The Bretton Woods system was a monetary system that 44 countries participated in between 1944 and 1971. As part of the Bretton Woods system, countries held US dollars in their central bank’s reserves while the United States held physical gold in Fort Knox.
Countries that signed the Bretton Woods agreement were able to redeem their US dollars for gold at a fixed exchange rate of $35 per ounce. At the same time, their local currencies were kept at relatively fixed exchange rates to the US dollar. This allowed governments to indirectly tie their currencies to gold without having to maintain a certain percentage of gold in their own central banks.
By the end of World War I, many countries in Europe had accumulated large war debts. In order to fund the war, Germany and other European countries temporarily halted convertibility of paper money into gold. This meant they were effectively not on the gold standard anymore and could expand the money supply.[1] Gross, Stephen: Confidence and Gold. German War Finance 1914-1918, in: Central European History 42 (2009), pp. 227ff.
After the war, returning to the gold standard and maintaining the pre-war gold exchange rate proved difficult.
The money supply had been expanded beyond the gold reserves held by the war nations. Once the war ended, more paper money was in circulation than gold, making it challenging to return to the pre-war gold peg.[2] Taylor, Frederick: The Downfall Of Money. Germany’s Hyperinflation And the Destruction Of The Middle Class (2014), pp. 288f.
The inter-war period was chaotic. Germany, Austria and Hungary experienced hyperinflation. France and Great Britain faced their own unique challenges.
Countries began devaluing their currencies against others in order to inflate away the war debt and gain advantages in international trade.
In the decade following the war, known as the Roaring Twenties, many countries including the United States experienced a post-war boom.
This boom ended abruptly in 1929 when the stock market crashed and the Great Depression took a hold of the world. Countries that were attempting to return to the gold standard completely abandoned it during the depression.
The Untied States was one of the last countries to end the gold standard. When president Franklin D. Roosevelt took office, he proclaimed a bank holiday and issued Executive Order 6102 which outlawed ownership of more than $100 worth of gold.[3] Roth, Benjamin: The Great Depression. A Diary. (2010), pp. 112ff.
By doing this, Roosevelt took the United States off the gold standard. In the following years, another war started raging in Europe. Once again, governments spent a lot more money than they had, taking on massive levels of debt and expanding the money supply.
As World War II came to an end, it became clear that the world needed a new monetary system. Almost all countries had abandoned the gold standard. The world was being reshuffled geographically, politically and economically.
In 1944, during the final months of World War II, global leaders met at the Mount Washington resort in Bretton Woods.
A lot of famous people attended the Bretton Woods conference, including economist John Meynard Keynes. The need for a new, post-gold standard monetary system was apparent. Many people, including Keynes, believed the gold standard had failed since it didn’t give governments enough flexibility to engage in counter-cyclical government spending to stimulate the economy.
After witnessing the Great Depression, Keynes believed that a downturn like this could have been prevented or significantly shortened with more aggressive government spending.
The chaotic inter-war period, where countries debased their currencies against others to gain an advantage in international trade, was viewed as something that could be stopped with a well-organized international monetary system.
The initial plan of Keynes included the creation of a new world-reserve currency called bancor. However, the United States opposed the idea and insisted that the US dollar become world-reserve currency due to the United States economic strength and geopolitical position after World War II. The United States owned two thirds of global gold reserves by the end of the war. Because of this, it was agreed that the US dollar would become the reserve currency of the world.[4] Federal Reserve History: “Creation of the Bretton Woods System” Accessed Feb. 22, 2022.
Apart from introducing a new reserve currency, the International Monetary Fund (IMF) and the World Bank were founded during the Bretton Woods conference.
The goal of the IMF was to promote international monetary cooperation, facilitate international trade, maintain high levels of employment among its member countries, promote exchange rate stability and provide emergency funding to member countries with balance of payment difficulties.[5] International Monetary Fund: “Articles of Agreement of the International Monetary Fund” Accessed Feb. 22, 2022.
Each member country contributed a certain amount of reserves and would in return be able to receive funds and loans when it faced economic hardship.
The World Bank, on the other hand, was set up in order to provide loans to countries that needed help with reconstructing and rebuilding their infrastructure after World War II. Later on, the focus of the World Bank shifted to aiding economic development and providing assistance to low and medium-income countries.
While many ideas were discussed during the Bretton Woods conference in 1944, a new monetary system was drafted in which the United States would keep its currency backed by gold at a fixed rate of $35 per ounce.
All other countries would in turn keep US dollars in their reserves. In other words, these countries’ local currencies were backed by US dollars held in their respective central banks. And the US dollar, now world-reserve currency, was backed by physical gold held by the Department of the Treasury of the United States.
In total 44 countries signed the Bretton Woods agreement. All countries that participated in the Bretton Woods system were officially off the gold standard. The United States was no exception, officially ending the gold standard in 1933, over a decade before the Bretton Woods conference.
Although bank notes until 1963 still contained the words “Will pay to the bearer on demand”, American citizens weren’t able to convert paper money into physical gold anymore. In fact, ownership of more than $100 worth of gold was outlawed in the United States.[6] Roth, Benjamin: The Great Depression. A Diary. (2010), pp. 112ff.
But central banks of member countries that were part of the Bretton Woods system were still allowed to convert their US dollar reserves into physical gold at a fixed exchange rate of $35 per ounce.
This allowed all currencies to maintain a peg to gold without effectively being on a gold standard. This indirect convertibility into gold, only granted to central banks for international settlement, is known as the gold window or gold exchange standard.
The Bretton Woods system ended unofficially when president Nixon halted the convertibility of foreign held US dollars into gold in 1971. This is known as the Nixon Shock.
As part of the Bretton Woods agreement, the Untied States had to keep the US dollar pegged at a fixed exchange rate to gold. This prevented the United States government from issuing as much new currency as it wanted.
During Nixon’s presidency, another costly war was being waged. This time it wasn’t in Europe but in Vietnam. Having to keep the US dollar pegged to gold at a fixed exchange rate was crippling the United States ability to expand the money supply, fund the Vietnam War and spend money on government programs.[7] Office Of The Historian: “Nixon and the End of the Bretton Woods System, 1971–1973” Accessed Feb. 22, 2022.
Nixon was also worried that there would be a “run” for gold on the United States. As countries began losing faith in the US dollar, many of them started withdrawing gold.
The Department of the Treasury didn’t own enough gold to pay out central banks in case they wanted to convert a majority of their US dollar reserves into physical gold as they were promised as part of the Bretton Woods agreement.
A run on gold could have quickly depleted the nation’s gold reserves which were already running low.
This is when Nixon declared that the Untied States would halt the redeemability of US dollars into gold. From this day onward, countries that signed the Bretton Woods agreement were left holding US dollars that weren’t backed by physical gold anymore but merely by the strength of the American economy and the full faith and credit of the United States government.
After the Nixon Shock, efforts were made to reform the Bretton Woods agreement.
During negotiations with the most prominent countries that signed the agreement, a regime of new fixed exchange rates was established.
This new system of fixed exchange rates became known as the Smithsonian Agreement. Despite re-pegging the dollar to gold at $38 per ounce, and effectively devaluing all existing dollars by 8.5%, the system failed a few years later and many countries adopted free-floating exchange rates.
The Bretton Woods system officially came to an end in 1976. Shortly after the Bretton Woods system collapse and the subsequent inability of the Smithsonian agreement to fix the problems experienced as part of the Bretton Woods system, all countries went on a fiat standard.
Their currencies became fiat currencies that weren’t backed by anything but the trust and creditworthiness of the governments that issued them.
By the early 80s, all countries adopted floating exchange rates. Despite the Bretton Woods system collapse, the US dollar remained world-reserve currency until this day.
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