In the days when physical gold was used for both domestic and international trade the international element presented no difficulties - trade was trade regardless of whom it was with and gold was the medium of exchange. However increasingly from the 18th century onwards as the industrial revolution gathered pace pound sterling notes became acceptable substitutes for gold, both in Britain and abroad, because the BoE not only 'promised to pay the bearer on demand the sum of .....', but did indeed (mostly) exchange the note for the equivalent value in gold. However, notes were never quite as secure as gold. During wartime when conditions caused gold shortages the Bank, on instruction from the government, was forced to restrict payment in gold in order to preserve its gold stocks, but later resumed payment when conditions improved. After the First World War, in 1925, the government again restored payment in gold, but only in quantities of 400 ounces or more. In 1931 Britain was forced to abandon the gold standard once again, and has never since restored it.[256]
After the First World War the world economy was in a mess. There erupted a series of economic crises - hyperinflation in Weimar Germany due to punitive and unpayable reparations[257], severe deflation in Britain following the 1925 restoration of the gold standard, and the Wall Street crash and subsequent worldwide depression. In fact it was only with preparations for the Second World War that high levels of production resumed, demanded by the war effort. During the war it was clear to all that something radical was needed in order to stabilise national currencies and to put world trade on a much more sound footing. Plans were being drawn up by Germany and also by the UK and the US, each assuming victory by its own side. By the time the war began to favour the allied powers Britain and the US started to negotiate in detail a post-war arrangement, to which all parties would be invited to join, aimed at avoiding the disastrous economic outcome of the First World War and providing for post-war reconstruction. Those negotiations culminated in the Bretton Woods conference and agreement in 1944, the story of which is superbly told by Ed Conway in his book 'The Summit' (Conway 2014).
Almost forgotten now, the Bretton Woods conference in 1944 was a pivotal moment in world economic history. It was the one and only time that world economic experts came together to design and agree an international financial system whose aim was to encourage and organise international trade for the benefit of all participants. It was led by the US and UK, and had its roots in the knowledge that economic failures after the First World War, especially the levying of punitive and unsustainable penalties on Germany, was a significant factor in leading to the Second World War. Although the war was still raging, the allied invasion of Normandy had begun just a month earlier and the allies were by then confident of ultimate victory. It was recognised that in order to preserve peace and international co-operation in the future it was necessary to establish a fair, stable and strong international financial system, and to have it ready when peace finally came. It was believed, quite rightly, that the more that countries established mutual dependence the less likely they were to go to war.
It was so important a development, and contains so many lessons that are as relevant today as they were then, that it is worth exploring what it was and what it did in some detail.
The two main contributors were Harry Dexter White for the US and John Maynard Keynes for the UK. Both men were highly intelligent and experts in their field, and had discussed and submitted their own plans beforehand. The two plans had both significant points of agreement and significant points of disagreement.[258]
The UK was very heavily in debt to the US, which made it very much the poor relation, and the US by far the strongest player at the table. Although Keynes had developed a more sophisticated plan the US was able to enforce in preference its own plan, in which the US dollar would in effect be the international currency, a role it has held ever since. As mentioned earlier the system established at Bretton Woods lasted until 1973, following the breakdown of the link between gold and the dollar in 1971, an outcome that Keynes had foreseen and which his plan would have avoided.
It is worth looking at Keynes' plan in more detail, not only because it achieves what the world needed at the time and still does in terms of fair and equitable international trading, but also because it is beginning to be considered again following the 2008 crash.[259]
Keynes began by considering the negative effects of world trade as then established:
i. Firstly it was based on the transfer of gold for wealth, which worked well as a currency of universally acknowledged value, but restricted trade to the availability of gold, and made hoarding advantageous to the hoarder (obtained by exporting) as it became less available and therefore more valuable, and correspondingly disadvantageous to everyone else, especially importers. Therefore international trade should not use gold, or at least should not be restricted to gold. Hoarding gold by excessive exporting is the international version of taking money out of circulation, and it has exactly the same effect as it does domestically - it reduces the ability to trade wealth.
ii. Secondly trade imbalances are caused just as much by excess exporting as by excess importing, so the obligation to restore balance should be shared by both sides instead of being placed wholly on the side of excess importers - a situation that is still in place today. Although there are pressures on both sides to rebalance (excess exporters see their exports becoming dearer and imports becoming cheaper, and vice versa), those pressures are not felt equally. If an excess exporter chooses to continue to export to excess, even if it has to reduce prices to maintain demand, then there is nothing to stop it from doing so - there is no ceiling to the amount of gold that they can accumulate. However an excess importer can't continue to import because eventually it runs out of gold and is forced either to stop or to borrow, but if it borrows the borrowing also stops when creditors fear that they will never be repaid. There is a very definite floor to the amount of gold that importers can lose or owe.
iii. Thirdly the existence of restrictive trade practices (import tariffs and quotas, export subsidies, currency devaluations etc.) represent attempts to improve a country's economic position at the expense of other countries and usually lead to similar reciprocal actions in other countries - known as beggar-thy-neighbour policies, thereby harming all parties and severely damaging world trade. Therefore any new system should encourage world trade and discourage restrictive practices.
Keynes recognised that threats to his scheme would come from individual countries feeling unduly disadvantaged by it, so he deliberately made the scheme attractive to join, avoiding any hint of compulsion or coercion. He further deliberately avoided any pressure to disrupt existing arrangements for international trade between countries or groups of countries; for bilateral currency agreements between central banks; or for restrictions on countries' ability to pursue their own interests through trade restrictions, though he hoped that the new measures would apply strong discouragement.
Countries would be encouraged to join both as members and non-members, members having a say in the running and management of the scheme, but all enjoying the benefits in terms of trade.
The essence of what he proposed was as follows:
i. The main administrating organisation of the scheme would be the International Clearing Union (ICU), governed by a board consisting of representatives of member countries.
ii. There would be a new international currency - the bancor (bank gold) - only ever held inside the ICU and having no material existence other than as records in ICU books. Bancor would have no use other than for international trade, and bancor balances would earn no interest from the ICU (though they might be charged interest - see vii). All currencies would initially have fixed exchange rates in terms of bancor, to be agreed between the participants themselves. Thereafter any exchange rate changes could only be made by agreement between the countries involved and the governing board.
iii. The governing board would fix the exchange rate between gold and bancor, and to avoid the bancor depreciating against gold outside the governing board's control member states would not be permitted to buy gold for more than the equivalent bancor price in terms of their own currency. No-one would be likely to sell gold for less than this value because they would be better off selling it to the ICU.
iv. Countries would be free to sell their gold reserves to the ICU for bancors, which would be credited to their account, but they could not sell bancors for gold. Keynes hoped that by these means gold would gradually disappear as a medium of world trade.
v. Each member country would begin with a zero bancor balance in its account at the ICU, but would be assigned a quota, measured in terms of bancor and based initially on its pre-war international trading volume. The quota would determine its level of responsibility for the management of the union and also the level of credit facilities provided by the union. Quotas would be subject to periodic review.
vi. Trading would continue between countries in the manner that was normal when the international gold standard was in force prior to the First World War, each importing from and exporting to others. At that time each pair of trading countries periodically cleared their outstanding balances by the transfer of gold from the debtor country to the creditor country. This transfer might be by physical shipment or merely by a change of ownership of gold in a trusted vault such as that held by the BoE. In the ICU system bancors would represent the equivalent of gold, and would be transferred between the countries instead of physical gold by crediting the ICU account of the creditor country (net exporter) and debiting the ICU account of the debtor country (net importer). The intent would be to make transfers at the ICU at the same frequency and times as transfers of gold were made under the old system.
vii. Countries with excessive debits or credits of bancors (measured relative to their quota) would be penalised for maintaining excesses by the levying of interest, though they would be free to lend and borrow bancors between themselves at rates that suited them in order to keep them active rather than lying idle and to avoid interest payments to the ICU. This is of vital importance - both debtor and creditor countries would have equal disincentives to run with high levels of bancor credits or debits - both would be responsible for correcting imbalances. The prevailing situation both then and now is that the responsibility for imbalance correction sits firmly with the debtor country, which is perverse as the debtor has little room for manoeuvre (as does anyone who needs to borrow) whereas the creditor country has a great deal of room (as does anyone with excess money to lend). If both share the responsibility the creditor is incentivised to import (not necessarily from the debtor country but from anyone in the system) so as to reduce its bancor balance, and the debtor is incentivised to export (again to anyone in the system) so as to increase its bancor balance.
This simple device would enhance world trade and help both economies at the same time as correcting the imbalance. If the responsibility lies wholly with the debtor then all it can realistically do is implement policies that cut down on imports - it can't force anyone else to buy its exports and there is no particular incentive for them to do so. Import reducing policies - raising interest rates and cutting public expenditure to limit spending by the public - reduces world trade and corrects the imbalance by shrinking the debtor's economy, causing great hardship for the population.
In a nutshell it is far better for a debtor country to expand exports than cut imports, thereby expanding world trade instead of contracting it. The principle behind Keynes' proposal was that creditors must buy what debtors have to sell. The ability to lend unused bancors was also important as it encouraged keeping them in circulation for trade purposes rather than having them lie idle.
viii. The system would be truly multilateral - exports to any country could be used directly to fund imports from any country via the clearing system embodied in the ICU. This is very different and much more powerful than the prevailing situation both then and now of many separate trading arrangements.
ix. The role of capital transfers in destabilising economies was well recognised from experiences between the wars, so countries would be strongly encouraged to restrict speculative capital transfers while still allowing transfers for legitimate investment purposes.
'The lesson that the main protagonists at the conference - John Maynard Keynes and Harry Dexter White - took from the economic chaos of the interwar experience was that a regime of unfettered capital flows (allowing money to cross borders freely for the purpose of buying and selling a country's financial assets as opposed to buying and selling goods and services) is fundamentally inconsistent both with a government's aim to achieve full employment and with liberal international trade. The reason is that significant capital flows have a destabilising effect on an economy and lead to calls for protective trade barriers. Therefore they preferred free trade to free capital flows - especially to short-term 'hot money' flows and flight capital. Hence the emphasis in the IMF's Articles of Agreement (drawn up at the Bretton Woods Conference) on currency convertibility for trade in goods and services rather than for trade in financial assets, and explicit recognition that countries may need to impose capital controls.[260]
Also free trade should not be seen as more trade. There is a great desire to trade internationally in spite of its cumbersome current nature. What Keynes' plan would have achieved in a properly managed manner is much more world trade in goods and services from which everyone would have benefited, without free movement of capital which benefits the few at the expense of the many.
By these provisions Keynes' system would have enhanced both world trade and international stability, rather than restricting world trade and threatening international stability. In short it was exactly what the world needed both then and now, but the US was having none of it. The US was the world's biggest creditor and had the biggest share of gold, so it saw no reason why it should in effect be penalised for enjoying so happy a position. Instead the White plan prevailed - because he had the power to insist - where gold was retained as the basis of international trade; the dollar was pegged to gold and all other currencies pegged to the dollar; multiple bilateral trading continued; and debtor countries bore full responsibility for correcting trade imbalances. Common to the two plans were proposals for the creation of an International Monetary Fund, designed to monitor exchange rates and lend reserve currencies to countries with trade deficits, and an International Bank for Reconstruction and Development, now known as the World Bank, initially to fund reconstruction after the Second World War and then to provide underdeveloped countries with capital. Both institutions survive today, though their functions have changed radically over the years.
It was never a foregone conclusion that the conference would reach agreement. Delegates had to convince their home governments to sign up and there were plenty of misgivings around the world. Right up to the last minute horse trading continued, until finally all signatures were obtained, the deal was done, and everyone could go home, thoroughly exhausted but deeply satisfied.
Nevertheless there were still major objections. The Wall Street banks in particular were desperate to prevent the agreement from becoming law. They had been doing their best to discredit both Keynes' and White's plans with equal vehemence ever since they had seen copies of them. Their motives were understandable; both plans would severely disrupt their business. During the interwar years the banks had provided loans to stricken countries - Britain had become dependent on loans from J P Morgan. Not only would White's scheme make the IMF the main port of call when a country faced a crisis, but it proposed to regulate international capital flows and foreign exchange, two of Wall Street's other profitable activities. There were many gruelling hearings, but the argument used by both White and the US Treasury was that if the US rejected the agreement it would put the country at risk from a possible third world war - this was a powerful argument indeed. As Conway put it: "The New York bankers, the only effective opponents of the bill, were repeatedly lambasted as wanting, for their own immoral reasons, to drive the world towards another war." (Conway 2014 pp300-301). The bill was passed by 345 votes to 18 in the House and by 61 to 16 in the Senate. By July 1945, Bretton Woods was officially law in the US (Conway 2014 Chapter 13).
In all fairness to the US it was extremely generous in providing funds and materials for the reconstruction of war-torn countries after the Second World War, both as direct aid and as cheap loans, and the world enjoyed more than twenty years of stability and high growth thereafter. Although it wasn't bound by the restrictions to which the Keynes plan would have subjected it, nevertheless it provided massive support voluntarily and freely. The policy was reinforced by political motives, in that the US recognised the potential attraction of communism to countries in desperate need of the means for their populations to survive, so generosity in providing aid countered any such attraction. Nevertheless it would be quite wrong to be critical of the US.
The US was the only country strong enough to fund the rebuilding of Europe and other devastated countries after the war, and it is to its great and enduring credit that it applied its enormous strength to do precisely that.
However the White plan did incorporate instabilities, which surfaced eventually and inevitably, and were made worse by the developed world's subsequent love affair with neoliberalism.
Keynes' ICU was perhaps the greatest of all his insights. It would have revolutionised and stabilised world trade without handing power to international creditors. It would have benefited everyone in the world, and would very likely still be in place and working well today. We would have avoided the chaos of floating exchange rates after the US was forced to abandon gold convertibility - the inevitability of which Keynes foresaw. Sadly however Keynes' plan was just too far ahead of its time. Hopefully it will be recognised that its time has now come.
Paul Davidson[261] and Joseph Stiglitz (Stiglitz 2006 Chapter 9 pp245-268) have both developed systems based on Keynes' plan that could be implemented today.
The experiences after the Second World War when the US gave aid to Europe and Asia contain valuable lessons that deserve more widespread acknowledgement and understanding. There were two major aid programmes - Western Europe (the Marshall Plan)[262], totalling $13 billion between 1948 and 1951; and Asia[263], totalling $6 billion up to 1953. In today's money the equivalent would be about $200 billion in all, not to mention the very substantial aid that was provided during the war itself - that's quite a gift! This was mentioned earlier in chapter 48 section 48.6.
The Marshall Plan represented about 2% of US output and lasted for four years, yet no US citizen felt deprived of goods or services because real income per person was still 25% more than it was in the last peacetime year of 1940 (see Paul Davidson's proposed system based on Keynes plan referenced above). The aid was spent on importing US produced food, goods and materials so US exports and employment boomed - and there was plenty of spare capacity in the US as troops came home looking for work. Paul Davidson highlighted the benefits that all enjoyed:
For the first time in its history, the United States did not suffer from a severe recession immediately after the cessation of a major war. The US and most of the rest of the world experienced an economic 'free lunch' as both the potential debtor countries [which they would have been if the US had lent rather than given the money] and the creditor country experienced tremendous real economic gains resulting from the Marshall Plan and other foreign aid give aways. (From Paul Davidson's proposed system referenced above.)
In other words the US gift both paid for itself and kept on paying as all countries enjoyed unparalleled growth and prosperity throughout the 1950s. This shouldn't really be surprising when we recall that money is not a commodity that is used up, but a lubricant that facilitates transactions, and transactions provide the willingness to create surplus wealth - the capacity for which already exists within all human beings. The US gift enabled all countries - giver and receivers - to apply their efforts to best effect in creating surplus wealth, and it was surplus wealth, amplified by the income multiplier - see chapters 16 and 17, that rebuilt Europe and Asia and brought everyone unequalled prosperity.
As members of prosperous societies this is a lesson we would do well to remember when we sympathise impotently when faced with the great sufferings of the world.
After the great recession there is massive spare capacity in the developed world - spare capacity that could be well utilised in relieving world suffering. With a modern spirit of generosity like that shown by the US after the Second World War we could do so much more - not only for the sufferers but also for ourselves.
The Bretton Woods system of monetary management established the rules for commercial and financial relations between the United States, Canada, Western Europe, Australia and Japan in the mid-20th century. It was the first example of a fully negotiated monetary order intended to govern monetary relations between independent nation states. Each country agreed to adopt a monetary policy that maintained its exchange rate by tying its currency to the dollar, and the IMF undertook to bridge temporary imbalances.[264]
The roles of the IMF and World Bank were hardly established when the US embarked on its massive aid programme to both Europe and Asia. The amounts involved swamped anything the new international organisations could muster so they remained largely ineffective in their early years. Only later did the World Bank begin to carry out its objectives of funding the development, infrastructure and anti-poverty programmes in the undeveloped countries of the world. The IMF fared even worse. It was largely emasculated when Britain massively devalued sterling in 1949 in order to improve export competitiveness and reduce its wartime debts. It didn't even consult with the IMF before doing this, though it did consult with the Truman Administration. It was only much later that the IMF became a player in world monetary relations, a period that began when the United States used the IMF as a vehicle to make an enormous loan for Great Britain after the Suez crisis in 1956-7.[265]
During this period world trade expanded at its most rapid pace of the 20th century. Between 1948 and 1968, the total volume of merchandise exports from non-communist countries grew by 290%, a rate that far exceeded the expansion in world output. However the extent to which this was due to the Bretton Woods agreement itself, to US generosity in funding post-war reconstruction, or to other factors such as technology, is debated. A paper by Andrew Terborgh of the London School of Economics in 2003[266] argues that the stable environment for multilateral payments established at Bretton Woods had a significant effect in allowing trade to flourish. This seems very plausible, especially considering that the biggest increase in world trade occurred in the 1960s, well after the US aid programmes had ended. This is strongly supported by another important study by Andrew Rose of the University of California in 2000[267], which shows that a common currency has a dramatic effect on international trade, also showing, conversely, that having different currencies severely limits international trade. This is unsurprising given that exchange rate volatility creates very high risks for businesses that import and export goods and services, risks that can easily wipe them out completely during periods of large adverse rate movements.
The period was also characterised by an extraordinary level of financial stability in comparison with earlier and especially later times. The chart in chapter 50 (figure 50.1) shows this clearly.
Nevertheless the system contained the seeds of its own destruction. The whole system relied on the US dollar as its anchor, and the dollar therefore became the world's reserve currency. A reserve currency confers significant advantages on its home country. A single dollar bill worth $100 costs the US only a few cents to print, yet because it is valued throughout the world at its face value it can buy wealth worth $100 and be retained by the country selling the wealth because it knows that it can use it in paying for wealth from other countries. In other words the US can exchange paper for wealth. The benefit of this to the US has been estimated to be in excess of $100 billion per year.[268] The same applies to a lesser extent for other reserve currencies, most notably today for the Euro which represents 21% of world reserves.
However there are also disadvantages in having the home currency as the rest of the world's