A History of the Federal Reserve, Volume 2 (9 page)

The first mention of renewed British problems came at the May 21 Board meeting. Governor Robertson reported on negotiations between the Treasury and the British government to refinance Britain’s external debt, much of it outstanding since World War II. Coombs described the pound as “in extreme danger” (FOMC Minutes, May 28, 1968, 17). In the six months following devaluation, Britain had borrowed $2.6 billion. Coombs expected renewed drawings on the swap line and a possible request to increase the line, and he was pessimistic about Britain’s ability to repay within the standard time frame. He suggested that the Federal Reserve consider turning down the British request. “In his judgment the British situation had come very close to being hopeless” (ibid., 15). The FOMC rejected his proposal. Chairman Martin reported that Britain agreed to repay all its swap credit, if it drew $1.4 billion from the IMF.

Britain had borrowed in aggregate between $5 and $6 billion, according to estimates, much of it to defend the exchange rate before the November 1967 devaluation. In addition, overseas holdings of blocked British pounds reached $7 billion, of which governments and central banks owned $4 billion (ibid., 27–28). Coombs said that it might take thirty years or longer to pay off the debt.

Solomon was less pessimistic than Coombs. He did not believe that the $2.40 exchange rate was untenable, and he urged the FOMC to consider the risk to the financial system if Britain floated its currency. “The Committee would have to be prepared to bear the responsibility for the chaos into which the international monetary system would be thrown. A run on the dollar by foreign central banks would undoubtedly follow” (ibid., 19). That clinched the argument.

Martin and Hayes supported Solomon. The FOMC voted to let the British continue drawing up to an additional $800 million on the swap line and to extend additional credit by purchasing up to $400 million of British pounds with an exchange rate guarantee. The British could use these longer-term funds and IMF borrowing to repay the swap line. Martin recognized that the debt could become illiquid. Like Solomon, he thought that risk was smaller than the risk that the British would float the pound.

Solomon’s analysis proved correct. Britain’s problems following devaluation proved temporary. The trade balance turned favorable within a few months. By 1969, Britain had a payments surplus of $1 billion. It began to repay the debts incurred in 1967–68. Also, the central banks of Europe, Japan, Canada, and the United States now supported an arrangement under which the British agreed to maintain the dollar value of the balances held as official reserves. The foreign central banks provided long-term dollar loans to permit holders of balances in London to diversify their assets. The
United States’ share, $600 million of the $2 billion total, was made by the Treasury as swaps through the Exchange Stabilization Fund (ESF).
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Since the ESF lacked the resources, the Federal Reserve agreed to warehouse the funds for the Treasury. This support of a longer-term loan raised both legal and policy issues. The Board’s counsel ruled that legality was not an issue. The Board would enter into swaps as it had done since 1962.

Governor Brimmer opposed on policy grounds because the agreement allowed the Treasury to borrow at long term from the Federal Reserve. Others expressed concern but not opposition. The result was an agreement that allowed the Treasury to warehouse for up to a year. The Federal Reserve could then demand payment, but the agreement did not say that the Treasury had to pay. Treasury would have to go to Congress to ask for funds, a step that warehousing avoided (Maisel diary, July 2, 1968, 11). President Johnson approved the agreement with the Federal Reserve.
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That ended the British problem for the present. France’s problem began with widespread strikes and demonstrations in May 1968. France was not alone; several countries experienced student demonstrations that year. France’s demonstrations spread to the economy when the strike became general. The Bank of France and the financial markets closed.

Coombs described a general flight from currency, not just in France but elsewhere as well. The demand for gold increased, and the higher price “panicked a lot of small central banks into buying gold from the United States” (FOMC Minutes, May 28, 1968, 4). France continued to lose gold and foreign exchange, $1.8 billion in May and June, more than 25 percent of its balance at the beginning of the year. The franc began to trade at a discount as rumors and fears of devaluation spread. France had not participated in the expansion of the swap network. It drew its entire $100 million from the Federal Reserve in early June, and it began to negotiate for an increase to $700 million. Despite its often hostile or contrary attitude, the European countries and the United States agreed to extend more credit.
France also sold gold, including $400 million to the United States in June. Between May and December, U.S. gold reserves rose $400 million.

57. The swaps of dollars for pounds were three-month renewable loans that could be drawn upon for three years and, after a two-year grace period, would be repayable in the next five years. This gave the loans a maturity of up to ten years. The Bank of England gave an exchange value guarantee for about two-thirds of the outstanding balances (Board Minutes, July 2, 1968, 4–5; Maisel diary, July 2, 1968, 4–6).

58. The Treasury would receive pounds sterling on swaps for dollars with the Bank for International Settlements (BIS). When the Treasury’s Exchange Stabilization Fund (ESF) needed additional dollars, it would sell pounds to the Federal Reserve and simultaneously buy pounds forward from the Federal Reserve. When the forward sale became due, the Federal Reserve could put the contract to the Treasury (ESF). The Treasury could put the contract to the BIS, which could put it to the British. The Board recognized that it
was at risk.

The European Commission staff estimated that the settlements in France would raise wages 23 percent in 1968 and 1969 and prices 10 percent. It projected that higher costs and prices would induce a $1 billion payments imbalance. Devaluation seemed likely (Fowler to the president, Department of State, June 6, 1968).

The United States’ concern was that weakness in the French financial system would make the international payments problems much worse. If a run from the franc triggered a large devaluation, the British could be forced to float. “There would be repercussions on the dollar and, perhaps, general monetary chaos—with everyone trying to get out of currencies and into gold. . . . The U.S. might have to cut the gold convertibility link to the dollar and float itself. And that would destroy the present system and probably badly cripple world trade” (ibid., 2).

Aside from loans, the expressed need was for a revaluation of the mark and realignment of the European currencies. The next months illustrate the problem of adjusting exchange rates under the Bretton Woods system even when the dollar was not directly involved. West Germany had reduced interest rates in 1967 during a mild recession. Rates remained low in early 1968. As imports fell during the recession, Germany’s current account surplus rose, but the capital account deficit during the recession reduced upward pressure on the mark. The market anticipated that higher future interest rates would bring a reduction in the capital account deficit or possibly a surplus. Fears of French devaluation after the general wage increase and higher French prices induced capital outflow from France to Germany.

In September, after the capital flow to Germany rose, the Bundesbank proposed a revaluation of the mark, but Karl Schiller, the Economics Minister, rejected the idea (Holtfrerich, 1999, 385). In Germany, as in the United States, the government, not the central bank, decided exchange rate policy. Speculation resumed in November. The Bundesbank purchased $2.8 billion, mainly from England and France, to maintain its exchange rates.
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The United States pressed for parity adjustments, a modest (less than 10 percent) devaluation of the franc and a 10 percent revaluation of the mark. President de Gaulle announced that France would not devalue. Germany put a special duty on exports and a special tax allowance on imports, each 4 percent, but the change was insufficient to stop the capital
flow. The German chancellor, Kurt Kiesinger, pledged publicly that his government would not revalue the mark. Germany closed its exchange market on November 20 and 21.

59. The Bank of France lost $1.1 billion of reserves, and the Bank of England lost $800 million. The gold price remained about $40. Coombs claimed that the crisis originated in an effort by France and Britain to get Germany to revalue by 10 percent.

A meeting of the Group of Ten, described as acrimonious, achieved very little. Much of the meeting pressed Germany to appreciate more and France to depreciate less than a threatened 15 percent devaluation. The Germans remained adamant; the French agreed, finally, to a maximum devaluation of 11.11 percent, but did not commit to do it. Although the meeting did not accomplish much, it showed a growing recognition of a need for parity changes and the difficulty of getting them. Germany put a 100 percent reserve requirement on short-term bank liabilities to foreigners, France reduced its budget deficit and increased exchange controls, and the central banks agreed to lend France $2 billion (Solomon, 1982, 160–61).
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The U.S. share was $500 million, $300 million from the Federal Reserve.
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The FOMC increased the French swap line to $1 billion and extended the term to one year as with other large countries. France increased some tax rates, reduced public spending, tightened price controls, restricted imports, subsidized exports, and imposed exchange controls. Germany and the United States agreed to sell marks forward at a 3 percent premium and to split the earnings with the Bundesbank. Following these actions, inflows into Germany reversed (FOMC Minutes, November 26, 1968, 15–16).

Coombs proposed that any further assistance to France be done by the Treasury. The Treasury would act as principal, but the Federal Reserve
would assist because “under existing arrangements the Treasury could ask the System at any time to warehouse some of its holdings of guaranteed sterling if the Stabilization Fund’s resources were inadequate to meet outstanding commitments” (ibid., 22–23). Although members expressed some concern about the possible long-term nature of this commitment, they took no action to change it.

60. France’s technocrats wanted a 15 percent change in the mark-franc exchange rate, but neither government would accept a change. The British said that if France devalued by 15 percent, it would float the pound. French officials accepted the German tax changes on imports and exports as almost a 4 percent appreciation, so they offered an 11.11 percent devaluation, subject to de Gaulle’s approval. He did not approve (Maisel diary, November 25, 1968, 3).

61. The German response to criticism at the meeting suggests why adjustment became infeasible under Bretton Woods. After making the obvious point that revaluation and devaluation had symmetric effects on exchange rates, Economics Minister Karl Schiller complained that German revaluation “would appear to be a punishment for a sound German policy” (telegram, embassy in West Germany to the White House, Department of State, 214, November 21, 1968). Secretary Fowler replied that no one wished to punish Germany. Germany had a persistent surplus since 1961. He claimed that it was a structural, not a cyclical, surplus. (At other times, Germany argued that it needed a current account surplus because it paid the offset for U.S. military costs.) During a break in the meeting, the Dutch representative proposed that Fowler talk to the Italian representatives. If Germany revalued by 10 percent and Italy by 5 percent, he offered a 5 percent revaluation of the guilder. The Italian representatives said revaluation by Italy was politically impossible (ibid.) The following day Schiller talked about the need to realign “all important parities” but indicated his belief that such a change “was not politically possible and is dangerous.” He denied that the German surplus was structural, blaming U.S. corporate purchases of German industry for the surplus. Pierre-Paul Schweitzer of the IMF “said he was frightened at the Schiller proposal” (ibid., 216, November 21, 1968).

Maisel (diary, June 9,1968, 7–8) expressed his view about why the twotier gold market did not set off a run on gold by central banks. He explained that the Europeans were “extremely reluctant” to permit exchange rate adjustments. Also, “the Europeans no longer felt in a position to threaten the United States with gold withdrawals. They were very much concerned over the potential cost to them if the international monetary system broke down” (ibid., 8). Once again, he portrayed the Europeans as concerned with the benefits to them, not the public good of an international system. Political costs had a major role.

After the failed November meeting, Stephen Axilrod at last said the “positive lesson . . . is a need for a more flexible means of correcting payments imbalances” (FOMC Minutes, November 26, 1968, 52). He was not optimistic about reaching agreement. “In the case of Germany, for example, the major obstacle to revaluation appears to be the political fallout from a drop in farm prices that would result from an appreciation of the mark” (ibid., 53).

A quiet period on exchange markets continued until March 1969. France did not recover the reserves it lost after May 1968, suggesting that the quiet period was a lull, aided by severe exchange controls, not an end to the French problem, an overvalued real exchange rate.

Several new events revived talk of franc devaluation. President de Gaulle retired on April 28 after losing a referendum on regional policy. West Germany’s strong recovery from recession produced an enlarged current account surplus. The central bank responded by raising interest rates to slow inflation. A suggestion by the German Finance Minister that Germany might revalue as part of a multilateral realignment stimulated “the heaviest flow in international financial history,” $4 billion inflow (DM 17 billion) to Germany in ten days (Solomon, 1982, 162). Throughout, the Bundesbank Council urged revaluation. By late spring the Economics Minister, Schiller, joined them, but the government, after intense debate, refused to go along. Instead, it voted to accelerate debt repayment and take other fiscal measures.
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62. In late June, Arthur Okun sent President Johnson a message warning that “the monetary system which lies as the basis of international commerce and trade has been impaired”
(memo, Okun to the president, Confidential Files, FI9, Box 53, Johnson Library, June 21, 1968). The problem was the persistent U.S. payments deficit and the belief that it would continue. Okun pointed out that a new British devaluation or other currency change would harm the dollar.