The Bretton Woods system was a remarkable achievement of global coordination. It established the U.S. dollar
as the global currency
, taking the world off of the gold standard
. It created the World Bank
and the International Monetary Fund
(IMF) as the two global organizations to help monitor the new system. In effect, since the U.S. was the only country with the ability to print dollars
, it established America as the major power behind these two organizations, and the global economy.
The Bretton Woods Agreement:
Under the Bretton Woods agreement, countries promised that their central banks
would maintain fixed exchange rates
between their currencies and the dollar. How exactly would they do this? If their currency's value became too low relative to the dollar, they would buy up their currency in foreign exchange markets
. This would decrease the supply, which would automatically raise the price. If their currency became too high, they'd print more of their currency, increasing the supply and automatically lowering its price.
Members of the Bretton Woods system also agreed to avoid any trade warfare, such as lowering their currencies strictly to increase trade. However, they could regulate their currencies if foreign direct investment
began to stream into their countries in such a way to destabilize their economies. They could also adjust their currency values to rebuild after a war.
How the Bretton Woods Agreement Replaced the Gold Standard:
Prior to Bretton Woods, the world had followed the gold standard. This meant each country guaranteed that its currency would be redeemed by its value in gold. After Bretton Woods, each member agreed to redeem its currency for dollars, not gold. Why dollars? The U.S. held three-fourths of the world's supply of gold. The dollar's value was set at 1/35 of an ounce of gold, so in a way the world was still on somewhat of a gold standard.
However, for all intents and purposes, the dollar had now become a substitute for gold. As a result, the value of the dollar began to increase relative to other currencies, since there was now more of a demand for it -- even though its worth in gold remained the same. This discrepancy in value planted the seed for the collapse of the Bretton Woods system three decades later.
Why the Bretton Woods System Was Needed:
Until World War I, most countries were on the gold standard. However, they went off so they could print the currency needed to pay for their war costs. This caused hyperinflation
, as the supply of money
overwhelmed the demand. The value of money
fell so dramatically that, in some cases, people needed wheelbarrows full of cash just to buy a loaf of bread. After the war, countries returned to the safety of the gold standard.
Role of the IMF and World Bank:
The Bretton Woods system could not have been put into place without the IMF. That's because member countries needed a mechanism to bail them out if their currency values got too low. They'd need a kind of global central bank they could borrow from in case they needed to adjust their currency's value, and didn't have the funds themselves. Otherwise, they would just slap on trade barriers or raise interest rates.
The Bretton Woods countries decided against giving the IMF the power of a global central bank, to print money as needed. Instead, they agreed to contribute to a fixed pool of national currencies and gold to be held by the IMF. Each member of the Bretton Woods system was then entitle to borrow what it needed, within the limits of its contributions. The IMF was also responsible for enforcing the Bretton Woods agreement.
The World Bank, despite its name, was not the world's central bank. At the time of the Bretton Woods agreement, the World Bank was set up to lend to the European countries devastated by World War II. Now the purpose of the World Bank is to loan money to economic development projects in emerging market countries.
The Collapse of the Bretton Woods System:
In 1971, the U.S. was suffering from massive stagflation
-- a deadly combination of inflation
. This was partly a result of the dollar's role as a global currency. In response, President Nixon
started to deflate the dollar's value in gold. The dollar was repriced to 1/38 of an ounce of gold, then 1/42 of an ounce. However, the plan backfired. It created a run on the U.S. gold reserves at Fort Knox as people redeemed their quickly devaluing dollars for gold. In 1973, Nixon unhooked the value of gold from altogether. Without price controls, gold quickly shot up to $120 per ounce in the free market
. The Bretton woods system was over. (Source: Time, Fuss Over Dollar Devaluation
, October 4, 1971)
(Article updated January 4, 2012)