Bretton Woods Reconsidered: The Dollar Standard
and the Role of China1
Ronald I. McKinnon2
August 2014

Although significant, the importance the 1945 Bretton Woods Agreement for the postwar internationalmonetary order has been over-rated. Its major Articles were not effective until many years after WorldWar II. It was not a grand treaty that reconciled the interests of many diverse counties over a few weeks.
Rather, BW was essentially an arrangement between just two countries—Britain and the UnitedStates—negotiating for more than two years before the founding conference in 1944.
After World War I, monetary chaos prevailed with the British trying and failing to re-establish theinternational gold standard, which ultimately imploded into the Great Depression. What then was theinternational exchange rate cum monetary regime that undergirded the remarkably rapid post WorldWar II economic recovery and growth in the noncommunist industrial countries— what the French,somewhat inaccurately, still call “Les Trente Glorieuses". The underlying reality was that commercial
banks and private traders—exporters and importers—began using the U.S. dollar as international
money, which was later codified by governments into a system of fixed-dollar exchange rates with othercurrencies.
In 1945, the United States had the world’s largest economy and the only intact financial system without
inflation or exchange controls restricting the free use of its currency by foreigners. Exporters the world
over (outside of the restricted but declining British sterling area) began invoicing and demanding
payments in dollars. Importers then began to hold dollar balances directly, but not exclusively, in
American banks. Importers also came to rely on their banks to provide dollars on demand for theirdomestic currencies. So commercial banks everywhere became money changers using the dollar as theintermediary currency, subject to its country’s more or less rigid exchange controls. And amazingly,
outside of today’s eurozone, the dollar is still the dominant vehicle currency for interbank foreignexchange transactions. Following the lead of private markets, central banks in 1945 began to build up
their official exchange reserves in dollars, in part as a backstop for their commercial banks’ fluctuating
dollar needs. In addition, as conveniently recognized international liquidity, interest-bearing U.S.
Treasury bonds (as distinct from gold) were favored as a precautionary reserve. But what then caused
1 This paper is written more as a memoir with only the occasional academic reference. Detailed references andsupporting data in figures and tables are contained in the author’s recent book The Unloved Dollar Standard: From
Bretton Woods to the Rise of China (Oxford University Press 2013, Chinese translation, China Financial Publishing
House 2013.)
2
Professor Emeritus, Stanford University, http:www.stanford.edu/~mckinnon

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this dollar-based regime to evolve into one of officially fixed exchange rates? (After all, as late as 1949,
there were chaotic and massive depreciations of some European currencies.)
The Marshall Plan and Fixed Exchange Rates
Basically, it was the 1947 Marshall Plan that set the stage for the remarkable recovery of the Western
European economies from World War II. The plan did not just allocate American funds bilaterally toindividual countries. Instead, aid was given multilaterally with the strong conditionality that Western
European governments start dismantling the currency restrictions and quota protections that were
hampering intra-European trade. The capstone was the formation of the European Payments Union(EPU) in September 1950 among 15 Western European countries. Each member country declared anexact dollar exchange rate parity—without even the 1% margins on either side of the central rate
permitted by the IMF's Article IV. Then Western European central banks (rather than private commercial
banks) began to clear intra European payments multilaterally. If any one European country had a net
payments deficit, ie., the sum of its payments for imports exceeded what it was earning on exports, its
central bank used a dollar line of credit from the EPU to fill the gap—but with effective sanctions
requiring repayment. In addition to stimulating Western Europe’s strong trade-led recovery from thewar, the Marshall Plan cum EPU started what became wider European trade and monetary integration.
This fixed-rate dollar standard was substantially broadened when Japan joined in 1949. Like many
continental European countries, Japan had suffered severe physical and financial damage during thewar. It had open and repressed inflation, interest rate and balance of payments restrictions, multiple
exchange rates, and virtually no postwar recovery. Then a Detroit banker, Joseph Dodge, visited Tokyo
empowered with an American line of dollar credit to provide advice for stabilizing the economy understrict conditionality. In 1949, the multiple exchange rate regime was unified into a single exchangeparity: 360 yen/dollar. For more 20 years, the Japanese government subordinated its monetary andfiscal policies to maintaining this fixed dollar exchange rate--thus ridding Japan of inflation andanchoring its price level (WPI). With a stable price level and stable exchange rate, the Japanese economy
then took off into its “miracle” phase of 9 to 10 percent growth in real output into the early 1970s.
After the United States’ emergence from World War II as the world’s unique economic and financial
hegemon, it did not complain about how other countries set their dollar exchange rates: a policy thencalled “benign neglect”. Not having an exchange rate obligation of its own, the U.S. could focus its
monetary and fiscal policy on the state of purely domestic inflation or unemployment. And the American
price level was stable in the 1950s into the mid-1960s—thus incidentally stabilizing prices in the rest of
the noncommunist industrial world.
Having foreign central banks intervene only in dollars to secure their exchange rates, with the Fed
staying out, has the great advantage of preventing official interventions at cross purposes: a greatstrength of the international dollar standard. But such a system only works smoothly if the government-2-

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of the center country (without a direct exchange rate policy of its own) remains passive, i.e., does not
object to the way other countries set their dollar exchange rates.
The Nixon Shock
However, the worldwide anchoring effect of a stable dollar began to unravel with the Nixon shock ofAugust 1971. By threatening to impose tariffs on imports of manufactures, the U.S. government forced
Japan and the Western European governments to appreciate their currencies against the dollar. As early
as 1970, in anticipation of the dollar’s being devalued, “hot” money flowed out of the United States toperipheral countries with at least semi-convertible currencies: Japan, Canada, and Western Europe. To
prevent their currencies from appreciating even more than Nixon wanted, their central banks
intervened massively to buy dollars with domestic base money. Their collective loss of monetary control
then created the great worldwide inflation of the 1970s into the early 1980s [McKinnon 2013, ch 4].
Although the dollar remained the facilitator of multilateral exchange in private markets, its anchor for
price and exchange rate stability worldwide was lost.
What so upset President Nixon? In the late 1960s, the U.S. began to lose control over its own price level.
Without proper tax financing, U.S. government spending for the Vietnam war escalated along withwelfare expenditures for President Lyndon Johnson’s so-called great society programs—all
accommodated by overly easy money by the U.S. Federal Reserve Bank. The surge in demand caused
U.S. prices to begin rising modestly: the CPI increased from about 1.6 percent annually in 1965 to 5.5
percent in 1969.
Under Article IV of the BW Agreement, other industrial countries kept their nominal dollar exchange
rates fixed. Thus, with even moderate internal inflation, U.S. industry became less competitive—
particularly from foreign manufactured imports. American industrial trade unions, with hubris from theprevious 25 years of uninterrupted growth, insisted on fully indexing nominal wages to internal priceinflation while bargaining for additional real wage increments. By 1969, the previously large U.S. trade
surplus had virtually disappeared.
By 1970, to restore America’s international competitiveness, particularly in manufacturing, the Nixon
government faced a difficult choice: either (1) raise taxes and tighten monetary policy to disinflate theAmerican economy, or (2) force other industrial countries to appreciate their currencies ostensibly tomake American industry more competitive. Although more painful politically, if (1) had been successfully
implemented, the dollar’s role as a stable nominal anchor for the rest of the world could still be with us!
Instead, the Nixon government chose dollar devaluation under (2), and the world experienced the great
inflation of the 1970s and much financial volatility subsequently—which harmed the American economy
as well foreign ones.

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The Exchange-Rate Trade-Balance Fallacy and the Weak Dollar
In defense of politicians, however, many economists advocated (and still advocate) floating exchange
rates. Worse, the standard textbook model linking a country’s exchange rate to its net trade balance—sometimes called the elasticities approach—suggests that a country with an unwanted trade deficit
should depreciate its currency, and countries with unwarranted trade surpluses should (be forced to)appreciate [Meade 1951]. Although having some validity for insular economies when international trade
had been severely truncated, and strict foreign exchange controls prevented the free movement of
capital, as in the 1930s into the 1950s, this insular economy model fails to correctly portray the impact
of exchange rate changes in today’s highly open economies with massive flows of international tradeand investment. When an economy is highly open, a government cannot manipulate its exchange tohave any predictable effect on its net trade balance [McKinnon 2013, chs 7 & 8]. But predictable
movements in future exchange rates can generate destabilizing hot money flows [McKinnon ch 5].
However, faced with a seemingly unending string of American trade deficits from the end of the 1970s
through to 2014, American policy makers have remained in thrall to the exchange-rate trade-balance
fallacy. They have continually tried to devalue the dollar—either by threatening to impose import
restrictions on trade-surplus countries unless they appreciate, or by following ultra low interest rate
policies that ignite hot money inflows into convertible-currency countries with naturally higher interest
rates on the dollar standard’s periphery—largely Western Europe and Japan in the 1970s, but more
emerging markets in the new millennium.
President’s Nixon’s demand in August 1971 that all the then industrial countries appreciate theircurrencies against the dollar, which they all did—averaging 17 percent by the following December— wasa harbinger of things to come. In the mid-1970s, Japan bashing on the yen/dollar rate started and lasted
for more than 20 years. The Japanese succumbed to American protectionist threats: the yen appreciated
all the way from 360 to the dollar in 1971 to touch 80 in April 1995. Japanese domestic investment
slumped, knocking Japan off its high growth path. The flood of hot money into Japan contributed to landand stock-market bubbles, which burst in 1990. In 1985, the Japanese price level (WPI) began fallingfrom the overvalued yen and then bursting asset bubbles—with even nominal wages falling into thenew millennium. Short-term interest rates approached zero in the late 1990s.The only thing that did not
fall was Japan’s trade surplus (Qiao 2007)! So Japan’s lost decades of economic growth could well be
attributed to what McKinnon and Ohno (1997) called “The syndrome of the ever-higher yen”.
The more recent China story has important parallels with Japan’s historical experiences under the dollar
standard. On the positive side, China unified its currency (eliminated multiple exchange rates) andsuccessfully disinflated its domestic economy by credible pegging the renminbi at 8.28 yuan/dollar in
1994—much like Japan’s earlier experience in 1949—while moving to current-account convertibility by
1996. China kept its nominal dollar exchange rate stable for the next decade of extremely high growth intrade and real GDP.
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However by 2000, China’s bilateral trade surplus with the U.S. surpassed that of Japan’s and continued
to rise rather sharply. Under the mantra of the exchange-rate cum trade-balance fallacy, many U.S.
politicians and economists then shifted from bashing Japan to bashing China on the RMB exchange rate.
But Chinese politicians resisted much more strongly and avoided a Japan-like debacle—although theresistance was not complete. In July of 2005, the People’s Bank of China began to loosen its dollar peg
and embarked on a series of mini- appreciations with occasional stops so as to average about 3 percent
per year. It appreciated from 8.28 yuan/dollar in 1994 to about 6.2 yuan/dollar in mid 2014—nothing
like the earlier more massive appreciations of the yen.
Although not much affecting China’s trade and GDP, China’s mini appreciations worsen hot money
inflows. With U.S. short-term interest rates near zero, and high-growth China with naturally higher
interbank rates averaging about 4 percent, and with expected RMB appreciation about 3 percent, thisamounts to a huge 7 percent gap in effective interest rates. Carry traders in various guises then try tomove hot money from dollars into RMB. So China is forced to retain exchange controls—inevitably
somewhat porous—on inflows of financial capital. Even so, the People’s Bank of China must continually
buy dollars to stabilize the yuan/dollar rate—thereby risking an inflationary loss of monetary control
unless this creation of excess base money is somehow sterilized.
Other emerging markets (EM) have similar monetary control problems arising from U.S. near- zerointerest rates creating an ebb and flow of hot money into their economies. But they are less able thanChina to contain the resulting exchange rate volatility—for their own economies as well in creating
cycles in primary commodity prices in the world at large [McKinnon 2014].
Losing the World’s Nominal Anchor and America’s Saving Deficiency
Since 1945, the dollar standard has played a dual role in the world economy—for private internationalcommerce, and for domestic macroeconomic control by governments—and these two roles are naturalcomplements in such a key currency regime.
(1) The dollar facilitates international trade by providing a common invoice currency for primarycommodities and for the exports of developing countries, and it is the vehicle currency used by banks togreatly reduce the private costs of making foreign exchange payments multilaterally both spot andforward.
(2) Insofar as foreign governments have pegged their exchange rates to the dollar, it acts as a nominal
anchor for their price levels—sometimes in the context of major domestic disinflationary financial
reforms.
In the Trente Glorieuses with very high growth in the postwar industrial economies, U.S. government
policy ensured that both (1) and (2) more or less held. The U.S. Federal Reserve acted correctly as theworld’s de facto central banker.
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But from the 1970s down to the present day, an unfortunate confluence of economic circumstances
began to undermine (2)—the dollar’s anchoring role in the world economy. U.S. saving rates, bothprivate and government, began to fall somewhat endogenously. Private saving edged downward but
public saving, in the form of federal fiscal deficits, fell quite sharply on occasion. In the 1980s, President
Reagan presided over a large military buildup that was not tax financed—and which led to the famous“twin” deficits of fiscal and trade. Although there were the usual dire warnings that such fiscal deficits
would harm the economy, U.S. interest rates actually fell in the course of the Reagan “boom” in the late1980s.
While generally unrecognized by politicians and most economists, it was (and is) the U.S. central
position within the world dollar standard that allows the United States to borrow very cheaply by selling
U.S. Treasury bonds and other financial assets to foreigners—mainly central banks in West Germany andJapan in the 1980s. Having learned a false lesson that deficits did (and do) not matter, this has
emboldened American politicians—Keynesians to be more Keynesian in targeting unemployment withmassive fiscal deficits during the 2008 downturn and disappointingly slow recovery—and supply siders(sometimes called the Club for Growth) to become ever more reckless in their demands to cut taxes, orrefuse tax reforms to raise more revenue, or to provide tax revenues for needed public goods—such as
highways.
In the new millennium, Emerging Markets have been the big buyers of U.S. Treasuries and other dollar
assets—with China alone having official foreign exchange reserves of more than 4 trillion U.S. dollars,
which is about half the EM total. But so what? What harm comes from America’s soft internationalborrowing constraint that reduces domestic saving and creates a more or less permanent fiscal andtrade deficits?
First, the trade deficit itself. America’s main international creditors—mainly West Germany and Japan in
the 1980s, but now more China and other industrialized Asian emerging markets—are major exportersof manufactures. Thus the real counterpart of their purchases of U.S. financial assets is to run trade
surpluses in manufactures with the U.S. Indeed, in recent decades, virtually the whole of the U.S.
current account deficit (equal to America’s saving deficiency) is equal to the U.S. trade deficit inmanufactures (McKinnon 2013, Ch 6).
If Democrats or Republicans wanted to ameliorate industrial decline, they should take steps to increase
America’s saving rate by reducing or eliminating the fiscal deficit. Instead they labor under the false
doctrine: the exchange-rate trade-balance fallacy. They accuse foreigners of unfairly manipulating theirexchange rates to keep them undervalued, and one result is the excessive use of antidumping duties
against many different kinds of manufactured imports. But the major cost of this false doctrine is to
distract political attention away from the fiscal deficit. And in his most recent budget, President Obamaprojects large federal fiscal deficits as far as the eye can see, through 2015 and beyond.
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Second, this exchange-rate trade-balance fallacy undermines the dollar standard’s natural stabilizingrole in world economy: providing a nominal anchor for other countries, most of whom for good reasons
would prefer to operate with stable dollar exchange rates. Without an exchange rate policy of its own,
the U.S. government continually tries to weaken the value of the dollar against other major currencies—
either directly as with Japan bashing followed by China bashing, or indirectly by setting interest rates toolow (now near zero) that induces volatile hot money outflows which force at least some EMs toappreciate and other more mature industrial countries to keep their interest rates similarly too low to
avoid appreciating.
Reforming the Unloved Dollar Standard: The Role of China
Despite this rather sorry tale of the loss of worldwide macro stability because of the erosion of thedollar’s anchoring role under (2) above, its remarkably resilient facilitating role for money changing
under (1) above remains in place. As of 2014, the dollar still remains the most commonly used currency
for invoicing exports, vehicle currency for interbank foreign exchange transacting, and reserve currency
for governments.
Even so, nobody loves it. Foreigners are distressed by macroeconomic shocks emanating from theUnited States, and the “exorbitant privilege” of America having an indefinitely long line of cheap dollar
credit from the rest of the world. Americans, laboring under the exchange-rate trade-balance fallacy andtheir large trade deficit, complain that foreign governments manipulate their dollar exchange rates
unfairly to secure a mercantile advantage—while the rules of the dollar standard game leave the U.S.
with no direct exchange rate policy of its own.
So we have the great paradox. Although nobody professes to love the dollar standard, the revealed
preference of both governments and private participants in the foreign exchange markets since 1945
has been to continue to use it. As the principal monetary mechanism ensuring that international traderemains robustly multilateral rather than narrowly bilateral, it is a remarkable survivor that is too
valuable to lose and too difficult to replace.
There are great economies of scale of having just one international money. But, many, many suggestions
have been made for replacing the dollar with something else—a commodity reserve currency in the
1950s, the IMF’s Special Drawing Rights in the early 1970s, an internationalized yen in the Japanese
bubble phase of the 1980s, the euro in its good phase in the early 2000s, and now an internationalized
renminbi from China’s trade ascendancy. I won’t rehearse the pros and cons of each one here, nor
propose a new one.
Realistically, the remarkable resilience of the dollar standard leads me to conclude that “international”
monetary reform really should be directed to improving the monetary and exchange rate policies of theUnited States—possibly with China becoming a more equal partner, and the IMF continuing to provide
important legal cover.
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The most important aspects of any such reform are conceptual:(i) To rid Americans of their weak-dollar syndrome by exposing the exchange-rate trade-balance fallacy
in textbooks and in the financial press, and(ii) To get U.S. politicians to see the link between ongoing fiscal deficits leading to trade deficits and the“excess” imports of manufactures that so upset many of their constituents.
Although eliminating U.S. fiscal deficits might be all well and good on domestic grounds, in a growing
world economy aren’t U.S. current account (trade) deficits are needed to provide sufficient international(dollar) liquidity for foreign central bank exchange reserves on the one hand, and foreign commercialbank working balances on the other? While seemingly plausible, this common objection to the U.S.
returning to fiscal and trade balance is misguided.
During the Trente Glorieuses, the U.S. ran with substantial current-account surpluses—the counterpartof Marshall and other foreign aid, large U.S. foreign direct investments, and substantial purchases of
longer-term foreign private bonds—usually denominated in dollars. In the immediate postwar, this large
American gross capital outflow meant that foreign central banks could rather rapidly restore theirofficial exchange reserves by building up stocks of U.S. Treasuries and dollar depository claims on
American banks. Thus the outflow from the United States of longer-term relatively illiquid investment
abroad was greater than its current-account surplus. This difference was then financed by a return
capital inflow (albeit smaller) in the form of foreigners building up liquid dollar claims on the UnitedStates—thus gaining international liquidity.
In effect, if American politicians could be persuaded to eliminate the current U.S. fiscal deficit or evenmove it into surplus, a reshuffling of the capital account of the U.S. balance of payments would ensure
the sufficient provision of international liquidity. As the current account deficit was phased out, U.S.
longer term capital outflows such as foreign direct investment would increase, possibly quite sharply,
while foreigners could continue to build up their liquid dollar claims unimpeded. As the U.S. moved
away from being a net borrower in world financial markets, more international capital could flow intopoorer countries—albeit only those which were credit-worthy. And U.S. protectionists would have a
tougher time making arguments for tariff or quota restrictions on the reduced flow of imports.
But this hypothetical reshuffling of U.S. international payments is best done in the context of mutualadjustment with America’s largest creditor, China. Just as the 1944 Bretton Woods Agreement was
negotiated between just two countries, the key to successful rehabilitation of today’s dollar standard isa modus vivendi between China and the United States.
China’s enormous trade-led growth since 1980, secured by its membership in the WTO in 2001, andmacroeconomic stability since 1994 when its dollar exchange rate was fixed, has greatly benefited fromunrestricted multilateral exchange under the dollar standard. The vast expansion of China’s dollar-based-8-

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trade has made it, albeit inadvertently, a pillar of the dollar standard. China would have a lot to lose if
the dollar standard were to collapse or become seriously damaged. So what is a short laundry list ofissues over which the two countries might negotiate?
(1) The end of American China bashing to appreciate the RMB, which has been a consequence of theinfluence on Americans of the exchange-rate trade-balance fallacy.
(2) The U.S. agrees to phase out its fiscal deficits in return for China phasing in higher domestic
consumption. Each country can decide on its own mix of tax and expenditure measures for achieving
these ends. If both governments move simultaneously, disturbances in the foreign exchanges areminimized so that it is easier to maintain stability in the yuan/dollar exchange rate [McKinnon 2013,
ch.9](3) The Fed agrees to begin raising U.S. interest rates to more normal levels to relieve the pressure of
hot money inflows into China and other emerging markets. China then agrees to start phasing out its
capital controls as a step toward “internationalizing” the renminbi and opening up its capital markets(McKinnon 2014b).
(4) Mutual goodwill coming out of these negotiations then could spread to other areas such as flawed
U.S. antidumping laws and Chinese regulatory pursuit of highly competitive foreign firms for “anti-trust”
and other questionable violations of Chinese laws.
Although cloaked in the garb of an international agreement, these measures could well increase
domestic economic efficiency in each country. A relevant historical example is China joining the WTO in
2001. At the time, one motivation of Premier Zhu Rongji was that the by-laws of the WTO would help
prevent protectionism from hampering China’s own interprovincial trade.
A Concluding Note on the International Monetary Fund
It may seem surprising that my “reconsideration of Bretton Woods” hasn’t included any call for revising
the present Articles of the International Monetary Fund established in 1944, with surprisingly few
amendments since then. However, once one realizes that the world’s basic money machine has all along
been an international dollar standard—albeit one which continually metamorphoses—it is not sosurprising.
Although not particularly useful in the immediate aftermath of World War II, the IMF has evolved into
an important and constructive legal adjunct to the dollar standard. In particular, it has successfullypressured virtually all member countries to adopt Article VIII, the commitment to current-accountcurrency convertibility for exports and imports of goods and services.
Although not required by any Article, the IMF has in the past been too hasty in pressuring someemerging markets with currency mismatches to get rid of capital controls—resulting in over- borrowing-9-

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in international financial markets. But that era seems to be over. Of course, if the United States itself
imposed comprehensive capital controls, the international dollar standard would collapse! But for
emerging markets on the dollar standard’s periphery, there is a strong case for using capital controls tocontain “hot” money flows [McKinnon 2013, Chs. 5&13].
The second constructive role of the IMF is that of a crisis manager in the foreign exchanges—making(mainly dollar) loans with strict conditionality, usually to less developed countries that are not big
enough to overwhelm the financial resources of the Fund. With its large body of financial experts, theIMF becomes (is) the natural lender of “first resort” in ameliorating foreign exchange crises around theworld.
However, really big crises—such as those associated with the world economic downturn of 2008 or the
euro crisis of 2011—are usually marked by a flight of private capital into dollars as the international
financial “safe haven”. Even when the world crisis was touched off by the subprime mortgage crisis in
the United States itself, international banks everywhere tried to replenish their depleted stocks of theworld’s vehicle currency. Then the U.S. Federal Reserve Bank becomes the natural lender of “lastresort”. And in both crises, the Fed lent heavily to selected foreign central banks by swapping dollars fortheir domestic currencies—collateralized lending.
Much of the spirit of the 1944 Bretton Woods agreement was to try to curb beggar-thy-neighborexchange-rate changes and hot money flows that so disrupted the world economy in the 1930s. A returnto exchange stability anchored by a credibly stable yuan/dollar rate, to which other countries—
particularly in Asia—attach themselves voluntarily, would reflect that spirit.
References
McKinnon, Ronald (2013), The Unloved Dollar Standard: From Bretton Woods to the
Rise of China, Oxford University Press, New York. (Chinese translation, China Financial
Publishing House, Beijing).
_________(2014a) “Hot Money Flows, Cycles in Primary Prices, and Financial Control in
Developing Economies” Stanford University.
_________(2014b) “China’s Currency Conundrum”, Policy Brief Stanford Institute for
Economic Policy Research, May.
McKinnon, Ronald and Ohno, Kenichi (1997) Dollar and Yen: Resolving Economic Conflict
between the United States and Japan, MIT Press, Cambridge, MA.
Meade, James (1951), The Balance of Payments Oxford University Press, London.
Qiao, Hong (Helen) (2007) “Exchange Rate Changes and Trade Balances Under the Dollar
Standard, Journal of Policy Modeling 29:765-82-10-

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