Allan H. Meltzer

Allan H. Meltzer is a professor of political economy and publicpolicy at Carnegie Mellon University and is a visiting scholar atthe American Enterprise Institute. This paper; the fifth annualHomer Jones Memorial Lecture, was delivered at WashingtonUniversity in St. Louis on April 8, 1991. Jeffrey Liang providedassistance in preparing this paper The views expressed in thispaper are those of Mr Meltzer and do not necessarily reflectofficial positions of the Federal Reserve System or the FederalReserve Bank of St. Louis.

54

U.S. Policy in the BrettonWoods Era

I

T IS A SPECIAL PLEASURE for me to givethe Homer Jones lecture before this distinguish-ed audience, many of them Homer’s friends.

I first met Homer in 1964 when he invited meto give a seminar at the Bank. At the time, I wasa visiting professor at the University of Chicago,on leave from Carnegie-Mellon. Karl Brunnerand I had just completed a study of the FederalReserve’s monetary policy operations for Con-gressman Patman’s House Banking Committee.Given its auspices, the study caught the atten-tion of many within the Federal Reserve. It wasnot surprising, then, that Homer invited me tovisit. The report had raised issues in whichHomer had a long-standing interest. One of thesewas the issue of monetary control procedures.

Although Homer was sympathetic to ourcriticisms, he was not easily persuaded aboutour proposals—such as monetary base control.Later, knowing him much better, 1 would sayhe was not easily persuaded about very much.You had to convince Homer with facts. He re-spected facts much more than clever arguments.

Homer’s concern for facts never left him. It isnot an accident that under his leadership, theeconomic staff at St. Louis began publishingthose data triangles that economists all over the

world now rely on when they want to knowwhat has happened to monetary growth andthe growth of other non-monetary aggregates. 1am persuaded that the publication and widedissemination of these facts in the 1960s and1970s did much more to get the monetarist caseaccepted than we usually recognize. 1 don’t thinkHomer was surprised at that outcome. He be-lieved in the power of ideas, but he believedthat ideas were made powerful by their cor-respondence to facts.

When Karl Brunner and I started the ShadowOpen Market Committee, we invited Homer tobe a member. He was a valuable and conscien-tious member who came to the meetings formany years armed with the kind of penetratingquestions that one learned to expect from him.When he believed that his energy had declinedand he could not contribute as fully and force-fully as in the past, he offered to resign. Wepersuaded him to stay on. He remained throughthe first ten years, leaving after the September1983 meeting, only a few years before his deathin 1986.

One of the facts about monetary policy during IHomer’s years at the St. Louis Federal ReserveBank is that the United States was part of the

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Bretton Woods system, in fact at the center ofthe system. Bretton Woods and internationalmonetary policy were not major concerns ofthe Federal Reserve however) despite the formalcommitment to the system and the responsibili-ty implied by the role of the dollar. The failureto honor the commitment is one part of the in-flationary policies of that period. I am pleasedto review and interpret the main facts aboutthat experience in this lecture in honor ofHomer Jones.

In the 45 years following World War 11, therewas a remarkable transformation of the interna-tional monetary system. At the war’s end, thedollar was the dominant currency for interna-tional transactions and was universally held as areserve asset or store of value. The BrettonWoods system recognized this role by makingthe dollar the principal reserve currency of theinternational system with the British pound as asecond reserve currency. Exchange rates ofother currencies were fixed to the dollar butwere adjustable under conditions defined by theagreement. But, by 1971 the Bretton Woodssystem was in shambles, and in 1973 majorcountries agreed to experiment with fluctuatingexchange rates.

This paper is about the history of U.S. inter-national economic policy under Bretton Woodsfrom 1959 to 1973. The period begins with therecognition of a problem that was to becomethe central problem of the international mone-tary system for the next decade. At first, theproblem was seen as a temporary balance ofpayments problem—the inability of the UnitedStates to balance its trade and payments at theprevailing fixed exchange rates. The end of thishistorical era is fixed by the decision in March1973 to abandon fixed exchange rates betweenprincipal currencies. The starting point, 1959, isthe year major currencies became convertible,subject in many cases to restrictions on capitalmovements that were increased or relaxed asreserve positions changed.

Soon after the start of the period, and at theend, policymakers expressed concern about thecompetitive position of the U.S. economy. Thisconcern about competitiveness returns againand again in the next four decades, althoughthe focus of concern and the principal manifes-tation of the alleged problem shift. The allegedcause in 1959-60 was trade discrimination,which had been accepted by the United Statesat the end of the war to assist in the recovery

from wartime destruction abroad. Soon after,the costs of foreign assistance and foreignmilitary expenditures were added as causes. Bythe late 1960s these concerns and concernabout foreign investment led successive adminis-trations to restrict payments to foreigners bymeans such as the interest equalization tax,taxes on tourist expenditures, “buy America”programs, and “temporary” controls of foreigninvestment. Inflationary financing of the war inVietnam and of domestic social spending morethan offset any effect these programs may havehad on the equilibrium value of the fixed,nominal exchange rate. Increasingly, the pro-blem came to be seen as an exchange rate pro-blem, specifically an overvalued dollar. As theBretton Woods system ended, the dollar wasfirst devalued against gold and major curren-cies, then allowed to fluctuate.

In the U.S. system, principal responsibility forinternational economic policy rests with theTreasury. The Federal Reserve is formally ofsecondary importance. Under Bretton Woodsthe Federal Reserve’s main responsibility was toconduct monetary policy so as to maintain thefixed exchange rate agreed to by the administra-tion. There is no specific legislative authoriza-tion for the Federal Reserve to buy and sellforeign currencies (Schwartz 1991). But theFederal Reserve had a larger, informal role. Of-ficials and staff participated in internationalmeetings, gave advice and counsel on whatwere seen to be the principal problems of theBretton Wood system, and proposed solutions.They participated, as observers, at the regularmeetings of the Bank for International Set-tlements, where central bankers held regulardiscussions and reviews of U.S. policies. Thereis little evidence, however, of any systematic ef-fort by the Federal Reserve to conductmonetary policy in a manner consistent withthe requirements of a fixed exchange ratesystem. And, there is no evidence that any ofthe administrations objected to this neglect. Onthe contrary, from the Kennedy to the Nixonadministrations, domestic economic policy objec-tives, though frequently changed, were of over-riding interest.

THE UNITED STATES IN THEBRETTON WOODS SYSTEM

The Bretton Woods agreement of 1944established a system of fixed exchange ratesbased on gold valued at $35 per ounce. The

IFIIIIIIIIIIIIIII

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agreement was the product of extensive negotia-tions, with much of the work done by the UnitedStates and British Treasuries. The intention ofthe drafters, principally John Maynard Keynesin Britain and Harry Dexter White in the UnitedStates, was to establish a set of rules to replacethe rules of the international gold standard andto avoid the rigidity of that system. Because theBritish feared that the United States would re-turn to the protectionist and deflationarypolicies of the interwar years, there weresafeguards against that occurrence. U.S. infla-tion was considered unlikely or, more accurate-ly, was not considered at all, so there were norules for adjustment to prevent inflation fromspreading to countries in the fixed exchangerate system.

The agreement obligated countries to in-tervene to keep their currencies within 1 per-cent of their fixed but adjustable (dollar) parities.As the principal reserve currency, the UnitedStates was obligated to buy and sell gold fordollars (or convertible currency) at the $35price. When the system started, the United Statesheld about ¾of the world’s monetary gold stock.Currencies other than the dollar were inconver-tible. By t960, the U.S. gold stock had fallen,but the U.S. still held $20 billion, almost half ofall monetary gold. In the early years, the UnitedStates’s loss of gold was looked on favorably asa step toward convertibility. By the end of 1958,major currencies had become convertible forcurrent transactions.’

The strengthening of foreign economies was amajor aim of early postwar U.S. economicpolicy. At first, balance of payments deficits,foreign accumulation of dollars, and the redistri-bution of the gold stock were seen as desirablesteps toward a viable international monetarysystem. By 1960, official concern about con-tinued U.S. payments deficits began to be cx-pressed.’ The President’s Economic Report for1960, the last report prepared by the Eisenhoweradministration, discusses the competitive pro-blems of the steel and automobile industries inworld markets during 1959 and the growth ofU.S. investment abroad, problems that were toremain for years to come (ERP, 1960).’ Sug-gested remedies are limited to pro-competitive

‘Germany permitted convertibility on capital account at thesame time. The Japanese yen did not become convertibleon current account until 1964.

‘For the year 1959 as a whole, the U.S. balance on currentaccount was negative, -$1.3 billion, for the first time since1953.

policies, such as the removal of quantitativerestrictions against imports from the UnitedStates, and to recommendations that foreigngovernments increase lending to developingcountries.

The major problem at the time was not a U.S.current account deficit. Throughout the 1960s,the United States typically had a surplus on cur-rent account. The problem was that the tradeand current account surpluses were not largeenough to finance net private investment abroadplus military, travel, and foreign aid spendingabroad. To settle the balance, the United Stateseither had to sell gold or accumulate dollar lia-bilities to foreigners. As the gold reserve declinedand liabilities rose, concern increased that theliabilities would become too large relative to thegold reserve to maintain confidence that thegold price would remain fixed. Under BrettonWoods rules, foreigners had the option of con-verting dollars into gold; the United States hadresponsibility for keeping the gold price fixedby permitting conversions and, at a more basiclevel, adjusting the production of dollars to main-tain confidence in future gold convertibility.This part of the agreement was an early casual-ty. As foreign liabilities rose, restrictions wereplaced on gold sales to private holders and pres-sure or persuasion was used to discourage cen-tral banks and governments from convertingdollars into gold.

Deficits and foreign dollar accumulation wasnot the only problem in the system as seen byU.S. policymakers at the time. A steady surplusin the U.S. balance of payments would havetransferred gold and dollars to the United States.Since dollar balances were part of foreignreserves, hut not U.S. reserves, total worldreserves would fall. A U.S. surplus was seen asundesirable, therefore. Under a U.S. paymentsdeficit, conversion of dollars into gold left worldreserves unchanged but lowered the gold re-serves behind the principal reserve currency.With growing foreign trade, and an implicitassumption that imbalances increase with trade,reserves would prove inadequate to finance im-balances at fixed exchange rates and a fixedgold price.

‘I will refer to these reports as ERP (year).

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plus the commitment to reduce internal tradebarriers as part of a common market stimulatedU.S. investment in Europe.4 Hence, a capital in-flow augmented the stock of foreign exchangereserves in countries outside the United States.In the two years 1958 and 1959, gold and dollarreserves of the principal European countries in-creased by $5 billion, about 25 percent of totalU.S. reserve assets at the end of the period.~

There were four possible solutions (Friedman,1953): (1) devaluation against gold and majorcurrencies, (2) deflation, (3) borrow as long asforeigners would lend, and (4) impose controlsof various kinds. Several of these solutionscould be achieved in different ways. For exam-ple, foreigners could revalue against the dollar.Or, foreigners could inflate faster than theUnited States, thereby changing the relativeprices of domestic and foreign goods at fixedexchange rates.

Policies of the Kennedy andJohnson Administrations

Under Bretton Woods rules countries werepermitted to devalue up to 10 percent withoutconsultation when faced with “fundamentaldisequilibrium.” The precise conditions char-acterizing fundamental disequilibrium were notspelled out, and the International Monetary Fund(IMF) did nothing to clarify the conditions. Thedrafters had wanted to avoid both the inflex-ibility of the classical gold standard and thecompetitive devaluations of the interwar period.The language may have been intended to permitdevaluation if the alternative was deflation whileavoiding devaluation if a country could expectto restore payments’ balance and repay a short-or medium-term adjustment loan.

Devaluations by major countries occurred. Inthe early years several countries followed theUnited Kingdom in a 30% devaluation in 1949,France devalued by 29 percent in 1958, and theUnited Kingdom devalued again in 1967. TheUnited States chose to regard its problem as lessthan “fundamental.” President Kennedy came in-

to office committed to maintain the $35 goldprice but also to “get the economy moving”after the relatively slow growth and two reces-sions in the previous four years. The commit-ment to a fixed nominal gold price ruled outdevaluation of the dollar against gold and allother currencies; the commitment to highereconomic growth removed the classical remedy,deflation of domestic prices and costs of pro-duction to raise the real dollar value of the U.S.gold stock and lower the relative price of U.S.exports. That left borrowing, controls and for-eign inflation as the principal options.

The decision to avoid devaluation and defla-tion reflects some strongly held views of theperiod. The $35 gold price was seen as a firmcommitment under the Bretton Woods Agree-ment. If the United States devalued once, itcould do so again, with costs to the stabilitythat Bretton Woods was supposed to provide.Avoiding repetition of the experience with defla-tion in the early 1930s and the decade-longdepression was a major factor in the passage ofthe Employment Act and the Bretton Woodsagreement. Few wished to repeat the prewarexperience even in milder form. Hence, theKennedy administration met little oppositionfrom business or political groups in excludingthe price options, devaluation and deflation.~

Kennedy’s main domestic campaign theme hadbeen getting the economy “moving” after therelatively slow average growth rate of the se-cond Eisenhower administration. The Kennedyadministration policies emphasized domesticgrowth, full employment and price stability astheir major aims and relied on a so-called fiscalmonetary mix to stimulate output while reduc-ing the capital outflow. In practice, this trans-lated into a series of tax measures—faster de-preciation for capital, an investment tax creditand, later, reductions in personal and corporatetax rates. To limit the capital outflow, the ad-ministration tried to prevent a sharp countem-cyclical decline in interest rates during the earlymonths of the recovery from the 1960-61 reces-

4See EAt’ (1959).‘Total U.S. reserve assets include the total U.S. gold stockand its reserve position in the International MonetaryFund. At the end of 1959, these balances were $19.5 and$2.0 billion respectively. EAt’ (1971).

6The Kennedy Treasury led by Douglas Dillon and RobertRoosa was firmly opposed to devaluation. Dillon was an in-vestment banker, and a Republican, who had served as

ambassador to France. Roosa had been a senior econo-mist at the N.Y. Fed and was very attracted to activistpolicies whether in domestic credit markets or internationalmarkets. At the Council of Economic Advisers (CEA),Walter Heller was mainly interested in domestic policy.Heller (1966) says very little about the dollar problem otherthan noting that the balance of payments required highershort-term interest rates. Kennedy saw the problem as amatter of prestige. Sorensen (1965), pp. 405-12.

56 I

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Figure 2aFederal Funds Rate During the 1960s

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sion.~In cooperation with the Federal Reserve,the Treasury attempted to “twist” the yield curveby buying long-term bonds and selling short-term ‘I’reasury bills.’ Since the market forgovernment securities is very active and highlycompetitive, participants were able to reverseany temporary change in interest rates achievedby the twist.

Neither- money growth nor interest ratesshows evidence of “tight money” in the early1960s. Figure 2a shows the federal funds ratefor that decade. The funds rate is the rate mosttightly controlled by the Federal Reserve. From1961 to 1966, the rate rose slowly, and it didnot exceed 3 percent until late in 1963. Figure

2h shows the growth rate of the monetary basefor the same period. The growth rate is com-

I 7See Heller (1966), p. 5.

I ‘The Treasury also auctioned “strips” of bills that requireddealers to buy more than one issue at a time on the im-

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puted as the percentage rate of change fromthe corresponding month of the preceding year.Shortly after the Kennedy administration cameinto office, growth of the base rose to about1-112 to 2 percent. By mid-1963 the growth rateof the base was consistently above the long-term growth of output, 3 percent per annum.Growth of the base continued to rise in 1964.

\%‘ith the possible exception of 1961-62, basegrowth shows no evidence that monetary policywas relatively restrictive. In fact, base growth,far from being deflationary, was inconsistentwith continuation of the relatively low rate ofinflation inherited from the past. To preventhigher inflation, the Kennedy administration in-troduced informal guidelines for prices andwages. The prevailing view was set out in the

plausible assumption that the additional distribution costwould be treated by the market as a rise in the effectiveinterest rate instead of a fee for service.

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Figure 2bAnnual Growth of the Monetary BaseDuring the 1960sPercent change

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1962 Economic Report of the President. In thisview, a relatively stable Phillips curve permittedpolicymakers to trade higher inflation for lowerunemployment. The price and wage guidelines~vere supposed to improve the trade-off byreducing wage and pt-ice increases as theeconomy approached full employment.

A slow recovery gave way in 1963 to robustreal growth. Inflation remained low. Until 1965,the fixed weight deflator rose between 1 per-cent and 1-1/2 percent annually and the con-sumer price index between 3/4 percent and 2

percent. Inflation was generally higher abroad,so relative prices of U.S. goods declined. Figure3 shows the ratio of the U.S. consumer price in-dex to a trade-weighted average of consumerprices abroad, based on the weights in FederalReserve index of nominal exchange rates. Theindex shows the sustained relative decline in theU.S. price level during the first half of thedecade. With few exceptions, the ratio declined

monthly until 1966. CPIs are relatively com-prehensive measures but, as is well known, notperfect measures of traded goods and services.Doubtless there are temporal differences bet-ween the price ratio in figure 3 and ratios com-puted using other prices, but the pattern of per-sistent decline would be little affected.

Under the impact of relative price changesand other factors, the merchandise trade balanceincreased. U.S. capital investment abroad con-tinued to rise and domestic and foreign bor-rowers used the U.S. market to raise funds forinvestment abroad, so the capital outflowcontinued.

Special Measures

From 1960 on, each administration sustainedor strengthened controls on trade and paymentsintended to reduce the balance of paymentsdeficit.’ At first, the measures consisted of

‘Various definitions were used but the official settlementsbalance appears to have been the main concern. Thisbalance consists of current account plus long-term capitalflows plus net private short-term capital flows. I report thisbalance from time to time in the text, but I base my judg-ments much more on the current account balance. The

concern about profitable investment abroad puzzles me;investment of this kind produces a subsequent inflow.Also, the current account balance is more useful for com-parison of the fixed and fluctuating rate periods. On therole of the current account see Corden (1990).

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p. 0

0) —4 0) cc

—-S

-‘

cm

2. (a p. m a- c,

-S MO

Co

01 to —4

C -4 —S

3 C 1 3

—S cc -4 F’,

-S C 0

-a 0 010

-s ‘p -J Ca

-a -a 01

Table 1Selected Balance of Payments Measures~Actualand Proposed)1960 Expansion of Expon-Import Bark lending ana guarantees of non-commercral risks

Reduction in mil’tary depenoents abroad (repealed in 19611Reduction in defense and nan-defense government purchases abroad

1961 Offsets for miRtary expend;ture in Europe ano adoi’tioral procurement at homeTieing 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.Treasur? inlervc-nuon n foreign exchange markets.Repayment of German loans.

1962 Expansion of earlier programsOffset purchases by Germany and ItalyIncreased borrowing authority for the IMFBeginning of Federal Reserve “swap” arrangements to’ currenciesTreasury issues foreign denom,nated securities

1963 An interest equahzation tax o1 i’Ve on foreign borrowers In ~ marketAdditional 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 Canada)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

1967 Perm~thtgher tax rates (up to 2°/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-term solution. Most of the controls and restric-tions in table I were introduced as temporarymeasures, although several were extended andstrengthened when renewed. Even if these mea-sures had succeeded in stemming the balance ofpayments deficit, they did not offer a perma-nent solution at a new equilibrium without con-trols. The problem would have returned whenthe controls were removed.

loans of foreign currencies and dollars. Typical-ly the Federal Reserve borrowed to purchasedollars held abroad instead of selling gold.boSwaps are a short-term accommodation. To re-pay the swaps, the Treasury began borrowingfrom foreign central banks at longer terms us-ing bonds denominated in foreign currencies.The proceeds from the bond sales (called Roosabonds) helped to repay the swaps without re-ducing the U.S. gold stock, again postponing theproblem. Lending facilities of the IMF were ex-panded under the General Agreements to Bor-row. The agreements provided that 10 countrieswould lend under specified conditions to aug-ment the Fund’s resources. This is the origin ofthe group of 10 (G-10).” Again, these weremainly short-term measures.

Later, Switzerland joined the G-10, but the nameremained.

62 1

IIII

ft11

To smooth fluctuations in the gold price andshort-term capital movements, the ‘Freasury in-troduced several measures. Eight countries join-ed a gold pool in 1961 to stabilize the Londongold market. Reciprocal credit agreements (call-ed “swaps”) with foreign central banks and theBank for International Settlements provided

105ee Solomon (1982), p. 42.

“Canada, Japan, Belgium, France, Germany, Italy,Netherlands, Sweden, United Kingdom. United States.

1C~fl~0M CDFSFRVF SANK OF St LOUIS a

IThe United States supplied 60 percent of the

gold sold in the London gold market; the othermembers of G-I0 were supposed to provide therest. Foreign countries replaced some of theirsales by purchases from the United States, sothe U.S. contribution to the pool, direct and in-direct, became a major cause of the decline inthe U.S. gold stock. In March 1968, with U.S.gold reserves under $11 billion, the gold poolwas abandoned. The price of gold for officialtransactions remained at $35, but the G-10 gov-ernments did not attempt to control the pricefor private transactions. To prevent arbitrage,foreign central banks agreed not to sell in thegold market.

For the years 1960-67 as a whole, the non-U.S.members of the G-10 (including Switzerland) ac-quired 150 million ounces of gold, an increaseof one-third over their holdings at the end of1960.12 Every country except Britain and Canadaadded to its stocks. Britain sold 38 million ounces,the U.S. 164 million ounces. France acquiredmore than 100 million ounces, two-thirds of thetotal acquisition by U-b countries.”

The year 1966 is the peak year for gold hold-ings of the G-I0, excluding the United States,and 1965 is the peak year for the eleven coun-tries, measured in ounces of gold. In these years,the value of the stock at $33 per ounce was ap-proximately $15 billion. The value of the U.S.stock was approximately $13 billion, about equalto the non-gold foreign exchange holdings ofthe other members of the U-lU. After 1968, non-U.S. members of the U-b as a group reducedtheir stocks slightly until 1971, but several ac-quired gold in the market. The embargo can besaid to have succeeded in this limited sense.

Also in 1961, the ‘Treasury’s Exchange Stabili-zation Fund (ESF) began operations in foreigncurrencies for the first time since the 1930s.The F’ederal Reserve joined in these operationsin 1962, and in 1963 the Fed began lendingdollars to the Treasury secured by Treasuryholdings of foreign exchange. These so-called“~‘varehousing”operations permitted the Trea-sury to expand its purchases of foreign ex-change without seeking Congressional appropri-

‘2Abb data on gold are from IMF (1990), p. 65.

“1967 is the peak for France’s accumulation of gold. The

followingyear France sold 40 million ounces to defend the

franc’s parity following the riots and disturbances.‘4The analogy neglects the role of the pound as an alter-

native reserve currency, but its role was small and of

declining importance.

ations to support the activity. Warehousing re-mained small in the 1960s but increased sub-stantially in the 1980s.

Proposals for Long-Term

Adjustment

The policies of the Kennedy and Johnson ad-ministrations may have stabilized the level offoreign official holdings in the years 1963-66but, as shown in figure 1 above, U.S. gold re-serves continued to decline. A popular analogyat the time treated the United States as a bankfor the international monetary system. Foreigndollar holdings were considered the analogue ofbank deposits and gold the analogue of bankreserves.14 The analogy suggests that the seriesof mainly short-term, one-time or allegedly tem-porary measures, such as the interest equaliza-tion tax, had not solved the problem of a futurerun on the bank. The gold reserve continued tofall absolutely and relative to official (or total)dollar clainis.

The Kennedy administration was aware of thelong-term problem. In 1962, the administrationasked economists at the Brookings Institution tostudy the longer-term prospects for balance ofpayments adjustment. The report took the “basicbalance”—balance on goods and services, govern-ment payments plus long-term capital flow—asits standard.” It projected that by 1968 this bal-ance would be between a surplus of $1.9 billionand a deficit of $600 million, depending on theassumptions about growth, prices and costs athome and abroad. This section of the reportwas greeted warmly by the administration. Theprojected improvement reflected the assumptionof a rise in foreign relative to domestic pricesand a slowing of U.S. investment abroad as pro-fit rates rose in the United States relative toabroad. The expected rise in domestic profitrates reflected the direct effect of the Adminis-tration’s proposed reduction in corporate taxrates and the indirect, stimulative effect of taxrate reductions for households and businesses.”As shown in figure 3, a relative increase inprices abroad occurred, but the projections pro-ved optimistic. The recorded 1967 balance was

—$2.1 billion.”

‘~SeeSalant et.al. (1963).“For the tax reduction to improve the basic balance, the

rise in expected real returns in the U.S. had to overcomethe expected positive effect of tax reduction on imports.

“See ERP (1964), p. 131.

63

II1I1III11III I•II

1II

a

‘The Brookings report also considered the ef-fects of a U.S. surplus in its basic balance onthe supply of world reserves and concluded thateither- a new source of world reserves wouldhave to be found, or there would have to hegreater flexibility of exchange rates. The reportdiscussed a dollar-pound bloc and a continentalEuropean bloc with fixed rates inside the blocand fluctuating rates between the blocs.’~TheCouncil of Economic Advisers summary of theBrookings study has no reference to thisdiscussion.

The Council of Economic Advisers arguedthat, although the Bretton Woods agreementpermitted exchange rate adjustments, “for areserve currency country, this alternative is notavailable.”° And, they added, “for other majorindustrial countries, even occasional recourse tosuch adjustments would induce serious specula-tive capital movements, thereby accentuatingimhalances.”bo

With exchange rates adjustments ruled out,only two alternatives were considered. One wasincreased fiscal expansion by surplus countriesand less expansive policies for countries in defi-cit. The other was introduction of some type ofnew reserve asset. The latter proposal led even-tually to the creation of special drawing rights(SUR5).

This was the heyday of Keynesian policy, so itis not surprising that Keynesian policies have aprominent place in administration proposals.The administration favored a policy mix andwhat later became known as policy coordina-tion. Under the fixed exchange rate system,countries were expected to buy and sell dollarsto maintain their exchange rate. The economicreports of the President for the period assumed,however, that countries can adjust capital flowby varying the mix of fiscal and monetary poli-cies. The ERP argues that “flexible changes inthe mix of fiscal and monetary policies can serveto reconcile internal and external policy goals.””For the United States, the prescription was taxreduction to expand domestic spending whileholding short-term interest rates high to reduceshort-term capital outflow. Surplus countries

with strong domestic demand were called uponto raise tax rates or lower government spendingand expand money growth to lower interestrates. The idea was that the inflationary conse-quences of domestic monetary expansion ~•vouldhe reduced or avoided by the restrictive fiscalpolicy.

The International Monetary Fund’s annualreport for the period offers similar advice, butit warns of an inflationary bias. Surplus coun-tries are subject to upward adjustment of wagesand prices) hut deficit countries are riot sub-ject to downward adjustments.22 ‘The IMF recog-nized that world trade had grown faster thanthe gold stock, hut they limited their recommen-dation to a study of possible future needs.23

The Germans, to whom the recommendationfor monetary expansion and fiscal restraint wasoften directed, were skeptical about the policymix proposals. Their expressed concern was theinflationary consequences of U.S. money growth.They held to a more classical view that the prob-blem was expansionary U.S. monetary policy, soit must be solved by restrictive policies in theUnited States, not expansive German policies.Their skepticism about “coordination” became apersistent feature of the policy dialogue underboth fixed and fluctuating exchange rates.

Initially the German response was to discouragecapital inflows. For example, German banks wererequired to hold relatively high reserve require-ments against foreigners’ deposits. The Germansargued, against the spirit of the Bretton Woodsagreement, that deficit countries should adjust.They opposed revaluation of the mark evenmore strongly than they opposed domestic ex-pansion, since they could avoid revaluation butcould avoid expansive monetary policy only byimposing severe restrictions on capital inflows.

After much delay, and many denials, Germanyrevalued the mark by 9.3 percent in October1969.24 With the revaluation, Germany removedmany of the border taxes and special reserverequirements on foreign deposits in Germanbanks that had been used to limit capital in-

23bbid p. 32.24The mark had been revalued by 5 percent in 1961.Solomon (1962), p. 162, reports the May 1969 statementgiven by a German official that the decision to not revaluewas “final, unequivocal and for eternity.’’ This is one ofmany strong denials during the period.

64 I

I

“See Salant et.ab. (1963).

“See ERP (1964), p. 139.2°bbid

“See ERP (1964), p. 143.‘2See IMF (1964), p. 28.

IIIII

~fltOAi o5e~Ow~ flxi’Jl( OF ST tfltfbS a

While urging German revaluation, the UnitedStates increased money growth in 1968. Afterthe German revaluation, the Federal Reserveshifted to a more restrictive policy, raising theFederal funds rate (figure 2a) and slowing thegrowth of the monetary base. The sharp con-traction in the growth of the base was followedby the start of a recession in the fourth quarter.The reduction in money growth, the increase inU.S. real rates of interest, and the recessionhelped to shift the current account balance to-ward surplus. By the middle of 1970 the quar-terly balance had returned to a level notreached since the latter part of 1965.

Proposals to increase Liquidity

ings during the middle b960s, and dollarliabilities had continued to rise relative to theU.S. gold stock. The United States argued that itexpected to bring its payment deficits to an end.When this happened, the world trading systemwould lack an adequate supply of reserves tofinance future demand for reserve assets at thefixed gold price. Hence, the United Statesfavored creation of a new reserve asset thatcould be increased with world trade or worlddemand for reserves.

Data in the IMF’ report, however, do not showa general problem of liquidity at the time. ‘TheIMF used reserves as a percentage of imports tomeasure liquidity—on the usual assumptionsthat reserves are used to finance imbalancesand imbalances increase with trade. The datashow that there was no general shortage of li-quidity on this measure. The problem was lim-ited mainly to the United States and the UnitedKingdom. Table 2 shows these data. Reserves in-clude gold, foreign exchange and reserve posi-tion at the IMF.

Iflows to Germany.” After the revaluation Ger-man prices rose more slowly than U.S. prices.

The experience of the late b960s had a lastingeffect on German monetary policy. After themark re-entered a fixed exchange rate systemwith the principal continental European coun-tries in the late b970s, Germany revalued morefrequently to avoid inflation and exchange con-trols. In the late 1960s, however, revaluationwas delayed too long and was much too smallto offset the effects of inflationary U.S.monetary policy.”

IIII1I1IIIIIIIIIIIIIIII

This argument is, at best, incomplete. If theUnited States had a payments surplus, othercountries would have deficits. The United Statescould add to reserves by buying other stablecurrencies, just as these countries bought dol-lars. The Economic Report recognizes that thisargument is correct. Even if each country wasin balance, the United States could buy foreignexchange for dollars to augment its reserves.’8

The IMF combined the liquidity and adjust-ment issues. They argued that the creation of anew reserve asset and additional reserves re-duced the need for deficit countries to adjustand increased the pressure on surplus countriesto adjust.” This is, of course, an argument forinflation as a solution to the adjustment prob-lem for the deficit countries and revaluation asthe remedy for the surplus countries. This pro-gram was asymmetric; world inflation would in-crease but not decline.

“Adjustment” was one of a triad of topics dis-cussed at numerous official and unofficial inter-national meetings. The other topics were “li-quidity” and “confidence.” Liquidity received themost attention.

Proposals for additional liquidity differed. TheFrench position was one extreme, the U.S. posi-tion the other. The International Monetary Fundtook a position close to that of the United States.Positions did not remain fixed, hut they werenever fully reconciled.”

The U.S. position was that a new reserve assetwas needed to supplement the stock of goldand dollars. Sales from official holdings in theLondon gold market had reduced official hold-

“See Solomon (1982), p. 164.“Other parity changes during the second half of the 1960s

include an 11.1 percent devaluation of the French franc in1968 and a 14.3 percent devaluation of the British poundin 1967. Many of the sterling bloc devalued followingBritain.

“Solomon (1982) gives a thorough account of the discus-sions, proposals and the meetings of various official groups.Solomon was a senior civil servant at the Federal Reservewith responsibility for international finance and an activeparticipant or observer at most of the discussions.

“See Economic Report (1964), p. 145.“See IMF (1966), p. 10.

a

Table 2

!~tatloof ssetves to ImportsISSI 1959 1966

Al countries’ 6 e 58% 43%Allcoumrees ~39 44 49

ex apt US310 73 68 43Japan 4Q 26Germany 4 34 42Un4ed~Cmgd*m 2 a 19USted tates ~ 126 67

tappr xirnatefy W cGuntries

Sc~ 11W 1

the United States aside, world reserves werea larger percentage of imports in 1965 than in1951 and not very different in 1965 than in1959. The IMF notes that the ratio of reservesto imports fluctuated around a constant value.”Among major countries, only the United King-dom shows a relatively low ratio. For manycountries, the ratio had converged to 40 to 50percent.”

The French complained about the specialrole of the dollar, the opportunity given to theUnited States to use domestic inflation to ac-quire foreign assets (at fixed exchange rates),and what they called U.S. hegemony. As a firststep, they proposed to limit the size of U.S.payments deficits that other countries wereobligated to finance, but they also sought a per-manent arrangement under which reserve assetswould he tied to gold. Later, they urged an in-crease in the price of gold. Jacques Rueff (1967)proposed a doubling of the price of gold accom-panied by commitments by the United Statesand the United Kingdom to use part of the pro-fit from revaluation to retire some of the dollarand sterling reserves held by foreign centralbanks.”

In its official proposals. the French governmentdid not at first go as far as Rueff in favoring anincrease in the gold price. Nor did it insist on areturn to the gold standard. It favored a larger

66

role for gold, restrictions on the financing ofU.S. deficits, and a refunding of the sterling anddollar balances, particularly the latter.” In earlydiscussions, France wanted to circumvent theIMF by creating a reserve asset for use by theGroup of 10. The new asset would have a per-manently fixed relation to gold. ‘The effect ofthis proposal was to increase the effective goldstock and to devalue the dollar against gold.

The French proposal was not accepted. Thealternative chosen was to create a new asset. InSeptember 1967, at the Rio de Janeiro meetingof the International Monetary Fund, agreementwas reached on the general principles govern-ing creation of a supplementary reserve assetcalled Special Drawing Rights (SDR5). The newasset was to be a supplement to gold and dol-lars. The United States was not required toredeem dollar balances, and the gold price re-mained fixed. SDRs could be issued only if an85 peccent majority approved, and they wouldbe held only by official holders, central banksand international monetary institutions. Finally,in July 1969, the amendments to the IMF agree-ment were ratified by a sufficient number ofmembers to come into effect. At the Rio meetingof the IMF, the first allocations were agreed tohut not issued.

In the IMF view, reserves were “less than ade-quate.”4 ‘The report acknowledged that “thesignals were conflicting.” The principal argu-ment for more reserves is that non-tariff bar-riers, aid-tying, domestic preference and othertrade restrictions had increased. At the time, noargument was made about the relation of re-serves to trade or imbalances. And the argumentabout trade restrictions makes no effort to linktrade restrictions to the liquidity problem. Infact, the restrictions continued in many coun-tries after 1973.

SDRs were issued in 1970-72 and again in1979-81. The 1970 issue added $3.1 billion toreserves. In the same year foreign exchangereserves increased by $14 billion, and totalreserves reached $91 billion, a 50 percent in-crease for the decade and a 22 percent increasefor 1970.’°ln total, 21.4 billion SURs (valued inStiR units) were issued through 1985 when new

‘°SeeIMF (1966), p. 12.“Ibid., p. 14.“Rueff was Economic Adviser to President DeGaubbe.“See Solomon (1982), p. 73.

I

I

“See IMF (1969), p. 27.“Ibid., p. 26.“See IMF (1971), p. 19.

IIII

FFflFOñi CFSFnVF R&tlt( OF ST i OtiiS a

Ii 67

issues ceased. SDRs never became an importantmeans of settlement. By the time the agreementto create SDRs had been reached, the BrettonWoods system was in its last days.

It seems doubtful that the SDR would havebecome a dominant medium of exchange orstore of international reserves if the fixed ex-change rate system had survived. The StiR wasa specialized money but did not dominate alter-natives as a means of payment or store of value.Gold is an established store of value with a longhistory. StiRs had to compete also with the dol-lar and later the mark, the yen and other cur-rencies as a reserve asset. Balances held in eachof these assets earn interest. At first, StiR bal-ances did not earn interest, so they were lessattlactive than balances held in short-term gov-ernment securities of the principal countries.There was no source of revenue or earnings;interest payments could only be made by crea-ting additional Stills.

Table 3 shows the pattern of money growthfor a sample of countries. Many countries showa decline in money growth from 1969 to 1970and all show a rise from 1970 to 1971, corre-sponding to the pattern in the United States, asFrance claimed. The size of the changes differsby country. All countries did not have the sametrade pattern, so they did not receive the sameproportional increase in base money. Some ster-ilized part of the increase for a time, and somecountries adopted controls to reduce the inflow.In the winter of 1971, Germany allowed its ex-

change rate to appreciate relative to the dollar,slowing the inflow of dollars. This action recog-nized, as France has insisted, that countriescould not prevent inflation while maintainingtheir dollar parities.

II1I1II

tthla\\ V

$ates \otflrowttt\of M~iy~1$i~tt

UnadStates StMoe 1etnany S S

Italy U SJapab t4

t~4ediqflnt 0~, ~ ~

St

inflation to the rest of the world. Countrieswere obligated to buy all dollars offered at afixed price. Sterilization of the inflow could besuccessful for short-periods, but as Switzerland,Germany and others discovered at the time, thefixed exchange rate gave speculators an oppor-tunity to invest in one-way gambles with lowrisk and relatively high expected return. TheSwiss franc or the mark were unlikely to depre-ciate, more likely to appreciate. Investors andspeculators knew this. Hence, flows into thesecurrencies became difficult to curtail.

After 1973, flexible exchange rates removedany need for a large stock of reserves for settl-

ing balances between principal countries,although countries continued to accumulatereserves and to intervene in the foreign ex-

change markets. The StiR could not be held byprivate wealthowners, so it could not be usedfor intervention. Further, the introduction ofStiRs did not adjust relative prices or real cx-

change rates. Failure to solve the adjustmentproblem meant that the major effort to sustainthe system by producing a supplementaryreserve asset was largely wasted effort.

Additional creation of StiRs in 1972 was againdivorced from events. World reserves (net of

gold) had doubled in two years (from StiR 56 in1970 to SDR 112 in 1972). Reserves in relationto imports were at the highest level in the post-

war period before or after; countries heldreserves equal to more than 14 weeks of im-ports at the end of 1972. In 1963, at about the

time that the discussion of additional reservesbegan, the ratio was equal to nine weeks. In thesame period, 1963-72, total teserves (net of gold)quadrupled in nominal value.”

The French were cortect on two points thatU.S. officials (and others) refused to acknow-ledge. First, the Bretton Woods system based on

the dollar permitted the United States to export

“Data are from International Financial Statistics, Yearbook

1990.

The second point on which the French posi-tion was correct was that revaluation of goldwould solve the liquidity problem. Their variousproposals would have devalued the dollar against

a MAY/JUNE 1991

68

other currencies, thereby providing the additionto the stock of reserves that the StiR was sup-posed to provide. French proposals did not limitfuture changes in the price of gold, so they areopen to the charge that expectations of futuredevaluation would lead to a run on the dollaronce it had been devalued. Much earlier, Keynes(1923) had proposed a type of commodity stan-dard in which gold served as a medium of ex-changes. In this proposal, the gold price wastied to an index of commodity prices. Had ascheme of this kind been adopted, it seems like-ly that the Bretton Woods system would havelasted longer.

A devaluation of the dollar against gold, withother currency values unchanged, would haveremoved the liquidity problem in the 1960s. Atthe end of 1968, the U.S. price level was ap-proximately 2-1/2 times the 1929 level. If thegold price had been raised proportionally fromits 1929 value ($20.67), the 1968 price wouldhave been approximately $52. At that price, theU.S. gold reserve would have been $17.6 billion,$1.6 billion more than U.S. liabilities to centralbanks and governments.

Although adjustments in the price of goldwould have extended the life of the BrettonWoods system, it is unclear whether the systemwould have survived for more than a few addi-tional years without some restriction on U.S.monetary policy, restrictions that the UnitedStates was unlikely to accept. Inflationary pol-icies in the United States continued through the1970s with only brief interruptions. Countriesthat chose to lower inflation in the 1970s wouldhave had to leave the system. Further, inflationwas not the only problem. The oil shocks of1974 and 1979 changed the terms of trade, re-

quiring changes in exchange rates that BrettonWoods system found difficult to accommodate.At best, devaluation of the dollar against goldwould have corrected for differences in produc-tivity growth and changing costs of productionbetween the United States and the principalsurplus countries, Germnany and Japan. U.S.devaluation and the oil shocks would havechanged the relative positions of other coun-tries. Some would have found their trade bal-ances in persistent deficit, requiring adjustmentof their relative prices and costs or devaluationsand revaluations of bilateral and multilateral

rates, adjustments that were difficult to makeand which would, in turn, have required fur-ther adjustments.

There is a plausible case to he made on theother side—that devaluation of the dollar’ wouldhave prolonged the life of the Bretton Woodssystem. The key assumption is that the oil pro-ducing countries raised the price of oil in re-sponse to the decline in their real incomes afterthe dollar floated. A modest devaluation to anew fixed parity might have avoided the first oilshock. If so, the mistaken policies in the UnitedStates, attempting to offset the real effects ofthe oil price rise by inflation, would have beenavoided. Inflation would have been lower andU.S. nominal gold reserves larger. It seemsunlikely, however, that other countries wouldhave accepted a U.S. policy of inflation andrepeated, periodic devaluation against gold.Without a lower rate of inflation in the UnitedStates, the Bretton Woods system %vould havefailed sooner or later.

Nevertheless, the French proposal was astraightforward solution to the liquidity prob-lem of the 1960s. It would have resolved the li-quidity problem at least for a time but wouldnot have resolved the more difficult “adjustmentproblems” arising from changes in countries’prices productivity, and costs of production.This was not the main reason for rejecting theproposal, however. Representatives of the gov-ernments and central banks claimed that anychange in the $35 gold price or devaluation bya reserve currency country would damage“confidence.”

confidence

Throughout the 1960s, there were concernsabout whether the United States could avoiddefault on its obligation to convert dollars intogold at the $35 gold price. Expressions of lackof confidence in the dollar often brought forthspeeches by Presidents, Treasury secretariesand others to bolster “confidence.” Words werenot the only response. Actions were taken tostrengthen or restore confidence.

The dollar and, to a lesser extent, the poundhad a special role in the Bretton Woods system.They were “reserve currencies.”” Central banksheld dollar or pound securities as reserves in Isterling bloc. The dollar’s robe evolved from the dollar blocand the unique position of the United States in the earlypostwar years.

II

III

“The use of reserve currencies was not part of the BrettonWoods plan. Britain’s role evolved from its prewar positionand the holding of sterling balances by countries in the

n~rai orccnvr Paidw os St tnuis a

IIIFI1I1

II

II

II

‘9See Schwartz (1987), p. 342.4°Unitlabor costs (ULC) are available for Canada, Japan,

Germany and the United Kingdom from 1963 to date. Theindex of foreign ULC is based on these countries. All data

69

are from OECD, Main Economic /ndicafors, HistoricalStatistics, 1990. The weights are Federal Reserve tradeweights normalized to sum to unity. 1985 is taken as thebase year for United States and the trade weighted ULC.

place of gold to earn interest on their balances.Devaluation reduces the real value of these re-serves, so anticipation of a devaluation couldlead to a run on the dollar or the pound. Oncetotal claims against the reserve currencies ex-ceeded the gold reserves held by the UnitedStates and Britain, discussion of the confidenceproblem intensified.

The first evidence of a lack of confidence inthe dollar was a temporary rise in the gold pricein 1960. In October, the gold price on the Lon-don market moved above the official inter-vention price, $35.20 an ounce. Speculators saidthat the market was concerned about the possi-ble election of John F. Kennedy as presidentand the continued capital outflow from theUnited States. Kennedy’s talk of “getting theeconomy moving” may have seemed inflationary.To counter these concerns, Kennedy made astrong commitment to maintain the gold value

of the dollar, and the Eisenhower administrationtook the first steps (discussed above) to reducethe U.S. payments deficit.

The temporary increase in the London goldprice reflected both a rising demand for goldfrom European central banks and private hold-ers and a refusal by the United States to supplygold to the market. ‘The London gold pr-ice wasset to clear trading. To maintain the pricewithin its band, the Bank of England bought or

sold gold for dollars, replacing the dollars orgold in an exchange with the U.S. Treasury. InOctober 1960. the ‘Treasury appeared unwilling

to restore the Bank’s gold holdings, so the Bankrefused to buy dollars for gold. With the resid-ual buyer of dollars inactive, actual and pro-

spective supply was reduced; the price of goldrose to $40 on October 27. The Treasury re-sumed sales, and the price returned to $35.

Two changes were introduced as a result ofthis experience. European central banks agreednot to buy gold on the London market if theprice rose above the U.S. price plus shippingcost, $35.20. In October 1961, seven Europeangovernments and the United States cr’eated agold pool. Each member of the pool agreed to

let the Bank of England buy and sell for thegroup, and each received a pro-rata share ofany gold purchases and supplied a share of gold

sales. During the years that the pool functioned,member countries sold gold worth (net) $2.5billion on the London market. ‘The U.S. sharewas $1.6 billion.” As shown in figure 1, duringapproximately the same period, 1961-67, U.S.gold reserves fell more than $5 billion, the dif-ference reflecting direct sales from the U.S.gold stock. But, as noted earlier, during thesame period, the countries in the G-10, andespecially France, added more than 100 millionounces ($3.5 billion) to their official goldreserves. The amount added by the G-10represents 97 percent of the sales by the UnitedStates outside the gold pool. ‘These data suggestthat the pool did not function as intended; theG-l0 replaced their sales from U.S. stocks.

The years 1962-64 saw a substantial increasein the U.S. current account surplus and reduc-tion in the payments imbalance. ‘The gold out-flow, figure 1, slowed. Part of the improvementresulted from the restrictions on military andother purchases abroad, but part was the resultof rising exports, achieved despite the relativelyrobust economic expansion in 1963 and 1964.

Figure 4 shows quarterly data on the currentaccount balance (in billion of dollars) from 1960to the end of the Bretton Woods system. Afterthe increase in the surplus, to 1964, there is asteady decline interrupted by the recession of1969-70. The temporary surplus of 1970 was

soon replaced by a deficit that eliminated the ef-fects of the surplus; the observations for 1972are on a straight line fitted to the data for thesecond half of the 1960s.

To slow the growth of dollar reserves abroad,the United States had to reverse the current ac-count balance sufficiently to cover private invest-ment abroad, transfers, and other capital flows,not in any particular year, but over time. Bythis standard, policy can be said to have failedto offset the negative trend in the current ac-count balance after 1964.

One reason for the rising surplus in the U.S.current account balance in the early 1960s isthat foreign costs rose relative to U.S. costs.Figure 5 shows the unit labor costs (ULC) forthe United States relative to unit labor costsahroad.~°The ULC ratio reaches a trough in

a

70

Figure 4Current Account Balance

Billions of dollars2.0

1.5

1.0

-5

0

—-5

— 1.0

—1.5

2.0

Quarterly Data

third quarter 1963, then reverses to reach alocal peak in fourth quarter 1968. The currentaccount (figure 4) has a similar movement; al-though its local peak is a bit earlier, the balanceremains relatively higher until second quarter1965. The trough of the current account is alsoin second quarter 1968. The next swing contin-ues the negative relation. The current accountrises until early 1970 while the ULC ratio falls.Thereafter, the two charts move together, fall-ing until the end of Bretton Woods. A sharpdecline in the ULC ratio accompanied the declinein the trade balance until 1972.

The comparison suggests that until 1970 or1971, changes in the current account balanceare consistent with the movements of relative

costs. After 1970 the situation changed. The fallin the current account is not the result of aworsening of the competitive position of theUnited States as reflected in relative costs ofproduction. The fall in relative costs may havecontinued to increase the current account bal-ance, but their influence was more than offsetby pressures in the opposite direction.

One possible explanation of the change in1970-71 is that relative real rates of return tocapital moved against the dollar. Such move-ments should be reflected in relative real ratesof interest. Figure 6 shows the ratio of the cxpost U.S. real interest rate to a trade weightedaverage of real interest rates using FederalReserve trade weights.~’‘The figure shows the

41The Federal Reserve uses shares of world trade to set in-dividual country weights. The real interest rate index forforeign countries is based on Treasury bills for Canadaand the United Kingdom and call money rates for Ger-many and Japan. The Federal Reserve trade weights are

standardized for the four countries to sum to unity. Infla-tion is measured by the consumer price index for eachcountry. The ratio shown uses three-month movingaverages (not centered) for both series.

I

Billions of dollars2.0

1.5

1.0

.5

0

-5

1.0

1960 61 62 63 64 65 66 67 68 69 70 71 1972

—1.5

—2.0 IIIII1I

~ZCfl~A~ occ2nwr SA~’~”~’Or ST OUtS a

71l~

I

I

Figure 5Ratio of U~S.Unit Labor Costs toTrade-Weighted Unit Labor Costs

1.36

1.32

1.28

1.24

I1.16

1 1.12

I 1.08

I

Quarterly Data

ratio of a three-month, non-centered, movingaverage of the U.S. short-term interest rate to athree-month moving average of short-term rates

abroad.All rates have been adjusted for infla-

tion in the particular country.These data show that from 1960 to 1969, U.S.

real interest rates rose on average relative torates abroad. The sharp rise in U.S. rates from1962 to 1964 contributed to the reduction inthe net capital outflow and is reflected in therise in current account surplus. The movementof relative interest rates, on average, reinforcedthe effect of falling relative costs of productionduring this brief period. After 1965, the relative

III

rate of interest continued to rise, but the risewas too small to reverse the falling current ac-count balance. And the increase in relative in-terest rates in the United States was apparentlytoo small to prevent the very large capital out-flow in that period. The path of relative interestrates does not explain the collapse of the cur-rent account balance and the large capital out-flow in the early 1970s.

Relative interest rates give little evidence of agrovving lack of confidence in the dollar in thelate 1960s. A flight from the dollar would havepushed real U.S. interest rates above rates inworld markets to compensate for the risk of

IIII

t36

.32

28

.24

.20

16

.12

.081963 64 65 66 67 68 69 70 71 1972

AW-’’•~~

Figure 6Ratio of U.S. Real Interest Rateto Trade-Weighted Real Interest Rate

3-Month Moving AverageMonthly Data

II

IIII

1.4

1.3

1.2

1.1

1.0

.9

.8

II

.4

devaluation and a run on the dollar. With fewexceptions real rates in the United States werebelow rates abroad, on average about 10 per-cent below from 1966 to 1972. There is no evi-dence of a sustained rise in U.S. rates. TheFederal Reserve pumped out monetary base tohold down interest rates. The rest of the worldabsorbed the dollar outflow with little change inreal U.S. rates relative to rates abroad. ‘The mainexception is a spike in 1968-69 that mainly re-flects a decline in the weighted average of realrates abroad.

The data on relative real rates of interest sug-gest that the Federal Reserve made little effortto slow or stop the capital flow. During the win-

ter of 1971 relative real rates in the UnitedStates fell until March along with U.S. real rates,despite the large dollar outflow. The rise in rel-ative rates in the spring and summer reflectsboth a decline in foreign rates and a rise inU.S. rates.

The gold and foreign exchange markets alsogive little evidence of a lack of confidence lead-ing to a flight from the dollar during the 1960s.An exception is the winter of 1968 when thegold price rose and the two-tier market began.By 1969, the gold price in the free London mar-ket had fallen back to $35.2 per ounce. Thesame cannot he said for the other reserve cur-rency, the pound sterling. By 1964, the poundwas subject to market pressure to devalue rela-

72

1.4

1 .3

1.2

1.1

1.0

.9

.8

.7

.6

.5

.4

1960 61 62 63 64 65 66 67 68 69 70 71 1972 IIIIII

FEDERAL RESERVE BANK OF St LOUIS

III

IIIIIIIIII

IIIIII

73

tue to gold and the dollar. Repeated attempts toreduce the pressure each succeeded for a shorttime, then failed. Finally in November 1967, Bri-tain devalued by 14.3 percent (from $2.80 to$2.40). Members of the old sterling blocfollowed.

Pressure to devalue sterling occurred againsta worsening problem of U.S. domestic inflationand a deteriorating relative cost position (figure5). The Johnson administration’s main efforts toslow price and wage increases were limited toexhortation (jawboning). These efforts extendedto interest rates. With short-term interest ratesfixed by the Federal Reserve (figure 2a), risingdemand for goods and services and anticipationsof higher inflation encouraged increased bor-rowing and higher money growth. As shown infigure 2b, the annual growth of the monetarybase rose in 1965. Base growth reached thehighest rate experienced in the postwar yearsto that time. Efforts to hold down rates paid ontime deposits under Regulation Q ceilings addedto the pressure on the banks. Depositors drewon balances to purchase securities in the openmarkets at home or abroad.

Early in December 1965, the Federal Reserveraised the discount rate from 4 to 4-1/2 percentand raised ceiling rates on time deposits. Al-though President Johnson criticized the change

publicly, the higher rates remained in effect. Asis often the case, however, the increase was toolittle and too late. Annual growth of the mone-tary base from the same month a year earlier

didnot decline until the second half of 1966, as

shown in figure 2b. Inflation rose early in 1966.U.S. interest rates, after adjusting for inflation,fell relative to foreign rates (figure 6). Declinesin relative unit labor costs and relative consumerprices ended, Reflecting these changes, the nom-inal current account balance plunged in the fivequarters following the December 1965 decision,eliminating most of the increase achieved in theprevious six years.

The Federal Reserve made a short-lived effortto slow the inflation in 1966. The federal fundsrate rose and the growth of the monetary basecontracted in the second half of the year. Re-sponding to the less inflationary policy, sensitivemeasures of prices, such as the producer priceindex, reversed direction of change, falling from

the local peak in third quarter 1966 to a localtrough in second quarter 1967. A six-month aver-age of consumer prices fell from a 4 percentannual rate in January 1966 to 1.3 percent inFebruary 1967. Given the upward bias in con-sumer prices, resulting from the heavy weighton service prices (that are not adjusted for pro-ductivity and quality changes in inputs and out-puts), it appears that the Federal Reserve hadstopped the inflation. But, as figures 2a and 2bshow, the Federal Reserve did not continue thepolicy. Federal funds remained at 4 percent formost of 1967 despite clear evidence of recovery.

By early 1968, consumer prices were rising ata 3 to 4 percent annual rate and, more impor-tantly for the payments problem, rising relativeto a weighted average of foreign prices. Relativeunit labor costs rose sharply. The effects ofchanges in relative costs and prices on the U.S.payments position were partially hidden at firstby a capital inflow from Europe; U.S. banks hadbegan borrowing from the Eurodollar market.In part, this reflected the rise in relative ratesof interest by 0.25 in the United States (figure6), in part efforts to circumvent ceilings on timedeposits including, at the time, all certificates ofdeposit (regardless of denomination). The resultwas a payments surplus in 1966, the first since1957, and repayment of earlier Treasury andFederal Reserve borrowing from central banksand governments.42

Confidence in the administration’s ability tomaintain convertibility into gold or avoid deval-uation reached a temporary low early in 1968.The immediate problem began with a run ongold when Britain devalued. The gold pool sold$800 million in November 1967. The run subsid-ed in January, following the announcement thatPresident Johnson had placed new controls onforeign investment by businesses, banks andfinancial institutions.

Demands for gold rose again in March. Rumorsthat the gold pool would end and the low costof speculating against a price that could fallvery little encouraged renewed speculation. Aftersales of $400 million on March 14, the Londongold pool closed the next day. That marked theend of the gold pool. The market did not reopenuntil April. When it did, central banks no

42See Solomon (1982), p. 102.43Haberler (1965) was one of the first to emphasize the

greater importance of the adjustment problem relative to

the liquidity problem, but neither his remonstrance norothers had much effect on official proposals. See alsoFriedman (1953).

longer supported the market price. There wasnow a two-tier market. Private transactorscould buy and sell at the market determinedprice, although the 1934 ban on U.S. citizens’ownership of gold remained. Transactions bet-ween central banks were placed outside themarket and continued at the $35 price. Also,the governments agreed that gold would not besold by the members of the former pool toreplace any central bank sales to the privatemarket.

The central bank governors’ communique’ puta positive interpretation on their announcement,repeated their intention to maintain existingparities, and referred to the then forthcomingagreement to establish the SDR. It made nomention of adjustment of parities.~3The centralbanks agreed to ‘no longer supply gold to theLondon gold market or any other gold market,”but they hedged their statement to retain thepossibility of buying gold.~~The two-tier agree-ment remained in effect until November 1973.

The fl-ce market gold price went to $38 perounce, suggesting that the market would havebeen satisfied by 10 to 15 percent devaluationof the dollar. For the rest of the year, the freemarket price remained between $38 and $43.Then the price fell back to $35 to absorb anincreased supply of South African gold.”

For the year 1968 as a whole, the UnitedStates had a surplus in the balance of payments.The reason is that banks continued to borrowin the Eurodollar market and, following theSoviet invasion of Czechoslovakia, foreign inves-tors purchased U.S. assets.” These decisionsand events produced a payments surplus in1968 despite a further decline of $2 billion to$0.6 billion in the current account surplus.

One lasting effect of the winter’s events wasthe elimination of the gold reserve requirementfor Federal Reserve notes. On March 12, Con-gress abolished the 25 percent gold reservebehind Federal Reserve notes. The legislationremoved one of the last links between gold andthe dollar in the original Federal Reserve Act.The initial requirement ratios, or backing, forbank reserves and currency had first been re-duced, then eliminated for bank reserves and,finally, eliminated for currency. The stated pur-pose was to make the gold stock available to de-

fend the $35 price. In fact, central banks didnot again convert dollars into gold until 1971.

The two-tier system and the decision by cen-tral banks to refrain from converting dollars in-to gold had an unanticipated effect on the soonto be created SDRs. The United States had spon-sored SDRs and urged their use as a substitutefor gold in central bank reserves. Since centralbanks refrained from selling gold, and boughtnewly mined gold from South Africa and theSoviet Union, issues of SDRs served as a substi-tute for dollars in central bank reserves.

Looking back after the fact, it is surprisinghow small was the loss of confidence in the dol-lar as a reserve currency before 1971. Centralbanks and governments preferred to absorbdollars rather than revalue their currencies.Some private speculators purchased gold orother assets, but the purchases were not largeenough to move the equilibrium gold price per-sistently above the fixed price until 1970.

Meeting after meeting during the last fiveyears of Bietton Woods mentioned the threeproblems: confidence, liquidity, and adjustment.Central bank governors, ministers and theirstaffs gave most of their attention to liquidityand then to confidence. Aside from a few re-latively small changes in parities, little was doneabout adjustment. The attitude of the IMF isrepresentative of the period. Their 1969 reportmentions adjustment of par values, followingthe French devaluation. The discussion reachedonly one conclusion: the par value system shouldbe retained.~~

THE END OF BRETTON WOODS IConcern about the rising budget deficit, the

payments problem and inflation led Congress inJune 1968 to accept the Johnson administration’sproposed 10 percent income tax surcharge and,in return, to require the administration toreduce the growth of government spending.The response of the Federal Reserve was almostimmediate; they reduced the federal funds ratein an attempt to mix easier monetary policywith tighter fiscal policy. Growth of the mone-tary base declined briefly, then rose to a 7 per-cent annual rate of increase (figure 2b). The sixmonth average rate of increase of consumer

445ee Solomon (1982), p. 122.“Ibid., p. 124.

46Jbid., p. 105.4TSee IMF (1969), p. 32.

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74 I

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III

a

prices rose at a 4 percent rate in 1968 but theannualized rate of increase was 6.5 percent atthe end of the year.

U.S. consumer prices now began to rise rela-tive to a trade weighted average of prices abroad(figure 3), reversing the trend decline of theearly 1960s. Unit labor costs rose sharply rela-tive to costs abroad (figure 5). The trade andpayments position deteriorated; real net exports(1982 dollars) fell to —$30 bilhon in 1968 and—$35 billion in 1969 from —$17 billion in 1967after a $6 billion surplus in 1964. As shown inFigure 4, the nominal current account balancecontinued to fall in 1968, reversed briefly dur-ing the 1969-70 recession, then resumed itsdecline.

The official settlements measure of the balanceof payments shows the United States in surplusin 1968 and 1969 for the first time in thedecade.48 This was misleading, much of it theproximate result of Regulation Q ceilings onpersonal and corporate time deposits. As U.S.interest rates rose above the legal ceiling rates,commercial banks lost time deposits to the Euro-dollar market.” The U.S. banks then borrowedin the Eurodollar market acquiring many of thedeposits they had lost and some additional funds.The effect was to have a large inflow of short-term capital, $4.3 billion on the official settle-ments basis for the two years.

Interest rates fell during the 1970 recession,real rates declined on average relative to ratesabroad, and the capital flow reversed with avengeance. The official settlements deficit of—$9.8 billion was by far the largest to thattime. But this flow was soon dwarfed by the—$31 billion outflow in the first three quartersof 1971.~°

Figure 1 shows the surge in liabilities toforeign central banks and governments. Theseliabilities more than doubled to $50 billion in1970, then rose another $11 billion in 1971. Theclassic response to a capital outflow for a coun-try on a fixed exchange rate is to raise interestrates and reduce money growth. The FederalReserve did the opposite, the federal funds ratefell from a peak of 9 percent early in 1970 to

less than 4 percent the following year. Growthof the monetary base rose from 4 to 8 percentannual rate in the same period.

To any outside observer, it must have beenclear that the United States did not intend tofollow the classical rules or the policies of acountry that intended to maintain a fixed ex-change rate. The run from the dollar began.Foreign central banks experienced large in-creases in dollar reserves. Germany added $3.1billion in the first six months of the year. Ger-man money growth rose from 6.4 percent in1970 to 12.0 percent in 1971. German consumerprices, which had increased 1.8 percent in 1969rose 5.3 percent in 1971. Despite rigid exchangecontrols, Japan could not escape the direct ef-fect of U.S. money growth through the tradeaccount. Japan’s reserves nearly tripled in thefirst nine months of 1971, rising $8.6 billion.The Japanese money stock (M1) rose more than25 percent in 1971. Other countries had qualita-tively similar experience.

In 1969, after much delay, Germany had closedthe foreign exchange market, allowed the markto float, then revalued by 9.3 percent on Octo-ber 24. Within two years, three major curren-cies—the British pound, the French franc andthe German mark—had been forced to changeexchange rates.” The belief that economicstability required exchange rate stability beganto erode.

The 1971 capital flow dwarfed previous ex-perience. The U.S. deficit on capital accountwas almost $30 billion for the full year 1971and $42 billion for the two years 1970-71. Ofthis amount, $40 billion became dollar reservesof other countries. Japan and Germany accumu-lated $11 billion each, more than half the total,and the United Kingdom acquired nearly $10billion.” On May 5, seven European countriesclosed their foreign exchange markets. The Ger-man Finance Minister, Schiller, tried to persuadeprincipal European countries to agree to a jointfloat, but France and Italy opposed. Four dayslater the mark and the Dutch guilder began tofloat. Switzerland revalued by 7 percent andAustria by 5 percent.53 Belgium, with a split cx-

aThe official settlements balance measures the change in

reserve assets minus the change in short- and long-termliabilities to foreign official institutions (central banks or in-ternational agencies).49A Eurodollar is a dollar deposit liability of a European

based bank, including European branches of U.S. banks.

50See ERP (1972), p. 150.51France devalued by 11.1 percent on August 10, 1969.

Canada floated its currency against gold in May 1970.“See IMF (1972), p. 15.“See Solomon (1982), p. ISO.

I 75

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III

MAVttUNF lost

76

change rate, allowed the financial rate to floatup. Early in August, faced with slow recoveryfrom the recession, rising inflation, a persistentpayments deficit, and fifteen months to electionday, President Nixon decided to change economicpolicy. After meeting at Camp David on theweekend of August 13 to 15, he ended the fixedexchange rate system by suspending temporar-ily the convertibility of the dollar into gold orother reserve assets.”

The plan announced on August 15 includedmuch more than the suspension of gold conver-tibility. Wages and prices were frozen for 90days, allegedly to stop inflation then running atan annual rate of 3 percent for the six monthsending in July. Tax credits to increase employ-ment and investment were introduced to in-crease demands for output and labor’ and toreduce unemployment below 6 percent. A 10percent surcharge was put on imports.” By theend of August, all major currencies except theFrench franc floated against the dollar.” Thelast remaining tie of the dollar to gold hadbeen severed, at least temporarily.

Many of the changes announced on August 15had been discussed for some time in advance.Chairman Burns of the Federal Reserve had ad-vocated a price-wage policy for months. JohnConnolly, the secretary of the Treasury, favor-edstrong action on trade and inflation. Steinreports that President Nixon and Connolly hadagreed in the spring that they would imposeprice and wage controls if foreign demand forgold required them to close the gold window.”

‘The triggering event was renewed demandsfor gold from France and Britain. On August 8,the press reported that France would ask for$191 million in gold to make a scheduled repay-ment to the IMF. Later in the same week, onAugust 13, Britain also requested to exchangedollars for gold. The combined requests were

small in comparison with the $12 billion in-crease in foreign holdings of dollars in the firstnine months of 1971. Reports of demands forgold, however, generated fears of a run againstthe remaining U.S. gold reserve.57 PresidentNixon and his principal advisers met at CampDavid on the weekend of August 13 to 15 toadopt the program based on the agreementreached by Nixon and Connolly in the spring.”

The earlier policy had been called ‘steady asyou go.” In fact, U.S. monetary policy had beenfar from steady in 1970-71. The federal fundsrate was driven down from 9 percent early in1970 to 3.7 percent in March 1971, then in-creased 5.3 percent in July. During the sameperiod, growth of the monetary base increasedfrom 4 percent to 8 percent. The effect, givenpolicies abroad, was to lower U.S. short-term in-terest rates relative to a trade-weighted averageof rate abroad as shown in figure 6.” The de-cline in relative real interest rates ended inMarch, then reversed but, by March, the dollar’sfixed exchange rate was falling, reflecting grow-ing fears of devaluation. These fears strength-ened as currencies began to float or revalueagainst the dollar.

When asset markets opened on MondayAugust 16, traders greeted the new economicpolicy enthusiastically. U.S. interest rates felland stock prices rose. Many of the foreign ex-change markets abroad were closed, but in theUnited States and, later in markets overseas, thedollar depreciated against most currencies. Anexception is the Canadian dollar which remain-ed in a narrow hand for the rest of the year.The Japanese yen was at the other extreme; itrevalued by about 5 percent initially and rose10 percent by the end of September despitemuch intervention by the Bank of Japan. Be-tween December 1970 and July 1971, the tradeweighted index of the real U.S. exchange I-ate

“More precisely, the surtax was used to raise import dutiesno higher than their statutory level from which tariff reduc-tions had been made. For autos, the increase was, there-fore, 6.5 percent (ERP, 1972, p. 148). Shultz and Dam(1977), p. 115 explain that the surcharge was to be usedas a bargaining chip to keep other countries from followingthe U.S. devaluation against gold. U.S. policy was todevalue against gold and other currencies. The surchargeraised the price of U.S. imports, so devalued the dollaragainst other currencies until they agreed to a formaldevaluation.

“France adopted a dual exchange rate with financial tran-sactions at a floating rate.

“See Stein (1988), p. 166. Herbert Stein was a member andlater chairman of President Nixon’s Council of Economic

Advisers. The decision was told only to George Shultz,director of the Office of Management and Budget and PaulMcCracken, chairman of the Council of EconomicAdvisers.

“See Shultz and Dam (1977), p. 110; Stein (1988). p. 166.“Arthur Burns, chairman of the Board of Governors, par-

ticipated in the meeting despite the independence of theFederal Reserve. Burns also participated in the administra-tion’s program as chairman of the Committee on Interestand Dividends.

“The local peak in the relative rate is 1.27 in January 1969.By March 1971 the relative rate reached 0.6.

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FEDERAL RESERVE BANK OF St LOUIS

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I

Figure 7Dollar’s Real Exchange Rate Index

134

126

118

110

declined by approximately 3 percent; between

I . July and the end of December 1971 the rate fellan additional 6.5 percent, so real devaluationfor the year was approximately 9.4 percent.

Figure 7 shows the real exchange rate forthe dollar against a trade-weighted basket of cur-rencies using Federal Reserve weights. Sincethere are few pamity changes prior to 1971, thereal exchange rate reflects mainly relative pricechanges. Hence, figure 7 for the most part dup-licates figure 3 until 1971. Thereafter, the twocharts differ; the real exchange rate reflectsboth the devaluation of the nominal exchangei-ate and the change in relative prices.

II

I

134

126

118

110

What Next?

The price-wage freeze, the surtax on importsand the floating dollar were thought to be tem-poraiy measures. There is no evidence that theadministration had developed a long-term pro-gram by August 15, but they began to do so.

The 1972 Economic Report summarizes someof their thinking by discussing three questions.Should realignment occur through market adjust-ment or negotiation? How large is the structuralor permanent deficit? How should the reductionin the U.S. payments deficit he distributedamong other trading countries? In practice, thedistribution would be determined by the choice

1973100 Monthly Data142

‘1973 = 100142

IIIIIIIIIII 1960 61 62 63 64 65 66 67 68 69 70 71 1972

a M~VLUIrJ~1004

78

of exchange rates, so the issue was the size ofrelative revaluations against the dollar.” Othercountries, particularly France, wanted acknowl-edgment by the United States of its past infla-tion in the form of a devaluation against gold.Perhaps more important was the effect oncountry wealth. A devaluation by the UnitedStates raised the value of country gold stockswhile a devaluation by other countries reducedthe value of their dollar assets.

In the first nine months of 1971 the U.S.short-term capital outflow rose to $23 billion,and the basic balance declined to —$10.2 billion.At an annual rate, these outflows were equiva-lent to the entire short-term capital outflow for1960-69. The outflow includes capital flight fromthe United States in anticipation of devaluationand a deteriorating current account balance. Inpart, deterioration reflected the worsening rela-tion in U.S. prices relative to foreign prices. Theratio of U.S. consumer prices to trade weightedconsumer prices in figure 3 shows an increaseof four percentage points between 1966 and theend of 1970.

Although Treasury Undersecretary PaulVolcker had testified in June that the basic im-balance was about $2.5 to $3 billion, Volckernow argued for a $13 billion adjustment toreach equilibrium.” The United States favored aperiod of free floating and offered to removethe 10 percent surcharge on imports if othercountries would remove barriers to trade. In-stead central banks intervened, and govern-ments imposed exchange controls. Exchangerates were not permitted to adjust freely; newrates were negotiated.

The Smithsonian Agreement

In December, finance ministers and centralbank governors met at the Smithsonian Institu-tion in Washington to agree on a new set ofexchange rates. Gold was repriced at $38 perounce, and bands on exchange rates were rais-ed from 1 percent to Z.25 percent of centralrates. The United States eliminated the 10 per-cent surcharge on imports, and the principalcountries agreed to discuss reductions of tradebarriers.”

The agreement on devaluation of the dollaragainst gold raised, or more accurately, con-tinued a problem. The official gold price re-mained below the open market price that hadnow reached $42. Central banks, therefore, hadan incentive to convert dollars into gold and sellthe gold on the open market. ‘The “solution” wasto raise the official price but not require thedollar to be convertible into gold!

The new exchange rates revalued the markby 13.6 percent against the dollar, the yen by16.9 percent, the pound and the French francby 8.6 percent, and most other European cur-rencies by 7.5 to 11,6 percent. The FederalReserve’s calculation showed a trade weighteddevaluation of the dollar of 6.5 percent againstall currencies and 10 percent against the cur-rencies of the Group of 10. The devaluation wasestimated to produce an $8 billion swing in theU.S. trade balance in two to three years.63 TheIMF estimated the dollar devaluation as 7.9 per-cent of its former par value.” The effect of allthe parity changes was to raise the world im-port prices by about 7.5 percent.65

Prior to the agreement, inflexibility and lackof an adjustment mechanism had been majorproblems. Surplus countries had been reluctantto revalue because of the effects of their exportson domestic employment. The United States hadbeen unwilling to devalue against gold. Manycountries had relied on exchange controls tostrengthen their currencies.

The Smithsonian agreement took two steps toimprove adjustment. The gold price changed,opening the possibility of further changes, andthe dollar was devalued against the leading cur-rencies. In addition, cross rates of exchangewere altered to reflect, partially, the changes inthe world financial system. Also, the 2-1/4 per-cent band on exchange rates permitted diver-gence of up to 4.5 percent. But, nothing wasdone to provide an orderly procedure for chang-ing parities when there were persistent deficitsor surpluses. The system remained relatively in-flexible and poorly designed for the eventwhich it soon faced.

“See ERP (1972), p. 149.61See Solomon (1982), p. 192-93; ERP (1972), p. 154. The

$13 billion included a $6 billion surplus to provide for len-ding to developing countries.

“Secretary Connally’s initial position included renegotiationof defense costs, but this issue was dropped. The discus-

sion of trade barriers produced very few changes.(Solomon, 1982), p. 191.

“See Solomon (1982), p. 211.“See IMF (1972), p. 38.6Slbid,, p. 22.

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

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79IIIIIIIIIIIIIIII

President Nixon called the agreement “themost significant monetary agreement in thehistory of the world.”69 In fact, it was a modestagreement that lasted less than fifteen months.Within a few months stresses reappeared in theinternational monetary system. In June, Britaindecided to let the pound float. Within a month17 members of the sterling bloc followed. In thesame month, Germany imposed controls on cap-ital inflows for the first time since the 1950s.°’

The underlying problem was that U.S. policyremained inconsistent with maintenance of afixed exchange rate system. Despite the pricecontrols introduced in August 1971, the report-ed rate of change in consumer prices in 1972was only 1 percent lower than in 1971. Moreimportantly, the future did not look promising.The Federal Reserve made no effort to restrictmoney growth. Despite a surge in aggregate de-mand and industrial production, the federalfunds rate was reduced to below 3-1/2 percentearly in the year and was held below 5 percentuntil the November election. Growth of themonetary base remained above 6-1/2 percent,and growth of M1 increased to 7 percent. Nomi-nal imports surged, reflecting the devaluationand the strong economic expansion. For theyear as a whole, real net exports were —$49billion, a 20 per-cent rise in a single year andthe largest deficit to that time. The nominal cur-rent account balance remained negative, —$5.8billion, more than four times the deficit of theprevious year.

For a few months in the summer and fall, thedollar stabilized. Prices in the United States de-clined relative to trade weighted prices abroad(figure 3) and, until September, U.S. real inter-est rates rose relative to trade weighted realrates abroad (figure 6). The rise in the relativereal interest rate during the fall and early win-ter was small, however, in relation to the capi-

tal outflow.In late January 1973, a new foreign exchange

crisis began. Italy announced a two-tier exchangeF market to discourage capital outflows. Switzer-

land floated to reduce the flow from Italy andto control money growth. Pressure shifted toGermany and Japan. Within two weeks, Japan

floated, and the Europeans closed their foreignexchange markets to halt the inflow of dollars.”

The United States made its last attempt to re-tain the par value system. On February 12, thedollar was devalued by 10 percent (to $42.22).Since the United States did not intervene tomaintain the new price, the action was moresymbol than substance. Secretary Shultz (whohad replaced Connally the previous summer)also announced an end to U.S. exchange con-trols, including the interest equalization tax andrestrictions on foreign loans and investmentsscheduled for December 1974.69

Within a few weeks, there was a renewedflight from the dollar, requiring additional pur-chases by foreign central banks under the rules.During the first quarter of the year, foreigncentral banks, mainly in the G-10, bought an ad-ditional $10 billion. The addition was more than17 percent of total G-10 foreign exchange bal-ances at the end of 1972.~°The new purchaseswere sufficient to convince most countries tobring the Bretton Woods system to an end. TheEuropeans agreed on a joint float against thedollar and other currencies. The yen had floatedearlier. De facto fluctuating exchanges ratesbecame the norm for major currencies.

~THY BRETTON WOODS FAILED

In retrospect, the Bretton Woods system offixed but adjustable exchange rates appears tohave failed for two main reasons. First, the sys-tern was poorly designed, and the flaws becamemore apparent as time passed. Second, theUnited States did not pursue the monetary pol-icy necessary to maintain a fixed exchange rate.On a few occasions, interest rates may havebeen raised to support the exchange rates (or toslow the capital flow), but monetary policy con-centrated almost exclusively on a variety ofdomestic objectives. This was particularly truewhen the climax came in 1970-72.

The Flaws in Bretton Woods

The designers of the Bretton Woods systemwanted to reduce the role of gold and make ad-

“See the Wall Street Journal, December 19, 1971.OlpreviousIy Germany used reserve requirements on foreign

deposits to reduce capital inflows. In June 1973 sales ofGerman securities to foreigners were prohibited.

“The Bundesbank purchased $5 billion in the week endingFebruary 9, 1973.

“See Pauls (1990), p. 897-98.

~°IMFYearbook (1990).

justment by deficit and surplus countries morenearly symmetrical. One of the designers, JohnMaynard Keynes, believed that with fixed butadjustable exchange rates and adjustment byboth deficit and surplus countries, fluctuationsin economic activity would be reduced; deficitcountries would not be forced to contract, orwould contract less, when faced with a tem-porary loss of reserves; instead, surplus coun-tries would lend to deficit countries. In thisway, fluctuations in output would be damped.

There were two problems with this plan foradjustment. First, surplus countries had no in-centive to adjust, and they were generally reluc-tant to do so. Keynes had proposed a penaltyon surplus countries that accumulated reserves,but this proposal was eliminated early in thedevelopment of the Bretton Woods system.” Se-cond, policymakers could not distinguish a tem-porary disequilibrium, to be resolved by bor-rowing and lending, from a permanent disequil-ibrium requiring a change in par values. Inpractice, the system became more rigid with thepassage of time. Britain delayed devaluation forseveral years before 1967. France delayed de-valuation in 1968. Germany, Japan and othersurplus countries delayed revaluations. Japansupported the yen for a few weeks even afterAugust 15, 1971, by intervening sizably to slowthe yen’s appreciation.’2

The flaws in the system appeared quickly, al-though they were not always recognized assuch. A starting point for the full operation ofthe system is 1959, when currencies becameconvertible. By 1968, the dollar was tie factoinconvertible into gold. Although the BrettonWoods system stumbled through the next severalyears, foreign central banks and governments,after March 1968, were discouraged from con-verting dollars into gold and did not do so.When some tried to convert, in August 1971,the U.S. formalized the restriction that hadbeen in effect for more than three years byrefusing to sell gold.

During the 10 years, 1959-68, from the moveto convertibility to the effective embargo onU.S. gold, restrictions on trade and paymentsgrerv. The United States paid considerable coststo avoid buying supplies abroad for its troops in

Europe and Asia. Much foreign aid was tied topurchases from the United States. Restriction ofcapital movements by Britain, the United Statesand other countries made the payments systemhighly illiberal and complex.

The ideal of Bretton Woods was a system offixed but adjustable exchange rates among con-vertible cuirencies. During its short life, the goalbecame increasingly one of maintaining fixedrates. Adjustment of exchange rates and conver-tibility of the dollar into gold were lost. Presi-dent Nixon’s August 1971 decision, in this light,should be seen as a choice of adjustment overgold convertibility.

[J.& Policy

The professed principal aims of U.S. interna-tional economic policy included maintaining con-vertibility into gold and sustaining the BrettonWoods system. The policy failed in part becauseit was often short-sighted or wrong, in part be-cause the United States placed much moreweight on domestic concerns than on the main-tenance of the world monetary system.

Throughout the 1960s, France urged, andthe United States opposed, a revaluation of gold.The French argument was correct insofar asit recognized that a devaluation of the dollaragainst gold would increase the supply of worldreserves and reduce dependence on the dollaras a reserve currency. The French were correctalso in insisting that gold had a long history asan international money, but this argument con-fused rather than clarified the issues under dis-cussion. Devaluation of the dollar against golddid not presuppose a change in the BrettonWoods system. That system was based on thedollar, a point that should have been completelyclear after March 1968 when, de facto, coun-tries could no longer convert dollars into gold.Had the United States agreed to revalue gold in1965 or shortly after, it seems entirely possiblethat the many discussions leading to the issuanceof SDRs would have been avoided and an ade-quate solution found for the liquidity problemmuch earlier. The U.S. policy delayed the solu-tion until long past the time when it shouldhave been apparent that a solution to the liquid-ity problem would not sustain the system.

llSee Meltzer (1988).

‘2The European exchange rate mechanism had muchgreater flexibility in its early years, and Germany and the

Netherlands revalued several times. By the late 1980s,however, countries tried to avoid exchange rate changes.

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Gold would have served as an effective meansof payment between central banks, a role thatthe SDH did not acquire. More importantly forthe Bretton Woods system, a revalued gold stock,if agreed to before 1968, could have imposedsome discipline on the United States to pay ingold. Discipline was lacking once the de factoembargo on gold was in place after March 1968.Devaluation was not a panacea, however. Coun-tries would have been unlikely to accept thecost of high U.S. inflation and frequent largedevaluations against gold, so the system’s sur-vival would have required some restriction onU.S. policy. SDRs provided no discipline at all.

The arguments against gold revaluation wereweak. The principal arguments were: (1) a de-valuation of the dollar against gold would notsolve the adjustment problem if other countriesdevalued against the dollar; (2) an increase inthe gold price would benefit South Africa orthe Soviet Union; (3) the gold standard wastoo rigid.

It is true that if all countries had devaluedagainst the dollar, exchange rates would haveremained fixed. But, the “liquidity” problemwould have been solved and perhaps part ofthe “confidence” problem as well. Countrieswould have taken losses on their dollar reserves,but devaluation of the dollar would have reduc-ed the risk that the system would collapse witha run on the dollar. Simultaneous devaluationwould have focused attention on the adjustmentproblem by removing the liquidity problem thatoccupied so much time and attention.

Arguments about South Africa and the SovietUnion addressed domestic political concerns.These arguments had no practical relevance. Inthe end, the revaluation of gold was not avoid-ed. South Africa and the Soviet Union continuedto sell gold. The IMF established rules for pur-chasing South African gold that accepted SouthAfrica’s right to sell gold in the market and tomember governments.

There is little reason to doubt that public opi-nion in many countries wanted to avoid a returnto the gold standard. The gold standard waswidely viewed as an excessively rigid, 19th cen-tury system. Some of the French, who favoreda greater role for gold, emphasized the “disciplineof gold” and the repayment of dollar and sterling

“See Rueff (1969).‘4There were many other private proposals including pro-

posals for a world central bank. Haberler (1g66), p. g

liabilities.” They wrote as if they did not wanta more flexible system of adjustment; theywanted greater discipline. They talked muchmore about the losses on holdings of dollarsthan the gain from a more stable, adjustablemonetary system. Although a return to a fullgold standard was not the consistent aim ofFrench policy toward the international mone-tary system, their proposals and argumentsmade it easy for others to dismiss their argu-ments. Neither France nor other governmentsoffered alternative proposals under which U.S.monetary policy would be subject to discipline.’~Perhaps it was inevitable in the 1960s that anyalternative to U.S. policy would he dismissed.

The U.S. argument that the dollar could notbe devalued was, at most, a half truth. Therestrictions placed on various types of transac-tions were partial devaluations that changed therelative prices of those transactions. The mostobvious example was the interest equalizationtax which raised the cost of borrowing dollars.Import-export bank subsidies lowered the costof favored U.S. exports. Other restrictions work-ed in much the same way to selectively devaluethe dollar.

Some of the restrictions were so short-sightedas to raise doubts about the purpose of the poli-cy and the objectives of the policymakers. Re-strictions on investment abroad by U.S. firmsare an obvious example. Absent the restrictions,investment abroad would have been higher andthe capital outflow larger. But. profitable invest-ment abroad would have produced a returnflow, increasing the current account surplus inthe future. Whatever short-term gain the re-strictions achieved, they had long-term, negativeconsequences. The problem was not a short-term problem of maintaining the Bretton Woodssystem for a few months or years. From alonger perspective the restrictions on invest-ment were counter-productive.

One reason for the investment restrictionsmay have been that policymakers often focusedon the basic balance or broader measures suchas the official settlements balance. For these bal-ances, U.S. long-term investment abroad isequivalent to an import of goods and services.Greater attention to the current account balance

refers to such proposals as endowing ‘the creation oftheir fantasy with perfect foresight, infinite wisdom...”

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would have shown the steady decline in thatbalance, thereby concentrating attention on i-cia-tive costs and prices. This focus would haveposed more sharply the basic issue: deflation ordevaluation. Reliance on investment controlspartially obscured this basic issue as well assacrificing the future for small, costly improve-mments in the present.

The interest equalization tax was no less short-sighted than the restrictions on investment. Theeffect of the tax was to raise the cost of tradingin U.S. markets, thereby encouraging part ofthe financial service industry to move abroad. Along-term result was loss of the export of somefinancial services.

By far the major flaw in U.S. policy, and themost damaging feature of the Bretton Woodssystem, was the failure to prevent U.S. inflation.As the system developed, the United States wasable to choose domestic over international goalswhenever a choice had to be made. At times,particularly in the early 1960s, U.S. nominal in-terest rates were kept higher for a few weeksor months to reduce the capital outflow. Butsuch choices usually were reversed if unemploy-ment rose. U.S. policymakers typically chose ex-pansion to deflation and used controls of vari-ous kinds to get temporary reductions in thecapital outflow. And, after 1966, policymakersadopted more inflationary policies than before.Given the priority placed on employment andother domestic goods, such as housing, pricestability was ruled out.

All of the responsibility for failure does notfall on the United States, Germany, Japan andothers pursued export growth as a holy grailand either made few efforts to adjust their ex-change rates or none at all. Spokesmen for Ger-many could point correctly to the inflationarypolicies of the United States, and the failure ofthe United States to adjust domestic policies soas to honor international commitments, but theywere less forthright about the adjustment ofcountries with sustained surpluses that had un-dervalued currencies.” After the Bretton Woodsexperience, Germany changed its policies towardadjustment. In the European Monetary System,Germany revalued frequently to keep that

system from experiencing the adjustment pro-blems of Bretton Woods.

It is surprising how little attention was paid tothe adjustment problem. The Kennedy, Johnsonand Nixon administrations did not propose apermanent solution.’°Each so-called crisis leftmore controls on capital movements or othertransactions, but these efforts were not followedby internal discussions of policies leading to along-term solution in which controls would beremoved. The Economic Reports of PresidentsKennedy, Johnson and Nixon have lengthy sec-tions each year on the international monetarysystem, but the reports say little about adjust-ment. ‘the typical comment was that surpluscountries should revalue or expand demand. Theexplanation for neglect of adjustment is not thatsuch discussions were sensitive. Solomon (1982)reports on the many meetings that were heldduring these years. There are pages on pro-posals and negotiations about liquidity, very lit-tle discussion of adjustment. The G-10 and theInternational Monetary Fund are no better.”They, too, avoided the issue or limited theircomments to suggestions that surplus countriesexpand without inflating. Even the devaluationsby Britain and France were not followed bydiscussions of the effect of the devaluation onthe United States.

As the Bretton Woods system developed, it ac-quired some of the characteristics its designershad hoped to avoid. Major countries were reluc-tant to change parities. Surplus countries arguedthat adjustment was the responsibility of deficitcountries. Deficit countries made opposite argu-ments, appealing to the need for symmetry.

The 1960s witnessed the beginning of effortsto solve international monetary or economicproblems by coordinating policy actions. Inpractice, this usually meant that surplus anddeficit countries were supposed to agree on dif-ferent mixes of monetary and fiscal policy ac-tions. Discussions produced few concrete steps.Foreign countries accepted the expansions im-plied by the flows of U.S. dollars, but they didnot systematically reduce government spendingor raise taxes to slow their expansions and lowerdomestic interest rates. And, as discussed earlier,the United States focused mainly on domestic

“See Emminger (1967) as an example. Otmar Emmingerwas a director and later president of the DeutscheBundesbank.

“See Shultz and Dam (1971), p. 111. Milton Friedman senta long memo to President-elect Nixon in December 1968

urging a prompt, decisive change in policy. Nothing wasdone. See Friedman (1988).

“See Solomon (1982), p. 173.

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objectives. The dialogue about coordination, oncestarted, was hard to stop. It continued into the1970s and 1980s. Countries that faced a balanceof payments deficit usually favored coordinatedaction. Countries in surplus usually wereopposed.

The end of the Bretton Woods system wasfollowed by diverse predictions. Some saw fluc-tuating exchange rates as a means of increasingstability or domestic policy. Some warned aboutthe instability that would follow. It is now clearthat neither was correct. The warnings aboutthe consequences of the collapse of BrettonWoods proved to be wrong. The inconvertibledollar continued to function as an internationalmedium of exchange and store of value. The ac-cumulation of dollar assets by foreign centralbanks and governments continued to rise. Bythe end of the 1970s, nominal dollar reserves ofthe G-10 countries, excluding the United States,had doubled from the level at the end of 1972.In the next decade, these reserves doubled againto more than $300 billion. Central banks andgovernments continued to be more willing toacquire additional dollars than to allow thedollar to devalue.

The end of Bretton Woods improved the ad-justment mechanism, but did not quickly elimi-nate inflation or inflationary policies. Countriesgained the opportunity to pursue independentpolicies. Inflation differed between major cur-rencies but both governments and some privateindividuals complained about the variability ofnominal and real exchange rates. During mostof the next 20 years, the principal currenciescontinued to fluctuate.

However, countries did not float freely. Dirtyfloating, managed exchange rates, intervention,exchange controls and trade restrictions wereretained or introduced. Despite these policiesand complaints about excessive variability of ex-change rates, there was no interest in a returnto Bretton Woods.

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Economic Report of the President (Government Printing Of-fice, various years).

Emminger, Otmar. “Practical Aspects of the Problem ofBalance-of-Payments Adjustment,” Journal of PoliticalEconomy, Vol. 75 (August 1967, Part II), pp. 512-22.

Friedman, Milton. “The Case for Flexible Exchange Rates,”in M. Friedman, ed., Essays in Positive Economics (Univer-sity of Chicago Press, 1953), pp. 157-203.

_______ - “A Proposal for Resolving the U.S. Balance ofPayments Problem?’ in Leo Melamed, ed., The Merits ofFlexible Exchange Rates: An Anthology (George MasonUniversity Press, 1988), pp. 429-38.

Haberler, Gottfried. Money in the International Economy (Har-vard University Press, 1965).

_______ - “The International Payments System: PostwarTrends and Prospects,” in International Payments Problems:A Symposium Sponsored by the American Enterprise In-stitute (Washington: American Enterprise Institute, 1965),pp. 1-16.

Heiler, Walter. New Dimensions of Political Economy (HarvardUniversity Press, 1966).

International Monetary Fund. Annual Report, various years.

Keynes, J.M. A Tract on Monetary Reform (London: Mac-millan, 1923), reprinted as vol. 4 of The Collected Writingsof John Maynard Keynes (London: Macmillan, 1971).

Meltzer, Allan H. Keynes’s Monetary Theory: A DifferentInterpretation (Cambridge University Press, 1988).

Okun, Arthur M. The Political Economy of Prosperity(Washington: The Brookings Institution, 1970).

Pauls, B. Dianne. “U.S. Exchange Rate Policy: BrettonWoods to Present,” Federal Reserve Bulletin, vol. 76(November 1990), pp. 891-908.

Rueff, Jacques. “The Rueff Approach,” in R. Hinshaw, ed.,Monetary Reform and the Price of Gold. (The JohnsHopkins Press, 1967), pp. 37-46.

Salant, Walter, and others. The United States Balance ofPayments in 1968. (Washington: The Brookings Institution,1963).

Schwartz, Anna J. “The Postwar Institutional Evolution of theInternational Monetary System?’ in A.J. Schwartz, ed.,Money in Historical Perspective (University of ChicagoPress for the National Bureau of Economic Research,1987), pp. 333-63.

- “The Performance of the Federal Reserve in Pur-suing International Monetary Obiectives,” Money and Bank-ing: The American Experience (Durrell Foundation, 1991).

Shultz, George P., and Kenneth W. Dam. Economic PolicyBeyond the Headlines. (Stanford University Press, 1977).

Solomon, Robert. The International Monetary System,1g45-19sl (Harper & Row, 1982).

Sorensen, Theodore. Kennedy (Harper & Row, 1965),pp. 405-12.

Stein, Herbert. Presidential Economics, 2nd rev. ed.(Washington: American Enterprise Institute for Public PolicyResearch, 1988).

The Wall Street Journal, December 1g, 1971.

REFERENCES

Corden, Max. “Does the Current Account Matter? The OldView and the New,” unpublished paper (Johns HopkinsUniversity, 1990).