The Great Depression in the 1930s led to the collapse of the gold standard. The primary goal of afflicted nations at the time was the restoration of prosperity as domestic output and employment fell.
They used protectionist measures and devalued their currencies. A series of such devaluation meant that the exchange rates were no longer fixed. As a major pillar of the gold standard had been undermined, the system broke down.
In 1944 an international conference of nations was held at Bretton Woods, New Hampshire to lay the ground works of a new international monetary system. Due to the Great Depression and the World War II the world economy was in shambles.
The nations gathered together to try to start anew and produced a new system: a modified fixed exchange-rate system called an adjustable peg system or the Bretton Woods system.
The Bretton Woods system tried to capture the advantages of the old system while avoiding its disadvantages. The International Monetary Fund was also created to make the system feasible and it prevailed with modifications until 1971. In this system each IMF member had to define its currency in term of gold or dollars. So this was the foundation laid for a dollar dominated world.
Under this system gold and dollar came to be accepted as standard reserves: the gold as a relic of the old system and the dollar because the United States had accumulated large quantities of gold, before it joined the war in 1942, by selling arms indiscriminately.
Between 1934 and 1971 it became the major gold dealer in the world at defined price of $35 per ounce. As the dollar was convertible into gold at any time it was deemed to be as good as gold.
The growing volume of dollars provided a medium of exchange for the expanding world trade, the discovery of new gold on the other hand being limited. But the United States experienced persistent deficits during the1950s and the 1960s which were paid mostly by dollars.
In 1971 the United States ended its 37 year old policy of exchanging gold for dollars and floated the dollar letting its value be determined by the market forces. With the withdrawal of the United States support of the Bretton Woods system, it sank into oblivion.
Since 1971 a, flexible system called managed floating exchange rates has been in use. Exchange rates among major currencies are free to float to their equilibrium levels and occasionally, interventions by governments take place to stabilize or alter these rates.
Now the question arises as to why the dollar has maintained its value and place in the international market even after being freely floated? Thanks to Alfred Marshalls brilliant plan, the United States lent all the wealth accumulated during the World War II, to the war torn world.
These loans were, of course, given in dollars. These loans were utilized by buying everything from infrastructure to basic commodities mainly from the United States; the only major country on whose shores the war did not reach-creating a Godzilla from a lizard.
Thus the United States economy expanded to become one of the richest and most powerful economies in the world. Before America got rid of the Bretton Woods system, it integrated its currency in the international market to such an extent that most of the countries, even at that time held dollars as a major portion of their reserves, against which they floated their currencies.
The United States created a demand for dollars strong enough to support its currency before removing the gold base on which its currency leaned on. Why is the US dollar on the decline? US economic growth rate has fallen from eight per cent earlier this year to four per cent plus which is still comfortable and well ahead of Europe and Japan.
But the expansion is out of balance. American consumers are buying imported goods and services in ever-increasing amounts and the country has to borrow to finance the trade deficit.
Since 1992, the US economy has grown more rapidly than the economies of several major trading nations. This growth of income has boosted US purchases of foreign goods while Japan, some European nations and Canada have suffered a recession or slow income growth during this period. Thus export of US goods to these countries have not kept pace with the galloping rise in US imports. Persistent trade imbalances with Japan are noteworthy.
Second, the US annual federal budget deficits have been large. These deficits have required the federal government to compete with the private sector for financing, which bid up the real interest rates.
The high interest rates increased the foreign demand for dollars resulting high international value of the greenback which made American exports costlier and imports cheaper.
Finally, a declining saving rate in the US has contributed to US trade deficit. The saving rate (Savings / Total Income) in the US has declined. At the same time, the investment rate (Investment / Total Income) has remained stable or even increased.
The gap has been met by foreign purchases of US real and financial assets creating a large capital account surplus. Foreigners are financing more of US investment, US citizens are able to save less and consume more, including consumption of imported goods.
The financing of American trade deficit has resulted in a larger foreign accumulation of claims against US financial and real assets than American claim against foreign assets.
Internationally, this fall in the value of dollar has caused major concerns. But the US businessmen eye this decline in dollar value as welcome and long overdue.
The dollar weakness has promoted fears around the world that the strong euro could have a serious effect on European and Asian economies in 2005 as a weak dollar makes it more expensive for Asian and European exporters to sell their goods in USA.
On the other hand, the US businessmen feel that the US suffers the least of all due to this decline. Although American consumers will find it harder to slake their thirst for imports, its companies will become far more competitive, reaping profits and boosting jobs.
The general consensus is that the pressure on the dollar will persist. Although the greenback has hit the headlines recently, the factors behind it are long-term structural issues that are not going to disappear in thin air.
On November 19, George Bush signed a legislation by which the ceiling of the US public debt was increased by $800 billion. This takes the total debt allowable to $ 8.2 trillion.
The deficit for the budget year 2004 alone was 413 billion following a deficit of $ 377 billion in 2003. The deficit in US international trade last year was more than $ 500 billion more than five per cent of the country's economy.
Since 1985 till 2001 dollars real trade-weighted value fell by 17 percent against a basket of major non-European currencies and by 35 percent against West European currencies. In recent months, the dollar has been beating all sorts of records.
If, as is predicted, the dollar keeps on declining, a domino effect may take place. It is believed that at present, the estimated holding of US government paper is US $11 trillion globally: a confounding amount. If the dollar value keeps falling and no concrete steps are taken, then a catastrophe is very likely.
Recently, the Shanghai based China Business News reported that China had cut the size of its US Treasury bond holdings in foreign exchange reserves to $180 billion to avoid losses from a weakening US dollar.
While Russia's Central Bank is reported to have said that the bank was reviewing its foreign exchange reserves "with the highest priority". Though euro already accounts for 25 to 30 percent of Russia's reserves, commentators believe she is craving for much more.
Developing countries may diversify their reserves to avoid catastrophic situations. Regional cooperation between various groups of countries may provide a way out to a more stable world.