Smithsonian Agreement

The Smithsonian Agreement, signed in December 1971, was an attempt by the Group of Ten industrialised nations to stabilise exchange rates after the collapse of Bretton Woods. Rather than return to the rigid peg Bretton Woods had enforced, it widened the bands around which currencies could fluctuate and revalued major currencies to reflect new economic realities. It lasted just over a year before floating exchange rates replaced it.

Why Bretton Woods collapsed in August 1971

The postwar Bretton Woods system had fixed the dollar to gold at $35 per ounce and pegged other currencies to the dollar. But by 1971, that peg was under acute strain. US gold reserves had shrunk from over 20,000 tonnes to under 9,000. Meanwhile, the dollar was overvalued relative to the deutschmark, yen, and franc; American inflation had eroded the dollar’s purchasing power. Speculators and foreign governments began converting dollars into gold, draining US reserves faster. On August 15, President Nixon suspended the dollar’s convertibility into gold—a temporary measure that was meant to last days but became permanent.

This was not a quiet technocracy. Bretton Woods required a fixed price for gold and fixed currency pegs. Without gold convertibility, there was no anchor. The system had collapsed.

The Smithsonian compromise: wider bands, new parities

The Group of Ten met at the Smithsonian Institution in Washington in December 1971 to patch things together. They agreed on three key changes. First, the dollar would remain central but would not be convertible into gold—countries would hold dollars as reserves, not gold. Second, each currency would be revalued against the dollar to reflect new equilibrium rates. The deutschmark, yen, and franc appreciated; the dollar depreciated in effective terms but remained the anchor. Third, and crucially, the bands around the new central rates were widened from ±1% to ±2.25%, giving currencies more room to fluctuate without triggering intervention.

The wider bands were meant as a safety valve. Under Bretton Woods, central banks had to intervene the moment a currency strayed 1% from parity, burning reserves. The new arrangement let markets breathe a little: if the pound drifted 2% weaker, central banks did not need to defend it immediately. This bought governments time and reduced the stress on reserves.

By all appearances, it was a sensible compromise: an orderly reset with some flexibility baked in.

Why it failed within 14 months

The Smithsonian fix could not work because it did not address the core problem: the dollar was still overvalued, and the United States still had structural economic imbalances. Speculation resumed almost immediately. Traders and governments, fearing another dollar crisis, began selling dollars again. The wider bands contained the pressure for a few months, but by February 1973, central banks were forced to intervene at a staggering pace, with the Bundesbank alone buying billions of dollars in a single morning to keep the mark from soaring.

By March 1973, the Group of Ten accepted the inevitable and moved to floating exchange rates. The wider bands had not solved the underlying crisis; they had merely delayed it. The insight was harsh: you cannot fix a currency at an equilibrium price if that price is wrong. You can only defend it by intervening endlessly until you run out of reserves.

There was also a deeper institutional problem. The Smithsonian was built on the assumption that governments and central banks would cooperate closely to maintain the new parities. But cooperation on exchange rates is fragile. Each country wants a competitive advantage; each wants to export-led growth. The moment pressure mounted, the political will to defend an outdated parity evaporated.

The legacy: from fixed to floating

The Smithsonian’s failure had one crucial consequence: it made policymakers accept floating rates. Before 1973, floating exchange rates were seen as chaotic and dangerous. But by 1973, after the collapse of Bretton Woods and the Smithsonian’s quick failure, it became clear that fixed-rate systems were no more stable. At least with floating rates, you did not have to burn reserves defending a parity that the market had rejected.

Floating rates arrived not as an ideal but as the least-bad option when all the fixed-rate experiments had failed. Over the following decades, floating became the norm, with occasional episodes (the Louvre Accord, the peg of the Chinese yuan, currency boards) of managed or fixed rates springing up and sometimes unravelling.

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