The Great Deformation (53 page)

Its first attempted solution was a Burns-Connally hybrid known as the Smithsonian Agreement of December 1971. This originated shortly after Camp David when Secretary Connally pronounced that whatever ailed the American economy, fixing it would be no problem: to wit, the United States needed precisely a $13 billion favorable swing in its balance of trade. This was not to be achieved the honest way—by domestic belt tightening and thereby a reduction of swollen US imports that were being funded by borrowing from foreigners. Instead, America's trading partners were to revalue their currencies upward by about 15 percent against the dollar.

The immediate effect of revaluation would have been a drastic loss on the billions of exchange reserves that major foreign central banks had previously not converted to gold in deference to Washington. This was September 1931 all over again.

Furthermore, along with taking this balance sheet hit, trading partners would also have to tighten their own belts by absorbing more American exports, which would now be cheaper and more competitive in their home markets. At the same time, they would be shipping fewer of their own goods to the American market, because their exports to the United States would now be more expensive and less competitive.

Connally's blatant mercantilist offensive was cut short in late November 1971, however, when the initially jubilant stock market started heading rapidly south on fears that a global trade war was in the offing. Seeing his opening, Paul Volcker, who was undersecretary for monetary affairs, deftly jerked the rug out from under Connally and Nixon. At a finance ministers' meeting in Rome he offered to increase the dollar price of gold by 10–15 percent.

In truth, this was an element of Burns' scheme to reset Bretton Woods at a higher, more defensible gold price. At the moment, however, it was received by the European negotiators as a huge US concession, because until then Nixon and Connally stoutly insisted there would be no change in the gold price. Realignment would consist exclusively of trading partners making their currencies more expensive against the dollar.

As it turned out, a few weeks later Connally's protectionist gauntlet ended in an amicable paint-by-the-numbers exercise in diplomatic pettifoggery. The United States agreed to drop the 10 percent import surtax and raise the price of gold by 9 percent to $38 per ounce. At the same time, the major foreign trading partners who had gathered at the Smithsonian
agreed to revalue their currencies against the dollar by an average increase of 8 percent, including a 14 percent upward adjustment by Germany and 17 percent by Japan.

On the surface, these agreements appeared to comprise a comprehensive realignment of the fixed-rate international monetary order, thereby providing the framework for a putative “Bretton Woods II.” Indeed, at the closing dinner at the Smithsonian on December 18, Nixon appeared unannounced to herald the agreement as “the most significant monetary agreement in the history of the world.”

THE SMITHSONIAN AGREEMENT:

GOLD STANDARD WITHOUT GOLD

In fact, the Smithsonian Agreement was a Texas Special: all hat and no cattle. Quite simply, the United States had made no commitment whatsoever to redeem paper dollars for gold at the new $38 price or to defend the gold parity in any other manner. Yet without an anchor on the dollar, there was absolutely nothing to stop a worldwide process of competitive devaluation in response to excessive dollar creation, an outcome which would doom the newly aligned matrix of fixed exchange rates to chronic turmoil and instability.

In reality, the Smithsonian deal granted the United States a monetary hall pass, allowing the Fed to print dollars at will and the American economy to continue binging on inflationary credit expansion, soaring imports, and an expanding current account debt to the rest of the world. Ironically, the traditionalist Burns had wished the Fed to be actually re-tethered to gold at $38 per ounce; that is, that there be an honest “reset” of Bretton Woods, including a US obligation to redeem dollars for gold when presented by foreign central banks.

But since the new $38 per ounce gold value was only a meaningless reference price, the Smithsonian outcome put him at the end of an altogether different kind of tether; namely, that of heavy-handed demands from the Nixon White House for an election-year spree of easy money. Without the threat of a run on gold, Burns' only defense was a stiff backbone, something he manifestly did not possess.

Paul Volcker had surveyed the scene at the time of Nixon's preposterous pronouncement at the Smithsonian dinner and had delivered a more sober and accurate verdict. “I hope it lasts three months,” said the man who years later would be brought into the Fed to stop the monetary mayhem which ensued.

Volcker's cynicism at the moment was absolutely warranted. At bottom, the Smithsonian Agreement attempted the futile task of perpetuating the
Bretton Woods gold exchange standard without any role for gold. It bestowed the responsibility for leadership of this jerry-built arrangement on a White House which quickly went AWOL. Yet without a US commitment to defend the gold parity, the newly minted Smithsonian exchange rates were sitting ducks for speculative attack.

Accordingly, the British pound soon came under heavy fire. By the late spring of 1972 when the pound crisis came to a head, there was no chance that the United States would help defend the system it had foisted on the world just a few months earlier.

By now Shultz had moved to the treasury secretary post, and his automatic refrain on exchange rate issues was to lip-synch Milton Friedman on the virtues of floating. For reasons that were purely political rather than ideological, Nixon was moving his lips on the subject, too. When the British finally gave up on June 22 and allowed the pound to float, Chief of Staff H. R. Haldeman mentioned this development the next morning and offered a briefing. “I don't care about it,” retorted Nixon.

When Haldeman persisted with the topic, the White House tape-recording system captured the essence of why chaos was about to descend on the international monetary system. Chairman Burns had informed the White House staff that the British float would encourage further attacks by speculators and that the Italian lira was likely the next currency in the line of fire. “Well,” the president of the United States observed, “I don't give a shit about the lira.”

During the next eight months, further international negotiations attempted to rescue the Smithsonian Agreement with more baling wire and bubble gum. But the die was already cast and the monetary oxymoron which had prevailed in the interim, a gold standard system without monetary gold, was officially dropped in favor of pure floating currencies in March 1973.

Now, for the first time in modern history, all of the world's major nations would operate their economies on the basis of what old-fashioned economists called “fiduciary money.” In practical terms, it amounted to a promise that currencies would retain as much, or as little, purchasing power as central bankers determined to be expedient.

WHEN A SPECULATOR'S PARADISE ARRIVED IN MONETARIST BLINDERS

In stumbling to this outcome, Nixon's advisors were strikingly oblivious to the monetary disorder they were unleashing. Indeed, they were creating a speculators' paradise, but their monetarist blinders did not permit them to see it coming.

In fact, there is no evidence of any awareness among Nixon administration policy makers of the financial pounding that industrial corporations and banking institutions alike would take when exchange rates and interest rates began to gyrate wildly—and over huge amplitudes that had never before been experienced in peacetime. Nor was there any attempt to explore with Wall Street, or other major financial institutions, the development of hedging and risk mitigation arrangements which might now be needed.

Alas, the reason for this glaring neglect was not a rigid White House commitment to laissez-faire. After all, at the time the gold dollar was being flushed, the Nixon White House was busy imposing wage and price controls across the length and breadth of the American economy. In fact, the passivity of the “religious floaters” club in the White House was owing to their reflexive adherence to the profoundly erroneous monetarist doctrines of Milton Friedman.

As detailed in
chapter 13
, Friedman was a committed anti-statist who had low regard for politicians and much disdain for their attempts at the economic betterment of society. And justifiably so. Yet in pushing the gold standard and fixed exchange rate system onto the scrap heap of history, the modern-day godfather of free markets helped foster the greatest project of statist intervention and subvention ever conceived—that is, monetary central planning of the national and, indeed, world economy by the Federal Reserve.

Milton Friedman never saw this lethal threat to free markets and sound money, however, owing to his blinding disdain for politics and the unaccountable presumption that—somehow—the inner sanctum of the Eccles Building would be populated by monetary eunuchs. Oblivious to short-term economic fluctuations, election cycles, unemployment rates, and sectoral and sectional economic dislocations, as well as the macroeconomic effects of pestilence, drought, and flood, they would operate far removed from the clamor for policy action on both ends of Pennsylvania Avenue.

A Friedmanite Fed would keep the money growth dial set strictly at 3 percent, year in and year out, ever steady as she goes. Like the fabled Maytag repairman of that era, central bankers in the Friedman mold would mostly sit around quietly in the library of the Eccles Building playing Scrabble and reading book reviews.

Not surprisingly, therefore, Friedman's pre-1971 writings nowhere give an account of the massive hedging industry that would flourish under a régime of floating paper money. This omission occurred for good reason: Friedman didn't think there would be much volatility to hedge if his Chicago-trained central bankers stuck to the monetarist rulebook.

Accordingly, Friedman never even entertained the possibility that once the central bank was freed from the stern discipline of protecting its gold reserves, it would fall into the hands of monetary activists and central planners. Most assuredly, he did not realize that once politically driven theories of macroeconomic betterment gained policy dominance, the Fed as an institution would become a fount of rationalizations for incessant tinkering and intervention in financial markets.

And, most certainly, Friedman did not see that an unshackled central bank would eventually transform his beloved free markets into gambling halls and venues of uneconomic speculative finance. Yet that would be the unavoidable outcome of a central bank that contaminated private financial markets with cheap credit, while providing “put” protections for carry trades and accommodation to dirty floats and pegged currencies. All of these deformations tended to fuel violent swings in exchange rates, interest rates, and capital markets.

In fact, Friedman was so blind to the hedging monster that would inexorably arise from his model of fiat central banking that within weeks of the Camp David events the renowned Professor Friedman put a pitifully low price tag on his own ideas for commercial exploitation of floating currencies. The precise number was $7,500, and even in that day it didn't amount to much.

As it happened, Friedman priced his own advice at rock bottom shortly after Nixon closed the gold window. He had been approached to consult on a potential currency-hedging market, but the inquiry did not come from the great currency-dealing international banks of New York, London, or even the big Loop banks in Friedman's hometown of Chicago.

At the time, institutions such as Morgan Guaranty, Citibank, and Continental Illinois were deeply immersed in the financing of world trade and capital and money flows, facilitating billions in currency transactions every week. Yet none of these great financial institutions even anticipated that a new business opportunity of immense magnitude was unfolding with each new monetary stumble in Washington. Even after Camp David very few experienced financiers believed that a purely floating-rate currency régime was likely or workable.

It thus happened that Leo Melamed, a small-time pork-belly (i.e., bacon) trader who kept his modest office near the Chicago Mercantile Exchange trading floor stocked with generous supplies of Tums and Camels, found his opening and hired Professor Friedman. Even as several dozen traders at the Merc labored in obscurity to ping-pong a thousand or so futures contracts per day covering eggs, onions, shrimp, cattle and pork bellies, Melamed was
busy plotting the launch of new futures contracts in the major currencies. In so doing, he inadvertently demonstrated how radically unprepared the financial world had been for the Friedmanite coup at Camp David.

THE PORK-BELLY PITS: WHERE THE AGE OF SPECULATIVE FINANCE STARTED

Leo Melamed was the genius founder of the financial futures market and presided over its explosive growth on the Chicago “Merc” during the last three decades of the twentieth century. He understandably ended up exceedingly wealthy for his troubles, but on Friday afternoon of August 13, 1971, it would not have been evident to most observers that either of these outcomes was in the cards.

At the time of the Camp David weekend that changed the world, the Chicago Merc was still a backwater outpost of the farm commodity futures business. It originated as the Butter and Egg Board a century earlier and had recently branched out into livestock. Leo Melamed was its rising star. He had been a sensation at an early age, trading egg, bacon, and onion contracts, and had emerged as a charismatic leader and innovator obsessed with growing the range and volume of contracts traded on the Merc.