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 for
the 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 Bretton
Woods. 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 nondollar 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.
The Rise of the Euro
Although the U.S. dollar has been battered or has fallen in value, its
role as the world’s reserve currency—the anchor of global commerce—
has never been challenged. Until now. The story begins
after World War II, when the European nations decided to ensure
peace by knitting themselves together.
In 1957, the European Economic Community was established in a
landmark treaty signed in Rome. Six countries—France, West Germany,
Italy, Belgium, the Netherlands, and Luxembourg—signed the
Treaty of Rome. It formed the bedrock of the European Community
and was the true beginning of the European Union and the euro.
Several other treaties followed, each one pulling Europe closer
together. The Maastricty Treaty, signed in the Dutch city on
February 7, 1992, amended the Treaty of Rome and established the
European Union, led to the creation of the euro, and established a
more cohesive whole that included initiatives on foreign policy and
security. The treaty, which called for bold steps to a closer union,
was by no means a certain thing. Only 51% of France voted in
favor, and Denmark rejected the first version.
Today, however, the euro is circulating in dozens of countries
and is used by hundreds of millions of people. If the U.S. dollar is
ever unseated as the world’s reserve currency, it will be the euro
that does it.
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