The collapse of Bretton Woods

In the Bretton Woods system, gold was fixed at $35 per ounce and other currencies were valued at fixed rates relative to the dollar. By the late 60s, the persistent U.S. current account deficit threatened the U.S. with an outflow of gold and the world with a loss of liquidity in its only reserve currency.

As a result, in 1969 the International Monetary Fund (IMF) was authorized by member countries to create Special Drawing Rights (SDRs), dubbed “paper gold,” to augment international reserves. The SDRs constituted a kind of artificial reserve currency used internally by the IMF and were valued according to a basket of international currencies.

No one could be certain of SDR’s impact. At the time, the only historic parallels of sudden reserve infusions came with the discoveries of gold deposits in places such as California, Alaska, South Africa, and Australia during the gold-standard era, or to the seizure of gold during colonial conquests, such as the Spanish takeover of Mexico. Each of these episodes led to outbursts of inflation.

As it turned out, central banks could not handle the new reserve tool and they let the world’s reserves explode out of control. By August 1971, reserves not including gold were increasing at a 70 percent year-over year clip — the very definition of a bubble. Reserves of currencies plus gold, a less telling measure as the IMF still values its gold reserves at $35 per ounce (a tactic appropriate for working inventory in a last-in/first-out accounting environment but puzzling in this context), grew more than 35 percent. The decade following this burst of reserves was unarguably one of inflation and high interest rates.