The “closing of the gold window” in August 1971 may seem like small potatoes compared to larger events in history that continue to affect the world today.
But just as decisions made during World War I continue to affect the Middle East today, so the Nixon administration’s decision to cut the dollar’s tie to gold and to end unilaterally an international system under which the world economy had experienced unprecedented growth continues to affect the world economy today. (One of the most visible and immediate effects was a many-fold increase in the price of gold.)
Indeed, if the choices made 40 years ago had not ended the system of pegged exchange rates established at the end of World War II, Europe might not have felt the need to establish a common currency two decades later, one that is now proving too rigid for the underlying political and economic realities of the 17 countries that adopted the euro.
People who are interested in current economic issues thus would do well to understand both the Bretton Woods payment system and why our nation reneged on the deal after 25 years. An op-ed piece by scholar and investment banker Lewis Lehrman in Monday’s Wall Street Journal is a good place to start. It explains in detail how and why the Nixon administration decided 40 years ago to bail out of the key role in the world’s economy to which we had made a contractual commitment in 1945.
The Bretton Woods Conference of July 1944, and the institutions and financial system it set up, stemmed from the realization that economic tensions after 1918 were one reason Europe returned to war in 1939. The world needed the stability of the international payments regime based on gold and silver that had collapsed with the outbreak of World War I. But it was impossible to recreate such a system since, by mid-1944, the United States held virtually all the world’s gold bullion. And European nations like the United Kingdom, France and Italy were effectively bankrupt.
So the new system tied participating nation’s currencies to the dollar at exchange rates that were to be changed only in the event of some long-term fundamental disequilibrium. The dollar in turn was tied to gold at the rate of $35 to one ounce.
Our country pledged by treaty that if any nation held unwanted dollars, it could redeem them for gold at that rate. This implicitly committed us to prudence in both fiscal and monetary policies, a commitment we increasingly ignored over time.
As long as post-war recovery meant European countries needed to buy machinery and food from the United States, none of them had surplus dollars. But as Europe became more self-sufficient, that need for U.S. money faded. Moreover, during the Vietnam war, U.S. budget deficits and the country’s money supply both grew relative to the economy. Such unsound U.S. policies made foreigners leery of holding dollars, as inflation posed an increasing danger. More and more dollars were redeemed for gold. By mid-1971, most of the dominant gold stocks the United States had held in 1945 were gone.
Key Nixon administration officials met at Camp David and agreed to unilaterally repudiate our gold redemption commitment without any warning to or discussion with key allies. They also decided to press for an increase in import tariffs and institute a wage-price freeze.
The rest is history.
“Closing the gold window” effectively killed the Bretton Woods payment system, which disintegrated over the next year. The basic global system became one of free-floating exchange rates with much manipulation by some governments, especially in developing countries like China.
Domestically, in one of the most cynical episodes in U.S. economic history, the Fed goosed the money supply in the runup to the 1972 elections while Nixon’s wage-and-price controls suppressed visible inflation. That, together with continued excessive money growth, caused the Great Inflation of the 1970s that ended only after Jimmy Carter’s 1979 appointment of Paul Volcker as Fed chair.
It is an error, however, to follow Lehrman in blaming the ending of Bretton Woods for a long litany of economic woes. By 1971, the system was doomed due to bad policies pursued by the Johnson and Nixon administrations, together with a Democratic-controlled Congress. While the budget deficits of the Vietnam era pale in comparison with those that came after 1980, they helped undermine the dollar and thus doomed the global pegged exchange rate system.
Similarly, while the Fed’s money creation in the late 1960s, under Fed chair William McChesney Martin, was less irresponsible than that of his successor, Arthur Burns, it was too high to maintain the price stability needed for Bretton Woods to work.
The collapse of Bretton Woods was a symptom of bad policies, not a cause, although the repudiation of our treaty commitments did remove one symbolic obstacle to future irresponsibility by presidents, Congress and the Federal Reserve. The old system had its flaws, but there is much evidence that the international financial regime we have had since is worse. It certainly is fragile on the 40th anniversary of its adoption by default.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.