Throughout 1970, principal attention was on domestic concerns. An occasional comment at FOMC suggested that policy should be as tight as possible, given domestic concerns. Usually, Hayes or his representative made this case. It did not have much effect on Burns or decisions.80 Burns’s main concern was the rising unemployment rate and, of course, the Penn Central bankruptcy and its aftermath. In September, Pierre-Paul Schweitzer, managing director of the IMF, caused a stir by urging the United States to finance its deficit using reserve assets, not euro-dollars. This irritated U.S. policymakers but did not affect policy.
79. At the turn of the year, the administration issued new credit restraint guidelines, slightly more relaxed than 1969. The Board was reluctant to relax its lending guidelines. It accepted the administration’s proposal when Chairman Burns assured the members that the revisions were “quantitatively insignificant” (Board Minutes, January 5, 1970). The new guidelines removed the exemption for Japan.
Solomon (1982, 177) reported that by spring 1970 domestic interest rates had fallen below euro-dollar rates, causing banks to repay euro-dollar holdings in excess of their reserve free bases. The payments deficit reached $3 billion in the fourth quarter and nearly $10 billion for the year. German reserves rose by about $6 billion as German companies borrowed euro-dollars to circumvent the relatively high interest rates at home. Belgium, the Netherlands, and Switzerland also experienced large inflows. Unlike Germany, these countries had not agreed formally to refrain from demanding gold, so they requested exchange guarantees on their swap lines (ibid., 177).
The FOMC and the Board returned frequently to consider possible actions the System could take to absorb euro-dollars or get U.S. banks to increase their holdings. At a Board meeting in November, Burns asked Robert Solomon for a staff recommendation. Solomon suggested reducing reserve requirements on demand deposits to release reserves equal to the amount of a bank’s euro-dollar borrowing (Board Minutes, November 24, 1970, 7). Neither this nor other proposals became policy.
Europeans complained about the easy monetary policy and urged the United States to rely more on restrictive fiscal policy. And Coombs reported that attitudes in Europe had started to turn. “Rather strong resistance was developing to the SDR operation and strong impetus was being given to the European Monetary Union—not simply as a long-range plan but also as a contingency plan in the event of a breakdown in the international payments system” (FOMC Minutes, February 9, 1971, 8). This change probably reflected the growing belief that the United States would not act to stop the outflow. Earlier, “an intensive discussion of limited exchange rate flexibility . . . [showed] more support for, and less opposition to, limited flexibility than was indicated in the earlier discussion in the Fund” (FOMC Minutes, May 5, 1970, 12).
The U.S. gold stock reached a local peak of $11.9 billion in February 1970, $1.2 billion above March 1968, when the two-tier system began. In August, it began the final decline leading to the end of the $35 gold price. By May 1971, the stock was below the March 1968 level. Part of the decline reflected requests from countries that had to pay part of their increased IMF quota in gold.
80. As the recession ended, Burns told the FOMC: “The Committee members recognized the risk on the international side of moving to lower rates but most thought it was necessary to take that risk” (FOMC Minutes, November 17, 1970, 101).
Until 1970 or 1971, changes in the U.S. current account balance mainly reflect changes in relative unit labor costs. After 1970, the situation changed dramatically. The current account deficit and relative unit labor costs are positively related (Meltzer, 1991, 70–71). Chart 5.5 shows the current account balance. The balance fell from 1964 to 1969, rose during the recession, then plunged. The United States now had a current deficit in addition to its net capital, military, and foreign aid spending abroad. To an observer at the time, the prospects for an end to the dollar outflow seemed remote or unlikely.
There was no sense of panic within official institutions. Robert Solomon again told the FOMC in January that “he felt there was no reason for the balance of payments to be a variable influencing the decisions in the domestic sphere” (Maisel diary, January 13, 1971, 1). It was important “to do something about the [euro-dollar] problem . . . to show its [our] good faith” (ibid., 2). The main reason for restricting the euro-dollar outflow was to convince the Europeans that we would cooperate. That was important for two reasons, avoiding a crisis and issuing more SDRs. “If a crisis occurred they would be more willing to cooperate” (ibid.) Despite rapidly growing international reserves, Solomon’s concern was to issue more SDRs. The Europeans had agreed to the first allocation because of the official settlement surplus; if euro-dollars outflow increased the official settlement deficit, “everyone could well argue that there shouldn’t be any new creation until the official settlement deficit of the United States had been stopped” (ibid.).81 This had been the French position all along.
At a March 12 meeting of the Board and the Council of Economic Advisers, Maisel asked Herbert Stein about the Council’s view of the balance of payments. The response surprised him: “we would be better off suspending payments and letting the dollar or other currencies float in the exchange market. . . . [Secretary] Connally felt even more strongly that this was true” (Maisel diary, March 12, 1971, 28).
This was not the official Council view. A lengthy memo from Chairman Paul McCracken to Peter Peterson, head of a new Council on International Economic Policy, proposed increased flexibility of exchange rates but did not mention floating the dollar. McCracken noted that part of the difference between the U.S. and the Europeans reflected the relative importance of the United States in world trade but the small relative size of trade as a share of U.S. GDP. He concluded that the United States had an obligation to achieve balance in its economy but, if payments problems remained, the surplus countries would have to adjust. And he suggested that this was likely to occur because a decline in the U.S. trade deficit would create or increase deficits elsewhere, leading to exchange rate adjustment by the deficit countries and renewing our problem (memo, McCracken to Peterson, Nixon papers, Box 98 Council on International Economic Policy, April 5, 1971).
Some explicitly opposed both floating rates and neglect of the payments imbalance. Coombs regularly expressed concern about a gathering “speculative crisis. . . . Corporation treasurers and other traders were now beginning to hedge against the risk of parity changes over the weekend— the first time that type of speculation had been seen in nearly two years” (FOMC Minutes, April 6, 1971, 3). European central banks reduced their discount rates, but the market interpreted the reduction as a response to international flows; the flows increased. Then Coombs warned: “In recent years the market has been listening to a great deal of official discussion of the virtues of exchange rate flexibility. . . . [W]idespread uncertainty had developed in financial markets both here and abroad as to whether the dollar and other major currencies would in fact be forcefully defended if they came under pressure” (ibid., 4).82
81. The main action was a Treasury decision to have the Export-Import Bank issue debt to the euro-dollar banks. This would absorb euro-dollars. To increase banks’ incentives to buy the new securities, they became eligible for inclusion in a bank’s reserve base used to calculate reserve requirements on euro-dollars. To supplement the Treasury’s action, the Board began offering repurchase agreements to absorb euro-dollars, as much as $1.5 billion in the first month (Maisel diary, January 13, 1971, 8).
The predicted crisis came the next month. The capital outflow reached $4 billion in the first week of May following an announcement by the German Research Institutes that floating the mark was necessary to stop inflation. The Bundesbank stopped purchasing dollars followed by the central banks of Switzerland, Netherlands, Belgium, and Austria. The Treasury issued a statement saying that there was no reason for changing exchange rates. The mark appreciated against the dollar by about 4 percent, from 3.63 in April to 3.51 in June. Appreciation
continued.
Volcker did not share the Treasury position. He saw the crisis as an opportunity and urged that the United States should “permit [the] foreign exchange crisis to develop without action or strong intervention by the U.S.” (paper prepared in the Department of the Treasury, Department of State, May 8, 1971, Department of the Treasury). After the crisis developed, the United States would threaten to suspend gold convertibility, impose trade restrictions, and reduce overseas military support in Europe and Japan.83 Volcker proposed five major changes: (1) a significant revaluation by major European countries and Japan; (2) an agreement to shift more of the military costs of defense to Europe and Japan; (3) a relaxation of trade restrictions by Europe and Japan; (4) sharing of foreign aid; and (5) greater exchange rate flexibility, phasing out of gold, and avoidance of exchange controls.
A memo to Volcker from the U.S. executive director of the IMF reinforced his view that the currency revaluations were a possible opportunity for reform. The memo proposed to get agreement on a $6 to $8 billion change in the United States payment position to be achieved by realignment of exchange rates. The U.S. would agree to give up its reserve currency position in exchange for exchange rate realignment and greater contribution by the Europeans to expenditures for world security (Volcker, 1970).
82. Coombs reported that he had started forward operations in marks to stabilize the dollar. This surprised Burns and the others, since they had not been asked or told. Coombs had cleared the operation only with the Treasury. The outflow of dollars to Europe and Japan reached $2.4 billion in February and over $4 billion in March.
83. On June 3, Congressman Henry Reuss introduced a resolution calling for an end to gold convertibility and a floating dollar unless a new international monetary conference convened to resolve outstanding issues. In the Senate the following day, Senator William Proxmire, chairman of Senate Banking, said that the Treasury would soon accept floating, though the administration denied it (Congressional Record, June 4, 1971, 18148–49).
From Volcker’s perspective, the two years he committed to negotiations were up. It was time to move unilaterally and force the changes that other countries were reluctant to make. Secretary Connally and the president had not yet reached that conclusion, but soon thereafter the secretary persuaded the president to take a modified version of Volcker’s proposal as part of the New Economic Policy.
Directors of the New York reserve bank voted to increase the discount rate by 0.5 percentage points to 5.25 percent. Their aim was to slow the dollar outflow by reducing the interest spread between New York and Europe. With inflation at 4 percent or more, the 5.25 percent rate seems a modest move. The action received little support at the Board. It decided to do nothing and informed New York that the Board rejected the higher discount rate. This lack of response reinforced the growing belief that the United States followed the policy of “benign neglect” publicly advocated by Gottfried Haberler and others.
Germany found that it faced a standard problem; it had to sacrifice one of three policies—unrestricted capital movements, independent policy to control domestic inflation, and fixed exchange rates. It tried first to get agreement on a joint float of the European currencies but found no support. Instead of additional controls of capital flows, as France and others proposed, it continued to float. The mark appreciated by 3 or 4 percent and the Swiss franc by 7 percent (Maisel diary, May 11, 1971, 39). Japan announced that it planned no parity change.
The United States was prepared for larger exchange rate changes. Volcker had commissioned a study of the overvaluation of the dollar. It suggested that the overvaluation was 10 to 15 percent (Volcker and Gyohten, 1992, 72). While he did not urge a floating rate for the dollar, he advised Secretary Connally and others that he “was pessimistic on prospects for negotiating a large enough change in parities to deal with the situation” unless the system underwent major reform (ibid., 73).84
In a meeting with President Nixon, Volcker and Burns disagreed. Volcker warned that the German decision to float the mark would subject the dollar to speculative pressure and would encourage speculators to sell U.S. assets. Protecting the dollar would require large-scale borrowing. The short-run effects of dollar devaluation might be negative, but exports
84. Volcker wanted to float at least temporarily: “Burns was against me. I wanted to get to a more sustainable rate, maybe with a much wider band” (Volcker, 2001).
would increase and the U.S. could remove capital controls. He added that any defense of the dollar had to include reduction in the inflation rate.
Burns wanted the president to speak out against the German decision to float. His argument was political. “If the Germans move, they’re going to blame us, and our political opponents at home are going to blame us.” He urged the president to call an international conference for the coming weekend (White House tapes, conversation 490-24, May 4, 1971).
The immediate problem ended with West Germany and the Netherlands floating and revaluations by Switzerland and Austria. Burns wrote to the president and Secretary Connally warning that the crisis was not over and that the United States might have to suspend gold sales. He proposed some tactics. The best course, he said, was to “make it appear that other governments had forced the action on us” (letter, Burns to the president, Burns papers, BN1, May 19, 1971). He urged the president to pay out as much as $2 million in gold before closing the gold window and blame the countries demanding gold. That would improve our bargaining position in the negotiations that followed.
Although the German decision to abandon the fixed rate system signaled growing dissatisfaction with U.S. policies, Paul McCracken minimized its importance. He told the president that the “four countries who changed their exchange rates account for roughly 11 percent of the developed world’s GNP” (McCracken to the president, Nixon papers, Box 42, May 17, 1971, 1). He proposed an unchanged policy and suggested that the president “communicate to Arthur Burns that you support fully the expansive monetary policies of the Federal Reserve this year” (ibid., 2). This was bad advice. The exchange rate system had lost support. A few weeks later, McCracken rethought his position and urged the president to promptly support implementation of the IMF’s flexibility study calling for wider bands and a moving peg (ibid., June 2, 1971, 2).
Secretary Connally reacted strongly to McCracken’s changed position. His sharp response suggests that he had not yet shifted to the decision he urged on the president only six weeks later. His response to McCracken was that he favored increased exchange rate flexibility “without—and this is the key—undermining confidence in the dollar and the general stability of the monetary system. Should we fail, forces of economic nationalism and isolation in one country after the other—including the United States— could become unmanageable.”
The Quadriad meeting on June 5 shows the lack of importance attached to international policy. The summary of the meeting made no mention of international economic policy and offered no suggestions for a less expansive domestic policy. Burns again urged a price-wage policy and followed it up with a memo proposing a six-month price-wage freeze beginning in January (memo, Burns to president, Nixon papers, June 22, 1971).85
At the end of May, Secretary Connally made a speech to an international banking conference in Munich. He forcefully restated the United States’ position: others must share more fully the burdens of maintaining the open trading system and paying for common defense. He ended by forswearing devaluation, a change in the gold price or continued inflation.86 Connally elaborated on his policy views after a Quadriad meeting with the president late in June. There would be no change in policy, at least not yet.
Volcker had a different idea. With John Petty and William Dale, he developed an operational plan for a unilateral suspension of gold payments, devaluation of the dollar, restoration of convertibility, and reform of international arrangements. He proposed to float the dollar until it reached a new equilibrium without gold convertibility. Connally insisted that Volc
ker add an import surcharge; although Volcker opposed the surcharge, he did include it. This memo became one part of what the administration called a New Economic Policy after August 15. The rest of the program included a domestic anti-inflation policy “to persuade foreign governments that were not to bear alone the full burden of correcting the dollar’s overvaluation” (Gowa, 1983, 148). The proposals included wage and price control and a cut in government spending.
The Federal Reserve divided over the benefits of devaluation. Coombs, Daane, and probably Burns wanted the Germans, Dutch, and others to go back to the old parity and fix their rates. Burns preferred exchange controls to devaluation, and he opposed Volcker’s proposal to float. Solomon, Maisel, and most of the other Board members accepted the revaluations and wanted Japan to revalue as well. The staff estimated that by 1973, the revaluations that had occurred, and a 10 percent appreciation of the yen, would reduce the payments deficit by $750 million (Maisel diary, June 8, 1971, 49–50).87
85. Coombs told the FOMC that “the reaction of the other European governments to the floating of the mark had been uniformly hostile” (FOMC Minutes, June 8, 1971, 5). Later that month the governments agreed not to place any deposits in the euro-dollar market. The French resisted because the “United States was not offering to do anything” though it was responsible for current problems (ibid., June 29, 1971, 8).
86. The following anecdote describes Connally’s approach. Volcker asked him whether he wanted to dismiss devaluation so strongly. “We might have to end up devaluing before too long. . . . ‘That’s my unalterable position today. I don’t know what it will be this summer’ ” (Volcker and Gyohten, 1992, 75). Volcker did not consider changing the gold price. This “would have been considered an enormous psychological defeat for the United States, as well as financially unsettling” (Mehrling, 2007, 174).
A History of the Federal Reserve, Volume 2 Page 10