After the First World War, the world set about restoring the international gold standard that existed before the fighting. It took years to bring to fruition and the restoration fell apart almost as quickly. After the Second World War, the world once again went about recreating a monetary order largely along pre-war lines, albeit with some reform. After years of rebuilding, this system, the Bretton Woods system, fell apart just like the interwar gold standard. There would be no third attempt. What has replaced it and survives through today is fundamentally different.

Bretton Woods

            The Bretton Woods system was named after a 1944 conference attended by forty-four countries held at the Mount Washington Hotel in Bretton Woods, New Hampshire. The purpose of the conference was to ensure that after the Second World War, the world would not simply revert to the monetary and related economic problems of the interwar period, including regular devaluations and speculative flows of capital between countries. A new system, it was hoped, could bring greater stability.

            The system devised at Bretton Woods called for the U.S. dollar to continue to be linked to gold at a value of $35 per ounce. Currencies of other participating countries were in turn linked to the U.S. dollar. The dollar was the means by which other countries’ currencies would be linked to gold as the United States possessed three-quarters of the world’s gold reserves at the time. Compared to a rigid gold standard, this system was supposed to be more flexible; currencies would be readjusted when appropriate, an occasion that was nonetheless supposed to be rare. Further, the International Monetary Fund was formed to provide assistance to countries facing temporary financial challenges.

            This system took a while to come to fruition. Essentially, it only operated as originally conceived starting from 1958. Still, it looked promising enough, even then. The dollar’s peg to gold was supported by strong demand for U.S. dollars at a time when American goods were imported in large quantities by other countries, especially with European and Japanese industry still recovering after the war. Soon though, industry there recovered and, with rebuilt modern plant and equipment, European and Japanese industry became more competitive than that of America.

Early Challenges

            So, in the late 1950s, gold was flowing out of the United States due to its emerging balance of payments deficits. Military spending and foreign aid also accelerated the outflow as the amount of dollars in foreign hands increased. Falling gold reserves and growing dollar holdings by foreigners raised the risk of a run on the dollar and the possibility that the U.S. would have insufficient gold to honor these withdrawals. The dollar holdings of foreigners already exceeded the gold reserves of the United States by 1959.

            President Eisenhower took some steps to diminish this outflow by reducing U.S. spending abroad; to this end, American servicemen stationed abroad were withdrawn. He later barred Americans from holding gold bullion outside the country. Still, in October 1960, the price of gold in London rose to $40 as compared to an official price of $35 in the United States. This selling of the dollar was driven by the prospect that John F. Kennedy, a potential next president, would enact inflationary policies to boost economic growth.

            In an earlier gold standard era, countries with balance of payments deficits would see outflows of gold lead to falling domestic money supplies lead in turn to falling wages and prices and the return of competitiveness. But this price of keeping to a gold standard was not so acceptable anymore. Not only was austerity to restore the dollar unacceptable domestically, it would also have been problematic for the rest of the world too. The elimination of the U.S. balance of payments deficit, and especially the creation of a U.S. balance of payments surplus, would have drained other countries of gold and U.S. dollar liquidity, potentially setting off financial crises or deflation elsewhere.

            In any case, the differential between the official price and market price of gold meant that gold purchased in the U.S. could be resold abroad for more. This risked triggering a run on the dollar. In anticipation, foreign banks converted dollars to gold to protect against devaluation. In 1961, Germany and the Netherlands increased the value of their currencies and many anticipated other countries would follow suit. Between 1958 and 1962, U.S. gold reserves fell from $22 billion to $17 billion.

Attempted Fixes

            To stabilize the system, the U.S. and U.K. were joined by other European countries which pooled their gold reserves and sold gold to keep the price down. Countries also promised to coin less gold. President Kennedy extended Eisenhower’s bans on Americans holding gold abroad. Wage and price guidelines were introduced in 1962 to reduce inflation and the President personally intervened to prevent increases in steel prices. A tax on American purchases of foreign securities was enacted, also with the intention of reducing pressure on the dollar and outflows of gold.

            Other measures to which the American government resorted included the application of pressure on Germany not to exchange dollars for gold for risk of losing U.S. defense cooperation. The United States also issued foreign currency government bonds, the ‘Roosa bonds’, to raise foreign currency reserves. Central banks made new commitments to increase the resources available to the IMF, commitments large enough to even allow the IMF to provide credit to the United States if needed.

            The list of measures goes on. The U.S. Treasury issued more short-term debt to raise short-term rates and encourage capital inflows while repurchasing long-term debt to lower longer-term rates and support investment. Further, the Exchange Stabilization Fund, a foreign exchange fund of the U.S. Treasury, was used to support the dollar. This could only provide so much support though as its resources were quite limited.

            Perhaps most importantly, swaps were arranged between central banks to reduce the need for transporting gold out of the United States. These were essentially simultaneous offsetting transactions, one on the ‘spot’ foreign exchange market and another ‘forward’ foreign exchange transaction. The practical effect was to guarantee to central banks that their unwanted U.S. dollars could be exchanged at a fixed rate in the future. The first of these was set up with the Banque de France in March 1962 and this was thereafter replicated with nine other central banks. The value of these swaps increased from $900 million to $30 billion in the next 20 years, revealing the growing volume of unwanted dollars in foreign hands. Nevertheless, these efforts did provide stability for a few years.

Inflation and Further Trouble

            Before the end of the decade, the Bretton Woods system would be at a risk of collapsing yet again. In the 1960s, American GDP doubled. Over the same period, an expansion of the welfare state and the Vietnam War increased government spending. Inflation rose, particularly after 1965, and neither increased taxes nor higher interest rates slowed inflation.

            In 1967, pressure on the dollar returned. This was prompted in part by the devaluation of other currencies, notably a November 1967 devaluation of the British pound. As before, central banks continued to sell off their holdings of gold in order to support the dollar. However, further outflows of gold were prompted by the 1967 Six-Day War in the Near East. American gold reserves fell below $13 billion in 1968; this was their lowest level since 1937. Around this time, France withdrew from efforts to support the dollar, leaving the gold pool formed earlier in the decade, and withdrew gold it held in the United States. The end was now near at hand for the system of fixed exchange rates.

Demise

            President Nixon did try to limit inflation but was judged to be half-hearted because the administration did not want to see unemployment rise, though it did anyway. For its part the Federal Reserve was also disinterested in acting because it believed that the inflation underway was caused by non-monetary factors and a monetary response would therefore be ineffective. Then, in August 1971, the British requested to convert $3 billion in U.S. dollar currency reserves into gold. France also demanded redemption of its dollar reserves.

            This prompted Nixon to announce a series of measures on Sunday, August 15, 1971 designed to control inflation and support the dollar. These included taxes on imports, the first firm peacetime wage and price controls in the United States, and the suspension of conversions of dollars into gold at $35 an ounce.

Newspaper Headline After the Nixon Shock

            This was intended to be temporary and at least for a while the exchange rates, though floating, continued to be managed. The dollar was devalued later in 1971 to $38 per ounce of gold and again in 1973, this time to $42.22 per ounce. Other countries were abandoning fixed exchange rates at this time. In practice, a return to even a half-hearted gold standard never came and currencies began to float freely from 1971-73 onwards.

Lesson

            The Bretton Woods system was intended to resolve the problems that plagued the old interwar gold standard. Though, in an inauspicious sign for the feasibility of gold standards in the modern era, this attempt fell apart also and, unremarkably in hindsight, for rather similar reasons too. In both experiments, a gold standard could not withstand growing imbalances between surplus and deficit producing countries. Under a gold standard, countries are supposed to accept tough medicine, willingly or not, and adjust to eliminate deficits or surpluses, ensuring the sustainability of the system. In the 20th century though, policymakers had become smart enough to realize that they could accept the benefits of the gold standard while rejecting its pains, at least for a while. In the long run though, they could not, and they chose to sacrifice gold rather than their economic policies.

More from the Tontine Coffee-House

           Read about the attempt to re-create a gold standard after the First World War, a European monetary union in the 19th century, and a monetary crisis in Europe in 1992. Consider subscribing to this blog’s newsletter or checking out book recommendations, which include many of the sources often referenced in my posts. 

Further Reading

1.      Bordo, Michael. “The Operation and Demise of the Bretton Woods System: 1958 to 1971.” VoxEU, Centre for Economic Policy Research, 23 Apr. 2017.

2.      Ghizoni, Sandra Kollen. “Nixon Ends Convertibility of U.S. Dollars to Gold and Announces Wage/Price Controls.” Federal Reserve History, Federal Reserve Bank of St. Louis, 22 Nov. 2013.

3.      Markham, Jerry W. A Financial History of the United States. Sharpe, 2002.

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