In July 1944, 44 allied nations gathered at the Mount Washington Hotel in Bretton Woods, NH to develop the structure for the economic and financial systems for the postwar world. The Bretton Woods agreement established a system of fixed exchange rates. Exchange rates were pegged to the U.S. dollar and the dollar could be swapped for gold at a fixed price of $35 per ounce. As part of this system, capital controls were widely deployed placing restrictions on the ability of investors to move funds overseas. In the wake of the Great Depression, international bankers were held in low regard so international transactions were mostly to facilitate current account (trade) activity, while capital account transactions were restricted.
A large enough number of nations adopted the plan and the system lasted from 1945 until August 1971, when President Nixon ended the ability of foreign dollar holders to swap for gold. Since 1971, most developed nations have adopted floating exchange rates and, over time, open capital accounts.
There is growing evidence that some policymakers in the U.S. are rethinking Nixon’s break with the Bretton Woods system and are considering a return to fixed exchange rates. In Part I of this report, we will introduce the Mundell Impossible Trinity, which will provide the framework of discussion for the three historical models and the potential change. In addition to the Impossible Trinity, we will discuss the gold standard and the Bretton Woods system. In Part II, we will examine the Treasury/dollar standard and introduce what could be called Bretton Woods II. We will discuss the strengths and weaknesses of each model. As always, we will conclude with market ramifications at the end of Part II.
The Impossible Trinity
In 1960, Robert Mundell postulated that a country can only implement two of these three policies:
- A fixed exchange rate
- An independent central bank
- An open capital account
For example, if a nation has a fixed exchange rate and an open capital account, then its central bank will conduct policy to maintain the exchange rate peg which will be affected by capital inflows and outflows. As such, it will not be independent. On the other hand, if the central bank is independent and the capital account is open, then the exchange rate will be required to float.