This, of course, was a very haphazard arrangement. Different countries adopted different tactics to make their goods cheaper than the others and conserve the national gold reserves. During the First World War this system was abused by most nations, leading to its downfall.
After the war, as there was no viable alternative to the gold standard, the victors had no choice but to reinstate the Gold Standard. But now both pounds and dollars were used as international currency and U.S. and U.K. held gold reserves to ensure ready liquidity for other countries that wished to exchange their reserve of pounds or dollars for gold.
But anyway, the predictable happened. Britain could no longer sustain the constant outflow of gold from its reserves and it did not have enough reserves to carry on currency conversion (implying it issued more pounds than it had reserves for). U.S. was no less vulnerable, which was the reason for confiscation of all private gold collections and nationalization of such gold.
In the meanwhile, the Second World War occurred and war cries drowned the need for a uniform exchange rate system. And finally, realising the growing need for a standardized system to determine exchange rates, the world leaders came up with the Bretton Woods System.
Bretton Woods system was very similar to the previous standard, now, only U.S. promised to redeem the dollar reserves of all other nation by exchanging for gold at a fixed rate. But persistent balance of payments deficit by U.S. reduced its gold reserves and it again became unable to pay for the dollar reserves, abandoning the system altogether. Finally the world settled for an exchange rate system without the backing of any product (e.g. gold).
The history of exchange rates (as any other history) only shows the fondness of humans to repeat mistakes. Now, the ballooning American deficits and ever increasing investment of East Asian countries in American securities are two issues raising serious concern. The present situation is remniscent of the last few years of the era of the Gold Standard, with the U.S. dollar also exhibiting the short run volatility (Iraq war, 9/11) similar to gold. It is not impossible that countries might lose confidence in the U.S. dollar. My FMI tutor had been very worried about the lack of diversity (in terms of saving instruments) in the reserves of Asian Countries and has been an advocate of saving in gold, given its recent stability.
But then I do not think American feds will remain quiet while the world sits up and takes notice of the alarming deficit of U.S. Now that the countries now have an option of investing in the relatively more stable euros, U.S. Dollar now faces serious challenge and a repeat of a colossal failure.
References
- Gold Standard by Michael D. Bordo.
- A refresher on the 1930s, The Economist
- Dollar Crisis and the American Empire by Jeffery Sommers