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A BRIEF HISTORY OF THE BRETTON WOODS AGREEMENT

[1]

By 1944, the political leaders of the West knew that somehow trade protectionism and currency warfare had crippled the world economy in the 1930s and helped bring on WWII. The British government called upon Lord Keynes (1883-1946) to help design a structure of international finance that would help avert WWIII. The Bretton Woods Agreement was the design of Lord Keynes and the undersecretary of the U.S. Treasury, Harry Dexter White (1892-1948). Keynes wanted a world bank, as if there were one world government. Participating nations would have their own currencies, but they would be fully convertible to one another through this World Bank, which Keynes called a clearing union. The bank would issue its own currency, the unitas, and would maintain its value not by tying it to gold, but by the “wisdom” of its directors. The Keynesian notion of a world bank that could expand credit without the restraint of a gold standard was rejected. The opposite argument by Undersecretary Harry Dexter White, who believed in the “hard money” approach, using the gold standard rather than the “soft money” approach of Lord Keynes, was accepted because the United States owned $24 billion in gold; the United States got its preferred hard money currency. The Bretton Woods Agreement and U.S. economic might after WWII gave the United States and the U.S. dollar undisputed dominance.

The system would work perfectly as long as the Federal Reserve Board of the United States enforced sound monetary operations by stopping the printing of dollars when people showed up with dollars demanding gold. The U.S. monetary and Federal Reserve authorities naturally would not be able to accommodate a huge run on U.S. gold; however, if such a circumstance were handled promptly and wisely, and if the U.S. authorities could convince the world of the United States' sound policies, then a crisis could be averted. The world economy would always have precisely the right amount of money.

In 1953, when President Eisenhower tried to boost the U.S. economy out of recession, instead of cutting tax rates, he leaned on the Fed to print dollars. Because all currencies were fixed together, the surplus flowed around the world. The printed dollars reduced the U.S. gold reserve by the same amount.

The system did break down. To run a dollar standard, the United States certainly did not need $24 billion in gold bullion, for the value of gold is not as a medium of exchange, which requires tonnage, but merely as an error signal to alert administrators when too many dollars are being printed. By 1965, the United States had depleted Fort Knox of approximately $12 billion of its gold tonnage, mainly to the Europeans and, in particular, France. A media story of the time reported that the weight of the gold accumulating on the second floor of the London Metal Exchange building was so heavy that the floor gave way.

In the spring of 1971, as the Fed tried desperately to expand the U.S. economy by flooding it with dollars, the rest of the world came demanding gold. On August 15, 1971, President Richard Nixon ordered the gold window closed, ending the international currency's link to gold.

An attempt to rebuild Bretton Woods around gold at $38 per ounce instead of $35 was made with the Smithsonian Agreement. Later, the gold-dollar window was shut permanently, and what Keynes suggested in 1944 became a reality. Economists around the world projected a dramatic increase in the price of oil and other commodities; another interesting twist in the accepted folklore that claims that oil prices increased because of the 1973 Arab-Israeli War. It is important to note that the inflation of the 1970s was not caused by the Organization of the Petroleum Exporting Countries (OPEC), but rather was caused by the breakdown of Bretton Woods. No country could escape the impact of inflation. Commodity prices skyrocketed between 1966 and the spring of 1974. Details of the price changes in many commodities like wheat, rice, crude oil, natural gas, and homes in the United States are discussed in Chapter 6. Here are some examples:

■ Oil price rose 344 percent, from $2.90 to $10 per barrel.

■ The price of rice climbed 375 percent, from $8 per hundredweight (cwt) to $30 per cwt.

■ Wheat price rose 322 percent, from $1.80 to $5.80 a bushel.

After President Nixon closed the gold window and currencies started to float, the world changed. Companies with costs in one currency and revenues in another needed to hedge exchange rate risk. In 1972, a former lawyer named Leo Melamed[2] was clever enough to see a business in this; he launched currency futures on the Chicago Mercantile Exchange. Futures in commodities had existed for more than a century, enabling farmers to insure themselves against lower crop prices. But Mr. Melamed saw that financial futures would one day be far larger than the commodities market. Today's complex derivatives are direct descendants of those early currency trades.

This same scenario with different players has repeated itself ever since. The Soviet Union was disassembled in the early 1990s. Iraq invaded Kuwait, and the United States subsequently liberated Kuwait. A heinous terrorist attack on American soil occurred on September 11,2001. The United States invaded Afghanistan to fight terrorism and simultaneously invaded Iraq to change the regime. In 2008-2009, the financial markets in the United States and the world suddenly collapsed, supposedly because of reckless lending and banking practices. There was a subsequent stock and credit market collapse in October 2008, which led to the U.S. government's rescue of Bear Stearns (a major investment banking company) and AIG Insurance Company by pumping almost $110 billion dollars into them. It also led to the bankruptcy of Lehman Brothers, an icon of investment banking in the United States and the world. Lehman Brothers' collapse took with it the capital of many countries and individuals who had trusted the government to supervise these banks properly. For the first time in the history of the capitalist world, there was a massive government effort to rescue banks by owning them outright (which happened in Britain) or owning a minority share (which happened in the United States and most European countries). Additionally, the United States approved a $700 billion rescue plan for its financial system. After all was said and done, more than $1.2 trillion was allocated to rescue the system. And, of course, we do not yet know what more will come upon us. In November 2008, the Fed started a new program called quantitative easing (QE). It was implemented at least in three stages (QE1, QE2, and QE3) to expand monetary liquid to allow the government to help create liquidity to buy bonds securities like mortgage-backed securities.

All we know is that the only way to come up with the needed amount of huge rescue money is simply to create it by “printing it.” In other words, the Fed will increase the money supply in the system, as discussed earlier. If the Fed uses — as an example — wheat, rice, or gold as money, there is no way the Fed can produce that much wheat, because it takes time and effort to produce it, let alone the productivity limits of the land. The same applies to rice and gold. In fact, there is a limit to what we can do to increase the production of agricultural commodities, let alone prospecting, finding, and mining gold. However, it takes almost no time at all to print a lot of money. That has spelled a lot of trouble in the past because this conceptually means that the price of reference commodities (gold, silver, rice, wheat, and others) will have to go up in paper money (dollars) because there are more dollars in the system compared to the limited production and supply of the commodities. That spells big trouble down the road. That trouble is called inflation, as we saw in the 1960s and 1970s.

  • [1] This section is based on a comprehensive review of history as outlined by Jude Wanniski, The Way the World Works (New York: Touchstone/Simon and Schuster, 1978).
  • [2] A short history of modern finance, The Economist (October 16, 2008), t. 79–81.
 
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