A History of the Federal Reserve, Volume 2 (11 page)

These conversations and others suggested that multilateral agreement on systemic changes would prove difficult. Appeals to the “discipline of fixed exchange rates” seem particularly odd, since neither the United States nor Britain was willing to restrict demand enough to maintain the exchange rate. True, neither country completely ignored its balance of payments deficit when it became a problem, but both were reluctant, or unwilling, to exert the necessary discipline. Nor would the surplus countries approve of policies that restricted demand in the deficit countries to a degree that significantly reduced their own exports. And the surplus countries would not adjust. The architects of the Bretton Woods system thought they had designed a fixed exchange rate system freed of the problems of the 1920s gold standard. In principle, exchange rates could adjust to clear permanent imbalances; in practice they did not, at least not for the principal surplus countries or for the principal reserve currency country.

Some small relief came in 1969. Early in April, the Federal Reserve raised the discount rate to 6 percent and increased reserve requirement ratios for demand deposits by 0.5 percentage points. Ten banks had requested an increase in the discount rate. Chairman Martin spoke about “the credibility gap” faced by the Board and the administration; “neither was willing to take the hard action required if inflation was to be stopped” (Maisel diary, April 3, 1969, 53).
⁶⁹
Later in the year, after an election, West Germany floated its exchange rate to reach a new fixed rate 9.3 percent above the old rate. No major country followed. Some adjustment had been achieved, but it was insufficient.

On June 23, Secretary Kennedy sent the president a long options paper explaining what choices he could make about international economic policy. The paper, prepared by the Volcker group, reiterated the choices presented earlier. There were three options.

First, the United States should obtain multilateral agreement on increased exchange rate flexibility and adjustment. Part of this program included early activation of special drawing rights (SDRs). The U.S. proposal called for $4 to $4.5 billion a year for five years. The Europeans proposed $2 billion a year. The memo favored the multilateral approach but warned that “multilateral agreement may fail to move rapidly enough to achieve
the objective and relieve the present strain” (Summary of Basic Options, Paul Volcker inter-agency group, Nixon papers, June 23, 1969).

69. All Board members agreed on the discount rate change. Maisel opposed the change in reserve requirements because he believed it would reduce growth of the aggregates, tightening policy. He issued a strong dissenting statement but was persuaded to shorten and soften it (Maisel diary, April 3, 1969, 53–56). Interestingly, differences of opinion still existed about whether increases in reserve requirement ratios would tighten policy. “Maisel described Martin, Robertson, Daane and probably Brimmer [as] believing that Board should push as hard as possible to stop inflatio
n” (ibid., 53).

Second was suspension of gold convertibility in part, on a negotiated basis, or wholly. The principal disadvantage came from the unilateral approach. Cooperation might end over trade and investment with the establishment of a dollar bloc and a European gold bloc. But this approach would force surplus countries to revalue.

Third was an increase in the gold price. This would require congressional approval and would be contentious. Also, a large change would be inflationary, and any change would be disadvantageous to countries like Canada and Japan that had held dollars and had not asked for gold. Gowa (1983, 137) found that only Arthur Burns, counselor to the president at the time, favored devaluation against gold. The dollar, he said, was overvalued, and the Bretton Woods system would remain at risk until adjustment occurred. By devaluing early, the president could blame the action on the Johnson administration’s policies. Burns’s opponents wanted to demonetize gold and substitute SDRs. They feared that devaluation would strengthen the role of gold (ibid., 138).

Two notable features of the memo and discussion are the absence of any discussion of more restrictive policies and the acceptance of the remaining capital controls that the president, as a candidate, promised to eliminate. However, the memo repeatedly recognized the importance of reducing inflation and ending the Vietnam War while avoiding deflation and unemployment.
⁷⁰
Of course, it did not say how this could be done.

The Volcker group cited three major problems. First, it questioned whether existing arrangements would continue to finance large United States deficits. Second, confidence in the United States had declined. “The uneasy feeling abroad that United States deficits are in danger of becoming uncontrolled erodes our bargaining position” (Paul Volcker inter-agency group, Nixon papers, June 23, 1969, 8). Third, after reviewing the principal sources of the deficit, it concluded that the long-term outlook was unfavorable. Further, devaluation against gold does not necessarily change exchange rates.
⁷¹
Others can follow. The conclusion was “Until appropriate
changes can be made in commercial policy, world trading rules, and/or monetary arrangements, our balance of payments position will continue to require the protection of capital controls” (ibid., 18).

70. The memo noted the diminished role of gold. The cumulative payments deficit of $24 billion from 1958 to 1968 had been financed only 40 percent ($10 billion) by gold sales (summary of basic options, Paul Volcker inter-agency group, Nixon papers, Annex I, June 23, 1969, 6). A few months later, Robert Solomon wrote to Arthur Burns urging no change in the gold price. The principal reason was that it would hamper the movement toward a multilateral system based on SDRs (memo, Solomon to Burns, Volcker papers, Department of the Treasury, March 16, 1970).

71. There was some basis for this concern. When the issue came up, some governments threatened to follow any devaluation of the dollar. Among other possible repercussions, the
memo reported that the Japanese said their government would fa
ll. Also, countries would ask for compensation for their losses to be paid from profits on the devaluation of the dollar. The report never considered Irving Fisher’s proposal for a compensated dollar that would tie the gold price to an international commodity basket.

The memo turned near its end to negotiations over creation of SDRs. It again compared the U.S. position to the European, then added, “Failure to achieve agreement on a large amount would be one of the important factors pointing toward a shift to the second [unilateral] option of suspension” (ibid., 42). The group expressed a willingness to negotiate but not to take the $2 to $2.5 billion that the Europeans proposed. The SDR agreement reached in late July allocated $3.5 billion the first year and $3 billion in each of the second and third years. Also, countries agreed to increase IMF quotas by 30 percent.

In a separate memo, Paul McCracken supported the “evolutionary approach” through multilateral negotiations. He disagreed with the Volcker group on two points. He did not believe that greater flexibility of exchange rates would “unsettle the foreign exchange markets,” and he placed less emphasis on getting a larger allocation of SDRs. The “additional liquidity can only make a modest contribution to the adjustment process” (McCracken to the president, Nixon papers, June 25, 1969, 1–2). Excessive exchange rate rigidity, he said, was the main reason for current problems. McCracken suggested also that he was less certain about the contribution of capital controls and preferred a phased reduction.
⁷²

Discussion of greater exchange rate flexibility began in March. In December 1969, Robert Solomon forwarded to the FOMC a staff report on progress and problems. In all of the discussions, participants assumed that the dollar would remain pegged to gold at $35 an ounce and that other currencies would peg to the dollar. The report recognized that the dollar could remain overvalued for long periods (Greater Exchange Rate Flexibility: Report on Bilateral Technical Discussions, Board Records, December 30, 1969, 1–2). Foreign participants were more concerned about the lack of monetary discipline that would result from wider bands or more frequent adjustment.

72. Henry Kissinger’s memo on the Volcker group proposal supported the main conclusion but added a skeptical note: “It will be extremely difficult to reach a negotiated multilateral agreement on a sufficient scale within a relevant time period unless the alternatives are clearly perceived as worse by the key Europeans” (Department of State, Kissinger to the president, June 25, 1969). Kissinger then asked how long they should pursue the multilateral approach. His answer was that commitment to that approach could last longer if we removed constraints on our behavior (capital controls, tied foreign aid, etc.).

One of the Europeans’ main continuing concerns about wider exchange rate bands again came from their agriculture policy. Any change in exchange rates would be reflected in agricultural prices causing political and economic repercussions within the European Community.
⁷³
The community was trying to find ways to narrow exchange rate bands for its group. “Most of the reactions [to wider margins] . . . is that margin widening is unnecessary and a belief that the results would be positively harmful” (ibid., 5). Some countries considered a 5 percent margin tantamount to a system of floating rates. Participants raised fewer objections to 2 percent bands, but “there was no evidence of any enthusiastic support for marginwidening” (ibid., 7).

Criticisms and objections to wider bands carried over to other proposals such as crawling pegs. Participants expressed more interest in a one-sided arrangement, in which surplus countries would appreciate but deficit countries would not depreciate. The intent was to preserve discipline and avoid competitive devaluation.
⁷⁴

Although the discussions were preliminary and at the technical level, they gave very little support to those who favored multilateral negotiations. A discussion with the French Minister of Economy, Valéry Giscard d’Estaing, drew a more positive response. At an informal discussion, the minister accepted the idea of limited exchange rate flexibility for the dollar against the European currencies after inflation had been lowered and the gold price increased (telegram, American Embassy in Paris to Secretary of State, Nixon papers, August 4, 1969, 3).

Events changed attitudes. When the Group of Ten deputies discussed increased flexibility, Solomon reported that “there is more support for, and less opposition to, limited flexibility” than in earlier discussions (FOMC Minutes, May 5, 1970, 12). A crawling peg, or more frequent adjustments, attracted most support. Wider bands did not appeal to the Europeans.

Euro-dollars

The inflow of euro-dollars became a principal concern in 1969. The problem was that the System had increased interest rates but had not changed reg
ulation Q ceilings. To offset the loss of time deposits, banks borrowed in the euro-dollar market. Complaints from European countries rose be
cause the flow of euro-dollars toward the United States increased pressure for higher interest rates in their countries. The Federal Reserve, for its part, did not raise regulation Q ceiling rates because it feared again that the market would interpret the increase in the volume of CDs as evidence of monetary ease and, therefore, lack of commitment by the Federal Reserve to its announced anti-inflation policy.
⁷⁵
Some members of FOMC subscribed to this view.

73. Under the Common Agricultural Policy, agricultural prices were the same in member countries and expressed in a common unit. A revaluing country would have to reduce agricultural prices and a devaluing country would have to raise them. The revaluing country would then increase subsidies to producers.

74. Gowa (1983, 144–47) argues that Volcker did not actively pursue exchange rate revaluation by surplus countries during this period.

By mid-February, two positions began to develop at the Board and FOMC. Brimmer wanted controls on euro-dollar borrowing by domestic banks. His reasoning was that euro-dollars were not subject to bank reserve requirements. Hence, banks could make “unwarranted reductions in reserve requirements” (Hackley, Board Minutes, February 19, 1969, 11) Most governors agreed, but Governor Robertson objected that the Board did not understand enough about these operations to regulate them. This did not prevent action. The vote directed the staff to prepare and publish amendments to regulations affecting reserve requirements.

At most FOMC meetings the System reported complaints from the Europeans about the effect of higher euro-dollar rates on rates in their markets.
⁷⁶
The Board staff proposed a marginal reserve requirement on euro-dollar borrowings by placing a reserve requirement ratio on deposits above some initial ceiling, but it wanted to avoid subjecting these deposits to regulation Q ceilings. Governor Mitchell was not convinced. He thought that acting without more knowledge of the effect was a mistake (Board Minutes, May 28, 1969, 13). Only Governor Brimmer urged prompt action. A month later, the staff returned with more information. They proposed a 10 percent reserve requirement ratio on deposits above a base period value, and they now argued that the current capital inflow, followed by an outflow at a later date, would affect the stability of the dollar exchange rate.

By June banks borrowed about $1 billion a week on the euro-dollar market. Interest rates reached as high as 13 percent for overnight loans. Pressed by some European gov
ernments, the Board issued new regulations for comment and on August 13, 1969, imposed the restrictions effective October 16. Banks that borrowed from foreign branches, or purchased
assets from those branches, and foreign branches that made loans to customers in the United States, became subject to 10 percent requirement for all transactions above a 3 percent base of deposits. To restrict a later return flow to the euro-dollar market, the Board lowered a bank’s base by the full amount by which liabilities to foreign branches fell below the 3 percent base. The intent was to restrict growth of the euro-dollar market and moderate flows. Governors Mitchell and Daane dissented, claiming, in Mitchell’s words, that “specific evidence that overall monetary restraint has been significantly diluted is lacking” (Board Minutes, June 25, 1969, 18). Both agreed that the regulation was complex and difficult to enforce. With hindsight they might have added that the new regulations encouraged banks to seek alternative sources of funds, such as commercial paper. This probably contributed to the rapid growth of bank related commercial paper and the Penn Central crisis the following year.
⁷⁷

75. This reasoning is repeated by the staff and members of FOMC. It suggests that eurodollar borrowings are a less than perfect substitute for bank CDs. A more plausible explanation is that corporations deposited surplus funds in the euro-dollar market instead of the domestic CD market to earn the higher return, and banks borrowed in the euro-dollar market instead of the CD market.

76. A typical example is Robert Solomon’s report (FOMC Minutes, April 29, 1969, 38): “The WP-3 discussion was concerned not with the posture of U.S. monetary policy but with whether the United States should not do something to temper the effects of its tight money policy in the Euro-dollar market.”