Insufficient gold supply

Another significant test of the Bretton Woods Agreement came in 1971, when the volume of world trade using US dollars as the medium of exchange, finally exceeded the ability of the United States to support its currency with gold. The restraints of the gold standard at $35 per ounce established under the Bretton Woods Agreement placed the United States in a very precarious position. As Keynes had predicted, there was not enough gold in the US Treasury to back the actual number of US dollars then in circulation. In fact, the Treasury was not really sure how many paper dollars actually were in circulation. What they did know, however, was that there was not enough gold in Fort Knox to back them. The problem was the US Treasury was not the only institution aware of this fact. All G-10 countries were aware of this. If demand were placed upon the US Treasury at any one time to exchange all the Eurodollars for gold, the US Treasury would have had to default, thereby effectively bankrupting the United States government.

France, the United Kingdom, Germany and Japan were concerned about their substantial holdings in US dollars. If just one of these countries demanded gold for dollars, a run on the US dollar could occur with devastating results. The United Kingdom quietly initiated such a demand at a meeting between its ambassador to the US, with Bill Connolly who was then Secretary of the US Treasury, and Under-secretary of the Treasury, Paul Volcker. Connolly listened to the ambassador and said, “I will answer you tomorrow”.

Nixon, Connolly and Volcker, in an ultra-secret weekend meeting with the brightest of the nation’s bankers and economists gathered to ponder “tomorrow’s” answer. Honouring the demand meant certain death to the US as an economic super power. Not meeting the demand would have catastrophic results. Was there a way out? What if the US unilaterally abandoned the gold standard and let its currency float in the market? Nixon and his advisors viewed the dilemma in terms of two mutually-exclusive alternatives: increasing the value of US gold reserves and maintaining a gold-backed economy, or considering the repercussions to the world’s economies if the US dollar were no longer backed by gold.

To resolve the crisis, the US needed to unilaterally abandon efforts to maintain the official price of gold at an artificial level of $35 per ounce, the same price that existed in 1933. Gold in 1971 had a market value of approximately $350 to $400 per ounce in the commercial world market, or about 10 times the official price. By letting gold seek its market price, the US Treasury’s gold would automatically become worth approximately 10 times its value at the official price. Under these circumstances, any government, bank or private investor would have to exchange $350 to $400 US dollars foran ounce of gold at the market price rather than one US dollar to acquire ^1/₃₅ an ounce of gold at the old official price. An ounce of gold would rise in exchange value by a factor of ten, and the US Treasury’s gold supply would increase correspondingly.

In addition, once the gold standard established at Bretton Woods at $35 per ounce was abandoned, why re-establish it at $350 an ounce? The same problem would eventually arise again, and Keynes would be right again. Why not adopt Keynes’ original idea of a currency, being backed by the good faith and credit of its government, its people, its national resources and its production capacity? The United States needed to let its currency “float” in value against all other world currencies and not tie it to gold. Market forces would set the dollar’s value through its exchange rate with other foreign currencies. Nixon and his advisors also realised that business world-wide had long ceased conducting international trade through gold or silver exchanges. The US dollar had become accepted as the principal world-wide medium of international trade and settlements. Therefore, taking the dollar off the gold standard and allowing its value to float in relation to other world currencies would create currency risks for international trade transactions, but it would not preclude or stall international commerce. The world of international business had, in practice, already abandoned the gold standard years before, considering it cumbersome and unworkable. Moreover, the other Western nations had neither the economic nor military power to force the US to honour its commitment to the gold standard and, therefore, could not prevent it from abandoning that standard.

Based upon a clear understanding of these two inter-related realities, Nixon and his advisors determined to abandon the gold standard and allow the US dollar to “float” in relation to other nations’ currency. The exchange rate would no longer be determined by an artificially-maintained gold standard, but rather by the value placed on each currency in the foreign exchange market