Despite the persistence of Bretton Woods into the 1970s, the seeds of Currency War II were sown in the mid- to late 1960s. One can date the beginning of CWII from 1967, while its antecedents lie in the 1964 landslide election of Lyndon B. Johnson and his “guns and butter” platform. The guns referred to the war in Vietnam and the butter referred to the Great Society social programs, including the war on poverty.
Although the United States had maintained a military presence in Vietnam since 1950, the first large-scale combat troop deployments took place in 1965, escalating the costs of the war effort. The Democratic landslide in the 1964 election resulted in a new Congress that convened in January 1965, and Johnson’s State of the Union address that month marked the unofficial launch of the full-scale Great Society agenda.
This convergence of the costs of escalation in Vietnam and the Great Society in early 1965 marked the real turning away from America’s successful postwar economic policies. However, it would take several years for those costs to become apparent. America had built up a reservoir of economic strength at home and political goodwill abroad and that reservoir now slowly began to be drained.
At first, it seemed that the United States could afford both guns and butter. The Kennedy tax cuts, signed by President Johnson shortly after President John F. Kennedy’s assassination in 1963, had given a boost to the economy. Gross domestic product rose over 5 percent in the first year of the tax cuts and growth averaged over 4.8 percent annually during the Kennedy-Johnson years. But almost from the start, inflation accelerated in the face of the twin budget and trade deficits that Johnson’s policies engendered.
Inflation, measured year over year, almost doubled from an acceptable 1.9 percent in 1965 to a more threatening 3.5 percent in 1966. Inflation then ran out of control for twenty years. It was not until 1986 that inflation returned to the level of just over 1 percent. In one incredible five-year stretch from 1977 to 1981, cumulative inflation was over 50 percent; the value of the dollar was cut in half.
U.S. citizens in this period made the same analytic mistake as their counterparts in Weimar Germany had in 1921. Their initial perception was that prices were going up; what was really happening was that the currency was collapsing. Higher prices are the symptom, not the cause, of currency collapse. The arc of Currency War II is really the arc of U.S. dollar inflation and the decline of the dollar.
Despite the centrality of U.S. policies and U.S. inflation to the course of CWII, the opening shots were fired not in the United States but in Britain, where a sterling crisis had been brewing since 1964 and came to a boil in 1967 with the first major currency devaluation since Bretton Woods. While sterling was less significant than the dollar in the Bretton Woods system, it was still an important reserve and trade currency. In 1945, UK pounds sterling comprised a larger percentage of global reserves—the combined holdings of all central banks—than the dollar. This position deteriorated steadily, and by 1965 only 26 percent of global reserves were in sterling. The British balance of payments had been deteriorating since the early 1960s, but grew sharply negative in late 1964.
Instability in sterling arose not only because of short-term trade imbalances but because of the global imbalance between the total sterling reserves held outside Britain and the dollar and gold reserves available inside Britain to redeem those external balances. In the mid-1960s there were about four times as many external sterling claims as internal reserves. This situation was highly unstable and made Britain vulnerable to a run on the bank if sterling holders tried to redeem sterling for dollars or gold en masse. A variety of techniques was orchestrated to support sterling and keep the sterling bears off balance, including international lines of credit, swap lines with the New York Fed, a UK austerity package and surprise currency market interventions. But the problem remained.
Three minor sterling crises arose between 1964 and 1966, but were eventually subdued. A fourth sterling crisis, in mid-1967, however, proved fatal to sterling parity. Numerous factors contributed to the timing, including closure of the Suez Canal during the 1967 Six-Day War between the Arabs and Israel and the expectation that the UK might be required to devalue in order to join the European Economic Community. Inflation was now on the rise in the United Kingdom as it was in the United States. In the UK, inflation was rationalized as necessary to combat rising unemployment, but its impact on the value of the currency was devastating. After an unsuccessful effort to fend off continued selling pressure, sterling formally devalued against the dollar on November 18, 1967, from $2.80 to $2.40 per pound sterling, a 14.3 percent devaluation.
The first significant crack in the Bretton Woods facade had now appeared after twenty years of success in maintaining fixed exchange rates and price stability. If the UK could devalue, so could others. U.S. officials had worked hard to prevent the devaluation of sterling, fearing the dollar would be the next currency to come under pressure. Their fears would soon be realized. The United States was experiencing the same combination of trade deficits and inflation that had unhinged sterling, with one crucial difference. Under Bretton Woods, the value of the dollar was not linked to other currencies but to gold. A devaluation of the dollar therefore meant an upward revaluation in the dollar price of gold. Buying gold was the logical trade if you expected dollar devaluation, so speculators turned their attention to the London gold market.
Since 1961, the United States and other leading economic powers had operated the London Gold Pool, essentially a price-fixing open market operation in which participants combined their gold and dollar reserve resources to maintain the market price of gold at the Bretton Woods parity of $35 per ounce. The Gold Pool included the United States, United Kingdom, Germany, France, Italy, Belgium, the Netherlands and Switzerland, with the United States providing 50 percent of the resources and the remainder divided among the other seven members. The pool was partly a response to an outbreak of panic buying of gold in 1960, which had temporarily driven the market price of gold up to $40 per ounce. The Gold Pool was both a buyer and a seller; it would buy on price dips and sell into rallies in order to maintain the $35 price. But by 1965 the pool was almost exclusively a seller.
The End of Bretton Woods
The public attack on the Bretton Woods system of a dominant dollar anchored to gold began even before the 1967 devaluation of sterling. In February 1965, President Charles de Gaulle of France gave an incendiary speech in which he claimed that the dollar was finished as the lead currency in the international monetary system. He called for a return to the classical gold standard, which he described as “an indisputable monetary base, and one that does not bear the mark of any particular country. In truth, one does not see how one could really have any standard criterion other than gold.” France backed up the words with action. In January 1965, France converted $150 million of dollar reserves into gold and announced plans to convert another $150 million soon. Spain followed France and converted $60 million of its own dollar reserves into gold. Using the price of gold in June 2011 rather than the $35 per ounce price in 1965, these redemptions were worth approximately $12.8 billion by France and $2.6 billion by Spain and at the time represented significant drains on U.S. gold reserves. De Gaulle helpfully offered to send the French navy to the United States to ferry the gold back to France.
These redemptions of dollars for gold came at a time when United States businesses were buying up European companies and expanding operations in Europe with grossly overvalued dollars, something De Gaulle referred to as “expropriation.” De Gaulle felt that if the United States had to operate with gold rather than paper money, this predatory behavior would be forced to a halt. However, there was fierce resistance to a pure gold standard in the late 1960s—as in the 1930s, it would have necessitated a devaluation of dollars and other currencies against gold. The biggest beneficiaries of a rise in the dollar price of gold would have been the major gold-producing nations, including the repugnant apartheid regime in South Africa and the hostile communist regime in the US
SR. These geopolitical considerations helped to tamp down the enthusiasm for a new version of the classical gold standard.
Despite the scathing criticisms coming from France, the United States did have one staunch ally in the Gold Pool—Germany. This was crucial, because Germany had persistent trade surpluses and was accumulating gold both from the IMF as part of operations to support sterling and through its participation as an occasional buyer in the Gold Pool itself. If Germany were suddenly to demand gold in exchange for its dollar reserve balances, a dollar crisis much worse than the sterling crisis would result. However, Germany secretly assured the United States it would not dump dollars for gold, as revealed in a letter from Karl Blessing, president of the Deutsche Bundesbank, the German central bank, to William McChesney Martin, the chairman of the Board of Governors of the Federal Reserve. Dated March 30, 1967, the “Blessing Letter” provided:Dear Mr. Martin,
There occasionally has been some concern . . . that . . . expenditures resulting from the presence of American troops in Germany [could] lead to United States losses of gold....
You are, of course, well aware of the fact that the Bundesbank over the past few years has not converted any . . . dollars . . . into gold....
You may be assured that also in the future the Bundesbank intends to continue this policy and to play its full part in contributing to international monetary cooperation.
It was extremely comforting for the United States to have this secret assurance from Germany. In return, the United States would continue to bear the costs of defending Germany from the Soviet troops and tanks stationed in the woods immediately surrounding Berlin and throughout Eastern Europe.
Germany, however, was not the only party with potential gold claims on the dollar, and in the immediate aftermath of the 1967 sterling devaluation the United States had to sell over eight hundred metric tons of gold at artificially low prices to maintain the dollar-gold parity. In June 1967, just one year after withdrawing from NATO’s military command, France withdrew from the Gold Pool as well. The other members continued operations, but it was a lost cause: claims on gold by overseas dollar holders had become an epidemic. By March 1968, the gold outflow from the pool was running at the rate of thirty metric tons per hour.
The London gold market was closed temporarily on March 15, 1968, to halt the outflow, and remained closed for two weeks, an eerie echo of the 1933 U.S. bank holiday. A few days after the closure, the U.S. Congress repealed the requirement for a gold reserve to back the U.S. currency; this freed the U.S. gold supply to be available for sale at the $35 price if needed. This was all to no avail. By the end of March 1968, the London Gold Pool had collapsed. Thereafter, gold was considered to move in a two-tier system, with a market price determined in London and an international payments price under Bretton Woods at the old price of $35 per ounce. The resulting “gold window” referred to the ability of countries to redeem dollars for gold at the $35 price and sell the gold on the open market for $40 or more.
The two-tier system caused speculative pressures to be directed to the open market while the $35 price remained available only to central banks. However, the U.S. allies reached a new, informal agreement not to take advantage of the gold window by acquiring gold at the cheaper official price. The combination of the end of the Gold Pool, the creation of two-tier system and some short-term austerity measures put in place by the United States and United Kingdom helped to stabilize the international monetary system in late 1968 and 1969, yet the dénouement of Bretton Woods was clearly in sight.
On November 29, 1968, not long after the collapse of the London Gold Pool, Time reported that among the problems of the monetary system was that “the volume of world trade is rising far more quickly than the global supply of gold.” Statements like this illustrate one of the great misunderstandings about the role of gold. It is misguided to say that there is not enough gold to support world trade, because quantity is never the issue; rather, the issue is one of price. If there was inadequate gold at $35 per ounce, the same amount of gold would easily support world trade at $100 per ounce or higher. The problem Time was really alluding to was that the price of gold was artificially low at $35 per ounce, a point on which the magazine was correct. If the price of gold was too low, the problem was not a shortage of gold but an excess of paper money in relation to gold. This excess money was reflected in rising inflation in the United States, the United Kingdom and France.
In 1969, the IMF took up the “gold shortage” cause and created a new form of international reserve asset called the special drawing right, or SDR. The SDR was manufactured out of thin air by the IMF without tangible backing and allocated among members in accordance with their IMF quotas. It was promptly dubbed “paper gold” because it represented an asset that could be used to offset balance of payments deficits in the same manner as gold or reserve currencies.
The creation of the SDR was a little-understood novelty at the time. There were several small issuances in 1970–1972 and another issuance in response to the oil price shock and global inflation in 1981. Thereafter, the issuance of SDRs came to a halt for almost thirty years. It was only in 2009, in the depths of a depression that had begun in 2007, that another, much larger amount of SDRs were printed and handed out to members. Still, the original issuance of SDRs in 1970 was a reflection of how badly unbalanced the supply of paper money had become in relation to gold and of the desperation with which the United States and others clung to the gold parity of $35 per ounce long after that price had become infeasible.
The entire period of 1967 to 1971 is best characterized as one of confusion and uncertainty in international monetary affairs. The devaluation of sterling in 1967 had been somewhat of a shock even though the instability in sterling had been diagnosed by central bankers years before. But the following years were marked by a succession of devaluations, revaluations, inflation, SDRs, the collapse of the Gold Pool, currency swaps, IMF loans, a two-tiered gold price and other ad hoc solutions. At the same time, the leading economies of the world were undergoing internal strains in the form of student riots, labor protests, antiwar protests, sexual revolution, the Prague Spring, the Cultural Revolution and the continuing rise of the counterculture. All of this was layered onto rapid technological change summed up in the ubiquity of computers, the fear of thermonuclear war and plain awe at landing a man on the moon. The whole world seemed at once to be on a wobbly foundation in a way not seen perhaps since 1938.
Yet through all of this, one thing seemed safe. The value of the U.S. dollar remained fixed at one thirty-fifth of an ounce of pure gold and the United States seemed prepared to defend this value despite the vast increase in the supply of dollars and the fact that convertibility was limited to a small number of foreign central banks bound to honor a gentleman’s agreement not to press too hard for conversion. Then suddenly this last anchor snapped too.
On Sunday, August 15, 1971, President Richard Nixon preempted the most popular show in America, Bonanza, to present a live television announcement of what he called his New Economic Policy, consisting of immediate wage and price controls, a 10 percent surtax on imports and the closing of the gold window. Henceforth, the dollar would no longer be convertible into gold by foreign central banks; the conversion privilege for all other holders had been ended years before. Nixon wrapped his actions in the American flag, going so far as to say, “I am determined that the American dollar must never again be a hostage in the hands of international speculators.” Of course, it was U.S. deficits and monetary ease, not speculators, that had brought the dollar to this pass, but, as with FDR, Nixon was not deterred by the facts. The last vestige of the 1944 Bretton Woods gold standard and the 1922 Genoa Conference gold exchange standard was now gone.
Nixon’s New Economic Policy was immensely popular. Press coverage was overwhelmingly favorable, and on the first trading day after the speech the Dow Jones Industrial Average had its largest one-day point gain in its history up until then. The announcement has been re
ferred to ever since as the Nixon Shock. The policy was conceived in secret and announced unilaterally without consultation with the IMF or other major participants in Bretton Woods. The substance of the policy itself should not have been a shock to U.S. trading partners—de facto devaluation of the dollar against gold, which was what the New Economic Policy amounted to, was a long time coming, and the pressure on the dollar had accelerated in the weeks leading to the speech. Switzerland had redeemed dollar paper for over forty metric tons of gold as late as July 1971. French redemptions of dollars for gold had enabled France to become a gold power, ranking behind only the United States and Germany, and it remains so today.
What most shocked Europeans and the Japanese about the New Economic Policy was not the devaluation of the dollar, but the 10 percent surtax on all goods imported into the United States. Abandoning the gold standard, by itself, did not immediately change the relative values of currencies—sterling, the franc, and the yen all had their established parities with the dollar, and the German mark and Canadian dollar had already been floated by the time of Nixon’s speech. But what Nixon really wanted was for the dollar to devalue immediately against all the major currencies and, better yet, to float down thereafter so that the dollar could indulge in continual devaluation in the foreign exchange markets. However, that would take time and negotiations to formalize, and Nixon did not want to wait. His 10 percent surtax had the same immediate economic impact as a 10 percent devaluation. The surtax was like a gun to the head of U.S. trading partners. Nixon would rescind the surtax once he got the devaluations he sought, and the task of negotiating those devaluations was delegated to his flamboyant Treasury secretary, John Connally of Texas.
Currency Wars: The Making of the Next Global Crisis Page 10