A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  The impetus for intervention came from Burns in response to repeated European complaints that the U.S. did nothing to maintain the Smithsonian parities. In March, the French had threatened to use exchange controls (FOMC Minutes, March 21, 1972, 13). Italy left in December 1972, France in January 1974. Germany learned not to repeat the inflexibility of Bretton Woods rates for the center country. It revalued four times between March 1973 and October 1978. The Dutch guilder and the Norwegian krone also revalued once. Other currencies devalued several times (Schwartz, 1987b, 31).

  36. Burns mentioned that an alternative to using swaps was borrowing from the IMF. “A Fund drawing would be accompanied by a great deal of publicity, it would raise questions of surveillance, and it would accomplish nothing that could not be accomplished with System drawings on swap lines” (FOMC Minutes, July 18, 1972, 13).

  The new agreement was less inclusive than the Smithsonian. Switzerland, Britain, and Italy joined Canada by floating. Further, the agreement did not last a month. Exchange markets reopened on February 14. By February 23, the gold price reached $89, more than twice the official price of $42.22, and the dollar weakened. On March 1, the Bundesbank bought $3.6 billion, then closed the exchange market. Once again the mark floated.

  During the first quarter of 1973, foreign central banks, mainly in the G-10, bought $10 billion. The purchases were more than 17 percent of G-10 foreign exchange balances at the end of 1972. Combined with strong beliefs that the United States did little to sustain the agreed parities, the inflow was sufficient to convince even the French to end the Bretton Woods system of fixed exchange rates with the dollar (Meltzer, 1991, 79).

  On March 16, 1973, a new system took shape. The continental European countries agreed to a joint float against the dollar, and the Japanese yen also floated. Countries agreed to intervene in exchange markets at their discretion.38

  Participants at the March 16 meeting may have believed that floating was a temporary expedient, a step along the path to an improved par value system. Agreement had not been reached despite several years of meetings and proposals.39 The oil embargo, the rise in the oil price and its effect on payments and imbalances, and the difficulty in reaching agreement on a new arrangement convinced the skeptics to accept floating as a permanent solution for major currencies. The Europeans continued by fits and starts to adopt fixed exchange rates and eventually a common currency within their region.40

  37. Others in the administration and the Federal Reserve agreed with Shultz. Volcker (Volcker and Gyohten, 1992, 107) says “the effectiveness of the controls was becoming more limited, and they had become an important irritant for international business.” The Federal Reserve had relaxed some of its voluntary controls in November 1971. Also, Commerce Secretary Maurice Stans proposed to weaken and end controls on foreign investment (letter Burns to Maurice Stans, Burns papers, Box B_B14, January 26, 1972). Burns agreed with the proposal but urged delay in implementing it.

  38. Arthur Burns participated in the March 16 meeting. Volcker described him as fearing “floating with a passion” (Volcker and Gyohten, 1992, 113). At lunch, he attempted to reverse the decision. “With some exasperation, I said to him, ‘Arthur, if you want a par value system, you better go home right away and tighten money.’ With a great sigh, he replied, ‘I would even do that’” (ibid.). But he didn’t. Annual growth of the monetary base remained above 9 percent.

  39. Before going to the March 16 meeting, Burns called a special meeting of the FOMC to discuss intervention in the foreign exchange market. Two opinions emerged. The first thought a European joint float would solve the problem and eliminate any need for intervention. John Balles (San Francisco) and Robert Mayo (Chicago) were spokesmen for this view. Alfred Hayes and Charles Coombs argued that a joint float would be followed by exchange controls. They argued that the main problem was lack of confidence. Intervention was necessary to restore confidence. As on several previous occasions (1928, 1936) the proponents of intervention and cooperation did not mention that real exchange rates had to adjust to restore equilibrium.

  During the summer of 1973, Coombs argued repeatedly for intervention, often with Burns’s support. At first his aim was to prevent depreciation but he became more ambitious. “Towards the end of July, I [Coombs] requested and secured Chairman Burns’s approval to switch . . . from purely defensive tactics to a more aggressive approach, designed to push the dollar rate up toward more realistic levels. After some delay, the Treasury also concurred. . . . Early in August, however, the situation turned completely the other way and the dollar was suddenly favored” (FOMC Minutes, August 21, 1973, 11–12).

  The weighted average value of the dollar fluctuated between monthly averages of 109.98 in January 1973 and 92.71 in July. See Chart 6.3 above. It then rose to 107.08 in January 1974. Fluctuations against the mark were much larger but in the same direction, down from January to July then up to the end of the year. Coombs did not mention that the U.S. inflation rate rose between 1972 and 1974 at a faster rate than inflation in Germany and several other countries. And neither he nor others who favored intervention expressed an opinion about the “correct” value that they wanted to maintain.

  After an informal agreement in January 1974 to permit floating rates, the finance ministers of the main developed countries agreed in November 1975 to an amendment of the International Monetary Fund agreement that permitted a country to float its currency. Effective January 1, 1976, countries could have either fixed or floating exchange rates. Although the initial experience with floating rates raised many criticisms of the size and frequency of changes, major currencies continued to float. More than four years after President Nixon’s decision to suspend convertibility, new and more flexible arrangements were in place. Gradually, countries relaxed capital controls finding them unnecessary with a floating rate.

  At the March 16 meeting in Basel, the United States made clear that the dollar would float and that it would intervene only if necessary to keep the market orderly. Coombs was in despair. The international system, he said, “has broken down so completely that it is difficult to describe even in general terms what is left of the system and how it may be expected to function in the future” (FOMC Minutes, March 19–20, 61). Obviously not all central bankers believe markets can achieve equilibrium.

  40. The United States and the Europeans continued to disagree about the role of gold (Volcker papers, National Archives, RG 56–79–15, Box 1, March 6, 1974). Eventually, gold was phased out of the system.

  THE DOMESTIC CONTROLS PROGRAM

  The New Economic Policy, announced on August 15, established a second arrangement for affecting prices and later interest rates. Monetary policy actions continued as before, but the new policy constrained most, but not all, prices and wages. Agricultural prices were a main exception. Interest rates responded to monetary actions, but the Committee on Interest and Dividends responded to congressional concerns by monitoring rates charged on mortgages and consumer credit. Its greatest influence was on dividends; it limited corporations to either a 4 percent increase or 25 percent of annual earnings.

  Burns testified against legislation that mandated control of interest rates. Competition, he said, was much more effective in financial markets than in product and especially labor markets.41 He now claimed that was why he favored mandatory controls on prices and wages but not on interest rates (Burns, 1978, 135–36). He promised Congress to monitor carefully the rates paid by consumers and farmers to assure that they promptly followed reductions in open market rates. His statement recognizes political concerns to protect particular groups.

  Congress did not make interest rate controls mandatory perhaps because market rates had fallen at the time Burns testified (November 1, 1971). Burns continued with the dual role of chairman of the Board of Governors and chairman of the Committee on Interest and Dividends. He turned down an appointment to the Cost of Living Council, but he served as an adviser. He believed that full recovery without inflation required increase
d profits and lower wage growth, so he wanted wage growth held to 3.5 to 4.5 percent (Wells, 1994, 81). This ran counter to the concerns of union leaders, especially their concern that wages would be restricted and profits allowed to rise (ibid.).

  Although union officers didn’t like it, the ninety-day freeze proved popular with the public. The president and several of his advisers disliked the program’s popularity. They preferred to weaken controls after ninety days, but they found it expedient to plan an effective and popular next step (Stein, 1988, 181).

  41. “Large segments of the labor market are fenced off from effective competition by trade unions or governmental regulation” (Burns, 1978, 136). The Board favored voluntary control of interest rates on loans to consumers with “no attempt to limit those interest rates set in the open market” (memo, Holland to Burns, Burns papers, Box B_B14, October 5, 1971).

  Phase 2

  Herbert Stein, chairman of a small planning group, considered a wide range of options including total decontrol. “My main interest was in getting out of controls promptly and in an orderly way” (ibid., 181).42 But the freeze remained popular, so Stein offered the president two options— (1) stay close to the freeze or (2) permit wages to increase 5.5 percent and prices 2 to 3 percent (ibid., 182). The president chose the second and announced the new program on evening television on October 7.43 He emphasized, not his concern, but his commitment to the program. After presenting his program to create new jobs, he turned to controls. “We began this battle against inflation for the purpose of winning it, and we are going to stay in it till we do win it” (Shouse, 2002, 45).

  The revised program had a seven-member Price Commission and a fifteen-member Pay Board, the latter designed to placate George Meany, president of the AFL-CIO. The Pay Board had five members each from labor, business, and the public. When Stein told the press that the Cost of Living Council would act as overseer for both boards, Meany objected. The administration retreated, and the two boards remained independent. The president appointed C. Jackson Grayson to head the Price Commission and Judge George Boldt to head the Pay Board.44

  The Pay Board adopted a standard that limited wage increases to 5.5 percent but permitted an additional 0.7 percent for increased benefits. But in one of its first actions, it approved a 17.5 percent increase for coal miners. The Price Commission showed its independence by refusing to allow coal companies to increase prices by the same percentage.

  Table 6.4 shows changes in average hourly earnings, productivity, and consumer prices during the period around phase 2. Real growth of hourly earnings rose 3 percent on average, the same as in 1970–71. Hourly earnings increased more than the 5.5 percent standard, but real earnings remained below productivity growth. Reported consumer price inflation slowed from the 1970–71 rates. The administration could claim that inflation had slowed, and contrary to their fears, labor unions could not claim that wage increases had slowed more than prices. Corporate profitability benefited from the greater increase in productivity growth than in real wages that typically occurs in an expanding economy.45

  42. Separately, the president asked Arthur Burns for a proposal. Burns gave it to the president in person on September 24. He did not favor decontrol until 1973, after the election, again showing the political basis of the program (Burns papers, Box B_N1, September 23, 1971).

  43. Within the administration, President Nixon explained that if he did not maintain controls, “the Democrats would win the presidency and they would impose permanent controls” (Stein, 1988, 182). For 1972, the administration predicted 6.25 percent increase in real GNP and 3.25 percent inflation. This was close to consensus.

  44. Meany was not the only critic. Ralph Nader testified in Congress that the program did not control profits, agricultural prices, and new housing and that it was easier to control wages than prices (Shouse, 2002, 46–48). The president invited seven people to serve as chairman of the Pay Board. All declined (Weber and Mitchell, 1978, 24).

  Increased profitability pleased Burns. He claimed that labor unions caused inflation. With slow growth, profits and investment declined. His strong beliefs about the political importance of wage-price controls before the election coexisted with his dislike of labor unions and the need to control wages. Wells (1994, 81) described his efforts to strengthen wage control and moderate price controls.46 But he also expressed concern about rising meat prices in a letter to the president in June 1972. The same letter expressed disappointment about slow productivity growth. His discussion of individual price increases suggests the extent to which he confused inflation and relative price changes. This problem became acute when oil prices rose in 1973 (letter Burns to the president, Burns papers, Box B_N1, June 24, 1972).

  In January 1973, motivated by reelection, the recovering economy, rising stock prices, the unemployment rate at 5 percent, and its preference for decontrol, the administration relaxed phase 2 standards. From January 11 to June 13, 1973, phase 3 controls depended mainly on self-administration and, for large firms, reporting of agreements. The Pay Board and the Price Commission ended; their remaining duties devolved to the Cost of Living Council.

  45. Phase 2 restricted profit growth by limiting margins to the best two of three fiscal years before August 15, 1971. Phase 3, beginning in January 1973, relaxed the limit slightly (Kosters, 1975, 16).

  46. Burns’s criticisms of the functioning of the controls program bought a rebuke from the White House (Wells, 1994, 83). Matusow (1998, chapter 7) traces the ups and downs of the programs and the reasons that the labor unions left the Pay Board in March 1972. Only Frank Fitzsimmons of the Teamsters agreed to remain on a reconstituted board.

  Phase 3 was mainly the work of George Shultz, Donald Rumsfeld, and Herbert Stein. Before the president announced the program, they talked with the heads of principal labor unions, corporations, members of Congress, and others. They learned that dissatisfaction with phase 2 had increased and reported that the program should rely more on voluntary compliance. The principal complaint from both business and labor was the “difficulty of obtaining prompt, reasonable decisions” (memo, Shultz to the president, Nixon papers, January 8, 1973, Tab A).

  Phase 3 came after the election. The administration intended to make the transition out of controls. Unfortunately, the change to phase 3 was “premised on a view of the price outlook that was far more optimistic than the inflation trend that actually emerged” (Kosters, 1975, 23).

  The problems came from bad luck and bad policies. The very expansive monetary and fiscal policies of 1972 began to affect prices in 1973. Bad weather in the Soviet Union increased demand for food crops and produced a rapid increase in food prices. The first evidence came in December 1972 (ibid., 24), but the administration had to decide whether the increase was temporary or persistent and what to do in either case.

  At first, it ignored the problem. At a Quadriad meeting on December 11, Stein exulted about rising output and falling inflation. With the election won, discussion turned to inflation. Burns wanted to set a target of 1.5 to 2 percent for calendar 1973, but Stein objected “that so low a goal would seem incredible” (memo, Stein to the president, Shultz papers, Box 3, December 11, 1972). President Nixon sided with Stein. Soon afterward, Burns sent a copy of a speech that made inflation “the most critical problem that we now face.47 And the problem is of such gravity that a broad governmental effort is required to cope with the threat of a new inflationary spiral” (letter, Burns to the president, Burns papers, Box B_N1, December 28, 1972). The letter promised cautious assistance from monetary policy but added that “monetary policy cannot do the job alone, since any such attempt would threaten another credit crunch.” A month later, he told the president that his staff analysis expressed concern that inflation would increase. He shared their concern (letter, Burns to the president, Shultz papers, Box 4, January 29, 1973).

  47. In a letter to Burns commenting on his speech, the president wrote that he agreed that inflation was “the most critical problem we now fa
ce” and that “the only responsible course is to fight inflation hard, and this is precisely what I intend to do” (letter, Nixon to Burns, Burns papers, Box B_N1, January 5, 1973). The president set an objective of 2.5 percent inflation by year-end. His administration’s forecast called for 6 percent growth and 3 percent inflation.

  On June 13, the president ended phase 3 by freezing prices for sixtynine days. This decision again rejected the advice of his principal advisers, especially Shultz and Stein.48 Stein outlined the economic and political dimensions. The economy had been in a very different place in August 1971. There would be more shortages now. Productivity growth had slowed. Prospects for wage increases were better than in 1971. There would be less conviction that controls would be temporary. This would affect compliance and investment.

  Stein’s principal political concern was that Congress would approve a comprehensive, temporary freeze, a popular remedy. That would hurt the president’s ability to lead and “the Republicans could be hurt in the 1974 elections” (memo, Stein to the president, Shultz papers, Box 5, April 9, 1973). Although Stein opposed the freeze, he must have known that his reference to the 1974 election would push the president toward the price freeze.

  Burns favored the freeze. On June 1, he wrote the president a letter with detailed recommendations for policy changes (Burns papers, B_N1, June 1, 1973). The letter warned of the public’s unhappiness and unease. Like President Carter’s famous 1979 speech warning of public anxiety, Burns, too, blamed inflation for “a crisis of confidence” (ibid., 3).