Appearance
9.10 — Bretton Woods and the Dollar World
In July 1944, with the war still being fought, delegates from 44 countries met at a hotel in Bretton Woods, New Hampshire, for three weeks.
They were there because everybody in the room agreed on the diagnosis of the 1930s: competitive devaluations, tariff wars, capital flight and the absence of any mechanism for a country in trouble to get help had turned a recession into a decade of misery and then a war (Chapter 9.9).
The system they designed governed the world economy for a quarter of a century, and its institutions are still running.
What was agreed
Fixed but adjustable exchange rates. Each currency was pegged to the US dollar, and the dollar was convertible into gold at $35 an ounce. So all currencies were indirectly tied to gold, through the dollar.
Why the dollar was the anchor is not ideology. At the end of the war the United States held roughly two-thirds of the world's monetary gold, produced around half of global manufacturing output, and was the only large industrial economy not physically wrecked. There was no alternative.
Pegs could be adjusted in case of "fundamental disequilibrium", with the Fund's agreement — which was the intended improvement on the rigid gold standard.
Capital controls were permitted and expected. This is the feature most often forgotten and it is essential to how the system worked. Money could not move freely across borders for speculation, which meant a country could set its own interest rates and run its own employment policy without being punished by capital flight. Trade in goods was to be free; movement of capital was not.
And two institutions were created.
The International Monetary Fund, to lend to countries with temporary balance of payments problems so they would not have to devalue or deflate.
The International Bank for Reconstruction and Development — the World Bank — initially to finance European reconstruction and later development.
What Keynes proposed and lost
Keynes led the British delegation and his plan was rejected, and the rejection matters for understanding the system's eventual failure.
He proposed an international clearing union with its own unit of account, the bancor, which no country would control.
And the crucial feature: symmetric adjustment. Under his design, a country running a persistent trade surplus would be penalised as well as a country running a deficit — through charges on excessive credit balances — on the reasoning that a surplus and a deficit are two sides of one imbalance and the deficit country cannot fix it alone.
The United States, which was going to be the great surplus country, refused. Harry Dexter White's American plan prevailed: the dollar as the anchor, adjustment falling on deficit countries, and the IMF with limited resources.
Keynes's objection was that a system placing the whole burden of adjustment on deficit countries has a deflationary bias, because deficit countries must contract while surplus countries are under no obligation to expand. That argument is now a standard one in analyses of the eurozone crisis and of global imbalances with China, and it is a reasonable summary to say Keynes lost the argument and was right about the mechanism.
Why it worked, and then didn't
The system presided over what the French call les trente glorieuses — roughly 1948 to 1973.
Growth was high and unusually widely shared across the industrialised world. Unemployment was low, inequality fell in most rich countries, and trade grew steadily under the General Agreement on Tariffs and Trade.
How much of that was the system and how much was post-war catch-up and reconstruction is genuinely arguable. What is clear is that no repeat of the 1930s occurred.
And then the built-in contradiction bit.
The Triffin dilemma
Robert Triffin identified it in 1959 and it is elegant and fatal.
The world needed dollars — for trade, for reserves, for international transactions — and the supply of dollars could only grow if the United States ran deficits, sending more dollars abroad than it took back.
But the dollar's credibility rested on being convertible into gold at $35. The more dollars accumulated abroad, the less plausible it became that they could all be converted, since American gold holdings were fixed.
So the system required the United States to run deficits to supply liquidity, and those same deficits destroyed confidence in the peg. It could not do both indefinitely.
The pressure built through the 1960s, driven by American spending on the Vietnam War and on domestic programmes, and by European and Japanese recovery.
And in the late 1960s countries began asking for the gold. France, under de Gaulle, converted dollars to gold deliberately and publicly, objecting to what a French minister called America's "exorbitant privilege" — the ability to run deficits indefinitely because its currency was the world's reserve.
On 15 August 1971 Nixon suspended convertibility, unilaterally, without consulting the other members. Attempts to restore fixed rates at new levels failed, and by 1973 the major currencies were floating.
The system since 1973
Floating exchange rates, with governments intervening to varying degrees. India runs a managed float (Chapter 9.7).
Free capital movement, progressively liberalised from the 1980s — which is the reversal of the Bretton Woods design and it is the source of most subsequent crises.
Because with mobile capital you cannot have everything.
The impossible trinity
A country can have at most two of these three: a fixed exchange rate, free capital movement, and an independent monetary policy.
Why. If capital moves freely and you fix the exchange rate, then your interest rate must match the anchor country's — set it lower and money floods out, higher and it floods in, and either way the peg breaks.
The three corners. Hong Kong fixes to the dollar and permits free capital movement, and has no independent monetary policy. The United States floats and has free capital movement and full monetary independence. China for a long period fixed and kept monetary independence by restricting capital movement. India sits deliberately in the middle — a managed float, partial capital controls, and substantial monetary independence — which is a defensible compromise and is why its rupee is not fully convertible on the capital account.
And the trinity is why crises happen. Every emerging market crisis of the last forty years — Latin America in the 1980s, Mexico in 1994, East Asia in 1997, Russia in 1998, Argentina in 2001, and India's own 1991 — involves a country with a pegged or managed rate, foreign borrowing, and a sudden reversal of capital flows.
The IMF and the World Bank, assessed
What the IMF does. Lends to countries in balance of payments crisis, with conditions — the loan is disbursed in tranches against agreed policy measures.
The standard conditions, which became known as structural adjustment and later as the Washington Consensus: fiscal deficit reduction, devaluation, trade liberalisation, privatisation, deregulation, and removal of subsidies.
The criticisms, and the strongest ones are now partly accepted by the Fund itself.
Procyclical austerity. Requiring a country in crisis to cut spending deepens the recession — the same error as 1931 (Chapter 9.9). The Fund's own Independent Evaluation Office has criticised its Asian crisis programmes on these grounds.
One template for very different countries.
Political consequences. Removing food and fuel subsidies has produced riots in dozens of countries, and the loss of legitimacy for governments that implement them.
Governance. Voting shares reflect 1944 economic weight and have been adjusted slowly. By convention the IMF is headed by a European and the World Bank by an American, which is an arrangement with no defence other than custom.
What can be said in their favour. A country in a balance of payments crisis has no other lender and the alternative is a disorderly default with worse consequences. Some conditions are genuinely necessary — a country that cannot fund its deficit must reduce it, and the IMF is frequently the messenger. And the Fund has changed: it now writes about inequality, supports capital controls in some circumstances, and has acknowledged that some fiscal consolidation was excessive.
India's own 1991 programme (Chapter 6.28) is a case where the reforms went considerably beyond IMF conditions and were designed and owned domestically, which is the difference between reform imposed and reform chosen.
Why the dollar is still on top
Fifty years after it stopped being convertible into anything.
Roughly 58 percent of global foreign exchange reserves are in dollars. A large share of international trade is invoiced in dollars, including nearly all oil and most commodities. Around half of international debt is dollar-denominated.
The reasons are network effects and depth. The market for US government bonds is the largest and most liquid financial market in the world, so a central bank with reserves can buy and sell without moving the price. Everyone uses dollars because everyone uses dollars, which is self-reinforcing.
The privilege it confers is real. The United States borrows in its own currency, which means it can never be forced into default by an inability to obtain foreign exchange. It pays lower interest than it otherwise would. And its financial sanctions have global reach, because almost any dollar transaction clears through American institutions — which is the instrument used against Iran and Russia and which is the main reason other countries are actively looking for alternatives.
The alternatives, honestly. The euro is second and the eurozone lacks a single fiscal authority and a unified bond market of comparable depth. China's renminbi cannot be a reserve currency while capital controls remain, and removing them would cost China the monetary independence it uses — the trinity again. Efforts at bilateral trade in local currencies, including India's rupee arrangements with several countries, are real and are small.
The reasonable forecast is gradual erosion rather than replacement, and Chapter 12.10 covers the geopolitics of it.
Where this shows up in your life
The rupee-dollar rate determines the price of imported oil, of foreign travel, of imported equipment, and of the components in the phone you are reading this on.
Indian foreign exchange reserves, currently among the largest in the world, exist because of 1991 and are held mostly in dollar assets — which means India lends to the United States government at low interest while borrowing at higher rates itself, an arrangement developing countries pay a great deal for and which is the strongest practical criticism of the system.
And the historical point worth carrying. The post-war system was designed by people who had lived through the 1930s and were determined not to repeat them, and it worked for twenty-five years. It then failed because of a contradiction that had been identified in public a decade earlier and that nobody acted on. Chapter 16.1 makes the general observation that systems usually fail from the flaw everyone already knew about.
What the next page covers
We have covered money, banking, companies, industry and the international system. Chapter 9.11 goes back to the foundation: how a market actually works — what supply and demand curves really mean, how prices carry information, what elasticity is and why it decides who bears a tax, what monopoly and competition do, and the specific ways markets fail. It is the toolkit for reading any economic argument, including the ones in Chapters 9.13 and 9.14.