Would it be beneficial to return to a Bretton Woods style system?

Back in the 1930’s it became almost common practice for countries to deliberately devalue their currencies in order to encourage business from abroad, whether that be in the form of increasing exports or encouraging foreign direct investment (FDI) within their nation. In order to avoid an economic disaster, world leaders and economists met in the mountains of New Hampshire in July 1944 at a place called ‘Bretton Woods’ to establish a system to essentially stabilise the economy.

Throughout these days a system was established which incorporated a number of factors. Firstly the international monetary fund (IMF) was set up to provide short term help for counties with balance of payments difficulties. Secondly the World Bank was set up which provided long term loans to nations and therefore facilitate investment mainly for production purposes. Thirdly the international trade organisation (ITO) was set up to compliment both the IMF and the World Bank, designed with the intention of encouraging free trade. However along with setting up  these organisations, the main outcome of the ‘Bretton Woods’ meeting was to fix each nation’s currency against the US Dollar, which itself was underpinned by the price of gold. This system was designed to remove foreign exchange risk (currency risk), promote international trade and increase globalisation, and in the main, until its demise in 1971, worked reasonably well.

So the main focus of this blog is to consider whether it would be beneficial to return to a system similar to that of Bretton Woods. Now obviously there would be no need to create organisations such as the IMF, World Bank or ITO as these have already been established, however what would be the implications of returning to a world of fixed currencies rather than floating currencies?

I suppose to answer this question we should look at the benefits and negatives resulting from the original system. Firstly there would be the implication of choosing which currency to tie to gold, to essentially fix every other price to. Back in the old system, the US Dollar was used, which gave the United States’ currency a dominant position. However global central banks deliberately pegged their currencies at a low level in order to support exports to the US which lead to the accumulation of massive dollar reserves in the hands of central banks. As central banks held vast quantities of surplus dollars, this meant the US cost of borrowing decreased, allowing it to consume beyond its means, strengthening its economy further against others. In theory this compromised the existence of the Bretton Woods system in the first place, which set out to avoid the problem of deliberate devaluation of currencies. If we did look to return to such a system, such problems are likely to occur again, as there has to be some form of ‘negotiation’ when fixing the currencies which nations are likely to turn in their favour.

Another key problem was that over time the world economy grew and needed more liquidity or reserve assets. Also as the world economy grew, the increased world demand for the dollar as reserve assets meant that US had to maintain increasing trade deficits. As the US was forced to swap dollars for gold, it had to admit that it could no longer keep its pledge to exchange gold for $35 per ounce. Between Bretton Woods’ establishment in 1944 and its demise in August 1971, the U.S. exported almost half of its gold reserves. In the 12 months leading up to the end of Bretton Woods, the Fed lost nearly 15% of its total gold reserves. Given this, it would have to be assumed that the Bretton Woods system would not be able to be implemented again, as no single nation would allow itself to be fixed to the price of gold based on the evidence regarding the Fed losing a vast quantity of its gold reserves.

However whilst this blog has assumed the Bretton Woods system was negative, it actually worked reasonably well through its existence, thus creating a potential argument for its reincarnation. As mentioned foreign exchange risk between currencies was removed. This means that exposures such as transaction risk, translation risk and economic risk were also removed which encouraged investment in foreign nations, thus promoting international trade which led to globalisation. Therefore if such a system was reintroduced, it would arguably lead to increased FDI across the world. When applying this to Dunning’s (1988) eclectic paradigm, such ownership, location and internalisation advantages may exist however firms may be discouraged from investing in nations which traditionally have unstable currencies. However under a Bretton Woods style system, raw material seekers or product efficiency seekers for example, may be more encouraged to invest in nations which may otherwise have had unstable currencies as this risk is removed.

However whilst it may be a ‘nice’ idea to return to the Bretton Woods system, in reality it would never be implemented. In my opinion, no nation would agree to be the main nation and therefore fix its price to gold, as maintaining trade deficits in situations whereby countries wish to purchase gold reserves could ultimately lead to the collapse of a nation’s economy. Also it would reduce liquidity as the foreign exchange market would essentially become non-existent along with arguably the main problem being actually deciding upon the price to fix each individual currency at. I believe that in the current world economic climate, FDI and therefore globalisation will remain without the need for a new system, as companies are constantly seeking nations to invest within which may have raw material, production efficiency or knowledge advantages for example. The potential for FDI is also constantly being strengthened, an issue highlighted earlier this week when David Cameron travelled to India to sign trade agreements, encouraging investment between nations.

Reference in this blog

Dunning, J. (1988) The eclectic paradigm of international production: A restatement and some possible extensions. Journal of International Business Studies. Volume 19 Issue 1. pp. 1–31.