Uneasy Money

Today, Sunday, August 15, 2021, marks the 50th anniversary of the closing of the gold window at the US Treasury, at which a small set of privileged entities were at least legally entitled to demand redemption of dollar claims issued by the US government at the official gold price of $35 an ounce. (In 1971, as in 2021, August 15 fell on a Sunday.) When I started blogging in July 2011, I wrote one of my early posts about the 40^th anniversary of that inauspicious event. My attention in that post was directed more at the horrific consequences of Nixon’s decision to combine a freeze on wages and price with the closing of the gold window, which was clearly far more damaging than the largely symbolic effect of closing the gold window. I am also re-upping my original post with some further comments, but in this post, my attention is directed solely on the closing of the gold window.

The advent of cryptocurrencies and the continuing agitprop aiming to restore the gold standard apparently suggest to some people that the intrinsically trivial decision to do away with the final vestige of the last remnant of the short-lived international gold standard is somehow laden with cosmic significance. See for example the new book by Jeffrey Garten (Three Days at Camp David) marking the 50th anniversary.

About 10 years before the gold window was closed, Milton Friedman gave a lecture at the Mont Pelerin Society which he called “Real and Pseudo-Gold Standards“, which I previously wrote about here. Many if not most of the older members of the Mont Pelerin Society, notably (L. v. Mises and Jacques Rueff) were die-hard supporters of the gold standard who regarded the Bretton Woods system as a deplorable counterfeit imitation of the real gold standard and longed for restoration of that old-time standard. In his lecture, Friedman bowed in their direction by faintly praising what he called a real gold standard, which he described as a state of affairs in which the quantity of money could be increased only by minting gold or by exchanging gold for banknotes representing an equivalent value of gold. Friedman argued that although a real gold standard was an admirable monetary system, the Bretton Woods system was nothing of the sort, calling it a pseudo-gold standard. Given that the then existing Bretton Woods system was not a real gold standard, but merely a system of artificially controlling the price of a particular commodity, Friedman argued that the next-best alternative would be to impose a quantitative limit on the increase in the quantity of fiat money, by enacting a law that would prohibit the quantity of money from growing by more than some prescribed amount or by some percentage (k-percent per year) of the existing stock percent in any given time period.

While failing to win over the die-hard supporters of the gold standard, Friedman’s gambit was remarkably successful, and for many years, it actually was the rule of choice among most like-minded libertarians and self-styled classical liberals and small-government conservatives. Eventually, the underlying theoretical and practical defects in Friedman’s k-percent rule became sufficiently obvious to cause even Friedman, however reluctantly, to abandon his single-minded quest for a supposedly automatic non-discretionary quantitative monetary rule.

Nevertheless, Friedman ultimately did succeed in undermining support among most right-wing conservative, libertarian and many centrist or left-leaning economists and decision makers for the Bretton Woods system of fixed, but adjustable, exchange rates anchored by a fixed dollar price of gold. And a major reason for his success was his argument that it was only by shifting to flexible exchange rates and abandoning a fixed gold price that the exchange controls and restrictions on capital movements that were in place for a quarter of a century after World Was II could be lifted, a rationale congenial and persuasive to many who might have otherwise been unwilling to experiment with a system of flexible exchange rates among fiat currencies that had never previously been implemented.

Indeed, the neoliberal economic and financial globalization that followed the closing of the gold window and freeing of exchange rates after the demise of the Bretton Woods system, whether one applauds or reviles it, can largely be attributed to Friedman’s influence both as an economic theorist and as a propagandist. As much as Friedman deplored the imposition of wage and price controls on August 15, 1971, he had reason to feel vindicated by the closing of the gold window, the freeing of exchange rates, and, eventually, the lifting of all capital controls and the legalization of gold ownership by private individuals, all of which followed from the Camp David meeting.

But, the objective economic situation confronted by those at Camp David was such that the Bretton Woods System could not be salvaged. As I wrote in my 2011 post, the Bretton Woods system built on the foundation of a fixed gold price of $35 an ounce was not a true gold standard because a free market in gold did not exist and could not be maintained at the official price. Trade in gold was sharply restricted, and only privileged central banks and governments were legally entitled to buy or sell gold at the official price. Even the formal right of the privileged foreign governments and central banks was subject to the informal, but unwelcome and potentially dangerous, disapproval of the United States.

The gold standard is predicated on the idea that gold has an ascertainable value, so that if money is made exchangeable for gold at a fixed rate, money and gold will have an identical value owing to arbitrage transactions. Such arbitrage transactions can occur only if, and so long as, no barriers prevent effective arbitrage. The unquestioned convertibility of a unit of currency into gold ensured that arbitrage would constrain the value of money to equal the value of gold. But under Bretton Woods the opportunities for arbitrage were so drastically limited that the value of the dollar was never clearly equal to the value of gold, which was governed by, pardon the expression, fiat rather than by free-market transactions.

The lack of a tight link between the value of gold and the value of the dollar was not a serious problem as long as the value of the dollar was kept essentially stable and there was a functioning (albeit not freely) gold market. After its closure during World War II, the gold market did not function at all until 1954, so the wartime and postwar inflation and the brief Korean War inflation did not undermine the official gold price of $35 an ounce that had been set in 1934 and was maintained under Bretton Woods. Even after a functioning, but not entirely free, gold market was reopened in 1954, the official price was easily sustained until the late 1960s thanks to central-bank cooperation, whose formalization through the International Monetary Fund (IMF) was one of the positive achievements of Bretton Woods. The London gold price was hardly a free-market price, because of central bank intervention and restrictions imposed on access to the market, but the gold holdings of the central banks were so large that it had always been in their power to control the market price if they were sufficiently determined to do so. But over the course of the 1960s, their cohesion gradually came undone. Why was that?

The first point to note is that the gold standard evolved over the course of the eighteenth and nineteenth centuries first as a British institution, and much later as an international institution, largely by accident from a system of simultaneous gold and silver coinages that were closely but imperfectly linked by a relative price of between 15 to 16 ounces of silver per ounce of gold. Depending on the precise legal price ratio of silver coins to gold coins in any particular country, the legally overvalued undervalued metal would flow out of that country and the undervalued overvalued metal would flow into that country.

When Britain undervalued gold at the turn of the 18^th century, gold flowed into Britain, leading to the birth of the British of gold standard. In most other countries, silver and gold coins were circulating simultaneously at a ratio of 15.5 ounces of silver per ounce of gold. It was only when the US, after the Civil War, formally adopted a gold standard and the newly formed German Reich also shifted from a bimetallic to a gold standard that the increased demand for gold caused gold to appreciate relative to silver. To avoid the resulting inflation, countries with bimetallic systems based on a 15.5 to 1 silver/gold suspended the free coinage of silver and shifted to the gold standard further raising the silver/gold price ratio. Thus, the gold standard became an international not just a British system only in the 1870s, and it happened not by design or international consensus but by a series of piecemeal decisions by individual countries.

The important takeaway from this short digression into monetary history is that the relative currency values of the gold standard currencies were largely inherited from the historical definitions of the currency units of each country, not by deliberate policy decisions about what currency value to adopt in establishing the gold standard in any particular country. But when the gold standard collapsed in August 1914 at the start of World War I, the gold standard had to be recreated more or less from scratch after the War. The US, holding 40% of the world’s monetary gold reserves was in a position to determine the value of gold, so it could easily restore convertibility at the prewar gold price of $20.67 an ounce. For other countries, the choice of the value at which to restore gold convertibility was really a decision about the dollar exchange rate at which to peg their currencies.

Before the war, the dollar-pound exchange rate was $4.86 per pound. The postwar dollar-pound exchange rate was just barely close enough to the prewar rate to make restoring the convertibility of the pound at the prewar rate with the dollar seem doable. Many including Keynes argued that Britain would be better with an exchange rate in the neighborhood of $4.40 or less, but Winston Churchill, then Chancellor of the Exchequer, was persuaded to restore convertibility at the prewar parity. That decision may or may not have been a good one, but I believe that its significance for the world economy at the time and subsequently has been overstated. After convertibility was restored at the prewar parity, chronically high postwar British unemployment increased only slightly in 1925-26 before declining modestly until with the onset of the Great Deflation and Great Depression in late 1929. The British economy would have gotten a boost if the prewar dollar-pound parity had not been restored (or if the Fed had accommodated the prewar parity by domestic monetary expansion), but the drag on the British economy after 1925 was a negligible factor compared to the other factors, primarily gold accumulation by the US and France, that triggered the Great Deflation in late 1929.

The cause of that deflation was largely centered in France (with a major assist from the Federal Reserve). Before the war the French franc was worth about 20 cents, but disastrous French postwar economic policies caused the franc to fall to just 2 cents in 1926 when Raymond Poincaré was called upon to lead a national-unity government to stabilize the situation. His success was remarkable, the franc rising to over 4 cents within a few months. However, despite earlier solemn pledges to restore the franc to its prewar value of 20 cents, he was persuaded to stabilize the franc at just 3.92 cents when convertibility into gold was reestablished in June 1928, undervaluing the franc against both the dollar and the pound.

Not only was the franc undervalued, but the Bank of France, which, under previous governments had been persuaded or compelled to supply francs to finance deficit spending, was prohibited by the new Monetary Law that restored convertibility at the fixed rate of 3.92 cents from increasing the quantity of francs except in exchange for gold or foreign-exchange convertible into gold. While protecting the independence of the Bank of France from government fiscal demands, the law also prevented the French money stock from increasing to accommodate increases in the French demand for money except by way of a current account surplus, or a capital inflow.

Meanwhile, the Bank of France began converting foreign-exchange reserves into gold. The resulting increase in French gold holdings led to gold appreciation. Under the gold standard, gold appreciation is manifested in price deflation affecting all gold-standard countries. That deflation was the direct and primary cause of the Great Depression, which led, over a period of five brutal years, to the failure and demise of the newly restored international gold standard.

These painful lessons were not widely or properly understood at the time, or for a long time afterward, but the clear takeaway from that experience was that trying to restore the gold standard again would be a dangerous undertaking. Another lesson that was intuited, if not fully understood, is that if a country pegs its exchange rate to gold or to another currency, it is safer to err on the side of undervaluation than overvaluation. So, when the task of recreating an international monetary system was undertaken at Bretton Woods in July 1944, the architects of the system tried to adapt it to the formal trappings of the gold standard while eliminating the deflationary biases and incentives that had doomed the interwar gold standard. To prevent increasing demand for gold from causing deflation, the obligation to convert cash into gold was limited to the United States and access to the US gold window was restricted to other central banks via the newly formed international monetary fund. Each country could, in consultation with the IMF, determine its exchange rate with the dollar.

Given the earlier experience, countries had an incentive to set exchange rates that undervalued their currencies relative to the dollar. Thus, for most of the 1950s and early 1960s, the US had to contend with a currency that was overvalued relative to the currencies of its principal trading partners, Germany and Italy (the two fastest growing economies in Europe) and Japan (later joined by South Korea and Taiwan) in Asia. In one sense, the overvaluation was beneficial to the US, because access to low-cost and increasingly high-quality imports was a form of repayment to the US of its foreign-aid assistance, and its ongoing defense protection against the threat of Communist expansionism , but the benefit came with the competitive disadvantage to US tradable-goods industries.

When West Germany took control of its economic policy from the US military in 1948, most price-and-wage controls were lifted and the new deutschmark was devalued by a third relative to the official value of the old reichsmark. A further devaluation of almost 25% followed a year later. Great Britain in 1949, perhaps influenced by the success of the German devaluation, devalued the pound by 30% from old parity of $4.03 to $2.80 in 1949. But unlike Germany, Britain, under the postwar Labour government, attempting to avoid postwar inflation, maintained wartime exchange controls and price controls. The underlying assumption at the time was that the Britain’s balance-of-payments deficit reflected an overvalued currency, so that devaluation would avoid repeating the mistake made two decades earlier when the dollar-pound parity had overvalued the pound.

That assumption, as Ralph Hawtrey had argued in lonely opposition to the devaluation, was misguided; the idea that the current account depends only, or even primarily, on the exchange rate abstracts from the monetary forces that affect the balance of payments and the current account. Worse, because British monetary policy was committed to the goal of maximizing short-term employment, the resulting excess supply of cash inevitably increased domestic spending, thereby attracting imports and diverting domestically produced products from export markets and preventing the devaluation from achieving the goal of improving the trade balance and promoting expansion of the tradable-goods sector.

Other countries, like Germany and Italy, combined currency undervaluation with monetary restraint, allowing only monetary expansion that was occasioned by current-account surpluses. This became the classic strategy, later called exchange-rate protection by Max Corden, of combining currency undervaluation with tight monetary policy. British attempts to use monetary policy to promote both (over)full employment subject to the balance-of-payments constraint imposed by an exchange rate pegged to the dollar proved unsustainable, while Germany, Italy, France (after De Gaulle came to power in 1958 and devalued the franc) found the combination of monetary restraint and currency undervaluation a successful economic strategy until the United States increased monetary expansion to counter chronic overvaluation of the dollar.

Because the dollar was the key currency of the world monetary system, and had committed itself to maintain the $35 an ounce price of gold, the US, unlike other countries whose currencies were pegged to the dollar, could not adjust the dollar exchange rate to reduce or alleviate the overvaluation of the dollar relative to the currencies of its trading partners. Mindful of its duties as supplier of the world’s reserve currency, US monetary authorities kept US inflation close to zero after the 1953 Korean War armistice.

However, that restrained monetary policy led to three recessions under the Eisenhower administration (1953-54, 1957-58, and 1960-61). The latter recessions led to disastrous Republican losses in the 1958 midterm elections and to Richard Nixon’s razor-thin loss in 1960 to John Kennedy, who had campaigned on a pledge to get the US economy moving again. The loss to Kennedy was a lesson that Nixon never forgot, and he was determined never to allow himself to lose another election merely because of scruples about US obligations as supplier of the world’s reserve currency.

Upon taking office, the Kennedy administration pressed for an easing of Fed policy to end the recession and to promote accelerated economic expansion. The result was a rapid recovery from the 1960-61 recession and the start of a nearly nine-year period of unbroken economic growth at perhaps the highest average growth rate in US history. While credit for the economic expansion is often given to the across-the-board tax cuts proposed by Kennedy in 1963 and enacted in 1964 under Lyndon Johnson, the expansion was already well under way by mid-1961, three years before the tax cuts became effective.

The international aim of monetary policy was to increase nominal domestic spending and to force US trading partners with undervalued currencies either to accept increased holdings of US liabilities or to revalue their exchange rates relative to the dollar to diminish their undervaluation relative to the dollar. Easier US monetary policy led to increasing complaints from Europeans, especially the Germans, that the US was exporting inflation and to charges that the US was taking advantage of the exorbitant privilege of its position as supplier of the world’s reserve currency.

The aggressive response of the Kennedy administration to undervaluation of most other currencies led to predictable pushback from France under de Gaulle who, like many other conservative and right-wing French politicians, was fixated on the gold standard and deeply resented Anglo-American monetary pre-eminence after World War I and American dominance after World War II. Like France under Poincaré, France under de Gaulle sought to increase its gold holdings as it accumulated dollar-denominated foreign exchange. But under Bretton Woods, French gold accumulation had little immediate economic effect other than to enhance the French and Gaullist pretensions to grandiosity.

Already in 1961 Robert Triffin predicted that the Bretton Woods system could not endure permanently because the growing world demand for liquidity could not be satisfied by the United States in a world with a relatively fixed gold stock and a stable or rising price level. The problem identified by Triffin was not unlike that raised by Gustav Cassel in the 1920s when he predicted that the world gold stock would likely not increase enough to prevent a worldwide deflation. This was a different problem from the one that actually caused the Great Depression, which was a substantial increase in gold demand associated with the restoration of the gold standard that triggered the deflationary collapse of late 1929. The long-term gold shortage feared by Cassel was a long-term problem distinct from the increase in gold demand caused by the restoration of the gold standard in the 1920s.

The problem Triffin identified was also a long-term consequence of the failure of the international gold stock to increase to provide the increased gold reserves that would be needed for the US to be able to credibly commit to maintaining the convertibility of the dollar into gold without relying on deflation to cause the needed increase in the real value of gold reserves.

Had it not been for the Vietnam War, Bretton Woods might have survived for several more years, but the rise of US inflation to over 4% in 1968-69, coupled with the 1969-70 recession in an unsuccessful attempt to reduce inflation, followed by a weak recovery in 1971, made it clear that the US would not undertake a deflationary policy to make the official $35 gold price credible. Although de Gaulle’s unexpected retirement in 1969 removed the fiercest opponent of US monetary domination, confidence that the US could maintain the official gold peg, when the London gold price was already 10% higher than the official price, caused other central banks to fear that they would be stuck with devalued dollar claims once the US raised the official gold price. Not only the French, but other central banks were already demanding redemption in gold of the dollar claims that they were holding.

An eleventh-hour policy reversal by the administration to save the official gold price was not in the cards, and everyone knew it. So all the handwringing about the abandonment of Bretton Woods on August 15, 1971 is either simple foolishness or gaslighting. The system was already broken, and it couldn’t be fixed at any price worth pondering for even half an instant. Nixon and his accomplices tried to sugarcoat their scrapping of the Bretton Woods System by pretending that they were announcing a plan that was the first step toward its reform and rejuvenation. But that pretense led to a so-called agreement with a new gold-price peg of $38 an ounce, which lasted hardly a year before it died not with a bang but a whimper.

What can we learn from this story? For me the real lesson is that the original international gold standard was, to borrow (via Hayek) a phrase from Adam Ferguson: “the [accidental] result of human action, not human design.” The gold standard, as it existed for those 40 years, was not an intuitively obvious or well understood mechanism working according to a clear blueprint; it was an improvised set of practices, partly legislated and partly customary, and partially nothing more than conventional, but not very profound, wisdom.

The original gold standard collapsed with the outbreak of World War I and the attempt to recreate it after World War I, based on imperfect understanding of how it had actually functioned, ended catastrophically with the Great Depression, a second collapse, and another, even more catastrophic, World War. The attempt to recreate a new monetary system –the Bretton Woods system — using a modified feature of the earlier gold standard as a kind of window dressing, was certainly not a real gold standard, and, perhaps, not even a pseudo-gold standard; those who profess to mourn its demise are either fooling themselves or trying to fool the rest of us.

We are now stuck with a fiat system that has evolved and been tinkered with over centuries. We have learned how to manage it, at least so far, to avoid catastrophe. With hard work and good luck, perhaps we will continue to learn how to manage it better than we have so far. But to seek to recreate a system that functioned fairly successfully for at most 40 years under conditions not even remotely likely ever again to be approximated, is hardly likely to lead to an outcome that will enhance human well-being. Even worse, if that system were recreated, the resulting outcome might be far worse than anything we have experienced in the last half century.