1944-71: Bretton Woods & The Gold Standard
Global economic policymakers sought to address the chaotic competitive devaluations and runaway inflation that preceded World War II with a new financial order established during an international conference in 1944 in the New Hampshire resort of Bretton Woods. But that agreement, which tied the dollar’s value to gold, caused a growing number of problems as the capitalist world expanded over the ensuing decades.
August 1971 brought a decisive change in the efforts to contain volatility when President Richard Nixon decided to end the dollar’s tie to gold. After the gold standard ended, so did the system of fixed exchange rates in which different currencies were tied to the dollar and thus also to gold. Efforts to maintain a pegged exchange rate to the dollar, which once involved building reserves of gold, now tended to pit markets against central banks, with the latter attempting to prove their bona fides by raising interest rates–until the rates grew unsustainable and the currency crashed. The advent of floating currencies added a valuable new adjustment mechanism to the world’s financial order but created its own volatility.
We can see the series of informal regimes that have followed Bretton Woods by looking at the price of the S&P 500 index in gold terms—in other words, the ratio of the S&P to the gold price.
1971-81: The Oil Standard
The world’s financial system shifted effectively to using oil as an anchor for the dollar once Nixon abandoned the peg to gold, given the central role petroleum played in global economic growth. Saudi Arabia and the other major petrostates agreed to conduct all their transactions in dollars, maintaining the currency’s central role in the global economic order.
The U.S., freed from the “cross of gold,” embarked on expansionary fiscal policies, creating inflation and sending the price of gold higher. Oil producers responded by cutting supply and forcing up oil prices in dollars to ensure they’d receive the same amount in gold terms as they had in the past. Ultimately the financial system remained tied to the value of one commodity—the crucial difference was that oil, unlike gold, was vital to the cost of everyday life. The rising price of oil lifted consumer prices throughout the 1970s, eventually creating one of the most savage bear markets in stocks ever witnessed. Judged in real or gold terms, share prices collapsed, as did the price of bonds. This was volatility on a scale that hadn’t been seen since before World War II.
1981-98: The Volcker Standard
The disruption driven by oil and widespread price inflation came to an end when the Federal Reserve, under Chairman Paul Volcker, convinced investors it was committed to curbing inflation—even at the cost of a serious recession. Once this stability had been earned, fiat money could begin to regain the credibility it had enjoyed while it was backed by gold. By 1985 the dollar had grown so strong that a group of finance ministers and central bankers met at the Plaza Hotel in New York to agree on concerted action to weaken it.
Once investors were confident that inflation was under control, interest rates steadily declined. After peaking at more than 15% early in Volcker’s tenure at the Fed, the 10-year Treasury yield—the single most important financial benchmark for transactions around the world—has dropped almost continuously since. Bond traders working today have no memory of the era when bond yields rose with any consistency. The fall in borrowing costs stimulated the economy and cushioned the stock market.
“Animal spirits” meant the market was still capable of overshooting, as it did leading up to the dramatic Black Monday crash in October 1987, when stock markets fell more than 20% in one day early in Alan Greenspan’s term as Fed chairman.
In 1994, when the Greenspan Fed took the market by surprise by hiking interest rates to avert inflationary risks, the move strengthened the dollar and caused a sharp drop in bond prices (sometimes dubbed the “great bond massacre”). It also put intolerable strain on emerging countries that had been trying to contain their own inflation problems by pegging their currencies to the dollar. First, Mexico, in December 1994, then the emerging Tiger economies of Asia, in 1997, succumbed to a wave of devaluation and default crises.
1998-2008: The Greenspan Put
As those emerging-market crises reverberated through the system, the “Pax Volckeriana” broke down, along with the great equities bull market more than a decade into Greenspan’s leadership. The 1998 implosion of Long-Term Capital Management, a hedge fund that had borrowed heavily from big Wall Street banks to place bets that soured quickly after Russia defaulted on its debt, was a critical moment. Credit markets froze almost completely.
Rather than let banks fail, the Fed coordinated a bank-led bailout for LTCM (over the public criticism of Volcker) and cut interest rates three times. That rescued the equity market, which started to melt up into the dot-com bubble driven by rising internet stocks.
Thus began an era characterized by what became known as the “Greenspan put”—total confidence that the Fed would always ease monetary policy to cushion falling asset prices. Concerned about “irrational exuberance” in the markets, the Greenspan put began raising rates in 1999 and early 2000. The dot-com bubble burst, and in 2001 the Fed started easing aggressively again. Bond yields continued their steady fall. The period soon became known as the Great Moderation—credit grew ever cheaper, and the volatility of stock markets dwindled to record lows.
Still, the rising gold price made clear that markets didn’t trust the Greenspan Fed to protect the dollar’s value in the same way they’d trusted the Volcker Fed. They trusted the Fed to protect share prices but not to control inflation. Eventually this confidence that interest rates would keep falling led to the risk-taking that ended with the global financial crisis of 2008. As money became too cheap, lending standards weakened. When investors belatedly woke up to the fact that many of the loans would never be repaid, the financial system almost collapsed.
2011-Present: The QE Standard
The disaster of 2008 created almost unprecedented volatility. Although U.S. authorities initially attempted to restore discipline by allowing the securities firm Lehman Brothers to fail, they quickly discovered the financial system was too interconnected to survive. The aftermath of Lehman’s failure was so disastrous that policymakers and traders recognized that no other large institution could be allowed to fail—creating a new level of “moral hazard” in the system. And so the Greenspan put was extended under his successor, Ben Bernanke. The Fed bought bonds under the so-called quantitative easing, or QE, program to keep interest rates low. The price of gold skyrocketed as investors became convinced that inflation would follow in its wake.
Around 2011, after years of desperate money-printing, investors still saw no sign that inflation was returning. With that came the idea that interest rates would remain stuck near zero forever. With the belief in “lower for longer” firmly installed, the price of stocks in gold rose once more, peaking about a year before the Covid‑19 pandemic and lockdowns created global recessions and scrambled all forecasts.
Central banks have responded by convincing markets that they remain determined to buy as many bonds as it takes to keep yields at minimal levels. In contrast to Volcker’s determination to keep inflation under control, and Greenspan’s refusal to let asset prices fall, we now have central banks’ insistence on keeping borrowing costs low. This effectively forces investors to lend to the government at low rates, a policy known in market jargon as “financial repression.” For the time being, it’s working. Equity market volatility remains elevated, but since spring 2020, bond market volatility has dropped to unprecedented lows.
The QE standard, or a refusal to let bond yields rise, has replaced the Bretton Woods gold standard as the anchor of the financial system. This can carry on as long as inflation doesn’t return to the economy. At such a point as it does, we should all brace for a return to volatility. And the search will be on for yet another replacement.
Authers is a senior editor for markets coverage at Bloomberg News in New York. This column doesn’t necessarily reflect the opinion of Bloomberg LP and its owners.
For more articles like this, please visit us at bloomberg.com
©2021 Bloomberg L.P.