The Nixon shock and dawn of a volatile world

Abhijeet Awasthi | Updated on August 31, 2021

Dollar World dominance   -  /iStockphoto

The rise of powerful central banks with untrammelled powers to print money is one the sad consequences

The era of currency volatility and global market complexity can be traced to an important event which happened 50 years back, in 1971. The Nixon Shock permanently altered the global markets landscape from simple and rule based to complex and chaotic.

On August 15 1971, the then US President Richard Nixon announced that US was suspending its pledge to convert US dollars into gold. Along with it he also announced a temporary wage freeze and a surcharge on imports. The shock however was felt by his international audience, especially other central banks, which were holding copious amount of US dollars in their reserves.

To understand the full impact of the event we need to look at its historical roots. In July 1944, as the World War II winding down, the allied powers gathered in the US town of Bretton Woods to create the new world order.

The US emerged as the natural leader and proposed the idea of US Dollar as the central currency. It was agreed that the world trade will be denominated in USD and all other major currencies will operate with a peg against the dollar. The dollar in turn was pegged against the gold. Gold was priced at $36/oz and the US was agreed as the custodian of the gold honestly maintaining the peg. Other countries earning US Dollars could convert them to gold in case they wished to. Wish being the operative word here.

Now as the owner of reserve currency, the US was given a free pass to supremacy. The ability to print dollars remains with it; other countries need to earn but the US just needs to print. The strength of US economy, which made it the ultimate consumer for every good, also helped its cause. The aid provided to other countries for rebuilding too played its role. US gave dollars to others as aid, which was then used by them to buy raw materials from US. They then produced goods which were sold to the US, thus making them hold more dollars. Ultimately most countries held lots of dollars and a promise that they can one day convert it to gold.

Post WWII years were one of the highest growth periods for the world economy. But then a booming economy needs more money but money supply was tethered to the gold availability. At some point in time, the US realised that the availability of gold and demand of dollar can not keep pace, so they kept printing more. Other countries slowly realising the game sheepishly started demanding the conversion of dollar to gold. Obviously they were wary of riling the US, which was their biggest supplier and biggest customer.

Ultimately amid the growing conversion chorus, US decided to cut the umbilical cord between the gold and the Dollar. In his speech, the US President sold the act as the pre-emptive action to protect US Dollar from the external assault. The temporary ban became permanent bringing Bretton Woods agreement to complete close. By 1973 the world moved into the era of floating currencies and exchange rates.

The floating exhange rates era

In the floating exchange rate world stability and certainty are in perennial short supply.

Post 1971, a vibrant currency market developed which soon eclipsed the equity market in terms of breadth and volume. The opportunities created their own ecosystem with clients, speculators, risk managers and regulators. New products and long-term bets became common place.

Countries and central bank also had to device strategies to remain competitive not just in production but through currency management.

Another impact was the rise in the price of gold. Gold was seen as a hedge against the fiat currency and the price rose from $36/oz when the shock came to $1800/oz currently. The search is still on to find the correct level where the fiat money supply can will match the physical gold availability with some purists still believing that the gold era should come back.

However, the most profound impact of Nixon shock was the rise of the almighty central banks. The breaking of gold peg started the pure fiat currency era and the key to the printing press lies with the central banks. The role of central banks changed from the lender of last resort and monetary policy tweakers to full fledged cynosure of the market economy.

In the pure fiat world central banks can print without fear and monetise government debts. This almighty central bank is a developed world malaise. In the developing world one still needs to worry about the rating agencies and bond market moods. But this is hardly a comfort.

We can see that the current public affection towards the decentralised digital coins is an attempt to break away from centrally controlled fiat money. But the experiment is too nascent and will need to pass the test of time. One thing is for sure that it certainly adds to volatility and chaos of the system. May be the post Nixon VUCA (volatility, uncertainty, complexity, and ambiguity) world is now moving towards E-VUCA where E stands for extreme. Sadly we don’t have the adequate tools to answer right now.

The writer is a banker and forex market expert

Published on August 31, 2021

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