The Power of Gold: The History of an Obsession

by Peter L. Bernstein

  The new arrangements provided that the United States-blessed with that dominant proportion of the world's gold stock-would be the only nation with a currency freely convertible into gold at a fixed rate; as in prewar days, however, the privilege of conversion was limited to national treasuries and central banks, not to private parties. All other countries were obligated to do their best to make their currencies convertible into dollars by everyone, but they were not required to maintain convertibility into gold. The conversion rate between dollars and gold was set at $35 per ounce, and then the rest of the world defined their currencies in terms of the dollar rather than gold.

  If that had been all there was to it, the new system would have left individual countries as much a prisoner of the dollar as once upon a time they had been prisoners of their gold stock. The Allied nations had few dollars left after paying for the monumental costs of the war, even with American aid; Britain owed massive debts to its imperial possessions; the enemy countries were flat broke. As a result, only the relationship between gold and the dollar at $35 an ounce was expected to be permanent-in cement, as in the old days-but different arrangements were established for the relationship between the dollar and all the other currencies. These relationships, known as "legal par values," were also expected to be fixed under the normal course of events, but provisions were established to provide for changes in the legal par values when a country's efforts to meet its international payment obligations ran into problems that were deemed more likely to be permanent than temporary. Setting these par values at a level that each country could manage to sustain was far from easy. Germany and Japan did not set theirs until 1953; Italy waited until 1960. Most of the original settings were changed more than once before the final breakdown of the system after 1971. Indeed, until well into the 1960s, Canada, Switzerland, and the United States were the only advanced countries that allowed uncontrolled outflows of capital to other countries.

  Arrangements for changes in legal par values was not the only step that the framers of the system took to avoid the suffocating deflations and unemployment that blind adherence to the old gold standard had mandated in the past. In the more frequent instances when trouble was expected to be temporary, the supply of foreign exchange available to be borrowed to tide a nation over such periods was to be augmented by the creation of a brand-new institution called the International Monetary Fund. The IMF was to function as a lender to governments and central banks requiring short-term accommodation that was not available from conventional sources.

  Nevertheless, gold was still very much in the picture. The resources that the IMF had available to lend out came from contributions by each of its member countries, in two forms. Seventy-five percent of the contributions consisted of the members' own currencies-the French paid in francs, the Dutch paid in guilders, the United States paid in dollars, and so on. The other 25 percent, however, had to be in gold, although a lesser percentage was permitted for countries that could not afford the payment. Over time, many transactions in gold took place between the Fund and its member countries.

  The new scheme, with its unfamiliar set of international obligations, encountered opposition from those who were fearful of newfangled systems. Their attitude provoked Keynes to a passionate defense of this new structure to which he had contributed so much: "I have spent my strength to persuade my countrymen and the world at large to change their traditional doctrines.... Was it not I, when many of today's iconoclasts were still worshipping the Calf, who wrote that `Gold is a barbarous relic'?"4

  The rest of the story is downhill all the way.

  A grand underlying assumption supported this entire framework: that the dollar would continue to appear invincible-as good as goldand therefore always acceptable everywhere and under all circumstances. This was an assumption that few people had stopped to question during the process of creation, or for the first ten years or so after all these arrangements were set in motion. Yet no matter how omnipotent economically, politically, and militarily the world may have perceived the Americans to be in 1945, there was no reason to expect that state of affairs to last forever.

  On the contrary. The whole scheme was contrived with the primary purpose of putting Europe and Japan back on their feet. Once that goal was achieved, the dynamic would undergo fundamental change. The spanking new European and Japanese industrial facilities would be competition for American industry. They would also be attractive areas for American investment. As a result, the Americans would end up spending increasing amounts of money on imports and investing in foreign countries to a point where their massive gold hoard would be drawn down below its original swollen levels and their debts to foreigners would increase above the levels of the 1940s.

  The Americans happily obliged by engaging in a great spending spree. As the economies of Europe and Asia revived according to plan and in response to American aid, the lure of the profit motive drove massive amounts of private capital from the United States into thousands of enterprises across the seas and attracted rising imports of foreign merchandise to America's shores. The United States undertook an unprecedented level of international economic assistance, launched large-scale social programs at home, deployed American military might around the world, and fought two hot wars in Asia as well as the Cold War against the Russians. Before the game was over, Americans would find themselves besieged by their economic enemies and forced by gold onto their knees before their friends.

  The impact of the process on America's international financial position was already visible by the end of the 1950s. The U.S. monetary gold stock, which had held steady at around $22 billion from 1950 to 1958, shrank by over $3 billion between the end of 1958 and the end of 1960. Meanwhile, as Americans spent their dollars abroad, foreign ownership of bank deposits in American banks and of short-term U.S. Treasury obligations increased from only $8 billion in 1950 to over $20 billion in 1960. If foreigners at that moment had decided to convert all their liquid dollar assets into gold, the U.S. gold stock would have been exhausted.'

  On October 27, 1960, provoked by news that the liberal John F. Kennedy was probably going to defeat Richard Nixon in the presidential election in the following week, the price of gold jumped as high as $40 an ounce in the London gold market, where gold was freely bought and sold in the form of bullion, not coins, and where most of the new supply came from South Africa. Kennedy did win the election at home, but he was alarmed by the adverse verdict in the gold market. Right after his election, Kennedy told his advisors that he ranked the dollar problem among his highest-priority concerns.'

  This was an odd moment for an incipient dollar crisis to appear on the scene. No one should have expected the enormous excess of U.S. gold over liabilities to foreigners that existed at the end of the Second World War-more than $20 billion in gold and less than $10 billion in liabilities-to last indefinitely. This was an imbalance inherited from the dismal days of the late 1930s and the wartime sacrifices made by the Allied nations to overcome Germany and Japan. With peace and reconstruction, a shift back to the more normal relationship of gold stocks smaller than liabilities to foreigners was inevitable.

  There is a case to be made that the process was not so alarming as the press and the television commentators tried to make the public believe. Nobody was forcing foreigners to hold that huge volume of dollars. Foreign owners of dollars were acting quite rationally. Dollars were acceptable everywhere in payment of obligations and to settle up balances between countries and between business firms. No other nation could match the magnitude or the wide variety of financial instruments offered in the U.S. money markets. Unlike gold, the dollars were easy to transfer from one owner to another. Dollars also earned interest income while held, which made them more attractive than gold as a reserve. As long as the dollars continued to serve as the most acceptable means of payment everywhere, no one had any need, or even any incentive, to cash in the dollars and hoard gold or hold some other country's currency instead.

  In ef
fect, the United States was functioning as a bank for the rest of the world, just as Britain had served as a bank for the rest of the world in the years before World War I, and for the same reason. The Bank of England carried only a small gold stock relative to its liabilities, because sterling was the foreign exchange reserve of choice and the capital markets of the City provided ready liquidity in a wide variety of instruments. At the same time, the earnings on Britain's investments abroad furnished a constant return flow of foreign exchange to the home country. Thus, sterling served as a ready means of payment not only to English people but to the world at large. Most banks carry modest cash reserves relative to their deposit liabilities precisely because their customers have found that transferring those deposits back and forth among themselves by writing checks, in other words-serves as a far more convenient and efficient means of payment than withdrawing cash that they would then have to send off to their creditors.*

  Inflation was the only force that should have threatened the viability of the dollar under these circumstances. And here is where questions began to be raised. True, the U.S. economy had been free of inflationary pressures, despite high rates of economic growth, during the first half of the 1950s; in fact, consumer prices had fallen during 1954. Signs of trouble first appeared in 1956-1957, as the business cycle approached its peak and inflation bubbled up to around 3 percent. Even that rate of inflation might have been tolerated in the late phases of an economic expansion, but the increase of 2.7 percent in consumer prices from the end of 1957 to the end of 1958 came as a shock. By then the boom was over, and a serious decline in business activity had begun. Unemployment had risen by over a million, pushing the unemployment rate close to 7 percent of the labor force.

  Such a thing had never happened before. Prices had always fallen in recessions and depressions. The Federal Reserve was so alarmed that it jacked up the Discount Rate in short order from V12 percent to 4 percent, a move that aborted the recovery from this recession just two years after it began. The Chairman of the Federal Reserve, William McChesney Martin, announced that he considered inflation as serious a threat as communism to the safety and future of the United States.

  Martin's determined stand against his hated enemy seems to have turned the trick. Once the bad news of 1958 was out of the way, the increase in consumer prices during the recovery years of 1959-1960 was even smaller than in 1958. The Federal Reserve's aggressive policy even persuaded Westinghouse and General Electric employees to abandon the cost-of-living clauses in their contracts and the militant West Coast longshoremen to give their employers free rein in introducing labor-saving machinery. From 1958 to 1964, inflation averaged only 1.4 percent a year though the economy was expanding at an annual rate of 5 percent. Between 1959 and 1971, the rate of inflation and the rate of growth in the money supply in the United States were lower than in any of the major European economies.'

  Perhaps these inflation numbers would have sufficed to calm the worries over the dollar, but other significant U.S. economic statistics spurred an accelerating drawdown of the gold stock. Just during the five years 1960-1964, imports totaled more than $80 billion, $11 billion was spent by the government sustaining the armed forces outside the United States, American business spent $29 billion investing in companies in Europe and Asia or building up financial assets in other countries, while foreign travel, other services, and foreign aid consumed another $18 billion. On the one hand, the American capital and the crowds of open-handed American tourists were welcome; on the other hand, resentment over the conspicuous display of American wealth festered throughout the 1960s.* The French were most vocal in their concerns and were determined to clip the wings of -he American juggernaut.

  During the second half of the 1960s, the inflation problem assumed more serious proportions, as the unemployment rate fell from over 5 percent of the labor force in 1965 to only 3.5 percent by 1969. Prices rose 3.4 percent a year from 1965 to 1968 and then increased by 5.5 percent in 1969. That was bad enough, but prices then rose by 5.7 percent in the recession year of 1970, again violating historical precedent. Further indications of an overheated U.S. economy appeared as the towering excess of merchandise exports over imports that had prevailed since the end of World War II peaked out at $6.8 billion in 1964 and then fell to only $600 million by 1969. At the same time, the volume of American capital continued to flow into foreign business firms as heavily as ever.

  The intensification of the U.S. commitment to the war in Vietnam was the primary source of inflationary pressure. Defense spending jumped by about 60 percent during the second half of the 1960s. The federal government had run surpluses through 1966, but in 1967 the budget deficit amounted to over $8 billion, and that was followed by a $26 billion deficit in 1968. In a rare exhibit of almost complete unanimity, professional economists of all stripes urged President Johnson to finance the swelling volume of defense expenditures by an increase in taxes. Johnson refused to follow their advice. To make matters even more difficult, most of the proceeds of rising military expenditures in Vietnam were ending up in French banks.

  Foreign governments had great difficulty navigating through this kind of corrosion in the American economy. Nobody wanted to flee the dollar: no other currency was so well equipped to serve as an international reserve and means of payment. On the contrary, a run on the dollar and a fall in its value in terms of all the other currencies would have meant enormous losses for the billions of dollars that foreigners now held. The impact could be total chaos. Yet, notwithstanding these misgivings, gold-as always-remained as a tempting alternative for at least a portion of the expanding foreign holdings of dollars.

  Consequently, the U.S. gold stock continued to sink despite the establishment of a variety of elaborate arrangements for short-term credits so that the United States would have other currencies available to meet its obligations abroad instead of drawing down its gold stock. The Federal Reserve attempted to maintain short-term interest rates high enough to make dollars more attractive than deutsche marks or Swiss francs and surely preferable to gold that paid no interest. The government pushed business groups and labor unions into "voluntary" agreements to check domestic inflation by limiting price and wage increases.

  There was more. In September 1964, a special tax called the Interest Equalization Tax was enacted to discourage American investment abroad by taxing interest earned on deposits and bonds held in foreign currencies. That tax was now supplemented by additional measures, as President Johnson announced on January 1, 1968, that he would put "all the muscle this administration has behind the dollar and to keep our financial house in order."" American investment in Continental European companies was curbed. Corporations were required to repatriate part of their profits earned overseas. Bank lending abroad was limited. American travelers were urged to stay home and explore the beauties of their own country instead of spending precious dollars touring in other peoples' countries. After Richard Nixon's victory in the presidential election of 1968, a 10 percent tax surcharge was enacted to narrow the budget deficit-a belated reversal of Lyndon Johnson's adamant opposition to such a move.

  Nothing sufficed. The accumulation of productive and profitable foreign assets by American firms and investors seemed to count for little. The U.S. gold stock declined every year from 1958 to 1971, falling from $19 billion to $10 billion, while America's liquid liabilities to foreigners rose every year over the same period of time until they had expanded to over $60 billion. 9 As the French economist Jacques Rueff put it on October 20, 1967, when the gold stock was $12 billion and the liabilities were $33 billion, the United States had exhausted its ability to pay off its creditors in gold: "It is like telling a bald man to comb his hair. There isn't any there.""'

  The United States seemed unable to restore any equilibrium to its international position. The gold bricks continued to move from American ownership at Fort Knox to foreign ownership stored for safety in the vaults of the Federal Reserve Bank of New York (or, for the French, at the Bank of
France). The Europeans gained gold, but the inflow failed to stimulate their demand for imports from the United States by enough to reverse the eastward movement of gold. Like the Asians in times past, Europe defied Adam Smith's prediction that "When the quantity of gold and silver imported into any country exceeds the effectual demand, no vigilance of government can prevent their exportation." The "effectual demand" in the 1960s seemed to have no limit.

  What appeared to be an unending sequence of bad news for everyone else was great news to the pessimists who were convinced that gold was the only hedge in a hopeless situation. These gold bugs, as they came to be known, had been accumulating gold in the London market since the late 1950s. The major financial powers were concerned that this buying could push gold above the official price of $35 an ounce, provoking an uncontrollable rush into gold that could topple the entire system. Starting in 1961, the United States, Great Britain, Germany, France, Italy, Switzerland, Holland, and Belgium had joined together to pool their resources in an effort to beat down these speculators. The pool would sell gold in the market whenever the price showed signs of moving more than a few cents above $35.

  At the beginning, with new production coming in large quantities into London, the pool was able to buy more gold at $35 than it had to sell. The struggle with the speculators became increasingly one-sided, however, after General de Gaulle started beating the drums for an increase in the price of gold. In fact, General de Gaulle had pulled France out of the gold pool during 1967. In early March 1968, the United States had to transfer $950 million in gold to London to keep the price close to $35; nearly $2.5 billion had been paid out from Fort Knox since November 18, 1967, when the British had devalued sterling for the second time since the end of World War II.