A History of the Federal Reserve, Volume 2 (13 page)

At a March 12 meeting of the Board and the Council of Economic Advisers, Maisel asked Herbert Stein about the Council’s view of the balance of payments. The response surprised him: “we would be better off suspending payments and letting the dollar or other currencies float in the exchange market. . . . [Secretary] Connally felt even more strongly that this was true” (Maisel diary, March 12, 1971, 28).

This was not the official Council view. A lengthy memo from Chairman Paul McCracken to Peter Peterson, head of a new Council on International Economic Policy, proposed increased flexibility of exchange rates but did not mention floating the dollar. McCracken noted that part of the difference between the U.S. and the Europeans reflected the relative importance of the United States in world trade but the small relative size of trade as a share of U.S. GDP. He concluded that the United States had an obligation to achieve balance in its economy but, if payments problems remained, the surplus countries would have to adjust. And he suggested that this was likely to occur because a decline in the U.S. trade deficit would create or increase deficits elsewhere, leading to exchange rate adjustment by the deficit countries and renewing our problem (memo, McCracken to Peterson, Nixon papers, Box 98 Council on International Economic Policy, April 5, 1971).

Some explicitly opposed both floating rates and neglect of the payments imbalance. Coombs regularly expressed concern about a gathering “speculative crisis. . . . Corporation treasurers and other traders were now beginning to hedge against the risk of parity changes over the weekend— the first time that type of speculation had been seen in nearly two years” (FOMC Minutes, April 6, 1971, 3). European central banks reduced their discount rates, but the market interpreted the reduction as a response to international flows; the flows increased. Then Coombs warned: “In recent
years the market has been listening to a great deal of official discussion of the virtues of exchange rate flexibility. . . . [W]idespread uncertainty had developed in financial markets both here and abroad as to whether the dollar and other major currencies would in fact be forcefully defended if they came under pressure” (ibid., 4).
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81. The main action was a Treasury decision to have the Export-Import Bank issue debt to the euro-dollar banks. This would absorb euro-dollars. To increase banks’ incentives to buy the new securities, they became eligible for inclusion in a bank’s reserve base used to calculate reserve requirements on euro-dollars. To supplement the Treasury’s action, the Board began offering repurchase agreements to absorb euro-dollars, as much as $1.5 billion in the first month (Maisel diary, January 13, 1971, 8).

The predicted crisis came the next month. The capital outflow reached $4 billion in the first week of May following an announcement by the German Research Institutes that floating the mark was necessary to stop inflation. The Bundesbank stopped purchasing dollars followed by the central banks of Switzerland, Netherlands, Belgium, and Austria. The Treasury issued a statement saying that there was no reason for changing exchange rates. The mark appreciated against the dollar by about 4 percent, from 3.63 in April to 3.51 in June. Appreciation continued.

Volcker did not share the Treasury position. He saw the crisis as an opportunity and urged that the United States should “permit [the] foreign exchange crisis to develop without action or strong intervention by the U.S.” (paper prepared in the Department of the Treasury, Department of State, May 8, 1971, Department of the Treasury). After the crisis developed, the United States would threaten to suspend gold convertibility, impose trade restrictions, and reduce overseas military support in Europe and Japan.
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Volcker proposed five major changes: (1) a significant revaluation by major European countries and Japan; (2) an agreement to shift more of the military costs of defense to Europe and Japan; (3) a relaxation of trade restrictions by Europe and Japan; (4) sharing of foreign aid; and (5) greater exchange rate flexibility, phasing out of gold, and avoidance of exchange controls.

A memo to Volcker from the U.S. executive director of the IMF reinforced his view that the currency revaluations were a possible opportunity for reform. The memo proposed to get agreement on a $6 to $8 billion change in the United States payment position to be achieved by realignment of exchange rates. The U.S. would agree to give up its reserve currency position in exchange for exchange rate realignment and greater
contribution by the Europeans to expenditures for world security (Volcker, 1970).

82. Coombs reported that he had started forward operations in marks to stabilize the dollar. This surprised Burns and the others, since they had not been asked or told. Coombs had cleared the operation only with the Treasury. The outflow of dollars to Europe and Japan reached $2.4 billion in February and over $4 billion in March.

83. On June 3, Congressman Henry Reuss introduced a resolution calling for an end to gold convertibility and a floating dollar unless a new international monetary conference convened to resolve outstanding issues. In the Senate the following day, Senator William Proxmire, chairman of Senate Banking, said that the Treasury would soon accept floating, though the administration denied it
(Congressional
Record,
June 4, 1971, 18148–49).

From Volcker’s perspective, the two years he committed to negotiations were up. It was time to move unilaterally and force the changes that other countries were reluctant to make. Secretary Connally and the president had not yet reached that conclusion, but soon thereafter the secretary persuaded the president to take a modified version of Volcker’s proposal as part of the New Economic Policy.

Directors of the New York reserve bank voted to increase the discount rate by 0.5 percentage points to 5.25 percent. Their aim was to slow the dollar outflow by reducing the interest spread between New York and Europe. With inflation at 4 percent or more, the 5.25 percent rate seems a modest move. The action received little support at the Board. It decided to do nothing and informed New York that the Board rejected the higher discount rate. This lack of response reinforced the growing belief that the United States followed the policy of “benign neglect” publicly advocated by Gottfried Haberler and others.

Germany found that it faced a standard problem; it had to sacrifice one of three policies—unrestricted capital movements, independent policy to control domestic inflation, and fixed exchange rates. It tried first to get agreement on a joint float of the European currencies but found no support. Instead of additional controls of capital flows, as France and others proposed, it continued to float. The mark appreciated by 3 or 4 percent and the Swiss franc by 7 percent (Maisel diary, May 11, 1971, 39). Japan announced that it planned no parity change.

The United States was prepared for larger exchange rate changes. Volcker had commissioned a study of the overvaluation of the dollar. It suggested that the overvaluation was 10 to 15 percent (Volcker and Gyohten, 1992, 72). While he did not urge a floating rate for the dollar, he advised Secretary Connally and others that he “was pessimistic on prospects for negotiating a large enough change in parities to deal with the situation” unless the system underwent major reform (ibid., 73).
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In a meeting with President Nixon, Volcker and Burns disagreed. Volcker warned that the German decision to float the mark would subject the dollar to speculative pressure and would encourage speculators to sell U.S. assets. Protecting the dollar would require large-scale borrowing. The short-run effects of dollar devaluation might be negative, but exports

84. Volcker wanted to float at least temporarily: “Burns was against me. I wanted to get to a more sustainable rate, maybe with a much wider band” (Volcker, 2001).

would increase and the U.S. could remove capital controls. He added that any defense of the dollar had to include reduction in the inflation rate.

Burns wanted the president to speak out against the German decision to float. His argument was political. “If the Germans move, they’re going to blame us, and our political opponents at home are going to blame us.” He urged the president to call an international conference for the coming weekend (White House tapes, conversation 490-24, May 4, 1971).

The immediate problem ended with West Germany and the Netherlands floating and revaluations by Switzerland and Austria. Burns wrote to the president and Secretary Connally warning that the crisis was not over and that the United States might have to suspend gold sales. He proposed some tactics. The best course, he said, was to “make it appear that other governments had forced the action on us” (letter, Burns to the president, Burns papers, BN1, May 19, 1971). He urged the president to pay out as much as $2 million in gold before closing the gold window and blame the countries demanding gold. That would improve our bargaining position in the negotiations that followed.

Although the German decision to abandon the fixed rate system signaled growing dissatisfaction with U.S. policies, Paul McCracken minimized its importance. He told the president that the “four countries who changed their exchange rates account for roughly 11 percent of the developed world’s GNP” (McCracken to the president, Nixon papers, Box 42, May 17, 1971, 1). He proposed an unchanged policy and suggested that the president “communicate to Arthur Burns that you support fully the expansive monetary policies of the Federal Reserve this year” (ibid., 2). This was bad advice. The exchange rate system had lost support. A few weeks later, McCracken rethought his position and urged the president to promptly support implementation of the IMF’s flexibility study calling for wider bands and a moving peg (ibid., June 2, 1971, 2).

Secretary Connally reacted strongly to McCracken’s changed position. His sharp response suggests that he had not yet shifted to the decision he urged on the president only six weeks later. His response to McCracken was that he favored increased exchange rate flexibility “without—and this is the key—undermining confidence in the dollar and the general stability of the monetary system. Should we fail, forces of economic nationalism and isolation in one country after the other—including the United States— could become unmanageable.”

The Quadriad meeting on June 5 shows the lack of importance attached to international policy. The summary of the meeting made no mention of international economic policy and offered no suggestions for a less expan
sive domestic policy. Burns again urged a price-wage policy and followed it up with a memo proposing a six-month price-wage freeze beginning in January (memo, Burns to president, Nixon papers, June 22, 1971).
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At the end of May, Secretary Connally made a speech to an international banking conference in Munich. He forcefully restated the United States’ position: others must share more fully the burdens of maintaining the open trading system and paying for common defense. He ended by forswearing devaluation, a change in the gold price or continued inflation.
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Connally elaborated on his policy views after a Quadriad meeting with the president late in June. There would be no change in policy, at least not yet.

Volcker had a different idea. With John Petty and William Dale, he developed an operational plan for a unilateral suspension of gold payments, devaluation of the dollar, restoration of convertibility, and reform of international arrangements. He proposed to float the dollar until it reached a new equilibrium without gold convertibility. Connally insisted that Volcker add an import surcharge; although Volcker opposed the surcharge, he did include it. This memo became one part of what the administration called a New Economic Policy after August 15. The rest of the program included a domestic anti-inflation policy “to persuade foreign governments that were not to bear alone the full burden of correcting the dollar’s overvaluation” (Gowa, 1983, 148). The proposals included wage and price control and a cut in government spending.

The Federal Reserve divided over the benefits of devaluation. Coombs, Daane, and probably Burns wanted the Germans, Dutch, and others to go back to the old parity and fix their rates. Burns preferred exchange controls to devaluation, and he opposed Volcker’s proposal to float. Solomon, Maisel, and most of the other Board members accepted the revaluations and wanted Japan to revalue as well. The staff estimated that by 1973, the revaluations that had occurred, and a 10 percent appreciation of the yen,
would reduce the payments deficit by $750 million (Maisel diary, June 8, 1971, 49–50).
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85. Coombs told the FOMC that “the reaction of the other European governments to the floating of the mark had been uniformly hostile” (FOMC Minutes, June 8, 1971, 5). Later that month the governments agreed not to place any deposits in the euro-dollar market. The French resisted because the “United States was not offering to do anything” though it was responsible for current problems (ibid., June 29, 1971, 8).

86. The following anecdote describes Connally’s approach. Volcker asked him whether he wanted to dismiss devaluation so strongly. “We might have to end up devaluing before too long. . . . ‘That’s my unalterable position today. I don’t know what it will be this summer’ ” (Volcker and Gyohten, 1992, 75). Volcker did not consider changing the gold price. This “would have been considered an enormous psychological defeat for the United States, as well as financially unsettling” (Mehrling, 2007, 174).

On July 27, Connally presented his recommendation to the president calling for a wage and price freeze, closing the gold window, a tax on imports, and tax reduction. Nixon wrote in his memoirs: “Even I was not prepared for the actions he proposed” (quoted in Matusow, 1998, 113). The president accepted the full program but decided to wait for Congress to return on September 7 before closing the gold window and possibly postpone the price and wage freeze until January 1972, as Burns had proposed.

Events took control. Belgium and the Netherlands asked that their swap lines be paid and closed. This was a major step away from the 1968 agreement to avoid a gold drain. The trade balance worsened. The OECD and BIS members other than France “agreed that a wider band would be better and they had also agreed that occasional floats for brief periods to change rates would be all right” (Maisel diary, July 15, 1971, 69).
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The discussion suggested that adjustment had more support and opened the possibility of agreement at the September IMF meeting.
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McCracken did not know about the president’s decision, but he recognized that some change had to be made. On August 9, he described the deteriorating trade position, growing overseas investment by domestic corporations, and increased reliance on foreign plants to service the domestic market. After rejecting proposals to insist either upon fewer restrictions against U.S. exports in Europe and Japan or deflation, McCracken joined those who favored either a “border tax” on imports and a credit for exports, devaluation against other currencies, or a floating dollar (McCracken to the president, Nixon papers, Box 42, August 9, 1971).

The Joint Economic Committee made a major contribution to ending gold convertibility. Before leaving for summer recess, the committee, led by Congressman Henry Reuss, issued a report that: (1) declared that the dollar was overvalued; (2) declared that the IMF should recommend exchange rate changes for countries in fundamental disequilibrium; (3) cited the United States as a country in fundamental disequilibrium; and (4) urged
the U.S. governor of the IMF (Connally) to ensure that the IMF take on this responsibility (James, 1996, 217–18).

87. Maisel described the Treasury as opposed to devaluation but that he did not agree with the official position. He explained the Treasury’s position by saying that “you might be worse off after the move” (Maisel diary, June 8, 1971, 50). Volcker, as noted, held a different view.

88. Burns wrote a letter to the president at about this time saying that the Japanese ambassador told him that Japan would agree to revalue as part of a multilateral adjustment but not unilaterally (Burns to the president, Burns papers, August 5, 1971).

89. Maisel (diary, July 15, 1971, 69) notes that Burns and Connally did not get along and did not meet regularly. They had little direct communication.