A New Look at the Bretton Woods Agreement

This 23-minute podcast was released Oct. 2, 2019.

“The second World War was coming to an end, and there were many fears about what was going to happen to the world economy after the end of the war,” says Paulina Restrepo-Echavarria, an economist at the Federal Reserve Bank of St. Louis. She talks with Christine Smith, a St. Louis Fed web content strategist. They discuss the Bretton Woods agreement, the establishment of an international monetary system, European reconstruction, and winners and losers from Bretton Woods.

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Transcript

Christine Smith: Thank you for listening to Timely Topics. This is a podcast series from the St. Louis Fed. I’m your host today, Christine Smith, and joining me in the studio we have Paulina Restrepo-Echavarria. She is a senior research economist here at the St. Louis Fed.

Hi, Paulina. How’s it going?

Paulina Restrepo-Echavarria: Hi. How are you?

Smith: I’m doing well. So you’ve recorded several podcasts with us on subjects like search and matching, government debt, and sovereign debt specific to oil-producing nations. But today we’re going to talk about a subject that’s a little different, even historical. Right?

Restrepo-Echavarria: Hm-hmm [affirmative].

Smith: So this is the Bretton Woods agreement. And you’ve been researching this recently—

Restrepo-Echavarria: Yes.

Smith: ...and finding some pretty interesting things about it.

Restrepo-Echavarria: I have.

Smith: What was the Bretton Woods agreement and what did it entail?

Restrepo-Echavarria: So in July 1944, a new international monetary system was established. And what the system entailed was that all currencies were pegged to the U.S. dollar, and the U.S. dollar was pegged to the price of gold. So that’s pretty much a very brief definition of what the system officially was.

Smith: OK. And it’s significant, too, because it’s been 75 years since the Bretton Woods agreement was negotiated. And this was happening toward the tail end of World War II. I think there were 44 nations who participated in this?

Restrepo-Echavarria: Yes, that’s absolutely right.

Smith: So as the war was coming to a tail end there, what were their objectives in wanting to agree to peg global currencies to the U.S. dollar, which was then backed by gold?

Restrepo-Echavarria: So, it’s a very interesting time, I think. The second world war was coming to an end, and there were many fears about what was going to happen to the world economy after the end of the war for several reasons.

First, there were a lot of men who used to be in the Army fighting who were now going to join the labor force. There was a question of, would it be the case that labor markets are able or capable to absorb all of these new people that are going to come into the labor force? And there was no definite answer to that.

Then, because pretty much everything was in ruins. So we know that Europe in May 1945 woke up at peace but in ruins. And what is kind of striking is that if you look at the relative GDP of Europe, it went from being 63% of the U.S., to 30% of what the U.S. was. And so the outlook in terms of economic growth was very dark. They had expectations of very slow economic activity and they were very worried.

On top of that, you have to bring into the equation that there were fears about what had happened in the past. So when we think about economic activity, we think about two things: whatever is handled by markets and what’s handled directly by governments.

And there was a lot of fear about markets working by themselves because they had in mind also the crash of the stock market in 1929. And then, there wasn’t a lot of trust in governments because between World War I and World War II, a lot of them had driven voluntary devaluations in order to take advantage of trade with other countries. So there was a lot of suspicion, I guess, of certain governments.

So the world was in a situation where: Very bad outlook in economic terms, and no trust in markets and no trust in governments.

They basically came with a solution, and this is, one of the main motivations for Bretton Woods, which is: OK, if we don’t trust markets and we don’t trust governments, we need to make an agreement that will make everyone stick to one plan, which we think would be the plan that would make economic growth more successful. And so that gave rise to the system itself because the peg of currencies to the U.S. dollar would prevent any government from doing voluntary devaluations.

And the fact that the U.S. dollar was pegged to gold also kind of gave an anchor to the whole economy. It was kind of a way of enforcing that no one would deviate in some sense from the agreement.

Smith: We appreciate some of that context, too. So we know that basically, out of Bretton Woods, the dollar was going to be the international reserve currency—

Restrepo-Echavarria: Yes.

Smith: —it was going to be backed by gold at $35 an ounce, and then any country could then exchange dollars for gold in theory.

Restrepo-Echavarria: Yes, that’s right.

Smith: You mentioned in your paper that Bretton Woods has been studied pretty extensively. So I’m curious to know what made you want to take on something so complex?

Also, what makes the approach that you and your coauthors took unique? I know that you’re undertaking this in conjunction with Mark L. J. Wright, who’s the research director at the Minneapolis Fed, as well as Lee Ohanian, who is a member of the Hoover Institution and a professor at UCLA.

Restrepo-Echavarria: So in our research agenda, we’ve always had an interest on capital flows. So why is it that capital flows where it flows?

This is a perfect context to look at this issue because we know that, even though the main purpose of Bretton Woods was to have an international monetary system, what that monetary system at the end implied was that there were constraints on capital flows, or in other words, there were capital controls that were implemented.

So given that we’re so interested in, why does capital flow where it flows? This is a perfect context to look at it. So this is what drove us to this question.

And the second thing is that we study capital flows in a real economic context, meaning that we use models that are real. They’re not nominal. So we don’t have money or exchange rates literally on them, but we just have quantities. And so we were very interested to see also what a real model could tell us about an issue that in everyone’s mind is pretty much a monetary or a nominal issue. So this would be a completely new approach to the problem.

Smith: Based on the research that you’ve done, have you discovered that in your estimation, there were evident winners or losers in this agreement? And if so, why?

Restrepo-Echavarria: Hm-hmm [affirmative]. So this is a very interesting question. Let me go back a little bit in terms of the motivation of the project and how that’s related to the fact that we saw winners or losers. We started with the motivation of, we know that the expectations about economic growth were very gloomy. Right? They expected growth to be weak. They weren’t sure if increasing the labor force participation was going to be absorbed by labor markets, etc.

Well, it turns out that what happened was pretty different. Actually, the world grew at a pretty good rate, and we saw growth both in Asia, Latin America, Europe, the U.S. And so these predictions of a gloomy economic atmosphere did not realize at the end.

However, what we find is that Europe would have been able to reconstruct even faster than they did if it hadn’t been for the Bretton Woods agreement.

So when we look at capital flows during the ’50s and ’60s, you can see very clearly the effects of the agreement because capital flows were close to zero during that period. And if you look at growth, you can see that the rest of the world—Asia, Latin America, Canada, Australia, mainly—they were growing faster than Western Europe and faster than the U.S.

Capital, as theory would predict, did flow in larger quantities through the rest of the world. However, Europe was growing faster than the U.S.

And when I say that Europe was growing faster than the U.S. and that the rest of the world was growing faster than Europe, I mean TFP; so total factor productivity, in the rest of the world grew faster. Second was Europe, with the second largest growth in productivity, and third was the U.S.

But when we look at capital flows to Europe and the U.S., the U.S. received more capital flows than Europe did. And that goes against economic theory, because economic theory would predict that capital should flow to the areas or regions where productivity growth is largest.

This means that Europe did not receive enough flows—enough capital—to reconstruct. So any reconstruction that happened was completely domestic. It was internal. They basically self-financed their reconstruction. And what we find is that if there hadn’t been these capital controls or if it hadn’t been for Bretton Woods, then sure enough, Europe would have received much more capital inflows and, as such, would have been able to reconstruct much faster.

This means, nevertheless, that at the end of those 20-something years, they would have ended up being much more indebted than they were. And this would clearly have implications for welfare, and that’s something that we’re still working on. We don’t have definite answers.

But we do know that in terms of output, the contribution of Europe to world GDP would have been much larger. And we know that in terms of consumption shares, Europe would also have had a larger consumption share, especially in the ’50s, than we observed under Bretton Woods.

So if you want to think that you’re losing because you are not contributing as much to the world economy as you could, then one would have said that Europe was a “loser” in terms of the system. However, as I said, this doesn’t mean that it wasn’t good for them, in the sense that they did not end up owing so much to the rest of the world, which could have welfare implications. As I said, we’re working on this part of the answer.

Smith: How was it then, as a follow-up question, that Bretton Woods had maybe a depressing effect on Europe, or it kind of tamped down potential growth that it could have realized?

Restrepo-Echavarria: It tamped down potential growth that it could have realized, that’s right.

Smith: And why was that?

Restrepo-Echavarria: Because they were not receiving any investment from the rest of the world. So basically that investment that they could have received as capital inflows would have boosted, even further, their production, if you transform that into capital. So that could have definitely allowed them to produce even more than they did.

Smith: Can you tell me some more about your key findings? What have you observed as far as implications for world economic activity because of Bretton Woods?

Restrepo-Echavarria: The main implication is just that the world would have grown even faster if it weren’t for Bretton Woods. Because basically what we see is that capital is being allocated in the wrong way in the sense that, as I mentioned, productivity was growing faster in Europe than it was growing in the U.S. But capital “flew” in larger quantities to the U.S. Very small quantities, because, as I said, during those 20 years, ’50s and ’60s, capital flows were, at most, 2% of GDP. So that’s very small capital flows. But nevertheless, they should have gone to Europe.

We basically find that our methodology is very successful in letting us interpret Bretton Woods. But this is kind of a theoretical result; it really allows us to very cleanly identify the period in which we observe Bretton Woods occurring and, as a result, we can run these counterfactuals.

Because from the beginning, there’s nothing that would have guaranteed that our methodology was actually going to be very successful at explaining the system, because we are parting from a real model and not a nominal model. But what we can see is that, using consumption data, we are actually very successful in identifying the capital controls that were imposed during this time.

So it turns out that we identified that Bretton Woods not only affected international capital controls, but had an effect on domestic capital frictions, as well. We can identify the size and how they changed over time, as well.

Smith: Paulina, when Bretton Woods was being negotiated back in the summer of 1944, two names that often get mentioned include John Maynard Keynes and then Harry Dexter White. Can you tell me who was at the negotiating table and maybe even which nations had some of the power and advantages?

Restrepo-Echavarria: So we know that representing Britain, we had Keynes. And then we know that Harry Dexter White, who was a chief economist of the U.S. Treasury at this time, was negotiating on behalf of the U.S.

What turned out to happen is that Keynes was pushing for a reserve currency called the “bancor.” That’s ideally what he wanted to have. But we know that what ended up happening was that the U.S. dollar ended up being chosen as the reserve currency. So in my view (and this is my interpretation from reading all the accords and all the documents that were signed at the time), Britain was not in a position to have a big bargaining power. They were in a position where they were the ones who needed the resources to reconstruct, and they could not bear their weight basically in the agreement.

The U.S. was in the opposite position. So at the end, what we see is that the U.S. was mostly the one who decided on the terms, and a proof of that is that the reserve currency ended up being the U.S. dollar, and that was the currency that ended up being pegged to gold.

So it was mainly an agreement that at the end, the details were decided by the U.S.

Smith: So this is 2019. We’re no longer on the Bretton Woods agreement. The U.S. dollar may be as good as gold, but it’s not officially pegged to a gold standard.

Restrepo-Echavarria: Hm-hmm [affirmative].

Smith: So, Paulina, tell me why did this agreement come to an end? What were some of the factors that ultimately led it to fail?

Restrepo-Echavarria: So I think that people have in mind one particular factor, which is the U.S. could not sustain the agreement anymore. It is true that in 1971, Nixon suspended dollar convertibility into gold because U.S. gold supply wasn’t enough to cover all the number of dollars in circulation.

However, when you look at what happened during all those years, you see that the relative consumption of the U.S. was going down largely. Meaning that, if you compare the per capita consumption in the U.S. relative to the rest of the world for example, the consumption in the U.S. was going down relative to the rest of the world.

It was also the case that it was going down relative to Europe. So what this means for us is that in some sense one could interpret this as the U.S. was kind of “giving gifts” to everyone else, to the rest of the world. And the U.S. was sacrificing its own consumption, and this was brought by the agreement itself. So we do think that, even though the explanation or the reason that everyone has in mind is that the U.S. wasn’t able to hold the parity to gold any longer—and that broke and after that, then people might have had doubts in terms of the dollar being a reserve currency—we think that more than that, the U.S. wasn’t getting anything out of the agreement.

It wasn’t a good agreement for the U.S. They were losing a lot of consumption relative to the rest of the world, and so there was really no point in continuing on it. So from a real perspective, we think that for the U.S., it was good to end the agreement.

Smith: That’s interesting what you just said in relation to the United States. So if we were in a position of “giving gifts” and ultimately it wasn’t good for the U.S.—and then earlier, how you discussed that Europe may have grown a lot faster were it not for Bretton Woods—looking back, can you say this was a good idea? It had good intentions, but maybe it didn’t work out the way everybody expected it to?

Restrepo-Echavarria: So it’s very hard to tell. Thinking about the counterfactual for the overall economy of the world is hard. However, as you correctly say, we do know that the world would have grown faster.

Now, it’s difficult, right, because, given that the outlook was so gloomy on the world economy, it was very hard for them to predict that things were going to turn out so different.

I think that it would be very harsh to just say, it was a really bad idea. It’s very easy to say it in retrospect. But our results do point out to the fact that maybe those policies were not so successful after all.

Smith: So in the context of today’s economy, what are some of the relevant points that we can learn from Bretton Woods?

Restrepo-Echavarria: It’s kind of hard to extrapolate policies that were implemented in one period of time to a different one, because everything changes, and policies are different, affecting different dimensions of the economy.

One of the main messages that we’ve found in our research with Lee and Mark is that labor market frictions are extremely important for capital flows. So it could be that you lift all your capital controls, but if you have frictions in the labor market, then that still prevents capital from flowing where it should flow.

However, I would say definitely that something that we have learned from our research is that capital controls don’t seem to have positive effect on the economy. They distort the way in which capital flows, to some extent. We can see the example between the U.S. and Europe in the ’50s and ’60s which I mentioned before, which is at the end what happened was that capital flew in larger quantities to the U.S. even though productivity grew slower in the U.S. and in Europe during this time. And so capital would have been much better allocated if sent to Europe—when we focus only on that dimension, because there are frictions in different markets that will affect the optimal allocation of capital.

But, if anything, I do think that we see that we haven’t gained in the past anything by having capital controls. If anything, we’ve lost. And also, if you want to take the traditional approach to thinking about Bretton Woods, one can say, it’s pretty costly to maintain a gold standard if you want to go there, right, because it takes a lot of effort. You need to maintain the money in circulation at the right level given the reserves of gold that you have.

On the other hand, if you’re going to peg other currencies to that currency which is pegged to gold, it takes also a lot of effort from countries because they also need to have the right levels of international reserves to be able to be pegged to the dollar. My personal view is that it requires a lot of effort and it doesn’t seem to pay off, is at least what we’ve seen in our research. So I would say that what we can learn today, I don’t think that going the way of capital controls is the best way to go.

Smith: That’s really interesting. We’d be remiss to talk about Bretton Woods and not mention two big entities that came out of it. So we have the World Bank and the International Monetary Fund—

Restrepo-Echavarria: Yes.

Smith: —coming out of the Bretton Woods agreement, too. I was curious to know if you had any thoughts on the legacy of those organizations and maybe even how they’ve evolved from what their original intent was under Bretton Woods?

Restrepo-Echavarria: That’s a very good question. So we know that the World Bank started as the International Bank for Reconstruction and Development. That was how it was initially called, and it was meant to finance the reconstruction of Europe, or send the necessary capital flows to Europe in order to reconstruct.

We know that there were hardly any capital flows to Europe between the ’50s and ’60s. And supposedly the International Bank for Reconstruction and Development was created for that. It was created to transfer funds or resources to Europe to reconstruct. What that tells us is, it seems like they didn’t do what they were meant to do. What they were created for, they did not do it. When you look at the actual amounts that they transferred to European countries, they’re not large, they’re not large at all, and so much so that you cannot see it in net exports. It’s not reflected in national accounts.

Now, how it has evolved now, you know, we know that it’s now the World Bank and it’s aiming towards development and improving equality. So to that extent, I think that it kind of evolved to an organization that is important worldwide. The world definitely needs an organization that aims towards decreasing inequality. My point is that we don’t really see in the data what we should have seen from the effect of the creation of the International Bank for Reconstruction and Development at the time.

Now in terms of the IMF, did they do their job when the IMF was created? Well, it seems like they did, because if their job was to control speculative capital flows, and we know that there were no capital flows during these two decades. Well, to that extent, it seems like they clearly controlled speculative capital flows. Now, the IMF has evolved to something very different, in my mind. I think that the IMF has now transformed into a “lender of last resort.” The IMF is basically the entity that rescues any country from default situations. So they’re very important when it comes to resolving that crisis.

It’s important to have a lender of last resort. I mean, we see countries like Argentina who repeatedly defaults, and the IMF is always there. The other thing that they do nowadays is that they impose fiscal stability in all the countries around the world basically. They’re like the economic police. They’re after every single country, checking that their fiscal deficits are not too large, that they’re able to repay their debts, and when they don’t, they stand by them.

So I think that that’s now the role that they play more than controlling speculative capital flows.

Smith: That’s interesting then, that the World Bank, as you mentioned, it was originally the International Bank for Reconstruction and Development and it was supposed to provide assistance to countries that had been ravaged by World War II. And now it’s kind of focused on reducing extreme poverty and then increasing prosperity around the world.

And the IMF, then, is the lender of last resort. Like, financial crisis hits, IMF is there.

Restrepo-Echavarria: Yes.

Smith: But you don’t want the IMF, you don’t want them to have to be there for you—

Restrepo-Echavarria: Exactly.

Smith: —to avoid financial crisis. Well, thank you so much for your thoughts today on Bretton Woods.

You can go to research.stlouisfed.org to find more of Paulina’s research on this and other subjects. And you can also go to our website, stlouisfed.org/timelytopics for more of Paulina’s podcasts. Finally, you can listen to this on any of your favorite podcasting apps, whether that’s Apple Podcast, TuneIn, Spotify or Stitcher.

Thank you so much for joining us today, Paulina. It’s been a pleasure speaking with you.

Restrepo-Echavarria: Thank you so much for having me.