The operation and demise of the Bretton Woods system: 1958 to 1971

Michael Bordo explains the BW system:

 He says key reason for breakdown was inflation in US:

A key force that led to the breakdown of Bretton Woods was the rise in inflation in the US that began in 1965. Until that year, the Federal Reserve Chairman, William McChesney Martin, had maintained low inflation. The Fed also attached high importance to the balance of payments deficit and the US monetary gold stock in its deliberations (Bordo and Eichengreen 2013). Beginning in 1965 the Martin Fed shifted to an inflationary policy which continued until the early 1980s, and in the 1970s became known as the Great Inflation (see figure 3).

The shift in policy mirrored the accommodation of fiscal deficits reflecting the increasing expense of the Vietnam War and Lyndon Johnson’s Great Society.

The Federal Reserve shifted its stance in the mid-1960s away from monetary orthodoxy in response to the growing influence of Keynesian economics in the Kennedy and Johnson administrations, with its emphasis on the primary objective of full employment and the belief that the Fed could manage the Phillips Curve trade-off between inflation and unemployment (Meltzer 2010).

Increasing US monetary growth led to rising inflation, which spread to the rest of the world through growing US balance of payments deficits. This led to growing balance of payments surpluses in Germany and other countries. The German monetary authorities (and other surplus countries) attempted to sterilise the inflows but were eventually unsuccessful, leading to growing inflationary pressure (Darby et al. 1983).

After the devaluation of sterling in November 1967, pressure mounted against the dollar via the London gold market. In the face of this pressure, the Gold Pool was disbanded on 17 March 1968 and a two-tier arrangement put in its place. In the following three years, the US put considerable pressure on other monetary authorities to refrain from converting their dollars into gold.

The decision to suspend gold convertibility by President Richard Nixon on 15 August 1971 was triggered by French and British intentions to convert dollars into gold in early August. The US decision to suspend gold convertibility ended a key aspect of the Bretton Woods system. The remaining part of the System, the adjustable peg disappeared by March 1973.

A key reason for Bretton Woods’ collapse was the inflationary monetary policy that was inappropriate for the key currency country of the system. The Bretton Woods system was based on rules, the most important of which was to follow monetary and fiscal policies consistent with the official peg. The US violated this rule after 1965 (Bordo 1993).

The system despite its demise remains with us:

The dollar standard was resented by the French in the 1960s and referred to as conferring “the exorbitant privilege” on the US, and the same argument was made in 2010 by the Governor of the Central Bank of China. However, the likelihood that the dollar will be replaced as the dominant international currency in the foreseeable future remains remote. The dollar standard and the legacy of the Bretton Woods system will be with us for a long time.



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