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Chapter 6: The Post World War II International Monetary System

By Dr. Yahia Abdul Rahman

The Bretton Woods System After World War II, the Western allies led by the U.S.A. met in Bretton Woods in 1944 to agree on an international monetary system.

The International Monetary Fund (IMF) was established by the Bretton Woods Agreement.

The Agreement foresaw the need for occasional adjustments in exchange rates among the various currencies of the Western allies.

At the time, this was thought to be a seldom used and highly exceptional emergency operation that most nations, and especially the industrialized nations, would not have to resort to.

To deal with the expected post World War II growth in international economic and trade activities, and to facilitate it, a set of rules was laid down at an international monetary conference in July 1944.

This is the well known Bretton Woods Agreement, which led to the creation of the International Monetary Fund, or IMF.

Among the stated objectives of the IMF are the following:

1. Expansion and balanced growth of international trade.

2. Promotion of exchange rate stability among international currencies, and

3. Shortening the duration and lessening the degree of disequilibrium in the international balances of payments of member countries.

So far, the only one objective that was met was the growth of international trade.

The Balance of Payment Concept

The U.S. experiences a balance-of-payment deficit when more U.S. dollars leave the country than enter it.

Dollars leave the country when Americans buy goods and services abroad (import) or when they invest abroad.

Conversely, dollars enter the country when foreigners buy U.S. made goods and services, or when foreigners invest here in the U.S.

These are not the only causes of international dollar flows, but they are the major ones.

Others are such as international remittances, military and non-military grants, international aid, etc.

The Bretton Woods Agreement worked reasonably well in the first few years of its existence, perhaps because the IMF, being in its infancy, moved with caution.

By 1950, the first signs of trouble started to appear.

From then on, the United States persisted in accumulating balance-of-payment deficits, with only rare and insignificant exceptions.

The question is, how did the U.S. get away with this persistent deficit accumulation for so long when no other nation could? The simple answer: By convincing the creditor nations to hold the U.S. dollar itself as a means of settling its deficit.

As the U.S. dollar continued to accumulate in foreign central banks, it was always thought that a simple reversal of policies could, in due time, reverse the trend.

In the meantime, as long as the U.S. government adhered to its policy of keeping its dollar pegged to gold and convertible into gold, a run on the U.S. gold stock was not likely.

If a run on gold were to be made, the U.S. would lose.

But so would most Western nations, since they would be left holding U.S. monetary units for which there was no gold backing.

As it became increasingly clear with time, the Bretton Woods Agreement discriminated in practice in favor of the U.S.

The U.S. assumed the role of the monopolistic money-supplier to the world.

The purchase mechanism provided the U.S. with foreign-made goods and/or services.

The loan mechanism (compounded by the Euro-and Asia-dollar markets) allowed the U.S. corporations to make capital investments abroad; i.e. to buy up foreign companies and productive facilities or to create such facilities on foreign soil.

In return for this accumulation of wealth, the U.S. has done no more than run the money printing presses a little faster.

The only way America could make U.S. dollars available to the outside world was by incurring balance-of-payments deficit.

The greater the deficit, the greater the international liquidity.

The world got hooked on the spend, spend and spend policies to meet their ever increasing consumptive behavior and localized war adventures.

These activities were financed indirectly through America by using the U.S. dollar as the reserve currency of the world through the IMF.

The fact that the pre-1971 international monetary system favored the United States was not the only area of friction among the leading nations of the West.

Money, at least the so called M1-concept, is defined as: all checking account deposits and currency in the hands of the U.S. non-bank public.

This part of the total money aggregate created by the Fed is watched closely by them to make sure that the economy is under control.

But since the U.S. dollars held outside the U.S. either privately or by foreign central banks, do not fall in the M1-category, the Fed did not concern itself with the supply of dollars held abroad.

As an example, suppose the U.S.

M1 money supply is $500 billion and that some $50 billion (only 10%) wind up abroad.

That would leave $450 billion at home here in the U.S.; not enough to sustain the growth of the economy (Gross National Product-GNP) at the previous level of $500 billion, since the reduction in money supply to the public de-stimulates and reduces the nation's public demand (to buy goods and services).

So, America has what looks like a demand-induced recession on its hands.

To keep the economy going in the U.S., the Federal Reserve in this case, will count and recount the M1-(domestic) money supply, find it short $50 billion and promptly fill the gap (that was during the 60's and 70's; now the Fed watches the M2-supply which includes large CD's and the M3-supply which include Eurodollar term deposits and large deposits and money market accounts).

This supposedly would solve the problem and bring back demand.

The GNP would rise, unemployment is reduced and the problem is solved.

The question is: is it really solved? The real question is: if America is short $50 billion, where did the money go? And what is its impact at the new locations overseas?

The answer: It went abroad and caused inflationary pressures there.

In summary, by not filling the money gap created by transfer of dollars abroad, a recession is generated in the U.S. and on the other hand, by filling the gap, a U.S. recession is averted but inflation is created abroad.

What would be the choice for the fed? The lesser of the two evils: inflate abroad.


In 1971, many European officials started realizing what was happening and they screamed foul.

Mr. Spiro Agnew (the then Vice President of the U.S.), the late Mr. John Connally (the then U.S. secretary of the Treasury), and Mr. George Schultz (the then Director of the U.S. office of Management and Budget, OMB and later Mr. Reagan's secretary of state and former chairman of Bechtel) all refused to address the problem of balancing the U.S. balance of payments.

In short, America refused to take action.

The dollar continued to accumulate abroad, and the inevitable finally took place.

During the second week of August 1971, another run on the U.S. gold reserves was stopped by President Nixon.

On August 15, 1971, Mr. Nixon suspended the back bone of the Bretton Woods Agreement.

He declared the suspension of the convertability of the U.S. dollar into gold.

There had been previous attacks on the U.S. dollar.

In 1965, France under President Charles de Gaulle, converted just under $1 billion into gold.

In 1968, the dollar was attacked again.

The "two-tier" gold market was then created as an emergency measure.

The U.S. no longer stood ready to exchange an ounce of gold for $35 (as per the Bretton Woods Agreement) to just anyone.

Only foreign governments and /or central banks were qualified for the trade.

At that time the U.S. cut itself loose from the private international gold market, just as it has abandoned and outlawed the private domestic gold market in 1933.

The trouble was that when that gate was shut, a small back door was left open.

Under the existing IMF rules at the time, member governments (except Switzerland) were obliged never to let their currency money-parity deviate by more than 1% up or down from the IMF set fixed exchange rate relative to the U.S. dollar.

Germany, in particular, was prohibited, by agreement, to let the price of the U.S. dollar fall.

The only option available to the Deutsche Bank (Germany's Central Bank, which always stood as politically independent and with a clear mandate to fight inflation) was to buy U.S. dollars at the fixed exchange rate to support the fixed exchange rate agreed upon by the IMF agreement.

The net result was expected.

The U.S. dollars were in the hands of foreign central banks.

In the days preceding President Nixon's new economic policy, that meant: That these foreign central banks had access to Fort Knox's gold through exchanging that gold for U.S. Dollars as the Bretton Woods agreement stipulated.

At the time, the foreign central banks of major European countries (many of them with American troops in some sort on their soils) were assumed to be reasonable institutions that would not make a run on the U.S. gold.

In early May 1971, such a private attack on the U.S. dollar forced four countries; i.e. Germany, Holland, Belgium and Switzerland, to buy up approximately U.S.

$3 billion within a few days.

Finally, these and other smaller countries decided they could not support the dollar any longer.

International foreign money exchanges were shutdown for days.

These countries reasoned that a wholesale conversion, in Europe, of U.S. dollars into European currencies, which were neither wanted or needed, is counterproductive.

This was the case of an instant inflation on a gigantic scale made in the U.S.A. and delivered in Europe.

In addition, the Keynesian economic policies, which advocates creating monetary liquidity by governments to support, encourage and sustain economic growth, were advocated in Western Europe.

This added more fuel to the raging fire of inflation.


On August 15, 1971, President Nixon suspended the convertability of the U.S. dollar into gold.

The immediate result was a joint upward floating of most major world currencies, in relation to the U.S. dollar.

By December, 1971, the Bretton Woods Agreement was modified.

The so-called Smithsonian Agreement (the meeting was held at the Smithsonian Institution) was reached among the IMF-nations.

The U.S. dollar was devalued by increasing the price of gold from $35 to $38 an ounce.

Another "innovation" of the Smithsonian Agreement permitted the IMF-nations to let their currencies fluctuate 2 1/4 % up or down from the official price as compared to Bretton Woods' originally established 1% bracket.

The U.S. dollar promptly fell to the floor and stayed there.

On February 1973 (just before the October/Ramadan -1973 war) a second devaluation of the U.S.dollar, this time a much more pronounced one, took place.

Shortly thereafter, most major Western nations followed the lead of Canada, Germany, Holland and others by allowing their currencies to float against the U.S. dollar.

The introduction of the "floating exchange rates" became an accepted fact.

As a result, and claiming that speculations contribute to stability, the so-called- International Monetary Exchange Market of the Chicago Mercantile Exchange was introduced.

Finally, in November 1973, the major countries agreed to "demonetize" gold.

The participating IMF major governments agreed to sell gold on the free market to define a fair market value for gold or indeed for the U.S.dollar.

Thus governments were no longer required to hold gold in reserve for the purpose of settling balance-of-payments deficit.

The IMF is now an active proponent of fiscal and monetary controls in many of the developing countries and the former Eastern European countries as well as the former Soviet republics.

The IMF policies are heavily flavored by the policies of the G-7 club of nations.

These are the U.S., England, Japan, France, Canada, Italy and Germany.

Chapter 7 Chapter 5