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Devaluing the Dollar: the Legacy of the End of Bretton Woods

A dollar under the gold standard

A gold standard 1928 US dollar bill. Note it is identified as a “United States Note” rather than a Federal Reserve Note.

In August of 1971 President Richard Nixon set off a chain of events that remain relevant to economic systems around the world: he ended the Bretton Woods system of fixed exchange rates by closing “the gold window,” eliminating the ability of dollar holders to convert the US currency into gold. According to President Nixon in his speech announcing the move, this was done to protect the United States and the U.S. dollar:

In recent weeks, the speculators have been waging an all-out war on the American dollar. The strength of a nation’s currency is based on the strength of that nation’s economy – and the American economy is by far the strongest in the world. Accordingly, I have directed the Secretary of the Treasury to take the action necessary to defend the dollar against the speculators. I have directed Secretary Connally to suspend temporarily the convertibility of the American dollar except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States.

Monetary authorities around the world reacted quickly and in December of that same year they met at the Smithsonian Institution in the hopes of breathing some life back into the monetary rule that had guided international economic exchange since the end of World War II. The Smithsonian Agreement provided a mechanism by which the United States would allow for the convertibility of gold at a devalued rate—changing the value of gold from $35 per ounce to $38 per ounce. This devaluation—the first since 1934 when the Gold Reserve Act decreased the gold content of dollar coins—went into effect this day, on April 3, 1972.

This was a coordinated devaluation but in the end it was a default by the United States government. By closing the gold window and devaluing the dollar the US government reneged on its obligation to maintain a stable and convertible currency. The Smithsonian Agreement did little to shore up international faith in the ability of the US to back the world’s monetary system and eventually, in 1973, the Bretton Woods system officially came to an end. The move to a generalized system of floating exchange rates provided the United States with temporary relief from the economic pressures associated with the guarantee of convertibility at a fixed price. As the exchange rates of America’s major trading partners were also able to float the relative value of the dollar declined bringing with it a reduction in the US trade imbalance.

While restoring the US’s balance of payments the move off of gold was roundly criticized in some quarters as a strategy that would debase the currency, destroy US economic credibility and usher in hyper-inflation. While the US economy did experience rapid inflation it is unclear whether this was due to the closing of the Gold Window or to the large deficits associated with the war in Vietnam and LBJ’s Great Society programs.

The US monetary system today is one based on fiat money whereby the value of the currency is not based on the price of an underlying commodity. Rather, the value of the US dollar is a matter of faith—faith that the US government will honor its commitment to the creation of a stable and non-inflationary supply of dollars. Some argue that this commitment is questionable, pointing to historically low US interest rates, high deficits and a lack of political will to manage taxation and spending. Others argue that given the size of the US economy there is no alternative, as a return to gold would mean that the supply of gold would place an upper limit on the bounds of US economic activity.

It is interesting that criticism of US monetary policy have not taken greater hold during the economic crisis that began in 2007. The value of the US dollar has dropped precipitously versus all major trading partners and every other week the experiment with a single currency in Europe gets called into question. Certainly Presidential candidates like Ron Paul and Rick Perry have taken pot shots at the Federal Reserve but only Paul has openly called into question the continued use of fiat money. The arguments that fiat money lead to debt and deficits to currency speculation and inflation have largely been overshadowed by the fact that tying a currency to gold places an economy in what Thomas Friedman has described as a “Golden Straitjacket” that allows a government no flexibility to use monetary policy in the face of a crisis. 

As your country puts on the Golden Straitjacket, two things tend to happen: your economy grows and your politics shrinks…the Golden Straitjacket narrows the political and economic policy choices of those in power to relatively tight parameters.

With a return to gold the government would have a limited ability to respond to a natural disaster, an economic downturn or a foreign conflict. That outcome may be desirable by some but not by the vast majority of elected politicians who have to deliver benefits to their constituents in order to get re-elected.

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