Why bretton woods system collapse

In particular, stability in tradable prices wholesale prices or WPI from the mid s to the late s was almost perfect and globally common.

This macroeconomic achievement was historically unprecedented. With such an excellent macroeconomic record, why did the Bretton Woods system collapse eventually? Economists still debate on this question, but it is undeniable that there was a nominal anchor problem. The collapse of the Classical Gold Standard was externally forced i. The American monetary discipline served as the nominal anchor for the Bretton Woods system.

But when the US started to inflate its economy, the international monetary system based on the US dollar began to disintegrate. The s was a period of dollar shortage. Europe and Japan wanted to increase imports in the process of recovery from war damage.

But the only internationally acceptable money at that time was the US dollar. So their capacity to import was severely limited by the availability of foreign reserves denominated in the US dollar. However, by the late s, there was a dollar overhang oversupply in the world economy.

This turnaround was due to the US balance of payments deficit, which in turn was caused by expansionary fiscal policy. The spending of the US government increased for three reasons: i the war in Vietnam; ii welfare expenditure; and iii the space race with the USSR send humans to the moon by the end of the s.

In the late s, the IMF felt the need to create a new international currency to supplement the dollar. But the international negotiation took a long time, and the artificial currency called the Special Drawing Rights, or SDR was created only in By that time, there was no longer a dollar shortage; in fact there was a dollar glut! When the US was providing price stability, other countries were willing to give up monetary policy independence and peg their currencies to the dollar. Through this operation, their price levels were also stabilized.

But when the US began to have inflation, other countries gradually refused to import it. There was a downward pressure on the dollar. In , the fixed linkage between dollar and gold was abandoned. The two-tier pricing of gold was introduced whereby the "official" gold-dollar parity was de-linked from the market price of gold. The market price of the dollar immediately depreciated. This was similar to the situation of multiple exchange rates: an overvalued official rate vs.

Finally, in , the fixed linkage between dollar and other currencies was given up. This completely terminated the working of the Bretton Woods system and major currencies began to float. At the same time, President Nixon also imposed temporary price controls and stiff import surcharges. These measures were all supposed to fight inflation and ameliorate the balance of payments crisis that the US was facing. This was called the "Nixon Shock. It would be told to tighten the budget and money first.

For 11 trading days that followed, the Bank of Japan intervened heavily in the currency market to fight off massive speculative attacks, losing 4 billion dollars of foreign reserves. Then, it gave up and let the yen appreciate. European central banks gave up much sooner before losing a lot of foreign reserves.

Between and , there was an international effort to re-establish the fixed exchange rate system at adjusted levels with a more depreciated dollar. In December , the monetary authorities of major countries gathered in Washington, DC to set their mutual exchange rates at new levels the Smithsonian Agreement.

But these rates could not be maintained very long. In early , under another bout of heavy speculative attacks, the Smithsonian rates were abandoned and major currencies began to float. Robert Triffin offered a famous explanation as to why the Bretton Woods system had to collapse inevitably. He noted that there was a fundamental liquidity dilemma when some country's national currency was used as an international money. Four days later, the three Benelux countries decided to retain the former range of fluctuation between their currencies and the dollar.

The fluctuation range of European currencies was widened to 2. That decision led European officials to see the need to narrow the margins between European currencies. The collapse of the Bretton Woods System In , the Bretton Woods Agreements introduced a gold standard system that transformed the US dollar into an international reserve currency, the only one convertible to gold. However, this proposal was rejected by the American government. Ultimately, the latent fatal weakness of USD as a dual-purpose currency exacerbated and led to the ultimate breakdown.

The operationalists, in contrast, believe that the problem lies in the mismanagement of Bretton Woods system. Han [2] points out that the uncooperative behavior of the European countries deviated from the original design of the system. Since US controlled most of the gold at the beginning of the Bretton Woods system, it was able to appoint USD as the reserve currency and let it replace gold as the central currency.

Acknowledging the undesirable outcome, the US decided to no longer make available for country to exchange USD for gold, announcing the end of the Bretton Wood system. However, the uncooperative behavior of European countries may not be wholly held responsible for the depreciation of USD, which ultimately resulted in the failure of the Bretton Woods system.

The US had also entered several wars during the Bretton Woods period, which means that the depreciation of dollar may have also been caused by its huge debt accumulated through war expense. Besides, according to the experiment of game theory Dominguez, [5] , any country that does not fix the exchange rate as indicated in the Bretton Woods system and depreciate its currency can have an advantage over other countries.

Dominguez argues that exports were facilitated through that currency depreciation, and exports were necessary during the post war period when countries were finding ways to get out of economic recession. Operationalists put forward another management flaw by arguing that other countries failed to comply with the adjustment of exchange rate assigned in the Article of Agreement.

However, other countries did not follow the agreement. Capital immobility, in turn, hindered trade among countries. Since encouraging free trade was one of the initial goals of the Bretton Woods system, it was undermined by capital immobility, leading to the collapse of the Bretton Woods system. More explicitly, the conditions under which countries were able to exercise the policy were not specified. As a result, countries were careful about altering their exchange rates.

In addition, another structural flaw may have predetermined the failure of the Bretton Woods system. This implies that it is not the management of exchange rate system but structural flaws that led to the failure of Bretton Woods system. Considering the structural flaws of the Bretton Woods system discussed above, fixed exchange rate should be changed into floating exchange rate.

In recent years, Asian markets have been thriving and created a rising demand that led to appreciation of their currency. However, the currency in Asia would fail to experience appreciation if the currency in Asia were pegged a fixed exchange rate to the dollars and other currency.

Conversely, a floating exchange rate would create a better international balance. However, some regulations of the exchange rate system is still needed.

The Jamaica Monetary system, which was created after the breakdown of the Bretton Woods system and centered on floating exchange rate, has experienced strong turbulence owing to the rapid change of exchange rate. Second, a successfully designed agreement is also needed to sustain a system. In the case of Bretton Woods as discussed above, the flawed design of Bretton Woods agreement precipitated the uncooperative behavior of its member countries. Therefore, to prevent these detrimental defaults, a restraint mechanism should necessarily be set.

First of all, countries should be given the incentive to cooperative even not under optimal conditions. In other words, although countries during the Bretton Woods system would be better off break the agreement and devalue their currency, they would still choose to cooperate because they would be promised to be compensating for their loss. In this way, countries are secured against potential loss of compliance, and may cooperate more effectively.

Under this circumstance, every country would weigh the cost and benefits more cautiously before making decisions to default in the agreement. This article researches the causes of the collapse of the Bretton Woods system.

It comes to the conclusion that structural flaws are the main causes of the breakdown, and puts forward some brief lessons that are useful to ensure a more stable international monetary system. Therefore, a lesson naturally comes up: a well-designed structure of the system is needed in order to successfully implement it. This article analyses a number of viewpoints of the cause of the breakdown of the Bretton Woods system from various papers and presents a conclusion based on the evaluation of the validity of these views according to the historical context.

This article focuses mainly on qualitative measures and may not include adequate models or graphs. It only explains and evaluates different factors that have led to the breakdown of the Bretton Woods system without plotting them in different graphs to verify the effect. Therefore, further quantitative researches could be done. Further research could focus on mathematical simulations of the effect of different factors on the exchange rates, which clearly shows the significance of each factor.

We would like to express our sincere appreciation to Dr. David C. Shimko of NYU for his valuable suggestions and guidelines for this research program. We would also like to thank CIS for offering us an opportunity to engage in scientific research training. The Undergraduates Award Library.