The Decline of the Bretton Woods System (1950s and 1960s)
As early as 1950, the U.S. current account balance showed a deficit. Until John F. Kennedy won the presidential election in 1960, the U.S. response to the increasing current account deficit was to introduce trade restrictions, which was exactly what the Bretton Woods Conference had tried to avoid. The struggle to maintain the gold parity of $35 per ounce intensified during the 1960s.
The Bretton Woods system forced the gold convertibility on the reserve currency country. However, gold convertibility wasn’t required for all countries, so that they could hold dollars instead of gold. The problem was, there was a gold market. If the dollar was pegged to gold at $35 per ounce, the market price of gold had better be $35 per ounce.
Persistent and large U.S. current account deficits indicated that the dollar was overvalued and the parity should be something higher than $35 per ounce of gold. This situation tempted investors into buying gold at the Bretton Woods price and selling at a higher price in the gold market. If you think about what investors are using to buy gold, the answer is the dollar.
All this further enlarged the discrepancy between the gold parity and the market price of gold, which fed the frenzy of selling dollars and buying gold. Of course, certain events during the Cold War, such as the Cuban Missile Crisis in 1962, fueled increases in the gold price as well.
The U.S. found itself in a situation called Triffin’s dilemma. On one hand, the U.S. current account deficit was helping mainly European countries and Japan grow. Therefore, if the U.S. eliminated its current account deficit, these countries would be adversely affected. On the other hand, persistent and large current account deficits were contributing to the increasing discrepancy between the gold parity and the market price of gold.
In an attempt to strengthen the Bretton Woods system, two ideas were introduced: the London Gold Pool and the Special Drawing Rights.
The London Gold Pool
Apparently, the U.S. wasn’t willing to give up its support to Europe and Japan. Instead, it tried to affect the market price of gold. In 1961, eight countries (the U.S., the U.K., Germany, France, Italy, Belgium, the Netherlands, and Switzerland) came together and created the London Gold Pool, in which the U.S. initially contributed 50 percent of the gold in the pool.
The aim of the Gold Pool was to affect the gold price set by the morning gold fix in London. Because most of the time the gold price was increasing, the Gold Pool sold gold in the market to counteract the increases in the price of gold.
The U.S. was also looking into domestic policy options to strengthen the economy and its export potential. The new Kennedy administration was considering a tax reform to increase productivity and promote exports, which would have helped prevent an increase in the gold parity (in other words, a devaluation of the dollar).
However, such attempts were unsuccessful. Finally, the Gold Pool disintegrated in 1968. Congress revoked the 25 percent requirement of gold backing of the dollar. Countries in the pool suspended the exchange of gold with private entities. Additionally, the U.S. suspended its gold sales to countries that were known to participate in the gold market by selling dollars in exchange for gold. However, these efforts didn’t stop the depletion of the U.S. gold reserves.
The Special Drawing Rights
In an attempt to create liquidity, in 1969, the IMF introduced the Special Drawing Rights (SDR) as a supplementary reserve asset. Basically, the SDR represented a claim to currency that IMF member countries held. When the SDR was introduced, its value was equivalent to 0.888671 grams of fine gold, which was also equivalent to one U.S. dollar. IMF members were required to accept SDR holdings equal to three times their share.
The main objective of the SDR was to prevent nations from buying gold at the Bretton Woods price and selling at the higher free market price. Another objective was to limit the amount of dollars that could be held.
Current account deficits weren’t only a U.S. problem. In 1964, a large current account deficit initiated a speculative attack on the British pound, eventually devaluating the currency. Another attack on the pound followed in 1967. Other countries faced the effects of these speculative attacks on the pound.
Some European countries with current account deficits devalued their currencies, and countries with surpluses revalued their currencies, which also affected capital inflows and outflows to and from these countries.
Consequently, parity changes became increasingly unilateral decisions. Countries with strong exports postponed revaluation of their currencies, and countries with larger imports postponed devaluation. Frequently used national discretion made the Bretton Woods system even weaker.