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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.

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 European economies 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 non dollar 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 dollar’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.