Nixon Shock - Background

Background

In 1944, the Bretton Woods system fixed exchange rates based on the U.S. dollar, which was redeemable for gold by the U. S. government at the price of $35 per ounce. Thus, the United States was committed to backing every dollar overseas with gold. Other currencies were fixed to the dollar, and the dollar was pegged to gold.

For the first years after World War II, the Bretton Woods system worked well. Japan and Europe were rebuilding from the war, and foreigners wanted dollars to spend on American goods - cars, steel, machinery, etc. Because the U.S. owned over half the world's official gold reserves - 574 million ounces at the end of World War II - the system appeared secure.

However, from 1950 to 1969, as Germany and Japan recovered, the US share of the world's economic output dropped significantly, from 35 percent to 27 percent. There was less demand for dollars and more demand for deutsche marks, yen, and francs. U.S. spending on the Vietnam war and domestic social programs flooded the world with dollars.

By the early 1970s, as the costs of the Vietnam War and increased domestic spending accelerated inflation, the U.S. was running a balance-of-payments deficit and a trade deficit. By 1971, America's gold stock had fallen to $10 billion, half its 1960 level. Foreign banks held many more dollars than the U.S. held gold, leaving the U.S. vulnerable to a run on its gold.

By 1971, the money supply had increased by 10%. In May 1971, West Germany was the first to leave the Bretton Woods system, unwilling to devalue the Deutsche Mark in order to prop up the dollar. In the following three months, this move strengthened its economy. Simultaneously, the dollar dropped 7.5% against the Deutsche Mark. Other nations began to demand redemption of their dollars for gold. Switzerland redeemed $50 million in July. France acquired $191 million in gold. On August 5, 1971, the United States Congress released a report recommending devaluation of the dollar, in an effort to protect the dollar against "foreign price-gougers". On August 9, 1971, as the dollar dropped in value against European currencies, Switzerland left the Bretton Woods system. The pressure began to intensify on the United States to leave Bretton Woods.