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[Economy] Bretton Woods and Fixed Exchange Rate system : Meaning ExplainedPosted By On 27/10/2012 @ 10:27 pm In Economy | 86 Comments

1. What is Bretton Woods?2. Why is important?3. Result of Bretton Woods4. Main Players in this Conference5. Impact of World War II on Economy6. Agenda of conference7. Fixed Exchange Rate system.8. Roosevelt Vs Mohan:9. Fast forward to 1970s

10. Inflation and Gold Prices11. Do we need Bretton Woods?

While reading newspaper columns about global economy or Eurozone crisis etc. you may have comeacross a sentence, multiple times : “we need another Bretton woods.” so,What is Bretton Woods?It’s a place in New Hampshire State of USA, just like BASEL is a city in Switzerland.Why is important?

In 1944, President Roosevelt hosted a conference here, to rebuild the world economy, after SecondWorld War.Delegates of 44 allied nations (�म� रा�) had came to participate in this conference.Officially it is known as United Nations Monetary and Financial Conference, commonly known asBretton Woods because of the place where it was held.This conference resulted into creation of four extremely important things

Result of Bretton Woods

1. IMFThey give short-term loans to help nations settle the balance of payment crisis.They’ve a system called “SDR” :Special Drawing rights. (requires another article)

2. World BankOfficially known as IBRD :International bank for reconstruction and Development, that timeThey give long term soft loans to rebuild the third world.Soft loans= interest rate is very low. Sometimes you don’t have to pay back the principle.

3. GATT (General Agreement on Trade and Tarrif) – later becomes WTOTo facilitate the international trade.This will later become WTO. Already written an article on this.

4. Fixed Exchange Rate system. (although Discarded in 1970s)Explained in this same article.

Main Players in this meeting

Total 44 nations participated, but Main players were:US President Franklin D RooseveltUK Prime Minister Winston ChurchillLord John Maynard Keynes, Famous economist, UK treasury advisor.

India @Bretton Woods

Absent from the meeting: Mohan, Montek, Pranab, and Chindu (good otherwise they’d have messed upInternational Economy, just like they did to Indian Economy.)India was represented by Sir C.D. Deshmukh, he was the first Indian Governor of RBI, Thisgentleman had cracked IAS exam in British-raj ,known as ICS exam in those days. And No, he is notthe grandfather of Ritesh Deshmukh.

Back to the topic,

Impact of World War II on Economy

Second world war started in 1939, ended in 1945There is large scale bombing and destruction in the world. Production has declined.Agriculture, Dairy, Manufacturing, Export- everything is brought to standstill=huge inflation

Agenda of conference

Help rebuilt the World Economy. Provide money, loan, finance to needy nations. (World Bank)After WW2, lot of colonies will get independence (India, Sri Lanka…), they’ll introduce their ownnational currencies without control of big superpowers (Britain, France etc) and they’ll enter ininternational trade in their own capacity.(Exchange rates, IMF)Hence, Some rules/order had to be created to facilitate smooth international trade. (GATT)

Fixed Exchange Rate system.

What is Fixed Exchange Rate System?

Under this system, if RBI says $1=30 rupees, and you’ve 30 rupees and want to convert it in dollarsbut the Foreigners are willing to give 1 dollar to you…don’t worry.RBI will accept your 30 rupees and give your one dollar out of its own reserve and vice versa.Cons are obvious : When India is not exporting enough and not attractive enough foreigninvestment (in dollars) and still RBI keeps paying people in dollars, one day the bank lockers will beempty, there will be no dollars to pay. System will collapse.But it has Pros (advantages) in the times of uncertainty- When you’re writing on a clean slate, afterWW2, if every nation decides to have a fixed exchange rate system- it leads to stability andpredictability in Exchange rates = good for foreign trade.

Roosevelt Vs Mohan: Pegging the Currencies

(Fictional, technically incorrect, imaginary)

President Roosevelt: ok I say we put fixed exchange rate system. Let’s fix the rates that 40 Rupees willequal to 1 dollar. 15 Yens will equal to 1 dollar. 12 Pounds will equal to 1 dollar and so on. In short, I’mpegging your currencies to US Dollar. Thus Dollar will be the international reserve currency. AND Yourcountry’s RBI (central bank) will make sure these exchange rates don’t fluctuate more than 1% from thesevalues.

Mohan: ya man, but what if the exchange rate fluctuates? for example, What If I start running my countryin a totally pathetic and irresponsible manner and hence nobody wants to invest in India so supply ofdollar is low but demand of dollar is high- because Indians love gold and we’ve to import crude oil and payin dollars. In short, this will fluctuate the exchange rates between Dollar vs Rupee.

President Roosevelt: Let me ask you a question. Suppose Onions are selling 100 rupees a kilo because oflow supply but suddenly farmers produce fresh new 50 million tonnes of onions and supply it to market,what will happen?

Mohan: Easy! Onion Price will drop down to 40 rupees a kilo because the supply has increased.

President Roosevelt: yes dude, the same way, whenever exchange rate fluctuates from our standard rate,you’ll tell your RBI to supply dollars from its own forex reserves in to the market to calm down the demandand bring the rate back to normal level.

If the reverse happens: (Onions are selling @ 2 rupees a kilo) then you tell your RBI to buy all Onionsdollars using its own rupees, until the supply is reduced and price is back to normal.

Mohan: What nonsense is this? If 40 rupees equals 1 dollar but then what does 1 dollar equal to? What isthe value of your own dollar? Why should we accept your dollar as international reserve currency?

President Roosevelt: I’ve fixed the value of your currency to my dollars. And I’m fixing the value of my owndollars to Gold. 1 ounce of Gold shall equal to 35 dollars. Meaning you walk in with 35 dollars in my RBI(Federal Reserve Bank of USA), and you’ll get one ounce of gold in return. Gold will remain preciousforever. So, it’s not like we’re running the show in thin air. Dollars are backed by GOLD.

Mohan: ya man but what if my RBI doesn’t have enough dollars in its lockers? What will we do then?

President Roosevelt: don’t worry, come to IMF. They’ll arrange short term loans for you, in dollars.

Mohan: but still, why should we fix price of our currency to dollars? Why should we accept dollar as thereserve currency and not Yuan, Yen or Pound? Why should we accept you as our big boss?

President Roosevelt: Because I’ve the aukaat to pay enough gold, so I say dollars will be the internationalreserve currency. IF you’ve enough gold reserve in your RBI, come sit in the chair and we’ll see whetherrupee is strong enough to become the international reserve currency or not.

Even Britain is so financially bankrupt after Second World War, they don’t have the guts to tell me set thisexchange rate according to their Pounds. Btw, I also got some nuke missiles in my limousine.

Mohan: no no…I was just kidding man. I’m well aware that you’re the superpower both financially andmilitarywise.

President Roosevelt: Besides When we’ve a stable and fixed exchange system like this, it’ll ensure smoothand long term trade deals between merchants of various countries. When you don’t have fixed exchangerate system, it is bad for economy. For example, today your call-center boss may give you free lunch andcoffee because $1=60 rupees but next day when value of rupee declines and it is $1=50 rupees, sameboss will even stop running the water-cooler in your office. Third day when $1=40 rupees, He will just kickyou out because outsourcing generate that much profit for him. Such uncertainty, is not good foreconomy.

And since Gold is in limited supply, Dollar will be spent carefully, and so your currency will be in spentcarefully. i.e. Since currencies are ‘pegged’, you will not indulge in extravagant spending in subsidies,welfare schemes, tax-reliefs or debt-waivers to farmers. This ensures fiscal discipline => That ensures lessFiscal deficit = less inflation.

Mohan: Mr. President Sir, I think I got the point now. I’ll tell my RBI Governor here to sign the BrettonWoods agreement papers, because fixed exchange rate system sounds safe and good.

Fast forward to 1970s

As you can see, the fixed exchange rate system, is good for stable international trade environment,atleast on paper.But this system can run smoothly only as long as USA has the aukaat to pay gold to every swingingdude that walks with dollars into their RBI (US Treasury).Problem started with Cold War. Both USA and USSR (not Russia), are busy in an arms race, buildingnew tanks, missiles and submarines every week.They’re also giving huge donations and help to poor nations, in order to win their support anddominate the region. This is a non-productive activity, they’re basically wasting money.Now, USA gets involved in a very lengthy and expensive Vietnam War from 1959 to 1975.

Inflation and Gold Prices

Fact: War leads to inflationFact: Inflation decreases the value of your money.Fact: Gold becomes more expensive because of Inflation.US still kept fixed value of 35 dollars = 1 ounce of gold. But thanks to this inflation, Gold is tradingat higher price in open market – 40 dollars per ounce.So there is an opportunity to make quick money, just tell the RBI manager to take suitcase full ofdollars from RBI’s locker to US Federal Reserve, take their gold in return, and sell it to the localjeweler at higher market price and use this profit to fix india’s problems- poverty, education etc.(may be by starting another welfare scheme named after Nehru-Gandhi family.)For a while, US Presidents had enough clout over international politics so that they could forceother nations’ RBI managers not to indulge in such cheap profiteering. But Vietnam war is fastdeteriorating America’s clout and now RBIs of various countries have started lining up with theirsuitcases full of dollars and they want gold in return.1971, President Nixon decides that if we continue giving gold for dollars, we will go bankrupt. Therewill be no gold left in our lockers. So I give up. I’m not going to let anyone exchange their dollars formy gold.And thus Bretton Wood system breaks down.1973, World moves to floating exchange rate system.What is Floating Exchange rate? Governments / Central Banks don’t fix exchange rates here. It isleft to the Forex markets, private players and laws of supply and demand.Government /RBI will onlyintervene if there is huge fluctuation in the exchange rates.

Do we need Bretton Woods?

With respect to the Eurozone crisis (click ME), many columnists write “We need another BrettonWoods”.They don’t actually mean that we need to move back to the same old Fixed Rate exchange system,in which every currency was pegged to Dollar and Dollar was pegged to Gold. Because that fixed

rate thing is impractical in real life scenario, as we saw in above paragraphs.Just imagine, if tomorrow World starts running according to Bretton Woods system, what willhappen?We know that China already has more than 1000 billion dollars in its Forex Reserves. So People’sBank of China will send its Probationary officer with suitcases full of dollars and take away all thegold from Fort Knox*. They don’t even need to fight a war, USA will come down to its kneesfinancially.[*Fort Knox is a place in Kentucky State, US Government keeps the gold reserves in this place.]In real life, not that China will actually do so, but the mere threat and possibility will keep USA on itstoes. Hence US will not agree to Fixed Exchange rate in the first place.There is no chance any other country will agree to become the ‘big brother’ and let their currencybecome the reserved currency and peg it to gold.Especially India, because if we peg our 10,000 Rupees to one ounce of Gold and declare that we arethe new international reserve currency, just like dollar before 1970s, What will be the Result?Pegged currency means Government can’t do extravagant spending in MNREGA. They’ll have tostop subsidy on diesel, kerosene, LPG and fertilizers, because they can dole out only as muchrupees as the amount of gold held in RBI’s locker.As You can understand, no political party has the guts to do that, hence no nation will want tobecome the big brother or Sacrificial goat (Bali kaa Bakraa) for “another Bretton Woods”.So, The sentence “We need another Bretton Woods” is just a metaphor, to say that all the Presidents,Prime ministers and Economists of the world should meet up once again and hold conference insome gambling den, drink some Desi liquor (दसेी दा�), watch some Item-song, brainstorm for newideas and start something from scratch, totally new, Just like the Gentlemen at Bretton Woods did,in 1944.

Then what to do?

It could be anything, untried and untested before like-China could agree that we’ll not dump our products in foreign market, we will not keep our yuanunder-valued,US could agree that we’ll bring back our troop from Afghanistan and cut down on our DefenseExpenditure and its inflationary effect on world economy. We will also stop supporting Pakistan.Thus reducing defense Expenditure of India in the arms race= that will also reduce fiscal deficit ofIndia= India could decrease taxes=boost for economy and world trade.Iran could agree that we’ll stop our irrelevant obsession with nuke weapons and give up, So that UNremoves the sanctions and our traders can make more money, thus improving the standard ofliving for Iranian aam-aadmis.EU could agree that we’ll kick out Greece, because it’s just way too messed up beyond fixing.And India could agree that we’ll bring all the black money from Switzerland and use it to financeour bogus Government schemes and subsidies instead of looting the aam-aadmi via direct andindirect taxes, to finance those things.And finally you and I could agree that facebook is a waste of time, so a serious Aspirant shouldconcentrate on his studies instead of uploading funny/motivational photos there.

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