So how did a shift from the gold standard to pure fiat or paper currency happen?
The problem with the gold standard was that if the government wanted to print more money than its gold reserves, it was difficult and so it was difficult to increase the supply of money with increasing population and rising levels of production and consumption. Moreover, governments just like individuals have patterns of unexpected needs. The only difference is that there is little that individuals can do to check the acts of governments. This, in fact, is a lesson which history has taught us far too many times.
During the two World Wars, governments around the world needed more and more money to support their militaries. They simply began printing more money than the amount of gold that was available. Eventually, it came to a point that so much money got printed that it could not be redeemed for gold. There wasn’t enough gold to do that. What remedy did the governments come up with, across the world?
► End the gold standard (i.e. no more currency conversion to gold).
Further, the war inflicted devastation. After all, all of this money was being printed to support wars in order to inflict devastation. To that extent governments collectively succeeded. They printed a lot of money and caused a lot of devastation. After the Second World War, the world embarked on a lengthy period of reconstruction and economic development to recover from this devastation.
What then started was a period of competitive trade policies which resulted in a world which slowly started retreating. Why did that happen?
Beggar thy neighbour
The name as it suggests comes from the resulting impact of the policy which is making a beggar out of neighboring nations. The goal of such a strategy is to increase the demand for your nation’s exports, while reducing your reliance on imports. This is often executed by devaluing the nation’s currency, which will make exports to other nations cheaper. How exactly this is done is as relevant today as it was back then. Let’s say, it takes Rs. 1,000 to produce a pair of jeans in India and it takes the same amount which is US$ 20 (assuming 1 USD = 50 RS) to produce the same in the United States. Now if you artificially reduce the value of your currency (in our case the Rs), in that 1 US$ converts to Rs. 62 instead of Rs. 50, you will be able to attract more business from the U.S. as Americans would get that jeans for US$ 16 from India, making India more attractive. So you kill the foreign market to improve your domestic exports. I am sure that like me, many of you at this point wonder, “What’s so wrong with that?”
Remember, the prices of goods are not reducing. The workers are not able to produce it for any less. It is the host nation’s government which is devaluing its currency and keeping it at artificially low levels to condition demand in its market. This leads to currency wars.
“Currency war, also known as competitive devaluation, is a condition in international affairs where countries compete against each other to achieve a relatively low exchange rate for their own currency. As the price to buy a particular currency falls so too does the real price of exports from the country. Imports become more expensive. So domestic industry, and thus employment, receives a boost in demand from both domestic and foreign markets. However, the price increase for imports can harm citizens’ purchasing power. The policy can also trigger retaliatory action by other countries which in turn can lead to a general decline in international trade, harming all countries.”
Now think about this. When international trade declines, aren’t we going back in time? Instead of exploiting the resources of the world and getting the best things from wherever they are available, we are closing our economies. Let’s not discuss any other repercussion of such protectionism and think in lay man terms. Did we not start trading with our neighbours because they could make certain things better and cheaper? Aren’t we hindering progress of the world by closing ourselves to foreign ideas? Further, not all countries produce all the goods. Aren’t we starving each other of goods which we don’t produce?
To solve the problems created by the devastation and excessive protectionism which resulted from the two World Wars, the fighting nations now felt the need to come together in order to devise some measures to rebuild most of what they had destroyed.
The Bretton Woods System – A return to the Gold Standard?
In an effort to free international trade and fund post-war reconstruction, delegates from 44 countries met in 1944 at a place called Bretton Woods in the United States in order to device a system to regulate the international monetary and financial order and signed agreements to set up the International Bank for Reconstruction and Development (IBRD) and the International Monetary Fund (IMF) which was designed to monitor exchange rates (i.e. an international basis for currency trading) and lend money to nations with trade deficits.
American politicians, meanwhile, assured the rest of the world that its currency was reliable by linking the US Dollar to gold; $1 equalled 35 oz. of bullion. In effect, this arrangement replaced gold with US$. In other words, the Bretton Woods system made US$ as good as gold. Keep in mind that the United States was mostly unscathed by the world wars and by the end of the Second World War had the biggest gold reserves in the world. Even till date, the U.S. remains the country with the highest gold reserves with almost 55% more gold reserves than Germany which has the second highest reserves of gold.
US Dollar as reserve currency meant that now instead of the governments printing money based on their gold reserves, the U.S. would print the (reserve) money for the world based on its gold reserves. In case there was another reckless money printing exercise (like it happened during the world wars), will the U.S. not suspend the gold standard like most nations did during the wars?
Also, in hindsight don’t you think that the Bretton Woods system was bound to fail given the same logic we discussed earlier? – As population of the world and effectively the production and consumption would increase, there would be need to print more paper money and there wouldn’t be enough gold to back this new paper or there would be a need for constant revaluation of gold.
Bretton Woods System – Collapse
The Bretton Woods system collapsed in 1971, when U.S. President Richard Nixon closed the gold convertibility window (i.e. disallowed any conversion of US$ into gold). Why? Because, countries had by now prospered since the signing of this agreement in 1945 and had accumulated enough US dollar reserves. They started demanding gold for their dollar reserves. The U.S. by then had only a third of the gold reserve necessary to cover the amount of dollars in foreign hands.
So the inevitable collapse of the Gold Standard came on 15th August 1971 when President Nixon withdrew it in order to avoid a run on American Gold (if you are interested in hearing about it… watch this video of Mr. Nixon’s speech).
Since then all reserve currencies have been fiat currencies and nothing is backed by gold or anything else. However one thing which the Bretton Woods system achieved was that it established the supremacy of the US$ as reserve currency or as I like to think of it, as ‘global money’. Central Banks around the world came to hold large quantities of US$ to transact with the world at large. Today, even though the U.S. accounts for only about 20% of the combined output of countries engaged in international transactions, US$ as a currency reigns supreme. The world trades in it. We buy gold, Oil and other imported items using the US$. Our conversion rates to other currencies are based on USD/INR quotes……
[i] A reserve currency, or anchor currency, is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves.