The Great Deformation (48 page)

Thus, a maneuver called Operation Twist attempted to push long-term interest rates lower to encourage domestic investment and growth while nudging short-term interest rates higher to support the dollar. It actually backfired, however, when foreign issuers raised cheap long-term debt in New York and then promptly swapped the proceeds back into their own
currencies, thereby dumping more unwanted dollars on the foreign exchange markets.

So the Treasury came up with a fix to the fix called an “interest equalization tax” to punish such speculators, but that didn't work either and only led to more expedients. A dangerous time bomb was thus being planted just below the surface. Foreign private and official claims on dollar denominated assets—much of it short term—began to build up rapidly after 1965, having been facilitated by the swap lines, the Roosa bonds, and the gamut of additional temporizing measures.

Compared to gains averaging about $2 billion per year in 1962–1965, foreign dollar claims grew by $7 billion, $10 billion, and $13 billion in 1967 through 1969, respectively. The glaring problem was that these off-shore dollar claims were now expanding at an annual rate which was larger than the entire remaining gold stock of the United States.

Any blow to confidence could cause a panic dumping of dollar assets for gold. This would trigger, in turn, an existential challenge to a global monetary system which was now saturated with unwanted dollars.

THE PENULTIMATE BLOW TO BRETTON WOODS:

THE BRITISH KEYNESIAN DEFAULT AGAIN

The challenge came decisively in 1967, when the Arab-Israeli Six Day War in June set off a cascade of unsettling forces. The fault line centered on the ragged British economy, which was suffering from the double whammy of a multi-decade decay in its union-crippled industrial sector and the inflationary fevers which had been introduced by the Keynesian policies of its Labour government.

Like the United States, the United Kingdom was living way beyond its means, as reflected in a festering balance of payments crisis. Even though by then it had dismantled most of its empire, it still could not make ends meet, owing to the heavy burdens of its welfare state.

When the Mideast war caused the closure of the Suez Canal, the outlook for the already substantial British trade deficit took a sharp turn for the worse, fueling a powerful new round of exchange market speculation against the pound. British policy had quashed two earlier sterling crises under Labour governments, but the confluence of forces working to undermine the pound now threatened a third and even more virulent drive by speculators to force devaluation.

Faced by this daunting challenge, the Labour government made a far-reaching error which soon triggered a devaluation of the pound, a run on the dollar, and the collapse of the London gold pool. Nixon's final demarche
from Camp David would complete the destruction of Bretton Woods a few years later.

The correct solution was embodied in a century and a half of British monetary history. Domestic demand needed to be throttled back by an immediate sharp increase in the Bank of England discount rate, and an emergency budget to staunch the flood of red ink that was financing imports the UK couldn't afford.

These classic measures would attract funds into sterling, curtail imports, and cauterize the payments deficit. They would also signal to speculators that the government was committed to financial discipline and defense of the pound sterling's $2.80 exchange rate.

The British Labour government resorted to the Keynesian playbook, instead, and resolutely refused to permit the Bank of England to raise the discount rate, even though interest rates were deeply negative in real terms. Like today's financially profligate governments, it thus attempted to borrow its way through the crisis, tapping its currency swap lines with the Fed and other European central banks for billions.

The swap lines were no financial bazooka. Despite frantic currency market intervention, the Bank of England could not buy pounds sterling fast enough to absorb the waves of selling by speculators who could see that the Labour government was borrowing its way to financial disaster.

The final match was thrown on this monetary kindling pile on November 14, 1967, when the British government announced that the October trade deficit had been its largest in history. This merely reinforced the obvious truth that the fundamentals of the UK economy were deteriorating rapidly, and that the government's fevered swap-line borrowing and currency support operations were doomed to fail. Four days later the pound was devalued by 14 percent, and the world was well on its way to Nixon's repudiation of Bretton Woods at Camp David.

THE FINAL ASSAULT ON THE LONDON GOLD MARKET:

HOW THE NEW ECONOMICS WAS ROUTED

In fact, the pound devaluation was announced on a Saturday, November 17. According to Coombs, by Monday morning “a tidal wave of speculation now swept through the London gold market.”

Although the gold pool had been increased to $350 million, this proved to be a trifling sum as the raw power of the free market in gold quickly made itself evident. Indeed, the attack on inflationary economic policies and financial indiscipline now moved swiftly to the dollar. On Monday, November 19th, the pool was forced to sell $27 million of gold to meet free
market demand at the $35 parity, which then soared to $106 million on Wednesday and $250 million on Friday.

Altogether, the central bankers' gold pool had been drained of nearly $600 million during the week after the pound devaluation and had to be hastily replenished by its members. In fact, the Treasury had to enlist a military transport to airlift American gold to London!

In the final weeks of 1967, then, the ancient financial discipline inherent in gold-convertible money brought itself to bear on the Johnson White House. LBJ's “guns and butter” fiscal policy and blatant efforts to intimidate the Fed into money printing were being given the Bronx cheer. Private traders and speculators still had the right to demand honest money when they feared the government's paper issue was being debased, and they exercised it lustily.

A new run on gold ensued in December, draining the central bankers' gold pool by another $400 million in just three days. At that point the White House partially capitulated, with Johnson announcing he would seek a 10 percent surtax and take other measures to balance the budget—measures that he had been deferring for months.

Just as under the ancien régime, the gold market was now handing the greatest politician of his generation the needed excuse to ask the legislature for tax increases and spending cuts. The administration also announced a clumsy set of bureaucratic measures to stem the outflow of US dollars, including mandatory controls on direct investment abroad, repatriation of foreign earnings, and, pathetically, an admonition to American citizens to postpone for two years all nonessential foreign travel.

Yet the root problem was excess dollar liabilities. During 1967 alone, the nation's central bank had increased its holdings of Treasury debt by 12 percent, and it had expanded its government debt purchases and bank reserve creation by 21 percent over the preceding twenty-four months. The associated flood of new dollar liabilities had no home, but LBJ refused to do the one thing that mattered most; namely, he did not ask the Fed to stop creating so many unwanted dollars by raising interest rates sharply and reversing the prodigious pace of money creation it had undertaken at the White House's behest.

Within a matter of weeks, therefore, the run on gold resumed, this time with even more ferocious intensity. And it was in the face of the free gold market's clarion call for financial discipline that Johnson's Keynesian economic advisors laid the planking for Tricky Dick's subsequent commission of the actual dirty deed.

After gold began hemorrhaging out of the London pool at $100 million per day on March 8, the Council of Economic Advisors chairman, Gardner
Ackley, urged Johnson to close the gold window—and strand the Europeans high and dry with their vast dollar reserves—if they did not accept his proposal to sell their gold on an uncovered basis to defend America's beleaguered currency. The implication was no less menacing than the British Treasury's treachery of September 1931. Europeans would now be forced to take huge losses on the massive dollar-exchange holdings that they had accumulated over the years on the presumption that the dollar was as good as gold.

To be sure, it took an even ruder Texan than Lyndon Johnson to tell the Europeans that the dollar was our currency, but their problem, as John Connally put it so famously three years later. Yet the remarkable fact remains that none of Johnson's Keynesian advisors betrayed any recognition that it was their inflationary policies which had precipitated the crisis.

As the end of the road neared, the smugly self-assured professoriate had no solution except to put goofy controls on the offshore activities of American citizens. Their position had been reduced to the embarrassingly trivial point that the commission of private acts of capitalism abroad by American tourists and businessmen was the cause of the market's thundering stampede out of paper dollars and into gold.

In the nick of time, a thin majority of the Senate approved an emergency measure repealing the vestigial requirement that Federal Reserve notes be backed with a gold cover of 25 percent. This meant that the Treasury now had access to nearly the full $12 billion of gold stocks reported at the end of 1967 to meet its obligations under Bretton Woods and defend the $35 parity.

Then and there, Washington had one last opportunity to take a stand for sound money. By politically leveraging the nation's humiliating loss of gold in order to drive tax increases and spending cuts through the Congress, and by empowering the Fed to bring the hammer down on inflation, which was then running at a 5 percent annualized rate, the run on gold could have been stopped. The framework of Bretton Woods could have been saved.

Clearly the Europeans, especially the Germans, Swiss, and Dutch, were more than ready to cooperate with any reasonable and decisive effort by the United States to get its financial house in order. But when the gold out-flow hit $400 million on March 14, Johnson threw in the towel and shut down the gold pool.

LBJ also proclaimed that the United States would defend the $35 gold price come what may, but that promise was entirely hollow. Henceforth, the only gold which would trade at $35 per ounce was between central banks, when and as Washington pleased.

So-called enlightened economic opinion at the time considered the gold pool closure to be a matter of secondary moment. Already grand plans were under way to create a new form of IMF fiat money called special drawing rights, or SDRs. Yet IMF money, as logic would have suggested then and history would prove later, was inherently even more suspect than the politically compromised greenbacks which were being so unceremoniously dumped in favor of the barbarous relic.

Unfortunately, the Keynesian consensus claimed more science than it actually possessed. The problem at hand was not a shortage of reserve assets in the global monetary system, as the professors argued. To the contrary, it was a shortage of financial discipline in the nation which had insisted that its own currency become the reserve asset in the new monetary system fashioned at Bretton Woods.

Once the link between the dollar and London's free market in gold was severed in March 1968, it was game over. The possibility that US financial discipline would ever again be revived was fatally diminished.

THE CRUSH OF EMPIRE AND THE ROAD TO CAMP DAVID

At the heart of the US financial profligacy was an unwillingness to pay for the huge and largely unacknowledged cost of empire. By the end of 1968, the outflow of funds to support the nation's far-flung military enterprises, the hot war in Southeast Asia, and the growing network of security assistance and foreign aid had accumulated to $70 billion since the start of the 1960s. It would reach nearly $100 billion by the time Nixon closed the gold window at the US Treasury.

By the lights of General Eisenhower, of course, this vast level of expenditure was not necessary to protect the national security, and most especially not that portion of it driven by the occupation of Vietnam. Still, as the free world's hegemonic power and bulwark against those Kremlin factions which harbored aggressive intentions, the United States could have certainly afforded to invest a few percentage points of GDP in the cause of a stable, peaceful, and more prosperous global order.

Yet what it could not do was fund a global empire on borrowed money. To be sure, spending abroad for military bases and economic aid did not automatically cause a balance of payments deficit, any more than did importing anchovies from the Peruvian fisheries or coffee from the Brazilian plantations. What did cause a payments deficit, however, was electing to incur these national security expenditures without earning a sufficient surplus in trade and services to offset the dollar outflow.

As Great Britain had shown in the nineteenth century, an imperial power needed to earn a consistent current account surplus to fund its overseas
enterprises, including both investments of private capital and the military projects of the state. That the United States could not operate a financially stable empire in the mid-twentieth century was therefore a tribute to muddled policy, not the inherent economics of venturing beyond its coastlines.

In 1964, the United States had a $9 billion current account surplus excluding defense spending. But this figure declined to $4.5 billion by 1968 and rolled over into nearly a $1 billion deficit by 1972.