Dreaming of a dollar-free world

The international monetary system defines the rules, customs, instruments, and instructions for managing international payments. The system defines the exchange rate regime to be followed in the world. The world has a history of different monetary arrangements. Significant ones are two, the gold standard and the Bretton Woods agreement. However, both collapsed giving way to the floating exchange regime.

 In 1880 the gold standard started operating. The gold standard act committed the United States to maintain a fixed exchange rate concerning other countries pegged at two gold. Between 1914 and 1919, the gold standard was suspended by several countries during World War I from 1919 to 1925 the world operated at fluctuating rates. In 1925 Great Britain returned to a gold standard. In 1931, Great Britain abandoned the gold standard upon the onset of the great depression. From 1931 to 1940 monetary nationalism took place.

In 1944 a meeting at the Bretton Woods established a gold exchange standard and two new international organizations were established, namely International Monetary Fund and World Bank. In 1971 US President Nixon ended the dollar link to gold established under the Bretton Woods agreement.

The world moved to a system of floating exchange rates and capital market liberalisation.

 What led to the demise of the gold standard agreement and Bretton Woods agreement? And during these current times of currency uncertainty, what lessons can we learn from those agreements? The classical gold standard period was between 1870 and 1914. One major reason why the gold standard was in place was because of the use of gold coins as a medium of exchange, store of value, and unit of account. The gold standard as a functioning system was acknowledged as a legal institution in 1819 when the British Parliament repealed long-standing restrictions on the export of gold coins and bullions from Britain.

Later in the 19th century, Germany, Japan, and other countries adopted the gold standard. The primary responsibility of the central bank wants to preserve official parity between its currency and gold and to maintain this price. The Central Bank needed a sufficient stock of gold reserves because international reserves were in the form of gold during this period, and any balance of payment deficit or surplus had to be financed by gold shipments between central banks. Any imbalance was adjusted by the inflow or outflow of gold.

This adjustment mechanism was explained as the price-specie-flow mechanism by Hume. The gold standard was a full-fledged gold coin standard where the value was set by the fixed weight of gold but it was abandoned in 1914 with the onset of the First World War.

The uneven magnitude of inflation in different countries during the First World War distorted the equilibrium of the gold standard, however, after the end of the war, attempts were made to restore the gold standard. Between 1919 and 1925 many countries allowed their exchange rates to float freely in the foreign exchange market.

 In 1925 UK reestablished the convertibility of the British Pound into gold and brought back the gold standard, other nations followed the route too. The new system however never functioned smoothly. The UK has lost its competitiveness and paying for the war created a huge balance of payment deficit.

Attempt to correct the deficit led to deflation in the UK and the problem worsened when France decided to settle its balance of payment variance with gold. The UK was forced to suspend the convertibility of gold and devalue the pound and the gold exchange standard came to an end in 1931. The onset of the Great Depression took place and led to the suspension of the gold standard by many nations.

In 1944, representatives from 44 countries met in Bretton Woods, this led to the establishment of IMF and the World Bank, then known as the International Bank for Reconstruction and Development. This system replaced the gold standard and establish parity for each currency in terms of both the US dollar and gold. It also moved towards the adjustable exchange rate system which could be adjusted from time to time when required. From 1945 to 1970, the world was on a dollar standard and the US dollar was the key currency. Power shifted to the USA, politically, economically, and militarily. This is the reason the new international monetary system reflected the plan of the American delegation led by Harry White.

 Bretton Woods system developed a method dealing with the effect of money supply on the balance of payments. It was required to reduce the role of gold in determining a nation’s money supply so the currencies were linked to something other than gold. It was decided to fix the price of gold in terms of US dollars and all other currencies fixed in terms of US dollars. The price of gold was fixed is $35 per ounce and the US was committed to exchanging dollars for gold without any restrictions or limitations.

Other nations were expected to keep their exchange rates within one percent of parity. Within this band, exchange rates were decided by the forces of demand and supply. Since the band was decided by the dollar value which in turn was fixed to a specific rate, the system was considered to be stable. The floating rates of 1930 discouraged trade and investment and encouraged competitive depreciation, however at the same time, nations were reluctant to return to the permanently fixed rates on the model of the 19th-century classical gold standard. A compromise was sought between freely floating and fixed-rate, what emerged was the adjustable peg system. There were questions on monetary policy reserves.

Two views came forward, one by Keynes who proposed something akin to the world central bank which can create reserves at will, and another proposed by Harry White being the limited borrowing mechanism.

Eventually, the system of fixed parities made it difficult for the economies to achieve external and internal balance simultaneously without discrete exchange rate adjustments. The story of the breakdown of the Bretton Woods is the story of unsuccessful attempts to reconcile internal and external balance under its rules.

The world economy today is more multipolar, with multiple major economic powers including China, the US, and the European Union at the forefront.

Even before the war in Ukraine, it was unrealistic to think that these nations could agree on and accept a single common set of rules governing trade and financial relations. With the current global geopolitical crisis, it seems the lessons of the gathering in Bretton Woods 78 years ago have been overlooked.

The Bretton Woods conference succeeded because the Second World War made the creation of a new system imperative. The world is facing a similar crisis now. The use of ongoing tariffs by the US as a protectionist measure may lead to a strain on the US-led international order.

Barot, is a business and financial analyst. Email: [email protected]