U.S. balance of payments crisis
After the end of World War II, the U.S. held $26 billion in gold reserves, of an estimated total of $40 billion (approx 60%). As world trade increased rapidly through the 1950s, the size of the gold base increased by only a few percent. In 1950, the U.S. balance of payments swung negative. The first U.S. response to the crisis was in the late 1950s when the Eisenhower administration placed import quotas on oil and other restrictions on trade outflows. More drastic measures were proposed, but not acted upon. However, with a mounting recession that began in 1958, this response alone was not sustainable. In 1960, with Kennedy’s election, a decade-long effort to maintain the Bretton Woods System at the $35/ounce price was begun.
The design of the Bretton Woods System was that nations could only enforce gold convertibility on the anchor currency—the United States’ dollar. Gold convertibility enforcement was not required, but instead, allowed. Nations could forgo converting dollars to gold, and instead hold dollars. Rather than full convertibility, it provided a fixed price for sales between central banks. However, there was still an open gold market. For the Bretton Woods system to remain workable, it would either have to alter the peg of the dollar to gold, or it would have to maintain the free market price for gold near the $35 per ounce official price. The greater the gap between free market gold prices and central bank gold prices, the greater the temptation to deal with internal economic issues by buying gold at the Bretton Woods price and selling it on the open market.
In 1960 Robert Triffin noticed that holding dollars was more valuable than gold because constant U.S. balance of payments deficits helped to keep the system liquid and fuel economic growth. What would later come to be known as Triffin’s Dilemma was predicted when Triffin noted that if the U.S. failed to keep running deficits the system would lose its liquidity, not be able to keep up with the world’s economic growth, and, thus, bring the system to a halt. But incurring such payment deficits also meant that, over time, the deficits would erode confidence in the dollar as the reserve currency created instability.
The first effort was the creation of the London Gold Pool on November 1 of 1961 between eight nations. The theory behind the pool was that spikes in the free market price of gold, set by the morning gold fix in London, could be controlled by having a pool of gold to sell on the open market, that would then be recovered when the price of gold dropped. Gold’s price spiked in response to events such as the Cuban Missile Crisis, and other smaller events, to as high as $40/ounce. The Kennedy administration drafted a radical change of the tax system to spur more production capacity and thus encourage exports. This culminated with the 1963 tax cut program, designed to maintain the $35 peg.
In 1967, there was an attack on the pound and a run on gold in the sterling area, and on November 18, 1967, the British government was forced to devalue the pound. U.S. President Lyndon Baines Johnson was faced with a brutal choice, either institute protectionist measures, including travel taxes, export subsidies and slashing the budget—or accept the risk of a “run on gold” and the dollar. From Johnson’s perspective: “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.” He believed that the priorities of the United States were correct, and, although there were internal tensions in the Western alliance, that turning away from open trade would be more costly, economically and politically, than it was worth: “Our role of world leadership in a political and military sense is the only reason for our current embarrassment in an economic sense on the one hand and on the other the correction of the economic embarrassment under present monetary systems will result in an untenable position economically for our allies.”
While West Germany agreed not to purchase gold from the U.S., and agreed to hold dollars instead, the pressure on both the dollar and the pound sterling continued. In January 1968 Johnson imposed a series of measures designed to end gold outflow, and to increase U.S. exports. This was unsuccessful, however, as in mid-March 1968 a run on gold ensued, the London Gold Pool was dissolved, and a series of meetings attempted to rescue or reform the existing system. But, as long as the U.S. commitments to foreign deployment continued, particularly to Western Europe, there was little that could be done to maintain the gold peg.
All attempts to maintain the peg collapsed in November 1968, and a new policy program attempted to convert the Bretton Woods system into an enforcement mechanism of floating the gold peg, which would be set by either fiat policy or by a restriction to honor foreign accounts. The collapse of the gold pool and the refusal of the pool members to trade gold with private entities—on March 18, 1968 the Congress of the United States repealed the 25% requirement of gold backing of the dollar—as well as the US pledge to suspend gold sales to governments that trade in the private markets, led to the expansion of the private markets for international gold trade, in which the price of gold rose much higher than the official dollar price. The US gold reserves continued to be depleted due to the actions of some nations, notably France, who continued to build up their gold reserves.
International Monetary Fund
Officially established on December 27, 1945, when the 29 participating countries at the conference of Bretton Woods signed its Articles of Agreement, the IMF was to be the keeper of the rules and the main instrument of public international management. The Fund commenced its financial operations on March 1, 1947. IMF approval was necessary for any change in exchange rates in excess of 10%. It advised countries on policies affecting the monetary system.
Designing the IMF
The big question at the Bretton Woods conference with respect to the institution that would emerge as the IMF was the issue of future access to international liquidity and whether that source should be akin to a world central bank able to create new reserves at will or a more limited borrowing mechanism.
Although attended by 44 nations, discussions at the conference were dominated by two rival plans developed by the United States and Britain. As the chief international economist at the U.S. Treasury in 1942–44, Harry Dexter White drafted the U.S. blueprint for international access to liquidity, which competed with the plan drafted for the British Treasury by Keynes. Overall, White’s scheme tended to favor incentives designed to create price stability within the world’s economies, while Keynes’ wanted a system that encouraged economic growth.
At the time, gaps between the White and Keynes plans seemed enormous. Outlining the difficulty of creating a system that every nation could accept in his speech at the closing plenary session of the Bretton Woods conference on July 22, 1944, Keynes stated:
We, the delegates of this Conference, Mr. President, have been trying to accomplish something very difficult to accomplish.[...] It has been our task to find a common measure, a common standard, a common rule acceptable to each and not irksome to any.
Keynes’ proposals would have established a world reserve currency (which he thought might be called “bancor”) administered by a central bank vested with the possibility of creating money and with the authority to take actions on a much larger scale (understandable considering deflationary problems in Britain at the time).
In case of balance of payments imbalances, Keynes recommended that both debtors and creditors should change their policies. As outlined by Keynes, countries with payment surpluses should increase their imports from the deficit countries and thereby create a foreign trade equilibrium. Thus, Keynes was sensitive to the problem that placing too much of the burden on the deficit country would be deflationary.
But the United States, as a likely creditor nation, and eager to take on the role of the world’s economic powerhouse, balked at Keynes’ plan and did not pay serious attention to it. The U.S. contingent was too concerned about inflationary pressures in the postwar economy, and White saw an imbalance as a problem only of the deficit country.
Although compromise was reached on some points, because of the overwhelming economic and military power of the United States, the participants at Bretton Woods largely agreed on White’s plan.
Subscriptions and quotas
What emerged largely reflected U.S. preferences: a system of subscriptions and quotas embedded in the IMF, which itself was to be no more than a fixed pool of national currencies and gold subscribed by each country as opposed to a world central bank capable of creating money. The Fund was charged with managing various nations’ trade deficits so that they would not produce currency devaluations that would trigger a decline in imports.
The IMF is provided with a fund, composed of contributions of member countries in gold and their own currencies. The original quotas were to total $8.8 billion. When joining the IMF, members are assigned “quotas” reflecting their relative economic power, and, it is as a sort of credit deposit, were obliged are to pay a “subscription” of an amount commensurate to the quota. The subscription is to be paid 25% in gold or currency convertible into gold (effectively the dollar, which was the only currency then still directly gold convertible for central banks) and 75% in the member’s own currency.
Quota subscriptions are to form the largest source of money at the IMF’s disposal. The IMF set out to use this money to grant loans to member countries with financial difficulties. Each member is then entitled to withdraw 25% of its quota immediately in case of payment problems. If this sum should be insufficient, each nation in the system is also able to request loans for foreign currency.
Financing trade deficits
In the event of a deficit in the current account, Fund members, when short of reserves, would be able to borrow foreign currency in amounts determined by the size of its quota. In other words, the higher the country’s contribution was, the higher the sum of money it could borrow from the IMF.
Members were required to pay back debts within a period of 18 months to five years. In turn, the IMF embarked on setting up rules and procedures to keep a country from going too deeply into debt year after year. The Fund would exercise “surveillance” over other economies for the U.S. Treasury in return for its loans to prop up national currencies.
IMF loans were not comparable to loans issued by a conventional credit institution. Instead, they were effectively a chance to purchase a foreign currency with gold or the member’s national currency.
The U.S.-backed IMF plan sought to end restrictions on the transfer of goods and services from one country to another, eliminate currency blocs, and lift currency exchange controls.
The IMF was designed to advance credits to countries with balance of payments deficits. Short-run balance of payment difficulties would be overcome by IMF loans, which would facilitate stable currency exchange rates. This flexibility meant a member state would not have to induce a depression to cut its national income down to such a low level that its imports would finally fall within its means. Thus, countries were to be spared the need to resort to the classical medicine of deflating themselves into drastic unemployment when faced with chronic balance of payments deficits. Before the Second World War, European nations—particularly Britain—often resorted to this.
Changing the par value
The IMF sought to provide for occasional discontinuous exchange-rate adjustments (changing a member’s par value) by international agreement. Member nations were permitted first to depreciate (or appreciate in opposite situations) their currencies by 10%. This tended to restore equilibrium in their trade by expanding their exports and contracting imports. This would be allowed only if there was a “fundamental disequilibrium”. A decrease in the value of a country’s money was called a “devaluation”, while an increase in the value of the country’s money was called a “revaluation”.
It was envisioned that these changes in exchange rates would be quite rare. Regrettably, the notion of fundamental disequilibrium, though key to the operation of the par value system, was never spelled out in any detail—an omission that would eventually come back to haunt the regime in later years.
IMF operations
Never before had international monetary cooperation been attempted on a permanent institutional basis. Even more groundbreaking was the decision to allocate voting rights among governments, not on a one-state one-vote basis, but rather in proportion to quotas. Since the United States was contributing the most, U.S. leadership was the key. Under the system of weighted voting, the United States exerted a preponderant influence on the IMF. The United States held one-third of all IMF quotas at the outset, enough on its own to veto all changes to the IMF Charter.
In addition, the IMF was based in Washington, D.C., and staffed mainly by U.S. economists. It regularly exchanged personnel with the U.S. Treasury. When the IMF began operations in 1946, President Harry S. Truman named White as its first U.S. Executive Director. Since no Deputy Managing Director post had yet been created, White served occasionally as Acting Managing Director and generally played a highly influential role during the IMF’s first year.
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