Bad Money Is the Driver of All This Populism and Dissatisfaction

Bad Money Is the Driver of All This Populism and Dissatisfaction
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On March 16, 1968, governors and leaders from central banks then operating the London Gold Pool met in Washington, DC, to review operations and conditions for their cartel. Joined by the Managing Director of the IMF as well as the General Manager of the BIS, all the Bretton Woods heavies were in attendance, with the notable exclusion of French officials (the chief agitator of gold conversion). The presence of officials drawn from international bodies wasn’t unusual at these gatherings, but in 1968 this later Bretton Woods modification had become threatened more seriously than at any other previous point.

A day later, on March 17, they issued what became known as the Washington Communique, or the substance of the Washington Agreement on gold. The parties had all concurred that international cooperation such as what was undertaken in late 1960 in establishing the Gold Pool was still their primary consideration. Thus, gold would continue to be acquired and disposed of among members at official prices for official business.

What changed was the Pool would no longer sell gold for private market purposes, primarily in that London market. The effect was to establish two prices for gold; one in official capacity at Bretton Woods parities, the other a floating, market-based price.

There really wasn’t any other choice for them at that point. Given the events of 1967 (too many of substance to fully recount and catalog here), some $3 billion in gold had been lost by the Pool in just the five months preceding the Washington Communique. Depleting supplies largely in defense of gold prices on private speculation was a major problem, but it was not the only one.

The result was not just a two-tiered system for pricing gold, there seems to have been established a dual view of the monetary system, too.  Paul Volcker would years later recall, according to Alan Meltzer’s A History of the Federal Reserve, Volume II, that on becoming Treasury Undersecretary for Monetary Affairs in 1969, “I can assure you that it was certainly a cause for removal from office – if you raised any question about the gold/dollar link or the exchange rate of the US dollar.”

And yet, more than a year before Volcker would take his position, in July 1968, some mere months after the Washington Communique, Robert Solomon would write a (strictly) confidential memo to the Federal Reserve Board outlining some initial complications with the two-tier gold price system that contradicted Volcker’s assessment of the official position. The immediate issue was, for Solomon, as well as the last vestiges of Bretton Woods, South Africa.

That particular nation was, of course, one of the world’s leading gold producers. But such bounty has never guaranteed prosperity, humans being no angels. In strict monetary terms, South Africa had a current account payments problem which it would meet in large part by selling gold often to the IMF as well as European central banks. Solomon argued that official US policy should be to allow the IMF to set $35 an ounce as a floor for newly-mined South African gold, but that any further supply should be sold into the private market, leaving the IMF only to buy up on special considerations and circumstances.

In the context of the two-tiered system, it was in many ways seemingly a solution to their problems. The flood of South African gold onto the private market would mean what was sure to be if not re-established parity among the gold price tiers than a significant reduction in the spread. Having achieved that (which they did in the second half of 1969), it would restore, Solomon believed, enough confidence in the old order to keep the tattered system in place that much longer (it didn’t).

For one, the IMF had just created the Special Drawing Right, or SDR. While 21st century conceptions of the SDR have changed remarkably, its original incarnation was relatively simple and straightforward. As officials saw it, indeed the whole purpose of the London Gold Pool, there was a desperate need to correct flaws in the original Bretton Woods design. In 1944, neither John Maynard Keynes nor Harry Dexter White could foresee the demands of globalization put upon the monetary system.

It led to what Robert Triffin characterized as a paradox or dilemma. The original Bretton Woods framework left no provision for international liquidity. It was dependent on the idiosyncrasies of individual producer nations, like South Africa, and then a tangled web of agreements and counter-agreements for any new supply to be distributed in any kind of reasonable fashion. Nothing about it was straightforward.

The two-tier pricing structure was, in broad terms, one method of trying to decentralize, strange as it may sound, this unwieldy structure. The SDR’s would be a supplement to gold reserves, as they would be added to the system as the system needed them, hopefully correcting these sharp imbalances that became by the late sixties far too common.

Of course, what’s missing from all that was the very thing nobody really wanted to discuss. The reason 1967 was so momentous, monetarily speaking, was to start with another crisis in sterling. The UK government had made a habit of monstrous deficits that it really couldn’t afford, leaving the gold system to attempt to check them through base money withdrawal. Politicians hate to be checked by private hands, certainly not when they have the power, or opportunity, to change the rules in their favor.

It wasn’t just the British, though, who were out of balance fiscally. The Americans were becoming far more of a problem on that front. The Great Society as well as military intervention in Vietnam destroyed all prior US fiscal sense (for good), unleashing some of the pressures for what was becoming the Great Inflation.

Gold had for much of human history formed a boundary for such things. From the outside perspective, it was as Volcker later described, an indissoluble, implicit agreement dating back to the founding of the republic. For Robert Solomon writing on the ground, on the inside in Summer 1968, it was a weakness, too much constraint for the whole world economy. Thus, his confidential memo to the Federal Reserve Board spelled out the opposite of what was being said publicly:

“In particular, if monetary authorities would act upon the statement that, in view of the prospective creation of the SDR facility, the amount of gold in monetary stocks is sufficient, gold would play no significant role in the future growth of monetary reserves. In effect, gold would have been demonetized at the margin.”

It would be nominally a gold system that didn’t depend on gold. Immediately after writing that, he noted that such a position was not then one held by European central banks and something “not possible at present to persuade them to accept it.”  Still, for many that was the whole point all along.

Robert Solomon wasn’t just a faceless bureaucrat, one of the thousands scattered about at any given time buried within one and all of these agencies. He was the Fed’s chief international monetary analyst and negotiator, a man well-versed in what we call today the financial plumbing. He saw very early on the drawbacks of Bretton Woods particularly in the fifties as the global economy became far more global far more rapidly than previously thought possible.

In May 1984, the Federal Reserve Bank of Boston held the 28thconference in its symposium series, dating back to June 1969 (Jackson Hole isn’t the only regular symposium among the branches), in of all places Bretton Woods, NH. The topic was the fortieth anniversary of that monetary agreement and the status of the world just a few years after it was gone.

Presenting to that audience was, among several noteworthy participants, both Robert Triffin and Robert Solomon. The former’s presentation was geared more toward a relatively new development in the international monetary scheme – the European Monetary System, or EMS. Created in 1979, its purpose was, as Triffin said, to reduce European members’ dependence on “the vagaries of the dollar.” 

That was an interesting phrase to use in 1984, for it echoed one that he, Solomon, and so many others had used in the late sixties, and later in describing after-the-fact the monetary circumstances of the latter sixties. Solomon had said in complimenting Triffin:

“And as Robert [Triffin] also pointed out, the supply of new reserves was haphazard, depending on the vagaries of gold production (or that part of it that found its way into official reserves) and changes in the U.S. balance of payments. The agreement to establish Special Drawing Rights was designed to correct this flaw in the Bretton Woods arrangements. To be more precise, SDRs were a necessary, but not a sufficient, condition for dealing with the unstable supply of world reserves.”

Others at the later Bretton Woods gathering were more precise. The breakdown of the postwar monetary order fell along the lines of liquidity and international mechanics, the sort of modern needs that gold was ill-suited to meet. Robert Roosa, who was Treasury Undersecretary for Monetary Affairs for the Kennedy/Johnson administrations a few years before Volcker, recounted the many official “improvisations” that were tried as ad hoc reforms for Bretton Woods’ more glaring flaws; not just the London Gold Pool but also a “ring of swaps” where both the Federal Reserve and US Treasury held standing credit agreements to swap currencies (really provide exchange cover) with as many as twelve other central banks, and then what was a precursor to the Dim Sum bond, a US obligation floated offshore denominated in foreign currency.

Those were all serious attempts to address the serious systemic shortcomings, but all for naught because in truth they were in no way serious enough. As Roosa stated in 1984, the ultimate answer came from way outside the official circle.

“But this combination of improvisations could not cope with, and indeed may have contributed to, the enormous expansion in markets for U.S. dollars offshore, and the new networks of interbank relations that made possible the creation of additional supplies of dollars outside the United States and beyond the control of the Federal Reserve. The ‘offshore’ currency markets soon became securities markets and, spurred by the U.S. effort to maintain control over capital exports from the United States, markets in Eurodollar securities (where the interest would not be subject to U.S. withholding taxes) flourished.”

Solomon recalled, “We used to talk in the 1960s of three elements of the system: adjustment, liquidity, and confidence.”  Far too much of the official reform effort toward the end of the Bretton Woods system was aimed only at the last of those three elements. That was, as Volcker said, the defining official characteristic for anyone working for the government; maintain the status quo at all costs.

And yet, what good is confidence when the system has defined needs?  I’ll put it another way; while officials were busy trying to maintain confidence in the old way, the system itself was forced by necessity (the mother) to invent the means to its own ends without waiting for officials to be successful, or be proved otherwise. That’s ultimately what happened to the SDR’s, they were beaten to the punch by the eurodollar. The IMF came up with the former in 1969, while the latter had been in operation for maybe fifteen years already by then, oftentimes augmented by official actions even if officials didn’t know that was what they were doing (the “ring of swaps”, for one).

The ragged end of Bretton Woods, the real story rather than the single final act undertaken in August 1971, is both a cautionary as well as opportunistic tale. We are conditioned to believe that it is governments who set all the monetary rules, but in this case it was the opposite. Official action is no prerequisite no matter how many times the orthodox textbook repeats the canard that central banks are essential (as well as central) to monetary operation. They just aren’t.

This misconception is a huge part of our current problem. I’ve spent countless hours researching the history of the eurodollar as well as the end of Bretton Woods (as the two are intricately related) and what amazes me the most is that up until about 1984 these concepts were very well understood, discussed openly and forthrightly. And then…nothing. It’s as if the eurodollar fell off the face of the earth, at least in official writing and study thrown down the memory hole of Orwell fame.

We know, of course, that didn’t actually happen. The eurodollar became larger, stranger, and ever more integral to the manifestation of an international economy despite the blackout. It supplied the liquidity and adjustment mechanics the system required (and solved the confidence issue on its own) while for years policymakers dithered here and there with unsurprisingly weak, and ultimately unsuccessful, “improvisations.”  

Having had the major problems of transition from A to B solved for (despite) them, the Great Inflation being the cost of their failure to produce an orderly one, nobody by the later eighties and forward had much interest to talk about it any longer. It was a sore spot, a blot on the official record that central bankers in particular were eager to leave to the history books and nowhere else. They wanted a second chance to get it right, one freed from their prior bad acts (confidence, after all, has always been a big part of how Economists see their role in monetary affairs).

The eurodollar was the uncredited star in the movie Economists were very eager to produce, the one they would later call the Great “Moderation” with Alan Greenspan being purposefully given its top billing instead, Paul Volcker his costar.

The cautionary part of the story is the messiness of that evolutionary period. Left by itself, the private system becoming more and more incompatible with the official system, like the two-tier experiment in gold, can create greater instability and therefore contribute to the irregularity of the systemic transformation; it can be very pro-cyclical as you might be aware today. I’m not sure any kind of paradigm shift of this magnitude could ever really be seamless, but a fifteen to seventeen-year period of serious malaise that produced the term stagflation strains the limits of good conscience.

That’s ultimately, I think, the point. These kinds of systemic breakdowns are drawn out affairs, marked more by inertia and turf wars than intentional progress. On the other side of it, the history is if not rewritten than at least refashioned to look a certain way. Bretton Woods was broken, so a bunch of international officials got together and fixed it with floating rather than fixed currencies. That’s what we’ve been told for decades.

Nope. Not even close.

It was appropriately Robert Solomon who advised not just of what went wrong, but what will always be an intrinsic struggle. The plumbing matters, in almost every case more than any other factor.

“The lessons of the 1930s may not have been learned perfectly, but they were learned… they acted on the idea that international economic and monetary arrangements are not God-given and immutable. Rather they are subject to improvement and reform…But I do want to make the point, with all due respect to those who labored here 40 years ago, that there were basic flaws in the monetary arrangements that emerged from the Bretton Woods conference. The breakdown of those arrangements in the 1970s was not just the result of human perversity or failure to live up to the rules that were established here.”

Though said thirty years ago, it should be ringing in the ears of every public official especially right now wondering what’s the deal with all this populism and dissatisfaction; like it’s the seventies all over. “It is not a mark of disrespect to the founding fathers to point out that the Bretton Woods Agreement was flawed. We who followed had the chance to improve it. It was we who failed, though sporadic attempts at reform were made over the years.” It was as if he was saying maybe don’t just try QE over and over again and then call it a day, or try claiming there is no problem and that what clearly isn’t a recovery is.

The price for failing is especially high – not just in failing with what was tried but also in failing to act in more honest fashion. The world changes, that’s what it does. What made the eurodollar an exceptionally good modern replacement for the flawed gold-exchange was its adaptability (something hard not to appreciate in the 21st century). What do we do now with a broken eurodollar? Will some official ever say the word eurodollar again?

Time is a luxury. The world doesn’t travel at the pace of official clocks, timed to official decrees about what officials alone wish for it. Because these paradigm shifts are a long time coming, however, it’s easy to fool yourself into thinking you have all the time in the world. And it’s even easier to therefore ignore all the clear warning signs that you don’t. 

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

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