A History of the Federal Reserve, Volume 2 (67 page)

Gold
and
Monetary
Policy

Gold and the balance of payments had an important influence on monetary policy in 1961. Despite the early rise in the unemployment rate to 7 percent and subsequent slow decline, the Federal Reserve held the Treasury bill rate between 2.2 and 2.5 percent until December.
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Average yields on long-term bonds remained between about 3.7 and 3.8 percent early in the year, but rose to 4 percent in August. Annual monetary base growth did not remain above 2 percent until October. In a pattern observed frequently during these years, base growth and monetary growth moved procyclically; as the economy recovered, base growth increased. But base growth remained relatively low in nominal terms, and close to zero in real terms early in the year. Annual consumer price inflation fell below 1 percent in October just as nominal base growth began to rise; real base growth increased (see Chart 3.9 above).

By year-end, the recovery strengthened without inflation. Industrial production increased 12 percent for the year. Real GNP growth reached 9 percent at annual rates in the fourth quarter with an unchanged GNP deflator. In December, the unemployment rate fell to 6 percent, 1.1 percentage points below the April peak.

The balance of payments and the gold outflow were troublesome. In March, West Germany and the Netherlands appreciated their currencies by 5 percent against the dollar to slow the rise in their current account surpluses and reduce imported inflation. The leadership of the Bundesbank favored capital exports and opposed revaluation of the mark (Holtfrerich, 1999, 365). Otmar Emminger, later president of the Bundesbank, was the main advocate of revaluation in the middle 1950s. He renewed his argument in 1960 (ibid., 368, 372). Ludwig Erhard, Economics Minister at the time, agreed. He preferred price stability to exchange rate stability, so he pressed the government to revalue. On March 3, 1961, the cabinet approved a 5 percent revaluation (ibid., 374).
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The Netherlands followed to keep its currency fixed to the currency of its main trading partner—not to the dollar and gold.

The West German surplus continued following the appreciation. In the second quarter, West Germany repaid a $2.3 billion loan, so the United States had a transitory surplus of $1.6 billion. Increased military spend
ing in the summer increased the expected budget deficit and capital outflow.
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127. In the early months of the 1954 recovery, Treasury bill rates remained between 1 and 1.5 percent and in 1958 between 0.6 and 1.5 percent. Martin stated explicitly that the 1958 policy was too expansive.

128. In the Federal Republic, as in the United States, the government, not the central bank, controlled decisions about the exchange rate.

None of these actions calmed the markets. Rather, the revaluations convinced speculators that rates would not remain fixed. They concentrated their resources on appreciation of the Swiss franc and depreciation of the British pound. After the central banks pledged $900 million in loans to support the pound, speculation slowed. Collective action had damped the currency crisis, but the problems had only begun (Coombs, 1962, 1140).

The Organization for Economic Cooperation and Development (OECD) held regular meetings of the economic officials of the major industrial countries. Working Party 3 of the OECD discussed the fiscal and monetary policies of the member countries and their implications for other countries through balance of payments surpluses and deficits. Many of these discussions emphasized a defect in the Bretton Woods arrangements; surplus countries urged deficit countries to adjust, and vice versa. Sovereign governments remained free to reject this advice, and they usually did. As in the 1920s, countries’ willingness to coordinate or cooperate did not include deliberate policy changes to produce inflation in surplus countries or deflation in deficit countries. Under the fixed exchange rate system, foreign governments had little choice. Unwilling to appreciate their currency or devalue the dollar, they complained about imported inflation but could not prevent it. Deflation in deficit countries was a common fear, but disinflation (called relative deflation) was often suggested as a solution for deficit countries.
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129. In July, the Soviet Union tried to pressure the United States and its allies to remove troops from Berlin and recognize the East German government. In a televised address, Kennedy asked for $3.2 billion of additional spending and an increase in the authorized size of the armed forces. Tensions of this kind typically strengthened the dollar temporarily.

130. Ralph Young’s report on the July 1961 meeting of Working Party 3 and the Economic Policy Committee (of senior officials) summarized the policy discussion that continued throughout the decade: “For convertibility to be maintained . . . surplus countries must allow external surpluses to be registered in internal inflation, i.e., surplus countries must import inflation, while deficit countries must allow deficits to be reflected in deflationary tendencies, i.e., must import deflation. These developments need only be relative . . . If relative adjustment is too slow and too inadequate, convertibility will break down. . . .

“Various delegates took exception to this doctrine and pointed out that there was much that could be done by governments to correct balance-of-payments disequilibria without relative inflation or deflation . . . Deficit countries could encourage export competitiveness, curb imports, and avoid capital outflow and surplus countries could discourage exports . . .

“[T]here were some delegates who contended that governments must retain their ability to alter their exchange values as an alternative to other courses of action. Other delegates, however, argued that . . . recurrent exchange rate alteration was no longer a tolerable alternative to a system of fixed exchange rates with relative inflation and deflation the central reliance for international adjustment” (FOMC Minutes, August 1, 1961, 16–17).

Meetings may perform the useful function of disseminating information and forcing attention to criticism and alternatives. The striking feature of much of the discussion of the OECD meeting was the political difficulty of coordination of sovereign governments through meetings and discussion. Officials who were very aware of political constraints in their own country acted, on occasion, as if there were no political constraints elsewhere. Or they fell back on remedies that at best bought time but did not resolve imbalances.

At the August FOMC meeting, Young reported on a lengthy discussion at OECD of West Germany’s persistent surplus. The economic solution required either German inflation, additional revaluation of the mark, or deflation elsewhere. The German delegation rejected inflation and revaluation (FOMC Minutes, August 1, 1961, 14–16). Soon after, the group discussed a British plan to deal with the current British exchange rate problem. In a pattern that countries repeated many times, West German “business and banking circles” reacted skeptically to the British policies. They could not support revaluation of the mark, but they favored devaluation of the pound.

Britain’s problem continued. Its gold reserves fell below $2 billion in the third quarter, raising concerns about devaluation. The Federal Reserve discussed the resulting gold price rise on the London market. One proposal called for a gold loan to Britain to be used to stabilize the pound price of gold. Governor Mills expressed concern that the decline in the United States gold stock following a loan would have adverse consequences that would more than offset the strengthening of the British pound (Board Minutes, July 18, 1961, 5–6).
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Gold movements and prices in summer 1961 reflected political disturbances about Berlin as well as concerns about the British balance of payments. Tighter British policy worked at the time, and the Berlin crisis ended. The FOMC remained concerned about the dollar but anxious to avoid responsibility. In August, it added “while giving consideration to in
ternational factors” to its directive (FOMC Minutes, August 22, 1961, 52). Chairman Martin said, “[T]hese words would not put the Committee in the guise of alone being able to defend the integrity of the dollar” (ibid., 52). In his view, foreign aid, military assistance, budget deficits, and foreign lending were the most important factors. Although he did not express it this way, the political system would not tolerate the deflation necessary to reduce the cost of exported goods, and increase the relative price of imported goods, to pay for foreign transfers and loans at an unchanged nominal exchange rate.
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131. The Board discussed legislation eliminating the gold reserve behind currency and bank reserves. Mills argued for keeping the reserve requirement as a safeguard against excessive expansion. Martin argued that the timing was poor. Robertson said there was never a good time. The currency was a managed currency, and prudence could be exercised without the requirements (Board Minutes, May 15, 1961, 4–7). Nothing happened until the restriction was close to binding in 1965 and 1968. The administration decided against asking for removal of the 25 percent requirement when it took office out of concern that it would be seen as evidence of weakness and that Congress would not go along (memo, Dillon to Kennedy, Dillon papers, May 9, 1961). Dillon’s memo urged that Kennedy support a bill by Congressman Abraham Multer to remove the requirement, but the administration did not act. This experience was characteristic of the delay in government response to policy problems.

Early in October, the gold outflow resumed. In the next thirteen weeks, the U.S. stock declined by $500 million, more than 3 percent of the remaining stock. At this rate of loss, the gold stock would fall below the $10 billion level within five years. This level was considered a critical threshold below which foreigners would demand the remaining gold, ending the system.

Although domestic economic expansion had slowed, October 1961 was one of the few occasions when about half of the FOMC favored a rise in short-term rates to slow the external drain. Bryan (Atlanta) argued that the payments position would not be helped by a small rise in the short-term interest rate, but Balderston and Hayes wanted to take some action.
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Mills noted that it was “impossible to pursue a ‘troika policy’ . . . to keep interest rates low while simultaneously trying to raise them and to take a strong attitude toward protecting the dollar” (FOMC Minutes, October 24, 1961, 31–32). The consensus called for resolving doubts on the side of ease. In practice, however, new issue Treasury bill rates and the federal funds rate declined slightly in the next few weeks, then rose.

Governors Mitchell and Robertson ignored the decline and criticized the rise in rates. Rouse explained that the rise was partly inadvertent, possibly caused by the Treasury’s decision to issue strips of bills. These required purchasers to buy ten weeks of bills at a time (a strip).
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132. At the October 3,1961, FOMC meeting, the manager (Rouse) for the first time used Euro-dollar rates to compare to rates in other countries.

133. The annual IMF–World Bank meeting had just ended. The press described the meetings as an attack on United States policies. Some countries expressed their doubts about whether the United States had the discipline to follow policies to end the balance of payments problem (FOMC Minutes, October 24, 1961, 13).

134. The sale of ten-week strips originated as part of the effort to raise short-term and lower long-term interest rates. The dealers disliked the strips of bills, so they bid a lower price, raising the stated yield. This pleased Roosa and his deputy Dewey Daane because it raised the quoted new issue bill rate. Along with David Meiselman, who worked with me in the Treasury, I argued that it was a mistaken policy that imposed a transaction cost that the buyers shifted to the Treasury and would have no effect on capital flows or on arbitrage. Rates on bankers’ acceptances remained unchanged.

Opinions at the FOMC about the seriousness of the balance of payments problem remained divided with Mills, Hayes, and Ralph Young at one end and Mitchell, Robertson, and Bryan more concerned about the domestic economy. At the December 5 meeting, Young made the strong case for more aggressive action, using phrases such as “breakdown in the payments system” and “end of the faith and credit of the United States government” (FOMC Minutes, December 5, 1961, 48–49).
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EXCHANGE MARKET INTERVENTION

In March 1961, the Treasury started to use the Exchange Stabilization Fund (ESF) to purchase and sell foreign exchange in spot and forward markets using the New York reserve bank as its agent. In September, Chairman Martin introduced the possibility that the Federal Reserve would assist the Treasury in these operations. He had prepared the members in June by sending staff memos by Ralph Young and J. Herbert Furth and a response by the New York bank. Martin closed his introductory statement by opining that “the nature of world conditions was such that some activities of this sort unquestionably would be engaged in some manner” (FOMC Minutes, September 12, 1961, 44). That left little doubt about Martin’s position and the likely outcome. Five months passed before the FOMC agreed.

Several major issues had to be resolved. First was the legality of foreign exchange operations. Second was the opinion of Congress, possibly its legislated approval and comparison to alternatives such as enlarging the ESF. Third was the way in which the Treasury and the Federal Reserve would work together. Would the Treasury be able to request purchases? Would joint operations be consistent with Federal Reserve independence? Fourth, would the decision to intervene be made by the FOMC, the Board, or some special group? Fifth, would intervention be sterilized?

The Federal Reserve was created when the United States was on the gold standard by men who accepted the real bills doctrine. The idea that it would purchase or sell foreign exchange instead of gold to influence the exchange rate probably did not occur to Congress. The idea that it would initiate purchases or sales of foreign exchange is inconsistent with the real bills doctrine, a basis of the act. Section 14 of the Federal Reserve Act enu
merated assets that the Federal Reserve could purchase. The list included cable transfers, bankers’ acceptances, bills of exchange, gold coin or bullion, and United States government securities. It did not explicitly include foreign currency, although cable transfers were claims to foreign currency. Further, in 1932, Carter Glass, who had a prominent role in writing the act, criticized the New York bank’s operations during the 1920s to assist Britain and other countries to restore and maintain the gold standard. The Banking Act of 1933 removed New York’s role in the foreign exchange market. Glass’s comments at the time opposed actions to support other currencies but did not explicitly oppose actions to support the dollar.
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In 1933, the Board took a narrow interpretation of the law and advised the New York bank that it could open and maintain foreign accounts only for the purposes mentioned explicitly in section 14. That did not permit currency purchases, but the ESF purchased and sold foreign exchange and gold from 1934 to 1939. The Board had considered the issue on other occasions, but it had not issued a formal opinion. Howard Hackley, the Board’s general counsel, remarked, “The Board took a position, which it did not publish, that would preclude this type of program. . . . [T]he Board can reinterpret the law somewhat differently” (FOMC Minutes, September 12, 1961, 48). Later, he did just that, writing an opinion that interpreted section 14 of the Federal Reserve Act to permit federal reserve banks to open accounts at foreign central banks, and vice versa. The Treasury’s general counsel, Attorney General Robert Kennedy, and the counsel for the New York reserve bank concurred.
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135. Young’s concerns may have reflected the views expressed at the OECD. On December 14, 1961, E. van Lennep, chair of Working Party 3, wrote to Undersecretary Roosa reporting on the U.S. balance of payments position. The report referred to the change in circumstances. The United States’ deficit, formerly a source of strength for the world economy, had become a source of concern. It asked for an equilibrium in the basic balance (covering net government purchases and foreign investment) and recommended control of costs and higher interest rates as the economy recovered (Dillon papers, Box 33, December 14, 1961). The recommendations or suggestions remained general.