The Nixon Shock
How the U.S. closed the gold window and why a return to the gold standard would likely encounter the same obstacles
On the evening of 15 August 1971, President Richard M. Nixon declared a New Economic Policy which involved a 90-day wage-price freeze, a 10% import surcharge, and most importantly the cancellation of the gold convertibility of the dollar. The “Nixon Shock” would break the Bretton Woods system where the dollar was pegged at $35 per ounce of gold and other currencies had fixed parities in relation to the dollar. It was a reflection of the build up of imbalances that had been accumulating at the time, and one that modern revival of a gold standard should take note of.
Bretton Woods was established at the United Nations Monetary and Financial Conference in 1944, and it forced the United States to exchange official foreign dollars at a fixed rate for gold. Other currencies were also fixed to the dollar within a rather narrow range with the IMF providing short term support to temporary imbalances. The setup was fairly successful in the early post-war period. Three-quarters of the world’s monetary gold was in the United States, and Europe and Japan were in need of dollars for imports of reconstruction goods. The system gave liquidity to the growing trade and the gold tie gave the stability to the expectations.
The situation had changed by the 1960s. The share of world output of the United States was diminished by the recoveries of Europe and Japan. Constantly large American trade surpluses were created by the cost of the Vietnam war overseas, American capital flight, and domestic fiscal expansion. The pressure was met by the Federal Reserve’s policy, which fuelled higher inflation. The foreign official dollar holdings soon far outstripped the dollar holdings in the U.S. reserves that were available for conversion.
The underlying paradox came to light in 1960: the world required continuous deficits on the U.S. side in order to provide the dollar liquidity needed, but if such continuous deficits were sustained, then confidence in gold convertibility would be eroded. French President Charles de Gaulle exacerbated the imbalance by exchanging dollars for gold and condemning America’s “exorbitant privilege”. In 1968 the London Gold Pool failed and in 1971 when Germany floated the mark and Britain sought conversion of $3 billion, speculative pressure increased.
In the face of rapidly diminishing reserves, Nixon’s advisors convened at Camp David between 13-15 August, without the public knowing. They decided that it would be too costly for them to maintain the current balance. The evening of the 15th saw Nixon announce the suspension of convertibility, wage and price controls, and the import surcharge to make trading partners revalue. The emphasis of the package was on domestic stimulus rather than on the deflationary adjustment that continued convertibility would have imposed.
Markets opened up with a rise and the Smithsonian Agreement of December 1971 devalued the dollar from $38 to $42 an ounce and expanded bands. The realignment did not last long. In 1973, another devaluation took place and by March the major currencies were floating. The dollar was still a reserve currency, thanks to oil pricing, and the strength of the U.S. financial markets, but there was no formal gold link. The 1970s ushered in the era of stagflation and currency volatility, and central banks were granted discretion, leading to financial instability.
The Nixon Shock demonstrated that a gold-exchange standard is an external constraint that is binding. The political authorities have strong motives to break the rule when domestic objectives (employment, defence, social expenditure or electoral requirements) conflict with it. The above are all pressures that would be felt today under the high level of public and private debt, continuing demands for welfare benefits, infrastructure and crisis spending, and complex financial systems. A credible gold standard will help countries to trim their deficits via deflationary policy and force deficit countries to expand via inflationary and imaginative methods. History has proven that such imbalance leads to political resistance and ultimately to political disintegration from the inter-war years up to 1971.
Gold’s relatively inelastic supply would also create a risk of deflationary bias, if it continued to grow, unless there is new gold to be discovered, which is an unsure and expensive process. The discipline imposed by an external anchor and the protection of chronic inflation are rightly emphasised. However, the political economy of contemporary democracies indicates that however much desirable a new gold standard is, it would be put to the test the next time of a major recession, geopolitical event or banking crisis. But, as in 1933 and 1971, the system would probably be suspended or diluted without limits on fiscal discretion and central-bank activism that could be credible and concurrent.
On 15 August 1971, the United States made a decision on domestic policy flexibility vs. Bretton Woods rules by closing the gold window. It was caused by the political decision of incompatible fiscal and monetary policies and gold convertibility, an imbalance of a technical nature. If a gold standard were to be reinstated, it would face the same dynamic. If the incentives that lead sovereign governments to increase spending and maintain monetary autonomy during times of crisis are not altered, then a new gold standard would be open to the dangers that struck the earlier gold standard. The current lesson from 1971 is that rules-based monetary orders have definite practical limits.