A History of the Federal Reserve, Volume 2 (18 page)

At the end of the same week, the Group of Ten ministers met at the Smithsonian Institution in Washington with Connally presiding. The members agreed on realignment of exchange rates and a simultaneous end to the 10 percent surcharge. The United States agreed to the 8.6 percent devaluation of the dollar against gold, but it deferred submitting the new gold price to Congress until after an agreement on removing trade restrictions. After much discussion about effective changes and bilateral rates, countries agreed to the changes shown in Table 6.2. Canada, the largest U.S. trading partner, announced it would continue to float. France had argued throughout that it would not revalue the franc. It accepted devaluation of the dollar against gold and the implied change in the dollar price of francs.

Solomon (1982, 309–10) reported that Federal Reserve staff calculations suggested that the trade weighted dollar devaluation was about 7 percent against all currencies and 10 percent against the Group of Ten. It estimated that dollar devaluation would increase net exports by $8 billion above 1972 levels, $5 billion less than Volcker had proposed.

30. Agreement with France was easier than usual. A memo by Paul McCracken explained that the French had approached him in late November to express concern about the effects of floating rates on German-French relations and suggest that without renewed leadership from the United States “it might be difficult for European unity to survive” (memo, McCracken to Kissinger, Nixon papers, McCracken Box 43, November 24, 1971, 2). Between October 1969 and November 1971, the mark appreciated about 20 percent against the French franc (McCracken to the president, ibid., December 1, 1971).

The net swing in the United States’ current account balance was sharply negative in 1972, falling from −$1433 to −$5795 millions. Principal currencies appreciated against the dollar in 1973 and the balance reversed, rising to $7140 million, a swing of $8.5 billion from 1971 and $12.9 billion from 1972.

President Nixon, always looking to make startling changes, called the Smithsonian agreement “the most significant monetary agreement in the history of the world.” It was far from that. There was still no accepted procedure for adjusting misaligned exchange rates. The dollar remained inconvertible. The group did not discuss monetary and fiscal policies of participating countries, so there was no assurance that the United States would treat maintenance of its new gold parity as a restriction on its domestic policies.

The dollar’s weighted average exchange rate fell almost immediately, declining nearly 4 percent between December and February (Board of Governors, 1981, 441, table 64). Base money growth remained at 6 to 7 percent. Within a few months, the annual increase in the consumer price index rose above 7 percent, the highest rate of increase since the Korean War. The new exchange rates came under pressure. United States policy emphasized domestic concerns after devaluation just as it had before. Since the dollar remained inconvertible, it now faced one less constraint.

Chart 6.3 shows the trade weighted real exchange rate. After an initial devaluation, the real exchange rate remained unchanged for a few quarters after the Smithsonian agreement. Then it plunged downward and contin
ued to decline, with occasional brief interruptions, until 1978. Charts for the dollar-mark and dollar-yen exchange rates show similar patterns.
³¹

After
the
Smithsonian
³²

The Smithsonian agreement had two fundamental weaknesses. First the dollar was not convertible and there was no restriction on U.S. monetary policy. Annual growth of the monetary base remained in a 7 to 8 percent range until the end of 1972. It then rose to 9 percent or more. The federal funds rate declined from 5.6 percent in August 1971 to a low of 3.3 percent in February 1972.
³³
Price controls hid the inflation, so it appeared to decline until a few months before the 1972 election. Second, the Europeans did not like the agreement. They feared a loss of exports and were concerned about bilateral rates within Europe. They soon narrowed the width of bands around their bilateral exchange rates to one-half the Smithsonian bands (±2.25 percent).

One of the main concerns prior to 1971 was that countries would not choose to hold inconvertible dollars. The monetary system would break down. In fact, holdings of foreign exchange reserves, mainly dollar securities, by foreign central banks and governments rose much faster after August 1971 than before. Table 6.3 suggests the size of the holdings. They continued to increase for three principal reasons. First, many countries preferred to subsidize exports instead of permitting their nominal exchange rate to adjust. To keep their prices from rising to adjust real exchange rates, governments used exchange controls to limit capital inflows. Second, prices of most internationally traded commodities were posted in dollars; the dollar remained the currency used in most transactions. Third, the Federal Reserve directed its policies to domestic not international objectives. Money growth rose and fell to achieve domestic objectives.

Adjustment to the new system took time. The period from December
1971 to March 1973 was marked by frequent exchange rate problems, currency adjustments, and renewed crises. Gyohten described it: “As it became increasingly apparent that the divergence of economic fundamentals among major economies was not disappearing, the effort to restore a regime of fixed parities . . . was in fact doomed to failure” (Volcker and Gyohten, 1992, 128). That realization occurred slowly. Several failed efforts and experience with floating convinced governments and central bankers that the system could work without fixed parities everywhere. European governments could have regionally fixed rates while permitting their currencies to float jointly against the dollar, the yen, and other currencies. That reconciled France’s desire for a fixed exchange rate on most of its trade with Germany’s desire for a joint float against the dollar. It also reconciled the United States policy of “benign neglect” of the exchange rate with European intervention to avoid adjustment, reducing this source of frequent conflict.

31. Makin (1974, 14) quoted the
Economist’s
comment at the time of the Smithsonian agreement. “The most important point about the new pattern of world exchange rates is that it will not last for long.”

32. Connally’s methods irritated not just Arthur Burns but also the Europeans and the Japanese. At a meeting with the president, George Shultz complained that Connally functioned as deputy president for both domestic and international affairs in addition to serving as chairman of the Cost of Living Council, and that he was “Secretary of the Treasury with vast responsibilities that he is not carrying out. . . . Connally has no staff and no time to do it” (Haldeman 1994, January 19, 1972, 399). The president later told Haldeman that Connally had decided to resign. He left in April, and Shultz became Treasury secretary.

33. Paul Volcker commented on Arthur Burns: “Despite his enthusiastic support of fixed exchange rates, he seemed to me to have a kind of blind spot when it came to supporting them with concrete policies” (Volcker and Gyohten, 1992, 104). Volcker added that President Nixon’s only interest was to avoid crises.

The first European approach became known as “the snake in the tunnel.” The tunnel was the band around the Smithsonian parities. When the dollar reached the band, central banks intervened, usually to buy dollars at the lower band. The snake referred to the narrower band within which initially six European governments fixed bilateral exchange rates. In May 1972, Britain, Denmark, and Ireland joined the snake.
³⁴

Britain’s membership did not last. It had joined the European Common Market, requiring adjustment of its trade. The initial effect was a deficit. This occurred with rising inflation. By late June Britain abandoned the snake and its Smithsonian rate, permitting its exchange rate to float.
³⁵
Denmark withdrew from the snake, and the Italian lira came under pressure.

34. The snake reduced the flexibility of dollar exchange rates. Depreciation of one or two currencies against all others required intervention to preserve the snake’s bilateral rates. The outer band mattered only if the dollar depreciated against all currencies in the snake.

35. Secretary Shultz told President Nixon that the Smithsonian agreement could break down. He proposed what he called “limited initiatives.” The aim was to show that the United States would support the Smithsonian rates, a step that Connally had refused to take. Shultz limited intervention to no more than $2 billion. The Germans especially complained to Shultz, Kissinger, and others about Connally’s policy (memo 234, Shultz to the president,
Foreign Relations of the United States, V. III, undated probably July 18). Commitment to the snake remained weak.

Next, pressure shifted to the dollar, in part because the trade deficit increased substantially in the initial response to devaluation. Treasury reactivated the swap line and intervened to maintain the exchange rate. The dollar remained in a narrow range against the European currencies and depreciated slowly against the yen until February 1973.

The July 1972 decision to reactivate swap lines permitted the Federal Reserve “to draw foreign currencies whenever it believed that sales of these currencies would have a useful effect in helping to reestablish orderly conditions in the foreign exchange markets” (FOMC Minutes, July 18, 1972, 3). Burns believed that the chief benefit came from showing leadership toward more stable international arrangements and defense of the Smithsonian rates. Charles Coombs pointed out, however, that stable rates meant that the Federal Reserve would support the dollar-yen exchange rate. He did not think that exchange rate was appropriate (ibid., 5). Also, Burns said, “primary responsibility . . . lay with the foreign central bank” (ibid.). Federal Reserve purchases would be smaller than foreign purchases.
³⁶
Many of the FOMC members praised Burns’s initiative. None objected to reopening the swap lines.

With the presidential election over, the United States ended the second phase of price controls by moving to a more voluntary system. Soon after, Italy established a two-tier foreign exchange system. Lire flowed to Switzerland, so Switzerland floated its exchange rate. Dollars flowed to Germany, anticipating revaluation of the mark. Germany tightened exchange controls. The Bundesbank bought $5.9 billion in early February to support the exchange rate. Japan bought $1.1 billion, then closed its foreign exchange market. Germany soon followed (Solomon, 1982, 229–30).

Paul Volcker proposed a 10 percent devaluation of the dollar against gold and other currencies, provided Japan would revalue by 10 percent and the Europeans would stand still. To satisfy George Shultz, the new Treasury secretary, the United States would lift exchange controls includ
ing the interest equalization tax.
³⁷
Japan agreed to a re
valuation of at least 7 percent, and by February 10 everyone had agreed on the additional 10 percent devaluation of the dollar. U.S. capital controls remained in place until January 1974. Volcker recognized at the time that nothing had been said about monetary policy. “The Fed was not ready, and no one except me seemed at all eager to press the point” (Volcker and Gyohten, 1992, 107).

The impetus for intervention came from Burns in response to repeated European complaints that the U.S. did nothing to maintain the Smithsonian parities. In March, the French had threatened to use exchange controls (FOMC Minutes, March 21, 1972, 13). Italy left in December 1972, France in January 1974. Germany learned not to repeat the inflexibility of Bretton Woods rates for the center country. It revalued four times between March 1973 and October 1978. The Dutch guilder and the Norwegian krone also revalued once. Other currencies devalued several times (Schwartz, 1987b, 31).

36. Burns mentioned that an alternative to using swaps was borrowing from the IMF. “A Fund drawing would be accompanied by a great deal of publicity, it would raise questions of surveillance, and it would accomplish nothing that could not be accomplished with System drawings on swap lines” (FOMC Minutes, July
18, 1972, 13).