John Connally played the role of chairman in Rome as though he wanted an Oscar. He spoke of the historical significance of their discussions, the appropriate setting in the birthplace of Western civilization, and urged everyone to renew their efforts to move toward a viable system of international cooperation. He then asked if there were new items of business, cuing Volcker with an imperceptible wink that left no doubt about what should come next.54
Volcker cleared his throat. “Well, suppose, just hypothetically, we were willing to discuss the price of gold. How would you respond if we increased the price by ten or fifteen percent?”
Connally interrupted. “All right, the issue has been raised. Let’s assume ten percent. What will you people do?”
Volcker had purposely overreached with his 15 percent proposal, knowing that Giscard d’Estaing had suggested France would accept 5 percent. America needed a bigger move to adjust exchange rates. Now Paul worried that his exaggeration, combined with Connally’s correction, advertised dissension within the U.S. Treasury. Unsure of how to set the record straight, Volcker said nothing, recalling a favorite quote attributed to Mark Twain: “Better to remain silent and be thought a fool than to speak out and remove all doubt.”
For the next hour, no one spoke. Most of the central bankers smoked, while the finance ministers looked at their shoes, probably checking whether they needed a shine.
Germany had always been the most flexible of America’s trading partners, so it was no surprise when Finance Minister Karl Schiller spoke first. The export powerhouse could afford to be generous because of its balance-of-payments surpluses. Moreover, preserving America’s commitment to defending Western Europe against Communist aggression carried great weight in West Germany. In March 1967, Karl Blessing, the then president of the Bundesbank, had written to Fed chairman William McChesney Martin pledging that Germany would refrain from demanding gold from the U.S. Treasury in consideration of American defense commitments in Europe.55
Schiller said Germany could live with a 10 percent U.S. devaluation “and would probably add some percentage to it.”56
One of the bankers asked, “What do you mean by ‘some’?”
Professor Schiller, a former academic at the University of Hamburg, responded with a brief linguistics lesson. “In the German language, ‘some’ does not mean ‘one.’ It means ‘two.’ ”
Volcker knew that Schiller’s proposed 12 percent appreciation of the mark had put Germany’s European partners on the spot. Everyone wanted the United States to remove the import surcharge and recognized that the price for that relief was a major realignment of exchange rates. But France could not afford anything close to a 12 percent appreciation of its currency. Most Americans loved the Volkswagen, but probably thought Peugeot, the pride of the French automobile industry, was a miniature poodle.
Nevertheless, Giscard d’Estaing remained silent. Nixon and Pompidou were scheduled to meet the following week. The French finance minister knew the final negotiations would take place then. And so did everyone else.57 The press anticipated “The Coming Devaluation of the Dollar.”58
The Azores Islands, a Portuguese archipelago in the mid-Atlantic, home to a U.S. air base and less than a thousand miles from continental Europe, served as the neutral meeting point for the American and French presidents on Monday, December 13, 1971. Georges Pompidou arrived prepared with a lecture on the centrality of gold to a stable international monetary system. He knew far more finance than Richard Nixon, having been an investment banker at Rothschild, and he recognized an opportunity to capitalize on France’s position in European economic affairs. French intransigence had paid dividends ever since de Gaulle withdrew from NATO in 1966.
Nixon, for his part, wanted to skip the economics and talk politics, in preparation for his scheduled visits to Peking in February 1972, and to Moscow the following May.59 He delegated the monetary discussions to Connally and Volcker. Pompidou, after his pitch to bury the dollar as the premier reserve currency, assigned the task of planning the greenback’s funeral to finance minister Valéry Giscard d’Estaing.
Two days of negotiations produced a compromise “Framework for Monetary and Trade Settlement,” signed by both presidents.60 Among the key items, the United States agreed to remove the import surcharge and to devalue the dollar by raising the price of gold from thirty-five dollars to thirty-eight dollars per ounce. France agreed to allow the franc to appreciate against the dollar by roughly the same 8 percent as the jump in the price of gold and, as an interim step toward monetary reform, would permit some flexibility around the newly established exchange rate.61
The presidents agreed to defer discussions of longer-term issues to a broader forum. The items on this “too hot to handle” list included the division of responsibilities among countries for defending stable exchange rates, the proper role of gold, and a timetable for resuming dollar convertibility into gold. However, Nixon committed the United States “to assist in the stability of the … newly fixed structure of exchange rates … by vigorous implementation of its efforts to restore price stability.”62 This benign pledge that every Boy Scout could support would become a source of conflict between the two presidents.
John Connally viewed the Azores agreement as a blueprint for the meeting of the G-10 scheduled for the following week in Washington. He chose the precise venue with purpose: the Commons Room of the Smithsonian Institution Castle, a 116-year-old red sandstone structure designed by James Renwick, architect of St. Patrick’s Cathedral in New York City. A crypt just inside the castle contains the remains of James Smithson, the illegitimate son of an English duke who left his fortune to the U.S. government and bestowed his name on the complex of museums and research centers now known as the Smithsonian.63 The Gothic architecture and forty-foot-high vaulted ceiling of the cathedral-like Commons Room conferred an aura of high purpose on the assembled ministers of finance and central bankers.
After two days of deliberations, on Saturday, December 18, 1971, the conclave unveiled a new structure of prices and arrangements in international finance. The dollar would be worth less against everything. An ounce of gold would now cost $38 rather than $35. A dollar would buy 3.22 German marks rather than 3.66 and would exchange for 308 yen rather than 360. Even the lowly Italian lira became more expensive: a dollar would buy only 581.5 lira rather than 625.0.64
Central banks would still intervene to maintain fixed exchange rates, but those rates could vary by 2¼ percent around their central values rather than the 1 percent leeway permitted under Bretton Woods.65 Dollar convertibility into gold remained suspended, meaning central banks could not exchange greenbacks for gold even at the higher price of $38. The international financial system had become a de facto dollar standard despite France’s success at embarrassing the United States.
Volcker should have been happy. He had engineered the depreciation of the dollar against all the major currencies, making American goods more competitive in world markets. He had shored up the Bretton Woods framework of fixed exchange rates by adding a built-in safety net of modest fluctuations around central values. He had avoided the freely floating exchange rate system advocated by Milton Friedman, George Shultz, and the Council of Economic Advisers. And he had had to swallow only a small devaluation of the dollar against gold.
President Nixon surprised the gathering of financiers by appearing at the Smithsonian to celebrate the accomplishment. The president hailed the agreement as inaugurating a new era of international finance. “It is my great privilege to announce on behalf of the finance ministers and the other representatives of the ten countries involved, the conclusion of the most significant monetary agreement in the history of the world.”66
Volcker, standing off to the side, muttered under his breath, “I hope it lasts three months.”67
Paul made a living as a professional skeptic, but his doubts about the newly minted Smithsonian Agreement were well founded. The realignment of exchange rates fell far short of the 15 percent adjust
ment needed for a new sustainable system.68 The dollar would remain under pressure.
6. Compromise
A letter of protest from French president Georges Pompidou to Richard Nixon landed for comment on Volcker’s desk on February 4, 1972.1 He did not like what he saw. The free-market price of gold had risen to a record high of fifty dollars an ounce, a 15 percent jump less than two months after the Smithsonian Agreement.2 Gold speculators were betting on another upheaval.
Pompidou began his note to Nixon with “Our conversations of December 13 and 14, 1971, were characterized by frankness and mutual understanding that were particularly useful.”3 This means anything but what it says, of course. A frank discussion is diplomatic speak for a fistfight. Pompidou actually meant “Our argument ended in misunderstanding.”
After the opening bow, the French president rolled up his sleeves. “I am not confident that the combination of a large budgetary deficit and a policy of low interest rates [in America] can strengthen the confidence of the international community … nor do I believe that such a course affords … for the defense of the new parity for the dollar which you yourself have fixed.”
Pompidou scolded Richard Nixon, but in fact blamed Federal Reserve chairman Arthur Burns for dollar weakness. The head of America’s central bank had allowed a half-point decline in U.S. interest rates since Nixon hailed the monetary agreement in December as the second coming of Bretton Woods. The decline in rates had encouraged investors to transfer money abroad to earn higher returns, leaving the dollar more than 2 percent lower.4 The French president had expected Nixon’s handpicked chairman of the Federal Reserve to support the president’s objective. Burns was doing precisely that … but it was not the same as Pompidou’s objective.
Nixon had been pressuring the Fed to ease monetary policy in preparation for the 1972 elections.5 As early as October 10, 1971, the president had told Burns, “I don’t want to go out of town fast.” A month later, Burns signaled progress in keeping the president in office with a brief telephone call: “I wanted you to know that we are reducing the discount rate today.” He called Nixon again on December 10, 1971, to report a second decline in the discount rate. This time Nixon replied, “Good, good, good.”
But the president wanted more. The day before Christmas, he told his budget director, George Shultz, “If I have to talk to [Burns] again I’ll do it. Next time I’ll just bring him in.” Shultz, a soft-spoken labor negotiator in real life, confirmed that he knew how to play rough. “I’m sure we’ll have to keep after him on it … It was good to have that discussion about the procedures for appointment [to the Federal Reserve Board] so that he sees that he doesn’t have complete control.”6
Shultz, the former dean at the University of Chicago business school, minimized any qualms Nixon might have had about the impact of an easier monetary policy on exchange rates. “Why worry about interest rates going down? … We want low interest rates. What’s the problem there? So, we don’t have a return flow of money from Europe? So what?”
Shultz knew that lower U.S. interest rates would reduce value of the dollar internationally and undermine the newly repaired system of fixed exchange rates agreed to at the Smithsonian. Milton Friedman, who supported floating exchange rates as the free-market solution to international finance, would have been pleased with his former colleague.
In his letter to Nixon, Pompidou broadened his concern about the dollar. “You must no doubt be impressed to see the extent to which we Europeans are directly interested in the strength of your currency. This is true because … it would be disastrous for the international monetary system and thus for the entire free world should the accords of last December … become only a precarious pause along the path to a new crisis.”7 The French hated the exalted status of the greenback, but could not help pleading for the dollar to remain the hub of international finance. Perhaps a split personality is the real French disease.
Volcker knew that Pompidou had identified a serious problem. The absence of an American commitment to sound money would weaken the dollar and torpedo the Smithsonian Agreement. He recalled the meeting he had in London on August 16, 1971, with the finance ministers of America’s trading partners to explain the New Economic Policy. Johann Schoellhorn of the West German Ministry of Economics had led off the questioning with whether “there had been any decisions on monetary policy.”8 Volcker had responded, “Since the president was announcing a [wage-price] freeze, he would not want to flaunt this by raising interest rates.” But after the recent drop in rates, Volcker had run out of excuses. He expected the Smithsonian accord to collapse sooner rather than later.
It did, but the country that led its downfall surprised him.
Volcker could not fight the president, so he battled the Federal Reserve chairman instead. On Friday, May 12, 1972, in Montreal, Arthur Burns gave the keynote speech before an international monetary conference sponsored by the American Bankers Association. He confronted the assembled financiers from twenty countries with an apocalyptic threat: “It is an urgent necessity to start the rebuilding process [of the international monetary system] quite promptly … If cooperative efforts … are long postponed … we might then find the world divided into restrictive and inward-looking blocs … a world of financial manipulation, economic restrictions, and political friction.”9
Burns presented a Ten-Point Program to avoid disaster, including a call for responsible domestic economic policies, a confirmation of greater exchange rate flexibility in a revised Bretton Woods System, an endorsement of a diminished role for gold as a monetary asset, and a plea for greater international cooperation. None of these was considered confrontational, except perhaps for the last comment on cooperation, which was a swipe at Connally for his aggressive negotiating style. The treasury secretary had been referred to as “Typhoon Connally” during his fall 1971 trip to Japan.10
Burns then stuck his nose where it did not belong by suggesting that America restore “some form of dollar convertibility into gold” as part of the total package of reforms. Volcker, who represented the Treasury at the conference in Connally’s absence, was not pleased. He believed (at least at this point in his career) that U.S. international financial policy was made at 1500 Pennsylvania Avenue, next door to the White House, in the building fronted by a statue of Alexander Hamilton, the first secretary of the treasury, and not in the marble edifice on Constitution Avenue that housed the Federal Reserve Board. “The Treasury was in charge of America’s gold, and we had not yet decided what to do about convertibility, except that it was best to say nothing. Arthur had gotten too far ahead. We could never resume convertibility without running a sustained surplus in our balance of payments. And for that we would need further concessions on exchange rates.”11
Volcker held a news conference repudiating the authority of the Federal Reserve chairman in terms that would have made John Connally proud. He assured everyone that Dr. Burns “is not speaking for the United States government” and added that Burns’s statement “certainly wasn’t any kind of a model for reform.”12 The press described the Treasury’s view of Burns’s Ten Point Program as “not being in quite the same class as the Ten Commandments that Moses brought down from Mount Sinai.”13
Arthur Burns did not like having his authority challenged, although the reference to Moses probably fed his ego despite the negative context. When asked why he had spoken out on convertibility when the administration had refrained from putting forward any specific proposals, he said, “In the United States we have an independent central bank. This was my decision.”14 Apparently Burns believed in an independent central bank when it came to gold but not interest rates.
On Tuesday, May 16, less than a week after Arthur Burns launched his guided missile at the U.S. Treasury, John Connally dropped a bombshell of his own. He resigned as secretary of the treasury. Connally had been saying that he “was tired after his eighteen months of service in Washington,” but no one had listened.15 The New York Times political columnist Jam
es Reston speculated that this was a prelude to the national elections in the fall, designed to “give the Republicans Texas in November … on a Nixon-Connally ticket.”16 But that prediction never materialized. Spiro Agnew remained Nixon’s running mate, and Connally returned to Texas to practice law.17 No one in Washington missed him more than Volcker.
“It was a great personal loss,” Volcker deadpans. “I had already thrown out all of my argyle socks.” And then he adds, “I learned how to get things done from a master tactician. His tough talk produced results because he had the political clout to back it up. And that was because he not only ran the Treasury but was also the chief economic spokesman for the administration. He sat at the head of the table, a position that promotes success … if you follow through.”18
Connally’s rough negotiating style had won grudging admiration abroad. Britain’s national daily newspaper the Guardian called him “a political superstar, the Nixon administration’s John Wayne.”19 His record at Treasury also garnered qualified praise from a not-so-friendly domestic press. The New York Times editorialized: “History has still to decide whether his tough tactics did more harm or more good. Unquestionably, his threats and pressures did produce a realignment of exchange rates more advantageous … than had been anticipated.”20 And the Washington Post reported, “European finance ministers with whom he came in contact stood in positive awe of him, and found him a shrewd and tough bargainer.”21
The president coupled the announcement of Connally’s resignation with the appointment of George Shultz to succeed him. Nothing could have been more threatening to Volcker, except perhaps if Milton Friedman himself had set up a classroom inside the Treasury Building. Shultz had tried to convince Nixon to accept floating exchange rates and had denigrated Volcker’s earlier support for the status quo. Moreover, Volcker had thrived under Connally’s bare-knuckle diplomacy, perhaps because foreign finance ministers were pleased when Volcker showed up to talk instead. He would not enjoy that advantage compared with Shultz, who was as conciliatory in public as Connally was confrontational.
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