Two Dates That Radically Changed the Financial World

Published on 01. Sep, 2010 by Thomas Herold in Government

From time to time, you find events that alter the course of the world. Two dates that radically changed the financial world were the Creation of the Federal Reserve in 1913 and the U.S. Departure from the Gold Standard in 1971. Both of these events had far ranging effects that still impact your life and that of the world economy today.

The Creation of the Federal Reserve System
The Federal Reserve System is commonly referred to as simply the Fed. This body functions as the United States’ central banking system. As a result of a number of financial panics that rocked the U.S. from the late 1800′s through an especially bad panic in 1907, congress enacted the Federal Reserve Act in 1913.

The body that began as simply a central bank organization for the United States gradually evolved into an outfit with vast powers and responsibilities. You saw these become especially evident in the Great Recession and accompanying financial crises of the last several years that began in 2007, fully a hundred years after the serious panic that led to the creation of the Fed in the first place.

The Evolving Powers of the Federal Reserve
The Great Depression first led to the expansion of powers and roles of the Federal Reserve System. From a primary role as central banker to the United States, the organization has evolved to its status today as the overseer of the country’s financial system stability, conductor of the country’s monetary policy, regulator and supervisor of the banking system and institutions, and provider of critical financial services to the banks, savings and loan companies, foreign banks, and the Federal government.

Perhaps the greatest power that the Fed gained in these intervening decades was the ability to set the official interest rates of the United States, in an effort to boost the economy in down periods and prevent it from overheating in periods of rapid expansion and growth.

The Recently Gained Powers of the Federal Reserve
In the financial crises that started in 2007, the Fed began to flex its muscles in a titanic effort to save the American based economic system and world economies. You saw the broadest definition imaginable for “stabilizing the nation’s financial system” interpreted. Suddenly the Fed began accepting questionable and vaguely valued assets of risky real estate, sub prime loans, and even derivatives as collateral from banks in desperate needs of immediate cash transfusions.

More like blood transfusions, these emergency loans totaled up to trillions of dollars. Without them, you have heard that the entire financial system would have collapsed completely and in a matter of days as a crises of confidence swept the entire Western based financial system.

You can easily see how the creation of the Fed proved to be a first date that radically altered the financial world in the last hundred years. There was yet a second date that saw an even more radical shift in the financial world. The American, and subsequently rest of the world, abandonment of the gold standard in 1971 caused earth shattering ramifications in the balance of the global financial system for both the United States and the entire world. You have possibly heard this referred to as the Nixon Shock before.

The Gold Standard
The gold standard and Breton Woods Agreements were the bedrock framework for the world financial system following the economic devastation of World War II. In this system of foreign exchange control, the dollar and other major world foreign currencies such as the British Pound, Swiss Franc, German Deutsche Mark, Canadian Dollar, French Franc, and others, all had direct values to the price of gold. This led to a generally stable international financial regime and economies.

By the time the 1970′s arrived, the United States had reached the point that both increasing domestic program spending and the Vietnam War created a simultaneous trade deficit and a deficit in balance of payments. These proved to be the first in the entire twentieth century for America. In the year 1970, the dollar declined in gold coverage from fifty-five percent down to twenty-two percent, representing a staggering decline of thirty-three percentage points.

The Austrian School of Economics, along with the Neoclassical Economists, highlight this year as the point where foreign holders of the American dollar finally lost their belief in the ability of the United States government to cut both trade and budget deficits. If you were an adult in those tumultuous years, you will remember the economic turbulence that these events caused.

The End of the Gold Standard
You may recall that the next year, 1971, saw the American government print even more dollars to pay the domestic and military spending bills. Washington printed fully ten percent more dollars that they then dispatched overseas. Confidence in the U.S. dollar was quickly crumbling, as $22 billion in physical assets were withdrawn from the United States in only the first six months of the year.

The U.S. was not the first country to abandon the Breton Woods agreement. West Germany made the first leap to avoid the inevitable inflation that they saw coming to the U.S. economy and dollar as a result of the reckless economic behavior that the U.S. had begun practicing.

After this, the other major economies of Western Europe started demanding more gold from the U.S. as fulfillment of its promise to actually pay the bills. The U.S. gold reserves began sinking rapidly, as both Switzerland and France demanded hundreds of millions of dollars in gold.

Switzerland became the second country to leave the Breton Woods agreement. Not to be outdone, and with the dollar tanking against other currencies and gold, President Richard Nixon finally decided to end the U.S. dollar to gold convertibility. In one swift move, he abandoned both the gold standard and the Breton Woods system, which more or less collapsed with the U.S. forsaking honest gold accountability.

The Results of the U.S. Departing from the Gold Standard
The resulting chaos that wracked currencies and financial markets over the next ten plus years demonstrated what a radical decision abandoning gold proved to be. Before Nixon withdrew from the dollar to gold convertibility agreement in 1971, the U.S. dollar stood at between $40 and $44 per ounce of gold. Within a year of Nixon leaving the gold standard in 1972, the dollar had dropped to an average of almost $64 per ounce.

This represented a staggering more than fifty percent drop in the value of the dollar in only that first year. The situation only became worse with time, as the dollar continued to crash and burn. 1973 saw an average gold price of $106.50 per ounce, 1974 witnessed $183 plus average price per ounce, and by 1980 gold had risen to nearly $595 per ounce against the dollar. The other way of saying this is, of course, that the dollar had dropped from only $42 per ounce average in 1971 to $595 per ounce by 1980, representing an unbelievable over 1,300 percent drop in the dollar in less than ten years.

Though the dollar managed to stabilize in the next few decades, with gold fluctuating wildly over the next twenty or so years, the continuing decline of the dollar since Nixon abandoned the gold standard only continues to this day.

2520% Inflation in 40 Years!
For 2009, the average gold price was $972, while the 2010 full year price is set to be over $1,100 per ounce. Since the gold standard and Breton Woods agreement were discarded then, the U.S. dollar has collapsed from around $42 per ounce to more than $1,100 per ounce. This represents a crushing nearly 2,520% in forty years. When you wonder how significant an event withdrawing from the gold standard and Breton Woods treaty was, consider this.

The government publishes an inflation rate that averages two to four percent per year. Yet gold tells us that the dollar has actually dropped more than 60% per year on average over the last forty years. Leaving the gold standard caused a radical change in the financial world.

Most likely history will repeat itself and hyperinflation will be the end of this cycle. After that we may finally learn something and create a better system.