Nixon’s decision to end the Gold Exchange Standard in 1971 transformed the concept of money. Let’s find out the implications
- Who ended the Gold Exchange Standard and why
- Moral hazard and more fractional reserve
- The amplification of the Cantillon effect: growing inequality
- The role of Bitcoin
Who ended the Gold Exchange Standard and why
In 1971, US President Richard Nixon suspended the convertibility of the dollar into gold, ushering in the era of fiduciary money. This decision was no accident; it was motivated by a number of economic pressures such as the trade deficit and the rising cost of the war in Vietnam.
Financing a war of such magnitude required enormous resources. The US government therefore started printing dollars in significant quantities to cover the costs of the war. This had an important effect in terms of depreciation: with more dollars in circulation and a constant amount of gold as reserve, the amount of gold per dollar decreased. Countries like France and the United Kingdom, seeing the depreciation and beginning to lose confidence in the US, began to demand the exchange of their dollars for gold, putting further pressure on US gold reserves.
Estimates vary, but it is estimated that the total cost of the Vietnam War to the US was about $168 billion, equivalent to more than $1 trillion today if inflation is taken into account. This expenditure led to a huge federal budget deficit, aggravated by the need to print more dollars, which in turn led to more inflation. Between 1965 and 1969, US gold reserves fell from 17,000 tons to about 10,000 tons, while foreign liabilities increased. The fiscal and monetary deterioration made it impractical to maintain the gold-based system, leading to Nixon’s historic decision in 1971.
From then on, money changed definition: from a representation of a scarce value (gold) it became for all intents and purposes fiduciary. Since then, the value of money depends solely on trust in the political and financial institutions that control it as a monopoly. The result? Uncontrolled spending, credit bubbles and inflation. In 1971, the US debt-to-GDP ratio stood at around 35%. Since then, it has grown to over 100%.
Since 1971, the US consumer price index (CPI) has increased by more than 500%. Real average wages, however, have risen by only 10%, creating an ever-widening gap between income and cost of living.
Moral hazard and more fractional reserve
After the end of the gold standard in 1971. One factor of particular relevance is the increase in bank bail-outs, a phenomenon that provides a clear demonstration of the concept of moral hazard in the post-1971 banking system.
Before 1971, bank bail-outs were relatively rare in the US and other Western countries. In the US between 1934 (the year the Federal Deposit Insurance Corporation, FDIC, was established) and 1971, fewer than 10 bailouts of major financial institutions were recorded.
From 1971 onwards, the story has been quite different. Between 1971 and 2020, more than 3,000 financial institutions were bailed out, rescued or liquidated with the intervention of federal authorities in the United States. Some of the best known examples include the bailout of Continental Illinois in 1984, the Savings and Loan crisis in the 1980s and, of course, the global financial crisis of 2008, which saw bailouts on an unprecedented scale.
Fractional reserve banking was common practice even under the gold standard; the end of pegging money to gold amplified the phenomenon. Banks had more freedom to issue loans with a higher leverage ratio. The implicit message to the markets was that, in the event of trouble, the government would step in to bail out the banks, thus incentivising greater risk-taking. This cycle of risk and bailout had a corrosive effect on public confidence and led to a systematic distortion of the integrity of the financial system.
The amplification of the Cantillon effect: growing inequality
Another noteworthy effect related to the end of the gold standard is the intensification of the Cantillon effect, a phenomenon that describes how the creation of new money unequally affects different segments of society. In simple terms, those who receive the new money first in the form of credit – typically governments (from central banks), large corporations (from governments) and already wealthy individuals (from large corporations and banks) – benefit at the expense of those who receive it last, often the lower social classes of the population.
In the US, the Gini index – a common measure of wealth inequality – was around 0.386 in 1970. In 2019, this number rose to about 0.485, indicating a significant increase in income and wealth inequality.
Another revealing indicator is the percentage of national wealth held by the richest 1%. In 1971, the richest 1% held about 20-22% of total wealth. Fast-forward to 2020 and that figure has risen to about 35%.
In a world pegged to gold, the ability to create new money is limited, which tends to restrict the Cantillon effect. In a system of fiduciary money, central banks can create money without friction and, above all, without being accountable to anyone as independent entities. The new money first enters the hands of financial institutions and large investors, who use it to invest in assets such as stocks, real estate and bonds, thus driving up their prices and further enriching those who already hold these assets.
The role of Bitcoin
In a world characterised by volatile economic cycles and increasing wealth inequality, Bitcoin emerges as a potentially revolutionary solution. Its structure stands in stark contrast to the problems associated with trust money and offers a number of advantages that could lead to a more equitable and stable economic system.
Unlike fiduciary currency, which can be created in unlimited quantities by monetary authorities, Bitcoin has a fixed maximum supply of 21 million units. This inherent limitation eliminates the possibility of inflation induced by the creation of new money, thus negating the consequences of the Cantillon effect and making the economic system fairer for all its participants.
Bitcoin is an open system that allows anyone to participate in the process of creating the scheduled new money through mining. Unlike the trust money system, where new units of money are distributed through mechanisms that favour financial elites, Bitcoin mining is open and competitive. Access to the new value is equal for all, inequality is not inherent in the very nature of the economic system.
Unlike fiat currency, created by decree and no longer guaranteed by any underlying, bitcoins are guaranteed by the energy and computational power required to generate them through mining. Each bitcoin in existence represents a certain amount of energy expended, thus providing a form of intrinsic value that does not exist in the landscape of traditional currencies today.
