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The evolution of the world’s monetary system

  • Writer: Sarah Baek
    Sarah Baek
  • Dec 6, 2021
  • 4 min read

https://unsplash.com/photos/eBWzFKahEaU

Our monetary system has evolved so much, for better or for worse, and it is up to us to study and reflect on its implications.


Throughout history, gold and precious metals were used as commodity money. Then the gold standard became the first global monetary system in 1871, where a fixed quantity of gold determined the economic unit of account.


While an average American may think that if the US returned back to the gold standard, price stability and employment will be better off, many economists disagree, for several reasons.


Unequal distribution of gold deposits makes the gold standard more advantageous for the countries that produce gold, such as Australia, Russia, the US, and South Africa. Furthermore, some economists argue that the gold standard limits economic growth. As productive capacity grows, the money supply should also increase. However, the limited supply of gold for backing money restricts the ability of an economy to produce more capital and grow.


Despite the long-run price stability of the gold standard, historical evidence shows its high short-run price volatility. Discoveries of gold and rapid increases in gold production made price stability difficult. Also, Anna Schwartz and others argued that short-term price levels will make lenders and borrowers uncertain of the value of debt, leading to financial instability.


Furthermore, nations faced an increased risk of destabilising capital flight and tradeoffs between price stability and domestic macroeconomic objectives. Then, with the US replacing Britain as the financial centre, the gold standard as a global monetary system was abandoned in 1932.


At the United Nations Monetary and Financial Conference in 1944, delegates reflected on the lessons of the previous gold standards and the Great Depression to establish a new international system for postwar reconstruction. The result was an extension of the gold standard, the Bretton Woods system.


John Maynard Keynes, one of the designers of the system with Harry Dexter White, initially planned for the Clearing Union, a global central bank, to issue an international currency called the “bancor” with $26 million in funds. However, White called for the Stabilisation Fund, one of more limited powers and resources, which would be funded by $5 million of gold and a pool of currencies to limit the supply of reserve credit.


White’s plan with some of Keynes’ concerns was adopted. Under this plan, the total fund increased to $8.5 million and the fund will ration a currency if it becomes scarce in world trade and authorise limited imports when a country runs a trade surplus.


Furthermore, European countries could have converted back to the gold standard in order to restore confidence in their currencies. However, with 70% of gold reserves stored in the US, this plan was practically impossible.


Under this new system, US dollars and gold convertibility was set at a fixed exchange rate of $35 per ounce. The US became responsible for fixing the price of gold and preserving confidence in gold convertibility by controlling the supply of dollars. In short, this system, backed by the IMF, assured people that holding a dollar was like holding gold.


Poor economic conditions of the post-war world, no international currency to provide additional liquidity, and limited loan capacities of the IMF, meant that the US had to provide external funding. In 1948, the US financed $13 billion through the Marshall Plan. In 1949, two dozen countries following Britain were allowed to devalue their currencies against the dollar. Such events reduced the current account surplus that the US had been running since the post-war, coming to a current account deficit in 1959.


In 1961, London Gold Pool was created by eight central banks in Europe and the US to address the worsening current account deficits and growing uncertainty with the gold convertibility of the US. The theory behind this was that the free market price of gold, set by the morning gold fix in London, could be controlled by selling a pool of gold reserves provided by these eight nations.


While the gold pool had maintained stability for a while, a chronic current account deficit and growing public debt from Great Society programs and the Vietnam War led the US to print more dollars. Charles de Gaulle, President of France and other countries, became more suspicious of the US’ future gold convertibility. After France and Britain exchanged $191 million and $750 million for gold in 1968 and 1971, President Richard Nixon closed the gold window.


The final attempt to maintain this system was the Smithsonian Agreement among the Group of Ten. The US pledged to peg $38 per ounce with 2.25 percent trading bands, and other countries agreed to appreciate their currencies against the dollar. However, the transition was too slow and the continued pressure on the official rate due to the dollar price in the gold free market led to a 10 percent devaluation. This announcement made Japan and European countries to float their currencies in 1973, bringing an end to the Bretton Woods System.


The Triffin Dilemma can explain the collapse of the system. Robert Triffin believed that the dollar cannot maintain its role as the reserve currency without the US running ever-increasing trade deficits. If the Federal Reserve stopped printing dollars in order to maintain its value and to stop running trade deficits, then there would not be enough reserves. Then, while a steady stream of dollars will support world economic growth, the US trade deficits will worsen. Excessive trade deficits and supply will weaken the confidence in the value of the dollar, and without strong confidence, the dollar is no longer accepted as the reserve currency. Under the latter situation, many countries would question the rule of “1 ounce of gold = $35.” The fixed exchange rate system could break down, leading to instability.


Since 1973, the floating exchange rate regime has been in place. The price of a local currency is set by the foreign exchange market based on supply and demand relative to other currencies. Just like previous monetary systems, the floating exchange rate system is not perfect, and it will be a great ride for this century’s economists to find solutions.


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