Islamic Finance and the New Financial System. Alrifai Tariq

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of four allies – Britain, Canada, Italy, and the United States, which saw their gross domestic product (GDP) increase during the war. The decline in the GDP in Austria, France, Russia, and the Ottoman Empire reached 30 to 40 percent. In Germany, the GDP declined by 27 percent.36

      In addition to the cost of war, high inflation and food shortages can be blamed for sparking the Russian Revolution in 1917. The tsar was overthrown, and a civil war began, bringing the Communist Party to power. The Union of Soviet Socialist Republics (U.S.S.R.) was established in 1922.

      The war officially ended in November 1918, but the Treaty of Versailles was not signed until six months later, in June 1919. The treaty forced Germany to disarm and imposed harsh reparations to pay for war damages. Notable economist of the time John Maynard Keynes voiced his concerns about excessive reparations, saying it was too hard a punishment and counterproductive.37 Most of Germany's reparations payments were funded by loans from U.S. banks. Between 1919 and 1932, Germany paid out 19 billion gold marks in reparations and received 27 billion gold marks in loans from New York bankers and others. These loans were later paid back by West Germany after World War II.38

      During the war, countries enacted trade embargoes on gold exports, leading many countries to abandon gold redemptions, thus dropping the gold standard altogether. This allowed their currency exchange rates to float freely. After the war, some countries deliberately weakened their currencies, hoping to boost exports and help their economies. In the 1920s, Austria, Hungary, Germany, Russia, and Poland began experiencing hyperinflation. Seeing the negative effects of this, the United States tried to persuade countries to go back to the gold standard and was fairly successful. By 1927, many countries had returned to the gold standard,39 but this wouldn't last long, as the world was again headed toward protectionist policies, which eventually made their way to the United States.

      The Stock Market Crash of 1929 and the onset of the Great Depression raised protectionist fears in the United States, leading President Herbert Hoover to sign the Smoot–Hawley Tariff Act in 1930. The act raised import tariffs on thousands of goods. U.S. trading partners responded by introducing tariffs on U.S. goods.40 Exports from the United States dropped 60 percent from 1930 to 1933.41 Worldwide international trade virtually ground to a halt. The international ramifications of the Smoot–Hawley Act – the spread of trade policies and the rise of economic nationalism – are credited by economists with prolonging the Great Depression.42

      The Great Depression brought about bank runs in Austria, Germany, and the United States, which put pressure on gold reserves in the United Kingdom to such a degree that the gold standard became unsustainable. Germany became the first country to formally abandon the post–World War I gold standard in July 1931. In September 1931, the United Kingdom allowed the pound to float freely. By the end of 1931, several other countries, including Austria, Canada, Japan, and Sweden, abandoned gold.43

      Some historians believe that the effects of the Great Depression, which lasted nearly a decade, were also the result of high interest rates and a contraction of the money supply.44 The Fed could not increase the money supply without more gold, putting pressure on the ability of the United States to maintain its gold standard. In 1934, Congress passed the Gold Reserve Act, nationalizing all gold by ordering the Fed to turn over its supply to the U.S. Treasury. In return, the banks received gold certificates to be used as reserves against deposits and Federal Reserve notes. The act also authorized the president to devalue the dollar gold redemption rate from $20.67 per ounce to $35 per ounce, effectively devaluing the dollar by more than 40 percent.

      The Allied Powers thought to avoid history repeating itself and saw financial cooperation as a way to encourage mutual cooperation among the countries affected by the war. In 1930, during the early days of the Great Depression, the Bank for International Settlements (BIS) was established. The main purposes of the BIS were to manage Germany's reparations payments imposed by the Treaty of Versailles as well as to function as a bank for central banks around the world. Countries can hold a portion of their reserves as deposits with the BIS. The BIS also operates as a trustee and facilitator of financial settlements between countries.45

      These efforts, however, did not stop the rise of nationalism, which was further fueled by the economic depression and protectionist trade policies. The crippling effects of the Treaty of Versailles on the German economy gave way to the rise of Hitler in the 1930s. In 1939, another world war was started, which would last six years and claim 61 million lives.46

      The Bretton Woods Agreement (1945−1971)

      In the aftermath of World War II, world powers again looked for ways to prevent future conflicts and bring about peace, stability, and prosperity. There were three major developments during this period: the birth of the United Nations, establishment of the Marshall Plan, and the negotiation of the Bretton Woods Agreement.

      The United Nations (UN) was born on October 24, 1945, as an intergovernmental organization established to promote international cooperation, replacing the League of Nations, which had been deemed ineffective.

      In 1948, the United States launched the Marshall Plan. The initiative was aimed at helping Europe rebuild after the war in order to prevent the spread of Soviet communism. The plan was in operation for four years, beginning in April 1948. Other objectives of the plan included removing trade barriers, modernizing industry, and making Europe prosperous again.47

      In 1944, delegates from the soon-to-be-created United Nations held a conference at a hotel in Bretton Woods, New Hampshire, called the United Nations Monetary and Financial Conference, which is now commonly referred to as the Bretton Woods Conference. With the effects of the Great Depression and two world wars still fresh in their minds, delegates devised a new system that would relieve them of the challenges of maintaining a gold standard while also reducing currency volatility and instability.

      Delegates at Bretton Woods favored pegged exchange rates for their flexibility over the previous fixed exchange rates. This arrangement would come to be known as the Bretton Woods System. Under this system, countries would peg their exchange rates to the U.S. dollar and the U.S. dollar would be convertible to gold at $35 per ounce.48 Countries pegging their currencies to the U.S. dollar would allow their exchange rates to fluctuate within a 1 percent band of the agreed-upon exchange rate. To achieve this, central banks would buy or sell their currency against the dollar to maintain the peg.49

      This effectively made the U.S. dollar, rather than gold, the world's reserve currency. The U.S. dollar would still be redeemable for gold; however, other countries would no longer be required to hold large gold reserves or ship gold back and forth to adjust any payment imbalances, since the dollar would now serve that purpose. A country wishing to receive gold would first need to convert its currency to U.S. dollars and then present them to the Fed for gold.

      Another important development following the Bretton Woods Agreement was the creation of two new institutions: the International Monetary Fund (IMF) in 1947 and the International Bank for Reconstruction and Development (IBRD) in 1946, which later became the World Bank. The IMF was established to support the Bretton Woods monetary system with the mission of facilitating multilateral cooperation on international monetary issues, providing assistance to member states, and offering emergency lending to countries experiencing crises and help in restoring their balance of payments.

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