A History of the Federal Reserve, Vol. II
Allan H. Meltzer
Part VI: Nixon Devalues the Dollar (1969-1973)
FUTURECASTS online magazine
Vol. 12, No. 6, 6/1/10
R) Devaluation Contagion
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.
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.
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.
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.
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.
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.
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.
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.
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.
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
S) Nixon Devalues the Dollar
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.
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
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.
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.
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
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.
Arthur Burns was the first professional
economist to chair the System Board. He was neither Keynesian nor
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.
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.
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)"
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.
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.
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
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.
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
In July 1970, Burns got the FOMC to vote for faster
growth in the monetary aggregates. In August, the Board reduced bank
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%.
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.
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.
These ridiculous measures were clearly futile, but at least trade restrictions were avoided and the GATT trade agreements survived.
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.
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.
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.
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
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 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 fundamental cause of the collapse of the dollar-gold exchange system is accurately described by Meltzer.
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.
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
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.
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.
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
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.
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
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
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.
T) Floating Exchange Rates
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.
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.
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
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
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