A History of the Federal Reserve, Volume 2

A HISTORY OF THE FEDERAL RESERVE

allan h. meltzer

a history of the

Federal Reserve

volume ii, book two, 1970–1986

the university of chi
cago press • ch
icago and london

A HISTORY OF THE FEDERAL RESERVE

FIVE

International Monetary Problems, 1964–71

A worldwide system of flexible rates would, I very much fear, be a continuous invitation to economic warfare as countries maneuvered their rates against each other—or more charitably, influenced their own rates to reflect in each case the immediate interest of the country concerned. There then would be no widely recognized established rate levels, and no presumption of any obligation to maintain rate stability. . . . “I doubt that forward markets could ever as a practical matter get started in any currencies—except perhaps at discounts so large as to make the nominal markets meaningless”

—Robert V. Roosa, in Friedman and Roosa, 1967, 50–52.

Robert Roosa, the person most directly responsible for international economic policy in the first half of the 1960s as Treasury Undersecretary, believed flexible exchange rates were impractical and unworkable. Markets could not be relied on to determine exchange rates. Only some version of a pegged exchange rate system, even if encumbered by controls, could be made to work satisfactorily. A principal reason was that all major countries had adopted full employment as their principal policy goal.
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That idea dominated international monetary policy in the 1960s.

The United States adopted two major pieces of economic legislation affecting economic policy in the 1940s, one domestic (the Employment Act) and one international. The Bretton Woods Agreement, in practice, became an international dollar standard. United States policy was responsible for maintaining the dollar price of gold at $35 an ounce. This objective required monetary policy either to accept the inflation rate or price level
consistent with the $35 gold price or to pursue a domestic employment goal by adopting controls and restrictions on trade or capital movements. Roosa chose capital controls.

I. The other person in the debate, Milton Friedman, argued the opposite. An unemployment goal would be easier to achieve if exchange rates were flexible.

The domestic and foreign objectives were often in conflict. Several administrations and the Federal Reserve gave most attention to the domestic effects of its policy. The Federal Reserve regarded the balance of payments and the exchange rate as mainly administration problems. Administrations chose to maintain high employment and to reduce the unemployment rate as much as possible. Policy did not totally ignore the balance of payments problem, as it was known, but government was reluctant to accept an increase in the unemployment rate, however temporary, to achieve an international policy objective. It relied instead on (1) a growing number of controls on capital movements to reduce the number of dollars going abroad, and (2) policy adjustments in countries receiving dollars to maintain existing exchange rates. During the 1960s, particularly after 1965, the United States did not have a long-run policy. It met each crisis with a short-run bandage.

Negotiators of the Bretton Woods Agreement spent much effort on preventing a return of deflation. They did not expect or plan for inflation. As Eichengreen (2004, 7) notes, the two principal negotiating countries had different objectives. The United States wanted a system that would maintain stability; the British wanted more policy flexibility. All of the concern about deflationary policy focused on avoiding repetition of United States policy in the 1920s. The principal surplus countries in the 1960s, Germany and Japan, were reluctant to appreciate, just as the United States had been in the 1920s.

In practice, U.S. inflation became the principal source of problems after 1965. Foreign governments complained repeatedly about the inflationary impact on them arising from their dollar receipts. It forced them to choose between allowing their prices to increase, increasing controls on capital movements, and revaluing their exchange rates. They didn’t want to do any of the three; in particular, they did not want to take any action that would reduce their exports and employment. They wanted the United States to solve the problem without slowing its growth enough to slow their growth and employment more than marginally.

The Bretton Woods system had a short life, both because member countries’ objectives and policy were dominated by maintaining full employment and because the agreement in practice had a flaw.
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Countries
other than the United States did not have to inflate or deflate. They could revalue or devalue their currencies against gold and the dollar when their exchange rates were misaligned. In practice the system’s operating rules did not permit the United States to devalue, and both Roosa and President Kennedy opposed devaluation. The general belief was that if the United States devalued against gold, other countries would follow by keeping their dollar exchange rate fixed.
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Even so, devaluation would have increased the nominal value of the gold stock, solving the so-called liquidity problem that concerned policymakers in the 1960s.

2. McKinnon (1993, 603, table 2) lists the formal and informal rules of the Bretton Woods system.

Trapped between the unwillingness of countries to revalue their currencies in response to export surpluses and higher rates of growth on the one hand and the inability or unwillingness of the United States to devalue on the other, the System stumbled from crisis to crisis in the late 1960s. At the outset, in recognition of its historic position, the British pound was a reserve currency, akin to the dollar. However, Britain was, more than most, on an employment standard—determined to pursue Keynesian policies of demand growth to maintain full employment. A series of crises ending in devaluation in 1967 greatly reduced the pound’s role as a reserve currency.

Between December 1965 and August 1971, when the United States unilaterally stopped selling gold, foreign official institutions (mainly central banks) accumulated $28 billion in dollar claims, an 18 percent compound annual rate of increase (Board of Governors, 1976, 934; 1981, 346).
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Most countries held these balances in U.S. Treasury bills.

France was an exception. The French government complained that the United States had a unique position. Its citizens could acquire assets and goods abroad, making payments in their own currency. Other countries had to hold the dollar as part of reserves; the United States received seigniorage. This complaint was a restatement of French complaints about the gold exchange standard in the 1920s; France (and others) could not do what the United States could do. Excess supplies of French francs required French disinflation or devaluation; excess supplies of U.S. dollars required France (and others) to inflate or revalue. The United States had to pay the interest cost only on the dollar assets that others accumulated.
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3. Devaluation would have required congressional legislation. The delay would have disrupted currency markets.

4. This compares to a 5 percent compound rate in the preceding six years. By the time of the breakdown, the Canadian dollar had left the system. Switzerland and Austria had revalued, and West Germany had floated the mark in spring 1971. On the role of excessive U.S. monetary expansion, see Darby et al. (1983), Bordo (1993), and Eichengreen (2000). For a contrary view, see Cooper (1993, 106).

5. Bordo, Simard, and White (1995) reviews the French position. See also Solomon (1982).

Stepping back from the many discussions and policy actions to look at the system’s evolution shows a steady increase in liquid dollar liabilities to foreigners and the nearly steady decline in the U.S. monetary gold stock available to convert the remaining dollar liabilities into gold. Claims against the stock passed the U.S. gold stock in 1960. By 1965, the claims were more than twice the stock, by 1968 more than three times. Legislation in 1965 first removed gold reserve requirements against bank reserves and in 1968 against currency. This made the entire gold stock available. These actions that were intended to show willingness to support the fixed gold price also called attention to the gold outflow and the ineffectiveness of U.S. policy. Table 5.1 shows these data.

By 1970, liquid liabilities to foreigners were four times as large as the available gold stock. Although the U.S. gold stock stopped falling in 1968 after an embargo was in place, claims or potential claims continued to rise. In the first nine months of 1971, claims rose an additional $21 billion. There was no sign that claims would slow, and no prospect that they would reverse. By 1969 the breakdown of the system would not surprise U.S. policy officials. They did not know when it would occur, but they expected it would. And they understood that any large claim to convert dollar liabilities into gold was likely to trigger a run that could exhaust the remaining stock.

Discussion of these problems went on for several years. Presidents and high officials promised repeatedly to maintain the $35 dollar per ounce gold price, but they did not say how they expected to do so. Officials spoke repeatedly about the three problems of the international monetary system—liquidity, adjustment, and confidence. In practice, they resolved the liquidity problem by producing the special drawing right (SDR) in 1968, a substitute form of international currency to supplement gold and dollars in settlements between central banks. This was a solution to the so-called Triffin problem, discussed in chapter 2, making the international
monetary system less dependent on the supply of U.S. dollars. By the time countries agreed on this solution, international reserves were rising rapidly. The SDR did not have much effect or much influence on subsequent events.

The problem that policymakers failed to solve, and rarely discussed, was the adjustment problem—how to get more flexibility in exchange rates.
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In the 1920s, the unresolved problem of the fixed exchange rate system was the absence of an adjustment mechanism acceptable to the participants. Then, the pound was overvalued, the franc undervalued. Britain would not deflate; France and the United States would not inflate. The system broke down, but the policymakers learned nothing. In the 1960s, the dollar was overvalued. The United States would not deflate or disinflate; the Europeans and Japanese disliked inflation.
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Again, countries would not adjust exchange rates. The Bretton Woods system ended in the same way; the fixed rate system collapsed.

In the 1920s, the nearly universal system of fixed exchange rates lasted from about 1925–27 to 1931, when Britain and several other countries left the gold standard. The Bretton Woods system lasted longer, but less than ten years—from the beginning of currency convertibility in January 1959 to March 1968, when the United States embargoed gold de facto. In the next few years, the system limped along until President Nixon made the gold embargo absolute in August 1971.
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The usual explanation of the failure of Bretton Woods invokes the impossibility of reconciling free capital movements and currency convertibility, fixed exchange rates and full employment. The conflict between fixed exchange rates and the full employment policies was the principal problem in the late 1960s. The choice was never a serious issue for the United States; the Johnson and Nixon administrations always chose em
ployment. The Federal Reserve retreated behind the institutional fact that the Treasury and the administration were responsible for international economic policy.

6. Robert Solomon, the principal Federal Reserve staff person in international negotiations, describes (Solomon, 1982, 187) the breakdown of the fixed exchange rate system as “inevitable” because of the absence of an adjustment mechanism for the overvalued dollar. Paul Volcker recognized the problem and the likely outcome on becoming Undersecretary for Monetary Affairs in 1969. For an early prediction, see Friedman (1953).

7. Volcker (2006, 17) described the official position. “I can assure you that it was certainly a cause for immediate removal from offi ce—if you raised any question about the gold/dollar link or the exchange rate of the U.S. dollar.”

8. Two incidents—the floating of the pound in fall 1931 and the floating of the mark in spring 1971—illustrate the change in beliefs and orientation. Despite depression and high unemployment rates, the New York Federal Reserve Bank responded to Britain’s 1931 decision by first raising the buying rate on acceptances and soon after raising the discount rates from 1.5 to 3.5 percent in two steps; other central banks followed. In 1971, the Board did not consider any changes in the discount rate or other restrictive action to defend the currency out of concern for domestic employment.