When the U.S. Gave Up Gold: WSJ

Nixon’s decision overturned arrangements created by the U.S. and its wartime allies in 1944 at Bretton Woods, New Hampshire, where Washington had agreed to exchange dollars for gold at a rate of $35 per ounce. Making the dollar convertible into gold, and pegging every other currency to dollars at a fixed rate, was meant to inject stability into international commerce. The hope was to avoid the sort of competitive currency depreciations and rampant tariff increases that had worsened the Great Depression in the 1930s and helped to precipitate a world war.

The dollar-gold link was credible because Uncle Sam owned most of the world’s gold after the war—and because American leaders publicly stressed their commitment to the agreement. In 1963, for example, President John F. Kennedy told Congress that “this nation will maintain the dollar as good as gold…the foundation stone of the free world’s trade and payments system.” President Lyndon Johnson echoed this promise on more than one occasion, as did successive chairmen of the Federal Reserve and secretaries of the Treasury.

Holders of the greenback knew that, in an economic crisis, they had access to an alternative asset that would maintain its value. The gold-dollar link became the basis of world trade and investment. Confidence in its solidity fueled the phenomenal recovery of Japan and Western Europe from wartime devastation and played a big part in the American economic boom of the 1950s and 60s.

So why did Nixon cast aside this system? In the late 1960s, inflation began to accelerate, and holders of dollars feared the erosion of the currency’s purchasing power. At the same time, U.S. trade balances were deteriorating, thanks to fierce competition in manufactured goods from Japan and West Germany. Protectionist sentiment in the country was growing. The Nixon administration, congressional leaders and many CEOs believed that the link to gold overvalued the dollar, making U.S. imports too cheap and exports too expensive. They thought that severing the gold link would devalue the dollar in relation to other currencies and boost American trade.

Perhaps more important was the fact that the U.S. no longer had the gold supplies to convert all the world’s dollars. In 1955, U.S. gold reserves exceeded dollars held by foreign governments and central banks by 160%; by 1971, those reserves equaled just 25% of dollars held abroad. The emperor had no clothes, and policy makers were deeply concerned that if too many countries requested gold for dollars, Washington would have to abruptly end its pledge of convertibility. Such a failure, it was feared, would not only undermine U.S. credibility in international finance but raise questions in the minds of allies about the durability of American military commitments under NATO and other treaties.

Detaching the dollar from gold was consistent with a larger U.S. retrenchment. By 1971, Washington no longer had the wealth, power or global confidence of the nation that mounted the Marshall Plan. Retreating from Vietnam and focusing its energies on building its own society, the U.S. demanded that its increasingly prosperous allies open their economies to more imports, share the costs of defense and take more responsibility for managing currencies. American hegemony was fading, to be replaced by greater across-the-board burden-sharing among allies.

The Camp David decisions opened the way for new arrangements, in which exchange rates were not fixed against one another and not backed by gold, but instead allowed to float up and down depending on market forces. Nothing tangible backed currencies—only domestic economic conditions and international trust in a country’s policies and institutions. Value was in the eye of the beholder, not in the price of gold. Developed in 1972, this system of fiat currencies continues today.

A world of fluctuating currencies can be volatile, complex and uncertain. In the years between 1945 and 1971, there were hardly any global banking crises. The era of floating exchange rates, by contrast, has produced many, from the Latin American debt explosion of the late 1970s to the market crash of 2007-08. Once the dollar was detached from gold, new financial instruments arose to hedge the risks associated with exchange rate fluctuations. Options, swaps and derivatives grew into a vast casino-like industry. Making money on money too frequently became the preoccupation of Wall Street, replacing the financing of factories, infrastructure and technology.

But floating exchange rates also had benefits. They could accommodate rapid changes in the global economy, such as gyrating oil prices or new competitive pressures from emerging markets. They allowed trade and capital flows to flourish, which helped to lower prices and expand consumer choices while dramatically reducing global poverty. They created a degree of interdependence that could be correlated to the absence of large-scale military conflict for more than two generations. And all the while, the dollar remained the world’s preeminent currency, bringing the U.S. enormous economic and political advantages.

Today, however, the global economy may have reached an inflection point not unlike the one Nixon perceived in August 1971. Significant inflation looms on the horizon, as consumer demand and supply-chain logjams drive up prices for everything from meat to cars. If interest rates rise sharply in response, the dollar could become overvalued. American budget and trade deficits are once again soaring.

For their part, the EU and China, fed up with Washington’s excessive use of economic sanctions, have been searching for ways to circumvent U.S. financial dominance. China’s size and influence could lead to a frontal challenge between the yuan and the dollar.

Disruptive new technologies also loom. Digital currencies will likely one day be issued by central banks or even by Facebook, with its 3 billion users, and could compete with the dollar for supremacy. Crypto currencies like Bitcoin could impart new instabilities in a rapidly changing financial landscape. The global monetary system may be due for another revamping—one that reduces the role of the dollar and boosts other currencies, but in a manner adapted to a digitized world.

Fifty years ago, President Nixon and his team made some hard but enlightened decisions when it came to the global economy. American leaders of the not-too-distant future may be forced to do the same.

—Mr. Garten is dean emeritus of the Yale School of Management. This essay is adapted from his new book, “Three Days at Camp David: How a Secret Meeting in 1971 Transformed the Global Economy,” to be published on July 6 by HarperCollins (which, like the Wall Street Journal, is owned by News Corp).