The mass reindustrialization and suburbanization of the United States in the post-war era, along with an American-centred global economy, allowed Americans to live an affluent lifestyle far beyond anything that had come before it.
On the surface, the Bretton Woods system was generally working well as member states adhered to the arrangements and the economies of Europe and Japan steadily improved. Demand for American goods such as cars, steel, and machinery was high and a steady inflow of dollars across the globe was welcomed by everyone as world trade gradually increased and living conditions improved. However, even early on there were embedded structural problems with the system that could not be contained. How the U.S. would maintain a reasonable balance of payments, secure two reserve assets together (the dollar and gold), and provide liquidity to the system, all at the same time, was highly problematic. These were all problems that the international community would have to contend with, gradually leading to greater instability in the global economy as time went by.
This article explores how many of the Bretton Woods system’s built-in problems along with Washington’s own policies, domestic and foreign, helped accelerate an inflationary crisis, the Great Inflation, that would eventually lead to the system’s collapse and the global paradigm to shift once again.
The 1950s is characterized as a period of sustained economic development and prosperity in the United States. This period is lionised in popular culture, by Hollywood especially, where picket fence Americana and the American dream were a lived reality, it is often called the golden age of economic growth symbolised by the iconic image of the Cadillac. War was over, employment was high, strikes were few and inflation low. Wages and benefits were improving all the time and job prospects were good nationwide. Consumer goods such as colour television sets and washing machines became accessible to many whilst shopping malls and fast-food restaurants sprang up everywhere. Huge infrastructure projects, such as the nationwide interstate highway, commenced. The U.S. economy grew by a staggering 37% during the 1950s, the level of economic prosperity America experienced had not been seen since the roaring 1920s as United States achieved a standard of living that no other country could rival.
Europe’s redevelopment was led by the Marshall Plan as America gave generous grants to European nations to help them rebuild their countries. Washington believed that economic growth in Europe and Japan would provide increased access for their goods and for capital investment as well as provide a strategic advantage over the Soviet Union (the Cold War was just beginning) by allowing the U.S. to expand its sphere of influence in those regions. From Europe’s point of view, rebuilding their severely damaged economies, industry and infrastructure was their foremost aim. Revitalising the economies and rebuilding their countries would increase prosperity and living conditions, in-turn improving morale and preventing the return of extremist politics. In western Europe especially, the era of war and conflict gave way to mutual trade and growing prosperity. The annual manufacturing and GDP growth in Europe was growing year on year and was as high as 8% annually for some countries.
In the aftermath of WWII, the world suffered from a shortage of available liquidity, thus the outflow of dollars was deliberately encouraged by everyone, but in order to provide the necessary liquidity the U.S. had to run a huge balance of payments current account deficit (meaning more money leaving the country than coming in) to assist in both the development of Europe and Japan and to rejuvenate the world economy. This deficit would obviously get larger as time went by. But given the condition that the world economy was in after the war, under a fixed exchange rates system where one nation is the sole creditor and is tasked with providing liquidity to the entire system and where no other alternative currency could provide supplemental leverage to prop up the dollar should the dollar encounter problems later down the line, maintaining a reasonable balance of payments that would protect both the U.S. economy and the dollar whilst providing the necessary liquidity to the global economy all together was just not possible.
The danger was that, over time, the dollar would steadily lose value, this would erode the purchasing power of the dollar, and with it, confidence in its suitability as the World Reserve Currency as well as the long-term viability of the Bretton Woods system as a whole. As the dollar gradually loses value it means that countries holding dollars would see their holdings decline in value and its purchasing power reduced, in turn undermining the system as a whole. Potentially, this could lead to a run on the dollar further accelerating its decline. As I have stated already, it is important to understand that no other currency could provide additional liquidity to the system if the dollar ever faced a crisis. And face a crisis it would.
Expansionary monetary policy from the U.S. would exasperate the problems Washington had with growing deficits. Washington was running balance of payments deficits from the 1950s and had a current account deficit from 1959 onwards. It didn’t take long for people to understand that, with more dollars in circulation than the U.S. could secure with gold, the U.S. dollar was overvalued, propped up by artificial demand and confidence that were both declining along with the dollar itself.
Another problem that was unavoidable is that large volumes of U.S. dollars were accumulating in central banks across the world. Keep in mind, that this was before the market for government debt securities was fully developed and the market for stocks, shares, dividends, and other financial instruments was still in its infancy so there were no other means of recycling these excess dollars. The looming threat was that if all these surplus dollars came flooding back to the U.S. at once the inflationary crisis would be overwhelming and the U.S. economy could potentially collapse under the strain of all of this.
In 1960, a decade before the gold peg would eventually be removed, a renowned economist called Robert Triffin identified this contradiction in what came to be known as “Triffin’s Dilemma’”. Triffin testified to Congress that if the U.S. failed to keep running deficits, then the global system would lose its liquidity and grind to a halt but, simultaneously, as the balance of payments deficit grew confidence in the dollar would erode as it became clear that the mass accumulation of dollars could not be secured by gold and that the dollar would depreciate in value as a result. Moreover, there is a conflict of interests between what is best for the United States and what is best for the global economy. Failing to provide the necessary liquidity for international markets would mean that economic growth would slow down, and the Bretton Woods system would no longer be viable. But, by the same token, a depreciating dollar would also spell the end of the system. The current arrangement could not support a strong dollar and provide the necessary liquidity to the global economy together.
As time went by the role of gold in the system was increasingly becoming a point of instability. The terms of the agreement meant that the U.S. had to secure two reserve assets simultaneously; the dollar and gold but the problem with that is that one of these is highly elastic (the dollar) and the other (gold) is not, so an anomaly or disequilibrium was always a real possibility. No other alternative currency or asset could provide additional liquidity to the system. At the close of World War II, the United States held $26 billion in gold reserves, approximately 65% of the estimated world total (the rest were in the possession of the Soviet Union). World trade was growing throughout the 1950s, but the supply of gold only increased slightly. This was because gold mining during the early Bretton Woods period was porous at best; the two countries that continued to source new gold were the Soviet Union and South Africa, but these weren’t nations that the U.S. and its allies wanted to trade with (for different reasons). The problem was that gold reserves could not keep up with world trade and over time this would prove to be an increasing source of instability as the volume of world trade increased.
Fundamentally, the U.S. was printing and circulating more money than it could back up with gold. The only way the system could endure was if nations collectively promised not to convert dollars into gold and simply held on to dollars. Another problem that presented itself was that there still remained an open market for gold, whilst central banks held gold reserves at a fixed price the price on the open market for gold was allowed to float if the price on the open market for gold was more than the Bretton Woods fixed price of $35 an ounce countries would exchange their dollars for gold and sell on the open market for a profit. This could help solve internal economic issues and settle the balance of payments deficits quicker. This also had the potential to cause a run on the dollar and destabilise the system.
Member nations tried to address these problems with the founding of The Gold Pool. The Gold Pool brought together the gold reserves of several European nations in order to keep the market price of gold from significantly rising above the official ratio, but once demand began outpacing supply, nations began seceding, and the Gold Pool would eventually collapse.
By 1966, non-US central banks held $14 billion in U.S. dollars, while the United States had only $13.2 billion in gold reserves. Of those reserves, only $3.2 billion was able to cover foreign holdings as the rest was covering domestic holdings.
It is undeniable that many of the policies of the U.S. government accelerated the decline of the system. By the mid-1960s it was clear to everyone that the monetary policy of the United States was robbing the dollar of its value. Both war and welfare contributed greatly to the inflationary crisis.
By the time it had concluded, the Vietnam War is estimated to have cost $168 billion (equivalent to $844 billion in 2019 dollars and $1.47 trillion in 2021 dollars), the war lasted almost 20 years and spanned the tenures of four American presidents. It is widely viewed as a catastrophe by many. The U.S. had to spend heavily to fight the war on its terms. In 1965 combat troops arrived and Operation Rolling Thunder, a campaign of sustained aerial bombing, commenced. The United States dropped 7,662,000 tons of ordnance along with over 20,000,000 gallons of herbicide and defoliant chemicals during the war. The Vietnam War required an expansionary monetary policy that contributed greatly to the inflationary crisis; indeed some have even called it the first American war waged solely on credit.
Lyndon Baines Johnson assumed the presidency in 1963. He wanted to eliminate poverty in the United States but knew that raising taxes to pay for social programmes would be unpopular to the American public (prior to him, Kennedy had cut taxes to historic lows). Between 1964 and 1967 spending on healthcare, education, housing and other areas increased exponentially; education went from $4 billion to $12 billion and healthcare from $5 billion to $16 billion. Medicaid, the federal-state healthcare programme, was founded in 1965. All of this led to an unhealthy growth in the money supply to keep pace with all this Federal spending. Inflation was a little over 1% in 1964, by the time Nixon ended the system in 1971 it was over 6% but would continue to rise as the deficits compounded year-on-year. President Johnson refused to pay for these through increased taxation and the monetary inflation that ensued led to a deterioration of America’s trade position as surplus dollars flooded international markets. By the end of the 60s, the Federal budget deficit of the U.S. was $25 billion.
Another problem was that as the 60s got underway U.S. economic dominance had already begun to decline as Europe and Japan gradually increased their share of global trade meaning that, in effect, the total share of world trade that the U.S. accounted for, in both relative and real terms, declined considerably as countries began trading among themselves more and more.
As the combined reserves of Europe and Japan gradually exceeded those of the U.S., and as their per capita income gradually caught up with America’s, the global paradigm once again started to shift and tilted away from Washington. The countries that had become the most successful economically saw their currencies strengthen against the dollar and this was a problem to which there was no easy solution. West Germany, which had revalued twice at Washington’s request before (in 1961 and 1969), had no intentions of revaluing a third time. Japan also did not want to revalue the yen. West Germany and Japan, who saw their export industries expand considerably, had no intention of assuming a weaker trade position and thereby making their exports more expensive (and thus less competitive) while the U.S. wanted to avoid devaluation in order to maintain the strength of the dollar and, as some have speculated, because Wall Street and the oil industry wanted to maintain a strong dollar. There was a clear conflict of interests between what was good for the U.S. and what was good for other countries. In the case of West Germany, Bonn had to revalue the mark in order to maintain greater parity with the dollar, making exports less competitive in the process and thereby reducing their economic growth as a result. For West Germany, revaluing was akin to penalising an Olympic sprinter with a 10-second penalty because they are winning the race.
There was less trade for the U.S., but the supply of dollars had risen sharply and, as a result, gold reserves were reduced as nations exchanged their dollars for gold when they realised that the dollar was losing value.
Numerous efforts were made to rescue the system including an expansion of the International Monetary Fund’s lending capacity in 1961, the formation of the Gold Pool (as previously mentioned) and the advent of a supplementary currency called SDRs (special drawing rights) that were implemented too late to prevent the system’s collapse. Ultimately, the IMF did not have the available foreign currency reserves required to correct the enormous balance of payments deficit.
It was too late. A global crisis was now underway and both sides of the Atlantic had cause for concern. Europe and Japan called into question America’s capacity to secure overseas dollars with gold. Meanwhile, Washington’s inflationary problems were growing, and the long-term tenability of the Bretton Woods system was in serious doubt.
The inflationary problems continued into the 70s as the war in Vietnam raged on and the cost of the Great Society grew the dollar continued to decline. Domestically, America’s problems with rising inflation and unemployment continued and the Bretton Woods system was on the verge of collapse. West Germany, unwilling to revalue the Deutsche mark for the third time, formally left the Bretton Woods system, a move that would eventually strengthen their economy. Switzerland and France soon followed, both withdrawing vast sums of gold from the U.S. Bullion as they departed: Bern exchanged $50 billion and Paris $191 billion, respectively. The economic fortunes of the U.S. were spiralling out of control and on August 5, 1971, Congress, in an effort to protect the dollar, recommended a devaluation. In the first six months of 1971 alone, assets of $22 billion fled the U.S.
Countries had lost faith in the Bretton Woods system, in the dollar, and in the United States altogether. In August 1971, President Nixon called an emergency meeting at Camp David, attended by key cabinet personnel including Treasury Secretary John Connally and Henry Kissinger. With both unemployment and inflation hovering around the 6% mark and rising and America’s problems spiralling out of control it was decided that the gold peg would be removed, abolishing the direct convertibility of the dollar into gold. The broader international community were not consulted and with that, the Bretton Woods system of fixed exchange rates and gold conversion was discarded altogether. The U.S. was no longer responsible for having to secure overseas dollars with gold.
Even if the signatory nations to the Bretton Woods accords had honest and genuine intentions, the structural problems were just too much to contain, and the U.S. had to shoulder too much of the responsibility and burden. Countries could not pursue free trade and maintain parity with other currencies at once and ultimately the discipline of a gold standard and fixed exchange rates proved to be too much for rapidly growing economies at varying levels of competitiveness.