The Bretton Woods Agreement: Definition & Collapse

Instructor: James Blackburn

James has an MBA from Auburn University and a MA in Humanities from Cal State-Dominguez Hills He writes on leadership, business strategy and finance.

The Bretton Woods Agreement was approved in 1944 to address the financial concerns of post-war reconstruction and recovery. In this lesson, we will review the key elements and its eventual collapse.

Rebuilding the International Economic System

World War II was nearing an end. The devastation in Europe and Asia was beyond belief. The funds needed to rebuild war-ravaged nations would be immense. The United States, the one remaining economic superpower, would shoulder more than its share of the recovery. World leaders had a real fear that post-war reconstruction could push the United States into another depression and carry the global economy with it. A big question remained. How could the US rebuild the world without jeopardizing its own financial security?

Women washing their laundry in the streets following the war because of the damage.
WWII Destruction

John Maynard Keynes, an advisor to the United Kingdom Treasury, and Harry Dexter White, the chief international economist for the US Treasury, had a few ideas. From them, The Bretton Woods Agreement and a renewed hope for the future emerged.

Bretton Woods, New Hampshire 1944

730 delegates from 44 nations gathered in Bretton Woods, New Hampshire in July of 1944 to draft a new international monetary policy. The goal of the new policy was to establish a stable foreign exchange rate system, prevent competitive currency devaluations, and promote economic growth. A key element of the agreement called for currency to be backed by gold. The US dollar would serve as a reserve currency and be pegged at an exchange rate of $35 USD to one ounce of gold. Nations could either peg their currency to gold or the US dollar. The agreement called for an adjustable peg system to allow for fluctuations in the economy. Nations were expected to maintain their currency within 1% of parity. The US Federal Reserve would maintain gold reserves equal to 40% of the US dollar currency in circulation.

Architects of the Bretton Woods Agreement, White (left) and Keynes (right)
Architects of the Bretton Woods Agreement

Both Keynes and White believed a central agency was needed to coordinate and stabilize current exchange. At the same time, post-war reconstruction financing was needed to help countries recover. The International Monetary Fund (IMF) and the International Bank for Reconstruction and Development were established to support both needs. The IMF would monitor exchange rates and lend reserve currency to settle account balances. The International Bank would provide and guarantee the funds needed to rebuild developing countries. The International Bank would later evolve into the World Bank and continue its mission.

The Collapse of the Bretton Woods Agreement

Depleted gold reserves, rising inflation and an unwillingness for surplus countries to adjust their currency eventually led to the suspension of the gold standard. From 1950 - 1957, the US Current Account experienced significant account balance deficits. Foreign nations increased their US dollar holdings by $500- 600 million and gold reserves by $400-500 million per year. The account balance deficits for the US during the policy period continued to rise year over year. By 1964, the US dollars held abroad exceeded the depleted gold reserves of the US and created a convertibility crisis.

The current account is a financial ledger of economic transactions between nations. The current account records exports, imports, income, and currency transfers. An account balance deficit may occur when imports exceed exports and/or currency outflow exceeds inflow. During the Bretton Woods policy period, the deficits experienced by the US were the result of foreign aid to help Europe and Asia rebuild, currency outflows.

Time Period Dollar Value of Account Balance Deficit in USD Account Balance Deficit as a % of Total Exports
1951-1955 $2 Billion 15%
1961-1965 $6 Billion 25%
1971-1975 $23 Billion 31%

Accelerating the decline of the policy, inflation had increased from 2% in 1965 to 6% by 1970. The rising rates elevated concerns that a weaker US dollar would trigger the exchange of dollars for gold in large numbers. In October of 1960, speculations of a weaker dollar pushed the free market price of gold up in the London markets from $35.20 to $40 USD. The US intervened in the markets and lowered the price back down to $35 USD per ounce. However, cross-exchange rates were not able to quickly adjust to the balance of payments disequilibrium and continued the risk of destabilization.

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