Where Did Floating Currencies Come From?
February 3, 2011
(This originally appeared at Forbes.com on February 3, 2011.)
If you listen to economists today, you might get the impression that floating currencies are some sort of economic law–that they have always existed, and always will.
The history of Western Civilization, from the Renaissance onward (in other words the entire history of modern capitalism), is mostly a history of stable currencies, pegged to gold and silver–and in some cases actually made from gold and silver. Floating currencies have always existed, but they were always on the margins. The most successful countries always had a gold-linked currency.
This was the case until 1971. In 1971, the most successful, most influential country was of course the United States, which had used a gold-linked currency from its inception in 1789. The first 182 years of U.S. history were on a gold standard.
Imagine this 182-year stretch of a dollar linked to gold, which was really a continuation of something like 600 years of European currencies linked to gold. Then Something Happened, followed by 40 years of floating currencies up to the present day.
It was the most important economic event of the 20th century. What happened?
We can list a few things that didn’t happen. There was no great economic disaster. There was no monumental failure of the global gold standard system, known then as the Bretton Woods system. There was no gathering of world governments, in some resort hotel, to work out a new global floating currency system. There wasn’t even a proposal for a global floating currency system.
There were no treaties, referendums or discussions, such as those that accompanied the creation of the eurozone. When the global floating currency system first appeared, on August 15, 1971, it was supposed to be a temporary measure. They didn’t even know, at the time, that a new system had emerged.
The global floating currency system, the system we have today, was an accident.
Imagine the year 1965. It was not a bad year. In fact, you could say it was the very best year, the peak moment, for the U.S. during the 20th century. If you weren’t there, ask someone who was an adult at that time if they agree with this assessment.
In 1965, the U.S. had been on a gold standard for 176 years. The U.S. middle class reached a zenith of prosperity, which has arguably never been matched since. Countries including Germany, Japan and even Mexico were rapidly becoming wealthier, as they participated in the global gold standard with fixed exchange rates.
In 1965, the U.S. was enjoying an economic boom set off by the Kennedy tax cuts of 1964. Soon after, President Johnson began raising income taxes again, to pay for the Vietnam War and his Great Society programs. In 1969, Nixon doubled the capital gains tax, to a top rate of nearly 50%. A recession ensued.
Nixon saw the 1972 elections coming up, and wanted to get an economic recovery going by then. In 1970, he installed his friend Arthur Burns as Chairman of the Federal Reserve. Burns agreed to an aggressive “easy money” strategy to counter the recession, in accordance to both Keynesian and Monetarist doctrine of the time.
Thus began what are known, outside the U.S., as the “Nixon Shocks.” The desire to pursue “discretionary monetary policy” came into conflict with the existing gold standard system. Eventually, things reached a decisive moment. Nixon would either have to give up his “easy money” strategy, or he would have to give up the gold standard. On Aug. 15, 1971, he gave up the gold standard.
Other countries now faced a stark decision. When the dollar was pegged to gold, they could peg their currencies to the dollar, at fixed exchange rates, and thus participate in the Bretton Woods gold standard. However, the U.S. dollar was no longer pegged to gold, but sinking in response to Nixon and Burns’ inflationary strategy. For a while, they went along with the situation, keeping their currencies pegged to the dollar as the dollar floated.
Nixon’s strategy worked. GDP grew 5.3% in 1972, according to the government statisticians, and Nixon was re-elected. Then the world collapsed into a decade of inflation and economic decline.
In the spring of 1973, the other countries of the world had reached their limit. They would no longer play along with Nixon’s currency games. They delinked their currencies from the dollar, and the world’s currencies began to float independently. They are still floating today.
Nixon’s popularity evaporated, and he soon became the only U.S. president ever to be thrown out of office in the middle of his term.
The benefits of “discretionary monetary policy” are tangible, but ephemeral. The problems it causes are real and lasting. The historical record is clear: The most successful countries have had the most stable currencies. When governments have learned their lesson, and are ready to abandon their experiments with currency manipulation, they will happily embrace the gold standard once again.