Dj vu, All Over Again

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The credit markets were reeling and people across the globe had lost confidence in the dollar. American tourists overseas found that many places in Europe were reluctant to exchange their dollars for European currency, and the world banking community was even more in an uproar.

Furthermore, U.S. armed forces were bogged down in an unpopular war overseas, and the U.S. economy seemed to be moving into a recession. Foreigners holding dollars were nervous and wondering if they had been fooled into holding worthless paper.

I am not describing the current economic scene in the United States; instead, this is a description of the crisis of August, 1971, when the U.S. dollar collapsed as the government’s currency Ponzi game ran its course, and Americans found it was time to pay the piper. The 1970s were wracked with stagflation, slow growth, economic uncertainty, and political turmoil.

Apparently, the lessons to be learned of the dollar’s collapse in 1971 have not been learned by the current crop of "leaders" in Washington and on Wall Street, but the thing about laws of economics is that they are impervious to the wishes and commands of politicians. Contra Franklin D. Roosevelt, who insisted that economic laws had been made up by people and could be changed by fiat, one cannot command an economy into prosperity.

What happened in 1971 provides a roadmap as to what is likely to happen in the coming years, should those in political authority continue on the current path. In fact, one can say that the U.S. financial situation is even more dire than it was on August 15, 1971, when President Richard Nixon closed the "gold window" to the world, and at the same time closed his mind to economic truth, instead declaring, "We are all Keynesians, now."

With that in mind, I am going to revisit what happened in 1971, what led to the financial disaster, and what should have been done. Like the Bourbons of France who "learned nothing and forgot nothing," the politicians in charge of the U.S. government, along with the vaunted "monetary authorities" of the Federal Reserve System, the decision-makers are demanding that all of us leap off the cliff together in the name of hitting with a non-existent "soft landing."

In 1944, as World War II was moving to its inevitable conclusion, the financial "leaders" of the Western powers gathered at the Mount Washington Hotel in Bretton Woods, New Hampshire, to hammer out how the currencies would be stacked in a post-war world. The U.S. Dollar would be the world’s reserve currency, and its value continued to be pegged at $35 an ounce of gold. All other currencies were pyramided upon the dollar at fixed exchange rates.

While no doubt the participants of this meeting (including John Maynard Keynes) believed they were making history, they actually were making the wrong kind of history: bringing in an inevitable age of inflation. The agreements were drawn up with the kind of arrogance that only politicians can display, and when the system imploded, they blamed everyone but themselves.

With fixed exchange rates and the dollar being linked to gold, U.S. politicians deluded themselves with the notion that they could inflate the dollar indefinitely with no consequences. Since exchange rates were fixed, Americans could purchase imported goods using currency that was cheapened with inflation. Murray Rothbard in What Has Government Done to Our Money? writes:

By the early 1950s, the continuing American inflation began to turn the tide the international trade. For while the U.S. was inflating and expanding money and credit, the major European governments, many of them influenced by “Austrian” monetary advisers, pursued a relatively “hard money” policy (e.g., West Germany, Switzerland, France, Italy). Steeply inflationist Britain was compelled by its outflow of dollars to devalue the pound to more realistic levels (for a while it was approximately $2.40). All this, combined with the increasing productivity of Europe, and later Japan, led to continuing balance of payments deficits with the United States. As the 1950s and 1960s wore on, the U.S. became more and more inflationist, both absolutely and relatively to Japan and Western Europe. But the classical gold standard check on inflation — especially American inflation — was gone. For the rules of the Bretton Woods game provided that the West European countries had to keep piling upon their reserve, and even use these dollars as a base to inflate their own currency and credit.

But as the 1950s and 1960s continued, the harder-money countries of West Europe (and Japan) became restless at being forced to pile up dollars that were now increasingly overvalued instead of undervalued. As the purchasing power and hence the true value of dollars fell, they became increasingly unwanted by foreign governments. But they were locked into a system that was more and more of a nightmare. The American reaction to the European complaints, headed by France and DeGaulle’s major monetary adviser, the classical gold-standard economist Jacques Rueff, was merely scorn and brusque dismissal. American politicians and economists simply declared that Europe was forced to use the dollar as its currency, that it could do nothing about its growing problems, and that therefore the U.S. could keep blithely inflating while pursuing a policy of “benign neglect” toward the international monetary consequences of its own actions.

However, as Rothbard notes, the European governments did have another option: purchase U.S. gold at $35 an ounce, and the purchases began to accelerate as it became clear that U.S. monetary authorities and politicians actually believed their own rhetoric about "easy money" being the source of prosperity. As domestic government spending skyrocketed after the imposition of President Lyndon Johnson’s "Great Society" programs, as well as the escalating war in Vietnam, government expenditures increased greatly in both nominal and real terms, financed in large part by the government’s printing press.

By 1965, domestic silver money disappeared as the U.S. Government began to mint its infamous "sandwich coins" of nickel and copper, the silver dimes, quarters, half-dollars, and dollars relegated to coin collectors. (And, keeping with the government’s dishonest rhetoric, Johnson and his allies insisted that the "sandwich" coins were just as valuable as the silver ones.)

In 1968, the government tried to stem the gold outflows by a series of financial tricks, first by changing the rules by keeping individual foreigners from purchasing U.S. gold. (Americans already were forbidden by law to own gold, another New Deal legacy that finally was repealed in 1974.) Johnson and his allies continued to insist that the dollar was sound, and that "speculators" really were the source of the problem.

Even though Johnson left office in 1969, to be replaced by Richard Nixon, the legacy of inflation continued. Finally, on August 15, 1971, Nixon via executive order closed the gold window, while continuing to insist that nothing was amiss, except that a devalued dollar now would make U.S. exports more attractive.

Although Nixon continued to insist that the U.S. economy was sound, and that the dollar was not in trouble, a decade of stagflation followed. To make matters worse, U.S. business were saddled by the remnants of New Deal policies, including powerful unions that permanently crippled a number of manufacturing industries, including automobiles, steel, mining, and other goods. Other industries, including telecommunications, banking and finance, and utilities were shackled with New Deal-era regulations that cartelized the industries, keeping innovation out.

If that were not bad enough, Nixon also imposed wage and price controls, and kept price controls on oil and gasoline throughout the 1970s, strangling that industry and creating an "energy crisis" that only invited more irresponsibility from politicians, who demanded that the USA follow a policy of "energy independence." (Nixon called his first actions "Phase I," to be followed by "Phase II." The only thing missing was "Phase V," a going-out-of-business sale.)

Whatever the economic legacy of John F. Kennedy and Lyndon Johnson, Nixon continued it with dreadful results. (His successor, Gerald R. Ford, also continued those policies, as did President Jimmy Carter, who at least had the foresight to overturn the price controls and many of the New Deal business and financial regulations. I have written elsewhere that Carter often does not receive the credit he deserves for his deregulatory acts, but it seems that not even Carter himself has touted those successes. Granted, his acts went against the Democratic Party boilerplate that is found in the columns of Paul Krugman, but nonetheless, Jimmy Carter really was the architect, at least in part, of more than two relatively prosperous decades.)

The parallels to 1971 are striking. Had Nixon simply told the truth and acted to end the inflation and to restore the dollar (including ending the Vietnam War sooner), the 1970s would have been a decade remembered for something other than inflation, unemployment, and the social angst that came with it.

At the present time, not one of the three major candidates left in the race for president is dealing with the real economic issues. (Ron Paul is the only candidate telling the truth, but he will not receive the Republican nomination under any circumstances.) The Democrats continue to make promises to add even more to domestic spending, expand the welfare state, and bring "energy independence" through government-sponsored programs to make fuel from corn and other plants. On the issue of the war in Iraq, they are promising something akin to Nixon’s "peace with honor."

John McCain, on the other hand, is promising to add to domestic spending, expand the welfare state, and bring "energy independence" through government-sponsored programs to make fuel from corn and other plants. On the issue of the war in Iraq, he promises something akin to Nixon’s "peace with honor." However, he also admits that U.S. forces might be in the Middle East for "the next 100 years," although I doubt McCain will live that long, even if he is elected president.

No contending presidential candidate is stating the obvious: the government’s stewardship of the dollar is pretty much the same as the government’s stewardship of everything else. Instead, we hear that all that is needed to prop up the dollar and to stabilize financial markets is for the government to print even more dollars, all in the name of providing "liquidity." It truly is a "throwing gasoline on the fire" moment.

I will say that I do not fear a recession the way that I fear the government doing all it can to prevent a recession that it cannot prevent, since a recession is the inevitable result of irresponsible government policies. With the stock market bubble and housing bubble thoroughly popped, there is nowhere for the new money to go, except into commodities, which means that the decade-long Federal Reserve policies of overt inflation finally are showing up in prices for consumer goods.

There is another road to take, one that Nixon did not take in 1971 or George W. Bush took in 2001. That is the road that Ronald Reagan took in 1982, when the worst post-World War II recession hit the U.S. economy. While Reagan did push through some tax increases to narrow the deficit (an unsuccessful policy), he did not convince the Fed to reflate and pretty much let the recession take its course. In 1982, the pundits were claiming him to be a one-term president; two years later, he would win in a landslide, as the economy was in full recovery.

Unfortunately, the current occupant of the White House, as well as the people who are trying to be the next occupants of 1600 Pennsylvania Avenue, are not willing to be seen as people doing nothing. From the insane "rebates" to Clinton’s claim (backed by Krugman) that "universal" (government-paid) medical care and corn-based ethanol programs will "stimulate" the economy, there is no shortfall of Really Bad Ideas being thrown forth by the political classes.

Interestingly, the Democrats (and most Republicans) love to revile Nixon. Yet, the policy prescriptions being put forth pretty much are out of the Nixon Playbook of more than three decades ago. All that is missing is the "Phase Something."

March 24, 2008

William L. Anderson, Ph.D. [send him mail], teaches economics at Frostburg State University in Maryland, and is an adjunct scholar of the Ludwig von Mises Institute. He also is a consultant with American Economic Services.

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