A History of the Federal Reserve, Volume 2 (53 page)

Chairman Martin disliked inflation and spoke against it forcefully. When he left office the annual rate of increase in consumer prices was 6 percent, a rate that he deplored. A puzzle of the 1960s is that Martin,
who successfully resisted inflation in the 1950s, permitted and abetted the increase. A principal reason is that he accepted coordination with the administration’s fiscal policy even to the point of increasing money growth and lowering interest rates after Congress passed the 1968 tax surcharge.

Policy coordination was the third policy error. Policy coordination and even keel policies permitted inflation to start. Reluctance in Congress, the administration, and the public to permit unemployment to rise made it impossible to reduce inflation permanently once it rose. Analytic mistakes played a role. Both the Federal Reserve and successive administrations professed, and most likely expected, that inflation could be stopped by slowing growth without a recession. After recessions started, policies shifted toward ease. The public soon recognized that inflation would persist.

The Federal Reserve was not passive. As the inflation rate rose, it raised its target for the federal funds rate and reduced free reserves. Chart 3.4 suggests that, after 1965, the difference between the federal funds rate and the maintained (or average) inflation rate narrowed, reducing the real interest rate. An exception was the relatively large increases in the funds rate in 1968–69 that soon reversed as the economy went into recession. The chart shows a major change in 1969–70; the inflation rate did not respond much to the recession, a result explained in part by the unanticipated decline in productivity growth. Reliance on free reserves or nominal interest rates as a measure of policy thrust proved to be a fourth policy error. The Federal Reserve relied mainly on free reserves to judge its policy. This proved to be a poor indicator of policy thrust.

The expanding economy lowered the unemployment rate to levels not seen since the Korean War and not repeated for more than a generation. By 1967, unemployment was half the rate when the new administration took office. Administration economists accepted inflation as the price of lower unemployment and regarded lower unemployment as a significant part of its welfare program. In the 1968 election campaign, President Nixon promised to reduce the inflation rate without causing a recession. This too was a policy error. His administration did not succeed, as Chart 3.5 shows.

Between 1960 and August 1971, gross federal debt increased more than 40 percent, and Federal Reserve holdings increased by $39.5 billion, 144 percent of their holdings at the end of 1960. These purchases were the main source of the increase in the monetary base. They more than offset the nearly $8 billion decline in the gold stock. Table 3.1 shows the stock of debt and its ownership on selected dates.

Between December 1969 and August 1971, foreign holdings of United States government debt doubled and redoubled, as foreign central banks and governments honored their obligations to maintain a fixed exchange rate with the dollar and avoided appreciation of their exchange rates. These purchases raised money growth and inflation abroad. Finally, on August 15, 1971, President Nixon ended the Bretton Woods system by announcing that the United States would no longer sell gold at $35 per ounce.

This dramatic policy shift recognized formally what had been true for some time. Beginning in March 1968, the United States discouraged gold sales to foreign central banks, and refused sales to others. The United States’ gold stock rose modestly for the next two years, but claims against the gold stock continued to rise. This policy enabled the Bretton Woods system to continue for more than three years after March 1968, but it survived only because most countries did not challenge the restriction on gold sales.

The weakness of the original Bretton Woods Agreement is suggested by its duration. If we start its effective operation when major currencies became convertible on current account at the end of 1958 and consider its effective end in 1968, when restrictions on United States’ gold sales severely limited the dollar’s convertibility into gold, the system lasted only ten years. And it had frequent crises in those years. Its overwhelming weakness was the commitment in many countries to a full-employment policy. The United States would not deflate and, with modest exceptions, surplus countries would not revalue. France favored devaluing the dollar by increasing the gold price, but the United States preferred revaluation by other countries. With memories of the 1930s in the minds of political leaders at home and abroad, no one in authority urged deflation.

The agreement was part of the problem. Britain, mindful of its prewar history, insisted on the right to pursue domestic policies of its own choosing and to devalue if these policies conflicted with its exchange rate. The British position became part of the agreement. In the Employment Act of 1946, the United States accepted an obligation to maintain “maximum employment.” Other developed countries, either de facto or de jure, accepted full employment as a principal domestic policy goal. Each of these countries could devalue against gold, the dollar, and other currencies by claiming that its problem would persist. Some did just that.
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United States policy
officials did not believe they had that option in practice. They considered that the only viable solutions were to: (1) encourage other countries, especially surplus countries, to revalue, (2) put controls on trade or capital flows, mainly the latter, or (3) tighten domestic policy without creating a substantial increase in unemployment. For foreign governments, the choices became revaluation or inflation. Mercantilist attitudes bolstered by concerns about employment ruled out revaluation.

9. France, which seems never to have tired of criticizing U.S. policies, devalued its cur
rency several times. Usually the devaluation undervalued the franc, permitting expansive policies to increase output temporarily.

At different times, the United States relied on each of its options. Only Germany and the Netherlands were willing to revalue, and their changes were small. The Johnson and Nixon administrations were reluctant to disinflate domestic prices, since that required slower growth and unemployment. Rising unemployment created demands for expansive policies. It did not take long for markets to recognize that any reductions in inflation and the payments deficit were temporary. By 1965, long-term market interest rates and other prices began to build in anticipations of continued inflation. Chart 3.6 shows the beginning of the rise in long-term interest rates in 1965 and the sustained increase from 1968 to 1970. Consumer prices rose 4 to 5 percent a year in the early 1970s. Recession reduced measured inflation in 1970, but the decline was modest and soon reversed.
See Chart 3.3 above. Bondholders expected inflation to continue. Long before economists and policymakers, financial markets recognized that reductions in inflation were temporary, increases persistent. They were not always clear, however, about the distinction or about the degree to which observed changes were permanent or temporary.

President Kennedy and the members of his administration repeated often that they considered maintenance of the Bretton Woods system and the $35 gold price a high priority. Before taking office, Kennedy consulted widely including with President Eisenhower and Treasury Secretary Anderson about the reasons for the current account deficit.
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President Johnson gave less emphasis to international economic policy. When a problem arose or became acute, he adopted a stopgap that hid or removed the immediate problem.
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By 1969, when President Nixon took office, the positive balance on goods and services had fallen to $2 to $2.5 billion from $7 to $8 billion in 1964–65. The monetary gold stock was $10.9 billion, far less than foreigners’ holdings of dollar claims and only marginally above the level at which professional opinion expected a run on gold that would end the system. Some advisers wanted to suspend gold payments and end the fixed exchange rate, but there was no agreement and, therefore, no action when the new administration took office.
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Governments and central banks devoted much time and effort to discussing how the system could be sustained. These efforts culminated in the creation of “special drawing rights,” or SDRs, a paper currency intended to supplement the available stocks of gold and dollars as a means of making payments and settling claims between countries or their central banks. The rationale for SDRs was that they could substitute for gold as a means of settlement if central banks and governments agreed to use them. As usage rose, the international system would become less dependent on the supply of dollars and gold. This conjecture proved incorrect. SDRs never become a common means of settlement.

Diagnoses of the international monetary system generally recognized three problems, at the time called confidence, adjustment, and liquidity.
Confidence referred to the willingness to hold and receive dollars as a means of payment and dollar securities as a reserve, or store of value. Adjustment referred to the mechanism that would restore equilibrium to the payments system, for example by changing prices or real exchange rates to reflect permanent changes in relative position. Liquidity referred to the stock of available means of payment.

10. President Eisenhower attributed much of the problem to the United States’ share of the cost of common defense. He described the European governments as free riders, unwilling to pick up “what seemed to us to be their fair share of the defense burden” (Ferrell, 1981, 382). Professor Paul Samuelson briefed President-elect Kennedy just after the election. After an hour, Kennedy said: “I was a lot happier an hour ago. But thanks for the briefing” (Samuelson, letter to the author, January 24, 2001).

11. These included the interest equalization tax and the voluntary credit restraint program discussed below.

12. Milton Friedman proposed a freely floating exchange rate, but other advisers did not agree. Author’s conversation with Professor Friedman.