Goodbye, Gold Redemption of the Dollar

By Alex J. Pollock

Forty years ago today, the entire world was launched into a brand new financial experiment. Viewing matters from 2011, how do we like the results?

Forty years ago today, the entire world was launched into a brand new financial experiment: a peacetime global monetary system with no link at all to redemption of money in precious metals. In other words, for the first time without being in a big war, governments offered people purely fiat money on a worldwide basis. This could be viewed as the logical end point of the modern trend of increasing the power of central banks.

Viewing matters from 2011, how do we like the results of the experiment?

The global fiat money regime arrived with President Nixon’s announcement that the United States was abrogating its commitment to foreign governments under the Bretton Woods agreement to redeem their dollars for gold at the fixed value of one ounce per $35.

In his “Address to the Nation Outlining a New Economic Policy” on August 15, 1971, Nixon said the situation required “bold leadership ready to take bold action.” He went on to say why and how:

— “In the past seven years, there has been an average of one international monetary crisis every year.”

— “In recent weeks, the speculators have been waging an all-out war on the American dollar.”

— “We must protect the dollar from the attacks of international money speculators.”

— “Accordingly, I have directed [Treasury] Secretary Connolly to suspend temporarily the convertibility of the dollar into gold.”

Of course, the “temporary” suspension of convertibility turned out to be permanent, and a new international financial paradigm had been established. Thus ended the Bretton Woods system, which had been based on dollars being convertible into gold, and had been designed at the end of World War II. It was negotiated in 1944 and ratified in 1945, so it lasted about 26 years—not bad for a complex institutional construct.

The key institutions in the new situation were governments which increasingly used permanent deficit financing; central banks which could issue, against the governments’ debt they bought, irredeemable paper currency (accompanied by coins which clunked instead of ringing when you dropped them on a table); and, of course, commercial banks, which issued deposits redeemable only in the central banks’ fiat currency.

The entire new system depended on the foresight, wisdom, and knowledge of the managers of these institutions. It resulted in the general acceptance of permanent inflation and the redefinition of “price stability” to mean a stable rate at which the purchasing power of the fiat currency depreciated.

The series of accompanying charts reflects the operation of the new system. The price of the U.S. dollar in gold is shown by how many ounces of gold it took to buy $100 from 1970 to 2000 in Chart 1, and from 2000 to 2011 in Chart 2.

Chart 1

Chart 2

The theory in opposition to the new system had been previously voiced by George Bernard Shaw. He was hardly a qualified economist, but it is hard to improve upon his witty objection: “You have to choose between trusting to the natural stability of gold and the natural stability of the honesty and intelligence of the members of the Government. And, with due respect to these gentlemen, I advise you … to vote for gold.”

In my opinion, neither of these choices (indeed no human construct) is perfect and both (indeed all) present inevitable problems. However, as we can now observe from the four decades since President Nixon’s direction to Secretary Connolly, there are certainly many problems with the second choice—the pure fiat money system, which trusts to the knowledge, foresight, and “natural stability” of government officers and central bankers.

“The effect of this action,” Nixon predicted of closing the gold window, “will be to stabilize the dollar.” Refer to Chart 3, the price of the dollar in Swiss francs and Japanese yen; and Chart 4, the price of gold in Swiss francs, Japanese yen, and dollars, to see the inaccuracy of this prediction.

Chart 3

Chart 4

Another element of the 1971 “New Economic Policy” was a temporary government-ordered national price and wage freeze “to stop the rise in the cost of living.” This obviously bad idea could not be anything other than temporary. Intended to “break the back of inflation,” it preceded the Great Inflation of the 1970s to early 1980s, when annual inflation rates rose into double digits. The Great Inflation, like the recent Great Financial Crisis, was an international, not just a U.S. experience.

Economist Robert Z. Aliber, who has prepared updated editions of Charles Kindleberger’s classic Manias, Panics and Crashes, has observed that the decades we are considering have witnessed a remarkable international series of rolling banking and financial crises. When compared to other periods of comparable length, he concludes that, “there have been more foreign exchange crises” and “more asset price bubbles.” These have brought us, of course, to the Great Financial Crisis of 2007-2009, and now the Sovereign Debt Crisis of 2010-2011—so far.

Do these recurring financial crises display fundamental fault lines in the global fiat money experiment that started in 1971? Do they suggest that the top of the market for central bank paper currencies has passed, in the metaphor suggested by James Grant? Is the worldwide system of fiat currencies, government deficits, central bank monetization of the government debt, and permanent inflation actually sustainable for another few decades? If not, what would replace it?

I do not know the answer to these questions. But it seems to me beyond doubt, even though most of us do not remember it happened, that something extremely important did occur on August 15, 1971.

Alex J. Pollock is a resident fellow at the American Enterprise Institute and the author of Boom and Bust. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.