The Empire, Crumble?

That's How the Credit, and the Empire, Crumble

TO SOME, August 15 marks the anniversary of a day that shall live in infamy in U.S. history. To invoke FDR's famous characterization of the bombing of Pearl Harbor a day after the anniversary of VJ day may seem ironic, but in the monetary history of the nation, Aug. 15, 1971 is worthy of that epithet.

On that day, President Nixon closed the "gold window," which means the United States no longer fixed the value of its dollar in terms of gold. Under the rules of the Bretton Woods monetary system, the U.S. would exchange dollars with foreign monetary institutions for 1/35 of an ounce of gold.

True, this wasn't a gold standard in the classical sense, in which ordinary citizens could turn in $35 at a bank and take away an ounce of gold. Franklin Delano Roosevelt took that right away as part of the New Deal. My mother would tell me how her German immigrant mother dutifully turned in the family's modest gold holdings, no doubt built on the memories of my grandfather having sent his savings back to the fatherland, where it had been consumed in the Weimar inflation. What fools we were to comply, my mother would say years later.

The closing of the gold window was perhaps the least appreciated part of Nixon's Aug. 15, 1971 announcement of his New Economic Policy. The imposition of wage-and-price controls and an import surcharge were the centerpieces that drew the cheers of the consensus thinkers, including the stock market. Among the lonely dissenters was Barron's editor Robert Bleiberg, who warned of the inflationary consequences of the new policies.

Of course, Bob would turn out to be right. Two years later, the inflationary maelstrom was unleashed as OPEC quadrupled the price of crude oil, all the way to $12 a barrel! While the Yom Kippur war of October 1973 was the proximate reason for the oil embargo, the oil producers mainly tired of parting with their precious petroleum for depreciated dollars. Not surprisingly, prices for all commodities soared once the dollar's purchasing power became, in today's parlance, whatever.

But more importantly, perhaps, untethering the dollar from gold meant Pandora's box was open. No longer was fiscal policy constrained by a monetary standard. The dollar's link to gold effectively had limited the nation's deficit, both internally and externally. Governments could not run up budget deficits willy-nilly; bond buyers could expect to be repaid, at a minimum, in dollars or the equivalent in gold. Foreign creditors who financed the current-account deficit also could expect dollars or their gold value.

That borrowing would be constrained by the supply of gold. But once Nixon closed the gold window 36 years ago today, the god of gold was dead and, to paraphrase Nietzsche, all was permitted.

The principle constraint on credit expansion became creditors' willingness to lend. As the past couple of weeks have demonstrated, that willingness can wax and wane.

Over the longer term, the ability to expand credit without a monetary constraint has sustained both the U.S. economy and financial markets. We are now witnessing what it means to have that flow of credit stanched to the mortgage market. For the equity market, it removes a major prop under prices; that is, the ability to arbitrage cheap credit versus equity, or in simpler terms to borrow on the cheap to buy stocks. Without those financial steroids, equities have folded like Mark McGwire in front of a Congressional committee.

But more important are the implications for the nation as a whole.

"The Roman Republic fell for many reasons, but three reasons are worth remembering: declining moral values and political civility at home, an overconfident and overextended military in foreign lands, and fiscal irresponsibility by the central government," says David Walker, the head of the Government Accountability Office, in a recent speech. "Sound familiar? In my view, it's time to learn from history and take steps the American Republic is the first to stand the test of time."

Walker's jeremiad is rooted in the massive liabilities facing the federal government, especially posed by demographics and the promises made to Baby Boomers now reaching retirement age. As I wrote over a year ago, the U.S. government then faced an unfunded liability of $66 trillion ("Good News from Rosy Scenario," July 12, 2006.)

The first step along that long road was taken 36 years ago today. For now, the federal government has been able to roll up those liabilities apparently without consequences while the dollar remains the world's main reserve currency, though intimations about the greenback's mortality shouldn't be ignored.