What Is the Nixon Shock?

What Is the Nixon Shock?

Let me tell you about the Nixon Shock—it's the term for the fallout from economic policies President Richard M. Nixon announced in 1971. These policies, most importantly, caused the breakdown of the Bretton Woods system of fixed exchange rates that had been in place since after World War II.

Key Takeaways

The Nixon Shock was a major shift in economic policy by President Nixon to focus on growing jobs, reducing inflation, and keeping exchange rates stable. It directly ended the ability to convert U.S. dollars into gold. This move sparked the stagflation we saw in the 1970s as the dollar lost value. Largely because of it, central banks now have greater control over their countries' money, including interest rates, money supply, and how fast money moves. Even today, economists argue about whether this was a good idea and what its long-term effects have been.

Understanding the Nixon Shock

The Nixon Shock came after President Nixon's televised speech on his 'New Economic Policy' on August 15, 1971. In it, he said the U.S. would shift focus to domestic problems after the Vietnam War. He set three main goals: cutting unemployment, stopping inflation from rising, and shielding the dollar from international speculators.

To achieve this, Nixon pointed to tax cuts and a 90-day freeze on prices and wages as ways to help jobs and control inflation. For the dollar speculation, he backed suspending its convertibility to gold. He also suggested a 10% tax on imports that already had duties, aiming to push U.S. trading partners to increase their currency values, much like the gold suspension.

The Need for Change

The Bretton Woods system started at a 1944 conference in Bretton Woods, New Hampshire. It fixed foreign currencies to the U.S. dollar, with values tied to gold at a price set by Congress. By 1958, those currencies could be converted to gold.

But in the 1960s, a surplus of dollars worldwide threatened the system. The U.S. lacked enough gold to back all those dollars, leading to an overvalued dollar. Governments under Kennedy and Johnson tried to fix it by discouraging foreign investment, limiting lending abroad, and changing monetary policies, but it didn't work.

Foreign exchange markets grew anxious, with traders worried about dollar devaluation. They started selling dollars more often and in larger amounts. After several dollar runs, Nixon decided the country needed a new economic path.

Nixon's Speech

Nixon's speech went over well in the U.S., but not so much internationally—many saw it as a one-sided move. In response, the Group of Ten industrialized democracies agreed on new exchange rates with a devalued dollar, called the Smithsonian Agreement, starting in December 1971. But that didn't last.

By February 1973, market speculation devalued the dollar further, creating various exchange setups. In March, the G-10 had six European countries link their currencies and float them together against the dollar. That basically ended the Bretton Woods fixed rate system.

Fast Fact

The Bretton Woods agreement set up two lasting institutions: the International Monetary Fund and the World Bank.

Aftereffects of Nixon Shock

At first, Nixon's policies were hailed as a political win. Now, their long-term value is debated among scholars. They mainly caused the 1970s stagflation and made floating currencies unstable, with the dollar dropping by a third in that decade. Over the last 40 years, the dollar has been far from stable, with big ups and downs.

For instance, from 1985 to 1995, the dollar's value index fell by up to 34%. It recovered fast but then dropped sharply again from 2002 to mid-2011. Nixon claimed this would stop bad recessions, but the U.S. has had severe ones, like the Great Recession from December 2007 to June 2009.

Advantages and Disadvantages

The 1971 policies from the Nixon administration brought both upsides and downsides. On the advantage side, we now have mostly free-floating currencies traded on markets, which helps with bold actions like quantitative easing. Central banks control their nations' money more, managing interest rates, supply, and velocity.

Government-backed money tends to be more stable than commodity-based like gold. Central banks can better shield economies from business cycle busts. We no longer need actions to protect gold reserves that caused economic swings.

But there are disadvantages too. It created uncertainties and a huge market for hedging currency risks. The 2007-2008 financial crisis showed central bank control doesn't always prevent severe recessions. It led to 1970s stagflation, and we still see bad recessions and dollar volatility. Gold used to self-regulate the economy, but now governments can manipulate variables. Economists are still debating this shift decades later.

What Was the Gold Standard and How Did It Work?

The gold standard is a system where a country's currency value is tied to a fixed amount of gold. Central banks ensured paper money could be easily swapped for gold at a set price. Gold coins circulated along with other coins and notes as currency.

When and Why Did Nixon End the Gold Standard?

President Nixon shut the gold window in 1971 to tackle inflation and stop foreign governments from trading more dollars for gold.

What Is Fiat Money?

Fiat money is currency issued by governments without backing from commodities like gold or silver—it's backed by the issuing government instead.

What Would Happen If We Returned to the Gold Standard?

Some economists say returning to the gold standard could destabilize prices, causing severe deflation and inflation. In a crisis, governments would have little room to act and limit damage.

The Bottom Line

The Nixon Shock is the result of President Nixon's August 1971 announcement of big economic changes to fix the balance of payments, stop inflation, and cut unemployment. Economists still debate if the actions were worth it, considering both the benefits and the problems they caused.