Photo by Ibrahim Boran
Artillery Row

Fifty years of easy money

Having gold as an anchor may not be perfect, but it does prevent the enormous expansion of public debt

Exactly fifty years ago, on 15 August 1971, U.S. President Richard Nixon made a crucial decision. During a TV address, he announced that the United States would unilaterally renege on the gold-dollar link, effectively no longer allowing the likes of France, Germany and the U.K. to request to exchange their dollars for gold. 

Even if the post-World War II “Bretton Woods” system of international fixed exchange rates (which ultimately broke up as a result of this decision) was not a genuine gold standard, it did provide some kind of a brake on wild expansion of the monetary base by both Central Banks and private banks. 

It should not surprise that there is no such thing as a free lunch

It’s hard to underestimate the importance of Nixon’s decision. A website comparing economic statistics before and after 1971, highlights great deterioration or stagnation when it comes to metrics like the U.S. national debt, U.S. productivity growth, real median weekly earnings of full-time workers, real family income, the share of employee compensation in gross domestic income, the income share of the “top one per cent” relative to the bottom ninety per cent, average black income, median male income, income inequality, cumulative inflation, how long it takes to save for a house, the U.S. savings rate, the incarceration rate per capita and even the percentage of children born to unwed women, which went up dramatically after 1971.

In effect, one could call this the U.S. sovereign default, while one could also argue it had become inevitable as a result of out-of-control U.S. welfare and warfare spending due to the “Great Society” programmes and Vietnam war and it should not surprise that there is no such thing as a free lunch and that there is a cost to everything. 

However, because of the position of the U.S. Dollar, this event also had great consequences for the rest of the world. In particular the “number of countries with banking crises” skyrocketed during the decades after the event. 

Perhaps one can make the case that London’s status as a financial center was greatly bolstered by the “Nixon shock”, given how the ensuing 1970s inflation caused the U.S. Federal Reserve to impose a ceiling on domestic bank deposits, in turn providing an extra boost to the market for “Eurodollars”, which are U.S. dollar-denominated deposits at foreign banks, for which London served as a key hub. 

The effects of Nixon’s decision to decouple from gold are all less than surprising, of course. Having gold as an anchor to the monetary system may not be perfect, but it does prevent the enormous expansion of money by both private and public banks, something which is ultimately meant to keep down financing costs for governments.  

The situation was extremely serious at the time. According to Charles Coombs, NY Federal Reserve foreign exchange chief, European countries were preparing for the U.S. to close the gold window. Germany was requesting the return of 500 million U.S. dollars worth of gold sold to the U.S. a year earlier, but the U.K. was also pressing for gold conversion. Coombs has said the following about the episode: “If the British, who had founded the system with us, were going to take gold for their dollars, it was clear the game was over”, a quote cited in David Marsh’s epochal book The Euro, which details the history of the European common currency.

What happened in 1971, and the period of monetary chaos afterwards, is very important to understand why European countries decided to create a common currency. Inflation in Germany reached 7.5 per cent in 1973, so it was thought that something had to be done. 

Already in 1972, a new regional system for controlled exchange rate fluctuation was set up by the European Economic Community, the EU’s predecessor. This system was called the “snake in the tunnel” and had first been proposed in the so-called Werner report in 1970. However, the tunnel already collapsed in 1973, one year after its creation, in an omen of how economically tricky it is to link currencies of very different economies together. 

The UK itself had also joined the tunnel, but abandoned the arrangement after only a few months, in June 1972, which could be seen as yet another omen. Just like with “Black Wednesday” in 1992, when the UK left the European Exchange Rate Mechanism (ERM), the Bank of England suffered heavy reserve losses in a fateful bid to stay in the arrangement. 

Indeed, despite the relentless failures to keep European currencies linked together, during the 1970s, 1980s and 1990s, European governments continued to try, ultimately agreeing to form a common currency in December 1995

From the beginning, there was always talk of political integration accompanying a common currency. As David Marsh describes it, in March 1973, only 2 months after the U.K. had joined the EEC, “Britain came tantalizingly close to joining the other Common market countries in a joint currency bloc to protect Europe from foreign exchange unrest.”

Marsh goes on to quote British Prime Minister Edward Heath as stating at the time, “there are times when political leaders have to take big decisions on a political basis. We are in such a case in relation to monetary affairs.”

The idea that the United Kingdom would easily join such schemes was naïve

Marsh recalls how in March 1973, the UK Treasury’s top international official, Derek Mitchell, even suggested that a “substantial acceleration” of the Werner plan might be needed. German state secretary Karl Otto Pöhl then responded positively to this, expressing his strong interest in bringing the UK into a European Economic Community currency bloc, which would also involve harmonization of fiscal policies and not only monetary and interest rate policies. Pöhl even boasted at the time that to enable this, the German government would simply overrule the Bundesbank, if necessary, as the Bundesbank had always been less than enthusiastic about sharing its reserves to defend weaker currencies, such as the British Pound. In other words: it was always written in the stars that a European common currency would be political, that it would involve large centralisation of power, and that economic considerations such as a Bundesbank prioritizing a strong currency and the interest of purchasing power would be trumped by political attempts to bind currencies together. One irony is that Pöhl later became a pretty hawkish Bundesbank President.

Of course, the idea that the United Kingdom, with its craving for national sovereignty, would easily join such kinds of constructions was naïve. That didn’t stop the likes of former British PMs like Heath and Tony Blair to relentlessly push for it. Thankfully, in the case of Blair, campaign groups like “Business for Sterling” managed to stop this from happening. 

The idea to set up a common currency would have never had a chance if it weren’t for the decoupling with gold in 1971. One can make a strong case that without the euro, and without all the accompanying concentration of power at the EU level and the Eurozone-only decision-making it entailed, Britain would not have left the EU. 

Britain’s first schism from the European project really was closely related to the German concession to France to give up its D-Mark, which helped to create the euro, which in turn helped European governments to finance their ailing welfare states, due to the greater capacity for unsustainable debt creation enabled by the common currency.

In 1979, French President Valéry Giscard d’Estaing and German Chancellor et Helmut Schmidt agreed to create the so-called “European Monetary System”, another semi-fixed rate arrangement, which also included the “European Currency Unit” (ECU), an accounting currency unit that was a weighted average of the currencies of the 12 participating member states, including the UK. 

The creation of the euro was all about expanding the capacity for governments to go into debt more deeply

At the time, both Giscard and Schmidt referred to the old 19th century gold standard as justification for a common fiat currency or binding fiat currencies together. Schmidt stated, “we had a currency up to 1914 in Western Europe the Gold Standard. From a historical point of view, I would draw a direct parallel.” Giscard concurred, while both also stressed that the point of a common currency was that “we need an organized Europe to escape German domination”, as Giscard put it. Today in 2021, virtually every political observer would agree that Germany has become more dominant than France, as much as it also serves as the ultimate paymaster within the Eurozone. Not exactly great French strategic thinking, to put it mildly. 

Furthermore, it is also nonsense to compare a monetary system whereby there is no limit to the authorities to create money out of thin air or to permit licensed private banks to do so with a monetary system where a commodity with a limited annual supply gold puts a firm brake on the total amount of money.

Nixon’s decision truly marked the end of an era where gold limited the amount of fiat currency that could be created. True, at one point, U.S. Fed chair Paul Volcker hiked interest rates to break the back of inflation, but this has merely signified a pause in the global easy-money carnival of the last fifty years.

The creation of the euro was all about expanding the capacity for governments to go into debt more deeply than they would have been able to otherwise a cartel of fiat money issuers, as one could put it. After European leaders agreed to actually introduce the euro at the Madrid Summit in December 1995, Italy saw its 10 year borrowing rates drop under 12 per cent again. Markets had rationally concluded that despite Italy’s massive debt burden, the country would be more sustainable as a member of the Eurozone, regardless of the so-called “no bailout” pledge, which later naturally appeared to be a paper promise. 

Unsustainable practices are unlikely to continue. Almost three hundred years ago, in 1729, Voltaire warned, “paper money eventually returns to its intrinsic value zero.” Time and again, he has been proven right. Only a brave man would think this time will be different. 

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