Although the historic, 10 nation 1971 Smithsonian Agreement can be credited with the end of fixed exchange rates, the end of the gold standard and a realignment of the par value system with 4.5 % trading bands, the agreement was disastrous for the United States and benefited European and Japanese economies because of the agreed upon stipulation the United States would devalue its currency. While the Smithsonian Agreement may not draw memorable historic attention, the fact that a nation can willfully sign an agreement to devalue its currency has lasting ramifications for an economy because a devaluation is a guarantor of deflation and enormous budget and trade deficits. The United States dollar declined approximately 8% during the next ensuing years causing the gold price to top out at $800 an ounce by the late 70’s because of its deleverage with the dollar and a commodity boom that would also last well into the late 70’s. Both are modern day ramifications of a declining dollar. To fully understand the Smithsonian Agreement and its implications, a brief walk through Bretton Woods may help.
The 1930’s saw a laizze faire free floating currency market that threatened not only destabilization and economic warfare for smaller nations but exchange rates were unfair discouraging trade and investment. Along came Bretton Woods in 1944 that stabilized the system through a new monetary order that would peg exchange rates set at a par value with a gold exchange. Government intervention was allowed if 1 % of a nation’s balance of payments fell into disequilibrium. So convertible currencies were pegged to $35 an ounce gold plus X amount of their own currencies all pledged and managed by the International Monetary Fund, a post war organization that became the regulator, enforcer and funder of this new monetary order.
Since the US dollar was the only stable currency, they managed the system through the IMF and became its major financier. This led to major outflows of dollars in financing world economies causing massive deficits in the United States. Why? Only the United States had gold in the post war world. So how much could a dollar be worth with massive deficits backed by gold and a world dependent on the United States for its growth. What a predicament. To fix deficits would limit dollars and increasing deficits would erode dollars, both highly detrimental to European and Japanese growth. So dollar confidence waned causing 1930’s style currency speculations except for the United States whose currency was fixed by gold. Adjustments were needed because the United States couldn’t stop the deficits while the Europeans and Japanese economies were threatened by massive surpluses. The answer was the Smithsonian Agreement.
Nations again realigned the currency system agreeing to a devalued dollar, a new par value and trading bands of 4.5 % with 2.25% on the upper and lower side of trading. One year after signature, Nixon removed completely the gold standard because of further dollar depreciation and erosion of balance of payments. So interventions began through the swap market by the United States then Europe to support their currencies. Interventions would be a first after the Smithsonian Agreement breakdown. Almost two years after the Smithsonian Agreement, currencies free floated because the United States refused to enforce the agreements after raising the gold fixed price twice within this two year period.
Free floating is a misnomer because trading bands were the protection for nation’s exchange rates not to fall outside the agreed upon ban. And how could they, nations didn’t have gold or X amount of currencies to pledge on their own to the IMF. The United States gold and dollar supply had to be implemented to finance the system. This allowed the United States to become the world’s reserve currency, a permanent financing currency. But the United States only had so much gold and dollars so with economic growth on the horizon for nations after World War 2, it was inevitable that Bretton Woods would breakdown. The United States would’ve destroyed its own economy for the sake of growth in Europe and Japan.
Bretton Woods and the Smithsonian Agreements were not monetary systems to allow currencies to trade like a fiat currency based on supply and demand through an open market. Instead Bretton Woods and later the Smithsonian Agreement was a monetary system designed for trade and investment managed by the IMF but financed by the United States. As the United States pledged its gold and dollars, they were gaining Special Drawing Rights trade credits and using those credits against other nation’s currencies to finance trade. In this respect, the United States had to fix their currency price so other nations would have a peg to the dollar and access to credits. For larger growth states, this was perfect yet detrimental for smaller states because they didn’t have enough gold or dollars to gain trade credits.
So a currency pricing imbalance would exist for many years through economic growth years after World War 2. The time for real tradable market driven exchange rates for retail traders would still be many years away. What would come later to assist poorer nations lacking access to the world’s trading system was trade weighted dollars used for trade. But this would take many more agreements before actual implementation.
The need for the IMF in this equation was substantial. The IMF ensured against the world’s central bankers not to dominate the exchange rate market on their own or in conjunction with other nations, a prevention against economic warfare. The par value system allowed trade to equalize through the use of trade credits. This equalization meant basing the price of a currency based on its balance of payments. If balance of payments fell into disequilibrium, the IMF allowed a nation’s current price to be adjusted up or down.
While the Smithsonian Agreement was not perfect and actually hurt the United States in the short term, it was an instrument needed then to further our path towards real market driven exchange rates.
Brian Twomey is a currency trader and Adjunct Political Science Professor at Gardner-Webb University