Constitutional questions arose during the 1930s over the authority of the President to violate the value of contracts and debts which stipulated payments in gold dollars. The doubtful power of Congress, subsequently to pass laws prohibiting the implementation of gold clauses in already existing U.S. contracts, gave rise to landmark Supreme Court Decisions. Congress was challenged by damaged plaintiffs but the Supreme Court upheld Roosevelt and the legislature. Existing gold contracts were pronounced dead: they were declared by congressional resolution to be “against public policy.” In addition, otherwise free American citizens were prohibited by law from owning gold, a right only recently restored by law in January 1975 after years of public debate.
It was clear that the dollar after 1934 was, as the phrase went, no longer quite “as good as gold.” Americans could not exchange their paper and bank deposit money for a specified weight of gold, even though in law the dollar was still nominally defined as – grams of gold. Ironically, foreigners were still permitted to exchange their undesired paper dollars for American gold. But domestically the dollar would no longer be linked to a real article of wealth. The way was therefore open in the future for the dollar to become a fully managed currency, whose value would be substantially determined and regulated by the opinions of politicians and the Board of Governors of the Federal Reserve System.
Ten years after Roosevelt’s devaluation of the dollar, and thirty years after the founding of the Federal Reserve System, the Bretton Woods Agreement of 1944 elaborated a new international Monetary System. Bretton Woods codified and institutionalized certain central bank decisions taken at a previous world Monetary Conference in Genoa held in 1922. The inauguration in 1913 of the U.S. Federal Reserve System, followed by the conference in Genoa were two events which changed the financial history of the Western World. This view of accidental history has never been sufficiently recognized. In 1922 Europe was trying to recover from World War I. The price level, or gold prices, had doubled or more than doubled throughout Europe. But the statutory value of the gold currency remained the same in America and the British government even contemplated a restoration of the pre-war gold value of sterling. Naturally, under the conditions, a scarcity of the under valued gold currencies developed. Therefore the central bankers of Europe agreed at Genoa in 1922 to three basic undertakings: (1) to attempt to stabilize the existing general price level or the gold value of the currency – instead of devaluing the monetary units which would have acknowledged the inflation of World War I; 2) to coordinate central bank credit policies in order to “manage” the value of their related currencies more effectively; and 3) to modify the rules of the international gold standard and to institute more or less officially the gold exchange standard in order “to conserve” the existing supply of gold while still facilitating the international movement of goods and capital.
The first point was best exemplified by Chancellor of the Exchequer Churchill who in 1925 restored the prewar value of the pound, a policy which tended to create deflation and unemployment in Britain for the remainder of the decade of the 1920s. The 1925 restoration over valued sterling and the level of wages in England, and is therefore a forerunner of the austerity program of Margaret Thatcher today. J.M Keynes was inspired to write his General Theory, published in 1935, partially an analysis and remedy for the defects of profound unemployment and stagnation of the post-war economy in England. Keynes realized that deflation and unemployment were partly caused by overvaluation of the pound sterling at its pre-war parity. Thus England failed to permit stinking wages to adjust to falling world prices. It is true that British prices fell; but manufacturing wages remained high because of protection, subsidies, and the dole. Thus, foreign competitors invaded England and foreign markets formerly dominated by English manufacturers. This displacement created the havoc of unemployment in traditional British industries like coal, steel, textiles, and shipping.
The second Genoa policy, central bank coordination of credit policies, began the practice of substituting central bank money market manipulation for the impartial and efficient adjustment mechanism which tended to preserve among nations true balance of payments equilibrium. The adjustment mechanism operated through gold flows and interest rate movements, the effect of which was to balance supply and demand in domestic and world markets.
The third policy altered the method by which money was created under the original gold standard mechanism. Under the true gold standard, a central bank creates money (its liabilities, bank rates or deposits) by purchasing gold or domestic financial claims, such as commercial loans or securities (its assets). Under the gold-exchange standard, an early form of the reserve currency system of today, a bank, or central bank, can create money (deposits bank rates or bank liabilities) by purchasing foreign exchange or foreign securities (its assets). By this analysis one sees clearly that modern money is in part made up of the liabilities or the deposits of the banking system. But there are two sides to every balance sheet. The counterpart of money exists in the loans or securities, the bank assets against which the money (or deposit liabilities and banknotes) has been issued. Under the Genoa agreement central banks endorsed the risky practice of issuing domestic money (deposits or currency) say pounds or Francs, against the purchase of foreign assets, such as dollars or U.S. Treasury securities. The problem thus created is straightforward. Under the gold exchange standard, a reserve currency system, if the foreign currency assets (say dollars or pounds), held by the German central bank, decline in value, or collapse, the domestic money (the liabilities of the bank) cannot be redeemed at its par value because the assets, valued at market, are less than the value of the liabilities. The gold value of the mark must therefore be repudiated. There are simply insufficient depreciating dollar values backing the German currency. Devaluation is the consequence. Such a process occurred twice, in 1931 when sterling collapsed and destroyed the value of the sterling backing of currency values in many other countries; and in 1971 when the dollar collapsed and caused all nations to repudiate the implied Bretton Woods – gold link of their currencies.
The gold-exchange standard had been officially confirmed at Genoa in 1922. The dollar and the pound sterling were acknowledged as defacto official reserve currencies. It was by means of this gold-exchange standard that gold was to be economized. To do so, dollars and pounds, instead of gold, were to be held as assets by foreign central banks and they were to be exchanged instead of gold by all central banks to settle balance of payments deficits. In 1944, the Bretton Woods Agreement reestablished the dollar alone as the post-World War II “official” reserve currency. Sterling continued until 1975 as an unofficial reserve currency for some nations tied closely to the so-called sterling bloc. But the dollar became the “numeraire” of all world monetary values between 1944 and 1971. The values of foreign currencies were to be determined by their relationship to the dollar. In turn, the paper dollar derived value, under the agreement, by virtue of its convertibility into a fixed weight of gold – for foreigners, but not for American citizens. Thus, the Bretton Woods Agreement wrote into international law the “official reserve currency status” of the dollar which, as a practical matter, had prevailed for at least the preceding 22 years.