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In April 1934, after a year
of flexible exchange rates, the United States went back to gold after a
devaluation of the dollar. This decreased the gold value of the dollar by
40.94 percent, raising the official price of gold 69.33 percent to $35 an
ounce. How history would have been changed had President Herbert Hoover
devalued the dollar, three years earlier!
France held onto its gold
parity until 1936, when it devalued the franc. Two other far-reaching
events occurred in that year. One was the publication of Keynes'
General Theory; the other signing of the Tripartite Accord among the
United States, Britain and France. One ushered in a new theory of policy
management for a closed economy; the other, a precursor of the Bretton
Woods agreement, established some rules for exchange rate management in
the new international monetary system.
The contradiction between
the two could hardly be more ironic. At a time when Keynesian policies of
national economic management were becoming increasingly accepted by
economists, the world economy had adopted a new fixed exchange rate system
that was incompatible with those policies.
In the new arrangements,
which were ratified at Bretton Woods in 1944, countries were required to
establish parities fixed in gold and maintain fixed exchange rates to one
another. The new system, however, differed greatly from the old gold
standard. For one thing, the role of the United States in the system was
asymmetric. A special clause allowed any country the option of fixing the
price of gold instead of keeping the exchange rates of other members
fixed. Because the dollar was the only currency tied to gold it was the
only country in a position to exercise the gold option. There thus came
into being the asymmetrical arrangements in which the United States fixed
the price of gold whereas other countries fixed their currencies to the
dollar. Another difference of the new system from the old was that not
even the United States was on anything that could be called a full gold
standard. The dollar was no longer in the old sense "anchored" to gold; it
was rather that the world price level, and therefore the real price of
gold, was heavily influenced by the United States. Gold had become a
passenger in the system.
Was a new system created at
Bretton Woods? From the early planning it seemed that this would be the
case. The British and American plans both contained provisions for a world
currency: John Maynard Keynes had his "bancor," and Harry Dexter White had
his "unitas." But these forward-looking ideas were soon buried. No doubt
the Americans came to believe that a world currency would clip the wings
of the dollar. There was not therefore a Bretton Woods "system" but rather
a Bretton Woods "order" outlining the charter of a system that already
existed.
World War II brought a
repetition of the monetary imbalances of World War I. The devaluation of
the dollar and gathering war clouds in Europe made the dollar a safe haven
and the recipient of gold to pay for war goods. The United State
sterilized the gold imports and imposed price controls. It was therefore
able to run deficits without going off gold. Because gold was still
"overvalued" in this era of "dollar shortage,"interest rates remained
incredibly low. By 1945, the public debt had soared to 125 percent of GDP.
At the end of the war, the
U.S. price level doubled as a result of the end of price control, the
unleashing of pent-up demand and the expansionary monetary policies of the
Federal Reserve System that continued to support the bond market. The
postwar inflation halved the real value of the public debt, increased tax
revenues as a result of "bracket creep" in the steeply-progressive income
tax system (which rose to 92.5 percent), halved the real value of gold and
eliminated its overvaluation. After further inflation during the Korean
War and the onset of steady "secular" inflation, gold became undervalued.
Meanwhile, Germany and
Japan, in the aftermath of their paper-money inflations, under the
auspices of the U.S. occupation authorities, had currency reforms in which
10 units of old money were exchanged for 1 unit of new currency; both
reforms took place in 1948, with the exchange rate for Germany set at DM
4.2 = $1, and for Japan at ¥360 = $1. The exchange rates later proved to
undervalue German and Japanese labor and the two economies performed
spectacularly in the post-war period, fulfilling their destiny of
overtaking Britain and France as the second and third largest economies in
the world.
Until the 1960's, U.S.
macroeconomic policy was based more on closed-economy principles than on
the requirements of an international monetary system. Monetary and fiscal
policy were directed at the needs of internal balance and the balance of
payments was all but ignored. In 1949 the United States had peaked at over
700 million ounces of gold, more than 75 percent of the world's monetary
gold. Gold losses began soon after, but the effect of these sales on the
money supply was sterilized by equivalent purchases of government bonds by
the Federal Reserve System. The gold losses were at first looked upon as a
healthy redistribution of the world's gold reserves but toward the late
1950's they were recognized as dangerous.
The Federal Reserve System
was required to keep a 25 percent (reduced from 40 percent in 1945) gold
cover behind its currency and deposit liabilities. If gold reserves fell
below this level, interest rates would have to be raised. If the fall in
gold reserves reached the level of required reserves, the United States
would be forced to take account of its balance- of- payments constraint
like any other country. The problem of the appropriate mix for monetary
and fiscal policy came to the foreground during the administration of
President John F. Kennedy, who took office in 1961.
At this time I played a part
in the story. Newly arrived in the Research Department at the
International Monetary Fund( IMF )in the fall of 1961, I was asked to look
into the theoretical aspects of the monetary-fiscal policy mix. The main
problem in this post-Sputnik era was sluggish growth and subpar employment
in the United States in contrast to Europe and Japan (precisely the
reverse of the situation today), and a now worrisome balance of payments
deficit. Three schools of thought had emerged. Keynesians, led by Leon
Keyserling, the first Chairman of the Council of Economic Advisers, pushed
for easy money and an increase in government spending. The Chamber of
Commerce argued for fiscal constraint and tighter money. The Council of
Economic Advisers, following the Samuelson-Tobin "neo-classical
synthesis," advocated low interest rates to spur growth and a budget
surplus to siphon off excess liquidity and prevent inflation.
In my analysis, I showed
that none of the above policies would work, and would lead the economy
away from equilibrium. The correct policy mix was to lower taxes to spur
employment, and tighten monetary policy to protect the balance of
payments. My paper was circulated by the IMF to its members in November
1961 and published in IMF Staff Papers in March 1962.
It gradually came to be
realized that the policies of the Kennedy administration were not working:
the wrong policy mix had produced increasingly disequilibrating effects: a
steel strike, a stock market crash, and stagnation. At the end of 1962,
Kennedy announced a reversal of the policy mix, with tax cuts to spur the
economy and interest rates to protect the balance of payments. Legislative
delays meant that the tax cut had to wait until the summer of 1964 but its
anticipation positioned the economy for the great expansion of the 1960's.
The adoption of my policy
mix helped the United States to achieve rapid growth with stability. It
was not intended to and could not solve the basic problem of the
international monetary system, which stemmed from the undervaluation of
gold. Nevertheless the problem of the U.S. balance- of- payments was
intricately tied up with the problem of the system. With very little
excess gold coming into the stocks of central banks from the private
market, and the US dollar the only alternative component of reserves, the
U.S. deficit was the principal means by which the rest of the world was
supplied with additional reserves. If the United States failed to correct
its balance of payments deficit, it would no longer be able to maintain
gold convertibility; on the other hand, if it corrected its deficit, the
rest of the world would run short of reserves and bring on slower growth
or, worse, deflation. The last scenario hinted at a repetition of the
problem of the interwar period.
Two basic solutions were
consistent with preserving the system. One solution was to raise the price
of gold. The founding fathers of the IMF had put a provision in the IMF
Articles of Agreement for dealing with a gold scarcity or surplus: a
change in the par values of all currencies, which would have changed the
price of gold in terms of all currencies and left exchange rates
unchanged. In the 1968 election campaign, candidate Richard M. Nixon chose
Arthur Burns as his emissary on a secret mission to sound out European
opinion on an increase in the price of gold. It turned out to be favorable
and Burns recommended prompt action immediately after the election.
Nothing, however, came of it.
The other option was to
create a substitute for gold. This course was in fact adopted. In the late
summer of 1967, international agreement was reached on an amendment to the
IMF articles to allow the creation of Special Drawing Rights (SDRs),
gold-guaranteed bookkeeping reserves made available through the IMF, with
a unit value equal to one gold dollar, or 1/35 of an ounce. Somewhat less
than SDR 10 billion were allocated to member countries in 1970, 1971 and
1972, but they proved to be inadequate—too little and too late--to meet
the main problems of the system.
On August 15, 1971,
confronted by requests for conversion of dollars into gold by the United
Kingdom and other countries, President Nixon took the dollar off gold,
closing the "gold window" at which dollars were exchanged for gold with
foreign central banks. The other countries now took their currencies off
the dollar and a period of floating began.
But floating made the
embryonic plans just forming for European monetary integration more
difficult, and in December 1971, at a meeting at the Smithsonian
Institution in Washington, D. C., finance ministers agreed on a
restoration of the fixed exchange rate system without gold convertibility.
A few exchange rates were changed and the official dollar price of gold
was raised but the act was almost purely nominal since the United States
was no longer committed to buying or selling gold.
The world thus moved onto a
pure dollar standard, in which the major countries fixed their currencies
to the dollar without a reciprocal obligation with respect to gold
convertibility on the part of the United States. But U.S. monetary policy
was too expansionary in the following years and, after another ineffective
devaluation of the dollar, the system was allowed to break up into
generalized floating in the spring of 1973. Thus ended the dollar
standard.
What lessons can be learned
from the second third of the century? One is that the policy mix has to
suit the system. Another is that a gold-based international system cannot
survive if war-related inflation makes gold undervalued and the
authorities are unwilling to adjust the gold price and create a sufficient
quantity of gold substitutes. A third lesson is that the superpower cannot
be disciplined by the requirements of convertibility or any other
international commitment if it is at the expense of vital political
objectives at home; the tail cannot wag the dog. A fourth lesson is that a
fixed exchange rate system can work only if there is mutual agreement on
the common rate of inflation. Europe was willing to swallow the fact that
the dollar was not freely convertible into gold in the 1960's, but when
U.S. monetary policy became incompatible with price stability in the rest
of the world (and in particular Europe), the costs of the fixed- exchange-
rate system were perceived to exceed its benefits.
A final lesson is that
political events, and in particular the Vietnam War soured relations
between the Atlantic partners and created a tension in the 1960's that can
only be compared with the pall cast over the international system by
disputes over reparations in the 1920's. Fixed- exchange- rate systems
work better among friends than rivals or enemies.
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