135. Mundell (2000, 335), using wholesale prices, claimed that the price increase in the United States from 1971 to 1982 was 157 percent. This exceeded the increases during any wartime period after independence.
136. The agreement legalizing floating exchange rates called on countries to achieve “orderly underlying conditions . . . for financial and economic stability.” It “did not offer any real guidance as to how the requisite cooperation would be achieved” (Volcker and Gyohten, 1992, 143). Criticism of floating was widespread. Gottfried Haberler (1990, 157) quotes a criticism of floating rates by Pope John Paul II in 1988.
The end of the Bretton Woods system did not eliminate differences among countries about how to share the cost of common defense or reconcile domestic demands to lower the unemployment rate or the inflation rate. Floating simply gave policymakers one more degree of freedom; they could permit the exchange rate to adjust, and they could choose to control domestic inflation. Foreign governments disliked these changes as much as or more than they disliked capital inflows. The United States, at first, chose to ignore the criticisms and the exchange rate. Later it intervened in the exchange market or proposed coordinated action to increase economic growth without changing exchange rates (Pauls, 1990).
INTERNATIONAL POLICY ACTIONS
Early 1974 found the Federal Reserve and other central banks trying to adjust to the oil price increases without a clear idea about what to do. The Arab countries embargoed oil sales to the United States, but the embargo proved mainly that oil was fungible. It sold in an international market, so the actual effect was much less than the Arabs anticipated. The embargo failed and ended in March. Governor Daane reported on the January meeting at the Bank for International Settlements (BIS) in Basel. The United States proposed multilateral intervention to avoid competitive devaluations. BIS President Zilstra sensibly pointed out that “it was necessary to determine the appropriate exchange rates before intervening, in order to know what rate levels to aim for” (FOMC Minutes, January 21, 1974, 12). Needless to say, the central bankers had no way to answer that question. Burns looked on the bright side. Appreciation of the dollar would lower the inflation rate and restore “some semblance of price stability” (ibid., 20). But Coombs saw only disorderly markets driven by speculation.
137. James’s (1996, 207) description of the breakdown of the Bretton Woods system remained applicable to the early years of floating. “The crisis of the Bretton Woods system can be seen as a particular and very dramatic instance of the clash of national economic regulation with the logic of internationalism. . . . [T]he description of the system followed very obviously and directly from the policies of the United States.”
138. In a widely cited paper, Meese and Rogoff (1983) showed that exchange rates under floating approximately followed a random walk.
In February, the United States called an energy conference in Washington. The discussion did not distinguish between a price level increase and continued inflation. Burns summarized his conversation with the finance ministers of leading countries by saying they were more concerned about maintaining aggregate demand than preventing inflation (ibid., February 20, 1974, 11).139 The size of their problem measured by the gross increase in payments to the oil-producing countries was $60 billion in 1974, about 2 percent of the combined GNP of the OECD countries (Solomon, 1982,307).
The United States removed exchange controls and freed capital exports and imports early in 1974. At first, the dollar appreciated. By February, the dollar was under pressure to depreciate. The Federal Reserve and the Treasury sold $155 million of foreign currency by mid-March to stem the decline (ibid., March 18, 1974, 47).140 Failure of the Franklin National Bank in New York and the Herstatt Bank in Germany increased intervention during the summer. Countries continued to meet and discuss various reforms, but their policies remained independent.
Active intervention continued in 1975. The trade-weighted dollar moved over a relatively wide range. The monthly average reached lows in March and June, then recovered to the end of the year. In the year ending December, the dollar rose 6.5 percent against the mark. In part, dollar appreciation against the mark reflected the more rapid increase in West German hourly compensation and the greater domestic production of oil in the United States.
Several efforts to coordinate policy reflect dissatisfaction with floating rates. The Federal Reserve and others focused attention mainly on short-term events and ignored expectations of differences in inflation and growth. In January, the staff reported that several countries lowered interest rates to coordinate actions with the United States and Germany. In February Chairman Burns met with Presidents Karl Klassen of the Bundesbank and Fritz Leutwiler of the Swiss National Bank. They agreed on “more concerted intervention policies” based on daily conversations by operating officials. The three agreed to expand operations in periods of dollar weakness (FOMC Minutes, February 19, 1975, A-2).
139. Some of the ministers may have recognized that a relative price had changed and did not choose to force the price level down.
140. This was much less than Japan. Between the oil shock in October 1973 and January 1974, Japan spent almost $7 billion on intervention to slow yen depreciation (Gyohten in Volcker and Gyohten, 1992, 131).
Very large differences in reported headline inflation rates and changes in reported inflation suggest that the mid-1970s was not a period in which exchange rates were likely to stabilize with or without intervention. Table 7.14 shows a sample of reported consumer price inflation rates during 1973–77. Reported inflation rates include both one-time responses to food and oil price increases and permanent or persistent underlying rates of inflation. There are few if any peacetime periods in which comparative inflation rates for industrial countries differed as much or changed as much from year to year. Given these data, exchange rate volatility should not have surprised central banks and governments. They did not agree, however, on the reasons for inflation.
Germany (and many others) criticized United States monetary policy as a main reason for exchange rate instability. They emphasized the excessive creation of dollars as a source of “monetary debauchery” for countries with current account surpluses and fixed exchange rates (Solomon, 1982, 301, quoting Otmar Emminger of the Bundesbank). This line of criticism usually did not mention that surplus countries could revalue. Maintaining or increasing employment and exports dominated their other goals. Others again pointed to the asymmetry of the international system based on the dollar.
Solomon (1982, 301–7) rejected Emminger’s argument. Although he recognized that the capital inflow to Germany and Japan was historically high, he pointed out that German wages began to increase before the capital inflow. He blamed German inflation on food and oil price increases and rising foreign demand for German exports. And he quoted from BIS and OECD reports to show that the non-monetary explanation of inflation was widely held. Solomon recognized that comparisons of timing cannot be decisive, but he offered no other evidence. And he ignored the cumulative effect of expansive policies in the United States and abroad and the growing expectation in many countries that those policies would continue.141
141. Volcker had a more classical interpretation. He urged Burns to “tighten money” if he wanted to restore a par value system (Volcker and Gyohten, 1992, 113–14).
United States policy did not try to fix the exchange rate. Instructions called on the desk to “maintain orderly markets” but left the definition of “orderly” to the desk (FOMC Minutes, December 16, 1975, 44). The meeting of the G-7 at Rambouillet (France) in November “suggested that intervention might be more active than in the past. However, the language of the agreement was so loose that its meaning could be determined only in the course of experience” (ibid., 17).142
The considerable volume of U.S. foreign exchange intervention was entirely sterilized, so it had no monetary effect. The FOMC did not discuss effectiveness. Scott Pardee, responsible for operations at the New York bank, like his predecessor, b
elieved intervention was effective but made no effort to gather evidence. Burns usually favored intervention. Despite his academic background and frequent public criticism of intervention as ineffective, he did not ask the staff to produce evidence of its effect.143
The facts about floating that most surprised policymakers were that volatility of exchange rates and large parity changes did not prevent recovery or noticeably reduce trade. Trade expanded and economies recovered from the oil shock, the surge in food prices, and economic mismanagement. As Volcker noted, the absence of crisis revised countries’ concern about exchange rates (Volcker and Gyohten, 1992, 103).
The agreement between France and the United States to include floating as a legitimate option required a difficult series of negotiations. Pressed by Representative Reuss and his own inclinations, Treasury Secretary William Simon continued the negotiations through 1975. He was probably aided by the large imbalances that countries faced and the belief that the balance could not be settled without exchange rate adjustment. Also, the French position favoring fixed but adjustable rates had little support in other countries. The agreement reached at Rambouillet became a new Article 4 of the IMF agreement in January 1976. The article stressed “stability” and called upon members to “promote stability by fostering underlying economic and financial conditions and a monetary system that does not produce erratic disruptions” (Solomon, 1982, 272).
142. Rambouillet was the first G-7 summit of heads of state. These meetings began with George Shultz’s “library group” consisting of the finance ministers of the United States, Britain, Germany, and France. Japan did not want to be excluded. It invited these four to meet at the Japanese embassy in Nairobi at the time of the IMF meeting in 1975. The French agreed to hold the next meeting at Rambouillet in 1976 and added Canada and Italy. The meetings began as an attempt to find acceptable common solutions to economic problems. Later it became a public relations effort for leaders of each of the principal countries.
143. Reports of international meetings at this time contain many endorsements of cooperative action. The international system organized special lending facilities to help developing countries finance balance of payments deficits resulting from the rise in oil prices and the decline in industrial countries’ demand. However, individual country concerns were not lost. In his report on a July OECD meeting, Henry Wallich described the continued dependence of foreign governments on United States policy much as it had been under the Bretton Woods system. “Several [members of the BIS] also expressed satisfaction over the recent rise of the dollar in the exchange markets. The Germans and Swiss went so far as to indicate that they were hoping for a stimulus to their exports as a result” (Notes on Meeting of Bank for International Settlements, Board Records, July 29, 1975).
Article 4 permitted countries to fix their exchange rate using SDRs or other base, but it forbade the use of a gold base. It also permitted floating. It is not clear that France recognized that it had accepted a permanent system of floating rates, but, in practice, most countries adopted some type of floating rate with intervention.
Gold
Finance ministers and governments also had to agree on the role of gold. The difficulty with this decision arose not only from the problem of reconciling the French and United States positions but also from the lack of agreement among policy officials in the United States. In part because French citizens traditionally held part of their wealth in gold, France wanted rules that permitted purchases and sales at market prices, and they wanted the right to increase gold held as a reserve asset. United States policy favored the elimination of gold as a reserve asset, called demonetization, and replacement with SDRs. After July 1974, valuation of the SDR used a basket of principal national currencies excluding gold.
In June 1975, Burns sent a memo to the president making the case against gold transactions by central banks and governments at market prices. At the time, the official gold price was $42.22 per ounce; the market price ranged from $160 to $175 per ounce (memo, Burns to the president, Greenspan files, Burns papers, Gerald R. Ford Library, Box 10, June 3, 1975). The large difference in price created an incentive to distribute the profits on IMF country quotas and to revalue reserves of individual countries. France favored both. Burns opposed.
The gold deposited at the IMF belonged to the IMF (subject to restrictions), so the gain on the stock also belonged to the IMF. Members control IMF decisions, if they can agree. The United States could veto any action, so its agreement and congressional approval mattered. Some wanted to use the capital gain on gold to finance redistribution to developing countries. Others, especially France, wanted to return gold to member countries at the original price so that the gain would accrue to the member, not to the IMF.
Secretary Simon was willing to compromise with the French by allowing countries to revalue gold reserves at the market price, permit purchases and sales at market prices, and authorize countries to increase gold holdings above the level on May 1, 1975, if they wished. Burns opposed all three, especially removing the ceiling on a country’s gold holdings. He quoted from the January 1975 statement by the IMF’s Interim Committee stating the Fund’s policy was to “ensure that the role of gold in the international monetary system would be gradually reduced” (ibid., 2). The aim was “to give the special drawing right the central place in the international monetary system” (Press Communiqué of the Interim Committee, Board Records, January 16, 1975, 1).
The first of Burns’s two greatest concerns was that the proposal would increase the relative importance of gold as a monetary asset. “In fact, there are reasons for believing that the French . . . are seeking such an outcome” (memo, Burns to the president, Greenspan Files, Gerald R. Ford Library, Box 10, June 3, 1975, 3) The second was that a higher gold price and higher gold reserves would add up to $150 billion to the value of nominal reserves. “Liquidity creation of such extraordinary magnitude would seriously endanger, perhaps even frustrate, our efforts and those of other prudent nations to get inflation under reasonable control” (ibid., 4).144
Burns’s memo did not carry the day. As usual in international dealings, the Treasury position prevailed. An August 1975 agreement by principal IMF members abolished the official price of gold and eliminated any requirement for using gold in transactions with the IMF. Also, the countries agreed that one-sixth of the Fund’s gold holdings would be sold at auction to finance a transfer of wealth to developing countries, and an additional one-sixth would be returned to member countries in proportion to their quotas. Between 1976 and 1980, the Fund auctioned 25 million ounces and returned 25 million ounces to members (Schwartz, 1987b, 353). The new agreement expired in two years and was not renewed.
Congress repealed the 1934 prohibition on a citizen’s private holdings of gold effective December 31, 1974. The law empowered the Treasury to offset any effect of private demand on the gold price by selling gold at auction. The Treasury auctioned gold in 1975, 1978, and 1979 (ibid., 353).
The agreements and actions during this period ended any remaining link between gold and money.145 Countries were free to value gold at the price they chose and without regard to decisions by other countries. Gold no longer served as a numeraire for the monetary system. It was a commodity with a historic past, a past that appealed to some. In the early 1980s, proponents of a link between the dollar and gold convinced the Reagan administration to establish a gold commission to examine the role of gold. It appointed Anna Schwartz as executive director. The Gold Commission report did not support a return to a gold-based currency.
144. Burns assured the president that the United States would not be isolated on the issue. “I have a secret understanding in writing with the Bundesbank—concurred in by Mr. Schmidt—that Germany will not buy gold either from the market or from another government at a price above the official price of $42.22 per ounce” (memo, Burns to the president, Greenspan Files, Burns papers, Gerald R. Ford Library, Box 10, June 3, 1975, 6).
145. In 1975, th
e System ended reliance on gold certificates for interdistrict settlements. The new procedure used government securities to equalize approximately the average rate of gold holdings to note liabilities at each reserve bank.
I believe it is correct to say that we have not returned to a gold standard because we are familiar with its attributes, not because we are ignorant of its attributes. A gold standard puts great weight on the objectives of price stability and fixed exchange rates. Countries must be willing to accept the fluctuations in employment and output necessary to maintain long-term price stability. The public, the political system, and policymakers after World War II were more concerned with avoiding recessions. After 1980, when low inflation received increased weight in policymakers’ objectives, a main argument for low inflation was that it encouraged long-term growth and employment. This argument gained support because the United States and much of the world had long expansions and relatively mild recessions in the twenty-five years after the 1979–82 disinflation.
Euro-dollars
Partly as a consequence of regulation Q ceiling rates and partly to protect foreign governments and citizens from the threat of blocked accounts by U.S. government order, a market for interest-bearing deposits developed abroad. The market expanded rapidly first in Europe and then elsewhere. Most of the instruments traded in these markets were denominated in dollars, hence the name euro-dollar.
A History of the Federal Reserve, Volume 2 Page 39