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54 I Allan H. Meltzer

Allan H. Meltzer is a professor of and public policy at Carnegie Mellon University and is a visiting scholar at the American Enterprise Institute. This paper; the fifth annual Homer Jones Memorial Lecture, was delivered at Washington University in St. Louis on April 8, 1991. Jeffrey Liang provided assistance in preparing this paper The views expressed in this paper are those of Mr Meltzer and do not necessarily reflect official positions of the System or the Federal Reserve of St. Louis.

U.S. Policy in the Bretton Woods Era I

T IS A SPECIAL PLEASURE for me to give world now rely on when they want to know the Homer Jones lecture before this distinguish- what has happened to monetary growth and ed audience, many of them Homer’s friends. the growth of other non-monetary aggregates. 1 am persuaded that the publication and wide I I first met Homer in 1964 when he invited me dissemination of these facts in the 1960s and to give a seminar at the Bank. At the time, I was 1970s did much more to get the monetarist case a visiting professor at the University of Chicago, accepted than we usually recognize. 1 don’t think I on leave from Carnegie-Mellon. Karl Brunner Homer was surprised at that outcome. He be- and I had just completed a study of the Federal lieved in the power of ideas, but he believed Reserve’s operations for Con- that ideas were made powerful by their cor- gressman Patman’s House Banking Committee. respondence to facts. Given its auspices, the study caught the atten- tion of many within the Federal Reserve. It was When Karl Brunner and I started the Shadow not surprising, then, that Homer invited me to Open Committee, we invited Homer to I visit. The report had raised issues in which be a member. He was a valuable and conscien- Homer had a long-standing . One of these tious member who came to the meetings for was the issue of monetary control procedures. many years armed with the kind of penetrating Although Homer was sympathetic to our questions that one learned to expect from him. criticisms, he was not easily persuaded about When he believed that his energy had declined our proposals—such as control. and he could not contribute as fully and force- Later, knowing him much better, 1 would say fully as in the past, he offered to resign. We he was not easily persuaded about very much. persuaded him to stay on. He remained through You had to convince Homer with facts. He re- the first ten years, leaving after the September spected facts much more than clever arguments. 1983 meeting, only a few years before his death 1 in 1986. Homer’s concern for facts never left him. It is not an accident that under his leadership, the One of the facts about monetary policy during I economic staff at St. Louis began publishing Homer’s years at the St. Louis Federal Reserve those data triangles that all over the Bank is that the was part of the I flflflfl~ Otfl~O~fl.t aA~dI( fl1 CT fl~ a F ______5~

Bretton Woods system, in fact at the center of from wartime destruction abroad. Soon after, I the system. Bretton Woods and international the costs of foreign assistance and foreign monetary policy were not major concerns of military expenditures were added as causes. By the Federal Reserve however) despite the formal the late 1960s these concerns and concern commitment to the system and the responsibili- about foreign investment led successive adminis- F ty implied by the role of the . The failure trations to restrict payments to foreigners by to honor the commitment is one part of the in- means such as the interest equalization tax, flationary policies of that period. I am pleased taxes on tourist expenditures, “buy America” I to review and interpret the main facts about programs, and “temporary” controls of foreign that experience in this lecture in honor of investment. Inflationary financing of the war in Homer Jones. Vietnam and of domestic social spending more In the 45 years following 11, there than offset any effect these programs may have I had on the equilibrium value of the fixed, was a remarkable transformation of the interna- tional . At the war’s end, the nominal . Increasingly, the pro- dollar was the dominant for interna- blem came to be seen as an exchange rate pro- blem, specifically an overvalued dollar. As the I tional transactions and was universally held as a reserve asset or . The Bretton ended, the dollar was Woods system recognized this role by making first devalued against and major curren- cies, then allowed to fluctuate. I the dollar the principal of the international system with the British pound as a In the U.S. system, principal responsibility for second reserve currency. Exchange rates of international rests with the I other were fixed to the dollar but Treasury. The Federal Reserve is formally of were adjustable under conditions defined by the secondary importance. Under Bretton Woods agreement. But, by 1971 the Bretton Woods the Federal Reserve’s main responsibility was to system was in shambles, and in 1973 major conduct monetary policy so as to maintain the I countries agreed to experiment with fluctuating fixed exchange rate agreed to by the administra- exchange rates. tion. There is no specific legislative authoriza- This paper is about the history of U.S. inter- tion for the Federal Reserve to buy and sell I national economic policy under Bretton Woods foreign currencies (Schwartz 1991). But the from 1959 to 1973. The period begins with the Federal Reserve had a larger, informal role. Of- recognition of a problem that was to become ficials and staff participated in international I the central problem of the international mone- meetings, gave advice and counsel on what tary system for the next decade. At first, the were seen to be the principal problems of the problem was seen as a temporary balance of Bretton Wood system, and proposed solutions. payments problem—the inability of the United They participated, as observers, at the regular I States to balance its and payments at the meetings of the Bank for International Set- prevailing fixed exchange rates. The end of this tlements, where central bankers held regular historical era is fixed by the decision in March discussions and reviews of U.S. policies. There I 1973 to abandon fixed exchange rates between is little evidence, however, of any systematic ef- principal currencies. The starting point, 1959, is fort by the Federal Reserve to conduct the year major currencies became convertible, monetary policy in a manner consistent with subject in many cases to restrictions on capital the requirements of a fixed exchange rate I system. And, there is no evidence that any of movements that were increased or relaxed as reserve positions changed. the administrations objected to this neglect. On the contrary, from the Kennedy to the Nixon I Soon after the start of the period, and at the administrations, domestic economic policy objec- end, policymakers expressed concern about the tives, though frequently changed, were of over- competitive position of the U.S. economy. This riding interest. concern about competitiveness returns again I and again in the next four decades, although THE UNITED STATES IN THE the focus of concern and the principal manifes- BRETTON WOODS SYSTEM tation of the alleged problem shift. The alleged I cause in 1959-60 was trade discrimination, The Bretton Woods agreement of 1944 which had been accepted by the United States established a system of fixed exchange rates I at the end of the war to assist in the recovery based on gold valued at $35 per ounce. The

MAY/JUNE 1991 56 I agreement was the product of extensive negotia- policies, such as the removal of quantitative tions, with much of the work done by the United restrictions against imports from the United States and British Treasuries. The intention of States, and to recommendations that foreign the drafters, principally governments increase lending to developing in Britain and in the United countries. States, was to establish a set of rules to replace 1 the rules of the international and The major problem at the time was not a U.S. to avoid the rigidity of that system. Because the current account deficit. Throughout the 1960s, British feared that the United States would re- the United States typically had a surplus on cur- I turn to the protectionist and deflationary rent account. The problem was that the trade policies of the interwar years, there were and current account surpluses were not large safeguards against that occurrence. U.S. infla- enough to finance net private investment abroad tion was considered unlikely or, more accurate- plus military, travel, and foreign aid spending I ly, was not considered at all, so there were no abroad. To settle the balance, the United States rules for adjustment to prevent from either had to sell gold or accumulate dollar lia- spreading to countries in the fixed exchange bilities to foreigners. As the gold reserve declined I rate system. and liabilities rose, concern increased that the liabilities would become too large relative to the The agreement obligated countries to in- gold reserve to maintain confidence that the tervene to keep their currencies within 1 per- I cent of their fixed but adjustable (dollar) parities. gold price would remain fixed. Under Bretton Woods rules, foreigners had the option of con- As the principal reserve currency, the United verting into gold; the United States had States was obligated to buy and sell gold for responsibility for keeping the gold price fixed I dollars (or convertible currency) at the $35 by permitting conversions and, at a more basic price. When the system started, the United States level, adjusting the production of dollars to main- held about ¾of the world’s monetary gold stock. tain confidence in future gold . Currencies other than the dollar were inconver- 1 This part of the agreement was an early casual- tible. By t960, the U.S. gold stock had fallen, ty. As foreign liabilities rose, restrictions were but the U.S. still held $20 billion, almost half of placed on gold sales to private holders and pres- all monetary gold. In the early years, the United sure or persuasion was used to discourage cen- I States’s loss of gold was looked on favorably as tral and governments from converting a step toward convertibility. By the end of 1958, dollars into gold. major currencies had become convertible for p current transactions.’ Deficits and foreign dollar accumulation was The strengthening of foreign economies was a not the only problem in the system as seen by major aim of early postwar U.S. economic U.S. policymakers at the time. A steady surplus policy. At first, deficits, in the U.S. balance of payments would have I foreign accumulation of dollars, and the redistri- transferred gold and dollars to the United States. bution of the gold stock were seen as desirable Since dollar balances were part of foreign steps toward a viable international monetary reserves, hut not U.S. reserves, total world system. By 1960, official concern about con- reserves would fall. A U.S. surplus was seen as tinued U.S. payments deficits began to be cx- undesirable, therefore. Under a U.S. payments pressed.’ The President’s Economic Report for deficit, conversion of dollars into gold left world ~ 1960, the last report prepared by the Eisenhower reserves unchanged but lowered the gold re- administration, discusses the competitive pro- serves behind the principal reserve currency. blems of the steel and automobile industries in With growing foreign trade, and an implicit world markets during 1959 and the growth of assumption that imbalances increase with trade, 1 U.S. investment abroad, problems that were to reserves would prove inadequate to finance im- remain for years to come (ERP, 1960).’ Sug- balances at fixed exchange rates and a fixed gested remedies are limited to pro-competitive gold price. II ‘Germany permitted convertibility on at the ‘I will refer to these reports as ERP (year). same time. The did not become convertible on current account until 1964. ‘For the year 1959 as a whole, the U.S. balance on current account was negative, -$1.3 billion, for the first time since 1953.

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4 See EAt’ (1959). ambassador to France. Roosa had been a senior econo- I ‘Total U.S. reserve assets include the total U.S. gold stock mist at the N.Y. Fed and was very attracted to activist policies whether in domestic credit markets or international and its reserve position in the International Monetary Fund. At the end of 1959, these balances were $19.5 and markets. At the Council of Economic Advisers (CEA), Walter Heller was mainly interested in domestic policy. $2.0 billion respectively. EAt’ (1971). 6 Heller (1966) says very little about the dollar problem other 1 The Kennedy Treasury led by Douglas Dillon and Robert than noting that the balance of payments required higher Roosa was firmly opposed to devaluation. Dillon was an in- short-term interest rates. Kennedy saw the problem as a vestment banker, and a Republican, who had served as matter of prestige. Sorensen (1965), pp. 405-12. I nt OT In’ lIe a 1 59 I Figure 2a I Rate During the 1960s Percent Percent I 10

I —8

I —6 I -4 I I —2 I 0

I sion.~In cooperation with the Federal Reserve, puted as the percentage rate of change from the Treasury attempted to “twist” the the corresponding month of the preceding year. by buying long-term bonds and selling short- Shortly after the Kennedy administration came term ‘I’reasury bills.’ Since the market for into office, growth of the base rose to about I government securities is very active and highly 1-112 to 2 percent. By mid-1963 the growth rate competitive, participants were able to reverse of the base was consistently above the long- any temporary change in interest rates achieved term growth of output, 3 percent per annum. I by the twist. Growth of the base continued to rise in 1964.

Neither- growth nor interest rates \%‘ith the possible exception of 1961-62, base shows evidence of “tight money” in the early growth shows no evidence that monetary policy I 1960s. Figure 2a shows the was relatively restrictive. In fact, base growth, for that decade. The funds rate is the rate most far from being deflationary, was inconsistent tightly controlled by the Federal Reserve. From with continuation of the relatively low rate of I 1961 to 1966, the rate rose slowly, and it did inflation inherited from the past. To prevent not exceed 3 percent until late in 1963. Figure higher inflation, the Kennedy administration in- troduced informal guidelines for prices and I 2h for showsthe samethe period.growthTherategrowthof the monetaryrate is combase- wages. The prevailing view was set out in the

I 7 I See Heller (1966), p. 5. plausible assumption that the additional distribution cost would be treated by the market as a rise in the effective instead of a fee for service. I I ‘ThedealersTreasuryto buyalsomoreauctionedthan one“strips”issue atofa timebills thaton therequiredim- a 60 I

Figure 2b

AnnualPercent changeGrowth of the Monetary Base Percent change During the 1960s

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6 6 I

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2 2

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—2 2 1960 61 62 6364’ 65 66 67 68 69 1970

1962 Economic Report of the President. In this monthly until 1966. CPIs are relatively com- view, a relatively stable Phillips curve permitted prehensive measures but, as is well known, not policymakers to trade higher inflation for lower perfect measures of traded goods and services. unemployment. The price and wage guidelines Doubtless there are temporal differences bet- ~vere supposed to improve the trade-off by ween the price ratio in figure 3 and ratios com- reducing wage and pt-ice increases as the puted using other prices, but the pattern of per- economy approached full employment. sistent decline would be little affected. A slow recovery gave way in 1963 to robust Under the impact of relative price changes real growth. Inflation remained low. Until 1965, and other factors, the merchandise trade balance the fixed weight deflator rose between 1 per- increased. U.S. capital investment abroad con- cent and 1-1/2 percent annually and the con- tinued to rise and domestic and foreign bor- sumer price index between 3/4 percent and 2 rowers used the U.S. market to raise funds for percent. Inflation was generally higher abroad, investment abroad, so the capital outflow so relative prices of U.S. goods declined. Figure continued. 3 shows the ratio of the U.S. consumer price in- dex to a trade-weighted average of consumer Special Measures prices abroad, based on the weights in Federal Reserve index of nominal exchange rates. The From 1960 on, each administration sustained index shows the sustained relative decline in the or strengthened controls on trade and payments U.S. price level during the first half of the intended to reduce the balance of payments decade. With few exceptions, the ratio declined deficit.’ At first, the measures consisted of I

‘Various definitions were used but the official settlements concern about profitable investment abroad puzzles me; balance appears to have been the main concern. This investment of this kind produces a subsequent inflow. balance consists of current account plus long-term capital Also, the current account balance is more useful for com- flows plus net private short-term capital flows. I report this parison of the fixed and fluctuating rate periods. On the balance from time to time in the text, but I base my judg- role of the current account see Corden (1990). ments much more on the current account balance. The 1 a pp a a S~ ~ — SS S N a S a aaa

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Table 1 I Selected Balance of Payments Measures ~Actualand Proposed) I 1960 Expansion of Expon-Import Bark lending ana guarantees of non-commercral risks Reduction in mil’tary depenoents abroad (repealed in 19611 Reduction in defense and nan-defense government purchases abroad I 1961 Offsets for miRtary expend;ture in Europe ano adoi’tioral procurement at home Tieing development aid to doilar purchases. I—creased taxes on foreign earnings of U.S. corporations. Reduced allowance for tourist purchases abroad from $500 to $100. I Treasur? inlervc-nuon n foreign exchange markets. Repayment of German loans.

1962 Expansion of earlier programs Offset purchases by Germany and Italy Increased borrowing authority for the IMF Beginning of Federal Reserve “swap” arrangements to’ currencies T reasury issues foreign denom,nated securities 1 1963 An interest equahzation tax o i’Ve on foreign borrowers In ~ market Additional lieing of foreign aid to domestic purchases

1965 Interest Equal zation Tax on bank bars with duration of one year or more made to bor- rowers in developed countries (except ) Limits on growth of bank lending to foreigners. Encourage private companies to increase exports and repatrtate earmngs. Guidelines for direct investment by non-financial corporations to limit growth of foregn direct investment 2 1967 Perm~thtgher tax rates (up to °/c)for interest equalization tax. Expansion of lending authority of Export-Import Bank.

Source EconomiC Report of the President various years

Controls and restrictions were, at best, a short- loans of foreign currencies and dollars. Typical- term solution. Most of the controls and restric- ly the Federal Reserve borrowed to purchase ft tions in table I were introduced as temporary dollars held abroad instead of selling gold.bo measures, although several were extended and Swaps are a short-term accommodation. To re- strengthened when renewed. Even if these mea- pay the swaps, the Treasury began borrowing sures had succeeded in stemming the balance of from foreign central banks at longer terms us- 11 payments deficit, they did not offer a perma- ing bonds denominated in foreign currencies. nent solution at a new equilibrium without con- The proceeds from the bond sales (called Roosa trols. The problem would have returned when bonds) helped to repay the swaps without re- the controls were removed. ducing the U.S. gold stock, again postponing the To smooth fluctuations in the gold price and problem. Lending facilities of the IMF were ex- short-term capital movements, the ‘Freasury in- panded under the General Agreements to Bor- troduced several measures. Eight countries join- row. The agreements provided that 10 countries ed a gold pool in 1961 to stabilize the London would lend under specified conditions to aug- gold market. Reciprocal credit agreements (call- ment the Fund’s resources. This is the origin of ed “swaps”) with foreign central banks and the the group of 10 (G-10).” Again, these were Bank for International Settlements provided mainly short-term measures. 10 5ee Solomon (1982), p. 42. Later, Switzerland joined the G-10, but the name “Canada, , Belgium, France, Germany, Italy, remained. Netherlands, Sweden, United Kingdom. United States. 1 C~fl~0M CDFSFRVF SANK OF St LOUIS a I 63

The United States supplied 60 percent of the ations to support the activity. Warehousing re- gold sold in the London gold market; the other mained small in the 1960s but increased sub- I members of G-I0 were supposed to provide the stantially in the 1980s. rest. Foreign countries replaced some of their sales by purchases from the United States, so Proposals for Long-Term I the U.S. contribution to the pool, direct and in- Adjustment direct, became a major cause of the decline in the U.S. gold stock. In March 1968, with U.S. The policies of the Kennedy and Johnson ad- gold reserves under $11 billion, the gold pool ministrations may have stabilized the level of 1 was abandoned. The price of gold for official foreign official holdings in the years 1963-66 transactions remained at $35, but the G-10 gov- but, as shown in figure 1 above, U.S. gold re- ernments did not attempt to control the price serves continued to decline. A popular analogy I for private transactions. To prevent arbitrage, at the time treated the United States as a bank foreign central banks agreed not to sell in the for the international monetary system. Foreign gold market. dollar holdings were considered the analogue of bank deposits and gold the analogue of bank 1 For the years 1960-67 as a whole, the non-U.S. reserves.14 The analogy suggests that the series members of the G-10 (including Switzerland) ac- of mainly short-term, one-time or allegedly tem- quired 150 million ounces of gold, an increase porary measures, such as the interest equaliza- I of one-third over their holdings at the end of tion tax, had not solved the problem of a future 1960.12 Every country except Britain and Canada run on the bank. The gold reserve continued to added to its stocks. Britain sold 38 million ounces, fall absolutely and relative to official (or total) the U.S. 164 million ounces. France acquired dollar clainis. I more than 100 million ounces, two-thirds of the The Kennedy administration was aware of the total acquisition by U-b countries.” long-term problem. In 1962, the administration The year 1966 is the peak year for gold hold- asked economists at the to I ings of the G-I0, excluding the United States, study the longer-term prospects for balance of and 1965 is the peak year for the eleven coun- payments adjustment. The report took the “basic tries, measured in ounces of gold. In these years, balance”—balance on goods and services, govern- 11 the value of the stock at $33 per ounce was ap- ment payments plus long-term capital flow—as proximately $15 billion. The value of the U.S. its standard.” It projected that by 1968 this bal- ance would be between a surplus of $1.9 billion stock was approximately $13 billion, about equal and a deficit of $600 million, depending on the to the non-gold foreign exchange holdings of II assumptions about growth, prices and costs at the other members of the U-lU. After 1968, non- U.S. members of the U-b as a group reduced home and abroad. This section of the report was greeted warmly by the administration. The their stocks slightly until 1971, but several ac- I I• quired gold in the market. The embargo can be projected improvement reflected the assumption said to have succeeded in this limited sense. of a rise in foreign relative to domestic prices and a slowing of U.S. investment abroad as pro- II Also in 1961, the ‘Treasury’s Exchange Stabili- fit rates rose in the United States relative to zation Fund (ESF) began operations in foreign abroad. The expected rise in domestic profit currencies for the first time since the 1930s. rates reflected the direct effect of the Adminis- The F’ederal Reserve joined in these operations tration’s proposed reduction in corporate tax 1 in 1962, and in 1963 the Fed began lending rates and the indirect, stimulative effect of tax dollars to the Treasury secured by Treasury rate reductions for households and businesses.” holdings of foreign exchange. These so-called As shown in figure 3, a relative increase in I “~‘varehousing”operations permitted the Trea- prices abroad occurred, but the projections pro- sury to expand its purchases of foreign ex- ved optimistic. The recorded 1967 balance was change without seeking Congressional appropri- —$2.1 billion.”

2 I ‘ Abb data on gold are from IMF (1990), p. 65. ‘~SeeSalant et.al. (1963). “1967 is the peak for France’s accumulation of gold. The “For the tax reduction to improve the basic balance, the rise in expected real returns in the U.S. had to overcome year France sold 40 million ounces to defend the the expected positive effect of tax reduction on imports. following4franc’s parity following the riots and disturbances. ‘ The analogy neglects the role of the pound as an alter- “See ERP (1964), p. 131. native reserve currency, but its role was small and of

declining importance.

a 64 I

‘The Brookings report also considered the ef- with strong domestic demand were called upon fects of a U.S. surplus in its basic balance on to raise tax rates or lower government spending the supply of world reserves and concluded that and expand money growth to lower interest either- a new source of world reserves would rates. The idea was that the inflationary conse- have to be found, or there would have to he quences of domestic monetary expansion ~•vould greater flexibility of exchange rates. The report he reduced or avoided by the restrictive fiscal discussed a dollar-pound bloc and a continental policy. European bloc with fixed rates inside the bloc and fluctuating rates between the blocs.’~The The International Monetary Fund’s annual I Council of Economic Advisers summary of the report for the period offers similar advice, but Brookings study has no reference to this it warns of an inflationary bias. Surplus coun- discussion. tries are subject to upward adjustment of wages and prices) hut deficit countries are riot sub- The Council of Economic Advisers argued ject to downward adjustments.22 ‘The IMF recog- that, although the Bretton Woods agreement nized that world trade had grown faster than permitted exchange rate adjustments, “for a the gold stock, hut they limited their recommen- reserve currency country, this alternative is not dation to a study of possible future needs.23 available.”° And, they added, “for other major industrial countries, even occasional recourse to The Germans, to whom the recommendation such adjustments would induce serious specula- for monetary expansion and fiscal restraint was tive capital movements, thereby accentuating often directed, were skeptical about the policy imhalances.”bo mix proposals. Their expressed concern was the With exchange rates adjustments ruled out, inflationary consequences of U.S. money growth. only two alternatives were considered. One was They held to a more classical view that the prob- increased fiscal expansion by surplus countries blem was expansionary U.S. monetary policy, so and less expansive policies for countries in defi- it must be solved by restrictive policies in the cit. The other was introduction of some type of United States, not expansive German policies. new reserve asset. The latter proposal led even- Their skepticism about “coordination” became a tually to the creation of persistent feature of the policy dialogue under (SUR5). both fixed and fluctuating exchange rates. This was the heyday of Keynesian policy, so it Initially the German response was to discourage is not surprising that Keynesian policies have a capital inflows. For example, German banks were prominent place in administration proposals. required to hold relatively high reserve require- The administration favored a policy mix and ments against foreigners’ deposits. The Germans what later became known as policy coordina- argued, against the spirit of the Bretton Woods tion. Under the fixed exchange rate system, agreement, that deficit countries should adjust. countries were expected to buy and sell dollars They opposed of the mark even to maintain their exchange rate. The economic more strongly than they opposed domestic ex- reports of the President for the period assumed, pansion, since they could avoid revaluation but however, that countries can adjust capital flow could avoid expansive monetary policy only by by varying the mix of fiscal and monetary poli- imposing severe restrictions on capital inflows. cies. The ERP argues that “flexible changes in the mix of fiscal and monetary policies can serve After much delay, and many denials, Germany to reconcile internal and external policy goals.”” revalued the mark by 9.3 percent in October I For the United States, the prescription was tax 1969.24 With the revaluation, Germany removed reduction to expand domestic spending while many of the border taxes and special reserve holding short-term interest rates high to reduce requirements on foreign deposits in German I short-term capital outflow. Surplus countries banks that had been used to limit capital in- I “See Salant et.ab. (1963). 23bbid p. 32. 4 “See ERP (1964), p. 139. 2 The mark had been revalued by 5 percent in 1961. 2 °bbid Solomon (1962), p. 162, reports the May 1969 statement given by a German official that the decision to not revalue I “See ERP (1964), p. 143. was “final, unequivocal and for eternity.’’ This is one of 2 ‘ See IMF (1964), p. 28. many strong denials during the period. I ~fltOAi o5e~Ow~ flxi’Jl( OF ST tfltfbS a I

flows to Germany.” After the revaluation Ger- ings during the middle b960s, and dollar I man prices rose more slowly than U.S. prices. liabilities had continued to rise relative to the The experience of the late b960s had a lasting U.S. gold stock. The United States argued that it effect on German monetary policy. After the expected to bring its payment deficits to an end. mark re-entered a fixed exchange rate system When this happened, the world trading system I with the principal continental European coun- would lack an adequate supply of reserves to tries in the late b970s, Germany revalued more finance future demand for reserve assets at the frequently to avoid inflation and exchange con- fixed gold price. Hence, the United States I trols. In the late 1960s, however, revaluation favored creation of a new reserve asset that was delayed too long and was much too small could be increased with world trade or world to offset the effects of inflationary U.S. demand for reserves. I monetary policy.” This argument is, at best, incomplete. If the While urging German revaluation, the United United States had a payments surplus, other States increased money growth in 1968. After countries would have deficits. The United States 1 the German revaluation, the Federal Reserve could add to reserves by buying other stable shifted to a more restrictive policy, raising the currencies, just as these countries bought dol- Federal funds rate (figure 2a) and slowing the lars. The Economic Report recognizes that this growth of the monetary base. The sharp con- argument is correct. Even if each country was I traction in the growth of the base was followed in balance, the United States could buy foreign 8 by the start of a in the fourth quarter. exchange for dollars to augment its reserves.’ The reduction in money growth, the increase in 1 U.S. real rates of interest, and the recession The IMF combined the liquidity and adjust- helped to shift the current account balance to- ment issues. They argued that the creation of a ward surplus. By the middle of 1970 the quar- new reserve asset and additional reserves re- terly balance had returned to a level not duced the need for deficit countries to adjust I reached since the latter part of 1965. and increased the pressure on surplus countries to adjust.” This is, of course, an argument for Proposals to increase Liquidity inflation as a solution to the adjustment prob- I lem for the deficit countries and revaluation as “Adjustment” was one of a triad of topics dis- the remedy for the surplus countries. This pro- cussed at numerous official and unofficial inter- gram was asymmetric; world inflation would in- national meetings. The other topics were “li- crease but not decline. I quidity” and “confidence.” Liquidity received the most attention. Data in the IMF’ report, however, do not show a general problem of liquidity at the time. ‘The Proposals for additional liquidity differed. The IMF used reserves as a percentage of imports to II French position was one extreme, the U.S. posi- measure liquidity—on the usual assumptions tion the other. The International Monetary Fund that reserves are used to finance imbalances took a position close to that of the United States. and imbalances increase with trade. The data Positions did not remain fixed, hut they were I show that there was no general shortage of li- never fully reconciled.” quidity on this measure. The problem was lim- The U.S. position was that a new reserve asset ited mainly to the United States and the United II was needed to supplement the stock of gold Kingdom. Table 2 shows these data. Reserves in- and dollars. Sales from official holdings in the clude gold, foreign exchange and reserve posi- II London gold market had reduced official hold- tion at the IMF. “See Solomon (1982), p. 164. “See Economic Report (1964), p. 145. “Other parity changes during the second half of the 1960s “See IMF (1966), p. 10. include an 11.1 percent devaluation of the in II 1968 and a 14.3 percent devaluation of the British pound in 1967. Many of the sterling bloc devalued following Britain. “Solomon (1982) gives a thorough account of the discus- II sions, proposals and the meetings of various official groups. Solomon was a senior civil servant at the Federal Reserve with responsibility for international finance and an active II participant or observer at most of the discussions. a 66 I

role for gold, restrictions on the financing of U.S. deficits, and a refunding of the sterling and Table 2 dollar balances, particularly the latter.” In early discussions, France wanted to circumvent the !~tatloof ssetves to Imports IMF by creating a reserve asset for use by the ISSI 1959 1966 Group of 10. The new asset would have a per- manently fixed relation to gold. ‘The effect of Al countries’ 6 e 58% 43% this proposal was to increase the effective gold Allcoumrees ~39 44 49 stock and to devalue the dollar against gold. ex apt US I 310 73 68 43 The French proposal was not accepted. The Japan 4Q 26 alternative chosen was to create a new asset. In Germany 4 34 42 Un4ed~Cmgd*m 2 a 19 September 1967, at the meeting USted tates ~ 126 67 of the International Monetary Fund, agreement was reached on the general principles govern- t appr xirnatefy W cGuntries ing creation of a supplementary reserve asset Sc~ 11W 1 called Special Drawing Rights (SDR5). The new asset was to be a supplement to gold and dol- lars. The United States was not required to the United States aside, world reserves were redeem dollar balances, and the gold price re- a larger percentage of imports in 1965 than in mained fixed. SDRs could be issued only if an 1951 and not very different in 1965 than in 85 peccent majority approved, and they would 1959. The IMF notes that the ratio of reserves be held only by official holders, central banks to imports fluctuated around a constant value.” and international monetary institutions. Finally, Among major countries, only the United King- in July 1969, the amendments to the IMF agree- dom shows a relatively low ratio. For many ment were ratified by a sufficient number of countries, the ratio had converged to 40 to 50 members to come into effect. At the Rio meeting percent.” of the IMF, the first allocations were agreed to hut not issued. The French complained about the special In the IMF view, reserves were “less than ade- role of the dollar, the opportunity given to the 4 United States to use domestic inflation to ac- quate.” ‘The report acknowledged that “the quire foreign assets (at fixed exchange rates), signals were conflicting.” The principal argu- and what they called U.S. . As a first ment for more reserves is that non- bar- step, they proposed to limit the size of U.S. riers, aid-tying, domestic preference and other payments deficits that other countries were trade restrictions had increased. At the time, no obligated to finance, but they also sought a per- argument was made about the relation of re- manent arrangement under which reserve assets serves to trade or imbalances. And the argument would he tied to gold. Later, they urged an in- about trade restrictions makes no effort to link crease in the price of gold. Jacques Rueff (1967) trade restrictions to the liquidity problem. In proposed a doubling of the price of gold accom- fact, the restrictions continued in many coun- panied by commitments by the United States tries after 1973. and the United Kingdom to use part of the pro- SDRs were issued in 1970-72 and again in fit from revaluation to retire some of the dollar 1979-81. The 1970 issue added $3.1 billion to and sterling reserves held by foreign central reserves. In the same year foreign exchange banks.” reserves increased by $14 billion, and total In its official proposals. the French government reserves reached $91 billion, a50percent in- I did not at first go as far as Rueff in favoring an crease for the decade and a22percent increase increase in the gold price. Nor did it insist on a for 1970.’°ln total, 21.4 billion SURs (valued in return to the gold standard. It favored a larger StiR units) were issued through 1985 when new I

‘°SeeIMF (1966), p. 12. “See IMF (1969), p. 27. “Ibid., p. 14. “Ibid., p. 26. I “Rueff was Economic Adviser to President DeGaubbe. “See IMF (1971), p. 19. “See Solomon (1982), p. 73. I FFflFOñi CFSFnVF R&tlt( OF ST i OtiiS a Ii 67

issues ceased. SDRs never became an important I means of settlement. By the time the agreement to create SDRs had been reached, the Bretton tthla\\ V Woods system was in its last days. $ates \otflrowttt\of M~iy~1$i~tt I It seems doubtful that the SDR would have become a dominant medium of exchange or store of international reserves if the fixed ex- change rate system had survived. The StiR was 1 a specialized money but did not dominate alter- UnadStates St Moe 1 natives as a means of payment or store of value. etnany S S Gold is an established store of value with a long Italy U S I history. StiRs had to compete also with the dol- Japab t4 lar and later the mark, the yen and other cur- rencies as a reserve asset. Balances held in each t~4ediqflnt 0 of these assets earn interest. At first, StiR bal- ~, ~ ~ 1 ances did not earn interest, so they were less St attlactive than balances held in short-term gov- ernment securities of the principal countries. inflation to the rest of the world. Countries There was no source of revenue or earnings; I were obligated to buy all dollars offered at a interest payments could only be made by crea- ting additional Stills. fixed price. Sterilization of the inflow could be successful for short-periods, but as Switzerland, I After 1973, flexible exchange rates removed Germany and others discovered at the time, the any need for a large stock of reserves for settl- fixed exchange rate gave speculators an oppor- tunity to invest in one-way gambles with low ing althoughbalancescountries betweencontinuedprincipaltocountries,accumulate risk and relatively high expected return. The reserves and to intervene in the foreign ex- or the mark were unlikely to depre- ciate, more likely to appreciate. Investors and speculators knew this. Hence, flows into these changeprivate wealthowners,markets. The StiRso itcouldcouldnotnotbebeheld usedby for intervention. Further, the introduction of currencies became difficult to curtail. StiRs did not adjust relative prices or real cx- Table 3 shows the pattern of money growth change rates. Failure to solve the adjustment for a sample of countries. Many countries show problem meant that the major effort to sustain the system by producing a supplementary a decline in money growth from 1969 to 1970 reserve asset was largely wasted effort. and all show a rise from 1970 to 1971, corre- sponding to the pattern in the United States, as Additional creation of StiRs in 1972 was again France claimed. The size of the changes differs divorced from events. World reserves (net of by country. All countries did not have the same trade pattern, so they did not receive the same gold)1970 hadto SDRdoubled112 inin1972).two yearsReserves(frominStiRrelation56 in proportional increase in base money. Some ster- to imports were at the highest level in the post- ilized part of the increase for a time, and some countries adopted controls to reduce the inflow. In the winter of 1971, Germany allowed its ex- warportsreservesperiodat theequalbeforeend toofmoreor 1972.after;than Incountries 1963,14 weeksat aboutheldof imthe- change rate to appreciate relative to the dollar, slowing the inflow of dollars. This action recog- nized, as France has insisted, that countries timesamebegan,thatperiod,thetheratio1963-72,discussionwas equaltotalof additionaltoteservesnine weeks.(netreservesofIn gold)the could not prevent inflation while maintaining quadrupled in nominal value.” their dollar parities. The French were cortect on two points that The second point on which the French posi- U.S. officials (and others) refused to acknow- tion was correct was that revaluation of gold ledge. First, the Bretton Woods system based on would solve the liquidity problem. Their various proposals would have devalued the dollar against the dollar permitted the United States to export “Data are from International Financial Statistics, Yearbook

1990.

a MAY/JUNE 1991 68 other currencies, thereby providing the addition rates, adjustments that were difficult to make to the stock of reserves that the StiR was sup- and which would, in turn, have required fur- posed to provide. French proposals did not limit ther adjustments. future changes in the price of gold, so they are There is a plausible case to he made on the open to the charge that expectations of future other side—that devaluation of the dollar’ would devaluation would lead to a run on the dollar have prolonged the life of the Bretton Woods once it had been devalued. Much earlier, Keynes system. The key assumption is that the oil pro- (1923) had proposed a type of commodity stan- ducing countries raised the price of oil in re- dard in which gold served as a medium of ex- sponse to the decline in their real incomes after I changes. In this proposal, the gold price was the dollar floated. A modest devaluation to a tied to an index of commodity prices. Had a new fixed parity might have avoided the first oil scheme of this kind been adopted, it seems like- shock. If so, the mistaken policies in the United ly I that the Bretton Woods system would have States, attempting to offset the real effects of lasted longer. the oil price rise by inflation, would have been A devaluation of the dollar against gold, with avoided. Inflation would have been lower and other currency values unchanged, would have U.S. nominal gold reserves larger. It seems removed the liquidity problem in the 1960s. At unlikely, however, that other countries would the end of 1968, the U.S. price level was ap- have accepted a U.S. policy of inflation and proximately 2-1/2 times the 1929 level. If the repeated, periodic devaluation against gold. gold price had been raised proportionally from Without a lower rate of inflation in the United its 1929 value ($20.67), the 1968 price would States, the Bretton Woods system %vould have have been approximately $52. At that price, the failed sooner or later. U.S. gold reserve would have been $17.6 billion, Nevertheless, the French proposal was a $1.6 billion more than U.S. liabilities to central straightforward solution to the liquidity prob- banks and governments. lem of the 1960s. It would have resolved the li- Although adjustments in the price of gold quidity problem at least for a time but would would have extended the life of the Bretton not have resolved the more difficult “adjustment Woods system, it is unclear whether the system problems” arising from changes in countries’ would have survived for more than a few addi- prices productivity, and costs of production. tional years without some restriction on U.S. This was not the main reason for rejecting the monetary policy, restrictions that the United proposal, however. Representatives of the gov- States was unlikely to accept. Inflationary pol- ernments and central banks claimed that any icies in the United States continued through the change in the $35 gold price or devaluation by 1970s with only brief interruptions. Countries a reserve currency country would damage that chose to lower inflation in the 1970s would “confidence.” have had to leave the system. Further, inflation was not the only problem. The oil shocks of confidence 1974 and 1979 changed the terms of trade, re- Throughout the 1960s, there were concerns quiring changes in exchange rates that Bretton I Woods system found difficult to accommodate. about whether the United States could avoid default on its obligation to convert dollars into At best, devaluation of the dollar against gold gold at the $35 gold price. Expressions of lack would have corrected for differences in produc- of confidence in the dollar often brought forth I tivity growth and changing costs of production speeches by Presidents, Treasury secretaries between the United States and the principal and others to bolster “confidence.” Words were surplus countries, Germnany and Japan. U.S. not the only response. Actions were taken to devaluation and the oil shocks would have I strengthen or restore confidence. changed the relative positions of other coun- tries. Some would have found their trade bal- The dollar and, to a lesser extent, the pound ances in persistent deficit, requiring adjustment had a special role in the Bretton Woods system. of their relative prices and costs or devaluations They were “reserve currencies.”” Central banks and revaluations of bilateral and multilateral held dollar or pound securities as reserves in I “The use of reserve currencies was not part of the Bretton sterling bloc. The dollar’s robe evolved from the dollar bloc Woods plan. Britain’s role evolved from its prewar position and the unique position of the United States in the early and the holding of sterling balances by countries in the postwar years.

n~rai orccnvr Paidw os St tnuis a I 69 place of gold to earn interest on their balances. sales. During the years that the pool functioned, Devaluation reduces the real value of these re- member countries sold gold worth (net) $2.5 I serves, so anticipation of a devaluation could billion on the London market. ‘The U.S. share lead to a run on the dollar or the pound. Once was $1.6 billion.” As shown in figure 1, during total claims against the reserve currencies ex- approximately the same period, 1961-67, U.S. I ceeded the gold reserves held by the United gold reserves fell more than $5 billion, the dif- States and Britain, discussion of the confidence ference reflecting direct sales from the U.S. problem intensified. gold stock. But, as noted earlier, during the F The first evidence of a lack of confidence in same period, the countries in the G-10, and the dollar was a temporary rise in the gold price especially France, added more than 100 million in 1960. In October, the gold price on the Lon- ounces ($3.5 billion) to their official gold I don market moved above the official inter- reserves. The amount added by the G-10 vention price, $35.20 an ounce. Speculators said represents 97 percent of the sales by the United that the market was concerned about the possi- States outside the gold pool. ‘These data suggest ble election of John F. Kennedy as president that the pool did not function as intended; the 1 and the continued capital outflow from the G-l0 replaced their sales from U.S. stocks. United States. Kennedy’s talk of “getting the The years 1962-64 saw a substantial increase economy moving” may have seemed inflationary. in the U.S. current account surplus and reduc- I To counter these concerns, Kennedy made a tion in the payments imbalance. ‘The gold out- strong commitment to maintain the gold value flow, figure 1, slowed. Part of the improvement resulted from the restrictions on military and 1 of tookthethedollar,first andstepsthe (discussedEisenhowerabove)administrationto reduce other purchases abroad, but part was the result the U.S. payments deficit. of rising exports, achieved despite the relatively robust economic expansion in 1963 and 1964. Theprice reflectedtemporarybothincreasea risingin demandthe Londonfor gold Figure 4 shows quarterly data on the current from European central banks and private hold- account balance (in billion of dollars) from 1960 ers and a refusal by the United States to supply to the end of the Bretton Woods system. After gold to the market. ‘The London gold pr-ice was the increase in the surplus, to 1964, there is a II set to clear trading. To maintain the price steady decline interrupted by the recession of within its band, the bought or 1969-70. The temporary surplus of 1970 was soon replaced by a deficit that eliminated the ef- soldgold goldin anforexchangedollars, withreplacingthe U.S.the Treasury.dollars or In fects of the surplus; the observations for 1972 October 1960. the ‘Treasury appeared unwilling are on a straight line fitted to the data for the second half of the 1960s. to ualrefusedrestorebuyer to ofthebuydollarsBank’sdollarsinactive,goldfor holdings,gold.actualWithso andthethepro-residBank- To slow the growth of dollar reserves abroad, the United States had to reverse the current ac- count balance sufficiently to cover private invest- spectivesumedrose to sales,$40supply onandOctoberwasthereduced;price27. returnedThethe Treasury priceto $35.of regold- ment abroad, transfers, and other capital flows, Two changes were introduced as a result of not in any particular year, but over time. By this experience. European central banks agreed this standard, policy can be said to have failed to offset the negative trend in the current ac- I not to buy gold on the London market if the count balance after 1964. price rose above the U.S. price plus shipping cost, $35.20. In October 1961, seven European One reason for the rising surplus in the U.S. governments and the United States cr’eated a current account balance in the early 1960s is I gold pool. Each member of the pool agreed to that foreign costs rose relative to U.S. costs. Figure 5 shows the unit labor costs (ULC) for the United States relative to unit labor costs let anygroup,thegoldBankandpurchaseseach of Englandreceivedand buysupplieda pro-rata and asellsharesharefor theofofgold ahroad.~°The ULC ratio reaches a trough in

9 ‘ See Schwartz (1987), p. 342. are from OECD, Main Economic /ndicafors, Historical I 4 Statistics, 1990. The weights are Federal Reserve trade °Unitlabor costs (ULC) are available for Canada, Japan, Germany and the United Kingdom from 1963 to date. The weights normalized to sum to unity. 1985 is taken as the I index of foreign ULC is based on these countries. All data base year for United States and the trade weighted ULC. a 70

Figure 4 Current Account Balance

Billions of dollars Quarterly Data Billions of dollars 2.0 2.0

1.5 1.5

1.0 1.0

-5 .5

0 0

—-5 -5

— 1.0 1.0

—1.5 —1.5

2.0 —2.0 1960 61 62 63 64 65 66 67 68 69 70 71 1972 I I third quarter 1963, then reverses to reach a costs. After 1970 the situation changed. The fall local peak in fourth quarter 1968. The current in the current account is not the result of a account (figure 4) has a similar movement; al- worsening of the competitive position of the I though its local peak is a bit earlier, the balance United States as reflected in relative costs of remains relatively higher until second quarter production. The fall in relative costs may have 1965. The trough of the current account is also continued to increase the current account bal- in second quarter 1968. The next swing contin- ance, but their influence was more than offset I ues the negative relation. The current account by pressures in the opposite direction. rises until early 1970 while the ULC ratio falls. One possible explanation of the change in Thereafter, the two charts move together, fall- I 1970-71 is that relative real rates of return to ing until the end of Bretton Woods. A sharp decline in the ULC ratio accompanied the decline capital moved against the dollar. Such move- in the trade balance until 1972. ments should be reflected in relative real rates of interest. Figure 6 shows the ratio of the cx 1 The comparison suggests that until 1970 or post U.S. real interest rate to a trade weighted 1971, changes in the current account balance average of real interest rates using Federal are consistent with the movements of relative Reserve trade weights.~’‘The figure shows the I

41 The Federal Reserve uses shares of world trade to set in- standardized for the four countries to sum to unity. Infla- dividual country weights. The real interest rate index for tion is measured by the consumer price index for each foreign countries is based on Treasury bills for Canada country. The ratio shown uses three-month moving and the United Kingdom and call money rates for Ger- averages (not centered) for both series. many and Japan. The Federal Reserve trade weights are I ~ZCfl~A~ occ2nwr SA~’~”~’Or ST OUtS a l~ 71 I Figure 5 Ratio of U~S.Unit Labor Costs to I Trade-Weighted Unit Labor Costs

I Quarterly Data 1.36 t36 I I 1.32 .32

1.28 28

I 1.24 .24 I .20

16 1.16

.12 1 1.12

.08 I 1.08 1963 64 65 66 67 68 69 70 71 1972 I rate of interest continued to rise, but the rise ratiothree-monthaverageof aofthree-month,themovingU.S. short-term averagenon-centered,of interestshort-termmovingrateratesto a was too small to reverse the falling current ac- count balance. And the increase in relative in- terest rates in the United States was apparently All rates have been adjusted for infla- too small to prevent the very large capital out- abroad.tion in the particular country. flow in that period. The path of relative interest These data show that from 1960 to 1969, U.S. rates does not explain the collapse of the cur- real interest rates rose on average relative to rent account balance and the large capital out- rates abroad. The sharp rise in U.S. rates from flow in the early 1970s. I 1962 to 1964 contributed to the reduction in the net capital outflow and is reflected in the Relative interest rates give little evidence of a rise in current account surplus. The movement grovving lack of confidence in the dollar in the I of relative interest rates, on average, reinforced late 1960s. A flight from the dollar would have the effect of falling relative costs of production pushed real U.S. interest rates above rates in I during this brief period. After 1965, the relative world markets to compensate for the risk of

AW-’’•~~ 72 II

Figure 6 Ratio of U.S. Real Interest Rate to Trade-Weighted Real Interest Rate II 3-Month Moving Average Monthly Data 1.4 1.4 II

1 .3 1.3

1.2 1.2

1.1 1.1

1.0 1.0

.9 .9

.8 .8

.7

.6 I

.5 I

.4 .4 1960 61 62 63 64 65 66 67 68 69 70 71 1972 I I devaluation and a run on the dollar. With few ter of 1971 relative real rates in the United exceptions real rates in the United States were States fell until March along with U.S. real rates, below rates abroad, on average about 10 per- despite the large dollar outflow. The rise in rel- I cent below from 1966 to 1972. There is no evi- ative rates in the spring and summer reflects dence of a sustained rise in U.S. rates. The both a decline in foreign rates and a rise in U.S. rates. Federal Reserve pumped out monetary base to hold down interest rates. The rest of the world The gold and foreign exchange markets also I absorbed the dollar outflow with little change in give little evidence of a lack of confidence lead- real U.S. rates relative to rates abroad. ‘The main ing to a flight from the dollar during the 1960s. exception is a spike in 1968-69 that mainly re- An exception is the winter of 1968 when the I flects a decline in the weighted average of real gold price rose and the two-tier market began. By 1969, the gold price in the free London mar- rates abroad. ket had fallen back to $35.2 per ounce. The The data on relative real rates of interest sug- same cannot he said for the other reserve cur- I gest that the Federal Reserve made little effort rency, the . By 1964, the pound to slow or stop the capital flow. During the win- was subject to market pressure to devalue rela-

FEDERAL RESERVE BANK OF St LOUIS I 73

tue to gold and the dollar. Repeated attempts to the local peak in third quarter 1966 to a local I reduce the pressure each succeeded for a short trough in second quarter 1967. A six-month aver- time, then failed. Finally in November 1967, Bri- age of consumer prices fell from a4percent tain devalued by 14.3 percent (from $2.80 to annual rate in January 1966 to 1.3 percent in $2.40). Members of the old sterling bloc February 1967. Given the upward bias in con- I followed. sumer prices, resulting from the heavy weight on service prices (that are not adjusted for pro- Pressure to devalue sterling occurred against a worsening problem of U.S. domestic inflation ductivity and quality changes in inputs and out- and a deteriorating relative cost position (figure puts), it appears that the Federal Reserve had stopped the inflation. But, as figures 2a and 2b 5). The Johnson administration’s main efforts to slow price and wage increases were limited to show, the Federal Reserve did not continue the exhortation (jawboning). These efforts extended policy. Federal funds remained at 4 percent for I most of 1967 despite clear evidence of recovery. to interest rates. With short-term interest rates fixed by the Federal Reserve (figure 2a), rising By early 1968, consumer prices were rising at I demand for goods and services and anticipations a 3 to 4 percent annual rate and, more impor- of higher inflation encouraged increased bor- tantly for the payments problem, rising relative rowing and higher money growth. As shown in to a weighted average of foreign prices. Relative I figure 2b, the annual growth of the monetary unit labor costs rose sharply. The effects of base rose in 1965. Base growth reached the changes in relative costs and prices on the U.S. highest rate experienced in the postwar years payments position were partially hidden at first to that time. Efforts to hold down rates paid on by a capital inflow from Europe; U.S. banks had II time deposits under ceilings added began borrowing from the market. to the pressure on the banks. Depositors drew In part, this reflected the rise in relative rates on balances to purchase securities in the open of interest by 0.25 in the United States (figure II markets at home or abroad. 6), in part efforts to circumvent ceilings on time Early in December 1965, the Federal Reserve deposits including, at the time, all certificates of raised the discount rate from 4 to 4-1/2 percent deposit (regardless of denomination). The result II and raised ceiling rates on time deposits. Al- was a payments surplus in 1966, the first since though President Johnson criticized the change 1957, and repayment of earlier Treasury and Federal Reserve borrowing from central banks 42 and governments. I publicly,littleis oftenandthethetoocase, higherlate.however,Annual rates remainedgrowththe increaseofintheeffect.wasmonetooAs- tary base from the same month a year earlier Confidence in the administration’s ability to not decline until the second half of 1966, as maintain convertibility into gold or avoid deval- didshown in figure 2b. Inflation rose early in 1966. uation reached a temporary low early in 1968. U.S. interest rates, after adjusting for inflation, The immediate problem began with a run on fell relative to foreign rates (figure 6). Declines gold when Britain devalued. The gold pool sold in relative unit labor costs and relative consumer $800 million in November 1967. The run subsid- I prices ended, Reflecting these changes, the nom- ed in January, following the announcement that inal current account balance plunged in the five President Johnson had placed new controls on quarters following the December 1965 decision, foreign investment by businesses, banks and I eliminating most of the increase achieved in the financial institutions. previous six years. Demands for gold rose again in March. Rumors The Federal Reserve made a short-lived effort that the gold pool would end and the low cost I to slow the inflation in 1966. The federal funds of speculating against a price that could fall rate rose and the growth of the monetary base very little encouraged renewed . After contracted in the second half of the year. Re- sales of $400 million on March 14, the London I sponding to the less inflationary policy, sensitive gold pool closed the next day. That marked the measures of prices, such as the producer price end of the gold pool. The market did not reopen index, reversed direction of change, falling from until April. When it did, central banks no 42 I See Solomon (1982), p. 102. the liquidity problem, but neither his remonstrance nor 43 Haberler (1965) was one of the first to emphasize the others had much effect on official proposals. See also I greater importance of the adjustment problem relative to Friedman (1953). 74 I longer supported the market price. There was fend the $35 price. In fact, central banks did now a two-tier market. Private transactors not again convert dollars into gold until 1971. could buy and sell at the market determined price, although the 1934 ban on U.S. citizens’ The two-tier system and the decision by cen- tral banks to refrain from converting dollars in- ownership of gold remained. Transactions bet- ween central banks were placed outside the to gold had an unanticipated effect on the soon to be created SDRs. The United States had spon- market and continued at the $35 price. Also, sored SDRs and urged their use as a substitute the governments agreed that gold would not be for gold in reserves. Since central sold by the members of the former pool to banks refrained from selling gold, and bought replace any central bank sales to the private newly mined gold from South Africa and the market. , issues of SDRs served as a substi- The central bank governors’ communique’ put tute for dollars in central . a positive interpretation on their announcement, Looking back after the fact, it is surprising repeated their intention to maintain existing how small was the loss of confidence in the dol- parities, and referred to the then forthcoming lar as a reserve currency before 1971. Central agreement to establish the SDR. It made no 3 banks and governments preferred to absorb mention of adjustment of parities.~ The central dollars rather than revalue their currencies. banks agreed to ‘no longer supply gold to the Some private speculators purchased gold or London gold market or any other gold market,” other assets, but the purchases were not large but they hedged their statement to retain the enough to move the equilibrium gold price per- possibility of buying gold.~~The two-tier agree- sistently above the fixed price until 1970. ment remained in effect until November 1973. The fl-ce market gold price went to $38 per Meeting after meeting during the last five years of Bietton Woods mentioned the three ounce, suggesting that the market would have problems: confidence, liquidity, and adjustment. been satisfied by 10 to 15 percent devaluation Central bank governors, ministers and their of the dollar. For the rest of the year, the free staffs gave most of their attention to liquidity market price remained between $38 and $43. and then to confidence. Aside from a few re- Then the price fell back to $35 to absorb an latively small changes in parities, little was done increased supply of South African gold.” about adjustment. The attitude of the IMF is For the year 1968 as a whole, the United representative of the period. Their 1969 report States had a surplus in the balance of payments. mentions adjustment of par values, following The reason is that banks continued to borrow the French devaluation. The discussion reached in the Eurodollar market and, following the only one conclusion: the par value system should Soviet invasion of Czechoslovakia, foreign inves- be retained.~~ tors purchased U.S. assets.” These decisions I and events produced a payments surplus in 1968 despite a further decline of $2 billion to THE END OF BRETTON WOODS I $0.6 billion in the current account surplus. Concern about the rising budget deficit, the One lasting effect of the winter’s events was payments problem and inflation led Congress in the elimination of the gold June 1968 to accept the Johnson administration’s for Federal Reserve notes. On March 12, Con- proposed 10 percent income tax surcharge and, I gress abolished the 25 percent gold reserve in return, to require the administration to behind Federal Reserve notes. The legislation reduce the growth of government spending. removed one of the last links between gold and The response of the Federal Reserve was almost I the dollar in the original . immediate; they reduced the federal funds rate The initial requirement ratios, or backing, for in an attempt to mix easier monetary policy bank reserves and currency had first been re- with tighter fiscal policy. Growth of the mone- duced, then eliminated for bank reserves and, tary base declined briefly, then rose to a 7 per- I finally, eliminated for currency. The stated pur- cent annual rate of increase (figure 2b). The six pose was to make the gold stock available to de- month average rate of increase of consumer I 44 4 5ee Solomon (1982), p. 122. 6Jbid., p. 105. 4T “Ibid., p. 124. See IMF (1969), p. 32. I a I 75

prices rose at a 4 percent rate in 1968 but the less than 4 percent the following year. Growth annualized rate of increase was 6.5 percent at of the monetary base rose from 4 to 8 percent I the end of the year. annual rate in the same period. U.S. consumer prices now began to rise rela- To any outside observer, it must have been I tive to a trade weighted average of prices abroad clear that the United States did not intend to (figure 3), reversing the trend decline of the follow the classical rules or the policies of a early 1960s. Unit labor costs rose sharply rela- country that intended to maintain a fixed ex- tive to costs abroad (figure 5). The trade and change rate. The run from the dollar began. I payments position deteriorated; real net exports Foreign central banks experienced large in- (1982 dollars) fell to —$30 bilhon in 1968 and creases in dollar reserves. Germany added $3.1 —$35 billion in 1969 from —$17 billion in 1967 billion in the first six months of the year. Ger- I after a $6 billion surplus in 1964. As shown in man money growth rose from 6.4 percent in Figure 4, the nominal current account balance 1970 to 12.0 percent in 1971. German consumer continued to fall in 1968, reversed briefly dur- prices, which had increased 1.8 percent in 1969 ing the 1969-70 recession, then resumed its rose 5.3 percent in 1971. Despite rigid exchange I decline. controls, Japan could not escape the direct ef- fect of U.S. money growth through the trade The official settlements measure of the balance account. Japan’s reserves nearly tripled in the of payments shows the United States in surplus I in 1968 and 1969 for the first time in the first nine months of 1971, rising $8.6 billion. decade.48 This was misleading, much of it the The Japanese money stock (M1) rose more than proximate result of Regulation Q ceilings on 25 percent in 1971. Other countries had qualita- I personal and corporate time deposits. As U.S. tively similar experience. interest rates rose above the legal ceiling rates, In 1969, after much delay, Germany had closed commercial banks lost time deposits to the - the , allowed the mark I dollar market.” The U.S. banks then borrowed to float, then revalued by 9.3 percent on Octo- in the Eurodollar market acquiring many of the ber 24. Within two years, three major curren- deposits they had lost and some additional funds. cies—the British pound, the French franc and II The effect was to have a large inflow of short- the German mark—had been forced to change term capital, $4.3 billion on the official settle- exchange rates.” The belief that economic ments basis for the two years. stability required exchange rate stability began Interest rates fell during the 1970 recession, to erode. II real rates declined on average relative to rates The 1971 capital flow dwarfed previous ex- abroad, and the capital flow reversed with a vengeance. The official settlements deficit of perience. The U.S. deficit on capital account was almost $30 billion for the full year 1971 —$9.8 billion was by far the largest to that II and $42 billion for the two years 1970-71. Of time. But this flow was soon dwarfed by the this amount, $40 billion became dollar reserves —$31 billion outflow in the first three quarters of other countries. Japan and Germany accumu- I of 1971.~° lated $11 billion each, more than half the total, Figure 1 shows the surge in liabilities to and the United Kingdom acquired nearly $10 foreign central banks and governments. These billion.” On May 5, seven European countries liabilities more than doubled to $50 billion in closed their foreign exchange markets. The Ger- 1970, then rose another $11 billion in 1971. The man Finance Minister, Schiller, tried to persuade classic response to a capital outflow for a coun- principal European countries to agree to a joint try on a fixed exchange rate is to raise interest float, but France and Italy opposed. Four days II rates and reduce money growth. The Federal later the mark and the began to Reserve did the opposite, the federal funds rate float. Switzerland revalued by 7 percent and 53 I fell from a peak of 9 percent early in 1970 to Austria by 5 percent. Belgium, with a split cx- 50 aThe official settlements balance measures the change in See ERP (1972), p. 150. 51 France devalued by 11.1 percent on August 10, 1969. reserveternationalliabilitiesassetsto agencies).foreignminusofficialthe changeinstitutionsin short-(central andbanks long-term or in- Canada floated its currency against gold in May 1970. 49 “See IMF (1972), p. 15. A Eurodollar is a dollar deposit liability of a European based bank, including European branches of U.S. banks. “See Solomon (1982), p. ISO.

MAVttUNF lost 76 I change rate, allowed the financial rate to float small in comparison with the $12 billion in- up. Early in August, faced with slow recovery crease in foreign holdings of dollars in the first from the recession, rising inflation, a persistent nine months of 1971. Reports of demands for I payments deficit, and fifteen months to election gold, however, generated fears of a run against day, President Nixon decided to change economic the remaining U.S. gold reserve.57 President policy. After meeting at Camp David on the Nixon and his principal advisers met at Camp I weekend of August 13 to 15, he ended the fixed David on the weekend of August 13 to 15 to exchange rate system by suspending temporar- adopt the program based on the agreement ily the convertibility of the dollar into gold or reached by Nixon and Connolly in the spring.” other reserve assets.” I The earlier policy had been called ‘steady as The plan announced on August 15 included you go.” In fact, U.S. monetary policy had been much more than the suspension of gold conver- far from steady in 1970-71. The federal funds I tibility. Wages and prices were frozen for 90 rate was driven down from 9 percent early in days, allegedly to stop inflation then running at 1970 to 3.7 percent in March 1971, then in- an annual rate of 3 percent for the six months creased 5.3 percent in July. During the same ending in July. Tax credits to increase employ- period, growth of the monetary base increased ment and investment were introduced to in- from 4 percent to 8 percent. The effect, given crease demands for output and labor’ and to policies abroad, was to lower U.S. short-term in- reduce unemployment below 6 percent. A 10 terest rates relative to a trade-weighted average percent surcharge was put on imports.” By the of rate abroad as shown in figure 6.” The de- end of August, all major currencies except the cline in relative real interest rates ended in French franc floated against the dollar.” The March, then reversed but, by March, the dollar’s last remaining tie of the dollar to gold had fixed exchange rate was falling, reflecting grow- been severed, at least temporarily. ing fears of devaluation. These fears strength- Many of the changes announced on August 15 ened as currencies began to float or revalue had been discussed for some time in advance. against the dollar. Chairman Burns of the Federal Reserve had ad- When asset markets opened on Monday vocated a price-wage policy for months. John August 16, traders greeted the new economic Connolly, the secretary of the Treasury, favor-ed policy enthusiastically. U.S. interest rates fell strong action on trade and inflation. Stein and stock prices rose. Many of the foreign ex- reports that President Nixon and Connolly had change markets abroad were closed, but in the agreed in the spring that they would impose United States and, later in markets overseas, the price and wage controls if foreign demand for dollar depreciated against most currencies. An gold required them to close the gold window.” exception is the which remain- ‘The triggering event was renewed demands ed in a narrow hand for the rest of the year. for gold from France and Britain. On August 8, The Japanese yen was at the other extreme; it the press reported that France would ask for revalued by about 5 percent initially and rose $191 million in gold to make a scheduled repay- 10 percent by the end of September despite ment to the IMF. Later in the same week, on much intervention by the Bank of Japan. Be- August 13, Britain also requested to exchange tween December 1970 and July 1971, the trade dollars for gold. The combined requests were weighted index of the real U.S. exchange I-ate

“More precisely, the surtax was used to raise import duties Advisers. The decision was told only to , no higher than their statutory level from which tariff reduc- director of the Office of Management and Budget and Paul tions had been made. For autos, the increase was, there- McCracken, chairman of the Council of Economic fore, 6.5 percent (ERP, 1972, p. 148). Shultz and Dam Advisers. (1977), p. 115 explain that the surcharge was to be used “See Shultz and Dam (1977), p. 110; Stein (1988). p. 166. as a bargaining chip to keep other countries from following the U.S. devaluation against gold. U.S. policy was to “Arthur Burns, chairman of the Board of Governors, par- devalue against gold and other currencies. The surcharge ticipated in the meeting despite the independence of the raised the price of U.S. imports, so devalued the dollar Federal Reserve. Burns also participated in the administra- against other currencies until they agreed to a formal tion’s program as chairman of the Committee on Interest devaluation. and Dividends. “France adopted a with financial tran- “The local peak in the relative rate is 1.27 in January 1969. sactions at a floating rate. By March 1971 the relative rate reached 0.6. “See Stein (1988), p. 166. Herbert Stein was a member and later chairman of President Nixon’s Council of Economic

FEDERAL RESERVE BANK OF St LOUIS I 77 I Figure 7 I Dollar’s Real Exchange Rate Index

1973100 Monthly Data ‘1973 = 100 I 142 142 I I 134 134 I I 126 126 I I 118 118 I 110 110 I 1960 61 62 63 64 65 66 67 68 69 70 71 1972 I declined by approximately 3 percent; between What Next? The price-wage freeze, the surtax on imports I . Julyan additionaland the end6.5 percent,of Decemberso real1971 devaluationthe rate fell for the year was approximately 9.4 percent. and the floating dollar were thought to be tem- poraiy measures. There is no evidence that the I Figure 7 shows the real exchange rate for administration had developed a long-term pro- the dollar against a trade-weighted basket of cur- gram by August 15, but they began to do so. rencies using Federal Reserve weights. Since The 1972 Economic Report summarizes some there are few pamity changes prior to 1971, the of their thinking by discussing three questions. I real exchange rate reflects mainly relative price Should realignment occur through market adjust- changes. Hence, figure 7 for the most part dup- ment or negotiation? How large is the structural licates figure 3 until 1971. Thereafter, the two or permanent deficit? How should the reduction charts differ; the real exchange rate reflects in the U.S. payments deficit he distributed both the devaluation of the nominal exchange among other trading countries? In practice, the I i-ate and the change in relative prices. distribution would be determined by the choice

a M~VLUIrJ~1004 78 I of exchange rates, so the issue was the size of The agreement on devaluation of the dollar relative revaluations against the dollar.” Other against gold raised, or more accurately, con- countries, particularly France, wanted acknowl- tinued a problem. The official gold price re- edgment by the United States of its past infla- mained below the open market price that had tion in the form of a devaluation against gold. now reached $42. Central banks, therefore, had Perhaps more important was the effect on an incentive to convert dollars into gold and sell country wealth. A devaluation by the United the gold on the open market. ‘The “solution” was States raised the value of country gold stocks to raise the official price but not require the while a devaluation by other countries reduced dollar to be convertible into gold! the value of their dollar assets. I The new exchange rates revalued the mark In the first nine months of 1971 the U.S. short-term capital outflow rose to $23 billion, by 13.6 percent against the dollar, the yen by and the basic balance declined to —$10.2 billion. 16.9 percent, the pound and the French franc I At an annual rate, these outflows were equiva- by 8.6 percent, and most other European cur- lent to the entire short-term capital outflow for rencies by 7.5 to 11,6 percent. The Federal 1960-69. The outflow includes from Reserve’s calculation showed a trade weighted the United States in anticipation of devaluation devaluation of the dollar of 6.5 percent against and a deteriorating current account balance. In all currencies and 10 percent against the cur- part, deterioration reflected the worsening rela- rencies of the Group of 10. The devaluation was estimated to produce an $8 billion swing in the tion in U.S. prices relative to foreign prices. The 63 ratio of U.S. consumer prices to trade weighted U.S. trade balance in two to three years. The consumer prices in figure 3 shows an increase IMF estimated the dollar devaluation as 7.9 per- of four percentage points between 1966 and the cent of its former par value.” The effect of all the parity changes was to raise the world im- end of 1970. 65 Although Treasury Undersecretary Paul port prices by about 7.5 percent. Volcker had testified in June that the basic im- Prior to the agreement, inflexibility and lack balance was about $2.5 to $3 billion, Volcker of an adjustment mechanism had been major now argued for a $13 billion adjustment to problems. Surplus countries had been reluctant reach equilibrium.” The United States favored a to revalue because of the effects of their exports period of free floating and offered to remove on domestic employment. The United States had the 10 percent surcharge on imports if other been unwilling to devalue against gold. Many countries would remove barriers to trade. In- countries had relied on exchange controls to stead central banks intervened, and govern- strengthen their currencies. ments imposed exchange controls. Exchange rates were not permitted to adjust freely; new The took two steps to rates were negotiated. improve adjustment. The gold price changed, The Smithsonian Agreement opening the possibility of further changes, and the dollar was devalued against the leading cur- In December, finance ministers and central rencies. In addition, cross rates of exchange bank governors met at the Smithsonian Institu- were altered to reflect, partially, the changes in tion in Washington to agree on a new set of the world financial system. Also, the 2-1/4 per- exchange rates. Gold was repriced at $38 per cent band on exchange rates permitted diver- ounce, and bands on exchange rates were rais- gence of up to 4.5 percent. But, nothing was I ed from 1 percent to Z.25 percent of central done to provide an orderly procedure for chang- rates. The United States eliminated the 10 per- ing parities when there were persistent deficits cent surcharge on imports, and the principal or surpluses. The system remained relatively in- countries agreed to discuss reductions of trade flexible and poorly designed for the event I barriers.” which it soon faced.

“See ERP (1972), p. 149. sion of trade barriers produced very few changes. 61 See Solomon (1982), p. 192-93; ERP (1972), p. 154. The (Solomon, 1982), p. 191. $13 billion included a$6 billion surplus to provide for len- “See Solomon (1982), p. 211. ding to developing countries. “See IMF (1972), p. 38. “Secretary Connally’s initial position included renegotiation 6Slbid,, p. 22. of defense costs, but this issue was dropped. The discus-

~fl~flAI R~SFRVF RANK OF St LOUIS a I 79

President Nixon called the agreement “the floated, and the Europeans closed their foreign most significant monetary agreement in the exchange markets to halt the inflow of dollars.” I 69 history of the world.” In fact, it was a modest The United States made its last attempt to re- agreement that lasted less than fifteen months. tain the par value system. On February 12, the Within a few months stresses reappeared in the dollar was devalued by 10 percent (to $42.22). I international monetary system. In June, Britain Since the United States did not intervene to decided to let the pound float. Within a month maintain the new price, the action was more 17 members of the sterling bloc followed. In the symbol than substance. Secretary Shultz (who I same month, Germany imposed controls on cap- had replaced Connally the previous summer) ital inflows for the first time since the 1950s.°’ also announced an end to U.S. exchange con- The underlying problem was that U.S. policy trols, including the interest equalization tax and I remained inconsistent with maintenance of a restrictions on foreign loans and investments fixed exchange rate system. Despite the price scheduled for December 1974.69 controls introduced in , the report- ed rate of change in consumer prices in 1972 Within a few weeks, there was a renewed flight from the dollar, requiring additional pur- I was only 1 percent lower than in 1971. More chases by foreign central banks under the rules. importantly, the future did not look promising. The Federal Reserve made no effort to restrict During the first quarter of the year, foreign money growth. Despite a surge in aggregate de- central banks, mainly in the G-10, bought an ad- I ditional $10 billion. The addition was more than mand and industrial production, the federal 17 percent of total G-10 foreign exchange bal- funds rate was reduced to below 3-1/2 percent ances at the end of 1972.~°The new purchases early in the year and was held below 5 percent I until the November election. Growth of the were sufficient to convince most countries to the Bretton Woods system to an end. The monetary base remained above 6-1/2 percent, bring Europeans agreed on a joint float against the and growth of M increased to 7 percent. Nomi- 1 dollar and other currencies. The yen had floated nal imports surged, reflecting the devaluation I earlier. fluctuating exchanges rates and the strong economic expansion. For the year as a whole, real net exports were —$49 became the norm for major currencies. billion, a 20 per-cent rise in a single year and I the largest deficit to that time. The nominal cur- ~THY BRETTON WOODS FAILED rent account balance remained negative, —$5.8 billion, more than four times the deficit of the In retrospect, the Bretton Woods system of I previous year. fixed but adjustable exchange rates appears to have failed for two main reasons. First, the sys- For a few months in the summer and fall, the tern was poorly designed, and the flaws became dollar stabilized. Prices in the United States de- more apparent as time passed. Second, the clined relative to trade weighted prices abroad I United States did not pursue the monetary pol- (figure 3) and, until September, U.S. real inter- icy necessary to maintain a fixed exchange rate. est rates rose relative to trade weighted real rates abroad (figure 6). The rise in the relative On a few occasions, interest rates may have I real interest rate during the fall and early win- been raised to support the exchange rates (or to slow the capital flow), but monetary policy con- ter was small, however, in relation to the capi- centrated almost exclusively on a variety of tal outflow. domestic objectives. This was particularly true I In late January 1973, a new foreign exchange when the climax came in 1970-72. crisis began. Italy announced a two-tier exchange F market to discourage capital outflows. Switzer- The Flaws in Bretton Woods I land floated to reduce the flow from Italy and to control money growth. Pressure shifted to The designers of the Bretton Woods system I Germany and Japan. Within two weeks, Japan wanted to reduce the role of gold and make ad- “See the Journal, December 19, 1971. “See Pauls (1990), p. 897-98. OlpreviousIy Germany used reserve requirements on foreign ~°IMFYearbook (1990). II deposits to reduce capital inflows. In June 1973 sales of German securities to foreigners were prohibited. “The Bundesbank purchased $5 billion in the week ending II February 9, 1973.

a 80 I justment by deficit and surplus countries more Europe and Asia. Much foreign aid was tied to nearly symmetrical. One of the designers, John purchases from the United States. Restriction of Maynard Keynes, believed that with fixed but capital movements by Britain, the United States adjustable exchange rates and adjustment by and other countries made the payments system both deficit and surplus countries, fluctuations highly illiberal and complex. in economic activity would be reduced; deficit The ideal of Bretton Woods was a system of countries would not be forced to contract, or fixed but adjustable exchange rates among con- would contract less, when faced with a tem- vertible cuirencies. During its short life, the goal porary loss of reserves; instead, surplus coun- became increasingly one of maintaining fixed I tries would lend to deficit countries. In this rates. Adjustment of exchange rates and conver- way, fluctuations in output would be damped. tibility of the dollar into gold were lost. Presi- There were two problems with this plan for dent Nixon’s August 1971 decision, in this light, I adjustment. First, surplus countries had no in- should be seen as a choice of adjustment over centive to adjust, and they were generally reluc- gold convertibility. tant to do so. Keynes had proposed a penalty on surplus countries that accumulated reserves, [J.& Policy but this proposal was eliminated early in the The professed principal aims of U.S. interna- development of the Bretton Woods system.” Se- tional economic policy included maintaining con- cond, policymakers could not distinguish a tem- vertibility into gold and sustaining the Bretton porary disequilibrium, to be resolved by bor- Woods system. The policy failed in part because rowing and lending, from a permanent disequil- it was often short-sighted or wrong, in part be- ibrium requiring a change in par values. In cause the United States placed much more practice, the system became more rigid with the weight on domestic concerns than on the main- passage of time. Britain delayed devaluation for tenance of the world monetary system. several years before 1967. France delayed de- valuation in 1968. Germany, Japan and other Throughout the 1960s, France urged, and surplus countries delayed revaluations. Japan the United States opposed, a revaluation of gold. supported the yen for a few weeks even after The French argument was correct insofar as August 15, 1971, by intervening sizably to slow it recognized that a devaluation of the dollar the yen’s appreciation.’2 against gold would increase the supply of world reserves and reduce dependence on the dollar The flaws in the system appeared quickly, al- as a reserve currency. The French were correct though they were not always recognized as also in insisting that gold had a long history as such. A starting point for the full operation of an international money, but this argument con- the system is 1959, when currencies became fused rather than clarified the issues under dis- convertible. By 1968, the dollar was tie facto cussion. Devaluation of the dollar against gold I inconvertible into gold. Although the Bretton did not presuppose a change in the Bretton Woods system stumbled through the next several Woods system. That system was based on the years, foreign central banks and governments, dollar, a point that should have been completely I after March 1968, were discouraged from con- clear after March 1968 when, de facto, coun- verting dollars into gold and did not do so. tries could no longer convert dollars into gold. When some tried to convert, in August 1971, Had the United States agreed to revalue gold in the U.S. formalized the restriction that had 1965 or shortly after, it seems entirely possible I been in effect for more than three years by that the many discussions leading to the issuance refusing to sell gold. of SDRs would have been avoided and an ade- During the 10 years, 1959-68, from the move quate solution found for the liquidity problem I to convertibility to the effective embargo on much earlier. The U.S. policy delayed the solu- U.S. gold, restrictions on trade and payments tion until long past the time when it should grerv. The United States paid considerable costs have been apparent that a solution to the liquid- 1 to avoid buying supplies abroad for its troops in ity problem would not sustain the system. 1 llSee Meltzer (1988). Netherlands revalued several times. By the late 1980s, 2 ‘ The European exchange rate mechanism had much however, countries tried to avoid exchange rate changes. greater flexibility in its early years, and Germany and the

a I 81

Gold would have served as an effective means liabilities.” They wrote as if they did not want of payment between central banks, a role that a more flexible system of adjustment; they I the SDH did not acquire. More importantly for wanted greater discipline. They talked much the Bretton Woods system, a revalued gold stock, more about the losses on holdings of dollars if agreed to before 1968, could have imposed than the gain from a more stable, adjustable I some discipline on the United States to pay in monetary system. Although a return to a full gold. Discipline was lacking once the de facto gold standard was not the consistent aim of embargo on gold was in place after March 1968. French policy toward the international mone- Devaluation was not a panacea, however. Coun- tary system, their proposals and arguments I tries would have been unlikely to accept the made it easy for others to dismiss their argu- cost of high U.S. inflation and frequent large ments. Neither France nor other governments devaluations against gold, so the system’s sur- offered alternative proposals under which U.S. I vival would have required some restriction on monetary policy would be subject to discipline.’~ U.S. policy. SDRs provided no discipline at all. Perhaps it was inevitable in the 1960s that any alternative to U.S. policy would he dismissed. The arguments against gold revaluation were weak. The principal arguments were: (1) a de- I The U.S. argument that the dollar could not valuation of the dollar against gold would not be devalued was, at most, a half truth. The solve the adjustment problem if other countries restrictions placed on various types of transac- devalued against the dollar; (2) an increase in I the gold price would benefit South Africa or tions were partial devaluations that changed the relative prices of those transactions. The most the Soviet Union; (3) the gold standard was obvious example was the interest equalization too rigid. tax which raised the cost of borrowing dollars. I It is true that if all countries had devalued Import-export bank subsidies lowered the cost against the dollar, exchange rates would have of favored U.S. exports. Other restrictions work- remained fixed. But, the “liquidity” problem ed in much the same way to selectively devalue I would have been solved and perhaps part of the dollar. the “confidence” problem as well. Countries would have taken losses on their dollar reserves, Some of the restrictions were so short-sighted but devaluation of the dollar would have reduc- as to raise doubts about the purpose of the poli- I ed the risk that the system would collapse with cy and the objectives of the policymakers. Re- a run on the dollar. Simultaneous devaluation strictions on investment abroad by U.S. firms would have focused attention on the adjustment are an obvious example. Absent the restrictions, I problem by removing the liquidity problem that investment abroad would have been higher and occupied so much time and attention. the capital outflow larger. But. profitable invest- ment abroad would have produced a return Arguments about South Africa and the Soviet flow, increasing the current account surplus in I Union addressed domestic political concerns. the future. Whatever short-term gain the re- These arguments had no practical relevance. In strictions achieved, they had long-term, negative the end, the revaluation of gold was not avoid- consequences. The problem was not a short- ed. South Africa and the Soviet Union continued I term problem of maintaining the Bretton Woods to sell gold. The IMF established rules for pur- system for a few months or years. From a chasing South African gold that accepted South longer perspective the restrictions on invest- Africa’s right to sell gold in the market and to ment were counter-productive. II member governments. There is little reason to doubt that public opi- One reason for the investment restrictions nion in many countries wanted to avoid a return may have been that policymakers often focused II to the gold standard. The gold standard was on the basic balance or broader measures such widely viewed as an excessively rigid, 19th cen- as the official settlements balance. For these bal- tury system. Some of the French, who favored ances, U.S. long-term investment abroad is I a greater role for gold, emphasized the “discipline equivalent to an import of goods and services. of gold” and the repayment of dollar and sterling Greater attention to the current account balance

II “See Rueff (1969). refers to such proposals as endowing ‘the creation of 4 ‘ There were many other private proposals including pro- their fantasy with perfect foresight, infinite wisdom...” posals for a world central bank. Haberler (1g66), p. g

a MAVJJiII’J~ ‘tool 82 I would have shown the steady decline in that system from experiencing the adjustment pro- balance, thereby concentrating attention on i-cia- blems of Bretton Woods. tive costs and prices. This focus would have It is surprising how little attention was paid to I posed more sharply the basic issue: deflation or the adjustment problem. The Kennedy, Johnson devaluation. Reliance on investment controls and Nixon administrations did not propose a partially obscured this basic issue as well as permanent solution.’°Each so-called crisis left sacrificing the future for small, costly improve- more controls on capital movements or other mments in the present. transactions, but these efforts were not followed The interest equalization tax was no less short- by internal discussions of policies leading to a I sighted than the restrictions on investment. The long-term solution in which controls would be effect of the tax was to raise the cost of trading removed. The Economic Reports of Presidents Kennedy, Johnson and Nixon have lengthy sec- in U.S. markets, thereby encouraging part of the financial service industry to move abroad. A tions each year on the international monetary I long-term result was loss of the export of some system, but the reports say little about adjust- financial services. ment. ‘the typical comment was that surplus countries should revalue or expand demand. The I By far the major flaw in U.S. policy, and the explanation for neglect of adjustment is not that most damaging feature of the Bretton Woods such discussions were sensitive. Solomon (1982) system, was the failure to prevent U.S. inflation. reports on the many meetings that were held As the system developed, the United States was during these years. There are pages on pro- able to choose domestic over international goals posals and negotiations about liquidity, very lit- whenever a choice had to be made. At times, tle discussion of adjustment. The G-10 and the particularly in the early 1960s, U.S. nominal in- International Monetary Fund are no better.” terest rates were kept higher for a few weeks They, too, avoided the issue or limited their or months to reduce the capital outflow. But comments to suggestions that surplus countries such choices usually were reversed if unemploy- expand without inflating. Even the devaluations ment rose. U.S. policymakers typically chose ex- by Britain and France were not followed by pansion to deflation and used controls of vari- discussions of the effect of the devaluation on ous kinds to get temporary reductions in the the United States. capital outflow. And, after 1966, policymakers As the Bretton Woods system developed, it ac- adopted more inflationary policies than before. quired some of the characteristics its designers Given the priority placed on employment and had hoped to avoid. Major countries were reluc- other domestic goods, such as housing, price tant to change parities. Surplus countries argued I stability was ruled out. that adjustment was the responsibility of deficit All of the responsibility for failure does not countries. Deficit countries made opposite argu- fall on the United States, Germany, Japan and ments, appealing to the need for symmetry. 1 others pursued export growth as a holy grail The 1960s witnessed the beginning of efforts and either made few efforts to adjust their ex- to solve international monetary or economic change rates or none at all. Spokesmen for Ger- problems by coordinating policy actions. In many could point correctly to the inflationary practice, this usually meant that surplus and I policies of the United States, and the failure of deficit countries were supposed to agree on dif- the United States to adjust domestic policies so ferent mixes of monetary and fiscal policy ac- as to honor international commitments, but they tions. Discussions produced few concrete steps. I were less forthright about the adjustment of Foreign countries accepted the expansions im- countries with sustained surpluses that had un- plied by the flows of U.S. dollars, but they did dervalued currencies.” After the Bretton Woods not systematically reduce government spending experience, Germany changed its policies toward or raise taxes to slow their expansions and lower adjustment. In the , domestic interest rates. And, as discussed earlier, Germany revalued frequently to keep that the United States focused mainly on domestic

“See Emminger (1967) as an example. Otmar Emminger urging a prompt, decisive change in policy. Nothing was was a director and later president of the Deutsche done. See Friedman (1988). Bundesbank. “See Solomon (1982), p. 173. “See Shultz and Dam (1971), p. 111. sent a long memo to President-elect Nixon in December 1968

FEDERAL RESERVE BANK OF St LOUIS a 83

objectives. The dialogue about coordination, once Economic Report of the President (Government Printing Of- started, was hard to stop. It continued into the fice, various years). I 1970s and 1980s. Countries that faced a balance Emminger, Otmar. “Practical Aspects of the Problem of of payments deficit usually favored coordinated Balance-of-Payments Adjustment,” Journal of Political Economy, Vol. 75 (August 1967, Part II), pp. 512-22. action. Countries in surplus usually were Friedman, Milton. “The Case for Flexible Exchange Rates,” I opposed. in M. Friedman, ed., Essays in Positive (Univer- The end of the Bretton Woods system was sity of Chicago Press, 1953), pp. 157-203. followed by diverse predictions. Some saw fluc- ______- “A Proposal for Resolving the U.S. Balance of I Payments Problem?’ in Leo Melamed, ed., The Merits of tuating exchange rates as a means of increasing Flexible Exchange Rates: An Anthology (George Mason stability or domestic policy. Some warned about University Press, 1988), pp. 429-38. the instability that would follow. It is now clear Haberler, Gottfried. Money in the International Economy (Har- I that neither was correct. The warnings about vard University Press, 1965). the consequences of the collapse of Bretton ______- “The International Payments System: Postwar Woods proved to be wrong. The inconvertible Trends and Prospects,” in International Payments Problems: A Symposium Sponsored by the American Enterprise In- I dollar continued to function as an international stitute (Washington: American Enterprise Institute, 1965), medium of exchange and store of value. The ac- pp. 1-16. cumulation of dollar assets by foreign central Heiler, Walter. New Dimensions of Political Economy (Harvard banks and governments continued to rise. By University Press, 1966). I the end of the 1970s, nominal dollar reserves of International Monetary Fund. Annual Report, various years. the G-10 countries, excluding the United States, Keynes, J.M. A Tract on Monetary Reform (London: Mac- had doubled from the level at the end of 1972. millan, 1923), reprinted as vol. 4 of The Collected Writings I In the next decade, these reserves doubled again of John Maynard Keynes (London: Macmillan, 1971). to more than $300 billion. Central banks and Meltzer, Allan H. Keynes’s Monetary Theory: A Different governments continued to be more willing to Interpretation (Cambridge University Press, 1988). acquire additional dollars than to allow the Okun, Arthur M. The Political Economy of Prosperity I dollar to devalue. (Washington: The Brookings Institution, 1970). Pauls, B. Dianne. “U.S. Exchange Rate Policy: Bretton The end of Bretton Woods improved the ad- Woods to Present,” Federal Reserve Bulletin, vol. 76 I justment mechanism, but did not quickly elimi- (November 1990), pp. 891-908. nate inflation or inflationary policies. Countries Rueff, Jacques. “The Rueff Approach,” in R. Hinshaw, ed., gained the opportunity to pursue independent Monetary Reform and the Price of Gold. (The Johns Hopkins Press, 1967), pp. 37-46. policies. Inflation differed between major cur- I rencies but both governments and some private Salant, Walter, and others. The United States Balance of Payments in 1968. (Washington: The Brookings Institution, individuals complained about the variability of 1963). nominal and real exchange rates. During most Schwartz, Anna J. “The Postwar Institutional Evolution of the of the next 20 years, the principal currencies International Monetary System?’ in A.J. Schwartz, ed., continued to fluctuate. Money in Historical Perspective (University of Chicago Press for the National Bureau of Economic Research, However, countries did not float freely. Dirty 1987), pp. 333-63. II floating, managed exchange rates, intervention, - “The Performance of the Federal Reserve in Pur- exchange controls and trade restrictions were suing International Monetary Obiectives,” Money and Bank- ing: The American Experience (Durrell Foundation, 1991). retained or introduced. Despite these policies and complaints about excessive variability of ex- Shultz, George P., and Kenneth W. Dam. Economic Policy Beyond the Headlines. (Stanford University Press, 1977). II change rates, there was no interest in a return Solomon, Robert. The International Monetary System, to Bretton Woods. 1g45-19sl (Harper & Row, 1982). Sorensen, Theodore. Kennedy (Harper & Row, 1965), II pp. 405-12. REFERENCES Stein, Herbert. Presidential Economics, 2nd rev. ed. (Washington: American Enterprise Institute for Public Policy 1 Corden, Max. “Does the Current Account Matter? The Old Research, 1988). View and the New,” unpublished paper (Johns Hopkins The Wall Street Journal, December 1g, 1971. 1 University, 1990). I