The Great Deformation

by David Stockman

  In the end, the Bank of England’s grand experiment in money printing failed to achieve domestic recovery. The British economy, unlike most of the rest of the world, stagnated for much of the 1920s. But this monetary profligacy did flood the international financial system with more sterling liabilities than were sustainable; that is to say, Great Britain attempted to borrow its way back to prosperity.

  This easy way out of the Great War’s legacy of debt, devalued sterling, and depleted industries inexorably came a cropper. As has been seen, when the global economy shrank sharply after Wall Street’s foreign bond financing machine shut down, world trade plunged even more rapidly. In turn, this downward trade spiral triggered the final unwinding of the worldwide debt bubble that had reached an asymptotic peak in 1928–1929.

  The bubble’s collapse began in central Europe, where some of the most egregious of Wall Street’s “subprime” loans of that era had been made, and most famously resulted in the May 1931 run on Credit Anstalt, Austria’s largest bank. Depositors in the Austrian banks, and a month later in German banks, too, correctly perceived that these institutions were insolvent because their hard-hit domestic customers could no longer service their loans—especially their dollar borrowings.

  Moreover, their own governments were too financially weak to save their domestic banks, and the taxpayers of the world had not yet bequeathed to the banking fraternity its very own IMF bailout machine. Consequently, there ensued a flight from the imperiled banks and currencies of Austria, Germany, and other central and eastern European nations and a corresponding scramble for gold.

  In short order, the flight to gold from the weak paper currencies of continental Europe during the summer of 1931 lapped up on the shores of England, too. As it happened, the British government had the tools in hand to turn back the assault and defend the very gold exchange system it had championed. But like the United States under Johnson and Nixon four decades later, it could not summon the political will to discharge its obligations as the reserve currency issuer.

  THE GREAT BETRAYAL OF SEPTEMBER 1931: WHEN THE BANK OF ENGLAND UNNECESSARILY DEFAULTED

  In August 1931, only a few weeks before England defaulted, a national unity government had been installed and stern measures to curtail its budget deficit by means of tax increases and reductions in lavish spending for industrial subsidies and social programs had been enacted.

  All that was needed was for the Bank of England to deploy its time-tested tool and implement a sharp increase in its discount rate, which was only 2.5 percent at the time, in order to stem the outflow of short-term money from London. Indeed, it was morally obligated to take these painful steps.

  For years, the imperious mandarins who ran the Bank of England had urged the French, Swedes, Belgians, and most especially Holland to accumulate outsized reserves of pounds sterling rather than demand gold. But there was no sustainability to it; it was just a kick-the-can ruse to avoid an unwelcome outflow of gold and contraction of England’s puffed-up domestic economy.

  As it happened, on September 20, 1931, England defaulted in a wave of panic and under withering pressure from its own economic nationalists. Keynes led the charge, declaiming loudly for default in the same words, albeit with better grammar, that Connally would employ four decades later. Like Nixon’s government at Camp David, the British wanted to shed the alleged “straitjacket” of fixed exchange rates and convertible money in order to “stimulate” the domestic economy.

  Yet in refusing to honor its obligation to convert pounds sterling to gold, Great Britain also crushed what remained of the very gold exchange standard it had so assiduously peddled around the world since 1921. Needless to say, those unlucky nations which had been persuaded to hold their reserves in pounds sterling were left holding the bag, suffering immense losses as the pound exchange rate against the dollar dropped by 35 percent in a matter of weeks.

  Holland, in particular, took a beating. On the explicit secret assurances of the Bank of England, the Dutch central bank had refused to reduce its large sterling holdings, despite the gathering market panic, through the very day of default.

  Once the dam broke, however, the world experienced a renewed flight from paper currencies and an extended period of gold hoarding and beggar-thy-neighbor protectionism. Then and there, the world plunged into a dark night of economic nationalism, protectionism, fiat currencies, and economic stagnation.

  JOHN MAYNARD KEYNES AND THE SECOND ATTEMPT AT MONETARY ORDER: THE IMPERFECT REVIVAL OF GOLD AT BRETTON WOODS

  By 1944 the entire world had been bankrupted by war, save for the United States. So when the United States hosted the crucial conference at Bretton Woods to plan postwar reconstruction of the world financial system and monetary arrangements, it had a unique opportunity to start afresh, applying the lessons learned from both the failed gold exchange standard of the 1920s and the even more disastrous beggar-the-neighbor nationalism of the 1930s.

  In one of the cruelest ironies of history, however, Keynes was made chairman of the committee on monetary arrangements. Already approaching his dotage, he nevertheless did not want for domineering pomposity or capacity to dispatch the arguments of the hapless Harry Dexter White (head of the delegation and under-secretary of treasury).

  Under Keynes’s tutelage, therefore, the conference in due course proceeded to revive the failed British experiment in debt-based money. It is not coincidental that the experiment on which Keynes himself had helped administer the coup de grâce in September 1931 would eventually meet a similar fate.

  Modern Keynesian historians now stoutly insist that the Great Depression was caused by the gold exchange standard. In truth, the cause was the hangover from the financial carnage brought on by the Great War, and the subsequent Wall Street foreign bond issuance spree that cantilevered massive debts on top of broken economies and already bankrupt nations.

  Yet these revisionists are undoubtedly correct in claiming that the demise of the gold exchange standard after 1929 amplified the decline that was already under way. What they fail to concede, however, is that it was not gold bullion per se, but the “exchange” part of the equation that caused the 1931 breakdown of the international economy.

  At the time of the crisis, it was true that the Bank of England had almost no gold and that most of the world’s gold reserves were actually domiciled in the United States and France. Still, the fault for this imbalance was not in the yellow metal, but in British policy which for an entire decade avoided financial discipline through the buildup of short-term sterling debt, a pattern which would be replicated under the dollar-based gold exchange system during the 1960s.

  In fact, the $3 billion in pounds sterling held by France, Holland, and the remainder of solvent Europe was British debt that had been turned into the world’s money. It was also debt which Great Britain voluntarily obligated itself to redeem for a fixed weight of gold under rules it largely formulated.

  At the time of the September 1931 crisis, however, Keynes proclaimed that the policy actions needed to defend the pound—higher interest rates and fiscal austerity—were “inconvenient.” So international default became the pathway to implementation of his pet nostrums at home, such as cheap money and deficit-financed pump priming via public works and public jobs.

  When the conference ended in July 1944, this same disability had been transplanted into the new system. It would only be a matter of time before it came under a new Keynesian assault.

  Only this time the nationalist assault would necessarily arise in the United States, and the executioners would be Keynes’s disciples. In the first wave, the attack came from liberal economists who acknowledged his tutelage.

  But in the end, it was the economic nationalists from the University of Chicago, the closet disciples of Keynes, who found the discipline of the gold exchange system to be as inconvenient in 1971 as he had found it in 1931. So the disciples of Friedman recommended to the president of the United States that the world’s richest nation default on its deb
t obligations, an act so perfidious that even J. M. Keynes himself might have abjured.

  THE BRETTON WOODS FLAWS

  WHICH TOOK TIME TO EMERGE

  Milton Friedman was ultimately able to take down Keynes’s Bretton Woods creation, once the great thinker’s new economics disciples paved the way. Their successful assault was enabled by two basic chinks in the Bretton Woods scheme to restrict the use of gold to official settlements between the US Treasury and foreign central banks. The first was that the private purchase and possession of monetary gold was outlawed in the United States, but there were no restrictions on American citizens buying and holding gold abroad.

  Thus, if a gap developed between the free market price in London and the official $35 parity, it would be quickly arbitraged. It would take little more than a good lawyer and a savvy banking house to get large amounts of American capital into the London gold trade.

  And equally consequential was the fact that foreign central banks with unwanted dollars could surreptitiously use them to buy small amounts of gold in the London market, rather than risking Washington’s ill will by coming to the official Treasury gold window. During the summer of 1960, in fact, it had been heavy gold buying in London by the Bank of Italy that first catalyzed private speculators.

  Thus, the potential existed for the London peephole into the free market for gold to be dramatically enlarged by both private speculators and central banks operating outside the official etiquette. Needless to say, this meant that from day one the new economics was on a collision course with Bretton Woods.

  If excessive fiscal expansion and deficit spending forced the Fed into too much monetary accommodation, the nation’s current account would deteriorate and its price level relative to the rest of the world would rise. In that event, speculators could effectively short the dollar by piling into the London gold market.

  The resulting conversion of unwanted paper dollars—whether held by speculators or central banks—into gold would drive its price rapidly higher. In short, the London gold market was a vestigial organ of the ancient monetary régime. It threatened to chase the Harvard economists right back into the Littauer Library the minute their Keynesian schemes went too far.

  To be sure, at the official level the US government might well continue to bully the West Germans or Japanese into foregoing the right to swap unwanted dollars for gold at the US Treasury window, and to refrain from cheating in the London gold market. Yet even heavy Washington diplomatic pressure could not stop private speculators from betting against the sustainability of such monetary imperialism.

  The US nuclear umbrella, of course, provided US officials with a powerful lever that the Bank of England did not possess in September 1931. Yet even the American Cold War hegemony had its limits when it came to monetary fundamentals.

  Sooner or later the buildup of excess dollars in foreign central banks would reach the breaking point. If they kept buying up dollars at the Bretton Woods exchange rate parities, they would be forced to print excess amounts of their own currency, thereby importing US inflation.

  So as the 1960s opened, the new economics amounted to a form of doubling down. There was already a severe dollar outflow owing to the US Cold War imperium and its vast string of military and security operations abroad. On top of that, the new economics was now almost guaranteed to eliminate the US surplus in private trade and services, owing to excess domestic demand and a rising level of merchandise imports. Absent a large surplus in merchandise trade, the vast cost of empire would generate unsustainable deficits in the overall US balance of payments. Speculators therefore had every reason to bet on eventual dollar devaluation and that the price of gold someday would break loose of its Bretton Woods parity.

  Stated differently, JFK’s Keynesian professors were puffing themselves up to take on the global free market in gold, even if they did not acknowledge it. Yet the battle which played out in the London gold market’s daily price auction was one they were destined to lose.

  Their theories of intentional deficit spending to goose the GDP were bound to be abused by politicians and would eventually lead to easy money, domestic inflation, trade deficits, and insuperable pressure on the dollar’s gold parity. It was only a matter of time before the frail Bretton Woods rendition of the gold exchange standard would fall victim to their math-model economics.

  JOHN F. KENNEDY: THE LAST GOLD STANDARD DEMOCRAT

  The day of reckoning did not occur until near the very end of the Kennedy-Johnson era, when LBJ shut down the London gold pool in March 1968 (see page 246). Yet, ironically, this long postponement of the inevitable was due to JFK’s foresight in staffing the Treasury Department with monetary traditionalists, who managed to find creative expedients to defend the dollar and pay the nation’s international debts in gold, even as the flood of unwanted dollars mounted.

  In fact, once JFK took the oath of office, it was soon evident that economic policy process had been put on a split screen: an internationalist, hard-dollar policy was consistently enunciated at the Treasury Department, while an aggressively expansionist domestic fiscal policy was loudly proclaimed by the Council of Economic Advisors. The result was continuous conflict.

  Keynesian demand management is nationalistic and autarkic, and can only work in a closed economy. So under the actual circumstances it stimulated a growing leakage of dollars abroad, a trend that the Treasury’s clever expedients temporarily papered over. Eventually, however, Lyndon Johnson’s rampant exercise in “guns and butter” deficits exhausted the capacity of his own Treasury staff to temporize.

  Kennedy initially counterbalanced the new economics threat by the appointment of Douglas Dillon as treasury secretary. Dillon was a Republican, a ranking official in the Eisenhower State Department, and the scion of an old-line Wall Street banking house. His appointment was designed to reassure financial markets, and initially it did exactly that.

  In fact, Dillon did not allow international financial markets and gold speculators even a brief opportunity to get spooked by the new economics professors who had set up camp across the street in the White House. Just days after the inauguration, he arranged for JFK’s first major speech on economics to address international monetary policy and the dollar.

  Kennedy’s speech pulled no punches. The new president pledged full support of the Bretton Woods system and committed his administration to an “immutable” gold price of $35 per ounce. In those days, presidential words meant something, and there wasn’t much not to understand about “immutable.”

  Secretary Dillon and the Treasury’s international staff backed Kennedy’s words with a stream of actions designed to ward off pressure on the $35 gold price. These included a central bankers’ gold pool, currency swap lines, and even issuance of public debt in foreign currencies (“Roosa bonds”).

  Secretary Dillon’s initiatives to defend Bretton Woods also had an advantage that would never again recur; namely, a Fed chairman who believed in sound money, fixed exchange rates, and meeting the nation’s international obligation to keep the dollar good as gold.

  Not coincidentally, Chairman Martin began each Fed meeting during the 1960s with a report by the New York Fed on international financial conditions and the foreign exchange markets. In those halcyon days, the New York Fed was a stalwart defender of a sound dollar, not the active debasement agent that it became after the 1990s.

  Indeed, it would have been horrified by the weak-dollar doctrine of recent occupants of its top job, such as Tim Geithner and Bill Dudley. Consequently, as the guardian of the dollar’s foreign exchange integrity it helped design and operate the London gold pool, which was the Treasury’s primary line of defense.

  THE LONDON GOLD POOL: PRIMARY LINE OF DEFENSE

  The gold pool was formally established in December 1961 by the Federal Reserve and seven European central banks led by Germany, France, and the United Kingdom. The United States provided half of the pool’s $270 million stock of gold, with the balance coming from the Europeans. W
hile in theory this central bankers’ syndicate could either buy or sell gold in the London free market, the underlying purpose was to sell gold whenever speculators tried to drive its price above $35 per ounce.

  The bet of the gold speculators, of course, was that the United States would eventually elect to cheapen its currency, rather than rein in its balance of payments deficits through domestic austerity or retrenchment of its overseas military and foreign aid spending. In that event, the gold price would soar, bringing windfall gains to the speculators.

  Initially, however, the central bankers’ syndicate kept the speculators at bay, in part because the size of the pool was never made known to the market. In reality, the United States had secretly pledged to its European partners that it would replenish their gold stocks at a later date by the full amount of any sales from the pool. Thus, the United States was still on the hook to defend the $35 parity entirely with its own gold. Yet by warehousing dollars on an interim basis, the European central banks helped minimize the appearance of a drain on US gold stocks.

  During the first half of the 1960s, the Treasury’s dollar defense was reinforced by the fact that the overall US balance of payments deficit remained moderate. Gold outflows cumulated to just $4 billion during 1961–1965.

  Serendipity also gave the Treasury an assist when the Soviet Union had another massive crop failure, forcing it to sell about $1.5 billion of gold during 1963–1964 to feed the starving Russian population. Since these sales had the effect of dousing upward pressure on the free market price of gold in London, speculators shorting the dollar, ironically, got burned by the pratfall of socialist agriculture.

  The need for large outflows of US gold to finance the cost of forward defenses against the Soviet menace was thus temporarily averted, as the menace was proving more adept at starving its own people than endangering others. As it worked out, the central bankers’ gold pool actually ended 1965 with a billion-dollar surplus.