US Financial Crisis: Is It the Moment for Bretton Woods II?

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US Financial Crisis: Is It theMoment for Bretton Woods II?

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The Beginning of the End The US’ ‘exorbitant privilege’ of resorting to budget deficit tomeet its trade deficit becamemore destabilising when its budget deficit-backed expenditure on social programmes and VietnamWar came up so huge. The dollar overhang outgrowing its gold stock led to the dilemma Robert Triffin anticipated in 1960 in his great work Gold and the Dollar Crisis. To preclude lack of confidence in dollar, the US deficits would have to cease. But this would, give rise to the liquidity problem - the problem that the classic gold standard failed to address and the BrettonWoods system was formed to avert.Again to obviate the liquidity problem, US deficits would have to continue. But this would undermine the credibility of dollar. Thus, the post-War international financial system hatched at Bretton Woods was inherently flawed because of this catch-22 situation between the need for the US trade deficits to provide theworldwith international liquidity in the formofUS dollar and the risk of such deficits making the US dollar unattractive to hold. The growing pressure on the US for convertibility of dollar into gold by trade surplus countries finally ledRichardNixon, the then President of the US, to unilaterally sever the gold tie to the dollar onAugust 15th 1971 when its dominant gold position weakened

When the supply of two key international reserves - gold stock and the US dollar - proved insufficient to support the ongoing expansion ofworld trade and financial development, itwas decided to create a supplementary international reserve asset called the Special Drawing Right (SDR) under the auspices of the IMF in 1969 to fortify the threatened BrettonWoods fixed exchange rate system. SDRs, the value of which is based on a basket of key international currencies, are allocated to member countries in proportion to their relative size in theworld economy.The SDRis not a currency, but “a potential claim on the freely usable currencies of IMF members”.⁵ These currencies in exchange for the SDRs can be realised either through the arrangement of voluntary exchanges between member countries or through the IMF’s mediation whereby members with strong external positions are designated to purchase SDRs from members with weak external positions. However, this could not ward off the collapse of the BrettonWoods system that occurred 2 years later.

Dollar after the Demise of BrettonWoods

When the dollar went off the gold convertibility and the era of free floating exchange rates followed, the US dollar, far from being relegated to sidelines, actually - and paradoxically - became more desirable. This was because despite all its shortcomings, the US currency was deemed to be the safest one to hold forth. The guarantee of the US government was seen to be far more credible than that of any other country in the world. Therefore, it is an exaggeration to state that the whole of BrettonWood systemhas broken down.What broke down was the convertibility of dollar into gold and the concomitant pegged exchange rate regimes. But the US financial hegemony remained unaffected. This encouraged theUS to indulge in substantial trade deficits through its budget deficits since its domestic currency continued to double up as the international currency.

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5] “A Factsheet: Special Drawing Rights (SDRs)”, http://www.imf.org/external/np/exr/facts/sdr.htm, September 2008