The Standard & Poor’s headquarters, inside one of the biggest skyscrapers in New York’s financial district, houses just about every kind of brainiac that Wall Street money can buy. Mathematicians, computer modellers, economists and market strategists pooled their collective wisdom before making last Friday’s decision to strip the United States of its triple-A credit rating.
It is a shame, however, that the ratings agency didn’t have a historian with a sense of irony on its team. If they had, S&P might have postponed the announcement, and the market turmoil it inevitably unleashed, for just a few days. The 15th of August would have been the perfect moment to unleash this particular bombshell.
Why? Because next Monday will mark the 40th anniversary of one of the most significant, if little recognised, turning points in post-war economic history. On 15 August 1971, President Richard Nixon ended the final link between the dollar and gold. And the moment he did so, the world began an experiment in what economists call ‘fiat’ money, and the rest of us know as ‘funny money’.
The scale of the change was immense. Throughout recorded history, money had been linked to something real: gold mostly, although sometimes silver, or even seashells. From that moment, it wasn’t any more. Money was just bits of paper, or more often bytes in a computer terminal.
Four decades on, we’re starting to have some idea of how that experiment is working out. And the answer is not very well. We’ve seen repeated booms and busts, and a succession of financial crises. Trade imbalances have exploded. The dollar has gone into rapid decline. The banking sector has risen to dominance. And, perhaps most importantly, we are literally drowning in debt.
The gold standard had been dying for a long time, of course, but it was Nixon who fired the final bullet. Under the post-war Bretton Woods system the dollar was exchangeable into gold at the rate of $35 an ounce. Other currencies were linked to the dollar. Ordinary people couldn’t swap their banknotes for gold the way they could in Victorian England, but central banks could. The link was a faded, threadbare one. But it was there all the same. A dollar, a pound, a yen or a franc still represented, in a way, a tiny sliver of gold.
By 1971, the system was untenable. The US was running vast debts to pay for the Vietnam war. The Swiss pulled out of the system. The Germans and the French were drawing on American gold reserves. The US was struggling to retain its credibility in the markets, much as it is today. Nixon had had enough. He unilaterally pulled the plug. The ‘Nixon Shock’ as it was known, because it was sprung on the markets by surprise, ended convertibility. If you had dollars, you could spend them on whatever they might buy, but the Federal Reserve would no longer swap them for anything else.
To most mainstream economists, that was an improvement. Currencies would float against one another. Independent central banks, free of political control, would maintain their value. The ‘barbarous relic’, as Keynes once described gold, would be removed from the system. Monetary policy would be run by experts on a far more rational basis.
It hasn’t worked out as most economists expected. Few things ever do. True, the old system didn’t work perfectly: there were balance of payments crises, during which countries were constantly having to revalue their currencies against the dollar (i.e. gold) — downwards in the case of slightly ropey economies such as Britain’s, or upwards in the case of better-managed ones such as Germany’s. But it did provide some measure of stability and discipline. Just take a look at the prices. The gold price of $35 an ounce had been set by President Roosevelt in 1933. It held that level for 38 years, despite the small matters of the second world war, the cold war, and the rapid industrialisation of Europe and Japan, which might have been expected to cause some instability. Countries couldn’t just print money whenever they felt like it. They needed to find some gold to back it.
Today, that sort of stability seems from a different world. In 40 years, gold has gone from $35 an ounce to $1,750, a more than forty-fold appreciation. And it is still climbing every day. This week, the investment bank JP Morgan raised its target price for gold to $2,500 by the end of this year. The way it is racing up in price, few people would wager against it hitting that.
After four decades of ‘fiat money’ we are starting to have some idea of what it is like. We have moved into an era of accelerating financial volatility. Pictures of brokers, their heads in their hands, staring bleakly into their Bloomberg terminals, are now part of the stock of most newsrooms. We’ve seen plenty of them this week as equity markets crashed and burned, and earnest-looking commentators warned us of the dangers of a fresh financial meltdown, more banking collapses, a double- or even triple-dip.
We had market crashes under gold-based money, of course. But they were rarer than rural buses. You usually had to wait a generation or two for a really big one. Now they come along with alarming regularity. From the hyperinflation of the 1970s to the soaring stock markets and currency crises of the 1980s, to the Asian crisis of the 1990s, to the dotcom bubble of 2000, to the housing and credit bubble of the mid-2000s, and then the sovereign debt crisis of the 2010s, we have witnessed one mania after another. Not only are they coming around more frequently, each one is more extreme than the last. Why? Because there is always too much cheap printed money swilling around.
That is not all. Trade imbalances have grown and grown. The US hasn’t run a trade surplus — that is, produced more than it consumed — since 1976. The banking system, which is the conduit by which printed money is released into the world, has exploded in size. It has come to dominate every other sector of the economy. The dollar has slipped and slipped. According to a UBS survey, the majority of asset managers no longer believe it can survive much longer as a reserve currency. A decade ago, the dollar accounted for 72 per cent of global currency reserves. That is now down to 60 per cent. Once it gets below 50 per cent, the dollar’s reign as a reserve currency can be declared officially over.
Perhaps most significantly, debt has exploded. According to McKinsey data, global debt, including government, corporate and personal borrowing, now stands at a towering $158 trillion dollars. That is up from $77 trillion in 2000. Put another way, global debt now amounts to 266 per cent of global GDP, compared with 216 per cent a decade ago. And why not? When money is simply printed, and debts are likely to be inflated away, why not just borrow more of the stuff?
People have noticed that money isn’t worth what it used to be. They are starting to lose faith — a worrying development, since faith is all fiat money really has going for it. One measure is the soaring gold price. Gold, remember, isn’t really worth anything, except as an alternative to paper money. Private investors are flocking back to the precious metal, along with other commodities. The World Gold Council estimates that central banks added to their net gold holdings in 2010 for the first time in two decades, and have tripled their purchases so far this year. The South Koreans have started buying gold for the first time in a decade — a significant event, because the country depends on the US for security — and the Mexicans, Russians and Thais have been buying as well. The Swiss, who hung on to the gold standard until 1999, are going a step further. The Swiss People’s Party is forcing a referendum on taking the country back to the gold standard.
James Grant, a veteran American analyst of economic policy, makes the point that few monetary systems last much more than 40 years. Even the classic Victorian gold standard survived only roughly that long: it fell apart during the first world war. Will Nixon’s great experiment in fiat money celebrate its 50th anniversary in 2021? You might bet a dollar or two on it — but not an ounce of gold.
Matthew Lynn is chief executive of Strategy Economics.