When the World Chose the Dollar

World War 2 had no real winners — at least not economically. 70 countries and territories at war for 6 years — around 70-85 million people killed. The military expenditure alone amounted to around USD 1.3 trillion — nearly USD 4 trillion in today's money. The full cost? Beyond accurate estimation.

World war 2 permanently changed how the global economy operated - Great Britain, a pre-war colonial superpower, was on the verge of bankruptcy, Germany and Japan saw their industrial output drop by 70% to 80% and the Soviet Union lost nearly one third of its national wealth. It didn’t matter whether a country was on the winning side or losing side – the price of war had to be paid.

With economic collapse evident, the military war had acquired an economic front as well – not just soldiers in trenches, but currencies, tariffs and trade blocs doing battle. Currencies were intentionally devalued to encourage cheaper exports, high trade tariffs were imposed to reduce imports, trading was restricted to friendly and politically allied nations. Hyper-inflation, loss in value of currency and barely-there gold reserves – war economies were struggling. Except for one nation.

Why America Held the Strongest Hand

The war catapulted the United States into a military and economic superpower, and by the end of the war, the US held roughly 70% of the world’s monetary gold. The transfer of gold was not an abrupt event – it had started as early as 1930’s when Europe began experiencing political instability. US, being geographically distant and not an active participant in the war till 1941, was a safe haven for wealth. US also happened to be the largest global supplier of arms, machinery and manufactured goods.

In 1941, after the Pearl Harbour attack, the US joined the war. Despite being an active participant in the war, the US economy did not falter — its industrial base remained intact and its soil untouched by the conflict. It continued to operate as the global export hub for the Allies and accepted payments in gold, as was the norm then. Gold, the commodity against which currencies were issued, was in short supply everywhere except for one country.

By 1944, the economic landscape was radically asymmetric. Pegging currencies to depleting gold reserves was no longer feasible and abandoning the peg system would result in currency wars. Without the United States, there could be no workable design. Only America had the industrial capacity and gold reserves large enough to lend credibility to whatever monetary rules the world agreed upon.

44 Nations, One Hotel, and a New Monetary Order

In July 1944, even as World War 2 still raged and almost a year before the bombing of Hiroshima and Nagasaki, 44 Allied countries quietly met in a hotel in the American town of Bretton Woods, New Hampshire, to redesign a post-war monetary order. 730 delegates spent three weeks locked up in this remote location, with little to no access to the outside world, arguing over economic philosophy, for whoever wrote those rules would shape the world that followed. This conference was officially called the United Nations Monetary and Financial Conference, but history remembers it simply as Bretton Woods.

John Maynard Keynes, famous economist from the almost bankrupt British empire and Harry Dexter White, Chief International Economist of the United States Treasury dominated the deliberations. Both men agreed on core ideas that the new system must be based on a fixed exchange rate to prevent destructive speculation and that such rates would be governed by newly established international institutions. These institutions would also implement large scale measures to rebuild war-damaged economies. However, they disagreed on how to implement this model.

Keynes Vs White - Bancor or Dollar?

John Maynard Keynes wanted to introduce a global currency called the “Bancor”, which would be issued by a relatively democratic global institution called “International Clearing Union”. The Bancor’s value would be tied to gold and all national currencies would be pegged to the Bancor. This system deliberately wanted to avoid making USD the central currency as US monetary policies would influence other economies. Keynes' argument was that if any single nation's currency becomes the global reserve currency, that nation gains unfair economic advantage over everyone else. Keynes believed in symmetric discipline for deficit and surplus countries. He advocated that countries with large, persistent Bancor credits would pay penalty for surplus hoarding while deficit countries would face devaluation.

On the other hand, Harry Dexter White wanted all the global currency to be pegged to the USD - with the USD pegged to gold. This structure placed the US at the centre of the system: other countries would hold dollar reserves. He leveraged the fact that US was, at that point, holding massive gold reserves and was the dominant and intact industrial economy. White’s system, given that it was backed by large gold reserves, inspired collective confidence and became the chosen model.

How the Dollar-Gold System Actually Worked

Bretton Woods model accepted the USD as the central currency backed by gold. It was announced that one ounce of gold would be USD 35 making USD “as good as gold”. Other countries fixed the value of their currencies against the dollar, and their central banks could swap local money for dollars and, in turn, ask the US Treasury for gold. This gold and dollar deal was strictly a government‑to‑government arrangement - ordinary people could not walk into a bank and demand gold.

This system addressed a major loophole that existed previously – “beggar thy neighbour” syndrome where nations adopted currency devaluations to make their exports cheaper. Bretton Woods was deliberately designed to lock in fixed exchange rates while using capital controls to make opportunistic devaluations and speculative attacks harder to pull off.

Bretton Woods did not completely ignore Keynes’ suggestions. In line with Keynes’ suggestions, international institutions like The International Monetary Fund (IMF) and The World Bank (IBRD) were established. The IMF was established to oversee the new exchange rate system and provide short‑term balance‑of‑payments support to countries in trouble. The IBRD was established to finance post‑war reconstruction and, later, development projects.

The Flaw Built Into Dollar Dominance

Under Bretton Woods, the world needed dollars to trade, so the US had to keep supplying them. From the late 1940s through the 1960s, the Bretton Woods system coincided with what is often called the “golden age” of post‑war capitalism. The system delivered exchange rate stability as promised, built confidence in central banks and provided support through IMF and IBRD.

As global trade grew, the demand for USD grew. The more dollars US supplied, the harder it became to maintain the promise that each one was worth the promised gold. It eventually led to a situation where the stock of USD held by foreign central banks kept growing, far exceeding the gold held by the nation. By 1959, the US gold stock was only just sufficient to cover foreign official dollar claims; within a few years, those external dollar liabilities had decisively overtaken the available gold. From the mid‑1960s onward, any attempt by foreign central banks to convert a large share of their holdings at 35 dollars per ounce would have mathematically exhausted US gold reserves. The credibility of the USD as the world’s reserve currency began to falter.

And this was foreseen by Robert Triffin, a Belgian‑American economist, as early as 1957.

The Contradiction Robert Triffin Saw Coming

Robert Triffin foresaw the failure of the Bretton Woods system. Triffin warned of the challenges that would be faced by a reserve currency due to constant demands from the world for liquidity. He stated that the US would have to export more dollars than its imports of goods and services to keep the global economy afloat and this would lead to US constantly running in deficits. Failure to supply dollars would restrict global trade and growth and perpetual supply would eventually lead to the reserve currency losing value and confidence to fulfil its obligation of promised gold. This is called Triffin’s Dilemma.

As predicted, the Bretton Woods gold-dollar system crashed in 1971. On August 15, 1971 US President Nixon went on television on a Sunday night, interrupting regular programming, and told the world the dollar was no longer convertible to gold. The gold‑backed dollar that White had placed at the centre of the system was finished, but the institutions Keynes had argued for—the IMF and the World Bank—survived and adapted to a new world monetary order.

When Money Lost Its Gold Anchor

For the first time in human history, major currencies were no longer backed by commodities like gold and silver. Instead, a currency's value was derived entirely from the public's trust in the government issuing it. The floating exchange rate system — still followed today — was adopted by 1973. The currency value fluctuates based on market demand and is no longer fixed to a pre-determined peg rate.

Post Nixon’s announcement, the value of the dollar plummeted. Coupled with costs of Vietnam War and other monetary factors, this caused rampant domestic inflation in the US. The purchasing power of a single dollar bill was eroding by the day.

Globally too, the echoes of this decision were visible. Countries no longer needed gold to back each new unit of money, which gave policymakers far more room — and temptation — to tolerate inflation.

This era of inflation affected the oil exporting OPEC countries hard as oil was sold in USD in the global markets. Due to fall in the dollar value and inflation, OPEC nations saw the purchasing power of their oil revenues plummeting along with the declining dollar. To compensate, and to assert political leverage, OPEC implemented an oil embargo in 1973 on the US due to its support to Israel in the Yom Kippur War. A second oil shock, triggered by the Iranian Revolution, followed in 1979.

And from this chaos, the petro-dollar system was born – which is covered in my next article of this newsletter.