Our Currency, Your Problem – The 1971 Nixon Shock
“The dollar is our currency, but it’s your problem.” Sounds familiar? This is not someone saying it today, but this remark, which caused tremors in the world of finance was from Richard Nixon’s treasury secretary John Connally, made after discussions with a group of European finance ministers during the 1971 G10 Rome meetings. Connally’s Candor was startling to the audience at the time, but as he told Nixon, “My philosophy, Mr. President, is that all foreigners are out to screw us and it’s our job to screw them first”. For people following Trump’s “Liberation Day” saga, there was and there is nothing new about the US promoting its own interests by exploiting the dollar’s reserve-currency status.
So, what was the context for Connoly’s statement? What we are seeing today is many ways a replay of what happened 54 years ago, when the US president Richard Nixon shocked the world by suspending the convertibility of the US dollar into gold and threatening trade restrictions unless other countries agreed to adjust their exchange rates to the advantage of US exporters. This was at the time considered to be a radical move that was born out of perceived injustice from close allies and leading trade partners.
What Nixon did overturned the very same structures that the US had established at Bretton Woods in 1944 and was designed to shift the onus of adjustment in the pegged exchange rate system from deficit countries to surplus countries. Nixon threatened a return to trade protectionism unless West Germany and Japan, who were the primary targets and others, increased the value of their own currencies against the US dollar. Shortly after Nixon’s announcement, Connally was confronted by furious European leaders whose countries were holding huge reserves of US Treasury Bills, and all these countries has built their entire post-war monetary and financial systems on the premise that the dollar was as good as gold. So, when Connally made his (in)famous statement, he was only half right. The inflation that Europeans feared would savage their dollar reserves was not very good for Americans either, a lesson that Americans might relearn painfully in the coming years.
The world we live in and our financial system of the past five decades is an outcome and consequence of Nixon’s decision. Today’s system of floating exchange rates operating within a context of almost unrestricted private capital flows is a product of the fall-out, adjustments and evolution in the aftermath, in a decade full of Geopolitical shocks and economic volatility. It set the US dollar on a radically new course and reshaped the economies globally.
But what triggered this move from Nixon?
It was the three days at Camp David in August 1971 that set the tone for Nixon’s announcements and what followed. It was a meeting that changed the course of history and ushered in a new era of financial globalization on a scale we had never experienced before. Nixon had with him - Treasury Secretary John Connally, Federal Reserve Chairman Arthur Burns, Chairman of the CEA Paul McCracken, Director of the OMB George Shultz, and White House Chief of Staff H. R. Haldeman. They were joined by - Undersecretary of the treasury Paul Volcker, advisors for international economic affairs Peter Peterson and Herbert Stein along with John Ehrlichman, director of the White House Domestic Council. Only a few of them knew the specific agenda, but everyone knew that this was something momentous. As George Shultz would say a day before to Nixon, “This is the biggest step in economic policy since the end of World War II.”
To understand what Shultz said, we need to step back and take a broader historic perspective. It was a moment when the United States began to rethink its role in the world, a realization that it could no longer shoulder all the burdens that were thrust on it after the Bretton Woods Summit in 1944. It was America’s attempt to redistribute part of its acquired responsibilities to its allies. It was a moment when the US was forced to recognize and accept its growing interdependence with other countries and the need to move from using its unilateral leverage to engaging in more multilateral diplomacy and cooperation. Above all it was about the US Dollar and Gold. As in today, the dollar was then the central issue at the intersection of foreign policy, national security, and international commerce.
Post the end of WW II in 1945, the western world including Japan was governed by the monetary management system established at the Bretton Woods summit in 1944, which defined the rules for commercial and financial relations among western nations. It pegged each nation’s currency to gold by a fixed exchange rate and enabled IMF to bridge any temporary imbalances of payments. The underlying idea was that of a global financial system, with exchange rates that couldn’t fluctuate against one another beyond 1 percent, and with rates that were tied ultimately to gold, would provide the stable platform for countries to trade with each other. As the reconstruction and economic recovery efforts in Europe and Asia gathered steam, these countries needed access to liquidity and due to its dominant economic status and ample gold supply, the dollar became the world’s reserve currency and the anchor of a new international monetary system and by default the US became the post-war financier of world production.
The world saw a golden period of economic growth and prosperity in the two decades following the war and this in turn spurred a high demand for the American dollar. For a time, this system worked well, and a US balance of payments deficit was welcomed as a way to offset the dollar shortage. But by the 1960s, the expansion of global production and trade increased the amount of dollars circulated worldwide to a point where the dollars circulated far outstripped the US gold supply. There simply was not enough gold to back excessive liquidity, making it evident that the dollar was overvalued.
A major contradiction was inadvertently built into the new dollar-centered global monetary system. The underlying assumption in the 1940s and early 1950s was that as the world economy recovered from the war, the economies of Western Europe and Japan would resume their growth and that international trade would expand accordingly. This revival would require more capital, much of which would come from the United States in the form of dollars. However, the more dollars that circulated, the more the law of supply and demand would cause each dollar to be worth less to those who used it. Over time, therefore, a fundamental readjustment of the Bretton Woods monetary system, based on the centrality of the dollar, would inevitably be required. In other words, the postwar monetary arrangement contained the seeds of its own demise. Many Americans advising the leaders understood this, but economic practicality and expediency got caught in a web of superpower status and ambitions. There seemed to be no other alternative than protecting the system and in fact, the dollar-gold link was enthusiastically supported time and again in public statements by Presidents Kennedy and Johnson. Both leaders saw a strong, stable dollar as the backbone of America’s leadership of the free world.
Well before the Camp David meeting, the writing was on the wall. It had become clear to many and in particular countries like France and UK that the United States had nowhere near enough gold reserves to make good on its commitments. Americans had been on a spending spree, flooding the world with dollars through the Marshall Plan, other foreign aid, military commitments and through the growing foreign investments of US MNC’s. But the supply of gold was not increasing at nearly the same rate as the dollar outflow and a major gap emerged between America’s gold reserves and official holdings of dollars held abroad, dollars held by central banks and governments that were eligible to be convertible into the precious metal. The gold drain relative to the dollars circulating outside the United States was dramatic. In 1955, the United States had enough gold, $21.7 billion worth at the $35 price, to cover its liabilities which totalled $13.5 billion. But by 1971, America had just $10.2 billion worth of gold, compared to official foreign dollar holdings of $40 billion, only 25 percent of what it needed to make good on its commitment to exchange gold for dollars.
Today we use the phrase “Exorbitant Privilege” to highlight the role and place of the dollar in the international monetary system. The term was coined in the 1960s by Valéry Giscard d'Estaing, then the French Minister of Finance. Today, we see and hear about China dumping US Treasuries to reduce its reliance on the dollar, but a similar situation played out in the 1960’s and it was France which set the wheels in motion.
The French have a term for the golden period of economic growth that followed the end of WWII - "les Trente Glorieuses" (The Thirty Glorious Years), referring to the 30-year period from 1945 to 1975, a time of rapid and sustained economic growth. As a result of this strong economic growth, in the decade from 1958 through 1968, France had a balance of payments surplus, accumulating large international reserves, majority of which were held in dollars. In 1961, advisors to Charles De Gaulle, theorized that Bretton Woods would not survive because central banks eventually would be unwilling to hoard dollars as the US was running out of gold and they would be forced to either devalue the dollar against gold or suspend gold convertibility. Their fears were based on a historic precedence of what happened in 1931, when the UK devalued sterling against gold in a similar fashion, causing the Banque de France (BdF) to suffer a loss of 2.35 billion French francs, twice the size of its capital.
Ever since De Gaulle again became the president of France in 1959, he and his most influential economic advisor Jaques Rueff were vocal critics of Bretton Woods and America’s “exorbitant privilege.” De Gaulle, whose problems with the United States originated in his dealing with Roosvelt in the aftermath of the war, opined that American imperialism supported its capital export and according to him,
· “Western Europe has become an American protectorate without even realizing it. We must now rid ourselves of their domination. But the difficulty here is that the colonized don't really want to emancipate themselves. Since the end of the war, the Americans have subjugated us painlessly and without much resistance.”
For De Gaulle, gold was also a tool to push back on America’s quest for domination, in which the dollar played a key role. He began to worry about the French gold reserves held in the US and demanded that all of it was to be repatriated to Paris believing that any gold held abroad could be used as leverage against France. To enable this, he authorized a secret operation “Vide-Gousset” that was launched in September 1963 to repatriate 400 tonnes of gold from New York. Between 1963 and 1966, France repatriated 3,313 tonnes of gold reserves from the vaults of the Federal Reserve in New York and the Bank of England in London. All France’s dollars were converted into gold, and it took 44 boat trips and 129 flights to bring home more than three thousand tonnes of gold to the Banque de France in Paris. In hindsight, France’s decision turned out extremely well. As was foreseen by the French, the price of gold in dollars increased sharply, from $35 to $800 dollars an ounce, from 1968 until 1980 and the dollar lost 96% of its value against gold.
But the real triggers for Nixon’s decisions came in 1971. The list of countries demanding US gold during July 1971 included Switzerland, which sought to convert $50 million of its holding to gold and France, which converted $191 million into gold and these transactions were confirmed by the Federal Reserve on July 21 and further noted that In August the UK and France will be converting a further $638 million and $600 million equivalent. But what really spooked the Americans was when in August 1971 the French government’s frustrations with American policies boiled over and they made a public statement of its unhappiness about it and President George Pompidou ordered a destroyer to sail to New Jersey to redeem US dollars for gold held at Fort Knox, as was his right under Bretton Woods. To add fuel to the fire, immediately following the French decision, in early August 1971, the British ambassador appeared before the United States Treasury and asked that $3 billion be converted into gold to act as a cover for all their dollar assets. It was then, in the midst of impending economic calamity, that Nixon had to confront the major crisis.
When President Nixon took office in 1969, inflation, excessive BOP deficits and a dwindling gold supply placed significant pressure on the value of the dollar and the American economy. Although President Nixon was more circumspect than his predecessors, he let the status quo to continue and never wavered from America’s commitment to the existing system and emphasized America’s determination to keep the dollar strong, and its commitment to the dollar-gold link. Even at the time of the Camp David meeting in August 1971, for the governments and investors around the world, the $35 dollar-gold link was seen as being sacrosanct and this perception gave other nations confidence to keep accumulating dollars with the assurance that they would always be able to cash them for gold.
As the Pax Americana’s burdens accumulated, Nixon believed that the United States could no longer afford to be a benefactor to its allies and according to him, the time for a reconsideration of priorities and an adjustment of responsibilities had arrived. The pursuit of national economic interests would have to play a far more important role in America’s foreign policy in the future. In a move to achieve his aim, he invited Peter Peterson to join his White House staff as director of the Council on International Economic Policy. In 1971, Peterson published an analysis titled “The United States in a Changing World Economy,” or simply, the Peterson Report. According to the report:
· “American growth rates had lagged behind West European and Japanese rates since the early 1950s, but the productivity gap had widened since the mid-1960s, which suggested that something more than postwar catch-up was going on: the Europeans and Japanese had caught up, and they were continuing to pull ahead. US manufacturers now accounted for just 31 percent of the world’s automobile production, down from 76 percent in 1949–50. Far from being the “arsenal of democracy,” as Franklin Roosevelt had envisaged, the United States was looking increasingly like a rentier superpower, Peterson concluded, “engaged largely in services, drawing income from foreign investments, and importing more goods than it exports.”
Peterson’s conclusions caught the attention of a president who viewed the world economy as an arena for competition and struggle. Nixon administration concluded that national decline was a consequence of monetary arrangements that overvalued the dollar and disadvantaged US exporters. American renewal hinged on the quest for a dollar devaluation, which would reflect changes in the real economic capacities of the industrialized countries, restore America’s competitive edge, and resolve the crises that had afflicted the international monetary system. To achieve the desired devaluation, Nixon was willing to take drastic measures, even to sever the dollar’s relationship to gold, which anchored the international monetary order since the mid-1940s.
The Camp David summit resulted in the approval of three emergency initiatives:
First, America with immediate effect would impose a 10 percent surcharge on imports into the United States.
Second, it would establish a system of formal wage-price controls to limit increases in consumer prices and workers’ wages, thereby restraining inflation across the US economy.
Third, it would slam the gold window shut, meaning that the dollar would no longer be convertible to gold.
Together, these measures would create a new US policy, the New Economic Policy, which Nixon compared to its “Opening of China”. While Nixon fancied himself a decisive president, it was the market circumstances that had determined the timing of the Camp David summit. The Treasury had announced on August 7 that the United States had recently sustained gold-reserve losses of more than $1 billion, news that increased the likelihood of further officialgold conversions and the US faced an imminent dollar crisis. To thwart it, Nixon closed the gold window and together with the import surcharge, this action promised to arrest the drain on US gold reserves and provide Washington with a lever, the import surcharge, to compel its trading partners to accept American demands. Nixon demonstrated little interest in the economic intricacies of the package, but he was aware of its political potency and its implications for the allies.
As was expected, the reaction from America’s trading partners was one of extreme concern about possible financial chaos, mixed with a certain resignation about the impending change. They were also angered about the abrupt, unilateral nature of the US decision. Vacationing Japanese officials were called back to Tokyo, Canadian prime minister Pierre Trudeau abruptly ended his cruise off Yugoslavia to rush back to Ottawa, and French president Georges Pompidou hurried back to Paris from the French Riviera.
In Japan, the stock market dropped 20 percent during the first week. Japan kept its currency markets open, and it continued to buy dollars and sell yen in order to prevent the dollar from sinking and the yen from rising with the goal of maintaining the earlier peg that had prevailed. This frenetic buying lasted about two weeks and proved too costly, as they had to sell government securities to buy about $3–$4 billion. But the markets had their own thinking and no amount of purchasing dollars could prevent it from sinking against the yen, because global markets were forcing a de facto dollar devaluation by selling it in all markets. In Europe, after a public holiday on the 15th, the following day, stock markets crashed everywhere and countries decided to keep the foreign exchange markets closed for two weeks, during which time they hoped to sort out the wreckage. Within two weeks, both Japan and Europe allowed their currencies to float, but within limits, intervening regularly to keep their currencies from strengthening too much and too fast against the dollar.
There was also rising anger and opposition to investment tax credits that would be available only to US firms and not to foreign-owned operations within the United States. This was viewed as a discriminatory measure and these kind of trade and investment provisions heightened anxiety by rekindling memories of the economic warfare that characterized much of the 1930s and eventually led to WWII. As one Japanese official put it, “The Japanese were too naïve in believing President Johnson and President Nixon when they repeatedly pledged that the United States would not devalue the dollar”. He recalled how, at the Munich bankers’ meeting just eleven weeks before the Camp David meeting, Secretary Connally had publicly repeated the pledge not to devalue. The Japanese could understand the closing of the gold window, but they never thought the United States would seek to break the fixed link of 360 yen to $1 that had been in effect for almost two decades.
Concerns mounted globally about what would happen next as the existing global framework for trade and investment seemed to be breaking and big questions loomed about America’s commitment to maintaining a multilateral system of free trade and capital flows, or was it retreating with the goal of redefining its interest in a much more nationalist way? Once an exchange rate alignment took place, did Washington intend to return to fixed exchange rates and dollar being backed by gold, or did it have a totally different idea of floating rates in which gold didn’t play any role? There was universal opposition to the import surcharge and coming from the world’s leading evangelist of free trade and its indeterminate nature caused resentment as it reeked of odious American power play that could backfire and usher in an era of protectionism.
After the initial recriminations subsided, there was a concerted effort to try and patch-up the existing system that had been in place since the Bretton Woods summit in 1944. After months of negotiation, finance ministers and central bankers of the world’s richest countries met in December 1971 at the Smithsonian Institution in Washington and agreed on a reform package, in what came to be known as “The Smithsonian Agreement”. While the convertibility to Gold was not restored, the US dollar was devalued by 8.57 per cent with a change in the price of gold from $35 to $38 per ounce, and by 12.5 per cent against currencies of its major trading partners.
The weekend in August 1971, during which a small group of men decided to sever the relationship between the dollar and gold was a critical turning point for the modern global economy. These actions led to the led to the most significant structural changes that concerned the dollar and the international monetary system after the 1944 Bretton Woods Summit. As Jeffrey Garten noted in his book, Three Days at Camp David:
· “The fact is that the international monetary system is always evolving. The geopolitical context changes. The markets themselves are growing bigger and more complex. A major challenge to the world is how to adapt to these changes. Can they be done smoothly, or are major disruption and political conflict inevitable? In the summer of 1971, Washington decided that brute unilateral force was the only way to effect change. It was a gamble, to be sure, but it worked.”
It is funny saying this after more than five decades of Nixon shock. While the entire world criticized and cursed Nixon for his unilateral actions, the irony is that the world that the Western liberal establishment is grieving over today came into being because of Nixon Shock. While pundits and experts are admonishing Trump over his brute tactics and delivering a rude shock to the world economy, they are forgetting that what is passing, came into being because of another president’s readiness to deliver an even ruder shock. It was the Nixon Shock that gave birth to the three darlings of the past five decades: neoliberalism, financialisation and globalisation.
Despite all the concerns, criticisms and the gloom, the US and the dollar continued to reign supreme, with all the associated economic and foreign policy benefits. Despite the choppy waters for the dollar after August 15, 1971, the dollar still accounts for about 60 percent of all foreign exchange reserves in central banks and is by far the most important currency in international trade and lending, while the US Treasury bonds and bills were considered the world’s safest financial asset. The dollar demand was universal as globalization spread its wings post the turbulent decade of 1970’s, which allowed the US to finance its deficits with considerable ease and at low interest rates. In foreign policy, the dollar has remained a central part of the United States image and soft power.
What happened in 1971 has many parallels with what is happening today and a number of issues confronting America today. Then, as now, the United States was asking itself the most basic questions about its place in the world. By the late 1960s and early 1970s, prominent politicians and ordinary citizens alike were convincing themselves that America gave much more than it received from the burdens of its leadership role. Then, as now, America was pushing for a trading system it deemed to be fairer to the United States. Then, as now, Washington was unhappy that its responsibilities for maintaining political alliances imposed too heavy an economic cost on it. In Nixon’s time and in ours, therefore, Washington was pressuring its NATO allies to contribute more to the common military defense. Then, as now, Americans are unsure of how to respond to increasing globalization, including growing trade imbalances, job-competing imports, and the outsourcing of jobs to foreign countries by multinational corporations, all in their early stages in the 1970s but nevertheless already contentious. In Nixon’s time, America’s allies worried Washington would turn inward, becoming nationalistic and protectionist and the same fears have risen again. In 1971, many said the dollar was “overvalued,” causing imports to be too cheap and exports to be too expensive, the same charge frequently made over the past few years
As Jeffrey Garten notes, there are also big differences between the early 1970s and now:
· It might appear that the Nixon administration was taking the initial steps of the America-first policy that has returned in acute form in the years of President Trump. But what began in 1971 as a harsh, unilateral set of actions to sever the dollar–gold relationship actually had the effect of increasing America’s involvement in the global economy, expanding its investment in international organizations, and deepening international coordination between the United States and its allies. Even though Washington had delivered a severe shock to Western Europe and Japan, Nixon never contemplated abandoning the principle of working closely with America’s partners to deal with problems through consultation. In 1971, Washington never eschewed the idea that more rather than less trade was good. It continued to search for a better system for managing currencies and never lost sight of the fact that, over time economic and political ties became intertwined and strengthened their economies. This pattern of cooperation among the United States, Western Europe, Japan and other countries lasted for over four decades.
The outcome of the Trump Shock and liberation day policies will depend on whether it has the staying power. His constant flip-flop has created an atmosphere of extreme uncertainty and mistrust with allies and others alike. It will also need bipartisan support, which does not seem forthcoming. After all, Nixon’s equivalent shock worked because president Jimmy Carter appointed Volcker to the Federal Reserve and allowed him to continue the Nixon project unhindered and later president Ronald Reagan turbocharged it further with the help of Alan Greenspan whom he appointed in 1987 to succeed Volcker.