August 15, 1971 may not exactly be a day that will live in infamy, but it is hardly a day to celebrate 40 years later. It was the day on which one of the most cynical Presidents in American history committed one of his most cynical acts: violating solemn promises undertaken many times previously, both before and after his election as President, Richard Nixon declared a 90-day freeze on wages and prices. Nixon also announced the closing of the gold window at the US Treasury, severing the last shred of a link between gold and the dollar. Interestingly, the current (August 13th, 2011) Economist (Buttonwood column) and Forbes (Charles Kadlec op-ed) and today’s Wall Street Journal (Lewis Lehrman op-ed) mark the anniversary with critical commentaries on Nixon’s action ruefully focusing on the baleful consequences of breaking the link to gold, while barely mentioning the 90-day freeze that became the prelude to comprehensive wage and price controls that were imposed after the freeze expired.
Of the two events, the wage and price freeze and subsequent controls had by far the more adverse consequences, the closing of the gold window merely ratifying the demise of a gold standard that long since had ceased to function as it had for much of the 19th and early 20th centuries. In contrast to the final break with gold, no economic necessity or even a coherent economic argument on the merits lay behind the decision to impose a wage and price freeze, notwithstanding the ex-post rationalizations offered by Nixon’s economic advisers, including such estimable figures as Herbert Stein, Paul McKracken, and George Schultz, who surely knew better, but somehow were persuaded to fall into line behind a policy of massive, breathtaking, intervention into private market transactions.
The argument for closing the gold window was that the official gold peg of $35 an ounce was probably at least 10-20% below any realistic estimate of the true market value of gold at the time, making it impossible to reestablish the old parity as an economically meaningful price without imposing an intolerable deflation on the world economy. An alternative response might have been to officially devalue the dollar to something like the market value of gold $40-42 an ounce. But to have done so would merely have demonstrated that the official price of gold was a policy instrument subject to the whims of the US monetary authorities, undermining faith in the viability of a gold standard. In the event, an attempt to patch together the Bretton Woods System (the Smithsonian Agreement of December 1971) based on an official $38 an ounce peg was made, but it quickly became obvious that a new monetary system based on any form of gold convertibility could no longer survive.
How did the $35 an ounce price became unsustainable barely 25 years after the Bretton Woods System was created? The problem that emerged within a few years of its inception was that the main trading partners of the US systematically kept their own currencies undervalued in terms of the dollar, promoting their exports while sterilizing the consequent dollar inflow, allowing neither sufficient domestic inflation nor sufficient exchange-rate appreciation to eliminate the overvaluation of their currencies against the dollar. After a burst of inflation in the Korean War, the Fed’s tight monetary policy and a persistently overvalued exchange rate kept US inflation low at the cost of sluggish growth and three recessions between 1953 and 1960. It was not until the Kennedy administration came into office on a pledge to get the country moving again that the Fed was pressured to loosen monetary policy, initiating the long boom of the 1960s long before the Kennedy tax cuts were posthumously enacted in 1964.
Monetary expansion by the Fed reduced the relative overvaluation of the dollar in terms of other currencies, but the increasing export of dollars left the $35 an ounce peg increasingly dependent on the willingness of foreign government to hold dollars. However, President Charles de Gaulle of France, having overcome domestic opposition to his rule, felt secure enough to assert French interests against the US, resuming the traditional French policy of accumulating physical gold reserves rather than mere claims on the gold held by someone else. By 1967 the London gold pool, a central bank cartel acting to control the price of gold in the London gold market, was collapsing, as France withdrew from the cartel, demanding that gold be shipped to Paris from New York. In 1968, unable to hold down the market price of gold any longer, the US and other central banks let the gold price rise above the official price, but agreed to conduct official transactions among themselves at the official price of $35 an ounce. As market prices for gold, driven by US monetary expansion, inched steadily higher, the incentives for central banks to demand gold from the US at the official price became too strong to contain, so that the system was on the verge of collapse when Nixon acknowledged the inevitable and closed the gold window rather than allow US gold holdings to be depleted.
Assertions that the Bretton Woods system could somehow have been saved simply ignore the economic reality that by 1971 the Bretton Woods System was broken beyond repair, or at least beyond any repair that could have been effected at a tolerable cost.
But Nixon clearly had another motivation in his August 15 announcement, less than 15 months before the next Presidential election. It was in effect the opening shot of his reelection campaign. Remembering all too well that he lost the 1960 election to John Kennedy because the Fed had not provided enough monetary stimulus to cut short the 1960-61 recession, Nixon had appointed his long-time economic adviser, Arthur Burns to replace William McChesney Martin as chairman of the Fed in 1970. A mild tightening of monetary policy in 1969 as inflation was rising above a 5% annual rate, had produced a recession in late 1969 and early 1970, without providing much relief from inflation. Burns eased policy enough to allow a mild recovery, but the economy seemed to be suffering the worst of both worlds — inflation still near 4 percent and unemployment at what then seemed an unacceptably high level of almost 6 percent.
With an election looming ever closer on the horizon, Nixon in the summer of 1971 became consumed by the political imperative of speeding up the recovery. Meanwhile a Democratic Congress, assuming that Nixon really did mean his promises never to impose wage and price controls to stop inflation, began clamoring for controls as the way to stop inflation without the pain of a recession, even authorizing the President to impose controls, a dare they never dreamed he would accept. Arthur Burns, himself, perhaps unwittingly, provided support for such a step by voicing frustration that inflation persisted in the face of a recession and high unemployment, suggesting that the old rules of economics were no longer operating as they once had. He even offered vague support for what was then called an incomes policy, generally understood as an informal attempt to bring down inflation by announcing a target for wage increases corresponding to productivity gains, thereby eliminating the need for businesses to raise prices to compensate for increased labor costs. What such proposals usually ignored was the necessity for a monetary policy that would limit the growth of total spending sufficiently to limit the growth of wage incomes to the desired target.
Having been persuaded that there was no acceptable alternative to closing the gold window — from Nixon’s perspective and from that of most conventional politicians, a painfully unpleasant admission of US weakness in the face of its enemies (all this was occurring at the height of the Vietnam War and the antiwar protests) – he decided that he could now combine that decision, sugar-coated with an aggressive attack on international currency speculators and a protectionist 10% duty on imports into the United States, with the even more radical measure of a wage-price freeze to be followed by a longer-lasting program to control price increases, thereby snatching the most powerful and popular economic proposal of the Democrats right from under their noses. Meanwhile, with the inflation threat neutralized, Arthur Burns could be pressured mercilessly to increase the rate of monetary expansion, ensuring that Nixon could stand for reelection in the middle of an economic boom.
But just as Nixon’s electoral triumph fell apart because of his Watergate fiasco, his economic success fell apart when an inflationary monetary policy combined with wage and price controls to produce increasing dislocations, shortages and inefficiencies, gradually sapping the strength of an economic recovery fueled by excess demand rather than increasing productivity. Because broad based, as opposed to narrowly targeted, price controls tend to be more popular before they are imposed than after (as too many expectations about favorable regulatory treatment are disappointed), the vast majority of controls were allowed to lapse when the original grant of Congressional authority to control prices expired in April 1974.
Already by the summer of 1973, shortages of gasoline and other petroleum products were becoming commonplace, and shortages of heating oil and natural gas had been widely predicted for the winter of 1973-74. But in October 1973 in the wake of the Yom Kippur War and the imposition of an Arab Oil Embargo against the United States and other Western countries sympathetic to Israel, the shortages turned into the first “Energy Crisis.” A Democratic Congress and the Nixon Administration sprang into action, enacting special legislation to allow controls to be kept on petroleum products of all sorts together with emergency authority to authorize the government to allocate products in short supply.
It still amazes me that almost all the dislocations manifested after the embargo and the associated energy crisis were attributed to excessive consumption of oil and petroleum products in general or to excessive dependence on imports, as if any of the shortages and dislocations would have occurred in the absence of price controls. And hardly anyone realizes that price controls tend to drive the prices of whatever portion of the supply is exempt from control even higher than they would have risen in the absence of any controls.
About ten years after the first energy crisis, I published a book in which I tried to explain how all the dislocations that emerged from the Arab oil embargo and the 1978-79 crisis following the Iranian Revolution were attributable to the price controls first imposed by Richard Nixon on August 15, 1971. But the connection between the energy crisis in all its ramifications and the Nixonian price controls unfortunately remains largely overlooked and ignored to this day. If there is reason to reflect on what happened forty years ago on this date, it surely is for that reason and not because Nixon pulled the plug on a gold standard that had not been functioning for years.