August 15, 1971, was a fateful day in the history of American economic policy: President Richard Nixon imposed far-ranging wage and price controls on the U.S. economy, abolished the fixed exchange rate system that had been in place since 1945, and took other significant actions to deal with inflation, which had become the economy’s overarching problem. In many ways, we are still dealing with the consequences of those actions.
From 1945 until 1971, the economy of the Western world was governed by a system established at a conference in Bretton Woods, New Hampshire, where the victorious powers from World War II (minus the Soviet Union) created rules and institutions designed, above all, to prevent a repeat of the Great Depression. Two principles in particular governed the system. First, there would be widespread free trade (further ensured by the Marshall Plan and the Organization for European Economic Cooperation, now known as the Organization for Economic Cooperation and Development). That is because the Smoot-Hawley Tariff and subsequent beggar-thy-neighbor policies were viewed as a root cause of the depression.
Second, the world monetary system was based on fixed exchange rates to prevent devaluations from being a substitute for protectionist trade policies. (When a currency falls in value, imports become more expensive and exports become cheaper in terms of other currencies.) Major nations fixed their currencies to the dollar, and the dollar was fixed to gold at $35 per ounce to provide an anchor for the system. The International Monetary Fund was established to manage this system and deal with fluctuations in currency values resulting from balance of payments problems.
One of the keys to maintaining this system was capital controls. Major nations did not permit the free flow of capital internationally because it could easily destabilize exchange rates. Businesses and individuals had to get permission to import or export capital, and access to foreign exchange by domestic investors or domestic currency by foreign investors was controlled by the central bank. As a consequence, investors were denied the opportunity to seek higher returns in other countries and were forced to invest domestically.