Though the International Monetary Fund and the World Bank, two financing institutions that were born because of the system are still existent, the initial system that they adopted were substantially altered by Nixon's cessation of gold standard.
Adam Smith, the father of economics, and his contemporary thinkers, has started recognizing and studying on the benefits from international trade and capital mobility. Though overseas trading has already been practiced centuries earlier before their era, there was no formal academic and scientific study for this. Smith, in his pioneering investigation on the British economy, has plotted out a fertile condition for nations to maximize their gains: the presence of a sufficiently functioning international monetary system that promotes and facilitates trade and efficient allocation of capital (Ferderer, 2002, p.1). The 18th century admired the prospects for mutual gain that they get from free trade between nations (Understanding economics, 2006).
In the past 200 years, capital mobility in large quantities and allocation of these to lucrative and promising investments became a tool that altered the standard of living. Effectiveness of financial institutions should then be measured by the contributions that they give to this process and eventually to a country's growth and employment (Eatwell & Taylor, 1999). They should then adapt a financial system that will facilitate the flow of capital and investment.
In 1717 Sir Isaac Newton 'accidentally' adopted a de facto gold standard that later became the monetary regime in those times. The renowned scientist, a master of the mint, set the gold price for silver at a level lower than that of the market, thus causing the disappearance of silver coins from the circulation. Because of this, gold standard has become popular in other countries as their monetary regime. Entering into the 'gold club' simplified their transactions and thus economizes trading and transaction costs.
According to McKinnon (as cited in Ferderer, 2002, p.2) the classical gold standard follows certain rules. From these rules he elaborated the following qualities of the classical gold standard:
1. It assures the convertibility of domestic currency to gold at a fixed price. In cases where this practice in not feasible, banks could buy domestic assets and can issue notes against them. A coverage ratio, the ratio of gold to notes often set at 40% delimits this practice. This partial backing of notes allows flexibility to solve liquidity problems within a disciplined structure.
2. It assures that "triangular arbitrage would retain the market exchange rates between the domestic currency and foreign currencies at an official (gold price determined) parities.
3. It considers central banks are lenders of last resort.
4. It makes gold as the "nominal anchor" that deters countries from exerting any lengthy influence over the common price level.
The Birth of the Bretton Woods System
World Wars 1 & 2 and the Great Depression stressed out the importance of creating a new system that will respond to these global financial shocks. International finance authorities