A History of the Federal Reserve, Volume 2 (82 page)

Many of the controls or restrictions were inefficient or could be circumvented. Tying foreign aid expenditures is inefficient and costly, but substitution is limited. Requiring foreigners to purchase military equipment to offset costs of U.S. troops abroad increased exports and reduced capital outflow. Tying foreign aid or military spending also reduced the real value of the spending but may have been offset by increased appropriations so that the actual dollar outflow was not much affected.
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The interest equalization tax had a strong initial effect but soon shifted lending to banks and foreign markets. But it shifted deposits also. Controls on bank lending to foreigners followed. Foreign interest rates rose relative to domestic rates, so the interest equalization tax had to be raised later in the decade. Eichengreen (2000) concluded that controls were ineffective. He found no evidence of an effect on the speed of adjustment to interest differentials after the controls were in place.

At most controls and restrictions may have given the United States more time to adopt a permanent program. The Kennedy, Johnson, and Nixon administrations never developed policies to sustain the Bretton Woods system. This left the solution to monetary policy, controls, and the market. As prices rose abroad relative to domestic prices, the current balance improved. Foreign governments did not like “imported inflation,” but they disliked currency revaluation or slower growth of the U.S. economy even more. Abroad, as at home, maintaining employment and preventing recession had higher priority.

Hayes reported that the interest equalization tax created a boom in foreign term loans instead of securities (FOMC Minutes, July 30, 1963, 6). The staff reported no effect of the policy announcements on covered interest differentials. The foreign press was critical of the tax as not well thought out and full of loopholes.
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Members disagreed on whether the attempt to twist the yield curve had failed. Martin expressed skepticism but urged them to continue with the twist, probably for political reasons. Interest rates on long-term Treasury
bonds remained in a narrow range, 3.99 to 4.07 percent, from July to October. Federal funds and short-term interest rates are shown in Table 3.10. By August the federal funds rate rose to the discount rate. Treasury bill rates at first rose more slowly. The System took no further policy action during 1963.
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The manager explained the decline in free reserves as a result of a series of missed forecasts. Almost all were in the same direction.

258. Fieleke (1969) estimated that buying military equipment at home reduced purchases abroad by $80 million. He makes no allowance for a possible increase in the number of troops abroad.

259.
Economist
(July 20, 1963, 276) added: “It is strains of generosity that afflict the American balance of payments, not any inability to earn a most satisfactory living in trade with the outside world. . . . [I]t took on burdens that some are foolish enough to take for weakness.” Balderston agreed that the administration “should impose controls at the point where he thought they would work” on the government’s own spending and lending (FOMC Minutes, July 30, 1963).

Growth of the monetary base rose to the 4 to 5 percent range, the highest rate of increase since 1952. Chart 3.15 shows the very different movements in monetary base growth and free reserves and the very different readings of policy action. The base suggests more expansive policy in 1963–65; free reserves remain on a plateau in late 1963,a brief pause on a declining trend that suggested to the FOMC that policy tightened.

Repeating a problem of the 1920s, shifts from demand to time deposits reduced effective reserve requirements, permitting banks to expand earnings assets and money plus time deposits (M 2 ) much faster than base growth. In 1963, M
₂
rose 8.4 percent after increasing 8.1 percent in 1962. The increase in regulation Q ceiling rates contributed to the growth after July. The Federal Reserve did not have a consistent view about which growth rate, M
₁
or M
₂
, was most relevant. Some liked the induced shift into time deposits because it increased credit expansion and slowed money growth (M
₁
) relative to base growth. They disliked ceiling rates. Others thought the ceiling was inflationary. Still others dismissed both credit and monetary expansion. In this, they did not differ from many mainstream academic economists.

The rate of economic expansion increased modestly in second quarter 1963 to 5.7 percent and more rapidly in the third. Stock prices continued to rise at an annual rate of 15 percent, slower than the 20 to 25 percent
earlier in the year, but evidence of rising profit anticipations. These and other changes showed no evidence of the modest contraction that Martin and Hayes had worked so hard to achieve. Nor did the balance of payments data show the improvement that a higher discount rate and the interest equalization tax were supposed to bring. Despite an $800 million increase in the balance on goods and services, the official settlements deficit for the year remained above $2 billion, only $700 million less than in 1963. And the gold outflow was the same in the second half year as in the first.
²⁶¹

260. At the September 10 meeting, the FOMC again changed the allocation formula. The declining gold stock and rising monetary base necessitated more frequent adjustments than the monthly formula.

The president’s July 18 message accepted the main idea of the Triffin plan. He called for steps to improve the international monetary system by providing additional liquid reserves. At the annual meeting of the International Monetary Fund and the World Bank the following October, G-10 countries undertook the first of many studies of international mon
etary reform (Solomon, 1982, 65).
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The decision taken less than five years after the return of current account convertibility suggests how different was the postwar world from the world envisaged at Bretton Woods. There, the aim had been to avoid deflation, high unemployment, stagnation, and trade barriers driven in part by repeated U.S. payments surpluses. Instead, the main problem was inflation driven by a sustained U.S. payments deficit.

261. Knipe (1965, 157) commented that “those in charge of the United States became . . . obsessed with the liquid capital flows rather than with the fundamental need to rectify the basic balance of payments. Oddest of all though, was that the expressions of apprehension brought home from Europe were frequently worded exactly like the expressions which were currently going round in the United States. In many cases this was easily understandable, because the apprehension probably started with the American visitor.”

The study group vented criticisms, particularly French criticisms, of the reserve currency system. France proposed ending the reserve currency system by creating a new international reserve asset. The United States opposed the French proposal and agreed only to have a study group consider the issue. The group’s report in the summer of 1964 proposed to increase IMF quotas when the issue was to be considered in 1965 but retained the existing system (Solomon, 1982, 69). The State Department was more willing to accept the French position. The outcome would have been different if the State Department had done the negotiating instead of the Treasury.

These discussions repeated several features of the 1920s discussions, with important differences. Again there was no agreement on how real exchange rates should adjust if nominal exchange rates remained fixed. Surplus countries were reluctant to inflate, though less reluctant than in the 1920s. They lacked a better alternative, so they accepted inflation reluctantly and to avoid revaluation and a sudden reduction or loss of their surpluses. As in the 1920s, deficit countries, Britain now joined by the United States, would not deflate. A notable difference from the 1920s was that most of the surplus countries wanted the deficit countries, especially the United States, to avoid deflation for fear of unemployment reaching them.

France repeated its earlier behavior. It devalued in 1958 (as in 1928) to a rate that undervalued the franc. Starting in 1962, it converted the resulting current account surplus into gold at the rate of $30 million a month. Later, it began a more aggressive gold purchase program.

With no solution acceptable to surplus and deficit countries, the United States increased reliance on capital controls. The interest equalization tax and the interest rate increases in July had little immediate success in slowing inflation abroad or improving the balance of payments. In October Coombs reported that speculative gold purchases in London were matched by Soviet gold sales, so the U.S. gold stock remained unchanged for ten weeks. Italian inflation was over 6 percent with wages rising 17 percent,
and there was a risk of devaluation. West Germany, the Netherlands, Canada, and Switzerland had larger dollar inflows and rising inflation. “In the Netherlands, the wage controls, which many of our European friends had strongly recommended as a model for a U.S. incomes policy, have apparently broken down” (FOMC Minutes, October 22, 1963, 31).
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France froze wages and prices. Capital outflow slowed in September, reducing concern and pressure for policy changes.

262. The members of the G-10 (group of ten) were Canada, Japan, Belgium, France, West Germany, Italy, Netherlands, Sweden, the United Kingdom, and the United States. Later Switzerland became the eleventh member, but the name did not change.

Many bankers and businessmen disliked the interest equalization tax. The Blough commission reported to Secretary Dillon that it favored reductions in tax rates, higher interest rates, and reductions in military aid and other government spending abroad, but it did not support the interest equalization tax (letter, Sproul to Roger Blough, Sproul papers, July 23, 1963). Allan Sproul, a prominent member of the Blough commission, had three complaints about administration policy: (1) “there never was enough power and pressure put behind tax reduction”; (2) it labored under “happy illusions about a reduction in the deficit of the balance
of payments during 1962, and its virtual elimination by the end of 1963”; (3) it delayed too long raising interest rates, including time deposit rates (ibid., 1–2).
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Coombs next proposed a modest program of “warehousing.” To support the Italian lire and other European currencies, the Federal Reserve would purchase lire in the spot market, at rates above par value, and immediately sell them forward to the Treasury’s Stabilization Fund to cover outstanding Treasury debt in lire. Like all past programs, this program started modestly. Coombs proposed a limit of $100 million (FOMC Minutes, November 12, 1963, 5–6). The FOMC did not limit the program to the lira and approved unanimously.
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From its modest beginning, authorized warehousing reached $20 billion in 1995 at the time of a Mexican peso crisis (Schwartz, 1997, 143).

263. The October 1 meeting showed an upsurge in concern about the growing size of the swap arrangements. Mills expressed strong opposition and suggested credit controls if the payments imbalance worsened (FOMC Minutes, October, 1963, 44). Balderston was concerned that the government relied too much on the swap arrangements as a substitute for policy. Although the FOMC approved new swap lines as before, there were two objections when the FOMC voted to add Japan to the swap network.

264. Sproul called the interest equalization tax “a mistaken departure from a general policy of non-interference with the international movements of private capital” (notes in preparation for a meeting of the Balance of Payments Committee, Sproul papers, Septem
ber 19, 1963, 1). Coombs replied to these comments: “I hasten to assure you that neither Al Hayes nor I hatched this ‘turkey’ . . . but we have been doing our best to minimize . . . its unsettling effects on the markets” (letter, Coombs to Sproul, Sproul papers, July 29, 1963).

265. The main concern was the use of above par value (but within the IMF bands). Coombs explained that the Italians decided to support the currency above par (FOMC Minutes, November 12, 1963, 6).