The Ghost of Bretton Woods and the Global Economic System

In July 1944, as Allied military planners focused on winning the war, a group of economists and policymakers around the world focused on winning the peace. With World War II still raging, delegates from 44 countries gathered at a bucolic compound in Bretton Woods, NH, to craft the framework for a new global financial system.

The delegates forged an agreement called the Bretton Woods Accord, which they hoped would create a mechanism for international economic cooperation that could prevent the kind of disastrous policies that contributed to the Great Depression.

Before World War II, nations had imposed crippling trade barriers and engaged in competitive devaluations of their currencies. Such beggar-thy-neighbour policies have been blamed for exacerbating the global economic downturn.

The agreement established a world exchange rate system

Under the agreement reached in July 1944, the countries would peg their currencies to the US dollar at a fixed but adjustable rate, while the dollar would then be pegged to gold at a rate of $35 an ounce. The peg of the dollar to gold provided assurance that the United States would keep its economy in order; other countries’ central banks could convert their dollars into gold if they lost faith in the US dollar.

“What we have done here at Bretton Woods is to devise mechanisms through which men and women everywhere can exchange freely, on a fair and stable basis, the goods they produce through their labor. ” US Treasury Secretary Henry Morgenthau Jr. said at the end of the conference (PDF). “And we have taken the first steps by which the nations of the world will be able to assist each other in economic development to their mutual advantage and for the enrichment of all.”

Given the severity of World War II, the Bretton Woods system of freely convertible currencies will not come into force until 1958. This system of stable exchange rates would last until August 1971, when President Richard Nixon, faced with inflation and the gold rush, ended the convertibility of dollars into gold. A December 1971 attempt, called Smithsonian Agreementattempted to preserve the Bretton Woods system, but by 1973 the deal was officially dead as nations began to float their currencies against each other.

Bretton Woods legacy includes the Eurodollar market

Although the Bretton Woods Accord collapsed 50 years ago, its legacy is still felt today. The International Monetary Fund and the World Bank, global lending institutions, originated from Bretton Woods. Even the huge eurodollar market – dollar-denominated accounts held in banks overseas – arose out of the need to circumvent the shortage of dollars created by the Bretton Woods system, as the authors pointed out. Paulina Restrepo-Echavarria and Praew Grittayaphong in a January 2022 blog post.

Dealing with the ghost of Bretton Woods has long been a research interest of Restrepo-Echavarria, a senior economist at the Federal Reserve Bank of St. Louis. She spoke about her work on Bretton Woods in a Twitter Q&A in 2021. Her comments below have been edited for clarity and length.

Q: Was the Bretton Woods collapse inevitable?

Restrepo-Echavarria: I think that was probably the case. And that was probably because the deal as we know it involved the US dollar being the benchmark currency and being pegged to gold. So there was parity between the US dollar and gold, and then all the other exchange rates of the other 43 countries were fixed against the US dollar.

It turns out that in the 1960s, the United States began to experience some inflation. This means that the US dollar has started to lose purchasing power. But gold has not lost value. Basically, the government, which had to respect this parity, was the one who could lose a lot by keeping the gold parity. Thus, in 1971, President Nixon announced that the [dollar’s] parity with gold ended. And that was the beginning of the end of the Bretton Woods agreements.

We could have thought of modifying the agreement to make it sustainable – perhaps a way to maintain capital controls so that capital flows are still in place and there is no flow of speculative capital, which was the fear of the time. But it’s pretty hard to say how that would have been implemented when you have a base currency that’s losing purchasing power due to inflation and the anchor, which was gold, is no longer the.

Q: Who were the winners and losers after Bretton Woods initially and who won/lost over time?

Restrepo-Echavarria: In my research with Lee Ohanian, Mark Wright and Diana Van Patten, we divided the world into three different regions:

  • United States
  • Northern and Western Europe
  • The rest of the world, which is mainly made up of East Asia, Latin America, Canada, Australia and New Zealand

We see that Europe and the rest of the world were the big winners from the Bretton Woods agreement, both during the period of the agreement and afterwards. These were winners in the sense of consumption equivalence, which is one way we measure well-being in economics. So basically we think how much more their consumption was because they were participating in the Bretton Woods agreement.

We see that Europe and the rest of the world have gained in terms of consumption while the United States has been the big losers. And the United States, during the agreement and over time, lost about 4.5% of its consumption because of its participation in the agreement.

Q: Is Bretton Woods still a drag on the global economy today?

Restrepo-Echavarria: This is a very good question and a bit difficult to answer. But the bottom line is that if I stick to the purely technical details of what we find in our results, what we see is that Bretton Woods had a long-term impact in terms of the level of production.

We looked at production in our counterfactuals, which are basically experiments where we assume Bretton Woods didn’t exist. And in our model, we can run a counterfactual where we say, well, imagine for a second that Bretton Woods doesn’t exist. What would have happened? And what we find is that the production would have been higher over time. There is therefore a difference in the level of production which is more or less constant over time. So in that sense, yes, there is a long-term effect of the Bretton Woods agreement in terms of lost production in the world when you look at it that way.