CHAPTER 5
Currency War II (1967–1987)
“The dollar is our currency, but it’s your problem.”
U.S. Treasury Secretary John Connally
to foreign finance ministers, 1971
“I don’t give a shit about the lira.”
President Richard M. Nixon, 1972
A
s World War II wound down, the major Allied economic powers, led by the United States and England, planned for a new world monetary order intended to avoid the mistakes of Versailles and the interwar period. These plans were given final shape at the Bretton Woods Conference held in New Hampshire in July 1944. The result was a set of rules, norms and institutions that shaped the international monetary system for the next three decades.
The Bretton Woods era, 1944 to 1973, while punctuated by several recessions, was on the whole a period of currency stability, low inflation, low unemployment, high growth and rising real incomes. This period was, in almost every respect, the opposite of the CWI period, 1921–1936. Under Bretton Woods, the international monetary system was anchored to gold through a U.S. dollar freely convertible into gold by trading partners at $35 per ounce and with other currencies indirectly anchored to gold through fixed exchange rates against the U.S. dollar. Short-term lending to particular countries in the event of trade deficits would be provided by the International Monetary Fund. Countries could only devalue their currencies with IMF permission and that would generally be granted only in cases of persistent trade deficits accompanied by high inflation. Although conceived in the form of a grand international agreement, the Bretton Woods structure was dictated almost single-handedly by the United States at a time when U.S. military and economic power, relative to the rest of the world, was at a height not seen again until the fall of the Soviet Union in 1991.
Despite the persistence of Bretton Woods into the 1970s, the seeds of Currency War II were sown in the mid- to late 1960s. One can date the beginning of CWII from 1967, while its antecedents lie in the 1964 landslide election of Lyndon B. Johnson and his “guns and butter” platform. The guns referred to the war in Vietnam and the butter referred to the Great Society social programs, including the war on poverty.
Although the United States had maintained a military presence in Vietnam since 1950, the first large-scale combat troop deployments took place in 1965, escalating the costs of the war effort. The Democratic landslide in the 1964 election resulted in a new Congress that convened in January 1965, and Johnson’s State of the Union address that month marked the unofficial launch of the full-scale Great Society agenda.
This convergence of the costs of escalation in Vietnam and the Great Society in early 1965 marked the real turning away from America’s successful postwar economic policies. However, it would take several years for those costs to become apparent. America had built up a reservoir of economic strength at home and political goodwill abroad and that reservoir now slowly began to be drained.
At first, it seemed that the United States could afford both guns and butter. The Kennedy tax cuts, signed by President Johnson shortly after President John F. Kennedy’s assassination in 1963, had given a boost to the economy. Gross domestic product rose over 5 percent in the first year of the tax cuts and growth averaged over 4.8 percent annually during the Kennedy-Johnson years. But almost from the start, inflation accelerated in the face of the twin budget and trade deficits that Johnson’s policies engendered.
Inflation, measured year over year, almost doubled from an acceptable 1.9 percent in 1965 to a more threatening 3.5 percent in 1966. Inflation then ran out of control for twenty years. It was not until 1986 that inflation returned to the level of just over 1 percent. In one incredible five-year stretch from 1977 to 1981, cumulative inflation was over 50 percent; the value of the dollar was cut in half.
U.S. citizens in this period made the same analytic mistake as their counterparts in Weimar Germany had in 1921. Their initial perception was that prices were going up; what was really happening was that the currency was collapsing. Higher prices are the symptom, not the cause, of currency collapse. The arc of Currency War II is really the arc of U.S. dollar inflation and the decline of the dollar.
Despite the centrality of U.S. policies and U.S. inflation to the course of CWII, the opening shots were fired not in the United States but in Britain, where a sterling crisis had been brewing since 1964 and came to a boil in 1967 with the first major currency devaluation since Bretton Woods. While sterling was less significant than the dollar in the Bretton Woods system, it was still an important reserve and trade currency. In 1945, UK pounds sterling comprised a larger percentage of global reserves—the combined holdings of all central banks—than the dollar. This position deteriorated steadily, and by 1965 only 26 percent of global reserves were in sterling. The British balance of payments had been deteriorating since the early 1960s, but grew sharply negative in late 1964.
Instability in sterling arose not only because of short-term trade imbalances but because of the global imbalance between the total sterling reserves held outside Britain and the dollar and gold reserves available inside Britain to redeem those external balances. In the mid-1960s there were about four times as many external sterling claims as internal reserves. This situation was highly unstable and made Britain vulnerable to a run on the bank if sterling holders tried to redeem sterling for dollars or gold en masse. A variety of techniques was orchestrated to support sterling and keep the sterling bears off balance, including international lines of credit, swap lines with the New York Fed, a UK austerity package and surprise currency market interventions. But the problem remained.
Three minor sterling crises arose between 1964 and 1966, but were eventually subdued. A fourth sterling crisis, in mid-1967, however, proved fatal to sterling parity. Numerous factors contributed to the timing, including closure of the Suez Canal during the 1967 Six-Day War between the Arabs and Israel and the expectation that the UK might be required to devalue in order to join the European Economic Community. Inflation was now on the rise in the United Kingdom as it was in the United States. In the UK, inflation was rationalized as necessary to combat rising unemployment, but its impact on the value of the currency was devastating. After an unsuccessful effort to fend off continued selling pressure, sterling formally devalued against the dollar on November 18, 1967, from $2.80 to $2.40 per pound sterling, a 14.3 percent devaluation.
The first significant crack in the Bretton Woods facade had now appeared after twenty years of success in maintaining fixed exchange rates and price stability. If the UK could devalue, so could others. U.S. officials had worked hard to prevent the devaluation of sterling, fearing the dollar would be the next currency to come under pressure. Their fears would soon be realized. The United States was experiencing the same combination of trade deficits and inflation that had unhinged sterling, with one crucial difference. Under Bretton Woods, the value of the dollar was not linked to other currencies but to gold. A devaluation of the dollar therefore meant an upward revaluation in the dollar price of gold. Buying gold was the logical trade if you expected dollar devaluation, so speculators turned their attention to the London gold market.
Since 1961, the United States and other leading economic powers had operated the London Gold Pool, essentially a price-fixing open market operation in which participants combined their gold and dollar reserve resources to maintain the market price of gold at the Bretton Woods parity of $35 per ounce. The Gold Pool included the United States, United Kingdom, Germany, France, Italy, Belgium, the Netherlands and Switzerland, with the United States providing 50 percent of the resources and the remainder divided among the other seven members. The pool was partly a response to an outbreak of panic buying of gold in 1960, which had temporarily driven the market price of gold up to $40 per ounce. The Gold Pool was both a buyer and a seller; it would buy on price dips and sell into rallies in order to maintain the $35 price. But by 1965 the pool was almost exclusively a seller.
The End of Bretton Woods
The public attack on the Bretton Woods system of a dominant dollar anchored to gold began even before the 1967 devaluation of sterling. In February 1965, President Charles de Gaulle of France gave an incendiary speech in which he claimed that the dollar was finished as the lead currency in the international monetary system. He called for a return to the classical gold standard, which he described as “an indisputable monetary base, and one that does not bear the mark of any particular country. In truth, one does not see how one could really have any standard criterion other than gold.” France backed up the words with action. In January 1965, France converted $150 million of dollar reserves into gold and announced plans to convert another $150 million soon. Spain followed France and converted $60 million of its own dollar reserves into gold. Using the price of gold in June 2011 rather than the $35 per ounce price in 1965, these redemptions were worth approximately $12.8 billion by France and $2.6 billion by Spain and at the time represented significant drains on U.S. gold reserves. De Gaulle helpfully offered to send the French navy to the United States to ferry the gold back to France.
These redemptions of dollars for gold came at a time when United States businesses were buying up European companies and expanding operations in Europe with grossly overvalued dollars, something De Gaulle referred to as “expropriation.” De Gaulle felt that if the United States had to operate with gold rather than paper money, this predatory behavior would be forced to a halt. However, there was fierce resistance to a pure gold standard in the late 1960s—as in the 1930s, it would have necessitated a devaluation of dollars and other currencies against gold. The biggest beneficiaries of a rise in the dollar price of gold would have been the major gold-producing nations, including the repugnant apartheid regime in South Africa and the hostile communist regime in the USSR. These geopolitical considerations helped to tamp down the enthusiasm for a new version of the classical gold standard.
Despite the scathing criticisms coming from France, the United States did have one staunch ally in the Gold Pool—Germany. This was crucial, because Germany had persistent trade surpluses and was accumulating gold both from the IMF as part of operations to support sterling and through its participation as an occasional buyer in the Gold Pool itself. If Germany were suddenly to demand gold in exchange for its dollar reserve balances, a dollar crisis much worse than the sterling crisis would result. However, Germany secretly assured the United States it would not dump dollars for gold, as revealed in a letter from Karl Blessing, president of the Deutsche Bundesbank, the German central bank, to William McChesney Martin, the chairman of the Board of Governors of the Federal Reserve. Dated March 30, 1967, the “Blessing Letter” provided:
Dear Mr. Martin,
There occasionally has been some concern . . . that . . . expenditures resulting from the presence of American troops in Germany [could] lead to United States losses of gold....
You are, of course, well aware of the fact that the Bundesbank over the past few years has not converted any . . . dollars . . . into gold....
You may be assured that also in the future the Bundesbank intends to continue this policy and to play its full part in contributing to international monetary cooperation.
It was extremely comforting for the United States to have this secret assurance from Germany. In return, the United States would continue to bear the costs of defending Germany from the Soviet troops and tanks stationed in the woods immediately surrounding Berlin and throughout Eastern Europe.
Germany, however, was not the only party with potential gold claims on the dollar, and in the immediate aftermath of the 1967 sterling devaluation the United States had to sell over eight hundred metric tons of gold at artificially low prices to maintain the dollar-gold parity. In June 1967, just one year after withdrawing from NATO’s military command, France withdrew from the Gold Pool as well. The other members continued operations, but it was a lost cause: claims on gold by overseas dollar holders had become an epidemic. By March 1968, the gold outflow from the pool was running at the rate of thirty metric tons per hour.
The London gold market was closed temporarily on March 15, 1968, to halt the outflow, and remained closed for two weeks, an eerie echo of the 1933 U.S. bank holiday. A few days after the closure, the U.S. Congress repealed the requirement for a gold reserve to back the U.S. currency; this freed the U.S. gold supply to be available for sale at the $35 price if needed. This was all to no avail. By the end of March 1968, the London Gold Pool had collapsed. Thereafter, gold was considered to move in a two-tier system, with a market price determined in London and an international payments price under Bretton Woods at the old price of $35 per ounce. The resulting “gold window” referred to the ability of countries to redeem dollars for gold at the $35 price and sell the gold on the open market for $40 or more.