The helicopter came in low over the Catoctin Mountains on Friday afternoon… but the men aboard had no idea why they had been summoned.
It was August 13, 1971. Fifteen of the top economic officials in the United States government were being flown to Camp David for a weekend meeting whose purpose had not been explained to most of them.
And they were sworn to secrecy. They were told not to tell their staff where they were going. They weren’t even permitted to tell their wives.
Curiously, the Secretary of State had not been invited. Neither was the President’s National Security Advisor. Whatever was about to happen, it was not going to be discussed with the diplomats first.
Now, Treasury Secretary John Connally already knew the plan. So did Paul Volcker, the Undersecretary for Monetary Affairs — a tall, chain-smoking technician who had spent years watching the international monetary system grind slowly toward the moment that had finally arrived.
Once the helicopter touched down at Camp David and the group had settled in, Connally got the meeting started.
“The British want three billion,” he stated ominously. “In gold.”
President Nixon immediately turned to Volcker. “Paul, can we cover it?”
“We can cover Britain,” Volcker answered. “We can’t cover what comes after Britain.”
The reality is that the run on the gold window had already started. Switzerland had recently taken some of its gold out of the US Treasury. And French president Georges Pompidou had sent a French warship across the Atlantic to collect France’s gold and carry it home. Everyone knew that was theater… but it was effective theater.
Volcker had spent his career defending this system. He understood better than anyone in the room what the British request signified — and it wasn’t about the money.
As he later put it: “If the British, who had founded the system with us, and who had fought so hard to defend their own currency, were going to take gold for their dollars, it was clear the game was indeed over.”
Arthur Burns, the Chairman of the Federal Reserve, made his objection plainly.
Burns was an economist of the old school, and he did not want to close the gold window. He warned about what would happen to confidence in a currency that was backed by nothing but a promise. And he argued that the United States should not blow up a 27-year-old international agreement over a weekend, without consulting any of the governments that were party to it.
He was overruled.
Connally’s position was simpler, and it carried the room. “The rest of the world has spent a generation accumulating American dollars,” he asserted. “Therefore, the rest of the world can deal with the consequences of holding them. The gold obligation is killing us… so it must end.”
Nixon came to his decision quickly – he sided with Connally on closing the gold window. He did have one major reservation, however. If he made the announcement on Sunday evening, he would be competing with Bonanza for eyeballs.
Bonanza was one of the most popular programs on American television at the time… and competing with it appeared to be Nixon’s chief concern when he decided to sever the dollar’s last connection to gold, thus thrusting the world onto a purely fiat monetary system.
Nixon pressed forward anyway, and he appeared on national television on Sunday, August 15, 1971.
The President had prepared a full speech addressing consumer prices, jobs, and the rising cost of living. Buried in the middle of his speech was a single sentence that changed the world forever: “I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets…”
Temporarily. That was 55 years ago, and the suspension has never been lifted. Nothing is more permanent than a temporary government program, it seems.
How It Got to That Point
When we left off, it was August of 1935, and Marriner Eccles had just won his fight to centralize power at the Federal Reserve.
The Banking Act of 1935 had consolidated control of American monetary policy in Washington. It created the modern Federal Open Market Committee (FOMC), and it gave the Federal Reserve Board control over reserve requirements and a national discount rate. It also gave the Fed something it didn’t have before – the authority to buy unlimited amounts of US government debt in the open market.
That last one may have been the greatest new power bestowed because it gave the Fed the ability to manipulate interest rates and borrowing costs throughout the economy.
To understand why, we must understand the inverse nature of bond prices and yields (interest rates). And it’s simple… when a bond’s price goes up, the yield goes down. In just the same way, a bond’s yield goes up when the price goes down.
Now, whenever we see heavy buying interest for a given bond, that’s what pushes the bond’s price higher – and thus its yield lower. And that’s where the Fed’s new power comes in.
The Banking Act of 1935 empowered the Fed to buy US government bonds at will. From that point forward, if the Fed wanted to push interest rates down, it could do so by purchasing an outsized amount of US debt.
The Fed did not use that power immediately, however. But then came the push to get the United States into World War II.
Under President Franklin D. Roosevelt, America entered the second World War in December of 1941. Modern history books tend to glorify the massive scale of the war, but what typically goes unspoken is that wars are excessively expensive. Especially world wars.
The reality is that governments cannot afford to pay for wars directly out of their tax revenue. So what do they do? They sell bonds. Which is to say, they go into debt.
In 1941, the US national debt stood at roughly $49 billion. By 1945, it had ballooned to $258 billion.
Those numbers may not seem big to us because of where the national debt is today, but they were massive at the time. For context, the US government had to borrow more money in those four years than it had borrowed in the entire history of the American republic.
Borrowing on that scale should have driven interest rates sharply higher. When any borrower — a family, a business, a government — seeks to take on massive loans, lenders usually demand higher yields to compensate them for the risk. That’s just how a normal credit market works.
But the US government did not want to pay higher yields. So to finance World War II, Treasury Secretary Henry Morgenthau Jr. asked Federal Reserve Chairman Marriner Eccles to use his newfound power to buy government debt without restriction.
Beginning in 1942, Eccles agreed to cap short-term US Treasury bills at three-eighths of one percent (0.375%). That’s compared to the previous going rate between two and four percent (2-4%). As for long-term US Treasury debt, the Fed put the ceiling at 2.5%.
Now, the Fed cannot just “set” interest rates. I think that fact is often lost on the financial media… but it’s not that simple.
If the Fed decides it wants to cap interest rates, as it did in 1942, it must be willing to print money to buy as much of the targeted bond issue as is necessary to keep rates suppressed.
So in 1942, the Federal Reserve began operating as the financing arm of the US Treasury. The Fed is what enabled the US government to go deep into debt to fund the war.
There is a name for this arrangement, though it wasn’t in common use at the time. When a government’s borrowing needs dictate what the central bank does, that’s called fiscal dominance.
But fiscal dominance has a direct cost. By 1947, consumer prices in the United States were rising at roughly 14% a year.
And here’s the thing – once a central bank starts printing money to buy government debt and suppress interest rates, it’s really hard to stop. Because the government gets used to being able to spend more, and certain sectors of the economy get used to borrowing money at lower rates than they otherwise could.
World War II officially ended on September 2, 1945. At that point, the Fed’s reason for buying government debt at scale ended as well… but it wasn’t a clean break. Some wanted a return to normalcy. Others wanted the Fed to keep interest rates low – at the expense of rising consumer prices.
The fight to get out of ongoing fiscal dominance took years, and it got ugly. President Truman summoned the entire FOMC to the White House on January 31, 1951 to pressure them into holding the line.
But the Fed pushed back. Marriner Eccles leaked the FOMC’s account of the White House meeting to the newspapers – to show that the Fed had not pledged to continue capping rates.
On March 4, 1951, the Treasury and the Federal Reserve issued a joint statement announcing that they had “reached full accord” — the Fed would no longer be obligated to peg the government’s borrowing costs.
That’s the Treasury-Fed Accord, and Keynesians will point to it as the moment the Federal Reserve got its independence back. But notice what the Accord did not do.
It ended the Fed’s obligation to buy government debt en masse. But it did not remove the Fed’s ability to do so. That would prove to be immensely consequential.
But we need to back up for a minute.
World War II forced the world to suspend the gold standard once again – just as it did during World War I. The gold standard was eventually restored after World War I, and we observed how the Fed went right to work helping Britain get back on gold at an elevated peg in an earlier installment of this series.
However, the classical gold standard was never restored after World War II. Instead, there was a fight over what would replace it.
The Bretton Woods Agreement
In July of 1944, delegates from forty-four nations assembled at the Mount Washington Hotel in Bretton Woods, New Hampshire. Their goal was to design the monetary system of the postwar world.
There were two men leading the charge forward with competing ideas. One was John Maynard Keynes, who represented Britain. The other was Harry Dexter White, who represented the United States.
Keynes arrived with a genuinely radical proposal. He wanted to create a new international currency called the bancor.
And Keynes proposed that it be issued by a global clearing union that wouldn’t be under the thumb of any single country. Under his plan, no nation’s currency would sit at the center of the monetary system.
White’s proposed plan was more conventional. He called for the dollar to be pegged to gold, and for all other currencies to be pegged to the dollar.
In short, White pushed for the monetary system to run through the United States and the US dollar… and a version of his plan won out for a simple reason – Europe was in rubble and effectively bankrupt. Meanwhile, the United States held roughly two-thirds of the world’s official gold reserves.
Thus, the Bretton Woods system was agreed upon. It called for fixing the US dollar to gold at $35 an ounce. Then every other currency was fixed to the dollar at a set exchange rate. However, the agreement stated that governments and central banks could exchange their dollars for gold, on demand, at the fixed price.
So it was that the dollar became the world’s reserve currency – the money that international trade is settled in. By default, this made US Treasury bonds the world’s reserve asset of choice, because countries that needed dollars for trade parked them in interest-bearing US government debt so that they could generate a small yield.
The great irony here is that the US Treasury’s massive gold hoard existed because President Franklin Roosevelt made gold illegal and required American citizens to turn in their holdings with the threat of imprisonment.
Under Bretton Woods, gold became central to the monetary system once again… but only for governments and central banks. It remained illegal for Americans to own gold coins and bars.
This was the same asymmetry we saw with President Roosevelt’s Executive Order 6102, where foreign central banks were exempted from the confiscation that fell on Americans. That distinction was effectively written into the architecture of the world’s monetary system in 1944.
The Quiet Removal Paved the Way for the Nixon Shock of 1971
Now, the convertibility promise to foreign governments was only half of the arrangement. There was a second constraint, and it was domestic.
Since 1913, the Federal Reserve had been required to hold gold in reserve against the currency it issued. The original ratio was 40%. Meaning, for every $100 in circulation, the Fed had to hold $40 worth of gold.
That requirement was something of a governor on the machine. It placed a hard ceiling on how much “elastic currency” the Federal Reserve could conjure into existence.
But in June of 1945, with the war ending and the debt at record levels, Congress cut the Fed’s gold reserve requirement from 40% to 25%. That gave the Fed legal cover to print more money to buy government debt.
This is also how the US government ultimately got extra legal room to push the “guns and butter” programs of the 1960s. With the Vietnam War and President Lyndon Johnson’s “Great Society” welfare programs, the US government’s spending increased dramatically during that decade.
With fiscal deficits ballooning, the US government’s national debt started rising at an unprecedented rate in the 60s. Some became concerned that the market would not be able to absorb all the debt the Treasury needed to issue.
So on March 18, 1968, Congress removed the Fed’s gold reserve requirement entirely. That paved the way for Nixon to close the gold window three years later, because gold had already been demonetized domestically.
That’s how President Nixon’s secret August meeting at Camp David came to be. What may appear to have been an isolated decision in passing was actually the result of a long chain of monetary history.
To make matters even worse, Nixon implemented a 90-day freeze on wages and prices across the American economy. That is to say, the government decreed that companies were prohibited from giving employees a raise and from raising the price of their products.
This was the first attempt at peacetime wage and price controls in the country’s history. And as anyone familiar with basic economics will know – it didn’t go well. Nixon also slapped a 10% surcharge on imports – making foreign goods materially more expensive overnight.
Nixon sold these moves on national television as necessary to defend the dollar. Here’s what he said in that August 1971 speech:
“Let me lay to rest the bugaboo of what is called devaluation… if you are among the overwhelming majority of Americans who buy American-made products in America, your dollar will be worth just as much tomorrow as it is today.”
That claim has not aged well. As I write, the US dollar has lost 89% of its purchasing power since 1970. This chart tells the story:
What we’re looking at here is the Federal Reserve’s own data. It shows that one dollar in 1970 is now worth about eleven cents in terms of what it can purchase. Said another way, it takes roughly nine dollars today to buy what one dollar bought in 1970.
But it wasn’t just American citizens who got the short end of the stick this time.
International Outrage
The reaction to Nixon’s speech abroad was fury. Here was the sitting US president unilaterally ending the Bretton Woods agreement and telling the world that they could no longer get their gold back.
And Treasury Secretary Connally handled the diplomacy exactly as we might expect from the man who had driven the decision. Meeting with the finance ministers of the countries whose reserves had just been converted into unbacked paper, he reportedly said something to the effect of: “The dollar is our currency, but it’s your problem now.”
To be fair, it was a true statement.
The rest of the world had accumulated dollars because the system required them to, but those dollars were convertible into gold upon demand. That was supposed to be the deal. But now the dollars were unbacked, and there was no recourse. It seems Connally saw no reason to pretend otherwise.
There was some jostling and some attempts to reconstitute a fixed global monetary arrangement in the wake of what became known as the Nixon Shock. But nothing stuck.
So for over fifty years now, we’ve been living with a global monetary system that consists of currencies that are essentially floating abstractions. That is to say, each country’s currency has constantly fluctuated in value relative to others. So it was that the foreign exchange (forex) trading market came to be.
If you were to ask a forex trader how much the Euro is worth, he might tell you $1.15 – or whatever the exchange rate happened to be at the time. And that’s technically true. As I write, one Euro is worth $1.15.
But what does that actually mean? What is $1.15 worth?
To answer that question, we must compare the US dollar to something tangible. And that’s why gold was so integral to the system for so long. Not only was it a check on excessive spending, but it was also an objective measuring stick.
In 1971, an ounce of gold cost $35. As I write this, an ounce of gold costs around $4,600.
But here’s the thing – gold didn’t get more valuable. Nothing about the physical metal has changed.
What changed is the measuring stick. It takes about 131 times as many dollars to buy the same gold coin today as it did in 1971.
And if we compared the US dollar’s purchasing power to other items – houses, cars, groceries – we’ll see a similar story. Nearly everything costs a lot more today than it did fifty years ago.
But again, that’s not because everything got more expensive. It’s because the US dollar has lost an enormous amount of purchasing power. And that’s the direct result of running our economy on a fiat monetary system.
The lesson is structural, and it’s the same lesson we’ve been tracking throughout this essay series. Every mechanism we’ve traced was justified by an emergency…
The Federal Reserve was created in 1913 to prevent financial panics… The Trading with the Enemy Act was amended in 1933 to save the banking system… American gold was then confiscated that same year to shore up the banking system that was saved… The Banking Act of 1935 was passed because the Fed failed at its one job… Interest rates were artificially suppressed in the 1940s to finance a war… The gold reserve requirement was removed in 1968 to finance “guns and butter”… The gold window was closed in 1971 to stop a run on the US Treasury’s gold reserves.
Every sequence in this monetary chain of events had a real problem behind it. But I would suggest that each event simply compounded the underlying problems without addressing the root cause. And by doing so, each “solution” paved the way for a future emergency.
That’s the pattern. The emergency ends, but the mechanism stays. And each mechanism becomes the foundation on which the next one is built… and so it was that we drifted farther and farther away from the vision of America’s founders.
Alexander Hamilton wanted a national credit system that would drive productivity and create an economically independent American republic. Meanwhile, Thomas Jefferson wanted a decentralized agrarian economy that would be insulated from corruption. Both wanted sound money and a system that would raise standards of living for Americans – even if they differed on what that system should look like.
By August of 1971, we were oceans away from those visions. And since there was no longer an external limit on how much credit could be created, and no mechanism at all requiring that the credit be productive, the central bank machine morphed into something that was capable of financing anything but accountable to nothing.
What followed over the next five decades would destroy the purchasing power of the US dollar, thus making it very difficult for Americans to maintain a middle-class lifestyle.
It’s easy to see that in the data. What’s harder to see is how this dynamic systematically ate away at American culture.
More on that to come…
-Joe Withrow