A History of the Federal Reserve, Volume 2 (6 page)

END OF THE GOLD POOL

Concerns that devaluation of the pound would increase pressure against the dollar and the gold pool proved correct. In the week following the British devaluation, the gold pool sold $578 million. Demand rose throughout the week, with nearly half the sales on Friday. In all, the pool members had agreed to provide a total of $1.37 billion to the pool. Less than 10 percent remained. For the month of November the pool sold $836 million; the U.S.’s direct share was 60 percent ($495 million), but it could be asked to reimburse other countries desiring to replace the gold they sold (FOMC Minutes, December 12, 1967, 3).

At a special meeting of the gold pool, in Frankfurt, with France absent, the members voted to continue their support of the pool, prevailing exchange rates, and the $35 gold price (ibid., November 12, 1967, 4–5, footnote 1).
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Several members showed reluctance, but they agreed (Solomon, 1982, 96). And all countries except France agreed to increase swap lines again, this time by more than $2.5 billion to $7.08 billion. During the year, Norway, Denmark, and Mexico joined the swap network.

Attitudes started to change. A group of leading academic economists met as consultants to the Treasury in early December 1967. The dominant view was that the United States should not tighten monetary policy for balance of payments reasons, and many opposed additional exchange controls. “They felt a floating dollar . . . would be preferable” (Maisel diary, December 6, 1967, 1). Let other countries decide whether they wished to peg to the dollar or float. The group divided on the role of gold in the proposed system. This position followed the writings of a leading international economist, Gottfried Haberler. As early as 1965, Haberler (1965)
urged a policy of “benign neglect.” As head of President Nixon’s task force, he urged the president-elect to ignore the balance of payments.

38. New York’s report to the FOMC hints at the tension in relations with the British. New York agreed with the West German and Swiss position that the British could have avoided devaluation. “No unacceptable conditions would have been attached. The blunt fact was that the British Government made the decision to devalue on its own accord” (FOMC Minutes, November 27, 1967, 8). Later, pressed by Hugh Galusha (Minneapolis), Bruce MacLaury argued that devaluation was not necessary (ibid., 23). The United States made $500 million available ($100 from the Federal Reserve, the rest from the Treasury) in addition to the $1.35 billion
swap line (ibid., 14).

Uncertainty, indecision, and differences of opinion also arose among central bank governors. Hayes reported that the bankers could not reach agreement at the Basel meetings in early December. Several countries wanted to withdraw from the gold pool. They urged the United States to reduce capital investment in Europe and borrow from the IMF to support the gold price instead of relying on the gold pool (Maisel diary, December 12, 1967, 2). Discussions began to consider alternatives to the gold pool including a two-tier system with official sales restricted to other central banks and governments.

During fourth quarter 1967 and first quarter 1968, the United States gold reserve fell $2.3 billion, more than 18 percent of its stock in September 1967. The federal funds rate rose from 4.02 percent in the week following the U.K. devaluation to 5.40 in the last week of March 1968. Bond yields, however, showed little net change, and stock price indexes rose until mid-January, then declined slightly. These markets showed no sign that participants thought a major event had occurred.

President Johnson met with his advisers and some principal members of Congress on November 18. The president made another strong commitment to the tax surcharge and probed the congressional leadership about what it would take to get the surtax passed. He remained reluctant, but yielded on spending reductions. He told the participants, “If we don’t act soon, we will wreck the Republic.” And he issued a public statement again “unequivocally” reaffirming his commitment to the $35 gold price (Sterling Devaluation and the Need for a Tax Increase, Johnson Library, National Security File, November 18, 1967).

Early on the first trading day following the British devaluation, Monday, November 20, the trading desk implemented the plan agreed to earlier by placing bids for long-term bonds slightly below the market. The System bought $121 million of one- to five-year issues, $65 million of longer-term issues, and $427 million of bills. Stock prices fell nearly fifteen points in the first half hour (Annual Report, 1967, 268). After those initial reactions, markets stabilized, and there was no crisis. By the close on the following day, bond prices were above the prices at which the System bought (FOMC Minutes, November 27, 1967, 63).

Despite their failure to prevent devaluation, participants in the negotiations regarded the experience as “a strong reaffirmation of international financial cooperation” (FOMC Minutes, November 27, 1967, 29). Only France had gone its own way, acting in “an unfriendly and mischievous fashion” (FOMC Minutes, November 27, 1967, 31). But it had “little power
to affect developments by means other than making press statements and leaking confidential information in an effort to embarrass the United States” (ibid.). These statements proved to be overly optimistic.

One of the anomalies of the gold pool was that the U.S. government supplied gold to match the demands of foreign citizens, but it was illegal for U.S. citizens to buy or hold gold. Contrary to claims about international cooperation, Solomon explained that if the U.S. failed to supply gold to the pool, the market price of gold would rise above $35 an ounce. Foreign central banks could then sell on the market and buy at the $35 price from the Treasury. “In fact, some central banks might be tempted to buy gold from the United States for the purpose of reselling it at the higher market price” (ibid., 30–31). Within a little more than three months, the two-price system became official policy.

To maintain fixed parities, the central banks agreed to sell their currencies for dollars in the forward market as required. This gave reassurance that they intended to maintain the exchange rate and moderated the effect of a dollar inflow on rates elsewhere. The amount of forward exchange market operations did not have to be shown on Federal Reserve statements. Also, the Federal Reserve agreed to a $1.5 billion temporary, additional increase in the swap line with eight participants. The main reason was concern that other countries might follow Britain by devaluing. Among developed countries, only New Zealand, Spain, and Denmark had done so. By the end of November, temporary increases brought the Federal Reserve’s swap lines to $6.08 billion (FOMC Minutes, November 27, 1967, 57–58).

The outflow from the London gold pool continued and showed signs of increasing. Hayes (New York) reported that several members of the pool had discussed a temporary suspension of gold trading if another surge of demand occurred. Perhaps with an eye on the falling U.S. gold stock, Italy and Belgium announced that they would not stay in the gold pool indefinitely (ibid., December 12, 1967, 15). “There was a growing sense of disenchantment. Mr. [Karl] Blessing of the German Federal Bank, one of the country’s most loyal friends in Europe, said that if the deficit in the U.S. balance of payments remained large the group’s discussions might as well be brought to an end because they would be futile” (ibid., 17). The program that President Johnson announced on January 1, 1968, tried to satisfy European demands to slow U.S. investment in Europe.
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39. According to Martin, the president’s new program convinced members of Congress that he had solved the problem, so they did not have to increase tax rates. This set off a new run on gold. Martin called the central bank governors and explained that the United States understood that its payments and budget deficits were “intolerable.” “Steps are going to be taken
as rapidly as possible to correct this” (extemporaneous remarks, Martin speeches, April 19, 1968, 3). The central bankers “agreed to continue in the pool operations” (ibid., 4).

The FOMC did not discuss a more restrictive monetary policy. The economy was emerging from the 1966–67 slowdown, so the System did not consider the classical solution to a currency problem—higher interest rates and slower money growth. In fact, it didn’t mention any change to give greater weight to its Bretton Woods obligation. Even repetition of Blessing’s clear warning made no difference. They placed their hopes on the surtax and devoted their efforts to persuading Congress, especially a reluctant Chairman Mills of the Ways and Means Committee.

As pressures on the pound and the dollar continued, Coombs came to believe that the pound could not be maintained at $2.40. He wanted Britain to borrow at the IMF to repay its liabilities to the United States. At the Board, Solomon argued the opposite side. Events showed him to be right. By early 1969, the British had a large current account surplus from which they repaid many of their debts (Solomon, 1982, 99).

The United States had the bigger problem. Controls on foreign lending and investing and government purchases were insufficient in 1967 to offset costs associated with the Vietnam War. The payments deficit (liquidity basis) reached a $7 billion annual rate in the fourth quarter. The administration responded with the additional “temporary” controls announced in the president’s message on January 1, 1968. The hope at the time was that over the longer term, Vietnam spending would decline and exports would increase enough to restore balance. The administration did not develop a long-run program, however.
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It relied on wage and price guidelines to control production costs, mandatory guidelines to control overseas investment, and the panoply of short-term measures discussed earlier. When the president announced the program on New Year’s Day, he said that it would bring the balance of payments close to equilibrium in 1968 by restricting $3 billion of outflows. Instead, the current account balance declined by $2 billion. By late January, the administration considered allocating an
additional $500 million for the Export-Import Bank to encourage exports in 1968.

40. Ackley’s discussion of the administration’s international economic policy explains that most of the policy actions originated in the Treasury.

We generally loyally supported the Treasury view . . . to have exchange controls without really having them, to invent ways of enticing or persuading foreigners to hold dollars and not demand gold, and to keep patching things up . . . to save what was probably an unsaveable situation. . . . [W]e did get by without any serious trade restrictions. We did a lot of stupid things in the government account: we spent a hell of a lot of money to buy in ways that minimized the balance of payments strain; we shipped beer to Germany for our troops to drink over there. . . .

[T]his is one of the areas where I, at least, believed that the scientific or professional involvement in the political process really involved some conflicts. (Hargrove and Morley, 1984, 265)

The president’s program received a mixed response.
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The gold outflow slowed, at first, but did not stop. At its February meeting, the bankers on the Federal Advisory Council told the Board that the program did not “come to grips with the basic problem” (Board Minutes, February 20, 1968, 30). They wanted “unmistakable evidence of fiscal restraint” (ibid.) and a determined effort to reduce inflation. Chairman Martin responded that “he was discouraged about the number of people who were expressing a non-cooperative attitude on the grounds that they expected the program to break down” (ibid., 30–31). He urged the bankers to reject the defeatist attitude and urge others to do the same.
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The president sent his advisers to brief foreign governments just ahead of his announcement. Coombs reported on European concerns. As usual, they wanted the capital outflow from the United States to end, but they feared that higher U.S. interest rates would cause them to increase their rates. They favored the tax surcharge as a way of avoiding tighter monetary policy (FOMC Minutes, January 9, 1968, 13). Robert Solomon reported, however, that at Working Party 3 late in January, the members expressed willingness to cooperate by expanding their economies as the United States adopted the surtax and other restrictive actions. “Even the French representative was anxious to have other continental European countries pursue expansionary domestic policies” (ibid., February 6, 1968, 15). President Johnson emphasized that he had maintained his commitment to European defense and had avoided trade restrictions. He asked for the
reaction abroad to the border tax proposal. The response was that foreign governments would not retaliate, if the tax was legal under GATT rules. The president decided not to propose the tax to Congress (Department of State, report of Nicholas Katzenbach and Frederick Deming to the president, January 7, 1968).

41. The president’s advisers split on two other recommendations. One put a border tax on imports and rebated indirect (real estate, excise, etc.) taxes on exports. The second taxed tourist expenditures. Vice-president Hubert Humphrey argued that politically the administration could not put a mandatory tax on tourism and keep voluntary restraints on capital investment abroad (Department of State, Minutes Cabinet Committee on the Balance of Payments, December 21, 1967). The president rejected both proposals. “I don’t like the ‘border tax adjustment’ at all. . . . It will stimulate speculation as a step toward devaluation. . . . It hits at an area that is not the root of the problem. . . . The tourist tax proposal is complicated— cumbersome—will obviously produce only limited results—advertises weakness to millions of people . . . inhibits international good will . . . certain to be used by the Republicans in an election year” (Dept. of State, telegram, President Johnson to Joseph Califano, December 23, 1967). The president proposed tax reduction for businesses that repatriated foreign capital and earnings. Taxation of foreign earnings was still under discussion in 2004.

42. Parts of the program violated rules of the General Agreement on Tariffs and Trade (GATT). By exempting Canada, Mexico, and Caribbean countries from new duties on tourist purchases, it violated the most favored nation clause that required equal treatment. Flat-rate duties on all tourists’ purchases differed from the specific duties negotiated under GATT, also a violation (letter, Trade Negotiator William Roth, to Secretary Fowler, Department of State, M
arch 8, 1968).