It is important to understand the full meaning of this expression. All foreign exchange rates are set in the first instance in a market where supply and demand determine the price of a currency, just as in the markets for common stocks, wheat, or oil. Suppose that a French commercial bank is accumulating more dollars than it needs because American tourists are exchanging large amounts in dollar traveler's checks for francs. There is a market where the bank can sell those excess dollars to foreign exchange dealers or to individuals or institutions willing to buy the dollars and pay for them with French francs. That fresh supply of dollars in the market may cause the price of the dollar to fall in terms of francs. That is, sellers of dollars will now receive fewer francs; however, buyers of dollars will have to pay fewer francs.
If the dollar is convertible into gold at a fixed price, however, the Bank of France may buy the unwanted dollars from the commercial bank, because the Bank can convert those dollars into gold at the U.S. Treasury at a price that will not decline-which means dollars are as good as gold. Under those conditions, the dollar-franc exchange rate will tend to be stable instead of deteriorating in response to the increased supply of dollars for sale.
But what happens when a currency is not convertible into gold, when the gold window in Washington is no longer available? Then no automatic limits exist for how low or how high the currency's exchange rate can go relative to the values of other currencies. The currency is floating. The only way to prevent the dollar from falling under these conditions is for the Bank of France to buy those dollars and just hold them, or for the U.S. Treasury to sell French francs from its reserves (a policy called "dirty floating"). If the Bank of France steps aside, however, or if the U.S. Treasury has too few francs in reserve to meet the demand, the dollar will depreciate and the value of the franc will appreciate.
If the gold window were shut, Nixon and Connally would force the foreign central banks to face a nasty set of alternatives. It was like a game of hearts, in which the Americans had passed the queen of spades to their opponents. The foreign central banks could continue to buy all dollars offered for sale, but that would only swell their already substantial dollar positions-in Wall Street parlance, the dollar was overowned. If they held back from buying, however, the dollar would decline in price in terms of other currencies. That would mean heavy losses to their citizens who had acquired dollars or dollar-denominated assets in the past and were still holding them. Furthermore, if French francs now cost Americans more dollars than before, Americans would tend to buy less French perfume and wine; at the same time, the French would now have to pay fewer francs to buy $1000 worth of American goods and services, which would give a boost to imports into France from the United States.
This was the precise outcome that Nixon and Connally hoped to achieve. All of that would be good for American business and jobs. Furthermore, by making American exports more attractive and foreign imports less attractive, the devaluation of the dollar might tend to be self-correcting as American demands for foreign currencies diminished and foreign demands for dollars picked up.
The second part of the Connally-Nixon strategy was designed to suppress the potentially inflationary consequences of this stimulus to business. In order to persuade the world (including Americans themselves) that the finale to gold convertibility was not also the last step on the sure road to runaway inflation, Nixon and Connally recognized they would have to package the shattering of the link to gold with price and wage controls that would confirm their dedication to fighting inflation.
Nixon was convinced that the time for half measures was past. He intended to stifle all criticism of pussyfooting by moving, as he described it, to "leapfrog them all."3 He anticipated little difficulty. The combination of abandoning the gold standard and adopting mandatory price and wage controls made a perfect fit. The economic attractions were strong, but both Nixon and Connally appreciated even more the political appeal of this new policy: conservatives liked the free market implications of the break with gold while liberals liked the activist policy of wage and price controls.
The last straw came during the week of August 9, in a note of extraordinary irony, when the British economic representative came in person to the Treasury and asked for $3 billion in gold. On the following Friday, the 13th, the President abruptly ordered the sixteen major economic policymakers of the administration to accompany him by helicopter to Camp David. The President made certain that no leaks about the proceedings would occur by cutting the group off from all communication with the outside world. Herbert Stein, Chairman of the Council of Economic Advisors at the time, described the occasion as "one of the most exciting and dramatic events in the history of economic policy."'
The group brought forth what they dubbed a New Economic Policy, which combined the closing of the gold window with a mandatory and comprehensive freeze on prices and wages. The freeze was for ninety days, but the expectation was that this initial step would be followed by voluntary restraints by business and labor. In addition to the decisions on controls and gold, the new policy included recommendations for tax cuts for business, reductions in government spending, and a 10 percent surcharge on about half of all U.S. imports. The import surcharge was the equivalent of a devaluation of the dollar, even without any change in the foreign exchange markets, because it automatically made those imports more expensive for Americans.
All the participants agreed that the announcement of the New Economic Policy should be designed to have major impact around the world. The President was urged to make a public statement on primetime television that Sunday evening. By making his decisions known before the markets opened on Monday morning, no leaks or rumors would be able to dilute the force of his words. Nixon demurred: he hesitated to make his speech on Sunday evening, for fear of irritating the public by preempting Bonanza, one of the most popular programs of the era.'
Under pressure from his advisors, Nixon managed to put the national interest ahead of the well-being of Bonanza fans. The news of his prime-time address broke with banner headlines on Monday morning's newspapers. The President minced no words:
I have directed the Secretary of the Treasury to defend the dollar against the speculators.... Now the other nations are economically strong, and the time has come for them to bear their fair share of the burden of defending freedom around the world. The time has come for exchange rates to be set straight.... There is no longer any need for the United States to compete with one hand behind its back.... We are not about to ease up and lose the economic leadership of the world.6
"They've really shot both barrels," observed the President of Bankers Trust Company on Monday morning. Paul Samuelson, the Nobel Prize-winning economist, asserted in an article for the New York Times that "The President had no real choice. His hand was forced by the massive hemorrhage of dollar reserves of recent weeks.... For more than a decade the American dollar has been an overvalued currency.... [The new policy] also helps Japan ... since it is foolish for Japan to give away goods without being repaid for them in equivalent goods." On Wall Street, one salesman exulted, "All brokers are the happiest people in the world today," as bond prices soared, the stock market boomed by nearly 4 percent, and trading volume was the highest on record up to that date.'
There were a few sour reactions. The only declared candidate for the Democratic presidential nomination, George McGovern, was unhappy: "It is a disgrace for a great nation like ours to end in this way the convertibility of the dollar.... By this act we will become the economic pariahs of the world."" The AFL-CIO (American Federation of Labor and Congress of Industrial Organizations), speaking for the labor unions and bristling at the prospect of controls on wage increases, announced that they had "absolutely no faith in the ability of President Nixon to successfully manage the economy of this nation."'
The negative views missed the whole point. Since the end of World War II, the Americans had locked themselves into a golden prison that only postponed the day of reckoning. They had tr
ied every which way to preserve the tie to gold even as they spent enormous sums of money on imports and investments in foreign countries. They borrowed from and wheedled their friends, they taxed their citizens, they warred on speculators, and they raised bars against their corporations' investing abroad. The one step that might have allowed them to hold onto their gold-the traditional policy of pushing down on the economy and increasing unemployment-was unacceptable in the postwar world.
The only other alternative would have been to abandon gold much sooner than in 1971. A few oddballs dared to suggest that solution, but they were shouted down. Foreigners wanted the gold window kept open so that they could cash in their dollar balances for gold at will. Hubris blocked the American leaders from taking drastic action until the very last moment. At the same time, the Europeans and the Japanese feared a devaluation of the dollar because it would have been bad for their business and would have produced big losses for their citizens who had accumulated dollars and dollar-denominated assets in the past. Dollar devaluation would also have meant fewer exports to America and greater competition from imports from America. Yet only dollar devaluation was likely to convert the reluctant foreigners into buying more American goods and services and bring balance back into the system.
With the golden anchor torn loose, once and for all, the New Economic Policy created instant pandemonium abroad. In contrast to Wall Street, foreign stock markets plummeted. In Tokyo, the market suffered a genuine panic, as the New York Times described it, "with sellat-any-price orders sending prices down sharply.""' One American who wanted to buy a loaf of bread in Paris and offered a dollar bill to the baker was told, "That's not worth anything any more.""
The only alternative to a fall in the value of the dollar against the world's currencies would have been for foreign governments and central banks to stand ready to buy all dol- s offered for sale by private parties who could no longer see any reason to continue taking the risk of holding dollars. While the authorities cogitated over what action to take, foreign exchange markets were shut down; no trading was permitted. Only Japan remained open, but after absorbing $4 billion in the two weeks after August 15, the Tokyo government let go and watched tl yen appreciate against the dollar. Other markets opened on the 23rd, with similar results. The dollar had been devalued.
The flood of dollar selling provoked foreign governments to demand a prompt return to some kind of system of fixed exchange rates. Even the Americans had to admit that such volatile exchange rates created uncertainty for all kinds of business decisions. A long series of negotiations culminated in a meeting in December 1971 at the Smithsonian Institution in Washington to reestablish order in the foreign exchange markets. A new set of parities was agreed upon, recognizing part of the depreciation of the dollar that had occurred in the markets over the past four months, and the United States withdrew the 10 percent import surcharge. A new official dollar price of gold was set at $38-the equivalent of a formal 7.9 percent devaluation of the dollar-although by that time gold in the London market was trading at between $43 and $44, about $5 higher than on August 15. With a preposterous degree of hyperbole, Nixon characterized this agreement as "the most significant monetary agreement in the history of the world."12
The new arrangements were incapable of surviving the intensifying inflationary pressures gathering all around the world. A series of crises led to another set of negotiations that produced an approved increase in the official dollar price of gold to $42.22 (which is the price still in use by the United States, 27 years later), but even this step failed to ward off a final breakdown in the efforts to sustain fixed exchange relationships among the major currencies. To make matters worse, OPEC (Organization of Petroleum Exporting Countries), a consortium of major oil-producing countries, joined together in October 1973 to restrict their production until the price of oil had jumped from $2.11 a barrel to over $10, igniting additional powerful and irrepressible inflationary impulses throughout the world economy.
All of this was too much for the U.S. system of price and wage controls. The administration had no choice but to abandon these arrangements in the face of the tremendous leap in the price of oil combined with the devaluation of the dollar, which automatically raised the price to Americans of most foreign goods and services.
Then, in November 1973, only a month after the OPEC countries had roiled the world economy, the central banks threw in the sponge on their 1968 decision to refrain from trading in gold except among themselves. Now the central banks could buy and sell in the London market at prices far above the official price of $42.22, and several loans from one government to another were collateralized by gold valued at more than $40. The French soon began valuing all their gold reserves at the market price, although others refused to follow their lead and left the French once again as outliers.
Beginning in 1975, tentative steps were taken to liberate the monetary system even further from gold. In January and June 1975, and again in 1978 and 1979, the U.S. Treasury auctioned a total of about 6 percent of its total gold stock, motivated by the belief that "Neither gold nor any other commodity provides a suitable base for monetary arrange- ments."13 Then in August, an International Monetary Fund committee reached two momentous decisions: they agreed to abolish the official price for gold, and they also decided to auction a portion of the Fund's gold holdings. The proceeds of the auction were to be used for the benefit of developing countries and also to return to member countries some of the money they had originally contributed to the Fund. After one hundred years in which hoarding gold was the fashion among the central banks, all of a sudden hoarding was out and dishoarding was in.
The speculating public was unimpressed with both the words and the deeds of the governments and official agencies. If governments wanted to play games with gold at artificial values, or auction off nominal quantities of gold, that was their problem. None of the international agreements to manage exchange-rate volatility seemed to hold up. Inflation in all countries was eating away at the values of stocks, bonds, and cash. Inflation was most intense in Britain, France, and the United States among the developed countries, but even Germany's inflation averaged 5 percent from 1974 to 1981 and included episodes above 7 percent. Consequently, many speculators were only too happy to buy gold from central banks that insisted on behaving as though gold was just a barbarous relic and not worth owning any longer.
The soaring demand for gold as a safe haven for wealth and as a hedge against inflation drove the price in the London market from $46 an ounce at the beginning of 1972 to $64 an ounce at the end of the year. The price broke through $100 during 1973; from 1974 to 1977, gold fluctuated between $130 and $180. A second OPEC oil price increase to $30 a barrel in 1978 created a frenzy that ignited a new and precipitous climb in the gold markets: the price of gold hit $244 an ounce before the year was out and then doubled to $500 in 1979. In the spirit of the times, the famous comedienne Bette Midler, about to depart on a European tour, demanded on July 3, 1978, that her $600,000 fee be paid in South African gold coins instead of in U.S. dollars.14
The headline on the cover of the March 12, 1979, issue of Business Week magazine read "The Decline of U.S. Power" and showed a closeup of the face of the Statue of Liberty with a tear running down her cheek. There was plenty to cry about in the U.S. economy, with most of the trouble homegrown. America had become the victim of her own success. At the end of World War II, American business was so far ahead of the ruined economies in the rest of the world that American managements were convinced they had all the answers. Corporate executives belittled change and played down the competitive pressures that were steadily building beyond the national borders of the United States as Europe and Asia recovered from the war. While a new generation of business management abroad achieved high rates of economic growth and technological innovation, American business continued to suffer from economic hardening of the arteries.
The tragic loss of competitive position by the American economy in the 1970s was th
e equivalent of a major military defeat. Inflation appeared out of control, unemployment remained stubbornly high, fiscal policy was a mess, the dollar was approaching a major crisis at the end of the decade, and America's share of world markets was shrinking at a distressing rate.
In October 1979, inflation in the United States was running over 12 percent-a significant increase from the distressing figure of 8 percent a year earlier-while the dollar was at bay in the foreign exchange markets. Paul Volcker, the Chairman of the Federal Reserve System, was now confronted by his agitated counterparts in the major European countries and Japan, who feared that the whole world would succumb to a crisis as devastating as the 1930s unless the United States took strong and decisive steps to mend its ways. Volcker pledged the Federal Reserve to bring the surging U.S. money supply under control, even if it meant pushing interest rates up to levels never before seen in history. The Federal Reserve was about to swallow the conventional medicine.
Volcker's strategy was ultimately victorious in the long battle against inflation, but the immediate impact of his policies unleashed another torrent of turbulence in the financial markets. Nobody knew for certain how measures as tough as this would play out over time. The major concern was that the blow to the economy might be so severe, with widespread bankruptcies, plunging production, and soaring unemployment, that the policy would have to be completely reversed, unleashing a whole new wave of inflationary pressures.
The United States was not the only country facing chaotic conditions at that moment. Inflation in most countries at the end of 1979 was running in double digits and even Germany was up to 6 percent. Political conditions were perhaps even more frightening. Iranian radicals in November 1979 took over the U.S. embassy in Tehran and held the entire staff as hostages, initiating a crisis that would endure for more than four hundred days. At the same time, the Russians were building up their strength in southern Yemen near Saudi Arabia, near Afghanistan's border with Iran, and near Bulgaria's border with Yugoslavia-at a moment when Yugoslavia's 87-year-old Marshal Tito was in poor health.
The Power of Gold: The History of an Obsession Page 41