Global Trade And The Currency Market

By Katrina Lamb AAA

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The global economy facilitates the fluid movement of products and services around the globe, a trend that has continued virtually uninterrupted since the end of World War II. It is unlikely that the architects of this system could have envisioned what it would become when they met in the New Hampshire resort of Bretton Woods in July 1944, but much of the infrastructure they brought into existence continues to be relevant in today's global market. Even the name "Bretton Woods" lives on in a modern guise, characterized by the economic relationship the U.S. has with China and other rapidly developing economies. Read on as we cover the modern history of global trade and capital flows, their key underlying economic principles and why these developments still matter today.

In the Beginning
The delegates from the 45 allied powers who attended the Bretton Woods conference in 1944 were determined to ensure that the second half of the 20th century would look nothing like the first half, which consisted mostly of devastating wars and a worldwide economic depression. The World Bank and the International Monetary Fund would ensure global economic stability. (For more insight, check out What Is The International Monetary Fund? and What Is The World Bank?)

In order to facilitate a fair and orderly market for cross-border trade, the conference produced the Bretton Woods exchange rate system. This was a gold exchange system that was part gold standard and part reserve currency system. It established the U.S. dollar as a de facto global reserve currency. Foreign central banks could exchange dollars for gold at the fixed rate of $35 per ounce. At the time, the U.S. held more than 65% of the world's monetary gold reserves and was thus at the center of the system, with the recovering countries of Europe and Japan at the periphery. (To learn more, read The Gold Standard Revisited.)

All Together Now
For a time, this seemed like a win-win opportunity. Countries like Germany and Japan, in ruins after the war, rebuilt their economies on the backs of their growing export markets. In the U.S., growing affluence increased the demand for an ever-growing array of products from overseas markets. Volkswagen, Sony and Philips became household names. Predictably, U.S.imports grew and so did the U.S.trade deficit. A trade deficit increases when the value of imports exceeds that of exports, and vice versa. (To learn more, read Current Account Deficits.)

In textbook economic theory, market forces of supply and demand act as a natural correction for trade deficits and surpluses. In the real world of the Bretton Woods system, however, natural market forces ran into the non-market exchange rate mechanism. One would expect the value of a currency to appreciate as demand for goods denominated in those currencies increased; however, the exchange rate system required the foreign central banks to intervene in order to keep their currencies from exceeding the Bretton Woods target levels. They did this through foreign exchange (forex) market purchases of dollars and sales of British pounds, German marks and Japanese yen. This kept the prices of exports from these countries lower than what market forces would predict, making them still more attractive for U.S. consumers, thus perpetuating the cycle. (For related reading, see Get To Know The Major Central Banks and What Are Central Banks?)

A system like Bretton Woods relies on the willingness of the participants to actively support it. For the countries that had accumulated large holdings of U.S. dollar reserves, however, that willingness decreased as the dollar's implied market value eroded. If you are holding a large quantity of an asset and think the value of that asset is going to decline, you are not likely to go right back out and buy more of the asset - but that is precisely what the system mandated they do.

Bretton Woods Is Dead
The system finally collapsed in August 1971, when U.S. President Nixon announced that foreign central banks would no longer be able to exchange dollars for gold at the fixed $35 per ounce level. Within two years, the fixed-rate system had been phased out entirely and the currencies of Europe and Japanfloated, changing daily in response to actual supply and demand. The dollar underwent a sharp devaluation and the foreign currency market grew and came to be dominated overwhelmingly by private traders rather than central banks. (For more insight, read Floating And Fixed Exchange Rates.)

However, fixed-rate systems never died out completely. The bureaucrats of Japan's Ministry of Finance and the Bank of Japan saw a weak yen as a critical element of the country's export-oriented economic policy. In the early 1980s, Deng Xiaoping, then leader of the Communist Party of China, exhorted his countrymen that "to get rich is glorious" and China emerged onto the world stage.

At the end of the same decade, Eastern Europe and Russia, which were never a part of the old Bretton Woods system, joined the globalization party. Suddenly, it was 1944 all over again, with the so-called "emerging markets" taking the place of Germany and Japan with a desire to sell their goods to the developed markets of the U.S. and Europe. Just like their predecessors, many of these countries, particularly China and other Asian economies, believed that maintaining undervalued currencies was a key to growing and sustainable export markets and thus to increasing domestic wealth. Observers call this arrangement "Bretton Woods II". In fact, it works in a very similar way to the original, but without an explicit mechanism like a gold exchange. Like the original, it requires that all of its participants - the U.S. and the developing economies - have the incentives to actively support the system.

The $1 Trillion Gorilla
The U.S. trade deficit continued to grow throughout Bretton Woods II, supported by strong U.S. consumer demand and the rapid industrialization of China and other emerging economies. The U.S. dollar has also continued to be the de facto reserve currency and the form in which the People's Bank of China, Reserve Bank of India and others hold a majority of these reserves is in U.S. Treasury obligations. China alone holds foreign reserves in excess of $1 trillion. Clearly, any dramatic moves on the part of the Chinese authorities to change the status quo arrangement would have the potential to create turbulence in international capital markets. The political relationship between the U.S. and China is also a significant part of this equation. Global trade has always been a sensitive political topic and protectionism is a strong populist instinct in the U.S. It is conceivable that at some point, one or another party to this arrangement will conclude that its self-interest lies in abandoning the system. (For more insight, read What Is International Trade?)

Conclusion
The similarities between the original Bretton Woods system and its more recent counterpart are interesting and instructive. Over the very long term, economies move in cycles and what were yesterday's emerging economies, like Japan or Germany, become today's stable, mature markets while other countries step into the role of the emerging tigers. Therefore, what made economic sense for the emerging markets of yesterday continues to make sense for those of today and likely for those of tomorrow. Despite the dramatic changes brought about by the forces of technology, globalization and market innovation, economic systems are still profoundly human. That is, they exist at the behest of those who profit by them and last for as long as these interested parties perceive that the value outweighs the cost - or at least that the cost of dismantling the system would be too great to bear. Sometimes, this happens gradually and rationally, other times the landing is much harder.

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