A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  The memo turned near its end to negotiations over creation of SDRs. It again compared the U.S. position to the European, then added, “Failure to achieve agreement on a large amount would be one of the important factors pointing toward a shift to the second [unilateral] option of suspension” (ibid., 42). The group expressed a willingness to negotiate but not to take the $2 to $2.5 billion that the Europeans proposed. The SDR agreement reached in late July allocated $3.5 billion the first year and $3 billion in each of the second and third years. Also, countries agreed to increase IMF quotas by 30 percent.

  In a separate memo, Paul McCracken supported the “evolutionary approach” through multilateral negotiations. He disagreed with the Volcker group on two points. He did not believe that greater flexibility of exchange rates would “unsettle the foreign exchange markets,” and he placed less emphasis on getting a larger allocation of SDRs. The “additional liquidity can only make a modest contribution to the adjustment process” (McCracken to the president, Nixon papers, June 25, 1969, 1–2). Excessive exchange rate rigidity, he said, was the main reason for current problems. McCracken suggested also that he was less certain about the contribution of capital controls and preferred a phased reduction.72

  Discussion of greater exchange rate flexibility began in March. In December 1969, Robert Solomon forwarded to the FOMC a staff report on progress and problems. In all of the discussions, participants assumed that the dollar would remain pegged to gold at $35 an ounce and that other currencies would peg to the dollar. The report recognized that the dollar could remain overvalued for long periods (Greater Exchange Rate Flexibility: Report on Bilateral Technical Discussions, Board Records, December 30, 1969, 1–2). Foreign participants were more concerned about the lack of monetary discipline that would result from wider bands or more frequent adjustment.

  72. Henry Kissinger’s memo on the Volcker group proposal supported the main conclusion but added a skeptical note: “It will be extremely difficult to reach a negotiated multilateral agreement on a sufficient scale within a relevant time period unless the alternatives are clearly perceived as worse by the key Europeans” (Department of State, Kissinger to the president, June 25, 1969). Kissinger then asked how long they should pursue the multilateral approach. His answer was that commitment to that approach could last longer if we removed constraints on our behavior (capital controls, tied foreign aid, etc.).

  One of the Europeans’ main continuing concerns about wider exchange rate bands again came from their agriculture policy. Any change in exchange rates would be reflected in agricultural prices causing political and economic repercussions within the European Community.73 The community was trying to find ways to narrow exchange rate bands for its group. “Most of the reactions [to wider margins] . . . is that margin widening is unnecessary and a belief that the results would be positively harmful” (ibid., 5). Some countries considered a 5 percent margin tantamount to a system of floating rates. Participants raised fewer objections to 2 percent bands, but “there was no evidence of any enthusiastic support for marginwidening” (ibid., 7).

  Criticisms and objections to wider bands carried over to other proposals such as crawling pegs. Participants expressed more interest in a one-sided arrangement, in which surplus countries would appreciate but deficit countries would not depreciate. The intent was to preserve discipline and avoid competitive devaluation.74

  Although the discussions were preliminary and at the technical level, they gave very little support to those who favored multilateral negotiations. A discussion with the French Minister of Economy, Valéry Giscard d’Estaing, drew a more positive response. At an informal discussion, the minister accepted the idea of limited exchange rate flexibility for the dollar against the European currencies after inflation had been lowered and the gold price increased (telegram, American Embassy in Paris to Secretary of State, Nixon papers, August 4, 1969, 3).

  Events changed attitudes. When the Group of Ten deputies discussed increased flexibility, Solomon reported that “there is more support for, and less opposition to, limited flexibility” than in earlier discussions (FOMC Minutes, May 5, 1970, 12). A crawling peg, or more frequent adjustments, attracted most support. Wider bands did not appeal to the Europeans.

  Euro-dollars

  The inflow of euro-dollars became a principal concern in 1969. The problem was that the System had increased interest rates but had not changed regulation Q ceilings. To offset the loss of time deposits, banks borrowed in the euro-dollar market. Complaints from European countries rose because the flow of euro-dollars toward the United States increased pressure for higher interest rates in their countries. The Federal Reserve, for its part, did not raise regulation Q ceiling rates because it feared again that the market would interpret the increase in the volume of CDs as evidence of monetary ease and, therefore, lack of commitment by the Federal Reserve to its announced anti-inflation policy.75 Some members of FOMC subscribed to this view.

  73. Under the Common Agricultural Policy, agricultural prices were the same in member countries and expressed in a common unit. A revaluing country would have to reduce agricultural prices and a devaluing country would have to raise them. The revaluing country would then increase subsidies to producers.

  74. Gowa (1983, 144–47) argues that Volcker did not actively pursue exchange rate revaluation by surplus countries during this period.

  By mid-February, two positions began to develop at the Board and FOMC. Brimmer wanted controls on euro-dollar borrowing by domestic banks. His reasoning was that euro-dollars were not subject to bank reserve requirements. Hence, banks could make “unwarranted reductions in reserve requirements” (Hackley, Board Minutes, February 19, 1969, 11) Most governors agreed, but Governor Robertson objected that the Board did not understand enough about these operations to regulate them. This did not prevent action. The vote directed the staff to prepare and publish amendments to regulations affecting reserve requirements.

  At most FOMC meetings the System reported complaints from the Europeans about the effect of higher euro-dollar rates on rates in their markets.76 The Board staff proposed a marginal reserve requirement on euro-dollar borrowings by placing a reserve requirement ratio on deposits above some initial ceiling, but it wanted to avoid subjecting these deposits to regulation Q ceilings. Governor Mitchell was not convinced. He thought that acting without more knowledge of the effect was a mistake (Board Minutes, May 28, 1969, 13). Only Governor Brimmer urged prompt action. A month later, the staff returned with more information. They proposed a 10 percent reserve requirement ratio on deposits above a base period value, and they now argued that the current capital inflow, followed by an outflow at a later date, would affect the stability of the dollar exchange rate.

  By June banks borrowed about $1 billion a week on the euro-dollar market. Interest rates reached as high as 13 percent for overnight loans. Pressed by some European governments, the Board issued new regulations for comment and on August 13, 1969, imposed the restrictions effective October 16. Banks that borrowed from foreign branches, or purchased assets from those branches, and foreign branches that made loans to customers in the United States, became subject to 10 percent requirement for all transactions above a 3 percent base of deposits. To restrict a later return flow to the euro-dollar market, the Board lowered a bank’s base by the full amount by which liabilities to foreign branches fell below the 3 percent base. The intent was to restrict growth of the euro-dollar market and moderate flows. Governors Mitchell and Daane dissented, claiming, in Mitchell’s words, that “specific evidence that overall monetary restraint has been significantly diluted is lacking” (Board Minutes, June 25, 1969, 18). Both agreed that the regulation was complex and difficult to enforce. With hindsight they might have added that the new regulations encouraged banks to seek alternative sources of funds, such as commercial paper. This probably contributed to the rapid growth of bank related commercial paper and the Penn Central crisis the following year.77

  75. This reasoning i
s repeated by the staff and members of FOMC. It suggests that eurodollar borrowings are a less than perfect substitute for bank CDs. A more plausible explanation is that corporations deposited surplus funds in the euro-dollar market instead of the domestic CD market to earn the higher return, and banks borrowed in the euro-dollar market instead of the CD market.

  76. A typical example is Robert Solomon’s report (FOMC Minutes, April 29, 1969, 38): “The WP-3 discussion was concerned not with the posture of U.S. monetary policy but with whether the United States should not do something to temper the effects of its tight money policy in the Euro-dollar market.”

  The new regulations did not end criticism. As domestic rates in the United States declined in the 1969–70 recession, the flow reversed. Now Europeans complained about the sizeable reflow of dollars. At the January 1970 meeting of OECD’s Working Party 3, critics recognized the cause of their problem. “Regulation Q once again came in for considerable criticism. Some delegates went so far as to say that there would not be a Eurodollar market if it were not for regulation Q” (FOMC Minutes, February 10, 1970, 17). These criticisms continued. The flows were sizeable; between December 1968 and November 1969, “liquid liabilities to commercial banks abroad” rose $10.2 billion, 71 percent of the December value. A year later, these liabilities were back to $18.6 billion, a decline of more than $6 billion.

  The Franc and the Mark

  Coombs warned the May 27 FOMC meeting that “the present international situation was the most dangerous of any that had yet been encountered” (FOMC Minutes, May 27, 1969, 7). Germany’s failure to revalue put pressure to devalue on Britain, France, Belgium, Denmark, and possibly some others. A string of devaluations would “have ominous implications for the U.S. foreign trade position which was already bad enough” (ibid.). Coombs also expressed concern about the euro-dollar market. He feared that foreigners would take “drastic restrictive action on the credit side in order to protect their reserve positions” (ibid., 8). Also, there would be some “spectacular bankruptcies.”

  77. Maisel (diary, June 26, 1969, 77–78) claims that the decisive change was Chairman Martin’s decision to support the new requirements. He had met with some European central bankers who wanted action. Also, with the federal funds rate above 9 percent, banks had raised their prime rates to 8.5 percent, setting off complaints from members of Congress. “Martin supported it because he was mad at the banks [for] using it to such an extent” (ibid., 78). Mitchell disliked the regulation Q ceiling and “felt that this was a logical way around [it]” (ibid., 78). At the same meeting, Martin opposed an increase in the discount rate to 6.5 or 7 percent, despite the 8.5 percent prime rate.

  The only action the FOMC took was to increase the amount of warehousing for the Treasury. The reasoning was that France would have to sell gold to repay the large volume of recent borrowing on its swap lines. The Treasury was reluctant to buy the gold at the time, so it wanted the alternative of warehousing with the Federal Reserve. The FOMC agreed to the increased warehousing (ibid., June 24, 1969, 15–17).

  France continued to borrow and lose reserves until it devalued by 4.25 percent on August 10 from 4.94 to 5.15 francs per dollar. France did not give any advance notice to the IMF or its European Community partners, as required by IMF rules, or to the United States, so the devaluation surprised the Federal Reserve and other observers. No countries (other than those that pegged to the franc) followed, but Belgium increased its swap line.78 At its next meeting the committee unanimously approved increases in the swap lines for Austria, Denmark, and Norway, bringing the total to $10.98 billion.

  A special meeting of the FOMC on August 12 showed greatest concern about avoiding effects on employment. Robert Solomon “in effect said that the balance of payments should not be used to influence domestic policy” (Maisel diary, August 13, 1969, 100). Euro-dollar borrowing had started to decline, but the general belief at FOMC was that the interest differences remained large enough to avoid a major decline in the official settlements deficit. By late October, euro-dollar rates had fallen to 9 percent (from 11), partly as a result of the forthcoming recession in the United States and partly as a result of an unwinding of positions in the German mark following revaluation.

  Following Germany’s revaluation by 9.3 percent to DM 3.66 per dollar, British payments went into surplus. The British chose to repay the European central banks and made only a token payment to the Federal Reserve. This irritated FOMC members. The United States was the largest creditor, with 71 percent of British debt (FOMC Minutes, November 25, 1969, 8). The Treasury did not support the Federal Reserve’s position about prompt British repayment. The Federal Reserve’s claims on the swap line now had sixteen months maturity, well above the earlier twelve-month maximum.

  78. The Belgian increase aroused some FOMC members. Phillip Coldwell complained that the FOMC responded to each crisis but did not consider the size of the contingent liability or its long-term implication. The FOMC asked the staff for a study of the basic purposes, ultimate size, maturity, and other aspects of the swap network (FOMC Minutes, September 9, 1969, 3). It must have been clear that the swaps had gone far beyond the original “experiment.”

  Hayes and Coombs expressed their irritation at the lack of Treasury support and at the Bank of England’s delay in repaying the United States. Some FOMC members expressed concern about the future of the swap lines, but no one proposed changes. The problem ended when Martin negotiated a better payment schedule by getting the Bank of England to reduce its payment to the Treasury and increase repayment of the swap line (FOMC Minutes, December 16, 1969, 10). Early in 1970, the Bank of England repaid the Federal Reserve and cleared its arrears.

  BEGINNING OF THE END

  “All in all, the official decisions, the academic debate, the performance of the markets, and the resentment about the restraints on policy sent a message that the Bretton Woods system was in deep trouble, and to a growing number, not worth saving” (Volcker and Gyohten, 1992, 47). The problems became more pressing as the long expansion of the 1960s ended. By September 1969, the monthly federal funds rate peaked at 9.19 percent and started to fall. In January the ten-year Treasury rate and in February the CPI inflation rate reached temporary peaks.

  The System and foreign governments were concerned about the prospect of a capital outflow to the euro-dollar market as domestic interest rates fell. To encourage banks to bid for time deposits, the Board, after discussions with the FDIC, the Home Loan Bank Board, and the Comptroller, raised ceiling rates on all types of savings deposits and negotiable CDs from 0.5 to 1.25 percentage points. The maximum rate for a one-year CD reached 7.5 percent. Opposition to the change came from two sources. Hayes and some others wanted to avoid the impression that FOMC had eased credit (despite the higher rates). He proposed regulation of commercial paper by applying a marginal reserve requirement ratio comparable to the ratio applied to euro-dollars earlier. Home Loan Bank officials’ main concern was the competitive position and profitability of thrift associations. They negotiated agreements on higher ceiling rates for their members (FOMC Minutes, January 15, 1970; Maisel diary, January 20, 1970, 9–15).

  An additional concern was to avoid a repeat of the 1966 experience, when the interest rate structure permitted commercial banks to drain sufficient deposits from other lenders to cause a major decline in lending for housing and state and local governments. Housing starts in 1970 remained at about the 1969 level. In 1966, housing starts had fallen 21 percent.

  The System was less successful in managing the capital outflow of $9.3 billion, much of it reflow to the euro-dollar market. The official settlements account went into surplus at $2.7 billion in 1969. On the liquidity definition that included changes in liquid liabilities to non-official holdings, the deficit was −$7 billion, a record.

  On January 1, 1970, countries received the first allocation of SDRs. The U.S. share was $867 million in 1970 followed by $717 and $710 million in 1972 and 1973. The Treasury issued $200 million of the i
nitial allocation to the Federal Reserve, increasing bank reserves and base money. The total allocation was $3.1 billion. In the same year, foreign exchange reserves of all countries increased $14 billion, and total reserves reached $91 billion, a 50 percent increase for the decade and a 22 percent increase for 1970 (IMF, 1971, 19). Countries did not agree to issue SDRs again until 1979. The SDR became an unimportant sidelight of international finance.79

  Despite the recession, the reserve banks kept the discount rate at 6 percent. The federal funds rate declined over the course of the year from 9 percent in January to 4.9 percent in December; growth of the monetary base rose from the recession low (3.8 percent) in January to 6.4 percent in December. By either measure, monetary policy eased, although the real value of annual monetary base growth was only about 1 percent. Stock prices continued to fall through June until they were 30 percent below the December 1968 peak.

  Euro-dollars continued as a major problem for foreign central banks. For West Germany, following revaluation, the more serious problem was a successful effort by the trade unions to increase their income. In 1970, gross hourly wages rose 13.9 percent and unit labor costs 11.6 percent (Holtfrerich, 1999, 310). Faced with rising labor costs and renewed capital inflow, Germany raised its discount rate to 7.15 percent and introduced a reserve requirement against new foreign deposits at German banks. The major inflow problem was still in the future.

  On May 31, Canada decided to float its dollar. The Canadian dollar rose modestly, from U.S.$0.932 in May to U.S.$0.984 in September. This was the first large country to (again) abandon the fixed exchange rate system. In September, Canada reduced its discount rate. The decision had no effect on Federal Reserve policy.