The Nixon shock and subsequent dissolution of the Bretton Woods system have resulted in untenable inflation, mounting national debt, and extreme income and wealth inequality as the world’s largest economy stands on the brink of hyperinflation.
In June this year, Deutsche Bank issued a stark warning to the US after the Federal Reserve’s balance sheet doubled during the pandemic,
“US macro policy and, indeed, the very role of government in the economy, is undergoing its biggest shift in direction in 40 years. In turn, we are concerned that it will bring about uncomfortable levels of inflation.”
How did we get here? How did money become so fundamentally broken? Who broke it? Let’s dive into that story.
Bretton Woods Agreement (1944)
The whole premise of the Bretton Woods agreement was to pursue a fixed exchange rates system backed by gold as the universal standard to forestall competitive devaluation of sovereign currencies and promote free trade in the aftermath of WWII.
Britain wanted flexible rates. However, given that Britain emerged from the war as the debtor and the US now poised to assume the role of creditor, Britain had to settle for a compromise of fixed but adjustable rates.
As per the agreement, the US had a commitment to back dollars held in foreign reserves with gold at a rate of $35 per ounce. Other sovereign currencies were pegged against the dollar and were required to be kept within 1% of the fixed-rate by buying/selling dollars.
Foreign currencies pegged to the dollar. Dollar pegged to gold
For as long as the US held the majority of the world’s gold reserves, this system would work, and it did work well in the early years as the US had a surplus of balance of payments.
What led to the collapse of this system?
The Marshall plan and US adoption of expansionary policies in the late fifties reversed the balance of payments in favor of other nations. By 1960, the US began running a deficit.
This, combined with the depletion of US gold reserves, would portend the beginning of the end for the Bretton Woods system. As dollar claims on gold outpaced the supply of gold, it created an arbitrage opportunity for other nations to further deplete US gold reserves.
What prevented this scenario was that everyone had a common interest in preserving the system, but only if the US would not resort to devaluing the dollar. In 1960, even before assuming office, JFK was forced to quickly move to allay such fears.
But without the US devaluing the dollar, other nations were required to revalue their own currency to redress the balance, which they were not keen on pursuing as it would adversely affect domestic policy.
A gold pool, known as The London Gold Pool, was formed with European nations to pool all the gold reserves to keep the ratio in check. However, demand for gold soon outpaced supply, and the gold pool was abandoned by 1968.
Among other abortive measures, an international currency (imagine that!) to replace the dollar was mooted in 1964 to salvage this system, but an agreement on that (what eventually became SDR) could not be reached in time.
By 1969, there was a run on the US gold reserves as other nations tried to cash their dollars to redeem gold. This led to emergency measures from President Nixon, known as the Nixon shock, which canceled the convertibility of the US dollar to gold and closed the gold window.
Thus collapsed the Bretton Woods system, and it resulted in the stagflation of the ’70s, a combination of high unemployment and high inflation, as the US dollar lost a third of its value.
In hindsight, the system was always untenable in the long run as it tried to promote free trade while allowing one country, the US, the “exorbitant privilege” of having its currency serve as the international reserve currency in a highly competitive macro-environment post-WWII.
The New York Times pans the Nixon’s paper standard, 1971
The Triffin paradox
In 1959, just as the US began running a deficit, Yale professor Robert Triffin proclaimed that the Bretton Woods system was unworkable and would inevitably collapse as the dollar could not retain its exorbitant privilege of being the reserve currency without running up deficits.
Any sovereign currency serving as a global reserve currency is required to run up a deficit to meet the world’s demand for the currency. This creates a conflict of interest between domestic and international monetary policies.
The Nixon shock and subsequent collapse of the Bretton Woods system proved the Triffin paradox right, but ironically only further exacerbated the exorbitant privilege of the US by now allowing the Federal Reserve absolute authority on monetary policy as the dollar was no longer required to be backed by gold reserves.
The Fed’s newfound ability to continually manipulate supply, interest rates, and velocity of money led to other deleterious consequences such as the Cantillon effect and exploitation of moral hazards that inhere within the fractional reserve banking system.
Perpetual expansion to spur economic growth sent deficits spiraling out of control, resulting in a vicious cycle of inflation and ever-increasing, now extreme, economic inequality. Let’s look at the metrics,
US national debt has risen from $398 billion in 1971 to 29 trillion as of this writing.
Income of the top 0.01 parabolic divergence from per capita GDP since 1980
Wealth owned by the top 0.1% crossed the bottom 90% in the aftermath of the global financial crisis of 2008
The Triffin paradox has remained an inscrutable puzzle for economists to this day.
What could solve the Triffin paradox?
Perhaps a decentralized, borderless, permissionless, durable, provably finite, infinitely divisible, instantly portable, objectively verifiable alternative to gold that doesn’t allow any one nation or its central bank an exorbitant privilege?
What if its monetary policy wasn’t arbitrary, couldn’t be controlled or manipulated by humans, but was predicated on a universal constant? Something like… mathematics?
Voila! Fix the money. Fix the world.
Author: Lamps T