What Is the Nixon Shock?
The Nixon Shock refers to the aftereffectofa set of economic policies announced by President Richard M. Nixon in 1971.
Most notably, the policies eventually led to the collapse of the Bretton Woods system of fixed exchange rates that took effect after World War II.
Key Takeaways
- The Nixon Shock relates to an economic policy shift undertaken by President Nixon to prioritize jobs growth, lower inflation, and exchange rate stability.
- It effectively led to the end of the convertibility of U.S. dollars into gold.
- The Nixon Shock was the catalyst for the stagflation of the 1970s as the U.S. dollar devalued.
- Thanks in large part to the Nixon Shock, central banks have more control over their nations' money and the management of variables such as interest rates, overall money supply, and velocity.
- Long after the Nixon Shock, economists are still debating the merits of this policy shift and its eventual ramifications.
Understanding the Nixon Shock
The Nixon Shock followed President Nixon’s televised "New Economic Policy" address to the nation on August 15, 1971. The crux of the speech was that the U.S. would turn its attention to domestic issues in the post-Vietnam War era. Nixon outlined three main goals:
- Lowering the unemployment rate
- Stemming the rise in inflation
- Protecting the U.S. dollar from international money speculators
Nixon cited tax cuts and a 90-day hold on prices and wages as the best options for boosting the job market and tamping down inflation. As for speculative behavior toward the U.S. dollar (USD), Nixon supportedsuspending the dollar’s convertibility into gold.
In addition, Nixon proposed an additional 10% tax on all imports that were subject toduties. Similar to the strategy of suspending dollar convertibility, the levy was intended to encourage the U.S.' primary trading partners to raise the value of their currencies.
The Need for Change
The Bretton Woods system was developed during an international conference held at Bretton Woods, New Hampshire in 1944. It involved the external values of foreign currencies. Fixed to the U.S. dollar, these values were expressed in gold at a price determined by Congress. In 1958, foreign currencies became convertible into gold.
However, a global dollar surplus imperiled the system in the 1960s. At the time, the U.S. did not have enough gold to cover the volume of dollars circulating throughout the world. That led to an overvaluation of the dollar.
The government attempted to shore up the dollar as well as theBretton Woods system, with the Kennedyand Johnson administrations tryingto deter foreign investment, limit foreign lending, and reforminternational monetary policy. However, their efforts were largely unsuccessful.
Anxiety eventuallycrept into the foreign exchange market, with traders abroad fearful of an eventual dollardevaluation. As a result, they began selling USD in greater amounts and more frequently. After several runs on the dollar, Nixon sought a new economic course for the country.
Nixon's Speech
Nixon’s speech was not received as well internationally as it was in the U.S. Many in the international community interpreted Nixon’s plan as a unilateral act.
In response, the Group of Ten (G-10) industrialized democracies decided on new exchange rates that centered on a devalued dollar in what became known as the Smithsonian Agreement. That plan went into effect in December 1971, but it proved unsuccessful.
Beginning in February 1973, speculative market pressure caused the USD to devalue and led to aseries of exchange parities. Amid still-heavy pressure on the dollar in March of that year, the G–10implemented a strategy that called for six European members to tie their currencies together and jointly float them against the dollar.
That decision essentially brought an end to the fixed exchange rate system established by the Bretton Woods agreement.
The Bretton Woods agreement created two major institutions that have stood the test of time: the International Monetary Fund and the World Bank.
Aftereffects of Nixon Shock
Initially, Nixon's economic policies were widely praised as a political success. Today, however, their long-term benefits are a matter of scholarly debate.
First, the policies were the primary catalyst for the stagflation of the 1970s. They also led to the instability of floating currencies, as the U.S. dollar sank by a third during the 1970s. Over the past 40 years, the U.S. dollar has been anything but stable, with several periods of severe volatility.
From 1985 to 1995, for example, the U.S. dollar value index lost as much as 34%. After quickly recovering, it fell sharply again from 2002 to mid-2011.
Nixon also promised that his move would prevent costly recessions. Over the past few decades, however, the U.S. has suffered severe recessions including the Great Recession of December 2007 to June 2009.
Advantages and Disadvantages
The Nixon administration's 1971 economic policy actions have provided advantages as well as disadvantages.
Advantages
Today, we live in a world of mostly free-floating, market-traded currencies. This system has its benefits, especially when facilitating radical monetary policy actions such as quantitative easing (QE).
Central banks have a greater degree of control over their nations' money and the management of variables such as interest rates, overall money supply, and velocity.
Disadvantages
On the other hand, Nixon's move also created uncertainties and led to a massive financial market based on hedging the risks created by currency uncertainty.
The financial crisis of 2007-2008, in particular, proved that central bank control is no guaranteed defense against severe recessions.
Many decades after the Nixon Shock, economists are still debating the merits of this remarkable policy shift and its eventual ramifications.
Advantages of Nixon Shock
Government-backed money is generally more stable than commodity-based currency
Central banks have more flexibility to protect their economies from severe busts of the business cycle
Actions to protect gold reserves that triggered economic volatility are no longer necessary
Disadvantages of Nixon Shock
Led to stagflation of the 1970s
Severe recessions and U.S. dollar volatility still occur under the watch of central banks
Gold provided a self-regulating effect on the economy and currency, while the Nixon Shock empowered the government to manipulate variables
What Was the Gold Standard and How Did It Work?
The gold standard is a monetary system in which the value of a country's currency is based on a fixed quantity of gold. In practice, central banks made sure that domestic currency (paper money) was easily convertible into gold at a specific fixed price. Gold coins also circulated as domestic currency alongside other metal coins and notes.
When and Why Did Nixon End the Gold Standard?
President Richard Nixon closed the gold window in 1971 in order to address the country's inflation problem and to discourage foreign governments from redeeming more and more dollars for gold.
What Is Fiat Money?
Fiat money is government-issued money that isn't backed by a physical commodity such as gold or silver. Instead, it is backed by the government that issued it.
What Would Happen If We Returned to the Gold Standard?
Some economists argue that if we returned to the gold standard, prices would actually destabilize, leading to episodes of severe deflation and inflation. Moreover, in the event of a financial crisis, the government would have little flexibility to either avert or limit the potential damage.
The Bottom Line
Nixon Shock refers to the aftermath of President Richard Nixon's August 1971 announcement of major economic policy changes that his administration intended to implement to improve the country's balance of payments, prevent inflation, and lower unemployment.
Economists still argue about the merits of the actions taken, as well as their ill-effects.
