Editor’s Note: The following excerpt is adapted from The Gold Standard: Retrospect and Prospect, by Peter C. Earle and William J. Luther, to be published by The American Institute of Economic Research on August 15, 2021.
Fifty years ago, President Richard Nixon closed the gold window, thereby preventing foreign governments from converting U.S. dollars into gold. This action was initially billed as a temporary measure. “I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets,” Nixon told a television audience. Indeed, he vowed to “press for the necessary reforms to set up an urgently needed new international monetary system” in “full cooperation with the International Monetary Fund and those who trade with us.” It soon became clear, however, that convertibility would not be reestablished. The U.S. would not work with other nations to establish a new international monetary system. Instead, the now-irredeemable dollar would continue to serve as the global reserve currency.
Nixon understood the role of gold in anchoring the price level and naturally worried that his unanticipated announcement would raise concerns about inflation. “Let me lay to rest the bugaboo of what is called devaluation,” he said at the time.
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.
Monetary policy, in other words, would ensure the domestic price level remained stable.
As with his commitment to set up a new international monetary system, Nixon’s promise of domestic price-level stability would not be kept. Inflation, which had averaged just 2.85 percent from Q3-1961 to Q3-1967, increased to 7.12 percent over the decade that followed. It was also quite volatile. Inflation soared to 12.30 percent in Q4-1974, fell to 4.10 percent in Q2-1976, and climbed back up to 10.96 percent in Q1-1981. Inflation has slowed in the years that followed, averaging nearly 3.25 percent since Nixon closed the gold window. Nonetheless, monetary policy has generally failed to produce the long-run purchasing-power stability of a genuine gold-backed money.
The Bretton Woods system, which Nixon unilaterally ended, was itself a far cry from a genuine gold standard. Anticipating the conclusion of World War II, 730 delegates from 44 Allied nations gathered in the White Mountain resort town of Bretton Woods, N.H., in July 1944 to discuss the future of the international monetary system. The system they came up with — a gold-exchange standard — fixed the exchange rates of each participating country’s money to the U.S dollar, with the dollar convertible to gold. The dollar’s convertibility was limited, however. U.S. citizens were not permitted to redeem their dollars for gold, as they had been prior to 1933. And foreign governments redeemed dollars for gold only intermittently.
By limiting redemption, the Bretton Woods system significantly curtailed the historical check on over-issuing paper money. Prior to the creation of the Federal Reserve system, private state-chartered and then national-chartered banks issued redeemable banknotes. These banks were contractually and legally obliged to pay the bearer on demand. Under this system, an over-issuing bank would see its notes spent and then deposited in other banks. These other banks, in turn, would bring the notes back to the over-issuing bank or common clearinghouse for redemption. As a result, the over-issuing bank would suffer adverse clearings and, hence, lose gold reserves to other banks. Lest it soon find itself without reserves, the over-issuing bank would be forced to correct. And, recognizing the consequences of over-issuing in advance, banks would try to avoid the prospect altogether.
Lacking an effective redemption mechanism, the Bretton Woods system permitted the U.S. to issue more notes than it could reasonably be expected to redeem. And the U.S. did just that. Increased expenditures during the Vietnam War and President Johnson’s Great Society programs saw the U.S. create more and more dollars and, correspondingly, find it more and more difficult to honor its commitments under the Bretton Woods system. Nixon cited growing inflation and instability as reasons to end the gold-exchange standard. But the fateful decision was to move toward a fiat monetary system rather than return to a genuine gold standard.
The designers of the Bretton Woods system understood the importance of fixed exchange rates for promoting international trade and the historical role gold had played in stabilizing the price level. But the system they ultimately adopted was not a genuine gold standard, governed by market discipline. It was a gold-exchange standard, dependent on government technocrats. Despite the best of intentions, therefore, the Bretton Woods system was fatally flawed.
There is little hope of tying the dollar to gold today. Politicians prefer the loose constraint of fiat money, which serves as a steady source of revenue in normal times and a convenient tool to reduce the real value of government debt outstanding in extraordinary times. Nonetheless, we would do well to remember what seemed so clear to those at Bretton Woods — and take steps not to repeat their mistakes in our own efforts to improve the monetary system.
William J. Luther is an associate professor of economics at Florida Atlantic University and director of the American Institute for Economic Research’s Sound Money Project. Peter C. Earle is a research fellow at the American Institute for Economic Research.