A History of the Federal Reserve, Volume 2 (4 page)

Solomon gave three main reasons for rejecting exchange rate adjustment. First, the $35 gold price was “a basic underpinning of the system” (Solomon, 1982, 61). Multilateral floating had not occurred and many, like Robert Roosa, did not believe it could maintain an equilibrium exchange rate system. Second, the large stock of dollars held by central banks and governments meant that devaluation of the dollar would be costly to holders and more costly to those who had not drawn gold than to others. Critics said foreigners would no longer willingly hold dollars, so there would be major changes in the international system (ibid.). Third, the United States had a current account surplus in 1964–65. European countries rejected the idea of adding to that surplus by revaluing their currencies, despite the fact that a large part of the capital outflow was the cost of defending them.
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The costs of the Vietnam War contributed greatly to the problem. Budget director Charles Schultze told the president that in contrast to business capital investment and bank lending abroad, government outlays had increased substantially. For fiscal years 1966 and 1967, “expanded defense activities in Southeast Asia account for all [the] $657 million increase [in net dollar outflow abroad], and more” (memo, the Gold Budget, Johnson Library, WHCF, FI9, July 14, 1966).

Rising inflation and the perceived inability to solve the adjustment problem or to reduce the payments deficit heightened pessimism. Repeated problems with the pound added to the gloom. One of the Federal Reserve’s senior staff stated his concern explicitly: “The long-run outlook for our balance of payments is dimmer now than it was a year ago, in my opinion, because of the gradually accelerating rise in U.S. industrial prices. The real news about the balance of payments is that there is no really good news to report” (FOMC Minutes, May 10, 1966, 33). Convinced that the nominal exchange rate could not depreciate and unwilling to reduce military spend
ing abroad or to disinflate or deflate to adjust the real exchange rate, policymakers saw exhortation and restriction as their only available course.

20. Charles Coombs mentioned that proposals by European and American economists for wider exchange rate bands disturbed the market as a possible prelude to devaluation of the pound (FOMC Minutes, March 1, 1966, 27). Coombs and the New York bank always opposed parity changes.

21. France favored the devaluation of the dollar. Jacques Rueff proposed a doubling or tripling of the dollar price of gold (Solomon, 1982, 64). Chairman Martin, in a speech in June 1965, publicly rejected a return to a gold standard as an attempt to “turn back the clock of monetary history” (ibid., 81). In the first half of 1966, the Treasury sold $324 million of gold to France. Without these sales, the gold stock would have increased. Some in the State Department proposed ending gold sales to France (“selective non-convertibility”) or ending gold sales entirely (memo, Fowler to the president, Johnson Library, Bator papers, Box 15, Ju
ne 21, 1966, n. 6).

During the System’s restrictive policy in 1966, banks borrowed from their foreign branches, importing euro-dollars.
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At the Board’s August 31 meeting, research director Daniel Brill reported that banks had imported $1 billion of deposits in the two months since mid-year. This reduced the payments deficit but permitted banks to expand domestic lending.

Governor Brimmer proposed making deposits in foreign branches subject to deposit reserve requirements. Maisel and Mitchell supported him, but the staff pointed out that in 1921 the Board had ruled that balances due to a bank’s foreign branch “did not constitute a deposit liability against which reserves must be maintained” (Board Minutes, August 31, 1966, 5). The inflow had slowed by the time the Board reconsidered the issue in October, so the Board did not act.

Pressure on the pound increased in the fall. Transfers out of pounds into euro-dollars increased, reducing British reserves and weakening the exchange rate. The Federal Reserve wanted to avoid devaluation of the pound, so it considered whether new restrictions would help. A report by officers of the New York reserve bank concluded that “controls that may be imposed on head office borrowings from foreign branches are likely to be severely limited by a variety of opportunities to circumvent them and to reduce their actual impact” (Report of the Committee of Officers, Board Records, October 9, 1967, 11). The main drawback was a likely shift of foreign loans to domestic offices, adding to the capital outflow. The value of loans was much greater than the value of euro-dollar deposits channeled from foreign branches to home offices. The committee concluded that the most feasible way for the Bank of England to avoid the loss of reserves was to raise its interest rate. The Board took no action. Soon after, the officers committee urged the Board to use “moral suasion” to encourage the large New York banks to reduce their borrowing from foreign branches to help
the pound. Suggestions of this kind, if implemented, called attention to the weakness of the pound, possibly encouraging speculation.

22. Euro-dollar deposits were dollar liabilities of banks outside the United States. At the time, these deposits were not counted as part of the base for deposit insurance fees or, as discussed in the text, reserve requirements. They avoided regulation Q ceilings. At the e
nd of 1966, $13 billion was outstanding (Report of Committee of Officers, Board Reco
rds, October 9, 1967, 1). The euro-dollar market grew rapidly after the United States imposed the interest equalization tax. The market was unregulated and operated mainly in London. Participants in the market bought and sold dollar-denominated assets that were a close substitute for deposits at U.S. banks in the United States. Some analysts saw the euro-dollar market as an escape mechanism by which the banking system could create money without holding reserves. The committee report did not make this error; it recognized that deposits were substitutes for deposits in U.S. banks. Private deposits could increase slightly from funds that might otherwise have been held as foreign official
reserves (ibid., 7).

In October 1967, the Board began work on revisions to the 1968 voluntary program of credit restraint. Governor Robertson, who administered the program, proposed removing the exemption from the guidelines for Export-Import Bank financing. The Board agreed, but the Treasury did not, so the proposal died (Board Minutes, October 10 and 19, 1967).
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After Britain devalued the pound from $2.80 to $2.40 on November 18, the administration had two concerns.
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First, if several other countries followed Britain, the benefits to Britain would be small and Britain’s problem would continue. Second, pressure might shift to the dollar. In fact, there was a run on gold. In the first week after the devaluation, the London gold pool sold $578 million. France had quietly withdrawn from the gold pool in June 1967 but chose to announce its withdrawal on the Monday following the British devaluation. A hastily assembled meeting of the other members on November 25 reaffirmed their intention to remain in the pool and support the $35 per ounce price. The run slowed, but the gold loss for the month was $1.5 billion. By January, U.S. sales to cover these losses reached $1 billion (Johnson, 1971, 316–17).

The administration and the Federal Reserve looked for more stopgaps. In November, the Board’s guidelines called for renewal of the ceiling at 109 percent of a bank’s 1964 loans.

These guidelines did not remain in effect. Soon afterward, Chairman Martin proposed to ask banks with foreign branches to shift a substantial share of their loans to foreigners from domestic to foreign offices (Board Minutes, December 19, 1967, 8–9). Governor Robertson outlined a new “voluntary program” for 1968. The proposal cut banks’ lending ceilings from 109 to 103 percent of their 1964 base; it called for ending all term credits (over one year) to Western Europe; and it asked banks to reduce short-term loans to Western Europe by 40 percent. Robertson estimated that these changes would reduce outflow by $300 to $500 million.
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23. Sherman (1983, 45) reported that long-term rates rose relative to short-term rates in 1967. He attributed the change to shifting demands for credit “because of growing expectations as the year progressed that interest rates were more likely to rise than decline in the future. . . . [T]he expanded growth in bank reserves, bank credit and money over the year as a whole moderated the rise in the overall interest rate structure despite the greatly increased demands for credit.” Sherman said reserve growth was 10 percent. He did not recognize that the Federal Reserve’s strong response to the 1966 slowdown induced anticipations of inflation. Instead of slowing the rise in long-term rates, policy induced it.

24. The next section discusses the British devaluation.

25. Until February 1968, banks could make equity investments in foreign banks. The Board voted to treat these investments as credits, thereby putting them under the credit
guidelines. The new regulation banned banks from making any equity investment in any corporation in Western Europe. A bank could open a branch abroad provided it remained within its overall credit ceiling (Board Minutes, February 7, 1968, 1–5).

Governor Brimmer wanted a mandatory program in place of the voluntary program. The Board agreed to drop the word “voluntary” but not to introduce “mandatory.” President Johnson invoked the Trading with the Enemy Act of 1917 to restrict capital flows to our allies. He announced the new program on January 1, 1968, as part of a balance of payments program that tightened corporate investment abroad and asked for repeal of the remaining gold reserve requirement against the note issue. The Board cooperated with the president’s program by asking bank and non-bank financial institutions to provide a capital inflow of $400 million for banks and $100 million for non-banks during 1968.

Gardner Ackley told the president that the aim of the program “was to get through 1968 without an international financial crisis” (memo, Ackley to the president, Johnson Library, Box 53, December 23, 1967, 1). He warned, however, that “most of the improvement sought by the program is not long-term. It will continue only as long as we continue doing things that are distasteful” (ibid., 2). Ackley later added: “A good case can be made that we are only buying time with our program; that the fundamental difficulties will not go away but will only be repressed; that a crisis will only be postponed not avoided” (ibid., 2). He proposed as a long-term solution to demonetize gold “quickly and at one stroke” (ibid.) The United States would offer to convert dollar liabilities to gold. If the desired conversions exceeded the gold stock, each holder would get a proportional share. The United States would pledge to stabilize its exchange rate at the existing parity by buying and selling foreign currencies. “If it subsequently developed that we could not maintain the parity of the dollar . . . we would have to let the dollar ‘float’ or else . . . announce a change in its parity” (ibid., 3).

There is no evidence that the president responded. The new program of restrictions went into effect. Even more than the program it replaced, the new program showed the government’s willingness to place its priorities and interests above the public’s.
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The new program did not require reduced lending by the Export-Import Bank. It exempted loans to Canada and developing countries. It failed repeatedly to meet its targets for reduc
tion in government spending abroad. This placed more of the burden of adjustment on private consumption, investment, and lending.
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26. At the October 1967 World Bank meetings, the United States supported a substantial increase in resources for the International Development Agency (IDA) of the World Bank. Bank rules restricted tying loans to domestic exports. At about this time Fred Borch, chairman of General Electric, wrote to Commerce Secretary Alexander Trowbridge complaining about the disproportionate burden placed on business, neglect of the long-term benefits of foreign investment, and the failure to restrict the public sector “where the deficit is created” (letter Borch to Trowbridge, Johnson Library, RG40, September 14, 1967).

The initial reaction to the new program was positive. In the first week, the London gold pool gained $5 million compared to net sales of U.S. gold in December. The administration resumed consideration of additional travel restrictions, though Congress was unlikely to adopt them in an election year. One proposal called for the president to impose them using the 1917 Trading with the Enemy Act. Secretary Fowler advised Johnson not to do that. He believed the market would interpret it as a step toward full exchange controls, setting off a run against the remaining gold stock. Further, he explained that international agreements permitted controls on capital movements. Travel restrictions would violate trade rules prohibiting controls on current transactions (memo, Fowler to the president, Johnson Library, Box 53, January 12, 1968).
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PRESSURES ON THE POUND

As the Bretton Woods system developed, it had two reserve currencies, the dollar and the pound. London supplemented New York as a market in which countries held reserves. It was the weaker of the two, more subject to pressures for devaluation. Six years after restoring current account convertibility, Britain experienced a loss of gold and dollar reserves. The 1964 “crisis” was the first of several culminating in devaluation of the pound in November 1967.

Even more than in the United States, Keynesian policies for growth and high employment were the main goals of British economic policy. Lacking the large initial postwar gold reserves of the United States, it could not ignore the bursts of inflation and balance of payments problems to which
these policies contributed. Like the United States, Britain rejected relative deflation as a permanent adjustment.

27. Chairman Martin reported that the administration had moved decisively toward capital controls. President Johnson’s executive order announcing the 1968 program said that anyone subject to the jurisdiction of the United States who owned over 10 percent interest in a foreign business venture was prohibited from engaging in any transaction that transferred capital to a foreign country or national outside the United States (Board Minutes, December 29, 1967, 13–17). In August, Secretary Fowler acknowledged that tied exports under the U.S. aid programs (AID) replaced regular commercial exports (Fowler to the president, Johnson Library, WHCF, File FO4-1, August 8, 1967).

28. Paul Volcker, who served as a Treasury official in the early 1960s and again during the Nixon administration, designed some of the restrictions and controls. He summarized the experience: “I don’t think anyone has satisfactorily answered the question of what was accomplished in terms of the ultimate balance of payments of the United States or in terms of the competition between national markets” (Volcker and Gyohten, 1992,35). But he noted that controls encouraged development of foreign financial markets, reducing the i
mportance of New York.