Anyone looking at this development was likely to conclude that the present arrangement could not be sustained. As a candidate, President Nixon opposed the restrictions on capital flows, but he did not propose any solution to the payments problem. The new Undersecretary of the Treasury, Paul Volcker, recognized that without restrictions on capital and possibly tourism and trade, there were two solutions: either a multilateral agreement or unilateral action to permit exchange rates to adjust. The other possible solution—defl ation—was so universally rejected that it was never mentioned. Exchange controls, pressures on some foreign governments, and a temporary surge of euro-dollar borrowing to finance domestic banks propped up the international monetary system in 1969.
The newly elected Nixon administration appointed a task force, chaired by Professor Gottfried Haberler, to recommend an international economic policy. Haberler made the case for wider bands, increased exchange rate flexibility and an end to capital controls. In a separate memo, Milton Friedman made the case for floating the dollar at the very start of the new administration. He warned that “later events may force the administration to take the same measures that it could at first take voluntarily, but if so, the measures will then involve great political and social cost” (Friedman, 1968a, 1).63
Arthur Burns summarized the task force report for the new president. The payments position “is very precarious.” He favored the elimination of exchange controls calling them wasteful, inefficient, and a tax on growth, and he warned that pressures against the dollar could become a problem. He proposed “confidential negotiations with the key industrial countries . . . with the main American objective being to secure quickly a significant realignment of parities of some currencies” (Department of State, Summary of the Report of the Task Force on U.S. Balance of Payments Policies, January 18, 1969, 1). He proposed wider bands and small “automatic adjustments,” a crawling peg, and separately a one-time realignment. He opposed a floating rate and revaluation of gold, and he warned that “if a ‘gold rush’ develops, the United States should suspend gold convertibility” (ibid.).
Separately, the new Treasury Undersecretary for Monetary Affairs, Paul Volcker, chaired a group similar to the Deming group in the Johnson administration. It did not recommend a floating rate, in fact gave it little attention. It confined discussion of exchange rate policy to fixed rates or limited flexibility.64 The memo did not take a position for or against limited flexibility. It suggested, however, that more flexible exchange rates would remove a restraint against inflation and “might worsen our current account deficit” if other currencies depreciated against the dollar (Department of State, Long-Term Aspects of U.S. International Monetary and Exchange Policies, Volcker group, January 30, 1969). Elsewhere in the memo, the group recommended prompt issuance of $3 to $4 billion a year of SDRs for five years.
63. Official views had started to change. Britain’s 1967 devaluation and discussion of French devaluation and German revaluation in November 1968 brought adjustment to the fore and removed parity changes from among the unmentionables. In both countries, proponents of exchange rate adjustment, including central bankers, moved the discussion from academia to official institutions. Solomon (1982, 168) mentions the desirability of a depoliticized process for exchange rate adjustment. The United States government was slow to support discussion of greater flexibility (ibid., 171). The Economic Report of the President, however, mentioned “greater flexibility of exchange rates” within the Bretton Woods system (Council of Economic Advisers, 1971, 145). Later, the report recognized “the political consequences inherent in exchange rate decisions have made countries hesitant to undertake said adjustments” (ibid., 152).
With limited support and some strong opposition to floating, President Nixon retained the existing arrangements at the start of his administration.65 The principal new thrust was the effort to get SDRs issued. The timing was helpful because the United States had raised interest rates as part of domestic policy. As a by-product it had an official settlements surplus at the time, and the French had made that a precondition for agreement. The principal issue in dispute within the administration was removal of exchange controls and the interest equalization tax when it expired in June. With these changes, Treasury estimated that the goods and services account would have to increase by $13 billion to achieve permanent balance.
All parties in the new government supported removal of controls in principle, but, prompted by his staff, National Security Adviser Henry Kissinger urged delay and deliberation. By late January, concern about foreign reaction to removing controls and the estimated increase of $2.1 billion of foreign direct investment, if the administration eliminated controls, caused further delay. Discussion with European officials aroused concern that an ambitious decontrol program could harm the administration’s efforts to issue SDRs. This had priority, and the priority was not questioned. Major decontrol that would widen the reported payments deficit by as much as $2 billion strengthened some European concerns that the United States wanted to use SDRs to avoid “discipline.” In any case, the need for SDRs would be reduced by a large payments surplus.
64. I worked for Paul Volcker briefly in the Kennedy administration. At the time, he was committed to a fixed rate system. Although he may have moderated his views in 1969, they had not changed. As noted below, he was pragmatic; he recognized that the current arrangement could not be sustained.
65. Before President Nixon traveled to Europe to discuss international monetary arrangements, he received memos from Paul McCracken at the CEA and Arthur Burns, his counselor. McCracken opposed any increase in the gold price except as part of a total package “that makes it worth our while.” Burns agreed about gold, then added, “Let us not develop any romantic ideas about a fluctuating exchange rate: there is too much history that tells us that a fluctuating exchange rate, besides causing a serious shrinkage of trade, is also apt to give rise to international political turmoil” (Nixon papers, Box 442, February–March 1969, Trip to Europe). President Nixon did not have much interest in international economics. Volcker and Gyohten (1992, 61) described him as unwilling to see finance as a binding constraint on his foreign or defense policies.
By March, the Volcker group was ready to propose a long-term strategy. This was a major step away from the short-term crisis management of the Johnson administration. With modest changes in response to events, the Nixon administration followed both of the proposals in turn.
The strategy called for “either (a) negotiating substantial but evolutionary changes in present monetary arrangements, or (b) suspending the present type of gold convertibility and following this with an attempt to negotiate a new system” (“Summary of a Possible U.S. Approach to Improving International Monetary Arrangements,” Department of State 119, March 17, 1969). The paper proposed a two-year period to terminate at the end of 1970 during which active negotiations, with high-level support, would try to achieve several objectives: (1) issue $15 to $20 billion of special drawing rights over five years; (2) increase IMF quotas in 1970 but not at the expense of the SDR allocation; (3) seek appreciation of the mark and other currencies of countries in surplus; (4) begin intensive consultations about moving parities, wider exchange rate bands, or a combination of the two; and (5) make other adjustments including relaxation of capital controls. The memo ruled out a change in the gold price.
If negotiations failed to achieve adjustment, the United States would act unilaterally to end gold convertibility. Then in “calm and unhurried negotiations,” the United States would try to reconstitute a system with greater exchange rate flexibility and other features of the earlier negotiations (ibid.) Volcker suggested about two years of efforts to change the system by multilateral agreement before taking a unilateral approach.66 He was not optimistic about what negotiations would achieve, but he was less enthusiastic about ending the gold peg. His recommendations were based on what he thought would happen (Volcker and Gyohten, 1992, 67–69).
On April 4, Presiden
t Nixon retreated from his campaign promise to remove capital controls and accepted the recommendations of the balance of payments task force. The new guidelines raised the ceiling for foreign direct investment by $400 million to $3.35 billion (Department of State, memo, Treasury Secretary Kennedy to President Nixon, April 1, 1969). The Federal Reserve relaxed lending restrictions as part of the program (Board Minutes, March 27, 1969, 16–17).67
66. Solomon (1982, 169) noted that the Deming group circulated to “senior colleagues of a number of countries” proposals for discussion of wider bands and crawling pegs for exchange rates. The main reason given for failure to get agreement was European concern that the United States would practice “benign neglect” of the effects of its policies abroad (ibid., 170).
Martin was unable to attend an October 22 meeting on the revision of capital restrictions for 1970. He sent a letter outlining his views on the balance of payments. The improvement in the official settlements balance was temporary, he said, the result of a $410 billion euro-dollar inflow that had ended. As the official settlements deficit increased, foreign monetary authorities would acquire dollars leading to a “large draw down of U.S. reserves (gold, our IMF position, SDRs)” (letter, Martin to Kennedy, Board Records, October 21, 1969, 2). Then he added a critical point: “foreigners’ response would be influenced by whether they regard the large deficits as temporary or permanent” (ibid., 2–3). Martin added that dismantling capital controls, when faced with a large deficit, would disturb foreign observers and lead them to “conclude that the U.S. deficit is here to stay” (ibid., 3).
In October, probably influenced by the Volcker proposals, the Federal Reserve staff proposed a study of the consequences of increasing exchange rate flexibility. The proposal listed wider bands for exchange rates, adjustable parities (e.g., crawling pegs), and wider gold-price margins, but it excluded floating rates. Later, the staff discussed some of the issues with foreign counterparts. The principal concern was the absence of “discipline.” A few participants favored increased flexibility, but several opposed wider bands as unnecessary or harmful to international stability. Members of the European Economic Community expressed particular concern that exchange rate flexibility would disrupt internal agricultural trade because the pricing formulas would change with the exchange rate (Greater Exchange Rate Flexibility: Report on Bilateral Technical Discussions, Board Records, October 1969).68 This hardly seems a strong reason for rejecting major reform of general benefit.
67. Chairman Martin continued to participate in meetings of the Cabinet Committee on the Balance of Payments. Secretary of State Rogers was a member also, but the National Security Adviser (Kissinger) was not. President Nixon saw foreign economic policy in its political aspect and had many of the discussions moved to the National Security Council, where Kissinger was present (Department of State, memo, C. Fred Bergsten to Henry Kissinger, April 14, 1969).
68. There were other proposals for change. William Dale, the Treasury representative at the IMF, proposed an end to gold convertibility, “sooner, rather than later” (“Limited Gold Convertibility in a Cooperative Framework,” Volcker papers, Department of the Treasury, March 10, 1969). He proposed unilateral action to replace what he called “pseudo convertibility” with a rule for limited convertibility. The U.S. would sell gold at $35 an ounce to countries as long as the ratio of gold to imports in the buying country’s official holdings were no higher than in the United States after the sale. Countries would converge to a common ratio. Dale did not specify how the rule would change if the world price exceeded $35 an ounce.
These conversations and others suggested that multilateral agreement on systemic changes would prove difficult. Appeals to the “discipline of fixed exchange rates” seem particularly odd, since neither the United States nor Britain was willing to restrict demand enough to maintain the exchange rate. True, neither country completely ignored its balance of payments deficit when it became a problem, but both were reluctant, or unwilling, to exert the necessary discipline. Nor would the surplus countries approve of policies that restricted demand in the deficit countries to a degree that significantly reduced their own exports. And the surplus countries would not adjust. The architects of the Bretton Woods system thought they had designed a fixed exchange rate system freed of the problems of the 1920s gold standard. In principle, exchange rates could adjust to clear permanent imbalances; in practice they did not, at least not for the principal surplus countries or for the principal reserve currency country.
Some small relief came in 1969. Early in April, the Federal Reserve raised the discount rate to 6 percent and increased reserve requirement ratios for demand deposits by 0.5 percentage points. Ten banks had requested an increase in the discount rate. Chairman Martin spoke about “the credibility gap” faced by the Board and the administration; “neither was willing to take the hard action required if inflation was to be stopped” (Maisel diary, April 3, 1969, 53).69 Later in the year, after an election, West Germany floated its exchange rate to reach a new fixed rate 9.3 percent above the old rate. No major country followed. Some adjustment had been achieved, but it was insufficient.
On June 23, Secretary Kennedy sent the president a long options paper explaining what choices he could make about international economic policy. The paper, prepared by the Volcker group, reiterated the choices presented earlier. There were three options.
First, the United States should obtain multilateral agreement on increased exchange rate flexibility and adjustment. Part of this program included early activation of special drawing rights (SDRs). The U.S. proposal called for $4 to $4.5 billion a year for five years. The Europeans proposed $2 billion a year. The memo favored the multilateral approach but warned that “multilateral agreement may fail to move rapidly enough to achieve the objective and relieve the present strain” (Summary of Basic Options, Paul Volcker inter-agency group, Nixon papers, June 23, 1969).
69. All Board members agreed on the discount rate change. Maisel opposed the change in reserve requirements because he believed it would reduce growth of the aggregates, tightening policy. He issued a strong dissenting statement but was persuaded to shorten and soften it (Maisel diary, April 3, 1969, 53–56). Interestingly, differences of opinion still existed about whether increases in reserve requirement ratios would tighten policy. “Maisel described Martin, Robertson, Daane and probably Brimmer [as] believing that Board should push as hard as possible to stop inflation” (ibid., 53).
Second was suspension of gold convertibility in part, on a negotiated basis, or wholly. The principal disadvantage came from the unilateral approach. Cooperation might end over trade and investment with the establishment of a dollar bloc and a European gold bloc. But this approach would force surplus countries to revalue.
Third was an increase in the gold price. This would require congressional approval and would be contentious. Also, a large change would be inflationary, and any change would be disadvantageous to countries like Canada and Japan that had held dollars and had not asked for gold. Gowa (1983, 137) found that only Arthur Burns, counselor to the president at the time, favored devaluation against gold. The dollar, he said, was overvalued, and the Bretton Woods system would remain at risk until adjustment occurred. By devaluing early, the president could blame the action on the Johnson administration’s policies. Burns’s opponents wanted to demonetize gold and substitute SDRs. They feared that devaluation would strengthen the role of gold (ibid., 138).
Two notable features of the memo and discussion are the absence of any discussion of more restrictive policies and the acceptance of the remaining capital controls that the president, as a candidate, promised to eliminate. However, the memo repeatedly recognized the importance of reducing inflation and ending the Vietnam War while avoiding deflation and unemployment.70 Of course, it did not say how this could be done.
The Volcker group cited three major problems. First, it questioned whether existing arrangements would continue to finance large United States defici
ts. Second, confidence in the United States had declined. “The uneasy feeling abroad that United States deficits are in danger of becoming uncontrolled erodes our bargaining position” (Paul Volcker inter-agency group, Nixon papers, June 23, 1969, 8). Third, after reviewing the principal sources of the deficit, it concluded that the long-term outlook was unfavorable. Further, devaluation against gold does not necessarily change exchange rates.71 Others can follow. The conclusion was “Until appropriate changes can be made in commercial policy, world trading rules, and/or monetary arrangements, our balance of payments position will continue to require the protection of capital controls” (ibid., 18).
70. The memo noted the diminished role of gold. The cumulative payments deficit of $24 billion from 1958 to 1968 had been financed only 40 percent ($10 billion) by gold sales (summary of basic options, Paul Volcker inter-agency group, Nixon papers, Annex I, June 23, 1969, 6). A few months later, Robert Solomon wrote to Arthur Burns urging no change in the gold price. The principal reason was that it would hamper the movement toward a multilateral system based on SDRs (memo, Solomon to Burns, Volcker papers, Department of the Treasury, March 16, 1970).
71. There was some basis for this concern. When the issue came up, some governments threatened to follow any devaluation of the dollar. Among other possible repercussions, the memo reported that the Japanese said their government would fall. Also, countries would ask for compensation for their losses to be paid from profits on the devaluation of the dollar. The report never considered Irving Fisher’s proposal for a compensated dollar that would tie the gold price to an international commodity basket.
A History of the Federal Reserve, Volume 2 Page 8
