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The Rise and Fall of the Modern Gold
Standard
The horror and destruction of two world wars filled the minds of
the men who gathered in 1944 in Bretton Woods, Vt. They were
determined to set the world right again and lay the foundation
for a new international economic order. The core of this system
was the strict pegging of all western currencies—British pounds,
French francs, German marks—to the U.S. dollar. The U.S. dollar
in turn was based on a set amount of gold—hence, the modern gold
standard.
The Bretton Woods system, however, was fated to ultimately
collapse. The reason became starkly clear over time. Banks
needed the U.S. dollar, which was pegged to gold, to establish
security in their reserve banks. The central banks of Europe
could not circulate more money in their own economies if that
meant overrunning the number of dollars they held. This system
depended, then, on the U.S. running dollar deficits with the
rest of the world, and the number of dollars in circulation soon
exceeded the amount of gold backing them up. With more and more
dollars in circulation, it became clear that the U.S.’s pledge
to back up its paper money in gold was more and more hollow. By
the early 1960s, an ounce of gold could be exchanged for $40 in
London, even though the price in the U.S. was $35. This
difference showed that investors knew the dollar was overvalued
and that time was running out.
Investors were not the only ones to recognize the fundamental
imbalance of the Bretton Woods system. American economist Robert
Trifflin had first identified the problem in 1960—for which
he has since been honored by having it named “Trifflin’s
Dilemma.”
There was a solution to Trifflin’s Dilemma for the U.S.—reduce
the number of dollars in circulation by cutting the deficit and
raise interest rates to attract dollars back into the country.
Both these tactics, however, would drag the U.S. economy into
recession, a prospect new President John F. Kennedy found
intolerable.
As the politicians dithered, the problem grew worse. Other
nations, especially France, exchanged dollars for gold, building
up their reserves. Throughout the 1960s and sitting atop a pile
of gold, France called for a return to the gold standard, rather
than dependence on the dollar. This tactic was partly inspired
by French resentment of American dominance in Europe. By 1968,
French officials openly attacked the notion that an ounce of
gold was still worth $35.
This caused ripples of unease in markets. In the late 1960s, the
U.S. had flooded the world markets with dollars printed to pay
forthe Vietnam War. Other nations accused the U.S. of exporting
inflation, and they chafed at a system that kept everyone in a
financial straitjacket except the U.S.
The cracks in the Bretton Woods system could no longer be
ignored. Dollars were flowing in Germany, bolstering the mark.
The German Central Bank, determined to protect the German
export-drive economy, sold marks to keep the currency’s value
down. But market forces were stronger than the bank. Eventually
it stopped trying, and the mark was allowed to gain value. The
Dutch followed and allowed their currency to also appreciate. In
August 1971, President Nixon acknowledged that the Bretton Woods
system was finished. He announced that the dollar could no
longer be exchanged for gold. The “gold window” was closed.
A last-ditch effort was made to save the
system when the major powers met in December 1971 in Washington,
D.C. to devalue the U.S. dollar against gold and other major
currencies.
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The resulting agreement, called the
Smithsonian agreement, was not much of an improvement, despite
President Nixon’s description of it as the “greatest monetary
agreement in the history of the world.” Gold was reset at $38 an
ounce, and currencies were allowed to fluctuate 2.25 percent,
rather than just the 1 percent allowed by BrettonWoods. It was
still not enough. The rates proved to be unsustainable. Within a
few months, several countries decided to abandon fixed exchange
rates and let their currencies float. However, the decision to
devalue the dollar broke the U.S.’s long-standing insistence
that $35 would always be worth an ounce of gold. This
effectively ended any pretense of a gold standard. In
February 1973, the dollar fell 10 percent. The nations of
western Europe linked their currencies, allowing a 2.5 percent
fluctuation rate, in a system called the snake. They also linked
their currencies to the dollar, permitting a 4.5 percent
fluctuation rate, in a system called the tunnel.
In hindsight, the end of the Bretton Woods system was
predictable. It was necessary to restore confidence in an
international economy shattered by war, but the Bretton Woods
system could not keep up with how that economy evolved. As
Europeaneconomies found their footing and grew again, the value
of their currencies would naturally have to gain against the
dollar. The system, however, did not have the flexibility. It
was also unable to adapt effectively to changes in how people
and institutions handled money. This is an old story—a replay of
governments trying to use money for their own ends in the face
of what the market wants. The collapse of the gold standard and
Bretton Woods meant that markets had regained a measure of
control over the value of currencies. Governments, however,
would continue to try to direct the market.
It didn’t take long for traders to see the potential for profits
in this new world of currency trading. Even if the governments
could maintain the snake and the tunnel, it still permitted
fluctuations— and where there are fluctuations, there’s a chance
for a profit. In 1971, the International Monetary Market of the
Chicago Mercantile Exchange was founded to trade foreign
currency futures. Before then, there was little chance to trade
currencies except through the banks. A new era had dawned. This
was clear little more than a decade after the collapse of
Bretton Woods. The U.S. economy was booming, but the dollar had
risen too far too fast. In 1985, the G-5, the most powerful
economies in the world—the U.S., Great Britain, France, West
Germany, and Japan—sent representatives to a secret meeting at
the Plaza Hotel in New York City. The dollar was simply too
high, crushing third-world nations under debt and closing
American factories because they could not compete with foreign
competitors.
Although the meeting was supposedly secret, news of it leaked
out, and rumors soon made their way through the markets. In
response to reporters’ questions, the G-5 released a statement
that they would encourage an “appreciation of nondollar
currencies.”
This became known as the “Plaza Accord.” Couched in this
diplomatic language was the hope that the dollar would decline
slowly and in an orderly manner, allowing everyone to adjust to
the dol-lar’s new value. But the markets are rarely orderly.
Instead of the hoped-for gentle fall, traders punished the
dollar, sending it down far faster than anyone had expected.
However, the Plaza Accord could rightly be called a success. In
the two years after the agreement, the dollar fell more than 30
percent. The U.S. trade deficit narrowed, and the countries met
again, this time in Paris, to sign another agreement—the Louvre
Accord. This time, the nations agreed to halt the decline of the
dollar. |
