Chapter 12
The Bretton Woods Era (1944–1973)
In This Chapter
Understanding the purpose of the Bretton Woods Conference
Identifying the international monetary system that came out of the conference
Pinpointing what did and didn’t work during the Bretton Woods era
The Bretton Woods era has a unique position among the historical experiences with an international monetary system. One of the reasons that made this era so special was the fact that the Bretton Woods system was much more multilateral than any of the previous international monetary systems. Forty-four countries attended the Bretton Woods Conference in 1944, but the number of countries in the system toward the end of the era was more than double that number. However, the system’s highly multilateral nature wasn’t enough for it to enjoy success: The Bretton Woods era lasted less than 30 years and it wasn’t very successful while it lasted.
This chapter covers the Bretton Woods era from start to finish. It shows the characteristics of the post-WWII international monetary system until the early 1970s. As Chapter 11 indicates, wars, revolutions, and so on, interrupted the metallic standard and WWII was not different in this regard. The Bretton Woods conference of 1944 marked the time when countries were trying to select a viable post-war international monetary system. In this chapter, I talk about the alternative proposals made during the conference, which proposal was accepted, and how the Bretton Woods system worked (or didn’t work).
Gaining Insight into the Bretton Woods System
By the time the Bretton Woods Conference started, participating countries were aware of the decisions and policies of yesteryears, especially the ones made during the interwar years (1918–1939) that led to the demise of the previous international monetary systems. As Chapter 11 explains, the tendency toward contractionary monetary policies to maintain the fixed exchange rates and toward trade restrictions to reduce persistent and large current account deficits had disastrous consequences during the 1920s and early 1930s. The Bretton Woods system sought to avoid protectionist trade policies and competitively contractionary monetary policies that led to deflation during the Great Depression. It wanted to reestablish the metallic standard after WWII without repeating the mistakes of the previous metallic standard periods.
However, pinpointing past mistakes wasn’t helpful in identifying and avoiding the mistakes associated with the new system. As Chapter 11 explains, the Bretton Woods Conference introduced a variation of the gold and gold exchange standard called the reserve currency system. Because the U.S. emerged from World War II as the new military and economic superpower, the dollar became the reserve currency. The special position of the dollar helped the U.S. afford autonomous macroeconomic policies, to some extent — and the very countries the U.S. helped rebuild (mainly Western European countries and Japan) later resented those policies.
Other reasons were to blame for the weakening of the Bretton Woods system. Among them was this one: Things change. One of the important changes in the external environment was rapidly developing and integrating financial markets. As Chapter 11 explains, the trilemma in international finance implies that maintaining internal and external balance in a fixed exchange rate system is impossible while capital flows freely. Therefore, at the beginning, the Bretton Woods system allowed capital controls. However, in the second half of the 1960s, it was clear that rapidly developing, highly liquid, and fast-integrating financial markets were reducing the efficiency of capital controls. The U.S., along with other countries, tried to intervene in some of the markets, such as the gold market, with little success.
The end of the Bretton Woods system came in the early 1970s, when another fixed exchange rate regime was dissolved. In 1944, the U.S. was a military and economic power whose currency seemed to be as good as gold. At the end of the era, the U.S. was fighting against large current account deficits, disappearing gold and foreign currency reserves, higher inflation rates, and constant pressure to devaluate the dollar.
Attending the Bretton Woods Conference in 1944
In July 1944, more than 700 delegates from 44 nations attended the United Nations Monetary and Financial Conference in Bretton Woods (New Hampshire), which later became known as the Bretton Woods Conference. The purpose of the conference was related to one of the facts of the metallic standard that Chapter 11 explores. A metallic standard doesn’t allow monetary policy to be conducted, which becomes a serious limitation during wars. As in the case of all wars and revolutions, the metallic standard was also abandoned during World War II in most countries. Therefore, the main objective of the Bretton Woods Conference was to establish a new post-war international monetary order.
This section provides information about the agenda of the Bretton Woods Conference. The relevance of the conference agenda lies in the fact that this conference was very different from the previous monetary arrangements that aimed to bring countries back to a metallic standard following a war. First, the sheer amount of participation made the Bretton Woods Conference a strongly multilateral setting. Second, more than ever before, and probably due to the extent of destruction during World War II, the participants were keen to make a list of all previous efforts toward establishing a metallic standard and to identify what worked and what failed in the past.
Lessons learned from the past and new realizations
The collective awareness among the participants of the Bretton Woods Conference had two main dimensions. First, many countries realized that certain past decisions weren’t particularly helpful for a successfully functioning international monetary system. Second, in the light of the new developments, there were also some new realizations. Following is an explanation of each of these dimensions.
Lessons learned from the past:
The conference participants wanted to avoid repeating the same mistake following World War I. In an attempt to punish Germany, countries had imposed large reparation payments starting in 1918. These payments were supposed to cover the debt accumulated by Allied forces during the war and help them pay to rebuild their countries. However, because of the heavy burden of these payments, Germany never recovered from World War I. To make reparation payments, Germany printed money and created hyperinflation. Especially during the Weimar Republic (1921–1924) in Germany, hyperinflation worsened: One pound of bread cost DM3 billion.
One of the responses to the Great Depression was to implement trade restrictions (see Chapter 11). Starting in the late 1920s, most countries introduced trade restrictions (tariffs, quotas, and so on) to improve their current account deficits and stop the reserve loss. Additionally, retaliation against trade restrictions only pushed the level of restrictions to international trade higher and further suppressed output and employment in many countries.
New realizations:
Despite cooperation, the tensions between the Western Allies and the Soviet Union became increasingly visible. By the way, the Soviet Union didn’t attend the Bretton Woods Conference. The conference participants declared their ideological views so that they would rely on capitalism to solve the economic problems of the post–World War II era. Despite their differences in views regarding the desired extent of government interventions in markets, the countries represented in the conference were dedicated to capitalism.
The then-flourishing Keynesian ideas implied specific expectations from governments. In his General Theory of Employment, Interest, and Money (published in 1936), Keynes prescribed during recessions an increase in government spending, to prevent aggregate spending from falling. Reflecting the Keynesian ideas, the welfare state emerged out of the Great Depression. The experience of the Great Depression promoted the expectation that governments actively try to improve the outcomes related to employment and growth.
Clashing ideas at the conference
The two major personalities at the conference reflected the leading countries of the Western world at the time: Britain as the previous world power and the U.S. as the emerging world power. Therefore, the ideas of John Maynard Keynes, an economist representing Britain, and Harry Dexter White, an economist and a senior Treasury official representing the U.S., dominated the Bretton Woods Conference.
The most important item on the agenda was the shape of the upcoming international monetary system. All participants wanted to establish a new metallic standard. However, disagreements arose regarding the format and the administration of the new metallic system. Memories of the adverse effects of current account imbalances on the gold standard were still fresh, so discussions centered on how to avoid such imbalances.
Checking out the British plan
Keynes proposed an International Clearing Union (ICU) as a way to addressing current account imbalances. He wanted to avoid the reappearance of persistent and large current account deficits that happened during the interwar years (1918–1939), which increased countries’ debt and debt payments and decreased growth at the global scale. Keynes thought of the ICU as a bank with its own currency (called Bancor), exchangeable with other currencies at a fixed rate. He proposed using Bancor to measure countries’ trade deficits or surpluses.
According to Keynes, countries with current account deficits would have an overdraft facility in their Bancor account with the ICU. He worked out specific numbers regarding the size of the overdraft facility. His proposal implied a maximum overdraft of half of the country’s average trade size over five years. If a country needed funds higher than the overdraft, it would be charged interest, thus motivating the country to devalue its currency.
Keynes also had an idea for countries with large and persistent current account surpluses. (See Chapter 11 for more on this topic.) One of the problems of the interwar years was that surplus countries didn’t do much to reduce their current account surplus. Then the pressure was all on countries with large and persistent current account deficits. During the interwar years, and especially around the times of the Great Depression, Keynes observed these deficit countries implementing increasingly contractionary monetary policies and increasing interest rates in an attempt to prevent funds from leaving these countries. However, as Chapter 11 shows, this led to deflation, lower output, and higher unemployment. Therefore, Keynes’s plan implied an interest charge of 10 percent if a country’s current account surplus was more than half the size of its permitted overdraft; this solution would motivate these countries to lend more. At the end of the year, if the country had a current account surplus that was half the overdraft, the ICU would confiscate the surplus.
Taking a look at the American plan
The American plan differed from that of the British. As indicated before, Harry Dexter White represented the U.S. at the Bretton Woods Conference. Even though Keynes objected to White’s ideas, at the end of the conference, the post–World War II international monetary system reflected almost exclusively the ideas of the U.S.
The U.S. agreed on the necessity of an agency to manage current account imbalances, but Keynes’s idea of the ICU was too interventionist for the American side. Additionally, the U.S. saw itself as a surplus country in terms of its current account in the years to come and didn’t want such interventionist ideas to be practiced on the U.S. Therefore, the White Plan emerged with two key components. First, White proposed the International Stabilization Fund (which later became the International Monetary Fund, or the IMF), which placed the burden of balancing current accounts on deficit countries and imposed no limits on surplus countries.
Since the international monetary system wasn’t the only item on the American agenda, White included a second aspect to the plan. After earlier wars, the aggressors were made to provide reparation payments. This time, however, the U.S. wanted to lead the reconstruction efforts. Therefore, the White Plan included a new multilateral development agency that would plan and finance economic reconstruction in all war-torn countries, allied or aggressor. The International Bank for Reconstruction and Development (IBRD, part of today’s World Bank) emerged from the American ideas about reconstruction.
The economic and military power of the U.S. at the end of World War II was extremely influential on countries choosing between the two alternative plans for the post–World War II international monetary system. The White Plan emerged as the winner.
Judging the Outcome of the Bretton Woods Conference
Three multilateral organizations were born at the Bretton Woods Conference: the International Monetary Fund (IMF), the International Bank for Reconstruction and Development (IBRD), and the General Agreement on Tariffs and Trade (GATT). These institutions were created based on the need for increased post–World War II international economic cooperation in issues related to international finance and international trade, as well as economic reconstruction of war-torn Europe and Japan. The U.S. was very interested in multilateral organizations because these organizations were considered insurance against economic nationalism that had proved extremely harmful during the Great Depression.
This section mostly focuses on the structure of the post-war international financial system. First, I discuss the version of the gold standard that the Bretton Woods system introduced. Second, I examine the role assigned to the IMF as the manager of fixed exchange rates.
Setting the reserve currency system
The reserve currency system that was established at the Bretton Woods conference is a version of the gold standard. In this system, one of the world currencies is identified as the reserve currency, and the reserve currency is pegged to gold. Then all other currencies are pegged to the reserve currency. Between the end of World War II and the end of the Bretton Woods system in the early 1970s, the dollar was the reserve currency; almost every country pegged its currency to the dollar.
In this system, even though the U.S. had to have gold reserves, other countries could do so but didn’t have to. However, nonreserve currency countries had to keep sufficient dollar reserves in order to intervene in their currencies by buying or selling the dollar to maintain the fixed exchange rates. Central banks of nonreserve currency countries held a large portion of their international reserves in U.S. Treasury bills, as well as short-term dollar deposits, which were (and are) highly liquid.
As in the case of any metallic standard, the reserve currency system also implies fixed exchange rates. Because under this system the dollar was convertible into gold and other currencies were pegged to the dollar, all cross rates (see Chapter 2) were automatically fixed as well.
This example is based on the discussion of cross rates in Chapter 2. Suppose that the French franc–dollar and German mark–dollar exchange rates are FFR2 per dollar and DM1.5 per dollar. The French franc–German mark exchange rate thus would be FFR1.33 per German mark (2 ÷ 1.5). If the French franc–German mark exchange rate were any different than FFR1.33, arbitrage would eliminate any exchange rate other than the fixed cross rates. Suppose that the French franc–German mark exchange rate is FFR1.60. In this case, you could sell $100 to the Bundesbank in Germany for DM150 ($100 × 1.5), sell your German marks to the Bank of France for FFR240 (DM150 × 1.60), and sell your French francs to the Fed for $120 (FFR240 ÷ FFR2), making $20 in the process. (However, this was not possible because the U.S. didn’t buy or sell gold at the Bretton Woods price.)
Time to take the lead
In the reserve currency system, the reserve currency country has a special position: It has more room to conduct monetary policy to achieve the internal balance. Therefore, the reserve currency country can attempt to maintain its internal balance through monetary policy without affecting its external balance. However, other countries that peg their currency to the reserve currency cannot change their monetary policy without affecting their reserves and messing up their external balance. Therefore, whenever the reserve currency country changes its monetary policy objectives, all other countries have to accept it.
For example, if a non-reserve currency country increases its money supply, it will lead to a decline in its international reserves. The reason is that an increase in the money supply decreases the interest rate in this country relatively to that of other countries. As investors flee this country in search for higher interest rates, an excess demand arises for foreign currencies, which revaluates the other countries’ currencies. But such a change in the exchange rate goes against the fixed exchange rates and maintenance of the external balance. Therefore, countries whose currencies are revalued engage in interventions in foreign exchange markets, where they can buy the assets of the reserve country with their own currency. This situation then increases the supply of these currencies, decreases interest rates, and devalues these currencies.
Power has its privileges
In fact, in a reserve currency system, the reserve currency country doesn’t have to intervene in the foreign exchange market to maintain the fixed exchange rate. Unlike in other countries, the central bank of the reserve currency country doesn’t have to buy or sell currencies in the foreign exchange market. The objective of the reserve currency country is to peg the reserve currency to gold. For example, the Federal Reserve was responsible for holding the dollar price of gold at $35 an ounce. Therefore, although the U.S. had more freedom to conduct monetary policy as the reserve currency country, its freedom had limits. For example, excessively expansionary monetary policy in the U.S. would make the gold parity of $35 for an ounce overvalued and pressure the gold parity to increase. A speculative attack on the dollar then would ensue. To avoid a possible decline in the value of their dollar reserves, other countries would attempt to sell their dollars in exchange for gold, depleting the gold reserves of the Federal Reserve Bank.
Clearly, the reserve currency system put the U.S. in a privileged position. The U.S. got away with the reserve currency system for essentially three reasons:
The basic gold standard, in which all countries peg their currency to gold and hold gold reserves, wasn’t attractive during the Bretton Woods conference because the Soviet Union was one of the major gold producers in the world.
The Soviet Union did not attend the Bretton Woods conference, and the wedge between the Soviet Union and the West was growing.
The U.S. emerged as the new superpower, taking the place Britain had occupied for so long. With the U.S. as the new economic and military power, the dollar became the reserve currency.
IMF: Manager of fixed exchange rates
The IMF’s Articles of Agreement implied both discipline and flexibility, to avoid the mistakes of the interwar period.
The discipline part of the agreement implied that the value of the dollar was to be pegged to gold and that all other currencies were to be pegged to the dollar, which led to fixed exchange rates. The flexibility part ensured that countries having trouble with keeping the fixed exchange rate would receive financial assistance. This was supposed to work as a remedy to the mistakes during the interwar period, when countries tried to maintain fixed exchange rates at the expense of free trade and employment.
Because unilateralism caused so many problems during the interwar years, the IMF, as a multilateral institution, had to offer facilities to assist countries with external balance problems. The lending facilities of the IMF aimed to reduce member countries’ current account problems by providing additional liquidity. However, if the IMF were to provide liquidity to member countries, the organization needed funds. Therefore, a subscription system was created in which IMF members were assigned quotas that reflected the countries’ relative economic power. This subscription was to be paid 25 percent in either gold or the reserve currency (dollar) and 75 percent in the member’s own currency. The quota system helped the IMF establish a pool of gold and currencies.
Now with funds at its disposal, the IMF was charged with managing current account deficits to avoid large currency devaluations. To make substantial changes in the exchange rate, a member country needed the IMF’s determination and approval that the country was suffering from a fundamental disequilibrium. However, no explicit definition was drafted for what constitutes a fundamental equilibrium. Clearly, what constitutes a fundamental disequilibrium would change from country to country as well as over time.
Even though international trade was a major headache in maintaining the external balance, the IMF promoted free international trade and urged its members to make their currencies convertible. Convertibility in currencies, also called current account convertibility, means that all currencies can be acquired and exchanged with other currencies. Clearly, if a country’s currency isn’t traded, it discourages trade with that country. U.S. and Canadian dollars became convertible as early as 1945. Most European countries restored convertibility in 1958, and Japan joined later, in 1964.
In addition to current account convertibility, capital account convertibility implies the free flow of capital between countries. As Chapter 11 discusses, capital account convertibility is part of the trilemma in international finance. Maintaining internal balance (full employment level of output) and external balance (fixed exchange rate) while capital freely moves between countries is called the trilemma because you cannot achieve these three goals simultaneously. Therefore, the IMF allowed restrictions on capital flows, which gave countries more freedom to use monetary policy to address internal imbalances. Based on the experience during the interwar years, in an attempt to attract investors in their countries, countries with current account deficits implemented contractionary monetary policies to keep their interest rates higher. As Chapter 11 shows, this particular policy decision led to lower output, higher unemployment, and deflation in a deficit country. Additionally, as other countries felt compelled to do the same, severe recessions simultaneously happened in many countries. To avoid such an outcome, the IMF allowed restrictions to be placed on capital flows so that countries could use their monetary policy to address domestic macroeconomic problems.
Marking the Decline of the Bretton Woods System
Britain, the world’s financial and military superpower until World War II, emerged from the war as a weaker country. The U.S., on the other hand, became the new superpower. The U.S. economy was strong, and the dollar became the reserve currency. The gold parity, $35 for an ounce of gold, was credible because the U.S. economy was strong, and the U.S. was committed to converting dollars into gold at this price. The dollar was about to play the same role as gold during the gold standards of previous decades. In terms of its political role, the U.S. was to help war-torn countries with their economic recovery, which implied a large outflow of dollars through grants, loans, military spending, and private investment.
Despite a promising start at the Bretton Woods conference, this section aims to show that the cracks in the Bretton Woods system appeared as early as 1947. In a way, the system died a slow death in the early 1970s.
Dollar shortage and the Marshall Plan (1947)
In the immediate aftermath of the Bretton Woods Conference, the problem of a dollar shortage emerged. During the late 1940s, the U.S. was running large current account surpluses, and its gold reserves were growing. At the same time, especially Western European countries were running large deficits. If the U.S. were to support the rebuilding efforts in war-torn countries, it was necessary to reverse this flow and make more dollars available for other countries’ use. The U.S. had to reverse the process and run current account deficits.
Even though the IMF and the IBRD were introduced to finance current account imbalances and reconstruction, respectively, it became apparent soon after the Bretton Woods Conference that these multilateral organizations didn’t have sufficient funds to do the job. By 1947, the IMF and the IBRD were admitting that they didn’t have enough funds (dollars) to fulfill their functions.
Therefore, in 1947, the U.S. introduced the European Recovery Program, also known as the Marshall Plan, which provided large grants to European countries. Between 1947 and 1958, the U.S. tried to encourage the outflow of dollars to improve liquidity around the world. Not only the Western European countries, but also the strategically relevant Mediterranean countries (such as Greece and Turkey) and other developing countries, received grants from the U.S. In the late 1940s, the Cold War had already started, and it was important for the U.S. to suppress the Soviet Union’s political influence. Not surprisingly, starting in 1950, large current account surpluses in the U.S. changed to large deficits.
The Bretton Woods system gave the U.S. a special place as the engine of stability. The U.S. was engaged in trade with developing countries, resulting in trade surplus. Then the U.S. sent these surplus dollars to Europe to be used in rebuilding their economies so that they could sell their goods to the U.S. In turn, European countries’ export earnings from the U.S. allowed them to trade with developing countries. To support Western European countries’ economic recovery, the U.S. did not retaliate against the protectionist trade practices of these countries. It seemed that the U.S. was the coordinator of these trade flows for the good of all parties involved. However, the successful working of this scheme depended upon the ability of the U.S. to keep having current account surpluses and using them in providing financial aid to Europe and Japan. During the 1950s, the system started showing signs of destabilization.
Systems getting out of hand (1950s and 1960s)
As early as 1950, the U.S. current account balance showed a deficit. Until John F. Kennedy won the presidential election in 1960, the U.S. response to the increasing current account deficit was to introduce trade restrictions, which was exactly what the Bretton Woods Conference had tried to avoid. The struggle to maintain the gold parity of $35 per ounce intensified during the 1960s.
As indicated earlier, the Bretton Woods system forced the gold convertibility on the reserve currency country. However, gold convertibility wasn’t required for all countries, so that they could hold dollars instead of gold. The problem was, there was a gold market. If the dollar was pegged to gold at $35 per ounce, the market price of gold had better be $35 per ounce. Persistent and large U.S. current account deficits indicated that the dollar was overvalued and the parity should be something higher than $35 per ounce of gold. This situation tempted investors into buying gold at the Bretton Woods price and selling at a higher price in the gold market. If you think about what investors are using to buy gold, the answer is the dollar. All this further enlarged the discrepancy between the gold parity and the market price of gold, which fed the frenzy of selling dollars and buying gold. Of course, certain events during the Cold War, such as the Cuban Missile Crisis in 1962, fueled increases in the gold price as well.
The U.S. found itself in a situation called Triffin’s dilemma. On one hand, the U.S. current account deficit was helping mainly European countries and Japan grow. Therefore, if the U.S. eliminated its current account deficit, these countries would be adversely affected. On the other hand, persistent and large current account deficits were contributing to the increasing discrepancy between the gold parity and the market price of gold.
In an attempt to strengthen the Bretton Woods system, two ideas were introduced: the London Gold Pool and the Special Drawing Rights.
The London Gold Pool
Apparently, the U.S. wasn’t willing to give up its support to Europe and Japan. Instead, it tried to affect the market price of gold. In 1961, eight countries (the U.S., the U.K., Germany, France, Italy, Belgium, the Netherlands, and Switzerland) came together and created the London Gold Pool, in which the U.S. initially contributed 50 percent of the gold in the pool. The aim of the Gold Pool was to affect the gold price set by the morning gold fix in London. Because most of the time the gold price was increasing, the Gold Pool sold gold in the market to counteract the increases in the price of gold.
The U.S. was also looking into domestic policy options to strengthen the economy and its export potential. The new Kennedy administration was considering a tax reform to increase productivity and promote exports, which would have helped prevent an increase in the gold parity (in other words, a devaluation of the dollar). However, such attempts were unsuccessful. Finally, the Gold Pool disintegrated in 1968. Congress revoked the 25% requirement of gold backing of the dollar. Countries in the pool suspended the exchange of gold with private entities. Additionally, the U.S. suspended its gold sales to countries that were known to participate in the gold market by selling dollars in exchange for gold. However, these efforts didn’t stop the depletion of the U.S. gold reserves.
The Special Drawing Rights
In an attempt to create liquidity, in 1969, the IMF introduced the Special Drawing Rights (SDR) as a supplementary reserve asset. Basically, the SDR represented a claim to currency that IMF member countries held. When the SDR was introduced, its value was equivalent to 0.888671 grams of fine gold, which was also equivalent to one U.S. dollar. IMF members were required to accept SDR holdings equal to three times their share. The main objective of the SDR was to prevent nations from buying gold at the Bretton Woods price and selling at the higher free market price. Another objective was to limit the amount of dollars that could be held.
Current account deficits weren’t only a U.S. problem. In 1964, a large current account deficit initiated a speculative attack on the British pound, eventually devaluating the currency. Another attack on the pound followed in 1967. Other countries faced the effects of these speculative attacks on the pound. Some European countries with current account deficits devalued their currencies, and countries with surpluses revalued their currencies, which also affected capital inflows and outflows to and from these countries.
Consequently, parity changes became increasingly unilateral decisions. Countries with strong exports postponed revaluation of their currencies, and countries with larger imports postponed devaluation. Frequently used national discretion made the Bretton Woods system even weaker.
Nailing the coffin in 1971 (and then again in 1973)
The U.S. accumulated persistent current account deficits to provide loans, grants, aid, and troops to Allied countries. During the 1960s, it became clear that the U.S. was putting the Bretton Woods system and its reserve currency status in danger. Still, the U.S. continued on the path designed in the late 1940s until the system broke down completely.
While the U.S. remained insistent on continuing its mission described by the Bretton Woods system, the world was changing. Throughout the 1960s and 1970s, important structural changes were taking place that also contributed to the breakdown of the Bretton Woods system:
The increasing monetary interdependence between countries. Most Western European currencies and the Japanese yen became convertible in 1958 and 1964, respectively. The return to convertibility led to an increase of international financial transactions, which strengthened monetary interdependence.
Due to the aftermath of World War II, a rapid development and integration of international financial markets was introduced. Starting in the mid-1960s, banks formed international syndicates. By 1971, most of the world’s largest banks became shareholders in these syndicates. These multinational banks moved around large amounts of funds for investment purposes, as well as for speculation and hedging against exchange rate fluctuations. These developments in financial markets made large capital flows possible.
The economies that the U.S. helped rebuild were becoming economic powers themselves. By the mid-1960s, the European Economic Community (EEC) and Japan were on their way to becoming international economic powers. Their total reserves exceeded U.S. reserves, they had higher growth rates, and their per-capita income was approaching that of the U.S. In fact, the international landscape of economic power in the mid-1960s looked very different than at the time of the Bretton Woods Conference in 1944. In a world with multiple economic powers, the privileged role of the dollar was being questioned. The U.S. was determining the level of international liquidity for all, which caused dissatisfaction among other countries. As the 1970s approached, the U.S., the reserve currency country, didn’t look the part.
Another reason lay behind the dissatisfaction of Europe and Japan with the system. U.S. policies were influencing not only economic conditions; some of these countries resented the military conflicts such as the Vietnam War in which the U.S. was involved. It seemed that holding the reserve country’s currency, the dollar, by other countries was enabling the U.S. in engaging military conflicts. By the late 1960s, higher inflation rates and large dollar outflows made the dollar overvalued. At the same time, the German mark and the yen seemed undervalued. Despite these imbalances, countries were reluctant to make the necessary adjustments. The Germans and the Japanese didn’t want to revalue their currencies because it would hurt their export performance. The U.S. avoided devaluation in order to maintain its international credibility. However, keeping everything the same was getting increasingly difficult because international currency markets were developing and large speculative capital was moving around in search of quick profits.
A political dimension of dissatisfaction with the U.S. as the reserve currency country also came into play. In 1971, détente (easing of strained relations) between the U.S. and the Soviet Union depreciated the role of the U.S. in protecting the Western world from the threat of communism. During the time of the Bretton Woods Conference in 1944 and throughout the 1950s, the protection the U.S. provided was valuable. However, when security fears lessened, the economic and military leadership of the U.S. became less acceptable.
By 1971, the U.S. had very few nongold reserves and only 22 percent gold coverage of foreign reserves. The dollar became significantly overvalued with respect to gold. Because of current account deficits, anti–free trade sentiments were rising in the U.S. Finally, President Nixon closed the gold window on August 15, 1971, ending the convertibility of the dollar into gold. The dollar was let to float according to its market price.
In December 1971, the Group of Ten met at the Smithsonian in an attempt to build a new international monetary system. The Smithsonian Agreement led to the devaluation of the dollar from $35 to $38 per ounce of gold. However, because U.S. expenditures and current account deficits were continuing, this devaluation did not stop the speculation against the dollar. In 1972, the devaluation of the dollar reached $44 per ounce of gold. Clearly, whatever remained of the Bretton Woods system couldn’t be rescued. In February 1973, the U.S. and other industrialized countries let their currencies float.