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The last time the United States declared bankruptcy

How the inflating of the US dollar caused the US to renege on its gold convertibility obligation in 1971

Published: 10-10-2013 00:00

The last time the United States declared bankruptcy

By: Vincent Tie

For the past week, the news making the headlines in the world economy is whether the United States will default as a result of the debt ceiling not being raised. I surveyed a number of my friends on this topic to see how many think that the United States will default on debt obligations this month. All of them believed that the debt ceiling will be raised and a default will be avoided.

When asked to explain their outlook, the common theme in their explanations is that to raise the debt ceiling is the simple thing to do to avoid the disastrous outcome of a default. After all, the United States has raised the debt ceiling 74 times since 1962. What is one more?

It seems that everyone wants the debt ceiling raised because no one has fully comprehended the magnitude of a United States default should it happen. Warren Buffet said that a default would be catastrophic and others said that it would dwarf the collapse of Lehman Brothers in 2008. When the 158-year old bank filed for bankruptcy, it owed $517 billion. The debt owed by the United States government is at least 23 times that of Lehman Brothers.

The prospect of a default is certainly unthinkable. However, the United States has defaulted on its obligations before. It happened in 1971 when then president, Richard Nixon, closed the gold convertibility window and severed the link of the US dollar to gold. This act as described in Ron Paul’s book, The Case For Gold, was tantamount to ‘declaring international bankruptcy’.

Back then, the world was on a monetary system known as the Bretton-Woods system. Under this agreement, foreigners (and later foreign governments) were able to convert the US dollar to gold at $35 an ounce. All other currencies were in turn pegged to the dollar. These countries were told that the dollar was ‘as good as gold’. Moreover, foreign holders of the US dollar were told that they could present the American currency to the US Treasury at any time and redeem an ounce of gold for $35 dollars.

Unfortunately, the US government inflated the supply of US dollars in the 1960s when it committed the nation to the Vietnam War and a slew of domestic programs known as the Great Society. More US dollars had to be printed to pay for such expenditures.

It did not help that the United States was registering severe trade deficits – it was paying for more of its imports with the dollar. Other countries began to question if the United States had the gold to back up its rapidly inflating currency. Countries like France and Switzerland began to redeem their dollars for gold. This drained the gold reserves of the United States.

The situation was complicated by rumours that the gold convertibility window was about to shut. The run on United States gold accelerated. In the first 7 months of 1971, only a paltry $300 million in gold left the United States. In August 1971, the drain of gold reached into the billions of dollars. This caused the US dollar to decline since many foreign governments were turning in the dollars at the US Treasury.

Unable to halt the dollar’s decline, President Nixon declared that the convertibility of dollars into gold would be suspended ‘temporarily’ on August 15, 1971. (This temporary suspension has since lasted for 42 years.) Nixon blamed ‘unfair exchange rates’ for the closure of the gold window. Of course, he avoided mentioning the US government’s erroneous ways of inflating the US dollar and running perpetual trade deficits. With the closure of the gold window, the US government essentially declared to foreign holders of its currency that they have no more gold for them to redeem and that they can hold paper only. 

The default on paying gold for dollars by the United States led the world to experiment with the current fiat monetary system. Paper currency is not backed by something of value such as gold. The value of currencies today is supported only by confidence that the government issuing the currency will continue to guarantee its value.

As the issuer of the world reserve currency struggles from the prospect of defaulting, foreign holders of US dollars are once again facing the the risk of holding a paper currency that may be further devalued. It is no wonder that foreign central banks are now net buyers of gold. The yellow metal has a characteristic that paper currencies does not have – it is a store of value.