A History of the Federal Reserve, Volume 2 (76 page)

Hayes explained that “countries relying upon the dollar as an important part of their international reserve assets are glad to participate in arrangements that reduce the possibility of temporary and capricious pressures on the dollar” (Joint Economic Committee, 1962, 576). Later he added that currency operations “rest upon the assumption that the pressures they have to meet are of a temporary and transitional nature. . . . [A]n indefinite continuation of large U.S. payments deficits would assure that the pressure upon the dollar becomes permanent rather than temporary” (ibid., 576). But neither Hayes nor others wanted to recognize that countries cannot maintain fixed exchange rates, capital mobility, and independent monetary policy. Either monetary policy had to control the exchange rate, or the exchange rate had to adjust, or other countries had to hold more dollars than they wished.

Since swaps were a temporary solution, members also asked Coombs why losing gold in six months was better than losing it at once. Coombs replied that European central bankers became nervous if they saw one country buying gold (FOMC Minutes, October 2, 1962, 56). Yet that was precisely what France did, and most others either did not follow or sought a much smaller gold reserve. See Table 3.5 above.
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210. The administration did not rely only on swaps. It promoted exports, reduced military spending abroad, made more defense purchases at home, and tied more foreign aid to exports. It sold some foreign currency debt (Roosa bonds) mainly to replace expiring swap links. It got agreement on an increase in IMF quotas to provide the IMF with enough foreign exchange to stop a future run on the dollar. In 1961 preferential trading arrangements for Europe ended. West Germany would not pay for maintaining U.S. troops in Europe, but it agreed to make offsetting military purchases in the United States.

211. In contrast Japan, which did not have a swap agreement, drew only $40 million in gold in the same two years. Japan delayed current account convertibility until 1964.

212. At the October 2 meeting, Coombs proposed a $50 million swap with Austria. Austria would keep its gold purchases to $30 million in 1962 and stretch out gold purchases into early 1963, delaying but not preventing the gold loss. Chairman Martin reminded Coombs
that his proposal violated the guidelines adopted at the February meeting that authorized intervention. Martin proposed changing the guidelines, but Hayes objected that the guidelines were meant to be permanent. The FOMC decided to make an exception to the guidelines but did not change them. At the October 23 meeting, members asked Coombs why he didn’t use the same approach with France to delay gold sales. He replied that the Austrians were “agreeable to stretching out contemplated purchases of gold. . . . The French had not indicated that they would be so disposed” (FOMC Minutes, October 23, 1962, 7). In November, Hayes reported that only Austria, France, and Sweden had accumulated significant amounts of uncovered dollar balances. Austria converted all to gold; France acquired gold or prepaid debt; Sweden held dollars.

Neither Hayes nor others at the Federal Reserve and the administration had a long-term plan. No one at the Federal Reserve was more concerned about the payments balance than Hayes or more willing to raise interest rates even if that brought slower growth. But though Hayes and others talked about the importance of a more competitive economy, they never discussed deflation, or relative deflation, as a means of depreciating the real exchange rate. They looked to the administration for new initiatives.
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Robert Roosa, Treasury undersecretary, shaped and guided the policy. He worked on the assumption that short-term measures, stand-by arrangements, and restrictions on government spending abroad would restore balance. While in office, he opposed efforts to supplement or supplant gold or devalue the dollar against gold. Later (Roosa, 1965) he partly reversed his position and favored international creation of money or credit, although he recognized the risk of international money creation.

With hindsight, we know that these and other measures did not restore balance. The financing of the Vietnam War brought more imports, larger budget deficits, and more inflation. Chart 3.11 suggests that without war and inflationary war finance, the current account surplus might have increased enough to balance the capital outflow. In early 1964, the current surplus was more than three times its 1962 low, in part because the United States had less inflation in these years than any of its major trading partners.
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Solomon (1982, 61–62), who headed the Board’s international staff, suggests that the U.S. current account surplus deterred adjustment because European countries were not prepared either to appreciate their
currencies relative to the dollar or allow the dollar to depreciate while the United States had a large trade and current account surplus. This is clearly mistaken. These countries were no more willing to adjust exchange rates when the United States’ current account surplus declined. Also, it neglects the effects of inflation abroad as a way of adjusting relative prices.

213. Balderston made one of the very few statements suggesting relative deflation as a long-term solution. After noting that a balance of payments crisis may be near, he expressed concern that foreigners would stop holding dollars. Then he added: “The Federal Reserve System could not, of course, control foreign spending and lending.” It could assist in keeping domestic inflation lower than in other countries (FOMC Minutes, December, 1962, 50–51).

214. Several outsiders offered long-term solutions. A summary in Joint Economic Committee (1962, Appendix, 950–51) briefly discussed five proposals including return to a pure gold standard (Jacques Rueff), creation of a world central bank with power to issue money tied to international reserves (Robert Triffin), and letting the IMF create stand-by credits to supplement reserves (several authors). Heller (1966, 48) preferred tying foreign aid and other restrictions as temporary measures. He did not propose a long-term program.

Chart 3.12 shows the change in relative prices using consumer price indexes.
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The current account balance leads the relative price change in 1964 but not in 1968–69. Relative unit labor costs in Chart 3.13 show a similar pattern with different timing. Relative U.S. labor costs reach a low point in the second half of 1965, the beginning of the sharp drop in the current account balance.

Most of the widely discussed proposals for reform both at this time and later concentrated on the Triffin problems—increasing world reserves and replacing the dollar as the principal international currency.
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Roosa
opposed both types of changes and also Fr
ench proposals to increase the gold price. He expected the United States to supply reserves by running a permanent current surplus larger than its capital outflow. “Whether or not there is a corresponding increase in the underlying supply of gold in the world’s mo
netary reserves, additional increases in the supply of dollars can rest upon an accumulation by the United States of incremental amounts of the currencies of other leading countries” (quoted in Solomon, 1982, 64). After leaving office, Roosa, in
a major change, supported a proposal to increase reserves by supplementing the dollar and gold with IMF paper, as noted earlier.

215. This is not an ideal measure since consumer prices include goods and services that are not traded. Nevertheless, it gives a reasonably accurate picture of the changes in prices over the decade. The trade weighted unit labor cost index uses data from Canada, West Germany, Japan, and U.K. for the denominator.

216. There were notable exceptions. Friedman (1953) made the case for floating exchange rates. Haberler (1965, 46) wrote, “Some of the ingenuity now so lavishly spent on how to guard against the possibility that international liquidity may become scarce could be profitably applied to the more basic and neglected problem of how to improve the adjustment mechanism.”

Most European governments pursued mercantilist policies, selling exports and accepting dollars. Their suggestions at regular meetings of the Organization for Economic Cooperation and Development (OECD) rarely mentioned proposals that their countries pay a larger share of military and defense spending in Europe. They criticized Federal Reserve policy as too easy and urged the Treasury to borrow at long term to raise long-term interest rates and make the United States less attractive to foreign borrowers. This would help to develop European capital markets. They did not mention that if their proposals slowed U.S. recovery, their exports would decline (FOMC Minutes, December 18, 1962, 24–25).

Federal Reserve concerns about a run on the dollar had some foundation. “In May [1962] rumors reached the President that France—alone or with West Germany—might convert its surplus dollars into gold as a way to pressure the Kennedy administration into changing its European policies” (Kennedy, 2001b, 386).
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In a conversation with the French ambassador, Kennedy threatened to pull United States troops out of Europe if the Europeans attempted to use their dollar holdings as a threat. The run stopped when President Kennedy in July repeated his pledge not to devalue.

Undersecretary of State George Ball proposed that if NATO countries agreed to hold excess dollars for two years, the United States would use the time to eliminate its payments deficit and to negotiate a new agreement to replace Bretton Woods. The United States would agree to sell $1 billion of gold to participating countries during the two-year period. Ball did not say how the deficit would be closed. In July, the French finance minister (later
president), Valery Giscard d’Estaing, visited Washington. He told officials that the dollar’s defense against a speculative attack was weak. He offered cooperation “on a grand scale.” U.S. officials were uncertain what the offer meant (Kennedy, Oval Office Tape Recordings, Tape 11, August 10, 1962, 2). In a contentious series of meetings, the president’s advisers clashed over different proposals.

217. One May 25, 1962, Secretary Dillon told the president that a Bank of France official had indicated “possible difficulties ahead with France. He said it must be realized that France’s dollar holdings represented a political as well as an economic problem” (memo for the president, Dillon papers, Box 289, May 25, 1962). I have found no support for the suggestion that West Germany would join France. Holtfrerich (1999) has no reference to a decision to increase gold and reduce dollar holdings despite 3 percent inflation in 1962–63 and rising unit labor costs. The Bundesbank kept its discount rate close to zero, after adjusting for
inflation (ibid., 378).

A proposal supporting Ball’s came from the Council of Economic Advisers. James Tobin explained that foreign central banks held $10.3 billion of claims against the U.S. gold stock. Private holders could sell their claims to central banks, and central banks could demand gold. Including these claims give a total of $18.9 billion against $16.1 billion in gold. Chart 3.14 compares the gold stock to dollar liabilities to foreigners. The two lines crossed in July 1961.

Tobin proposed to internationalize the provision of world currency and eliminate the special role of the dollar. Foreign governments would agree to hold a fixed proportion of their reserves in dollars and to hold a fixed proportion of their future acquisition of dollars, whether from existing private holdings or from future payments deficits. In return, the United States would agree to hold the same proportion of gold to total reserves as foreigners, holding the balance in foreign currencies. All countries would agree to compensate other governments for any losses of reserves result
ing from devaluation (A Gold Agreement Proposal, Heller papers, Box 19, July 5, 1962).