During the Bretton Woods era (1944 1972), the proportion of dollars in world reserves rose steadily. As a result, it was in the countries with a persistent tendency torunbalance ofpaymentsdeficits (the United States and the United Kingdom) that the shortage of world liquidity was observed. In surplus countries (Germany, Italy, and the Netherlands), there was a widespread suspicion that deficit countries were all too ready to accept inflation rather than reduce growth and undergo the discipline needed to restrain their external trade to a position without deficits. In reality, however, world trade growth was not noticeably impeded by reserve shortages when the United States had run more conservative or restrictive policies. But the system was put under significant strain after 1967, when the United States followed policies that greatly increased the supply of dollars and necessitated devaluations. The expansionary policies of the United States, and the inflationary finance of the Vietnam War, are now generally credited with undermining the Bretton Woods system.
In this context, many governments responded to the oil price rise of 1973 by cutting taxes tomaintain the level of demand. Governments did this to differing extents, and the industries of different countries also showed differing abilities to adapt to a new pattern of demand in world trade. This combination of policies led to large current account imbalances and, in particular, a weakness in the dollar. But despite those policies, unemployment rose generally largely because profits bore the brunt of the adverse terms of trade shock, while wages did not adjust. At this point policymakers regarded unemployment as themore serious problem, and the view that potential growth had been permanently reduced was not widely accepted. Meanwhile, inflation, though subsiding from its 1974 peak, remained high in many countries.
Several years of discussion among governments in this climate led to the Bonn Summit agreement of 1978, which epitomized the period. Long discussions and careful staff work finally led to a wideranging agreement that embraced, but went beyond, macroeconomic policy. In an effort to offset what was seen as flagging growth, while contributing to better-balanced international payments, Japan and Germany were asked to take stimulative fiscal policy actions. In return, the United States agreed to liberalize its energy prices so that they would rise to world levels, dampen U.S. energy demand, and reduce prices for all oil importers.
This agreement has been extensively criticized. It has been viewed by many as the imposition of American power, pressuring Germany and Japan to accept inflationary policies in order to assist the United States. It was also widely criticized as an example of inappropriate and procyclicalfine-tuning of aggregate demand. In fact, the Bonn Summit agreement helped each country to achieve the domestic policies it favored but had been unable to achieve because of political opposition at home (Putnam and Henning 1989). The summit may therefore have been necessary to bring about the policies at the time that they were implemented, but the governing groups in each country favored them anyway. Coordinated policies were not imposed on reluctant governments.
Indeed, given the priorities of the time, the summit measures were not mistaken. Policy preferences did change soon afterward, however. In 1978, the German government wanted faster growth when faced with forecasts of 3.5 percent real growth and 3.5 percent inflation while unemployment was only 4 percent.Moreover, a strong but temporary surge of inflation, caused by the second oil shock, and the replacement of the governments of the United States and Germany in 1980 and 1982 by Republican and Christian Democratic administrations respectively, led to a substantial reordering of priorities (Holtham 1989).
In practice, the expansionary effects of the fiscal policy changes inGermany and Japanweremodest at best. In Germany, they barely offset the automatic claw back through the tax system, and they were accompanied by a tightening of monetary policy. This was acceptable because the summit agreement did not cover monetary policy, although it was clear that any German expansions would have to be bond financed. The fiscal measures therefore had a negligible impact on inflation and a very small effect on the current account. As a result, the main effect of the summit was the deregulation of American oil prices which most commentators now agree was beneficial.
The aftermath of the Bonn agreement looked rather different fromthe circumstances that brought it about.Unlike the first oil shock, it is implausible to ascribe the second oil shock (1979 80) to monetary expansions or loose policies in the industrial countries. Instead it was triggered by the fall of the shah of Iran. Although this did not lead to a substantial reduction in oil supplies, it caused a surge of speculative buying that drove up the oil price.
Nonetheless, by 1980 popular tolerance of inflationwas exhausted, and the threat that a newsurge in inflation could again ratchet up the trend inflation rate made for considerable uniformity of view in all countries. This reflected several changes of government, and resulted in a lack of interest in policy coordination plus a perception that each country should concentrate on putting its own house in order.
At this point, there was general agreement among governments on the need to reduce inflation and a much greater readiness to bear the costs in unemployment and recession a readiness that had democratic endorsement. In part this readiness was disguised behind an assertion that there would be no lasting output or unemployment costs of eliminating inflation. Indeed, some analysts even suggested that therewould beno costs at all so long as the authorities showed enough commitment to their policies, since the private sector would then adjust its expectations to the new regime. There was also some concern, however, that the Bonn Summit’s attempt at coordination had failed because governments had failed to carry through their part of the bargain, preferring to free-ride on the stimulus provided by other governments. There is little evidence that this in fact happened. But it is a good example of the potential difficulties in negotiating and then sustaining a program of coordinated policies among sovereign governments. See also balance of payments; Bretton Woods system; international liquidity; international policy coordination; international reserves; Plaza Accord; Smithsonian Agreement