The transition of the world monetary system from gold standard to the modern Forex markets was anything but smooth. Governments from all over the world collaborated to make two pacts which would form the basis of the modern monetary system. However, both the arrangements failed. In this article, we will have a closer look at those arrangements.
Situation: The European countries were fighting World War-2. As such the economies of the world had been destroyed. Many countries had resorted to printing money to be able to finance the humungous war expenses. Therefore, there was a looming threat that as soon as the war got over, many economies in Europe would simply implode because of the inherent instability in their currency markets. As such to prevent such an outcome from happening, all the countries in the world, with all the prominent political leaders and economists held a conference at Bretton Woods in the United States. This came to be known as the Bretton Woods conference and had huge implications on the future monetary system and evolution of the Forex market.
Objective: The objective of the conference was to create a new monetary system that could withstand the possible shocks that it would receive once the war ended. This meant that the conference was meant to create a system that would enable the nations to avoid rapid depreciation and complete fallout of their currency systems.
The arrangement decided at the Bretton Woods system was slightly complex as compared to the gold standard that was already in place.
- Dollar Pegged to Gold: The United States had the largest reserve of gold in the world after World War-2. According to many estimates, it had more gold than all the European economies put together. This is the reason that the United States dollar overtook the British pound sterling as the most important currency during this period.Since United States had most of the gold in the world, the value of the United States dollar was pegged to gold. The price was fixed at $35 for an ounce of gold. There was a Federal gold window where anybody holding a dollar bill could go to exchange it for gold.
- Peg to the Dollar: All the other currencies in the world were pegged to the dollar. This meant that if the value of the dollar changes by 5% then the value of the other currencies would also change by 5% only. There was a 1% fluctuation that was allowed between the value of the dollar and other currencies. If the difference in the value of the dollar and the value of other currencies was greater than 1% then the Central Banks were instructed to engage in open market buying and selling operations and bring the currency within the relevant range.
- Concept of Reserve Currency: The Bretton Woods system ended up making the dollar the reserve currency of the world. Since all the countries were now transacting in US dollars instead of gold, the essential commodities such as gold and oil also came to be priced in terms of US dollars instead of gold. As such, dollar became a reserve currency. This means that every country that wanted to conduct foreign trade had to hold some amount of US dollars regardless of whether or not they wanted to trade with the United States.
Many of the stalwart economic institutions that we see today were formed as a result of the Bretton Woods agreement. Institutions like the International Monetary Fund (IMF) and the World Bank were created as a result of this agreement.
The Bretton Woods system was one of the most popular arrangements between countries to form a formal monetary system. However, it could only survive for a period of 27 years i.e. till 1971. The Bretton Woods system was officially over after the Nixon shock i.e. when the United States unilaterally took the world off the gold standard.
President Nixon took the world off the gold standard in 1971. However, he was concerned that free market operations in the Foreign exchange markets would bring distress and devaluation to many currencies. Therefore, he persuaded many countries to enter into an agreement called the Smithsonian agreement. This agreement was largely a failure as it lasted for less than a couple of years and ended up in the complete suspension of the Foreign Exchange markets !
Fixed Exchange Rates: The United States persuaded the G-10 countries to enter into an agreement wherein they would keep their exchange rates pegged to the dollar. However, the dollar would not be pegged to gold. Hence, it was essentially a Bretton Woods agreement minus the gold backing. Also, Central Banks were allowed certain liberties as the value of their currencies was allowed to fluctuate to 2.5% plus or minus of the value of the dollar before their Central Banks were supposed to conduct open market operations.
US Trade Deficit
This arrangement seemed weak on paper. However, it completely crumbled under the pressure of markets in the real world. The United States trade deficit kept soaring and as a result the value of gold went up to $210 for an ounce in 1972. As a result, all the members of the G-10 abandoned the Smithsonian agreement. This ended up in the closure of the Forex markets for a while!
The failure of the governments of the world to create a system wherein the exchange rates of the currencies would be fixed and stable left no alternative other than having a market for freely floating currencies. This is the stage where we find ourselves today. The Forex market as we know today is the result of the failure of the Bretton Woods and the Smithsonian agreement.