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

There are four possible solutions to the adjustment problem (Friedman, 1953): (1) devaluation against gold and major currencies, (2) deflation, (3) borrowing as long as foreigners would lend, and (4) imposing controls of various kinds. Some of these solutions could be achieved in different ways. For example, countries could revalue their currency relative to the dollar. Or, foreigners could inflate faster than the United States. In practice, the United States relied mainly on three and four, usually to a degree insufficient to solve the long-term problem.

The system might have continued if price adjustment had occurred promptly in response to domestic policy choices, differences in productivity growth, changes in the extent of capital mobility, and the like. Flexible prices would have adjusted domestic real wages and the real exchange rates, avoiding the domestic policy problem and the misalignment of the dollar exchange rate.
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One factor strengthening wage and price downward rigidity was the growing belief that policymakers would not end inflation.

The Bretton Woods Agreement reflected the problems of the interwar gold exchange standard. The authors could not foresee the rapid postwar growth in Europe and Japan, the permanent change in their relative real output and productivity, and the need to adjust real exchange rates to the permanent changes that occurred.
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The agreement recognized that adjustment to structural (i.e., permanent) changes would occur, but it left to each country to decide how and when to make the change. Countries were slow to recognize the need for appreciation, slower still to implement it.

Japan, West Germany, and France illustrate two extremes. The yen remained fixed at 360 to the dollar throughout the period. The Bank of Japan and the Japanese government accumulated dollar assets, mainly short-term instruments. Monetization of the dollar inflow increased Japan’s money stock. Japan’s price level rose more rapidly than the U.S. price level, especially in the early 1960s. The real exchange rate appreciated against the dollar by about 25 percent. Chart 5.1 shows the yen-dollar exchange rate adjusted for consumer price level changes.

9. Johnson (1970) makes this point. See also Aliber (1993). Bernstein (1996, 497) adds that in the years leading up to 1958, the IMF had to assure countries that a U.S. recession was not “the beginning of a great depression.”

10. The authors also did not foresee the extent of the change in United States policy. After World War II, the U.S. worked to achieve lower tariffs and increased its lending to recovering and developing countries. Further, it took responsibility for maintaining political stability, adding to its foreign spending by keeping armed forces in several countries.

The West German government and the Bundesbank tried to limit domestic inflation. In 1961 and 1969, the government revalued the mark against the dollar; taken together, the mark appreciated by 12.5 percent. Inflation rates were similar for the period as a whole, so the real exchange rate appreciated much less than the yen-dollar exchange rate and much less than needed to reduce the persistent German payments surplus. Chart 5.2 shows these data.

The French franc appreciated against the dollar during the early and mid-1960s (Chart 5.3). In 1969, France depreciated its exchange rate, restoring about the same real exchange rate as in 1960. Although France drew regularly on the U.S. gold stock, it did not permit its gold purchases to adjust its real exchange rate.

In contrast to the bilateral real exchange rates, the deflated price of gold shows a steady decline during the postwar years after 1949. By September 1959, the real price of gold had fallen back to the level reached in October 1929 (Chart 5.4). Price increases had fully offset the nominal revaluation of gold in January 1934. Between autumn 1959 and the closing of the gold window in 1971, the real price of gold declined an additional 3.3 percent to a level far below any price during Federal Reserve history to that time. No wonder many observers expressed concern about the scarcity of gold for transactions. A 50 percent increase in the nominal gold price, to $52.50 an ounce, would have restored the real price to the 1956 level and increased the 1965 U.S. gold reserves to more than $21 billion, more than enough to maintain the fixed exchange rate system for several years or longer.

An increase in the dollar price of gold would have increased international liquidity and adjusted the dollar to the permanent postwar changes. Political considerations—including concern about benefits to South Africa and the Soviet Union, but also beliefs about response by Europeans—ruled out that solution. An adjustable gold price, such as Fisher’s compensated dollar, would have adjusted the dollar-gold price based on changes in an index of commodity prices. This would have solved the confidence prob
lem by keeping the system close to equilibrium and reduced adjustment and liquidity problems.

Bordo (1993) showed that during the short life of the Bretton Woods system, which he dates as 1959–70, developed economies experienced relatively high and stable growth and relatively stable prices compared to other international monetary systems. For these years, the mean inflation rate rose 3.9 percent in the countries that are now members of the G-7.
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This is higher than the low inflation rate during the years of the classical gold standard, 1881–1913. Real per capita growth during these years was substantially higher than in any other period in Bordo’s table (1993, 7). The relatively low standard deviation of the seven countries’ inflation rates shows up again in the relatively modest mean change in the real exchange rate.

This good performance is subject to four qualifications, however. First, many countries prevented adjustment of prices, output, and the exchange rate by maintaining exchange controls. Second, real per capita growth rates depend on the spread of new technology, the reduction in trade barriers, the development and expansion of the European common market, and other forces. Third, pressures increased for price and real exchange rate changes that occurred after the Bretton Woods system ended. Fourth, the United States introduced several restrictions on capital movements, tied
foreign aid to dollar purchases, and required purchases of military and other goods and services in home markets. These are selective devaluations of the dollar that do not appear in the published exchange rate data. Some had a large welfare cost. Despite these qualifications, the exchange rate system worked comparatively well until the cumulative effect of U.S. expansive policies and declining real growth caused the breakdown (Darby and Lothian, et al., 1983; Schwartz, 1987a, chapter 14).

11. United States, United Kingdom, West Germany, France, Japan, Canada, and Italy are the G-7 members.

The experience of the 1920s and the 1960s taught a common lesson: fixed exchange rate systems rarely last long in the contemporary world.
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Countries are unwilling to make their economies adjust to the exchange rate. The public is unwilling to accept the at times large temporary losses of employment required to maintain the international value of its money.

PROPOSALS AND ACTIONS 1965–67

In 1964, the United States had its largest trade balance and current account surplus since 1947. The expanding world economy, low domestic inflation, and improvement in the terms of trade contributed to bring the balance of payments problem toward a satisfactory equilibrium. Unfortunately, the good news did not last. Table 5.2 shows current and capital account balances for the decade; the capital outflow in 1964 was the largest to that time.

The tone of official discussions mirrors the current account data in
Table 5.2. Optimism that the problem would be managed rose in 1964 and remained in 1965. A little extra push from new controls might be all that was needed. “Voluntary” controls on bank lending and foreign investment lowered the liquidity measure of the deficit for two years despite reductions in the current account surplus. After that the trade surplus began a precipitate decline and the growth of claims against gold (liquidity basis) reached levels far above previous values. The response to the 1967 British devaluation, rising domestic prices, and continued expenditures for the Vietnam War was a virtual embargo on gold; the two-tier system begun in 1968 ended gold sales to the public and ended the London gold pool. The Johnson and Nixon administrations continued the “voluntary” programs, strengthened them, made some mandatory, but did little to solve the longterm problem of an overvalued real exchange rate.

12. Obstfeld and Rogoff (1995) show this for a large number of countries. It remains to be seen whether the European Monetary System will change that conclusion by introducing a common currency and making exit difficult.

Reductions in the capital outflow in 1965 reflect the initial response to the so-called voluntary programs. The large fluctuations in outflow in 1968 to 1970 reflect a number of factors but especially the response to interest rate changes at home and abroad. These gave the appearance in 1968 that the outflow had reversed. The change was transitory, reflecting the effect of regulation Q on banks’ decisions to repay euro-dollars in 1968 and borrow euro-dollars in 1969.

The initial effect of controls on lending or investing abroad was much stronger than its permanent effect. Banks and firms found ways to substitute. The interest equalization tax encouraged bank lending, so it became necessary to put a ceiling on bank loans. Banks could acquire eurodollars, borrowing the dollars that flowed abroad and relending to their customers.

The main problem in the 1960s was not a U.S. current account deficit. Throughout the 1960s, the United States typically had a surplus on current account. The problem was that the trade and current account surpluses were not large enough to finance private investment abroad plus military, travel, and foreign aid spending abroad. As foreigners bought gold and accumulated dollars, concern rose that the gold price would not remain fixed or the dollar would not remain convertible into gold.

The Kennedy and Johnson administrations faced a choice—slow the outflow of dollars by reducing money growth or adjust the exchange rate system by devaluing. They chose instead to impose controls of various kinds. Each new crisis brought new controls. At first, they may have hoped that the problem was temporary, that the controls would get the system through a transition. This hope must have died by the late 1960s, but the Johnson economic and financial advisers never developed a lasting solution to the international problem.