A History of the Federal Reserve, Volume 2 (10 page)

On August 8, France devalued by 11.1 percent. Solomon (1982, 163) was skeptical about the need for devaluation at that time. He suggested that the French government “felt it imperative to put an end to the expectation that they would devalue” (ibid., 113). Others saw the devaluation as an effort by France to undervalue the franc to stimulate its economy as in 1927 and on other occasions. Following devaluation, France removed exchange controls.

In the September German election the Social Democrats favored revaluation and the Christian Democrats opposed. The Bundesbank again closed the foreign exchange market three days before the election. The new Social Democrat government reopened the market and permitted the mark to float. Soon after the new government revalued the mark by 9.3 percent to DM 3.66 per dollar and removed the special taxes on exports and subsidies to imports introduced the previous November (Holtfrerich, 1999, 389). Following revaluation, capital flow reversed to such an extent that Germany drew on its IMF quota for the first time.

The German revaluation reduced Germany’s current account surplus in 1969 and 1970 and induced a record capital account deficit in 1969. The revaluation came during the period of rising interest rates in the United States that increased the U.S. capital inflow. For 1968 and 1969, the United States had a surplus on the official settlements account. That helped to put the balance of payments problem aside for the rest of the Johnson administration. Its last act was to extend its controls on capital flows, and increase the ceiling permitted for direct investment. Once again, the Cabinet Committee pointed to tourism, trade, and overseas military spending as problems, but it made no new proposals (letter, Fowler to the president, Johnson Library, F04–1, December 11, 1968).

A NEW ADMINISTRATION

At the end of 1968, the United States had $33.8 billion of dollar claims against a $10.9 billion gold stock. Between 1964 and 1968, the trade and current account surpluses had changed from $6.8 and $5.8 billion to $0.6 and −$0.5 billion. This was the first current account deficit since 1959.

Anyone looking at this development was likely to conclude that the present arrangement could not be sustained. As a candidate, President Nixon opposed the restrictions on capital flows, but he did not propose any solution to the payments problem. The new Undersecretary of the Treasury,
Paul Volcker, recognized that without restrictions on capital and possibly tourism and trade, there were two solutions: either a multilateral agreement or unilateral action to permit exchange rates to adjust. The other possible solution—defl ation—was so universally rejected that it was never mentioned. Exchange controls, pressures on some foreign governments, and a temporary surge of euro-dollar borrowing to finance domestic banks propped up the international monetary system in 1969.

The newly elected Nixon administration appointed a task force, chaired by Professor Gottfried Haberler, to recommend an international economic policy. Haberler made the case for wider bands, increased exchange rate flexibility and an end to capital controls. In a separate memo, Milton Friedman made the case for floating the dollar at the very start of the new administration. He warned that “later events may force the administration to take the same measures that it could at first take voluntarily, but if so, the measures will then involve great political and social cost” (Friedman, 1968a, 1).
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Arthur Burns summarized the task force report for the new president. The payments position “is very precarious.” He favored the elimination of exchange controls calling them wasteful, inefficient, and a tax on growth, and he warned that pressures against the dollar could become a problem. He proposed “confidential negotiations with the key industrial countries . . . with the main American objective being to secure quickly a significant realignment of parities of some currencies” (Department of State, Summary of the Report of the Task Force on U.S. Balance of Payments Policies, January 18, 1969, 1). He proposed wider bands and small “automatic adjustments,” a crawling peg, and separately a one-time realignment. He opposed a floating rate and revaluation of gold, and he warned that “if a ‘gold rush’ develops, the United States should suspend gold convertibility” (ibid.).

Separately, the new Treasury Undersecretary for Monetary Affairs, Paul Volcker, chaired a group similar to the Deming group in the Johnson ad
ministration. It did not recommend a floating rate, in fact gave it little attention. It confined discussion of exchange rate policy to fixed rates or limited flexibility.
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The memo did not take a position for or against limited flexibility. It suggested, however, that more flexible exchange rates would remove a restraint against inflation and “might worsen our current account deficit” if other currencies depreciated against the dollar (Department of State, Long-Term Aspects of U.S. International Monetary and Exchange Policies, Volcker group, January 30, 1969). Elsewhere in the memo, the group recommended prompt issuance of $3 to $4 billion a year of SDRs for five years.

63. Official views had started to change. Britain’s 1967 devaluation and discussion of French devaluation and German revaluation in November 1968 brought adjustment to the fore and removed parity changes from among the unmentionables. In both countries, proponents of exchange rate adjustment, including central bankers, moved the discussion from academia to official institutions. Solomon (1982, 168) mentions the desirability of a depoliticized process for exchange rate adjustment. The United States government was slow to support discussion of greater flexibility (ibid., 171). The Economic Report of the President, however, mentioned “greater flexibility of exchange rates” within the Bretton Woods system (Council of Economic Advisers, 1971, 145). Later, the report recognized “the political consequences inherent in exchange rate decisions have made countries hesitant to undertake said adjustmen
ts” (ibid., 152).

With limited support and some strong opposition to floating, President Nixon retained the existing arrangements at the start of his administration.
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The principal new thrust was the effort to get SDRs issued. The timing was helpful because the United States had raised interest rates as part of domestic policy. As a by-product it had an official settlements surplus at the time, and the French had made that a precondition for agreement. The principal issue in dispute within the administration was removal of exchange controls and the interest equalization tax when it expired in June. With these changes, Treasury estimated that the goods and services account would have to increase by $13 billion to achieve permanent balance.

All parties in the new government supported removal of controls in principle, but, prompted by his staff, National Security Adviser Henry Kissinger urged delay and deliberation. By late January, concern about foreign reaction to removing controls and the estimated increase of $2.1 billion of foreign direct investment, if the administration eliminated controls, caused further delay. Discussion with European officials aroused concern that an ambitious decontrol program could harm the administration’s efforts to issue SDRs. This had priority, and the priority was not questioned. Major decontrol that would widen the reported payments deficit by as
much as $2 billion strengthened some European concerns that the United States wanted to use SDRs to avoid “discipline.” In any case, the need for SDRs would be reduced by a large payments surplus.

64. I worked for Paul Volcker briefly in the Kennedy administration. At the time, he was committed to a fixed rate system. Although he may have moderated his views in 1969, they had not changed. As noted below, he was pragmatic; he recognized that the current arrangement could not be sustained.

65. Before President Nixon traveled to Europe to discuss international monetary arrangements, he received memos from Paul McCracken at the CEA and Arthur Burns, his counselor. McCracken opposed any increase in the gold price except as part of a total package “that makes it worth our while.” Burns agreed about gold, then added, “Let us not develop any romantic ideas about a fluctuating exchange rate: there is too much history that tells us that a fluctuating exchange rate, besides causing a serious shrinkage of trade, is also apt to give rise to international political turmoil” (Nixon papers, Box 442, February–March 1969, Trip to Europe). President Nixon did not have much interest in international economics. Volcker and Gyohten (1992, 61) described him as unwilling to see finance as a binding constraint on his foreign or defense policies.

By March, the Volcker group was ready to propose a long-term strategy. This was a major step away from the short-term crisis management of the Johnson administration. With modest changes in response to events, the Nixon administration followed both of the proposals in turn.

The strategy called for “either (a) negotiating substantial but evolutionary changes in present monetary arrangements, or (b) suspending the present type of gold convertibility and following this with an attempt to negotiate a new system” (“Summary of a Possible U.S. Approach to Improving International Monetary Arrangements,” Department of State 119, March 17, 1969). The paper proposed a two-year period to terminate at the end of 1970 during which active negotiations, with high-level support, would try to achieve several objectives: (1) issue $15 to $20 billion of special drawing rights over five years; (2) increase IMF quotas in 1970 but not at the expense of the SDR allocation; (3) seek appreciation of the mark and other currencies of countries in surplus; (4) begin intensive consultations about moving parities, wider exchange rate bands, or a combination of the two; and (5) make other adjustments including relaxation of capital controls. The memo ruled out a change in the gold price.

If negotiations failed to achieve adjustment, the United States would act unilaterally to end gold convertibility. Then in “calm and unhurried negotiations,” the United States would try to reconstitute a system with greater exchange rate flexibility and other features of the earlier negotiations (ibid.) Volcker suggested about two years of efforts to change the system by multilateral agreement before taking a unilateral approach.
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He was not optimistic about what negotiations would achieve, but he was less enthusiastic about ending the gold peg. His recommendations were based on what he thought would happen (Volcker and Gyohten, 1992, 67–69).

On April 4, President Nixon retreated from his campaign promise to remove capital controls and accepted the recommendations of the balance of payments task force. The new guidelines raised the ceiling for foreign direct investment by $400 million to $3.35 billion (Department of State, memo, Treasury Secretary Kennedy to President Nixon, April 1, 1969).
The Federal Reserve relaxed lending restrictions as part of the program (Board Minutes, March 27, 1969, 16–17).
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66. Solomon (1982, 169) noted that the Deming group circulated to “senior colleagues of a number of countries” proposals for discussion of wider bands and crawling pegs for exchange rates. The main reason given for failure to get agreement was European concern that the United States would practice “benign neglect” of the effects of its policies abroad (ibid., 170).

Martin was unable to attend an October 22 meeting on the revision of capital restrictions for 1970. He sent a letter outlining his views on the balance of payments. The improvement in the official settlements balance was temporary, he said, the result of a $410 billion euro-dollar inflow that had ended. As the official settlements deficit increased, foreign monetary authorities would acquire dollars leading to a “large draw down of U.S. reserves (gold, our IMF position, SDRs)” (letter, Martin to Kennedy, Board Records, October 21, 1969, 2). Then he added a critical point: “foreigners’ response would be influenced by whether they regard the large deficits as temporary or permanent” (ibid., 2–3). Martin added that dismantling capital controls, when faced with a large deficit, would disturb foreign observers and lead them to “conclude that the U.S. deficit is here to stay” (ibid., 3).

In October, probably influenced by the Volcker proposals, the Federal Reserve staff proposed a study of the consequences of increasing exchange rate flexibility. The proposal listed wider bands for exchange rates, adjustable parities (e.g., crawling pegs), and wider gold-price margins, but it excluded floating rates. Later, the staff discussed some of the issues with foreign counterparts. The principal concern was the absence of “discipline.” A few participants favored increased flexibility, but several opposed wider bands as unnecessary or harmful to international stability. Members of the European Economic Community expressed particular concern that exchange rate flexibility would disrupt internal agricultural trade because the pricing formulas would change with the exchange rate (Greater Exchange Rate Flexibility: Report on Bilateral Technical Discussions, Board Records, October 1969).
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This hardly seems a strong reason for rejecting major reform of general benefit.

67. Chairman Martin continued to participate in meetings of the Cabinet Committee on the Balance of Payments. Secretary of State Rogers was a member also, but the National Security Adviser (Kissinger) was not. President Nixon saw foreign economic policy in its political aspect and had many of the discussions moved to the National Security Council, where Kissinger was present (Department of State, memo, C. Fred Bergsten to Henry Kissinger, April 14, 1969).

68. There were other proposals for change. William Dale, the Treasury representative at the IMF, proposed an end to gold convertibility, “sooner, rather than later” (“Limited Gold Convertibility in a Cooperative Framework,” Volcker papers, Department of the Treasury, March 10, 1969). He proposed unilateral action to replace what he called “pseudo convertibility” with a rule for limited convertibility. The U.S. would sell gold at $35 an ounce to countries as long as the ratio of gold to imports in the buying country’s official holdings were no higher than in the United States after the sale. Countries would converge to a common ratio. Dale did not specify how the rule would change if the world price exceeded $35 an ounce.