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The Nixon Shock was a series of economic measures taken by United States President Richard Nixon in 1971 including unilaterally canceling the direct convertibility of the United States dollar to gold. It helped end the existing Bretton Woods system of international financial exchange, ushering in the era of freely floating currencies that remains to the present day.
In 1944, the Bretton Woods system fixed exchange rates based on the U.S. dollar, which was redeemable for gold by the U. S. government at the price of $35 per ounce. Thus, the United States was committed to backing every dollar overseas with gold. Other currencies were fixed to the dollar, and the dollar was pegged to gold.
For the first years after World War II, the Bretton Woods system worked well. With the Marshall Plan Japan and Europe were rebuilding from the war, and foreigners wanted dollars to spend on American goods - cars, steel, machinery, etc. Because the U.S. owned over half the world's official gold reserves - 574 million ounces at the end of World War II - the system appeared secure.
However, from 1950 to 1969, as Germany and Japan recovered, the US share of the world's economic output dropped significantly, from 35 percent to 27 percent. Furthermore, a negative balance of payments, growing public debt incurred by the Vietnam War and Great Society programs, and monetary inflation by the Federal Reserve caused the dollar to become increasingly overvalued in the 1960s. The drain on US gold reserves culminated with the London Gold Pool collapse in March 1968.
By 1971, the money supply had increased by 10%. In May 1971, West Germany was the first to leave the Bretton Woods system, unwilling to devalue the Deutsche Mark in order to prop up the dollar. In the following three months, this move strengthened its economy. Simultaneously, the dollar dropped 7.5% against the Deutsche Mark. Other nations began to demand redemption of their dollars for gold. Switzerland redeemed $50 million in July. France acquired $191 million in gold. On August 5, 1971, the United States Congress released a report recommending devaluation of the dollar, in an effort to protect the dollar against "foreign price-gougers". On August 9, 1971, as the dollar dropped in value against European currencies, Switzerland left the Bretton Woods system. The pressure began to intensify on the United States to leave Bretton Woods.
To combat these issues, President Nixon consulted Federal Reserve chairman Arthur Burns, incoming Treasury Secretary John Connally, and then undersecretary for international monetary affairs and future Fed Chairman Paul Volcker.
On the afternoon of Friday, Aug. 13, 1971, these officials and other high-ranking White House and Treasury advisors met secretly with Nixon at Camp David. There was great debate about what Nixon should do, but ultimately Nixon, relying heavily on the advice of the self-confident Connally, decided to break up Bretton Woods by suspending the convertibility of the dollar into gold, freezing wages and prices for 90 days to combat potential inflationary effects, and impose an import surcharge of 10 percent. "Connally brilliantly packaged the program not as America abandoning its commitment to the gold standard but as America taking charge. He turned the dollar's collapse, which could have appeared shameful, into a moment of hubris."
To prevent a run on the dollar, stabilize the US economy, and decrease US unemployment and inflation rates, on August 15, 1971, Nixon issued Executive Order 11615, pursuant to the Economic Stabilization Act of 1970, which imposed a 90-day maximum wage and price ceiling, a 10% import surcharge and most importantly, "closed the gold window", ending convertibility between U.S. dollars and gold.
Speaking on television on a Sunday before the markets opened, Nixon said the following:
The third indispensable element in building the new prosperity is closely related to creating new jobs and halting inflation. We must protect the position of the American dollar as a pillar of monetary stability around the world.
In the past 7 years, there has been an average of one international monetary crisis every year...
I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States.
Now, what is this action — which is very technical — what does it mean for you?
Let me lay to rest the bugaboo of what is called devaluation.
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.
The American public felt the government was rescuing them from price gougers and from a foreign-caused exchange crisis. Politically, Nixon's actions were a massive success. The Dow rose 33 points the next day, its biggest daily gain ever at that point, and the New York Times editorial read, "We unhesitatingly applaud the boldness with which the President has moved."
By December 1971, the import surcharge was dropped as part of a general revaluation of the Group of Ten (G-10) currencies, which under the Smithsonian Agreement were thereafter allowed 2.25% devaluations from the agreed exchange rate. In March 1973, the fixed exchange rate system became a floating exchange rate system. The currency exchange rates no longer were governments' principal means of administering monetary policy.
The Nixon Shock has been widely considered to be a political success, but an economic mixed bag in bringing on the stagflation of the 1970s and leading to the instability of floating currencies. The dollar plunged by a third during the '70s, and in 1997 several Asian and Latin countries faced currency crises. Even to the present, Paul Volcker regrets the abandonment of Bretton Woods. "Nobody's in charge," Volcker says. "The Europeans couldn't live with the uncertainty and made their own currency and now that's in trouble."
In 1996, liberal economist Paul Krugman summarized the post-Nixon Shock era as follows:
The current world monetary system assigns no special role to gold; indeed, the Federal Reserve is not obliged to tie the dollar to anything. It can print as much or as little money as it deems appropriate. There are powerful advantages to such an unconstrained system. Above all, the Fed is free to respond to actual or threatened recessions by pumping in money. To take only one example, that flexibility is the reason the stock market crash of 1987—which started out every bit as frightening as that of 1929—did not cause a slump in the real economy.
While a freely floating national money has advantages, however, it also has risks. For one thing, it can create uncertainties for international traders and investors. Over the past five years, the dollar has been worth as much as 120 yen and as little as 80. The costs of this volatility are hard to measure (partly because sophisticated financial markets allow businesses to hedge much of that risk), but they must be significant. Furthermore, a system that leaves monetary managers free to do good also leaves them free to be irresponsible—and, in some countries, they have been quick to take the opportunity.
Debate over the Nixon Shock has persisted to the present day, with economists and politicians across the political spectrum trying to make sense of the Nixon Shock and its impact on monetary policy in the light of the recent financial crises. Conservative columnist David Frum sums up the situation this way:
The modern currency float has its problems. There is no magical monetary cure, monetary policy is a policy area almost uniquely crowded with trade-offs and lesser evils.
If you want a classical gold standard, you get chronic deflation punctuated by depressions, as the U.S. did between 1873 and 1934.
If you want a regime of managed currencies tethered to gold, you get regulations and controls, as the U.S. got from 1934 through 1971.
If you let the currency float, you get chronic inflation punctuated by bubbles, the American lot since 1971.
System 1 is incompatible with democracy, because voters won’t accept the pain inherent in a gold standard.
System 2 is incompatible with the free market economics I favor.
That leaves me with System 3 as the worst option except for all the others.