The End of Bretton Woods, Worldwide Inflation, and the Transition to Floating Rates
By the late 1960s, the Bretton Woods system of fixed exchange rates was beginning to show strains that would soon lead to its collapse. These strains were closely related to the special position of the United States, where inflation was gathering strength because of higher monetary growth as well as higher government spending on new social programs such as Medicare and on the unpopular Vietnam War.
The acceleration of American inflation in the late 1960s was a worldwide phenomenon. Table 19-1 shows that by the start of the 1970s, inflation had also broken out in European economies.25
The worldwide nature of the inflation problem was no accident. The theory in Chapter 18 predicts that when the reserve currency country speeds up its monetary growth, as the United States did in the second half of the 1960s, one effect is an automatic increase in monetary growth rates and inflation abroad as foreign central banks purchase the reserve currency to maintain their exchange rates and expand their money supplies in the process. One interpretation of the Bretton Woods system’s collapse is that foreign countries were forced to import unwelcome U.S. inflation through the mechanism described in Chapter 18. To stabilize their price levels and regain internal balance, they had to abandon fixed exchange rates and allow their currencies to float. The monetary trilemma implies that these countries could not simultaneously peg their exchange rates and control domestic inflation.
Adding to the tensions, the U.S. economy entered a recession in 1970, and as unemployment rose, markets became increasingly convinced that the dollar would have to be devalued against all the major European currencies. To restore full employment and a balanced current account, the United States somehow had to bring about a real depreciation of the dollar. That real depreciation could be brought about in two ways: The first option was a fall in the U.S. price level in response to domestic unemployment, coupled with a rise in foreign price levels in response to continuing purchases of dollars by foreign central banks. The second option was a fall in the dollar’s nominal value in terms of foreign currencies. The first route—unemployment in the United States and inflation abroad—seemed a painful one for policy makers to follow. The markets rightly guessed that a change in the dollar’s value was inevitable. This realization led to massive sales of dollars in the foreign exchange market.
After several unsuccessful attempts to stabilize the system (including a unilateral U.S. decision in August 1971 to end completely the dollar’s link to gold), the main industrialized countries allowed their dollar exchange rates to float in March 1973.26
Floating was viewed at the time as a temporary response to unmanageable speculative capital movements. But the interim arrangements adopted in March 1973 turned out to be permanent and marked the end of fixed exchange rates and the beginning of a turbulent new period in international monetary relations.