For many years, countries made the process of currency exchange simple by agreeing to fixed rates of exchange. Toward the end of World War II, Allied leaders met at Bretton Woods, New Hampshire to discuss ways to improve international relations by improving international trade. Believing that many of the trade policies adopted by nations during the Great Depression—protective tariffs, closed regional trade alliances—contributed to the tensions that led to the war, these leaders pledged to build a more free and cooperative international market. One critical piece in their plan was a schedule of fixed exchange rates—a list of currency exchange rates that would only be rarely, and then only minimally, adjusted so that international commerce would be predictable and stable.
Since the participating economists believed that the United States had the strongest economy and possessed most of the world’s gold, they agreed to “peg” their currencies to the dollars. In effect, American dollars became the international reserve currency backing the value of all other currencies. For most of the next twenty-five years, for example, one American dollar bought roughly four German marks, 360 Japanese yen, 625 Italian lira, and .357 British pounds. For importers and exporters, prices could be simply calculated. You could make long range spending decisions because the rates rarely, and then only slightly, changed.
But by the mid 1960s, the Bretton Woods system was breaking down. America’s growing trade deficits and spiraling spending to pay for the Vietnam War led many to lose confidence in the American economy and the American dollar, the key currency upon which the Bretton Woods agreements hinged. In 1971, President Richard Nixon announced that the United States would no longer convert its dollars to gold, essentially eliminating the dollar’s value as the unchanging backbone of international finance. The Bretton Woods system essentially bit the dust, replaced by a new regime of flexible exchange.
Why It Matters Today
The Bretton Woods system is mostly gone today, but the thinking that led to its creation still matters. The fixed exchanged rates of Bretton Woods were designed to encourage world trade by preventing important nations from manipulating their currencies in pursuit of mercantilist policies. What does that mean? If a nation keeps its currency artificially cheap, that makes its products cheaper and thus more in demand on the world market, crowding out exports from other countries with more expensive currencies. The other countries tend to get a bit cheesed off about this, leading to retaliation, trade wars, and even the kind of breakdown in global trade that we saw during the Great Depression.
What nation is pursuing just such a strategy today? China, the world's most important emerging economic power. Growing discord over China's mercantilist currency policy may well become one of the major economic and political controversies of our time.
Sometimes, a Song Says it Better: Bread and Circuits, by Bretton Woods
Bread and Circuits were NOT fans of Bretton Woods. They accuse the negociators of liberalizing a flow of lies.