Why did the Bretton Woods system break down? Did the ERM of the EMS fail for the same reasons?

It is a feature of the international economic system that each country has its own individual currency with which purchases and transactions of goods and services provided by that country can be paid for. The absence of a centralised institution, be that a form of collective international government or merely a supranational economic body that penetrates and regulates directly the economic activity in all the countries subordinate to it, means that these currencies are competing with one another on international markets, both for buyers who wish to purchase goods from different countries, and savers who wish to maximise their benefits by holding assets from different countries. This leads to enormous transactions costs that must be incurred whenever inter-country trade is conducted - these costs are a waste of resources that could be avoided were the problem of the plethora of currency units overcome either through the evolution of a single world currency (at best, a staggeringly ambitious solution), or by attempts to overcome the problems of uncertainty and credibility through forms of regulated monetary systems. These have been attempted for most of the past 100 years, most notably in the post-W.W.II Bretton Woods system, and more recently on a European level in the EMS. Both collapsed, and it is the intention of the discussion to establish why this is so, and what lessons can be drawn for any future attempts to adopt similar schemes.

In order to maximise the benefits from international trade, a country must be able to assure its partners that its currency will maintain a stable and predictable value. The commitment of the national monetary authorities to smoothing the fluctuations of the exchange rate (or in the case of a fixed exchange rate system, to defending the absolute value of the currency) must be credible. An international extension of the authority's domestic promise to ensure that the national banking system is kept solvent at all times, this is normally achieved by asserting to the maintenance of a fixed price of the currency in terms of another asset over which the domestic authorities have no control, usually gold or another currency. Such credibility is difficult to sustain in the long-run, as investors are usually aware that a government will only follow such a policy for as long as it is in its interest to do so, and in period's of increased freedom of mobility of capital, this has given speculators' the power to mount attacks on currencies they view as weak and/or overvalued, attacks which few currencies have been able to resist without being forced to devalue. Yet this is an oversimplification of the problems associated with fixed exchange rate systems, and thus a closer examination of the problems of both the Bretton Woods and EMS systems is needed.

The Bretton Woods system was based on the gold standard arrangement that had existed between the late 19th century and 1914 and then again in the early inter-war period, under which countries had committed the free convertibility of their currency into gold at a fixed price. Under the Bretton Woods regime, however, a two-tier system of convertibility was arranged, with only one currency - the US dollar - freely convertible into gold at a fixed price (but only to foreign central banks), but with all other currencies in the system freely convertible into dollars. This was implemented due to the disproportionate distribution of gold reserves that favoured the US, and the belief that gold would not suffice on its own in the future as a guarantee of international liquidity. Thus the countries in the scheme would effectively link their currency to the dollar, and would be forced to follow fluctuations in it, but by holding the threat of converting their dollar assets into gold at any time at a fixed price, could exercise considerable influence on the US monetary authorities to act in the interests of all the international players. Despite being drawn up as early as 1945, Bretton Woods was not fully implemented until 1958. This was due to multiple monetary crises that European countries were experiencing as a result of post-war reconstruction, which included a devaluation of sterling after American pressure forced a premature return to convertibility, and a devaluation of the franc following the multiple crises in Algeria, domestic labour markets, and the breakdown of the Fourth Republic. During this period (1945-58), only central monetary authorities were able to trade in currencies at fixed prices; private economic agents could not. As reconstruction proceeded, Europe became an attractive destination for American investors, and the dollar shortage that had manifested itself as a persistent US balance of trade surplus was reversed as the US moved into deficit. As the financial condition of Europe improved, full convertibility was instituted in 1959.

As the 1960s progressed, the US began to run larger budget deficits in order to both maintain full employment and fund its increasing involvement in Vietnam. This was combined with a monetary expansion which fuelled inflation, which was imported to the countries that maintained a fixed parity with the dollar. Anti-inflationary tendencies in countries such as Germany and Switzerland were initially combated whilst maintaining exchange rate parity with the dollar, but speculators sensed a revaluation would occur, bought these currencies, and effectively destroyed the credibility of the fixed exchange rate commitment. This resulted in a huge increase in the dollar holdings of the central banks in these countries, but also an increase in the respective domestic money supplies, which prompted the very inflation they were attempting to avoid. The system of converting foreign currency into gold as was outlined above was not used as it was intended as countries such as Germany and Japan were too dependent on the US politically and militarily to risk a confrontation. Thus instead of a gold-dollar standard system evolving, Bretton Woods was a de facto pure dollar-standard. As a result, there was no restraint on the policies adopted by the US authorities, and when there was an asymmetry between the policy priorities of the countries, the system came under strain. This eventually led to speculative pressures on the pound as well as the dollar which caused the system to collapse in 1971 (despite two devaluations of the dollar), when countries allowed their currencies to float out of the narrow 1% bands either side of a fixed parity rate after the US had closed the gold window. In short, the inflationary policies pursued by the US resulted in a conflict among the major participants as to what was an appropriate monetary policy, which undermined the credibility of the system, and caused it to collapse.

The European Monetary System (EMS) also suffered from such shortcomings. Created in 1979 as a joint venture between France and Germany with the intention of smoothing the disruptions in international trade flows that was the experience of the exchange rate volatility of the 1970s, it allowed currencies to fluctuate within 2 �% bands around a fixed central rate. During the first half of the 1980s, the system worked well as it allowed for periodic revaluations of currencies within it, and thus speculative pressures were avoided. From 1987 onwards however, the system became much more restrictive, as attempts were made to eliminate these revaluations by keeping the central rates fixed. This was part of the overall scheme for a movement towards monetary integration. However at the same time, the system became asymmetric in a similar fashion to Bretton Woods, as the Deutschmark became the preponderant currency. This was a result of both German economic power, and its acquired reputation as a low inflation country - thus the other members believed that by pegging their currencies to the Deutschmark, they could benefit from this austerity. However, conflict arose within the system that involved not only a divergence of opinion within the member countries as in Bretton Woods, but that was prompted by domestic economic conditions in a single member, namely Germany. As a result of reunification in 1992, the new Germany had to cope with the inflation of the former GDR whilst there was a simultaneous recession across most of the rest of Europe, This acute deviation of economic experience posed a dilemma for the Bundesbank - if it concerned itself solely with domestic economic interests, it risked prolonging the recession in the rest of Europe. On the other hand, if it relaxed its monetary policy and allowed recovery to take place, it risked losing its reputation for anti-inflationary zeal, and undermining the very basis of the ERM, not to mention risking an inflationary boom at home. The course of action chosen - the former - demonstrates how the "absorption" problem (as de Grauwe terms it), namely the fact that domestic internal and external balance must be achieved through disinflation if a commitment to maintaining a fixed exchange rate is undertaken, feeds through as a conflict of interest between the different members of such a system. The raising of interest rates by the Bundesbank to contain German inflation led to an appreciation of the Deutschmark - other countries were required to follow in order to maintain their currencies within the tight bands that the system required, and this prolonged the recessions they were experiencing. This well-publicised contradiction was seized upon by speculators who believed that governments would not allow domestic considerations to be outweighed by exchange rate stability. This led to attacks on numerous currencies, most spectacularly the exit of sterling from the ERM on Black Wednesday, but also the lira, franc, Danish krone, and the Irish punt. Eventually, the system disintegrated as the permissible bands of fluctuation were widened to 15% either side of a central rate.

The failure of the ERM led to a reassessment of traditional models of speculation based on inappropriate and unsustainable policies whereby the speculators were acting as checks that periodically reshaped the long-term health of the economy through provoking such crises. Now it was clear that the attacks were self-fulfilling prophecies, and that not even the combined resources of several governments could defend the currencies against the pressures of the volumes of capital that the speculators had access to. The Asian currency crises of the last 18 months have again demonstrated the vulnerabilities of currencies to the activities of speculators. Yet there is a fundamental weakness of fixed exchange rate systems as de Grauwe points out, in that there will always come a time when the interests of the partners diverge, and the credibility of their promises to maintain the integrity of the system can be questioned. From this viewpoint, it seems to be the case that any fixed exchange rate system where there is freedom of capital mobility, even if it is restricted to the central banks and not extended to all citizens, is doomed to failure.