Allan H. Meltzer’s critically acclaimed history of the Federal Reserve is the most ambitious, most intensive, and most revealing investigation of the subject ever conducted. Its first volume, published to widespread critical acclaim in 2003, spanned the period from the institution’s founding in 1913 to the restoration of its independence in 1951. This two-part second volume of the history chronicles the evolution and development of this institution from the Treasury–Federal Reserve accord in 1951 to the mid-1980s, when the great inflation ended. It reveals the inner workings of the Fed during a period of rapid and extensive change. An epilogue discusses the role of the Fed in resolving our current economic crisis and the needed reforms of the financial system.
In rich detail, drawing on the Federal Reserve’s own documents, Meltzer traces the relation between its decisions and economic and monetary theory, its experience as an institution independent of politics, and its role in tempering inflation. He explains, for example, how the Federal Reserve’s independence was often compromised by the active policy-making roles of Congress, the Treasury Department, different presidents, and even White House staff, who often pressured the bank to take a short-term view of its responsibilities. With an eye on the present, Meltzer also offers solutions for improving the Federal Reserve, arguing that as a regulator of financial firms and lender of last resort, it should focus more attention on incentives for reform, medium-term consequences, and rule-like behavior for mitigating financial crises. Less attention should be paid, he contends, to command and control of the markets and the noise of quarterly data.
At a time when the United States finds itself in an unprecedented financial crisis, Meltzer’s fascinating history will be the source of record for scholars and policy makers navigating an uncertain economic future.
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About the Author
Allan H. Meltzer is the Allan H. Meltzer University Professor of Political Economy at Carnegie Mellon University and a distinguished visiting fellow of the Hoover Institution.
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A HISTORY OF THE Federal Reserve
By ALLAN H. MELTZER
THE UNIVERSITY OF CHICAGO PRESSCopyright © 2009 The University of Chicago
All right reserved.
Chapter OneInternational Monetary Problems, 1964–71
A worldwide system of flexible rates would, I very much fear, be a continuous invitation to economic warfare as countries maneuvered their rates against each other-or more charitably, influenced their own rates to reflect in each case the immediate interest of the country concerned. There then would be no widely recognized established rate levels, and no presumption of any obligation to maintain rate stability.... "I doubt that forward markets could ever as a practical matter get started in any currencies—except perhaps at discounts so large as to make the nominal markets meaningless"
—Robert V. Roosa, in Friedman and Roosa, 1967, 50–52.
Robert Roosa, the person most directly responsible for international economic policy in the first half of the 1960s as Treasury Undersecretary, believed flexible exchange rates were impractical and unworkable. Markets could not be relied on to determine exchange rates. Only some version of a pegged exchange rate system, even if encumbered by controls, could be made to work satisfactorily. A principal reason was that all major countries had adopted full employment as their principal policy goal. That idea dominated international monetary policy in the 1960s.
The United States adopted two major pieces of economic legislation affecting economic policy in the 1940s, one domestic (the Employment Act) and one international. The Bretton Woods Agreement, in practice, became an international dollar standard. United States policy was responsible for maintaining the dollar price of gold at $35 an ounce. This objective required monetary policy either to accept the inflation rate or price level consistent with the $35 gold price or to pursue a domestic employment goal by adopting controls and restrictions on trade or capital movements. Roosa chose capital controls.
The domestic and foreign objectives were often in conflict. Several administrations and the Federal Reserve gave most attention to the domestic effects of its policy. The Federal Reserve regarded the balance of payments and the exchange rate as mainly administration problems. Administrations chose to maintain high employment and to reduce the unemployment rate as much as possible. Policy did not totally ignore the balance of payments problem, as it was known, but government was reluctant to accept an increase in the unemployment rate, however temporary, to achieve an international policy objective. It relied instead on (1) a growing number of controls on capital movements to reduce the number of dollars going abroad, and (2) policy adjustments in countries receiving dollars to maintain existing exchange rates. During the 1960s, particularly after 1965, the United States did not have a long-run policy. It met each crisis with a short-run bandage.
Negotiators of the Bretton Woods Agreement spent much effort on preventing a return of deflation. They did not expect or plan for inflation. As Eichengreen (2004, 7) notes, the two principal negotiating countries had different objectives. The United States wanted a system that would maintain stability; the British wanted more policy flexibility. All of the concern about deflationary policy focused on avoiding repetition of United States policy in the 1920s. The principal surplus countries in the 1960s, Germany and Japan, were reluctant to appreciate, just as the United States had been in the 1920s.
In practice, U.S. inflation became the principal source of problems after 1965. Foreign governments complained repeatedly about the inflationary impact on them arising from their dollar receipts. It forced them to choose between allowing their prices to increase, increasing controls on capital movements, and revaluing their exchange rates. They didn't want to do any of the three; in particular, they did not want to take any action that would reduce their exports and employment. They wanted the United States to solve the problem without slowing its growth enough to slow their growth and employment more than marginally.
The Bretton Woods system had a short life, both because member countries' objectives and policy were dominated by maintaining full employment and because the agreement in practice had a flaw. Countries other than the United States did not have to inflate or deflate. They could revalue or devalue their currencies against gold and the dollar when their exchange rates were misaligned. In practice the system's operating rules did not permit the United States to devalue, and both Roosa and President Kennedy opposed devaluation. The general belief was that if the United States devalued against gold, other countries would follow by keeping their dollar exchange rate fixed. Even so, devaluation would have increased the nominal value of the gold stock, solving the so-called liquidity problem that concerned policymakers in the 1960s.
Trapped between the unwillingness of countries to revalue their currencies in response to export surpluses and higher rates of growth on the one hand and the inability or unwillingness of the United States to devalue on the other, the System stumbled from crisis to crisis in the late 1960s. At the outset, in recognition of its historic position, the British pound was a reserve currency, akin to the dollar. However, Britain was, more than most, on an employment standard—determined to pursue Keynesian policies of demand growth to maintain full employment. A series of crises ending in devaluation in 1967 greatly reduced the pound's role as a reserve currency.
Between December 1965 and August 1971, when the United States unilaterally stopped selling gold, foreign official institutions (mainly central banks) accumulated $28 billion in dollar claims, an 18 percent compound annual rate of increase (Board of Governors, 1976, 934; 1981, 346). Most countries held these balances in U.S. Treasury bills.
France was an exception. The French government complained that the United States had a unique position. Its citizens could acquire assets and goods abroad, making payments in their own currency. Other countries had to hold the dollar as part of reserves; the United States received seigniorage. This complaint was a restatement of French complaints about the gold exchange standard in the 1920s; France (and others) could not do what the United States could do. Excess supplies of French francs required French disinflation or devaluation; excess supplies of U.S. dollars required France (and others) to inflate or revalue. The United States had to pay the interest cost only on the dollar assets that others accumulated.
Stepping back from the many discussions and policy actions to look at the system's evolution shows a steady increase in liquid dollar liabilities to foreigners and the nearly steady decline in the U.S. monetary gold stock available to convert the remaining dollar liabilities into gold. Claims against the stock passed the U.S. gold stock in 1960. By 1965, the claims were more than twice the stock, by 1968 more than three times. Legislation in 1965 first removed gold reserve requirements against bank reserves and in 1968 against currency. This made the entire gold stock available. These actions that were intended to show willingness to support the fixed gold price also called attention to the gold outflow and the ineffectiveness of U.S. policy. Table 5.1 shows these data.
By 1970, liquid liabilities to foreigners were four times as large as the available gold stock. Although the U.S. gold stock stopped falling in 1968 after an embargo was in place, claims or potential claims continued to rise. In the first nine months of 1971, claims rose an additional $21 billion. There was no sign that claims would slow, and no prospect that they would reverse. By 1969 the breakdown of the system would not surprise U.S. policy officials. They did not know when it would occur, but they expected it would. And they understood that any large claim to convert dollar liabilities into gold was likely to trigger a run that could exhaust the remaining stock.
Discussion of these problems went on for several years. Presidents and high officials promised repeatedly to maintain the $35 dollar per ounce gold price, but they did not say how they expected to do so. Officials spoke repeatedly about the three problems of the international monetary system—liquidity, adjustment, and confidence. In practice, they resolved the liquidity problem by producing the special drawing right (SDR) in 1968, a substitute form of international currency to supplement gold and dollars in settlements between central banks. This was a solution to the so-called Triffin problem, discussed in chapter 2, making the international monetary system less dependent on the supply of U.S. dollars. By the time countries agreed on this solution, international reserves were rising rapidly. The SDR did not have much effect or much influence on subsequent events.
The problem that policymakers failed to solve, and rarely discussed, was the adjustment problem—how to get more flexibility in exchange rates. In the 1920s, the unresolved problem of the fixed exchange rate system was the absence of an adjustment mechanism acceptable to the participants. Then, the pound was overvalued, the franc undervalued. Britain would not deflate; France and the United States would not inflate. The system broke down, but the policymakers learned nothing. In the 1960s, the dollar was overvalued. The United States would not deflate or disinflate; the Europeans and Japanese disliked inflation. Again, countries would not adjust exchange rates. The Bretton Woods system ended in the same way; the fixed rate system collapsed.
In the 1920s, the nearly universal system of fixed exchange rates lasted from about 1925‐27 to 1931, when Britain and several other countries left the gold standard. The Bretton Woods system lasted longer, but less than ten years—from the beginning of currency convertibility in January 1959 to March 1968, when the United States embargoed gold de facto. In the next few years, the system limped along until President Nixon made the gold embargo absolute in August 1971.
The usual explanation of the failure of Bretton Woods invokes the impossibility of reconciling free capital movements and currency convertibility, fixed exchange rates and full employment. The conflict between fixed exchange rates and the full employment policies was the principal problem in the late 1960s. The choice was never a serious issue for the United States; the Johnson and Nixon administrations always chose employment. The Federal Reserve retreated behind the institutional fact that the Treasury and the administration were responsible for international economic policy.
There are four possible solutions to the adjustment problem (Friedman, 1953): (1) devaluation against gold and major currencies, (2) deflation, (3) borrowing as long as foreigners would lend, and (4) imposing controls of various kinds. Some of these solutions could be achieved in different ways. For example, countries could revalue their currency relative to the dollar. Or, foreigners could inflate faster than the United States. In practice, the United States relied mainly on three and four, usually to a degree insufficient to solve the long-term problem.
The system might have continued if price adjustment had occurred promptly in response to domestic policy choices, differences in productivity growth, changes in the extent of capital mobility, and the like. Flexible prices would have adjusted domestic real wages and the real exchange rates, avoiding the domestic policy problem and the misalignment of the dollar exchange rate. One factor strengthening wage and price downward rigidity was the growing belief that policymakers would not end inflation.
The Bretton Woods Agreement reflected the problems of the interwar gold exchange standard. The authors could not foresee the rapid postwar growth in Europe and Japan, the permanent change in their relative real output and productivity, and the need to adjust real exchange rates to the permanent changes that occurred. The agreement recognized that adjustment to structural (i.e., permanent) changes would occur, but it left to each country to decide how and when to make the change. Countries were slow to recognize the need for appreciation, slower still to implement it.
Japan, West Germany, and France illustrate two extremes. The yen remained fixed at 360 to the dollar throughout the period. The Bank of Japan and the Japanese government accumulated dollar assets, mainly short-term instruments. Monetization of the dollar inflow increased Japan's money stock. Japan's price level rose more rapidly than the U.S. price level, especially in the early 1960s. The real exchange rate appreciated against the dollar by about 25 percent. Chart 5.1 shows the yen-dollar exchange rate adjusted for consumer price level changes.
The West German government and the Bundesbank tried to limit domestic inflation. In 1961 and 1969, the government revalued the mark against the dollar; taken together, the mark appreciated by 12.5 percent. Inflation rates were similar for the period as a whole, so the real exchange rate appreciated much less than the yen-dollar exchange rate and much less than needed to reduce the persistent German payments surplus. Chart 5.2 shows these data.
The French franc appreciated against the dollar during the early and mid-1960s (Chart 5.3). In 1969, France depreciated its exchange rate, restoring about the same real exchange rate as in 1960. Although France drew regularly on the U.S. gold stock, it did not permit its gold purchases to adjust its real exchange rate.
In contrast to the bilateral real exchange rates, the deflated price of gold shows a steady decline during the postwar years after 1949. By September 1959, the real price of gold had fallen back to the level reached in October 1929 (Chart 5.4). Price increases had fully offset the nominal revaluation of gold in January 1934. Between autumn 1959 and the closing of the gold window in 1971, the real price of gold declined an additional 3.3 percent to a level far below any price during Federal Reserve history to that time. No wonder many observers expressed concern about the scarcity of gold for transactions. A 50 percent increase in the nominal gold price, to $52.50 an ounce, would have restored the real price to the 1956 level and increased the 1965 U.S. gold reserves to more than $21 billion, more than enough to maintain the fixed exchange rate system for several years or longer.
An increase in the dollar price of gold would have increased international liquidity and adjusted the dollar to the permanent postwar changes. Political considerations—including concern about benefits to South Africa and the Soviet Union, but also beliefs about response by Europeans—ruled out that solution. An adjustable gold price, such as Fisher's compensated dollar, would have adjusted the dollar-gold price based on changes in an index of commodity prices. This would have solved the confidence problem by keeping the system close to equilibrium and reduced adjustment and liquidity problems.
Bordo (1993) showed that during the short life of the Bretton Woods system, which he dates as 1959-70, developed economies experienced relatively high and stable growth and relatively stable prices compared to other international monetary systems. For these years, the mean inflation rate rose 3.9 percent in the countries that are now members of the G-7.11 This is higher than the low inflation rate during the years of the classical gold standard, 1881-1913. Real per capita growth during these years was substantially higher than in any other period in Bordo's table (1993, 7). The relatively low standard deviation of the seven countries' inflation rates shows up again in the relatively modest mean change in the real exchange rate.
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).
The experience of the 1920s and the 1960s taught a common lesson: fixed exchange rate systems rarely last long in the contemporary world. 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 long-term problem of an overvalued real exchange rate.
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Table of Contents
5. International Money Problems, 1964-71
6. Under Controls: Camp David and Beyond
7. Why Monetary Policy Failed Again in the 1970s
9. Restoring Stability, 1983-86
10. Past Problems and Future Opportunities
Epilogue: The Global Financial Crisis