The 1944 Bretton Woods agreement established a new global monetary system. It replaced the gold standard with the U.S. dollar as the global currency. By so doing, it established America as the dominant power in the world economy. After the agreement was signed, America was the only country with the ability to print dollars.
The Bretton Woods Agreement
The Bretton Woods agreement was created in a 1944 conference of all of the World War II Allied nations. It took place in Bretton Woods, New Hampshire.
Under the agreement, countries promised that their central banks would maintain fixed exchange rates between their currencies and the dollar. How exactly would they do this? If a country’s currency value became too weak relative to the dollar, the bank would buy up its currency in foreign exchange markets. That would lower the currency’s supply and raise its price. If its currency became too high, the bank would print more. That would increase the supply and lower its price.
Members of the Bretton Woods system agreed to avoid trade wars. For example, they wouldn’t lower their currencies strictly to increase trade. But they could regulate their currencies under certain conditions. For example, they could take action if foreign direct investment began to destabilize their economies. They could also adjust their currency values to rebuild after a war.
How It Replaced the Gold Standard
Before Bretton Woods, most countries followed the gold standard. That meant each country guaranteed that it would redeem its currency for its value in gold. After Bretton Woods, each member agreed to redeem its currency for U.S. dollars, not gold. Why dollars? The United States held three-fourths of the world’s supply of gold. No other currency had enough gold to back it as a replacement. The dollar’s value was 1/35 of an ounce of gold. Bretton Woods allowed the world to slowly transition from a gold standard to a U.S. dollar standard.
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The dollar had now become a substitute for gold. As a result, the value of the dollar began to increase relative to other currencies. There was more demand for it, even though its worth in gold remained the same. This discrepancy in value planted the seed for the collapse of the Bretton Woods system three decades later.
Why It Was Needed
Until World War I, most countries were on the gold standard. But they went off so they could print the currency needed to pay for their war costs. It caused hyperinflation, as the supply of money overwhelmed the demand. The value of money fell so dramatically that, in some cases, people needed wheelbarrows full of cash just to buy a loaf of bread. After the war, countries returned to the safety of the gold standard.
All went well until the Great Depression. After the 1929 stock market crash, investors switched to forex trading and commodities. It drove up the price of gold, resulting in people redeeming their dollars for gold. The Federal Reserve made things worse by defending the nation’s gold reserve by raising interest rates. It’s no wonder that countries were ready to abandon a pure gold standard.
The Bretton Woods system gave nations more flexibility than a strict adherence to the gold standard. It also provided less volatility than a currency system with no standard at all. A member country still retained the ability to alter its currency’s value if needed to correct a “fundamental disequilibrium” in its current account balance.
Role of the IMF and World Bank
The Bretton Woods system could not have worked without the IMF. Member countries needed it to bail them out if their currency values got too low. They’d need a kind of global central bank they could borrow from in case they needed to adjust their currency’s value and didn’t have the funds themselves. Otherwise, they would just slap on trade barriers or raise interest rates.
The Bretton Woods countries decided against giving the IMF the power of a global central bank. This power involved printing money as needed. Instead, they agreed to contribute to a fixed pool of national currencies and gold to be held by the IMF. Each member of the Bretton Woods system was then entitled to borrow what it needed, within the limits of its contributions. The IMF was also responsible for enforcing the Bretton Woods agreement.
The World Bank, despite its name, was not the world’s central bank. At the time of the Bretton Woods agreement, the World Bank was set up to lend to the European countries devastated by World War II. Now the purpose of the World Bank is to loan money to economic development projects in emerging market countries.
The Collapse of the Bretton Woods System
In 1971, the United States was suffering from massive stagflation. That’s a deadly combination of inflation and recession. It was partly a result of the dollar’s role as a global currency. In response, President Nixon started to deflate the dollar’s value in gold. Nixon revalued the dollar to 1/38 of an ounce of gold, then 1/42 of an ounce.
But the plan backfired. It created a run on the U.S. gold reserves at Fort Knox as people redeemed their quickly devaluing dollars for gold. In 1973, Nixon unhooked the value of the dollar from gold altogether. Without price controls, gold quickly shot up to $120 per ounce in the free market. The Bretton Woods system was over.