This topic will be in two posts. In this one, I’ll try to sketch how the post-WWII currency system was set up and why it eventually broke apart. In the second post, I’ll talk about how I think the present situation compares with that time and how our current federal budget deficit poses a serious threat to US economic power similar to that of the Sixties.
In even the simplest world where there are a number of different countries, each with its own currency, but all wanting to trade with one another, the issue of foreign exchange comes up. The grower of American corn, for example, probably wants to be paid in dollars. The maker of German printing presses expects to be paid in marks (or, in today’s world, in euros). The Mexican buyer of either not only wants to know the peso price of each, he needs to have a currency market where he can exchange his pesos for the appropriate foreign currency.
Previous, unofficial, reserve currencies
There have been times in the past when one country has held a leading position in wealth, culture, prestige, military power or something else that has resulted in its currency being used in other countries as well. In the 18th and 19th centuries, for example, the Spanish real de a ocho (dollar, or piece of eight) was an accepted medium of exchange in large parts of the world. In the US it was preferred for its greater purity to the output of our own government mints. During the same period, Spanish gold often formed the basis for many countries’ official foreign currency reserves.
Bretton Woods makes the US dollar the first explicit reserve currency
The idea of using an individual country’s currency as a standard for transactions in many countries took a quantum leap forward after the World War II. Large portions of the industrial bases of most major combatants had been destroyed in the course of the fighting. National treasuries were severely depleted by the cost of waging the war, as well. The United States, however, had emerged from the conflict relatively unscathed and had become, by default if nothing else, by far the most powerful industrial country on earth.
The Bretton Woods agreements ratified shortly after the end of the war established a new world monetary system. The US volunteered to stand squarely at its center. The signatories agreed to establish the value of their own currencies in terms of US dollars at a pre-determined, fixed, exchange rate. The US, which at that time held over half the world’s official gold reserves, pledged to act as the central currency in the system and provide liquidity to the rest of the world. It also agreed to anchor the accords to gold, by committing itself to exchange dollars for gold a the fixed rate of $35 per ounce. In effect, the US became the central banker for the world.
The Bretton Woods collapse
The Bretton Woods arrangement lasted over twenty years before collapsing in 1971, when in the face of sharply depleted gold reserves, the US declared it would no longer exchange dollars for gold at $35 an ounce.
Why the change of heart?–or, the better question, what strains in the fixed rate system caused its collapse?
There were two key ones:
1. The initial exchange rates had been fixed at a relatively high rate for the dollar, as a way of trying to stimulate growth of export-oriented manufacturing in the countries ravaged by the war. Twenty years later, thanks in part to the Marshall Plan and other US aid programs, Europe and Japan had reindustrialized. Their plants were brand-new, and more efficient than the US industrial base, which, was still using, for example, blast furnaces for steel built in the 1800s. Their countries were growing more rapidly than the US. In 1970, the exchange rates fixed in the late Forties were no longer appropriate and would have to change.
2. Since everything in the system was explicitly or implicitly priced in dollars, the US had volunteered to provide enough dollars to the rest of the world to allow world trade to grow. This outflow of dollars was not necessarily the best thing for the long-term health of the domestic American economy.
More important, Washington soon figured out that its central position gave it an unparalleled opportunity to “game” the system. If the budget didn’t balance, why raise taxes or cut out some pork barrel projects. Instead, use our position as the world’s banker to print up a few more dollars to cover the shortfall. Who would notice?
At first no one did–or grateful for the generosity of the US in helping the world rebuild after the war, they pretended not to notice and just absorbed the “extra” Treasury bonds as part of their national foreign currency reserves. But by the mid-Sixties, the US government was financing the ambitious social programs of the War on Poverty as well as the war against North Vietnam (as part of the larger Cold War), not by raising the necessary taxes or trimming expense, but by printing a lot more dollars than the system needed or wanted.
As US debts to the rest of the world mounted, foreign governments eventually showed their displeasure at US economic and foreign policy in the only way they could. They began to liquidate their holdings of US government bonds by cashing them in for gold.
By 1971, this pressure was great enough that the Bretton Woods system fell apart.
Transition to a new order
What took its place? The outlines of the currency situation we have now.
–US remained the dominant–though no longer the sole–economic power in the world, so the dollar retained its key role in world commerce.
–But the link to the gold price was gone.
–Currency prices were no longer officially fixed, but were allowed to fluctuate based on supply and demand. –Initially, governments attempted to nudge currencies in the direction they preferred. But as time passed, the trading desks of large commercial banks grew to dwarf the power of individual government treasurers. As a result, government attempts to set currency policy by establishing a specified rate of exchange in the market began to disappear.
In my next post: where we are now.