Reflections on the Monetary History of the West – 1700-1974

Written by Lewis E. Lehrman

Monday, January 03, 2011

Lyndon Johnson even put an end to the historic use of silver in the production of the subsidiary coinage of the United States. The vast silver hoard of the U.S. Treasury, part of the patrimony of every American taxpayer, was liquidated in the market at about 90 cents per ounce. (Footnote: Peter Grace chart) Next, in March 1968, Johnson suspended the London Gold Pool as the foreigners began to cash in their excess dollars for more gold than we were willing to supply. Between November of 1967 and March of 1969, the U.S. lost one-fifth of its gold reserves. Beginning in 1960-61, the Gold Pool had underwritten the Bretton Woods convertibility agreements, having grown increasingly shaky by excessive credit expansion in the United States and the United Kingdom. By selling gold at the stipulated dollar-gold parity of $35 per ounce in order to redeem excess dollars and sterling accumulating abroad, the Anglo-Saxon powers had been able to finance their inordinate domestic and foreign policies. After 1968 the U.S. refused to supply gold for dollars in London. The linchpin of Bretton Woods, the link between gold and the dollar, had been ruptured if not definitively broken.

These dramatic changes in the international monetary system were welcomed by most of the academic and policy-making communities. The Bretton Woods agreement was an unnecessary discipline. Gold and silver were “outdated,” declared these “experts.” Professional economists – neo-Keynesians and monetarists alike – gladly dismissed the Bretton Woods fixed rate regime as the last vestige of the pre-World War I gold standard. They herald the coming of a new era of central bank “managed money” and floating exchange rates.

From 1945 to 1965 the neo-Keynesians had ruled economic policy making and academic circles in Washington and in the universities. Their demand management policies, especially during recessions, relied on budget deficits, financed by the creation of new credit at the central bank, the Federal Reserve System. The neo-Keynesians were not very much interested in the consequences of credit and monetary policy. Fiscal policy was their primary tool. Then came the counter-revolution of the monetarists who captured much of the field of economic policy and university departments in the late 1960s. From them one learned in general that money matters as much, or more, than fiscal policy. And in particular, we learned from the monetarists that men can manage inconvertible paper currencies according to certain prescribed monetary rules. Their favorite technique for controlling the money supply was so-called open market operations, the buying and selling of government debt securities by the Federal Reserve System. Simply stated, monetarists promoted the idea of a gradual growth in money and credit by means of a so-called steady “quantity rule” – say, 3 to 4 percent money growth per annum. Neo-Keynesians had, of course, offered “countercyclical” monetary management, that is, a discretionary quantity rule, whereby money and credit growth was geared to demand management policies and adjusted as well to finance the budget deficits caused by their “compensatory” fiscal policies.

Both warring schools of thought criticized the faltering Bretton Woods fixed exchange rate regime, itself a form of the ill-fated official gold exchange standard originating at Genoa in 1922. Ironically the warring monetarists and neo-Keynesians agreed – but not upon the reform of Bretton Woods. Instead they advocated its demolition. In its place, monetarists and neo-Keynesians alike endorsed central bank managed currencies; floating exchange rates (“clean” for some, “dirty” for others); and the demonetization of gold. Simply put, they wanted an end to any international exchange rate regime. The idea of monetary standard had been destroyed. These monetary doctrines soon became the fashionable credo propagated by academic economists and policy makers everywhere.

President Nixon followed Johnson and under the influence of his advisors gradually went through his own conversion to Keynesian economics (“We are all Keynesians now,” he remarked.) But Nixon also absorbed some of the teachings of the Monetarist School – in particular, the importance of an independent monetary policy and the desirability of replacing the Bretton Woods fixed rate system with floating exchange rates. On August 15, 1971, the test came. The dollar had collapsed in May on the foreign exchanges and European governments became increasingly impatient to exchange their excess dollars for gold. Nixon responded by defaulting at the gold window: he refused to redeem the excess dollars for gold, as the British government a few days earlier had demanded under the contract terms of the Bretton Woods treaty. In one of those curious historical ironies, it was the anti-New Deal Nixon who affirmed in 1971 the final demonetization of gold, begun at home by the liberal FDR in 1934. The last vestiges of an official domestic and international gold standard had been abrogated by the undisputed leader of the free world. The dollar had ceased to be a real money, linked directly to an article of wealth such as gold. It would henceforth be a nominal paper money, an empty monetary token, linked to nothing but the judgment of its regulators at the Federal Reserve System.