A History of the Federal Reserve, Volume 2 (51 page)

United States policy did not try to fix the exchange rate. Instructions called on the desk to “maintain orderly markets” but left the definition of “orderly” to the desk (FOMC Minutes, December 16, 1975, 44). The meeting of the G-7 at Rambouillet (France) in November “suggested that intervention might be more active than in the past. However, the language of the agreement was so loose that its meaning could be determined only in the course of experience” (ibid., 17).
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The considerable volume of U.S. foreign exchange intervention was entirely sterilized, so it had no monetary effect. The FOMC did not discuss effectiveness. Scott Pardee, responsible for operations at the New York bank, like his predecessor, believed intervention was effective but made no effort to gather evidence. Burns usually favored intervention. Despite his academic background and frequent public criticism of intervention as ineffective, he did not ask the staff to produce evidence of its effect.
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The facts about floating that most surprised policymakers were that volatility of exchange rates and large parity changes did not prevent recovery or noticeably reduce trade. Trade expanded and economies recovered from the oil shock, the surge in food prices, and economic mismanagement. As Volcker noted, the absence of crisis revised countries’ concern about exchange rates (Volcker and Gyohten, 1992, 103).

The agreement between France and the United States to include floating as a legitimate option required a difficult series of negotiations. Pressed by Representative Reuss and his own inclinations, Treasury Secretary William Simon continued the negotiations through 1975. He was probably aided by the large imbalances that countries faced and the belief that the balance could not be settled without exchange rate adjustment. Also, the French position favoring fixed but adjustable rates had little support in
other countries. The agreement reached at Rambouillet became a new Article 4 of the IMF agreement in January 1976. The article stressed “stability” and called upon members to “promote stability by fostering underlying economic and financial conditions and a monetary system that does not produce erratic disruptions” (Solomon, 1982, 272).

142. Rambouillet was the first G-7 summit of heads of state. These meetings began with George Shultz’s “library group” consisting of the finance ministers of the United States, Britain, Germany, and France. Japan did not want to be excluded. It invited these four to meet at the Japanese embassy in Nairobi at the time of the IMF meeting in 1975. The French agreed to hold the next meeting at Rambouillet in 1976 and added Canada and Italy. The meetings began as an attempt to find acceptable common solutions to economic problems. Later it became a public relations effort for leaders of each of the principal countries.

143. Reports of international meetings at this time contain many endorsements of cooperative action. The international system organized special lending facilities to help developing countries finance balance of payments deficits resulting from the rise in oil prices and the decline in industrial countries’ demand. However, individual country concerns were not lost. In his report on a July OECD meeting, Henry Wallich described the continued dependence of foreign governments on United States policy much as it had been under the Bretton Woods system. “Several [members of the BIS] also expressed satisfaction over the recent rise of the dollar in the exchange markets. The Germans and Swiss went so far as to indicate that they were hoping for a stimulus to their exports as a result” (Notes on Meeting of Bank for International Settlements, Board Records, July
29, 1975).

Article 4 permitted countries to fix their exchange rate using SDRs or other base, but it forbade the use of a gold base. It also permitted floating. It is not clear that France recognized that it had accepted a permanent system of floating rates, but, in practice, most countries adopted some type of floating rate with intervention.

Gold

Finance ministers and governments also had to agree on the role of gold. The difficulty with this decision arose not only from the problem of reconciling the French and United States positions but also from the lack of agreement among policy officials in the United States. In part because French citizens traditionally held part of their wealth in gold, France wanted rules that permitted purchases and sales at market prices, and they wanted the right to increase gold held as a reserve asset. United States policy favored the elimination of gold as a reserve asset, called demonetization, and replacement with SDRs. After July 1974, valuation of the SDR used a basket of principal national currencies excluding gold.

In June 1975, Burns sent a memo to the president making the case against gold transactions by central banks and governments at market prices. At the time, the official gold price was $42.22 per ounce; the market price ranged from $160 to $175 per ounce (memo, Burns to the president, Greenspan files, Burns papers, Gerald R. Ford Library, Box 10, June 3, 1975). The large difference in price created an incentive to distribute the profits on IMF country quotas and to revalue reserves of individual countries. France favored both. Burns opposed.

The gold deposited at the IMF belonged to the IMF (subject to restrictions), so the gain on the stock also belonged to the IMF. Members control IMF decisions, if they can agree. The United States could veto any action, so its agreement and congressional approval mattered. Some wanted to use the capital gain on gold to finance redistribution to developing countries. Others, especially France, wanted to return gold to member countries at the original price so that the gain would accrue to the member, not to the IMF.

Secretary Simon was willing to compromise with the French by allowing countries to revalue gold reserves at the market price, permit purchases and sales at market prices, and authorize countries to increase gold holdings above the level on May 1, 1975, if they wished. Burns opposed
all three, especially removing the ceiling on a country’s gold holdings. He quoted from the January 1975 statement by the IMF’s Interim Committee stating the Fund’s policy was to “ensure that the role of gold in the international monetary system would be gradually reduced” (ibid., 2). The aim was “to give the special drawing right the central place in the international monetary system” (Press Communiqué of the Interim Committee, Board Records, January 16, 1975, 1).

The first of Burns’s two greatest concerns was that the proposal would increase the relative importance of gold as a monetary asset. “In fact, there are reasons for believing that the French . . . are seeking such an outcome” (memo, Burns to the president, Greenspan Files, Gerald R. Ford Library, Box 10, June 3, 1975, 3) The second was that a higher gold price and higher gold reserves would add up to $150 billion to the value of nominal reserves. “Liquidity creation of such extraordinary magnitude would seriously endanger, perhaps even frustrate, our efforts and those of other prudent nations to get inflation under reasonable control” (ibid., 4).
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Burns’s memo did not carry the day. As usual in international dealings, the Treasury position prevailed. An August 1975 agreement by principal IMF members abolished the official price of gold and eliminated any requirement for using gold in transactions with the IMF. Also, the countries agreed that one-sixth of the Fund’s gold holdings would be sold at auction to finance a transfer of wealth to developing countries, and an additional one-sixth would be returned to member countries in proportion to their quotas. Between 1976 and 1980, the Fund auctioned 25 million ounces and returned 25 million ounces to members (Schwartz, 1987b, 353). The new agreement expired in two years and was not renewed.

Congress repealed the 1934 prohibition on a citizen’s private holdings of gold effective December 31, 1974. The law empowered the Treasury to offset any effect of private demand on the gold price by selling gold at auction. The Treasury auctioned gold in 1975, 1978, and 1979 (ibid., 353).

The agreements and actions during this period ended any remaining link between gold and money.
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Countries were free to value gold at the price they chose and without regard to decisions by other countries. Gold no longer served as a numeraire for the monetary system. It was a com
modity with a historic past, a past that appealed to some. In the early 1980s, proponents of a link between the dollar and gold convinced the Reagan administration to establish a gold commission to examine the role of gold. It appointed Anna Schwartz as executive director. The Gold Commission report did not support a return to a gold-based currency.

144. Burns assured the president that the United States would not be isolated on the issue. “I have a secret understanding in writing with the Bundesbank—concurred in by Mr. Schmidt—that Germany will not buy gold either from the market or from another government at a price above the official price of $42.22 per ounce” (memo, Burns to the president, Greenspan Files, Burns papers, Gerald R. Ford Library, Box 10, June 3, 1975, 6).

145. In 1975, the System ended reliance on gold certificates for interdistrict settlements. The new procedure used government securities to equalize approximately the average rate of gold holdings to note liabilities at each reserv
e bank.

I believe it is correct to say that we have not returned to a gold standard because we are familiar with its attributes, not because we are ignorant of its attributes. A gold standard puts great weight on the objectives of price stability and fixed exchange rates. Countries must be willing to accept the fluctuations in employment and output necessary to maintain long-term price stability. The public, the political system, and policymakers after World War II were more concerned with avoiding recessions. After 1980, when low inflation received increased weight in policymakers’ objectives, a main argument for low inflation was that it encouraged long-term growth and employment. This argument gained support because the United States and much of the world had long expansions and relatively mild recessions in the twenty-five years after the 1979–82 disinflation.

Euro-dollars

Partly as a consequence of regulation Q ceiling rates and partly to protect foreign governments and citizens from the threat of blocked accounts by U.S. government order, a market for interest-bearing deposits developed abroad. The market expanded rapidly first in Europe and then elsewhere. Most of the instruments traded in these markets were denominated in dollars, hence the name euro-dollar.

Growth of the market as an unregulated market was at first misunderstood. Some observers argued that the market permitted banks to avoid restrictive monetary policy. Some feared that the market would collapse, plunging the financial system into widespread default. Some, including members of the Board of Governors, wanted to subject euro-dollar deposits to high mandatory reserve requirement ratios.

In September 1979, the Board asked the members of the Federal Advisory Council whether major central banks should expand surveillance, regulation, and reserve and capital requirements for the euro-dollar market. FAC members showed better understanding than the governors. They issued a statement explaining that high legal reserve requirements do nothing to improve either the solvency or the survival prospects of individual institutions. Further, the FAC explained that the euro-market did not allow banks or other intermediaries to evade monetary policy actions. “So long as a central bank can regulate the monetary base and the size of its domestic commercial banking system, it has nominal GNP on its
leash, and the dog will wag the nonbank-intermediary tail.” There is no evidence that eurobank subsidiaries “or other financial intermediaries . . . permit any meaningful evasion of monetary restraint” (Board Minutes, Addendum, Federal Advisory Council, September 7, 1979, 4).

The Board did not attempt to close the euro-market by regulation. The market remains, but it is better understood as an efficient credit market.

Mexico

The first of several financial crises in a Mexican election year came in 1976. Excessive fiscal and monetary expansion produced inflation and capital flight. Mexico delayed or limited exchange depreciation by drawing $360 million on its swap line with the Federal Reserve.

In the executive session to the November 16 FOMC meeting, Burns criticized the FOMC and the staff for asking too few questions and providing too little information about the Mexican financial position.
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Mexico’s position was “scandalous.” They had no evidence that Mexico could service its debts. Nevertheless, he acceded to the Treasury by agreeing to share the cost of $150 million additional loan to Mexico. Burns explained participation as a way of preventing financial repercussions in the world financial system. A more plausible explanation was the desire to protect the liabilities of money market banks that had large loans to Mexico.

Mexico devalued the peso on August 31 and later repaid its loans by borrowing from the IMF. This was the first of four financial problems Mexico experienced at six-year (election) intervals. Volcker, who managed the 1982 crisis, forecast his approach at the 1976 meeting. He felt “very strongly” that “there is nothing we can walk away from, and we will be called upon from time to time for this kind of difficult operation” (FOMC minutes, executive session, November 16, 1976, 21–22). He compared the risk on the assistance to Mexico to the risk of a mismanaged situation and preferred to take the former.

Policy
Actions
1976–78

The years 1976–78 saw the return of higher inflation. The Federal Reserve let twelve-month growth of the monetary base rise from 5.7 to 9 percent
during these years. FOMC members recognized some of the main problems. Although the Committee discussed the control problem, very little changed.

146. Burns overlooks the discussion in August 1976, when the FOMC voted to roll over the Mexican swap agreement. Coldwell objected, but Burns cited foreign policy concerns— politics—and Gardner added that the Federal Reserve would choose a different outcome but the Treasury was doing the negotiating (Burns papers, FOMC, August 17, 1976, tape 1, 4–6). Burns also failed to mention that he participated in the negotiation with Mexico. He described the negotiation at the time as requiring no action by the FOMC. “We [the Federal Reserve? the United States?] are no worse off and we may be significantly better off” (Burns papers, FOMC, September 2, 1976, t
ape 1, 8).