whereby countries pursued beggar-thy-neighbor policies of competitive devaluations and trade restrictions. To most, the culprit behind the international economic collapse was a free market out of control, fueled by pernicious speculators who had no concern for the larger implications of their greed-driven actions. This economic collapse unleashed autarky and eventually war. A market-driven international monetary system was no longer compatible with stability and international cooperation. Any situation that remotely looked like a repeat of the 1930s was to be avoided at all costs. IMF planners and Western policymakers determined that in the postwar world the market had to be tamed and national interest replaced with international cooperation that would be fostered by enlightened rules and institutions. Strangely, few seemed to understand how chaotic and inefficient the IMF Bretton Woods system eventually became. Massive American aid and constant intervention tended to obscure the system's failings. The intellectual framework that produced the IMF Bretton Woods blueprint, though deeply flawed, had a profound impact on the postwar planners in most Western countries, including the United States, and thrived well into the 1970s.
More than anything else, policymakers in America and western Europe were afraid of the unknown. While the system was inefficient and prone to crisis, monetary relations, no matter how strained, were far better than during the interwar period. Furthermore, Western monetary relations were interwoven into a complex fabric that included key political and military relationships, including U.S. troop commitments to West Germany and Japan. No one knew what would happen to this fabric if the IMF Bretton Woods system collapsed, and few were anxious to find out.
What eventually destroyed the original IMF Bretton Woods system was that it did not have an effective, consistent process to adjust payments imbalances between countries. In order to preserve or restore a balance in international payments, payments imbalances between a country and the rest of the world must be brought into equilibrium through an adjustment process. The adjustment process can take many different forms, depending upon the rules of the international monetary system in question. There are two monetary systems where the adjustment mechanism is automatic, at least in theory: a gold standard and a system of free exchange rates. The nineteenth-century gold standard eliminated payments deficits and surpluses automatically through changes in a country's aggregate demand brought about by importing or exporting gold. The present system of free exchange rates eliminates prospective payments imbalances through market-driven shifts in exchange rates. In both systems, payments imbalances are brought into equilibrium through processes that are largely automatic and independent of any governmental interference. The adjustment process in gold standard and free exchange rate regimes tends to be less politicized.
But this is not how payments imbalances were adjusted in the IMF Bretton Woods system. Instead, domestic economies were protected from demand fluctuations produced by gold or other reserve movements, and the system of fixed exchange rates prevented the market from determining the equilibrium price for a nation's currency. Since there were inevitably great differences among national monetary policies, some method was needed to adjust for the changes in the relative value of currencies produced by differential rates of inflation and savings. But exchange-rate variations were difficult because they unsettled foreign exchange markets, and it was impossible to get countries to agree to shifts because they feared the adverse effects on their terms of trade. Countries were equally reluctant to sacrifice full employment and social policy goals for balance-of-payments purposes. This left no effective means to close balance-of-payments gaps automatically. As the economist Robert Stern stated in 1973, "Since the functioning of the pegged rate system may appear to avoid rather than expedite adjustment, it might be more fitting to characterize this system … as the 'international disequilibrium system.'"
Consider the lengths to which the Kennedy and Johnson administrations went to settle America's balance-of-payments deficits in the early 1960s. After the Eisenhower administration went into a near panic over the loss of gold in the days immediately before and after the 1960 presidential election (Eisenhower even proposed using the more abundant uranium in place of gold to settle America's payments deficit), the new Democratic administration made solving the problem one of its key foreign policy goals. A whole series of complicated formal and informal arrangements ensued—some through the IMF, others bilaterally, and still others with the so-called Group of Ten, or industrialized nations. But none of these American policies dealt with the crucial issue of creating a more effective adjustment mechanism.
The liquidity issue was much discussed both within and outside of the IMF during the late 1950s, 1960s, and 1970s. Liquidity, which was merely a euphemism for reserves, was the vehicle for financing balance-of-payments deficits in the Bretton Woods system. The greater and more persistent the imbalances, the more reserves, or liquidity, are needed to make the system work. In a system of fixed exchange rates that does not have an automatic adjustment mechanism, differential inflation and savings rates will quickly produce large imbalances between countries. Government leaders, unwilling to adjust exchange rates or alter domestic priorities for balance-of-payments purposes, clamored for more liquidity to finance balance-of-payments deficits. But it was rarely pointed out that this liquidity would be unnecessary if there was an efficient, effective, and automatic process for adjusting imbalances.
During the late 1950s and 1960s, when both policymakers and academics recognized that the international monetary system was flawed, hardly a proposal for reform was produced that did not emphasize the need for more liquidity. Suggestions ranged from increasing the country subscriptions to the IMF to inventing a whole new form of liquidity. The most dramatic American proposal came during the summer of 1965, when the Johnson administration's secretary of the treasury, Henry Fowler, called for a "new Bretton Woods conference" to create new liquidity. When the major western European nations eased capital controls and allowed for convertibility of their currencies into dollars, trade and capital flows increased dramatically. This made liquidity a more important issue: larger trade and capital flows increased the payments imbalances that inevitably arose in a fixed exchange-rate regime. More reserve assets were needed by national foreign exchange authorities to defend their exchange rate in the face of increasingly large and sophisticated currency markets. If controls were to be avoided (and they were not), countries would have to cooperate to manage disequilibrium. This would require agreements and institutional arrangements, such as the IMF, the General Agreement to Borrow, the swap arrangements, the Group of Ten, and the gold pool. But in the end, all of these reforms and ad hoc measures were merely Band-Aids to cover the deep structural flaws within the IMF Bretton Woods monetary system.