Nixon's Legacy

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The graph below, posted by Luke Gromen, highlights the long-term impact of the Nixon Default, when President Nixon on August 15, 1971 unilaterally suspended convertibility of the US Dollar to Gold. This spelled the demise of the Bretton Woods system of managed exchange rates and led to widespread adoption of free-floating exchange rates by 1973.

Luke Gromen on twitter

Suspension of convertibility to Gold was part of a three-pronged attack on rising inflation that included a 90-day wage- and price-freeze and a 10% import surcharge to protect US products against expected exchange rate fluctuations. Paul Volcker, the architect of the scheme, related how they waited with trepidation for the market reaction. But it turned out to be a non-event, with bond and equity markets sailing on unperturbed. The Dow rose 33 points the next day, the largest daily gain at the time.

The move unshackled federal government from restraints of the gold standard and deficits ballooned. Apart from a brief respite during the Dotcom bubble, deficits have grown progressively larger and are expected to reach -14% of GDP during the current crisis, breaking all post-war records.

US Federal Deficit

The Dollar depreciated sharply over the next two decades, forcing the Bank of Japan to buy Dollars to slow appreciation of the Yen. Other central banks followed suit and a new era of currency manipulation was born.

Japanese Yen/USD and Pound Sterling/USD

Federal debt held by foreign investors started to climb, especially when used by trading partners (e.g. China) to slow appreciation against the Dollar and maintain a trade advantage in export markets. Prior to 1971 the US would have been likely to neutralize capital account inflows, to maintain a stable exchange rate, by buying gold in international markets. But successive governments living beyond their means have grown to accept foreign investment in Treasuries as a legitimate form of funding.

Foreign & International Holdings of US Federal Debt

This had unfortunate consequences for the manufacturing sector. It lost the ability to compete in export markets � and against imports in domestic markets � because of the over-priced dollar.

US Manufacturing Jobs

Foreign investment in US federal debt is slowing in response to trade tensions, leaving Treasury with a problem: who is going to buy the expected net $3 trillion in new debt issuance this year? Their answer is the Federal Reserve: purchasing Treasuries in secondary markets and issuing newly printed Dollars in payment.

US Federal Debt Holdings

The result is likely to be another epic depreciation of the Dollar. This will probably pass largely unnoticed because other central banks are doing QE on a similar scale. Currency markets may seem undisturbed because all major currencies are depreciating together.

How do we fix the problem? A number of commentators over the years have suggested re-introducing the Gold standard. While this is usually met with cries of derision from some quarters, it would impose a stricter discipline on government finances and offer greater transparency when currencies are devalued. Realistically, however, it's not going to happen.

A more practical step may be to impose some discipline or limit on capital account imbalances. By definition, the capital account is a mirror of the current account in international trade. A current account deficit (or outflow) must be funded by a capital account (or investment) inflow. Setting a ceiling on capital account imbalances would limit the scope for federal government to fund deficits with foreign borrowing, restricting some of the excesses and limiting damage done to the exchange rate.

Current Account as Percentage of GDP

Requiring the Fed to purchase gold (and other hard assets in international markets) to offset capital account inflows in excess of 1.0% of GDP would set a healthy discipline in managing the fiscal budget. Over time, the limit could be restricted even further, with the long-term goal of maintaining parity in international trade.

This is no easy fix, though. Reducing excesses in one area is likely to expose countering imbalances in other parts of the international financial system, with a shortfall in the international Eurodollar market the most likely complication.

It is time to recognize that financial markets are inherently unstable. ....the choice confronting us is whether we will regulate global financial markets internationally or leave it to each individual state to protect its interests as best it can. The latter course will surely lead to the breakdown of the gigantic circulatory system, which goes under the name of global capitalism.

~ George Soros, The Crisis of Global Capitalism (1998)


Colin Twiggs is director of The Patient Investor Pty Ltd, an Authorised Representative (no. 1256439) of MoneySherpa Pty Limited which holds Australian Financial Services Licence No. 451289.

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