Read an Excerpt

1

Origins of Dysfunction: How We Got Here

Richard Nixon was the accidental architect of our current global financial system. That makes him the ideal starting place for getting a grip on the dysfunctional nature of the world economy. In the late 1960s and early 1970s, outlays for the Vietnam War were playing havoc with the finances of the U.S. government. The trade deficit was expanding monthly as American consumers gravitated toward cheap new imports from Europe and Japan. A growing band of nervous foreign investors began exchanging their dollar reserves for gold, driving U.S. gold holdings down to dangerously low levels. President Nixon felt trapped by an economic juggernaut he could not control.

So, on August 5, 1971, Nixon gave a televised address to the American people. Its significance was likely lost on most of his audience, but it hit like an earthquake in the halls of the world’s banks. Looking solemnly into the camera, the president began by speaking gravely about an “all-­out war” waged by “international money speculators” against the United States. Then, as he vowed without a trace of irony to protect the dollar “as a pillar of monetary stability around the world,” Nixon let it be known that he had instructed Treasury Secretary John Connally to suspend the dollar’s convertibility into gold. With those words, the Bretton Woods system, a regime that had maintained global monetary stability since the end of World War II, was finished. The amount of dollars in circulation would no longer be backed by the requirement that the Federal Reserve hold the equivalent value in gold, an arrangement that had made the greenback an anchor for every currency in the world. Nixon described the measure as “temporary” and vowed to work with the International Monetary Fund (IMF) and America’s trading partners to create “an urgently needed new international monetary system” that would ensure “stability and equal treatment.” But these pledges proved impossible to fulfill. A year and a half later, the major currencies of the world had delinked from the dollar and were now free-­floating. The end of the gold backing became permanent, and no coordinated global currency system was ever established again.

The “Nixon Shock,” as it became known, had profound, far-­reaching consequences. It allowed money and credit to flow more freely across borders, which meant that economic growth rates accelerated. But it also meant that financial volatility and instability rose dramatically and that financial institutions garnered more power. The dramatic end to the Bretton Woods system transformed the global economy, setting it on a path to its current unbalanced state.

Gold: Stabilizer or Straitjacket?

In freeing the Federal Reserve from the constraints of the gold pledge, Nixon unshackled the Fed’s most powerful—­and some would say reckless—­instrument for economic pump priming: the power to create money. The same went for other central banks when their governments responded by delinking their currencies from the dollar. The world was catapulted into an age of fiat currencies, the legal tender that is backed not by some tangible asset but by the intangible concept of the public’s confidence in the government. Three decades later, the true implications of that power played out in the unprecedented monetary measures taken after the 2008 crisis. It made possible the Fed’s massive “quantitative easing” efforts, the bond-­buying programs through which the Fed pumped trillions of fresh dollars into the U.S. economy in the years following the crisis. Those contentious monetary injections were hugely controversial. Rick Perry, the governor of Texas and a contender for the Republican presidential nomination as of this writing, called Fed chairman Ben Bernanke’s action “almost treasonous” and said that he would be treated “pretty ugly down in Texas.” But Bernanke and the Fed likely saved the U.S. economy from the ravages of a Japan-­like cycle of deflation. Still, in driving down the dollar—­which made other countries’ exports more expensive—­they also infuriated America’s trading partners and contributed to inflation in oil and other commodities. The Fed’s actions stirred up hard-­core critics of fiat monetary systems and reignited one of most fractious and emotion-­laden debates of the economics profession.

The 2008 crisis led to an increase in the ranks of those advocating a return to the gold standard—­by which its fans mostly mean something more populist than the Bretton Woods system, whose dollars-­to-­gold pledge applied solely to governments and did not grant individuals the same right to fixed-­rate exchange of bullion for cash. These people argue that full gold convertibility lends stability to the monetary system by denying profligate governments the temptation to monetize their debts. Printing money is the easy way out, and a dangerous one, they say, since monetary expansion is inherently inflationary. The Weimar Republic, if it had been constrained by the gold standard, would not have become a byword for hyperinflation. Nor would there ever have been such a thing as a $100 billion Zimbabwean banknote, a denomination that bought just three eggs when it was released in July 2008. A proper gold standard makes such episodes impossible. Yet that does not make it a magic bullet for ending financial instability.

Central bankers are human and prone to both mistakes and political pressure. That’s why some fiscal conservatives argue that we should limit these officials’ discretionary power by tying the monetary base to the value of some external asset. And gold, they believe, has proven itself through time as the natural choice. Although it has only modest industrial uses and little intrinsic value beyond its aesthetic appeal, gold has a rare and pure atomic structure that bolsters the integrity of the metal and makes it perfectly fungible. It has been sought after as a store of value across cultures, national borders, and political systems. It was the currency of the realm in feudal kingdoms. Empires were founded upon the quest for it. Wars have been both fought over it and funded by it while those made homeless by such conflicts have used gold to ferry their savings to safer harbor. Southern Vietnamese refugees stuffed thin 15-­gram “gold leaf” bars into their shoes or the lining of their clothing when they fled their homeland in the 1970s. European Jews who escaped the Holocaust put all their savings into transportable gold; so too did Palestinian refugees who strapped gold chains, coins, and bars to their bodies before Jewish soldiers expelled them from their homes during the 1948 Arab-­Israeli War. Gold prices have always rallied when investors fear inflation or generally lose confidence in governments. As we’ll see in Chapter 9, that’s precisely why gold made a spectacular comeback in the wake of the 2008 crisis.

Still, in the globalized financial system that evolved out of the Nixon Shock, one in which automated, high-­speed trading programs now place multibillion-­dollar buy orders and then follow them up with equivalent sell orders milliseconds later, the efficacy of restoring a currency pact based on this alluring metal is questionable. Gold supplies are tiny relative to financial flows. Whereas average turnover in the foreign exchange market now stands at $4 trillion every day, the total amount of gold produced throughout history runs to only about 165,000 tons, enough to fill just three Olympic swimming pools. This scarcity makes the precious metal susceptible to hoarding. A gold standard would also leave governments overly focused on securing bullion supplies, a distracting priority for macroeconomic policy making. By the same token, countries blessed with large gold deposits would have an unfair advantage; extracting more of it would allow them the privilege of being able to expand their economies at no cost.

Given the massive international financial flows that technology has fostered in the age of globalization and because of the central role the dollar plays as the world’s reserve currency, any U.S. gold standard would need to be internationalized via a system of gold exchanges so as to prevent financial imbalances from developing. But that would leave governments subordinating their domestic national priorities to the system’s demands for automatic balancing. It seems doubtful that this would be tenable in the modern democracies of today. (The economic historian Barry Eichengreen has convincingly demonstrated how the advent of universal suffrage produced the strains that ultimately undermined history’s only true international gold standard exchange, which existed from 1870 to 1914.) Here’s why: when a country on the gold standard runs a trade deficit, its gold reserves decline automatically, which according to the strictures of the system requires that it raise interest rates to attract foreign capital and restore its depleted gold reserves. But if that happens during an economic contraction, this brake on growth can have a brutal impact on people’s lives. (Greece subjects itself to the same under the de facto “gold standard” of its economy’s peg to the euro.) Over time, the international system balances itself out as growth returns to the affected country. But in the short term, the forbidden tool of devaluation looms temptingly, a solution that’s easier to administer politically as it shares the burden with foreigners. It’s hardly surprising that on that evening in August 1971, Nixon, who fundamentally mistrusted multilateral institutions, cast blame on shady foreign “money speculators.”

What is most lost in this age-­old debate, however, is the fact that the rigid system preferred by goldbugs has historically failed to deliver the holy grail of permanent financial stability for the same basic reason that fiat currency regimes have failed: governments face overwhelming national political pressures that prevent them from coordinating policies internationally. Without the giant imbalances in trade and capital flows that arise from misaligned policies, and without the politically untenable outflows of jobs and price pressures that come with them, either the gold standard would survive or economies would be sufficiently stable that there’d be no need for it. Either way, the conclusion is the same: we desperately need to improve international cooperation between governments.

Currencies Go Topsy-­Turvy

Nixon’s bold currency move ended one problem but created a host of others. The sharp drop in the dollar and the world’s sudden immersion in a system of floating exchange rates wreaked havoc with international contracts and drastically shifted the terms of trade between countries. It especially posed a threat to the newly amalgamated European Economic Community, forcing its members to take steps to align their currencies. These measures would eventually lead to the ultimate manifestation of continental monetary union: the euro.

As currencies realigned in the wake of the Nixon Shock, so too did the prices of every asset affected by them. The immediate impact was a collapse in world stock prices. Although the devaluation initially gave a big boost to the U.S. economy, which grew rapidly in 1972, things turned sour in 1973 once the pound, the yen, and the Deutschmark were all fully floating against each other. That year delivered one of the worst bear markets in global stock market history. By the time prices stabilized in December 1974, the Dow Jones Industrial Average had lost 47 percent of its valuation. London’s FTSE 100 index dropped by 73 percent, as Britain’s exporters lost money on the back of a stronger pound and as its internationally active banks were blindsided by rising global inflation.

The suspension of dollar convertibility into gold landed in a period of intense geopolitical tension. Most notably, the Organization of Arab Petroleum Exporting Countries hit financial institutions with the economic equivalent of an atomic bomb. OAPEC’s 1973 oil embargo produced an exponential increase in energy prices and drove up the prices of virtually everything. Since it coincided with a decline in the now floating dollar, this inflationary surge meant that demand for U.S. bonds fell, which in turn led to higher borrowing costs. This toxic environment produced stagflation, an unprecedented combination of unemployment and inflation, which stuck around for the rest of the decade. It was not an auspicious beginning to the post–­Bretton Woods era.