Searching for Solutions

In the early 1960s, the world searched for ways to remedy the flawed Bretton Woods system of a fixed dollar-gold exchange rate:

• Western Europe and the United States cooperated to try to support the price of gold in the face of strains caused by speculators and hoarders.
  
• The United States adopted policies aimed at slowing the flow of dollars abroad.
  
• The IMF focused on adding liquidity without relying on gold or dollars. A new reserve asset, the SDR, was created to increase the total world money supply.

Could these efforts save the Bretton Woods international monetary system, or were its flaws so fundamental that a complete overhaul was needed?

The International Response

Europe and the United States Cooperate: The Gold Pool

In 1961, Belgium, France, West Germany, Italy, Switzerland, the Netherlands, the United States, and the United Kingdom agreed to contribute gold to a fund that could be used to support the price of gold at $35 per ounce, as decided at Bretton Woods. Gold could be sold from the pool if high demand threatened to raise its price on the open market.

The End of the Gold Pool

After 1966, dramatic increases in private gold buying by hoarders, speculators, and industrial users exhausted the gold pool supply. Member countries were forced to dip into their own gold reserves to meet the demand.

A rush to purchase gold from November 1967 to March 1968 finally caused the pool to disband.

The American Response

Decreasing the Dollar Drain

Alarmed at the flow of dollars abroad, the United States enacted policies designed to stem the flood.

• Tied Aid: More aid dollars were required to be spent on U.S. exports. In 1960, less than half of U.S. laid money was spent on U.S. products and services. By the mid-1960s, the proportion was close to 90%.
• Interest Equalization Taxes: Special taxes passed in 1963 and 1964 made it more expensive for non-U.S. citizens to buy U.S. stocks and bonds or borrow U.S. dollars.
• Voluntary Capital Control Program: In 1965, President Johnson launched a program to discourage U.S. corporate investing and spending abroad.

Initially, these and other efforts helped reduce the U.S. balance of payments deficit. In 1965, it reached its lowest level since the 1950s.

U.S. Policy Failure

The balance of payments deficit continued, despite government efforts to eliminate it.

• U.S. military spending abroad soared due to new involvement in Vietnam and continuing NATO responsibilities.
• U.S. tourists were spending several billion more dollars abroad than foreign tourists spent in the United States.
• U.S. private investment abroad continued to grow. Income from previous investment abroad continued to grow. Income from previous investments provided a substantial dollar inflow, but not enough to offset the overall balance of payments deficit.
• The U.S. trade surplus was rapidly diminishing, finally becoming a deficit in 1971.

The IMF Response

The Debate

Beginning in 1963, discussions on how to solve the international liquidity problem took place within the IMF and among its member nations.

• Some countries, such as France, wanted to set up additional international credit with strict rules for its use and payment - but continue to rely on gold as the main reserve asset.
• Others, such as the United States and the United Kingdom, wanted to create a new reserve unit to be used as freely as gold or the reserve currencies.

Which countries would receive the new reserve unit?

• The leading industrial countries favored a limited participation.
• The IMF and developing countries advocated giving all members - industrial and developing - a proportional amount of the new reserve unit.

The Decision

The Special Drawing Right (SDR) that was finally adopted in 1968 represented a compromise. It was essentially a new reserve unit, rather than additional credit, but because of certain restrictions, it could not be used as freely as gold.

SDRs were to be allocated to all participating IMF members, according to the size of their IMF quotas.

The SDR: Mixed Success

The additional liquidity provided by the SDR was quickly assimilated into the international monetary system. However, by the time the first SDRs were allocated in 1970, the world did not need more liquidity, since the United States had not reduced its balance of payments deficit. In fact, precisely in 1970-72, a big jump in the U.S. deficit caused a tenfold increase in members’ currency reserves. The SDR was designed to offset a dollar shortage that never materialized.

"...the first creation of international paper money, literally out of thin air."

The Economist, 1970

Problem Persists

Flight from the Dollar

The efforts to mend the Bretton Woods exchange-rate system were no match for the severe exchange-rate crises of the late 1960s. Continual balance of payments deficits finally forced Britain to devalue the pound in 1967. People speculated that the dollar might soon follow. Private holders rushed to exchange their dollars for gold.

As a result, in 1968, the United States stopped redeeming privately held dollars for gold. Only central banks could still redeem their dollars at the fixed rate of $35 per ounce. Unable to get gold, private holders now sold their dollars for stronger currencies, such as the German mark, the Japanese yen, the Swiss franc, and the Dutch guilder.

For a time, many central banks, particularly the West German Bundesbank and the Bank of Japan, bought dollars to defend the U.S. currency and keep their own currencies from appreciating. This ended in May 1971, when the central banks began to redeem their dollar reserves for ever greater quantities of U.S. gold.

U.S. gold reserves were vanishing. If dollar redemption continued, they would soon be gone!