by John Brooks
Nor does the gold represent anything like all the foreign deposits at Liberty Street; investments of various sorts brought the March ’68 total to more than twenty-eight billion. As a banker for most of the central banks of the non-Communist world, and as the central bank representing the world’s leading currency, the Federal Reserve Bank of New York is the undisputed chief citadel of world currency. By virtue of this position, it is afforded a kind of fluoroscopic vision of the insides of international finance, enabling it to detect at a glance an incipiently diseased currency here, a faltering economy there. If, for example, Great Britain is running a deficit in her foreign dealings, this instantly shows up in the Federal Reserve Bank’s books in the form of a decline in the Bank of England’s balance. In the fall of 1964, precisely such a decline was occurring, and it marked the beginning of a long, gallant, intermittently hair-raising, and ultimately losing struggle by a number of countries and their central banks, led by the United States and the Federal Reserve, to safeguard the existing order of world finance by preserving the integrity of the pound sterling. One trouble with imposing buildings is that they have a tendency to belittle the people and activities they enclose, and most of the time it is reasonably accurate to think of the Federal Reserve Bank as a place where often bored people push around workaday slips of paper quite similar to those pushed around in other banks. But since 1964 some of the events there, if they have scarcely been capable of inspiring reverent obeisance, have had a certain epic quality.
EARLY in 1964, it began to be clear that Britain, which for several years had maintained an approximate equilibrium in her international balance of payments—that is, the amount of money she had annually sent outside her borders had been about equal to the amount she had taken in—was running a substantial deficit. Far from being the result of domestic depression in Britain, this situation was the result of overexuberant domestic expansion; business was booming, and newly affluent Britons were ordering bales and bales of costly goods from abroad without increasing the exports of British goods on anything like the same scale. In short, Britain was living beyond her means. A substantial balance-of-payments deficit is a worry to a relatively self-sufficient country like the United States (indeed, the United States was having that very worry at that very time, and it would for years to come), but to a trading nation like Britain, about a quarter of whose entire economy is dependent on foreign trade, it constitutes a grave danger.
The situation was cause for growing concern at the Federal Reserve Bank, and the focal point of the concern was the office, on the tenth floor, of Charles A. Coombs, the bank’s vice-president in charge of foreign operations. All summer long, the fluoroscope showed a sick and worsening pound sterling. From the research section of the foreign department, Coombs daily got reports that a torrent of money was leaving Britain. From underground, word rose that the pile of gold bars in the locker assigned to Britain was shrinking appreciably—not through any foul play in the vault but because so many of the bars were being transferred to other lockers in settlement of Britain’s international debts. From the foreign-exchange trading desk, on the seventh floor, the news almost every afternoon was that the open-market quotations on the pound in terms of dollars had sunk again that day. During July and August, as the quotation dropped from $2.79 to $2.7890, and then to $2.7875, the situation was regarded on Liberty Street as so serious that Coombs, who would normally handle foreign-exchange matters himself, only making routine reports to those higher up, was constantly conferring about it with his boss, the Federal Reserve Bank’s president, a tall, cool, soft-spoken man named Alfred Hayes.
Mystifyingly complex though it may appear, what actually happens in international financial dealings is essentially what happens in private domestic transactions. The money worries of a nation, like those of a family, are the consequence of having too much money go out and not enough come in. The foreign sellers of goods to Britain cannot spend the pounds they are paid in their own countries, and therefore they convert them into their own currencies; this they do by selling the pounds in the foreign-exchange markets, just as if they were selling securities on a stock exchange. The market price of the pound fluctuates in response to supply and demand, and so do the prices of all other currencies—all, that is, except the dollar, the sun in the planetary system of currencies, inasmuch as the United States has, since 1934, stood pledged to exchange gold in any quantity for dollars at the pleasure of any nation at the fixed price of thirty-five dollars per ounce.
Under the pressure of selling, the price of the pound goes down. But its fluctuations are severely restricted. The influence of market forces cannot be allowed to lower or raise the price more than a couple of cents below or above the pound’s par value; if such wild swings should occur unchecked, bankers and businessmen everywhere who traded with Britain would find themselves involuntarily engaged in a kind of roulette game, and would be inclined to stop trading with Britain. Accordingly, under international monetary rules agreed upon at Bretton Woods, New Hampshire, in 1944, and elaborated at various other places at later times, the pound in 1964, nominally valued at $2.80, was allowed to fluctuate only between $2.78 and $2.82, and the enforcer of this abridgment of the law of supply and demand was the Bank of England. On a day when things were going smoothly, the pound might be quoted on the exchange markets at, say, $2.7990, a rise of $.0015 from the previous day’s closing. (Fifteen-hundredths of a cent doesn’t sound like much, but on a round million dollars, which is generally the basic unit in international monetary dealings, it amounts to fifteen hundred dollars.) When that happened, the Bank of England needed to do nothing. If, however, the pound was strong in the markets and rose to $2.82 (something it showed absolutely no tendency to do in 1964), the Bank of England was pledged to—and would have been very happy to—accept gold or dollars in exchange for pounds at that price, thereby preventing a further increase in the price and at the same time increasing its own reserve of gold and dollars, which serve as the pound’s backing. If, on the other hand (and this was a more realistic hypothesis), the pound was weak and sank to $2.78, the Bank of England’s sworn duty was to intervene in the market and buy with gold or dollars all pounds offered for sale at that price, however deeply this might have cut into its own reserves. Thus, the central bank of a spendthrift country, like the father of a spendthrift family, is eventually forced to pay the bills out of capital. But in times of serious currency weakness the central bank loses even more of its reserves than this would suggest, because of the vagaries of market psychology. Prudent importers and exporters seeking to protect their capital and profits reduce to a minimum the sum they hold in pounds and the length of time they hold it. Currency speculators, whose noses have been trained to sniff out weakness, pounce on a falling pound and make enormous short sales, in the expectation of turning a profit on a further drop, and the Bank of England must absorb the speculative sales along with the straightforward ones.
The ultimate consequence of unchecked currency weakness is something that may be incomparably more disastrous in its effects than family bankruptcy. This is devaluation, and devaluation of a key world currency like the pound is the recurrent nightmare of all central bankers, whether in London, New York, Frankfurt, Zurich, or Tokyo. If at any time the drain on Britain’s reserves became so great that the Bank of England was unable, or unwilling, to fulfill its obligation to maintain the pound at $2.78, the necessary result would be devaluation. That is, the $2.78-to-$2.82 limitation would be abruptly abrogated; by simple government decree the par value of the pound would be reduced to some lower figure, and a new set of limits established around the new parity. The heart of the danger was the possibility that what followed might be chaos not confined to Britain. Devaluation, as the most heroic and most dangerous of remedies for a sick currency, is rightly feared. By making the devaluing country’s goods cheaper to others, it boosts exports, and thus reduces or eliminates a deficit in international accounts, but at the same time it makes both imports and
domestic goods more expensive at home, and thus reduces the country’s standard of living. It is radical surgery, curing a disease at the expense of some of the patient’s strength and well-being—and, in many cases, some of his pride and prestige as well. Worst of all, if the devalued currency is one that, like the pound, is widely used in international dealings, the disease—or, more precisely, the cure—is likely to prove contagious. To nations holding large amounts of that particular currency in their reserve vaults, the effects of the devaluation is the same as if the vaults had been burglarized. Such nations and others, finding themselves at an unacceptable trading disadvantage as a result of the devaluation, may have to resort to competitive devaluation of their own currencies. A downward spiral develops: Rumors of further devaluations are constantly in the wind; the loss of confidence in other people’s money leads to a disinclination to do business across national borders; and international trade, upon which depend the food and shelter of hundreds of millions of people around the world, tends to decline. Just such a disaster followed the classic devaluation of all time, the departure of the pound from the old gold standard in 1931—an event that is still generally considered a major cause of the worldwide Depression of the thirties.
The process works similarly in respect to the currencies of all the hundred-odd countries that are members of the International Monetary Fund, an organization that originated at Bretton Woods. For any country, a favorable balance of payments means an accumulation of dollars, either directly or indirectly, which are freely convertible into gold, in the country’s central bank; if the demand for its currency is great enough, the country may revalue it upward—the reverse of a devaluation—as both Germany and the Netherlands did in 1961. Conversely, an unfavorable balance of payments starts the sequence of events that may end in forced devaluation. The degree of disruption of world trade that devaluation of a currency causes depends on that currency’s international importance. (A large devaluation of the Indian rupee in June, 1966, although it was a serious matter to India, created scarcely a ripple in the international markets.) And—to round out this brief outline of the rules of an intricate game of which everybody everywhere is an inadvertent player—even the lordly dollar is far from immune to the effects of an unfavorable balance of payments or of speculation. Because of the dollar’s pledged relation to gold, it serves as the standard for all other currencies, so its price does, not fluctuate in the markets. However, it can suffer weakness of a less visible but equally ominous sort. When the United States sends out substantially more money (whether payment for imports, foreign aid, investments, loans, tourist expenses, or military costs) than it takes in, the recipients freely buy their own currencies with the newly acquired dollars, thereby raising the dollar prices of their own currencies; the rise in price enables their central banks to take in still more dollars, which they can sell back to the United States for gold. Thus, when the dollar is weak the United States loses gold. France alone—a country with a strong currency and no particular official love of the dollar—required thirty million dollars or more in United States gold regularly every month for several years prior to the autumn of 1966, and between 1958, when the United States began running a serious deficit in its international accounts, and the middle of March 1968, our gold reserve was halved—from twenty-two billion eight hundred million to eleven billion four hundred million dollars. If the reserve ever dropped to an unacceptably low level, the United States would be forced to break its word and lower the gold value of the dollar, or even to stop selling gold entirely. Either action would in effect be a devaluation—the one devaluation, because of the dollar’s preeminent position, that would be more disruptive to world monetary order than a devaluation of the pound.
HAYES and Coombs, neither of whom is old enough to have experienced the events of 1931 at first hand as a banker but both of whom are such diligent and sensitive students of international banking that they might as well have done so, found that as the hot days of 1964 dragged on they had occasion to be in almost daily contact by transatlantic telephone with their Bank of England counterparts—the Earl of Cromer, governor of the bank at that time, and Roy A. O. Bridge, the governor’s adviser on foreign exchange. It became clear to them from these conversations and from other sources that the imbalance in Britain’s international accounts was far from the whole trouble. A crisis of confidence in the soundness of the pound was developing, and the main cause of it seemed to be the election that Britain’s Conservative Government was facing on October 15th. The one thing that international financial markets hate and fear above all others is uncertainty. Any election represents uncertainty, so the pound always has the jitters just before Britons go to the polls, but to the people who deal in currencies this election looked particularly menacing, because of their estimate of the character of the Labour Government that might come into power. The conservative financiers of London, not to mention those of Continental Europe, looked with almost irrational suspicion on Harold Wilson, the Labour choice for Prime Minister; further, some of Mr. Wilson’s economic advisers had explicitly extolled the virtues of devaluation of the pound in their earlier theoretical writings; and, finally, there was an all too pat analogy to be drawn from the fact that the last previous term of the British Labour Party in power had been conspicuously marked, in 1949, by a devaluation of sterling from the rate of $4.03 to $2.80.
In these circumstances, almost all the dealers in the world money markets, whether they were ordinary international businessmen or out-and-out currency speculators, were anxious to get rid of pounds—at least until after the election. Like all speculative attacks, this one fed on itself. Each small drop in the pound’s price resulted in further loss of confidence, and down, down went the pound in the international markets—an oddly diffused sort of exchange, which does not operate in any central building but, rather, is conducted by telephone and cable between the trading desks of banks in the world’s major cities. Simultaneously, down, down went British reserves, as the Bank of England struggled to support the pound. Early in September, Hayes went to Tokyo for the annual meeting of the members of the International Monetary Fund. In the corridors of the building where participants in the Fund met, he heard one European central banker after another express misgivings about the state of the British economy and the outlook for the British currency. Why didn’t the British government take steps at home to check its outlay and to improve the balance of payments, they asked each other. Why didn’t it raise the Bank of England’s lending rate—the so-called bank rate—from its current five per cent, since this move would have the effect of raising British interest rates all up and down the line, and would thus serve the double purpose of damping down domestic inflation and attracting investment dollars to London from other financial centers, with the result that sterling would gain a sounder footing?
Doubtless the Continental bankers also put such questions to the Bank of England men in Tokyo; in any event, the Bank of England men and their counterparts in the British Exchequer had not failed to put the questions to themselves. But the proposed measures would certainly be unpopular with the British electorate, as unmistakable harbingers of austerity, and the Conservative Government, like many governments before it, appeared to be paralyzed by fear of the imminent election. So it did nothing. In a strictly monetary way, however, Britain did take defensive measures during September. The Bank of England had for several years had a standing agreement with the Federal Reserve that either institution could borrow five hundred million dollars from the other, over a short term, at any time, with virtually no formalities; now the Bank of England accepted this standby loan and made arrangements to supplement it with another five hundred million dollars in short-term credit from various European central banks and the Bank of Canada. This total of a billion dollars, together with Britain’s last-ditch reserves in gold and dollars, amounting to about two billion six hundred million, constituted a sizable store of ammunition. If the speculative assault on the pound should con
tinue or intensify, answering fire would come from the Bank of England in the form of dollar investments in sterling made on the battlefield of the free market, and presumably the attackers would be put to rout.
As might have been expected, the assault did intensify after Labour came out the victor in the October election. The new British government realized at the outset that it was faced with a grave crisis, and that immediate and drastic action was in order. It has since been said that summary devaluation of the pound was seriously considered by the newly elected Prime Minister and his advisers on finance—George Brown, Secretary of State for Economic Affairs, and James Callaghan, Chancellor of the Exchequer. The idea was rejected, though, and the measures they actually took, in October and early November, were a fifteen-percent emergency surcharge on British imports (in effect, a blanket raising of tariffs), an increased fuel tax, and stiff new capital-gains and corporation taxes. These were deflationary, currency-strengthening measures, to be sure, but the world markets were not reassured. The specific nature of the new taxes seems to have disconcerted, and even enraged, many financiers, in and out of Britain, particularly in view of the fact that under the new budget British government spending on welfare benefits was actually to be increased, rather than cut back, as deflationary policy would normally require. One way and another, then, the sellers—or bears, in market jargon—continued to be in charge of the market for the pound in the weeks after the election, and the Bank of England was kept busy potting away at them with precious shells from its borrowed-billion-dollar arsenal. By the end of October, nearly half the billion was gone, and the bears were still inexorably advancing on the pound, a hundredth of a cent at a time.