A History of the Federal Reserve, Volume 2 (12 page)

The new regulations did not end criticism. As domestic rates in the United States declined in the 1969–70 recession, the flow reversed. Now Europeans complained about the sizeable reflow of dollars. At the January 1970 meeting of OECD’s Working Party 3, critics recognized the cause of their problem. “Regulation Q once again came in for considerable criticism. Some delegates went so far as to say that there would not be a Eurodollar market if it were not for regulation Q” (FOMC Minutes, February 10, 1970, 17). These criticisms continued. The flows were sizeable; between December 1968 and November 1969, “liquid liabilities to commercial banks abroad” rose $10.2 billion, 71 percent of the December value. A year later, these liabilities were back to $18.6 billion, a decline of more than $6 billion.

The
Franc
and
the
Mark

Coombs warned the May 27 FOMC meeting that “the present international situation was the most dangerous of any that had yet been encountered” (FOMC Minutes, May 27, 1969, 7). Germany’s failure to revalue put pressure to devalue on Britain, France, Belgium, Denmark, and possibly some others. A string of devaluations would “have ominous implications for the U.S. foreign trade position which was already bad enough” (ibid.).
Coombs also expressed concern about the euro-dollar market. He feared that foreigners would take “drastic restrictive action on the credit side in order to protect their reserve positions” (ibid., 8). Also, there would be some “spectacular bankruptcies.”

77. Maisel (diary, June 26, 1969, 77–78) claims that the decisive change was Chairman Martin’s decision to support the new requirements. He had met with some European central bankers who wanted action. Also, with the federal funds rate above 9 percent, banks had raised their prime rates to 8.5 percent, setting off complaints from members of Congress. “Martin supported it because he was mad at the banks [for] using it to such an extent” (ibid., 78). Mitchell disliked the regulation Q ceiling and “felt that this was a logical way around [it]” (ibid., 78). At the same meeting, Martin opposed an increase in the discount rate to 6.5 or 7 percent, despite the 8.5 percent prime rate.

The only action the FOMC took was to increase the amount of warehousing for the Treasury. The reasoning was that France would have to sell gold to repay the large volume of recent borrowing on its swap lines. The Treasury was reluctant to buy the gold at the time, so it wanted the alternative of warehousing with the Federal Reserve. The FOMC agreed to the increased warehousing (ibid., June 24, 1969, 15–17).

France continued to borrow and lose reserves until it devalued by 4.25 percent on August 10 from 4.94 to 5.15 francs per dollar. France did not give any advance notice to the IMF or its European Community partners, as required by IMF rules, or to the United States, so the devaluation surprised the Federal Reserve and other observers. No countries (other than those that pegged to the franc) followed, but Belgium increased its swap line.
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At its next meeting the committee unanimously approved increases in the swap lines for Austria, Denmark, and Norway, bringing the total to $10.98 billion.

A special meeting of the FOMC on August 12 showed greatest concern about avoiding effects on employment. Robert Solomon “in effect said that the balance of payments should not be used to influence domestic policy” (Maisel diary, August 13, 1969, 100). Euro-dollar borrowing had started to decline, but the general belief at FOMC was that the interest differences remained large enough to avoid a major decline in the official settlements deficit. By late October, euro-dollar rates had fallen to 9 percent (from 11), partly as a result of the forthcoming recession in the United States and partly as a result of an unwinding of positions in the German mark following revaluation.

Following Germany’s revaluation by 9.3 percent to DM 3.66 per dollar, British payments went into surplus. The British chose to repay the European central banks and made only a token payment to the Federal Reserve. This irritated FOMC members. The United States was the largest creditor, with 71 percent of British debt (FOMC Minutes, November 25, 1969, 8). The Treasury did not support the Federal Reserve’s position about prompt
British repayment. The Federal Reserve’s claims on the swap line now had sixteen months maturity, well above the earlier twelve-month maximum.

78. The Belgian increase aroused some FOMC members. Phillip Coldwell complained that the FOMC responded to each crisis but did not consider the size of the contingent liability or its long-term implication. The FOMC asked the staff for a study of the basic purposes, ultimate size, maturity, and other aspects of the swap network (FOMC Minutes, September 9, 1969, 3). It must have been clear that the swaps had gone far beyond the original “experiment.”

Hayes and Coombs expressed their irritation at the lack of Treasury support and at the Bank of England’s delay in repaying the United States. Some FOMC members expressed concern about the future of the swap lines, but no one proposed changes. The problem ended when Martin negotiated a better payment schedule by getting the Bank of England to reduce its payment to the Treasury and increase repayment of the swap line (FOMC Minutes, December 16, 1969, 10). Early in 1970, the Bank of England repaid the Federal Reserve and cleared its arrears.

BEGINNING OF THE END

“All in all, the official decisions, the academic debate, the performance of the markets, and the resentment about the restraints on policy sent a message that the Bretton Woods system was in deep trouble, and to a growing number, not worth saving” (Volcker and Gyohten, 1992, 47). The problems became more pressing as the long expansion of the 1960s ended. By September 1969, the monthly federal funds rate peaked at 9.19 percent and started to fall. In January the ten-year Treasury rate and in February the CPI inflation rate reached temporary peaks.

The System and foreign governments were concerned about the prospect of a capital outflow to the euro-dollar market as domestic interest rates fell. To encourage banks to bid for time deposits, the Board, after discussions with the FDIC, the Home Loan Bank Board, and the Comptroller, raised ceiling rates on all types of savings deposits and negotiable CDs from 0.5 to 1.25 percentage points. The maximum rate for a one-year CD reached 7.5 percent. Opposition to the change came from two sources. Hayes and some others wanted to avoid the impression that FOMC had eased credit (despite the higher rates). He proposed regulation of commercial paper by applying a marginal reserve requirement ratio comparable to the ratio applied to euro-dollars earlier. Home Loan Bank officials’ main concern was the competitive position and profitability of thrift associations. They negotiated agreements on higher ceiling rates for their members (FOMC Minutes, January 15, 1970; Maisel diary, January 20, 1970, 9–15).

An additional concern was to avoid a repeat of the 1966 experience, when the interest rate structure permitted commercial banks to drain sufficient deposits from other lenders to cause a major decline in lending for housing and state and local governments. Housing starts in 1970 remained at about the 1969 level. In 1966, housing starts had fallen 21 percent.

The System was less successful in managing the capital outflow of $9.3 billion, much of it reflow to the euro-dollar market. The official settle
ments account went into surplus at $2.7 billion in 1969. On the liquidity definition that included changes in liquid liabilities to non-official holdings, the deficit was −$7 billion, a record.

On January 1, 1970, countries received the first allocation of SDRs. The U.S. share was $867 million in 1970 followed by $717 and $710 million in 1972 and 1973. The Treasury issued $200 million of the initial allocation to the Federal Reserve, increasing bank reserves and base money. The total allocation was $3.1 billion. In the same year, foreign exchange reserves of all countries increased $14 billion, and total reserves reached $91 billion, a 50 percent increase for the decade and a 22 percent increase for 1970 (IMF, 1971, 19). Countries did not agree to issue SDRs again until 1979. The SDR became an unimportant sidelight of international finance.
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Despite the recession, the reserve banks kept the discount rate at 6 percent. The federal funds rate declined over the course of the year from 9 percent in January to 4.9 percent in December; growth of the monetary base rose from the recession low (3.8 percent) in January to 6.4 percent in December. By either measure, monetary policy eased, although the real value of annual monetary base growth was only about 1 percent. Stock prices continued to fall through June until they were 30 percent below the December 1968 peak.

Euro-dollars continued as a major problem for foreign central banks. For West Germany, following revaluation, the more serious problem was a successful effort by the trade unions to increase their income. In 1970, gross hourly wages rose 13.9 percent and unit labor costs 11.6 percent (Holtfrerich, 1999, 310). Faced with rising labor costs and renewed capital inflow, Germany raised its discount rate to 7.15 percent and introduced a reserve requirement against new foreign deposits at German banks. The major inflow problem was still in the future.

On May 31, Canada decided to float its dollar. The Canadian dollar rose modestly, from U.S.$0.932 in May to U.S.$0.984 in September. This was the first large country to (again) abandon the fixed exchange rate system. In September, Canada reduced its discount rate. The decision had no effect on Federal Reserve policy.

Throughout 1970, principal attention was on domestic concerns. An occasional comment at FOMC suggested that policy should be as tight as possible, given domestic concerns. Usually, Hayes or his representa
tive made this case. It did not have much effect on Burns or decisions.
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Burns’s main concern was the rising unemployment rate and, of course, the Penn Central bankruptcy and its aftermath. In September, Pierre-Paul Schweitzer, managing director of the IMF, caused a stir by urging the United States to finance its deficit using reserve assets, not euro-dollars. This irritated U.S. policymakers but did not affect policy.

79. At the turn of the year, the administration issued new credit restraint guidelines, slightly more relaxed than 1969. The Board was reluctant to relax its lending guidelines. It accepted the administration’s proposal when Chairman Burns assured the members that the revisions were “quantitatively insignificant” (Board Minutes, January 5, 1970). The new guidelines removed the exemption for Japan.

Solomon (1982, 177) reported that by spring 1970 domestic interest rates had fallen below euro-dollar rates, causing banks to repay euro-dollar holdings in excess of their reserve free bases. The payments deficit reached $3 billion in the fourth quarter and nearly $10 billion for the year. German reserves rose by about $6 billion as German companies borrowed euro-dollars to circumvent the relatively high interest rates at home. Belgium, the Netherlands, and Switzerland also experienced large inflows. Unlike Germany, these countries had not agreed formally to refrain from demanding gold, so they requested exchange guarantees on their swap lines (ibid., 177).

The FOMC and the Board returned frequently to consider possible actions the System could take to absorb euro-dollars or get U.S. banks to increase their holdings. At a Board meeting in November, Burns asked Robert Solomon for a staff recommendation. Solomon suggested reducing reserve requirements on demand deposits to release reserves equal to the amount of a bank’s euro-dollar borrowing (Board Minutes, November 24, 1970, 7). Neither this nor other proposals became policy.

Europeans complained about the easy monetary policy and urged the United States to rely more on restrictive fiscal policy. And Coombs reported that attitudes in Europe had started to turn. “Rather strong resistance was developing to the SDR operation and strong impetus was being given to the European Monetary Union—not simply as a long-range plan but also as a contingency plan in the event of a breakdown in the international payments system” (FOMC Minutes, February 9, 1971, 8). This change probably reflected the growing belief that the United States would not act to stop the outflow. Earlier, “an intensive discussion of limited exchange rate flexibility . . . [showed] more support for, and less opposition to, limited flexibility than was indicated in the earlier discussion in the Fund” (FOMC Minutes, May 5, 1970, 12).

The U.S. gold stock reached a local peak of $11.9 billion in February 1970, $1.2 billion above March 1968, when the two-tier system began. In
August, it began the final decline leading to the end of the $35 gold price. By May 1971, the stock was below the March 1968 level. Part of the decline reflected requests from countries that had to pay part of their increased IMF quota in gold.

80. As the recession ended, Burns told the FOMC: “The Committee members recognized the risk on the international side of moving to lower rates but most thought it was necessary to take that risk” (FOMC Minutes, November
17, 1970, 101).

Until 1970 or 1971, changes in the U.S. current account balance mainly reflect changes in relative unit labor costs. After 1970, the situation changed dramatically. The current account deficit and relative unit labor costs are positively related (Meltzer, 1991, 70–71). Chart 5.5 shows the current account balance. The balance fell from 1964 to 1969, rose during the recession, then plunged. The United States now had a current deficit in addition to its net capital, military, and foreign aid spending abroad. To an observer at the time, the prospects for an end to the dollar outflow seemed remote or unlikely.

There was no sense of panic within official institutions. Robert Solomon again told the FOMC in January that “he felt there was no reason for the balance of payments to be a variable influencing the decisions in the domestic sphere” (Maisel diary, January 13, 1971, 1). It was important “to do something about the [euro-dollar] problem . . . to show its [our] good faith” (ibid., 2). The main reason for restricting the euro-dollar outflow was to convince the Europeans that we would cooperate. That was important for two reasons, avoiding a crisis and issuing more SDRs. “If a
crisis occurred they would be more willing to cooperate” (ibid.) Despite rapidly growing international reserves, Solomon’s concern was to issue more SDRs. The Europeans had agreed to the first allocation because of the official settlement surplus; if euro-dollars outflow increased the official settlement deficit, “everyone could well argue that there shouldn’t be any new creation until the official settlement deficit of the United States had been stopped” (ibid.).
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This had been the French position all along.