The End of Bretton Woods
When currency values began to fluctuate
Bretton Woods system refers to a set of economic agreements made during the late stages of World War II. It was started in response to the collapse of the economies between World Wars I and II. After World War II the allies set up a system of fixed exchange rates between currencies described as “Bretton Woods”. Bretton Woods was the location where the actual process was agreed to.
Reasoning and Creation
After World War I, the Treaty of Versailles created a system of international payments fueled by reparations to be paid for by Germany. These loans depended on German payments to the allies, particularly France, after World War I. The payments crippled Germany and lead to rampant inflation, which collapsed the economies of Germany and France.
When Britain pulled back from international trade in the early 1930s, a depression occurred in nearly all countries. The closure of Britain to international trade combined with the inability of Germany to repay its burdensome loans, destroyed the international trading system. The system of international trade and currency conversion levels fell apart and currency was devalued extensively to gain a bigger share of foreign markets (“beggar thy neighbor”).
During the planning for the post-World War II world, the allies, driven by the United States, did not want a repeat of this when their economies left a war footing. In order to keep the international system from slipping back into isolationism, the United States, Canada and Western Europe created the Bretton Woods system. After World War II the United States controlled 2/3s of the World’s gold and 1/2 of Global GDP. This allowed the United States to set the tone for a post-war world.
In summary, the Bretton Woods system set up the United States Dollar as the world’s defacto currency, backed by gold. The system called on the United States to tie its currency to the gold standard - which was held to be $35 an ounce. Major currencies, like British Sterling or Canadian Dollars or French Francs would be pegged to a set dollar exchange rate. Once the agreed to this system their currencies could always be exchanged for dollars at that set rate and have the US gold standard backing as well.
Strains on Bretton Woods
The first strain of the system occurred shortly after the end of World War II. The United States controlled most of the world’s manufacturing and wealth. After the war the US ran a huge foreign trade surplus. As the United States vacuumed up more and more dollars with the surplus, the Bretton Woods system strained. The United States needed to run a trade deficit to prop up the system, but a trade deficit was nearly impossible since the rest of the world was still recovering.
The United States determined to rectify this trade surplus in multiple ways, the largest being the “Marshall Plan”. The guiding principle was defined by Secretary of State George Marshall. He outlined the key points in a speech in 1947:
The breakdown of the business structure of Europe during the war was complete. … Europe's requirements for the next three or four years of foreign food and other essential products … principally from the United States … are so much greater than her present ability to pay that she must have substantial help or face economic, social and political deterioration of a very grave character.
— "Against Hunger, Poverty, Desperation and Chaos"[Notes 4]
Collapse
Without delving too much into details, the system collapsed due to three main features (we will ignore other reasons, although there were other reasons the system became unworkable over time.).
First, the United States economy grew, but so did the economies of other nations. Therefore, the percentage of the US trade versus world output declined. The locked exchange systems lead to inflated prices for US dollars. Those countries where economic growth led to undervalued currencies did not want to convert them to dollars at an unfavorable rate.
Second, the system required a conversion of dollars to gold on demand. While the cost of the dollars was set, the cost of gold was not. The price of gold fluctuated, but the United States had guaranteed a conversion of $35 dollars per ounce of gold. This divergence cost the United States much of its gold reserves.
Third, the United States increased the supply of dollars to fund its war in Vietnam. This created a very large imbalance of US dollars to gold prices. Combined with reason two (above), the situation was untenable.
In 1971 these forces required / allowed Richard Nixon to go off the gold standard in 1971. The US would no longer exchange US dollars to gold at a set rate. The United States attempted to manage this system by adjusting the dollar to other currencies at the time. But the new system still used fixed rates within bands of control, which did not remedy the system.
A slow death of fixed rates ran from 1971 to 1976 when the fixed rate system broke down, and the United States let the US dollar exchange rate “float”. In this context float meant the exchange rates were based on the relative strength of local currencies to the dollar.
Lingering Effects of Bretton Woods
The most important effect of Bretton Woods was to set the US Dollar as the world’s default currency. For easy example, Saudi Arabia sells oil to India at a price of $100 a barrel. In the local currencies this would be 375 Saudi Riyal - SAR. For India this translates to 8,218 Indian Rupees - IND. But India doesn’t pay the Saudis in SAR Riyal or IND Rupees. India pays the IND 8,218 to a bank or financial institution which then pays Saudi Arabia in US$.
As it stands now, nearly all current transactions are conducted and priced in US dollars. There are exceptions, particularly where the countries are under US sanctions like Iran, Cuba, and Russia.
Therefore, the United States can print a LOT of dollars without expecting currency inflation because there is a market for US dollars as the currency of savings. This provides a great incentive for other countries to try and make their currencies stable alternatives to the US dollar. At different times these other currencies that have attempted to be the international currency have been the Euro, the Chinese Yuan and, for a brief time, the Japanese Yen. But these attempts all suffered from the same problem, outside of local markets dollars are still used to clear currency exchanges.
A very negative side effect is that if a country borrows money in dollars and the local currency collapses, repayment is suddenly much more expensive. Take the 1980s Asian currency crisis for example. The Thai Baht before the collapse traded near 25 THB per 1 US$. The stable currency allowed loans in US dollars. But in 1990s the Thai Baht currency quickly fell to over 50 THB per 1 US$. The cost of Thailand’s loans (which had to be paid back in US dollars) doubled in less than year. This situation was similar in all of Southeast Asia and some other countries.
Since this experience, countries try to take loans in local currencies, but that is often not possible.
There are a few ways that countries try to limit their exposure.
Some countries peg their currency to a fixed amount of dollars. Hong Kong, Saudi Arabia, and most of the Caribbean Island nations do this. Other countries keep their exchange rate fixed within a tight band. The largest example of this is Chinese Yuan. This why it is always news in the United States when China changes it “peg” (number of yuan to the dollar).
The Euro floats, but its large economies share the Euro and thus the risk.
Finally many countries have just adopted the US$ as their official or official second currency. These include Ecuador, Panama, El Salvador, Zimbabwe, and Timor-Leste.
The Future
The US dollar should continue to be the world’s clearing currency unless the United States does something stupid, which can happen. If the United States cannot guarantee its ability to pay for loans, countries may move away from the US$ as a reserve currency. This will happen if the debt ceiling is not lifted in time. Albeit the world market has had time to prepare for this eventuality since 2006.
President Trump floated the idea of declaring bankruptcy to wipe out our debts to China and other countries. This was immediately shot down as it would break treaties and the ability of the US to borrow and run a trade deficit.
As the United States tumbles from political crisis to political crisis a reevaluation of the US Dollars strength may cause countries to use other currencies. The current situation is favorable to the United States and only the US can destabilize it. This would have unknown and possibly terrible economic effects.