(Bloomberg Opinion) — “Prosperity without war requires action on three fronts,” President Richard Nixon told America in a televised address 50 years ago today. “We must create more and better jobs; we must stop the rise in the cost of living; we must protect the dollar from the attacks of international money speculators.”
Then he administered what is now known as the “Nixon Shock”: He closed the “gold window.” Under the Bretton Woods Agreement, sealed at a hotel in Bretton Woods, New Hampshire, in 1944, the U.S. promised to convert into gold any dollars brought by other countries’ central banks at a rate of $35 per ounce. Other currencies traded at fixed exchange rates to the dollar. In effect, the entire Western financial system was pegged to gold, via the dollar.
No more, Nixon announced. Henceforward, the dollar would be worth whatever people thought it was worth. He meant this as a temporary measure. Gold was flowing out of the U.S. as the war’s defeated countries re-emerged as economic competitors. Other countries had to let the dollar drop a little. Closing the gold window for a while would show that Nixon was serious.
But as it turned out, the gold standard was over. Months of frantic diplomacy by Paul Volcker, the future Federal Reserve chairman, yielded a 10-country agreement on a new system of fixed rates at a new gold price, but this soon collapsed, and nothing replaced it. Rather than adjust Bretton Woods as he intended, Nixon ushered in 50 years of fiat currencies, backed only by confidence in the issuing governments and central banks.
Also unwittingly, Nixon ended fixed exchange rates. Flexible rates have been the norm ever since, putting all currencies at the mercy of the “international money speculators” whom Nixon excoriated. Free markets in currencies, commodities and debt have flourished in a way unimaginable under Bretton Woods.
The U.S., along with much of the rest of the world, has largely enjoyed 50 years of the “prosperity without war” Nixon promised, albeit with increasing inequality in the developed world. But the anniversary arrives amid great apprehension. In the wake of the pandemic, inflation has spiked higher. The global financial system has never found a replacement for gold, and currently rests on minimal interest rates and, in turn, on the presumption that inflation has been definitively slayed, even without the discipline of a gold standard. If the pandemic drives up inflation, that could administer a shock to rival Nixon’s. A number of standards have risen to replace gold over the past half-century, and have ended in crisis. What might happen if the world now loses faith in central banks’ ability to control inflation is alarming to contemplate.
America’s Role in the World
Nixon may have appeared to abdicate American leadership, but losing the gold peg has made the U.S even more central to global finance than it was in 1971. Liaquat Ahamed, author of “Lords of Finance,” which tells the story of the disastrous moves on and off the gold standard between the world wars, said: “The centrality of the U.S. dollar as the world’s currency of denomination for trade and capital markets actually was helped by 1971. It eliminated a constraint on U.S. fiscal and monetary policy. The liberalization of capital markets after 1971 actually was a giant boon for the U.S. financial system and U.S. financial firms because there was no alternative.”
The Fed remains the world’s most powerful financial institution. The one truly global financial crisis, in 2008, was made in America, and it was only the Fed’s swap lines that saved a number of large emerging markets from incipient disaster. Twice, an aggressive tightening of interest rates in the U.S. — by Paul Volcker in the early 1980s and by Alan Greenspan in 1994 — attracted money to the U.S., pushed up the dollar, and wrought havoc in emerging markets that had borrowed heavily in dollars.
Wall Street also grew more powerful, aided by radical deregulation in the three decades after 1971. Bankers from the “money center” banks that had dealt with Wall Street panics before the creation of the Fed popped up as essential ambassadors in debt crises from Latin America to the Pacific Rim.
The 10-year Treasury yield is entrenched as the world’s “risk-free” benchmark for transactions. Even after U.S. sovereign debt was downgraded from AAA to AA+ by Standard & Poor’s in 2011, the response of international investors was to run for safety — in Treasuries. They see no alternative.
Some argue that 1971’s other Nixon Shock, Henry Kissinger’s visit to Chairman Mao Zedong, did more to reduce America’s role in the world, but that is tenuous. The great Chinese growth story was decades away when Nixon made his diplomatic opening. Only after Mao’s death, Deng Xiaoping’s economic reforms in the wake of the 1989 Tiananmen Square Massacre, and accession to the World Trade Organization in 2001 did China’s economic miracle take shape. China is altering America’s role in the world now, but the end of Bretton Woods has little to do with it.
Arguably, Nixon’s coup was just a recognition that the U.S. had completed its post-war task of overseeing global recovery. Bretton Woods was designed primarily by John Maynard Keynes, who called the gold standard a “barbarous relic.” His rules were designed to avoid the tragic mistakes that followed the First World War. That meant fixed rates with some give in them, and a central position for the world’s preeminent financial power to police the post-war rebuilding project. Gold bolstered confidence that there could be no repeat of Weimar Germany’s hyper-inflation. By 1971, the Japanese and German economic miracles had happened. America’s job was done.
Nixon ended a Keynesian system that made the world safe for the Keynesianism of the 1950s and 1960s. And, all unknowingly, he ushered in a free market order built on the principles of Milton Friedman.
Friedman, growing in influence in the 1960s, claimed that Bretton Woods “practically insures the maximum of destabilizing speculation.” He wanted to do away with government involvement and allow markets to reconcile international imbalances through freely floating exchange rates. As Volcker put it, Friedman wanted to “leave currencies to the whim of the (in his view, perfectly rational) market, without any concern for other countries’ wishes.”
Friedman was dismissed by most of the people around Nixon, but international markets were emerging even under the gold peg. Dollars poured into the then exciting growth markets of Europe. By “dithering” for years over the gold peg, says David Mulford of the Hoover Institution, the U.S. “actually helped expand and deepen the fledgling, unregulated Euro markets” and “inadvertently laid the foundation for the modern, sophisticated, truly global financial markets of today.”
Entrepreneurial Americans spied opportunities. In early 1971, Leo Melamed of the Chicago Mercantile Exchange, a forum for trading agricultural products, proposed new futures in foreign exchange rates. “The idea,” Melamed said, “prompted a prominent New York banker to laughingly say that ‘foreign exchange couldn’t be entrusted to a bunch of pork belly crapshooters in Chicago.’”
Yet in early 1972, the CME launched the International Money Market, with intellectual backing from a paper by Friedman himself. By allowing for swift and liquid risk management in foreign exchange, the CME helped make floating exchange rates a practical reality — and itself became a financial behemoth.
With money increasingly nimble, no government could defend an unrealistic exchange rate, unless it imposed controls on the flow of capital. Post-1971 financial history became a litany of governments setting a peg for their currency which the markets then broke.
Sterling, the dollar’s predecessor as the global reserve currency, suffered serial humiliations. Already forced to devalue in 1967 under the gold peg, the pound suffered another run in 1976 that forced the U.K. to borrow from the International Monetary Fund. In 1992, it suffered ejection from the exchange rate mechanism of the European Monetary Union. George Soros (the kind of “speculator” Nixon had inveighed against in 1971) had bet that Britain could not maintain its peg to the deutschmark.
Much the same fate befell a series of emerging markets in the 1990s, from Mexico to the Asian “tiger” economies to Argentina. Just as Friedman wanted, nobody got to set anyone else’s currency.
And yet, Nixon’s abandonment of gold is widely reviled today, often by free marketeers otherwise in tune with Friedman. Free markets tend to overshoot, in both directions, and that makes economic life harder for economy ministers and entrepreneurs alike. Currencies need some kind of standard. The 50 years of fiat have seen a series of alternative, less-than-golden standards, each of which has ended in crisis.
The Search for a New Standard
There have been four post-gold standards, and all of them can be understood by looking at the ratio of share prices (which rise on optimism) to gold (which rises on pessimism). When the stocks-to-gold ratio is rising, confidence is high, but when it falls, there is fear of inflation.
Oil Standard: Once unpegged from gold, the market delivered a savage judgment on the dollar. Its value swiftly fell by 90% in gold terms, and has never recovered. Instead, gold offered an indirect anchor through an effective oil standard. The U.S. struck a deal with Saudi Arabia to standardize all oil transactions in dollar terms. This maintained U.S. centrality, while oil exporters primed global dollar-denominated markets by recycling their “petrodollars.” The problem was that oil exporters wanted to maintain their oil’s value in terms of gold, and oil, unlike gold, is central to the industrial economy.
As Nixon’s inflationary policies…