[Taken from Chapter 1, International Financial Markets, 3rd edition, by J. Orlin Grabbe, © 1996 Prentice-Hall, Inc., a Simon & Schuster Company, Englewood Cliffs, New Jersey. ISBN 0-13-206988-1.]


by J. Orlin Grabbe

Killing is all right, and you could attack religion with some impunity, but you were threatening something dearer than life to many people . . .

Letter from Franklin Delano Roosevelt to John Steinbeck, rejecting the author's proposal to counterfeit German currency (Bloom, 1988)

[Nixon] had no strong interest in international economic affairs, as shown by an incident recorded on the Watergate tapes where Haldeman comes in and wants to tell him about the Italian lira. His response was "(expletive deleted) the Italian lira!"

Hendrik Houthakker, member of Nixon's Council of Economic Advisors

The end of the Second World War can be taken as year zero for the current system of international finance. There wasn't much in the way of foreign exchange or international bond trading in 1945 and another decade would pass before eurocurrency markets were created. The depression of the 1930s, followed by the war, had vastly diminished commercial trade, the international exchange of currencies, and cross-border lending and borrowing. Left were only memories of what the system had once been, along with competing visions of what could and should be resurrected from the rubble. Revival, it was generally agreed, entailed new institutions and political agreements. Certainly not much thought was given to the enormous progress in information technology and telecommunications that had come about during the war and would later have a profound impact on international financial practice.

Reconstruction of the postwar financial system began with the Bretton Woods agreement that emerged from the International Monetary and Financial Conference of the United and Associated Nations in July 1944 at Bretton Woods, New Hampshire. Bretton Woods is a tiny ski village in the White Mountains whose notable features are the world's longest cog railway and the mammoth Mount Washington Resort Hotel--which, situated at the foot of the Presidential range, is an ideal setting for a conference. The 1944 agreement, setting out the major parameters of the postwar system, represented an unusual degree of advance planning. The establishment of a beachhead on Normandy by Allied forces under General Dwight Eisenhower had taken place only the month before, and even the outcome of the war with Germany could not yet be predicted with total certainty.

But there was a deep-rooted reason for the timing of the Bretton Woods debate about postwar finances. Many at the conference were convinced that, by making advance preparations for the peace, they could avoid the mistakes associated with the aftermath of the Great War of 1914-1919. They had concluded that the primary reason they were at war¾ once again with Germany¾ was that, although the Allies had won the earlier war, they had mismanaged the peace. This mismanagement, they felt, had resulted from the squabbling among the great powers, who had yielded to the political sentiments of the moment and had shown a lack of foresight in the economic provisions of the peace negotiations of 1919. Bretton Woods was part of an attempt to avoid a repetition of the same mistakes when the war with Hitler was over.

American and British rivalry was another factor that underlay the early planning. Although forty-four nations signed the Bretton Woods agreement, it was primarily the United States and Great Britain who negotiated the terms, each intent on persuading everyone else to adopt its particular vision of postwar monetary arrangements. The two principal individuals involved in the negotiations were Harry Dexter White, representing the United States, and John Maynard Keynes, representing Great Britain.

The chain of events leading to Bretton Woods had started in 1940. German propaganda broadcasts were describing a "New Order," the National Socialist vision of how the world would be organized financially and economically in the future, under German leadership. Such propaganda can be effective in two senses. By being first to propose a plan you get people thinking your way: you structure the debate. Second, such a plan implied Germany was so sure of winning the war that it could get on with planning the next stage. Such confidence invited neutral third parties to join a winning team. In November 1940, the British Ministry of Information asked John Maynard Keynes, the noted British economist, to prepare counterpropaganda broadcasts, which required Keynes to give some thought to financial organization after the war. Aside from the propaganda needs of the moment (Winston Churchill said that "in wartime, truth is so precious that she should always be attended by a bodyguard of lies"), both Keynes and British government officials were determined that, whatever plans were made, they could not afford to repeat the miscalculations associated with the Treaty of Versailles that had ended World War I.

In fact, Keynes had first become famous in 1919 with his international bestseller The Economic Consequences of the Peace. The official representative of the British Empire to the Supreme Economic Council that set out the terms of German reparations, Keynes had resigned in protest and had written a book explaining why. He had argued that the primary policy objective of the Allies should be the stabilization of central Europe, not the imposition of unpayable reparations on Germany. Europe was in a dangerously chaotic political condition following the collapse of the Austro-Hungarian Empire, he had said, and the terms of the Versailles treaty would aggravate the situation and play into the hands of extreme elements.

In warfare, the spoils traditionally go to the victor. The modern interpretation of this principle meant that the loser in the war reimbursed the victor for costs associated with conducting the war. This reimbursement was referred to as reparations. Germany had exacted reparations from France after the Franco-Prussian War of 1870-1871, for example. And in Article 231 of the Treaty of Versailles (signed on June 28, 1919) Germany and its allies were named the aggressors in the recent war and were held responsible for all loss and damage suffered by the Allies. But it seemed obvious, at least to Keynes, that the degree of international interdependence had now increased to the point that it was no longer necessarily in one's own self-interest to demand from the loser payment in gold and goods. He sounded the ominous warning that the "Carthaginian peace is not practically right or possible. . . . You cannot restore Central Europe to 1870 without setting up such strains in the European structure and letting loose human and spiritual forces as . . . will overwhelm not only you and your 'guarantees,' but your institutions and the existing order of your society."

Whether for the reasons Keynes set out or for others, events did not follow the course anticipated by most members of the Versailles Peace Conference in 1919, and by 1940 officials in both the British and the U.S. treasuries viewed Versailles as an administrative disaster. The treaty had been followed in Germany by the hyperinflation of 1920-1923 that had effectively undermined the power of the German middle class, with its moderating political influence, by destroying the real value of middle-class savings--which had been generally kept in the form of financial assets. The extent of the inflation can be seen in the exchange value of the mark, which was about 14 per U.S. dollar at the end of the war in 1919. When the inflation ended on November 20, 1923, the exchange rate was 4 trillion marks per U.S. dollar. (That same day the president of the Reichsbank--the German central bank--died of a heart attack, raising an interesting question of cause and effect.) Hitler's famous Munich beer-hall putsch occurred in November 1923, at the height of the inflation, and later the National Socialists were able effectively to exploit popular resentment over the terms of the treaty. Oswald Spengler, no admirer of Hitler, expressed the common view when he wrote:

The war of 1914, however, was fought by England, not on France's behalf nor on Belgium's, but for the sake of the 'week-end,' to dispose of Germany, if possible, for good, as an economic rival. In 1916 there set in, side by side with the military war, a systematic economic war, to be carried on when the other came inevitably to an end . . . The Treaty of Versailles was not intended to create a state of peace but to organize the relation of forces in such a way that this aim could at any time be secured by fresh demands and measures. Hence the handing over of the colonies and the merchant fleet, the seizure of bank bonds, property, and patents in all countries, the severence of industrial areas like Upper Silesia and the Saar valley, the inauguration of the Republic--by which it was expected (and correctly) that industry would be underminded by the power assumed by trade unions--and finally the reparations, which England, at least, intended not as war idemnification but as a permanent burden on German industry until it should collapse (Spengler, 1934),

In 1941, Keynes was sent to Washington as a representative of Churchill and the Chancellor of the Exchequer to settle the terms of Lend-Lease aid that Britain would receive from the United States. As part of the conditions for receiving the ultimate $30 billion in aid, the British were pressured to commit themselves to postwar arrangements as foreseen by the United States. While not in much of a bargaining position, the British did press for their objectives. They did not want to surrender the reserve currency status of the pound sterling. They took it for granted (as did the United States) that exchange rates should be fixed. In this context, they assumed that Britain would have a persistent tendency to import more from the United States than it exported to the United States and thought that this factor, combined with the British goal of full employment, would require various types of import restrictions, barter arrangements, and capital controls. Keynes, in fact, approved of the methods practiced by Hjalmar Schacht--the German "financial wizard" who had brought about the termination of the German hyperinflation and later served as Hitler's economic minister--which involved economic units directly bartering (trading) one type of good for another without the use of currency.

On the U.S. side, Secretary of the Treasury Henry Morgenthau gave Harry Dexter White the task, in December 1941, of thinking about future international money arrangements. White's views were already on record in an earlier study he had done in 1934 for Jacob Viner at the Treasury. It had stressed the need for fixed exchange rates, international cooperation, and settlement in gold as the basis for the international financial system. White's report to Morgenthau, making similar proposals, formed the basis for the Bretton Woods agreement. The White report also proposed an Inter-Allied (later a United Nations) Stabilization Fund to stabilize exchange rates and remove exchange controls and an Inter-Allied (later United Nations) Bank to provide capital for economic reconstruction. These two proposals came to fruition as the present-day International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank).

The views of other U.S. officials were also important in setting the tone of the Bretton Woods negotiations. Secretary of State Cordell Hull believed that the fundamental causes of the two world wars lay in economic discrimination and trade warfare. Specifically he had in mind the trade and exchange controls (bilateral arrangements) of Nazi Germany and the imperial preference system practiced by Britain (by which members or former members of the British Empire were accorded special trade status). An internal State Department paper in 1939 had even proposed a trade agreement with Germany as a way to avoid war. Overall, the Americans wanted a postwar system in which trade could expand. William Clayton, the assistant secretary of state for economic affairs, said: "We need markets--big markets--around the world in which to buy and sell." The free trade concerns would finally lead in 1947 to the General Agreement on Trade and Tariffs (GATT), by which member nations would generally agree to accord no special trade status to any one member that was not accorded to all. The concern over exchange controls was incorporated in the articles of agreement of the International Monetary Fund. Members were pledged to work for the removal of all such controls.

In the State Department the view prevailed that the United States should remove itself from its historical isolation and play a leading role in a new world order in which it was thought power politics would be absent. According to Harry Dexter White, "it was expected that the early post-war world would witness a degree of unity and good-will in international political relationships among the victorious allies [including Russia] never before reached in peace-time. It was expected that the world would move rapidly . . . toward 'One World.' . . . No influential person, as far as I can remember, expressed the expectation or the fear that international relations would worsen during those years." International institutions like the International Monetary Fund and the World Bank, with willing U.S. participation, were a step in the direction of this one, united world.

Finally, a strong anti-banking perspective led Secretary of the Treasury Morgenthau to throw his support to the new international financial institutions. At the Bretton Woods conference he predicted that the establishment of the IMF and the World Bank would "drive the usurious money lenders from the temple of international finance." Morgenthau's view contrasted with U.S. private-sector sentiment, which was not greatly exercised over usurious moneylenders but rather saw the proposed institutions as a covert scheme to subsidize debtor nations.

The main points of the postwar system evolving from the Bretton Woods agreement that are important for our purposes can be summarized as follows:

1. A new institution, The International Monetary Fund (IMF), would be established in Washington, D.C. Its purpose would be to lend foreign exchange to any member whose supply of foreign exchange had become scarce. This lending would not be automatic, but would be conditional on the member's pursuit of economic policies consistent with the other points of the agreement, a determination that would be made by the IMF.

2. The U.S. dollar (and, de facto, the British pound) would be designated as reserve currencies, and other nations would maintain their foreign exchange reserves principally in the form of dollars or pounds.

3. Each Fund member would establish a par value for its currency, and maintain the exchange rate for its currency within 1 percent of par value. In practice, since the principal reserve currency would be the U.S. dollar, this meant that other countries would peg their currencies to the U.S. dollar, and--once convertibility was restored--would buy and sell U.S. dollars to keep market exchange rates within the 1 percent band around par value. The United States, meanwhile, separately agreed to buy gold from or sell gold to foreign official monetary authorities at $35 per ounce in settlement of international financial transactions. The U.S. dollar was thus pegged to gold, and any other currency pegged to the dollar was indirectly pegged to gold at a price determined by its par value.

4. A Fund member could change its par value only with Fund approval and only if the country's balance of payments was in "fundamental disequilibrium." The meaning of fundamental disequilibrium was left unspecified, but everyone understood that par value changes were not to be used as a matter of course to adjust economic imbalances.

5. After a postwar transition period, currencies were to become convertible. That meant, to anyone who was not a lawyer, currencies could be freely bought and sold for other foreign currencies. Restrictions were to be removed, and hopefully eliminated. So, in order to keep market exchange rates within 1 percent of par value, central banks and exchange authorities would have to build up a stock of dollar reserves with which to intervene in the foreign exchange market.

6. The Fund would get gold and currencies to lend through "subscription." That is, countries would have to make a payment (subscription) of gold and currency to the IMF in order to become a member. Subscription quotas were assigned according to a member's size and resources. Payment of the quota normally was 25 percent in gold and 75 percent in the member's own currency. Those with bigger quotas had to pay more but also got more voting rights regarding Fund decisions.


The Bretton Woods agreement committed member countries to peg exchange rates¾ or rather to keep them within a plus or minus 1 percent margin around a declared par value. What does it mean to fix the price (the exchange value) of something? If no trading other than with official authorities is allowed (as where a currency is "inconvertible"), then fixing the price is easy. The central bank or exchange authority simply says the price is S, say S = 4 German marks per 1 U.S. dollar, and no one can say differently. If you want to trade German marks for dollars, you have to deal with the central bank, and you have to trade at central bank prices. The central bank may in fact even refuse to trade with you, but it can still claim that the exchange rate is fixed. If, however, free trade is allowed, fixing the price requires a great deal more. The price can be fixed only by altering either the supply of or the demand for the asset. For example, if you wanted to fix the price of gold at $35 per ounce, you could only do so by being willing and able to supply unlimited amounts of gold to the market to drive the price back down to $35 per ounce whenever there would otherwise be excess demand at that price, or to purchase unlimited amounts of gold from the market to drive the price back up to $35 per ounce whenever there would otherwise be excess supply at that price.

In order to peg the price of gold you would thus need two things: a large stock of gold to supply to the market whenever there is a tendency for the market price of gold to go up, and a large stock of dollars with which to purchase gold whenever there is a tendency for the market price of gold to go down. The same is true if the central bank wants to peg the exchange value of the domestic currency with respect to a foreign currency. If the German central bank wants to peg the exchange rate at DM4 = U.S.$1, it has to have a stock of deutschemarks and a stock of dollars. The deutschemarks are no problem--the central bank can always create more of them at will. But dollars are a problem to the German central bank. If there is excess demand for dollars, perhaps because at the pegged exchange rate dollars are too cheap (the central bank is selling them for DM4 when it should be selling them for, say, DM5), the central bank may run out of dollars and will no longer be able to maintain the peg. Dollars in this case are the German central bank's reserves, so we may summarize by saying: If the central bank or exchange authority sets an exchange rate that undervalues foreign currency--that is, overvalues domestic currency--the central bank will lose reserves. Conversely, if the pegged rate overvalues foreign currency, the central bank will gain reserves.

If a central bank is losing reserves, there is an excess demand for foreign currency (an excess supply of domestic currency) at the rate at which the central bank is pegging. In this case, the country is said to be running a balance of payments deficit. If a central bank (or exchange authority) is gaining reserves, there is an excess supply of foreign currency (an excess demand for domestic currency) at the rate at which the central bank is pegging. In the second case, the country is said to be running a balance of payments surplus.

We will explore the concept of balance of payments in Chapter 21. It should be obvious from the preceding paragraph, however, that if the central bank is not pegging or otherwise making any attempt to influence the market value of its currency, it will not have either a surplus or a deficit on the balance of payments except as an accounting artifice. This qualification is used because creative accountants can always jerry-rig a "deficit" or a "surplus" by calculating the balance in an arbitrary way. Such engineered deficits or surpluses may have no importance, however, except as political entertainment.

As an additional part of the Bretton Woods agreement, the United States committed itself to trade gold with foreign officials at a fixed price of $35 per ounce. In a sense, this was a commitment to peg the market price of gold, because if the private market price of gold differed from the official price--if, for example, the private market price were $37 per ounce--a foreign central bank would have an incentive to buy from the United States at $35 per ounce and sell on the private market at $37 per ounce. So the U.S. commitment meant that the United States needed, in principle, a large stock of gold to sell whenever the private market price rose above $35. Gold the United States had aplenty: by war's end in 1945 the United States had about 60 percent of the total world stock.

The U.S. commitment to peg the price of gold had other implications. Suppose that gold would always at any time trade for the same amount of other real goods--wheat, steel, bananas. In such a situation, the price of gold would by synonymous with purchasing power. You could always trade an ounce of gold for a predetermined bundle of other commodities. The U.S. commitment to buy and sell gold for $35 per ounce would then mean that the purchasing power of the dollar would have to be maintained at a constant level; there could be no inflation in the United States. In addition, if other countries did not alter the par value of their currencies in terms of the U.S. dollar, their currencies would also have fixed purchasing power, and there could be no inflation in these countries either.

It will, of course, not work exactly that way in practice. The relative price of gold in terms of wheat, steel, and bananas will change over time depending on relative supply and demand in each of those commodity markets. Thus, the price of gold will at best only roughly approximate purchasing power. In addition, the 1 percent margins around par value for exchange rates will allow some additional variation in the gold value of other countries' currencies. Finally, in case of "fundamental disequilibrium," a country might be allowed to change its par value from time to time, which would also alter its currency's gold value.

But even when we grant all these modifications, it is still safe to summarize: The Bretton Woods agreement, if adhered to, precluded sustained inflation on the part of member nations The values of other currencies were pegged to the dollar, which was pegged to gold. On the other hand, if the requirement that the dollar be pegged to gold were dropped and only the requirement that the par values of other currencies be maintained with respect to the dollar kept, a different implication would emerge. The implication, without the dollar-gold peg, would be that the United States and other countries would in the long run have to have the same rate of inflation or deflation. (For further details see Chapters 20 and 22.)


The Bretton Woods agreement committed member nations to restore the convertibility of their currencies as soon as possible, and there was no reason free trade in foreign exchange could not have begun immediately. Without government controls or threats of punishment, a foreign exchange market would automatically emerge through the voluntary association of buyers and sellers. (Some trade in foreign exchange would take place anyway, despite controls. Such trading, defined as illegal by the government, is referred to as the black market or parallel market. Parallel markets exist whenever government exchange or other restrictions create a divergence between the market value of a currency and the government's declared official value. In recent decades, parallel markets have been widespread throughout Latin America, Eastern Europe, and certain countries of the Middle East.)

Most governments at the end of the war, however, were not inclined to allow free trading in their currencies. If private citizens were allowed free access to foreign exchange, they would use it as they desired. Governments, however, wanted prior access to foreign exchange so they could spend it on what they wanted: to import food, to import materials considered essential for reconstruction, to buy military equipment, or to reward companies who politically supported the current regime. In addition, many governments had pre-conceived ideas of what exchange rates ought to be. Back in 1925, Great Britain had set the exchange rate for the pound sterling at £1 = $4.86, the pre-Great War rate, "so the pound could look the dollar in the face" (meaning that British government officials could look American government officials in the face and pretend that the world of 1925 was not different from the world of 1910.) And, in the new postwar years of the late 1940s, if free trading were allowed in its currency, a government would either have to set a par value that represented market equilibrium or find itself continuously intervening in order to maintain an artificial price.

When governments got around to restoring convertibility as planned under the Bretton Woods agreement, they would need a supply of dollars with which to do exchange intervention. And that, they felt, was the key missing ingredient: There was a shortage of dollar reserves with which to intervene in the exchange market. As Hendrik Houthakker, a later member of the U.S. Council of Economic Advisors, was to say: "You can't play poker unless all the participants have at least some chips." The Cold War would eventually assure European nations enough dollar chips to play the intervention game.

The U.S. Congress had agreed only reluctantly to fund the American contribution to the new IMF, and there was a great deal of skepticism in the private sector concerning an increased international role for the United States. Domestic support for a traditional U.S. isolationist stance began to erode, however, as tensions between the Soviet Union and the other nations allied against Nazi Germany--the United States, Britain, and France--increased following the war. In the United States, the overriding foreign policy concern became that of stopping the spread of communism internationally. An early expression of this policy was the European Recovery Program (Marshall Plan) proposed by Secretary of State Marshall at the Harvard commencement in 1947. The idea was to supply capital to European economies to enable them to rebuild and to become capable military allies of the United States against the Soviet Union. The Organization for European Economic Cooperation (OEEC), later reorganized as the Organization for Economic Cooperation and Development (OECD), was set up to administer Marshall Plan aid. (One important Marshall Plan economist, Richard Bissell, later became the CIA Deputy Director of Operations, and the architect of the failed Bay of Pigs invasion.) The Soviet Union responded by forming an Eastern European equivalent, the Council for Mutual Economic Assistance (COMECON).

The opening rounds of the Cold War arrived in connection with currency reform in occupied Germany. In 1945, the American army had brought with it to Germany occupation reichsmarks printed in the United States. The Soviets had also been given printing plates for the currency, and the millions of reichsmarks printed in Russia were used to extract, in a matter of weeks, several hundred million dollars worth of goods from the American and British occupation zones. The Soviet paper was then declared unacceptable in Western zones. The payment of troops in reichsmarks was discontinued, and cigarettes became the de facto medium of exchange and store of value in Germany, Lucky Strikes reaching at one point a price of $2300 a carton. Currency reform, planned under the name Operation Bird Dog, involved the replacement of the old reichsmarks with new deutschemarks (DM) printed in Washington at an exchange ratio of 1000 reichsmarks = 65 DM. The new currency would be legal tender in the Western zones, and its supply would be outside Soviet control. The Soviet Union viewed this as a part of an overall American plan to set up a separate West German government that would be ideologically opposed to the Soviets. On the day the new currency was to go into circulation in Berlin's Western zones, the Soviet military blockaded the city.

With the Berlin blockade of 1948, the successful communist revolution under Mao Tse-tung in China in 1949, and the outbreak of the Korean War in 1950, the mood of the U.S. Congress and the country changed to one of support for effecting a real financial transfer from the United States to Western Europe.

Initially, foreign trade was carried out in Europe through a set of clearing accounts. Under an arrangement called the European Payments Union, member countries kept track of all their payments deficits and surpluses with other member countries. The monthly net deficit or surplus of a particular country with all other member countries combined was considered a deficit or surplus of the union. At the end of each month, each country settled its net position with respect to the union in terms of U.S. dollars, gold, or credits. Credits were any amounts not settled in dollars or gold and could be accumulated only up to a specified limit. Calculation of the monthly surplus or deficit among countries took place at fixed exchange rates. Thus member countries could maintain the fiction that they were adhering to the Bretton Woods system of par values.

Throughout the 1950s, European governments, who never felt they had enough dollar reserves, made frequent reference to a "dollar shortage." In one sense, there actually was not a dollar shortage, since dollars would have always been available at some exchange rate, though not necessarily at the rate countries were willing to pay. A better phrase would have been "capital shortage," since capital goods were really the issue. The demand for dollars was equivalent to a demand for imports and raw materials to rebuild the European industrial base. "Hard currencies," such as the U.S. and Canadian dollars, could be spent anywhere in the world for such goods, while (because of exchange controls and other restrictions) so-called soft currencies had to be spent in the country in which they were earned. The reduction of the European capital shortage through Marshall Plan aid made it possible for European nations to build up foreign exchange reserves. While the total amount of Marshall Plan aid constituted only about 4 percent of European gross national product (GNP), it made up about 40 percent of European receipts of hard currency.

In addition to receiving aid, European countries were encouraged by the United States to liberalize trade among themselves. Official support was given to the ideas of individuals like Jean Monnet and Robert Shuman, who wanted to bring about a united Europe and to so integrate the economies of Germany and France that the two countries could never go to war again. "There will be no peace in Europe if States reestablish themselves on the basis of national sovereignty, with all that this implies by way of prestige politics and economic protectionism," Monnet had written in 1943. The European Coal and Steel Community, with Jean Monnet as its head, was formed in 1952, and in 1958, the European Economic Community (abbreviated EEC but frequently referred to as the Common Market) went into operation. The goal of the Common Market was to create a free trade area among member nations with free movement of labor and capital. It also entailed, however, the erection of common tariff barriers against the rest of the world. The political motivation for this economic organization was emphasized by a president of the EEC commission: "We are not in business at all; we are in politics."

European nations were officially encouraged by the United States to expand their exports to the dollar area even while maintaining restrictions on U.S. goods, and to use part of the earnings to build up dollar exchange reserves. As a consequence, between the end of 1949 and the end of 1959, U.S. liabilities to foreign monetary authorities rose from $3.1 billion to $10.1 billion. Toward the end of the 1950s, European authorities felt they had enough dollar reserves both to allow trade in their currencies and to defend their chosen par values, and at the end of 1958, current account convertibility was restored for the major European currencies. Current account convertibility meant that foreign exchange could be freely bought and sold provided its use was associated with international trade in goods and services. But there were still restrictions that applied when the intended use of the foreign exchange was to purchase foreign financial assets or to make equity investments. (Free trade in currencies for the latter purpose is called capital account convertibility.) Current account convertibility for the Japanese yen was not restored until 1964. (Japan is discussed in Chapter 2.)

Thus, almost fifteen years after the Bretton Woods agreement, foreign exchange markets were once again in operation in the Western world.


After the return to European convertibility, it was discovered that there was no longer any dollar shortage. Par values of roughly the market equilibrium values had been chosen. The deutschemark price of dollars had been set too high, however. The dollar was overvalued and the deutschemark undervalued, so the Bundesbank, the German central bank, continued to accumulate dollars (Germany continued to run a balance of payments surplus).

With a dollar shortage no longer a problem, European countries began to add up the total stock of U.S. dollars in foreign official hands and compare them to the total U.S. gold supply. They began to realize that the United States could no longer keep its part of the Bretton Woods agreement to convert dollars into gold at $35 per ounce. By 1960 total foreign dollar claims on the United States were greater than the total value of the U.S. gold stock when gold was valued at $35 per ounce. If all foreign official dollars were turned in for gold at the same time, U.S. gold would run short. The United States would either have to turn away dollar-holders or increase the dollar price of gold. (An increase in the dollar price of gold was referred to as a devaluation of the dollar.)

The right to exchange dollars for gold had become roughly equivalent to the right to exchange the money in a checking account for cash. Anyone has the right to convert his or her checking account into cash. But if everyone tries to exercise this right at once, the bank will eventually run out of cash, since a bank's vault cash amount is much smaller than its checking-account liabilities. Now, in one sense, it did not make a material economic difference whether the United States could convert dollars to gold or not. As long as the purchasing power of the dollar remained constant, dollar-holders would suffer no economic loss, and if they really wanted gold they could always buy it in the private market. Moreover, even if there were dollar inflation, as long as official reserve holders were paid an interest rate sufficient to compensate them for inflation and in addition pay them a competitive real return, they had no basis to complain that holding dollars involved an opportunity cost on their part.

There were, however, problems of perception. First, suppose that the price of gold had a tendency to rise above $35 per ounce in the private market. This could happen because there was dollar inflation, so that prices in general--including the price of gold--would rise. Or there could be an increase in the value of gold relative to other goods. If the increase were due to inflation, then Germany, for example, might not be happy, because Germany cnuld argue that the Bretton Woods agreement was implicitly an agreement by the United States to maintain a stable price level. (Memories of the 1920s hyperinflation have since given Germany a strong noninflationary stance.) If there was inflation in the United States, then--since the mark was pegged to the dollar--there would be inflation in Germany. Secondly, if the market price of gold rose above $35 per ounce, whether due to inflation or to an increase in the relative price of gold, even official dollar-holders might be tempted to switch from dollars to gold in order to enjoy a capital gain if the official U.S. dollar price of gold were later altered also. Finally, as we shall see, the French president de Gaulle made an issue out of gold purely on principle.

The inability to convert dollars into gold at $35 per ounce was therefore treated as a political problem by the U.S. administration. It became concerned about the private market price of gold (discussed further in the following section) and about the statistical measure of the U.S. balance of payments. The growing U.S. liabilities to foreign official agencies--obligations that could be converted into gold--reflected the deficit on the U.S. balance of payments, which was matched by a European surplus. American President Kennedy said he feared only two things: nuclear war and a deficit in the balance of payments. Nuclear war could wipe out all of one's assets. A deficit in the balance of payments could--in the context of German and French complaints--be used as a basis for domestic politicians to charge the administration with economic mismanagement and could act as an impediment to the Kennedy administration's plan to construct an Atlantic Alliance against the Soviet Union.

One solution to the "problem" of the U.S. balance of payments deficit would have been to allow the prices of major foreign currencies with respect to the U.S. dollar to rise. This action wnuld have decreased the demand for those currencies: equivalently, it would have decreased the supply of dollars to foreigners. However, many felt that the dollar, as the central reserve currency, should not be allowed to devalue generally with respect to other currencies (and thus to devalue with respect to gold). They felt that the dollar ought to be a riskless asset. Another solution might have been to take no action at all, since it was not clear there was a problem. The accumulation of dollars by foreign official agencies was, after all, voluntary, and if they desired to continue to add dollars to their reserves, the United States would have to run a deficit to supply those reserves. But this fact was also ignored. Instead, the concern over the deficit led to a series of credit restrictions and capital controls under Presidents John Kennedy and Lyndon Johnson.

On July 18, 1963, Kennedy proposed an Interest Equalization Tax (IET) on American purchases of foreign securities. This tax raised the cost to foreign borrowers who came to New York to issue bonds in the Yankee bond market. Bond coupons would have to be raised to compensate bond-buyers for the withholding tax they would have to pay the U.S. government. The naive idea of the tax was to keep dollars out of foreign hands, so outsiders would not have any dollars with which to demand gold. (This tax created a reason for issuing eurobonds denominated in dollars. Such bonds would be issued internationally, in foreign capital markets, and would be free of the tax; see Chapter 12.) In February 1965, the IET was extended to apply to loans with a maturity of one to three years when these loans were made by U.S. banks and other financial institutions to designated foreign borrowers.

In February 1965, the U.S. Voluntary Foreign Credit Restraint Program (FCRP) was also instituted. (It was "voluntary" in the sense that the government would not interfere in bank lending activity as long as the banks obeyed the general guidelines of the FCRP anyway). This program involved the setting of quotas--maximal amounts--on lending by U.S. banks to U.S. multi-nationals involved in foreign direct investment. On January 1, 1968, these controls were made legally mandatory. This set of controls gave companies an incentive to borrow dollars from sources not subject to these quotas.

The effect of the IET and FCRP was to give a strong impetus to the rate of growth of a new international money market that had slowly begun to emerge: the eurodollar market. In order to make clear what was involved, a slight digression from the historical sequence will be useful. An up-to-date definition of a eurodollar is "a dollar-denominated deposit in a bank outside the United States or in International Banking Facilities in the United States." (International Banking Facilities did not yet exist in the 1960s but were created beginning December 1981 and will be discussed in Chapter 8). The typical eurodollar deposit is a thirty- or ninety-day time deposit. The principal characteristic that makes it a "euro" deposit is the location of the bank giving the deposit, not the ownership of the bank or the funds. For example, if a U.S. corporation owns a dollar deposit at the Cayman Islands branch of a U.S. bank, the deposit is a eurodollar deposit because it is a deposit in a bank outside the United States. It is irrelevant whether the Cayman Islands bank is or is not a U.S. bank, and it is irrelevant whether the deposit is owned by a foreigner or a U.S. citizen. If a German corporation owns a dollar deposit in a New York bank, the deposit is not a eurodollar deposit, because the bank is not located outside the United States.

Similarly, a eurocurrency is a foreign-currency-denominated deposit in a bank outside the country where the currency is issued as legal tender. For example, a deutschemark-denominated deposit in a bank in Luxembourg is a euro-deutschemark deposit. As of 1990, there were fifteen eurocurrencies regularly traded in London. The dollar accounted for 60 percent of the total euromarket's gross liabilities and the deutschemark for another 14 percent.

A eurodollar is created this way. Suppose a U.S. company transfers $1 million from a U.S. domestic bank to a eurobank. This eurobank may, for example, be a branch of the U.S. bank in London or Nassau, or it may be a foreign bank. The company wires funds from the U.S. bank to the eurobank. The eurobank now owns a deposit at the U.S. bank. In return, the company is issued a time deposit at the eurobank. The $1 million transfer would show up on the books of the two banks as follows:

U.S. Domestic Bank








- $1 million deposit of U.S. company

+ $1 million deposit at U.S. domestic bank

+ $1 million deposit of U.S. company


+ $1 million deposit of Eurobank

Dollar liabilities of U.S. domestic banks have not altered in the slightest by this transaction. All that has changed at this point is that ownership of the $1 million deposit has been transferred from the U.S. company to the eurobank. The company may have been moved to transfer its deposit to the eurobank by the offer of a higher interest rate on deposits. The eurobank in turn can afford to pay higher interest only if it can loan out the deposit acquired at the U.S. domestic bank at an interest rate sufficiently higher than its deposit rate to obtain an acceptable profit margin. The U.S. domestic bank, meanwhile, is indifferent as to whether its liability is to a U.S. company or to a eurobank, except in the sense that there are legal distinctions (such as reserve requirement differences) among deposit-holders. Prior to May 1969, for example, there was no reserve requirement if the deposit-holder was a foreign branch of the U.S. domestic bank.

If the eurobank now makes a $1 million loan to Party Z, where Party Z may be another eurobank or a corporate customer, the accounting changes that take place are:

U.S. Domestic Bank


Party Z








- $1 million deposit of Eurobank

- $1 million deposit at U.S. domestic bank


+ $1 million deposit at U.S. domestic bank

+ $1 million debt to Eurobank


+ $1 million deposit of Party Z

+ $1 million loan to Party Z


The Eurobank makes the loan, in effect, by writing a check on its account at the U.S. domestic bank. The net result is that the $1 million deposit at the U.S. domestic bank again undergoes a transfer of ownership. But there has been no change in U.S. domestic bank liabilities.

Eurobanks acquire ownership of demand deposits at commercial banks and loan out these same demand deposits. Whether U.S. domestic bank liabilities are affected by eurobank activity depends on the structure of reserve requirements. If all deposit (or similar) liabilities of U.S. domestic banks are treated uniformly according to reserve requirements, eurobank activity cannot affect the quantity of total U.S. domestic bank liabilities. But if, for example, foreign branch banks have a smaller reserve requirement, an increase in the ownership share of U.S. domestic bank liabilities by foreign branch banks will free up reserves and will--under conditions of excess loan demand--expand total U.S. domestic bank liabilities.

Returning now to our main story, the eurodollar market had emerged shortly before the general return to European currency convertibility and had come about this way. International financial practice had established the British pound sterling as a reserve currency along with the dollar. During the 1950s, the par value was set as £1 = $2.80. As a result of the Suez crisis in 1956, during which Egyptian president Gamal Abdel Nasser's nationalization of the canal was followed by a joint British-French-Israeli attack on Egypt, there was a run on the British pound as pound-holders switched from pounds to dollars. The Bank of England had difficulty maintaining the market price at the lower range of the 1 percent band, $2.7720/£. The U.S. Federal Reserve was itself a seller of pounds, and, as a way of pressuring Britain to withdraw from Egypt, the United States blocked British attempts to borrow from the IMF. One consequence of the sterling crisis was that the Bank of England prohibited external sterling loans, the notion being that if foreigners did not have sterling they could not put pressure on the exchange rate by trading sterling for dollars.

However, one group of financial institutions, London overseas and merchant banks, made their living in part by arranging sterling financing for international trade. Trade between India and Nigeria, for example, was usually denominated in sterling, as opposed to the currencies of either of these two countries. These London institutions had the choice of closing shop or finding some other way to provide international trade financing. Their solution was to open a market in U.S. dollars. By offering to take in dollar deposits at competitive interest rates, they could acquire dollars to lend. (Bank of England prohibitions said nothing about dollars.) The idea that financial institutions in one country would open up a deposit market denominated in the currency of another country was considered a practice so strange that only merchant bankers would engage in it and in its early years was referred to as the Merchant Bank's Market. When a journalist for the Financial Times, Paul Einzig, discovered the market's existence, he was asked not to write about it.

The eurodollar market turned out to be a spectacular financial innovation, and as with any successful invention, all sorts of people later claimed to have thought of it first. What was new about the new market was that it was a market for both deposits and loans denominated in a foreign currency. The simple fact that these banks offered foreign currency deposits was not new: banks in Vienna and Berlin had commonly done this prior to World War II. Later, in the early 1950s, when currencies in Europe were generally inconvertible, Italian banks took in dollars in a small way to make loans to local businessmen. But this was viewed as a temporary expedient and did not endure. During the early years of the Cold War, the Soviet Union began to fear expropriation of its dollar deposits in New York and so switched ownership of these deposits to Soviet-controlled banks like the Moscow Narodny in London and the Banque Commerciale pour l'Europe du Nord in Paris. It was felt that the United States would not expropriate deposits owned by a British or a French bank. These banks in turn issued dollar deposits to the Soviet Union. Although this practice would later give rise to the rumor that Russians created the eurodollar market, the two banks were simply holding dollars in trust and did not get involved in dollar-lending until the later emergence of the Merchant Bank's Market in 1957.

There is no reason a specialty market in dollars could not have arisen in London without the artificial help of official regulatory restrictions. British banks might, for example, have specialized knowledge of financing trade in former parts of the British Empire that New York did not and might enjoy a comparative advantage of financing in dollars even given the fact that British banks would, in turn, have to hold and lend deposits in New York. Nevertheless, it is historically clear that regulatory restrictions were enormously important in inspiring the rapid growth of the market.

First of all, there were supply restrictions that hindered the ability of some to borrow dollars in New York. The Interest Equalization Tax and the Foreign Credit Restraint Program increased the interest cost, and placed limits on the amount, of bank loans available to foreigners and to U.S. companies investing abroad. Thus, for dollar loans many had little choice but to turn to the eurodollar market.

Second, there were demand restrictions that reduced the attractiveness of New York as a place to lend dollars by placing deposits with New York banks. In particular, the Federal Reserve's Rdgulation Q placed an interest ceiling on the amount U.S. banks could pay on bank deposits. Of course, such a ceiling is irrelevant if it is not binding--if market interest rates are lower than the ceiling. But, as seen in Figure 1.1, in 1966 and again in 1968-1969, market interest rates rose above Regulation Q ceiling rates--eurodollar deposits in the latter case paying as much as 500 basis points more.

As market interest rates rose above Regulation Q ceilings in 1966, money center banks experienced disintermediation: funds were switched out of time deposits and into Treasury bills and commercial paper, assets for which there were no interest ceilings. Banks with eurobank branches were better able to maintain their deposit base, since eurobank branches could pay market interest rates and relend the funds to headquarters. With a repetition of disintermediation in 1968-1969, many banks looked to open up eurobranches as a temporary solution to their funding problem but were hindered by the $500,000 minimum capital investment required to open a branch in London. A change in Federal Reserve regulations enabled them to open so-called shell branches in the Caribbean. Although such branches were legally established in a foreign country, a branch was really operated as a separate set of books in New York. The Cayman Islands branch of a major New York bank might, for example, be nothing more than a fellow named Bill with a desk and a telephone next to the foreign exchange traders in the New York bank's trading room. During 1969, forty U.S. banks opened branches, referred to as "Nassau shells," in the Bahamas. For a small investment of capital, U.S. banks could offer competitive rates of interest on deposits through eurobank branches in Nassau.

FIGURE 1.1 Short-term interest rates compared to Regulation Q ceiling rate. [Source: Bank for International Settlements, Annual Report (1970).]


In addition to the various restrictions referred to above, the United States joined with the central banks of the Common Market countries as well as with Great Britain and Switzerland to intervene in the private market for gold in the fall of 1960. If the private market price did not rise above $35 per ounce, it was felt, the Bretton Woods price was de facto the correct price, and in addition no one could complain if dollars were not exchangeable for gold. This coordinated intervention, which involved maintaining the gold price within a narrow range around $35 per ounce, became formalized a year later as the gold pool. Since London was the center of world gold trading, the pool was managed by the Bank of England, which intervened in the private market via the daily gold price fixing at N. M. Rothschild. In order to see how this worked, we now turn to a brief description of the gold market and once again depart slightly from a strictly chronological sequence.

In its current form, the London gold price fixing takes place twice each business day, at 10:30 A.M. and 3:00 P.M. in the "fixing room" of the merchant banking firm of N. M. Rothschild. Five individuals, one each from five major gold-trading firms, are involved in the fixing. The firms represented are Mocatta & Goldsmid, a trading arm of Standard Chartered Bank; Sharps Pixley, a dealer owned by Deutsche Bank; N. M. Rothschild & Sons, whose representative acts as the auctioneer; Republic-Mase, a bullion subsidiary of Republic Bank; and Samuel Montagu, a merchant banking subsidiary of Midland Bank (owned by HSBC). Each representative at the fixing keeps an open phone line to his firm's trading room. Each trading room in turn has buy and sell orders, at various prices, from customers located all over the world. In addition, there are customers with no existing buy or sell orders who keep an open line to a trading room in touch with the fixing and who may decide to buy or sell depending on what price is announced. The N. M. Rothschild representative announces a price at which trading will begin. Each of the five individuals then confers with his trading room, and the trading room tallies up supply and demand--in terms of 400-ounce bars--from orders originating around the world. In a few minutes, each firm has determined if it is a net buyer or seller of gold. If there is excess supply or demand a new price is announced, but no orders are filled until an equilibrium price is determined. The equilibrium price, at which supply equals demand, is referred to as the "fixing price." The A.M. and P.M. fixing prices are published daily in major newspapers.

Even though immediately before and after a fixing gold trading will continue at prices that may vary from the fixing price, the fixing price is an important benchmark in the gold market because much of the daily trading volume goes through at the fixing price. Hence some central banks value their gold at an average of daily fixing prices, and industrial customers often have contracts with their suppliers written in terms of the fixing price. Since a fixing price represents temporary equilibrium for a large volume of trading, it may be subject to less "noise" than are trading prices at other times of the day. Usually the equilibrium fixing price is found rapidly, but sometimes it takes twenty to thirty tries. Once in October 1979, with supply and demand fluctuating rapidly from moment to moment, the afternoon fixing in London lasted an hour and thirty-nine minutes.

The practice of fixing the gold price began in 1919. It continued until 1939, when the London gold market was closed as a result of war. The market was reopened in 1954. When the central bank gold pool began officially in 1961, the Bank of England--as agent for the pool--maintained an open phone line with N. M. Rothschild during the morning fixing (there was as yet no afternoon fixing). If it appeared that a fixing price would be established that was above $35.20 or below $34.80, the Bank of England (as agent) became a seller or buyer of gold in an amount sufficient to ensure that the fixing price remained within the prescribed bands.

While the gold pool held down the private market price of gold, gold politics took a new turn in the international arena. While it was actually Germany that was running the greatest surplus and accumulating dollar reserves in the early 1960s, it was France under the leadership of Charles de Gaulle that made the most noise about it. During World War II, in conversations with Jean Monnet, de Gaulle had supported the notion of a united Europe¾ but a Europe, he insisted, under the leadership of France. After the war, France had opposed the American plan for German rearmament even in the context of European defense. France had been induced to agree, however, through Marshall Plan aid, which France was not inclined to refuse after it became embroiled in the Indo-China War. But now, in the 1960s, de Gaulle's vision of France as a leading world power led him to withdraw from NATO because NATO was a U.S.-dominated military alliance. It also led him to oppose Bretton Woods, because the international monetary system was organized with the U.S. dollar as a reserve currency.

In the early 1960s there was, however, no realistic alternative to the dollar as a reserve asset, if one wanted to keep reserves in a form that both would bear interest and could be traded internationally. Official dollar-reserve holders not only were made exempt from the interest ceilings of Regulation Q for their deposits in New York but also began as a regular practice to hold dollars in the eurodollar market. Prior to 1965, central banks were the largest suppliers of dollars to the euromarket. Thus reserve holders received a competitive return on their dollar assets, and the United States gained no special benefit from the use of the dollar as a reserve asset.

Nevertheless, de Gaulle's stance on gold made domestic political sense, and in February 1965, in a well-publicized speech, he said: "We hold as necessary that international exchange be established . . . on an indisputable monetary base that does not carry the mark of any particular country. What base? In truth, one does not see how in this respect it can have any criterion, any standard, other than gold. Eh! Yes, gold, which does not change in nature, which is made indifferently into bars, ingots and coins, which does not have any nationality, which is held eternally and universally. . . ." By the "mark of any particular country" he had in mind the United States, which announced the Foreign Credit Restraint Program about a week later, in part as a direct response to de Gaulle's speech. France stepped up its purchases of gold from the U.S. Treasury and in June 1967, when the Arab-Israeli Six-Day War led to a large increase in the demand for gold, withdrew from the gold pool.

Then in November 1967, the British pound sterling was devalued from $2.80 to $2.40. Those holding sterling reserves took a 14.3 percent capital loss in dollar terms. This raised the question of the exchange rate of the other reserve assets: if the dollar was devalued with respect to gold, a capital gain in dollar terms could be made by holding gold. Therefore demand for gold rose and, as it did, gold pool sales in the private market to hold down the price were so large that month that the U.S. Air Force made an emergency airlift of gold from Fort Knox to London, and the floor of the weighing room at the Bank of England collapsed from the accumulated tonnage of gold bars.

In March 1968, the effort to control the private market price of gold was abandoned. A two-tier system began: official transactions in gold were insulated from the free market price. Central banks would trade gold among themselves at $35 per ounce but would not trade with the private market. The private market could trade at the equilibrium market price and there would be no official intervention. The price immediately jumped to $43 per ounce, but by the end of 1969 it was back at $35. The two-tier system would be abandoned in November 1973, after the emergence of floating exchange rates and the de facto dissolution of the Bretton Woods agreement. By then the price had reached $100 per ounce.

When the gold pool was disbanded and the two-tier system began in March 1968, there was a two-week period during which the London gold market was forceably closed by British authorities. A number of important changes took place during those two weeks. South Africa as a country is the single largest supplier of gold and had for years marketed the sale of its gold through London, with the Bank of England acting as agent for the South African Reserve Bank. With the breakdown of the gold pool, South Africa was no longer assured of steady central bank demand, and--with the London market temporarily closed--the three major Swiss banks (Swiss Bank Corporation, Swiss Credit Bank, and Union Bank of Switzerland) formed their own gold pool and persuaded South Africa to market through Zurich. In 1972, the second major country supplier of gold, the Soviet Union, also began to market through Zurich. In 1921, V. I. Lenin had written, "sell [gold] at the highest price, buy goods with it at the lowest price." Since the Soviet ruble was not convertible, the Soviet Union used gold sales as one major source of its earnings of Western currencies, and in the 1950s and 1960s sold gold through the Moscow Narodny in London (the same bank that provided dollar cover for the Soviets during the early days of the Cold War). In Zurich, the Soviet Union dealt gold via the Wozchod Handelsbank, a subsidiary of the Soviet Foreign Trade Bank, the Vneshtorgbank. (In March 1985, the Soviet Union announced that the Wozchod would be closed because of gold-trading losses and would be replaced with a branch office of the Vneshtorgbank. The branch office, unlike the Wozchod, would not be required to publish information concerning operations.)

London, in order to stay competitive, has since become more of a gold-trading center than a distribution center. When the London market reopened in March 1968 after the two-week "holiday," a second daily fixing (the 3:00 P.M. fixing) was added in order to overlap with U.S. trading hours, and the fixing price was switched to U.S. dollar terms from pound sterling terms. In more recent years, London's role as a trading center has also been challenged by the Comex gold futures market in New York.

During the early years of the gold pool, it came to be believed that there was a deficiency of international reserves and that more reserves had to be created by legal fiat to enable reserve-holders to diversify out of the U.S. dollar and gold. In retrospect, this was a curious view of the world. The form in which reserves are held will ultimately always be determined on the basis of international competition. People will hold their wealth in the form of a particular asset only if they want to. If they do not have an economic incentive to desire a particular asset, no legal document will alter that fact. A particular currency will be attractive as a reserve asset if these four criteria exist: (1) an absence of exchange controls so people can spend, transfer, or exchange their reserves denominated in that currency when and where they want them; (2) an absence of applicable credit controls and taxes that would prevent assets denominated in the currency from bearing a competitive rate of return relative to other available assets; (3) political stability, in the sense that there is a lack of substantial risk that points (1) and (2) will change within or between government regimes; (4) a currency that is in sufficient use internationally to limit the costs of making transactions. These four points explain why, for example, the Swiss but not the French franc has been traditionally used as an international reserve asset.

Many felt that formal agreement on a new international reserve asset was nevertheless needed, if only to reduce political tension. And while France wanted to replace the dollar as a reserve asset, other nations were looking instead for a replacement for gold. The decision was made by the Group of Ten (ten OECD nations with most of the voting rights in the IMF) to create an artificial reserve asset that would be traded among central banks in settlement of reserves. The asset would be kept on the books of the IMF and would be called a Special Drawing Right (SDR). In fact it was a new reserve asset, a type of artificial or "paper gold," but it was called a drawing right by concession to the French, who did not want it called a reserve asset.

The SDR was approved in July 1969, and the first "allocation" (creation) of SDRs was made in January l970. Overnight, countries gained more reserves at the IMF, because the IMF added new numbers to its accounts and called these numbers SDRs. The timing of the allocation was especially maladroit. In the previous four years the United States had been in the process of financing the Great Society domestic social programs of the Johnson administration as well as a war in Vietnam, and the world was being flooded with more reserves than it wanted at the going price of dollars for deutschemarks, yen, or gold. In the 1965 Economic Report of the President, Johnson wrote, in reference to his Great Society Program and the Vietnam War: "The Federal Reserve must be free to accommodate the expansion in 1965 and the years beyond 1965." U.S. money supply (M1) growth, which had averaged 2.2 percent per year during the 1950s, inched upward slightly during the Kennedy years (2.9 percent per year for 1961-1963) but changed materially under the Johnson administration. The growth rate of M1 averaged 4.6 percent per year over 1964-1967, then rose to 7.7 percent in 1968. Under the Nixon administration that followed, money growth initially slowed to 3.2 percent in 1969 and 5.2 percent in 1970, then accelerated to 7.1 percent for 1971-1973. The latter three years would encompass the breakdown of Bretton Woods.


In order to succeed, a regime of fixed exchange rates (and under Bretton Woods, rates for the major currencies were fixed in terms of their par values, which could not be casually altered) requires coordinated economic policies, particularly monetary policies. If two different currencies trade at a fixed exchange rate and one currency is undervalued with respect to the other, the undervalued currency will be in excess demand. By the end of the 1960s both the deutschemark and the yen had become undervalued with respect to the U.S. dollar. Therefore the countries concerned (Germany and Japan) had two choices: either increase the supplies of their currencies to meet the excess demand or adjust the exchange values of their currencies upward enough to eliminate the excess demand.

As long as either country intervened in the market to maintain the par value of its currency with respect to the U.S. dollar, an increased supply of the domestic currency would take place automatically. To see why this is so, take the case of Germany. In order to keep the DM from increasing in value with respect to the U.S. dollar, the Bundesbank would have to intervene in the foreign exchange market to buy dollars. It would buy dollars by selling DM. The operation would increase the supply of DM in the market, driving down DM's relative value, and increase the demand for the dollar, driving up the dollar's relative value.

Any time the central bank intervenes in any market to buy or sell something, it potentially changes the domestic money supply. If the central bank buys assets such as government bonds or foreign exchange, it does so by writing a check on itself. Central bank assets go up: the central bank now owns the bonds or the foreign exchange. But central bank liabilities go up also, since the check represents a central bank liability. The seller of the bonds or foreign exchange or other asset will deposit the central bank's check, in payment for the value of the assets, in an account at a commercial bank. The commercial bank will in turn deposit the check in its account at the central bank. The commercial bank will now have more reserves, in the form of a deposit at the central bank. The bank can use the reserves to make more loans, and the money supply will expand by a multiple of the initial reserve increase.

A typical central bank balance sheet follows. Central banks have two general types of assets: domestic and foreign. Domestic assets are things like government bonds and direct loans to the commercial banking system. In some countries they have included corporate stock and direct loans to private industry. Foreign assets are things like gold, SDRs, and foreign exchange.


Central Bank



Domestic assets

High-powered money

Foreign assets


Central bank liabilities make up the monetary base, or "high-powered money." In the case of the Federal Reserve in the United States, the two principal components of this liability are currency in circulation (printed money and coins) and commercial bank checking accounts (federal funds). Either component can serve as reserves of commercial banks. Checking accounts at the Federal Reserve are automatically reserves, and currency can serve as bank reserves if it is held in a bank's vault ("cash in the vault").

Different banking systems differ in detail but generally have a similar structure. Consider now the Bundesbank, the German central bank, intervening in the foreign exchange market to buy up $1 billion, at a fixed exchange rate of DM4 = $1. The transaction would show up on the books of the Bundesbank as follows:




+ DM 4 billion in foreign assets

+ DM 4 billion in reserves of banking system

The foreign exchange intervention automatically increases the monetary base in Germany by DM4 billion. Eventually the money supply in Germany will increase by a multiple of this amount. The total increase in the German money supply will depend on the size of the money multiplier in Germany. If the money (M1) multiplier were 2.5, then the M1 money supply in Germany would eventually rise by (DM4 billion)(2.5) = DM10 billion.

Is there anything the German authorities can do to prevent the money-supply increase? Essentially not, as long as they attempt to maintain the fixed exchange rate. There is, however, an operation referred to as sterilization. Sterilization refers to the practice of offsetting any impact on the monetary base caused by foreign exchange intervention, by making reverse transactions in terms of domestic assets. For example, if the money base went up by DM4 billion because the central bank bought dollars in the foreign exchange market, a sterilization operation would involve selling DM4 billion worth of domestic assets to reduce central bank liabilities by an equal and offsetting amount. If the Bundesbank sold domestic assets, these would be paid for by checks drawn on the commercial banking system and reserves would disappear as the commercial banks' checking accounts were debited at the central bank.

However, the Bundesbank could not simultaneously engage in complete sterilization (a complete offset) and also maintain the fixed exchange rate. If there was no change in the supply of DM, the DM would continue to be undervalued with respect to the dollar, and foreign exchange traders would continue to exchange dollars for DM. During the course of 1971, the Bundesbank intervened so much that the German high-powered money base would have increased by 42 percent from foreign exchange intervention alone. About half this increase was offset by sterilization, but, even so, the increase in the money base--and eventually the money supply--by more than 20 percent in one year was enormous by German standards. The breakdown of the Bretton Woods system began that year.

It came about this way. From the end of World War II to about 1965, U.S. domestic monetary and fiscal policies were conducted in such a way as to be noninflationary. As world trade expanded during this period, the relative importance of Germany and Japan grew, so that by the end of the 1960s it was unreasonable to expect any system of international finance to endure without a consensus at least among the United States, Germany, and Japan. But after 1965, U.S. economic policy began to conflict with policies desired by Germany and Japan. In particular, the United States began a strong expansion, and moderate inflation, as a result of the Vietnam War and the Great Society program.

When it became obvious that the DM and yen were undervalued with respect to the dollar, the United States urged these two nations to revalue their currencies upward. Germany and Japan argued that the United States should revise its economic policy to be consistent with those in Germany and Japan as well as with previous U.S. policy. They wanted the United States to curb money-supply growth, tighten credit, and cut government spending. In the ensuing stalemate, the U.S. policy essentially followed the recommendations of a task force chaired by Gottfried Haberler. This was a policy of officially doing nothing and was commonly referred to as a policy of "benign neglect." If Germany and Japan chose to intervene to maintain their chosen par values, so be it. They would be allowed to accumulate dollar reserves until such time as they decided to change the par values of their currencies. That was the only alternative if the United States would not willingly change its policy. It was clearly understood at the time that a unilateral action on the part of the United States to devalue the dollar by increasing the dollar price of gold would be matched by similar European devaluations.

In April 1971, the Bundesbank took in $3 billion through foreign exchange intervention. On May 4 it took in $1 billion in the course of the day. On May 5 the Bundesbank took in $1 billion during the first hour of trading, then suspended intervention in the foreign exchange market. The DM was allowed to float upward. On August 15 the U.S. president, Nixon, suspended the convertibility of the dollar into gold and announced a 10 percent tax on imports. The tax was temporary and was intended to signal the magnitude by which the United States thought the par values of the major European and Japanese currencies should be changed.

An attempt was made to keep the Bretton Woods system going by a revised agreement, the Smithsonian agreement, reached at the Smithsonian Institution in Washington on December 17-18, 1971. Called by President Nixon "the most important monetary agreement in the history of the world," it lasted only slightly more than a year, but beyond the 1972 U.S. presidential election. At the Smithsonian Institution the Group of Ten agreed on a realignment of currencies, an increase in the official price of gold to $38 per ounce, and expanded exchange rate bands of 2.25 percent around their new par values.

Over the period February 5-9, 1973, history repeated itself, with the Bundesbank taking in $5 billion in foreign exchange intervention. On February 12, exchange markets were closed in Europe and Japan, and the United States announced a 10 percent devaluation of the dollar. European countries and Japan allowed their currencies to float and, over the next month, a de facto regime of floating exchange rates began. The floating rate system has persisted to the present, with none of the five most widely traded currencies (the dollar, the DM, the British pound, the Japanese yen, the Swiss franc) in any way officially fixed in exchange value with respect to the others. (Briefly, from October 1990 to September 1992, the DM and the British pound were nominally linked in the Exchange Rate Mechanism of the European Monetary System.) With the breakdown of Bretton Woods, there began a slow dismantling of the array of controls that had been erected in its name. Over 1973-1974, for example, the Interest Equalization Tax, the Foreign Credit Restraint Program, and the two-tier system for gold were all discarded.

The U.S. inflationary process, mild as it was by later standards, had a profound impact, via the Bretton Woods regime of par values, on other industrial countries. Economist Ronald McKinnon notes "the remarkable loss of monetary control among the major industrial economies concurrently in the last years of the fixed exchange rate regime. Taking ten industrial countries combined, their aggregate money supply grew about 12 percent per annum in the 1971-1973 period as compared to a little over 7 percent per annum in the preceding ten years." The stage was set for the inflationary seventies.


1. Suppose that free trading is allowed in both the Belgian franc and the French franc, but that the French and Belgian central banks peg their currencies with respect to each other at an exchange rate that undervalues the French franc relative to the Belgian franc. Which central bank will gain foreign exchange reserves? Which central bank will lose foreign exchange reserves?

2. The central bank of Surlandia pegs the peso to the U.S. dollar at a price of Ps.150/$. The market exchange rate is Ps.180/$. Will the central bank of Surlandia gain or lose dollar reserves?

3. Which of the following items would be defined as eurodollars: German-owned dollar deposits in a New York bank; any deposit in a branch of a U.S. bank located in Zurich; a dollar deposit in the Los Angeles branch of the Bank of Tokyo; U.S. Treasury bills owned by the Saudi Arabian Monetary Authority; dollar deposits in London banks owned by French exporters?

4. A company in Houston transfers $10 million to a eurobank in Panama, writing a check on Texas Commerce Bank. The bank in Panama deposits the check in Chemical Bank, New York, and subsequently loans $8 million to a eurobank in Nassau. Show the accounting changes that take place on the balance sheets of Texas Commerce Bank and the Panamanian eurobank.

5. Suppose the Bundesbank intervenes in the foreign exchange market and sells dollars. How does this affect the German monetary base?

6. The Federal Reserve sells 24 million ounces of gold at $35 an ounce, buys $2.38 billion worth of Treasury bills, and sells DM2.2 billion at an average exchange rate of DM3.90/$. What is the net change in the U.S. monetary base from these operations? If the U.S. money (M1) multiplier is 2.58, what will be the net change in the U.S. money supply?

7. Suppose the Federal Reserve were required to buy gold from, or sell gold to, anyone at a fixed price of $35 per ounce. Assume that the gold market is currently in equilibrium at that level. Explain why inflation in the United States would then automatically lead to a decrease in the U.S. money supply, assuming that changes in the price of gold accurately reflected changes in the purchasing power of the dollar.

[Taken from Chapter 1, International Financial Markets, 3rd edition, by J. Orlin Grabbe, © 1996 Prentice-Hall, Inc., a Simon & Schuster Company, Englewood Cliffs, New Jersey. ISBN 0-13-206988-1.]