A History of the Federal Reserve, Volume 2 (50 page)

To carry out foreign exchange market intervention, the Federal Reserve increased its swap lines several times. Use of swap lines in transactions altered the monetary base of the foreign country unless it sterilized the Federal Reserve’s action; for example, by selling marks for dollars, the Federal Reserve increased the market’s holdings of marks. To prevent a domestic impact, the Bundesbank had to sterilize the sale by reducing domestic securities in its portfolio.

The Treasury was the dominant partner in United States foreign exchange operations after 1933. The Gold Reserve Act of 1934 established the Exchange Stabilization Fund (ESF) for this purpose and authorized the secretary, after consultation with the president, to intervene. The ESF did not have large resources, so it borrowed from the Federal Reserve by “warehousing” foreign exchange with the Federal Reserve as collateral. Since the Federal Reserve Act prohibited loans to the Treasury, warehousing evaded the restriction. Congress failed to interpret warehousing as a loan, so the practice continued.
¹³²
The Treasury absorbed any losses if the collateral value declined.

The Federal Reserve’s authority to engage in foreign exchange transactions was not explicitly recognized in the Federal Reserve Act. The legal staff interpreted the provision permitting the System to purchase and sell cable transfers and to hold foreign exchange in accounts abroad as sufficient to permit these transactions (Humpage, 1994, 3).
¹³³

Humpage (ibid., 16) produced a table of the Federal Reserve’s realized and unrealized gains and losses from its dealings in foreign currencies between 1975 and 1992. Many of the gains resulted from holding foreign assets that appreciated relative to the dollar.
¹³⁴

Floating exchange rates permitted countries to control inflation. None managed to restore price stability in the 1970s, but significant differences emerged. Table 7.13 shows these differences on average for 1977–80 and in 1979 and 1980.

Differences in measured inflation rates re
flect mainly sustained differences in mone
tary policy and the weight on oil prices in the country’s
consumer price index.
¹³⁵
Those who expected that a shift to floating rates would totally separate economies were disappointed. Capital movements continued, driven in part by the policy and inflation differences that underlie the table. The resulting volatility of exchange rates gave rise to considerable negative comment about floating rates, but little evidence of systematic effects of variability on trade flows. In time, policymakers remembered that whether exchange rates were fixed or floating, stability depended on the policies pursued. In the United States and many other countries, full employment was the main policy goal. The exchange rate reflected the actions taken to achieve the employment goal. Absorbing the increased price of oil also increased instability.

132. Members of the FOMC reopened the issue about legal authority in 1990 (Schwartz, 1997, 145).

133. For the legal reasoning see volume 2, book 1, chapter 3.

134. Humpage found relatively large gains from 1985 to 1987 and 1990, mainly from dollar depreciation. Overall, the cumulative gain for these years was $4.8 billion, or 0.66 percent of the Federal Reserve’s payments to the Treasury. Humpage shows losses in eleven years and gains in seven.

International agreements advised countries to cooperate.
¹³⁶
One popular proposal called upon leading countries to limit floating by agreeing upon target zones for exchange rates. Such proposals attempted to move back toward fixed exchange rates with wider, perhaps much wider, bands within which exchange rates could change. They required an agreement to limit domestic policy actions and to change domestic policy when called for by a foreign government, but the proponents did not discuss the loss of control over domestic policy. Efforts by the Carter administration to get agreement for joint action in 1977–78 showed that countries gave different weights to employment and inflation. West Germany, in particular, was reluctant to risk higher inflation to reduce U.S. unemployment and finance
its overseas commitments for common defense and military assistance.
¹³⁷
These problems continued to exist after exchange rates became free to float; international disagreement on how to manage the consequences remained.
¹³⁸
Volcker summed up the problem: “Coordination becomes much more complicated when it moves into broad questions of trying to manage different economies at different rates of growth, or of influencing tax policy or energy policy. To a politician, that all implies some loss of sovereignty” (Volcker and Gyohten, 1992, 145).

135. Mundell (2000, 335), using wholesale prices, claimed that the price increase in the United States from 1971 to 1982 was 157 percent. This exceeded the increases during any wartime period after independence.

136. The agreement legalizing floating exchange rates called on countries to achieve “orderly underlying conditions . . . for financial and economic stability.” It “did not offer any real guidance as to how the requisite cooperation would be achieved” (Volcker and Gyohten, 1992, 143). Criticism of floating was widespread. Gottfried Haberler (1990, 157) quotes a criticism of floating rates by Pope
John Paul II in 1988.

The end of the Bretton Woods system did not eliminate differences among countries about how to share the cost of common defense or reconcile domestic demands to lower the unemployment rate or the inflation rate. Floating simply gave policymakers one more degree of freedom; they could permit the exchange rate to adjust, and they could choose to control domestic inflation. Foreign governments disliked these changes as much as or more than they disliked capital inflows. The United States, at first, chose to ignore the criticisms and the exchange rate. Later it intervened in the exchange market or proposed coordinated action to increase economic growth without changing exchange rates (Pauls, 1990).

INTERNATIONAL POLICY ACTIONS

Early 1974 found the Federal Reserve and other central banks trying to adjust to the oil price increases without a clear idea about what to do. The Arab countries embargoed oil sales to the United States, but the embargo proved mainly that oil was fungible. It sold in an international market, so the actual effect was much less than the Arabs anticipated. The embargo failed and ended in March. Governor Daane reported on the January meeting at the Bank for International Settlements (BIS) in Basel. The United States proposed multilateral intervention to avoid competitive devaluations. BIS President Zilstra sensibly pointed out that “it was necessary to determine the appropriate exchange rates before intervening, in order to know what rate levels to aim for” (FOMC Minutes, January 21, 1974, 12). Needless to say, the central bankers had no way to answer that question. Burns looked on the bright side. Appreciation of the dollar would lower the inflation rate and restore “some semblance of price
stability” (ibid., 20). But Coombs saw only disorderly markets driven by speculation.

137. James’s (1996, 207) description of the breakdown of the Bretton Woods system remained applicable to the early years of floating. “The crisis of the Bretton Woods system can be seen as a particular and very dramatic instance of the clash of national economic regulation with the logic of internationalism. . . . [T]he description of the system followed very obviously and directly from the policies of the United States.”

138. In a widely cited paper, Meese and Rogoff (1983) showed that exchange rates under floating approximately followed a rando
m walk.

In February, the United States called an energy conference in Washington. The discussion did not distinguish between a price level increase and continued inflation. Burns summarized his conversation with the finance ministers of leading countries by saying they were more concerned about maintaining aggregate demand than preventing inflation (ibid., February 20, 1974, 11).
¹³⁹
The size of their problem measured by the gross increase in payments to the oil-producing countries was $60 billion in 1974, about 2 percent of the combined GNP of the OECD countries (Solomon, 1982,307).

The United States removed exchange controls and freed capital exports and imports early in 1974. At first, the dollar appreciated. By February, the dollar was under pressure to depreciate. The Federal Reserve and the Treasury sold $155 million of foreign currency by mid-March to stem the decline (ibid., March 18, 1974, 47).
¹⁴⁰
Failure of the Franklin National Bank in New York and the Herstatt Bank in Germany increased intervention during the summer. Countries continued to meet and discuss various reforms, but their policies remained independent.

Active intervention continued in 1975. The trade-weighted dollar moved over a relatively wide range. The monthly average reached lows in March and June, then recovered to the end of the year. In the year ending December, the dollar rose 6.5 percent against the mark. In part, dollar appreciation against the mark reflected the more rapid increase in West German hourly compensation and the greater domestic production of oil in the United States.

Several efforts to coordinate policy reflect dissatisfaction with floating rates. The Federal Reserve and others focused attention mainly on short-term events and ignored expectations of differences in inflation and growth. In January, the staff reported that several countries lowered interest rates to coordinate actions with the United States and Germany. In February Chairman Burns met with Presidents Karl Klassen of the Bundesbank and Fritz Leutwiler of the Swiss National Bank. They agreed on “more concerted intervention policies” based on daily conversations by operating officials. The three agreed to expand operations in periods of dollar weakness (FOMC Minutes, February 19, 1975, A-2).

139. Some of the ministers may have recognized that a relative price had changed and did not choose to force the price level down.

140. This was much less than Japan. Between the oil shock in October 1973 and January 1974, Japan spent almost $7 billion on intervention to slow yen depreciation (Gyohten in Volcker and Gy
ohten, 1992, 131).

Very large differences in reported headline inflation rates and changes in reported inflation suggest that the mid-1970s was not a period in which exchange rates were likely to stabilize with or without intervention. Table 7.14 shows a sample of reported consumer price inflation rates during 1973–77. Reported inflation rates include both one-time responses to food and oil price increases and permanent or persistent underlying rates of inflation. There are few if any peacetime periods in which comparative inflation rates for industrial countries differed as much or changed as much from year to year. Given these data, exchange rate volatility should not have surprised central banks and governments. They did not agree, however, on the reasons for inflation.

Germany (and many others) criticized United States monetary policy as a main reason for exchange rate instability. They emphasized the excessive creation of dollars as a source of “monetary debauchery” for countries with current account surpluses and fixed exchange rates (Solomon, 1982, 301, quoting Otmar Emminger of the Bundesbank). This line of criticism usually did not mention that surplus countries could revalue. Maintaining or increasing employment and exports dominated their other goals. Others again pointed to the asymmetry of the international system based on the dollar.

Solomon (1982, 301–7) rejected Emminger’s argument. Although he recognized that the capital inflow to Germany and Japan was historically high, he pointed out that German wages began to increase before the capital inflow. He blamed German inflation on food and oil price increases and rising foreign demand for German exports. And he quoted from BIS and OECD reports to show that the non-monetary explanation of inflation was widely held. Solomon recognized that comparisons of timing cannot be decisive, but he offered no other evidence. And he ignored the cumulative effect of expansive policies in the United States and abroad and the growing expectation in many countries that those policies would continue.
¹⁴¹

141. Volcker had a more classical interpretation. He urged Burns to “tighten money” if he wanted to restore a par value system (Volcker and Gyohten, 1992, 113–14).