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Banknotes, Reserve Money, Gold and Bretton Woods

Bretton Woods and the Absolute Domination of the DollarIf we analyze the word banknote, whose literary meaning is paper money, from an etymological point of view, it takes us to 14th century Italy. This word, which means Nota di Banco in Italian, was actually the general name of the documents issued by banks and given to merchants at that time. Merchants brought the coins and precious metals they had earned in those years to the banks and received a certificate from the bank for these entrusted assets. But the banknote did not appear for the first time in 14th century Italy. If we trace paper money, we have to go back to the 7th century.


As far as we know, in the history of world finance, the Chinese were the first civilization to use paper money. In the seventh century, Chinese merchants who did not want to carry their gold and silver with them began entrusting it to other merchants in exchange for a certificate. This was because carrying and storing a piece of parchment was much easier and safer than storing large amounts of gold or silver. When the document in question changed hands, so did the owner of the entrusted gold and silver. It was not to be long before this method, which over time became widespread in business and was used as a means of payment and even inheritance, attracted the attention of the central authorities. The Tang Dynasty, which ruled China in the seventh century, decided to monopolize this system, that is, to print money as we know it. After a while, Venetian merchants who came to China to trade must have been convinced that this was a very clever method, and so they brought the banknote system to the European continent.


Trade and Central Financial System

In the history of the founding of the Bank of England we see the traces of a commercial activity that began among merchants and was then preferentially monopolized by the state. The 17th century was a time when especially gold traders on the European continent became very rich. This was because since the middle of the 16th century, tons of looted gold from Aztec and Inca civilizations were brought by explorers to the great cities of Europe. After a while, gold traders who were gaining strength in business started to use some written notes called Goldsmith Notes and started to operate like a bank. The government, wanting to prevent this situation and keep the management of the monetary system, needed an official institution that printed banknotes. Thus, in 1964, the Bank of England was created.

What is Reserve? What is Reserve Money?

You know the saying "Save for a rainy day". It advises people to take precautions against all kinds of negative things that might happen to them, or to save money so that they can cope with the situation for a while. Like people, states need savings to protect themselves. These savings by countries' central banks are called reserves in the financial literature. Central banks can technically have two types of reserves. While one of them may be one of the world's accepted currencies, the other is undoubtedly gold. This is because gold is a reserve asset that is easily convertible into money and is accepted worldwide.

We may need to elaborate a bit more on the reserve currency phenomenon. For not every currency has the characteristic of being a reserve currency. For example, we can safely say that the Thai government's possession of the Thai baht as a reserve currency will not give it credibility internationally. On the other hand, the U.S. dollar and the euro are held as reserve money in the central banks of the countries with the largest economies in the world. This is because the basis of the concept of reserve money lies in its acceptance by all countries and its widespread use in international trade. If we look at IMF data for 2021, we conclude that about 60% of reserve currencies held by central banks around the world are in U.S. dollars. Another important reserve currency is the euro, which is the common currency of the European Union at 20%. The British pound and the Japanese yen have a share of 4%, while the remaining 13% is divided into small shares among hundreds of currencies.

The Gold Standard and the Sterling as Reserve Money

The gold standard is the financial system formed by valuing countries' own currencies against pure gold. In other words, it was based on a simple calculation of how many units of paper money equal 1 gram of gold. While this relationship between money and gold is defined as parity; The situation in which paper money has real value against gold, i.e. the ability to convert gold into paper money and paper money into gold in the financial system, is called convertibility.

The Gold Standard System first emerged with the adoption by the United Kingdom. In the 19th century, the use of banknotes spread around the world. England was the most dominant state of that time in terms of international trade, political and military power criteria. As a natural consequence, the British pound, the currency of the empire where the sun never set, became accepted in the world as a gold-linked reserve currency.

Under the gold standard system, the currencies of other nations were also pegged to a fixed value against gold. This was because the power to print money was in the hands of the central banks, and the central banks could print as many bars as they had gold. This indirectly created the parities of the countries' currencies with each other. In summary; This system, where money has an equivalent value in the form of gold reserves, worked successfully until the First World War.

After World War I, the demand for gold increased significantly. The Bank of England was unable to hold as many gold reserves as the pound, and thus the gold standard system collapsed for Britain. The United States took good advantage of this gap and continued to print its money in gold depending on its reserves. Thus, the American dollar began to replace the pound sterling as the reserve currency.

Bretton Woods and the Absolute Domination of the Dollar

Towards the end of World War II, at a meeting in the small town of Bretton Woods in New Hampshire, USA, in 1944, the world economic order changed completely and the reserve currency became the American dollar in absolute terms.

Why did the U.S. dollar replace gold? There is nothing more natural than asking the question. The answer to the question can be considered in two dimensions. First, the United States was clearly the military force that won the Allies the World War, which gave them the right to dominate other states. Second, the United States had three-quarters of the world's gold supply in 1944. No other country had enough gold to have a say in the matter.

The Bretton Woods Agreement of 1944 created a new international monetary system. The U.S. dollar replaced the gold standard as the world's currency. Under the agreement, countries promised that their central banks would maintain fixed exchange rates between their currencies and the dollar. When the value of a country's currency was too weak against the dollar, that country's central bank would buy the currency on the foreign exchange markets. Thus, the money supply would decrease and its price would increase. Even if the price of a currency rose sharply against the dollar, the central bank would print more, increasing the money supply and lowering the price of the currency.

The Bretton Woods Agreement of 1944 also opened the door for the United States, which was the only country that could print dollars, to become the dominant power in the world economy. The agreement also spawned the World Bank and the International Monetary Fund (IMF), the U.S.-backed institutions that oversaw this new financial system.

Consequences of the Bretton Woods Agreement for the World Economy

- The transition to the Bretton Woods system led other countries to peg their currencies to the U.S. dollar.

- 35 USD are pegged to 1 ounce of gold and the US became dominant in the world economy.

- The U.S. was the only country that could print a globally accepted currency and other countries had more flexibility than the previous system, the gold standard.

- Later (1971), the fixed value of the dollar against gold was lowered, so the value of other countries' currencies was calculated in dollars instead of gold.

The transition to the Bretton Woods system increased the world demand for the dollar, although its value against gold remained the same. Thus, the value of the dollar began to increase relative to other currencies. This inconsistency in dollar-gold parity also laid the foundation for the collapse of the Bretton Woods system thirty years later.

The Collapse of the Bretton Woods System

In 1971, the United States was struggling with massive stagflation, a combination of inflation and recession that led to unemployment and low economic growth.

In response to a dangerous decline in value caused by too many U.S. dollars in circulation, President Nixon decided to devalue the dollar against gold. The U.S. government reduced the value of $1 to 1/38 and then to 1/42 of 1 ounce of gold. This devaluation plan soon backfired. People began rushing to buy gold in exchange for its rapidly declining value. The Federal Reserve's gold reserves were running low. In response, President Nixon completely separated the value of the dollar from gold. Without price controls, gold quickly rose to $120/ounce on the open market, effectively ending the Bretton Woods system.

Was the Bretton Woods Agreement Necessary?

Until World War I, most countries used the gold standard system. However, in order to cover the costs of the war, they had to print money that had no equivalent in the form of gold reserves, thus loosening the central banks' ties to gold. Throughout the war, hyperinflation emerged around the world as the supply of money outstripped the demand for it. In particular, the currencies of some war-torn countries depreciated so dramatically that in some cases people would give a bag of money just to buy a loaf of bread.

After the war, countries tried to return behind the safe gates of the gold standard system. This was hardly possible, but the system somehow lasted until the Great Depression. After the stock market crash of 1929, investors turned to commodities, which drove up the price of gold. This would lead to more and more people exchanging their dollars for gold. The Federal Reserve also tried to protect the country's gold reserves by raising interest rates. This would go down in history as a move that would worsen the country's economic picture.

The Bretton Woods system was an attempt to prevent global economic disasters such as the Great Depression, which began in 1929 and lasted for nearly a decade. The purpose of the Bretton Woods meeting was to create new rules, regulations, and procedures to ensure the economic stability of the world's leading countries. Two institutions such as the International Monetary Fund (IMF) and the World Bank were created to make the system work better and to monitor it.

The main purpose of the IMF is:

- Promote monetary cooperation at the global level

- Achieve greater financial stability

- Facilitate international trade

- Reduce unemployment and poverty around the world

- Promote sustainable economic growth

The World Bank has a similar mission, but focuses its efforts in two areas:

- Eradicating extreme poverty

- Promoting wealth sharing

Given all this information, it can be argued that the Bretton Woods system is necessary, at least in theory.


Did Bretton Woods achieve its goals?

There is no definitive answer to the question, but it most likely did not succeed. Since the abandonment of the gold standard, all world currencies have fluctuated against each other. The current situation can be described as even less stable than in the period from 1944 to 1971.

The IMF and the World Bank, which are the legacy of the Bretton Woods system, still exist effectively today. However, there are serious question marks about the success of both institutions. Although no one objects to the theoretical underpinnings of the IMF and World Bank, opinions are being raised on all platforms that they operate through methods that worsen the conditions of the weak economies they seek to improve.