The International Financial System
(part B)
by
Charles Lamson
The International Financial System
from 1944 to 1973
From the end of World War II until the early 1970s, the major economies of the world participated in a fixed exchange rate system with the U.S. dollar functioning as the official reserve currency. Other countries defined their currencies in terms of the U.S. dollar and agreed to buy or sell dollars to maintain the agreed-upon exchange rates. The dollar, in turn, was defined in terms of gold. During the post-war period, one ounce of gold was set equal to $35, and the United States agreed to convert any unwanted dollars of foreign central banks into gold.
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This fixed exchange rate system was established by the Bretton Woods Accord of 1944, which was worked out by representatives from the major industrialized counties who met at Bretton Woods, New Hampshire, to design a new international financial system. Under the Bretton Woods Accord, if the trade deficit of a country other than the United States increased, that country effectively increased the supply of its currency in international markets. The increased supply put downward pressure on the exchange rate. To maintain the agreed-upon exchange rate, the country's central bank had to purchase the excess supply of its currency using dollars.
An example will help clarify. Assume that the exchange rate between the dollar and the British pound was set at $1 = 2 pounds, but supply and demand were causing the market value of the two currencies to gravitate to $1 = 3 pounds. Perhaps, ceteris paribus (all things being equal), Brittain's trade deficit had increased significantly in recent months causing Brittain's balance of payments on current and capital accounts to move into a deficit position. The smaller supply of dollars relative to pounds in international markets puts upward pressure on the exchange rate of the dollar while the larger relative supply of pounds puts downward pressure on the value of the pound. In such a case, the Bank of England, the central bank of Great Britain, would intervene in the market by buying pounds with dollars until the market value of the two currencies converged to the agreed-upon exchange. By changing the supply of dollars and pounds outstanding, the Bank of England could manipulate the market value of the pound. In this manner, the values of the dollar and the pound could be maintained at the agreed-upon exchange rate.
Such government transactions in foreign currencies were measured in the Official Reserve Account of the balance of payments. By supplying dollars and demanding pounds, the Bank of England would run a surplus in the Official Reserve Account that would just equal the deficit in the current and capital accounts of the balance of payments. Hence, under fixed exchange rates, it was (and always is) official government transactions in foreign exchange markets that brought the balance of payments into balance at the fixed exchange rate.
Because the Bank of England was maintaining the fixed exchange rate by buying pounds with dollars. Great Britain could continue to maintain the fixed rate only so long as it had, or it could acquire sufficient dollars to support the value of its currency as needed. If Great Britain (or another foreign country) ran a persistent deficit in its current and capital accounts, its central bank would eventually run out of dollars and have to devalue, or decrease the value of, its currency in terms of the dollar in order to reflect the diminished value of the pound. Devaluation occurs when the monetary authorities reduce the value of a country's currency under a fixed exchange rate system. In terms of this analysis, the pound is devalued if the official rate is changed from $1 per 2 pounds to $1 per 4 pounds. At the original rate, each pound was worth $.50, while at the latter rate, after the devaluation, each pound is worth $.25.
In the decades immediately after World War II, the U.S. dollar served as the official reserve currency. The United States was eventually in the unique position of being able to run persistent balance of payments deficits on the current and capital accounts. Foreign central banks desired to accumulate stockpiles of dollars to function as international reserves.
Once foreign central banks had acquired sufficient reserves, the ability of the United States to run chronic deficits in the balance of payments on current and capital accounts was also limited. In this case, the dollar, ceteris paribus, would become overvalued in terms of one or more foreign currencies. Under the Bretton Woods accord, the United States would lose gold as the unwanted dollars were presented for conversion. The United States would then pressure foreign central banks to revalue, or increase the value of, their currency in terms of the dollar.
Revaluation occurs when the monetary authorities increase the value of a country's currency under a fixed exchange rate system. For example, the pound is revalued if the official rate is changed from $1 equals 2 pounds to $1 equals 1 pound. In the original case, each pound was worth $.50 while in the latter case, each pound is worth $1. Ceteris paribus, the revaluation would in time reduce the U.S. balance of payments deficit on current and capital accounts and slow the flow of unwanted dollars abroad. In turn, the gold outflow would diminish.
A foreign central bank might be hesitant to revalue, however, because revaluation could adversely affect its country's economy. Among other things, revaluation could reduce net exports and have a negative impact on employment. Consequently, foreign central banks would pressure the United States to correct the imbalance by reducing its deficit on the current and capital accounts. Note the irony of the situation and the potential for a stalemate in which each country is pressuring the other to take action.
A balance of payments deficit on current and capital accounts could also be caused by increases in the capital outflows of a country, ceteris paribus. If a country experienced a net capital outflow, this had the same effect as an increase in the trade deficit of the same magnitude. Likewise if a country experienced an increased net capital inflow, this had the same effect on the balance of payments on current and capital accounts as an increase in the trade surplus. As we have seen, ceteris paribus, such capital flows resulted from changes in domestic interest rates relative to foreign rates.
During the 1960s and 1970s, some countries including the United States, expanded their economies and their domestic money supplies relatively faster than others, such as Japan and Germany. The United States experienced inflationary pressures in the mid- to late 1960s as a result of monetary and fiscal policies associated with the Great Society's War on Poverty and the Vietnam War buildup. Consequently, some central banks outside the United States accumulated more dollars than they wished to hold as reserve assets. Rather than revaluing their currencies, they asked the United States to convert these unwanted dollars to gold. As more and more central banks requested conversion, it became clear that the United States would not be able to redeem the dollars in gold. In late 1971, the United States suspended the international conversion of dollars into gold. At the same time, the dollar was devalued by setting the value of one ounce of gold equal to $42 rather than the $35 that had been in effect since the inception of the Bretton Woods Accord. Hence, the official value of the dollar was reduced from $1 = 1/35 ounce of gold to $1 = 1/42 ounce of gold, even though the United States was no longer redeeming dollars with gold. In 1973, most countries abandoned fixed exchange rates altogether, and the value of the dollar began to float. The Jamaican Agreement of 1974 officially adopted floating exchange rates, underscoring what had unofficially been done in 1973.
A final comment is in order. During the Bretton Woods Accord, the amount of cross-border trading of financial assets such as stocks, bonds, and mortgages was much less than it is today. Under normal circumstances, exchange risk was minimal during this period, but many countries had capital controls that did not allow the purchase of foreign financial instruments. Also, technology was such that it did not foster cross-border financial flows.
Recap
The international financial system consists of the arrangements, rules, customs, instruments, facilities, and organizations that enable international payments to be made and funds to flow across borders. The international financial system includes the international money and capital markets and the foreign exchange market. The Bretton Woods Accord of 1944 established fixed exchange rates among major world currencies. The U.S. dollar which was backed by gold, served as the official reserve currency, and other countries defined their currencies in terms of the dollar. If a country other than the United States had a deficit in its balance of payments, it used supplies of dollars to purchase its own currency to maintain fixed exchange rates. If a country other than the United States had a surplus in the balance of payments, it demanded dollars to maintain the value of its currency. The system broke down in late 1971 when the United States suspended the international conversion of dollars to gold. A flexible exchange rate system was adopted in 1973. In the Bretton Woods period, cross-border investment in financial instruments was much less than it is today.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA
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