The Smithsonian Agreement was an attempt to reform the Bretton Woods system after president Nixon closed the gold window in 1971.
The new agreement and reforms to the monetary system included devaluing the dollar against gold and adjusting the fixed exchange rates at which currencies were pegged to the US dollar. The Smithsonian Agreement was short-lived and abandoned in favor of floating exchange rates.
Until 1933, the Untied States was on a gold standard. This meant, gold backed at least 40% of circulating paper currency.[1] Federal Reserve of St. Louis “The Federal Reserve Act of 1913 : History and Digest” Accessed March 1, 2022. If an American citizen wanted to convert their dollars into gold, they could do so at a fixed exchange rate.
This made sure people trusted the US dollar as a stable store of value, medium of exchange and unit of account. Until World War I, most countries were on a gold standard. Before that, the silver standard was common.[2] BBC “A Short History of the Pound” Accessed March 1, 2022. The world had a long history of commodity money.
Precious metals served as money while paper receipts, in the form of gold certificates and bank notes, could be redeemed for money at any time. This form of paper money overcame an important limitation of gold and silver. It made money more transportable and convenient for everyday transactions.
However, to finance World War I, many countries temporarily abandoned the gold standard.[3] Taylor, Frederick: The Downfall Of Money. Germany’s Hyperinflation And the Destruction Of The Middle Class (2014), pp. 288f. While they attempted to return to it after the war, this proved difficult. World War I was expensive. To fund it, nations had to halt convertibility of paper currency into gold. Countries like Germany, France and the United Kingdom expanded the money supply to finance their war efforts.[4] Gross, Stephen: Confidence and Gold. German War Finance 1914-1918, in: Central European History 42 (2009), pp. 227ff.
Once the war ended, returning to the pre-war gold peg was challenging. This is why it is generally believed the traditional gold standard ended with the beginning of World War I in 1914.
Several countries attempted to return to the gold standard after the war but abandoned it shortly after. The United States only left it after the Great Depression, when president Roosevelt issued Executive Order 6102.[5] The American Presidency Project. “Executive Order 6102—Requiring Gold Coin, Gold Bullion and Gold Certificates to Be Delivered to the Government” Accessed February 24, 2022.
From that point onward, gold ownership in excess of $1,000 became illegal for American citizens.
Shortly after the Great Depression, World War II began. By the end of the war, geopolitical power had shifted. The United States emerged as the dominant world power with the strongest military and largest gold supply.
During the last months of World War II, world leaders met at the Mount Washington resort in Bretton Woods to draft a new monetary system.
Due to the geopolitical power and financial strength of the United States, the US government had significant bargaining power during the conference. John Meynard Keynes proposed the creation of a new, neutral currency called bancor to facilitate international trade.
The idea was rejected in favor of adopting the US dollar as world-reserve currency. This placed the United States at the center of the global monetary system that emerged after World War II.
This monetary system, known as the Bretton Woods system, pegged the US dollar to gold at a fixed exchange rate of $35 per ounce.[6] Federal Reserve History: “Creation of the Bretton Woods System” Accessed February 22, 2022. Countries that signed the Bretton Woods agreement pegged their currencies at fixed exchange rates to the US dollar.
This system allowed the United States and other countries to keep their currencies backed by gold without having to maintain a traditional gold standard.
The Bretton Woods system came under pressure in the early 1960s.
The United States had increased the US dollar supply in order to fund government spending. This included financing the Vietnam war. The Vietnam war was unpopular among the general public. Since the public was less willing to buy war bonds and finance the war, the Federal Reserve largely monetized the war debt. This meant, the central bank created money to pay for the war.
As a result, the dollar supply increased, which contributed to rising inflation. Additionally to financing the Vietnam war, the Federal Reserve engaged in loose monetary policy. The Federal Reserve let inflation run high to keep unemployment low, expecting this wouldn’t be a problem.[7] Federal Reserve History: “The Great Inflation” Accessed March 18, 2022. But the combination of financing the Vietnam war, and an increasingly expansionary monetary policy by the Federal Reserve, led to the Great Inflation.
The Great Inflation was a period of heightened inflation between 1965 and 1980. At the end of this period, inflation reached double digits and Federal Reserve chair at the time, Paul Volcker, reversed the loose monetary policy by rising the federal funds rate to 19%.[8] Federal Reserve Bank of St. Louis: “Federal Funds Effective Rate” Accessed April 22, 2022.
In the meantime, the Great Inflation contributed to the collapse of the Bretton Woods system.
As US government spending increased and inflation fears led to a loss of trust in the US dollar, many investors exchanged their US dollars for foreign currencies. At the same time, countries that signed the Bretton Woods agreement became increasingly nervous about the United States ability to redeem US dollars for gold.
The US dollar supply had grown beyond the United States gold reserves. This meant it was increasingly unable to keep the US dollar pegged to gold at a fixed exchange rate of $35 per ounce.
As foreign nations questioned the United States ability to redeem their dollar reserves into gold, they began withdrawing their gold.
France sent a war ship to the United States to pick up gold in return for US dollars. Other countries, including the United Kingdom, were nervous to exchange their US dollars for gold as well. As a result, the gold supply of the United States began draining.
After World War II, the United States owned almost two thirds of the world’s gold. In the early 1970s, this gold supply was shrinking fast. The United States risked losing a majority or even all of its gold.
As a result of “speculators” exchanging their US dollars for foreign currencies and nations draining the gold reserves of the United States, Nixon closed the gold window in 1971. This sent shock waves through the international community and became known as the Nixon Shock.
As part of the Nixon Shock, countries that were promised they could redeem their US dollars into gold at $35 per ounce were left holding paper currency. Some people view this as a default on the side of the United States.
The abrupt closing of the gold window led to an international crisis of trust. To resolve the crisis, the International Monetary Fund (IMF) suggested a meeting between G-10 world leaders.
A group of 10 countries, including Belgium, Canada, France, West Germany, Italy, Japan, the Netherlands, Sweden, the United Kingdom and the United States, met at the Smithsonian institution to discuss the future of the monetary system.
The goal was to resolve the international crisis by reforming the Bretton Woods system.
The Nixon Shock should temporarily halt redeemability of US dollar reserves into gold. When Nixon made this decision, it was not an official abandonment of the Bretton Woods system.
The countries that met at the Smithsonian institution came to an agreement and drafted a plan to reform the Bretton Woods system. This plan, known as the Smithsonian agreement, included devaluing the US dollar against gold.
From a practical standpoint, this meant repricing gold from $35 per ounce to $39 per ounce.[9] Federal Reserve History: “The Smithsonian Agreement” Accessed May 4, 2022. As a result, the US dollar effectively lost 8.5% of its value.
Countries that participated in the Smithsonian agreement agreed to re-peg their currencies to the US dollar. Under the Bretton Woods and Smithsonian agreement, currencies were pegged at fixed but adjustable exchange rates to the US dollar.
This meant, currencies had to maintain their peg to the US dollar within a certain band or percentage range. Under the Smithsonian agreement, the exchange rates were increased which meant foreign currencies appreciated against the US dollar.
The changes made under the Smithsonian Agreement were short-lived and didn’t fix the underlying problems that the Bretton Woods system faced.
The Untied States couldn’t maintain the peg of $39 per ounce of gold and had to further devalue the dollar and reprice gold to $42 per ounce.[10] Federal Reserve History: “The Smithsonian Agreement” Accessed May 4, 2022. This resulted in the US dollar losing another 10% of its value.
Foreign currencies continued to gain value against the US dollar, making it difficult to maintain their pegs despite the adjusted exchange rate bands. Shortly after it was called into life, it became clear that the Smithsonian agreement had failed. It didn’t restore trust in the Bretton Woods system.
Within a month after repricing gold to $42 per ounce, countries abandoned the Smithsonian agreement in favor of floating exchange rates.
As a result, the Bretton Woods system ended officially in 1973.[11] Federal Reserve History: “The Smithsonian Agreement” Accessed May 4, 2022. This severed all ties to gold. While some people attribute the end of Bretton Woods to the Nixon Shock, it only formally ended two years later.
After the failure of the Smithsonian agreement all countries adopted floating exchange rates. This means that all currencies became fiat currencies.
Under the gold standard and Bretton Woods system, gold backed paper money. Since 1973, only the faith and credit of governments backs their currencies.
Some people argue that a new monetary system, called the Petrodollar system, emerged.[12] Lyn Alden: “The Fraying of the US Global Currency Reserve System” Accessed April 1, 2022.[13] Gladstein, Alex: Check Your Financial Privilege. Inside the Global Bitcoin Revolution (2022), pp. 39ff. This unofficial monetary system backed the US dollar with oil from OPEC nations.
However, the theory of the Petrodollar system is controversial and not accepted by mainstream economists. If it exists, which is debated, it isn’t based on fixed exchange rates like the Bretton Woods system. Under a Petrodollar system, floating exchange rates prevail. At most, the US dollar is indirectly backed by oil.
The officially accepted theory is that after the collapse of the Bretton Woods system the world adopted a fiat currency regime with floating exchange rates. This means, currencies aren’t formally backed by a commodity like gold or oil.
The Smithsonian agreement remains an often overlooked but important period in monetary history. It marks the transition from a commodity-based monetary system to fiat currencies.