The Day Gold Died: Understanding The Nixon Shock

May 15, 2011 8:49 am

We all know, as part of Bretton Woods, all currencies in the world is were pegged against the US Dollar (fixed exchange rate). (“Members were required to establish a parity of their national currencies in terms of the reserve currency (a “peg”) and to maintain exchange rates within plus or minus 1% of parity (a “band”) by intervening in their foreign exchange markets (that is, buying or selling foreign money).”).

But this move from all the member countries required enormous faith in the dollar. Those days (and arguably today) faith meant gold.

“Meanwhile, to bolster faith in the dollar, the U.S. agreed separately to link the dollar to gold at the rate of $35 per ounce of gold. At this rate, foreign governments and central banks were able to exchange dollars for gold. Bretton Woods established a system of payments based on the dollar, in which all currencies were defined in relation to the dollar, itself convertible into gold, and above all, “as good as gold”. The U.S. currency was now effectively the world currency, the standard to which every other currency was pegged. As the world’s key currency, most international transactions were denominated in US dollars.”

This move is what gave the dollar the “reserve currency”status – note the phrase as good as gold – for a world moving away from transacting in gold-pegged currencies, this was an important promise.

So everything is good until this point – everyone pegs against dollar, and you can exchange dollar to a fixed amount of gold anytime you want. Good.

The issue was, due to the huge outflow of dollars to maintain liquidity for world trade, the US soon got into a situation where more and more dollars were printed and sent abroad. Also, “by the early 1970s, as the costs of the Vietnam War and increased domestic spending accelerated inflation,the U.S. was running a balance-of-payments deficit and a trade deficit, the first in the 20th century.”

Soon, the US got into a situation where every country started saying “give us the gold” –

“Due to the excess printed dollars, and the negative U.S. trade balance, other nations began demanding fulfillment of America’s “promise to pay” – that is, the redemption of their dollars for gold. Switzerland redeemed $50 million of paper for gold in July.[1] France, in particular, repeatedly made aggressive demands, and acquired $191 million in gold, further depleting the gold reserves of the U.S.[1] On August 5, 1971, Congress released a report recommending devaluation of the dollar, in an effort to protect the dollar against foreign price-gougers.[1] Still, on August 9, 1971, as the dollar dropped in value against European currencies, Switzerland unilaterally withdrew the Swiss franc from the Bretton Woods system.[1]”

The US was left with no choice but to decouple the Dollar from Gold. Otherwise, pretty soon, all dollars in the world would have come back to the US and all Gold would have been gone. So Nixon did the unthinkable: he closed the Gold window.

“To stabilize the economy and combat the 1970 inflation rate of 5.84%[2], on August 15, 1971, President Nixon imposed a 90-day wage and price freeze, a 10 percent import surcharge, and, most importantly, “closed the gold window”, ending convertibility between US dollars and gold. The President and fifteen advisors made that decision without consulting the members of the international monetary system, so the international community informally named it the Nixon shock. Given the importance of the announcement — and its impact upon foreign currencies — presidential advisors recalled that they spent more time deciding when to publicly announce the controversial plan than they spent creating the plan.[3] He was advised that the practical decision was to make an announcement before the stock markets opened on Monday (and just when Asian markets also were opening trading for the day). On August 15, 1971, that speech and the price-control plans proved very popular and raised the public’s spirit. The President was credited with finally rescuing the American public from price-gougers, and from a foreign-caused exchange crisis.[3][4]”

So that was the Nixon shock – many countries around the world were left holding dollars that they could no longer exchange for gold – the best they could do was, of course to buy gold from the open market (which would have been dumb and difficult) or, to remove the peg with the US dollar and allow their currency to float freely, which is what they ended up doing. The impact is explained by Paul Krugman:

“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.”

Statistics Source: Wikipedia

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3 Comments for “The Day Gold Died: Understanding The Nixon Shock”

  1. […] Of course we have written about the total stock of gold in the world and other gold statistics and silver statistics. We have also written about returns from gold investment and the Nixon shock. […]

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