A History of the Federal Reserve, Vol. II (1961-1986)
by
Allan H. Meltzer

Part VI: Nixon Devalues the Dollar (1969-1973)

Page Contents

Keynesian blight

Richard M. Nixon administration

Recession of 1969-1970

Monetary policy under Arthur Burns

Penn Central RR bankruptcy

Dollar devaluation

Price & wage controls

Floating exchange rates

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R) Devaluation Contagion

The Keynesian blight:

 

Keynesians confidently set out to "obsolete the business cycle."

  Keynesian economic theory had triumphed in many of the first-world nations. Full employment had been adopted widely as the predominant economic policy goal during the 1960s. Keynesian policymakers in the U.S. and England confidently set out to "obsolete the business cycle" and maintain high levels of economic growth and low levels of unemployment. See, Meltzer, History of Federal Reserve, Part V, "Obsoleting the Business Cycle (1961-1969)." In the two decades from 1965, their conceit and hubris would bring them and their nations to much grief.
 &

Monetary inflation designed to maintain full employment was obviously inconsistent with fixed exchange rates. Inevitably, it had to be inflation, not Keynesian policies, that would triumph.

  The Bretton Woods agreements following WW-II had placed the world on a dollar standard. The dollar was pegged to gold at $35 per ounce in the major foreign gold markets. However, monetary inflation designed to maintain full employment was obviously inconsistent with fixed exchange rates. Inevitably, it had to be inflation, not Keynesian policies, that would triumph.
 &
  Government monetary policy makers were again reduced to posturing during the last half of the 1960s because of their conflicting objectives. "Moral suasion" was again monetary policy at the Federal Reserve System (the "System"). There was "jaw boning" and implementation of futile controls. Meltzer sets forth in considerable detail the increasingly frantic efforts to stem the tide and the vast complications that thwarted each stopgap measure implemented. (See, Meltzer, History of the Federal Reserve v. 2 (1951-1986), Part V, "Obsoleting the Business Cycle  (1960-1969).")

  For 15 years before the 1971 devaluation of the dollar, high officials of both Republican and Democratic administrations climbed Capitol Hill to solemnly affirm their unquestionable will and capability - first to maintain the silver in the coinage and later to keep the dollar as good as gold. Surely, a balance of payments deficit that was just a small fraction of the vast U.S. GDP could be easily managed. The ridiculousness of such assertions was blatantly evident to any observer whose brains were not addled by Keynesian concepts, as the publisher of FUTURECASTS kept explaining for a dozen years from 1967. See, Blatt, "Dollar Devaluation," (1967); Let Look at the Record (I) "A Dozen Years of Perfect Economic Forecasts (1966 - 1978)."

Under a "benign neglect" policy, balance of payments problems should be ignored and other nations left free to peg their currencies to the dollar or not as they wished.

 

Martin began disparaging gold reserve systems as "barbarous," preparing the psychological environment for acceptance of defeat.

  Dollars flowed abroad at an accelerating 18% compound rate from 1965 until the official devaluation of the dollar in 1971. The rate had been only 6% prior to 1965. The rising cost of the war in Vietnam was of course a major factor. France and Spain became particularly active in demanding gold for their ballooning dollar reserves. Meltzer provides interesting details of the planning and maneuvering during this period.
 &
  A floating dollar exchange rate and a "benign neglect" policy,
attributed initially to economist Gottfried Haberler, was increasingly advocated by Keynesian economists to avoid the higher interest rates that threatened to cause economic contraction and frustration of their policies. Balance of payments problems should be ignored and other nations left free to peg their currencies to the dollar or not as they wished.
 &
  William M. Martin, Jr., chairman of the System Board of Governors (the "Board") was distressed over the increasingly defeatist attitude and urged confidence in the half-measures adopted. He began disparaging gold reserve systems as "barbarous," preparing the psychological environment for acceptance of defeat. He advocated displacement of gold with international cooperation and an international reserve currency - "special drawing rights" ("SDRs").
 &
  Congress continued  the process of removing the dollar's gold peg in 1965 when it removed the System's gold reserve requirements against bank reserves. An increasingly liberal Congress was turning against the constraints of the gold reserve system. On March 18, 1968, Congress eliminated the last gold reserve requirements for the issuance of Federal Reserve notes, thus completing transformation of the dollar into a fiat currency. Gold poured out of U.S. reserves and monetary inflation ballooned. Abroad, pressure increased against the Canadian dollar and again against the pound.
 &

  The U.S. suspended sales of gold on the London market in March, 1968. International monetary authorities adopted another fudge - a two tier gold price. They refused to sell more gold to monetary authorities to replace gold sold on international markets.

  "Gold in official monetary reserves at the time of the meeting could be used for transactions between monetary authorities at $35 an ounce. Gold not in official monetary reserves, including any new production, could be purchased or sold in the free market."

  The gold price on the French market surged to $44, but then fell back. The result on the London gold market was similar. In Europe, people were having trouble exchanging dollars for foreign currency. A thoroughly frightened Pres. Johnson accepted an increase in the discount rate to 5% to defend the dollar. In April, it was increased to 5.5%.
 &

  Fear of collapse of the international financial system induced most major nations to comply with the new arrangement. Trade surplus nations, including Germany and Japan, accumulated dollars and dollar denominated securities without requesting gold. The surtax, higher interest rates, creation of SDRs under the auspices of the IMF, and the advent of the new Nixon administration supported hope that the new arrangement would hold.
 &
  France, as well as the major gold producers, Australia and South Africa, did not join this agreement. France, suffering major riots in 1968 and an 11% increase in wages provided to mollify the crowds, had a payments deficit in 1968 and 1969. Thus, pressure on U.S. gold reserves abated. However, de facto, the dollar was no longer convertible for most purposes.
 &

There was still no resolution to the problem of adjusting exchange rates as the major reserve currencies - the dollar and the pound - withered under pressures caused by Keynesian policies.  U.S. economic and monetary officials blandly kept assuming that the U.S. would eventually end its payments deficit, but refused to initiate the substantial austerity policies needed to achieve that objective.

  SDRs were established at the beginning of 1970. They were touted as "paper gold." Creation of SDRs required approval of an 85% supermajority of IMF member votes. Thus, both the U.S. and the EU had veto power over any future increase, and Congress had to authorize any U.S. approval.

  "IMF members could create an asset to serve as a substitute for gold in settlement between central banks and government but not as payment for quota increases at the IMF."

 Developing countries treated SDR allocations like a wealth transfer, quickly trading them for hard currencies such as the dollar, mark and yen. Balances in securities denominated in national currencies paid interest, after all.
 &
  A massive diplomatic effort had been directed at achieving this increase in international monetary liquidity, but there was still no resolution to the problem of adjusting exchange rates as the major reserve currencies - the dollar and the pound - withered under pressures caused by Keynesian policies.  U.S. economic and monetary officials blandly kept assuming that the U.S. would eventually end its payments deficit, but refused to initiate the substantial austerity policies needed to achieve that objective.
 &
  Several influential economists joined French officials in repeatedly emphasizing the lack of attention to the adjustment problem, but they were determinedly ignored by U.S. and British policymakers. However, the markets could not be indefinitely ignored.
 &

Neither the Johnson nor Nixon administrations offered any adjustment towards long term equilibrium. The System did not commit to a less inflationary monetary policy.

  It was all much too little, much too late. Payments deficits are inexorable and remorseless under Keynesian policies. Neither the Johnson nor Nixon administrations offered any adjustment towards long term equilibrium. The System did not commit to a less inflationary monetary policy. The payments outflow became a torrent in 1971, and the dollar was officially devalued.

  "The conflict between fixed exchange rates and the full employment policies was the principal problem in the late 1960s. The choice was never a serious issue for the United States: the Johnson and Nixon administrations always chose employment. The Federal Reserve retreated behind the institutional fact that the Treasury and the administration were responsible for international economic policy."

  Ultimately, of course, Keynesian policies inevitably destroy price stability, stable exchange rates and full employment. Thus, currencies have to be left free to "float" and price inflation becomes chronic.

  Since the dollar was the world's primary reserve currency, inflation in the U.S. unfortunately quickly moved abroad. Foreign nations did not want to revalue against the dollar, since they depended upon exports into the U.S. market to stimulate economic activity. Dollar reserves in foreign hands more than doubled in the 1960s and U.S. gold reserves dropped by about 60%. The System had no monetary policy response for this problem.

  "Trapped between the unwillingness of countries to revalue their currencies in response to export surpluses and higher rates of growth on the one hand and the inability or unwillingness of the United States to devalue on the other, the System stumbled from crisis to crisis in the late 1960s."

As always, the Keynesian effort to push interest rates down ultimately resulted in higher interest rates.

  The British pound was also still a reserve currency. Coming out of WW-II and its disastrous experiment with socialist and Keynesian policies, Britain was financially weak and the pound under repeated pressure. Under such policies, efforts to defend the pound and maintain its status as a reserve currency proved futile and indeed wasteful. Export subsidies and import tariffs and an "incomes policy" just increased the damage.
 &
  There was always fear that a successful run on the pound would be followed by a run on the dollar. Several billions of dollars were borrowed by Britain in the support effort, which succeeded only in delaying the inevitable past Britain's 1964 election. The System bought billions of dollars of pounds and extended billions more in swap lines. However, with the advent of war in the Middle East and the closing of the Suez Canal in 1966, gold and dollar reserves were pouring out of Britain. Britain refused to increase its bank rate for fear of destabilizing its economy - with the result that it ultimately got both higher interest rates and more economic instability.
 &
  After the election, Bank of England interest rates rose to 7%. "The British government tried credit controls, wage and price guidelines, and reduced spending with little effect." As always, the Keynesian effort to push interest rates down ultimately resulted in higher interest rates.
 &
  By 1967, the British bank rate was going up. Frantic efforts to arrange further support for the pound failed as European central banks and the IMF refused to commit further resources to the doomed effort. On November 18, 1967, Britain devalued the pound, increasing doubts about all paper currencies, including the dollar. Britain's bank rate rose to 8%.
 &
  New Zealand, Spain and Denmark also devalued their currencies, but otherwise the crisis was successfully contained at this time with only minor economic ramifications. By 1969, Britain's payments surplus was sufficient to repay many of its crisis debts. However, Italy and Belgium joined France in withdrawing from the international gold pool stabilization effort in the gold markets. They, at least, recognized that the continuing U.S. balance of payments deficit rendered currency stabilization efforts futile.
 &

Johnson had inherited the strongest financial system in the world when he took office, but he left Nixon a financial system that was in shambles.

  However, France suffered widespread riots in 1968 that were pacified with widespread wage increases. Suddenly, just as pressure on the pound eased for awhile, the U.S. had to arrange massive support for the franc. Efforts to reach agreements for a managed revaluation of the mark and devaluation of the franc proved impossible politically within those two nations. Italy, too, was politically paralyzed. Administered alternatives to the "barbarous" gold exchange rules based market mechanism were indeed proving beyond the capacity of mere mortal political leadership. Dollars were piling up in vast amounts in the major trade surplus nations.
 &
  By the end of 1968, de Gaulle was no longer in charge of the French government and a new Social Democratic government took over in Germany. Franc devaluation and mark appreciation quickly followed. Rising interest rates in the U.S. supported the dollar. By 1969, Nixon was president. Johnson had inherited the strongest financial system in the world when he took office, but he left Nixon a financial system that was in shambles.

S) Nixon Devalues the Dollar

President Richard M. Nixon:

  Richard M. Nixon had little interest in economics but he was, if anything, even more intolerant of unemployment than President Johnson.
 &

  Paul McCracken was the chairman of his Council of Economic Advisers. Herbert Stein was an influential member of the Council and would succeed McCracken. Arthur Burns was an influential adviser on the president's staff and succeeded William M. Martin, Jr., as chairman of the System Board in February 1970.
 &

  Nixon administration economic policy was initially based on a mix of Keynesian and monetarist theory. Economic policy officials accepted the 4% definition of full employment and the Phillips curve tradeoff between price inflation and unemployment. However, they put much greater emphasis on money growth as a policy factor.
 &
  Neither Martin nor Burns, his successor, thought that the monetary aggregates were a practical target for monetary policy. The Nixon economists believed (hoped?) that inflation could be reduced gradually without recession. However, they initially had no faith in controls, guidelines, guideposts, jawboning and similar methods of temporarily evading the need to grapple with inflation realities.
 &
  Despite overwhelming evidence by now of the ineffectiveness of controls and guideposts, Democratic criticism of failure to use these wheezes was fierce and effective. Nixon slowly retreated, imposing guideposts and controls on construction, chain stores, copper and steel.
 &

Deflation - the only effective weapon available - was out of the question politically.

  There was less than $11 billion in gold reserves left to secure almost $40 billion in international claims against the dollar when Nixon took office. Paul Volcker, the new Treasury Undersecretary for  Monetary Affairs, understood the untenable monetary situation. Deflation - the only effective weapon available - was out of the question politically. Restrictions on capital, tourism and trade were rejected by the Nixon administration as both costly and futile, so some method of exchange rate adjustment was both essential and unavoidable. Martin recognized that the improvement in the balance of payments in 1969 was due to temporary factors.
 &
  Gottfried Haberle was selected to lead a task force to find a solution. Milton Friedman advised that an immediate voluntary floating of the dollar would be far less damaging than if devaluation were forced later by financial crisis. Arthur Burns advocated wider bands for the fixed exchange rate system and small "automatic adjustments" - a "crawling peg" - after a separate one-time major realignment. He wanted immediate devaluation - while the mess could be credibly blamed on the previous administration. The need to suspend gold convertibility under pressure was widely recognized.
 &
  However, Volcker was already warning that dollar devaluation adjustments would unleash substantially higher rates of price inflation. Burns, too, warned that a floating exchange rate was no magic cure. It could unleash all manner of financial and economic disruption.
 &

It was recognized that a decade of Keynesian policies was undermining U.S. strength and influence in the midst of the cold war struggle.

 

System staff recognized that floating exchange rates would remove the budgetary and monetary discipline that political leaders hated but were in desperate need of. It was precisely the rejection of such disciplines that was causing the increasingly vicious crises in the fixed rate system.

  Monetary policy was not a strong point for Nixon, and he refused to let it get in the way of his diplomatic and domestic policy priorities. Thus, the unwinding of his predecessor's capital controls was delayed.
 &
  Volcker ultimately accepted the need for multilateral adjustment negotiations and the limited exchange rate flexibility of wider bands and crawling pegs. There were hopes for relief from the issuance of SDRs. The SDR compromise that summer called for issuance of $9.5 billion in the first three years and a 30% increase in IMF quotas. However, SDRs had no national economy behind them, so they remained a relatively insignificant factor in international monetary flows.
 &
  An interagency group headed by Volcker candidly recognized the probable failure of multilateral efforts and the need to raise the gold price, reduce price inflation and end the Vietnam war. However, they also wanted to avoid deflation and higher levels of unemployment. Nobody addressed the means by which the war could be ended or inflation could be dealt with. It was recognized that a decade of Keynesian policies was undermining U.S. strength and influence in the midst of the cold war struggle.
 &
  However, the multilateral approach was of course impossible. Diplomacy was simply too slow and burdened by too many conflicting objectives to deal with rapidly changing financial and monetary conditions. Unilateral abandonment of gold and acceptance of dollar devaluation was recognized as a last resort, and Volcker was not optimistic about the impact on international and domestic commerce. System staff recognized that floating exchange rates would remove the budgetary and monetary discipline that political leaders hated but were in desperate need of. It was precisely the rejection of such disciplines that was causing the increasingly vicious crises in the fixed rate system.
 &
  Meltzer briefly summarizes European views. European monetary authorities feared the economic and commercial disruptions of substantial valuation swings in major currencies.

  "[Both the U.S. and Britain were] reluctant, or unwilling, to exert the necessary discipline. Nor would the surplus countries approve of policies that restricted demand in the deficit countries to a degree that significantly reduced their own exports. And the surplus countries would not adjust.." (This is much like today - with respect to China.)

1969-1970 recession:

  With price inflation increasing in the spring of 1969, the System raised its discount rate to 6% and increased bank reserves requirements. Martin feared a "credibility gap" if no action were taken against inflation. Germany allowed the mark to appreciate by 9.3% later that year. However, these measures proved insufficient.
 &

  The 1969-1970 recession flowed naturally from the rising interest rates. The federal funds rate on interbank lending peaked at 9.19% in September 1969 and price inflation peaked in January 1970. By the end of 1970, the federal funds rate was down to 4.9%, but the System kept its discount rate at 6% while Martin was chairman. Burns replaced him in February, 1970, and quickly started reducing the discount rate.
 &
  The money markets were swinging violently, producing substantial capital inflows with the rising market interest rates and substantial outflows with reduced market interest rates. Meltzer briefly summarizes the difficulties faced by the System as it struggled with its multiple conflicting objectives and the rapidly shifting currents. The problems involved in attempting to provide a competent administered alternative to the gold standard were proving increasingly daunting. Franc devaluation and mark revaluation and high interest rates had helped stabilize the pound and the dollar in 1969, but that did not last long.
 &

There was no stomach for a serious anti-inflation effort.

 Alarm bells were set off in the Nixon administration as unemployment rose to 5.9%. The 1969-1970 recession peaked during the 1970 congressional election. There was just a half percent decline in the rate of price inflation which was 6% for the full year. Meltzer attributes the stubborn price reaction to inflationary expectations.

  Expectations are actually just one element in the processes by which inflation becomes entrenched, but economists aggregate them all under this label.

  The expectations were correct. Monetary policy eased after January 1970. The Reg. Q interest rate ceiling was increased to 7% for one year CDs. There was no stomach for a serious anti-inflation effort. The public, would not consider price inflation a major problem until it approached double digits at the end of the 1970s. All the "real" inflation adjusted monetary aggregates reflected the switch. Short term interest rates declined sharply, but the rate for long term Treasury bonds declined just one percentage point to 6%.
 &
  Burns accepted the ridiculous Keynesian "cost push" explanation for inflation. Wage increases were emphasized. He thus absolved himself and System monetary policy from all blame and switched to support for wage and price controls. The equally ridiculous Keynesian "full employment budget" concept was invoked to justify the budget deficit. A Democratic Congress went its own way with the budget, resulting in budget deficits that reached a massive $26 billion in fiscal 1971.
 &

  There were about 13,100 banks in 1970. System membership was down to 5,773 as inflation increased interest rates and thus the cost of keeping reserves with the System. Through this period, the Federal Reserve Banks were still not considered federal government agencies. From 1968, the System had recognized its role as lender of last resort for the entire financial system. This role was in evidence in 1987, 1998 and 2007-2009. 
 &

Monetary policy under Arthur Burns:

  Arthur Burns was the first professional economist to chair the System Board. He was neither Keynesian nor monetarist.
 &

  However, he viewed himself as part of the administration economic team. In addition to giving his advice, he supported administration economic objectives. Avoiding unemployment remained the primary economic policy objective. The result was the Great Inflation decade of the 1970s, with price inflation rates reaching as high as 11.5% and unemployment rates also approaching double digit levels at the same time.
 &
  Burns tried to dominate the Board and the System Federal Open Market Committee (the "FOMC"), which under Burns met just 12 or 13 times a year. "He had the right personality to make large errors," Meltzer comments.
 &
  Burns favored more precise directives and reductions in the influence of the N.Y. Federal Reserve Bank (the "N.Y. Fed") and the discretion of the manager of the System account at the N.Y. trading desk. He wanted less frequent policy changes. He focused policy on bank credit because control of the money aggregates was so imprecise. The monetary data was imprecise and was subject to major revisions and substantial temporary fluctuations. Forecasts remained highly unreliable. It would be 1994 before the System would announce interest rate targets.
 &

In December 1969, the money supply was recognized for the first time as an indicator for System monetary policy.

  Attention was focused on several monetary policy problems by a March 1970 System committee report.

  "It called for a change in the target from money market conditions to one or more monetary aggregates; it attempted to shift attention from short-term changes in the money market to longer-term changes in aggregate demand, economic activity and prices; and it recognized that there was very little relation between money market changes and longer-term policy goals."

  This was all true, but as Meltzer points out, imprecise statistics and unreliable forecasts afflicted all alternative targets. In December 1969, the money supply was recognized for the first time as an indicator for System monetary policy. A 2% annual growth rate was chosen - a triumph for Friedman's monetarist ideas. (See three articles beginning with Friedman & Schwartz, Monetary History of U.S (1867-1960), Part I, "Greenbacks,& Gold (1867-1921)"
 &
  Unfortunately, bank reserves calculations were based on deposits accounted for with a two week lag. Member banks strongly favored this policy since it reduced their costs. Deposit volatility sometimes forced them to borrow from the System to meet reserve requirements, and the two week lag permitted last minute adjustments that minimized this cost. However, the lag undermined the precision of both reserves and monetary aggregate statistics. The lagged reserves requirement was in effect from 1966 to 1988 and from 1998 past the publication date of this book.
 &
  Monetary targets had other problems. Money stock figures were available only weekly and were subject to substantial transitory and seasonal fluctuations. FOMC members could not agree on the precise target to be aimed at. Free reserves were clearly an inadequate target, so total bank reserves became the default target recommended for awhile. The gathering international storm that would soon break upon the nation and the System with the ultimate devaluation of the dollar was still ignored.
 &

Confounding Keynesian economists, unemployment and price inflation were increasing at the same time.

  The need to move towards monetary aggregate targets was acknowledged by FOMC members. There was pressure from Congress for monetary aggregate targets in a growth range of about 2% to 6%. The FOMC decided to target the federal funds rate within a range that could be expected to achieve desired growth in the three month averages for monetary aggregates and bank credit. Staff forecasts of the weekly and monthly impacts on the targets would be used to establish the federal funds rate range. The monetary aggregates would provide the primary guidance.
 &
  This proved impractical, and Burns was not convinced. There were strong practical reasons for responding to short term money market fluctuations. "Adjusting fully to short term movements in money growth or bank credit required frequent, large changes, up and down, in market rates, larger changes in interest rates than the FOMC would accept." The changed emphasis resulted in wide swings in the monetary aggregates, the federal funds rate and bank credit. By May, the directive shifted to money market conditions supplemented by guidance from reserve aggregates. Unfortunately, these aggregates were prone to move in varying, sometimes different, directions.
 &
  It was a bad time for new monetary policy experiments since the invasion of Cambodia and domestic riots introduced substantial instability. The stock market had been falling for 16 months and unemployment was still climbing. Confounding Keynesian economists, unemployment and price inflation were increasing at the same time. When price inflation finally declined, the decline was just half a percent even as unemployment reached 6% and remained at about that level through the first half of 1971.
 &

  Burns' desire for monetary policy stability was abandoned. Stock margin requirements were reduced and money and credit targets were ignored so the System could assist Treasury financing and push interest rates down. Burns lost his cool, fearing financial panic. However, the FOMC responded just by restoring the discretion of the System account manager at the N.Y. Fed trading desk so he could meet developing money market conditions.
 &
  The problem of "even keel" support for Treasury financing operations gradually faded away as the Treasury shifted in 1972 to auctioning its medium and longer term securities, letting the market choose a market clearing interest rate.
 &

Penn Central bankruptcy:

  Recessions cleanse the economic system of the weak and outmoded, the over extended and the fraudulent. The Penn Central Railroad. had been on financial life support for years, and finally succumbed.
 &

The Board, like the administration, refused to be stampeded. It restricted System response to the expanded lender of last resort role and the freeing up of the Reg. Q interest rate ceiling on large time deposits.

 

The System protected the market, not the players in the market. Discounts and large CDs expanded substantially to provide the financial resources needed.

  The Penn Central - then the nation's seventh largest corporation - suddenly couldn't role over its commercial paper liabilities. Half had been paid off, but $100 million remained - enough to threaten the liquidity of both the commercial paper market and the eurodollar market.
 &
  Unlike in 2008 with AIG and the modern money market, Congress would not be stampeded. It refused an emergency loan, and George Shultz, an influential Nixon administration official, also opposed assistance. On June 11, 1970, Penn Central filed for Bankruptcy Code reorganization.
 &
  Burns was alarmed. He got the Board to suspend Reg. Q ceilings on large CDs. This enabled banks to raise major sums to meet their sudden liquidity needs and service the credit needs of the major customers who had suddenly been shut out of commercial paper market financing.
 &
  The System had extended its lender of last resort facility to mutual savings banks and savings and loan associations in December, 1969. It now extended it to the Federal Home Loan Bank system for liquidity problems rather than solvency problems. The discount window was now widely available for good but temporarily illiquid assets. However, the Board, like the administration, refused to be stampeded. It restricted System response to the expanded lender of last resort role and the freeing up of the Reg. Q interest rate ceiling on large time deposits.
 &
  Although jarred, the financial world did not come to an end. It responded appropriately. The vast commercial paper market was declining at a rate of $200 million a day in the middle of a recession, and other major firms were under stress, but no financial panic developed.
 &
  Money market funds quickly sprung up, purchasing the large high interest CDs that had been freed from Reg. Q interest rate ceilings. These money market funds cut up the CD proceeds for their small investors. This helped the banks raise large sums, and also began the process of undermining Reg. Q. However, Reg. Q controls would still cause major damage.

  Was it really necessary to bail out AIG in 2008, or was this just a colossal raid on the Treasury to funnel money through AIG to the major financers of subprime mortgage-backed securities like Merrill Lynch, Goldman Sachs. Such investment banks truly deserved to bear the losses of the collapsing Credit Crunch bubbles that they had generated and reaped colossal profits from.

  Meltzer approves the System response to the Penn Central crisis. The System protected the market, not the players in the market. Discounts and large CDs expanded substantially to provide the financial resources needed.
 &

Dollar devaluation: 

  In July 1970, Burns got the FOMC to vote for faster growth in the monetary aggregates. In August, the Board reduced bank reserve requirements.
 &

  Administration officials were now feverishly urging stimulation and rapid growth in the monetary aggregates. Nixon simply would not accept anything other than booming prosperity for the 1972 election campaign period. The FOMC directives repeatedly called for "promoting some easing in credit markets." Burns and the FOMC began targeting an M1 growth rate of 5.5%.

  "Monetary indicators such as base growth and real interest rates suggested that policy had become more expansive. Those who expected the rising unemployment rate to reduce inflation were disappointed. They had assured themselves, and others, that a modest increase in unemployment would lower inflation. After more than six months, many began to doubt. Arthur Burns, especially, proclaimed at an FOMC meeting in June and in congressional testimony in July that the old rules no longer worked as they had before. Once a principal critic of the idea that price and wage guidelines could shift the Phillips curve, thereby changing the tradeoff between inflation and unemployment, Burns now became a prominent advocate of the need to change the short-run tradeoff. He had delivered M1 growth of 3 to 5 percent in the first two quarters of his term and seemed to expect a more prompt response than he achieved. By the time the inflation rate began to fall, early in 1971, Burns was committed to price-wage guidelines as a necessary adjunct to monetary and fiscal policy."

The FOMC staff, now dominated by Keynesians, advised even faster rates of money growth. They wanted M1 growth over 7%, as did most academic economist consultants.

 

Price inflation ran at 5.1% for 1970 - a recession year.

  Pressure from McCracken and other administration officials for rapid monetary inflation was intense. The discount rate was lowered towards the end of 1970. The FOMC staff, now dominated by Keynesians, advised even faster rates of money growth. They wanted M1 growth over 7%, as did most academic economist consultants (also heavily infected with the Keynesian madness). Meltzer mentions James Duesenberry of Harvard, James Tobin of Yale, Franco Modigliani and Paul Samuelson of MIT, and Robert Gordon of Northwestern. (All of these much honored Keynesians - and many others - thus demonstrated the vast extent of their ignorance as to how the economy actually worked.) They still ridiculously thought that unemployment above 5% would alone bring down price inflation rates.
 &
  European economic authorities complained bitterly that the U.S. was exporting inflation - but still pursued the mercantilist policy of refusing to allow their now undervalued currencies to revalue. The U.S. international payments deficit ballooned to almost $10 billion for the year, with Germany and France the primary surplus nations.
 &
  By the end of the year, the federal funds rate had been brought down 3 percentage points to 4.8%. The spread with long term Treasury bonds widened as the bonds declined only 1 percentage point to 6%. M1 grew at a 6.5% annual rate through the last half of the year. Price inflation ran at 5.1% for 1970 - a recession year. With market short term interest rates declining sharply, there were frequent decreases in the discount rate in quarter point increments.
 &

By the start of 1971, the Nixon administration was in retreat on its opposition to controls. They had no other answer to the stubbornly high rates of price inflation.

 

To justify a projected $15 billion budget deficit - that turned out to be $23 billion - the administration even accepted the Keynesian "full employment budget" nonsense. "We're all Keynesians now," Nixon proclaimed.

  Discretionary presidential authority to impose controls was provided by Congress in August 1970. In frustration and with the realization that the public would not tolerate any recession sufficient to eliminate price inflation, Burns turned to the wage and price control nostrum. By the start of 1971, the Nixon administration was in retreat on its opposition to controls. They had no other answer to the stubbornly high rates of price inflation.
 &
  Reluctant to give the Democrats a campaign issue, the administration plunged into the effort with increasing intensity. Control efforts proliferated - predictably with gross inefficiency and increasing complexity, costs and futility. To justify a projected $15 billion budget deficit - that turned out to be $23 billion - the administration even accepted the Keynesian "full employment budget" nonsense. "We're all Keynesians now," Nixon proclaimed.

  "The administration did not develop a long-run program, however. It relied on wage and price guidelines to control production costs, mandatory guidelines to control overseas investment, and the panoply of short-term measures discussed earlier."

  These ridiculous measures were clearly futile, but at least trade restrictions were avoided and the GATT trade agreements survived.

  In the "full employment budget" rationalization as in everything else, reality perversely refused to conform to Keynesian expectations. Rationalizations are not the equivalent of reason.

The System was again paralyzed by the conflicting needs of stimulating full employment and restraining both price inflation and the international payments outflow.

  System deliberations and efforts to understand and react appropriately to the multitude of financial and political crosscurrents are set forth in interesting detail by Meltzer. Basically, the System was again paralyzed by the conflicting needs of stimulating full employment and restraining both price inflation and the international payments outflow. Europe's loss of faith in the dollar undermined European support for SDRs and increased support for the European Monetary Union.
 &

  The capital outflow reached $4 billion in the first week of May, 1971. By summer, U.S. gold stocks began their final fatal outflow. Private corporations and speculators began hedging against possible dollar devaluation on a regular basis. Price inflation was rising. European central banks stopped purchasing dollars. The mark began to rapidly appreciate.
 &
  Volcker recognized the need under these circumstances to float the dollar exchange rate. The time for multilateral negotiations was now up. It was time for unilateral action. However, the System once again hesitated, leaving the discount rate at 4.5%. The mark and Swiss franc were permitted to appreciate, putting additional pressure on the dollar. Austria and the Netherlands revalued.
 &
  Meltzer tells how, one after another, top administration officials were forced by the accelerating crisis to abandon previous  positions and accept the need for some degree of dollar devaluation. There was widespread fear that loss of faith in the dollar and the breakdown in the existing monetary system would undermine multilateral commercial arrangements and create unmanageable political, economic and financial forces. Even price and wage controls were being considered, but nobody accepted the need to deflate to trim the balance of payments deficit.
 &
  Treasury Secretary John Connally was still forcefully denying any intent to devalue the dollar or change the gold price as late as May, 1971. The onrushing crisis would not alter expansive Keynesian domestic policies. However, Volcker was making implementation plans for the inevitable fall of the dollar. Connally participated in the planning, but Volcker was opposed by Burns who favored exchange controls. Most of the System governors and staff now favored Volcker's position.
 &

  Inflation surged higher as 1971 began. The GNP deflator rose at 6.7% and 7.6% annual rates in the first and second quarter of 1971. CPI inflation was again over 6% even with unemployment still at 6%. The nation's balance of international payments deficit grew alarmingly. Inflationary expectations were widespread and entrenched. The economy was booming, but the stock market was not.

  Risks were growing much faster than rewards - something that always happens during inflationary times. Also, earnings figures became increasingly suspect as replacement costs for inventory and capital assets rose. The result throughout the decade was decline in the stock price/earnings ratio.

As always, efforts to push interest rates down caused higher interest rates. The entire economy was increasing its leverage in response to inflationary expectations. As the money markets became increasingly disorderly, the manager was having increasing difficulty executing monetary policy.

  The FOMC now  targeted the federal funds rate, something the manager could precisely peg. Burns decided to monetize enough debt to push it down until M1 was growing rapidly. At a federal funds rate of 3.75%, monetary inflation surged above 7% reaching almost 11% in May, 1971. The federal funds rate was thus permitted to rise to about 5.3% in July. However, it was still negative, below price inflation rates. Long term rates also rose.
 &
  As always, efforts to push interest rates down caused higher interest rates. The entire economy was increasing its leverage in response to inflationary expectations. As the money markets became increasingly disorderly, the manager was having increasing difficulty executing monetary policy.
 &
  The FOMC was yet  once again, as in 1929 and 1933, at a loss as to what to do. The human administered alternative to the gold standard rules based market mechanism was once again in a state of collapse. The members considered switching targets back to bank reserve growth. They learned that, despite all their efforts to accommodate administration policies, the Nixon administration planned to use the System as a scapegoat and blame it for the failure of economic policy.
 &

  International monetary arrangements in place since 1968 now began to unravel. The U.S. trade deficit worsened. The Congressional Joint Economic Committee now officially recognized the need to adjust the dollar exchange rate downwards, and the capital outflow became a torrent.
 &
  When five European nations including Germany floated away from their dollar peg in May, Nixon adamantly refused to support the dollar. So the System did not respond either. Burns rejected any System responsibility for the nation's international payments and exchange rate problems. He would not go against the president.
 &
  The moment of crisis acceleration had arrived. In just 18 months through mid-1971, dollar reserves in Europe more than tripled at a rate that was accelerating. Events forced the issue. The run on the nation's dwindling gold stock was accelerating. Even a brief delay to September to orchestrate the appearance of a controlled deliberative process became untenable, and the announcement came in August.
 &

The full employment objective required rising budget deficits, artificially low interest rates and increasing rates of monetary inflation - a certain recipe for financial turmoil and the failure even of the full employment objectives.

  The gold window was closed, devaluing the dollar. As part of the emergency package accompanying the decision, another national - futile - destructive effort at price and wage controls was implemented. The System had surrendered its independence and become a team player in administration policies. It was slow to act to restrain economic activity as price inflation gathered steam. By the time of the Nixon administration, the System would not even raise its discount rate to combat exchange market turmoil.
 &
  Meltzer accurately emphasizes monetary inflation as the primary force behind the deteriorating trade and payments balances, increased price inflation, and ultimate dollar devaluation.

  However, it was administration budgetary deficits and doomed Keynesian efforts to "obsolete" the business cycle and the lack of political support for true System independence that forced the monetary inflation needed to keep interest rates down below constraining levels - much like in 2004 and 2010.

  Meltzer further emphasizes that it was the huge gold reserves that permitted the appearance of success during the Kennedy/Johnson administration until the gold reserves dwindled in the last half of the 1960s. He emphasizes the cumulative noxious impacts of the Keynesian policies that ultimately overwhelmed the financial stability of the strongest financial power in world history. He emphasizes the unwillingness of the U.S. to even temporarily sacrifice its full employment objective to sustain the dollar. The full employment objective required rising budget deficits, artificially low interest rates and increasing rates of monetary inflation - a certain recipe for financial turmoil and ultimately the failure even of the full employment objectives.

  "The first half of 1971 was an example of how not to conduct monetary policy operations. The System had several objectives, and the members had different priorities. Some expressed greatest concern about inflation; some gave more attention to unemployment and slow economic growth; some wanted to lower money growth to bring down inflation or respond to the growing balance of payments deficit and complaints from abroad; some wanted to shift emphasis back to money market conditions; and some wanted tighter control of money growth or monetary aggregates. With the FOMC divided along several dimensions, agreement could be obtained only, if at all, by making small changes that accomplished none of the objectives. Adding to the System's woes were administration complaints that unemployment and inflation were both too high and, if they were receding, they were doing so much too slowly."

  The government had become a Keynesian madhouse. There were even some Keynesians who celebrated the devaluation in the belief that relief from the gold constraint now freed the System to conduct a Keynesian monetary policy. They were totally ignorant of the obvious fact that it was gold, and only gold, that had shielded the nation from the most noxious impacts of the Keynesian madness up to that point.

  The fundamental cause of the collapse of the dollar-gold exchange system is accurately described by Meltzer.

  "The Bretton Woods system of fixed but adjustable exchange rates broke down because no major country or group of countries was willing to subvert domestic policy to improve international policy. Exchange rate stability was a public good; no country was willing to pay much to supply it. The United States chose to maintain high employment even if its policy required rising inflation, as it did after 1965. When problems arose, it used capital controls to hide the problem temporarily. The Johnson administration developed many clever stopgaps, but it would not adopt a long-term solution."

  Constant Keynesian efforts to boost "liquidity" (a Keynesian euphemism for monetary inflation) inevitably undermined confidence in the System, while failure to agree on an adjustment mechanism allowed explosive pressure to build against the dollar. Administered alternatives - capital controls, SDRs and other stopgaps - served merely to fudge the ineptness of U.S. exchange rate policy.
 &

Even with no gold backing, the dollar was still supported by the massive, flexible, vibrant private U.S. economy which would continue to limit the rate of dollar devaluation. With gold unavailable, the dollar was the best alternative.

  However, there was no rejection of the dollar. With the advent of financial turmoil, nations wanted to increase their dollar reserves. The other advanced nations, too, had domestic full employment goals. All had a major interest in the maintenance of international commerce. Even with no gold backing, the dollar was still supported by the massive, flexible, vibrant private U.S. economy which would continue to limit the rate of dollar devaluation. With gold unavailable, the dollar was the best alternative.
 &
  As it turned out, the Bretton-Woods dollar-gold exchange system worked like the previous gold standard. If nations - especially the U.S. - didn't follow the rules and favor international benefits at the temporary expense of domestic employment objectives, the system was unsustainable. Under either system, instead of temporary cyclical unemployment problems, they would get both chronic unemployment and chronic inflation problems.

  "Countries act in their perceived self-interest; typically they overweight short-term costs and underweight any long-term benefits."

Administered alternatives:

  The failure of price and wage controls - administered alternatives to market mechanisms - is explained at length - over 80 pages - by Meltzer. Instead of conquering inflation, controls are themselves inflationary and ultimately generate increased rates of price inflation. (See, "Understanding Inflation.")
 &

Controls deter the increases in supply that are needed to balance the pressures for price increases generated by monetary inflation.

  Meltzer tells a story of failure - of failure of Keynesian full employment policies, of System failure to maintain the purchasing power of the dollar, of Keynesian failure to control price inflation, and the failure of Nixon administration controls to provide an adequate administered alternative to market mechanisms.

  "Political concerns dominated economic policy both in the decision to impose price and wage controls and in the unwillingness to raise interest rates high enough to stop inflation."

  Nixon's "New Economic Policy" of price and wage controls began in August 1971 with a measured price inflation rate of 3.6% and left the nation with a 12.2% rate of inflation when they were fully terminated in April, 1974.  It's simple supply and demand. Controls deter the increases in supply that are needed to balance the pressures for price increases generated by monetary inflation.
 &
  War in the Middle East and the surge in oil prices were blamed, but they were actually minor factors. It was dollar devaluation and monetary inflation that were the primary driving forces. The dollar no longer had the strength to shield the economy from the economic impact of foreign crises.

  With the dollar no longer as good as gold, oil in the ground was worth more than oil produced. Weakness in the dollar thus supported the embargo. Almost a decade later, another Middle East war produced no oil embargo. However, by then, Paul Volcker, supported by Ronald Reagan, had employed double digit interest rates and monetary austerity and a severe recession to break inflation. This restored strength to the dollar, caused oil prices to collapse and destroyed the Soviet Union.

  Of course, price and wage controls break the thermometer, so there is always an initial appearance of success in reducing price inflation. The pricing mechanism simply doesn't register the proliferating subterfuges generated to avoid controls or the time and effort wasted in dealing with the controls.
 &
  However, controls were a political rather than an economic policy, and as such they were a success in the short run period running through the 1972 election. The economic cost imposed on the American people was vast. Wage rate increases initially declined modestly, but were surging in 1972 to almost 8%, chasing price inflation that reached double digit levels in 1974.
 &
  Other elements to the program included an embargo on gold sales, a 10% surtax on imports, reinstatement of an investment tax credit, some budget reductions, and some tax reductions. Economic growth was robust in 1972 - at a 7% annual rate through September - and unemployment dipped to 5.5% - supporting Nixon's reelection bid. The weakness in the dollar was blamed on "speculators" (an ever-handy scapegoat recently targeted by Greek and other EU officials). Blame has to be deflected away from incumbent political leaders. No thought was given to long term consequences. Nobody knew what they would be. The Nixon administration had its hands full dealing with the short term situation. Few economists found any economic benefit in the control program. 
 &

  Burns persistently sounded the alarm against inflation, just like Miller before him. Inflation was undermining public confidence in government and undermining Republican electoral prospects. However, System monetary and interest rate policy was constrained by fears of precipitating a credit squeeze and a recession.
 &
  Meltzer considers the System's record from 1971 to 1973 "the worst in Federal Reserve history." Burns blatantly shaped monetary policy to support the political purposes of the Nixon reelection effort. He was supported by widespread notions that chronic inflation had causes other than monetary inflation. If controls could just inhibit "wage-push" and "cost-push" forces and end inflationary expectations, monetary inflation would not cause price inflation during periods when there was substantial unemployment and economic slack.

  "Burns was able to get a majority vote of the FOMC because he could appeal to beliefs that considerable resources were idle, that inflation would be held back by price controls, and that their principal mandate was to contribute to full employment. This was compatible with service to the president's reelection campaign. There is no doubt that he urged an easier policy in January 1972 after his discussions with President Nixon."

  There were 2500 years of monetary history that contradicted such ridiculous beliefs and hopes, but history had to be determinedly ignored to support Keynesian policies.

  By spring, 1972, consumer prices were rising at annual rates above 6%, causing public irritation. The federal funds rate refused to cooperate. It rose from about 3.3% in February to about 4.5% that summer and exceeded 5% during the election period. Because of controls, official rates of CPI price inflation were kept below 3.5%, but the federal funds rate was clearly responding to increasing inflationary pressures that reflected base money growth that hit 8.4% that November. This was the highest rate of increase since 1946, and it was still rising. M1 rose 7.7% for the year ending in November.
 &
  Real GDP growth surged at declining annual rates of 9.1%, 8% and 4.2% in the first three quarters of 1972, but unemployment declined only to 5.5% in September from 6% at the end of 1971. However, even with controls, the GDP deflator registered 5% for the last half of 1972.
 &

The Democrats who controlled Congress, along with their Keynesian economists, all advocated higher rates of monetary expansion.

  Nixon attributed his loss to Kennedy in 1960 to rising unemployment rates. The government had to appear to be trying to restrain wages and prices, but must do nothing that might adversely affect employment that year. System staff forecast that unemployment would be down to 5.3% by the end of 1972, well above the 4% "full employment" benchmark. However, unemployment remained stubbornly at 5.6% into October. However, Burns remained delighted at the pace of economic recovery - apparently oblivious to surging inflation and the crumbling of the dollar and the international exchange rate mechanism that was still based upon the dollar.
 &
  The desire for rapid monetary expansion was not confined to the Nixon administration. The Democrats who controlled Congress, along with their Keynesian economists, all advocated higher rates of monetary expansion.
 &

1973:

 

Nixon immediately shifted gears.

  Concern about monetary inflation returned during the last quarter of 1972, as expansion of the monetary aggregates surged far above the target. Price inflation and the federal funds interest rate were both surging higher, but that mattered not. Nixon won a smashing electoral victory. He immediately shifted gears, proposing a 1974 budget with a $14 billion cut in spending.
 &

  Nixon tried to repair some of the damage by impounding funds appropriated for many of the programs authorized by Congress. The System increased stock margin requirements from 55% to 65%. However, the genii was out of the lamp. Consumer prices were rising at 8.4% on an annual bases by the end of 1973. Real wages fell, food prices soared and a weak dollar was no longer attractive enough to deter a Middle East war oil embargo. The electorate was not amused.
 &
  The System increased bank reserves
to tighten monetary policy immediately after the election. Meltzer sets forth the technical and political complications involved. The discount rate was increased to 6% in December 1972, but market rates were much higher. Borrowing from the System surged. The Board had to raise the discount rate even further in the summer of 1973 as price inflation surged higher.
 &
  The control programs were eased and then phased out during 1973, leaving a price surge that revealed the full extent of the resulting price inflation. By that time, both labor and business leaders were complaining about the delays and difficulties of working through government bureaucratic mazes that were increasingly subject to the push and pull of conflicting private and political interests.
 &
  The budget deficits of 1971 and 1972 were triple that of 1970. The federal budget for 1973 was 20% bigger than for 1970.

T) Floating Exchange Rates

Chronic inflation:

 

&

  Japan was the first nation to register the impact of the dollar devaluation in 1971 since there was a holiday in Europe. Attempting to maintain the yen at 360 to the dollar, Japan bought 4 billion dollars in two weeks, increasing its dollar reserves 50%. Inflation in Japan surged in 1973 and 1974.
 &

  The dollar declined broadly. Foreign currency appreciation ranged from 2% for the franc to 9.5% for the mark. The cheaper dollar and the surtax on imports reduced U.S. imports and increased its exports. There was a dramatic reduction in capital transfers. Forward markets were limited to pounds and marks. Capital controls were widely adopted.
 &
  After a substantial initial surge, the stock market headed down. Negotiations with the other advanced nations were running into the same roadblocks as before. Each nation's immediate domestic concerns prevented agreements. By late November 1972, instability and uncertainty were visibly affecting commerce, and Nixon instructed his negotiators - led by John Connally - to wrap them up with a suitable agreement.
 &

There was no austerity effort so devaluation failed to provide anything more than just momentary relief.

  The result - the Smithsonian Agreements - was a meager $3 - 8.6% - increase in the dollar price for gold, a dollar devaluation against all currencies of 7% on average and 10% against the G-10 advanced states. Trade and payments balances swung rapidly into surplus for the U.S. However, within a few month, price inflation surged past 7% - the highest since the Korean war.

  "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."

  Domestic concerns were still emphasized over exchange rate concerns. There was now no restraint on budget deficits or monetary inflation so both surged higher. The new exchange rates thus quickly came under renewed pressure.
 &
  The real - inflation adjusted - exchange rate - resumed its decline after a few quarters of stability. With a brief interruption towards the end of the 1973-1975 recession, it declined until 1978. There was no austerity effort so devaluation failed to provide anything more than just momentary relief. Growth of the monetary base stayed above 7% and then surged to 9% and higher.
 &
  The "monetary base" frequently referred to by Meltzer includes currency and bank reserves. The "money stock" frequently referred to by Milton Friedman includes currency and demand deposits, and is thus generally a broader measure than monetary base.
 &

Fixed exchange rates have many benefits, but undisciplined domestic budgetary and monetary policies make fixed rates untenable. 

  The economic turmoil of floating exchange rates was untenable. Frantic, complex diplomatic and monetary efforts quickly developed to control exchange rates - regionally in Europe, which adopted the monetary snake in the tunnel - and bilaterally elsewhere. Meltzer provides a blow-by-blow account. Arrangements were reached and broke down with some regularity. Monetary crises shifted from one currency to another. There were frequent revaluations and devaluations.
 &
  Dollar devaluation continued in February, 1974, when the official dollar price of gold was increased 10% to $42.22. It was an obvious fiction as the market price soared to $89. The "barbaric metal" was revealing the weakness of the fiat dollar.
 &
  Efforts to fix exchange rates gave way to floating rate systems by 1976. Fixed exchange rates have many benefits, but undisciplined domestic budgetary and monetary policies make fixed rates untenable. Gold was phased out of the international system, but large stockpiles continued to be held. Many nations pegged their currency to the dollar, but surges in gold prices continue to reveal periods of gross failure of U.S. budget and monetary policy.

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