It was clear during the Second World War that a new international system would be needed to replace the Gold Standard after the war ended. The design for it was drawn up at the Bretton Woods Conference in the US in 1944. US political and economic dominance necessitated the dollar being at the centre of the system. After the chaos of the inter-war period there was a desire for stability, with fixed exchange rates seen as essential for trade, but also for more flexibility than the traditional Gold Standard had provided. The Bretton Woods system was drawn up and fixed the dollar to gold at the existing parity of US$35 per ounce, while all other currencies had fixed, but adjustable, exchange rates to the dollar. Unlike the classical Gold Standard, capital controls were permitted to enable governments to stimulate their economies without suffering from financial market penalties.
During the era of the Bretton Woods system, the world economy grew rapidly. Keynesian economic policies enabled governments to dampen economic fluctuations, and recessions were generally minor. However, strains started to show in the 1960s. Persistent, albeit low-level, global inflation made the price of gold too low in real terms. A chronic US trade deficit drained US gold reserves, but there was considerable resistance to the idea of devaluing the dollar against gold; in any event this would have required agreement among surplus countries to raise their exchange rates against the dollar to bring about the needed adjustment. Meanwhile, the pace of economic growth meant that the level of international reserves generally became inadequate; the invention of the ‘Special Drawing Right’ (SDR)[1] failed to solve this problem. While capital controls still remained, they were considerably weaker by the end of the 1960s than in the early 1950s, raising prospects of capital flight from, or speculation against, currencies that were perceived as weak.
In 1961 the London Gold Pool was formed. Eight nations pooled their gold reserves to defend the US$35 per ounce peg and prevent the price of gold moving upwards. This worked for a while, but strains started to emerge. In March 1968, a two-tier gold market was introduced with a freely floating private market, and official transactions at the fixed parity. The two-tier system was inherently fragile. The problem of the US deficit remained and intensified. With speculation against the dollar intensifying, other central banks became increasingly reluctant to accept dollars in settlement; the situation became untenable. Finally in August 1971, President Nixon announced that the US would end on-demand convertibility of the dollar into gold for the central banks of other nations. The Bretton Woods system collapsed and gold traded freely on the world’s markets.
[1]A new reserve asset, the SDR was created and given the value of 0.888571 gram of fine gold, the same value as the dollar in July 1944.
Information and writing from gold.org