The Burden of Bretton Woods
When President Nixon took office in 1969, inflation, excessive balance of payments deficits and a dwindling gold supply placed significant pressure on the value of the U.S. dollar and the American economy. It was due to these factors that President Nixon made one of his most consequential decisions in office. On August 15, 1971, in an address to a national television audience, he shocked the world with an announcement that the United States would no longer honor its commitment to redeem dollars for gold, effectively ending the era established at Bretton Woods, an agreement developed at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire in 1944. His decision, backed by his most senior economic advisors, initiated the era of the American fiat currency and a global floating exchange rate.
Some context is required to understand why President Nixon made this decision. Since 1945, the Bretton Woods monetary management system established rules for commercial and financial relations among western nations. It pegged each nation’s currency to gold by a fixed exchange rate and enabled an international monetary advisory council called the International Monetary Fund (IMF) to bridge temporary imbalances of payments.
Following World War II, war-ravished and destitute countries needed access to liquidity to recover from their economic malaise. Because of its ample gold supply and its post-war global position, the United States agreed to act as the world reserve currency and as the anchor of the new international monetary system. In essence, the U.S. became the de facto post-war financier of world production.
For the next twenty years, the world experienced an era of substantial economic growth, spurred by high demand for the American dollar and a post-war liberal trade policy. For a time, this system worked well. A U.S. balance of payments deficit (a calculation of dollars spent on imports, foreign military engagements, and foreign aid minus exports) 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 — so much so that dollar circulation far outstripped the U.S. gold supply. There simply was not enough gold to back excessive liquidity, making it evident that the U.S. dollar was overvalued.
Because the Bretton Woods system barred the United States from revaluing its currency, the Nixon administration pressured world leaders to revalue their currency. Their requests were heeded by some but ignored by others. Countries such as Japan were reluctant to do so lest they jeopardize their competitive export industry. As a result, countries began holding more and more U.S. dollars as reserve assets to maintain their value. By the mid 1960s, this practice was global; a third of the total market-economy reserves were held in reserve currency, a majority being made up of U.S. dollars.
At the cusp of the new decade, excessive deficits and dwindling confidence in the U.S. dollar not only threatened the American economy but the world financial order. The uneasiness surrounding the leading currency prompted private financial holders to exchange their dollars for gold. Central Banks quickly followed, with Japan and France leading the way. In the second week of August 1971, the British ambassador appeared before the United States Treasury and asked that $3 billion be converted into gold to act as “cover” for all their dollar assets. It was then, in the midst of impending economic calamity, that Nixon had to confront the major crisis.
Three choices stood before the president. If the U.S. obliged, it would have set off further requests for conversions. If they refused, it would be a blatant admission that the U.S. could not honor its commitment to convert dollars to gold. The third choice was aimed at taking the international financial situation head on and one in which President Nixon chose to follow — the closing of the “gold window,” or in other words, suspending the convertability of the dollar into gold.
In choosing the third option, President Nixon did what he believed best protected American interests. Either this or let the dollar get pummeled by foreign speculation and watch idly as American enterprise keel over.
Granted, the dollar did depreciate some after this decision, but President Nixon avoided delving deeper into a destructive currency war. Surely, this would have done more significant damage, perhaps even precipitating the complete collapse of the U.S. dollar and causing a detrimental realignment of the international economic system — a situation the U.S. president would have wanted to avoid at the height of the Cold War.