The Rise and Fall of the Bretton Woods System

Both the World Wars proved to be very beneficial for the United States and particularly, the Second World War. In the First World War, the US made huge fortunes through loans and arms sales to Allied Nations. It amassed huge reserve of gold and resulting in the USA becoming a creditor nation. The Second World War transformed the USA into a superpower of the world, which was later challenged by the Union of Soviet Socialist Republics (USSR or today's Russia). The WWII boosted the US industries at a time when the whole Europe and Japan was devastated. By 1945, the US held 70% of world gold reserve. The Bretton Woods System put the foundation of an economic and financial architecture in the world, which transformed the USA into a formidable economic force which none could ignore and the US currency, US dollar (USD) global reserve currency.

Background and Foundation (1944-1945)

The Bretton Woods system resulted from the United Nations Monetary and Financial Conference at Bretton Woods, New Hampshire, during July 1944. 44 Allied countries came together during a time when World War II was ongoing to create a new international monetary order that would avoid economic mayhem in the 1930s. The system formally came into operation in 1945, making the US dollar the world's major reserve currency, supported by gold at $35 an ounce. Other currencies were fixed against the dollar in a 1% fluctuation band, producing a semi-fixed exchange rate system that was supposed to deliver stability and predictability in international trade.

Early Success and Rising Tensions (1945-1965)

The Bretton Woods system during the initial two decades facilitated unprecedented growth in the global economy resulting into tremendous trade expansion. Initially, the US held about 70% of the global gold reserves and had huge trade surplus while supplying the US dollars to its trading partner countries. As a result this arrangement worked very well. However, as soon as the European economies and Japan recovered from the devastation of the Second World War, the cracks in the system became visible. By the early 1960s, the US experienced a persistent trade deficits resulting into balance of payments deficits. It forced the US economy to pump more dollars into the global economic system while its gold reserves kept on dwindling. This peculiar situation the US economy created what economist Robert Triffin identified to as the "Triffin Dilemma" - the inherent contradiction between domestic monetary policy and international liquidity needs.

The Crisis Unfolds (1965-1971)

1965-1968: Rising Vietnam War expenditures and domestic Great Society programs generated enormous US budget deficits that flooded the world with dollars.
 

1968: Collapse of gold pool due to private sector demand for gold overwhelming attempts at central bank coordination; two-tier market in gold created.
 

1969-1970: The productivity in the US decelerated while the US inflation accelerated. This resulted in the dollar increasingly overvalued against with other pegged currencies.

1971: For the first time in the 20th century, the US economy experienced deficit turning the trade balance negative and the US goods were less competitive in the global market.

 

The Nixon Shock and System Collapse (August 15, 1971)

On 15 August, 1971, The US President Richard Nixon announced a temporary devaluation of dollar and suspension of convertibility to gold. This brought an end to the Bretton Woods system. This decision of the US is called the "Nixon Shock". Nixon Shock was motivated by a number of pressing immediate factors: increasing speculation against dollar, a sharp fall of 60% in the US gold reserves (to $10 billion in 1971 from $25 billion in 1949), and the threat of France to convert all its dollar holdings into gold. Nixon also levied a 10% import tariff and wage-price controls for combating domestic inflation. The "temporary" freeze turned into a permanent one when efforts to resuscitate the system via the Smithsonian Agreement in December 1971 broke down within 18 months.

 

 

Immediate Economic Consequences (1971-1973)

The breakdown caused immediate worldwide financial instability. Currency markets witnessed unprecedented volatilities as countries jettisoned fixed exchange rates and floated their currencies. The dollar weakened drastically against key currencies - about 15% against the Deutsche Mark and Japanese Yen up to 1973. Trade flows internationally were affected as companies grappled with exchange rate volatility, although this improved over time as newer hedging tools evolved. The demise of the system brought with it a first oil shock in 1973 when OPEC increased oil prices fourfold, in part as a reaction to devaluation of the dollar.

 

 

 

Long-term Economic Consequences

The shift to floating exchange rates reshaped the world economy. Though it closed the artificial limits of fixed parities and gave nations more monetary policy freedom, it also unleashed permanent exchange rate uncertainty that persists today. The lack of an international monetary anchor helped fuel the inflationary pressures of the 1970s because nations could no longer use gold convertibility to sustain price discipline. But the flexible system was also less vulnerable to economic shocks, being able to make automatic adjustments to avoid the deflationary spirals of the Great Depression. The dollar continued to be the world's reserve currency, but no longer backed by gold - a system some refer to as "Bretton Woods II."

Legacy and Modern Implications

The collapse of Bretton Woods was the demise of metallic money standards and the beginning of fiat money under central bank control. This shift allowed more activist monetary policy but also brought new sources of international financial instability, as revealed by repeated currency crises in emerging markets. The collapse of the system underscored the unfeasibility of sustaining fixed exchange rates in the period of heightened capital mobility - a lesson repeatedly rediscovered through the ensuing currency crises in Europe, Asia, and Latin America. The contemporary international monetary system is still rooted in the post-Bretton Woods system of floating rates, although regional systems such as the European Monetary Union are efforts to reestablish some of the stability the original system used to provide.

Rajeev K Upadhyay