The Similarities Between 1961 and 2007 Are Disconcerting

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On October 19, 1960, the financial press was in high gear describing the near-chaos that was prevailing in London gold markets. Gold had spiked all of 28 and one half cents from the prior close, having traded as high $35.65, to end the day at $35.60. That was an enormous change to global perceptions of monetary stability, though in the modern, high-flying world of everything floating it sounds perfectly quaint if not totally over-excited. Rumors flew around the world of irregularity with regard to Swiss circumstances, or as the Chicago Tribune recorded, "Market sources attributed the ‘substantial' demand to the recent decision by Swiss authorities to check the flow of short term foreign funds into the country..." Gossip is a human constant, so market gossip is perhaps the only truly immutable law of finance.

Compared to the next day, however, the $0.285 surge has been forgotten. On October 20, the London price of gold surged above $40, briefly touching $40.50, in what was threatening to undo the entire global monetary framework - Bretton Woods. The price of converting (by central banks alone, which is telling) dollars into gold was supposed to be almost perfectly fixed at $35 per ounce (rather, more appropriately, one dollar for 0.88671 grams of gold). The London trade had, since reopening just six years before, varied only slightly between $34.85 and $35.17. That range was established by New York/London arbitrage, which would factor about eight to ten cents per ounce for shipping and insurance and then another eight cents for trade commissions and any final profit spread.

To see gold trading at $40 was a dutiful shock, as it meant buy orders far in excess of any perceived ability to maintain arbitrage order; governments and all. It was one of those forgotten historical days where everything in an instant had changed; the world would not be the same thereafter.

It took almost a decade, but Bretton Woods was mostly gone by 1968 when gold started trading at a two-tiered price. In reality, functionally, Bretton Woods ended not long after October 20, 1960, in the formation of what would become known as the London Gold Pool - a consortium of government and central bank allocations that would actively supply gold when needed to "hold" its price and enforce the official price. By the standards of Bretton Woods, to have a foreign pool established in order to maintain the convertibility of the dollar alone was breaking the rules.

That fact occurred almost immediately after gold flirted with $40. In fact, on October 27, 1960, the Bank of England was called upon to work closely with the Fed to supply gold in an attempt to calm that market (though there is little paper trail, you know there were gold swaps flying the Atlantic from that point). It was the initial formation of the Gold Pool, and had some success in at least keeping further "devaluation" from rapidly destabilizing global affairs, financial and economic.

Economic history being so neglected as it is (or history in general), the timing of all this is easily relatable. The US was captured by a stubborn economic recession (that would turn into a true double-dip) and after-effects combining with the politics of a Presidential campaign. Senator Kennedy's election efforts were well-known to include the likes of Paul Samuelson and his Keynesian "innovation" of "purchasing" unemployment through inflation. There were also fears, unfounded or not, that Kennedy might go so far as FDR and officially devalue the dollar in his first hundred days of 1961.

Apart from those political uncertainties, orthodox tradition paints the "current account" problem as a major point of emphasis in the growing dollar destabilization. In general terms, the US was sending too many dollars abroad due to military expenditures and the basic economic nature of the close post-war world. That supposedly led to increasing fears that the US, at some point, would not be able to meet convertibility at all - more foreign-held dollars for a fixed quantity of US-held gold since American gold stockpiles were not any longer growing.

In fact, since 1958, American gold holdings had been rapidly shrinking. Again, that was attributed to the current account imbalance (and what would become known as Triffin's Paradox) but that explanation has always been far too simplistic and incomplete. The Fed, too, felt as much though never displaying an attempt to explore the inconsistency. Perhaps they were too mechanically pre-occupied contemporarily, as they were marshalling resources to fight the huge gold outflow. The Wall Street Journal screamed the scale of the gold issue in a headline from September 21, 1960, just a month before the great price event, registering, "Largest Regular Weekly Decline Since 1931."

Any comparison to the Great Depression was bound to foster unchecked excitability, particularly when that calamity was still within memory of those "in charge." At the January 1961 FOMC meeting, staff economist Mr. Marget followed the staff presentation about the rather grim economic situation with an update to the gold outflow: $280 million in October 1960, $490 million in November and $440 million in December plus a further $130 million the first week of January 1961.

"What is disquieting about this is not the mere fact of the large increase in the rate of outflow, but the nature of the forces lying behind this increase. Up to last November, it was possible to say that, despite our balance-of-payments difficulties, there was no evidence of a ‘flight from the dollar,' in the sense of a significant conversion of dollar balances by the holders of those balances into gold. Our proof of this was the level of those dollar balances themselves. As long as these dollar balances not only failed to show any significant decrease, but actually continued to increase, it was impossible to argue that a ‘run' on the dollar was occurring."

Not only were prior friendly governments beginning to convert their "accretions" in dollar balances, they were openly expressing their desires to go beyond that and start converting past dollar balances. It was a run.

As Mr. Marget would continue, the theoretical link of gold outflows to the current account in 1961 was indeed tenuous:

"It is one of the paradoxes of the current situation that nothing has happened with respect to our basic balance-of payments position which would warrant a sudden loss of confidence in the dollar on the part of foreign monetary authorities. On the contrary, it can be argued (as it is in fact argued on page 26 of the current staff report on recent economic developments prepared for this Committee) that, at the very time when the gold drain has been accelerating, our deficit on current and long-term capital transactions combined (leaving out of account, that is, only short-term capital movements, which by definition may be regarded as reversible) was running at a seasonally adjusted annual rate of under $1 billion."

Instead, Marget ties the power of the Fed's "flexible" monetary policy to that very balance-of-payments improvement, thus getting very close to the nature of the issue while still finding a way, as orthodox economists seem to do no matter what time in history, to manage the opposite interpretation.

"It would be a very serious matter indeed if both the liberal foundations of our international commercial and financial policies for bringing our international accounts into balance and the degree of flexibility which we have been able to maintain in our domestic monetary policy were to be shaken by so rapid a deterioration in our reserve position, as the result of gold losses due to a loss of international confidence in the future of the dollar, that we should have no alternative to a policy of contraction, on both the international and domestic fronts, which would be the very opposite of what may be called for by the basic economic facts of both the international and the domestic situations."

By this retelling of the late 1950's, the Fed had taken a greater guiding hand in more "liberal" economic agendas and transactions which improved the one grand imbalance that had been leading to gold's sudden departure from our shores, but which then produced not its reversal and solution but greater acceleration? At the very least, you can gain a sense of twisted logic if not something rather significant missing from Marget's exhortation (as well as the fact the current account was nowhere sufficient an explanation).

The scale of gold outflow from 1958 to 1962 is, to this day still, unbelievable. The total was 30%, including a six-fold increase in the average yearly amount starting with 1958; 10% that year alone, 5% in 1959 and another 9% in 1960 before and after October 20.

Mr. Marget's "something" is both rather easily located in 1958 and of globally historic proportion; outside of major war, no gold flow had been so immense. In this sad little tale of the specifics of this paradigm shift, the year 1958 was just that prominent. That was the year foreign treasuries, through their central banks, suddenly commenced exercising their rights under Bretton Woods. They had been given those rights back in 1944 at the start, but for "some" reason they were reluctant to do so even during some very grim circumstances (Korea, and inflation, notably) before. Undoubtedly, part of that was due to, again, the post-war world where foreign partners were still rebuilding not just societies but the economic and monetary systems within them.

And so some assert, to this day, that part of the change in 1958 was newfound confidence of mainly Europe to start exercising some independence. That may be true, and I don't want to discount that at all, but that still doesn't produce the exact nature of the catalyst.

If 1960-61 was the double-dip, 1958 was the first part of that recession pattern; and a particularly serious one. Given that circumstance, it isn't surprising to find the FOMC very busy, particularly in the first part of the year as the recession careened toward its ultimate trough. In January 1958, the FOMC allowed margin requirements on listed securities to decline from 70% to 50%; the Discount rate was reduced 25 bps to 2.75% in February, followed by another 50 bps in March and a further 50 bps by May; reserve requirements were adjusted by 50 bps across the reserve system, freeing up an estimated $500 million in bank reserves (the Fed's June 1958 estimate).

While all that was certainly significant, the FOMC had also been actively purchasing securities on the open market - historically active. Exports had fallen by about one-eighth, some of which was attributed to the re-opening of the Suez and thus a decline in US exports of petroleum, but was mostly due to the global effects of recession. Imports, however, were little changed. Gold had begun flowing in late 1957 to foreign hands, which was threatening, as it should given what are supposed to be the Rules of the Game regarding gold restraint on credit and money, bank reserve balances during recession.

The Open Market Desk went into overdrive to counteract that monetary "tightening", just as the system had tried to do in the middle and late 1920's. FRBNY's monetary mechanism had purchased $600 million in T-bills between the February and May FOMC meetings. That was more than was expected (and likely authorized, so there is some inconsistently about the legal authority, though I am sure there was some plausible justification provided somewhere) as it proved not nearly enough. From the June 1958 FOMC transcript:

"In comments supplementing the reports which had been distributed, Mr. Larkin drew attention to the magnitude of operations in the System Open Market Account since the last meeting of the Committee. During that period the Account purchased approximately $600 million of Treasury bills, which was more than the Management had envisioned at the time of the last meeting and perhaps more than the Committee had envisioned. Despite these operations, however, Treasury bill rates had risen gradually and the average rate at yesterday's auction was .95. Furthermore, the New York city banks had encountered some reserve shortages, primarily because of the substantial increase in their loans to Government securities dealers."

The Fed responded to the reserve problem, again, caused by the combined gold outflows and recessionary reluctance of banks to expand issues, by purchasing an astounding $1.75 billion in government bonds and notes in a rather short window. The effects were obvious, even by June 1958 (and highlight some of the suppositions that support current monetary theory):

"System policies and the response of the banks to those policies have resulted in bank credit expansion during the past four or five months at a seasonally-adjusted annual rate of 12 per cent and sharp declines in short-term rates to exceedingly low levels. Much of this credit has directly or indirectly financed long-term commitments. Some of it has evidently been speculative or at least is believed to be of a temporary nature. In view of the changed tenor of current business statistics, indicated by Mr. Young's review, the major policy question to be determined is whether there should be some moderation of the recent vigorous policy of ease."

This was the classic orthodox setup whereby gold is blamed as the primary pro-cyclical agent - just as has been described of how the Great Depression became "Great." In other words, during recession gold flows were enforcing restraint on financial and monetary conditions and instead the FOMC was using its "flexibility" to directly counter it; a task it has given itself from that view of the Great Depression. Instead, the world market viewed such flexible design with immediate skepticism and even hostility, as the four-year outflow of gold would prove; culminating in the end of Bretton Woods altogether in the London Gold Pool. Orthodox economists will claim that the FOMC was correct, but there was another recession only a year and half into the future.

Further, if the "required" flexible monetary medicine led directly to the destruction of the global monetary arrangement anyway, it might fairly be said that economists were prioritizing themselves and their own power (as Mr. Marget lamented the possibility of losing "flexibility" if Fed economists and the Treasury couldn't find a workable solution to the gold outflow; they never did but economists' power only grew) more so than any monetary righteousness.

And that is the central highway that transits Bretton Woods into the Great Inflation (and dollar default). It is a story about power and control, one in which has become entirely too familiar. As the Fed bypassed gold once again with the official London Gold Pool in 1961, they were gaining more internal abilities toward their own discretion. Coming at an age where economists were full of unearned self-ascribed technical capabilities, it was the perfect storm of disaster. Just four years later, the world was lifted into a decade and a half of some of the worst economic circumstances; the FOMC departed gold and the rest of the world suffered from it.

If that were truly the end of this story, it would still be tragic. As I described several weeks back, by 1980 all of this monetary control was being thoroughly and in truly bipartisan fashion repudiated. Yet, "somehow", economists managed to do it all over again. That is the true tragedy here, as this same pattern has been repeated in almost exact fashion. The actual money market, gold in the case of the 1950's, was trying to rein back monetary flexibility, to which the Fed ascribed to itself an unknown duty to override the market - ending in economic and financial disaster that produced innumerable social consequences.

In that view, the similarities between October 20, 1961, and August 9, 2007, are unnatural and hugely disconcerting. In both cases, the market was trying to restore some semblance of reality and rational boundaries after undertaking great financial imbalance prior to those days (in the 1950's, it wasn't nearly as large and prolonged, which tells you a lot about what happens once economists cede themselves more influence and ability). It obviously didn't work in 2008, just as it didn't past 1965. Worse, by virtue of QE (multiple issues), the Fed (and other central banks globally) has continued to ignore the market's verdict by viewing 2007 and all its financial destitution as if that were some ideal to replicate.

That the results thereafter are the same, the Great Inflation as the aftermath of the Great Recession, is dictated in just these attempts - malaise and broad, global malcontentedness once more threaten social order. You allow economists the flexibility and the power to produce soft central planning and they will without fail prove themselves unequal to both that task and its assumed responsibility. That can be the only lesson, the only uniting and underlying factor; all the mechanics and methods of money and banking have been completely erased and rewritten and yet the result is the same. Economists ascribed to themselves great powers of flexibility that were unthinkable even in 1958, and what they produced was the same garbage to exponentially higher scales though with the same earth-shattering paradigm alteration.

In William Silber's book on Paul Volcker he quotes the man who would establish his reputation based on "inflation-fighting" as contemporarily viewing this theoretical transition to greater monetary "flexibility" saying,

"It all sounded too easy. Push this button twice and out pops full employment. Equations do not work as well on people as they do on rockets. I remember sitting in class at Harvard listening to [the fiscal policy expert] Arthur Smithies say, ‘A little inflation is good for the economy.' And all I can remember after that was a word flashing in my brain like a yellow caution sign: ‘Bullshit.'"

Yet for all that post-added posturing, Volcker was in 1983 (and more) carrying out exactly the same kind of interference that the FOMC was doing in 1958. The purpose was different, but the design was an exact replication. The problem is not so much "inflation" as Volcker was clearly against the concept, but rather it is power and discretion in all its forms and attempts. It should not be vested in any manner in centralized fashion, even in the hands of those lionized as "inflation-fighters." Volcker's Fed left behind our current central bank format, more powerful than anything in history (in what it can do) resulting from the intent ironically dedicated to still fighting inflation by interfering whenever and wherever it so chooses.

And just as the Fed lapsed into ineffectiveness and disaster with its newfound power in the 1970's, Greenspan's Fed did exactly the same, run over by the eurodollar which he actually noticed but somehow remained fully confident that his own pleasure (passed on to Bernanke and now Yellen) would be more than enough for the US and global economy. The eurodollar by 2015 has proved that disastrously wrong, but anyone not captured by the ideology could see it coming.

If there is a silver lining, it is this opportunity to recognize the problem as not just "inflation" mandates or practicing variations of economic theory but rather as one of centralization and discretion. As Alan Greenspan told Congress in July 2005:

"And, indeed, since the late '70s, central bankers generally have behaved as though we were on the gold standard. And, indeed, the extent of liquidity contraction that has occurred as a consequence of the various different efforts on the part of monetary authorities is a clear indication that we recognize that excessive creation of liquidity creates inflation, which, in turn, undermines economic growth."

While noting the timing of such a statement which would reveal not long thereafter its total absurdity, I would add, strenuously, that what truly undermines economic growth is both those who think inflation is beneficial as well as those who think they can and should overturn markets in order to control inflation or decide the "right" amount. Either effort ends in the same place, showing, again, Greenspan had no idea what he was talking about (or that he was being proactively disingenuous about his legacy). The true general means for getting the world stuck yet again in extended economic disaster and "lost decades" is not gold, not markets, but central bank flexibility of any kind and the economists who prioritize their power above market ability to self-correct.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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