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Gold, Bretton Woods & the Dollar

How the gold-backed Bretton Woods plan of 1944 fell apart thanks to the US Dollar...

IN 1944, the world leaders and economists gathered in New Hampshire decided on a global monetary system based on Gold Bullion, writes Nathan Lewis for The Daily Reckoning.

This was no innovation, as monetary systems for the past few centuries had also been based on gold. In the Bretton Woods system, however, the US Dollar was pegged to gold at $35 per ounce, and other currencies were then pegged to the Dollar.

Currencies didn't float in value in those days. Floating currencies were considered an abomination. Exchange rates remained fixed, instead, and this stable, gold-linked system formed the foundation for a wonderful worldwide expansion of wealth in the 1950s and 1960s, led – incredibly – by the war's losers, Germany and Japan.

Unfortunately, however, there was a flaw in this plan. Interest rate manipulation, as practiced by the Federal Reserve, was surging in popularity. It was hoped this currency tomfoolery would prevent another Great Depression, and every other little recession along the way. Such "monetary policy" and currency manipulation was contrary to the simple, automatic mechanisms by which gold standard systems should be operated. The result was that the fixed exchange rates and gold link came under constant pressure.

For a while, governments attempted to have it both ways. They imposed various capital controls to keep exchange rates fixed – while at the same time their central banks played games that caused exchange rates to diverge. The Dollar/gold peg was not maintained by judicious supply adjustment, as a currency board would operate, but by heavy-handed intervention in the gold market in London.

Eventually, the conflict between manipulative central banks and the gold link became overwhelming. In January 1970, Richard Nixon installed his friend Arthur Burns as Chairman of the Federal Reserve. Burns immediately opened the monetary floodgates to help offset the recession of the time – following the day's conventional wisdom.

In August 1971, the conflict between Burns' manipulation and the link to Gold became too great, and, rather than abandoning Burns' currency games, it was decided to abandon the gold link instead. The Dollar had become a floating currency. By 1973, all the major currencies floated.

An economic catastrophe ensued, the inflation of the 1970s. Even in the 1980s and 1990s, as currencies were stabilized somewhat, economies never regained the health they showed in the 1950s and 1960s. Emerging markets, in particular, were beset by regular currency disasters.

The environment of monetary chaos that we have lived in for the past thirty-seven years has finally produced a political willingness to fix the problem. Governments sense that, if they do not take action now, a worldwide crisis may ensue. Just as in 1944, governments want to return to the monetary stability upon which capitalism was founded. Indeed, earlier this month, in Washington, governments gathered to talk about a "New Bretton Woods". Or so the media claimed.

There was even some talk that Gold would play a part. And the creators of this New Bretton Woods, if they are able to agree on anything at all, would do well to recognize the successes and fairlures of the original Bretton Woods.

Bretton Woods was, overall, a great success. This was due to the link with gold, and the fixed exchange rates worldwide. Capitalism since the Industrial Revolution had been based on this monetary principle, and it worked again as it had in the past. The reason that the Bretton Woods gold standard did not persist indefinitely was not government deficits, or insufficient gold bullion reserves, "current account imbalances" or any other such thing. The only reason that governments decided to abandon the gold link was that they preferred to play central bank games with their currencies.

A New Bretton Woods must wholly and completely abandon such practices. Without applying the necessary guiding principles instead, any discussions are likely to devolve into an unworkable hodgepodge of currency baskets, Consumer Price Index targets, promises likely to be broken, and rhetorical vagaries. Certainly no usable system would emerge, although an unusable system might.

A New Bretton Woods, of gold-linked currencies worldwide, would be very easy to create. It could be done in a weekend, and wouldn't cost a dime. It is merely a decision to manage currencies one way – a gold link – rather than another way. Unfortunately, I don't think today's generation of monetary bureaucrats in the United States and Europe have the talent, skills or understanding to accomplish this solution. They can't even identify it.

That's why I place my hopes on Russia, China and the Middle East. Their monetary bureaucrats don't have the skills either, as far as I can tell, but they are willing to learn. As outsiders, they can see that the G7's conventional wisdom isn't working.

I wish the best for those governments willing to step up with a solution to the problems that have plagued the world since 1971. I just hope they get on with it before things get too out of hand.

Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.

See the full archive of Nathan Lewis articles.

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