Episode 1: The Gold Standard
Jim Grenn: What if you had to make a top 10 list of the most impactful people that shaped the world around you. Maybe your list would include an athlete, maybe a family member, maybe a musician, maybe a politician.
Few of you would include Paul Volcker on that list.
That would be a mistake.
Or would it?
In 1971, in a cabin in the Maryland mountains, Volcker was the point man on a decision to kill the gold standard, a decision that set into motion a series of falling dominos that altered the course of US monetary policy. Eight years later, he set into motion a series of unfortunate economic events that decimated the economy for an entire region. But Volcker isn’t the antagonist in the story. In many ways, he’s the hero… making brave and unpopular decisions that had to be made.
To an economist, Paul Volcker is a legend.
He was well educated, an Ivy league guy, from Princeton with a master’s from Harvard. He was quiet and fairly unassuming in personality, but Volcker was physically imposing. He stood 6′7′′ he was a former college basketball player and frequently smoked Cuban cigars. His unusual height had even kept him out of the military when he attempted to join, as it considered any height above 6′6 ′′ a physical impairment. When playing basketball also hadn’t panned out, Volcker had turned to life as a public servant.
As you'll see in coming weeks, his impact shaped the world around you.
Paul Volcker should be in top 10 list.
Over the next several episodes we will examine the impact of this series of falling dominos that had a ripple effect on the global economy. This is Domino.
I’m Jim Grenn, the host of Domino. Today we are going to examine the Nixon Shock – the circumstances around the surprise decision to abandon the gold standard and the transition to, seemingly, the oil standard. To really understand this story, we need a little background
Brady Raanes: Towards the end of WW2, delegates from 44 countries convened in a small mountain town in New Hampshire called Bretton Woods.
Jim Grenn: that’s Brady Raanes. He’ll fill in the details to the questions you may have.
Brady Raanes: These forty-four delegates agree to a new economic world order in something called the Bretton Woods agreement. One big takeaway was the dollar would be the world’s “reserve currency”, an important designation at the time.
Jim Grenn: And how did the US get this distinction?
Brady Raanes: The dollar was chosen as such for two reasons: The United States had been able to maintain their economic strength throughout the war and the United States had the largest gold stockpile in the world – an important consideration at the time.
Kent Oliver: People have always had something of an obsession with gold.
Jim Grenn: That’s Kent Oliver, He’ll paint a bigger picture for everything going on.
Kent Oliver: The interesting part is how the US came to have so much gold in the first place. I mean… the US government was flush with gold, a big reason being it was confiscated from Americans during the previous decade.
Jim Grenn: when you say confiscated…
Kent Oliver: well, Prior to the Great Depression, physical gold backed all US currency in circulation. Gold coins were still in circulation in the US, and anyone could exchange US currency for gold at a fixed rate of, at the time, $20.67 per ounce. When the stock market crashed and the demand for gold rose, people exchanged their dollars for it. Things got even worse as banks began to fail.
Jim Grenn: that makes sense – as fear grew, people decided that would rather hold gold than dollars.
Kent Oliver: Yeah, and people began to hoard more of the precious metal because they distrusted financial institutions. But in 1933 FDR takes office as president. One of the very first things he does is close the banks in response to a run on the gold reserves. By the time banks re-opened several days later, they had turned in all their gold to the Federal Reserve and could no longer redeem dollars for it. Less than a month later the president orders Americans to turn in their gold (except that used for jewelry). If you chose not to adhere to the order… the penalty was imprisonment.
Jim Grenn: that’s extreme…
Kent Oliver: This created the gold reserves at Fort Knox, and soon the US held the world’s largest supply of gold.
Brady Raanes: anyway, by 1944 – the US has more gold than anyone else, so the dollar is chosen as the world’s reserve currency.
Jim Grenn: There is something comforting about having a currency that is backed by something.
Brady Raanes: There was, and in many ways still is, this long held belief that a currency not backed by some physical commodity would eventually become worthless and cause hyperinflation. Which has been mostly true throughout history. It’s kinda sobering actually. But anyway, in this case, as long as governments could convert their reserves to gold they could be confident in the knowledge that the government controlling the reserve currency, in this case the dollar, wouldn’t print too much money and create an imbalance.
Kent Oliver: and following the Bretton Woods agreement, near the end of WW2 until 1971 the US dollar was convertible into gold at the request of any country, a fact that helped solidify the dollar’s status as the world’s reserve currency.
Jim Grenn: ok, so the dollar becomes the official reserve currency of the world because the US has so much gold and their economy looks the healthiest. And any country can convert their dollars to gold whenever they prefer.
Kent Oliver: a quick point of note, this convertibility feature into gold only applied to foreign governments not everyday Americans like you and me. We couldn’t convert our dollars to gold on a whim. That convertibility for regular folks ended around the time of the Great Depression.
Jim Grenn: And that’s when the US confiscated gold
Kent Oliver: Right, so really the important consideration in terms of convertibility is dollars held overseas.
Brady Raanes: That system worked pretty well for decades. The US economy was able to grow and expand and global trade grew and overtime more and more dollars wound up overseas in the hands of foreign governments. And soon a problem arose. The US didn’t have enough gold to back all those dollars floating around.
Gold conversion began occurring in larger numbers and the US gold supply began to dwindle. In 1960, the US held $19 billion in gold reserves, enough to cover the $18 billion in foreign dollars outstanding. By 1971 the US only had $12 billion worth of gold backing $70 billion in dollars.
Kent Oliver: In order to keep the 1 for 1 ratio in place, the US would need about $58 billion in additional gold.
Jim Grenn: Is it even possible that they could have acquired that much?
Kent Oliver: Well, at $35/ ounce which was the price of gold in 1971 that would have equated to about 47,000 tons of gold they would have needed to balance the scale. But in 1971 that would have equated to more than half of the gold ever mined in the history of the world. I mean, even today, central banks all over the world have less than 40,000 tonnes in total reserves.
Jim Grenn: Oh… Well… that wouldn’t work.
Brady Raanes: So, things get interesting in August of 1971. The United Kingdom requested a $3 billion conversion. Which would have made a big dent in the US supply – so the President calls this emergency meeting at Camp David with some of his closest advisors. Few of whom however were well versed in economic matters. There was one exception: Paul Volcker.
Brady Raanes: Despite being the youngest in attendance, 43-year-old Volcker was seen as the technical expert and the main proponent of the emergency meeting. Volcker had been vocal about the pending dilemma for the last two years, preparing and distributing research papers on a regular basis. The administration had taken a ‘wait and see’ approach in hopes that time would heal the problem. It hadn’t.
Kent Oliver: His analysis led him to the difficult conclusion that the only wise move was for the US was to close the window of convertibility. Volcker didn’t take the idea lightly. Doing so would mean abandoning the Bretton Woods agreement that had governed the world’s economic system for the previous 27 years. Volcker feared that some countries may even see the decision as an act of economic warfare.
Brady Raanes: Furthermore, Volcker was concerned about the potential impact on the value of the US dollar. At a minimum, if the US dollar weakened (i.e., required more dollars to purchase goods and services), it would lead to increased prices for American consumers, which might send the economy into a tailspin. Still, there appeared to be no other choice but to cancel the dollar’s convertibility into gold and reject the United Kingdom’s request to convert.
Jim Grenn: who else was at this meeting? What were their thoughts?
Kent Oliver: There were some opposing views. The loudest of which was Arthur Burns, Chairman of the Federal Reserve at the time. He was a staunch believer in the role of gold in monetary policy. Burns was the first PhD to Chair the Federal Reserve and a well-respected voice in the administration. He echoed Volcker’s concern that breaking the link between the dollar and gold could potentially lead to disaster and usher in massive currency problems for years to come. Instead, Burns lobbied for a simple devaluation that would allow foreign banks to continue to convert their dollars to gold, but to do so at a much higher price than $35 per ounce.
Jim Grenn: So, Arthur Burns just wanted to change the price of gold?
Kent Oliver: Yeah. So, at that point, the US would trade gold for dollars at a fixed price of $35/oz – but if they changed that conversion price to something like $60/oz then they would have been able to stretch their gold reserves farther. But in a backwards way, it would have also been an inadvertent devaluation of the dollar. Which is a tough pill to swallow politically.
Jim Grenn: good point. Politics seem to always factor into these types of decisions. What’s the political landscape looking like?
Brady Raanes: By the summer of 1971 Nixon had taken a bunch of heat. The Vietnam War hadn’t made him very popular and he his approval ratings were pretty sluggish. Nixon didn’t want to be remembered as the president that blatantly devalued the dollar. Plus… most importantly, 1972 was an election year. Nixon couldn’t accept Arthur Burn’s idea. He couldn’t just re-value gold – it was to risky for his reputation.
Jim Grenn: But would closing the gold window help him politically?
Kent Oliver: It would if he was able to put a positive spin on it.
Brady Raanes: Nixon goes on National TV and basically gives a victory speech for violating the terms of the Bretton Woods agreement that had governed the monetary system over the last three decades.
Kent Oliver: Abandoning the gold standard ultimately meant that the government was free to print money and run deficits without being backed by anything. Over the following 25 years the federal deficits averaged more than 3% per year – ten times larger than the previous 25 years. The average rate of inflation was double the previous 25 years as well.
Jim Grenn: basically, it ushered in the age of monetary excess.
Kent Oliver: pretty much.
Brady Raanes: That speech marked a pivotal turning point in economic policy. Without the convertibility to gold, the dollar had become just another piece of paper, the same as other currencies around the world, And the dollar did weaken considerably. The average American needed $17,000 in 1979 to buy the same goods that $10,000 bought at the start of the decade.
Jim Grenn: ok, so the US abandons the gold convertibility and puts a nice spin on things, but why is the dollar allowed to remain as the worlds reserve currency? I mean, what gave people faith in the dollar – that the US government wouldn’t just print money from here to infinity without gold backing it?
Kent Oliver: That’s a good question Jim. For starters, there wasn’t a great replacement. The US economy was still by far the most dominant in the world in the early 1970s and there really wasn’t any other currency that could replace the dollar. But over time, it certainly appeared to be a risk. That is, until 1975 (dramatic pause) when the US struck a pretty impressive deal with Saudi Arabia.
Jim: Domino will be right back
Brady Raanes: 3 years after the Nixon shock, the US Treasury Sec William Simon flies over to Saudi Arabia for a secret meeting with the Saudi royalty. Now, William Simon was a pretty interesting guy. He had been the head of the bond trading desk for Solomon Brothers. He looked kind of like Clark Kent. He was a millionaire before it commonplace. I mean, the guy was a real dream boat.
Jim Grenn: Tell us how you really feel about him, Brady.
Brady Raanes: anyway, Simon is on a mission. He wants to sell Treasury Bonds to the Saudis. Not on a small scale, but basically, he wants the Saudis to billion of dollars of government bonds each year
Jim Grenn: this seems obvious, but tell us why?
Brady Raanes: Well, the Saudis were flush with oil profits, and if the Saudis committed to buying billions of dollars of Treasury bonds every year it would provide the US with a willing borrower to finance our deficits. Think about it like this. Now that the US was off the gold standard, they could print more and spend more, but they still needed someone to play the role of lender. William Simon hoped that the Saudis would play that role.
Jim Grenn: And clearly, they did
Kent Oliver: Interestingly though, this wasn’t common knowledge until word got out after the freedom of information act in 2016, some 41 years later.
Jim Grenn: Wait, that’s crazy! For 40 years the Saudi’s were secretly buying our treasury bonds?
Kent Oliver: yeah, Bloomberg wrote a fascinating article revealing the details. You can find a link our show notes at dominopodcast.com. Before then few people knew that the Saudis were basically funding our budget deficit each year.
Jim Grenn: That’s pretty fascinating.
Kent Oliver: It certainly gives us a glimpse into why we continue to be so present within the Middle East to this day. Without that deal, I’m not sure what would have happened the value of the dollar, and if for some reason that agreement changes in the future it will be very interesting to see what happens to the demand for the dollar.
Brady Raanes: The Saudi Arabian story doesn’t end there. Henry Kissinger, the former Secretary of State, struck an equally important deal with the Saudis shortly thereafter. He negotiated an agreement for the Saudis to price all their oil in US dollars AND he got them to talk all the OPEC countries into doing to same thing. And to this day, virtually all oil transactions between countries occur in US dollars.
Jim Grenn: So, if a country like… let’s say Japan… wants to buy oil from Saudi Arabia, they have convert their yen into US dollars first?
Brady Raanes: Basically. With oil being priced in dollars rather than yen or whatever other currency, foreign countries still have a great demand for the US dollar. Isn’t that wild? Think about it, every country in the world needs oil to keep their economy running, and with oil priced in US dollars it makes the value of the dollar extremely important to the rest of the world.
Jim Grenn: Needless to say, this helped to solidify the US dollar’s status as the reserve currency
Kent Oliver: really, you can make an argument that the US moved from the gold standard to the oil standard.
Jim Grenn: we started this discussion talking about how the US dollar was back by gold and now we saying that the US dollar is unofficially backed by, or at least propped up by the demand for oil. So, what happens next?
Kent Oliver: well, it may have been coincidental, but the US starts making some fairly strange monetary decisions. Authur Burns, who we mentioned earlier as one of the attendees at Camp David, becomes the Chairman of the Federal Reserve. Throughout his tenure at the Fed Burns engaged in abnormally ‘loose’ monetary policies of money printing and low interest rates. Many economists argued that Burns purposefully tried to juice the economy leading up to Nixon’s 1972 re-election at a time when the economy didn’t need such policies. Can you imagine Nixon doing something unethical? Those policies, coupled with rising oil prices came back to haunt the American economy with dramatically higher inflation.
Brady Raanes: In hindsight, it strongly appears as through Burns, a Republican supporter, allowed politics to cloud his decision making as Chairman of the Fed. Burns appeared to take similar steps leading up to the 1976 election, presumably again to try and help Republicans retain control of the White House. In light of Nixon’s scandals, however, the Republican party was ultimately defeated.
Kent Oliver: The impact of Burn’s policies was felt at the cash register. Across the country, prices of everyday goods were rising faster than incomes. With little incentive to hold savings in the bank. The prudent strategy was to buy everything at once rather than wait for prices to rise further. The idea caught on quickly. Consumers bought more because prices were rising, but the more they bought the quicker prices rose. Inflation was becoming a self-fulfilling prophecy. Consumer borrowing doubled from 1975-1980.
Brady Raanes: Washington politicians were feeling the heat over the inflation issue. Arthur Burn’s tenure as chairman of the Federal Reserve ended with the election of Democratic President Jimmy Carter, who appointed G. William Miller, a Democrat, to the position. Despite the persistent inflation, Miller continued with the easy policies, apparently trying to mimic Burn’s approach to juice the economy for his own party affiliation. Less than a year into his tenure, the rate of inflation in the US hit 9%.
Kent Oliver: Yeah, and inflation ramped up even more in 1979, when the US was hit with another oil embargo. The country teetered on the brink of a serious recession as inflation hit double digits. President Carter’s approval rating fell to a low point of 30%, prompting a decision to clean house. Carter fired his entire senior staff. He also swapped Fed chair G. William Miller to the Secretary of the Treasury, opening the door for a new chairman of the Federal Reserve – one who could tackle the real issue.
Brady Raanes: Enter Paul Volcker. Unfortunately, Volcker had no choice but to start hiking rates dramatically. Interest rates soared in the early 1980s as the US entered a deep recession…
Jim Grenn: Since the Nixon Shock in 1971 the national budget deficit has been roughly double what it was in the decades preceding the shock…. And this ultimately added to the growing pile of government debt. The Nixon Shock stands as a pivotal moment in monetary policy in US history, and one that shaped our global economy.
This event is a good starting point to understand much of the framework of many other dominoes that fell. As we will examine in coming episodes, each falling domino leads to unpredictable yet pivotal moments for the global economy. Over the next several weeks, we will examine each falling domino’s impact on another. We will continue this discussion next week beginning in Latin America.