Here’s an interesting idea: we can blame Tricky Dick Nixon for the financial crisis. Well, that’s one way to get at the historic roots of the credit market and banking collapse that we are still experiencing, all the current optimism coming from the Obama Administration about a retreat from the brink notwithstanding.
And this historical exercise has real policy implications for the current situation because it highlights the difficulty of resolving the current crisis with either market choices or government intrusion.
Here’s the story: until roughly 1971 the US dollar was backed by gold. And since all other currencies in the world were pegged to the dollar it meant that as long as the US government was willing to pay someone gold for their dollars there was a certain kind of stability in the global currency markets.
Specifically, as part of the Bretton Woods agrements set in place in 1946, the USG agreed to pay out an ounce of gold for 35 US dollars. But by the time Nixon took office this commitment had become largely a dead letter. The US, frankly, was running out of gold and France, of all countries, began to sell its dollars for gold thus increasing pressure on the dollar.
(First lesson for today: instead of France we fear today China and Japan may decide that their accumulation of dollar based assets (largely US Treasuries) are too risky and could lead a similar global sell-off.)
France was exploiting a problem caused by deeper problems afflicting the US: LBJ and Nixon had spent huge sums on defense, in particular fighting the Vietnam war, as well as social spending to head off a restive black population energized by the civil rights movement as well as an increasingly restive working class that was responding to declining living standards with absenteeism, lower productivity and strikes. In other words, the New Deal era social contract with organized labor was unraveling.
So, President Nixon closed the gold window in 1971, in a single stroke devaluing the US dollar by nearly half its previous market value. Whatever dollars the French had not already sold off were suddenly worth a lot less. Take that, DeGaulle!
What is the link to the current crisis? With the end of tie to gold, capitalism lost an anchor that gave it some real sense of the value of its cash flows! A huge amount of uncertainty was now part of the global economy as currencies began to float in ever more volatile swings.
When the dollar was exchangeable for gold it told you something: a certain amount of labor power went into producing an ounce of gold and that labor was “worth” 35 US dollars an ounce. That became a global, universal metric for world currencies and commodities, from tea to coffee, from steel to cars.
Once the gold window was closed that assessment of value was no longer available to business to determine the value of their investments.
How to cope? Create a range of hedging instruments that allow you to insure against the possibility that you have guessed wrong about the future price of supplies, inputs, raw materials, consumption goods, bank savings, etc.
Today we know those hedging instruments as “derivatives.”
Derivatives, in other words, emerged as a substitute for the destruction of the previous anchor of value, gold. Gold, of course, was a commodity, a physical asset that could be fairly easily and reliably priced in global markets. The substitute for gold as an anchor of value – derivatives – is not so easy to understand or value.
What critics like George Soros and Warren Buffett warn are financial WMDs are in fact central to the survival of modern capitalism!
Clearly the market creation of derivatives – an ultimate example of private ordering – has failed. But can government intervention with a new regulatory framework, such as forcing all derivatives to trade on an exchange, do a better job? There is little evidence of that!
As long as we are dependent on a system of abstract value to anchor basic business decision making – the only way for capitalism to function – we are likely to oscillate between anarchic and volatile private ordering and bumbling government intervention.