Restoration of gold peg and the Bretton Woods failure

After the Great Depression, the prevailing view was that an inefficient international monetary system was one of contributing factors that caused the Great Depression, and thus was in great need of reform. It was believed that one of the major problems with the international monetary system at that time was lack of cooperation and coordination between countries regarding their national currencies, which lead to a collapse of the international monetary system during the 1930’s.

Uncoordinated devaluations of national currencies were seen as moves especially detrimental to the stability of the global monetary system. However, World War II put reform plans on hold until 1944, when two major “imperialistic” powers, the US and the United Kingdom, negotiated the new world’s monetary system known as the Bretton Woods agreement.

Bretton Woods is a small town in New Hampshire where an international monetary conference took place in 1944. Nazi Germany was already in ruins and did not participate. The Bretton Woods agreement created a “par value” international monetary system. Under this agreement, currencies other than the US dollar were pegged to the dollar and the dollar was pegged to gold at $35 an ounce. Thus the dollar became the world’s only reserve currency. Currencies were allowed to fluctuate only within 1% of established par values. Also under the agreement, IMF (International Monetary Fund) was formed in 1946. The par values may be changed only with IMF approval. So the whole system was pegged to gold through the US dollar. It was expected that the US would maintain enough gold reserves to guarantee convertibility of the dollar and other countries will maintain their reserves in dollars.

The idea looked pretty good on paper, but since early stages of implementation was plagued with numerous real issues.

First of all, countries in Europe were too impoverished after the war to follow the agreement. It was not until the late 1950’s that the economies of Europe and Japan became strong enough to meet their obligations. By the 1960’s, those economies had improved so much that much more dollars were accumulated than spent by foreign countries and US gold reserves were inadequate to guarantee them. A series of modifications failed to resuscitate the “dying patient” and on August 15 of 1971 President Nixon eliminated the dollar’s peg to gold, since the US did not have enough gold reserves, and by 1973 the system of fixed exchange rates was gone. The end.

Thus, the modern system of free-floating interest rates was formed. The mighty dollar became just a small piece of green paper. Mr. Franklin on a $100 bill was not carrying around three ounces of gold in his virtual pocket anymore. As a byproduct of this metamorphosis, the forex market was propelled from obscurity into the major financial market.

In 1978, the IMF Articles were finally amended to reflect the new reality. According to these articles, countries are free to set up a floating or fixed exchange rate system as soon as it leads to an “orderly monetary system”.

Interestingly, lately due to the ongoing financial crisis some experts express their nostalgia about the “old good” times and call for restoration of gold peg and fixed exchange rates systems, arguing that this will bring much-needed stability. Chances of it happening in the foreseeable future are very close to zero.