The Two Markets

transition to the modern era

While World War II was under way, the world’s leading economists were meeting together to fashion a new global currency system to replace the failed gold standard. They wanted to fashion a reserve system whereby national currencies could be made to move in lockstep with each other, in the way the gold-based system did, but without the disadvantages attaching to a non-fiat commodity. As the war was winding down, an agreement was fashioned at Bretton Woods, New Hampshire, which became the blueprint for the postwar international currency order.

This system reestablished gold, but with a difference. Not only gold but the US dollar was deemed the world’s reserve currency: either gold or US dollars could serve as reserves upon which domestic currencies could be issued. Gold and the dollar were made interchangeable: the price of gold was fixed at $35 per ounce.

Since the dollar served as the reserve currency of banking systems around the world, US domestic monetary policy could be conducted without reference to the requirements of foreign exchange. The rest of the world simply had to adapt to the dollar, and the dollar’s value was targeted according to the needs or wants of domestic monetary policy. In time this arrangement came to be seen as unfair, the USA’s so-called “exorbitant privilege” (a phrase coined by the French economist Jacques Rueff) precisely because it allowed the USA to set monetary policy independently of foreign considerations, a privilege denied other countries. This led to so-called “deficits without tears” (another of Rueff’s pithy assertions) as the USA might run budget deficits to its heart’s content, while other nations had to pay attention to the havoc such deficits might wreak upon their currency’s exchange rate.

In 1971, President Nixon abolished the link between the dollar and gold. From that point on, currencies were officially floating.