A Day of Infamy August 15th, 1971
By Tony Allison, August 20, 2007
"In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value” – Allan Greenspan in The Objectivist newsletter published in 1966.
Last Wednesday, August 15th, was a significant anniversary, known only to a few. This was the day, 36 years ago, that President Richard Nixon “closed the gold window” by Executive Order. That meant that foreign countries could no longer exchange their dollar reserves for gold. This decision was made without consulting members of the international monetary system or even conferring with the State Department. It was thought to be merely a political slap at French president Charles DeGaulle, who was demanding gold for France’s dollar reserves. As of that day, the US dollar (and the world’s reserve currency) became a fiat currency, which enabled its creation in unlimited amounts.
Few Americans likely cared or noticed, since it had been illegal to privately hold gold (except collectable coins) since Franklin Roosevelt shut the domestic “gold window” in 1933, which Mr. Greenspan referred to in the above 1966 quote. However, by January 1975, Americans could once again own gold without restriction.
In August of '71, Watergate was still just an unknown hotel complex in Washington D.C. But while the Watergate break-in ten months later would ultimately shake up the world, Nixon’s actions regarding gold on August 15th, 1971 went relatively unnoticed. The big news was Nixon declaring wage and price controls the same day. Someday, historians may look at that date a little differently.
Note the acceleration in the money supply after the early 1970’s.
More than 100 years of stable purchasing power
“It was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, has allowed a persistent over issuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess." — Fed Chairman Alan Greenspan before the Economic Club of New York, New York City December 19, 2002 "Issues for Monetary Policy"
While an amusingly ironic quote, Mr. Greenspan doesn’t give deserved credit to the Federal Reserve for starting the inflation wheels turning in 1913. Throughout the 19th century and into the early 20th century, the inflation rate in the United States was essentially zero. Admittedly, there were nasty bouts of inflation (particularly during the Civil War when the U.S. went off the gold standard), as well as periods of deflation. But in the aggregate, a dollar in 1929 could buy approximately the same amount of goods or services as in 1800. Money in those days was “as good as gold” since one could redeem the paper note for gold at a fixed rate at the local bank.
Using a small measure of common sense, one would think that a system that kept price levels absolutely flat for over 100 years might be worth revisiting. The only problem, fiat currency means immense power to those in control of it. Why would politicians ever want to loosen their grip on the power of the purse?
The Corrosive Effects of Inflation
Over time, the inflationary implications of this decision, and its effects on the purchasing power of the dollar would greatly affect America’s middle class. Looking back into the dark ages of the 1950’s and 1960’s, one-income middle class families lived fairly well (albeit in smaller homes and without today’s gadgets), built savings for retirement, paid off their mortgages, and college-educated their children without massive loans. Is this feasible today for most two-income families? Not a chance. It’s a good thing inflation has been “under control” since 1982.
In recent years, inflation has not been a topic of national interest, but it may be in the years ahead as hugely excessive liquidity (fiat dollars printed at a much faster rate than GDP growth) seeps into many areas of the economy beyond real estate. American families are currently “saving” through inflation-driven gains in home equity. Liquidity had been pouring into housing in recent years, creating inflated prices, but no real wealth.
As the air is now rapidly exiting the real estate bubble, housing values are likely to revert back to their historic trend line, and the “savings” of millions of Americans will vaporize. Unfortunately, so may the dream homes of many overleveraged souls with variable, negative amortization loans. That process seems to now be underway.
Is the Middle Class Better Off Than in 1960?
The middle class family in 1960 may not have been as blessed with the technological advances available to the middle class family today, but it was blessed with much less debt, and much more purchasing power. The same is true for the retired seniors in 1960. And unfortunately, the ultimate price for all those years of fiat currency-driven inflation has likely yet to be paid.
The CPI doesn’t measure housing inflation (only owner’s equivalent rent). If it did, the inflation rate wouldn’t be quite so benign.
A Mountain of Debt
Much of the American public appears prosperous, but it’s an illusory prosperity, built on a growing mountain of debt. It takes the form of over-leveraged homes, cars, boats, credit-cards and college loans. When the aggregate debt reaches an unsustainable level, the piper will be paid as the system rebalances. But that process is likely to cause much unnecessary and far-reaching pain. Lives will be changed, futures de-railed.
Of even more concern is the enormous trade deficit created in recent decades. Currently, in excess of $2 trillion in US government debt alone is held in foreign hands (17% of GDP). These imbalances are also unsustainable. When the dollars come marching home, as foreign sources spend them or diversify, our exported inflation will march home as well.
Foreign holdings of US securities have doubled since 2002. The last time foreigners owned so much US debt (as a % of GDP) was in the mid-19th century, when Europeans bought state and corporate bonds for the construction of highways, canals and railroads, according to Professor Alan Taylor, professor of Economic History at UC Davis. Unfortunately, the trillions in foreign debt held today have mostly financed consumption, not our national infrastructure, which is aging and looking increasingly fragile.
With a gold-backed dollar, the Federal Reserve would have been constrained from flooding the globe with excessive liquidity. Politicians will always seek self-preservation by the spending and channeling of money. The only way to control the money supply is to take that power out of politics with a self-correcting system. With a gold-backed dollar, GDP growth may have been slower since 1971, but it would have been sustainable. Debt would likely be much lower, as would inflation. People could plan their lives with much more certainty than today. The growing mountain of overhanging debt is our “Sword of Damocles.” Someday, unfortunately, the sword will fall.
Guns and Butter
Perhaps our ambitions were too great. As with most politicians throughout history, ours desired both guns and butter. Spending generously at home and financing wars abroad. A fiat dollar made it all too easy to have both.
Our dynamic and entrepreneurial economy has kept the growth engine chugging these past 36 years. However, if you’ve noticed, our economy has inexorably moved toward a financial economy; workers creating and selling paper to each other. Looking back through the ages, prosperity has been created through saving, investing and building. Today’s “modern” service economy is more geared toward consuming, leveraging and trading paper. This does not seem to be a magic formula for long-term prosperity.
The “Permanent” Debt Ceiling
In March 1971, six months before Nixon closed the gold window, the "permanent" U.S. debt ceiling had been frozen at $US 400 billion. By 1982, U.S. funded debt had tripled to about $US 1.25 trillion, while the "permanent" debt ceiling still stood at $US 400 billion. The debt ceiling rises since 1971 had been officially designated as "temporary." In late 1982, the U.S. Treasury eliminated the difference between the "temporary" and the "permanent" debt ceiling.
The way was thus cleared for the subsequent explosion in U.S. debt. And as the world's reserve currency, this opened the gates for a global debt explosion as well. Today our once permanent debt ceiling of $400 billion is approximately $9 trillion and counting. Our debt “ceiling” appears to be expanding much like the universe after the Big Bang.
Central Banks Still Pouring on Liquidity
Within the last few weeks, central banks around the world have injected hundreds of billions (soon to be trillions) of dollars of liquidity into the credit markets in response to the spreading sub prime contagion. This will likely mean more inflation in the pipeline, and less buying power for the beleaguered dollar down the road. And we have no way of knowing if the central banks are finished, or just getting warmed up. The secular move in tangible assets may just be warming up as well.
At some point, rising interest rates, rising debt service, and rising inflation will likely come home to roost. It didn’t necessarily have to be that way. Perhaps Presidents Ford or Carter would have ultimately closed the gold window anyway, but the infamy of August 15th, 1971 will forever reside with Richard M. Nixon. I recall a bumper sticker from the 1972 presidential campaign that read “Nixon’s the One.” Well, he was indeed.
My guess is that before the 50th anniversary rolls around in 14 years, some modified form of gold-backed currency will be in place for global commerce. My hope is that it’s the U.S. dollar and not the Chinese Yuan.
Stocks fluctuated Monday mildly as investors appeared relieved that more bad news didn't emerge about sub prime mortgages and tightening in the credit markets. Treasury bonds, which have rallied in recent weeks as investors fled to safe-haven securities, continued to move higher Monday. Bond prices moved opposite their yields. Yields on the benchmark 10-year Treasury bond fell to 4.63 percent from 4.68 late Friday, while the shorter-duration notes such as the 3-year T bill saw yields fall sharply.
The Dow Jones Industrial Average ended at 13121.35, up 42.27. The S&P500 ended down .39 at 1445.55. The Nasdaq settled at 2508.59, up 3.56.
At the market open Monday, the Fed also announced it injected another $3.5 billion into the banking system. The central bank has infused the market with nearly $120 billion of liquidity since last week.
Natural-gas futures dropped nearly 14% Monday to close at their lowest level in a month, and crude futures fell more than 1% as traders registered relief that Hurricane Dean will likely spare key energy-production facilities in the Gulf of Mexico.
Wishing you a good evening,
© 2007 Tony Allsion