Bretton Woods Part 2, Why it Unraveled

After World War II, the Bretton Woods system seemed stable, but a hidden tension quickly emerged. World trade was growing and countries needed more international reserves to finance it. Under Bretton Woods, these reserves were mainly U.S. dollars, but every dollar was supposed to be convertible into gold at $35 an ounce. This created a contradiction: to supply the world with reserves, the United States had to run balance-of-payments deficits, sending dollars abroad. Yet the more dollars accumulated outside the U.S., the less credible it became that America’s gold stock could cover them all. This problem, called the “Triffin dilemma,” meant that the system had serious deficiencies.

In the 1950s and 1960s, this flaw became more visible. Europe and Japan recovered, U.S. inflation slowly increased. Britain’s repeated currency crises were early warning signs. In 1949, and again in 1967, sterling was forced to devalue sharply against the dollar. Each devaluation encouraged speculation against other currencies and against the $35 gold price . This significantly diminished confidence in the system.

To defend the official gold price, the United States and seven other central banks created the London Gold Pool in 1961, secretly coordinating gold sales to keep the market price at $35. For a few years this worked, but pressure increased. After the 1967 sterling devaluation, speculative demand for gold surged, putting pressure on official reserves. In March 1968 the Gold Pool collapsed. A two-tier system was put in practice: governments would continued with $35 per ounce, but private markets could buy and sell gold freely at higher prices. This split the market and made the official promise of convertibility far less convincing.

At the same time, U.S. policies deepened the strain. Spending on the Vietnam War and President Johnson’s Great Society programs expanded government deficits. Monetary policy was too loose to control inflation. As American prices rose, the dollar became overvalued compared with stronger economies like Germany and Japan. To keep their exchange rates fixed, surplus countries had to keep buying dollars that they didn't need, which imported U.S. inflation and left them holding reserves they no longer trusted. The United States could have tightened monetary and fiscal policy, but that was politically impossible. Other countries could have revalued their currencies, but they resisted. This left the gold as the weakest link.

By 1971 the tension broke. Several countries began openly doubting the dollar, and France in particular converted dollars into gold. The U.S. gold stock fell incredibly. In May 1971 Germany allowed the Deutsche Mark to float to escape further inflationary pressure. By mid-1971, a speculative run on the dollar developed. The system reached its breaking point.

On August 15, 1971, President Richard Nixon announced a shock decision: the dollar would no longer be convertible into gold. He also imposed a temporary wage and price freeze and a 10 percent import surcharge to support the domestic economy. Overnight, the foundation of Bretton Woods was non-existent.

World leaders attempted to save the fixed-rate system with the Smithsonian Agreement in December 1971. Currencies were re-pegged at new values, the dollar was devalued, and the official gold price was raised to $38 an ounce, with slightly wider fluctuation bands allowed. But U.S. inflation continued and speculation quickly returned. In February 1973 the dollar was devalued again, raising the official gold price to $42.22, but by March 1973 major currencies such as the Deutsche Mark and the yen abandoned their pegs and moved to floating exchange rates. The Bretton Woods system was functionally dead.

The final step was to adjust the legal framework. In 1976, at Jamaica, IMF members agreed to legitimize floating rates, abolish the official price of gold, and recognize the Special Drawing Right as a reserve asset. The IMF’s Second Amendment, which came into force in 1978, gave this legal backing. Thus the Bretton Woods order formally ended, replaced by today’s system of a mix of floating, fixed, and managed currencies.