The Bretton Woods conference of 1944 produced the most ambitious and far-reaching international economic agreement between sovereign states in history. By far the most important aspect of these arrangements were the articles that created the International Monetary Fund and established the rules for global monetary relations. American and British financial officials, led by John Maynard Keynes and Harry Dexter White, hoped to establish a system that would maintain stable, fixed exchange rates, allow national currencies to be converted into an asset over which they had no issuing control (gold), and to provide an effective mechanism to adjust exchange rates in the hopefully rare event that a "fundamental" balance-of-payments disequilibrium emerged. In the event of nonfundamental deficits that normally arose in international transactions, the deficit country would pay with a reserve asset (gold or a key currency convertible into gold), or seek short-term financing from the International Monetary Fund, which would supply the currency needed. The IMF was also assigned the task of overseeing and enforcing these arrangements.
This IMF-guided system was much different from any previous international monetary system. It was not like a traditional gold standard, where the domestic money supply, and hence the domestic price level, was directly determined by the national gold stock. Under the gold standard, a balance-of-payments deficit would be paid for through the export of gold, resulting in a decrease in the domestic money base and a deflation of prices. The decreased purchasing power would lower that country's imports, and the increased international demand for that country's lower-priced goods would increase exports, naturally correcting the balance-of-payments deficit. Conversely, an influx of gold, by increasing the domestic monetary base and domestic prices, had the opposite effect of boosting imports and discouraging exports, thereby eliminating a payments surplus. According to standard market theory, any balance-of-payments disequilibrium would be adjusted more or less automatically, eliminating the need for government interference. But the cost of making payments balance could be very high, and included deflation that caused widespread unemployment in deficit countries. In reality this system worked much better when capital flows from London, and to a lesser extent Paris, kept the system functioning smoothly.
The founders of the IMF explicitly rejected the gold standard as a model for future international monetary relations. White and especially Keynes believed that the interwar experience had demonstrated that a balance-of-payments adjustment process that relied on deflating the economy of a deficit country was draconian in an age when national governments promised full employment and a wide array of social spending. Decreasing the monetary base in a deficit country would lead to a fall in national income, unleashing unemployment and necessitating large cuts in government spending. To avoid such a politically unacceptable system, the Bretton Woods IMF regime allowed nations to import and export gold without penalty (that is, without having to change their domestic monetary base). If and when balance-of-payments deficits arose between countries, they would be corrected through short-term IMF financing and small, IMF-approved changes in the exchange rate. This points to an interesting fact about the Bretton Woods conference and agreement. Although Bretton Woods was hailed as the hallmark of international cooperation, in reality it provided national economic and political authorities an unprecedented amount of immunity from the international pressures of the global market. To a large degree, this was the policy preference of both the United States and Great Britain. Macroeconomic decisions were the sole province of national governments, which were quick to sacrifice measures that would bring about balance-of-payments equilibrium in order to achieve important domestic goals.
Because U.S. economic foreign policymakers worried that the existing gold stock was too small to sustain the growing demand for international liquidity, the Bretton Woods IMF regime was set up to be a two-tiered system in which certain key currencies—those convertible into gold, such as the dollar and (it was hoped) sterling—could be used in lieu of gold to settle international transactions. It was hoped that this would conserve the use of gold and dramatically increase the amount of liquidity available to finance international transactions. This meant that much of the world's reserve requirements would be supplied through the balance-of-payments deficits of the key currency economies. Why did the Bretton Woods planners allow such a thing? Keynes recognized that Great Britain would face postwar deficits, and he wanted a system that did not penalize sterling. Ironically the British economist also feared American surpluses and wanted to guarantee that the United States fulfilled international liquidity needs.
But it was unclear how large these deficits had to be to fulfill international reserve needs. If the key currency economies had no deficit, or too small a deficit, then the world would have to rely on gold alone to finance trade. Without key currency deficits, liquidity would dry up and international transactions disappear. But if the key currency country ran balance-of-payments deficits that were too large, the resulting inflation would test the value of the key currency and set off a large-scale conversion of the currency into gold. This would remove valuable liquidity from the system and set off a fierce competition for gold, with deflationary effects on the international economy. Capital controls, trade restrictions, and currency blocs might ensue. This made the meaning of British, and to a greater extent, American balance-of-payments deficits somewhat ambiguous. The system was designed to make deficits necessary, but it was never clear how large or how small a deficit was needed to supply liquidity without undermining confidence in the value of the dollar.
What were the larger motives of the founders of the IMF plan? U.S. and British foreign and economic policy goals were often at cross-purposes by 1944. It has often been noted how remarkable it was that Keynes and White, despite the vastly different economic priorities of the countries they represented, were able to come up with such an extraordinary compromise. Indeed, Keynes's original proposal envisioned a "currency union" in which countries would have had to pay a penalty on their surplus payment balances. Additionally debtor nations would have unrestricted and virtually unlimited access to the resources of the clearing fund without having to seek international approval or make domestic adjustments to correct payments disequilibria. Keynes's original plan had an enormous inflationary bias, and would have allowed Great Britain to tap the immense resources of the United States without having to go through the arduous and embarrassing process of asking for direct aid.
The IMF Bretton Woods system has often been portrayed as an attempt to move away from the vicious economic competition of the late nineteenth and early twentieth centuries. American policymakers were motivated, it has been suggested, "by a humanitarian desire to prevent the kind of financial stresses and economic dislocations that might lead to future wars." The noted policy analyst Judy Shelton summed up the conventional wisdom when she argued in 1994 that "Keynes and White were convinced that international economic cooperation would provide a new foundation of hope for a world all too prone to violence. 'If we can continue,' Keynes observed, 'this nightmare will be over. The brotherhood of man will have become more than a phrase.'"
Keynes's own writings call this interpretation into doubt. Not only would his blueprint protect Great Britain's planned full-employment policies from balance of payments pressures, it would also present a convenient and politically painless way to get money out of the United States in the guise of international banking and monetary reform:
It would also be a mistake to invite of our own motion, direct financial assistance after the war from the United States to ourselves. Whether as a gift or a loan without interest or a gratuitous redistribution of gold reserves. The U.S. will consider that we have had our whack in the shape of lend lease and a generous settlement of consideration…. We in particular, in a distressed & ruined continent, will not bear the guise of the most suitable claimant for a dole … On the contrary. If we are to attract the interest and enthusiasm of the Americans, we must come with an ambitious plan of an international complexion, suitable to serve the interests of others sides ourselves. … It is not with our problems of ways and means that idealistic and internationally minded Americans will be particularly concerned.
While the Americans rejected the currency union plan as too radical, the British came up with a substitute in the scarce-currency clause for the IMF, which permitted extensive capital controls and trade discrimination against major surplus countries. Roy F. Harrod, a U.S. Treasury official and Keynes protégé, even suggested that the scarce currency not be discussed in public, for fear that the U.S. Congress might figure out its true implications. Keynes agreed, stating, "the monetary fund, in particular, has the great advantage that to the average Congressman it is extremely boring." But the heated debates in Congress over the IMF demonstrated that some Americans had a better understanding of the scarce-currency clause than Keynes assumed.
The controversial scarce-currency clause was eventually included as Article 7 in the IMF Bretton Woods agreement, but the Truman administration interpreted its provisions very narrowly. This angered many British policymakers, who in later years blamed many of Britain's economic woes on the Americans' narrow interpretation of the clause. During deliberations over whether or not to devalue sterling in 1949, the UK president of the Board of Trade bitterly lamented the American position:
In particular, United States policy in the Fund has been directed … to making the "scarce currency" clause a dead letter. We thought originally that this clause might give some real protection against a dollar shortage; indeed, Lord Keynes's conviction that this was so was one of the main factors which led His Majesty's Government and Parliament to accept the Loan Agreement. Once the clause comes into operation, it gives wide freedom for discriminatory exchange and trade controls against the scarce currency; and then there is real pressure on the country concerned to play its full part in putting the scarcity right, e.g., by drastic action such as we want the United States to take to stimulate imports.
In the end, the British had little to complain about. By the late 1940s the Truman administration's foreign policy goal of promoting European reconstruction and eventual integration led the United States to permit extensive dollar discrimination while furnishing billions of dollars of aid through the Marshall Plan. Furthermore, to the surprise of many, the United States ran consistently large balance-of-payments deficits throughout the postwar period. The problem was not, as Keynes and White had feared, too little liquidity. The opposite was the case. By the late 1950s and early 1960s, there was a growing sense that the flood of postwar dollars had become too large, and that measures had to be taken to choke off the persistent American balance-of-payments deficit.
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