A History of the Federal Reserve, Volume 2
Page 5
The outflow from the London gold pool continued and showed signs of increasing. Hayes (New York) reported that several members of the pool had discussed a temporary suspension of gold trading if another surge of demand occurred. Perhaps with an eye on the falling U.S. gold stock, Italy and Belgium announced that they would not stay in the gold pool indefinitely (ibid., December 12, 1967, 15). “There was a growing sense of disenchantment. Mr. [Karl] Blessing of the German Federal Bank, one of the country’s most loyal friends in Europe, said that if the deficit in the U.S. balance of payments remained large the group’s discussions might as well be brought to an end because they would be futile” (ibid., 17). The program that President Johnson announced on January 1, 1968, tried to satisfy European demands to slow U.S. investment in Europe.39
39. According to Martin, the president’s new program convinced members of Congress that he had solved the problem, so they did not have to increase tax rates. This set off a new run on gold. Martin called the central bank governors and explained that the United States understood that its payments and budget deficits were “intolerable.” “Steps are going to be taken as rapidly as possible to correct this” (extemporaneous remarks, Martin speeches, April 19, 1968, 3). The central bankers “agreed to continue in the pool operations” (ibid., 4).
The FOMC did not discuss a more restrictive monetary policy. The economy was emerging from the 1966–67 slowdown, so the System did not consider the classical solution to a currency problem—higher interest rates and slower money growth. In fact, it didn’t mention any change to give greater weight to its Bretton Woods obligation. Even repetition of Blessing’s clear warning made no difference. They placed their hopes on the surtax and devoted their efforts to persuading Congress, especially a reluctant Chairman Mills of the Ways and Means Committee.
As pressures on the pound and the dollar continued, Coombs came to believe that the pound could not be maintained at $2.40. He wanted Britain to borrow at the IMF to repay its liabilities to the United States. At the Board, Solomon argued the opposite side. Events showed him to be right. By early 1969, the British had a large current account surplus from which they repaid many of their debts (Solomon, 1982, 99).
The United States had the bigger problem. Controls on foreign lending and investing and government purchases were insufficient in 1967 to offset costs associated with the Vietnam War. The payments deficit (liquidity basis) reached a $7 billion annual rate in the fourth quarter. The administration responded with the additional “temporary” controls announced in the president’s message on January 1, 1968. The hope at the time was that over the longer term, Vietnam spending would decline and exports would increase enough to restore balance. The administration did not develop a long-run program, however.40 It relied on wage and price guidelines to control production costs, mandatory guidelines to control overseas investment, and the panoply of short-term measures discussed earlier. When the president announced the program on New Year’s Day, he said that it would bring the balance of payments close to equilibrium in 1968 by restricting $3 billion of outflows. Instead, the current account balance declined by $2 billion. By late January, the administration considered allocating an additional $500 million for the Export-Import Bank to encourage exports in 1968.
40. Ackley’s discussion of the administration’s international economic policy explains that most of the policy actions originated in the Treasury.
We generally loyally supported the Treasury view . . . to have exchange controls without really having them, to invent ways of enticing or persuading foreigners to hold dollars and not demand gold, and to keep patching things up . . . to save what was probably an unsaveable situation. . . . [W]e did get by without any serious trade restrictions. We did a lot of stupid things in the government account: we spent a hell of a lot of money to buy in ways that minimized the balance of payments strain; we shipped beer to Germany for our troops to drink over there. . . .
[T]his is one of the areas where I, at least, believed that the scientific or professional involvement in the political process really involved some conflicts. (Hargrove and Morley, 1984, 265)
The president’s program received a mixed response.41 The gold outflow slowed, at first, but did not stop. At its February meeting, the bankers on the Federal Advisory Council told the Board that the program did not “come to grips with the basic problem” (Board Minutes, February 20, 1968, 30). They wanted “unmistakable evidence of fiscal restraint” (ibid.) and a determined effort to reduce inflation. Chairman Martin responded that “he was discouraged about the number of people who were expressing a non-cooperative attitude on the grounds that they expected the program to break down” (ibid., 30–31). He urged the bankers to reject the defeatist attitude and urge others to do the same.42
The president sent his advisers to brief foreign governments just ahead of his announcement. Coombs reported on European concerns. As usual, they wanted the capital outflow from the United States to end, but they feared that higher U.S. interest rates would cause them to increase their rates. They favored the tax surcharge as a way of avoiding tighter monetary policy (FOMC Minutes, January 9, 1968, 13). Robert Solomon reported, however, that at Working Party 3 late in January, the members expressed willingness to cooperate by expanding their economies as the United States adopted the surtax and other restrictive actions. “Even the French representative was anxious to have other continental European countries pursue expansionary domestic policies” (ibid., February 6, 1968, 15). President Johnson emphasized that he had maintained his commitment to European defense and had avoided trade restrictions. He asked for the reaction abroad to the border tax proposal. The response was that foreign governments would not retaliate, if the tax was legal under GATT rules. The president decided not to propose the tax to Congress (Department of State, report of Nicholas Katzenbach and Frederick Deming to the president, January 7, 1968).
41. The president’s advisers split on two other recommendations. One put a border tax on imports and rebated indirect (real estate, excise, etc.) taxes on exports. The second taxed tourist expenditures. Vice-president Hubert Humphrey argued that politically the administration could not put a mandatory tax on tourism and keep voluntary restraints on capital investment abroad (Department of State, Minutes Cabinet Committee on the Balance of Payments, December 21, 1967). The president rejected both proposals. “I don’t like the ‘border tax adjustment’ at all. . . . It will stimulate speculation as a step toward devaluation. . . . It hits at an area that is not the root of the problem. . . . The tourist tax proposal is complicated— cumbersome—will obviously produce only limited results—advertises weakness to millions of people . . . inhibits international good will . . . certain to be used by the Republicans in an election year” (Dept. of State, telegram, President Johnson to Joseph Califano, December 23, 1967). The president proposed tax reduction for businesses that repatriated foreign capital and earnings. Taxation of foreign earnings was still under discussion in 2004.
42. Parts of the program violated rules of the General Agreement on Tariffs and Trade (GATT). By exempting Canada, Mexico, and Caribbean countries from new duties on tourist purchases, it violated the most favored nation clause that required equal treatment. Flat-rate duties on all tourists’ purchases differed from the specific duties negotiated under GATT, also a violation (letter, Trade Negotiator William Roth, to Secretary Fowler, Department of State, March 8, 1968).
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.43 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.44 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.45
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.46 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 pr
ice 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).47
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.48 Participants recognized that if the market price fell below $35, some central banks might try to take advantage of the price spread.