Bretton Woods Jude Wanniski November 12, 2004

Memo To: SSU Students
From: Jude Wanniski
Re: Why Bretton Woods Broke Down

The most important economic event of the last half of the 20th century was the breakdown of the international monetary system that had been created in September 1944 by the allied powers at a meeting in Bretton Woods, New Hampshire. The participants agreed that the United States would be at the center of the system and would keep the dollar fixed to gold at $35 per ounce, an exchange rate at which it had been kept since 1934. The allied powers, including the British Commonwealth partners, France, Mexico and other Latin countries, agreed to fix their respective currencies to the dollar.

Imagine a wagon wheel with the U.S. at the center and the other nations at the rim, at the end of the spokes. The system worked beautifully for almost 30 years, preventing inflations and deflations, and competitive currency devaluations. Interest rates were virtually identical in all countries because the paper currencies defining their issuances of debt and equity were all ultimately defined in terms of gold. The system unraveled in 1971 when President Nixon was persuaded to end the BW commitment to $35 gold and engage in a competitive devaluation of the dollar on the theory that it would translate into more American jobs at the expense of the rest of the world.

The lesson on Bretton Woods is timely today because the Federal Reserve is again flying blind in trying to manage the value of the dollar. And at the same time, China is struggling with its own banking and currency problems as it keeps its currency, the yuan, fixed to the U.S. dollar, just as the Bretton Woods participants did – except the yuan is being whipped around as the dollar floats up and down against the world gold price. There is even informal discussion in Asia about this “Bretton Woods II,” and how long it might last. I was asked the question last week by an acquaintance in Singapore, and here is how I answered him:

There is really no BWII as far as I am concerned. BW was a systematic way of keeping the world currencies tied to the dollar and the dollar to gold, so all currencies would be indirectly anchored to gold. It was simply another variation of the old gold standards that were arranged unilaterally, where each country committed itself to maintain the gold value of its paper money, and in so doing, they arranged a de facto Bretton Woods.

In that sense, countries that have serious trading relationships with each other find it efficient and economic to keep their currencies tied to each other, at least within narrow bands. It becomes very expensive to make trades across national boundaries with contracts that have time functions, because the currencies can change in their rates of exchange over time, causing unnecessary losses or windfall gains to the traders. They then have to take out insurance, hedging their currency positions. With perfectly fixed rates, tied to gold -- the most monetary of all commodities -- commerce can proceed without any currency risk at all. Well, there would always be the risk that country X in a regional trading bloc would mess up on fiscal policy, and come to believe that the problem was in its exchange rate. It might then want to devalue, causing losses to its own business community or to those in the trading bloc who were not expecting a devaluation.

Part of the BW deal in 1944 was to conceive of an International Monetary Fund that would supervise the system. Remember the British disease? The Brits kept their income tax rates at ridiculous levels -- 96% at the top -- and could not grow fast enough to avoid financial problems and social distress. So they got IMF permission to devalue a few times, and each time the following inflation pushed the work force into the higher tax brackets, and things go worse!! This was Keynesianism at its worst.

BW had at its heart a vulnerability that its founders could not anticipate in 1944, when the U.S. was the strongest nation in the world and had amassed two-thirds of all the monetary gold in the world... Some $20 billion @$35 per ounce... having taken in bullion from European allies who needed dollars to buy wartime goods from us. When you have a system when one country is at the center and all others are on the periphery, all those outside are vulnerable to the central country taking a surprise unilateral action to alter the foundation of the system -- which in this case was the US commitment to keep the dollar defined as one-35th of an ounce of gold. In exchange for its central role, the US at Bretton Woods agreed to convert dollars acquired by the European banks into gold from our hoard, upon their request. This was automatic, at least until the US had run its gold hoard down to $10 billion or so from $20 billion.

Bretton Woods finally broke down in 1971 after an interim period, from 1967 to 71 when the system came under increased stress as the U.S. was supplying more dollars to its own banking system than the banks wanted. They could not turn the surplus dollars into gold at Fort Knox, as could be done under the traditional gold standard. This is because the government in 1934 made it illegal for Americans to hold monetary gold. The system held together only because US banks could convert the surplus dollars to foreign currencies and the foreign banks could convert the surplus dollars into gold at the U.S. Treasury.

The intellectual disconnect occurred because American governments, following the kind of Keynesian principles that had brought the British disease of stagflation on the UK, tried to get the economy moving faster by pushing more and more paper reserves into the banking system. The gold losses finally persuaded the Johnson administration to announce that instead of giving foreign banks gold for the surplus dollars they would give them "special" interest-bearing US securities. France's DeGaulle kicked up a fuss in 1966, demanding gold and getting it, but the Germans, Brits, etc., agreed to take the bonds.

In 1969, Nixon became President and promptly took several tax measures to try to balance the wartime Vietnam budget. These included an increase in the capital gains tax and an extension of the Vietnam war tax. These two measures caused a contraction of the US stock market, a weaker economy, and lower tax revenues. These errors came about because Nixon's economic advisors were one and all conservative Keynesians, believing the incipient inflation caused by Johnson's actions and his closing of the London gold pool could be addressed by tighter fiscal policies. It had the opposite effect. (This was the James Tobin policy mix, of using higher taxes to fight inflation and cheap money to grow the economy, as opposed to the Mundell policy mix of using lower taxes to grow the economy and hard money to fight inflation.)

The 1971 breakdown occurred when the decision was made in January to push "money supply" into the banks in hopes of spurring economic activity. Because of BW, the surplus was immediately shipped to Europe where it went to the central banks that were willing to convert them into those special bonds. It is clear now by hindsight that the dollars were going in circles and having no effect on US economic activity... Although gold began trading in private markets above the official $35 per oz. The Nixon economists, not prepared to admit having blundered in 1971 when they urged the increase in tax rates to balance the budget, persuaded Nixon that gold was the problem. If they could only close the BW gold window, they could keep the dollars at home. The banks would be forced to lend them and this would boost economic activity. The second benefit, supposedly, was that the dollar would devalue against other currencies and make U.S. goods cheaper for foreign purchasers. (Another aspect of the British "disease.")

At the time, it was anticipated that as soon as the cheaper dollars got the US economy on the move, the dollar would be re-pegged at some higher gold price. But when over the course of some 18 months the economy did not respond, further devaluation was officially sanctioned as gold climbed to $140 oz. It was then, early 1973, that Treasury Secretary George Shultz, a close friend of Milton Friedman, persuaded Nixon to "float the dollar" and forget about repegging. Bretton Woods was finished for good.

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I’ve written about the BW breakdown many times, once in more greater detail in a “Private Lesson for Pat Buchanan” in 1999, when he was seeking the Reform Party nomination to the presidency. Because Pat was a special assistant to President Nixon in 1971 when Bretton Woods blew up, ever since he has carried around the idea that his boss had no choice. It was in that framework that I presented the 1999 “lesson,” which you can also read at the link below if today’s has whet your appetite. It is still conventional wisdom today that Nixon was forced to do what he did, when of course he could have avoided the whole problem if he had had better economic advisors. If you have noticed the gold price drifting up steadily these days, please also note the dollar is still floating, and it does not have to. We could soon be in the inflationary soup again unless President Bush gets some better economic advice.