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on Woods System

The benefits of the Bretton Woods system were a significant expansion of international trade and investment as well as a notable macroeconomic performance: the rate of inflation was lower on average for every industrialized country except Japan than during the period of floating exchange rates that followed, the real per capita income growth was higher than in any monetary regime since 1879 and the interest rates were low and stable. It has to be noted that leading economists nowadays argue “whether macroeconomic performance stability was responsible for the successes of Bretton Woods, or the controversy.”

Under the gold exchange standard, a country has to address the problem by deflating the domestic economy when faced with chronic Balance Payment deficits. Before World War II, European nations often used this policy, in particular the Great Britain. Even though few currencies were convertible into gold, policy makers thought that currencies should be backed by gold and willingly adopted deflationary policies after World War I. Deflationary policy is not the only option when faced with BP deficits. Devaluation is accepted in Bretton Woods. The adjustable peg was viewed as a vast improvement over the gold exchange standard with fixed parity. Currencies were convertible into gold, but unlike the gold exchange standard, countries had the ability to change par values. For this reason, Keynes described the Bretton Woods system as 'the exact opposite of the gold standard.'

On the contrary, weaknesses of the system were capital movement restrictions throughout the Bretton Woods years (governments needed to limit capital flows in order to have a certain extent of control) as well as the fact that parities were only adjusted after speculative and financial crises. Another negative aspect was the pressure Bretton Woods put on the United States, which was not willing to supply the amount of gold the rest of the world demanded, because the gold reserves declined and eroded the confidence in the dollar.

In the post-World War II scenario, countries devastated by the war needed enormous resources for reconstruction. Imports went up and their deficits were financed by drawing down their reserves. At that time, the US dollar was the main component in the currency reserves of the rest of the world, and those reserves had been expanding as a consequence of the US running a continued balance of payments deficit; other countries were willing to hold those dollars as a reserve asset because they were committed to maintain convertibility between their currency and the dollar.

The problem was that if the short-run dollar liabilities of the US continued to increase in relation to its holdings of gold, then the belief in the credibility of the US commitment to convert dollars into gold at the fixed price would be eroded. The central banks would thus have an overwhelming incentive to convert the existing dollar holdings into gold, and that would, in turn, force the US to give up its commitment. This was the Triffin Dilemma after Robert Triffin, the main critic of the Bretton Woods system. Triffin suggested that the IMF should be turned into a ‘deposit bank’ for central banks and a new ‘reserve asset’ be created under the control of the IMF. In 1967, gold was displaced by creating the Special Drawing Rights (SDRs), also known as ‘paper gold’, in the IMF with the intention o