Monetary System



From the end of World War II to the early 1970s, the United States was part of the international monetary system known as the Bretton Woods system. The system was designed to establish economic stability for the nations emerging from the ravages of the war, as well as promote trade by increasing the cooperation and interdependence of national economies.

The Bretton Woods system, established at the Bretton Woods Conference in 1944, created two bodies, one of which, the International Monetary Fund (IMF), was responsible for coordinating the world monetary system. Member nations contributed to the fund, from which they could draw to overcome temporary exchange deficits. Each nation was required to declare a par value of its currency in terms of the gold value of the American dollar. Member nations were not allowed to make transactions at an exchange rate that diverged more that 1% from the established parity.

Role of the American dollar in the Bretton Woods System

Emerging from the World War II as the only major industrial nation strong and stable enough to provide an anchor for the system, the United States played a crucial role in the Bretton Woods System. The American dollar was the most frequent used currency in international transactions, so it was chosen as a basis by which to set international exchange rates. In 1949, the United States agreed to establish and maintain the international value of the dollar at $35 per ounce of gold. The American dollar was declared the numeraire and reserve currency of the system. Thus, the dollar was pegged to gold, and other currencies were pegged to the dollar, making the system a modified form of a gold standard. Foreign nations would use the dollar as an intervention currency, and would keep their foreign reserves in the form of dollars as well as gold. The British pound was officially sanctioned as an intervention and reserve currency like the dollar, but, in reality, the dollar was the only widely-used, internationally recognized currency. Most foreign national banks kept dollars rather than gold as monetary reserves, since dollars could be kept in the form of US government. securities, which earned interest, as opposed to gold, which did not. In 1968, another feature was added to the IMF: Special Drawing Rights (SDRs). These SDRs supplemented gold and dollars as currency reserves.


Decline of Bretton Woods System:

The Bretton Woods System was well-designed for the immediate post-war international economy. Through the 1950s and into the 1960s, the international economy outgrew the system. European economies grew rapidly, and the American dollar's strength declined. American dollars were being spent overseas, in the form of foreign aid, defense spending, investment, trade, and travel/tourism. This outpouring of dollars into the international economy was not reciprocated by an equal inflow of currency. This brought about a deficit in the capital account, resulting in a balance of payments deficit.


To control the balance of payments deficit, the federal government adopted a number of measures to help bring about equilibrium, beginning in the late 1950s. Foreign aid was tied to purchases of goods and services in the United States, so that aid outflows could be counteracted. Duty-free allowances were reduced for American tourists returning from travels abroad. Government agencies reduced their overseas spending. The Federal Reserve lowered the ceiling on bank loans to foreigners. A number of other measures were taken, including the creation of a gold pool funded by the central banks of several industrial nations to intervene in the London gold market to maintain the official price of gold.


When John F. Kennedy and his administration moved into Washington, they brought with them a new set of goals: to actively promote domestic growth, far beyond the conservative efforts of Eisenhower, and to maintain a strong international presence. Unfortunately, the balance of payments deficit was not only persisting but getting worse, and Kennedy's economic objectives were not compatible with a balanced balance of payments. In order to promote growth by facilitating entrepreneurial efforts, domestic interest rates were kept low. This had the side effect of causing investors to seek investment opportunities abroad, where they could get a better return on their money. In order to establish a significant presence in the international political and economic scene, the United States needed to maintain a high level of overseas spending, through foreign investment and aid, military and defense spending.


The countermeasures of the 1950s and early 1960s had proven insufficient to remove the deficit. There were several basic policy options available to bring the balance of payments into balance: reduce federal spending overseas in the form of foreign aid, foreign investment, and military spending; raise interest rates to attract foreign investors and keep domestic investors; or adjust the exchange rate in order to devalue the dollar, making American exports more attractive and improving the current account. Nevertheless, Kennedy's economic advisors faced a serious dilemma. All the obvious methods of reducing the balance of payments deficit were in opposition to the economic goals that Kennedy had articulated. Reducing federal spending might have eroded the United States' position as an important international power in the post-war Cold-War international political scene. In addition, such cut-backs might have jeopardized the economic and political security of a number of nations which were, at least in part, dependent on U.S. aid, capital investment, military protection, and programs like the Peace Corps and the Alliance for Progress. Kennedy's economists were also reluctant to raise interest rates, especially on long-term investments, since such an action might have discouraged domestic entrepreneurs, thus slowing growth. The third option, to devalue the currency, was not possible under the Bretton Woods System, since, as the anchor of the monetary system, the American dollar was the only currency that could not be devalued or revalued, even in a state of fundamental disequilibrium.


The Kennedy Administration chose to deal with the balance of payments deficit by trying to indirectly influence the private sector to reduce its overseas investments, as well as to give foreign investors disincentives to borrow money from the relatively low-interest American capital market. Operation Twist and the Interest Equalization Tax were policies which attacked the problem by influencing short-term interest rates and effectively taxing foreign stocks and bonds, as well as American loans to foreign borrowers.


Operation Twist was a set of policies designed to stem the outflow of dollars by manipulating the structure determining interest rates without directly restricting capital outflows. The goal was to push short-term interest rates up toward world levels, while keeping long-term interest rates down, in order to stem the capital outflows from the US. In order to raise the short-term rates and keep the long-term rates low, the Fed had to do the opposite of what it usually did. It sold more short-term T-bills than (long-term) T-bonds. In addition, Regulation Q was altered in January 1962, July 1963, and November 1964. The changes allowed banks to give higher interest rates on deposits in savings accounts and time accounts, thus increasing the inflow of money into commercial banks. The additional funds were to be used for mortgages and state and local government bonds, thus putting downward pressure on long-term rates. The Fed also raised discount rates from 3% to 3.5 % in July 1963, then from 3.5% to 4% in November 1964, in order to raise short-term rates and help balance the US BOP. In addition, in order to reduce incentive to sell dollars and buy foreign currency, the Treasury became involved in foreign exchange operations together with foreign central banks, for the first time since the 1930s. By working in both the spot and forward markets, the Treasury in creased the cost of exchange risk on dollars to speculators and traders, thus reducing their incentives to sell dollars for foreign currencies.


The Interest Equalization Tax, recommended by Kennedy in July 1963 and passed in August 1964 (made retroactive to July 1963), was basically a tax on the purchase of foreign stocks and bonds in the United States. It was intended to reduce long-term capital outflows caused by American purchases of foreign securities. The tax effectively raised borrowing costs for foreigners in the American capital market, as well as lowering yields to American investors in foreign securities by about 1%. Thus, Americans were discouraged from investing abroad, without the domestic long-term interest rate being affected. Securities from underdeveloped countries, as well as Canada and Japan, were exempt. This kept the IET consistent with "Operation Twist" policies. In 1965, the IET was extended to most long-term (one year or more) lending by financial institutions, such as banks and insurance companies, on a voluntary basis.

It soon became apparent, however, that the clever ad hoc solutions concocted by Kennedy's economists were insufficient to solve the underlying problem: the tension between the goals of the Kennedy and Johnson administrations and their consequences to the domestic economy was pushing the nation toward a severe economic crisis. The deficit in the balance of payments meant that there were more claims on American reserve currency than actual reserves to back up the claims. As a result of such an imbalance, foreign banks and individuals with U.S. dollars and, thus, claims on U.S. foreign reserves, could falter in their confidence in American monetary stability and demand gold or reserve currency in exchange for dollars. In 1931, a situation like that just described occurred in Britain, and the run on the pound caused a major disaster in the British economy.


The problem of the American balance of payments deficit was becoming more pressing, and increased military spending in Vietnam was exacerbating the difficulties. Nevertheless, none of the remedy policies prescribed were able to even stop the growth of the capital account deficit, let alone reverse the trend. By 1964, the capital account deficit had increased tremendously, pushing the balance of payments further into deficit despite the $2.4 billion increase in the current account (trade) balance. Despite the efforts of the Operation Twist policies, both the short term and long term interest rates rose, due to the internationalization of the American capital market. The higher long-term capital interest rates had the potential to slow domestic growth, and, since the rates remained lower than in Europe, the outflow of capital continued. The Johnson Administration tried to establish voluntary guidelines to slow US corporations' investments abroad. Although this did help reduce the capital deficit in 1965, the nation faced the beginnings of a trade deficit, which put pressure on the balance of payments from the other side.


The restrictions on private capital flow helped encourage investors to enter the Eurodollar market. The Eurodollar Market is a decentralized system in which dollar banks accounts held in European banks are reloaned abroad without being converted to another currency. In the 1960s, it enabled foreigners to access American capital without being subject to capital restrictions. Unlike banks, the Eurodollar market had no reserve requirements through the 19760s and 1970s. Thus, a few American dollars could circulate through the Eurodollar system and expand to many times the initial credit. American bankers were wary of the system initially, but the combined effects of rising inflation and tightening federal restrictions made the unregulated overseas market increasingly attractive. It is not clear how large the Eurodollar system was in the 1960s, but it grew rapidly through the late years of the decade and into the 1970s. Through the Eurodollar system, foreign nations could keep up their dollar reserves simply by borrowing from the vast Eurodollar system, putting off any structural difficulties or unhealthy patterns in their balance of payments. By allowing foreign nations to elude a balanced national account, the system may have contributed to the eventual failure of the Bretton Woods system. The dollar crises of the 1960s further weakened the international monetary system under Bretton Woods.


Dollar Crisis

The fact that more currency was flowing out of the United States than was coming in meant that the Federal Reserve's foreign currency reserves were in danger of being seriously depleted. Since holding a dollar represented a guarantee that one could exchange it for foreign currency or for gold at any time, such a depletion of currency could cause a crisis of confidence and a massive panic. A run on the dollar, in which large numbers of people attempted to sell their dollars to the Federal Reserve, could occur, causing the Fed to approach insolvency. As the national bank of the United States and the bedrock of the American economy, a major run on the dollar could wreak havoc not just on the United States, but on the international monetary system.

There were two serious American dollar crises in the 1960s. The first occurred in the early months of 1965. Among the contributing factors were the worsening situation in Vietnam; the rumor that the United States intended to eliminate the gold reserve requirement against Federal Reserve deposits and notes, and French verbal attacks on the role of the dollar in the international monetary system. On March 5, 1965, the price of gold peaked at $35.17 an ounce, and the United States had to find a way to bring the price back down to $35.00 in order to maintain the dollar's value in the Bretton Woods system. According to the Federal Reserve Act of 1913, the Federal Reserve bank was required to keep a reserve of gold certificates worth at least 25% of its holdings in commercial banks deposits. Congress voted to remove that reserve requirement, thus freeing about $4.9 billion worth of gold in order to meet potential international claims on American gold reserves.

The second crisis occurred in 1968, when there was a drastic increase in purchases of gold. The seven major industrial countries could not maintain the market price of gold at $35 an ounce, so they gave up their efforts, except for the United States, which agreed to continue selling gold to governments at $35 an ounce. In order to support this commitment, Congress freed more gold from currency reserves. In addition, Congress eliminated the requirement that the Federal Reserve Bank keep reserves in gold certificates of at least 25% of its Federal Reserve notes (currency) in circulation. This law freed up to $10.7 billion in gold, which had been set aside to back the dollar, for use in meeting potential claims on gold reserves.


The Looming Crisis

By the end of the 1960s, it was clear that the ills plaguing the international monetary system and the American dollar would have to be addressed at a basic level. The Kennedy and Johnson Administrations had applied solutions to the mounting balance of payments crisis that were at best patch-up jobs, postponements of the inevitable. The balance of payments was off-balance, the dollar was overvalued, inflation was picking up speed, and the United States could do little to restore economic order without compromising major aspects of domestic and foreign policy. Not until the 1970s would the United States take action to fundamentally restructure the international monetary order.