The Heyday of Bretton Woods and the Reserve Debate
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CHAPTER 6 The Heyday of Bretton Woods and the Reserve Debate At least in retrospect, a warm glow often overcomes policymakers as well as academic analysts looking back on the "classical Bretton Woods system" as it operated until 1971. "The golden age of capitalism," "the most successful international monetary regime the world has ever seen," "the best overall macro performance of any regime," there are many such encomia.1 In 1977, the distinguished economist Simon Kuznets gave the following verdict on the whole history of economic growth: over the previous 25 years, in both the developed and the less-developed worlds, "material returns have grown, per capita, at a rate higher than that ever observed in the past."2 Inflation rates were lower than in the following period of floating exchange rates, real long-term interest rates were lower, and growth higher. Above all, growth was more evenly distributed. Internationally, differences between regional performances were limited: the real annual growth rates of GDP in the 1960s stood at 5 percent in member countries of the Organization for Economic Cooperation and Development (OECD), 4 percent in Latin America, and 6 percent in Asia. Domestically, too, most countries moved toward greatly reduced inequalities of income distribution. Both these experi- ences present a marked contrast with the decades following. In the era of boundless opportunities, of President Kennedy's "New Fron- tier," or of British Prime Minister Harold Macmillan's "you've never had it so good," no limits seemed to exist on the capacity of societies to organize themselves to produce growth. The proponents of "growthmanship" believed that the task of the international financial system lay in supporting growth. They feared that a shortage of reserves might constrain or curtail economic 148 150 INTERNATIONAL MONETARY COOPERATION advance through the need to deal with balance of payments problems, and believed that counteraction was urgently required. The major function of reserves no longer lay in providing a backing for the issue of domestic currency, as it had under the gold and gold exchange standards, but rather in supplying a "buffer" that could allow sudden swings in the trade balance to be accommodated without requiring the imposition of either trade protec- tion or monetary deflation. Such swings were bound to occur and could only be accommodated given an adequate supply of reserves. (The analogy is sometimes made with a taxi stand. There needs to be a line of taxis in order to accommodate the demands of a sudden flow of passengers without causing them delays; in normal times, taxis return and fill up the stand.) This chapter traces the evolution of the reserve discussion and the attempt to produce a workable reform that would command an international consensus. The latter requirement, however, would ensure that the new instrument, the SDR or special drawing right, in practice never came to play the central role in the international system that its advocates had envisaged. Trade and Shocks Perhaps the most striking feature of the classical Bretton Woods system in retrospect appears as the expansion of international trade at a rate unparal- leled either before or since. This trade performance was correlated, at both the international and the national levels, with a very vigorous growth in output (see Figures 1-1 and 1-2). One of the forces that propelled this development was the reduction in tariff levels for manufactured goods and the substantial elimination of quotas between industrial countries as the result of rounds of multilateral trade negotiations under the General Agreement on Tariffs and Trade (GATT). The most impressive reductions occurred at the beginning, at the Geneva Round of 1947, and the Annecy Round of 1949, when the United States negotiated bilaterally with 20 other governments.3 In 1951 the United King- dom and Germany and in 1955 Japan joined the GATT, with the result that all major developed countries were now members. In the 1960s, the Kennedy Round extended the negotiating process. Instead of bilateral agreements, multilateral arrangements were made; and instead of product- specific concessions, liberalization was conducted across the board. 6 Bretton Woods and Reserve Debate 151 Trade growth and trade liberalization reinforced each other. Growth con- vinced policymakers of the concrete benefits to be obtained through liberal- ization, and encouraged them to take further steps, which in turn generated larger markets and further growth. Later, the falling off of growth rates in the 1970s helped to provoke a reversal of the progress made in trade talks, and the results then, conversely, further harmed the prospects for trade. Since liberalization gives rise to a virtuous cycle, and protectionism correspondingly produces a vicious cycle, politicians, policymakers, and economists felt more and more sensitive to the possibility of a shock that might reverse the beneficent process and send the world on the disastrous downward spiral. The longer the successes of the golden age lasted, the more nervous the participants became. Could the eventual shock come from the financial system? How far was the impressive international economic performance the result of international financial arrangements, and how far was the successful out- come simply a consequence of the chance absence of destabilizing shocks? What is the relationship between the system and the incidence of shocks? Did the discipline imposed by the "classical Bretton Woods system" avoid little shocks by postponing them until they accumulated into the giant inflationary shock of the 1970s that destroyed the system? The counterpart of trade liberalization was the adoption in Europe between 1958 and 1961 of current account convertibility, and the acceptance of Article VIII of the Fund Articles of Agreement on convertibility in place of the protection offered by Article XIV. It is only at this moment that it became possible to speak of a genuine international monetary system: indeed, the phrase only entered the general vocabulary in the context of discussions in the early 1960s regarding the creation of the General Arrangements to Borrow.4 There was no longer simply a world of nation-states, and an institu- tion supervising rules on conduct, but rather a system in which nation- states, and the rules affecting their behavior, interacted with markets, and in particular with growing currency and capital markets. (This makes the international financial system conceptually entirely different from the inter- national political system: in the latter, states alone interact with each other, while in the former there is a large body of other agents, private as well as official, continually judging and second-guessing the decisions made by the states.) As trade expanded and the "system" developed, its management required additional resources or reserves. Inadequate reserves would be the most frequent reason given for a refusal to open trade, or for a willingness to contemplate higher levels of protection. A monetary shock might reverse 152 INTERNATIONAL MONETARY COOPERATION the successes of trade liberalization. Finding a solution to the reserve problem thus took on the character of a quest for stability in the system as a whole. Unfortunately, this question touched the most sensitive political nerves. In what had become more and more a dollar system (or perhaps a dollar-sterling system), the expansion of dollar reserves looked to many non-Americans like an extension of U.S. power. Even more frustratingly for Europeans and others, it was a costless extension: by making the rest of the world hold dollars, the United States was exchanging its paper for the goods and services of others. In order to operate smoothly, any international financial system re- quires three elements: liquidity, confidence, and adjustment.5 Liquidity, in the form of a maintenance of adequate reserve levels, was essential to the operation of convertible currencies with par values: the reserves allowed the financing of short-term deficits in the balance of payments, in cases when the causes of those deficits were assumed to be temporary. Confidence allowed the augmentation of reserves through borrowing. If there were longer-term difficulties, eventually the supply of reserves and the fall-back supply of credit would be limited and the country concerned would require adjustment of its external position. The pre-1914 gold standard had generated a high degree of confidence and had operated on surprisingly low levels of reserves (liquidity), but it had required the political sacrifice of painful adjustment to deflation by its mem- bers in the 1870s and 1880s. After the First World War, the gold exchange standard had provided a greater degree of liquidity (relative to world trade) than the prewar system, but had suffered and in the end collapsed because of confidence problems. After 1945, and particularly in the 1960s, the existence of confidence allowed the delaying of adjustment, especially in the case of two major reserve centers, the United Kingdom and the United States; as a result, when adjustment was eventually required, when liquidity was exhausted and when confidence ebbed, the extent of the adjustment that would have been needed to return the system to smooth operating was too large to be accept- able to national policymakers. If adjustment under the gold standard had been too painful, under Bretton Woods it was too delayed because of the high level of expectations about growth. The success of the Bretton Woods system actually contributed, through increasing expectations, to the growing difficulties of managing the system. The postponement of the adjustment mechanism was further encouraged by the great difficulty of making the exchange rate an instrument of international economic policy. And when adjustment came to be required, in 1971, it was too large to be handled in any way except by the improvised measures of crisis management. 6 Bretton Woods and Reserve Debate 153 Figure 6-1.