Dollar Crisis of 1971

Dollar Crisis of 1971

In August 1971 the United States government suspended the convertibility of dollars into gold for foreign official holders of dollars, marking the final break with the gold standard in the world economy. Uneasiness about the dollar reached crisis levels in 1971 as the rest of the world became increasingly aware that the United States did not own enough gold to redeem all the foreign-owned dollars. The drain on its gold reserves also concerned the United States government. Before the suspension, foreign official holders of dollars (foreign central banks and foreign governments) had been able to convert dollars into gold at the rate of $35 per ounce. (Domestic holders of dollars had been unable to convert dollars into gold since the 1930s.) Gold has remained an important component of international monetary reserves, but currencies are no longer convertible in gold at a fixed, official rate.

The Bretton Woods System, created in 1944, established a world gold standard for international purposes, requiring each country to define a par value of its currency in terms of a fixed weight of gold. A shortage of world gold reserves, however, led countries to define domestic currencies in terms of United States dollars, and the United States stood ready to redeem dollars into gold at the official rate for foreign official holders. The redemption of dollars into gold drained the United States gold stock from $25 billion in 1949 to $12 billion in the early 1970s.

Largely because of worldwide military and political obligations, the United States ran what are called balance of payments deficits after World War II, infusing additional dollars into a world economy hungry for monetary reserves. A balance of payments deficit occurs when the outflow of dollars from U.S. imports and investment abroad exceeds the inflow of dollars from U.S. exports and foreign investment in the United States. The consequence in 1971 was an increase in the number of foreign-owned dollars that the United States was committed to redeeming in gold. After the mid-1960s, the U.S. balance of payments deficits grew at a faster tempo because of military involvement in Vietnam and heavy investment abroad. The rest of the world saw that the United States gold stock was insufficient to redeem all foreign-held dollars in gold. In August 1971 President Nixon announced that the United States would no longer convert dollars into gold for foreign official holders. Between August 1971 and May 1973 world governments endeavored, without success, to save the Bretton Woods System with a dollar devalued in terms of gold.

After 1973 the value of the dollar was no longer defined in terms of a fixed weight of gold, and other currencies were no longer defined in terms of dollars. The exchange rates between currencies floated freely and were based upon supply and demand. Today governments manage the floating exchange rates, but currencies are not tied to each other in fixed exchange rates.

Historically, the suspension of convertibility of paper money into precious metal has occurred during wartime—the Civil War and the War of 1812 being prime examples in the United States. The suspension of the convertibility of the dollar in 1971 occurred when the United States was engaged in an expensive cold war with the Soviet Union, coupled with a lengthy effort in Vietnam. Some observers attribute the inflation of the 1970s to the collapse of the gold standard, and the loss of the discipline that the gold standard had imposed on monetary growth. As control over monetary growth brought inflation down in the 1980s, however, a connection between the gold standard and price stability seemed less necessary.