The Great Deformation (47 page)

The bet of the gold speculators, of course, was that the United States would eventually elect to cheapen its currency, rather than rein in its balance of payments deficits through domestic austerity or retrenchment of its overseas military and foreign aid spending. In that event, the gold price would soar, bringing windfall gains to the speculators.

Initially, however, the central bankers' syndicate kept the speculators at bay, in part because the size of the pool was never made known to the market. In reality, the United States had secretly pledged to its European partners that it would replenish their gold stocks at a later date by the full amount of any sales from the pool. Thus, the United States was still on the hook to defend the $35 parity entirely with its own gold. Yet by warehousing dollars on an interim basis, the European central banks helped minimize the appearance of a drain on US gold stocks.

During the first half of the 1960s, the Treasury's dollar defense was reinforced by the fact that the overall US balance of payments deficit remained moderate. Gold outflows cumulated to just $4 billion during 1961–1965.

Serendipity also gave the Treasury an assist when the Soviet Union had another massive crop failure, forcing it to sell about $1.5 billion of gold during 1963–1964 to feed the starving Russian population. Since these sales had the effect of dousing upward pressure on the free market price of gold in London, speculators shorting the dollar, ironically, got burned by the pratfall of socialist agriculture.

The need for large outflows of US gold to finance the cost of forward defenses against the Soviet menace was thus temporarily averted, as the menace was proving more adept at starving its own people than endangering others. As it worked out, the central bankers' gold pool actually ended 1965 with a billion-dollar surplus.

THE HELLER-TOBIN ASSAULT ON SOUND MONEY

It was all downhill thereafter and mainly because the fundamental terms of the US financing equation steadily deteriorated. On the one hand, the dollar outflow owing to the “cost of empire” intensified, rising from $6–$7 billion per year before Johnson's big 1965 escalation of the Vietnam conflict to $9–$11 billion per year during 1968 and several years afterward.

At the same time, Kennedy's new economics professors had succeeded beyond their wildest dreams. By mid-1962 they had worn down President Kennedy's aversion to deliberate deficit finance, and by year-end had gotten him to deliver a speech on behalf of stimulative tax cuts to the Economics Club of New York City.

Much to Kennedy's surprise, the prospect of a sizeable reduction in personal income tax rates and corporate taxes was widely applauded on Wall Street. The federal budget was still in deficit and a tax cut had not yet been earned under Eisenhower's fiscal rules, but the idea of “stimulative” tax cuts on Uncle Sam's credit card was taking hold.

So Kennedy was emboldened to embrace the new economics game plan and propose a substantial tax cut in his January 1963 budget message. In doing so, he had overridden the concerns of Secretary Dillon that this resort to a deliberate fiscal deficit would undermine the Treasury's dollar defense strategy. History would now record that, apart from the resolute stand taken by Paul O'Neill against the Bush tax-cut mania in 2003, Dillon was one of the last treasury secretaries to defend the nation's revenue base in the name of sound finance.

Moreover, Dillon's dissent had come on top of what by then had become a heated and divisive battle inside the Kennedy administration on the fundamental balance of payments and dollar issue. Only months earlier, in fact, the Keynesian professors led by Walter Heller and James Tobin had proposed an inflationist plan to suspend the gold window, cut domestic
interest rates, and negotiate a “long-term borrowing arrangement” with the Europeans.

Already the inherent corruption of language which goes with the Keynesian brief had cropped into the debate. The “borrowing” arrangement proposed by Heller and Tobin was nothing more than a meaningless sleight-of-hand. Rather than pay off the rapidly growing short-term dollar claims held by other central banks, the professors were proposing to re-label them as long-term debt and tell the Europeans to suck it up.

In truth, the Heller-Tobin proposal was a nationalistic, frontal assault on Bretton Woods because it removed the free convertibility linchpin from the system; it told the Europeans who had accumulated dollar exchange reserves in good faith to choke on them.

A much agitated Secretary Dillon, therefore, had to admonish the professors that such a step would “shake the system to its core in the same way as the German standstill announcement of 1931 or the dollar devaluation of 1933 had done.”

Secretary Dillon and Fed chairman Martin were able to quash the Heller–Tobin plan after it predictably set off alarm bells in Europe and warnings that it would lead to the early demise of Bretton Woods. Still, justifiably irritated by the constant attacks of the White House professors, Dillon explained in no uncertain terms that sound international policy had to be based on consistent financial discipline, not Tobin's ten-year loan from Europe designed to kick the US balance of payments problem down the road indefinitely.

Dillon thus called out his internal adversaries as follows: “They search for ways to make this very real problem go away without interfering with their own projects—be they extra low interest rates in the US or the maintenance of large US forces in Europe. However, such individuals are asking the impossible. The sine qua non of all international monetary dealings … is that no country can run a consistently large balance of payments deficit.”

Chairman Martin was equally aghast at the Heller-Tobin prequel, in 1962, to what turned out to be the same flimsy logic as that behind Nixon's actual gold dollar default nine years later. “The proposed plan …” he declared, “would hit world financial markets as a declaration of US insolvency and a submission to receivers to salvage the most they could get out of the mess to which past US policies had led. It is incredulous to expect from it any resurgence of confidence.”

These were the words of sound-money men at a time when political expediency and debt-based financing schemes could still be called out. Yet it was only a matter of time before their voices would go quiet. The monetary
policy battles inside the Kennedy administration did, indeed, demarcate the twilight of sound money.

HIGH TIDE OF THE NEW ECONOMICS

The wisdom of Dillon and Martin did not slow down the White House professors one bit, who instead aggressively pushed the 1963 tax-cut plan to the top of Kennedy's agenda. They insisted it was a watershed breakthrough into enlightened fiscal policy—the international value of the dollar be damned.

Later praising Kennedy and Johnson for doing his bidding, Heller boasted that they had shown a “willingness to use, for the first time, the full range of modern economic tools” and that by “narrowing the intellectual gap between economic advisers and decision-makers … the paralyzing grip of economic myth and false fears on policy has been loosened.”

Keynesian zealotry was now at high tide. Under the original Heller tax plan there was even an “on/off “switch. Tax rates would be raised and lowered by presidential order depending upon what the White House economists were seeing in the economic weather reports. It was shades of FDR's breakfast with Professor Warren.

In convincing Kennedy to take the first fateful step down the slippery slope of deficit-financed tax cuts, the professors were paving the way for the eventual transformation of the tax code into a tool of national prosperity management. They were also offering it up as a piñata to be battered endlessly by crony capitalist lobbies.

The Keynesian professors had not made much headway on Capitol Hill, however. The bill got bottled up in the Senate Finance Committee, with Republicans declaring the Kennedy tax cut to be “the biggest gamble in history.” Only in the wake of the tragic event in Dallas was Lyndon Johnson able to summon a congressional majority willing to abandon the ancient taboo against deliberate deficit finance in peacetime.

For a brief moment thereafter it appeared that the old-time fiscal religion had been benighted after all. Upon enactment of the “Kennedy tax cut,” real GDP grew by 5.3 percent in 1964 and 5.9 percent in 1965 while inflation remained subdued, rising at only a 1.5 percent rate during each year.

Yet in a sure fire sign of trouble to come,
Time
magazine put Keynes on its year-end 1965 cover and pronounced that the business cycle had been abolished. According to the editors, policy makers had “discovered the secret of steady, stable, non-inflationary growth.”

Needless to say, the same “secret” would be continuously rediscovered in the decades ahead—by the Reagan White House after 1984, by Alan
Greenspan after December 1996, and by Bernanke's specious proclamation of the “Great Moderation” in February 2004.

Time
's essay also dispensed copious hokum about the mid-1960s boom being “the most sizeable, prolonged and widely distributed prosperity in history.” But it's more cogent, and perhaps unintended, insight had to do with a profound change it detected in the attitude of the business community.

The predicate that economic progress and prosperity would flow from macromanagement by the state, rather than from free market interaction of businesses and consumers, had now been embraced, even by the capitalists: “They believe that whatever happens, the Government will somehow keep the economy strong and rising.”

COMEUPPANCE OF THE NEW ECONOMICS

Exactly fifteen months later, in the spring of 1967, the US economy was visibly out of control, with inflation not subdued at all, but running at a 5 percent annual rate and gaining momentum. The White House professors found themselves no longer the toast of the town, but in headlong retreat.

Their putatively “balanced” full-employment budget had morphed into LBJ's huge “guns and butter” deficits. So there emerged in 1967–1968 a white-hot national economy that desperately needed to be throttled back.

Alas, the professors also discovered they had let the “fine-tuning” genie out of the bottle but couldn't get it back in. LBJ and the congressional rank and file were now proving to be far more reluctant to hit the fiscal brakes with tax hikes and spending restraint than they had been to embrace tax cuts and spending stimulus.

This earlier boost to domestic demand resulted in rapid import growth and caused the $7 billion merchandise trade surplus of 1964 to swoon toward zero by 1968, meaning that nothing was coming in to pay for the cost of empire. Even a modest rise in the surplus from income earned on US assets abroad was now being offset by greater private capital outflows.

So on a bottom-line basis, unwanted dollars began to build up in offshore markets once again. This time there was no Soviet famine to douse the London gold market with fresh bullion. Accordingly, the upward pressure on the gold price became intense.

In the interim, the Treasury and Fed had adopted additional support tools—central bank currency swap lines—to bolster their dollar defense. Yet the swap lines were an even weaker reed than the gold pool, and merely bought some modest increment of extra time while upward pressures on the gold market continued to accumulate.

DEFERRING THE DAY OF RECKONING:

SWAP LINES AND ROOSA BONDS

The currency swap lines were in theory a two-way street, depending upon whether the dollar's exchange rate was weak or strong. In practice, however, the swap lines were mainly used by the Fed to mop up unwanted dollars abroad, thereby avoiding their disposal on the London gold market or presentation for official redemption in gold.

The Fed's intentions were initially viewed with suspicion by the European central banks since, as Coombs of the New York Fed noted in his memoir, the swap line initiative looked “like an attempt to devise means of blocking access to the Treasury gold window. This was not far from the mark.”

In what would become a familiar kick-the-can syndrome, the swap lines were therefore limited to one-year maturities. This was meant to emphasize that they would be deployed only as a short-term exchange-market-smoothing mechanism, not as a substitute for fundamental financial discipline and correction of the US payments imbalance.

The insuperable challenge faced by the Treasury was that the swap lines became a drug, and the addiction got steadily worse with time. After their 1962 creation they ballooned to multibillion-dollar scale and were used on a routine but haphazard basis to prop up the dollar. The underlying balance of payments issue was never even addressed, let alone ameliorated.

So yet another expedient was invented: the US Treasury's so-called Roosa bonds denominated in European currencies. But the billions of proceeds from these issues were used simply to pay off earlier foreign currency loans, such as D-mark loans from the Bundesbank, as they came due under the one-year rule. They thus amounted to a thinly disguised ruse to violate the very principle—running an indefinite current account deficit—which Secretary Dillon had properly denounced.

At the end of the day, though, the Kennedy-Johnson Treasury was drawn and quartered in financial terms by the war spenders in the Pentagon and the domestic expansionists at the Council of Economic Advisors. Every new gimmick they invented to support the dollar and protect the nation's gold reserves led to a new round of technical complications, but no gain in underlying financial discipline.