If you don’t know by now, today is the 40th anniversary of the day when Richard Nixon officially closed the gold window and dissolved the Bretton Woods agreement. For me, that moment marked in earnest the beginning of the downward spiral of bad economic policy, and short termism that has resulted in the predicament we find ourselves in today. It is overlooked by the majority of economic commentators, unsurprisingly, as those individuals advocate the bad policy and short termism that inevitably comes with the monetary system Nixon officially put us on 40 years ago.
From this distance, 40 years on, watching Nixon justify severing the dollar from gold is quite interesting. The circumstances that he faced were not his doing by any stretch – similar to the fact that President Obama walked into office with a difficult proposition on his own hands. However, like Obama (so far), Nixon chose to shirk economic responsibility in the hopes that the fallout would take place on someone elses’ watch.
One could blame the subsequent ills of our monetary system on the Federal Reserve Act of 1913, or the actions of FDR in 1933. I would not oppose such assessments, but World War II did a lot to change the landscape of the global marketplace and more directly led to Nixons dilemma than anything before it. The post war monetary standard, the Bretton Woods Agreement of 1944, saw that countries around the world would maintain an exchange rate with the US dollar. In turn, the US dollar would be convertible to gold, at the price of $35/oz. This agreement came about due to the standing of the United States as the only world power to have its infrastructure unharmed by World War II, and the fact that it housed nearly half of the worlds gold reserves at the time. Due to the devastation in Europe and Asia in the post war years, there existed high global demand for the dollar, as it was required to purchase American goods, which were necessary in the rebuilding of war torn lands. As Europe and Japan began to repair themselves, the need for American goods waned slightly. That, combined with outlays on LBJs Great Society and Vietnam, meant that the United States began running trade and budget deficits, relying on the status of the dollar to support it all.
It soon became apparent what the Bretton Woods system had set up. A system in which the US dollar was ‘as good as gold’ meant that the United States could, as the sole producer of US dollars, produce as many dollars as it liked to pay for the goods and services it desired. The only problem was that the US dollar was not, and is not ‘as good as gold.’ Gold is a metal with specific properties that lend itself well to being used as money. A dollar is a piece of paper that gave its owner a right to a certain amount of that gold. That paper becomes more and more worthless the more it becomes apparent that there are too many claims (dollars) on the limited gold reserves in existence.
The French seemed to understand this principle and made quite a few noises about the ‘exorbitant privilege’ the United States enjoyed. President Charles De Gaulle stated that:
The fact that many countries accept as a principle dollars as good as gold for the payment of the differences existing to their advantage in the American balance of trade, this very fact leads Americans to get into debt, and to get into it for free at the expense of other countries. Because what the US owes them, it is paid at least in part with dollars only they are allowed to emit. Considering the serious consequences a crisis would have in such a domain, we think that measures must be taken on time to avoid it. We consider it necessary that international trade be established, as it was the case, before the great misfortunes of the world on an indisputable monetary base, one that does not bear the mark of a particular country. Which base? In truth, how could one have any standard criterion other than gold?
De Gaulle was correct. He acknowledged the fact that the US could trade paper for real goods and services, and given that the world accepted that paper as equivalent to gold, the US was on easy street. De Gaulle wasn’t having it, and he slowly began to demand to redeem the piles of dollars France had accumulated for gold. Other countries followed suit if they hadn’t done already, and an old fashioned run on the bank was taking place, except with a massive sovereign playing the role of the bank.
The US had landed in this situation thanks to the actions of prior administrations, as was mentioned before. But the pressure was still on Nixon. With rising inflation and unemployment and the country facing recession in 1970, he called on his Federal Reserve Chairman Arthur Burns to get him out of jail. Unwilling to face the prospect of recession under his watch, Nixon bullied Burns into employing expansionary monetary policy, expanding the money supply and cutting interest rates. In response to the falling dollar price on the international markets, foreign central banks continued to buy the dollar in order to prop it up, preventing their own currencies from rising too much as a result.
With dollars flooding the world, and with it looking more and more likely that a run on the dollar was possible, Nixon capitulated and addressed the nation on August 15, 1971. He announced that he would be closing the gold window, as per the video above. This action was tantamount to default, a subject that would resurface 40 years later, nearly to the day. This was an actual default however, given that the US Federal Reserve Note was really an IOU. If you held one, you were entitled to gold. As of Nixons address, you were no longer entitled to gold if you held a Federal Reserve Note. Changing the terms of payment is default. Remarkably, Nixon framed the decision not as an admittance of the failure to have the gold necessary to back the dollars in existence, but a proactive move of strength to ‘save’ the dollar from speculators. He says:
In the past 7 years, there has been an average of one monetary crisis per year. Now who gains from these crises? Not the working man, not the investor, not the real producers of wealth. The gainers, are the international money speculators. Because they thrive on crises, they help to create them. In recent weeks, the speculators have been waging an all out war on the American dollar.
He uses language that many politicians and executives of failing companies have used over the years when their respective economies or companies are in trouble. However, speculators do not have the power to ruin a company or country that is perfectly fine over the long term. Rather, speculators are trained to spot weaknesses and dangers in the marketplace and to act accordingly. It is true that when they pile on they may cause a market to ‘overshoot’ in one direction or the other, but it is not the fault of the speculator that a company cooked its books, such that when it was discovered the stock price dropped 90%. It is not the fault of the speculator that a sovereign embarked on inflationary monetary policies to pay for promises to its citizens or to pay for war, such that speculators sold that particular currency. Such moves are correct, and for Nixon to demonize them as ‘war on the American dollar’ shows a lack of understanding of economics. Far from being a flaw in his character, it seems to be a trait in nearly all politicians. He continues:
Now what does this action, which is very technical, mean for you? Let me lay to rest the bugaboo of what is called ‘devaluation.’ If you want to buy a foreign car, or take a trip abroad, market conditions may cause your dollar to buy slightly less. But, if you are among the overwhelming majority of Americans who buy American made products in America, your dollar will be worth just as much tomorrow as today. The effect of this action, in other words, will be to stabilize the dollar.
Nixon makes a key mistake here, one that many economic commentators also make. He first admits that the US dollar will depreciate compared to other currencies, and rightly so. He then talks about the domestic market and claims that nothing will change in regards to the value of the dollar. I see several people making this claim as well, particularly when it comes to discussing recent policy plans such as Quantitative Easing. While admitting that these actions will weaken the dollar on the international market, many claim that Americans will not be harmed by this weakening unless they want to take a trip to Europe or Brazil. Because $20 is always $20. This is complete nonsense. It is true that a $20 bill will always be a $20 dollar bill. What is not necessarily true is the fact that the value of a $20 bill will maintain over time in a devaluation scheme. In other words, $20 will buy you much less than it did before the devaluation. According to measuringworth.com, the purchasing power of a $20 bill in in 1971 is roughly equal to $108 in 2010. So much for stability. In 1971, $1 was worth 1/35 oz of gold. Now it is worth 1/1765 oz.
Devaluation is not a ‘bugaboo.’ It’s a real and harmful phenomenon that no politician admits exists. It is the systematic robbery of the purchasing power of a group of citizens over time. People such as Elizabeth Warren and Michael Moore have famously lamented the fact that the middle class has been systematically destroyed over the last 40 years. They correctly describe the effects and how we have gone from one breadwinner to two breadwinners, and from two breadwinners to two breadwinners plus credit to maintain the same standard of living. They recognize that Americans have been getting poorer over this time period. They incorrectly explain the ‘why’ of it all and constantly fail to understand the monetary aspect. They fail to understand that the inflation tactic is employed over and over again because it forestalls the politically damaging effects of recession. Nixons’ Fed Chairman, Arthur Burns outlined this brilliantly in a speech made in 1979, after he had left his post. Emphasis mine.
…Many results of this interaction of government and citizen activism proved wholesome. Their cumulative effect, however, was to impart a strong inflationary bias to the American economy. The proliferation of government programs med to progressively higher tax burdens on both individuals and corporations. Even so, the willingness of government to levy taxes fell distinctly short of its propensity to spend. Since 1950, the federal budget has been in balance only five years. Since 1970 a deficit has occurred in every year. Not only that, but the deficits have been mounting in size…they have been incurred when business conditions were poor and also when business was booming. When the government runs a deficit, it pumps more money into the pocketbooks…the demand for goods and services therefore tends to increase all around.
The pursuit of costly social reforms often went hand in hands with the pursuit of full employment…inflation came to be widely viewed as a temporary phenomenon – or, provided it remained mild, as an acceptable condition. Maximum, or full employment, after all, had become the nations major economic goal – not stability of the price level. That inflation ultimately brings on recession and otherwise nullifies many of the benefits sought through social legislation was largely ignored. Even conservative politicians and business men began echoing Keynesian teachings…Fear of immediate unemployment -rather than fear of current or eventual inflation – thus came to dominate economic policymaking.
The entire speech is a must read in my opinion, however this excerpt outlines nicely the problems that faced Nixon, and each subsequent administration. The prevailing idea that governments and central banks could mitigate the negative consequences of recession (namely unemployment) dominated thinking. The basic idea was that an economy that had gone into recession needed an outside actor to step in and prime the pump and revive the animal spirits of the economy. That outside actor would be the government and their ability to inflate and foster expansionary conditions as long as necessary were seen as the answer. However, what is overlooked is that these measures are only short term in nature, as Burns points out when he talks of the ultimate recession that is brought on by the same inflation that was intended to mitigate a prior recession.
It must be understood that the reason the economy went into recession the first place was relating to the fact that the prevailing structure of the economy was out of balance. This could be the case for a few reasons, most common is the imbalance that may exist between prices. For example, if the price level is too high, as we saw in the years leading up to the Great Financial Crisis, consumers may not be able to consume without credit, given their incomes. Once they aren’t able to take on more debt to spend, businesses are going to have to lower prices to clear their goods. Presumably, the high prices are prices that are needed to make a profit. In other words businesses had already paid a high cost of making the good such that lowering the end price at this point in time is not profitable for them. This happening on an economy wide scale means that businesses go bust, unemployment rises. It should be stressed that this process is imperative to getting the economy back on solid footing again.
Politicians do not have the ‘luxury’ of waiting for an economy to restructure. They only have so long before election season, and to have the necessary rise in unemployment happen on their watch is unacceptable, regardless of the fact that the unemployment will be short term itself. So they look to inflate. They look to expand the money supply and lower the rate of interest such that more money finds its way into pocketbooks spurring the demand for goods, as in the Burns quote above. The problem is that these actions drive up the price level further. The natural course of a recession is to drive the price of goods lower such that they are more in line with the prevailing wage levels. The government action retards this phenomenon to prevent unemployment. So while seemingly rescuing the economy from recession in the short term, what it does is create a scenario for further recession in the long term. Because it is not true that all actors in the economy will keep up with the increased price level. At some point, they will not be able to spend further. The governmental expansion is temporary, as it cannot keep rates low or expand monetary supply forever without destroying the currency. When it stops, actions that were totally dependent on their expansion also stops. And you are left in recession once again, as the high price level means that business fail or downsize, employment declines and so forth. And the cycle continues as a new set of politicians cannot bear to have these things occur on their watch.
For the last 40 years we have been subject to such a repeated cycle of folly. Each cycle following the Great Inflation of the 70s has been worse than the last. Each cycle has built more imbalances into the system, such that we are at a point now that allowing the necessary restructuring will mean devastation for many, many people. That fact does not render the process any less necessary than it has ever been. And still many economic commentators call for the inflationary option. And the policymakers across the globe continue to engage in such inflationary policies, although with some restraint this time. The half life of these measures are dwindling further and further with each action and the social effects are getting uglier by the day. It is finally apparent to more people that the fact that they have been faced with increased costs for food, energy, education, healthcare, housing etc while simultaneously failing to see appropriate gains in income boils down to the inflationary effects of recession mitigating policies. Even though the economics of it may be unclear to some, the riots in China, Egypt, and now England may be a sign of things to come should the inflationary policies of the West continue. We are at the point now where the options are for policy makers to allow massive unemployment, or to confiscate what little purchasing power remains in the hands of the average earner via inflation. In my view, the former option is preferable as it is a much shorter and swifter option. As Mises famously said:
There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved
As ‘voluntary abandonment of further credit expansion’ is not in the vocabulary of a politician or central banker, we may be headed for the latter part of the quote. There is still time to undo what has happened over the last 40 years. It will be painful, but surely better than that latter option.