What is the Nixon Shock?
The term Nixon Shock was popularized as a reference to the impact of a set of economic policies enacted by former U.S. President Richard Nixon.
The New Economic Policy, announced by Nixon in 1971, market a systemic shift in domestic US economic and monetary policy. On a global level, the policies marked the effective end of the Bretton Woods system of currency exchange, and they solidified dollar domination.
- The term Nixon Shock was popularized as a reference to the impact of a set of economic policies enacted by former US President Richard Nixon.
- The economic policies included measures to address unemployment, inflation, and protecting the US dollar from international speculation.
- Nixon’s acts marked the end of the Bretton Woods Era of currency exchange. It created fiat currency and the floating rate currency exchange system being followed today.
Post-War US Economic Policy
Richard Nixon’s presidency was overshadowed by the Vietnam War, which the U.S. eventually lost. The decades-long war had caused major civil unrest at home. Post-World War II, the military-industrial complex drove the U.S. to the Korean and Vietnam Wars.
Prior to that, the U.S. invested large amounts of money in the Marshall Plan for the reconstruction of Europe and Japan, which were devastated after the Second World War. As part of the reconstruction plan, the U.S. opened its own economy and quickly became a net importer.
Nixon’s Response to Domestic Troubles
As a result of these post-war policies, U.S. unemployment rose in tandem with the cost of living for most Americans. In the post-Vietnam War era, Nixon decided to turn his attention to domestic policy. His New Economic Policy was meant to address unemployment, inflation, and protecting the US dollar from international speculation.
The measures included a 90-day holiday on the increase in prices and wages, tax cuts for the middle class, and 10% additional tariffs on all imports into the US.
The Bretton Woods Era
Before the Second World War, the Pound Sterling or Gold Standard was the prevalent currency exchange system. Under the system, government-issued currency would be exchangeable with fixed amounts of gold at any given time.
After the Second World War, the Gold Exchange standard system was created at the famous Bretton Woods conference. Here, the US dollar was backed by gold, which was exchangeable for other central banks and not any claimant (as under the gold standard). Other sovereign currencies would be tied in a fixed ratio to the dollar.
To finance its expenditures, the US started devaluing the dollar. Towards the end of the 1960s, as interest rates rose, the US lacked enough gold to back all the dollar printed by the Federal Reserve, which meant that the dollar was largely overvalued.
Other countries started sitting on the dollar and speculating on it, exacerbating the situation. As the US became a net importer, the dollar reserves of other countries grew to unprecedented levels.
The End of the Bretton Woods Era
Johnson and Kennedy Administrations tried to bring back offshore dollars. They deterred foreign investment in the US and limited lending, but their efforts were mostly in vain.
Towards the end of the 1960s, anxiety gripped the global currency exchange markets, and other countries began demanding gold in exchange for the dollar. Fearing a collapse, the Nixon government suspended dollar convertibility, which meant that the US dollar would no longer be exchangeable for gold, and it started printing fiat money.
The Floating Exchange Rate System
The U.S. government’s move led to the beginning of fiat currency and the era of floating exchange rates, which are still prevalent today. The group of 10 most industrialized nations, called G-10, was highly critical of the decision, which, in its opinion, was unilaterally taken by the U.S. government.
They entered into the Smithsonian Agreement, under which a new exchange system was to be established, but it failed soon enough. In 1973, the countries created a joint floating rate system, under which the currencies of six European countries were floated against the dollar.
It marked the effective end of the Bretton Woods System and created the currency exchange regime that we know today. Global trade continued to be denominated in the dollar even after the collapse of Bretton Woods due to logistical reasons. The petro-dollar system established US hegemony in global markets.
CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: