ML DAHANUKAR COLLEGE OF COMMERCE

TYBMS B
SUB-INTERNATIONAL FINANCE
TOPIC BRETTON WOOD SYSTEM
SUBMITTED TO- PROF.SANJAY

GROUP MEMBERS

SR.NO

NAME

ROLL NO

1.

RAJANI RAJAPPAN

84

2.

SONIYA MORE

85

3.

PRAVIN KOYANDE

86

4.

ROHAN TRIVEDI

88

5.

SHRADHA CHINDARKAR

89

THE BRETTON WOOD SYSTEM

INTRODUCTION
The depression of 1930s, followed by another world war had vastly diminished
commercial trade, the international exchange of currencies and cross border lending and
borrowing. What was left was only the memories of what that system had once been.
Revival of the system was necessary and the reconstruction of the post war financial
system began with the Bretton Woods agreement that emerged from the international
monetary and financial conference of the united and associated nations in July 1944 at
Bretton Woods, New Hampshire.
There was a general agreement that restoring the gold standard was out of
question, that exchange rates should basically be stable, that government needed access to
credits in convertible currencies if they were to stabilise exchange rates and the
government should make major adjustments in exchange rates only after consultations
with other countries. On specific, however, opinion was divided. The British wanted a
reduced role for gold, more exchange rate flexibility than had existed with the gold
standard, a large pool of lendable resources at the disposal of a proposed international
monetary organisation and acceptance of the principle that the burden of correcting the
payment disequilibria should be shared by both , surplus countries and deficit countries.
The American favoured a major role for gold, highly stable exchange rate, a small pool of
lendable resources and the principle that the burden of adjustment of payment imbalances
should fall primarily on the deficit countries.
The negotiators at Bretton Woods made certain recommendations in 1944:

Each nation should be at liberty to use macroeconomic policies for full

employment.( this tenet ruled out a return to the gold standard)

Free floating exchange rates could not work. Their ineffectiveness had been
demonstrated in 1920s and 1930s. But the extremes of both permanently fixed
and free-floating rates should be avoided.

A monetary system was needed that would recognize the exchange rates were
both a national and international concern.

This agreement established a dollar based International Monetary System and created
two new institutions:
1. The International Monetary Fund(IMF)
2. The International Bank for Reconstruction and Development later came to
be known as the World Bank.
The basic role of the IMF would be to help countries with balance of payment and
exchange rate problems while World Bank would help countries with post-war
Reconstruction and general economic development.
The basic purpose of this new monetary system was to facilitate the expansion of
world trade and to use the US dollars as a standard of value. This Bretton Woods
Agreement produced 3 Propositions:
(i)

The stable exchange rates under the gold standard before World War I
were desirable but there were certain conditions to make adjustments
in exchange rates necessary.

(ii)

Performance of fluctuating exchange rates had been unsatisfactory and

(iii)

The complex network of government controls during 1931-1945

discouraged the expansion of world trade and investment. However,
there were certain conditions which required government controls
over International trade and payments.

The Bretton Woods Agreement placed major emphasis on the stability of

exchange rates by adopting the concept of fixed but adjustable rates. The
keystones of this system were
(i)

no provision was made for the United States to change the value of gold at
$35 per ounce and

(ii)

each country was obligated to define its monetary unit in terms of gold or
dollars. While other currencies were required to exchange their currencies
for gold, US Dollar remained convertible into gold at $35 per ounce. Thus,
each country established par rates of exchange between its currency and
the currencies of all other countries.

Thus, the main points of the post-war system evolving from the Bretton Woods
conference were as follows:
1. A new institution, the International Monetary Fund (IMF), would be established
in Washington DC. Its purpose would be to lend foreign exchange to any member
whose supply to foreign exchange had become scare. This lending would not be
automatic but would be conditional on the members pursuit of economic policies
consistent with the other points of the agreement, a determination that would be
made by IMF.
2. The US dollar (and, de factor, the British pound) would be designated as reserve
currencies and other nations would maintain their foreign exchange reserves
principally in the form of dollars or pounds.
3. Each Fund member would establish a par value of its currency and maintain the
exchange rate for its currency within one percent of par value. In practice since
the principle reserve currency would be the US dollars, this meant that other
countries would peg their currencies to the US dollar, and, once convertibility was
restored, would buy and sell US dollars to keep market exchange rates within the
1% band around par value. The United States, meanwhile, separately agreed to

buy gold from and sell gold to foreign official monetary authorities at US$35 per
ounce settlement of international financial transactions. The US dollars were thus
pegged to gold and any other currency pegged to the dollar was indirectly pegged
to gold at a price determined by its par value.
4. A Fund Member could change its par value only with fund approval and only if
the countrys balance of payment was in fundamental disequilibrium. The
meaning of fundamental disequilibrium was left unspecified but everyone
understood that par value changes were not to be used as a matter of course to
adjust economic imbalances.
5. After a post-war transition period, currencies were to become convertible. That
meant, to anyone who was not a lawyer , that currencies could be freely bought
and sold for other order to keep market exchange rates within 1% of par value,
central banks and exchange authorities would have to build up to stock of dollar
reserves with which to intervene in foreign exchange market.
6. The Fund would get Gold and currencies to lend through subscription. That is,
countries would have to make payment (subscription) of gold and currency to the
IMF in order to a member. Subscription quotas were assigned according to a
members size and resources. Payment of the quotas normally was 25% in gold
and 75% in the members own currency. Those with bigger quotas had to pay
more but also got more voting rights regarding fund decision.
THE BREAKDOWN OF THE BRETTON WOODS SYSTEM
The Bretton Woods system worked without major changes from 1947 till 1971.
During this period, the fixed exchange rates were maintained by official interventions in
the foreign exchange markets. International trade expanded in real terms at a faster rate
than world output and currencies of many nations, particularly those of developed
countries, became convertible.

The stability of exchange rates removed a great deal of uncertainty from

international trade and business transactions thus helping the countries to grow. Also the
working of the system imposed to a degree of discipline on the economic and financial
policies of the participating nations. During the 1950s and 1960s, the IMF also
expanded and improved its operation to preserve the Bretton Woods System.
The system, however, suffered from a number of inherent structural problems. In
the first place, there was much imbalance in the roles and responsibilities of the surplus
and deficits nations. Countries with persistent deficits in their balance of payments had to
undergo tight and stringent economic policy measures if they wanted to take help from
IMF and stop the drain on their reserves. However, countries with surplus positions in
their balances of payments were not bound by such immediate compulsions. Although
sustained increases in their international resources meant that they might have to put up
with some inflationary consequences, these options were much more reasonable than
those for the deficit nations.
The basic problem here was the rigid approach by the IMF to the balance of
payments disequilibria situation. The controversy mainly centres on the conditionality
issue which refers to a set of rules and policies that a member country is required to
pursue as a pre-requisite to using IMFs resources. These polices mainly try and ensure
that the use of resources by concerned members is appropriate and temporary. The IMF
distinguishes between two levels of conditionality- low conditionality where a member
needs funds only for a short period and high conditionality where the member country
wants a large access to the Funds resources. This involves the formulation of a formal
financial programme containing specific measures designed to eliminate the countrys
balance of payment disequilibrium. Use of IMF resources, under these circumstances,
requires IMFs willingness that the stabilization programme is adequate for the
achievement to its objectives and an understanding by the member to implement it.

THE BRETTON WOODS SYSTEM OF FIXED EXCHANGE RATES

The Bretton Woods system sought to secure the advantages of the gold standard without
its disadvantages. Thus, a compromise was sought between the polar alternatives of either
freely floating or irrevocably fixed ratesan arrangement that might gain the advantages
of both without suffering the disadvantages of either while retaining the right to revise
currency values on occasion as circumstances warranted.
The rules of Bretton Woods, set forth in the articles of agreement of the International
Monetary Fund (IMF) and the International Bank for Reconstruction and Development
(IBRD), provided for a system of fixed exchange rates. The rules further sought to
encourage an open system by committing members to the convertibility of their
respective currencies into other currencies and to free trade.
What emerged was the "pegged rate" currency regime. Members were required to
establish a parity of their national currencies in terms of gold (a "peg") and to maintain
exchange rates within plus or minus 1% of parity (a "band") by intervening in their
foreign exchange markets (that is, buying or selling foreign money).
In practice, however, since the principal "Reserve currency" would be the U.S. dollar, this
meant that other countries would peg their currencies to the U.S. dollar, andonce
convertibility was restoredwould buy and sell U.S. dollars to keep market exchange
rates within plus or minus 1% of parity. Thus, the U.S. dollar took over the role that gold
had played under the gold standard in the international financial system.
Meanwhile, in order to bolster faith in the dollar, the U.S. agreed separately to link the
dollar to gold at the rate of $35 per ounce of gold. At this rate, foreign governments and
central banks were able to exchange dollars for gold. Bretton Woods established a system
of payments based on the dollar, in which all currencies were defined in relation to the
dollar, itself convertible into gold, and above all, "as good as gold." The U.S. currency
was now effectively the world currency, the standard to which every other currency was
pegged. As the world's key currency, most international transactions were denominated in
dollars.

The U.S. dollar was the currency with the most purchasing power and it was the only
currency that was backed by gold. Additionally, all European nations that had been
involved in World War II were highly in debt and transferred large amounts of gold into
the United States, a fact that contributed to the supremacy of the United States. Thus, the
U.S. dollar was strongly appreciated in the rest of the world and therefore became the key
currency of the Bretton Woods system.
Member countries could only change their par value with IMF approval, which was
contingent on IMF determination that its balance of payments was in a "fundamental
disequilibrium."
This Conference at Bretton Woods, representing nearly all the peoples of the world, has
considered matters of international money and finance which are important for peace and
prosperity. The Conference has agreed on the problems needing attention, the measures
which should be taken, and the forms of international cooperation or organization which
are required. The agreements reached on these large and complex matters are without
precedent in the history of international economic relations.
I. THE INTERNATIONAL MONETARY FUND
Since foreign trade affects the standard of life of every people, all countries have a vital
interest in the system of exchange of national currencies and the regulations and
conditions which govern its working. Because these monetary transactions are
international exchanges, the nations must agree on the basic rules which govern the
exchanges if the system is to work smoothly. When they do not agree, and when single
nations and small groups of nations attempt by special and different regulations of the
foreign exchanges to gain trade advantages, the result is instability, a reduced volume of
foreign trade, and damage to national economies. This course of action is likely to lead to
economic warfare and to endanger the world's peace.
The Conference has therefore agreed that broad international action is necessary to
maintain an international monetary system which will promote foreign trade. The nations
should consult and agree on international monetary changes which affect each other.

They should outlaw practices which are agreed to be harmful to world prosperity, and
they should assist each other to overcome short-term exchange difficulties.
The Conference has agreed that the nations here represented should establish for these
purposes a permanent international body, The International Monetary Fund, with powers
and resources adequate to perform the tasks assigned to it. Agreement has been reached
concerning these powers and resources and the additional obligations which the member
countries should undertake. Draft Articles of Agreement on these points have been
prepared.
II. THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELPOMENT
It is in the interest of all nations that post-war reconstruction should be rapid. Likewise,
the development of the resources of particular regions is in the general economic interest.
Programs of reconstruction and development will speed economic progress everywhere,
will aid political stability and foster peace.
The Conference has agreed that expanded international investment is essential to provide
a portion of the capital necessary for reconstruction and development.
The Conference has further agreed that the nations should cooperate to increase the
volume of foreign investment for these purposes, made through normal business
channels. It is especially important that the nations should cooperate to share the risks of
such foreign investment, since the benefits are general.
The Conference has agreed that the nations should establish a permanent international
body to perform these functions, to be called The International Bank for Reconstruction
and Development. It has been agreed that the Bank should assist in providing capital
through normal channels at reasonable rates of interest and for long periods for projects
which will raise the productivity of the borrowing country. There is agreement that the
Bank should guarantee loans made by others and that through their subscriptions of
capital in all countries should share with the borrowing country in guaranteeing such
loans. The Conference has agreed on the powers and resources which the Bank must have

and on the obligations which the member countries must assume, and has prepared draft
Articles of Agreement accordingly.
The Conference has recommended that in carrying out the policies of the institutions here
proposed special consideration should be given to the needs of countries which have
suffered from enemy occupation and hostilities.
The proposals formulated at the Conference for the establishment of the Fund and the
Bank are now submitted, in accordance with the terms of the invitation, for consideration
of the governments and people of the countries represented.
TRIFFINS PARADOX
Under the Bretton Woods Agreement, countries were given the choice of setting the par
value of their currencies for current account transactions in terms of gold or dollars. Since
virtually all belligerent countries finished the war in debt to the US for aid or supplies,
the US held virtually all the gold or a claim on it. Thus, the US was the only country able
to fix the par value of its currency in terms of gold, while all other countries set their par
values in terms of the dollar. The dollar thus effectively replaced gold in the Bretton
Woods system and the value of the dollar was determined by the holdings of US gold
reserves. Since all other countries had set par values against the dollar, they required
dollar reserves to ensure current account convertibility. This meant that the
stability of exchange rates was the result of intervention in terms of dollars by all central
banks except the US. It made the US dollar the only intervention currency and placed the
stability of exchange rates on the willingness and ability of non-US central banks to
intervene in foreign exchange markets to defend the value of the dollar. (It also meant
that the US dollar enjoyed an intervention band that was double that of the other
currencies since all cross rates were traded and calculated by trading against the dollar.)
As a result the US dollar became the source of international liquidity and the basis for the
reserves of the international monetary system. It thus effectively replaced gold. However,
under the Bretten Woods system, unlike the operation of the gold standard, where the
supply of gold was determined by mining and the dishoarding and jewelry,
thesupplyofdollarswasdeterminedbythebalanceofpaymentspositionoftheUS.

Immediately following the war, nearly all of the worlds monetary gold was in the US,
most of the signatories of the Bretton Woods treaties owed money to the US. Further,
their reconstruction depended on imports from the US, the only economy not damaged by
war, so the US was in balance of payments surplus. Thus, not only was gold scarce
outside the US, the dollar was also scarce.However, the amount of dollars held outside
the US eventually surpassed the gold reserves held by the US evaluated at the official
Bretten Woods parity. Thus the Triffin paradox: the successful operation of the
international financial system depended on an expansion of dollar reserves to keep
international liquidity growing in step with rapidly expanding world trade.
But,thiscouldonlybeachievedbyaUSpaymentsdeficitthatcontinuallyincreased
foreignclaimsonthefixedUSgoldsupply.Oncetheseclaimsexceededthedollarvalue
ofthegoldsupplyatthe$35parity,theconvertibilityofthedollarintogoldattheofficial
paritydependedonthewillingnessofforeignerstorefrainfromconvertingdollarsinto
gold.Thiscreatedadilemmaforforeignholdersofdollars,inparticularforeigncentral
bankswhowereresponsibleforstabilisingthedollarandthushadtoaccumulateever
largerdollarbalances asnonofficialholders converteddollarstoothercurrencies,in
particularDM.Arecognitionoftheappreciationofthedollarvalueofgolda
depreciation of the dollar relative to the other currencies would mean capital losses on
the dollar reserves. Thus foreign holders of the dollar faced a catch-22 situation reflected
in the Triffin paradox. If they converted the dollars into gold at the US Treasury (they
could not sell the dollars for other currencies since they were responsible for fixing the
rates of their currencies relative to the dollar, which was already in chronic excess supply
in foreign exchange markets) this would further reduce the gold backing the outstanding
dollar balances and make it more likely that the dollar would be devalued, depreciating
all of their dollar reserve holdings and producing large foreign exchange losses on their
balance sheets. If they converted excess dollar balances they risked precipitating a
devaluation, and if they did not they risked even larger losses if the devaluation
occurredinanycase.
Many countries (especially France) argued that the problem of excess dollar balances
couldbe resolved if the US tightened its domestic policies and ran balance of payments
surpluses, but this remedy for the dollar surplus would simply have reduced the growth of

international liquidity and created the risk of global recession it was just such a case
that Keynes had warned against when he pointed out the necessity of avoiding
asymmetric balance of payments adjustments in the new Bretten Woods system.
An international monetary system has been in existence since monies have been
traded, its analyses have been traditionally started from the late 19th century when
the gold standard began.
THE GOLD STANDARD
Exact date for the commencement of the gold standard is not known however the 188090 period is important. Currencies are valued in terms of a gold equivalent known as the
mint parity price (an ounce of gold was worth $ 20.67 in terms of the U.S. dollar over the
gold standard period) in gold standard. Each currency is defined in terms of its gold value
hence all currencies are linked together in a system of fixed exchange rates. Gold was
used as a monetary standard because it is an internationally-recognized homogeneous
commodity that is easily storable, portable, and divisible into standardized units, such as
ounces. Since gold is costly to produce, it possesses another important attribute
governments cannot easily increase its supply.
THE GOLD EXCHANGE STANDARD
An international conference at Bretton Woods, New Hampshire, in 1944 at the close of
World War II transformed the international monetary system into one based on mutual
cooperation and freely convertible currencies. By this each country had to fix the value of
its currency in terms of gold. This established the "par" value of each currency. The U.S.
$ was the main currency in the system and $1 was equated in value to 1/35 oz. of gold.
By this all currencies were linked in a system of fixed exchange rates.
The members were committed to maintaining the value of the currency within +/-1% of
parity. The various central banks were to achieve this goal by buying and selling their
currencies (usually against the dollar) on the foreign-exchange market. When a country

experienced difficulty maintaining its parity value due to balance of payments

disequilibria, it could turn to the International Monetary Fund (IMF), which was created
to monitor the provision of short-term loans to countries experiencing temporary balance
of payment difficulties.
EXTERNAL AND INTERNAL CONVERTIBILITY
When all holdings of the currency by non-residents are freely exchangeable into any
foreign (non- resident) currency at exchange rates within the official margins than that
currency is said to be externally convertible. All payments that residents of the country
are authorized to make to non-residents may be made in any externally convertible
currency that residents can buy in foreign exchange markets. And if there are no
restrictions on the ability of a country to use their holdings of domestic currency to
acquire any foreign currency and hold it, or transfer it to any nonresident for any purpose,
that countrys currency is said to be internally convertible. Thus external convertibility is
the partial convertibility and total convertibility is the sum of external and internal
convertibility.
CONVERTIBILITY: WHY?
Externally inconvertible currencies may be of rather limited value to their holder. An
exported item from a developing country to the USSR, for example, may be paid for in
rubles or the currency of a country that has ratified Article VIII. The proceeds may be
used to purchase goods anywhere.
In considering possible import suppliers, therefore, a developing country will have some
interest in directing its importers to those countries that will have some interest in
directing its importers to those countries whose inconvertible currencies are in large
supply. This is, of course, a case of trade discrimination that is condemned by traditional
theory. This means that goods are not being purchased from the cheapest source. Recent
economic writing has, however, reopened the question in view of the continued existence
of inconvertible currencies. Where it is profitable on the export side to trade with

countries maintaining inconvertible currencies, and the government wishes to encourage

imports from those countries to offset its credit balances, it will utilize its exchange
distribution mechanism to limit the availability of convertible exchange where there are
alternative suppliers of the same type of goods in inconvertible currency countries.
CURRENT ACCOUNT CONVERTIBILITY
Current account is defined as including the value of trade in merchandise, services,
investment, income and unilateral transfers. Current account convertibility, being
essential to the development of multilateral trade, three approaches to current account
convertibility has been adapted by developing countries. These are the preannouncement, by-product, and front-loading approaches. Each approach is distinguished
by the importance it attaches to convertibility relative to other economic objectives.
CAPITAL ACCOUNT CONVERTIBILITY
Capital account includes transactions of financial assets. Its convertibility refers to the
freedom to convert local financial assets into foreign assets in any form and vice versa at
market-determined rates of exchange.
Capital controls normally restrict or prohibit cross-border movement of capital. Thus,
controls on capital movements include prohibitions: need for prior approval;
authorization and notification; multiple currency practices; discriminatory taxes; and
reserve requirements or interest penalties imposed by the authorities that regulate the
conclusion or execution of transactions. The coverage of the regulations would apply to
receipts as well as payments and to actions initiated by non-residents and residents.

PROS AND CONS OF CONVERTIBILITY

Full currency convertibility is technically easy to achieve: simply permit

everyone, residents and non-residents alike, to buy and sell home currency for other
currencies freely and without restriction. Convertibility for current account transactions
(foreign trade in goods and services, including the remittance of earnings), such as is
required by the Articles of Agreement of the International Monetary Fund, is more
complicated, since the allowable market is limited to a certain class of transactions -- or,
put another way, it is designed to exclude certain transactions, especially the purchase by
residents of foreign financial assets. It therefore requires some detailed rules and close
monitoring, to prevent transactions supposedly made for current purposes from
concealing what in fact are capital transactions.
While convertibility strictly refers to the freedom to purchase foreign exchange
for domestic currency, convertibility would not be economically meaningful if licensing
were required for the activities that require foreign exchange, e.g. importing goods or
services. In what follows, therefore, I will use convertibility in the economically
meaningful sense, rather than in the narrowly legal sense, of the term. That is,
convertibility cannot be considered independently of the accompanying regime for
foreign trade. In particular, a currency is de facto convertible if would-be importers for a
wide range of goods or services are free to buy foreign exchange and to import with
minimal requirements, possibly subject to import duties that are not prohibitively high.
The typical objection to a move to convertibility is that it would lead to an
unsustainable loss of foreign exchange reserves and a balance of payments crisis. This
objection obviously presupposes that the government has pegged the exchange rate, or at
least has taken a view on how rapid a change is permissible. If the exchange rate is
pegged (including a crawling peg), then an unsustainable outflow of funds, e.g. through a
current account deficit, must be met by some contractionary monetary policy, which in
many countries will often imply the need for a smaller government budget deficit. In
either case it may lead to a decline in output and income in the short run -- something that

is never politically popular and if it persists, it was widely believed, to slower growth in
the long run.
The alternative is to alter the rate of exchange between home and foreign currency
by enough to stop the outflow -- either by allowing it to float, or by depreciating by so
much that market participants believe it will depreciate no further, that imported goods
become so expensive in home currency that demand for them will fall significantly, and
that exports become so profitable that their supply will increase significantly (or,
depending on the significance of our country in the world product market, that the price
of exports will fall sufficiently in foreign currency that foreign demand will be greatly
stimulated). For a period in the 1950s some "elasticity pessimists" doubted that any
exchange rate could clear the foreign exchange market, by which they really meant that
the required depreciation might be very large. That in turn could have other undesirable
consequences, to wit: a sharp increase in the domestic price level, driven by the rise in the
prices of tradable goods, which might trigger higher inflationary expectations, either
because the public cannot distinguish a once-for-all rise in the price level from an
acceleration of inflation, or because the price increase would in fact trigger an
inflationary process whereby wage-earners and others attempted to restore their real
incomes by insisting on higher nominal wages (and other incomes).
These are the kinds of concerns that opponents or skeptics of currency
convertibility held in the 1950s, and hold even today in some quarters. In addition,
several other inhibitions should be mentioned. First, it might be argued that the practical
distinction between current and capital transactions is difficult or impossible to sustain,
and that to prevent outflows of resident capital requires controls over current transactions
as well, with a view to ensuring domestic savings are invested domestically - i.e. as an
adjunct of a policy to stimulate economic growth. $$Word$$ some governments felt they
had a clearer idea than private investors could of what activities were required to generate
and sustain economic growth, or they took a view of where sectoral growth was
especially meritorious. Short of undertaking the desired sectoral investments themselves
(as many governments in developing countries did, through state-owned-enterprises),
they needed some instrument for steering investment in the desired direction. Allocation

of credit was the principal chosen instrument, e.g. in France, Japan, and South Korea, but
allocation of foreign exchange played an important adjunct role, and in the early 1950s
was perhaps even more important. Even when allocation of foreign exchange was not
undertaken aggressively in pursuit of particular objectives, its possible withdrawal was a
potent source of discipline over firm managers who were not otherwise inclined to follow
the guidance of the planning ministries.
Finally, once exchange controls are in place, there is another, usually unstated,
justification for keeping them in place: foreign exchange allocation is a useful channel for
political favoritism and/or personal enrichment, by political leaders and by administering
officials alike. Especially in poor countries, where control of the government is viewed as
one of the few, and perhaps the only sure, route to riches, allocation of foreign exchange
under an over-valued currency is one of the ways government authority can be used to
enhance tribal, regional, or personal wealth.
First, the key to a modern, flexible and innovative economy is competitive
markets, wherein information on new patterns of demand or new technological
developments is transmitted to the entire economy through price signals, to which both
households and enterprises can respond by adapting their behavior. The Soviet Union has
intentionally concentrated production of most manufactured goods in one or relatively
few enterprises. Monopolies do not respond to market signals in the same way as other
enterprises, and their responses are not socially optimal. Some method must be found for
introducing competitive pressures on Soviet enterprises at an early stage of restructuring
so that enterprises feel these pressures in making their decisions. One way to do this, and
for some sectors the only effective way, is to introduce foreign competition, so that Soviet
enterprises have a price and a quality standard that they must match in order to sell at
home or abroad.
"A second reason for introducing currency convertibility early is to encourage
from the beginning an alignment of Soviet prices with world prices of traded goods and
services, subject to such deviations as the economic authorities wish explicitly and
consciously to make. The alternative of administrative price adjustment to approximate

world prices is inadvisable, both because it perpetuates the principle of administrative

control of prices (as opposed to market determined prices) and because such control
cannot be fully effective in a world with millions of products of diverse qualities.
"A third reason for favoring early convertibility of the ruble is to provide goods to
Soviet workers whose incentive to work is now adversely affected by extensive
shortages. Opening the economy would offer a wide array of new goods, albeit for
purchase at high prices. It would not only provide effective wage goods, but would also
help reduce the ruble overhang, since firms and households would be more willing to
hold financial assets, which are not high by western standards. It would also provide the
Government with revenue from taxes levied on imports, as we propose below.
"Finally, convertibility would provide a strong stimulus to develop export
markets. At the exchange rate required to make the ruble convertible, exports would be
extremely profitable for newly independent enterprises. Autonomous enterprises would
have a strong financial incentive to develop export markets, and that would push them
from the beginning to take into account not only the price but also the quality of products
that are sold in the world market."
While the argument was made for the then-USSR, it has more general
applicability to the shift of any command economy to a market-oriented one. And in fact
currency convertibility was introduced in the early reform packages of many of them, or
soon thereafter. We will explore below the extent to which the concerns expressed by
those anxious about currency convertibility came to pass, followed by a discussion of
some of the considerations inhibiting a move toward convertibility in Europe in the late
1940s and early 1950s.