Afterglow or Adjustment? Domestic Institutions and Responses to Overstretch

Mark R. Brawley

Columbia University Press

1998

3. Afterglow Avoided?: The Federal Reserve, the Treasury, and the Breakdown of Bretton Woods

 

If the British case provides us with an example of the political and economic consequences of responding to an overhang with policies of afterglow, then the American case shows how the more damaging aspects of afterglows may be avoided. The Bank of England tried to save the gold standard, even when that effort hurt other parts of Britain’s economy; why did American policymakers, when faced with similar circumstances, decide to abandon the monetary regime they had created? Naturally, we will again focus on the origins of the central bank, and link its design to the pursuit of international liberalization. Yet once an overhang developed, the response differed. One of the more obvious possible explanations is based on the large size of the American domestic market. This might have made American decisionmakers more willing to sacrifice international economic connections for domestic goals. Unfortunately, this argument lacks consistency. Calculations of internal versus external gains alone may appear to explain U.S. policies of the early 1970s, but they are less persuasive for explaining the policies of the 1980s. A more compelling argument, able to explain monetary policy in both decades, stresses the importance of rival international financial centers and fiscal deficits.

In order to understand institutional design and give the afterglow hypothesis full play, it is first necessary to examine the creation of the central bank, and its early development and role in U.S. liberal leadership. Identifying the characteristics of the American dollar prior to the founding of the Fed sheds light not only on the pressure for domestic reforms, but also for understanding where the dollar stood vis-à-vis the pound. Though the pressures for assuming the leadership in international liberalization were quite similar to those in the British case, the adjustments necessary for making the dollar more attractive to foreigners were quite different.

 

The Economic Rise of the United States

As in the British case, the key factor in the American ascendance to liberal leadership was a rapid accumulation of capital. Not only was there a rapid increase in the relative capital abundance of the United States, but this change also altered the structure of American business, including the introduction of some instabilities. During the years 1897&-;1904 business rapidly increased its capitalization via the sale of stocks, which in turn sparked a growth in mergers. Just as Britain’s financial system had become less stable in the early decades of the nineteenth century, the U.S. financial system too became increasingly unstable at the end of the 1800s. ₁ One of the monetary consequences of this rise in capital abundance was a dramatic increase in the gold held in the United States. The country’s total gold stock increased from $589 million in 1896 to close to $2 billion in 1913. This accounted for almost a quarter of the world’s total supply of monetary gold, and most of it (worth $1.3 billion—more than the reserves of the Bank of England, the Bank of France and the Reichsbank combined) was held by the U.S. Treasury Department. Private holdings of gold and other assets increased enormously as well. ₂

The increase in the relative abundance of capital was a national phenomenon—signifying the declining domination of New York as the only major source of capital in the economy. Importantly, too, the national banks were declining in relative weight in comparison to non-national banks; in 1896 non-national banks had been 61 percent of the total, with control over 54 percent of total banking resources, but by 1913 those figures had risen to 71 percent with 57 percent of the total banking resources. ₃ Thus the period of rapid accumulation of capital coincided with a great proliferation of weaker financial actors, as had occurred in Britain when that country had gone through a similar phase of capital accumulation.

Unlike the British case, however, this rise in weaker financial actors did not undermine confidence in the currency, as in Britain these weaker banks had been able to expand credit in ways that brought sterling’s value into question. During the rise of the U.S. to liberal leadership, the public retained confidence in the currency. The U.S. had been on a de facto gold standard since 1879, when the Resumption Act of 1875 took effect. This law required the Secretary of the Treasury to redeem U.S. legal tender notes in coin; since silver coins were not issued after 1873, only gold was in use. ₄ Yet the political choices surrounding the gold and silver coins remained open until the Currency Act of 1900 put the U.S. clearly on the gold standard and ended any questions about the international value of the currency. With an established currency already treated as legal tender, the rising number of weak financial actors did not alter confidence in the currency. As with other gold-standard currencies, confidence was high—but confidence came at the cost of liquidity. The requirements of maintaining confidence made it impossible to alter the amount of currency in circulation when needed.

 

The Shortcomings of Existing Monetary Institutions

Before the founding of the Federal Reserve System, the Treasury had performed some of the functions of a central bank. Already, the National Banking system had created a relatively uniform currency, by setting the same backing (government securities) for notes issued by nationally chartered banks. ₅ Therefore some of the basic problems the British had had to deal with, such as establishing a paper currency of uniform strength, and making it legal tender, had already been resolved. The Treasury also acted much like a central bank in that it tried to move funds in and out of different national banks to stabilize regional money markets. Such efforts prior to 1900 had met with limited success, however. Under Secretary Leslie M. Shaw (1902–1907), the Treasury developed its most aggressive intervention and stabilization policies. Shaw even began intervening in foreign exchange markets to stimulate incoming flows of gold when needed. The obvious flaw with this method of stabilization was that the only resources available to the Treasury were its excess funds—in other words, the Treasury needed a large surplus to play with, and could not do much at all if it was short of funds. ₆

These stabilization efforts were important, because with such a sound currency, a liquidity shortage was a constant threat. Because the previous legislation had enhanced confidence while making it very difficult to increase liquidity when needed, the banking system was especially vulnerable to panics. In an effort to resolve these problems by following the precedent set by the British banks caught in similar circumstances after the empowerment of the Bank of England, some banks had banded together to pool their resources during emergencies and thereby provide some insurance against runs. The New York Clearing House Association had been developed as a scheme to bring banks together to serve as lenders to each other during a crisis; it had failed to function as well as had been hoped, however. In a serious crisis, additional liquidity could only come from importing gold. A liquidity crisis in the U.S. could quickly draw down international liquidity. ₇

In the Panic of 1907, large-scale international funds could not be found. The need for reforms could no longer be ignored. The challenge was not to enhance confidence in the currency, but rather to develop methods for expanding liquidity whenever a run on banks began. The Panic of 1907 underlined problems in the relationship between New York and the rest of the country, since it proved impossible to move funds from locales where they were available to those where they were needed with enough speed to stem the panic. ₈ Since foreign sources of liquidity were not forthcoming, the need for domestic measures was obvious.

The first reform legislation designed to deal with these problems was the Aldrich-Vreeland Act (passed in May 1908), which permitted banks to group together in associations which in turn were empowered to issue emergency currency in a panic. Each association would hold reserve assets deposited by members. ₉ This legislation was based on the Republican-sponsored Aldrich Plan, which reflected Wall Street interests. The Aldrich Plan was drawn up by several important representatives of the New York banks (Frank A. Vanderlip of National City Bank, Henry P. Davison of the Morgan Bank, and Paul Warburg from the investment firm of Kuhn, Loeb) who had met at the resort Jekyll Island. The Aldrich Plan called for the creation of a National Reserve Association (divided into 15 regions) which would provide liquidity (or “currency elasticity” in the terms they used) when needed; the Association would be sanctioned by the government, but controlled by commercial bankers. ₁₀

Because of its links to powerful New York bankers, Congress received the Aldrich Plan with some skepticism, and soon modified it. The final product, the Aldrich-Vreeland Act, still included many of the bankers’ wishes. Yet these reforms were considered defective, since the Reserve Associations established were not comprehensive. Weak banks remained, and whenever one experienced difficulties, the public’s inability to discriminate between strong and weak banks could still cause a panic to spread. Since bankers and reformers doubted the ability of the Reserve Associations to limit future crises, debate continued. The Federal Reserve System emerged from these concerns, so liquidity provision was a paramount element in the new institution’s design. The Federal Reserve Act sought to overcome currency inelasticity, and also to improve bank reserve requirements. ₁₁ Thus despite their roots in similar general economic patterns, there were significant differences in the monetary problems facing Britain and the U.S. during each country’s hegemonic ascendance. The two institutions created were intended to resolve different aspects of a similar dilemma—balancing the currency’s confidence and liquidity so that it could serve as an international medium of exchange.

In the British case, liquidity had to be reduced to instill the level of confidence necessary for sterling to play a greater international role. In the American case, confidence was not in question because growth in liquidity was so tightly restricted—the problem was how to loosen up liquidity without undermining confidence in the currency. The decentralization of the financial system meant that even when reserves were relatively high across the system in total, it was difficult to move reserves to where they were needed when a panic began. The reformers’ main concern was the threat posed by a liquidity squeeze and the resulting banking crises (other issues such as price stability or strength of the currency were not major elements of the debate). ₁₂ International factors also played a more direct role in the discussions, since measures to develop monetary instruments attractive in international affairs also generated keen interest (as will be discussed below).

Another critical difference in the American versus the British political debates can be traced to the financial center’s relationship with other actors. In the British case, the problems were blamed on the irresponsible and reckless actions of the country banks, therefore the political debate centered around giving London-based financial concerns their goals by restricting the provincial banks’ practices. In the U.S. case, the banking community could not be so neatly divided. Carter Glass, chairman of the House Banking Committee, believed in the need to centralize resources, but he also feared that Wall Street bankers would dominate a single central bank. Since Glass wanted a central bank to represent broader interests, he proposed a system of regional banks, who, if cooperating, could resolve the need for centralization without trading off representation. ₁₃

Representatives of the New York financial sector disagreed. Benjamin Strong, later to serve as head of the New York Federal Reserve Bank, originally argued very forcefully for a single central bank. In the end, he accepted the system of regional banks. Strong was merely promoting the New York banks’ concerns and wishes; they wanted to ensure confidence in the dollar’s convertibility into gold to facilitate the dollar’s rise as an international currency, and hence the rise of New York as an international financial center. ₁₄ Strong therefore argued that the best solution would be for a single actor to manage the national supply of currency and credit in defense of the dollar’s value, much as the Bank of England defended the value of the pound.

Another critical difference between the two cases is that the United States did not have an existing institution to fall back on, once the Treasury was ruled out. There was no single national bank which could be empowered, as Britain had done. Any central bank would have to be created from scratch, and would therefore be a political institution, not a private one. This also presented the opportunity for the creation of channels of political influence. For example, President Woodrow Wilson developed the concept of the controlling Federal Reserve Board, to sit in Washington with executive branch officials as members. In Wilson’s view, the Federal Reserve Board would serve as the President’s force within the Fed. ₁₅

While the politicians pushed for their own ends, sectoral interests were also at the forefront of the debates over the design of the Fed. Recent analysis has emphasized the important role of internationally oriented economic interest groups in the creation of the new central bank. ₁₆ Of critical importance were the New York bankers, who supported the creation of an institution that could provide liquidity during a time of crisis, but who also pushed for narrower goals as Strong had urged. These internationally oriented bankers wanted an expansion in the use of bankers’ acceptances (i.e., bills of exchange that had already been discounted by a bank), in order to compete directly with European practices. It was hoped that any reforms would include support for the use of these instruments, thereby allowing more use of short-term credit and supporting the banking community’s involvement in international trade and finance. At the time it was easier to put funds into riskier endeavors, namely stock market speculation, than it was to finance trade. Wider use of bankers’ acceptances could also reduce domestic illiquidity, since use of acceptances would enhance the flow of funds across regions as well. ₁₇

To serve both the international and domestic goals, the New York banking community suggested that provisions be made for the new central bank itself to discount bills of exchange, in order to develop a market for them in the U.S. ₁₈ The international trading community had argued that British merchants had an advantage over their American competitors when financing their trade because British exporters were able to discount bills of exchange, which could then be rediscounted at the Bank of England. (In other words, in Britain merchants’ transactions could create credit on their own; that credit could be converted into cash at banks; the banks could then take the bills to the Bank of England for cash.) With the addition of a central bank that would rediscount bills of exchange, a more liquid market for bills would be created, and the risks individuals faced upon entering this market would be greatly reduced. ₁₉ Moreover, the liquidity of the system would more accurately reflect the level of economic activity. ₂₀

Other economic sectors were heard from as well. The National Citizens’ League for a Sound Banking System, organized in Chicago in May 1911 under the leadership of J. Lawrence Laughlin, was business- rather than bank-oriented. In its publications supporting the Federal Reserve Act, it listed numerous goals, including the need to centralize bank activity without giving control to narrow interests, to create greater liquidity to meet emergency needs as well as seasonal fluctuations, and to strengthen the market for bills of exchange in order to support trade. ₂₁

In short, the same general pattern of political economic change emerged as observed in Britain in the early 1800s. As capital was accumulated, and the comparative advantage of the American economy shifted, groups pressuring for access to foreign markets emerged; heightened competition among financial actors also resulted in instabilities in the financial system. These forces combined to give birth to a new institution, designed to overcome financial instabilities, enhance the ability of the national currency to serve as an international medium of exchange, and to give U.S. actors a greater role in the international economy.

 

Political Compromise and the Fed’s Design

The Federal Reserve Act created an institution designed to deal with the specific manifestations of problems emerging from the underlying economic changes: decentralization of the financial system, low liquidity in currency, cumbersome transfer facilities, and an inadequate government depository system. ₂₂ The preamble to the Act states its purpose as “To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States and for other purposes.” ₂₃ Note that two of the most prominent desires of the internationally oriented capital-intensive sectors (expanding liquidity and rediscounting bills) were identified as goals of the legislation.

In choosing members to serve on the Federal Reserve’s Board of Governors, the President was (and still is) supposed to give due regard to a fair representation of not only the financial, but also the agricultural, industrial, commercial, and regional interests of the country. ₂₄ The President’s seven appointees are confirmed by the Senate. Whether or not these appointees represent a broad spectrum of interests, it was clear that political control over this central bank would be greater than that exercised over the Bank of England after its empowerment. Of even greater importance was the decision to divide the Federal Reserve into regional banks, which ensured that different sectors were heard. There is an obvious connection to the federal structure of the U.S. government, and the fact that the Congress designed the central bank. The Federal Reserve Act required all national banks to join the system, and opened up membership to any state-chartered bank that could meet the requirements. System members purchase stock in the Federal Reserve, and must comply with membership rules, and also receive the right to elect the board of directors at the regional reserve bank. ₂₅

The Fed meets our definition of a central bank, because it controls the supply of money and credit. This control was initially quite limited, however, by the utility of the policy instruments placed in the Fed’s hands. The Fed was originally given one basic tool to control the supply of money and credit, but then later developed two others. The first policy instrument placed at its disposal was the discount rate, which is the amount charged to banks when they borrow from the Fed. This affects liquidity since it can be used to manage the amount of funds banks have, but note that this was a one-way tool. The discount rate was only effective as a means to expand the money supply, since it could be lowered to encourage new borrowings when there was a shortage, but when liquidity was too high changes in the discount rate had little effect, since no banks would wish to borrow from the Fed anyway. A second instrument, developed only later, was the reserve requirement placed on member banks. The legislation establishing the Fed required banks to hold a percentage of funds against deposits at a fixed ratio. Only later was this legislation altered to entrust the Fed with the discretion to shift this ratio. Only by adjusting the amount of reserves banks must hold could the Fed not only expand but also contract liquidity. The third tool was open market operations, directly influencing market returns via intervention. This policy instrument was developed through practice, and only later recognized by legislation. At its inception, then, the Fed only had an instrument to provide more liquidity, but not one to reduce the supply of money and credit. Only later would it develop the powers to control both the rise and fall of liquidity, and truly manage the balance between confidence and liquidity. ₂₆

In terms of its international aspects, the Federal Reserve Act contained most of the same positions endorsed in the Aldrich Plan (which had been turned down as too biased toward the interests of the New York bankers). ₂₇ The legislation explicitly delivered an institution that could rediscount bills of exchange, and expand liquidity whenever it was necessary to stave off panics. Thus while we see an overlap between domestic and international goals, the increasing internationally oriented interests help explain why these changes occurred when they did, rather than before.

 

The Financial and Fiscal Impact of World War I

While many recognize that World War I hastened the financial and economic ascent of the U.S., and the rise of New York as a financial center rivaling London (as noted in the previous chapter), fewer people appreciate how much the creation of the Fed facilitated this transformation. ₂₈ Without such an institution, the previously unstable American financial system would have experienced difficulties supporting the flows of vast sums of money to the Allied governments during the War. The Federal Reserve Act had created an institution designed primarily to expand the money supply when seasonal demands or emergencies required. The Fed’s designers had not intended the institution to manage both expansion and contraction of the money supply. ₂₉ As seen with the Fed’s policy instruments, the institution was aimed only at expanding the money supply. Whereas the Bank of England was empowered as a central bank to contract the money supply to support confidence, the Fed was designed to ease the growth of the supply of currency and credit. (Again, we might note that despite the intensive investigations and discussions about the duties and obligations of the new central bank, domestic lender of last resort functions mattered little, in either case, in their initial stages.)

Unlike the Bank of England, the Fed was not able to consolidate its position free of interference from other monetary authorities. The great pressures of government financing (brought on by America’s entry into World War I) sparked a conflict between the Fed and the Treasury. Federal government debt rose from $1.225 billion in June 1916 to more than $25.834 billion in December 1919. ₃₀ The Treasury put pressure on the Fed to lower interest rates, so that the Treasury could finance the war budgets more cheaply. ₃₁ On the other hand, the Fed began handling government finances, and proved so adept at doing so that the Independent Treasury System was finally closed down in 1920; the Federal Reserve Banks acted as agents for the Treasury. ₃₂ The Treasury had previously conducted its own transactions through its network of “subtreasury offices” which it sought to retain, but Congress refused to renew the subtreasury offices’ operating budget in 1921. ₃₃

The Treasury and Fed worked together to concentrate gold and gold certificates in Federal Reserve Banks, and to put Federal Reserve Notes into circulation. While private citizens were never denied their right to redeem certificates for gold, they were discouraged from exercising that right by numerous frustrating regulations. Foreign exchange operations and gold exports were controlled more directly. In these ways the U.S. defended its supply of gold and managed to stay on the gold standard throughout World War I. ₃₄ International confidence in the currency was supported by both institutions.

Part of the rapid expansion in the money supply had been intended by the reforms undertaken, since improving liquidity was a central goal. The Federal Reserve Act changed the reserve requirements banks faced, and did so in a fashion designed to provide greater liquidity immediately. Before November 16, 1914, banks in municipalities designated as central reserve or reserve cities were required to hold funds equaling 25 percent of deposits, while other banks held 15 percent. The Federal Reserve Act lowered these figures to 18 percent in the central reserve cities, 15 percent in reserve cities, and 12 percent elsewhere. This freed up some $465 million in reserves at the same time that gold came flowing in from abroad (escaping risks associated with the outbreak of World War I). In less than three years, the volume of deposits and currency would grow from $20 billion to $28 billion. The Fed could do nothing to prevent an overexpansion of liquidity, for it had no real tools for contracting the money supply. It had yet to develop its other policy instruments, and since the banks had no need to turn to the Fed for resources, the discount rate was powerless. ₃₅ Thus the Fed quickly faced a situation its empowering legislation had not anticipated.

On the other hand, the development of bills of exchange as monetary instruments was rapid and positive. Greater business activity and inflationary pressures did make it harder to finance trade through traditional methods, so that the increased activity was largely financed by the use of bankers’ acceptances. This transition was possible thanks in large part to the success of the Fed’s rediscounting operations. In fact, this part of the legislation was so successful that the Fed’s powers to deal in acceptances based on imports and exports (covered by Section 13 of the Federal Reserve Act) was expanded in March 1915, and then again in September 1916. ₃₆

Because the national debt grew so rapidly during World War I (from $1 billion to $25 billion), it created the opportunity for the Fed to develop a new tool for discretionary policy—open market operations using not only bankers’ acceptances but also government securities. ₃₇ Originally, the designers of the Fed had thought that each Federal Reserve Bank would act independently in buying and selling government securities. It quickly became apparent that some regions lacked the necessary markets to support such activity. Those Reserve Banks in regions where the markets for securities were too shallow turned to New York, acting through the New York Fed, which emerged as the leader of the system because the east coast money centers had larger markets in rapidly maturing commercial loans to deal in (especially when compared to agricultural regions), and New York had the largest market of all. ₃₈ As early as 1916, Strong had proposed that all such operations be entrusted to a committee of Federal Reserve Bank governors, although this step was only taken in 1922 with the establishment of the Open Market Committee. The first obstacle in the working of open market activities was a dispute over where the earnings from such operations would go. ₃₉ This dispute illustrates one of the problems in coordinating the actions of the various Reserve Banks, which was worsened by the fact that there was an ongoing battle over who should set overall policy for the Fed.

As mentioned earlier, President Wilson had altered the original legislation by establishing a board to preside over the Federal Reserve. The Secretary of the Treasury and the Comptroller of the Currency sat on the Federal Reserve Board. Moreover, whenever the Secretary of the Treasury was present, he automatically chaired the Board meeting. ₄₀ Wilson had hoped that this would give the President control over central bank policy. The Federal Reserve Board, though, was relatively weak in the early days. It was based in Washington, with only a small research staff, and had to rely on the Reserve Banks for information. Strong, who had argued for a single central bank during the period when the Fed was set up, then tried to get the regional banks to cooperate more closely. He did his best as governor of the New York Fed to establish common policies and practices. But he actively resisted the attempts to coordinate the Reserve Banks under the leadership of the Federal Reserve Board, for he feared this was dominated by political appointees who placed too much importance on nonbanking interests. ₄₁ Strong was for centralization, but not for centralization under the direction of politicians.

This contest developed between the Federal Reserve Banks and the Treasury. The Fed Banks (under Strong’s informal leadership) and the Treasury had plenty to fight over. Most important was discount rate policy. The Fed wanted to raise the discount rate in an effort to counteract the expansion of the money supply, which the Treasury resisted since it would increase charges on the government’s debt. The completion of the Victory Loan issue in 1919, plus a small tax surplus that year, eased some of the Treasury’s problems so that the Fed was allowed to increase discount rates. The Fed was sensitive to Treasury concerns, as it did try to keep preferential rates for paper secured by Treasury obligations. ₄₂ By early 1920, though, Strong was arguing for a single higher discount rate supported by all the Federal Reserve Banks. Strong’s policy preference reflected greater concerns with the country’s financial position and the currency’s international appeal rather than national economic growth more generally. ₄₃

The Secretary of the Treasury opposed Strong’s plan of action—and the Secretary just happened to be Carter Glass, the man responsible for guiding the original Federal Reserve Act through Congress. Glass said that the Reserve Banks had to listen to the Reserve Board, whether they liked it or not, because that was the way he had understood the Federal Reserve Act when he was involved in its conception. He even got the Attorney-General to issue a legal report supporting this position. The letter of the Act said the Board had the power to review the discount rate policies of the Reserve Banks, not initiate them; but by successfully vetoing all policy actions but the one desired, the Board eventually made clear its intention to control the discount rate. ₄₄ Clearly when push came to shove, the U.S. Treasury was in a much better position to dominate policymaking than the British Treasury had been in during the 1920s.

As the use of market intervention with government securities increased, the governors of the Reserve Banks of New York, Boston, Philadelphia, Chicago, and Cleveland formed a committee (1922) to coordinate their purchasing and offering of government securities. This committee was originally meant to reduce any frictions created by independent actions, and to continue to support Treasury securities, though it later became a rival source of policy. Once it became clear that this Governors Committee might challenge the Federal Reserve Board’s powers, it drew opposition from the Treasury. The Treasury was also concerned with the amount of income the Reserve Banks were earning off Treasury Bills, due to the large amounts the Federal Reserve Banks held. After some debate, the Governors Committee was formalized and reconstituted, but under the control of the Federal Reserve Board. ₄₅ Once the Treasury got the Federal Reserve Banks to sell some of their Treasury Bills, the Reserve Banks discovered that it did not affect their own earnings substantially, but did have an effect on other banks’ reserves and money market activity. This inadvertently proved the utility of open-market actions, thus giving the Fed another policy instrument on top of the discount rate. The Fed used the instruments in tandem in 1924 to halt a deflationary turn and draw in international money. ₄₆ The Fed was still subordinate to the Treasury, though, since the Treasury had exerted control over policy through the Federal Reserve Board. ₄₇

 

Monetary Policy in the 1920s: Competing with London

World War I and its consequent economic changes not only altered the relationship between the Fed and the Treasury, they also affected the way many U.S. firms did business. The mix of the U.S. banking sector’s activities shifted in the 1920s. The composition of loans moved away from commercial activity and toward securities and real estate (including a growing emphasis on foreign securities). It is hard to gauge how important foreign holdings became, since foreign securities made up an average of 14 percent of all bank holdings during the 1920s, but the volume never rose above about 18 percent. ₄₈ It is also true that these and other overseas investments were not widely held, but instead were controlled by a concentration of important actors. ₄₉ Domestic opportunities were also increasing, as business firms turned to the securities markets to raise capital, and just at the same time as finance companies emerged as a source of consumer credit. ₅₀

Historian Lester V. Chandler argues that the Federal Reserve was already developing a new set of targets different from those intended by its founders. Prior to World War I, central banks on the gold standard were merely charged with protecting the country’s reserve position and complying with the rules of the gold standard. But by the mid-1920s, the Fed was concerned with the promotion of high and stable levels of economic activity without inflation, curbing speculation, and achieving the reconstruction of international monetary affairs. Each of these would take a much more aggressive government policy than the present leaders, including even Strong, were willing to support. (Strong opposed price stability as a legitimate goal for Fed activity, for instance.) ₅₁

As governor of the New York Reserve Bank, Strong believed that price stability could be important, but he also believed that the best route for internal price stability was a return to a world-wide gold standard. ₅₂ After World War I had ended, Strong had urged the U.S. to hold an international conference to resolve the issue of war debts; he argued that all payments should be suspended for up to five years (or even longer if possible), and that the payments be reduced as much as possible, with the U.S. government extending credits to countries in difficulty. ₅₃ Strong’s views reflected those of the internationally oriented financial firms based in New York, which saw gains from the United States leading the reopening of the liberal international economic system. Instead, official policy (set by the executive branch) refused to take on any burdensome obligations. The U.S. funding commission set up in 1922 to renegotiate debt repayments refused any reduction of the amounts outstanding. This stand prompted the U.S. to refuse to send an official participant to the Geneva Conference held in 1922, thus leaving it without representation in crucial international monetary negotiations. ₅₄

When Washington’s officials did support the interests of the internationally oriented financial sector, they did so in a heavy-handed and ineffective way. In the discussions surrounding the reestablishment of the Reichsbank, which Paul Warburg saw as a “unique opportunity for putting America’s discount market on the map and complete our position as world bankers,” U.S. officials argued that the Reichsbank should base its reserves on gold or currency convertible into gold (dollars, in other words, since no other currency was then available). Yet the City of London and the Bank of England were sure to block any policies that would force the Germans to hold large balances in New York, since that might steal away business and also make Britain’s return to the gold standard at the desired rate of £1 equal to $4.86 more difficult. ₅₅

Perhaps most interesting, although Strong was acting to support the rise of the U.S. as an international financial power, he foresaw the problems that could develop from playing such a role. His fears of losing control over the dollar due to an overhang prompted him (along with others in the U.S.) to oppose the movements toward a gold-exchange standard, for he wanted to preempt the rise of large dollar deposits held abroad. Such large foreign deposits might eventually weaken the Fed’s independence and its ability to manage the domestic money market. ₅₆ As Strong noted in a letter to Montagu Norman of the Bank of England dated July 14, 1922, “the domestic functions of the bank of issue are paramount to everything.” ₅₇ Thus even the most outward-looking officials in the Fed were still primarily concerned with the domestic sphere, and understood that the achievement of international monetary goals depended on creating a strong domestic financial base.

What is important then is to understand how Strong and others in the Fed viewed the rise of the U.S.—not as a potential liberal leader per se, but as a rival financial center to London. The pound and gold both had served admirably as international media of exchange, and it was undoubtedly apparent to the Americans that many of Britain’s monetary problems in the 1920s were due to sterling’s international role. While the Americans were interested in challenging British firms for business opportunities, they were not necessarily interested in seeing the dollar replace the pound completely. This view of rivalry is another dimension of difference between this case of currency adaptation for international use and the previous case. Whereas Britain had established the pound as the most important international medium of exchange in a period when no clear rival currency existed, the U.S. faced a different situation, with the pound and other strong European currencies already in existence.

In fact, with Britain fighting to retain its currency’s international role, the Bank of England had looked for bureaucratic allies to enhance the effectiveness of its tools—and the New York Fed offered the Bank of England support. When Britain was struggling to increase the value of the pound in order to get back on the gold standard, it was clear they would have to raise prices in Britain. To facilitate Britain’s return to gold, Strong urged the Fed to help raise prices in the U.S. in complementary fashion—something other Federal Reserve officials refused to do. ₅₈ Charges arose that the Fed’s activities were biased toward the goals of the internationalists. One such episode occurred in 1927, when there was a surge of gold flowing out of Europe and into the United States. Other central bankers appealed to the Fed to ease its policies and reduce its drawing power. Strong agreed, and so the New York Fed began dealing in government bonds and bills of exchange. This was unusual action for the Fed, for it was only the second time that the Fed had attempted to run a counter-cyclical policy. (The first had been in 1924, and again the goal was to help establish an international gold standard.) The key aim of policy was to establish and maintain an interest rate differential between New York and London to divert international funds to Britain, not to manage the relative money supply, domestic prices, or reserves. ₅₉ Strong hoped that not only would lower interest rates in the U.S. stabilize the two currencies, thereby lessening disruptive influences on trade, but also help New York attract business away from London. ₆₀

These actions ended the strong flows of gold and stabilized the international financial system, but Strong’s opponents argued that domestic economic goals had been subordinated to international needs. Worse still, because bank holdings were high, when extra reserves were released, the competition in lending caused banks to take on more risks which in turn merely fueled stock market speculation prior to the Crash of October 1929. ₆₁ Herbert Hoover (who had served as Coolidge’s Secretary of Commerce prior to becoming President) clearly linked the Fed’s international interests to its easy money policy and then on to the stock market speculation and crash. Others have argued, however, that while Fed policy was slanted toward international goals in 1927, when sterling was under pressure in 1928–1929 the Fed followed a policy guided by domestic concerns. ₆₂ Since different Reserve Banks were doing different things, both interpretations have an element of truth.

Hoover had similar criticisms of his own appointee on the Federal Reserve Board, Eugene Mayer. As President, Hoover placed Mayer as head of the Board in 1930, but then came to believe Mayer was too preoccupied with international problems (such as Britain’s withdrawal from the gold standard in 1931). ₆₃ And when the Fed faced choices concerning domestic stability versus defending the gold standard in late 1931, the Fed placed more importance on the support for the commitments of the international regime. After Britain went off gold, and fears caused investors to begin to withdraw dollars from circulation in exchange for gold, the Fed responded by tightening monetary policy even though this was hard on the domestic economy. ₆₄

 

The Great Depression, the Glass-Steagall Act, and the Banking Act of 1933

The Fed’s response to the stock market crash and the subsequent downturn in the economy has been critically analyzed for decades. Most recent analyses confirm that the Fed continued to run pro-cyclical policies consistent with its original mandate—expanding the money supply only when demand from business dictated. Meaningful counter-cyclical reflationary policies were not attempted. ₆₅

Part of the Fed’s inability to develop an adequate or appropriate policy response rested with the limitations of its policy instruments. The Fed’s only useful tool for facilitating economic reflation was its open market operations. These needed to be expanded. The Glass-Steagall Act of 1932 permitted government bonds to serve as eligible paper in meeting the 60 percent collateral requirement for backing funds. This strengthened the impact of Federal Reserve Banks’ open market operations. ₆₆ In late 1931, when the Fed had tried to defend the U.S. position on the gold standard, it had been forced to use discount rate alone, which of course hurt an already weakened domestic economy. With government securities added to the range of assets that could back Federal Reserve Notes (although gold still had to make up at least 40 percent of the reserves backing the issue), the Fed had a new range of markets and resources to employ in interventions. ₆₇

In April, 1933, the U.S. went off the gold standard. The first step occurred when the Secretary of the Treasury halted the granting of licenses for gold exports, which was then backed up by an executive order. These actions occurred even though the U.S. stock of gold was quite high—as much as $4 billion worth, as against a monthly outflow of $22 million in March 1933, and inflows in January and February. Faced with the prospect of having the Fed raise its discount rate again, and thus push interest rates up when the economy was in such a bad state, the executive branch resisted. Instead of going off gold because reserves were no longer adequate, the Treasury pulled the U.S. off the gold standard in order to free the government to run inflationary policies to aid economic recovery. ₆₈ The executive branch feared that the U.S. would remain with gold-standard constraints while all other states dropped them.

As the Roosevelt Administration continued to feel that the Fed was uncooperative, they continued to pursue ways of circumventing the Fed’s powers. One significant step involved passage of the Gold Reserve Act of 1934. The President wanted to tilt the balance of powers between the Fed and the Treasury more in favor of the latter. According to the Act, the Treasury would take over the Fed’s gold holdings, and it would have greater powers to buy and sell gold at home and abroad which would give the Treasury greater control over the exchange rate. While there was wide agreement that any profits created by a devaluation of the dollar should go to the Treasury, there were those within the Federal Reserve who resisted these policies because they felt the Fed’s gold holdings provided much of its political independence. ₆₉

The Gold Reserve Act resulted in the creation of the Equalization Fund, designed along the same lines as the British Treasury’s EEA. In its public pronouncements, the Administration claimed that the fund was to serve as protection against internationally inspired disruptive movements of the exchange rate. In other words, the public explanation was that if Britain had developed a new policy instrument to manipulate exchange rates in its favor, then the United States needed such an instrument too, “to fight fire with fire.” Yet the new Equalization Fund also gave the Treasury important powers versus the Fed—as the Governor of the Boston Federal Reserve Bank claimed of the Gold Reserve Act, “This bill gives the Secretary of the Treasury such powers, of a permanent nature, that he could nullify anything we could do.” ₇₀

Whereas the British EEA was designed to adjust the exchange rate in ways that would make the government’s debts easier to handle, the U.S. fund was used to counter other countries’ devaluations, but more importantly, to separate out exchange rate questions from domestic policy so that domestic reflation could be pursued. ₇₁ The EEA had been attractive to the British Treasury precisely because it offered a way for that bureaucracy to pay low interest at home, but defend the value of sterling so that foreign denominated debts did not become more burdensome. For the U.S. Treasury, the appeal was similar—separate defense of the dollar from domestic policy as much as possible, in order to reduce interest rates at home and reflate the economy without weakening international confidence in the currency.

The Banking Act of 1933 formally set up the Fed’s Open Market Committee (FOMC). Earlier, in March 1930, the Open Market Investment Committee had been disbanded and replaced by the Open Market Policy Conference. This new body brought together representatives from all twelve reserve banks, in an effort to create a more comprehensive policy. Yet since the Conference lacked any enforcement mechanisms, each Reserve Bank could still do as it pleased. The FOMC is made up of seven members of the Federal Reserve Board, the President of the New York Fed, and four other regional bank presidents drawn from among the other regional banks (who rotate terms on the FOMC). ₇₂ This was Congress’s first legal authorization of open market operations, but it did not resolve the problem of enforcing the coordination of Reserve Bank actions, for the FOMC did not have authority over individual Reserve Banks.

Both the 1933 and 1935 Banking Acts resulted from Congressional disapproval of the Fed’s policies. In late 1932 and early 1933, bond prices had been falling, loan defaults were up, currency hoarding was becoming increasingly common, and therefore the pressure on banks was rising—yet when gold started to leave the country the Fed was forced to tighten money again, with the New York and Chicago Federal Reserve Banks raising discount rates and immediately sparking bank failures. ₇₃ To show its displeasure with such actions, Congress turned the temporary deposit insurance scheme of the 1933 Act into the Federal Deposit Insurance Corporation (FDIC) in the 1935 Banking Act. This served notice that other government policies could be created which could cover some of the Fed’s responsibilities (as defined by Congress) if the Fed were reluctant to carry them out. ₇₄ The 1933 legislation also gave the Federal Reserve Board the sole power to deal with foreign banks, in an effort to prevent the New York Fed from dominating international policy.

As we can see from the first two decades of the Federal Reserve System’s history, its position was constantly being challenged and redefined. Unlike the Bank of England during the middle of the nineteenth century, the Fed found itself under constant political pressure from the Treasury. It had to struggle to create and maintain its independence, and to develop stronger policy instruments. While it solved the immediate problems of the pre-World War I period by developing a market for bankers’ acceptances and expanding liquidity, it was not willing to act as a true lender of last resort and it was actually conceding control over exchange rates and interest rates to executive branch agencies.

 

Bureaucratic Struggles after the Legislation of the 1930s

The political battle over control of monetary policy was now joined. Pressure grew from the financial community to remove the Secretary of the Treasury and the Comptroller of the Currency from the Federal Reserve Board. The financiers argued that the Board needed to be depoliticized, and that this required these executive branch officials be removed. Congress responded by removing the Secretary of the Treasury and the Comptroller of the Currency from the Federal Reserve Board in 1935. The same legislation consolidated control of the system in a new position, that of Chairman of the Federal Reserve System. The Federal Reserve Board was also given more power in the FOMC, so that it could outvote the Federal Reserve Banks. ₇₅ Soon after this reorganization of the Fed’s policymaking bodies, the Fed faced more problems stemming from international connections. Gold entered the U.S. in large amounts, causing bank reserves and lending to increase. The Fed was concerned that boom-bust cycles might be emerging, so Reserve Banks argued for the selling of government bonds in order to soak up the excess reserves. The Fed finally took action by raising reserve requirements, therefore reducing the amount available for borrowing.

The executive branch was again displeased with the Fed’s actions. Secretary of the Treasury Henry Morgenthau was particularly unhappy with the Fed’s policy, as well as with the lack of consultation between the Fed and the Treasury. The Fed had pushed interest rates up, and therefore affected the Treasury’s own policies by forcing a higher interest rate on government bonds. Morgenthau retaliated by setting up the Treasury’s own open market operations. The Treasury’s Stabilization Fund would sell 90-day Treasury Bills, and then use the dollars raised this way to stockpile gold, which the Treasury would then add to or sell off, to counteract or “sterilize” international gold flows. The Treasury could thereby offset whatever impact international flows of gold had previously had on the domestic money supply. Just as important, it was an effective way for the Treasury to lower interest rates and counter the Fed’s policy. The Fed protested, but was forced to back down when the President threw his support in with the Treasury. ₇₆

The year 1936 also saw the first serious attempt in several years to reconstruct international agreements on exchange rates when the U.S., Britain and France signed the Tripartite Agreement (with Belgium, the Netherlands and Switzerland later agreeing to the same activities). While it was dealing with the immediate issue of a devaluation of the French franc, and paved the way for further international cooperation, it was significant for forcing countries to admit responsibility for their exchange rate movements. ₇₇

In the recession of 1937, Fed policies seemed to have no effect, with the only reprieve coming from fiscal policy, as the Federal government ran a deliberate deficit. ₇₈ Because of the changes in the mix of policy instruments (the Treasury’s development of the Equalization Fund, the Stabilization Fund, and the use of fiscal policy as a direct tool preferred over the indirect use of discount rate), the Fed’s importance declined significantly, which led some to argue that the Treasury had become “the real central bank” of the United States. ₇₉

How then should we think about American monetary ascendance prior to World War II? With the rise of the United States as a financial power, pressures had arisen to develop the dollar as an international currency. By and large, these pressures had been to develop policies and monetary instruments to allow New York and other American financial centers to compete with London—not displace London entirely. A new institution had been created, and monetary commitments had changed, but so had resources. The new institution had been limited in its freedom of movement by the Treasury, and by circumstances. Overcommitment had not occurred.

 

Hegemonic Ascendance: World War II, Korea, and the 1951 Fed-Treasury Accord

During the 1930s the Treasury appeared to establish a dominance over the Fed. This dominance, to whatever degree it existed, was short-lived, for once the United States began to rearm to face foreign threats the Treasury would need the Fed’s support. Just as World War I had increased the national debt, and thus placed the Treasury in greater conflict with the Fed, so did World War II. It remained unclear as to which institution had ultimate authority over monetary policy. The war established the U.S. as the leader of the liberal economic subsystem, and the U.S. government accepted the obligations of leadership, thus making it more urgent for the two institutions to work out their relationship.

The obvious problem during the war was that the Treasury needed to float an immense amount of government debt, which it wanted to pay consistently low interest on. The Treasury argued that because the Fed’s first responsibility in such a national emergency was to assist in the servicing of this debt, Fed policies should be aimed at keeping a stable market with low interest rates where the Treasury could sell securities. The Fed cooperated fully with the Treasury’s demands during the war, much as it had during World War I. But after the war ended, the Fed began to push for greater freedom in policy, even though the government debt was still quite large. Once the Korean War broke out, and it became clear that the government would not be able to pay off the debt in the near future, and indeed would have to borrow more money, the conflict between the two institutions began to heat up. As the disagreement grew more serious and became public, President Truman stepped in. At the end of February 1951 Truman called a meeting of ten of the top officials from agencies involved in economic policy to resolve the dispute. A more serious blow-up, which might have upset the Treasury’s operations in the short run or led to a challenge of the Fed’s authority, was prevented when these officials worked out a “peace treaty.” ₈₀ The 1951 Accord between the Fed and the Treasury sought to resolve some of the overlapping responsibilities of the two institutions, as well as rectify the more immediate problems in coordinating their policies.

First, the Treasury agreed to exchange marketable 2.5 percent bonds for nonmarketable 2.75 percent bonds with a 29-year maturity, thus reducing some of the Fed’s burden of market stabilization. In return, the Fed promised to use its open market operations to keep the market orderly to aid the Treasury in the sale of securities. The Fed also agreed to keep the discount rate at 1.75 percent, and to change that rate only after consultation with the Treasury. The Fed would not promise to support the Treasury’s short-term market, however. The Fed was only willing to assure a stable market—it would allow gradual changes, but would no longer seek to fix the market at a specific rate of interest. Finally, the Fed and the Treasury agreed to consult on establishing a method for financing government debt. ₈₁

Many scholars see the Accord as the Fed’s final assertion of independence, and certainly it marks the Fed’s return to institutional parity with the Treasury. ₈₂ Yet even after the Accord, their relationship was still so ambiguous it was necessary to have a meeting of the Joint Economic Committee in March 1952 to reach a consensus on the extent of the Fed’s independence. The consensus proved fleeting. When asked about the relationship between the Fed and the Treasury shortly thereafter, Federal Reserve Chairman William McChesney Martin responded that “I do not think you should subordinate the Treasury to the Federal Reserve or the Federal Reserve to the Treasury. I think they have both got to be equal,” and if the two institution’s policies conflicted Martin said, “we would sit around the table and hammer it out.” ₈₃

 

Setting Hegemonic Obligations: The Bretton Woods Negotiations

The fact that the Treasury was the dominant monetary authority during World War II critically shaped the conduct of wartime negotiations over the construction of future international monetary relations. Treasury representatives such as Secretary Henry Morgenthau and Harry Dexter White supervised the American role in the negotiations. Their preferences reflected the Treasury’s greater concerns with the performance of the domestic economy.

John Maynard Keynes, the British representative at the wartime talks, argued for the creation of an International Clearing Union. Keynes’s proposal drew on the lessons Britain had learned from its period as the provider of the international money. Having seen Britain’s domestic currency play an important role as an international medium of exchange for a long period, only to wind up being in oversupply internationally and threatening to return home and flood the domestic economy, Keynes was looking for a more distinct separation between domestic and international monies. Gold, which had theoretically served this role before, had its disadvantages: its supply could not be manipulated in the same way a paper currency could. Keynes therefore suggested the creation of an international money that would have the characteristics of a paper currency, to be known as “bancor.” Bancor would be used only by central banks in their transactions with each other, thus giving central banks a monopoly over exchange. ₈₄ Keynes also wanted controls on flows of capital.

The Bank of England didn’t like the Bretton Woods proposals because it did not feel that the need for such strong assistance would be required in the postwar period. ₈₅ The American representatives, being drawn from the Treasury, were more interested in protecting the domestic economic recovery engineered by Roosevelt’s administration. This meant preventing market instabilities from upsetting domestic economic performance. Secretary of the Treasury Morgenthau defined his objectives as moving “the financial center of the world from London and Wall Street to the United States Treasury,” and founding multilateral international institutions which would be “instrumentalities of sovereign governments and not of private financial interests, to drive the usurious money-lenders from the temple of international finance.” ₈₆

Not surprisingly, Wall Street and the Fed had different ideas. Their position was elucidated by John H. Williams, a professor in the Economics Department at Harvard and also vice president at the New York Fed. Williams proposed a key-currency plan, not to push sterling out of use, but to place primary focus of policy on the dollar-sterling exchange rate. (These were just about the only currencies being used in exchange after the war ended.) It was intended to be the least political of the plans under discussion. ₈₇ This position was not taken seriously during the negotiations, as U.S. Treasury officials controlled the American side of the bargaining.

 

Bretton Woods in Operation

The goals of the Bretton Woods system, as it was established under the powerful guidance of the Treasury officials, were to achieve an orderly balance of payments adjustment system, provide adequate liquidity for international trade, facilitate private international investment, and stabilize financial markets (by limiting speculative flows), while maximizing the effectiveness of domestic monetary and fiscal policies. ₈₈ The monetary system was intended to be subordinate to and supportive of the open international trading system, while governments would be allowed to intervene in the domestic economy.

The dollar assumed the chief functions of an international money under the Bretton Woods rules, even though this was perhaps not the intention. Supported by U.S. economic and political strength, the dollar became the primary medium of international payment, the primary reserve asset (serving along with gold and several other currencies), and became the primary currency used by governments to intervene in exchange markets to stabilize the value of their own currency. ₈₉ But since the U.S. dollar remained a national currency, American monetary authorities were given two separate sets of goals to decide between: its own domestic goals versus the system’s requirements. ₉₀ During the early years of Bretton Woods, these goals were not necessarily in conflict.

The U.S. allowed foreigners to increase their holdings of dollars not only because they wanted foreigners to be able to pay for American exports, but also because they did not necessarily want gold to flow out of the United States. Since confidence in the dollar was so high, with the pound being the only serious alternative, and with the American market the largest open market in the world, demand for dollars soared. American firms could use dollars to purchase assets abroad, thus supporting the spread of American multinational corporations. This situation also made it possible for the government to wield dollars as a diplomatic weapon. Through these various channels, American policy provided enough international liquidity to support the resurrection of commerce, and boost international trade and investment to new levels. The accumulation of dollar balances abroad accounted for approximately one half of the increase in world liquidity between 1949–1958. ₉₁

While the international monetary system’s needs were met, policymakers did not forget the domestic economy. Some scholars, such as Marcello de Cecco, interpret most of the important events in the international financial system of the Bretton Woods period as results of decisions about U.S. domestic policies, driven by domestic priorities. ₉₂ When Britain was the center of the international financial system, it always let the periphery borrow long, while London held short-term deposits. De Cecco claims this could not work as well in the U.S. case. According to Arthur Okun, the Fed allowed the demand for liquidity and credit in the early 1960s to be met with stable interest rates. ₉₃ This expansion of the domestic money supply was on top of the dramatic expansion in international holdings which continued to increase. As the Bretton Woods system continued to operate, several problems emerged, but the most significant was an inability to balance the confidence in the U.S. dollar with its liquidity. As the U.S. balance of payments disequilibrium grew larger, U.S. monetary officials lacked the necessary tools to reduce the deficit; the U.S. became increasingly vulnerable to disruptions caused by short-term capital flows. ₉₄

The government began searching for new policy instruments to battle against this emerging problem of overliquidity. The Treasury created Roosa Bonds in the early 1960s. Roosa Bonds aimed at reducing some of the dollar overhang by taking in dollars held by foreigners, and promising to redeem the bonds in foreign funds. Also, tax laws were changed to discourage investors from bringing their dollars back to the United States. In January 1968, the Johnson Administration introduced a policy aimed at prohibiting the flow of dollars going abroad to finance foreign direct investment by U.S. firms in other economically advanced countries, and lessening the outflow of dollars due to international bank lending, trade, and even tourism. ₉₅ The overhang represented a danger, yet as long as no other rival currency existed there was less threat of a rapid switch out of the dollar.

Whereas Britain had managed to establish its national currency as the primary international medium of exchange and maintain it in this role at a stable value for the second half of the nineteenth century, the United States had difficulty in keeping its national currency in a similar role for more than two decades. Perhaps the strongest explanation for this difference was that Britain’s adherence to the gold standard was more credible; perhaps the United States’ position was doubted precisely because of the previous history of sterling. In any case, the dollar was in oversupply by the late 1960s, and this meant the Bretton Woods fixed exchange rate system was coming under increasing pressure. Since the dollar was the numeraire of the system—the reserve by which others measured the value of their own currency—the U.S. did not have the option of devaluing the dollar; such a change would require the cooperation of other major economic powers. To rectify the situation and stay within the rules, American monetary authorities would have to reduce the domestic supply of currency and credit so much that international liquidity would be reduced. The U.S. faced the possibility of an afterglow: would the monetary authorities sacrifice domestic economic performance to maintain the international monetary system as it then stood?

 

Responding to an Overhang During Relative Decline: Breaking Up Bretton Woods

Instead of submitting domestic economic performance to the needs of the international monetary regime, the United States chose to pull Bretton Woods down with the “Nixon shocks” of August 1971. In her analysis in Closing the Gold Window, Joanne Gowa clearly stresses the Nixon Administration’s emphasis on the domestic economy and the need for autonomy in the domestic realm as reasoning behind the shocks. ₉₆ Instead of supporting the continuance of the international monetary regime it created, the U.S. destroyed the regime in order to throw off the constraints the international regime placed on its own domestic policy.

These policy announcements have been dubbed the Nixon “shocks” because they caught other states’ policymakers off-guard. The New Economic Policy Nixon announced in conjunction with the decision to take the dollar off gold also froze wages and prices in order to slow inflation, while seeking to stimulate employment by reducing taxes and spending. ₉₇ Nixon presented these policy decisions as an effort to make the international economic competition a “fair game” for the United States. Trade statistics issued in the summer of 1971 showed that the U.S. would have a yearly trade deficit for the first time in almost eighty years. In Nixon’s view, “The time has come for exchange rates to be set straight and for the major nations to compete as equals. There is no longer any need for the United States to compete with one hand tied behind her back.” ₉₈

Gowa’s assessment of these decisions includes an exploration of domestic explanations. She argues that the U.S. economy, because of its low reliance on international trade, lacked a powerful constituency that would support Bretton Woods at the expense of the domestic economy’s performance. Saving Bretton Woods would require ending the balance of payments deficit, which in turn would require lowering the domestic economy’s performance; in Gowa’s words, “The idea of increasing domestic unemployment in order to preserve the monetary regime commanded no political following either within or outside the executive branch....As a consequence, domestic economic policy was considered virtually sacrosanct, very largely immune from the conduct of U.S. balance-of-payments or international monetary policy.” ₉₉

The primary actors we might expect to support the hegemon-led international monetary regime, even at the cost of the domestic economy’s performance, would be those sectors which derived much of their income from international interactions. One obvious group would be the New York bankers, who had been so prominent in the creation of the Federal Reserve and the rise of the U.S. dollar as an international currency. Yet the internationally oriented banking community, multinational corporations, and other likely supporters of the Bretton Woods regime remained silent. Even they were unwilling to trade off the health of the domestic economy to save the Bretton Woods regime. ₁₀₀

While there is little evidence that powerful constituencies desired a continuation of leadership policies, there is also little evidence that powerful constituencies voiced strong support for the decision to eliminate the official role of gold. Instead, Gowa argues that the executive branch decisionmakers foresaw electoral repercussions if the economy’s performance sagged, and were therefore indirectly constrained when evaluating the policy tradeoffs. ₁₀₁ On the other hand, John Odell’s analysis of these decisions challenges this interpretation for he sees no such pressure building up; as he puts it, “an analyst monitoring only public opinion, electoral struggles, and group pressures would have had virtually no clue that a change in international monetary policy was imminent. Instead this analyst would have anticipated a shift in trade policy that did not occur.” Thus Odell puts little faith in the notion that domestic pressure was the source of the changes in monetary policy. Evidence confirms Odell’s suggestion that instead of targeting international monetary policy, the domestic groups adversely affected by the dollar’s overvaluation were interested in achieving more sector-specific, traditional forms of protection. Some of Nixon’s top advisers, such as Gottfried Haberler and Hendrik S. Houthakker, considered the rising pressures for protectionism to be a much more serious threat to the open international economy than any depreciation of the U.S. dollar. Since depreciation was the lesser of two evils, these advisers argued in favor of changes in monetary policy to head off demands for protectionism. ₁₀₂

Given the weakness of pressures from constituencies, how strong were the bureaucratic and systemic factors in play? Consistent with the earlier discussion about the relationship between the two institutions, Gowa claims the Treasury had the greatest say in international monetary affairs, and that the Treasury opposed reform within Bretton Woods, preferring to abandon the monetary regime instead. The Federal Reserve Board was relatively more interested in domestic than in international economic affairs. The exception to this pattern was the New York Fed, which was more concerned with international finance than other parts of the Fed, and which was also responsible for the execution of international monetary policy originating from the Fed Board or the Treasury. ₁₀₃

The bureaucratic politics argument I am making is subtle, and can be best appreciated when this case is compared with British decisions in the 1920s. During Britain’s currency overhang, when the monetary authorities were confronting the threat of foreigners exchanging pounds for gold and transferring wealth into a rival currency based on a rival financial center (which would force Britain off the gold standard), the Bank of England had sought to defend the pound with ever higher interest rates, even if that meant depressing national economic performance. Britain’s Treasury increasingly resisted the Bank of England’s position, and finally took the opportunity afforded by the creation of the EEA to influence international monetary policy and divorce it from domestic policy as much as possible. In the U.S. case, faced with a choice between supporting the role of the dollar at the cost of domestic economic performance or letting the international monetary regime collapse, the U.S. quickly moved to the position we would expect to be supported by the Treasury but perhaps opposed by the Fed—protect the domestic economy. Yet the Fed accepted the decision to end the Bretton Woods regime, including elimination of the commitment linking gold to the dollar. I argue that the difference between the cases rests at the system level: though there were overhangs in both instances, the Fed was much less concerned about a strong currency rivaling the dollar.

It would be wrong however to imply that international monetary policy represented a victory of the Treasury over the Fed. Instead, during the early years of the Nixon Administration, international monetary policy flowed from an interagency team known as the “Volcker Group,” which consisted of members of the Council of Economic Advisors, the State Department, the Staff of the Assistant for National Security Affairs, the Treasury, and the Fed. Despite the broad composition of this group, all shared a common belief that national interest should be defined in terms of the domestic economy rather than preservation of the international monetary regime. ₁₀₄ This evidence suggests there was little or no disagreement along bureaucratic lines.

Other policymaking elements of the executive branch which discussed international monetary affairs were the Cabinet Committee on Economic Policy, and the Cabinet-level Council on International Economic Policy. Similar to the Volcker group, the Council on International Economic Policy included a broad representation of different agencies (in fact an even broader mix). ₁₀₅ Perhaps none of this matters, and in the end Nixon selected policies on the advice of Treasury Secretary John Connally and chose to ignore the others, as Odell argues. But it is surprising to see how much consistency there was in the views of officials from different agencies; at first glance, this consensus suggests bureaucratic concerns did not factor into the decision.

It was the Fed however, which put up the most significant opposition to Connally’s decision to suspend the dollar’s convertibility to gold. The Fed knew something had to change, but rather than see the Bretton Woods system undermined in one fell swoop, the Fed argued for a more effective devaluation of the dollar. In other words, the Fed wanted to reduce commitments, but not as far as the Treasury wanted. The Federal Reserve Chairman argued that devaluation was the most sensible policy because the dollar would still be difficult to defend on international markets at the existing rate. ₁₀₆ Thus the Fed may have valued the Bretton Woods system more than the Treasury, but it too wanted international monetary policy brought into line with domestic needs one way or another. The end result of these discussions was a partial adjustment of the dollar’s value which more accurately reflected the ratio of currency in circulation to reserves, though it certainly did not close the gap between the two. It fits the notion of partial adjustment put forward in chapter 1, because the U.S. was reducing the gap between resources and commitments by reducing commitments, yet the gap remained and in fact commitments remained above the level of sustainability. This is precisely the response to an overhang we would expect in a situation where the central bank was not yet concerned about rival foreign currencies, and therefore would allow the Treasury to dominate policy; the Treasury, in turn, was now ready to take some sort of action because of fiscal deficits.

While these changes may have shaken confidence in the dollar, they did not end the its role as the primary instrument for international payment because there were no readily available substitutes that could serve as international media of exchange. Indeed, Nixon only wanted to throw off the constraints of the Bretton Woods system, while maintaining the dollar’s status as the main reserve currency for two reasons: prestige, as well as the practical leverage this brought the U.S. over other states. ₁₀₇ Yet commitments remained above the level of resources to back them up, and above the level of sustainability. When the dollar was devalued further in the Smithsonian accords, confidence continued to wane. The dollar could no longer be supported via interventions by the spring of 1973. The failure to reestablish any sort of binding international monetary regime in the 1970s can be traced to the decision that the domestic economy’s performance was of paramount importance. In discussions concerning the creation of a new international monetary regime held in the fall of 1975, French and American officals agreed that domestic economic stability was more important than exchange rate stability. ₁₀₈ Yet large numbers of dollars continued to be held abroad and the dollar’s role as international medium of exchange remained largely unchallenged (figure 7).

Figure 7: Initial U.S. Responses to the Dollar Overhang

In a technical sense the overhang was immediately resolved. The decision to end convertibility into gold severed the link between the currency’s value and reserves. The underlying problem—too much liquidity undermining confidence in the currency—remained unresolved, however. Moreover, the advent of stagflation in the 1970s meant increasing problems for the Fed. It found its wielding of the usual policy instruments failed to achieve the desired results, while drawing mounting criticism. Typically, any inflationary sparks could be snuffed out by a hike in interest rates, which meant a slowdown in the economy. With stagflation, the economy was already in a slowdown, so higher interest rates were politically unpalatable. In 1974 for instance, domestic groups put pressure on the Fed through Congress, which attacked the Fed for following too restrictive a policy. Congressional hearings on Fed policy were backed up with legislation (Concurrent Resolution 133, which was made binding in 1978), which brought Fed officials before Congressional committees on a semiannual basis. ₁₀₉ The Full Employment and Balanced Growth Act of 1978 (also known as the Humphrey-Hawkins bill) ordered the Fed to air its annual targets for monetary growth publicly, and then to justify those targets before Congress. ₁₁₀ The threat to the Fed’s independence was thinly veiled.

Because the overliquidity problem was unresolved, and foreign holdings of dollars continued to be large, the partial adjustment achieved by the U.S. withdrawal from Bretton Woods was short-lived. Moreover, the Carter Administration hoped to stimulate American exports by allowing a depreciation of the dollar. The Administration made it clear that it would not be active in supporting the dollar in exchange markets, because the dollar was overvalued. The dollar’s fall was so steep, however, that intervention had to be undertaken by early 1978. In 1978 and throughout early 1979, the dollar was stabilized through coordinated intervention by the Fed and other central banks. But by the Fall of 1979, inflation was building upon itself at an ever higher rate. The dollar was no longer a convincing store of value, even for domestic investors. ₁₁₁ Speculative purchases of all sorts of assets increased dramatically as people transferred wealth out of dollars.

Under Paul Volcker, President Jimmy Carter’s appointee to the chairmanship, the Fed would begin a major assault on inflation. According to William Greider’s analysis (which admittedly has a strong populist slant), there was little domestic pressure for such a hard- money policy—indeed, few Americans probably understood what the Fed was truly beginning. ₁₁₂ The Fed could hide its actions behind new economic and policy models. Under the guise of monetarism, the Fed would institute a hard-money policy aimed at restoring confidence in the dollar. In the late 1970s the monetarists had begun to infiltrate into the Fed itself, building up a base of support at the St. Louis Reserve Bank. Led by Milton Friedman, supporters of this economic perspective had been growing in numbers since the early 1960s. They had long been critical of the the way the Fed made policy, but now, with a strong contingent of monetarists in place at the St. Louis bank, they had a platform to criticize Fed policymaking from within the institution itself. ₁₁₃

While some might portray the swing in policy as the result of a transition to new dominant ideas (i.e., monetarism becoming the dominant form of theorizing), in fact Volcker and the other key decisionmakers were merely able to build a consensus around the targeting of monetary aggregates in the short run. A change in targets does not necessarily indicate that Volcker and others had been completely converted to monetarism. By dropping interest rate changes as an explicit policy target, Volcker had a way to get the Fed off the hook for the soaring interest rates which he and other Board members knew were necessary to stem inflation. The Fed was changing outcomes drastically, but the Board members sought to shed some of their responsibility for these choices by claiming to use new policy instruments which shifted direct responsibility onto markets. In other words, they anticipated the unpopularity of such policies and sought a way to deflect criticisms. When Volcker warned G. William Miller (Carter’s Secretary of the Treasury) and Charles Schultze (then Chairman of the Council on Economic Affairs) that the Fed was about to change operations in such a way that they would bring about a recession, Miller and Schultze both voiced their opposition, to no avail. ₁₁₄

When the squeeze came, the big multinational banks (such as Citibank, Chase Manhattan, Morgan Guaranty, et al.) were able to avoid the pressures of higher interest rates by drawing on foreign sources of dollars. This allowed them to continue domestic lending during the Fed’s 1979–1980 tightening of monetary policy. ₁₁₅ This highlighted a weakness in the Fed’s ability to manage the domestic monetary system in the absence of a foreign policy. Reducing the domestic money supply not only drew in dollars held abroad and which thereby reduced international overliquidity, it also stimulated the creation of credit in terms of dollars in foreign markets. Deregulation of capital markets and the international rules on capital flows meant monetary authorities had much less control than before. As Federal Reserve Governor Henry Wallich put it,

The Fed could, of course, adjust the domestic targets so as to keep the combined amount of domestic and Euromoney on the right track. But as the Eurodollar market grows, the Federal Reserve would have to bear down increasingly hard on the domestic supply of money and credit in order to offset the expansion of Eurodollars. This would work a hardship on our domestic economy and particularly on U.S. borrowers who did not have access to the Euromarket. ₁₁₆

When the Federal Reserve Board took special measures to raise marginal reserve requirements on managed liabilities in October 1979, they were aiming to raise the costs of drawing funds from the Eurodollar market. Yet the effect of their action was merely to encourage corporate borrowers to go to foreign branches of American banks, so that the entire transaction took place outside the Fed’s jurisdiction. The monetary authorities could try to reduce dollar liquidity, but since their instruments were primarily of a domestic nature, their actions were continually offset by international sources of dollar creation. Overliquidity remained a problem.

 

Responding to Overliquidity Again: The Route to Adjustment after 1979

The U.S. was able to put together a good economic performance in the 1980s. GNP grew, as did total employment, while inflation and unemployment rates fell. Inflation was fought with high interest rates, while government spending was maintained even though taxes were reduced. New problems emerged, however, as a large and consistent current account deficit appeared and a massive foreign debt arose. Foreign financial centers were also on the rise, most notably in Japan. Foreign capital financed the positive American economic performance (defeating stagflation). The combination of tight monetary policy and loose fiscal policy was arrived at more by accident than by plan. ₁₁₇ Placing it in the context of afterglow or adjustment is somewhat problematic, given that the collapse of the Bretton Woods regime ended explicit commitments concerning the dollar. Implicit commitments still mattered, but now there is no easy way to measure the gap between resources and commitments, let alone infer much about sustainability. I argue that the U.S. went from partial adjustment in the early 1970s toward a worsening afterglow at the end of that decade, but then to adjustment—with the central bank initially pushing for a higher exchange rate as it sought to reassert the dollar’s international role, then letting it slide back down, while the Treasury first stood aside but then grew worried about a mounting fiscal deficit. Before the 1980s ended, both would face additional domestic criticism as well.

During the first Reagan Administration, official intervention in the exchange markets was sworn off for ideological reasons. The Treasury’s foreign activities instead focused on pressuring other countries to liberalize their capital markets. While this was ostensibly aimed at allowing American service-sector businesses to enter foreign markets that had previously been closed, the net effect of the agreements such as that reached with Japan in May 1984 was to loosen up foreign funds to flow to the United States. The Treasury also began to woo foreign capital more directly that same year by altering tax laws on foreign holders of U.S. government and corporate bonds, and introducing new bond issues of its own aimed at the foreign market. The Treasury conceded the dollar’s value to the Fed.

The Fed, on the other hand, was actively pushing up the value of the dollar. Several actors voiced concerns about the resulting increase in the dollar’s worth. Volcker, chairman of the Fed, was still interested in defeating inflation, so he was unwilling to change domestic policy for any particular international value of the dollar. Instead, Volcker spoke out against the consequences of the Administration’s lack of a foreign exchange policy, tossing responsibility back to the Treasury. ₁₁₈ Not only were foreign governments asking the Treasury to intervene in currency markets, so was the Fed. ₁₁₉

Who was in charge of international monetary policy? The Fed had long before guaranteed the Treasury that it would never intervene in exchange markets without Treasury approval, but at the same time the Fed never recognized the Treasury’s right to veto any planned Fed actions. In the early 1970s, the Treasury had blocked Fed interventions on several occasions. ₁₂₀ The Treasury and the Fed coordinated foreign exchange intervention through regular consultation (the Fed Chairman and the Secretary of the Treasury have had the regular practice of meeting weekly for breakfast on Thursdays since the late 1930s), institutional bonding (through policies such as constant exchange of personnel), equal participation in operations (each agency contributing around half the funds for intervention, and splitting the proceeds), and having all intervention for either agency handled by the New York Fed. But in the late 1970s and early 1980s, each bureaucracy was pulling monetary policy in its own direction: the Fed was tightening the money supply while the Treasury was running a loose fiscal policy. The Fed was reacting to the fact that other currencies were emerging as clear rivals to the dollar and other financial centers were developing to match those in the United States. The Treasury was now borrowing heavily from abroad, so it was unwilling to resist the rise in the dollar’s value. If commitments were rising above sustainability this represents afterglow; if they weren’t, the increase in commitments was but failure to support them, and could be seen as underfulfillment of leadership responsibilities. The Treasury and the Fed shared responsibility in the 1980s with other actors, such as interest groups, with Congress and other executive branch agencies entering by the mid-1980s. The fact that one of these other actors posed a common threat—Congress—helped drive the Fed and Treasury together, so that this example of worsening afterglow did not have the vitriolic public atmosphere one might expect, nor did it last long. ₁₂₁

Although some sectors of the economy were clearly hurt by the rising value of the dollar, such as several large manufacturing sectors and parts of agriculture, evidence of their influence on policy is only persuasive after the two bureaucracies’ policies diverged; these groups failed to take political action on monetary policy prior to 1985. ₁₂₂ Only after the split between the Fed and the Treasury became apparent did business leaders such as Lee Iacocca (of Chrysler) and Lee Morgan (of Caterpillar Tractor) begin to campaign for a lower dollar, especially as the way to regain a competitive stance against Japanese firms. Of course, other actors benefited from the higher dollar. Yet there is little evidence that such groups had lobbied to support the dollar’s rise. The most obvious candidates to engage in such lobbying activities in terms of both interests and access to the Treasury and Federal Reserve would be the large, money-center banks, which had the most to gain internationally. These actors’ interests in the domestic economy cut across their international interests, however; their portfolios were sufficiently mixed that they had no clear interest in supporting specific movements of the exchange rate. The large money-center banks have also learned how to turn exchange rate fluctuations into profits, so that foreign exchange trading is increasingly important as a source of revenue. The rise and fall of the dollar in the 1980s did not elicit a strong reaction from the banking community until 1987, when the continuing fall in the dollar’s value made bankers concerned about a possible return of inflation. ₁₂₃

Despite these weak and varied signals from different economic sectors, a broad consensus among both political parties arose in Congress which blamed the high dollar for the burgeoning trade imbalance. ₁₂₄ In July 1985, Democrats in Congress, led by Lloyd Bentsen, Dan Rostenkowski, and Richard Gephardt, introduced a bill to impose a 25 percent duty on imports from countries running large trade surpluses with the U.S. At the same time, other Democrats such as Bill Bradley, Daniel Patrick Moynihan, and M. S. Baucaus submitted bills in various banking committees to legislate specific foreign exchange market interventions when the U.S. was running large current account deficits. Similar pieces of legislation would later be included as provisions of the 1988 Trade Act. ₁₂₅ When Senator Robert Byrd threatened to order the Fed to ease its policies via legislation in a confrontation with Volcker on December 18, 1982, he reminded Volcker who was ultimately responsible by asking “To whom are you accountable?” Volcker responded by noting “the Congress created us and the Congress can uncreate us,” although it would be hard to imagine that there would be popular approval for a radical change in the Fed’s mandate. ₁₂₆ Still, the threat of Congressional action was made clear.

Within the executive branch, some decisionmakers whose bailiwicks were under pressure also fought to get a change in policy. Secretary of Commerce Malcolm Baldrige, Special Trade Representative Brock, and Secretary of Agriculture John Block all argued in cabinet meetings in 1984 that the dollar’s international value was too high. Secretary of State George Shultz identified the high value of the dollar as the main source of the trade imbalance (and thus international friction) with Japan. But each of these actors had no way to control monetary policy. ₁₂₇

In Secrets of the Temple, Greider used “The Triumph of Money” as the title for the chapter recapping the Fed’s monetary policies of the late 1970s and early 1980s. The title fits, for the Fed achieved its aim of restoring confidence in the dollar. Inflation was reduced so significantly that public expectations of future inflation were cut. To attain these ends, the Fed had pursued strengthening the dollar regardless of the short-run economic consequences on the dollar’s international value, the trade balance, growth, or employment. ₁₂₈ But now the dollar had risen in value quite sharply.

 

Coordination to Bring the Dollar Down

The threat of Congressional activity to mandate not only Fed policy but also Treasury actions convinced the Treasury to respond to some of the problems related to the rising value of the dollar. ₁₂₉ Once the Treasury decided to move on the exchange rate, it had to abandon its earlier position of unilateral inaction on the exchange markets. Instead, it sought to establish a policy based on multilateralism. ₁₃₀ The multilateral approach was necessary in order to deal with the trade imbalance directly, while convincing other countries it could preempt the threat of protectionism. In the second Reagan Administration, the Secretary of the Treasury James A. Baker led the efforts to coordinate a reduction in the dollar’s value. ₁₃₁ This parallels the internationalization of bureaucratic politics viewed in the 1920s, though in this case we have the coordination on the part of the Treasury; it made it known that the dollar should fall, and that it was interested in engaging resources in a cooperative effort toward that end. During the 1985–1986 negotiations the same bureaucratic split could be seen in almost all the major economic powers’ negotiating teams. Finance ministers promoted currency coordination, while central bankers resisted. As a group the central bankers placed institutional independence ahead of other goals, including price stability and economic growth, during these discussions. ₁₃₂

For the Treasury and the Fed, the overall goals of policy weren’t all that different—ease monetary policy, lower the value of the dollar, but without setting the dollar’s market value into a downward spiral. Again, at first glance bureaucratic politics do not seem to be a major factor, yet there is still debate about the degree of coordination of their activities and about how close their preferences were. The result was that the Treasury made international commitments to lower the dollar which were backed up with policy, while occasionally Volcker at the Fed put the brakes on with the Fed’s own policies. At the same time, use of the G5 tended to reassert the Treasury’s control over international monetary policy. ₁₃₃ While the Fed and Treasury were interested in dealing with their own policy objectives, they also seemed able to coordinate their actions in a satisfactory manner. As long as the two appeared to work together, the domestic politicization of monetary policy subsided. This kept Congressional oversight at bay.

In this interaction of Fed and Treasury policies, the Treasury required additional international coordination. In the Plaza Accords of 1985, Baker got the other G5 countries to commit to participation in bringing the dollar’s value down. Other countries agreed in order to avert protectionism in the United States. Fears of further inflation had largely subsided by then. In related talks which produced the Baker-Miyazawa Accord of late 1986, the U.S. got the Japanese to agree to lower their discount rate significantly, to proceed with tax reform, and to introduce a supplemental stimulus package to the Diet. The U.S., in return, agreed to stabilize the exchange rate between the dollar and the yen. In fact, by January 1987, the dollar was falling in value so rapidly that the Fed began to threaten to use higher interest rates once again to stop the slide in its value. ₁₃₄

In the Louvre Accord of February 1987, the G5 (plus Canada) secretly agreed to stabilize the exchange values of the dollar, yen, and Deutsche Mark. (Subsequently, Italy also cooperated in the implementation of these decisions.) The U.S. got other central banks to intervene to prevent increases in the value of their currencies. As a result, the dollar not only stabilized but actually began to appreciate, which generated the need to renegotiate the dollar-yen exchange rate. These policies reduced the flow of private capital into the U.S. ₁₃₅

The stock market collapse in late 1987 brought renewed criticism of the Fed and the Treasury, sparking calls for an end to American cooperation in international monetary affairs. The calls continued in 1988. That year the Fed began to tighten monetary policy to restrain domestic demand in order to make sure that improvements in trade did not ignite domestic inflation. ₁₃₆ The Federal Reserve was concerned more with domestic policy considerations than with the exchange rate, particularly given the upcoming elections and the apparent weakness of the U.S. economy. Monetary policy was aimed at stimulating the economy, while pressure was placed on other countries to change what they were doing and to assist in management of the dollar’s international value alongside the Fed. ₁₃₇

Because the Treasury’s actions had lessened the problems with exchange rates, domestic political activity aimed at monetary policy was reduced. Policy had deflated protectionist pressures, even as the legal aspects of earlier actions were coming into effect. The 1988 Trade Act gave Congress the power to review the Treasury’s exchange rate policy every six months. ₁₃₈ Under the present arrangements, senior Fed officials come before Congressional committees (or subcommittees) around forty times per year, with the Chairman himself called upon to testify approximately twenty times a year. ₁₃₉ Yet after all of this, exchange rates do not rank very high in importance compared to other variables if their placement in FOMC directives is any indication. In a brief overview of twelve FOMC directives from early 1985 through 1988, exchange rates were mentioned first only once, and were typically mentioned third or later. ₁₄₀ Under Alan Greenspan, the Fed has focused even more closely on managing the domestic economy than the international monetary system. ₁₄₁

What has been most apparent since the early 1980s is that policy has wound up adjusting the value of the dollar at a sustainable level. The theoretical overhang continues to exist, though the dollar’s value remains solid. This was largely by accident: although the Fed and the Treasury do their best to keep up a united front in the face of Congress and the public, differences over policy goals and policy instruments have erupted. Domestic constituencies’ interests may have entered the political fray from time to time, but they have not driven policy decisions. Instead, the politicization of monetary policy reflects the inability of groups outside the institutions’ core constituencies to gather enough strength to alter institutional arrangements.

 

Conclusions: Will the Successful Management of the Overhang Continue?

The American experience has clearly shown that the possibility of successful adjustment exists, for such policies were pursued if only temporarily. As long as so many dollars are held abroad and used in international transactions, the overhang remains. The story shares many of the same elements as that told about the Bank of England in the previous chapter. Just as the Bank of England was empowered to develop the pound into an international currency during the period when rising capital abundance caused various economic sectors to push for Britain to lead international economic liberalization, so too in the U.S. did rising capital abundance cause the capital-intensive sectors to push for changes in the monetary institutions. In the British case, the key question was how to strengthen the pound in order to make it more attractive for international use. In the American case, confidence was not the problem—what was needed was sufficient liquidity, and in forms that could be used in short-term finance. Thus the institution created was designed to push the balance of the currency’s characteristics in the opposite direction when contrasted with the Bank of England’s mandate. The Fed was originally created with the expectation that it would follow pro-cyclical monetary policies.

Another, more obvious difference, is that the Fed was not developed as a single centralized actor. Perhaps because the U.S. Congress reflects regional differences, the authorities created a system of central banks which did not even have to have complementary policies according to the original design. Also, because the institution was designed from scratch, rather than built by empowering an existing bank, political influence has always been an important part of the Fed’s experience. When one adds in the fact that the Treasury entered into monetary affairs quite soon in the Fed’s life due to concerns over the fiscal deficits of the World War I, and then reasserted its influence in the 1930s and again during the World War II, it should be clear that the Fed’s relative position in government was quite different from the Bank of England’s.

That being said, the systemic and international structural problems faced during relative economic decline were quite similar in the two cases. Too much of the domestic currency was serving as an international medium of exchange, and circulating outside the country. With the resulting overhang, confidence in the currency had fallen, and would continue to slide further without action. The choices were to force the currency’s value back up through tight monetary policies at home (honoring commitments that had been set unrealistically high), or allow the domestic economy to take first place in economic planning and therefore let the currency’s value continue to drop versus other currencies (letting commitments fall to a level closer to realized resources). Britain struggled in the 1920s to get the pound back on the gold standard at too high a value, and then defended it there, at the cost of domestic economic performance. In 1931, the value of the pound could no longer be sustained. In the U.S. case we can separate out two distinct periods when the overhang caused policy changes: the early 1970s and then again in the late 1970s and early 1980s.

In the early 1970s, the choice was whether or not to save the dollar’s international value, but also its overt political role as the international medium of exchange. The Bretton Woods regime was at stake. Yet the decision arrived at, and concurred with by Treasury and Fed officials was to let the international monetary regime fall in order to support domestic growth and employment. The Fed could accept such policies because there was no rival currency poised to overtake the dollar’s role internationally. This decision of course stimulated the continued fall in the dollar’s value, however. By the late 1970s, the Fed had reached its threshold for defending the dollar, not simply for international reasons, but for concern over the domestic impact of inflation. The Fed’s efforts to increase the dollar’s value in the late 1970s and early 1980s were undertaken with domestic targets in mind, and lacked sufficient concern for the international repercussions. The impact on the U.S. Treasury, and the repercussions for other currencies prompted a bureaucratic politics battle between the Fed and the Treasury which spilled over internationally. Just as the Bank of England had sought international allies in the 1920s to bolster its own position vis-à-vis the British Treasury, the Fed sought international bureaucratic allies to support its policies in the face of opposition from the U.S. Treasury. The Treasury sought its own support from other finance ministries. The U.S. often appeared to be running more than one international monetary policy, as we would expect with (figure 8) worsening afterglow.

Figure 8: U.S. Policy Responses to the Dollar Overhang 1960s–1980s

The comparison with the British case yields insight into how the institution’s initial design affects the nature of afterglow faced. The Fed was designed to supply greater liquidity, and was under more direct political pressure from its inception. The Treasury kept some control over international monetary affairs, and due to continual fiscal problems has constantly tried to influence Fed policy. The relative weight of the Treasury, earned in the 1930s and 1940s, gave it much more say in international monetary policy decisions when the possibility of an afterglow was confronted in the late 1960s and early 1970s, than the British Treasury had in the 1920s. Thus when the critical decisions had to be made, the Fed consistently put domestic interests first, while the Treasury does more of the balancing of domestic and international interests, but also feels the pressure from electoral support. While the overall patterns are similar, the institutional context in which the policy decisions are made are so different that the U.S. has handled these pressures more effectively (at least from the standpoint of consistency with national interest).

Of greater interest, of course, is the fact that the U.S. has not sacrificed its domestic economy for the enhancement of the international performance of the dollar. Unfortunately, overliquidity continues, though the Fed and Treasury have cooperated sufficiently to manage the dollar successfully in the 1990s. So far, other currencies have seen limited employment internationally, but their use is on the rise. At the moment, the Deutsche Mark and the yen are the two top candidates to replace the dollar. Neither of these currencies are supported by a domestic economy (or domestic financial markets) sufficiently large or open enough to woo large numbers of dollar holders to transfer their holdings into one of these other currencies. If Europe achieves monetary union, the new currency thereby created might well challenge the dollar, as many are predicting. ₁₄₂ As long as so many dollars are in circulation internationally, and the U.S. maintains large fiscal deficits and extensive borrowing from abroad, the overhang will continue.

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Endnotes

Note 1: Gabriel Kolko, The Triumph of Conservatism (Chicago: Quadrangle Paperbacks, 1967), pp. 18–19.  Back.

Note 2: J. Lawrence Broz, The International Origins of the Federal Reserve System (Ithaca: Cornell University Press, 1997), pp. 134–135.  Back.

Note 3: Kolko, The Triumph of Conservatism, p. 140.  Back.

Note 4: Robert A. Degen, The American Monetary System (Lexington, MA: Lexington Books / D. C. Heath, 1987), pp. 5–6.  Back.

Note 5: Jeffrey A. Miron, “The Founding of the Fed and the Destabilization of the post-1914 U.S. Economy,” in A European Central Bank?, eds. Marcello de Cecco and Alberto Giovannini (New York: Cambridge University Press, 1989), p. 305.  Back.

Note 6: Miron, “The Founding of the Fed,” pp. 303–304; Broz, The International Origins of the Federal Reserve System, pp. 135–137.  Back.

Note 7: Broz, The International Origins of the Federal Reserve System, pp. 135–138.  Back.

Note 8: Kolko, The Triumph of Conservatism, p. 155.  Back.

Note 9: Degen, The American Monetary System, pp. 16–17.  Back.

Note 10: William Grieder, Secrets of the Temple: How the Federal Reserve Runs the Country (New York: Simon & Schuster, 1987), pp. 276–277.  Back.

Note 11: Degen, The American Monetary System, p. 17.  Back.

Note 12: Allan H. Meltzer, “The Federal Reserve at 75,” in Aspects of Central Bank Policy-Making, ed. Zvi Eckstein (New York: Springer-Verlag, 1991), pp. 1–2.  Back.

Note 13: Meltzer, “The Federal Reserve at 75,” pp. 1–2; Robert C. West, Banking Reform and the Federal Reserve, 1863–1923 (Ithaca: Cornell University Press, 1974), p. 107.  Back.

Note 14: Lester V. Chandler, Benjamin Strong, Central Banker (Washington, DC: Brookings Institution, 1958), pp. 39, 84.  Back.

Note 15: Grieder, Secrets of the Temple, pp. 276–277.  Back.

Note 16: This is the central thrust of Broz, The International Origins of the Federal Reserve System. The same ideas appear in recent works by Jeff Frieden.  Back.

Note 17: Chandler, Benjamin Strong, Central Banker, pp. 86–87.  Back.

Note 18: Meltzer, “The Federal Reserve at 75,” pp. 1–2.  Back.

Note 19: Meltzer, “The Federal Reserve at 75,” p. 72; Broz, The International Origins of the Federal Reserve System, Chapter 1.  Back.

Note 20: West, Banking Reform and the Federal Reserve, p. 151.  Back.

Note 21: Carl H. Moore, The Federal Reserve System, A History of the First 75 Years (London: McFarland & Co., 1990), p. 28.  Back.

Note 22: James N. Land, “The Federal Reserve Act,” in The Federal Reserve System, ed. Herbert V. Prochnow (New York: Harper & Row, 1960), p. 31.  Back.

Note 23: Moore, The Federal Reserve System, p. 7.  Back.

Note 24: Land, “The Federal Reserve Act,” p. 20.  Back.

Note 25: Donald F. Kettl, Leadership at the Fed (New Haven: Yale University Press, 1986), p. 4.  Back.

Note 26: Ibid.  Back.

Note 27: Broz, The International Origins of the Federal Reserve System, pp. 190–194, 201–203.  Back.

Note 28: For a good discussion of the relevant factors, see Broz, The International Origins of the Federal Reserve System, pp. 254–260.  Back.

Note 29: Elmus Wicker, Federal Reserve Monetary Policy 1917–1933 (New York: Random House, 1966), p. 53.  Back.

Note 30: Moore, The Federal Reserve System, p. 47.  Back.

Note 31: Kettl, Leadership at the Fed, pp. 26–27; West, Banking Reform and the Federal Reserve, p. 173.  Back.

Note 32: Chandler, Benjamin Strong, Central Banker, pp. 104–105.  Back.

Note 33: Moore, The Federal Reserve System, p. 46.  Back.

Note 34: Chandler, Benjamin Strong, Central Banker, pp. 103–104.  Back.

Note 35: Chandler, Benjamin Strong, Central Banker, pp. 63–64.  Back.

Note 36: Moore, The Federal Reserve System, pp. 43–45, 50.  Back.

Note 37: Kettl, Leadership at the Fed, p. 29. Marcello de Cecco argues that even this growth of the national debt remained too small to give the Fed’s operations efficacy in the financial markets, and that it would take the New Deal and World War II to create the proper conditions. See “International Financial Markets and U.S. Domestic Policy Since 1945,” International Affairs 52 (3) (July 1976): 381–382. For the point on bankers’ acceptances, see West, Banking Reform and the Federal Reserve, pp. 223–224.  Back.

Note 38: West, Banking Reform and the Federal Reserve, p. 213.  Back.

Note 39: Chandler, Benjamin Strong, Central Banker, pp. 77–78.  Back.

Note 40: Kettl, Leadership at the Fed, pp. 24–25.  Back.

Note 41: Chandler, Benjamin Strong, Central Banker, pp. 40–42.  Back.

Note 42: Ibid., pp. 149–150.  Back.

Note 43: Grieder, Secrets of the Temple, p. 291.  Back.

Note 44: Chandler, Benjamin Strong, Central Banker, p. 163; West, Banking Reform and the Federal Reserve, pp. 219–223.  Back.

Note 45: Chandler, Benjamin Strong, Central Banker, pp. 214–216, 222–224.  Back.

Note 46: Ibid., pp. 238, 241.  Back.

Note 47: See for instance, Kettl, Leadership at the Fed, p. 28.  Back.

Note 48: Albert Fishlow, “Lessons from the Past: Capital Markets during the Nineteenth Century and the Interwar Period,” International Organization 39 (3) (Summer 1985): 78.  Back.

Note 49: Jeffry Frieden, “Sectoral Conflict and U.S. Foreign Economic Policy, 1914–1940,” International Organization 42 (1) (Winter 1988): 61.  Back.

Note 50: Degen, The American Monetary System, p. 51.  Back.

Note 51: Chandler, Benjamin Strong, Central Banker, p. 199.  Back.

Note 52: Wicker, Federal Reserve Monetary Policy 1917–1933, p. 63.  Back.

Note 53: Chandler, Benjamin Strong, Central Banker, pp. 143–145, 294–295; Stephen V. O. Clarke, “The Reconstruction of the International Monetary System: The Attempts of 1922 and 1933,” Princeton Studies in International Finance No. 33 (November 1973): 15.  Back.

Note 54: Clarke, “The Reconstruction of the International Monetary System” pp. 7–8.  Back.

Note 55: Stephen V. O. Clarke, Central Bank Cooperation 1924–1931 (New York: Federal Reserve Bank of New York, 1967), p. 62.  Back.

Note 56: Frank Costigliola, “Anglo-American Financial Rivalry in the 1920s,” Journal of Economic History 37 (4) (December 1977): 919.  Back.

Note 57: As quoted by Clarke, in Central Bank Cooperation 1924–1931, p. 31.  Back.

Note 58: Clarke, Central Bank Cooperation 1924–1931, pp. 75–76.  Back.

Note 59: Wicker, Federal Reserve Monetary Policy 1917–1933, pp. 106, 114–115; Clarke, Central Bank Cooperation 1924–1931, p. 125; Ursula K. Hicks, The Finance of British Government, 1920–1936 (Oxford: Clarendon Press, 1970 [reprint of 1938 original]), pp. 346–347.  Back.

Note 60: Clarke, Central Bank Cooperation 1924–1931, pp. 72–73.  Back.

Note 61: Kettl, Leadership at the Fed, pp. 33–34; Grieder, Secrets of the Temple, pp. 301–303; Albert Fishlow, “Lessons from the Past,” pp. 80–81.  Back.

Note 62: Clarke, Central Bank Cooperation 1924–1931, pp. 42–43.  Back.

Note 63: Kettl, Leadership at the Fed, p. 37.  Back.

Note 64: David C. Wheelock, The Strategy and Consistency of Federal Reserve Monetary Policy, 1924–1933 (New York: Cambridge University Press, 1991), p. 6; Mable T. Wallich and Henry C. Wallich, “The Federal Reserve System During the 1930s,” in The Federal Reserve System, ed. Herbert V. Prochnow (New York: Harper & Row, 1960), p. 319.  Back.

Note 65: Wheelock, The Strategy and Consistency of Federal Reserve Monetary Policy, p. 66.  Back.

Note 66: Degen, The American Monetary System, p. 70.  Back.

Note 67: Wallich and Wallich, “The Federal Reserve System During the 1930s,” p. 320. For a discussion of the Glass-Steagall Act, see Grieder, Secrets of the Temple, pp. 311–312. The Act is perhaps best-known today for its legal separation of commercial banking from investment houses. This was an attempt to keep speculative ventures apart from savings institutions, in order to protect the holdings of small savers.  Back.

Note 68: G. Griffith Johnson, Jr., The Treasury and Monetary Policy 1933–1938 (Cambridge: Harvard University Press, 1939), pp. 11–13.  Back.

Note 69: Ibid., pp. 29–30.  Back.

Note 70: Ibid., pp. 31, 36.  Back.

Note 71: Ibid., pp. 57, 75–76.  Back.

Note 72: Kettl, Leadership at the Fed, pp. 4, 45–46.  Back.

Note 73: Wallich and Wallich, “The Federal Reserve System During the 1930s,” pp. 321–322.  Back.

Note 74: Kettl, Leadership at the Fed, pp. 45–46; Degen, The American Monetary System, p. 73.  Back.

Note 75: Kettl, Leadership at the Fed, pp. 51–52.  Back.

Note 76: Kettl, Leadership at the Fed, pp. 55–56; Moore, The Federal Reserve System, p. 90; Wallich and Wallich, “The Federal Reserve System During the 1930s,” p. 334.  Back.

Note 77: Edward M. Bernstein, “The Search for Exchange Stability: Before and After Bretton Woods,” in The Future of the International Monetary System, Change, Coordination, or Instability?, eds. O. F. Hamoude, R. Rowley, and B. M. Wolf (Aldershot, U.K.: Edward Elgar, 1989), p. 29.  Back.

Note 78: Wallich and Wallich, “The Federal Reserve System During the 1930s,” p. 336.  Back.

Note 79: Johnson, The Treasury and Monetary Policy 1933–1938, p. 7.  Back.

Note 80: A. Jerome Clifford, The Independence of the Federal Reserve System, (Philadelphia: University of Pennsylvania Press, 1965), pp. 229, 247–250.  Back.

Note 81: Kettl, Leadership at the Fed, p. 74.  Back.

Note 82: Ibid., p. 82.  Back.

Note 83: Moore, The Federal Reserve System, p. 112.  Back.

Note 84: Kenneth W. Dam, The Rules of the Game, Reform and Evolution in the International Monetary System (Chicago: University of Chicago Press, 1982), p. 77.  Back.

Note 85: Benjamin N. Rowland, “Preparing the American Ascendancy: The Transfer of Economic Power from Britain to the U.S., 1933–1944,” in Balance of Power or Hegemony?: The Interwar Monetary System, ed. Benjamin N. Rowland (New York: New York University Press, 1975), p. 217.  Back.

Note 86: As quoted by Rowland in “Preparing the American Ascendancy,” pp. 222–223, fn. 41.  Back.

Note 87: Rowland, “Preparing the American Ascendancy,” pp. 220–221.  Back.

Note 88: Edward L. Morse, “Political Choice and Alternative Monetary Regimes,” in Alternatives to Monetary Disorder, ed. Michael Schwarz (New York: McGraw-Hill, 1977), pp. 81, 83.  Back.

Note 89: John S. Odell, U.S. International Monetary Policy, Markets, Power and Ideas as Sources of Change (Princeton: Princeton University Press, 1982), p. 84.  Back.

Note 90: Morse, “Political Choice and Alternative Monetary Regimes,” p. 85.  Back.

Note 91: Barry Eichengreen, “Hegemonic Stability Theories of the International Monetary System,” in Can Nations Agree? Issues in International Economic Cooperation, (Washington, DC: Brookings Institution, 1989), p. 275.  Back.

Note 92: Marcello de Cecco, “International Financial Markets and U.S. Domestic Policy Since 1945,” International Affairs 52 (3) (July 1976): 382, 394.  Back.

Note 93: Arthur M. Okun, The Political Economy of Prosperity (New York: Norton, 1970), p. 53.  Back.

Note 94: Herbert G. Grubel, “The Benefits and Costs of Being the World Banker,” in The International Monetary System, Problems and Proposals, eds. Lawrence H. Officer and Thomas D. Willett (Englewood Cliffs, NJ: Prentice-Hall, 1969), p. 62.  Back.

Note 95: Odell, U.S. International Monetary Policy, p. 175.  Back.

Note 96: Joanne Gowa, Closing the Gold Window: Domestic Politics and the End of Bretton Woods (Ithaca: Cornell University Press, 1983), p. 14.  Back.

Note 97: Odell, U.S. International Monetary Policy, p. 165.  Back.

Note 98: Ibid., pp. 166, 202.  Back.

Note 99: Gowa, Closing the Gold Window, p. 25.  Back.

Note 100: Ibid., p. 67; Odell, U.S. International Monetary Policy, pp. 238–239.  Back.

Note 101: Gowa, Closing the Gold Window, p. 151.  Back.

Note 102: Odell, U.S. International Monetary Policy, pp. 192, 233, 346–347.  Back.

Note 103: Gowa, Closing the Gold Window, pp. 31, 107–108, 115.  Back.

Note 104: Ibid., p. 62.  Back.

Note 105: Odell, U.S. International Monetary Policy, pp. 268–269.  Back.

Note 106: Ibid., p. 270.  Back.

Note 107: Gowa, Closing the Gold Window, p. 132. Also see Jonathan Kirshner, Currency and Coercion (Princeton: Princeton University Press, 1995).  Back.

Note 108: Dam, The Rules of the Game, p. 256.  Back.

Note 109: Michael Munger and Brian Roberts, “The Federal Reserve and its institutional environment: a review,” in The Political Economy of American Monetary Policy, ed. Thomas Mayer (New York; Cambridge University Press, 1990), p. 91.  Back.

Note 110: Grieder, Secrets of the Temple, pp. 96–97.  Back.

Note 111: See Laurence A. Krause, Speculation and the Dollar (Boulder, CO: Westview Press, 1991), pp. 220–222 and Grieder, Secrets of the Temple, p. 83.  Back.

Note 112: Grieder, Secrets of the Temple, pp. 46–47.  Back.

Note 113: Ibid., pp. 96–97.  Back.

Note 114: Ibid., pp. 110–112, 116.  Back.

Note 115: Ibid., p. 142.  Back.

Note 116: As quoted by Grieder in Secrets of the Temple, p. 143.  Back.

Note 117: I. M. Destler and C. Randall Henning, Dollar Politics: Exchange Rate Policymaking in the United States (Washington, D.C.: Institute for International Economics, 1989), pp. 2, 28.  Back.

Note 118: Destler and Henning, Dollar Politics, p. 31.  Back.

Note 119: Yoichi Funabashi, Managing the Dollar: From the Plaza to the Louvre (Washington, D.C.: Institute for International Economics, 1988), p. 68; Destler and Henning, Dollar Politics, pp. 2–3, 29.  Back.

Note 120: Destler and Henning, Dollar Politics, p. 88.  Back.

Note 121: Ibid., pp. 12, 89; David M. Jones, The Politics of Money: The Fed Under Alan Greenspan (New York: New York Institute of Finance, 1991), p. 119.  Back.

Note 122: Funabashi, Managing the Dollar, pp. 69–74.  Back.

Note 123: Destler and Henning, Dollar Politics, pp. 132–133.  Back.

Note 124: I. M. Destler and C. Randall Henning, “From Neglect to Activism: American Politics and the 1985 Plaza Accord,” Journal of Public Policy 8 (June 1989): 323.  Back.

Note 125: Destler and Henning, Dollar Politics, p. 39.  Back.

Note 126: Grieder, Secrets of the Temple, pp. 473–474.  Back.

Note 127: Destler and Henning, Dollar Politics, p. 40.  Back.

Note 128: Grieder, Secrets of the Temple  Back.

Note 129: Destler and Henning, Dollar Politics, pp. 43–44.  Back.

Note 130: Destler and Henning, “From Neglect to Activism,” p. 317.  Back.

Note 131: Destler and Henning, Dollar Politics, pp. 2–3.  Back.

Note 132: Funabashi, Managing the Dollar, p. 46.  Back.

Note 133: Destler and Henning, Dollar Politics, p. 53, and also “From Neglect to Activism,” pp. 326–327.  Back.

Note 134: Destler and Henning, Dollar Politics, pp. 43–44, 58–59.  Back.

Note 135: Ibid., pp. 60–61.  Back.

Note 136: Ibid., pp. 67–68.  Back.

Note 137: Funabashi, Managing the Dollar, p. 57.  Back.

Note 138: Destler and Henning, Dollar Politics, pp. 74–75.  Back.

Note 139: Jones, The Politics of Money, p. 113.  Back.

Note 140: Meltzer, “The Federal Reserve at 75,” p. 61.  Back.

Note 141: Jones, The Politics of Money, p. 45.  Back.

Note 142: For an interesting look at these issues, see “Will the Buck Stop Here?” The Economist, November 12, 1994, p. 88. Also see George Tavlas, “On the International Use of Currencies: The Case of the Deutsche Mark,” Princeton Essays in International Finance No. 181 (March 1991).