Fifty years ago, on August 15, 1971, US President Richard Nixon abandoned the gold standard. In fact, this did not happen overnight; in fact, the global monetary system was no longer backed by gold, but by the US dollar by 1973.
We use this system to this day. What did she give us, and what will happen next? Why has the Bretton Woods system always been imperfect?
Shortly before the end of World War II (in July 1944, to be precise), politicians of the US allies, in particular John Maynard Keynes, who worked on behalf of the UK Treasury Department, met in the American city of Bretton Woods to develop a new monetary system for post-war world.
Without going into details, let’s say that as a result, the US dollar was pegged to gold, and everything else was pegged to the US dollar. The International Monetary Fund and the World Bank were also established.
The dollar was pegged to gold at $ 35 an ounce. Only central banks could buy or sell it – ordinary US citizens were prohibited from owning gold bars since the 1930s (this right was restored only in 1974).
The currencies of other allied countries were fixed against the dollar, although they could be adjusted within 1%. Also allowed “one-off” devaluations if necessary.
In fact, the system has been operating in full force since 1958; before that, the countries maintained their exchange rate regime. As a result, the full Bretton Woods system did not last as long as it might seem.
Problems arose almost immediately, and by 1968 the system was on the brink. In simple terms, the United States, which in many respects emerged as the only winner from the war, had a currency that was overvalued compared to the rest of the world at the start.
In part, this was done precisely with the aim of rebuilding Europe. And this is normal, because the United States had about three-quarters of the world’s gold reserves, so the dollar had enough supply and demand from people who needed American currency to exchange it for American goods and services.
But as the world rebuilt after the war, the United States lost dominance in terms of its share of global GDP and became much less competitive in terms of exports. So at a time when more and more dollars were leaving the territory of the United States in the form of demand for imports, other countries began to need less of the American currency.
Thus, converting US dollars into gold has become “more expedient,” according to the Federal Reserve History website. In 1960, there was a surge in the price of precious metals in the London gold market, and in this connection in 1961 the leading central banks of the world decided to create the London Gold Pool. Basically, it was a price-fixing mechanism whereby central banks sold gold on the open market to keep the price at $ 35 an ounce.
In 1962, the US Federal Reserve also had to establish currency swap lines with foreign central banks to protect its gold reserves while maintaining a fixed exchange rate system.
Meanwhile, under President Lyndon Johnson in 1964, the US embarked on a “full-time” course. This meant a much softer inflationary monetary policy. The Vietnam War also entailed large government spending. And all of this meant an increase in the global dollar supply.
The threat of a gold price hike was enough to delay the gold rush
By 1965, the amount of dollars in foreign institutions that could theoretically be exchanged for US gold reserves surpassed the actual amount of gold held by the States.
Thus, by 1968, as Adrian Ash, the head of BullionVault’s analytical service, put it, the gold standard system was “out of touch with reality, but crashed into it, confusing everyone.”
By 1971, the US was facing high demand for its gold reserves (which France most needed, although Britain was also in line), as well as rising inflation and weak growth. Nixon wanted to be re-elected as president in 1972, so he had to do something.
Thus, using the traditional scapegoat of “international money speculators”, he told the American people in a televised address on Sunday night (thereby postponing the recurrence of the Klondike gold rush) that he was “temporarily” suspending the conversion of dollars into gold.
Among other things, he introduced price and wage controls. Curiously, in his 18-minute address, the word “gold” is mentioned only once. We remember this to this day, and it is what made the biggest impact in the long run.
The US stock market was very pleased with this move. The next day on Monday, it rose 3%. This may sound surprising since it was a pretty radical decision, but abandoning the gold standard meant looser monetary policy, and we know the markets love it.
In late 1971, a brief attempt was made to restore the US currency to $ 38 per ounce of gold. In other words, breaking this bond was seen as a way of devaluing the dollar to a more manageable level, rather than ending the Bretton Woods system altogether.
However, by February 1973, the US had depreciated again to $ 42.22, and the actual price of gold was already much higher than on the open market. In March 1973, the fixed exchange rate system was abandoned and gold ceased to be an official part of the world monetary system.
Three important lessons learned from leaving the gold standard
So what do investors need to understand from this? There is a lot to be said here, but rather than delving deeper into the mechanism of inflation or the implications of the abolition of the gold standard for the markets, here are three key points.
The first is that when the monetary system collides with reality, reality wins. The perceived advantage of the gold standard is that it establishes order. But when this order becomes too much, the gold standard is dropped (and this is clearly not the first time).
This is akin to the independent operation of a central bank. Central banks are independent exactly as long as they do not do something contrary to the wishes of the government.
Therefore, in difficult situations, the rules change. You cannot rely on old beliefs.
Second, the long-term is a series of short-term ones. Nixon did what many politicians understand: he wanted to be re-elected. His speech and the changes he made had such a geopolitical impact that we talk about them to this day, but Nixon was not aspiring to 2021, but to 1972.
Perhaps the Bretton Woods system was the best solution in those specific circumstances, but as the changes and peace were restored, it ceased to meet the requirements of reality.
There is something good for investors here. While the inflection point will always be difficult to identify (and may never be possible, even years after it occurs), the direction is often quite obvious, so you must be prepared for the inflection point if you think ahead.
Thirdly, continuing the previous point, let’s talk about currency eras. At first, the pound sterling was the global reserve currency, then the First World War began, then we had a transitional period, and after the Second World War, the US dollar took the dominant position. It is clear that the status of a reserve currency is associated with economic and military power.
However, this can create a false impression of periods of stagnation interspersed with world-historical shifts. After all, the reality is that the monetary system develops continuously and constantly.
Russell Napier’s book The Asian Financial Crisis states that the Asian crisis represented a major shift in the world’s monetary system, at least on the same scale as the Nixon Shock.
What’s next? Keep an eye on yuan and cryptocurrencies
Where are we going now? The obvious contenders for its big role in the global monetary architecture are the Chinese yuan and all kinds of digital currencies – from decentralized cryptocurrencies to CBDCs supported by the central bank (which are the absolute opposite of each other and which will surely fight for a place in the sun in the not too distant future).