Adjustment Mechanisms
Bretton Woods

The main obstacles to smooth adjustment during the Bretton Woods period were the inflexibility of wages and prices as well as levels of external capital mobility, which were high enough to threaten foreign reserves while also too low to secure reliably stabilizing liquidity inflows. Consequently, the discretionary escape clauses of the IMF Articles of Agreement undermined government credibility, promoting instability in international financial markets. The increasing efficiency of these markets, and major governments' inability or unwillingness to maintain key systemic commitments, caused the system to unravel.

In Discussion Paper No. 648, Research Fellow Maurice Obstfeld argues that limits to foreign sources of credit during the early years of Bretton Woods constrained investment and induced high saving in most countries needing easy access to a buffer stock of internationally liquid assets to smooth consumption or stabilize investment. The requirement to maintain fixed exchange rates increased the desire for international liquidity, while sizeable levels of reserve stocks were thought to inspire confidence in the peg. Under the gold standard, resilient international capital markets had aided exchange rate credibility. In the early post- war years, however, official credits helped countries maintain exchange parities and the pace of trade liberalization. Obstfeld argues that imperfect capital mobility persisted after the return to convertibility, despite increasing financial integration. The interaction of a country's external liquidity and its government's credibility involves a circular process; the relation between capital mobility and credibility may not always be monotonically increasing. Limited capital mobility may do little to help a government defend an exchange rate; if the underlying motives for realigning are strong, even limited capital mobility may allow money flows to have destabilizing effects.

Limited price flexibility is a major reason for exchange rate adjustment. Obstfeld maintains that wages and prices displayed considerable inertia even under the gold standard. Post-war governments, however, were responsible for, or committed to, high employment and economic growth; IMF credits allowed countries to sit out transitory shocks while avoiding the uncertainty and possible spillover effects of frequent exchange rate changes. The realignment option was available for persistent or `fundamental' disequilibria. Governments became increasingly reluctant to use the realignment weapon as the Bretton Woods system evolved. Speculative currency crises sometimes forced governments' hands, however; by 1971 speculative pressures were fuelling uncontrollable global reserve growth. Obstfeld argues, therefore, that a well-designed international payments system must recognize the incentives of member governments and modify those incentives to deter beggar-thy-neighbour behaviour. The founders of Bretton Woods appreciated this, but their success was incomplete. The mismatch between the system's rules and the incentives of some major participants proved fatal to its survival.

The Adjustment Mechanism
Maurice Obstfeld

Discussion Paper No. 648, May 1992 (IM)