The historic Smithsonian Agreement of 1971 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. However, the agreement was disastrous for the United States and mostly benefited European and Japanese economies because of the agreed upon stipulation that the U.S. 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 U.S. dollar declined approximately 8% during the years following the agreement, causing the gold price to top out at $800 an ounce by the late 70s because of its deleverage with the dollar and a commodity boom that would also last well into the late 70s. 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.

Bretton Woods
The 1930s saw a laissez faire, free-floating currency market that threatened not only destabilization and economic warfare for smaller nations, but exchange rates that were unfairly discouraging trade and investment. Along came Bretton Woods, in 1944, and 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. Convertible currencies were pegged to $35, with the U.S. buying and selling gold to maintain the price.

Since the U.S. dollar was the only stable currency, the States managed the system through the International Monetary Fund (IMF) and became its major financier. This led to major outflows of dollars in financing world economies, causing massive deficits in the U.S. The reason for this was because the U.S. owned a majority of official gold reserves in the 1940s. 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.

The Smithsonian Solution
To fix deficits would limit dollars and increasing deficits would erode dollars, and both instances would be highly detrimental to European and Japanese growth. So, dollar confidence waned causing 1930s-style currency speculation, except for the U.S., whose currency was backed by gold. Adjustments were needed because the U.S. couldn't stop the deficits, while the European and Japanese economies were threatened by massive surpluses. The answer to these problems 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 signing the agreement, Nixon removed the U.S. from the gold standard because of further dollar depreciation and balance of payments erosion. So, the U.S. started interventions through the swap market, and then through Europe, to support its currencies. This was the first time interventions were used after the Smithsonian Agreement breakdown. Almost two years after the Smithsonian Agreement, currencies free floated because the U.S. refused to enforce the agreements, after raising the gold fixed price twice within this two-year period.

Free Floating Currencies
Free floating is a misnomer because trading bands ensured that a nation's exchange rates did not fall outside of the agreed upon range. Nations didn't have gold or an amount of currencies to pledge on their own to the IMF, and the U.S.'s gold and dollar supply had to be implemented to finance the system. This allowed the American dollar to become the world's reserve currency, a permanent financing currency. But the U.S. only had so much gold and dollars, so with post WWII economic growth on the horizon, it was inevitable that Bretton Woods would break down. If not, then the United States would have destroyed its own economy for the sake of growth in Europe and Japan.

Bretton Woods and the Smithsonian Agreement 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 U.S.

As the U.S. pledged its gold and dollars, it was gaining Special Drawing Rights trade credits and using those credits against other nation's currencies to finance trade. In this respect, the U.S. had to fix its currency price so other nations would have a peg to the dollar and get access to credits. For larger growth states, this was perfect, but detrimental for smaller states because they didn't have enough gold or dollars to gain trade credits. So, a currency pricing imbalance existed for many years through economic growth years after WWII. 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 to be 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 that the world's central bankers did not dominate the exchange rate market on their own or in conjunction with other nations; it prevented 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 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.

The Bottom Line
While the Smithsonian Agreement was not perfect and actually hurt the U.S. in the short term, it was an instrument needed to further our path toward real market-driven exchange rates.

SEE: Global Trade And The Currency Market

Related Articles
  1. Forex Strategies

    Two Great Currencies To Profit From Oil Volatility

    U.S. dollar crosses with Canadian and Australian dollars offer easy access to crude oil trends due to their tight correlation with energy futures.
  2. Mutual Funds & ETFs

    ETF Analysis: ProShares UltraPro Short S&P500

    Find out information about the ProShares UltraPro Short S&P 500 exchange-traded fund, and learn detailed analysis of its characteristics and suitability.
  3. Stock Analysis

    4 Companies Affected by the Appreciating Dollar

    Learn why the appreciating dollar negatively impacts certain companies such as Google, Facebook, Procter & Gamble and Johnson & Johnson.
  4. Forex Strategies

    These Are The Best Hours To Trade the Euro

    Six popular currency pairs and numerous secondary crosses offer euro traders a wide variety of short- and long-term opportunities.
  5. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  6. Economics

    Is the Yuan a Yawn or a Nightmare for Investors?

    China’s decision to change the method of setting its currency exchange rate caused global shock waves last week.
  7. Forex Strategies

    How To Avoid Exchange Rate Risk

    What are the best strategies to avoid exchange rate risk when trading?
  8. Forex Strategies

    Benefits & Risks of Trading Forex with Bitcoin

    Want to trade forex using bitcoins? Don’t jump on the bandwagon until you compare the risks to the benefits.
  9. Forex Strategies

    How To Trade Forex With Bitcoin

    We look at ways to trade forex with bitcoin and the pitfalls in doing so.
  10. Forex Fundamentals

    Chinese Yuan an Unlikely Reserve Currency

    As the world's second largest economy, China's challenge to America’s dominance includes a push to make the yuan (RMB), the world’s reserve currency. Whether it can do that now is unclear.
  1. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  2. Derivative

    A security with a price that is dependent upon or derived from ...
  3. European Sovereign Debt Crisis

    A period of time in which several European countries faced the ...
  4. XCD (Eastern Caribbean Dollar)

    The currency abbreviation or the currency symbol for the Eastern ...
  5. Transfer Risk

    The risk that a local currency cannot be converted into the currency ...
  6. Reference Equity

    The underlying equity that an investor is seeking price movement ...
  1. What are the goals of covered interest arbitrage?

    The goals of covered interest arbitrage include enabling investors to trade volatile currency pairs without risk as well ... Read Full Answer >>
  2. What are the main risks associated with trading derivatives?

    The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
  3. Should you calculate Value at Risk (VaR) for counterparty credit risk?

    Value at risk (VaR) calculations may be helpful for risk management when trading credit default swaps and other derivatives ... Read Full Answer >>
  4. What are the advantages and disadvantages of the International Monetary Fund?

    Established following World War II to help with post-war recovery, the International Monetary Fund (IMF) serves as a lender ... Read Full Answer >>
  5. What risks does a Foreign Institutional Investor (FII) face?

    The term "foreign institutional investor" (FII) normally refers to large, non-Indian companies investing in Indian financial ... Read Full Answer >>
  6. For what financial instruments is a modified duration relevant?

    The modified duration is a formula used to calculate the percent change in the price of a financial instrument when there ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!