THE HELLER-TOBIN ASSAULT ON SOUND MONEY
It was all downhill thereafter and mainly because the fundamental terms of the US financing equation steadily deteriorated. On the one hand, the dollar outflow owing to the “cost of empire” intensified, rising from $6–$7 billion per year before Johnson’s big 1965 escalation of the Vietnam conflict to $9–$11 billion per year during 1968 and several years afterward.
At the same time, Kennedy’s new economics professors had succeeded beyond their wildest dreams. By mid-1962 they had worn down President Kennedy’s aversion to deliberate deficit finance, and by year-end had gotten him to deliver a speech on behalf of stimulative tax cuts to the Economics Club of New York City.
Much to Kennedy’s surprise, the prospect of a sizeable reduction in personal income tax rates and corporate taxes was widely applauded on Wall Street. The federal budget was still in deficit and a tax cut had not yet been earned under Eisenhower’s fiscal rules, but the idea of “stimulative” tax cuts on Uncle Sam’s credit card was taking hold.
So Kennedy was emboldened to embrace the new economics game plan and propose a substantial tax cut in his January 1963 budget message. In doing so, he had overridden the concerns of Secretary Dillon that this resort to a deliberate fiscal deficit would undermine the Treasury’s dollar defense strategy. History would now record that, apart from the resolute stand taken by Paul O’Neill against the Bush tax-cut mania in 2003, Dillon was one of the last treasury secretaries to defend the nation’s revenue base in the name of sound finance.
Moreover, Dillon’s dissent had come on top of what by then had become a heated and divisive battle inside the Kennedy administration on the fundamental balance of payments and dollar issue. Only months earlier, in fact, the Keynesian professors led by Walter Heller and James Tobin had proposed an inflationist plan to suspend the gold window, cut domestic interest rates, and negotiate a “long-term borrowing arrangement” with the Europeans.
Already the inherent corruption of language which goes with the Keynesian brief had cropped into the debate. The “borrowing” arrangement proposed by Heller and Tobin was nothing more than a meaningless sleight-of-hand. Rather than pay off the rapidly growing short-term dollar claims held by other central banks, the professors were proposing to re-label them as long-term debt and tell the Europeans to suck it up.
In truth, the Heller-Tobin proposal was a nationalistic, frontal assault on Bretton Woods because it removed the free convertibility linchpin from the system; it told the Europeans who had accumulated dollar exchange reserves in good faith to choke on them.
A much agitated Secretary Dillon, therefore, had to admonish the professors that such a step would “shake the system to its core in the same way as the German standstill announcement of 1931 or the dollar devaluation of 1933 had done.”
Secretary Dillon and Fed chairman Martin were able to quash the Heller–Tobin plan after it predictably set off alarm bells in Europe and warnings that it would lead to the early demise of Bretton Woods. Still, justifiably irritated by the constant attacks of the White House professors, Dillon explained in no uncertain terms that sound international policy had to be based on consistent financial discipline, not Tobin’s ten-year loan from Europe designed to kick the US balance of payments problem down the road indefinitely.
Dillon thus called out his internal adversaries as follows: “They search for ways to make this very real problem go away without interfering with their own projects—be they extra low interest rates in the US or the maintenance of large US forces in Europe. However, such individuals are asking the impossible. The sine qua non of all international monetary dealings … is that no country can run a consistently large balance of payments deficit.”
Chairman Martin was equally aghast at the Heller-Tobin prequel, in 1962, to what turned out to be the same flimsy logic as that behind Nixon’s actual gold dollar default nine years later. “The proposed plan …” he declared, “would hit world financial markets as a declaration of US insolvency and a submission to receivers to salvage the most they could get out of the mess to which past US policies had led. It is incredulous to expect from it any resurgence of confidence.”
These were the words of sound-money men at a time when political expediency and debt-based financing schemes could still be called out. Yet it was only a matter of time before their voices would go quiet. The monetary policy battles inside the Kennedy administration did, indeed, demarcate the twilight of sound money.
HIGH TIDE OF THE NEW ECONOMICS
The wisdom of Dillon and Martin did not slow down the White House professors one bit, who instead aggressively pushed the 1963 tax-cut plan to the top of Kennedy’s agenda. They insisted it was a watershed breakthrough into enlightened fiscal policy—the international value of the dollar be damned.
Later praising Kennedy and Johnson for doing his bidding, Heller boasted that they had shown a “willingness to use, for the first time, the full range of modern economic tools” and that by “narrowing the intellectual gap between economic advisers and decision-makers … the paralyzing grip of economic myth and false fears on policy has been loosened.”
Keynesian zealotry was now at high tide. Under the original Heller tax plan there was even an “on/off “switch. Tax rates would be raised and lowered by presidential order depending upon what the White House economists were seeing in the economic weather reports. It was shades of FDR’s breakfast with Professor Warren.
In convincing Kennedy to take the first fateful step down the slippery slope of deficit-financed tax cuts, the professors were paving the way for the eventual transformation of the tax code into a tool of national prosperity management. They were also offering it up as a piñata to be battered endlessly by crony capitalist lobbies.
The Keynesian professors had not made much headway on Capitol Hill, however. The bill got bottled up in the Senate Finance Committee, with Republicans declaring the Kennedy tax cut to be “the biggest gamble in history.” Only in the wake of the tragic event in Dallas was Lyndon Johnson able to summon a congressional majority willing to abandon the ancient taboo against deliberate deficit finance in peacetime.
For a brief moment thereafter it appeared that the old-time fiscal religion had been benighted after all. Upon enactment of the “Kennedy tax cut,” real GDP grew by 5.3 percent in 1964 and 5.9 percent in 1965 while inflation remained subdued, rising at only a 1.5 percent rate during each year.
Yet in a sure fire sign of trouble to come, Time magazine put Keynes on its year-end 1965 cover and pronounced that the business cycle had been abolished. According to the editors, policy makers had “discovered the secret of steady, stable, non-inflationary growth.”
Needless to say, the same “secret” would be continuously rediscovered in the decades ahead—by the Reagan White House after 1984, by Alan Greenspan after December 1996, and by Bernanke’s specious proclamation of the “Great Moderation” in February 2004.
Time’s essay also dispensed copious hokum about the mid-1960s boom being “the most sizeable, prolonged and widely distributed prosperity in history.” But it’s more cogent, and perhaps unintended, insight had to do with a profound change it detected in the attitude of the business community.
The predicate that economic progress and prosperity would flow from macromanagement by the state, rather than from free market interaction of businesses and consumers, had now been embraced, even by the capitalists: “They believe that whatever happens, the Government will somehow keep the economy strong and rising.”
COMEUPPANCE OF THE NEW ECONOMICS
Exactly fifteen months later, in the spring of 1967, the US economy was visibly out of control, with inflation not subdued at all, but running at a 5 percent annual rate and gaining momentum. The White House professors found themselves no longer the toast of the town, but in headlong retreat.
Their putatively “balanced” full-employment budget had morphed into LBJ’s huge “guns and butter” deficits. So there emerged in 1967
–1968 a white-hot national economy that desperately needed to be throttled back.
Alas, the professors also discovered they had let the “fine-tuning” genie out of the bottle but couldn’t get it back in. LBJ and the congressional rank and file were now proving to be far more reluctant to hit the fiscal brakes with tax hikes and spending restraint than they had been to embrace tax cuts and spending stimulus.
This earlier boost to domestic demand resulted in rapid import growth and caused the $7 billion merchandise trade surplus of 1964 to swoon toward zero by 1968, meaning that nothing was coming in to pay for the cost of empire. Even a modest rise in the surplus from income earned on US assets abroad was now being offset by greater private capital outflows.
So on a bottom-line basis, unwanted dollars began to build up in offshore markets once again. This time there was no Soviet famine to douse the London gold market with fresh bullion. Accordingly, the upward pressure on the gold price became intense.
In the interim, the Treasury and Fed had adopted additional support tools—central bank currency swap lines—to bolster their dollar defense. Yet the swap lines were an even weaker reed than the gold pool, and merely bought some modest increment of extra time while upward pressures on the gold market continued to accumulate.
DEFERRING THE DAY OF RECKONING:
SWAP LINES AND ROOSA BONDS
The currency swap lines were in theory a two-way street, depending upon whether the dollar’s exchange rate was weak or strong. In practice, however, the swap lines were mainly used by the Fed to mop up unwanted dollars abroad, thereby avoiding their disposal on the London gold market or presentation for official redemption in gold.
The Fed’s intentions were initially viewed with suspicion by the European central banks since, as Coombs of the New York Fed noted in his memoir, the swap line initiative looked “like an attempt to devise means of blocking access to the Treasury gold window. This was not far from the mark.”
In what would become a familiar kick-the-can syndrome, the swap lines were therefore limited to one-year maturities. This was meant to emphasize that they would be deployed only as a short-term exchange-market-smoothing mechanism, not as a substitute for fundamental financial discipline and correction of the US payments imbalance.
The insuperable challenge faced by the Treasury was that the swap lines became a drug, and the addiction got steadily worse with time. After their 1962 creation they ballooned to multibillion-dollar scale and were used on a routine but haphazard basis to prop up the dollar. The underlying balance of payments issue was never even addressed, let alone ameliorated.
So yet another expedient was invented: the US Treasury’s so-called Roosa bonds denominated in European currencies. But the billions of proceeds from these issues were used simply to pay off earlier foreign currency loans, such as D-mark loans from the Bundesbank, as they came due under the one-year rule. They thus amounted to a thinly disguised ruse to violate the very principle—running an indefinite current account deficit—which Secretary Dillon had properly denounced.
At the end of the day, though, the Kennedy-Johnson Treasury was drawn and quartered in financial terms by the war spenders in the Pentagon and the domestic expansionists at the Council of Economic Advisors. Every new gimmick they invented to support the dollar and protect the nation’s gold reserves led to a new round of technical complications, but no gain in underlying financial discipline.
Thus, a maneuver called Operation Twist attempted to push long-term interest rates lower to encourage domestic investment and growth while nudging short-term interest rates higher to support the dollar. It actually backfired, however, when foreign issuers raised cheap long-term debt in New York and then promptly swapped the proceeds back into their own currencies, thereby dumping more unwanted dollars on the foreign exchange markets.
So the Treasury came up with a fix to the fix called an “interest equalization tax” to punish such speculators, but that didn’t work either and only led to more expedients. A dangerous time bomb was thus being planted just below the surface. Foreign private and official claims on dollar denominated assets—much of it short term—began to build up rapidly after 1965, having been facilitated by the swap lines, the Roosa bonds, and the gamut of additional temporizing measures.
Compared to gains averaging about $2 billion per year in 1962–1965, foreign dollar claims grew by $7 billion, $10 billion, and $13 billion in 1967 through 1969, respectively. The glaring problem was that these off-shore dollar claims were now expanding at an annual rate which was larger than the entire remaining gold stock of the United States.
Any blow to confidence could cause a panic dumping of dollar assets for gold. This would trigger, in turn, an existential challenge to a global monetary system which was now saturated with unwanted dollars.
THE PENULTIMATE BLOW TO BRETTON WOODS:
THE BRITISH KEYNESIAN DEFAULT AGAIN
The challenge came decisively in 1967, when the Arab-Israeli Six Day War in June set off a cascade of unsettling forces. The fault line centered on the ragged British economy, which was suffering from the double whammy of a multi-decade decay in its union-crippled industrial sector and the inflationary fevers which had been introduced by the Keynesian policies of its Labour government.
Like the United States, the United Kingdom was living way beyond its means, as reflected in a festering balance of payments crisis. Even though by then it had dismantled most of its empire, it still could not make ends meet, owing to the heavy burdens of its welfare state.
When the Mideast war caused the closure of the Suez Canal, the outlook for the already substantial British trade deficit took a sharp turn for the worse, fueling a powerful new round of exchange market speculation against the pound. British policy had quashed two earlier sterling crises under Labour governments, but the confluence of forces working to undermine the pound now threatened a third and even more virulent drive by speculators to force devaluation.
Faced by this daunting challenge, the Labour government made a far-reaching error which soon triggered a devaluation of the pound, a run on the dollar, and the collapse of the London gold pool. Nixon’s final demarche from Camp David would complete the destruction of Bretton Woods a few years later.
The correct solution was embodied in a century and a half of British monetary history. Domestic demand needed to be throttled back by an immediate sharp increase in the Bank of England discount rate, and an emergency budget to staunch the flood of red ink that was financing imports the UK couldn’t afford.
These classic measures would attract funds into sterling, curtail imports, and cauterize the payments deficit. They would also signal to speculators that the government was committed to financial discipline and defense of the pound sterling’s $2.80 exchange rate.
The British Labour government resorted to the Keynesian playbook, instead, and resolutely refused to permit the Bank of England to raise the discount rate, even though interest rates were deeply negative in real terms. Like today’s financially profligate governments, it thus attempted to borrow its way through the crisis, tapping its currency swap lines with the Fed and other European central banks for billions.
The swap lines were no financial bazooka. Despite frantic currency market intervention, the Bank of England could not buy pounds sterling fast enough to absorb the waves of selling by speculators who could see that the Labour government was borrowing its way to financial disaster.
The final match was thrown on this monetary kindling pile on November 14, 1967, when the British government announced that the October trade deficit had been its largest in history. This merely reinforced the obvious truth that the fundamentals of the UK economy were deteriorating rapidly, and that the government’s fevered swap-line borrowing and currency support operations were doomed to fail. Four days later the pound was devalued by 14 percent, and the world was well on its way to Nixon’s repudiation of Bretton Woods at Camp David.
THE FINAL ASSAULT ON THE LONDON GOLD MARKE
T:
HOW THE NEW ECONOMICS WAS ROUTED
In fact, the pound devaluation was announced on a Saturday, November 17. According to Coombs, by Monday morning “a tidal wave of speculation now swept through the London gold market.”
Although the gold pool had been increased to $350 million, this proved to be a trifling sum as the raw power of the free market in gold quickly made itself evident. Indeed, the attack on inflationary economic policies and financial indiscipline now moved swiftly to the dollar. On Monday, November 19th, the pool was forced to sell $27 million of gold to meet free market demand at the $35 parity, which then soared to $106 million on Wednesday and $250 million on Friday.
Altogether, the central bankers’ gold pool had been drained of nearly $600 million during the week after the pound devaluation and had to be hastily replenished by its members. In fact, the Treasury had to enlist a military transport to airlift American gold to London!
In the final weeks of 1967, then, the ancient financial discipline inherent in gold-convertible money brought itself to bear on the Johnson White House. LBJ’s “guns and butter” fiscal policy and blatant efforts to intimidate the Fed into money printing were being given the Bronx cheer. Private traders and speculators still had the right to demand honest money when they feared the government’s paper issue was being debased, and they exercised it lustily.
A new run on gold ensued in December, draining the central bankers’ gold pool by another $400 million in just three days. At that point the White House partially capitulated, with Johnson announcing he would seek a 10 percent surtax and take other measures to balance the budget—measures that he had been deferring for months.
Just as under the ancien régime, the gold market was now handing the greatest politician of his generation the needed excuse to ask the legislature for tax increases and spending cuts. The administration also announced a clumsy set of bureaucratic measures to stem the outflow of US dollars, including mandatory controls on direct investment abroad, repatriation of foreign earnings, and, pathetically, an admonition to American citizens to postpone for two years all nonessential foreign travel.
The Great Deformation Page 35
