Bretton Woods and the Nixon Shock

For twenty-five years after World War II, the world's currencies didn't float against each other the way they do today. Under the Bretton Woods system, agreed in 1944, every major currency was pegged at a fixed rate to the U.S. dollar, and the dollar itself was pegged to gold at $35 an ounce, with the U.S. promising to convert dollars held by foreign governments into gold on demand. It was a system built around the dollar as the anchor, backed by America's enormous gold reserves at the time.

The system worked as long as the world's demand for dollars didn't outstrip America's willingness (or ability) to back them with gold. Through the 1960s, that assumption broke down. The U.S. ran large deficits — partly from the Vietnam War, partly from domestic spending — and printed more dollars than its gold reserves could plausibly redeem at $35 an ounce. Foreign governments, led by France, began actually asking to convert their dollar holdings into gold, and the U.S. gold stock steadily drained.

On August 15, 1971, President Nixon announced the U.S. would no longer convert dollars to gold — a move so abrupt and unilateral it became known as the Nixon Shock. It effectively ended the Bretton Woods system overnight. Within two years, the attempt to patch the system with a slightly wider peg (the Smithsonian Agreement) also collapsed, and by 1973 the major currencies were left to float freely against each other — the system the world still uses today, where exchange rates move continuously based on markets rather than being fixed by governments.

The immediate consequences were large. The dollar devalued sharply against other major currencies once it was no longer gold-backed, import prices in the U.S. rose, and the shock to the monetary system arrived just as oil producers were about to reassert pricing power — a combination widely seen as one of the seeds of the inflationary 1970s that followed. It also created the eurodollar system and floating FX markets that underpin nearly all modern currency trading, since currencies now had to be actively priced against each other rather than simply read off a fixed peg.

For anyone studying market history, the Nixon Shock is the hinge point between a world of governments fixing exchange rates by decree and the modern world where currency values are a continuously traded market price, subject to the same supply-and-demand forces as any other asset.