How the ounce-of-gold promise US broke is playing out 50 years on

On August 15 India celebrates its Independence Day. But there is another “Independence Day” on the same date that the world has largely forgotten. In fact, two days ago, it was the golden jubilee of that event.
 
This was the freeing of the world of the tyranny of fixed exchange rates by Richard Nixon (pictured), the 37th president of the United States of America. In a sudden and completely unexpected move, he announced on August 15, 1971, that the US would no longer honour its commitment to the holders of dollars that for every dollar the US would give an ounce of gold in return.

 
It had agreed to do so at the Bretton Woods conference in 1944. The dollar had thus become the reserve currency for the world. It continues to be that to date.
 

Why Nixon repudiated the promise
 
Nixon decided to dump the fixed exchange rate system because the US treasury discovered in 1970 that if everyone who held dollars came asking for an ounce of gold, the US would not only be depleted of its gold but would also have to borrow a lot of it to keep its promise.
 
So, because the US was so powerful, Nixon simply told the world to take a walk. From that date on, he said, if you come to me with 35 dollars you will get 35 dollars instead of an ounce of gold.

 
The consequences for the world economy were nearly cataclysmic. But before we come to that, we must see what had happened between 1945 and 1970.
 
Euro-dollars and budget deficits

For 20 years from 1945, faced with the challenge of an aggressively Communist USSR, the US backstopped the West European economies by buying more than it sold to them. It also invested huge sums there, almost $20 billion.
 
(Amazingly it has made the same mistake with China since 2000, except that this time it doesn’t owe gold but only paper money).
 
So by 1965, billions of dollars were deposited in European banks. These dollars, moreover, were outside the control of the US monetary authority, the Federal Reserve.

 
Simultaneously, throughout the 1960s, the US government was spending more than it was earning. One reason was the cost of the Vietnam War and the other was the inauguration of the welfare state in 1968 by the Democratic Party.
 
All taken together this meant the US government’s finances had become unsustainable. So Nixon did two things because he could not do the third, mainly undo the welfare expenditure. That was politically impossible.
 
He, therefore, started the slow process to end the Vietnam War and, as that would take time, he went off the gold standard with a single executive order. It was his way of telling the world what Donald Trump would say in 2017 at his inaugural speech: America First.

 
Consequences
 
Suddenly, the world monetary system, from being a stable and predictable ship that sailed boringly on, became a betting shop where everyone — individuals, firms and countries— took their chances. That’s how it has been for the last 50 years.
 
Throughout the 1970s, volatility of the dollar became the main problem for everyone. This was compounded by the fact that the US was no longer constrain­ed by a gold peg and could merrily print as many dollars as it wanted to.
 
The impact was quickly felt on inter­est rates of the major trading countries, namely, US, Japan and Western Europe. Inflation became a permanent feature, along with unemployment and declining productivity.

 
The 1980s then saw the growth of what is called financialisation where firms make money by trading in money rather than goods and services. That aspect has become permanent in the West.
 
The freely floating exchange rates also put a lot of pressure on developing countries, and those that did not manage their finances well — like practically the whole of Latin America and Africa — went into prolonged negative growth.
 
In the 1990s, the same aspects of the world economy led to the Asian crisis.
 
In 2008, the western economies fell before the tsunami of dollars.

 
So half a century out, it's hard to say if the Nixon “shokku”, as the Japanese called it, has helped or not. To be sure, it has been instrumental in making world output grow faster and to an unprecedented level.
 
But that success has come at a cost: financial stability.
 
 

Japan’s response to doru shokku
 
Japan was the hardest hit by the sudden repudiation by the US of its promise. The doru shokku (dollar shock) would eventually force the Japanese to revalue the yen. It went from 350 to the dollar to around 290-300. But in late 1971, Japan was as furious as it was shell-shocked. Costlier exports meant a huge hit on the profits of its industries. In the event it had no choice.

To compensate, the Japanese companies became even more efficient and by the mid-1980s had the US in panic over the flood of imports. That’s what led to the Plaza Accord of 1985 over the dollar-yen rate. After 1991, the Japanese economy went into steady state low growth.

It’s still there.