A History of the Federal Reserve, Volume 2 Read online

  This good performance is subject to four qualifications, however. First, many countries prevented adjustment of prices, output, and the exchange rate by maintaining exchange controls. Second, real per capita growth rates depend on the spread of new technology, the reduction in trade barriers, the development and expansion of the European common market, and other forces. Third, pressures increased for price and real exchange rate changes that occurred after the Bretton Woods system ended. Fourth, the United States introduced several restrictions on capital movements, tied foreign aid to dollar purchases, and required purchases of military and other goods and services in home markets. These are selective devaluations of the dollar that do not appear in the published exchange rate data. Some had a large welfare cost. Despite these qualifications, the exchange rate system worked comparatively well until the cumulative effect of U.S. expansive policies and declining real growth caused the breakdown (Darby and Lothian, et al., 1983; Schwartz, 1987a, chapter 14).

  11. United States, United Kingdom, West Germany, France, Japan, Canada, and Italy are the G-7 members.

  The experience of the 1920s and the 1960s taught a common lesson: fixed exchange rate systems rarely last long in the contemporary world.12 Countries are unwilling to make their economies adjust to the exchange rate. The public is unwilling to accept the at times large temporary losses of employment required to maintain the international value of its money.

  PROPOSALS AND ACTIONS 1965–67

  In 1964, the United States had its largest trade balance and current account surplus since 1947. The expanding world economy, low domestic inflation, and improvement in the terms of trade contributed to bring the balance of payments problem toward a satisfactory equilibrium. Unfortunately, the good news did not last. Table 5.2 shows current and capital account balances for the decade; the capital outflow in 1964 was the largest to that time.

  The tone of official discussions mirrors the current account data in Table 5.2. Optimism that the problem would be managed rose in 1964 and remained in 1965. A little extra push from new controls might be all that was needed. “Voluntary” controls on bank lending and foreign investment lowered the liquidity measure of the deficit for two years despite reductions in the current account surplus. After that the trade surplus began a precipitate decline and the growth of claims against gold (liquidity basis) reached levels far above previous values. The response to the 1967 British devaluation, rising domestic prices, and continued expenditures for the Vietnam War was a virtual embargo on gold; the two-tier system begun in 1968 ended gold sales to the public and ended the London gold pool. The Johnson and Nixon administrations continued the “voluntary” programs, strengthened them, made some mandatory, but did little to solve the longterm problem of an overvalued real exchange rate.

  12. Obstfeld and Rogoff (1995) show this for a large number of countries. It remains to be seen whether the European Monetary System will change that conclusion by introducing a common currency and making exit difficult.

  Reductions in the capital outflow in 1965 reflect the initial response to the so-called voluntary programs. The large fluctuations in outflow in 1968 to 1970 reflect a number of factors but especially the response to interest rate changes at home and abroad. These gave the appearance in 1968 that the outflow had reversed. The change was transitory, reflecting the effect of regulation Q on banks’ decisions to repay euro-dollars in 1968 and borrow euro-dollars in 1969.

  The initial effect of controls on lending or investing abroad was much stronger than its permanent effect. Banks and firms found ways to substitute. The interest equalization tax encouraged bank lending, so it became necessary to put a ceiling on bank loans. Banks could acquire eurodollars, borrowing the dollars that flowed abroad and relending to their customers.

  The main problem in the 1960s was not a U.S. current account deficit. Throughout the 1960s, the United States typically had a surplus on current account. The problem was that the trade and current account surpluses were not large enough to finance private investment abroad plus military, travel, and foreign aid spending abroad. As foreigners bought gold and accumulated dollars, concern rose that the gold price would not remain fixed or the dollar would not remain convertible into gold.

  The Kennedy and Johnson administrations faced a choice—slow the outflow of dollars by reducing money growth or adjust the exchange rate system by devaluing. They chose instead to impose controls of various kinds. Each new crisis brought new controls. At first, they may have hoped that the problem was temporary, that the controls would get the system through a transition. This hope must have died by the late 1960s, but the Johnson economic and financial advisers never developed a lasting solution to the international problem.

  Eichengreen (2000, 212) found no evidence that controls had a significant effect. As is often the case, markets circumvent controls and regulations. A main reason in this case was that the availability of substitutes undermined control programs. The public reacted negatively to controls, and officials were unwilling to introduce stronger measures that might have succeeded in prolonging the system. The records of the period suggest a growing sense of resignation, belief in the inevitability of a breakdown.

  In December 1964, the Cabinet Committee on the Balance of Payments forecast the 1965 balance of payments deficit at slightly under $2 billion, the smallest deficit since 1958, about equal to the projected deficit for 1964.13 The committee anticipated a decline in the trade surplus and further increases in bank loans and foreign investment. It recommended a balance of payments speech by the president reporting progress and extension of the interest equalization tax (IET) to bank loans.14

  By late January, the committee had completed its recommendations. In addition to renewing the IET and extending the tax to bank loans with more than one year to maturity, the committee recommended a Federal Reserve–administered program to reduce the number of banks lending abroad, additional reductions in military spending abroad,15 a 2 percent increase in the IET for shorter maturities declining to 1 percent on longer maturities, and “an attack on overseas investment in the developed countries” (memo, McGeorge Bundy to the president, Johnson Library, National Security File, Balance of Payments, January 22, 1965).

  The Federal Reserve was responsible for the “voluntary” lending program with assistance from the Comptroller and the FDIC. In the first year, banks were asked not to lend more than 5 percent above the amount lent in 1964.16 Loans to foreigners with maturity greater than one year became subject to the IET. At the Board, Governor Robertson was responsible for the program.

  13. The Cabinet Committee consisted of the Secretaries of State, Defense, Commerce, and Treasury (chair) plus the Chairman of the Board of Governors and others from the administration. The committee often met with the president to present its findings. The committee recognized that the policy of requiring U.S. exports to be shipped in U.S. flag carriers lost sales to competing suppliers.

  14. Congress gave the president standing authority to apply the IET to bank lending abroad when it passed the IET.

  15. The memo recognized the cost of some of its proposals for the military. For example, supplying oil from the United States to troops in Europe cost twice as much as buying it from the Middle East. Nevertheless, the committee favored the policy of spending at home to reduce the dollar outflow. These and other decisions show the emphasis on appearance and the neglect of effective actions.

  16. The 5 percent ceiling included export finance, a step that seems counterproductive. The reporting and consultation requirements exposed banks to anti-trust violations. The government asked for a legal waiver of these requirements for two years. The Board recognized the problem posed by including export credit but feared creating a large loophole if it did not restrict such credits (Board Minutes, February 18, 1965, 6–7).

  Initially, the investment program was also voluntary. Secretary of Commerce John Connor asked all companies to participate if they had investments of at least $10 million in develop
ed countries at the end of 1964 or exports of at least $10 million in 1964. Companies were supposed to report quarterly on their assets and exports and to forecast for the following year. Participating firms were asked to reduce holding of short-term assets abroad to the 1963 level, to increase exports, repatriate export proceeds, and reduce the rate of investment. The goal was to reduce net outflow by 15 to 20 percent below the 1964 flow. Johnson (1966) concluded that the program had a modest effect.

  The most controversial item among the proposed changes called for a tax on tourist travel. Opponents cited the regressivity of the tax, the reaction of foreign governments, and the effects on trade negotiations in progress at the time. The tax proposal reappeared several times but was not adopted. The most the administration did on this issue was to reduce tourists’ dutyfree allowance from $500 to $100.17

  The effectiveness of controls varied with the opportunity or ability to substitute uncontrolled for controlled transactions. Tying military spending is inefficient, but substitution is limited. Tying foreign aid or military spending reduces the real value of the spending but may induce larger appropriations. Controls on private financial transactions are most easily circumvented.

  Offsetting steps to reduce the balance of payments deficit and the gold outflow were decisions of the French and Spanish governments to convert excess dollar stocks into gold. The Treasury estimated that France would convert $300 million and Spain $210 million during 1965. In addition, France planned to convert its monthly flow dollar surplus of about $50 million. The Treasury estimated that Russian gold sales would decline that year. The net effect would be a sale of about $500 million in gold in 1965 (memo, Secretary Dillon to the president, Johnson Library, Francis Bator papers, Box 16, January 4, 1965). Actual gold outflow reached $1665 million that year, the largest outflow since 1960 and the largest percentage loss in the postwar years to that time. Part of the increased gold outflow went to pay $258 million for an increase in the U.S. IMF quota. In addition to the U.S. payment, countries bought gold from the U.S. stock to pay for the portion of their increased quotas that had to be paid in gold. By yearend, the Treasury held only $13.8 billion, of which approximately $13 billion was held as required gold reserves for bank reserves and currency.

  17. The report notes Chairman Martin’s “promise . . . that if confidence can be sustained, U.S. domestic credit will be kept easy” (McGeorge Bundy to Johnson, Johnson Library, National Security File, Balance of Payments, January 22, 1965).

  In his February 10 message to Congress, the president asked Congress to repeal the gold reserve requirement against bank reserves. Removing the gold requirement on reserves meant that monetary action was less restricted, and more of the gold stock was available for payment. This concerned several members of Congress, and some bankers wanted a letter from the president to Congress disavowing Congressman Patman’s recommendations that would have reduced Federal Reserve independence. The president agreed, and Secretary Dillon testified in favor of continued independence (memo, Dillon to the president, Johnson Library WHCF Box 51, January 13, 1965). Patman accused the bankers of using “blackmail” to defeat his legislation (letter, Patman to president, Johnson Library, WHCF Box 51, January 15, 1965). On March 3, 1965, Congress approved the change. The gold reserve requirement for currency remained in effect until 1968.18

  The Board discussed a new ruling that would restrict access to the discount window by banks that made foreign loans. Opinions differed. Governors Charles N. Shephardson and Mills preferred to reduce reserve growth (Board Minutes, January 19, 1965, 15–16). There was no agreement at the time. Later, the Board rejected the proposal to restrict discounting.

  President Johnson’s message extended Federal Reserve responsibility for voluntary compliance by non-banks and financial institutions, including insurance companies, pension funds, and investment companies. This was the first time that the System had responsibility for non-bank lending. Few, if any, savings and loan associations made foreign loans, so the program excluded them (ibid., February 18, 1965, 10).

  Banks in the aggregate did not use the 5 percent limit in 1965. On December 3, the Board extended the program for another year and increased the 1966 lending limit to 109 percent of the December 1964 base. The Board’s statement gave priority to loans supporting exports and for nonexport credits, and to loans to developing countries. The Board asked that the four percentage point increase in lending be spread evenly over the four quarters of 1966 (Board Minutes, December 3, 1965, Item 4). By February 1966, banks were $800 million below their ceiling.

  In October 1966, Governor Robertson proposed that the voluntary program be put on standby for 1967. Banks were $1.2 billion below the guideline. He regarded the guidelines as ineffective. Mitchell and Shephardson supported him, but Maisel said the voluntary program was ineffective and should be made mandatory. Brimmer and Daane argued that the Federal Reserve was part of an overall administration program. Dropping the lending program would increase pressure on the other parts. Chairman Martin favored suspension, but he did not think the administration would agree to it.

  18. Governor Mills opposed the change. He preferred to let the reserve banks hold deficient positions. Under the Federal Reserve Act, the Board could assess a fine against deficient reserve positions. The majority favored eliminating all gold reserve requirements and notified the Treasury to that effect (Board Minutes, January 4,1965, 3–10).

  The decision authorized Robertson to make the case for suspension to the Cabinet Committee on the Balance of Payments (Board Minutes, October 19 and 20, 1966). The Board would not issue new guidelines but would continue to monitor data and reinstate the program if necessary or desirable.

  The cabinet committee rejected the proposal for a standby program. It asked the Federal Reserve to recommend ways to restrict use of the $1.2 billion unused in 1966 and to give additional incentives for credits to finance exports and loans to developing countries. The 1967 guidelines, announced on December 12, 1966, followed the cabinet committee’s suggestions (Board Minutes, December 12, 1966, Item 3).

  The Commerce Department program was even less effective than the Board’s. The administration chose to maintain the voluntary program but tightened the standards. Corporations were asked to repatriate earnings, borrow abroad, and bring home all dollar balances held abroad not needed for working capital (Fowler to the president, Fowler papers, Johnson Library, Box 52, October 12, 1965). Secretary Fowler wanted to tighten the program sufficiently to bring the balance of payments to full balance in 1966. By March 1966, he recognized that this would not happen. He proposed a new program—a tax of $6 per individual for each day spent abroad with a $100 deposit paid before an individual could leave the country. The tax would be $50 for travel in North America or the Caribbean.19 Fowler estimated that the tax would yield between $585 million and $1.17 billion a year. The State and Commerce Departments opposed the tax, and it was not adopted.

  In May, Secretary Fowler wrote to President Johnson advising him that despite the new controls, the payments deficit for 1966 would be at least as large as in 1965 and probably larger. “The fundamental problem can be summarized as follows: our trade surplus is shrinking; growth of our services surplus is being held back by the growing tourist deficit; together our surplus on goods and services combined will not be sufficiently large to compensate for the governmental dollar outflows . . . ; and private capital outflows” (memo, Fowler to the president, Johnson Library, Balance of Payments, Vol. 3, Box 2, May 10, 1966). The memo recommended again a tax on tourists, additional reductions in government military spending abroad, prepayment of debt owed by foreigners, and getting foreigners to commit to purchase long-term debt instead of more liquid short-term debt. No one proposed reductions in foreign aid. The administration worked to reduce private spending and to maintain its own spending.

  19. Fowler suggested an alternative, a progressive tax of one-tenth of one percent of adjusted gross income per day with a minimum of $6 and a maximum of $
50 per day (Ball papers, Johnson Library, Lot 74 D272, March 18, 1966). The administration also wanted South Vietnam to invest surplus dollars in U.S. bonds and larger offset payments by West Germany. Secretary McNamara said that the Germans should be told “no money—no troops” (Cabinet Committee on Balance of Payments, Fowler papers, Johnson Library, Box 53, March 25, 1966). Germany paid $700 million in 1966.

  Fowler then discussed some policy changes such as increased tax rates and tighter monetary policy (higher interest rates) if “it could be tolerated here” (ibid.). Also, the interest equalization tax could be extended to direct investment abroad in place of the voluntary program.

  The Cabinet Committee on the Balance of Payments proposed a more restrictive, but still voluntary, program for business external investment. The committee asked for a reduction of $30 million in foreign investment. To offset the reduced cost of foreign travel, it asked, again, for more reduction in tourist expenditures abroad.

  Fiscal and monetary policy changes aside, most of the proposals offered only one-time changes that would not permanently reduce the payments deficit. Like the earlier programs, the 1967 policy proposals responded to a perceived crisis but offered no permanent solution. Maintenance of employment dominated other goals. Restrictions, of course, relieved some pressure by selectively devaluing the dollar to overcome some specific problem.