The Great Deformation (45 page)

The rub was that this gold settlement process under the official Bretton Woods system was highly discretionary and political, not automatic and market driven as under the pre-1914 gold standard. Consequently, official gold settlements did not necessarily “clear the market” and force immediate monetary tightening and economic adjustments in the deficit countries, as occurred under the classic gold standard mechanism.

Under the dollar-based gold exchange standard, in fact, trading partners with dollar surpluses could be “persuaded” (by Washington) to forego the conversion of these dollars at the US gold window. They were instead forced to accumulate short-term dollar claims which counted as monetary “reserve” assets.

As the hegemonic power during the early Cold War era, the United States self-evidently had the wherewithal to enforce a de facto policy of involuntary reserve accumulation. The overseas hoard of dollars piled up in foreign central banks was thereby steadily enlarged, even as the US balance of payments deficits grew during the 1960s and remained uncured.

The one escape valve was the ability of countries with unwanted dollars to quietly swap them for gold in the London market. Accordingly, in the early days of Bretton Woods, bureaucrats at the International Monetary Fund (IMF) made efforts to get participants to outlaw private gold markets.

They recognized that someday official parities could be threatened if the free market price of gold diverged too far from $35 per ounce. But the presence of makeshift private gold markets in places like Macau, Tangiers, and Hong Kong, along with the steady clandestine sale of gold for desperately needed hard currency by the Soviet Union, finally encouraged the Bank of England to reopen the old London gold market in March 1954.

For the next half decade, the London market operated quietly alongside the official gold window of the US Treasury. This nascent London-based free market in gold provided an outlet for Soviet bullion sales, small transactions by foreign central banks, and a venue for a corporal's guard of private speculators to make small-time bets.

There was little reason to speculate against the gold dollar at $35 per ounce so long as the disciplined fiscal and monetary policies championed by Eisenhower and Martin, respectively, remained intact. But the combination of a modest deterioration in the US balance of payments during 1960 and the prospect that US economic policies would lurch away from orthodoxy quickly ended the quietude.

As Charles A. Coombs, then a key player at the New York Fed's international desk, observed in his memoir of the era, “The market could smell thunder in the air…. [S]entiment shifted abruptly during the weekend of October 15, 1960.”

After years of somnolent fluctuations around parity, the gold price in the London market thus flared to $40 per ounce in late October 1960, which was an unexpected and shocking development at the time. The free market gold price came off the boil only after candidate Kennedy publicly committed to maintenance of convertibility at the official $35 price. Still, as Coombs further noted, the Fed's earlier worry that “the London gold price
would become a barometer of confidence in the dollar was being vindicated with a vengeance.”

This pre-election gold panic was the free market's premonition of the lethal threat to Bretton Woods posed by the new economics. Yet the Keynesian professors were largely oblivious to the warning.

Notwithstanding the two full months that Professor J. M. Keynes and comrade Harry Dexter White had spent at Bretton Woods, New Hampshire, perfecting a new world monetary order during the summer of 1944, they had not expurgated the “barbarous relic” of free market gold, after all. In fact, the London gold market was a peephole back into the pre-1914 monetary order.

Under the classical gold standard régime, as previously noted, the propensity of governments and central banks to debauch the official paper money could be swiftly checked by its conversion into gold coins and bullion by private investors and speculators. On the eve of John F. Kennedy's presidency and the arrival of the new economics in Washington, therefore, the ancient discipline of free market gold was energetically reemerging through the London market.

BRETTON WOODS AND GOLD: THE VESTIGIAL LINK TO THE ANCIENT MONETARY RÉGIME

This development was not exactly anticipated or welcomed by officialdom. In fact, the turmoil in the London gold market was a complete contradiction of the framers' fervid intention that Bretton Woods function essentially as a hybrid form of international money that was ultimately state managed.

Indeed, there was only one reason why gold, rather than Keynes' pure fiat script, called “bancor,” had been made the official settlement asset under Bretton Woods, and it had nothing to do with monetary theory. As of July 1944, the United States held 80 percent of the world's stock of gold. Not surprisingly, the US delegation thought the Fort Knox hoard would provide more than enough chips for the international settlements table created by Bretton Woods.

From this signal fact the conference had leapt to the large, although unarticulated, conclusion that the United States could succeed as the reserve currency issuer under a gold exchange standard, notwithstanding the historical precedent of England's miserable failure in the role during the 1920s. And on the surface, of course, that wager was plausible given the vastly different circumstances of the two countries.

The British Empire had emerged from the Great War deeply wounded economically, with its public accounts heavily in debt, the London money market enfeebled, and the Bank of England's gold reserves down to a trifle.
It was only British arrogance that had presumed that a gold exchange standard could be reconstituted on this wobbly foundation.

The Bretton Woods conference appropriately judged that the United States was in a far better position to function as the anchor in this attempted revival of the gold exchange system. With $20 billion of gold reserves behind it, the dollar was a far more plausible candidate to function as a reliable reserve currency; that is, the US dollar of 1944 had every appearance of being the anti-sterling of 1925.

Indeed, in 1944 most of the world's economies outside North America were prostrate. Accordingly, the prospect that the United States would be plagued by chronic balance of payments deficits did not stir the imagination of the conference's leading thinkers.

So the “barbarous relic” had been reinstalled as the “reserve” or “settlement” asset at the heart of the new Bretton Woods system. Yet despite the conferees' genuine desire to revive honest international money after the calamity of 1930s economic autarky and depreciated national currencies, the arrangement ignored the fundamental flaw of the sterling exchange system.

If America's vast gold hoard was ever dissipated, then the danger would arise that the United States, as the issuer of the reserve currency, would find itself in the British position of the 1920s. Like the British, it could be tempted to force its trading partners to accumulate vast unwanted dollar liabilities rather than put its own domestic financial house in order.

THE LESSONS OF THE STERLING EXCHANGE STANDARD UNLEARNED

Owing to the trauma of the 1930s and the totalitarian monsters to which it had given rise, the conferees at Bretton Woods understood perfectly well that a repeat of the British gold exchange standard failure had to be avoided at all hazards. Unlike today, it was then self-evident that in the absence of global financial discipline and settlement of trade and financial accounts on a regular basis, there lurked a monetary terra incognito teeming with financial terrors.

However, in attempting to revive, for the second time, the efficiencies of a single world money and the financial disciplining mechanism of the pre–World War I gold standard, the conference succumbed to the same error as the 1920s go-round; namely, under Keynes's tutelage it focused on accommodating economic growth and the alleged problem of a shortage of gold reserves. The real imperative, however, was resurrecting a mechanism for international financial discipline that did not depend upon the political self-control of the reserve currency issuer.

Indeed, the deeply flawed idea of “economizing” on the world's gold stock by allowing nations to settle their current account imbalances through payments in a designated “reserve currency,” as well as gold, had been launched at a 1921 conference in Genoa. It had been convened by the League of Nations to reconstitute the international financial system from the monetary ruins left by the Great War.

The self-serving British theory at the time was that world recovery would be better nurtured by a more ample and elastic system of monetary reserve assets than would have obtained from a return to a pure gold specie system. Since Britain had exhausted all of its gold during the Great War, it amounted to a pauper's monetary standard.

Nevertheless, during the course of the 1920s this “gold plus reserve currency” arrangement became widespread, as more than thirty nations ended wartime fiat money régimes and returned to fixed exchange rates and convertibility of their currencies into either gold or sterling and dollars. As previously indicated, this jerry-built gold exchange standard appeared to be just the ticket, as the entire global economy recovered and grew at a robust pace between 1924 and 1929.

As has also been seen, however, the boom had been fueled by massive Wall Street foreign bond issuance and a temporary surge in US exports and world trade. When that daisy chain of faux prosperity came to a screeching halt, the underlying flaw of the sterling exchange system became apparent; namely, that Britain had neither the resources nor political will to perform its obligations as the reserve currency issuer.

THE BRITISH MONEY-PRINTING SPREE UNDER THE GUISE OF THE GOLD EXCHANGE STANDARD

In fact, the postwar gold exchange standard turned out to be the first great experiment in sovereign debt–based money. In this case, the money in question was the massive accumulation during the 1920s boom of pound sterling monetary reserves by France, Holland, Sweden, Italy, and the central and eastern European nations.

But these “reserves” were just a back-door form of British borrowing which permitted it to live beyond its means. The financial devastation of the Great War had depleted the British industrial economy and left the government and much of industry deeply in debt. But rather than reduce consumption, wages, and living standards in order to rebuild its economy and pay down its war debts, British policy embraced an illusion.

It attempted to return to pre-war exchange rate parity ($4.86 per pound sterling) at postwar wages and prices. Yet since the British price level had risen by 200 percent during the course of its desperate money printing
during the Great War, its attempt at “resumption” on the cheap was a disaster. It resulted in an overvalued pound, chronic current account deficits, and an inflationary monetary policy that printed far too much sterling.

In the end, the Bank of England's grand experiment in money printing failed to achieve domestic recovery. The British economy, unlike most of the rest of the world, stagnated for much of the 1920s. But this monetary profligacy did flood the international financial system with more sterling liabilities than were sustainable; that is to say, Great Britain attempted to borrow its way back to prosperity.

This easy way out of the Great War's legacy of debt, devalued sterling, and depleted industries inexorably came a cropper. As has been seen, when the global economy shrank sharply after Wall Street's foreign bond financing machine shut down, world trade plunged even more rapidly. In turn, this downward trade spiral triggered the final unwinding of the worldwide debt bubble that had reached an asymptotic peak in 1928–1929.

The bubble's collapse began in central Europe, where some of the most egregious of Wall Street's “subprime” loans of that era had been made, and most famously resulted in the May 1931 run on Credit Anstalt, Austria's largest bank. Depositors in the Austrian banks, and a month later in German banks, too, correctly perceived that these institutions were insolvent because their hard-hit domestic customers could no longer service their loans—especially their dollar borrowings.

Moreover, their own governments were too financially weak to save their domestic banks, and the taxpayers of the world had not yet bequeathed to the banking fraternity its very own IMF bailout machine. Consequently, there ensued a flight from the imperiled banks and currencies of Austria, Germany, and other central and eastern European nations and a corresponding scramble for gold.

In short order, the flight to gold from the weak paper currencies of continental Europe during the summer of 1931 lapped up on the shores of England, too. As it happened, the British government had the tools in hand to turn back the assault and defend the very gold exchange system it had championed. But like the United States under Johnson and Nixon four decades later, it could not summon the political will to discharge its obligations as the reserve currency issuer.

THE GREAT BETRAYAL OF SEPTEMBER 1931: WHEN THE BANK OF ENGLAND UNNECESSARILY DEFAULTED

In August 1931, only a few weeks before England defaulted, a national unity government had been installed and stern measures to curtail its
budget deficit by means of tax increases and reductions in lavish spending for industrial subsidies and social programs had been enacted.

All that was needed was for the Bank of England to deploy its time-tested tool and implement a sharp increase in its discount rate, which was only 2.5 percent at the time, in order to stem the outflow of short-term money from London. Indeed, it was morally obligated to take these painful steps.