A History of the Federal Reserve, Volume 2 (5 page)

Britain, represented by Lord Keynes, had done much to create the International Monetary Fund (IMF) as an institution to enhance international monetary cooperation. The first reaction was to treat the payments problem as temporary, borrow from the IMF and its trading partners, and avoid devaluation. In this respect, the policy repeated the mistakes of 1925 to 1931.

International cooperation failed in this case as in so many others. The British payments problem proved persistent, not temporary, so it required a permanent solution such as devaluation of the real exchange rate. Borrowing and restrictions on spending succeeded in changing the timing of the devaluation, and in that sense the various programs were successful for a time. But to the extent that spending restrictions and other measures slowed the economy or increased unemployment, they were followed by expansive measures and a renewed capital outflow.

As in the 1920s, the pound was overvalued against most currencies. This time the dollar was overvalued also. U.S. officials feared that devaluation of the pound exchange rate would shift pressure to the dollar, just as it had in 1931. And once again, France followed its own policies, cooperating with others at times but failing to do so when it served its purpose. Since one of the purposes was to force devaluation of the dollar against gold, it was often at odds with the United States and others.

Pressure against pound exchange rates rose before the 1964 election.
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By September 1964, a month before the election, Britain had to borrow $500 million from the Bank for International Settlements and draw $200 million, to support the pound. The economy operated at a high level, so the new government of Harold Wilson tried to shift spending from imports toward home output. In a telegram to President Johnson, Wilson explained the government’s program. The current budget deficit was worse than he anticipated before the election.
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He had rejected both devaluation and higher interest rates, the latter “because of its restrictive effect on the economy and because of its impact on your own problems” (Department
of State, Johnson Library, Central Files, FN (2UK, October 24, 1964)). Instead, he planned to rely at first mainly on non-monetary changes—a surtax on imports, a rebate (subsidy) for exports, and an incomes policy related to productivity.

29. Solomon (1982, 82–99) describes the problems and the actions taken. He participated in most of the meetings. This discussion supplements his with materials from administration and Federal Reserve records.

30. Wilson projected a £800 million deficit for the year. This number, like the $2.5 billion U.S. deficit at about this time seems small by current standards. The U.S. price level increased approximately 3.5 times between 1964 and 2003, but the nominal payments deficit increased twentyfold.

The announcement did not include strict fiscal measures or higher interest rates. Under market pressure, the Bank of England raised its discount rate in late November and spent up to $1 billion to defend the exchange rate.

In late November the U.S. Treasury organized a $3 billion loan, $500 million from the United States and $2.5 billion from the central banks in Europe, Canada, and Japan. France participated but announced that this was the last time.
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The U.S. commitment included a $250 million increase in the Federal Reserve swap or credit line. This time the Bank of England raised its lending rate from 5 to 7 percent. The Federal Reserve followed with a 0.5 percentage point increase. Renewed reserve drains followed brief periods of improved international payments. The British government tried credit controls, wage and price guidelines, and reduced spending with little lasting effect.

On March 27, 1965, Secretary Dillon expressed renewed concern about the pound. He did not expect the British to offer a fiscal budget in April stringent enough to strengthen international reserves. He told President Johnson that the French had launched a speculative attack and spread rumors that the British would devalue that weekend. Dillon suggested that the French wanted to “indirectly attack the dollar” (memo, Dillon to the president, Johnson Library, WHCF F04-1, Box 32–39, March 27, 1965).
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By early August, the Federal Reserve was back to planning what it would do if the British devalued. The plan was to buy long- and medium-term securities to prevent a disorderly dollar market. The FOMC, with Treasury support, would maintain bond prices close to pre-crisis levels. The members rejected smaller purchases at declining prices. The strength of System action would depend on the size of devaluation and the number of
countries that followed Britain. Paul Volcker, the Treasury representative at the meeting, asked whether the Federal Reserve would want to tighten policy in the event of a large (15 percent) devaluation. He suggested that after the Federal Reserve protected the dealers, interest rates could be raised to support the dollar (memo, Young to Martin, Board Records, August 7, 1965). Chairman Martin discussed the proposal at the FOMC the following day. He recommended raising the ceiling on the amount the manager could buy to $2.5 billion between meetings (from $1.5) and to allow the manager to exercise discretion.

31. Although the circumstances differed, this episode is in some respects a replay of the 1927 experience, when Britain was reluctant to raise interest rates and France was reluctant to lend its support (see Meltzer, 2003, 175–76). Soon after the loan, Prime Minister Wilson came to the United States seeking a longer-term credit. At the time, the United States favored a 25 percent increase in IMF quotas and would not ask for additional IMF credit for Britain.

32. Soon afterward, the French ambassador tried to ease tension by telling Horace Busby, one of the president’s aides, that journalists in Washington and Paris promoted bad relations. He compared Chairman Martin’s speech at Columbia University to statements by General de Gaulle. “The General does not know much about gold . . . what he has asked for . . . is not a return to the Gold Standard . . . [but] to look for a better standard then we now have” (memo, Busby to the president, Johnson Library, C081 FI9, June 10, 1965).

Planning continued after the threat of a crisis passed. A year later, September 1966, the staff reaffirmed the earlier proposal and decided that in the event of a major collapse the Federal Reserve would either ease policy generally or open the discount window. The Treasury would be responsible for supporting the government securities and agency markets (memo, Staff to FOMC, Board Records, September 1, 1966).

Higher interest rates in Germany and the United States, and a dockworkers strike in Britain, a new budget and rising wage rates renewed the run on the pound in May 1966. The U.S. Treasury bought £2 million to support the currency. European governments were not willing to support the pound further except for its reserve currency status; they would lend only to offset liquidation of reserve balances held by other countries in the London market (FOMC Minutes, June 7, 1966, 7–8).
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The balances had accumulated during World War II.

Anti-inflation actions in the United States and West Germany raised market interest rates in 1966. Other countries followed to maintain their payments balances. In January 1967, Secretary Fowler met with the finance ministers of Germany, Britain, Italy, and France to coordinate lower interest rates. The meeting did not reach an explicit agreement, but the participants agreed to “cooperate in such a way as to enable interest rates in their respective countries to be lower than they would otherwise be” (Chequers trip, Johnson Library, Bator papers, Box 8, January 23, 1967). Germany reduced its rate following the meeting. The Federal Reserve did not lower the federal funds rate until March, but Treasury bill rates began to decline the week after the meeting.

By August the special manager, Charles Coombs, was both agitated and fearful. “He thought there was a clear danger of a breakdown of the international financial system within the next month or six weeks. He saw
very little that the Group of Ten could do to stop it; their negotiations had reached an impasse. . . . The burden therefore fell directly on the Open Market Committee” (FOMC Minutes, August 23, 1966, 10). The FOMC authorized expansion of the swap lines.

33. The following is representative of prevailing attitudes: “The British stabilization program of July 1966 led to rising unemployment, which exceeded 2 percent of the labor force in the summer of 1967. . . . [T]his level of unemployment must have been politically onerous for the Wilson government” (Solomo
n, 1982, 93).

In the next three weeks, the System added $1.7 billion to its swap lines, bringing the total to $4.5 billion. The largest change was $600 million additional for Britain, bringing its line to $1.35 billion. The FOMC increased twelve of its thirteen lines; France was the exception.

These efforts again postponed the devaluation but did not prevent it. On November 12, two British Treasury officials met in Washington with Secretary Fowler to warn him that devaluation was likely, perhaps that week. Only “assurance of substantial long-term credit” could change the outcome (memo, Fowler to the president, National Security File, Johnson Library, Gold Crisis, Box 54, November 12, 1967, 1). The British position had been hurt by a new war in the Middle East, the closing of the Suez Canal, and the withdrawal of Middle East deposits from London. They expected to lose much of their remaining (net) reserve of $800 million when they announced the latest trade data the following week. Overall, Britain’s gold stock declined from 71 million ounces in 1964 to 37 million in 1967.

The immediate problem arose because the British government would not raise the Bank rate to the level of euro-dollar rates. Money flowed out of covered sterling deposits into euro-dollars, draining reserves. The Bank of England used several stopgaps that raised market rates without raising Bank rate. The outflow continued.

Market data suggested that Bank rate should have increased by one percentage point. After some delay, the Bank raised the rate by 0.5. This was not sufficient to stop reserve losses (Maisel diary, October 24, 1967, 1–3).

Fowler mentioned the advantage of ending the recurrent problem by devaluing the pound. He rejected that course. “The risks to us are just too great to take this gamble” (ibid., 2).
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Pressure would shift to the dollar. France might follow Britain by devaluing to increase pressure on the U.S. to raise the gold price. There would be a run on the gold market.

Fowler tried to get agreement on another loan. International cooperation failed. The United States offered to buy $500 million in pounds with a guar
antee of exchange value, but the principal European central banks would not agree to a long-term loan, and the British would not accept additional short-term loans. The IMF directorate would not agree to a $3 billion dollar package as an alternative (Board Minutes, November 14, 1967, 4–9).
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34. More than two years earlier the State Department made its position clear. It opposed devaluation. “If they should make a big external move, they would wreck much more than the monetary system. Our foreign political and defense policies would be badly mangled” (“Some thoughts on the British Crisis,” Department of State, Ball papers, Johnson Library, Lot 74 D272, July 28, 1965).

Martin urged Fowler to try to persuade the IMF’s managing director, Pierre-Paul Schweitzer, to change his mind. The most Schweitzer would offer was $1.4 billion.
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That was not enough for the British. Unlike the 1920s, they wanted no more short-term credit or partial support. In a sign of the change in attitudes that had occurred, Britain preferred devaluation to repetitive crises. Governor Robertson opined that “funds advanced to the British and disbursed by them were likely in the end to represent additional drains on the U.S. gold stock. The decision regarding the position of the United States was for the administration rather than the System to make, but in his opinion the time for sterling devaluation was at hand” (FOMC Minutes, November 14, 1967, 28). Robertson recognized that a British devaluation would increase speculation against the dollar. “The United States was in a better position to deal with them [speculators] now than it might be one or two years hence” (ibid.).

Only Maisel supported Robertson. Brimmer took issue with them, claiming that the pound was not overvalued permanently. The measures to control spending and costs “appeared to be taking hold” (ibid., 33). He thought that the United States should help the British continue their program.
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As often happens in decisions of this kind, there was less interest in facts than in being finished with the problem.

Four days later, on Saturday, November 18, 1967, Britain devalued the
pound from $2.80 to $2.40. As in 1931, this was a major break in the fixed exchange rate system. The system was now under increased pressure from gold losses. The Federal Reserve responded by raising the discount rate 0.5 to 4.5 percent to defend the dollar. The British government imposed new restrictions, and the Bank of England raised the discount rate to 8 percent. France let it be known that it had withdrawn from the gold pool in June. This increased the U.S. share of withdrawals from the gold pool.

35. Discussions in Washington, Basel, and Paris continued to the end. Chairman Martin added that he and Dewey Daane had sat through several meetings with the Treasury. They “had taken pains to make it clear that they could not in any way commit the System to participation in the guaranteed sterling proposal and that such participation would involve a change in the character of the System’s operations to date” (Board Minutes, November 14, 1967, 13).

36. Martin later explained Schweitzer’s reasoning. First, the $3 billion credit was so large it “would endanger the entire structure of the Fund if anything went wrong” (Board Minutes, November 14, 1967, 21). (How the IMF changed in the 1990s!) Also, the IMF did not believe Britain was a good credit, given its outstanding foreign debt (ibid., 22).

37. The Board’s attorney, Howard Hackley, told the members that “there was no express authority in the Act for the Federal Reserve to extend credits to foreign banks” (FOMC Minutes, November 14, 1967, 34). However, there was a precedent in the 1925 loan to Britain when it returned to the gold standard. No money had been drawn, however. Hackley concluded that the program for longer-term assistance “would not involve greater legal questions than now existed” (ibid., 35). With this weak assurance, the FOMC voted unanimously to participate in the Treasury’s purchase of covered pounds and increased the ceiling on purchases of forward foreign currencies.