With the First World War, political alliances changed, international debt increased, and public finances deteriorated. Although the gold standard was not suspended, it was in limbo during the war, demonstrating its inability to endure good times and bad.
This created distrust of the gold standard, which only exacerbated the economic hardship. It became more and more obvious that the world needed something more flexible to establish its global economy.
At the same time, the desire to return to the idyllic years of the gold standard remained strong among the nations. As the supply of gold continued to lag behind the growth of the global economy, the British pound sterling and the US dollar became the world’s reserve currencies. Smaller countries began to hold more of these currencies instead of gold. The result was increased consolidation of gold in the hands of several large countries.
The stock market crash of 1929 was just one of the world’s post-war hardships. The pound and the French franc were incompatible with other currencies; war debts and repatriations were still choking Germany; commodity prices were falling, and banks were overextended.
Many countries tried to defend their gold reserves by raising interest rates to encourage investors to keep their deposits intact rather than convert them into gold. These higher interest rates only worsened the world economy. In 1931, the gold standard in England was suspended, and only the United States and France were left with large gold reserves.
Then, in 1934, the US government revalued gold from $20.67 an ounce to $35 an ounce, increasing the amount of paper money it took to buy one ounce to help improve the economy. As other countries were able to convert their existing gold reserves into more US dollars, there was an immediate sharp devaluation of the dollar.
This higher gold price increased the conversion of gold into US dollars, effectively allowing the US to take over the gold market. Gold production skyrocketed, and by 1939 there was enough gold in the world to replace all of the world’s currency in circulation.
As World War II drew to a close, the leading Western powers met to develop the Bretton Woods Agreement, which would be the basis for world currency markets until 1971. Under the Bretton Woods system, all national currencies were valued against the US dollar.
The US dollar has become the dominant reserve currency. The dollar, in turn, could be converted into gold at a fixed rate of $35 per ounce. The world financial system continued to operate on the gold standard, albeit in a more indirect way.
The agreement has led to an interesting relationship between gold and the US dollar over time. In the long run, a falling dollar usually means a rise in the price of gold. In the short term, this is not always true, and the relationship can be negligible at best, as the following yearly daily chart shows.
At the end of World War II, the US held 75% of the world’s monetary gold, and the dollar was the only currency still directly backed by gold. However, as the world recovered from World War II, the U.S. gold reserves steadily dwindled as money flowed into the war-torn countries and their strong demand for imports. The high inflationary environment of the late 1960s sucked the last breath of air out of the gold standard.
In 1968, the Gold Pool, which included the United States and several European countries, stopped selling gold on the London market, which allowed the market to freely determine the price of gold.
From 1968 to 1971, only central banks could trade with the US at $35 an ounce. By making the pool of gold reserves available, the market price of gold can be maintained in line with the official parity rate. This has reduced the pressure on member countries to strengthen their currencies to support their export-led growth strategies.
However, the growing competitiveness of foreign nations, combined with the monetization of debt to pay for social programs and the Vietnam War, soon began to put pressure on America’s balance of payments. With surpluses turning into deficits in 1959 and growing fears that foreign nations would buy their dollar holdings for gold, Senator John F. Kennedy stated in the later stages of his presidential campaign that if elected, he would not there be an attempt to devalue the dollar.
The gold pool collapsed in 1968 as the member countries were unwilling to cooperate fully in keeping the market price at the level of the American gold price. In subsequent years, Belgium and the Netherlands cashed gold in dollars, with Germany and France expressing similar intentions.
In August 1971, Britain demanded payment in gold, forcing Nixon’s hand and officially closing the gold window. By 1976 it was official; the dollar would no longer be defined by gold, ending any semblance of a gold standard.
In August 1971, Nixon stopped the direct conversion of US dollars into gold. With this decision, the international currency market, which since the entry into force of the Bretton Woods agreement has been increasingly dependent on the dollar, has lost its formal connection with gold. The US dollar, and by extension the global financial system it effectively supports, has entered the era of fiat money.
