Illustration by Jay Wright
Illustration by Jay Wright

Both the international monetary system and American fiscal policy began to change in the 1960s. The system developed at the United Nations Monetary and Financial Conference, held in Bretton Woods, New Hampshire, in July 1944, fixed exchange rates to a dollar backed by gold. It worked successfully for years. But it couldn’t last forever.

By 1960, foreign dollar holdings exceeded U.S. gold reserves. The country was like a 19th-century bank that had issued more notes than it had gold coins in the vault. In that year’s presidential election, both Vice President Richard M. Nixon and Senator John F. Kennedy took pains to emphasize the importance of maintaining gold reserves, which were seen as a crucial element of national strength. As President Kennedy later said: “Britain has nuclear weapons, but the pound is weak, so everyone pushes it around. Why are people so nice to Spain today? Not because Spain has nuclear weapons but because of all those lovely gold reserves.”

The gold drain, in which foreign central banks turned in dollars for gold, had been a constraint on fiscal policy. Big budget deficits, it was feared, would increase aggregate demand, raising imports and sending dollars overseas, which would increase gold outflows even more. But presidents must balance many priorities, and Kennedy was no exception. If gold reserves were important, the Cold War was more important. He chose to increase military spending.

Deficit Spending

Sustaining economic growth was also a top priority, and Kennedy’s administration was the first to wholeheartedly embrace deficit spending as a tool for managing the economy. In the 1930s, British economist John Maynard Keynes originally made the case for stimulating a slow economy by increasing government spending or cutting taxes. Either would put money in people’s hands, increase overall demand and boost economic activity.

Kennedy’s advisers were confident that Keynesian demand management could be used to fine-tune the economy by increasing deficits during slowdowns and reducing them during booms. For the first time in American history, a president was arguing that deficits could be a good thing, and needn’t be used only in a military or economic emergency.

Kennedy’s successor, Lyndon B. Johnson, also found that some things were more important than a balanced budget: Faced with the choice between guns and butter, he chose both. Johnson oversaw America’s expensive commitment to the Vietnam War while also expanding domestic social programs to fight poverty.

Spending wasn’t the only reason for the gold drain. The inflation that contributed to gold outflows was also good for the government’s balance sheet. After World War II, the U.S. government was a major debtor and, like any debtor, benefited from inflation. Modest but persistent inflation combined with regulation of interest rates meant that real (inflation-adjusted) interest rates were always low and often negative. Since creditors’ interest payments didn’t keep up with inflation, part of the debt was inflated away.

Vietnam War spending helped produce budget deficits throughout most of the late 1960s and also contributed to inflationary pressures, both of which reduced foreign central banks’ appetite for dollars. Those banks began to worry whether they would always be able to cash in $35 for an ounce of gold, prompting a wave of gold purchases in March 1968. Negotiations to reset exchange rates, which would have slowed the dollar outflow, had little impact. The U.S. could have protected its gold reserves, but only at the cost of hurting the economy -- a price its leaders didn’t want to pay.

Breaking Point

In effect, the U.S. was the banker to the world, and it faced a bank run. The breaking point came on Aug. 11, 1971. President Nixon took the advice of Treasury Secretary John Connally and closed the gold window, refusing to convert dollars into gold and abandoning the cornerstone of the Bretton Woods system. Framing the announcement as a New Economic Policy, Nixon added some tax cuts, a reduction in the number of federal employees, a 90-day wage-and-price freeze, and a temporary 10 percent surcharge on imports. The era of gold was finally over.

After Nixon closed the gold window, the dollar was devalued against other currencies, but the new exchange rates could not be maintained against another run on the dollar in 1973. The world abandoned the fixed-exchange-rate system for a floating-rate system in which the value of a currency is set by supply and demand, and the dollar depreciated further, leading Time magazine to quip, “Once upon a very recent time, only a banana republic would devalue its money twice within 14 months.”

But countries still needed reserves in part to intervene in foreign currency markets, and there was no discernible shift away from the dollar as a reserve currency. In 1977, it still accounted for about 80 percent of total identified foreign-exchange reserves, and dollars held abroad in official reserves increased by $91.3 billion from 1975 through 1981.

The 1970s was a rocky time for the U.S., particularly as inflation increased and the dollar weakened. But predictions that the end of Bretton Woods would mean permanently higher inflation weren’t borne out. After becoming chairman of the Federal Reserve in 1979, Paul Volcker tightened monetary policy and, at the cost of higher unemployment, managed to squeeze inflation down.

The next major test for the U.S. came in the 1980s. Ronald Reagan won the 1980 presidential election promising to cut taxes, strengthen national defense and balance the budget by slashing other government spending. His first major initiative was convincing Congress to cut income-tax rates across the board, with the top rate falling from 70 percent to 50 percent. The largest tax cut in history combined with a severe recession in 1981-1982 reduced government revenue from 19.6 percent of gross domestic product in 1981 to only 17.3 percent in 1984.

Reagan Deficits

At the same time, government spending climbed, thanks to increases in the defense budget, producing what were then the largest peacetime deficits in history. These deficits, combined with increasing current-account deficits, made the U.S. -- both the federal government and the private sector -- increasingly reliant on borrowing from other countries.

Under the Bretton Woods system, this would have been a serious problem. Borrowing from overseas depended on foreign investors’ willingness to hold dollars (or dollar-based assets), which required confidence in the value of the dollar. But the more dollars those investors accumulated, the less faith they had that the U.S. would be able to maintain the gold standard at $35 per ounce, until the entire system collapsed.

After Bretton Woods, however, every country still needed foreign currency reserves to facilitate international trade, and the dollar remained the reserve currency of choice. Large budget deficits in the 1980s helped push up U.S. interest rates, which made the dollar more attractive to international investors. Convertibility into gold was no longer an issue to worry about.

At the time, economists and others wondered how long large budget deficits and current-account deficits could be sustained. Heated rhetoric about deficits became a constant theme in Washington. In 1990 and 1993, Presidents George H. W. Bush and Bill Clinton pushed through legislation that cut spending and increased taxes. As budget deficits narrowed through the decade and America gained a reputation for stable growth and low inflation rates, the dollar only became more attractive.

The new world, however, contained great risks. In the 1990s, foreign capital rushed into the newly industrialized countries of East and Southeast Asia, fueling economic booms that caused rapid increases in asset prices and currency values. Cheap money encouraged companies to borrow heavily to invest in risky projects, until the boom couldn’t be sustained without infusions of new capital.

Asian Crisis

The International Monetary Fund, a product of the Bretton Woods conference, made emergency loans to several Asian countries during the crisis. The money came with numerous conditions that made the IMF deeply unpopular in certain parts of the world, reinforcing a stigma associated with borrowing from the IMF that had been developing for decades. The lesson for many emerging-market countries was that they never wanted to have to borrow from the IMF again.

Attempts to stop the private sector from borrowing too much foreign capital, however, have had limited success. So central banks around the world protect themselves by building up large war chests. Some countries, notably China, accumulate dollars as a way of suppressing the value of their own currencies. China’s huge trade surplus with the U.S. gives it a surplus of dollars, but if it traded them for yuan on the open market, that would increase the value of the yuan, making it harder to export goods. Instead, it invests those dollars in U.S. Treasury bonds and other dollar-denominated assets.

Ultimately, the instability of the global economy increases demand for safe assets, and there is still no safer asset than U.S. Treasury bonds. But how long will dollar pre-eminence last -- and what happens to the sustainability of American budget deficits when it ends?

(Simon Johnson and James Kwak are authors of “13 Bankers” and co-founders of The Baseline Scenario, a blog on economic and public policy. Johnson is also a Bloomberg View columnist. This is the last of three excerpts from their new book, “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You,” to be published by the Knopf Doubleday Group on April 3. The opinions expressed are their own. Read Parts 1 and 2.)

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To contact the writers of this article: Simon Johnson at sjohnson@mit.edu James Kwak at jkwak@law.harvard.edu

To contact the editor responsible for this article: Paula Dwyer at pdwyer11@bloomberg.net