U.S. dominance occurred from the early 20th century, when the country cemented its position as the dominant world political and economic power. The U.S. pursued an aggressive policy of expansionism, exerting its political and economic influence around the globe. After establishing herself as the world super-power, it employed all-out campaign to control everything-ranging from political, cultural, economic and monetary aspects. The whole world has been Americanized systematically.
Classic Gold Standard
Throughout the years gold has been accepted as money and the preferred currency or medium of exchange. The classic gold standard began to take shape in 1871 in Europe and elsewhere. From 1871 to the beginning of WWI, the currency of all the major trading countries of the world was pegged to gold. Gold coins circulated as medium of exchange daily. Gold was deposited in commercial banks and lent out. These commercial banks created credit by lending out more than the original amount of gold deposited. But they were always forced to keep sufficient reserves of gold on hand in order to meet demand of their depositors’ withdrawals.
The gold standard prevented imbalances in trade accounts between countries. Gold acted as an independent automatic adjustment mechanism. This prevented a country to drift away too far from the balance of trade (export/import).
The gold standard also stopped governments from acquiring large budget deficits. With a limited amount of credit available, government borrowing would drive up interest rates, making it more difficult for the private sector to borrow and invest. And if the private sector cannot borrow and invest profitably, the economy suffers. Government budget deficits spilled over into trade deficits leading to more gold flowing out; leading to eventual return to balanced trade.
The undesirable side effects of deficit spending made governments to strive to maintain balanced budgets.
Bretton Woods System
In July of 1944, delegates of 44 nations gathered at the United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire in USA. In that historic meeting, among other economic landmarks, came the Bretton Woods Agreement, which ESTABLISHED U.S. DOLLAR AS THE WORLD’S RESERVE CURRENCY. The Agreement pegged the dollar to gold at $35 per ounce and all other major currencies were pegged to the Dollar at fixed rates. The critical point here that, the value of dollar was BACKED BY GOLD RESERVES OF U.S. GOVERNMENT, and foreign governments were able to exchange $35 U.S. Dollar for an ounce of gold on demand.
Dollar As Reserve Currency Of The World
Thus US Dollar became the reserve currency of the world. This meant that the dollar became the currency used by other governments and institutions as part of their foreign exchange reserves and it also became the international pricing currency for products traded on the global markets, like OIL.
By virtue of using its own currency, the U.S. has run tremendous trade deficits without repercussions simply because the dollar is the reserve currency of the world. The truth is, between 1945 and the early 1960s, the world enjoyed relative monetary stability thanks to the Bretton Woods Agreement. However, the arrangements put in place in 1945 became strained in the second half of the ‘60s.
U.S. Dominance And Aftermath
During the 1960’s the U.S. became the undisputable world power by virtue of several factors,
- Military supremacy over all its rivals.
- Strength of the U.S. economy and the production method of America being far superior to any other nation. As told by Calvin Coolidge, 30th President of the United States, “The Business of America is Business”.
- With the dollar now the global reserve currency, America had control over global financial markets.
At these times, the US governments implemented the GUNS AND BUTTER POLICIES. At one end, it operated its imperialistic ploy of controlling the strategic places of the earth, especially which have much holding of oil reserves. So it raged the war in Vietnam. At the same time in internal arena, it funded such mega schemes like Great Society Programs, fighting the War of Poverty and notably, Putting Man on the Moon. All these resulted in gigantic budget deficits, that were monetized (financed by in increase in money supply) by the Federal Reserve. All these put enormous pressure on dollar.
Other countries, beginning to realize that they were holding increasing amounts of US Dollars, began redeeming the dollar reserves for gold. At first there was not a lot of concern, because the amounts were relatively small. But, in the second half of sixties Washington became very worried.
By 1971, the trickle of gold leaving U.S. Treasury turned into flood. As a consequence, in August 1971, President Nixon decided not to exchange dollars for gold at the agreed upon rate.
Nixon Shock
Historically the governments have been incapable of maintaining the value of their currencies. Political leaders always face the dilemma of need for enormous funding to finance large schemes, at the same time pressure for keeping the taxation lower. Desperate to appease all the constituencies, they inevitably resort to “borrow to finance some new spending without raising taxes”.
Back to the context, President Nixon in 1971 decree repealed the Gold Standard i.e. keeping physical possession of gold against the physical currency (dollar); thus making the “real money” into “fiat currency”. This paved the way of unbridled expansion of dollar without any real asset behind it. This may be construed as the root of Fall of the Dollar.
Thus America truly entered the age of paper money: MONEY BACKED BY NOTHING! The Dollar was officially a “fiat” currency. By fiat currency, it means a common type of currency whose VALUE is based on issuing authority’s “guarantee”, not on any intrinsic worth or extrinsic backing.
The Dollar Tsunami
After President Nixon “closed the gold window”, the U.S. leadership worked feverishly to develop a new system of international monetary management. Due to super-heavy spending by U.S. government, such as in Vietnam War and Great Society Programs, the dollar was greatly overvalued. The American economy was also under serious inflationary pressure. The Nixon action effectively paved the way of monetary expansion,i.e. devaluation of dollar. The U.S. government then entered negotiations with its industrialzed allies to appreciate their own currencies, in response to this change. In December 1971, a meeting at the Smithsonian Institute by a group of 10 countries (G10), all industrialized, created the Smithsonian Agreement.
This Agreement effectively ended the fixed exchange rate system established under the Bretton Woods Agreement. This Agreement:
- Reestablished an international system of fixed exchange rates, without the backing of gold or silver.
- Allowed for the devaluation of the U.S. dollar; in other words appreciation of other currencies.
- Was the first time in which currency exchange rates were negotiated.
This is when the industrialized nations of the world started to abandon the devalued peg against the dollar (BUT: it is still being done in case of Chinese currency, Renminbi, i.e. pegged with U.S. Dollar). By end of February 1973, all resemblance to the Bretton Woods currency exchange or the Smithsonian fixed rate of exchange system was closed. It was when the major currencies began to float against each other, as governments still had difficulties maintaining the exchange rates within +/-2% band, as stated in the agreement. It essentially brought into effect the FLOATING exchange rate system, which determined the exchange rates based on the market forces of supply and demand.
The Flood Gates Are Opened
When the U.S. abandoned the gold standard, it hampered an orderly economic policies that the entire world was bound to. This is very significant. All of the barriers to keep the U.S. in check just disappeared. The country was no longer required to pay for its imports with gold, or even dollars backed by gold. The U.S. could pay for its imports with dollars with no backing at all or with dollar-denominated debt instruments. America had the unlimited freedom to expand its monetary bases at own desire.
This created a surge in the central banks around the world holding U.S. dollars as reserve assets, due to the ever growing trade imbalances between the America and rest of the world.
