Fifty years ago this month, then-President Richard Nixon did you a favor: He rendered the US trade deficit utterly meaningless. That, in my view, is one of the biggest after-effects of the Nixon gold shock, and it is largely absent from the flood of retrospectives dotting the financial news world this week, which preferred to focus on the 1970s’ inflation, seemingly playing off today’s fears. So let us take a short stroll down memory lane to see how Nixon’s fateful announcement played a small role in helping the US prosper alongside an ever-increasing trade deficit.
A lot of this week’s commentary called Nixon’s announcement the end of the gold standard, which isn’t technically true. The US actually went off the gold standard in the 1930s, when FDR pulled the plug after the Great Depression’s deep monetary contraction. But under the post-WWII Bretton Woods international monetary system, which pegged major currencies to the dollar, the US agreed to redeem all overseas dollars for gold at a fixed rate. This convertibility is what Nixon ended.
Before then, other nations’ dollar reserves had the potential to be a ticking time bomb for the US Treasury, as governments could theoretically cash in at any time. Officials began viewing that as problematic in the mid-1960s, when foreign dollar reserves grew larger than the US’s gold stockpile. One important counterbalance at the time? The US’s consistent small trade surplus. When US firms import goods from foreign companies, they pay in dollars. When the exporting companies convert those dollars into their local currency, they generally end up at their central bank as foreign exchange reserves.
Now, contrary to widespread belief, this doesn’t amount to a giant sucking sound of dollars draining out of the US, bankrupting Uncle Sam. The US economy creates plenty of money. But before Nixon ended guaranteed dollar convertibility, a country could have theoretically run up a large trade surplus with the US, amassed mountains of dollars, and then forced the Treasury to redeem them for gold on demand. So when the US ran its first goods trade deficit with the rest of the world, it was understandably a cause for concern, particularly with gold reserves dwindling.
The end of guaranteed redemption at a fixed rate changed the calculus. Foreign banks could still convert their dollars to gold, but they had to do so on the open market, removing a large liability from the Treasury. As a result, balancing the trade deficit lost all urgency. Once net trade lost its potential influence over the Treasury’s gold reserves, the trade deficit lost any ability, however remote, to cause serious financial harm to the nation. Instead, international trade became roughly like interstate commerce. Now, the trade deficit is just an accounting identity, offset perfectly by inbound foreign investment. Dollars amassed overseas are invested here—in US Treasurys, stocks, factories, offices, capital equipment, research and development and all the glorious things that power economies and capital markets.
Enabling larger trade deficits was a revolutionary change. It opened the door to specialization. That allowed the US economy to modernize, shifting more toward services and, eventually, high technology. It opened the door for other nations to specialize in the manufacturing of all manner of goods, fostering development internationally and greatly reducing global poverty. Even as the trade deficit ballooned steadily since the mid-1970s, American wealth exploded. Between 1951 and Q2 1971, just before Nixon’s big announcement, household net worth grew from 1.28 trillion to 4.11 trillion, a mere 221.1% increase in 20 years.[i] But 20 years later, in Q2 1991, household net worth had jumped to $23.23 trillion, a 465.2% increase over 1971. As of Q1 2021, the latest available, wealth had mushroomed to $136.27 trillion, a 3,215.6% increase from 1971.
Did the trade deficit directly cause that explosion in wealth, which brought an unparalleled increase in living standards? Of course not—it was a byproduct, not a catalyst. But if you want to try to argue that shifting from manufacturing to services and technology freed people up to dream up all the innovation—and create all the new things—that drove such astronomical wealth gains, I won’t stop you. Specialization is at the root of the US’s economic miracle, and penalty-free trade deficits helped make that possible.
Nixon’s economic policies were far from an unalloyed good. Between price controls and Nixon’s strong arming of then-Fed head Arthur Burns, the Nixon administration’s economic maneuverings were a key contributor to the 1970s’ sky-high inflation. But no presidential administration’s economic record is entirely good or bad, and on the dollar and gold at least, the benefits seem clear.
[i] Source: St. Louis Federal Reserve, as of 8/19/2021.
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