A History of the Federal Reserve, Volume 2 (17 page)

Representatives of France, Germany, Japan, and Italy joined the British at the London meeting. Volcker opened the meeting by explaining the president’s program and asking for initial reactions of the foreign participants.
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He insisted that he had not come to open negotiations and explained that one of the reasons for the international measures was to head off rising protectionist pressures. A main reason for using executive authority to impose the surtax was that legislation would be easy to adopt but hard to repeal. The United States wanted a long-term solution, he said, and it would not be satisfied with short-term measures. “The U.S., at this stage, had no program that it was going to spring on anyone. . . . [W]e would not be satisfied without a reform that would repair the erosion that had taken place in the U.S. position over the years” (memorandum of conversation 170, United States Department of State, August 16, 1971). However, the president had decided that the price of gold would not change.

The European reaction focused on the surcharge. Several complained that they could not negotiate new exchange rates until the U.S. removed the surcharge. They also expressed concern about problems of keeping exchange markets closed versus reopening them. They asked Volcker what objective the United States had in mind. “Mr. Volcker said the U.S. should have a period of surplus” (ibid.). He also mentioned removal or reduction of barriers to U.S. exports, especially agricultural exports, and greater contribution to the common defense and security. Later, he quantified the objective as a $13 billion change in the U.S. trade position—from a $4 billion deficit to a $9 billion sustained surplus. This shocked the Europeans. “Few of our trading partners really wanted to see any significant deteriora
tion in their own trade positions” (ibid., 81). Although most recognized the benefits of a stable system, they were not disposed to provide or maintain a public good if it required them to bear a major cost.

22. One of the Japanese participants, Masaru Hayami, later became governor of the Bank of Japan. He described the European reaction as claiming that they could not reopen their exchange markets until the United States announced a new parity (Hayami, 2002, 2). They soon gave up that position. By the end of August all major countries had floated except France. France imposed exchange controls and adopted two-tier exchange rates. Volcker described the European response. “They were stunned and didn’t know how to react. . . . [T]heir idea of an appropriate exchange rate change was very small—certainly well under 10 percent—and then simply put the old system back together again. That didn’t make any sense, from our perspective”
(Mehrling, 2007, 175).

Volcker and Daane went on to Paris, where they met the next day with the French finance minister, Valéry Giscard d’Estaing. The minister was most interested in the extent of U.S. intervention in the foreign exchange market. Volcker said that except in unusual circumstances, the United States would not intervene. “Basically, the U.S. had not changed the parity of the dollar. Others would make that decision; we could not. We did not assume that there would be no changes in parities. We simply didn’t know in which direction the dollar would move” (ibid.). Giscard questioned whether the United States expected to return to a fixed exchange rate system. Volcker gave a qualified yes; the system had to change in the direction of wider bands and fewer crises.

A few days later, Germany proposed a joint float of European currencies, but France opposed and, like Belgium, adopted a two-tier system bolstered by exchange controls. The Europeans made a formal complaint against the surcharge on exports. European irritation was out of proportion to its effect on them. The main effect was on Japan and Latin America (Solomon, 1982, 189; Nixon papers, Shultz Box 7, August 25, 1971).
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At a series of meetings, the developed countries gradually recognized the issues to be resolved and the positions that had to be negotiated. Early in these discussions, the Europeans rejected as too large both the proposed $13 billion swing in the United States’ trade balance and the argument that the United States should have a trade surplus to cover some of its development assistance and defense spending.
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But they accepted that a realignment of exchange rates was necessary. All but the United States agreed that realignment would require adjustment by the United States. Also, “there was nearly unanimous agreement among them that the surcharge was an obstacle to the achievement of an adequate realignment of exchange rates and should be removed as soon as possible” (FOMC Minutes, Septemb
er25, 1971, 3).

At most of the meetings, the foreigners expressed concern about in
creased protection, dual exchange rates, capital controls, and a return to the “miseries of the 1930s” (ibid., 5). Secretary Connally continued to insist on the $13 billion swing, a U.S. trade surplus, no dollar devaluation, maintenance of the surtax, and agreements on trade barriers and sharing of defense costs.
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23. The Academic Consultants to the Treasury endorsed the basic program but preferred to eliminate the surcharge at an early date. Some favored floating; others preferred a large devaluation against principal foreign currencies and increased flexibility. None supported a return to the Bretton Woods arrangements or gold convertibility.

24. Volcker reported on a meeting at the OECD. He explained that the U.S. balance-ofpayments surplus had to increase to $9 billion from −$4 billion, a $13 billion swing. The representatives offered to provide $3 billion, $2 billion of it from Germany. The French, Dutch, and Belgians explained why they would not help. The Japanese remained silent (Volcker and Gyohten, 1992, 83).

Currency markets were thin for most currencies, and trading was limited to commercial transactions. Trading costs had increased, and there were “virtually no capital flows” (ibid., 15). Forward markets existed only in British pounds and German marks. Governor Brimmer pointed out that capital controls were a main reason for the absence of capital transfers.
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Connally was in charge of negotiations for the United States. He started with three objectives: exchange rate adjustment, reduced barriers to trade (especially to U.S. exports), and increased foreign contributions to the common defense and the cold war. “Somewhere along the way between August 15 and the Smithsonian meeting of December 17–18, the defense sharing objective was dropped and the request for reduced trade barriers abroad was watered down to a few trivial demands” (Solomon, 1982, 191).
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He was in no hurry to reach agreement. The surtax and appreciation of foreign currencies against the dollar helped U.S. exports and reduced imports. By early October, the yen had appreciated about 8 percent, the mark 9.5 percent, the Dutch guilder 7 percent, the British pound 3 percent, and the French financial franc about 2 percent.

Connally tried to get agreement without devaluing the dollar against gold. On this too, he had to retreat. Foreigners, particularly France, insisted on some dollar devaluation as part of any agreement. Solomon (ibid., 191) described Connally as “every inch the politician. . . . [H]is keen intelligence enabled him to grasp the substance of the economic problems he was
forced to deal with, [but] he brought to the job no broad vision of how to improve the economic welfare of his own country or the world.”

25. In late September, Congressman Henry Reuss introduced legislation to float the dollar. The administration rejected it.

26. The Board’s staff estimated that to achieve balance the United States would have to increase net exports by $8 to $10 billion above 1970 (Maisel diary, August 25, 1971, 85). Chairman Burns said that “the experiment with floating exchange rates . . . was unlikely to prove successful. . . . Such [academic] arguments seemed highly reasonable until one realized that they involved the tacit assumption that there were no governments and no political pressures in the world. . . . [R]estraints were apt to multiply” (FOMC Minutes, September 21, 1971, 16–17). Burns favored negotiations leading to the prompt reestablishment of fixed exchange rates, and he favored retaining the surcharge to speed agreement (ibid., 18). Volcker had commissioned a study that found that the dollar had to be devalued by 10 to 15 percent to restore equilibrium (Volcker and Gyohten, 1982, 72).

27. Connally initially asked for a 24 percent revaluation of the yen and 18 percent for the mark. He settled for much less, 16.88 for the yen and 13.6 percent for the mark. Gyohten suggests that Japanese negotiators had authorization to go to 20 percent. He describes Connally as a “superb negotiator, a magnificent deal maker” who never humiliated the Japanese (Volcker and Gyohten, 1992, 97).

Connally was not eager to reach agreement quickly. He may have recognized that the long period of an overvalued dollar and the presence of capital controls had distorted both trade and capital flows. No one could estimate accurately how much the dollar had to depreciate to achieve equilibrium. Bilateral rates were also a problem. Delay let markets make some of the adjustment and encouraged Europeans to reach an agreement that would eliminate the surcharge. By insisting on his demands, he delayed agreement.

Connally’s aggressive demands irritated not only foreigners but members of the administration. Burns wanted a more conciliatory approach and a prompt return to fixed exchange rates. Henry Kissinger, the assistant for national security, opposed Connally’s confrontational approach, and his emphasis on burden sharing invaded the political domain that Kissinger considered his own.

The result was that Connally’s approach created opposition both at home and abroad. The change in market exchange rates for the dollar also changed bilateral rates between trading partners, particularly France and Germany. German officials expressed concern about the appreciation of the mark relative to the French franc. Perhaps for that reason French officials supported Connally’s position that favored delay in reaching agreement (ibid., 195). But they insisted on an increase in the gold price. French officials said that the franc price of gold was “an important political issue in France, given the widespread and long-standing custom of the French population to hold gold as a hedge against inflation and political uncertainty” (U.S. Department of State, letter from Arthur Burns to the president, 183, October 14, 1971). A revaluation of the franc against the dollar with an unchanged dollar price of gold would lower the franc price of gold and penalize gold holders. This was unacceptable to French politicians.

In a meeting with George Shultz on October 25, the president expressed concern about the slow pace of negotiations and urged Shultz to “take a more aggressive role in bringing the international monetary crisis to resolution” (ibid., Editorial Note 187, October 25, 1971). The president continued to oppose any change in the gold price. At a meeting of the Quadriad on October 28 to discuss Connally’s trip to Asia, the president authorized Shultz to work with Kissinger on negotiations during Connally’s absence. Connally had set out a negotiating position that included a significant realignment of parities, no return to convertibility for at least two years, and a substantial reduction in the role of gold. He thought currency realignment less important politically than trade concessions.

The United States changed its position on the gold price soon afterward. Three factors played a role. First, Congressman Henry Reuss and Senator William Proxmire introduced legislation permitting the president to devalue against gold as part of an international agreement that adjusted exchange rates. They assured the administration that Congress would approve a change in the gold price promptly. That reduced the president’s concern about politically motivated resistance.

Second, delay increased uncertainty. At first, the administration attributed the uncertainty to concerns about the next phase of price and wage controls. After the new program became known, uncertainty continued. The stock market had boomed after August 15, but in October and November stock prices fell sharply. The president’s friends on Wall Street blamed Connally’s policy and warned that continued uncertainty would delay recovery. In late November, the president told Connally to break the impasse (Matusow, 1998, 174–75).
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Third, the Europeans agreed to a larger dollar devaluation if the United States accepted an increase in the gold price. Table 6.1 shows the substantial differences proposed at the time. Peter Peterson, an assistant, drove home the point by estimating that each percentage point of realignment increased net exports by $800 million. The president could translate the four to five percentage points of difference in exchange rates into $3 to $4 billion of net exports and a corresponding increase in employment. That effectively ended his resistance to a change in the gold price and moved toward a solution.
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The most important next step came at a meeting in the Azores between Presidents Nixon and Pompidou (France) on December 13 and 14. The presidents agreed to a $3 (8.6 percent) increase in the gold price to $38
an ounce. They also agreed that other countries would revalue their currencies and widened the former one percentage point band on parities. To satisfy President Nixon, they made a vague statement about trade negotiations. President Pompidou did not insist on convertibility of the dollar.
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28. “Nixon had grown tired of the whole business and was anxious to move on” (Matusow, 1998, 177). Soon afterward he reached agreement with President Pompidou of France to put the issue aside.

29. Opponents of an increase in the gold price agreed that it would (1) reward those who held gold against developing countries that did not, and hurt Japan, which held its reserves in dollars; (2) encourage a shift from dollars to gold in anticipation of additional changes in the gold price; and (3) partly reverse the effort to reduce the role of gold in the international system (Solomon, 1982, 197–98). Only the first proved correct.