Policymakers can learn from Nixon's 'dollar shock'

The decision in 1971 to suspend the convertibility of the US dollar into gold has lessons for addressing the challenges faced by the modern international economic system.

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Professor Catherine Schenk

Former Associate Fellow, Global Economy and Finance Programme

US president Richard Nixon shocked the world 50 years ago by suspending the convertibility of the US dollar into gold and threatening trade restrictions unless other countries agreed to adjust their exchange rates to the advantage of US exporters.

A highly radical move born out of frustration with close allies and leading trade partners, it overturned structures the US had established at Bretton Woods in 1944 and was designed to shift the onus of adjustment in the pegged exchange rate system from deficit countries to surplus countries.

In effect, Nixon threatened a return to trade protectionism unless West Germany and Japan, among others, increased the value of their own currencies against the US dollar. US Treasury Secretary John Connally even told other G10 countries that the dollar ‘is our currency, but it’s your problem’.

The initial response was to try patching up the existing system. After months of negotiation, finance ministers and central bankers of the world’s richest countries met in December 1971 at the Smithsonian Institution in Washington and agreed on a reform package.

The Smithsonian Agreement effectively devalued the US dollar by 8.57 per cent with a change in the price of gold from $35 to $38 per ounce – although direct convertibility into gold was not actually restored – and by 12.5 per cent against currencies of its major trading partners.

Preserving pegged exchange rates

The architects of the agreement hoped new parities would enhance the competitiveness of US exports sufficiently to resolve its chronic balance of payments deficit, while preserving pegged exchange rates was viewed as essential to a well-functioning international monetary system.

The long-term consequences of both the Nixon shock itself and the way the aftermath was managed is still seen in today’s system of floating exchange rates operating within a context of almost unrestricted private capital flows

This was despite a growing body of academic opinion in favour of more flexible or floating exchange rates to allow greater national policy autonomy, and the growing weight of international capital flows which could no longer be contained through exchange controls.

But market confidence in the new rates quickly deteriorated. Within six months the British government had to abandon its new peg and move to a floating regime, while European governments and central banks planned to establish a regional fixed exchange rate system. Support for a global fixed rate system finally collapsed in early 1973 as the Yen and European currencies floated free from their dollar pegs.

The ‘Nixon shock’ of 1971 marked an abrupt turn in American international policy, reflecting the failure of the Kennedy/Johnson strategy of negotiation and a new administration that was much less inclined to be conciliatory with major allies.

The robust ‘America first’ international policy stance was driven by domestic political pressures linked to the Vietnam war and an era of protest, as well as enormous economic challenges which built up in the US through the 1960s, including rising inflation and fiscal deficits – in part due to spending in the war. When Nixon issued his ultimatum on the dollar, he also introduced domestic wage and price freezes.

Paradoxically, Nixon’s move led initially to a broadening of participation in the reform process at the International Monetary Fund (IMF). The Committee of 20 countries deliberated over proposals to reform the international monetary system from 1972-1974, ultimately leading to the IMF abandoning gold as its main numeraire in favour of a reformed Special Drawing Right (SDR).

But many of their other proposals were never implemented and, with the establishment of the G7 Finance Ministers in 1976, the main oversight of the global currency system moved to a much smaller group.

The shock’s legacy

The long-term consequences of both the Nixon shock itself and the way the aftermath was managed is still seen in today’s system of floating exchange rates operating within a context of almost unrestricted private capital flows. Established in an unplanned way, this has clearly enhanced the global economy’s flexibility to respond to shocks but leaves plenty of scope for improvement.

These lessons are important for the many reform challenges in today’s broader international economic system

The system continues to rely on the US dollar as the dominant reserve currency and suffers from the persistent risk of exchange rate overshooting or destabilising capital flows particularly for developing economies. It also relies on ad hoc measures such as bilateral dollar swaps or limited scale IMF and regional liquidity arrangements, rather than having a comprehensive financial safety net.

The system remains vulnerable to exploitation by organized crime and its governance arrangements have failed to keep pace with the shifting balance of economic weight in the global economy. They may also struggle to adapt quickly to new issues such as the international implications of central bank digital currencies and the enhanced role of central banks in financing government deficits.

Now, 50 years on from the cathartic experience of the Nixon shock, there are three important lessons for policymakers.

First is that any system of multilateral economic cooperation needs to work sufficiently well for all participants, otherwise it will not be sustained and problems become worse if allowed to fester.

Back then, governments trying to work out how to respond to a growing US deficit tried to kick the can down the road and were insufficiently flexible and appreciative of others’ positions. If a sustainable deal had been struck earlier, arguably all would have been better off.

The second lesson is that any serious reform effort following a crisis must address the fundamental factors that brought the system down, otherwise the solution will not be sustainable and could lead to an even messier and more intractable situation. Although the economic tools were available, the architects of the Smithsonian Agreement failed to be radical enough to reflect the new situation the world faced with a rapid rise in private capital mobility.

Third, while it may require a small and focused group of countries to come up with a reform plan, it is critical there is wide support across the international community if the proposed approach is to be lasting. Efforts by the G7 to reform the international monetary system such as to build a better global financial safety net have often foundered on this point.

How to tackle reform

These lessons are important for the many reform challenges in today’s broader international economic system. For example, it is in China’s long-term interest to recognize that the US and other western economies may not support the World Trade Organization (WTO) system indefinitely unless gaps in the current rules on state subsidies are addressed.

Similarly, climate negotiators preparing for COP26 should recognise that compromising on radical measures needed to secure a credible path to global net zero by 2050 would only lead to a much messier and more costly set of measures being required later on. Moreover, by that time the damage to global prospects could be irreversible.

And the advanced and emerging economies seeking to shape a new global system for digital governance need to design a system that accommodates their different human rights, privacy, and national security concerns while maximising the economic benefit available to be shared by all - this may require a radically new global architecture quite unlike anything seen to date.

If the world can learn the lessons of the Nixon shock and apply them to today’s practical problems in international economic policy, it would add another element to that flawed president’s international legacy.