The Great Depression brought about bank runs in Austria, Germany, and the United States, which put pressure on gold reserves in the United Kingdom to such a degree that the gold standard became unsustainable. Germany became the first country to formally abandon the post–World War I gold standard in July 1931. In September 1931, the United Kingdom allowed the pound to float freely. By the end of 1931, several other countries, including Austria, Canada, Japan, and Sweden, abandoned gold.43
Some historians believe that the effects of the Great Depression, which lasted nearly a decade, were also the result of high interest rates and a contraction of the money supply.44 The Fed could not increase the money supply without more gold, putting pressure on the ability of the United States to maintain its gold standard. In 1934, Congress passed the Gold Reserve Act, nationalizing all gold by ordering the Fed to turn over its supply to the U.S. Treasury. In return, the banks received gold certificates to be used as reserves against deposits and Federal Reserve notes. The act also authorized the president to devalue the dollar gold redemption rate from $20.67 per ounce to $35 per ounce, effectively devaluing the dollar by more than 40 percent.
The Allied Powers thought to avoid history repeating itself and saw financial cooperation as a way to encourage mutual cooperation among the countries affected by the war. In 1930, during the early days of the Great Depression, the Bank for International Settlements (BIS) was established. The main purposes of the BIS were to manage Germany's reparations payments imposed by the Treaty of Versailles as well as to function as a bank for central banks around the world. Countries can hold a portion of their reserves as deposits with the BIS. The BIS also operates as a trustee and facilitator of financial settlements between countries.45
These efforts, however, did not stop the rise of nationalism, which was further fueled by the economic depression and protectionist trade policies. The crippling effects of the Treaty of Versailles on the German economy gave way to the rise of Hitler in the 1930s. In 1939, another world war was started, which would last six years and claim 61 million lives.46
The Bretton Woods Agreement (1945−1971)
In the aftermath of World War II, world powers again looked for ways to prevent future conflicts and bring about peace, stability, and prosperity. There were three major developments during this period: the birth of the United Nations, establishment of the Marshall Plan, and the negotiation of the Bretton Woods Agreement.
The United Nations (UN) was born on October 24, 1945, as an intergovernmental organization established to promote international cooperation, replacing the League of Nations, which had been deemed ineffective.
In 1948, the United States launched the Marshall Plan. The initiative was aimed at helping Europe rebuild after the war in order to prevent the spread of Soviet communism. The plan was in operation for four years, beginning in April 1948. Other objectives of the plan included removing trade barriers, modernizing industry, and making Europe prosperous again.47
In 1944, delegates from the soon-to-be-created United Nations held a conference at a hotel in Bretton Woods, New Hampshire, called the United Nations Monetary and Financial Conference, which is now commonly referred to as the Bretton Woods Conference. With the effects of the Great Depression and two world wars still fresh in their minds, delegates devised a new system that would relieve them of the challenges of maintaining a gold standard while also reducing currency volatility and instability.
Delegates at Bretton Woods favored pegged exchange rates for their flexibility over the previous fixed exchange rates. This arrangement would come to be known as the Bretton Woods System. Under this system, countries would peg their exchange rates to the U.S. dollar and the U.S. dollar would be convertible to gold at $35 per ounce.48 Countries pegging their currencies to the U.S. dollar would allow their exchange rates to fluctuate within a 1 percent band of the agreed-upon exchange rate. To achieve this, central banks would buy or sell their currency against the dollar to maintain the peg.49
This effectively made the U.S. dollar, rather than gold, the world's reserve currency. The U.S. dollar would still be redeemable for gold; however, other countries would no longer be required to hold large gold reserves or ship gold back and forth to adjust any payment imbalances, since the dollar would now serve that purpose. A country wishing to receive gold would first need to convert its currency to U.S. dollars and then present them to the Fed for gold.
Another important development following the Bretton Woods Agreement was the creation of two new institutions: the International Monetary Fund (IMF) in 1947 and the International Bank for Reconstruction and Development (IBRD) in 1946, which later became the World Bank. The IMF was established to support the Bretton Woods monetary system with the mission of facilitating multilateral cooperation on international monetary issues, providing assistance to member states, and offering emergency lending to countries experiencing crises and help in restoring their balance of payments.50
Under the agreement, members were authorized and encouraged to employ capital controls as necessary to help manage payment imbalances and meet pegging targets, but were prohibited from relying on IMF financing to cover particularly short-term capital hemorrhages.
The IBRD was established to serve as a financial intermediary for channeling global capital toward long-term investment opportunities and postwar reconstruction projects.51 The creation of these two organizations was a crucial milestone in the evolution of the international financial architecture, and some economists consider it the most significant achievement of multilateral cooperation following World War II.
Post–Bretton Woods−−Fiat Currencies (1971−Today)
Under the Bretton Woods system, international trade grew, but this success masked an underlying flaw in the system's design. There was no mechanism for increasing the supply of international reserves to support continued growth in trade. In the late 1950s and early 1960s52 central banks worldwide needed more dollars to hold as reserves but were unable to expand their money supplies, as that meant exceeding their dollar reserves and threatening their exchange rate pegs. For the system to be successful, the United States needed to run dollar deficits. As a consequence, the value of the dollar began exceeding its gold backing.
During the early 1960s, investors could sell gold at a higher price in London than the stated rate of $35 per ounce in the United States, indicating that the dollar was overvalued. In 1960, Belgian-American economist Robert Triffin defined this problem, which came to be known as the Triffin dilemma, whereby a country's economic interests conflict with its international objectives as the custodian of the world's reserve currency.53 This means that the United States couldn't provide the world with a reserve currency while at the same time doing what is best for the country's economy; it had to choose one policy to follow at the expense of the other.
France voiced concerns over the artificially low price of gold in 1968 and even called for a return to the former gold standard. Around this same time, excess dollars flowed into international markets as the United States expanded its money supply to accommodate the costs of its military campaign in the Vietnam War. Speculators began attacking the dollar to exploit this weakness.
In August 1971, President Richard Nixon suspended the exchange of dollars for gold.