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International Trade and Finance

Notes trade, BOP deficits (and surpluses) of countries increased. This necessitated the supply of gold
and of the dollar. But the production of gold in Africa was increasing very little. This led to
larger demand and holdings of the dollar. Countries also wanted to have more dollar holdings
because they earned interest. As the supply of dollars was inadequate in relation to the liquidity
needs of countries, the US printed more dollars to pay for its deficits which other countries
accepted as reserves.

The Bretton Woods System finally collapsed in 1971, and this was caused by the so-
called Dollar Crisis of 1971. The dollar crisis stemmed from the US balance of
payments deficits.

4. Mistakes in US Policies : The BOP deficits of the US became steadily worse in the 1960s. To
overcome them, the policies adopted by the US government ultimately led to the world crises.
Rising US government expenditure in the Vietnam War, the financing of US space programme
and the establishment of the “Great Society” (social welfare) programme in the 1960s led to
large outflow of dollar from the US. But the US monetary authority (FED) did not devalue the
dollar. Rather, it adopted monetary and fiscal measures to cut its BOP deficit.
5. Destabilising Speculation : Since countries with “fundamental disequilibrium” in BOP were
reluctant to devalue their currencies and also took time to get the approval of the IMF, it provided
speculators an opportunity to resort to speculation in dollars. When devaluations were actually
made, there were large doses of devaluation than originally anticipated. This was due to
destabilising speculation which made controls over capital flows even through monetary-fiscal
measures ineffective. This was the immediate reason for the UK to devalue the pound in 1967.
6. Crisis of Confidence and Collapse : The immediate cause of the collapse of the Bretton Woods
System was the eruption of a crisis of confidence in the US dollar. The pound had been devalued
in November 1967. There was no control over the world gold market with the appearance of a
separate price in the open market. The immediate cause for the collapse of the Bretton Woods
System was the rumour in March 1971 that the US would devalue the dollar. This led to a huge
outflow of capital from the US. On 15 August 1971, the US suspended the conversion of dollars
into gold when some small European central banks wanted to convert their dollar reserves into
gold at the US. It refused to intervene in the foreign exchange markets to maintain exchange
rate stability and imposed a 10% import surcharge. Thus the main cause of breakdown of the
Bretton Woods System was the problems of liquidity, adjustment and confidence. The increase
in liquidity (international reserves) was in the form of dollars arising from BOP deficits of the
US. But as the US was unable to adjust its deficits and excessive dollars accumulated in foreign
countries, there was a crisis of confidence in the dollar and the Bretton Woods System brokedown.
25.3 The Present International Monetary System

At the beginning of March 1973 India, Canada, Japan, Switzerland, the UK and several smaller
countries had floating exchange rates. However, the “joint float” of the EEC countries continued even
after March 1973 and was now called the “snake in the lake”, as there was no band within which the
EEC currencies could fluctuate relative to other currencies. In March, 1979 the European Monetary
System (EMS) was formed which created the European Currency Unit (ECU) which is a “basket”
currency of a unit of account consisting of the major European currencies. The EMS limits the internal
exchange rate movement of the member countries to not more than 2.25 per cent from the “central
rates” with the exception of Italy whose lira can fluctuate up to 6 per cent.
In the meantime, the Jamaica Agreement of January 1976 (ratified in April 1978) formalised the regime
of floating exchange rates under the auspices of the IMF. A number of factors forced the majority of
member countries of the IMF to float their currencies. There were large short-term capital movements
and central banks failed to stop speculation in currencies during the regime of adjustable pegs. The

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