Look in the rearview mirror

Pipruit: And how did it happen that the dollar became the dominant currency in the world?

Commander in Pips: In general there were a couple of major turning points – the Bretton Woods System and the Marshall Plan after the WWII.

Bretton Woods System

Closer to the end of WWII has appeared a necessity to develop new rules of international commercial and financial relations among world’s major industrial states. For that purpose 730 delegates from 44 Allied nations gathered in Bretton Wood (USA) for the United Nations Monetary and Financial Conference in 1944. The major result of this conference was a decision that all countries should maintain a fixed rate for their own domestic currency in terms of gold within a 1% deviation (plus or minus). Also this conference established the International Monetary Fund (IMF) and the International Bank of Reconstruction and Development (IBRD). If, for example, the rate of some national currency skewed more than 1% to one side or the other from the fixed rate, that country should use their own gold reserves to reestablish equilibrium. If some country did not have a sufficient amount of gold reserves – it could call for IMF credits. That was the major purpose of the IMF – to provide credits to reestablish the normal currency rate in terms of gold, in other words, liquidate the current account deficit.

But the major problem began appeared after WWII, when the totally destroyed European economy couldn’t maintain any fixed rates for European currencies to gold. Because the major portion of gold reserves has been spent for military purposes, national currencies of Europe had totally collapsed compared to the USD due to absolute destruction of some nations’ economies. European capitalism suffered from a huge dollar shortage. The IMF couldn’t help in these circumstances, because according to the Bretton Woods Articles of Agreement, the IMF could make loans only for current account deficits and not for capital and reconstruction purposes. But Europe desperately needed long-term investments for rebuilding its totally destroyed economy after WWII. IBRD also couldn’t help, because had only a $570 million contribution from the USA. According to IBRD policy, it could provide loans only when its repayment was assured. This was impossible with most European countries after the war. In turn, the United States was running a huge balance of trade surpluses, and the USA’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 outbound payments. All these circumstances led to the Marshall Plan…



Secretary of State George K. Marshall Plan, aka European Recovery Program (ERP)

This plan was announced by its author in June 5th 1947 in Harvard University. In general, the Marshall Plan (officially the European Recovery Program, ERP) was the primary program, 1947–51, of the US for rebuilding and creating a stronger economic foundation for the countries of Europe. The total amount of funds that were involved in this program was about $13 Billion. Great Britain, France, Italy, Germany and Netherlands received the major part of this help.

What was the reason for this plan? As we’ve said, after WWII, the European economy was effectively destroyed; nearly all of the gold reserves of European countries had been spent on different military purchases. In one word, European nations had not even one single strong currency to reestablish international trade, and no machines, plants and factories to restart domestic industrial production. Last, but not least, it had no money to buy all any of these items from other countries.

This situation also was absolutely unwelcome for US and Canada, because they had demand only from domestic markets and couldn’t sell their goods internationally. These were the reasons the ERP had come to life.

According to the ERP, the US provided $13 billion during 4 years that could be spent by European countries for purchasing different US made goods, machines and equipment – all that was necessary to develop each nation’s own industrial production. As a result Europe has received the necessary equipment and the US gained an additional international market where it could offer its own goods. This stimulated the US national economic growth and simultaneously promoted more international trade without any additional limitations. European countries that were involved received the funds were called The Organization for European Economic Cooperation.

But money used for the ERP program was not just a gift to different European countries - it should be repaid. American suppliers sold their goods for USD that had been credited against the ERP funds which was provided to a particular country. Then, this country had to repay this credit, but in its national currency. This amount in local currency was transferred into a counterpart fund. This fund could be used for further different investment programs by ERP countries.

As a result, the Europe economy grew 35% during the ERP time. The international transactions and trade had become simpler and had fewer limitations than before WWII. Europe has raised their own economy and the US has received new international markets in which to sell their own goods. This also stimulated the US national economy.

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 that ultimately led to its collapse.

But for us, the major conclusion is that the US Dollar became and still is the dominate currency in international trading. Think about it – all funds used in the ERP were provided in US Dollars. European countries bought US goods for US Dollars. The USD started to dominate in the world economy already in 1940s-50s. Besides, the US had the largest gold reserves. There were just no real rivals to it.


Bretton Wood System crisis

After WWII the US held about $26 Billion of gold reserves out of total reserves about $40 Billion - it’s over 60% of the overall world’s reserves! As world trade increased rapidly, the size of gold base increased just a few percent.

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. 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 official price of $35 per ounce. 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.

When Bretton Woods had started to work, there were 3.1 times less dollars deposited in foreign banks than the value of US gold reserves. In the 1970s there were 6.1 times greater dollars in turnover than US gold reserves.

Here is appearing the so-called Triffin’s paradox: according to the Bretton Woods system, the amount of the world reserve currency should be equal to the gold reserves of the issuing country (USA). If there are more USD issued than US gold reserves allow, then there will be a problem with potential exchanges of reserve currency into gold, and the Bretton Woods system is designed for free, unlimited exchange between US Dollars and gold. From the other side, fast growth of international trade demands more currency be available to serve all trading transactions and the international trading growth was much faster than the growth of gold reserves. In the endm this became a reason for cancelling the gold standard and the fixed US dollar rate to gold of $35 per 1 Troy Oz. And here is how it has happened…

After some time in the 60s the German and Japanese economics rose significantly and their gold reserves became even greater than those of the USA. They had gained monetary interdependence by the return to convertibility of Western European currencies in 1958 and the Japanese yen in 1964. This led to a vast expansion of international financial transactions. In fact, Germany and Japan had each become great economic powers.

In the meantime, the US had problems due to the Cold War and the Vietnam War that caused growing inflation and an increasing trade deficit. Due to these reasons there was growing dissatisfaction with the privileged role of the U.S. dollar as the international currency. 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 USA could carry out massive foreign expenditures for its own political purposes—military activities and foreign aid—without the threat of balance-of-payments constraints.

In the late 1960s, the dollar was overvalued with its current trading position, while the Deutsche Mark and the yen were undervalued. 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.

By the early 1970s, as the Vietnam War accelerated inflation, the United States as a whole began running a trade deficit. The crucial turning point was 1970, which saw U.S. gold coverage deteriorate from 55% down to 22%. This, in the view of neoclassical economists, represented the point where holders of the dollar lost faith in the ability of the US to cut its budget and trade deficits.

In 1971 more and more dollars were being printed in Washington to be pumped overseas to pay for government expenditures on military and social programs. In the first six months of 1971, assets of $22 billion fled the US.


Furthermore, then France exchanged their dollars to the physical gold with the US. Germany and Japan epressed their wish to do the same as US Gold reserves fell to $11.1 Billion. 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 Bretton Woods system and dollar-gold standard has failed.

Bretton Woods II

Some refer to the current currency exchange system as Bretton Woods II. The major reason for this is the fact that we still have a single dominant currency in the world, the US Dollar, and other nations on the periphery threatening to destabilize that position. In the 1960s, the periphery was Europe and Japan. This old periphery has since graduated, and the new periphery is Asia and Emerging markets.