The Nixon Shock
“Inauguration Day was cloudy, grim,” wrote Arthur Burns in his diary on Jan. 20, 1969. As he watched President-elect Richard Nixon, Burns—an immigrant from Galicia, the son of a housepainter who had risen to become the foremost expert on U.S. economic cycles and chief economist to Dwight Eisenhower—saw a man with “a look of exaltation about him.” It was not a feeling Burns shared. “I would have felt better if his head were bowed and his body trembled some.”
Nixon was inheriting an overheated economy—inflation was already a concern. Burns, 64, would be joining the Administration as a uniquely trusted adviser. In 1960, when then Vice-President Nixon was seeking the White House, Burns had warned him that if the Federal Reserve tightened interest rates, it could damage Nixon’s chances. It had played out just so: The Fed tightened, the economy suffered a recession, and Nixon lost to John F. Kennedy. Nixon never forgot the power of the Fed, and he remembered Burns as an economist with political savvy.
So it was that a year into his term, with the economy faltering, Nixon tapped Burns to replace William McChesney Martin Jr., the Fed chief who had dashed his hopes in 1960. According to Burns biographer Wyatt Wells, Nixon issued his appointee some blunt instructions: “You see to it,” Nixon said. “No recession.”
Burns had more to address than a faltering economy and a famously meddlesome patron. By December 1969, inflation had topped 6 percent—its highest level since the Korean War. Inflation had disturbing international implications because, in the system known as Bretton Woods that had prevailed since the end of World War II, the U.S. was committed to backing every dollar overseas with gold. Thus, foreign countries had the right to exchange their greenbacks at the rate of $35 per ounce. The other currencies were fixed to the dollar, and the dollar—the sun in the monetary sky—was pegged to gold.
For the first years after World War II, Bretton Woods (named for the New Hampshire resort where delegates from 44 Allied nations met in 1944) worked perfectly. Japan and Europe were still rebuilding, and foreigners were eager for dollars they could spend on American cars, steel, and machinery. Even as they accumulated currency reserves, America’s trading partners were content to park them in interest-bearing dollars rather than in inert metal. And since the U.S. owned over half the world’s official gold reserves—574 million ounces at the end of World War II—the system seemed secure.
But from 1950 to 1969, as Germany and Japan recovered, the U.S. share of the world’s economic output fell decisively, from 35 percent to 27 percent. Other nations had less need for dollars and more for deutsche marks, yen, and francs. Also, U.S. spending on Vietnam and domestic programs flooded the world with dollars. Bit by bit, America’s allies began to ask for gold.
The official charged with monitoring gold and other international exchanges was the Undersecretary for Monetary Affairs, a gruff, 6-foot, 7-inch banker named Paul Volcker. He had been worried about the gold market for quite some time. Although the U.S. fixed the official gold price, a market existed in London, in which, in effect, companies sold metal to jewelers and dentists, with central banks sopping up the surplus. Generally, the banks kept the price near to $35. One day in 1960, when Volcker was working at Chase Manhattan, someone burst into his office with news: Gold was at $40. Volcker couldn’t believe it. The price receded, but it was a worrisome foretaste. Jitters in the gold market were an early symptom of domestic inflation.
By the time Nixon took office, officials knew they were sitting on a powder keg. As Volcker, then 41, recalls, he warned incoming Treasury Secretary David M. Kennedy that they had two years to save the dollar. America’s balance of payments deficit in 1969 had reached $7 billion—small by today’s standards but scary then. This meant more dollars accumulating in London, Bonn, and Tokyo. Volcker pressed the Europeans to revalue their currencies; if Americans had to pay more for French wine, fewer dollars would pile up overseas. Germany modestly revalued; others refused. The Europeans, as well as Japan, were caught in a trap: They were reluctant to hold dollars, but unwilling to give up their dependence on exporting goods to America.
Nixon had minimal patience for the details of international finance. When an aide informed him of monetary problems in Rome, Nixon snapped, “I don’t give a s— about the lira.” What he did care about was the domestic economy, especially the politically sensitive unemployment number. And despite his instructions to Burns, in 1970 the U.S. suffered a recession, triggering a rise in unemployment to 6 percent, its highest mark in a decade.
Nixon was furious with Burns. He began taking economic cues from George Shultz, the Labor Secretary and then Budget Director. Shultz argued that Burns had erred by limiting the expansion of the money supply, which over the course of 1970 was less than 4 percent. Shultz, a former business school dean at Chicago, was echoing the theories of his close friend, Milton Friedman, the architect of the Chicago School. To Friedman, money supply was the single key tool at the Fed’s disposal. Friedman viewed money in terms of supply and demand: If the Fed printed more dollars, then money would be worth less and goods would cost more, i.e. inflation. But he also saw overly tight money as having worsened the Great Depression.
Burns, only eight years older than Friedman, had taught Friedman at Rutgers and been a mentor to him since. The two maintained a close friendship, and their families summered at nearby homes in Vermont. However, Burns didn’t share the rigid Friedman-Shultz belief that the money supply was everything. Burns distrusted single-answer diagnoses and blamed inflation partially on other factors, such as the growing power of labor unions. When even the 1970 recession failed to curb inflation, Burns was stumped. “What the boys around the White House fail to see,” Burns scribbled in his diary, “is that the country now faces an entirely new problem—sizable inflation in the midst of recession.” As Burns would tell a congressional committee, “The rules of economics are not working the way they used to.” Prices were going up even when factories stood idle—a seeming refutation of the economic rules.
Despite the galloping inflation, Nixon pressured Burns to loosen monetary policy. White House aides, violating the central bank’s supposed independence, inundated the Fed with memos on the need to lower rates. “The pressure that Nixon exerted was unbelievable,” says Joseph Burns, the late Fed chief’s son. Volcker agrees that it got “very rough.”
As the economy shifted into a tepid expansion in ’71, Burns allowed the money supply to expand at an annual rate of 8 percent in the first quarter, 10 percent in the next. This was wildly expansionary. Allan Meltzer, a Fed historian, says Burns’s policy was partly attributable to honest miscalculations. (Determining the rate of money supply growth is fiendishly difficult.) But Meltzer says Burns was also influenced by Nixon’s bullying. The President alternately flattered Burns and excluded him, and Burns careened between feisty shows of independence and toadying displays of loyalty. In his diary, Burns assures the President that “his friendship was one of the three that has counted most in my life”; a few months later he is recoiling at Nixon’s “cruelty” and, still later, at his anti-Semitic outbursts. He feared the consequence of higher unemployment, yet was committed to the success of the Nixon Administration. This conflict led Burns to a dramatic about-face. In 1970, the Democratic-led Congress had authorized the President to impose wage and price controls. Nixon, who had played a small role in administering war-time price controls while working for the Office of Price Administration, thought they wouldn’t work. The issue became a political football. Then, at the end of 1970, Burns gave a speech advocating a wage and price review board that would issue guidelines and try to restrain inflation through suasion and public statements. Milton Friedman regarded it as an endorsement of centralized planning—and a personal betrayal. He stayed up all night writing his mentor what, he said later, was an overly harsh letter; Burns and Friedman were never friends again.
In the first half of 1971, unions representing copper, steel, and telephone workers negotiated wage increases of more than 30 percent over three years, in addition to cost-of-living adjustments. To modern readers, it may seem odd that the chairman of the Federal Reserve was reluctant to raise interest rates in the teeth of double-digit inflation, but the modern view that only the Fed can control inflation was not widely accepted. Balanced budgets were thought to be of equal importance. And, as Meltzer notes, few Americans thought inflation was worth sacrificing jobs for. That summer, Time magazine opined that, “once an inflation starts, no government could accept the severe recession and unemployment needed to stop it cold.” This was the conventional view—that the Fed was powerless.
Friedman argued that it was better to snuff out inflation because, in the long run, inflation (which merely amounted to printing money) wouldn’t truly create jobs. Friedman’s position was later to become gospel. At the time, though, many economists believed that by adding to the money supply, the central bank could spur growth. Burns, therefore, urged the White House to curb inflation by non-monetary means. He encouraged the President to “jawbone” industries to show restraint and to form a council of wise men who would publish guidelines. Nixon feared guidelines were a step toward controls; his solution was to bring inflation down without a recession, by working toward a balanced budget. Herbert Stein, his economic adviser, told him flatly it wouldn’t work. Burns chafed: “I am convinced that the President will do anything to be reelected.”
Rampant domestic inflation was mirrored, franc for franc, in markets overseas. Foreign governments intervened to buy dollars to shore up America’s currency (and their export trade). This left their central banks swollen with greenbacks. “Foreigners buying dollars caused a monetary expansion, similar to today,” says Ronald McKinnon, an economist at Stanford University. Meanwhile, America’s gold stock had dwindled to $10 billion, half its 1960 level. The gold standard now existed only in name, for foreign banks held far more dollars than the U.S. held gold. This left the U.S. vulnerable to a run.
With shrewd timing, in early 1971, Nixon appointed a new Treasury Secretary, John Connally, a hulking former Texas governor, who saw these various financial trials—inflation, the pressure on the dollar, the mounting trade deficit—as affronts to the national honor. It was the peak of the Vietnam protest movement, and Connally felt the U.S. had absorbed enough humiliations. He had no abiding economic philosophy; as he proclaimed to Nixon, “I can play it square, I can play it round, just tell me how you want me to play it.” What he brought to the Nixon team was enormous ego, force of personality, and a political intuition that economic reforms, which appeared imminent, had to be presented in a program acceptable to ordinary Americans. That Connally lacked financial expertise bothered him not a whit. “I can add,” he said upon taking the job. His role, as he saw it, was to pull together the competing recommendations of Shultz, Burns, and Volcker into a policy suggesting coherence.
Burns continued to back a wage council; he also thought the U.S. should devalue against gold (that is, raise the gold price above $35). Volcker believed this would be ineffectual, as other countries would simply devalue their currencies by the same percentage. To Volcker, the key to restoring balance was a 10 percent-to-15 percent devaluation of the dollar against the yen and the European currencies. Even if America’s allies refused to budge, Volcker thought the U.S. could force the issue by temporarily halting gold-dollar convertibility.
The pressure intensified that spring. In April and into May, as speculators sold dollars and hoarded deutsche marks, Germany was forced to purchase $5 billion to stabilize the exchange rate. This was a huge sum in an era in which hedge fund goliaths did not exist. On May 5, Germany caved to the upward pressure on its currency and let the deutsche mark float. This brought the West a step closer to Friedman’s dream of freely trading currencies, but it did not alleviate the crisis.
The gold exodus continued and, to make matters worse, the U.S. began running a substantial trade deficit, a politically charged issue given that unemployment remained at 6 percent. Nixon had to act, but his advisers were split. Volcker, as well as Shultz, wanted to close the gold window. Burns was vehemently opposed. Severing the gold link would turn money into … paper. If the government no longer had to preserve the dollar’s value in metal, how could the Administration claim, with any credibility, to be countering inflation?
This question prompted officials to give controls a second look. No one in the Administration, from Nixon down, believed in controls in an economic sense. They were Sovietized economics, an attempt to force markets where they didn’t want to go. But the economics didn’t matter to Connally; what counted was a forceful display of power. Over the summer, Connally, with Nixon present, briefed Shultz—essentially so the latter could air his objections and then get behind the program. Secrecy was imperative. “Don’t tell your wife,” Nixon warned Shultz.
The intent was to move after Labor Day, but on Aug. 12, a Thursday, Britain stunned the U.S. by demanding that it guarantee the value of $750 million. On Friday, Nixon summoned 15 advisers to Camp David; he insisted no outsiders be told. Volcker wisely took exception and briefed a colleague in the State Dept. and also the Japanese. Stein, the economic adviser, told William Safire, the speechwriter, that they were embarking on the most momentous economic decision since March 1933. “[Are] We closing the banks?” Safire asked. Stein said no, but the gold window might be disappearing. “What a tragedy for mankind,” wrote Burns in his diary.
The plan, presented by Connally, had three key points. First, America would stop converting dollars to gold. Second, to combat the potential inflationary effects, wages and prices would be frozen for 90 days. And third, the U.S. would impose an import surcharge of 10 percent. Connally’s idea was to use the surcharge as a cudgel, to pressure other countries to renegotiate their exchange rates.
The Camp David weekend was intended for Connally to get everyone’s support before the program was announced. People slept two to a cabin (the bed was too short for Volcker) and convened in the dining room. Nixon remained cloistered in his cabin, the Aspen Lodge, but called anxiously for updates. Burns spent an evening pacing the grounds with Volcker, wringing his hands over the gold standard. Burns alone was invited to the President’s cabin for a private audience. Although Nixon regarded the pipe-smoking Fed chairman as pompous and long-winded, he knew Burns was trusted by the public, and he needed his support. Otherwise, it was Connally’s show.
Connally brilliantly packaged the program not as America abandoning its commitment to the gold standard but as America taking charge. He turned the dollar’s collapse, which could have appeared shameful, into a moment of hubris. The emphasis would be on righting America’s trade balance, as well as minor points such as a 5 percent cut in foreign aid. An aide to William P. Rogers, the Secretary of State, called and interjected, “You can’t cut foreign aid.” Connally said, “Tell him if he doesn’t shut up we’ll make the cuts 15 percent.” Shultz muzzled his disquiet over price controls; even Burns joined ranks. The group feverishly debated whether Nixon should address the country on Sunday night, which would mean preempting the popular Gunsmoke. The public relations aspect was paramount. Stein wrote later that the discussion at Camp David assumed “the attitude of scriptwriters preparing a TV special.” No one pretended to know how controls would work; the question was scarcely debated.
Addressing the nation on Sunday, Nixon blamed currency speculators and “unfair” exchange rates rather than U.S. monetary policy. Politically, he hit the jackpot. Monday’s nearly 33-point rise in the Dow was the biggest ever to that point. Nixon’s “New Economic Policy” drew raves from the press. “We unhesitatingly applaud the boldness with which the President has moved,” read the New York Times editorial. In the present era, America’s inability to repair its fiscal problems has tarnished its credibility and hampered its currency negotiations with China. The Nixon Shock showed the U.S. taking action. That December, Shultz and Volcker successfully negotiated a broad revaluation of exchange rates.
Volcker envisioned that once exchange rates were modified, Bretton Woods would be restored, perhaps with a more flexible mechanism for adjusting rates. He tirelessly negotiated with Europe and Japan, but Bretton Woods could not be put back together. The gold window stayed shut. More devaluations followed, and by 1973, currencies were freely floating.
Friedman’s prediction that, left to the market, currencies would regulate themselves with only gradual adjustments proved wildly incorrect. The dollar plunged by a third during the ’70s, and currency volatility has threatened several national economies since; in 1997, Asian and Latin American countries were wrecked by currency runs. To this day, Volcker regrets that Bretton Woods was abandoned. “Nobody’s in charge,” he says. “The Europeans couldn’t live with the uncertainty and made their own currency and now that’s in trouble.” The effect on America’s domestic economy was even worse. As Shultz says, “Price controls gave the illusion of doing something about inflation.” They further liberated Nixon from concern for the normal rules. Late in 1971, he wrote to the Fed chief, “You have given me absolute assurance that money supply growth will be adequate to maintain growth.” Burns scrawled in the margin, “Never gave him absolute assurance. What nonsense!” But Burns, intentionally or not, delivered on Nixon’s demand for an expansionary monetary policy.
Controls had the desired short-term effect; inflation was quiescent through the end of 1972, when Nixon easily won reelection. The controls, however, proved difficult to end. The 90-day freeze begat a more complicated wage and price regime, a Phase II, followed by a Phase III, lasting into ’74. And Burns’s easy money fostered a monetary steam cooker that controls could not suppress. By August ’74, when Nixon resigned, inflation had topped 11 percent. Soon it would go even higher. Expectations of rising prices became embedded in the system.
The Nixon Shock was a central cause of the Great Inflation. It also spelled the end of the fixed relationships that had governed the financial universe. Previously, people took out mortgages for set periods and at fixed rates. They had virtually no options for saving money other than in banks, and the interest rates that banks could pay were capped. Floating currencies unleashed a new world of risk and instability. For the first time, investors could bet on the direction of interest rates or the Swiss franc. New financial instruments, new speculative tools, proliferated. The world gravitated from the certainties of Bretton Woods to the dizzying market cycles we’ve lived with since. Donald Kohn, who joined the Fed in 1970 and retired last year as vice-chairman, thinks Bretton Woods was doomed. But bankers have yet to find as rigorous a standard as gold. And they have become ever more apt to please politicians, deferring recessions at the risk of inflating asset bubbles.
Burns was replaced by Jimmy Carter in 1978. The following year, with inflation rocketing toward 15 percent, Burns delivered a keynote speech, “The Anguish of Central Banking,” in which he argued that central bankers around the world were failing because elected leaders were unwilling to risk displeasing constituents. The new Fed chief, Volcker, did tame inflation; unlike Burns, he had the fortitude to subject the country to a brutal recession. But the dilemma faced by Burns—how to withstand the demands of the public for limitless monetary expansion—did not go away. We see it now in the troubles of nations from Greece to Ireland to the U.S. And the anguish that Burns felt is Ben Bernanke’s unfortunate inheritance.