Bretton Woods, Gold, and the current monetary system

17 April 2013

In the next post, I intend to describe what I personally deem to be bearish arguments against gold, and make out a case why the secular bull market that began in 2001 probably ended in September 2011. Undoubtedly, there will be many believers in gold who will vehemently disagree. My bullish arguments FOR gold are laid out in this post (but as my next post will explain, I think the bear case outweighs the bull case).

First however, I will need to devote one post to describing a little bit of history to set the context for the discussion. We need to understand how the current monetary system evolved, as well as its flaws.

Post World War II, the Bretton Woods system fixed global exchanged rates to the US dollar, and the USD was in turn pegged to gold at a price of $35 per ounce. The US Federal Reserve guaranteed USD-gold interconvertibility between central banks at this rate, and the free market for gold was naturally tied down by this arrangement.

The system initially worked well. The United States had emerged from the War as the sole global superpower, and it was then also a huge exporter to the global economy. The US held the majority of the world’s government gold reserves, and this acted as a stabilizing force which anchored the US permanently as the center of gravity of the global monetary system.

However, the huge international demand for US dollars in the 1950’s caused the US to embark on a deliberate policy of running a balance of payments deficit in order to provide liquidity to the global economy. The Bretton Woods system was then used to establish a triangular system of trade in which the US profited from trade with developing countries, the surplus was sent to Europe to enable Europe to rebuild itself, and Europe in turn used its new financial muscle to purchase goods from the Third World and enable the emerging economies to prosper.

However, as other industrialized countries grew and overtook the US as export economies, and as deficit spending in the US soared due to domestic welfare spending as well as the Vietnam War, the US experienced increased inflation, increased unemployment, and an ever-widening balance of payments deficit as well as a trade deficit by the start of the 1970’s.

America’s gold reserves fell drastically, and the risk of a run on the remaining reserves increased as other countries like Germany, Switzerland, France and Japan held more and more US dollar reserves. One by one, countries started leaving the Bretton Woods system as the fixed exchange rates were hurting their own economies through inflation and other price distortions.

The US dollar predictably starting falling against other major currencies, US domestic inflation accelerated, and as gold outflows from the US increased steadily, the US was also pressured to leave Bretton Woods. The dollar shortage of the late 1940’s had been transformed into a dollar glut, wrecking havoc on the global monetary system and threatening the financial stability of the US in particular.

On August 15, 1971, US President Nixon issued Executive Order 11615, pursuant to the Economic Stabilization Act of 1970, which closed the gold window, meaning that the inter-central bank convertibility between US dollars and gold was abolished.

Within a couple of years, the global currency system was firmly anchored on floating exchange rates, totally unbacked by gold, and subject purely by market forces as well as the confidence of economic participants in the integrity of fiat currency.

This is today’s fiat money system — the first truly global experimental fiat money system tried out by mankind. The monetary system of today is also known as Bretton Woods II.

The Bretton Woods II regime became notorious for engendering asset bubbles, periodic bouts of inflation, and general currency instability.

This eventually led Europe to embark on an equally ambitious experimental politico-monetary system which culminated in the founding of the Euro, the official currency of the Eurozone, and the currency used by the Institutions of the European Union (EU).

When Nixon closed the gold window in 1971 and forever doomed the world to a system of fiat currency which can be manipulated at will by central banks, gold embarked on its first ever secular bull market in the history of mankind. It rose from $35 per ounce in 1971 all the way to $850 per ounce in 1980 — an increase of 24 times within a period of 9 years.

The spectacular bull market in gold was driven also by geopolitical tensions arising from Middle East, as well as rampant inflation in the United States and other economies. It soon entered bubble territory, with rampant speculation abound.

When US Fed Chairman Paul Volcker initiated tough measures to combat inflation from 1979 to 1981, the gold bubble was burst. Inflation peaked in 1981, one full year after gold made its bubble high on 21 Jan 1980.

Volcker’s most important contribution to reducing inflation came after the US economy began to recover from the deep recession of 1982. Volcker embarked on a policy of preemptive restraint during the economic upturn after 1983. This increased real interest rates and pushed Congress and the President to balance the budget. The combination of sound monetary and fiscal policy led to price stability and a new era of benign disinflation and positive economic growth.

Meanwhile, gold never returned to its 1980 high for the next two decades, during which the price spent most of its time going sideways, and eventually drifted down to a secular bear market low of $250 in 2001.

From there, a new secular upswing emerged. It is now my contention that this second secular upswing is now over. That was be the topic of my next post.