Toward the end of World War II, there appeared to be a necessity for an international monetary system so as to accomplish meaningful economic coordination between countries, if they were to rejuvenate their economies and live in peace. To attain these goals, delegates from 44 countries led by the United States, Great Britain, and France met at the United Nations Monetary and Financial Conference in Bretton Woods, a small town north of Mt. Washington, New Hampshire, in July 1944.
The location was chosen because most of the European countries were still in the turmoil of war, while the United States was the only major country to remain unscathed and keen to rebuild an international economic system. The dollar was chosen as the index currency over the British pound because the latter had lost considerable luster during the war (because the Nazis undertook a major counterfeiting effort against it). The dollar, on the other hand, had recovered from being a failed currency in 1929 after the stock market crash to being a benchmark currency by which most international currencies were compared, since the United States had emerged as a world power and its economy was thriving.
The major currencies were pegged to the U.S. dollar and allowed to fluctuate by 1 percent of the set standard, and subsequently, the International Monetary Fund (IMF) was founded. The respective central bank intervened to bring the exchange rate back into the accepted range when it fluctuated 1 percent on either side of the set standard. Furthermore, the U.S. dollar was pegged to gold at a price of $35 per ounce. For example, the Deutsche Mark (Germany’s currency) was set to one-fortieth of an ounce of gold, implying that it was worth $0.25 ($35/DM140). This was intended to be permanent, and policed by the IMF, and for almost three decades it also brought stability to the world foreign exchange situation.
Another aspect of the Bretton Woods Accord was a commitment not to use devaluation as a competitive trade policy. Nevertheless, a devaluation of up to 10 percent was allowed without the formal approval of the IMF, if a currency became too weak to defend— larger devaluations required IMF approval.
The Bretton Woods system began to gradually collapse in the mid-1960s as national economies moved in different directions. Several realignments kept the system alive until the early 1970s, when President Richard Nixon suspended gold’s convertibility in August 1971. Increasing U.S. budgets and trade deficits resulted in the dollar no longer being considered as the sole international currency. By then, however, it had accomplished the important task of reestablishing worldwide economic stability, particularly in Europe and in Japan.
The Smithsonian Agreement was signed in December 1971—it was similar to the Bretton Woods Accord, but allowed greater flexibility and fluctuation bands for the currencies. In 1972 the European Joint Float was formed by West Germany, France, Italy, the Netherlands, Belgium, and Luxembourg, as the European community tried to move away from their dependence on the dollar.
Both agreements collapsed in 1973, signaling the official switch to the free-floating system by default, as no further agreements were signed. Governments were now free to peg, semi-peg, or freely float their currencies. In 1978 the free-floating system was officially mandated by the IMF. Europe, however, created the European Monetary System in 1978, in a final effort to gain independence from the dollar, but in 1993 it too failed, like all of the previous agreements.
The major currencies today move independently from each other. Central banks occasionally intervene to move or attempt to move their currencies to desired levels. The free-floating system is ideal for today’s foreign exchange markets—the underlying factor is mostly supply and demand.
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