1. Principles of Macroeconomics
Global Economic Challenges

2. Learning Objectives
How were the lessons from the Great Depression put into a new post WWII economic order?
Why did the system of fixed exchange rates collapse?
Why did the oil crises of the 1970s remind the world again of a need for policy cooperation?

3. The Legacy of the Great Depression
The era of Bretton Woods had two objectives that can be directly linked to the legacy of the Great Depression:
Prevent competitive tariff races.
Prevent competitive depreciation races.
The first objective was supposed to be put into practice through trade policy and the second through a system of fixed exchange rates.

4. The Bretton Woods Conference, 1944

5. Post WW II Trade Policy
The original idea was to create an International Trade Organization.
The United States, however, blocked its formation. As the world’s new superpower, it did not want to subordinate itself to a supra-national organization.
However, the world agreed on the so-called General Agreement on Tariffs and Trade (GATT).
GATT had three principles: Liberalization, Reciprocity, and the Most- Favored Nation clause.

6. The Principle of Liberalization
Says that all countries should make continuous efforts to liberalize trade.
This was done in so-called trade liberalization rounds.
These negotiation rounds were often subject to several years of bargaining and arm-twisting.
Nevertheless, although GATT was until 1995 a preliminary agreement, it was highly successful.

7. The GATT Negotiation Rounds
Year
Place/Name
Subjects Covered
1947
Geneva, Switzerland
Tariffs
1949
Annecy, France
1951
Torquay, UK
1956
Geneva, Switzerland / Dillon Round
Geneva, Switzerland /Kennedy Round
Tariffs and anti-dumping measures
Geneva, Switzerland / Tokyo Round
Tariffs, non-tariff measures
Geneva, Switzerland / Uruguay Round
Tariffs, non-tariff measures, rules, services, intellectual property, dispute settlement, textiles, agriculture, creation of WTO.
Present
Doha Round
Agricultural subsidies, market access by developing countries.

8. The Principles of Reciprocity and Most-Favored Nation Clause
The Principle of Reciprocity: Simply states that if one country makes a trade-liberalization effort, other countries shall do so, too.
The Most-Favored Nation Principles: Simply states that if country A liberalizes trade for imports of good X from country B, then all GATT member countries C to Z may export good X to country A at the same condition like country B. In other words, what applies to the “Most-favored nation” applies to all others, too. The idea is to avoid a “Spaghetti bowl” of bilateral trade agreements.

9. The System of Fixed Exchange Rates and the Fear of a Dollar Shortage
The international organization to manage the new international monetary order became the International Monetary Fund (IMF).
The US dollar was the key currency and backed by gold. Thus, the US promised to issue a new dollar bill only if it increased its gold reserves.
There were initially fears that the US could not provide enough US dollars in order to meet the financial needs of especially war-destroyed Europe (“dollar shortage”).
The fear was that the US would run trade surpluses for many years with the rest of the world.
In 1969, the IMF created the so-called Special Drawing Rights, which is a currency basket. Back in 1969 it included the German Mark, the French Franc, the US Dollar, the Japanese Yen, and the British Pound Sterling
The idea was for all IMF member countries to fund the common reserve system so that individual countries in case of a balance of payment crisis could “draw from.”

10. The System of Fixed Exchange Rates, Benign Neglect, and Dollar Glut
However, instead of a dollar shortage, there was soon a dollar glut.
Beginning in the 1970s, the US had trade deficits.
At the same time, the US issued many more US dollars than it had backed by gold reserves.
The US was more concerned with financing and winning the war in Vietnam than maintaining global financial stability.
The policy of neglecting its responsibility as a key currency in the system of Bretton Woods, which is to issue only new bills when they are backed by gold, has become known as a policy of “benign neglect.”

11. The Collapse of the System of Fixed Exchange Rates
Benign neglect also led to inflation beginning in the second half of the 1960s, averaging around 4% between 1968 and 1972.
Because all economies were tied to each other through the fixed exchange rate, the US exported inflation.
The US dollar’s credibility sank. In 1968, France began to convert US dollars into gold and other countries threatened to do so as well, when in Nixon closed the gold window.
This was the beginning of the end of the system of Bretton Woods.
It fully collapsed in Spring of 1973 when most countries adopted flexible exchange rates.
The US was no longer seen as a guarantor of price stability and maintaining fixed exchange rates would have meant that US inflation would infect other countries.

12. The Oil Crises of the 1970s
Shortly after the collapse of Bretton Woods, the first oil crisis shocked the world in the fall of 1973 when Arab oil exporters issued an oil embargo against the US and other Western nations supporting Israel in the so-called Yom Kippur war.
The oil-embargo drove up inflation in the 1970s even more.
In response to inflation, countries engaged in competitive appreciation races, which were as much a collective rationality trap as had been competitive depreciation races during the 1930s.
The oil crises led to a transatlantic economic policy conflict, especially between Germany and the USA.

13. How competitive appreciation worked?
Assume the German Mark (DM) – USD exchange rate was 𝑒= 4 𝐷𝑀 𝑈𝑆𝐷 and the price of a gallon of crude oil 𝑃=1 𝑈𝑆𝐷. Thus, Germany paid for one gallon of oil, 4 DM.
Following the oil crisis, the price for oil went up to P=4 𝑈𝑆𝐷, meaning that inflation-scared Germany had to pay now 16 DM for a gallon of oil.
In order to fight inflation, Germany appreciated its currency from 𝑒= 4 𝐷𝑀 𝑈𝑆𝐷 to 𝑒= 1 𝐷𝑀 𝑈𝑆𝐷 . This way, Germany paid now again 4 DM for a gallon of oil.
This now made the oil exporting countries angry because if they wanted to buy a Porsche or Mercedes from Germany, after the currency appreciation, one gallon of oil did still buy the same amount of Porsche and Mercedes.
So what did the oil exporting countries do? They increased the oil price even more. And what did Germany then do? They appreciated even more.
In the meanwhile, the gas price at the pump in the US got more and more expensive, so that the US eventually saw itself forced to appreciate the US dollar, which was equivalent to depreciating the German Mark, and to which Germany responded with even more appreciation.

14. How to appreciate a currency?
In order to appreciate the Deutschmark from 𝑒= 4𝐷𝑀 𝑈𝑆𝐷 to 𝑒= 1𝐷𝑀 𝑈𝑆𝐷 (or 𝑒= 0.25𝑈𝑆𝐷 𝐷𝑀 to 𝑒= 1𝑈𝑆𝐷 𝐷𝑀 ), it is necessary to reduce the supply of and increase demand for DM on global foreign exchange markets and get DM into the German banking system.
For this to happen, Germany raises its interest rate, which causes people on foreign exchange markets to want more DM and those who have DM not to offer them anymore.
In other words, when Germany raised interest rates, demand for DM increased and supply of DM decreased.

15. Transatlantic Policy Conflict Resulted – These were the main positions
The US was mostly concerned with “crowding out” of private investment as a result of competitive appreciation and demanded Germany to stop its high interest rate policy.
Germany, on the other hand, argued that the US’s insatiable thirst for energy is the problem and the US should learn to save energy. If the US demanded less energy, oil prices would also come down again.
Obviously, both have a point. What followed was a couple of world economic summits in which the US and Europe tried to reach a compromise.
Such a compromise was eventually reached in 1978 when Germany agreed to devalue (lower interest rates) and the US to save energy.
The agreement, however, was never implemented, because the 1979 Iranian revolution caused a second oil price shock that made it impossible for Germany to lower interest rates as promised.

16. The End of the Keynesian Era
The second oil crisis put an end to the Keynesian era which dominated world economics since the Great Depression.
The idea that governments could macro-manage economies with wise fiscal and monetary policies was no longer credible.
In fact, government was increasingly seen as the problem, not the solution (Ronald Reagan).
Beginning with the 1980s, the world economy embarked again on an economic policy that focuses more on strengthening markets.

17. Summary
The era of Bretton Woods intended to avoid the mistakes of non- cooperation during the Great Depression.
Major pillars of Bretton Woods were GATT and the IMF.
The system of fixed exchange rates eventually collapsed because the US was no longer able to guarantee dollar gold conversion.
The post Bretton Woods era was again characterized by collective rationality traps in economic policy (competitive appreciation races).