What Is the Nixon Shock? Definition, What Happened, and Aftereffects

What Is the Nixon Shock?

The Nixon Shock refers to the aftereffect of a set of economic policies announced by President Richard M. Nixon in 1971.

Most notably, the policies eventually led to the collapse of the Bretton Woods system of fixed exchange rates that took effect after World War II.

Understanding the Nixon Shock

The Nixon Shock followed President Nixon’s televised "New Economic Policy" address to the nation on August 15, 1971. The crux of the speech was that the U.S. would turn its attention to domestic issues in the post-Vietnam War era. Nixon outlined three main goals:

1. Lowering the unemployment rate
2. Stemming the rise in inflation
3. Protecting the U.S. dollar from international money speculators

Nixon cited tax cuts and a 90-day hold on prices and wages as the best options for boosting the job market and tamping down inflation. As for speculative behavior toward the U.S. dollar (USD), Nixon supported suspending the dollar’s convertibility into gold.

In addition, Nixon proposed an additional 10% tax on all imports that were subject to duties. Similar to the strategy of suspending dollar convertibility, the levy was intended to encourage the U.S.' primary trading partners to raise the value of their currencies.

The Need for Change

The Bretton Woods system was developed during an international conference held at Bretton Woods, New Hampshire in 1944. It involved the external values of foreign currencies. Fixed to the U.S. dollar, these values were expressed in gold at a price determined by Congress. In 1958, foreign currencies became convertible into gold.

However, a global dollar surplus imperiled the system in the 1960s. At the time, the U.S. did not have enough gold to cover the volume of dollars circulating throughout the world. That led to an overvaluation of the dollar.

The government attempted to shore up the dollar as well as the Bretton Woods system, with the Kennedy and Johnson administrations trying to deter foreign investment, limit foreign lending, and reform international monetary policy. However, their efforts were largely unsuccessful.

Anxiety eventually crept into the foreign exchange market, with traders abroad fearful of an eventual dollar devaluation. As a result, they began selling USD in greater amounts and more frequently. After several runs on the dollar, Nixon sought a new economic course for the country.

Nixon's Speech

Nixon’s speech was not received as well internationally as it was in the U.S. Many in the international community interpreted Nixon’s plan as a unilateral act.

In response, the Group of Ten (G-10) industrialized democracies decided on new exchange rates that centered on a devalued dollar in what became known as the Smithsonian Agreement. That plan went into effect in December 1971, but it proved unsuccessful. 

Beginning in February 1973, speculative market pressure caused the USD to devalue and led to a series of exchange parities. Amid still-heavy pressure on the dollar in March of that year, the G–10 implemented a strategy that called for six European members to tie their currencies together and jointly float them against the dollar.

That decision essentially brought an end to the fixed exchange rate system established by the Bretton Woods agreement.

Aftereffects of Nixon Shock

Initially, Nixon's economic policies were widely praised as a political success. Today, however, their long-term benefits are a matter of scholarly debate.

First, the policies were the primary catalyst for the stagflation of the 1970s. They also led to the instability of floating currencies, as the U.S. dollar sank by a third during the 1970s. Over the past 40 years, the U.S. dollar has been anything but stable, with several periods of severe volatility.

From 1985 to 1995, for example, the U.S. dollar value index lost as much as 34%. After quickly recovering, it fell sharply again from 2002 to mid-2011.

Nixon also promised that his move would prevent costly recessions. Over the past few decades, however, the U.S. has suffered severe recessions including the Great Recession of December 2007 to June 2009.

Advantages and Disadvantages

The Nixon administration's 1971 economic policy actions have provided advantages as well as disadvantages.

Advantages

Today, we live in a world of mostly free-floating, market-traded currencies. This system has its benefits, especially when facilitating radical monetary policy actions such as quantitative easing (QE).

Central banks have a greater degree of control over their nations' money and the management of variables such as interest rates, overall money supply, and velocity.

Disadvantages

On the other hand, Nixon's move also created uncertainties and led to a massive financial market based on hedging the risks created by currency uncertainty.

The financial crisis of 2007-2008, in particular, proved that central bank control is no guaranteed defense against severe recessions.

Many decades after the Nixon Shock, economists are still debating the merits of this remarkable policy shift and its eventual ramifications.

The Bottom Line

Nixon Shock refers to the aftermath of President Richard Nixon's August 1971 announcement of major economic policy changes that his administration intended to implement to improve the country's balance of payments, prevent inflation, and lower unemployment.

Economists still argue about the merits of the actions taken, as well as their ill-effects.