electricity. Structurally, the U.S. was untouched by World War II, while its manufacturing base had grown fat selling armaments to Europe so that they could destroy each other’s factories, and Europe had paid for those armaments with most of their gold. Very quickly world leaders realized the dire economic situation they were in. This huge trade imbalance meant that at the end of the war the world monetary system would be in shambles.
About a year before the end of the war, representatives from forty-four countries met in July of 1944 at Bretton Woods, New Hampshire, to figure out how they were going to make the world of international trade and finance work again. They needed a system of international payments that permitted trade without the wild fluctuations in currency exchange rates or the fear of sudden currency depreciation that had crippled international trade during the Great Depression.
It was decided that all countries would peg their currencies to the U.S. dollar and the U.S. would make the dollar redeemable in gold, to foreign central banks only, at a rate of $35 per ounce. This meant that, from World War II on, all foreign central banks bad to hold dollars instead of, or in addition to, what was left of their gold reserves.
But there were two big flaws in the Bretton Woods system. Actually the flaws were more like big gaping holes.
First, there was no reserve ratio set as to how many dollars could be created for each unit of gold, allowing the U.S. to run trade and budget deficits and print the dollars to cover these deficits.
Second, even though U.S. citizens couldn’t own gold, there was still an open gold market in the rest of the world, operating in parallel with the Bretton Woods gold market.
The Deficit War
The Vietnam War was the first large war where the American public wasn’t asked to make financial sacrifices outside of paying taxes. We weren’t asked to buy war bonds. We weren’t asked to turn our consumer economy into a war economy. In fact, President Lyndon Johnson refused to pay for the war through taxation, and because the Bretton Woods system didn’t require a reserve ratio, he was able to fund the entire Vietnam War through deficit spending. This truly was a deficit war. And on top of that, he added his Great Society programs, enacting a guns and butter policy that borrowed heavily to fund wars abroad and social programs at home.
But while we were waging a deficit-funded war in Vietnam, Charles de Gaulle, the president of France, was using the loopholes in the Bretton Woods system to quietly launch a full-blown assault on the U.S. dollar.
De Gaulle vs. the Dollar
Time magazine, Friday, February 12, 1965
Perhaps never before had a chief of state launched such an open assault on the monetary power of a friendly nation. Nor had anyone of such stature made so sweeping a criticism of the international monetary system since its founding in 1944 . . . [as] Charles de Gaulle last week [calling] for an eventual return to the gold standard. . . . Just before de Gaulle spoke, Treasury Secretary Douglas Dillon made the first public admission that the U.S. payments deficit in 1964 moved higher than anyone had expected. It totaled about $3 billion, all of which the U.S. is legally committed to exchange for U.S. gold on demand. The Federal Reserve announced that the U.S. gold supply declined last week by $100 million, to a 26-year low of $15.1 billion. [Note that the deficit for 1964 is equal to 20 percent of the U.S. gold stocks.] . . . France converted $150 million into gold last month, and plans another $150 million conversion soon.
France withdrew from the London Gold Pool, a regulatory scheme that was doomed to failure, whereby central banks would sell tons of gold into the markets to keep the price of gold at $35 U.S., and resumed their redemption of dollars for gold. Then Great Britain devalued the pound in November 1967, causing a run on gold.
The pool was stretched to the breaking point, and the outflow of gold increased twenty-fold. By the end of the year more than 1,000 tons of gold had left the vaults. For years Gold Pool sales had averaged five tons per day. By March of 1968 sales were heading past 200 tons per day!
Take a look at Chart 3. It’s the same as Chart 2, but with another twenty-one years added. You can clearly see the rampant currency creation through the mid- and late 1960s. You can also see that from 1959 to 1971, more than 50 percent of the U.S. gold left the vaults of the Treasury destined for far-off lands.
Chart 3. U.S. Monetary Base and Gold Reserves, 1918-1971
Source: St. Louis Federal Reserve Bank
The Gold Pool was closed and the parallel free market for gold was allowed to find its own price. All the while, the official central bank price stayed at $35. Gold had the dollar on the ropes and delivered a one-two punch! Gold had won this round, but the fight was not over yet.
The Collapse of the Bretton Woods System
By 1971 the Bretton Woods system had been completely overwhelmed by the will of the public and the free markets. Gold had once again forced the government’s hand, and on August 15, 1971, President Richard Nixon was forced to close the gold window. The U.S. dollar was no longer convertible to gold, and all currencies became free-floating. For the first time in U.S. history, the currency supply was entirely fiat. And since the Bretton Woods system had pegged all the world’s currencies to gold through the dollar, all currencies on the planet became fiat currencies simultaneously. This was tantamount to the United States declaring bankruptcy. Gold had won this match, and it was now free to set its own value on the open market.
At this point most countries and central banks were now on a dollar standard, and were using dollars for international trade instead of gold. So with the end of the Bretton Woods system, in 1971, the dollar was freed from any fiscal constraints, allowing the U.S. to print as much paper “gold” as it wanted. A power it still holds today.
No other country has this hidden advantage, and now U.S. politicians seem to consider it their birthright. This advantage gives the U.S. the ability to run budget, trade, and other deficits and imbalances far in excess of anything the world has ever seen.
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