A History of the Federal Reserve, Volume 2 (7 page)

Martin tried to calm the markets. In a speech on February 14, he insisted that “the future evolution of the system can and should be based on the present price of gold” (Martin Speeches, February 14, 1968, 1). Devaluation against gold “would undoubtedly be accompanied by an equal change in terms of virtually all other currencies” (ibid., 8). Even if true, and there is much less certainty than his statement claims, the United States would have more gold to satisfy the claims against it. He called “man’s enslavement to gold for monetary purposes” barbarous. The solution to international money problems, he said, was international cooperation and replacement of gold with SDRs. As usual, he made no mention of the need for realigning real exchange rates.

It was too late for soothing words and pledges. If the administration and the Federal Reserve wanted to maintain the fixed exchange rate system, they had either to find a way to devalue the dollar against other currencies or deflate. They were not ready for either choice, and they rarely mentioned the real exchange rate. Political opinions had started to change, however. A growing group in Congress favored an end to the fixed rate system. Senator Jacob Javits’s statement in late February, calling for suspension of convertibility into gold, expressed this sentiment publicly (Eichengreen, 2000, 209).

The System’s immediate concern was removing the last gold reserve requirement. Gold reserve requirements began in 1882, when Congress established a gold reserve (Krooss, 1969, v. 4, 3150). The opposition blamed the administration’s inflationary policies and wanted to have an election issue. Congressman Patman introduced amendments that would have prevented gold sales to countries that permitted their citizens to own gold. This included most countries (letter, Fowler and Martin to Patman, Volcker papers, Department of the Treasury, February 20, 1968). A majority recognized that the Bretton Woods system could not continue unless the United States exchanged dollars for gold at a fixed price and, if they did not release the gold reserve, the end would come soon. On March 18, President Johnson signed the Act to Eliminate the Gold Reserve Against Federal Reserve Notes.
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The bill passed the Senate with a two-vote margin.
At the time, the Federal Reserve held only $3.5 million in free gold (FOMC Minutes, April 2, 1968, 30). The act severed the last tie of money to gold.

43. Some Federal Reserve banks were below the 25 percent statutory gold requirement. On March 14, the Board and the reserve banks agreed to compute the requirement weekly
instead of daily, level the requirements of the reserve banks instead of permitting deficiencies at one or more banks, reallocate gold daily instead of monthly, and reduce the tax for gold reserve deficiencies from 0.5 to 0.1 percent for ratios from 20 to 25 percent. Once the legislation passed, none of these changes remained relevant. The Federal Reserve could then settle interdistrict transfers using securities instead of gold (Board Minutes, March 14, 1968, 7 and 23–24).

By March 5, the breakdown of the system seemed at hand. Coombs reported to the FOMC that the gold pool continued to lose “record breaking sums,” that the Canadians had also lost “record breaking sums” trying to support the Canadian dollar, and the British “were not gaining on sterling” (Maisel diary, March 6, 1968, 14). The Canadians threatened to float. This raised concerns that the British and others would use this as a reason to float.

The United States’ gold stock declined nearly $1.2 billion in March, 10 percent of its holdings at the end of February, almost all of it prior to closing the gold market. When the Board met on the morning of March 14, Governor Robertson announced that the United States had sold $350 million on the London market that day. Britain sold $250 million on the same day. Late that afternoon, the FOMC held a telephone meeting. Chairman Martin reported that, in a meeting with President Johnson and Secretary Fowler, they had accepted the British decision to suspend operations of the London gold pool (FOMC Minutes, March 14, 1968, 3). Participating central banks agreed to meet in Washington on March 16 and 17 to stop the run against the dollar and the pound. That was the end of the gold pool. Closing the gold market prevented further decline in aggregate official gold stocks.
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The United States and other countries remained obligated to buy and sell gold to other members of the Bretton Woods system at the $35 price. Much of the gold sold on the London market went to private holders. Canada, West Germany, Switzerland, and others sold gold (net). The difference for these countries was that their reserves changed composition.
They acquired dollars. For the U.S., the sale of gold meant a reduction in international reserves.

44. Canada also faced a serious reserve drain. Governor Louis Rasminsky told U.S. officials that Canada lost $1 billion of reserves out of $2.5 billion held at the end of February 1968 defending its par value. Rasminsky wanted a $1.5 billion short-term loan. The Federal Reserve agreed to increase the swap line by a maximum of $100 million. Canada also wanted renewed exemption from U.S. controls on lending and investing. The Board agreed to the exemption because the Treasury had agreed with the Canadians (Board Minutes, March 7, 1968, 9–10; memo, Robert C. Holland to FOMC, “The Two-Market System for Gold,” Board Records, March 29, 1968, 15). After suspending sales to the London market, the Paris market gold price rose to $44 an ounce, a 26 percent discount of the dollar. The London market did not reopen until April.

Six reserve banks proposed a 0.5 percentage point increase in the discount rate to 5 percent. Two banks proposed 5.5 percent and New York asked for 6 percent, an extraordinary 1.5 percentage point increase, the largest change since 1931. Chicago asked for 0.25, an increase to 4.75 percent. Clearly there were differences of opinion about the severity of the problem and the appropriate response.

Governor Maisel supported a 5 percent rate but insisted that “any solution to the gold problem should be compatible with what was best for the domestic economy” (Board Minutes, March 14, 1968, 15). Sherrill agreed about the domestic economy and, like Brimmer, Robertson, and Mitchell, preferred the 5 percent rate. This made a majority, but Chairman Martin was reluctant to impose a discount rate on directors who had voted for a different rate. He favored treating the reserve banks as members of a system and did not want to make the reserve bank directors less secure about their role in setting the discount rate. He proposed allowing the bank directors to reconsider. Chicago, St. Louis, and Dallas revised their requests, and the Board approved the 5 percent rate. New York would not revise its increase below 5.5 percent, and the Board was not willing to grant so large an increase. The Board’s press release cited the international position of the dollar as the reason for the increase, despite New York’s absence.
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The FOMC’s telephone meeting also had difficulty agreeing on Coombs’s proposal to increase the size of the swap lines by 50 percent with some main countries other than Britain. The Board’s staff opposed the increase first because it signaled that foreign central banks would not want to hold additional dollars and second because it would increase short-term claims against the remaining gold stock. They preferred to force some change in international financial arrangements and thought that the United States would be in a better bargaining position if it held more gold and had fewer liabilities (Maisel diary, March 15, 1968, 26). Mitchell, Robertson, and Maisel supported the staff, but Martin and Daane supported the manager. FOMC approved the increase in swap lines.

On March 16 and 17, central bank governors of the United States, Belgium, West Germany, Italy, the Netherlands, Switzerland, and Britain met
in Washington to decide on common strategy to stop the drain of gold through the London gold pool. The managing director of the IMF and the general manager of the Bank for International Settlements attended also. France did not participate (memo, Walt Rostow to the president, Department of State, March 12, 1968).

45. In New York’s absence the statement is not credible. Martin told President Johnson about the need for a discount rate increase before the vote. The president accepted the decision. Bremner (2004, 196), quoting Wilbur Mills, records that the president “was scared almost out of his body when he heard that people in Europe were having trouble exchanging dollars for foreign currency.”

The first day’s meeting was contentious. Martin asked Governor Carli to introduce his proposal for a two-tier market. The British and Dutch introduced their proposal to increase the gold price, devaluing the dollar against gold. Instead of devaluing, the United States mistakenly wanted to maintain the $35 price but restrict purchases and sales to central banks, the Carli proposal.
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The Germans were uncertain, and the Italians, Belgians, and Swiss strongly opposed an increase in the gold price. Martin presided, allowed discussion to continue, then announced at the end of the day that the gold price would not be increased (Coombs, 1976, 168). That left Carli’s proposal. The following day, Sunday, the United States agreed to borrow from the IMF to redeem the dollars that central banks had acquired by supplying gold to the pool and agreed to establish what it had previously feared—a two-tier gold market. “They decided no longer to supply gold to the London gold market or any other gold market. Moreover, as the existing stock of monetary gold is sufficient in view of the prospective establishment of the facility for special drawing rights, they no longer feel it is necessary to buy gold from the market. Finally, they agreed that henceforth they will not sell gold to monetary authorities to replace gold sold in private markets” (Krooss, 1969, v. 4, 3168).
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The Bank of England pointed out that closing the London market would move trading to other markets in Paris and Zurich. They proposed to keep the market open but restrict sales and purchases by central banks. The new rule set two restrictions. Gold in official monetary reserves at the time of the meeting could be used for transactions between monetary authorities
at $35 an ounce. Gold not in official monetary reserves, including any new production, could be purchased or sold in the free market.
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Participants recognized that if the market price fell below $35, some central banks might try to take advantage of the price spread.

46. Switzerland agreed to this arrangement but said it was obligated under Swiss law to buy from and sell gold to Swiss citizens.

47. The two-tier gold market was discussed and discarded earlier. Arthur Okun explained that much of the contingency planning after 1965 was done by the Deming group, chaired by Treasury Undersecretary Frederick Deming, a former Federal Reserve Bank president. The other members were Dewey Daane of the Board of Governors, Okun while he was a member of the Council of Economic Advisers, Francis Bator of the National Security Council, and Anthony Solomon of the State Department. This group both preferred to pay out gold and doubted that other countries would agree to close the gold window. Okun claimed that in March “the outflow got up to hemorrhage proportions. It was at this point, I think, that the negotiability of the two-tier system first became clear. . . . They wanted to stop their losses of gold. They did not want to keep paying it into the gold pool” (Okun, Oral History, Interview II, tape I). Okun credits Guido Carli, governor of the Banca d’Italia, with the idea of the two-tier system.

The U.S. gold stock rose slightly in 1969–70. One reason was that Germany and Japan, the countries with large payments surpluses at the time, limited gold purchases. France had regularly demanded gold, but it experienced a payments deficit in 1968 and 1969, so it had to sell gold.

The German decision was formally stated in a March 1967 letter from President Karl Blessing of the Bundesbank to Chairman Martin supported by a letter from the chancellor of the West German government. Germany committed to refrain from purchasing gold from the U.S. Treasury (Solomon, 1982, 111). The decision came “following threats of a partial troop withdrawal” (Holtfrerich, 1999, 384). Japan did not make a public pledge or require direct pressure. It simply accumulated dollars and did not demand much gold.

Table 5.3 shows the change in short-term dollar assets and gold between 1966 and 1970 for France, Germany, and Japan. After it recovered from the 1968 strikes, disruptions, and wage increases, France accumulated dollar assets and did not replace the gold sold before the August 1969 devaluation of the franc. But it must have been clear to everyone that the agreement eroded the gold base of the fixed exchange rate system. De facto, the dollar was no longer convertible for most purposes.

The March 16–17 meeting took a long step toward ending the Bretton Woods system. It solved the short-term problem but left the long-term problem untouched. Vietnam spending had increased. The projected United States budget deficit reached a postwar record ($25 billion), and the
dollar remained overvalued. The Johnson administration did not devalue the dollar against gold and offered no other adjustment toward long-term equilibrium. The Federal Reserve did not commit to a less inflationary policy. Until 1970–71 there was little pressure from Congress or others to develop a long-term policy.

48. The commitment not to sell official gold (no longer to supply) was much stronger than the decision not to buy (no longer necessary because the existing stock is sufficient). The claim of sufficiency reflected the belief that the SDR would soon be approved as a source of international reserve growth. The Board’s staff pointed out that IMF members had a right to obtain foreign currencies for gold and to repay the IMF in gold. The gold could be obtained from (or sold to) the market (memo, Holland to FOMC, Board Records, March 29, 1968, 9). Among large gold holders, France, Australia, and South Africa did not subscribe to the agreement. The last two were important gold producers.