Presidents and Economics: Richard Nixon and the "Nixon Shock"
What, one might ask, is the Nixon Shock? I was curious about the term too. I learned that it was the name given to a series of economic measures taken by President Richard Nixon in 1971, in which he unilaterally took the United States off of the gold standard. It was the beginning of the modern era of freely floating currencies that remains in place today.
By way of background, in 1944 at a place called Bretton Woods, New Hampshire, representatives from forty-four nations met with the goal of developing a new international monetary system that would later come to be known as the Bretton Woods system. The new system was supposed to ensure that exchange rates between various currencies remained stable, in turn making the entire international banking and monetary system more stable. The Bretton Woods System became fully operational in 1958. The system required the signatory nations to settled their international accounts in US dollars as the base currency, which could be converted to gold at a fixed exchange rate of thirty five dollars per ounce, redeemable by the U.S. government. This meant that the United States was committed to backing every dollar overseas with gold. Other currencies were tied to the dollar, and the dollar was pegged to gold.
Initially, the Bretton Woods system worked well. After World War II, under the Marshall Plan, Japan and Europe were rebuilding from the war. With many foreign economies in trouble, there was a high demand for dollars to spend on American goods such as automobiles, steel, and machinery. At the time the U.S. owned over half of the world's official gold reserves (574 million ounces at the end of World War II) so the system appeared secure. But over the next two decades, from 1950 to 1969, as Germany and Japan recovered, the US share of the world's economic output dropped significantly, from 35 percent to 27 percent. American public debt grew, in part due to the costs of the Vietnam War and President Lyndon Johnson`s Great Society programs. This resulted in a rise in inflation, which put pressure on the American dollar, which became overvalued.
By 1966, money held by foreign central reached $14 billion, while the United States had only $13.2 billion in gold reserve. Of those reserves, only $3.2 billion was available to cover foreign holdings, with the rest was covering domestic holdings. The Bretton Woods system no longer provided security for foreign currencies.
In May 1971, West Germany was the first to leave the Bretton Woods system, a move which strengthened its economy. When it did so, the value of the US dollar dropped 7.5% against the Deutsche Mark. Other nations began to demand redemption of their dollars for gold. Switzerland redeemed $50 million in July. France acquired $191 million in gold. On August 9, 1971, as the dollar dropped in value against European currencies, Switzerland also left the Bretton Woods system.
At the time, the U.S. had unemployment and inflation rates of 6.1% and 5.84% respectively. President Nixon sought the advice of Federal Reserve chairman Arthur Burns, incoming Treasury Secretary John Connally, and future Fed Chairman Paul Volcker (who was then Treasury Undersecretary for International Monetary Affairs) On Friday, August 13, 1971, Nixon met with these men and a larger group of advisers at Camp David. Nixon decided to end the Bretton Woods system by suspending the convertibility of the dollar into gold. He also froze wages and prices in the United States for 90 days to combat potential inflationary effects, and he imposed an surcharge on imports of 10 percent. To prevent a run on the dollar, on August 15, 1971 Nixon directed Treasury Secretary Connally to suspend the convertibility of the dollar into gold or other reserve assets. He ordered the gold window to be closed so that foreign governments could no longer exchange their dollars for gold.
To give this the force of law, Nixon issued Executive Order 11615 (which he was entitled to do under the Economic Stabilization Act of 1970). It imposed the 90-day freeze on wages and prices, which was intended to order to counter inflation. The import surcharge was set at 10 percent to ensure that American products would not be at a disadvantage because of the expected fluctuation in exchange rates.
Nixon addressed the nation on television on August 15, the Sunday before the markets opened. He said:
"We must protect the position of the American dollar as a pillar of monetary stability around the world. In the past 7 years, there has been an average of one international monetary crisis every year... I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States. Now, what is this action, which is very technical? What does it 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 it is today. The effect of this action, in other words, will be to stabilize the dollar."
The American public perceived the actions as the government rescuing them from price gougers and from a foreign-caused exchange crisis. Nixon's actions were well received. The Dow Jones index rose 33 points the next day, its biggest daily gain ever at that point. The New York Times editorial page read, "We unhesitatingly applaud the boldness with which the President has moved."
Later that year, in December 1971, the import surcharge was dropped as part of a general agreement between the Group of Ten (G-10) nations about revaluation of their currencies. Further discussions were had and by March 1973, the fixed exchange rate system became a floating exchange rate system.
The Nixon Shock was considered to be a political success, and contributed to his landslide re-election in 1972. Subsequently however, the economy suffered as the dollar plunged by a third during the '70s. Viewed through the telescope of hindsight, modern day economists question its wisdom. Paul Volcker later said that regretted the abandonment of the Bretton Woods agreement because "nobody's in charge. The Europeans couldn't live with the uncertainty and made their own currency and now that's in trouble."
In 1996, economist Paul Krugman (who won the Nobel Prize in Economics in 2008) made this assessment:
The current world monetary system assigns no special role to gold. Indeed, the Federal Reserve is not obliged to tie the dollar to anything. It can print as much or as little money as it deems appropriate. There are powerful advantages to such an unconstrained system. Above all, the Fed is free to respond to actual or threatened recessions by pumping in money. To take only one example, that flexibility is the reason the stock market crash of 1987, which started out every bit as frightening as that of 1929, did not cause a slump in the real economy. While a freely floating national money has advantages, however, it also has risks. For one thing, it can create uncertainties for international traders and investors. Over the past five years, the dollar has been worth as much as 120 yen and as little as 80. The costs of this volatility are hard to measure, partly because sophisticated financial markets allow businesses to hedge much of that risk, but they must be significant. Furthermore, a system that leaves monetary managers free to do good also leaves them free to be irresponsible, and, in some countries, they have been quick to take the opportunity."
Debate over the Nixon Shock continues to the present day, but there is no obvious answer. As conservative pundit and former George W. Bush speechwriter David Frum put it:
"The modern currency float has its problems. There is no magical monetary cure, monetary policy is a policy area almost uniquely crowded with trade-offs and lesser evils. If you want a classical gold standard, you get chronic deflation punctuated by depressions, as the U.S. did between 1873 and 1934. If you want a regime of managed currencies tethered to gold, you get regulations and controls, as the U.S. got from 1934 through 1971. If you let the currency float, you get chronic inflation punctuated by bubbles, the American lot since 1971. System 1 is incompatible with democracy, because voters won’t accept the pain inherent in a gold standard. System 2 is incompatible with the free market economics I favor. That leaves me with System 3 as the worst option except for all the others."
I think that last sentence pretty much sums it up best.
By way of background, in 1944 at a place called Bretton Woods, New Hampshire, representatives from forty-four nations met with the goal of developing a new international monetary system that would later come to be known as the Bretton Woods system. The new system was supposed to ensure that exchange rates between various currencies remained stable, in turn making the entire international banking and monetary system more stable. The Bretton Woods System became fully operational in 1958. The system required the signatory nations to settled their international accounts in US dollars as the base currency, which could be converted to gold at a fixed exchange rate of thirty five dollars per ounce, redeemable by the U.S. government. This meant that the United States was committed to backing every dollar overseas with gold. Other currencies were tied to the dollar, and the dollar was pegged to gold.
Initially, the Bretton Woods system worked well. After World War II, under the Marshall Plan, Japan and Europe were rebuilding from the war. With many foreign economies in trouble, there was a high demand for dollars to spend on American goods such as automobiles, steel, and machinery. At the time the U.S. owned over half of the world's official gold reserves (574 million ounces at the end of World War II) so the system appeared secure. But over the next two decades, from 1950 to 1969, as Germany and Japan recovered, the US share of the world's economic output dropped significantly, from 35 percent to 27 percent. American public debt grew, in part due to the costs of the Vietnam War and President Lyndon Johnson`s Great Society programs. This resulted in a rise in inflation, which put pressure on the American dollar, which became overvalued.
By 1966, money held by foreign central reached $14 billion, while the United States had only $13.2 billion in gold reserve. Of those reserves, only $3.2 billion was available to cover foreign holdings, with the rest was covering domestic holdings. The Bretton Woods system no longer provided security for foreign currencies.
In May 1971, West Germany was the first to leave the Bretton Woods system, a move which strengthened its economy. When it did so, the value of the US dollar dropped 7.5% against the Deutsche Mark. Other nations began to demand redemption of their dollars for gold. Switzerland redeemed $50 million in July. France acquired $191 million in gold. On August 9, 1971, as the dollar dropped in value against European currencies, Switzerland also left the Bretton Woods system.
At the time, the U.S. had unemployment and inflation rates of 6.1% and 5.84% respectively. President Nixon sought the advice of Federal Reserve chairman Arthur Burns, incoming Treasury Secretary John Connally, and future Fed Chairman Paul Volcker (who was then Treasury Undersecretary for International Monetary Affairs) On Friday, August 13, 1971, Nixon met with these men and a larger group of advisers at Camp David. Nixon decided to end the Bretton Woods system by suspending the convertibility of the dollar into gold. He also froze wages and prices in the United States for 90 days to combat potential inflationary effects, and he imposed an surcharge on imports of 10 percent. To prevent a run on the dollar, on August 15, 1971 Nixon directed Treasury Secretary Connally to suspend the convertibility of the dollar into gold or other reserve assets. He ordered the gold window to be closed so that foreign governments could no longer exchange their dollars for gold.
To give this the force of law, Nixon issued Executive Order 11615 (which he was entitled to do under the Economic Stabilization Act of 1970). It imposed the 90-day freeze on wages and prices, which was intended to order to counter inflation. The import surcharge was set at 10 percent to ensure that American products would not be at a disadvantage because of the expected fluctuation in exchange rates.
Nixon addressed the nation on television on August 15, the Sunday before the markets opened. He said:
"We must protect the position of the American dollar as a pillar of monetary stability around the world. In the past 7 years, there has been an average of one international monetary crisis every year... I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States. Now, what is this action, which is very technical? What does it 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 it is today. The effect of this action, in other words, will be to stabilize the dollar."
The American public perceived the actions as the government rescuing them from price gougers and from a foreign-caused exchange crisis. Nixon's actions were well received. The Dow Jones index rose 33 points the next day, its biggest daily gain ever at that point. The New York Times editorial page read, "We unhesitatingly applaud the boldness with which the President has moved."
Later that year, in December 1971, the import surcharge was dropped as part of a general agreement between the Group of Ten (G-10) nations about revaluation of their currencies. Further discussions were had and by March 1973, the fixed exchange rate system became a floating exchange rate system.
The Nixon Shock was considered to be a political success, and contributed to his landslide re-election in 1972. Subsequently however, the economy suffered as the dollar plunged by a third during the '70s. Viewed through the telescope of hindsight, modern day economists question its wisdom. Paul Volcker later said that regretted the abandonment of the Bretton Woods agreement because "nobody's in charge. The Europeans couldn't live with the uncertainty and made their own currency and now that's in trouble."
In 1996, economist Paul Krugman (who won the Nobel Prize in Economics in 2008) made this assessment:
The current world monetary system assigns no special role to gold. Indeed, the Federal Reserve is not obliged to tie the dollar to anything. It can print as much or as little money as it deems appropriate. There are powerful advantages to such an unconstrained system. Above all, the Fed is free to respond to actual or threatened recessions by pumping in money. To take only one example, that flexibility is the reason the stock market crash of 1987, which started out every bit as frightening as that of 1929, did not cause a slump in the real economy. While a freely floating national money has advantages, however, it also has risks. For one thing, it can create uncertainties for international traders and investors. Over the past five years, the dollar has been worth as much as 120 yen and as little as 80. The costs of this volatility are hard to measure, partly because sophisticated financial markets allow businesses to hedge much of that risk, but they must be significant. Furthermore, a system that leaves monetary managers free to do good also leaves them free to be irresponsible, and, in some countries, they have been quick to take the opportunity."
Debate over the Nixon Shock continues to the present day, but there is no obvious answer. As conservative pundit and former George W. Bush speechwriter David Frum put it:
"The modern currency float has its problems. There is no magical monetary cure, monetary policy is a policy area almost uniquely crowded with trade-offs and lesser evils. If you want a classical gold standard, you get chronic deflation punctuated by depressions, as the U.S. did between 1873 and 1934. If you want a regime of managed currencies tethered to gold, you get regulations and controls, as the U.S. got from 1934 through 1971. If you let the currency float, you get chronic inflation punctuated by bubbles, the American lot since 1971. System 1 is incompatible with democracy, because voters won’t accept the pain inherent in a gold standard. System 2 is incompatible with the free market economics I favor. That leaves me with System 3 as the worst option except for all the others."
I think that last sentence pretty much sums it up best.