Here is Wikipedia article explaining the Bretton Woods system and how the US became the world's reserve currency.
Bretton Woods system
Preparing to rebuild the international economic system as World War II was still raging, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial Conference. The delegates deliberated upon and signed the Bretton Woods Agreements during the first three weeks of July 1944.
The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value-plus or minus one percent-in terms of gold and the ability of the IMF to bridge temporary imbalances of payments. In the face of increasing strain, the system collapsed in 1971, following the United States' suspension of convertibility from dollars to gold. This created the unique situation whereby the United States dollar became the "reserve currency" for the states which had signed the agreement.
The political basis for the Bretton Woods system was in the confluence of several key conditions: the shared experiences of the Great Depression, the concentration of power in a small number of states (further enhanced by the exclusion of a number of important nations because of the war), and the presence of a dominant power willing and able to assume a leadership role in global monetary affairs.
The Great Depression
A high level of agreement among the powerful on the goals and means of international economic management facilitated the decisions reached by the Bretton Woods Conference. The foundation of that agreement was a shared belief in capitalism. Although the developed countries' governments differed somewhat in the type of capitalism they preferred for their national economies (France, for example, preferred greater planning and state intervention, whereas the United States favored relatively limited state intervention), all relied primarily on market mechanisms and on private ownership.
Thus, it is their similarities rather than their differences that appear most striking. All the participating governments at Bretton Woods agreed that the monetary chaos of the interwar period had yielded several valuable lessons.
The experience of the Great Depression was fresh on the minds of public officials. The planners at Bretton Woods hoped to avoid a repeat of the debacle of the 1930s, when weakly regulated financial institutions led to a world-wide economic depression. The "beggar thy neighbor" policies of 1930s governments-using currency devaluations to increase the competitiveness of a country's export products in order to reduce balance of payments deficits-worsened national deflationary spirals, which resulted in plummeting national incomes, shrinking demand, mass unemployment, and an overall decline in world trade. Trade in the 1930s became largely restricted to currency blocs (groups of nations that use an equivalent currency, such as the "Sterling Area" of the British Empire). These blocs retarded the international flow of capital and foreign investment opportunities. Although this strategy tended to increase government revenues in the short run, it dramatically worsened the situation in the medium and longer run.
Thus, for the international economy, planners at Bretton Woods all favored a regulated system, one that relied on a regulated market with tight controls on the value of currencies. Although they disagreed on the specific implementation of this system, all agreed on the need for tight controls.
The rise of governmental intervention
The developed countries also agreed that the liberal international economic system required governmental intervention. In the aftermath of the Great Depression, public management of the economy had emerged as a primary activity of governments in the developed states. Employment, stability, and growth were now important subjects of public policy. In turn, the role of government in the national economy had become associated with the assumption by the state of the responsibility for assuring of its citizens a degree of economic well-being. The welfare state grew out of the Great Depression, which created a popular demand for governmental intervention in the economy, and out of the theoretical contributions of the Keynesian school of economics, which asserted the need for governmental intervention to maintain an adequate level of employment.
To ensure economic stability and political peace, states agreed to cooperate to regulate the international economic system. The pillar of the U.S. vision of the postwar world was free trade. Free trade involved lowering tariffs and among other things a balance of trade favorable to the capitalist system.
Thus, the more developed market economies agreed with the U.S. vision of postwar international economic management, which was to be designed to create and maintain an effective international monetary system and foster the reduction of barriers to trade and capital flows.
Throughout the war, the United States envisaged a postwar economic order in which the U.S. could penetrate markets that had been previously closed to other currency trading blocs, as well as to expand opportunities for foreign investments for U.S. corporations by removing restrictions on the international flow of capital.
The Atlantic Charter, drafted during U.S. President Roosevelt's August 1941 meeting with British Prime Minister Winston Churchill on a ship in the North Atlantic, was the most notable precursor to the Bretton Woods Conference. Like Woodrow Wilson before him, whose "Fourteen Points" had outlined U.S. aims in the aftermath of the First World War, Roosevelt set forth a range of ambitious goals for the postwar world even before the U.S. had entered the Second World War. The Atlantic Charter affirmed the right of all nations to equal access to trade and raw materials. Moreover, the charter called for freedom of the seas (a principal U.S. foreign policy aim since France and Britain had first threatened U.S. shipping in the 1790s), the disarmament of aggressors, and the "establishment of a wider and permanent system of general security."
As the war drew to a close, the Bretton Woods conference was the culmination of some two and a half years of planning for postwar reconstruction by the Treasuries of the U.S. and the UK. U.S. representatives studied with their British counterparts the reconstitution of what had been lacking between the two world wars: a system of international payments that would allow trade to be conducted without fear of sudden currency depreciation or wild fluctuations in exchange rates-ailments that had nearly paralyzed world capitalism during the Great Depression.
Without a strong European market for U.S. goods and services, most policymakers believed, the U.S. economy would be unable to sustain the prosperity it had achieved during the war. In addition, U.S. unions had only grudgingly accepted government-imposed restraints on their demand during the war, but they were willing to wait no longer, particularly as inflation cut into the existing wage scales with painful force. (By the end of 1945, there had already been major strikes in the automobile, electrical, and steel industries.)
In early 1945 Bernard Baruch described the spirit of Bretton Woods as: if we can "stop subsidization of labor and sweated competition in the export markets," as well as prevent rebuilding of war machines, "oh boy, oh boy, what long term prosperity we will have." The United States would therefore use its position of influence to reopen and control the world economy, so as to give unhindered access to all nations' markets and materials.
Wartime devastation of Europe and East Asia
Furthermore, U.S. allies—economically exhausted by the war—accepted this leadership. They needed U.S. assistance to rebuild their domestic production and to finance their international trade; indeed, they needed it to survive.
Free trade relied on the free convertibility of currencies. Negotiators at the Bretton Woods conference, fresh from what they perceived as a disastrous experience with floating rates in the 1930s, concluded that major monetary fluctuations could stall the free flow of trade.
The liberal economic system required an accepted vehicle for investment, trade, and payments. Unlike national economies, however, the international economy lacks a central government that can issue currency and manage its use. In the past this problem had been solved through the gold standard, but the architects of Bretton Woods did not consider this option feasible for the postwar political economy. Instead, they set up a system of fixed exchange rates managed by a series of newly created international institutions using the U.S. dollar (which was a gold standard currency for central banks) as a reserve currency.
In the 19th and early 20th centuries gold played a key role in international monetary transactions. The gold standard was used to back currencies; the international value of currency was determined by its fixed relationship to gold; gold was used to settle international accounts. The gold standard maintained fixed exchange rates that were seen as desirable because they reduced the risk of trading with other countries.
Imbalances in international trade were theoretically rectified automatically by the gold standard. A country with a deficit would have depleted gold reserves and would thus have to reduce its money supply. The resulting fall in demand would reduce imports and the lowering of prices would boost exports; thus the deficit would be rectified. Any country experiencing inflation would lose gold and therefore would have a decrease in the amount of money available to spend. This decrease in the amount of money would act to reduce the inflationary pressure. Supplementing the use of gold in this period was the British pound. Based on the dominant British economy, the pound became a reserve, transaction, and intervention currency. But the pound was not up to the challenge of serving as the primary world currency, given the weakness of the British economy after the Second World War.
The architects of Bretton Woods had conceived of a system wherein exchange rate stability was a prime goal. Yet, in an era of more activist economic policy, governments did not seriously consider permanently fixed rates on the model of the classical gold standard of the nineteenth century. Gold production was not even sufficient to meet the demands of growing international trade and investment. And a sizeable share of the world's known gold reserves were located in the Soviet Union, which would later emerge as a Cold War rival to the United States and Western Europe.
The only currency strong enough to meet the rising demands for international liquidity was the U.S. dollar.
The strength of the U.S. economy, the fixed relationship of the dollar to gold ($35 an ounce), and the commitment of the U.S. government to convert dollars into gold at that price made the dollar as good as gold. In fact, the dollar was even better than gold: it earned interest and it was more flexible than gold.
The Bretton Woods system of fixed exchange rates
The Bretton Woods system sought to secure the advantages of the gold standard without its disadvantages. Thus, a compromise was sought between the polar alternatives of either freely floating or irrevocably fixed rates—an arrangement that might gain the advantages of both without suffering the disadvantages of either while retaining the right to revise currency values on occasion as circumstances warranted.
The rules of Bretton Woods, set forth in the articles of agreement of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), provided for a system of fixed exchange rates. The rules further sought to encourage an open system by committing members to the convertibility of their respective currencies into other currencies and to free trade.
What emerged was the "pegged rate" currency regime. Members were required to establish a parity of their national currencies in terms of gold (a "peg") and to maintain exchange rates within plus or minus 1% of parity (a "band") by intervening in their foreign exchange markets (that is, buying or selling foreign money).
In practice, however, since the principal "Reserve currency" would be the U.S. dollar, this meant that other countries would peg their currencies to the U.S. dollar, and—once convertibility was restored—would buy and sell U.S. dollars to keep market exchange rates within plus or minus 1% of parity. Thus, the U.S. dollar took over the role that gold had played under the gold standard in the international financial system.
Meanwhile, in order to bolster faith in the dollar, the U.S. agreed separately to link the dollar to gold at the rate of $35 per ounce of gold. At this rate, foreign governments and central banks were able to exchange dollars for gold. Bretton Woods established a system of payments based on the dollar, in which all currencies were defined in relation to the dollar, itself convertible into gold, and above all, "as good as gold". The U.S. currency was now effectively the world currency, the standard to which every other currency was pegged. As the world's key currency, most international transactions were denominated in dollars.
The U.S. dollar was the currency with the most purchasing power and it was the only currency that was backed by gold. Additionally, all European nations that had been involved in World War II were highly in debt and transferred large amounts of gold into the United States, a fact that contributed to the supremacy of the United States. Thus, the U.S. dollar was strongly appreciated in the rest of the world and therefore became the key currency of the Bretton Woods system.
Member countries could only change their par value with IMF approval, which was contingent on IMF determination that its balance of payments was in a "fundamental disequilibrium".
Readjusting the Bretton Woods system
The dollar shortages and the Marshall Plan
The Bretton Wood arrangements were largely adhered to and ratified by the participating governments. It was expected that national monetary reserves, supplemented with necessary IMF credits, would finance any temporary balance of payments disequilibria. But this did not prove sufficient to get Europe out of its doldrums.
Postwar world capitalism suffered from a huge dollar shortage. The United States was running huge balance of trade surpluses, and the U.S. reserves were immense and growing. It was necessary to reverse this flow. Dollars had to leave the United States and become available for international use. In other words, the United States would have to reverse the natural economic processes and run a balance of payments deficit.
From 1947 until 1958, the U.S. deliberately encouraged an outflow of dollars, and, from 1950 on, the United States ran a balance of payments deficit with the intent of providing liquidity for the international economy. Dollars flowed out through various U.S. aid programs: the Truman Doctrine entailing aid to the pro-U.S. Greek and Turkish regimes, which were struggling to suppress socialist revolution, aid to various pro-U.S. regimes in the Third World, and most important, the Marshall Plan. From 1948 to 1954 the United States gave 16 Western European countries $17 billion in grants.
Bretton Woods, then, created a system of triangular trade: the United States would use the convertible financial system to trade at a tremendous profit with developing nations, expanding industry and acquiring raw materials. It would use this surplus to send dollars to Europe, which would then be used to rebuild their economies, and make the United States the market for their products. This would allow the other industrialized nations to purchase products from the Third World, which reinforced the American role as the guarantor of stability. When this triangle became destabilized, Bretton Woods entered a period of crisis which led ultimately to its collapse.
The late Bretton Woods System
The U.S. balance of payments crisis (1958—68)
After the end of World War II, the U.S. held $26 billion in gold reserves, of an estimated total of $40 billion (approx 60%). As world trade increased rapidly through the 1950s, the size of the gold base increased by only a few percent. In 1950, the U.S. balance of payments swung negative. The first U.S. response to the crisis was in the late 1950s when the Eisenhower administration placed import quotas on oil and other restrictions on trade outflows. More drastic measures were proposed, but not acted upon. However, with a mounting recession that began in 1958, this response alone was not sustainable. In 1960, with Kennedy's election, a decade-long effort to maintain the Bretton Woods System at the $35/ounce price was begun.
The design of the Bretton Woods System was that nations could only enforce gold convertibility on the anchor currency-the United States' dollar. Gold convertibility enforcement was not required, but instead, allowed. Nations could forgo converting dollars to gold, and instead hold dollars. Rather than full convertibility, it provided a fixed price for sales between central banks. However, there was still an open gold market, 80% of which was traded through London, which issued a morning "gold fix", which was the price of gold on the open market. For the Bretton Woods system to remain workable, it would either have to alter the peg of the dollar to gold, or it would have to maintain the free market price for gold near the $35 per ounce official price. The greater the gap between free market gold prices and central bank gold prices, the greater the temptation to deal with internal economic issues by buying gold at the Bretton Woods price and selling it on the open market.
However, keeping the dollar was still more desirable than holding gold because of the dollar's ability to earn interest. In 1960 Robert Triffin noticed that holding dollars was more valuable than gold was because constant U.S. balance of payments deficits helped to keep the system liquid and fuel economic growth. What would later come to be known as Triffin's Dilemma was predicted when Triffin noted that if the U.S. failed to keep running deficits the system would lose its liquidity, not be able to keep up with the world's economic growth, and, thus, bring the system to a halt. But incurring such payment deficits also meant that, over time, the deficits would erode confidence in the dollar as the reserve currency created instability.
The first effort was the creation of the "London Gold Pool". The theory behind the pool was that spikes in the free market price of gold, set by the "morning gold fix" in London, could be controlled by having a pool of gold to sell on the open market, that would then be recovered when the price of gold dropped. Gold's price spiked in response to events such as the Cuban Missile Crisis, and other smaller events, to as high as $40/ounce. The Kennedy administration drafted a radical change of the tax system in order to spur more productive capacity, and thus encourage exports. This culminated with his tax cut program of 1963, designed to maintain the $35 peg.
In 1967, there was an attack on the pound and a run on gold in the "sterling area", and on November 17, 1967, the British government was forced to devalue the pound. U.S. President Lyndon Baines Johnson was faced with a brutal choice, either institute protectionist measures, including travel taxes, export subsidies and slashing the budget-or accept the risk of a "run on gold" and the dollar. From Johnson's perspective: "The world supply of gold is insufficient to make the present system workable-particularly as the use of the dollar as a reserve currency is essential to create the required international liquidity to sustain world trade and growth." He believed that the priorities of the United States were correct, and, although there were internal tensions in the Western alliance, that turning away from open trade would be more costly, economically and politically, than it was worth: "Our role of world leadership in a political and military sense is the only reason for our current embarrassment in an economic sense on the one hand and on the other the correction of the economic embarrassment under present monetary systems will result in an untenable position economically for our allies."
While West Germany agreed not to purchase gold from the U.S., and agreed to hold dollars instead, the pressure on both the Dollar and the Pound Sterling continued. In January 1968 Johnson imposed a series of measures designed to end gold outflow, and to increase U.S. exports. However, to no avail: on March 17, 1968, there was a run on gold, the London Gold Pool was dissolved, and a series of meetings began to rescue or reform the existing system. But, as long as the U.S. commitments to foreign deployment continued, particularly to Western Europe, there was little that could be done to maintain the gold peg.
The attempt to maintain the peg collapsed in November 1968, and a new policy program was attempted: to convert Bretton Woods to a system where the enforcement mechanism floated by some means, which would be set by either fiat, or by a restriction to honor foreign accounts.
Structural changes underpinning the decline of international monetary management
Return to convertibility
In the 1960s and 70s, important structural changes eventually led to the breakdown of international monetary management. One change was the development of a high level of monetary interdependence. The stage was set for monetary interdependence by the return to convertibility of the Western European currencies at the end of 1958 and of the Japanese yen in 1964. Convertibility facilitated the vast expansion of international financial transactions, which deepened monetary interdependence.
The growth of international currency markets
Another aspect of the internationalization of banking has been the emergence of international banking consortia. Since 1964 various banks had formed international syndicates, and by 1971 over three quarters of the world's largest banks had become shareholders in such syndicates. Multinational banks can and do make huge international transfers of capital not only for investment purposes but also for hedging and speculating against exchange rate fluctuations.
These new forms of monetary interdependence made possible huge capital flows. During the Bretton Woods era countries were reluctant to alter exchange rates formally even in cases of structural disequilibria. Because such changes had a direct impact on certain domestic economic groups, they came to be seen as political risks for leaders. As a result official exchange rates often became unrealistic in market terms, providing a virtually risk-free temptation for speculators. They could move from a weak to a strong currency hoping to reap profits when a revaluation occurred. If, however, monetary authorities managed to avoid revaluation, they could return to other currencies with no loss. The combination of risk-free speculation with the availability of huge sums was highly destabilizing.
The decline of U.S. monetary influence
A second structural change that undermined monetary management was the decline of U.S. hegemony. The U.S. was no longer the dominant economic power it had been for more than two decades. By the mid-1960s, the E.E.C. and Japan had become international economic powers in their own right. With total reserves exceeding those of the U.S., with higher levels of growth and trade, and with per capita income approaching that of the U.S., Europe and Japan were narrowing the gap between themselves and the United States.
The shift toward a more pluralistic distribution of economic power led to increasing dissatisfaction with the privileged role of the U.S. dollar as the international currency. As in effect the world's central banker, the U.S., through its deficit, determined the level of international liquidity. In an increasingly interdependent world, U.S. policy greatly influenced economic conditions in Europe and Japan. In addition, as long as other countries were willing to hold dollars, the U.S. could carry out massive foreign expenditures for political purposes—military activities and foreign aid—without the threat of balance-of-payments constraints.
Dissatisfaction with the political implications of the dollar system was increased by détente between the U.S. and the Soviet Union. The Soviet threat had been an important force in cementing the Western capitalist monetary system. The U.S. political and security umbrella helped make American economic domination palatable for Europe and Japan, which had been economically exhausted by the war. As gross domestic production grew in European countries, trade grew. When common security tensions lessened, this loosened the transatlantic dependence on defence concerns, and allowed latent economic tensions to surface.
The decline of the dollar
Reinforcing the relative decline in U.S. power and the dissatisfaction of Europe and Japan with the system was the continuing decline of the dollar—the foundation that had underpinned the post-1945 global trading system. The Vietnam War and the refusal of the administration of U.S. President Lyndon B. Johnson to pay for it and its Great Society programs through taxation resulted in an increased dollar outflow to pay for the military expenditures and rampant inflation, which led to the deterioration of the U.S. balance of trade position. In the late 1960s, the dollar was overvalued with its current trading position, while the Deutsche Mark and the yen were undervalued; and, naturally, the Germans and the Japanese had no desire to revalue and thereby make their exports more expensive, whereas the U.S. sought to maintain its international credibility by avoiding devaluation. Meanwhile, the pressure on government reserves was intensified by the new international currency markets, with their vast pools of speculative capital moving around in search of quick profits.
In contrast, upon the creation of Bretton Woods, with the U.S. producing half of the world's manufactured goods and holding half its reserves, the twin burdens of international management and the Cold War were possible to meet at first. Throughout the 1950s Washington sustained a balance of payments deficit in order to finance loans, aid, and troops for allied regimes. But during the 1960s the costs of doing so became less tolerable. By 1970 the U.S. held under 16% of international reserves. Adjustment to these changed realities was impeded by the U.S. commitment to fixed exchange rates and by the U.S. obligation to convert dollars into gold on demand.
The paralysis of international monetary management
"Floating" Bretton Woods (1968—72)
By 1968, the attempt to defend the dollar at a fixed peg of $35/ounce, the policy of the Eisenhower, Kennedy and Johnson administrations, had become increasingly untenable. Gold outflows from the U.S. accelerated, and despite gaining assurances from Germany and other nations to hold gold, the profligate fiscal spending of the Johnson administration had transformed the "dollar shortage" of the 1940s and 1950s into a dollar glut by the 1960s. In 1967, the IMF agreed in Rio de Janeiro to replace the tranche division set up in 1946. Special Drawing Rights were set as equal to one U.S. dollar, but were not usable for transactions other than between banks and the IMF. Nations were required to accept holding Special Drawing Rights (SDRs) equal to three times their allotment, and interest would be charged, or credited, to each nation based on their SDR holding. The original interest rate was 1.5%.
The intent of the SDR system was to prevent nations from buying pegged gold and selling it at the higher free market price, and give nations a reason to hold dollars by crediting interest, at the same time setting a clear limit to the amount of dollars which could be held. The essential conflict was that the American role as military defender of the capitalist world's economic system was recognized, but not given a specific monetary value. In effect, other nations "purchased" American defence policy by taking a loss in holding dollars. They were only willing to do this as long as they supported U.S. military policy. Because of the Vietnam War and other unpopular actions, the pro-U.S. consensus began to evaporate. The SDR agreement, in effect, monetized the value of this relationship, but did not create a market for it.
The use of SDRs as "paper gold" seemed to offer a way to balance the system, turning the IMF, rather than the U.S., into the world's central banker. The U.S. tightened controls over foreign investment and currency, including mandatory investment controls in 1968. In 1970, U.S. President Richard Nixon lifted import quotas on oil in an attempt to reduce energy costs; instead, however, this exacerbated dollar flight, and created pressure from petro-dollars. Still, the U.S. continued to draw down reserves. In 1971 it had a reserve deficit of $56 billion; as well, it had depleted most of its non-gold reserves and had only 22% gold coverage of foreign reserves. In short, the dollar was tremendously overvalued with respect to gold.
The "Nixon Shock"
By the early 1970s, as the Vietnam War accelerated inflation, the United States as a whole began running a trade deficit (for the first time in the twentieth century). The crucial turning point was 1970, which saw U.S. gold coverage deteriorate from 55% to 22%. This, in the view of neoclassical economists, represented the point where holders of the dollar had lost faith in the ability of the U.S. to cut budget and trade deficits.
In 1971 more and more dollars were being printed in Washington, then being pumped overseas, to pay for government expenditure on the military and social programs. In the first six months of 1971, assets for $22 billion fled the U.S. In response, on August 15, 1971, Nixon unilaterally imposed 90-day wage and price controls, a 10% import surcharge, and most importantly "closed the gold window", making the dollar inconvertible to gold directly, except on the open market. Unusually, this decision was made without consulting members of the international monetary system or even his own State Department, and was soon dubbed the "Nixon Shock".
The surcharge was dropped in December 1971 as part of a general revaluation of major currencies, which were henceforth allowed 2.25% devaluations from the agreed exchange rate. But even the more flexible official rates could not be defended against the speculators. By March 1976, all the major currencies were floating—in other words, exchange rates were no longer the principal method used by governments to administer monetary policy.
My reaction: I found this wikipedea article very interesting. Some of the points I noted:
1) When you read the quote, "weakly regulated financial institutions led to a world-wide economic depression," did it sound familiar?
2) Did you catch the part about the U.S. producing half of the world's manufactured goods in 1944? Anyone want to guess what that percentage is today?
3) The Bretton Woods system ended the British pound's role a the world's primary currency (after gold). Again, does the quote "the pound was not up to the challenge of serving as the primary world currency, given the weakness of the British economy", make you wonder about the dollar?
4) I found the quote a little shocking: "[After WWII] The United States was running huge balance of trade surpluses, and the U.S. reserves were immense and growing." I am not used to seeing "United States" and "huge trade surpluses" used in the same sentence.
5) "After the end of World War II, the U.S. held $26 billion in gold reserves, of an estimated total of $40 billion (approx 60%)." WOW!!!
6) Notice the US's failed attempts to hide the dollar's devaluation by controlling gold prices by the creation of the "London Gold Pool".
Final comment: Does anyone else want to go back to the time when the US was producing half of the world's manufactured goods, was running huge trade surpluses, had immense foreign reserves, and owed 60% of the world's gold?