What Is the Nixon Shock?
Nixon Shock is a phrase used to describe the aftereffect of a set of economic policies touted by former President Richard Nixon in 1971.
Most notably, the policies eventually led to the collapse of the Bretton Woods system of fixed exchange rates that went into effect after World War II.
- The Nixon Shock was an economic policy shift undertaken by President Nixon to prioritize the United States' economic growth in terms of jobs and exchange rate stability.
- The Nixon Shock effectively led to the end of the Bretton Woods Agreement and 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 now have a greater degree of control over their own money, making it easy to "manage" variables such as interest rates, overall money supply, and velocity.
- Many decades after the Nixon Shock, economists are still debating the merits of this massive 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. 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 for the plan:
- Creating better jobs
- Stemming the rise in the cost of living
- 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 the cost of living. As for speculative behavior toward the U.S. dollar (USD), Nixon supported suspending the dollar’s convertibility into gold. In addition, Nixon proposed an additional 10% tax on all imports that were subject to duties. Similar to the strategy of suspending dollar convertibility, the levy intended to encourage the United States’ main trading partners to raise the value of their currencies.
The Bretton Woods Agreement revolved around the external values of foreign currencies. Fixed versus the U.S. dollar, the value of foreign currencies was expressed in gold at a price determined by Congress. However, a 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 and Bretton Woods, with the Kennedy and Johnson administrations trying to deter foreign investment, limit foreign lending, and reform international monetary policy. However, their efforts were largely unsuccessful.
Nixon Shock and the Bretton Woods Agreement
Anxiety eventually crept into the foreign exchange market, with traders abroad fearful of an eventual dollar devaluation. 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 was not received as well internationally as it was in the United States. 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 a series of exchange parities. Amid still-heavy pressure on the dollar in March of that year, the G–10 implemented 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 Bretton Woods.
The Bretton Woods agreement created two major institutions that have stood the test of time: the International Monetary Fund and the World Bank.
Legacy of the Nixon Shock
Initially, the Nixon Shock was widely praised as a political success. Today, however, the long-term benefits of the Nixon Shock are a matter of scholarly debate.
First, Nixon's actions were the primary catalyst for the stagflation of the 1970s. It 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 of the Nixon Shock
Today, we live in a world of mostly free-floating, market-traded currencies.
This system has advantages, especially in terms of making radical monetary policy such as quantitative easing (QE) possible. Central banks now have a greater degree of control over their own money, making it easy to "manage" variables such as interest rates, overall money supply, and velocity.
On the other hand, Nixon's move also created uncertainties and led to a massive 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 massive policy shift and its eventual ramifications.
Government-backed money is generally more stable than commodity-based currency
Gives central banks more flexibility to "protect" their economies from severe busts of the business cycle
Actions to protect gold reserves triggered volatility in the economy
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
Nixon and the Gold Standard FAQs
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.