Having the curiosity to reach the problem of the Global Economy since post WW II era I’ve been searching my old papers and scripts of some economists and;
Economic thinkers were just beginning to appreciate the notion that national economies were inextricably linked together, that the health of individual national economies affected the health of the international economy as a whole. These thinkers – John Maynard Keynes foremost among them – viewed mercantilism, punitive reparations, and trade wars as destructive. Economic distress, Keynes warned, ultimately caused political instability and social upheaval, leaving desperate populations little choice other than to turn to communism, socialism, or fascism to restore economic and social stability. And the situation in Germany seemed to bear him out.
In America, the newly elected Franklin D. Roosevelt promoted an economic recovery program known as the New Deal to stimulate employment, which, Keynes maintained, was the key to prosperity and growth. Keynes opposed the gold standard (currencies backed by gold) because it caused nations with trade deficits to draw down their gold reserves to settle their debts, which contracted the amount of currency they could issue and circulate, which in turn shrank the money supply, increased unemployment, and brought hard times. Keynes favored paper currency, unfettered by the constraints of gold, as the key to full employment and prosperity. He believed that government could cure economic distress by injecting money into the economy, thereby stimulating it. Just prime the pump, Keynes counseled, and the rest would take care of itself Government should deficit spend (borrow money) to prime the pump, then pay itself back during subsequent prosperity. In that way economic downturns could be moderated, if not eventually eliminated.
The New Deal went a long way toward helping America’s ailing economy, but it was World War II that really stimulated employment, production, and created the prosperity that put America back on its feet. In the process, it turned America into the world’s dominant industrial power.
Mindful of the disorder in the world economy that followed World War I – the destructive policy of reparations, inflation, high unemployment, depression, and social upheaval – economic thinkers all over the world began to understand the necessity for economic order after the conclusion of this second great war. Without some mechanism for stability, they feared another worldwide depression accompanied by political instability and possible military confrontation. So in July 1944, delegates from 44 nations met in Bretton Woods, New Hampshire, to create a stable economic climate for the postwar world and facilitate international trade, which they had come to appreciate was vital to the health of all economies.
From the Bretton Woods meeting arose the International Monetary Fund (IMF) and International Bank for Reconstruction and Development (known as the World Bank). The IMF was created to formulate and enforce rules trading nations could live with, as well as provide access to automatic credits (a general line of credit, as it were) so that members would not have to depend on private-sector banks or on loans from other governments in times of financial distress. The World Bank was created to provide loans to rebuild the devastated nations of Europe and to provide loans to emerging nations for specific projects such as manufacturing plants or dams.
In order to borrow from the World Bank, a country had to be a member of the IMF, in which was vested the authority to police the trade practices and monetary practices of members in other words, ensure their good behavior. Bretton Woods attendees anticipated that the availability of credit and the oversight of the IMF would do away with prewar practices of currency devaluation, protectionism, and other potentially destructive actions nations took to gain advantages over trading competitors.
In addition to the IMF and World Bank, the United States, through the Marshall Plan, provided billions of dollars to the war-ravaged nations of Europe. Without access to credit, they would have been forced to pay for reconstruction and imports with dwindling gold reserves and in the process bankrupt themselves. And without foreign markets, the U.S. would have had to reduce production, which could easily have precipitated a recession, or even another depression. The international postwar recovery and the prosperity that followed would not have been possible without the IMF, the World Bank, and the Marshall Plan.
The two main players at Bretton Woods were the British representative, John Maynard Keynes, and the U.S. representative, Harry D. White, chief technical advisor to Secretary of the Treasury Henry Morgenthau. Keynes’ main agenda was to create an international safeguard for full employment and to look after Britain’s interests as a debtor nation. White’s agenda was to look after America’s interests as a creditor nation.
White wanted strict conditions attached to IMF money. He wanted to make sure that nations that drew IMF money could be required to take unpleasant and unpopular domestic measures, such as raising interest rates and cutting spending, to straighten out their financial affairs. IMF money was not to be welfare, but a means to allow a nation to catch its breath and solve its financial problems without creating a potentially destructive disruption in the international economy. White made it clear that the United States would call the shots on how the IMF was organized, and how it would be run. The United States would retain veto power over major IMF policy decisions—and no one was in a position to argue.
It was clear at Bretton Woods that America was the only major power capable of financing postwar reconstruction. It had replaced Great Britain as the financial center of the world, largely as a result of having financed the war with loans and aid. The United States also supplied most of the capital for the World Bank. America had become creditor to the world and in the process, the dollar had become the international currency. No other currency could match its historical integrity or its economic underpinnings, the backing of the most powerful military and industrial apparatus on earth.
Keynes lobbied hard for policies that favored his theories, most important of which was the “paper standard,” currency backed not by gold, but only the good faith of the issuing nation. Needless to say, private bankers were mistrustful (and perhaps rightly so) of any government’s ability to exercise fiscal sell-restraint. The powerful New York banking community was skeptical of Keynesian notions in general and of the paper standard in particular. The so-called paper standard (which bankers regarded as no standard at all) seemed to be an open invitation to print as much currency as expedient for whatever purpose. Nor were bankers keen on the idea of any international entity that encroached on their banking turf.
Eventually, White and Keynes reached a compromise, a dollar redeemable in gold by governments, but not by individuals. A dollar redeemable in gold at the rate of $35 per ounce, the 1934 price. A dollar coequal to gold for purposes of international commerce.
The Bretton Woods dollar/gold-exchange system allowed for the creation of money, while at the same time permitting settlement in the time-honored method gold. In effect, the Bretton Woods Agreement formalized the dollar’s role as the world’s currency.
Central banks of most countries held dollars as part of their reserves, their faith in the United States so great that rarely did they redeem them for gold. A torrent of dollars flowed out of the United States in the form of aid and loans, payments for military bases, and investments by U.S. businesses and corporations. The flood of dollars stimulated the international economy, and kept stimulating it.
In no time, the United States found itself incurring a balance of payments deficit, i.e. it was spending more abroad than it was taking in. And the deficits continued year after year. You might say that the world’s postwar prosperity was built on the U.S. balance of payments deficit.
Unfortunately, the dollar/gold exchange system contained one glaring defect while the United States could create as many new dollars as it wanted, the amount of gold on reserve did not grow proportionately. By 1961, the amount of dollars abroad began to surpass the amount of gold in the U.S. Treasury and that triggered speculation in gold on overseas markets. President Kennedy tried to calm nervous financial markets by assuring them that the United States would stand behind the Bretton Woods agreement to redeem dollars in gold, but despite his assurances, gold redemptions increased and U.S. reserves shrank, which only made the problem worse.
Financial markets around the world began to see the handwriting on the wall. Sooner or later, either the U.S. would have to curtail creating new dollars, which would cause an international economic contraction, or suspend redeeming dollars in gold, which would precipitate an international financial crisis.
By the mid-1960s the U.S. balance of payments deficits had skyrocketed. Although the deficit was partially attributable to the war in Vietnam, other more profound factors were at work. Germany and Japan, with dynamic reborn economies, increasingly cut into American markets both domestic and foreign. Americans began to see more and more foreign cars on the road, and notice more and more foreign consumer electronics on store shelves. And Lyndon Johnson’s policy of financing both a war and a huge expansion in domestic social spending without raising taxes ignited inflation. The government ran huge deficits, but kept interest rates low and the economy humming by printing (borrowing) more and more money.
Foreign governments, which up until that time had been content to hold dollars, began to think it wiser to redeem them for gold. U.S. gold reserves plummeted. Although the U.S. continued to stand by its Bretton Woods pledge, everyone realized it could not do so indefinitely. The concept of a dollar coequal to gold had begun to die.
The only reason America found itself able to continue to run huge balance of payment deficits was that its currency functioned as the international currency. It continued to create as many dollars as it needed for its domestic purposes. In doing so – by inflating the dollar – it began to export its domestic inflation overseas.
Charles De Gaulle, then president of France, decried the U.S. privilege of being able to fund its balance of payment deficits by printing more and more dollars. He demanded a return to an international gold standard, and when he didn’t get it, he began redeeming France’s dollar reserves for gold.
A panicky Treasury, pointing out that France’s raid on America’s gold reserves could trigger a stampede that would have disastrous economic implications for the entire world, quickly convinced its allies to create a gold pool to support redemptions of the dollar, and thus reassure nations that might otherwise have followed France’s lead in making a run on the yellow metal. The Treasury, in effect, borrowed gold from other IMF members to meet redemptions. In theory, the gold was to be replaced later, during periods of low demand. At the same time, the Treasury began selling bonds denominated in foreign currencies to reduce overseas holdings of dollars. It encouraged the IMF to create Special Drawing Rights (SDRs), which were intended to replace the dollar as international currency, and thus remove the pressure the inflated dollar exerted on the international monetary system. But SDRs merely supplemented dollars and gold rather than replacing them, and didn’t solve the problem. What bankers feared at the time of Bretton Woods had become reality the world was being flooded by paper money.
The glut of dollars increased daily. The more dollars the U.S. pumped out, the less they were worth. The value of the dollar in comparison to other currencies was artificially high and, in normal circumstances would have been ripe for devaluation, but IMF protocols controlled the value of all major currencies in relation to one another, so the dollar remained at its artificially high level. The U.S. balance of payments deficit continued to rise. World financial markets fretted. The international currency was in the hands of a power, which rather than understand its special role and act responsibly, showed no interest in self-restraint and little interest in the negative effects of its actions. More and more, the United States, which had been held in such high esteem after the war, was perceived as having abused its special position. Resentment and concern grew in foreign capitals.
The root cause of the dollar’s problem, declining international competitiveness, chronic balance of payments deficits, and deficit spending to finance both a war and expanded domestic social programs, only grew worse with the passing of time. These problems were not attributable to any particular presidential administration, for all had become thoroughly wedded to the philosophy that government should spend – and could do so with impunity. No one seemed able to see beyond the immediate and the expedient – or care. No one seemed to recognize the long-term danger of too many dollars.
Richard Nixon reacted to the recession of 1970 – which he found politically painful – by becoming a born-again Keynsian. He prevailed upon his newly appointed Federal Reserve chairman, Arthur Burns, to loosen money and stimulate the domestic economy.
During the Johnson years, Treasury Undersecretary Robert Roosa had carefully cobbled together a system of foreign central bank intervention and support for the dollar, which worked because it was mutually beneficial to both the U.S. (as creators of dollars) and its allies (as holders of dollars). Nixon and his Treasury Secretary, John Connelly, chose not to continue that close cooperation. They blamed the balance of payments deficit on the dollar being overvalued – a consequence of the fixed exchange rate mandated by the Bretton Woods agreement – rather than on the root causes. Clearly – Nixon felt – the answer was to devalue the dollar, but at the same time, he worried that it would be regarded as a sign of weakness, so he abandoned the idea.
By 1971, continuing balance of payments deficits and the Fed’s easy money policy had caused further inflation and further erosion in the value of the dollar. Foreign speculators, sensing that the dollar would have to be revalued sooner or later, began dumping dollars. European central banks supported the dollar (bought dollars) as long as they could, but finally threw in the towel. The selling frenzy proved too much for them. In August 1971, Nixon announced that the United States would henceforth no longer redeem dollars for gold, pulling the rug out from under the Bretton Woods agreement. In addition, he slapped a ten-percent surcharge on imports and imposed price controls. The dollar had become a 100 percent “paper standard” currency.
Closing the gold window sent shock waves through the world’s financial community. The world’s banker had just defaulted on backing its currency the world’s currency. And the import surcharge infuriated the Europeans and Japanese, but there was nothing they could do about it.
During the 1960s, the Europeans and Japanese had begun to have misgivings about the way the United States handled its financial affairs: its deficits, its lack of fiscal restraint, the way it managed its economy. They worried because the dollar functioned as the international currency, and because they held dollars. Historically, whenever the Europeans and Japanese got too nervous, Treasury officials had been quick to reassure them that everything was under control and that things would work out. So the Europeans and Japanese, like a banker holding a shaky loan, smiled, tried to ignore their misgivings, and hoped for the best.
Closing the gold window changed all that. Foreign financial markets realized they could no longer rely on the dollar or be sure how the United States would behave. The stage was set for the rampant inflation of the 1970s and the international free-for-all that followed.
In December 1971, Nixon revalued gold from $35 to S38 an ounce, thus devaluing the dollar by 8V2 percent. Smart money, however, had stopped trusting “remedies” after the gold window closed the previous August. Nixon’s devaluation triggered another wave of currency speculation against what the market perceived as weak currencies the dollar and the British pound. The pound went down in flames first. By mid 1972, after spending more than $2.5 billion to support it, the British government threw up its hands and let the pound float.
Despite Nixon’s remedies, the U.S. balance of payments deficit showed no sign of improving, and inflation continued unabated. By early 1973, the most massive flight out of the dollar the world had ever seen got under way. German, Swiss and Japanese central banks bought dollars (more than $8 billion worth) in a desperate attempt to prop it up, but they could not begin to absorb the torrent of surplus dollars.
On February 12, 1973, the United States officially devalued the dollar by another 10 percent, but the action came too late. Foreigners no longer trusted Washington. The run against the dollar continued unabated. Central banks absorbed another $4 billion expatriate dollars to no avail. They simply did not possess the resources to absorb the endless sea of dollars being dumped by private banks, corporations, individuals, and even overseas branches of U.S. banks. On March 2, 1973, major central banks suspended all foreign exchange transactions. They remained closed for an astonishing two and a half weeks, while finance ministers and central bankers huddled to solve the crisis. When foreign exchange markets finally reopened, currencies were allowed to float. Central banks had come to the conclusion that currency supports were futile and decided to let nature take its course. During the following week, the dollar lost another 10 percent. The postwar era of the stable dollar was over.
As a result, no one wanted dollars or dollar-denominated financial instruments or securities. Knowledgeable buyers wanted German marks (strong economy and aversion to inflation) and Swiss francs (fiscal conservatism and partial backing of the franc by gold). Nervous investors around the world wanted their financial assets in currencies that functioned as a reliable store of value.
Then, as if things weren’t bad enough, along came the oil shock of 1973. Skyrocketing oil prices drained even more dollars out of the United States, dramatically increasing the costs of domestic businesses, simultaneously causing both recession and inflation an effect that would come to be known as stagflation. Worried that the United States would resort to paying for increasingly expensive oil by printing more dollars, Arabs opted for gold. Smart money the world over began to turn to gold. Central banks began increasing their gold reserves, which put tremendous pressure on the gold market. The price of gold climbed.
The oil-induced recession of 1974-75 lingered like a bad cold into the beginning of the Carter administration. Unemployment stood at seven percent. Carter desperately wanted to pull the nation out of recession. So, like his predecessors, he primed the pump by increasing government spending. Smart money across the world realized that meant more inflation and an even weaker dollar. So they bet against the dollar. They bought German marks, Swiss francs, Japanese yen, and gold. Lots of gold.
In fairness, Carter did not create the situation he found himself in. Still, when it came to solving the problem, he was out of his depth more than any president since World War II, and his ineptitude terrified foreign financial markets.
At the meeting of the Organization for Economic Cooperation and Development (OECD) in Europe in June 1977, Carter’s Treasury Secretary W. Michael Blumenthal informed the Germans and Japanese that they should help pull the world out of recession by stimulating their economies with increased government spending. The Germans were aghast; they were not about to embark cn any course of action even remotely inflationary. Not after their experience with hyperinflation in 1923. The Japanese economy was already booming because of exports of automobiles and consumer electronics to the U.S.; they saw no reason to artificially stimulate it. To make matters worse, Blumenthal told them that the United States would address the problem by reflating its economy unilaterally if necessary, an action that would further decrease the value of the dollar and their dollar holdings.
Perhaps most shocking to OECD leaders was Blumenthal’s attitude toward them. From the end of World War II, U.S. Treasury Secretaries had consistently reassured them about the value of the dollar whenever it had been in doubt. Not only did Blumenthal not reassure them, he in essence threatened to further devalue the dollar by reflating the U.S. economy. Where once there had been cooperation, now it seemed more like confrontation.
Blumenthal’s performance at OECD removed any lingering trace of trust or goodwill and ignited yet another round of speculation against the dollar. The proximate cause was Blumenthal’s performance at the OECD conference; the underlying cause was the mistrust of America’s ability to manage its financial affairs. No sooner had he finished speaking at the OECD than the electronically intertwined financial markets began to react. Flight out of the dollar began in earnest like an old fashioned bank run. Sellers couldn’t dump dollars fast enough.
Like any commodity, currencies react to the law of supply and demand. The supply of hard currencies is finite. There weren’t nearly enough marks, yen or francs to go around, so prices soared panicky buyers wanted them at any price. Conversely, the dollar sank like a stone. Blumenthal’s response was that the U.S. would not intervene to support the dollar, and the dollar continued to slide.
In the eighteen months following Blumenthal’s speech and Carter’s malign neglect, the dollar lost 66 percent of its value against the Swiss franc, 55 percent against the Japanese yen, and 35 percent against the German mark. OPEC threatened to increase oil prices to offset losses incurred by having to accept dollars in payment for oil. And when, at last, Blumenthal tried to calm the stormy seas, no one listened. Trust in U.S. policy had been rewarded with an inflated international currency, the closing of the gold window, official devaluation, the abandonment of fixed exchange rates, and as the last straw, the refusal of the U.S. to even try to support the floating dollar. International money markets were in no mood to listen to anything the United States in general, or Carter and Blumenthal, in specific had to say.
Carter seemed stunned by how badly foreign financial decision makers viewed the dollar, which, in reality was nothing more than a reaction to his management – or mismanagement – of both the economy and economic relations with other nations. Inflation continued to rage and the dollar continued to weaken. Eventually, it seemed to dawn on him that the downward spiraling dollar could trigger a worldwide financial collapse. He announced that the United States would support the dollar, raise interest rates, tighten money, and cool inflation, which he perceived – belatedly – as the root problem. Although Carter’s pronouncements were intended to reassure global financial markets, smart money shrugged them off as palliatives. They knew that U.S. deficit spending would continue to increase, that the supply of dollars would continue to grow ever larger. So, they bet for their own self-interest – against the dollar – and the dollar continued to slide.
Carter fired Blumenthal. Still the dollar continued to sink. Inflation hit double digits. The mark, franc, and yen soared in value. As the climate of uncertainty intensified, investors (central banks, private banks, Arabs, multinational corporations, and individuals) turned more and more to gold, pushing its price from $200 to $450 an ounce by the end of 1979. The election campaign of 1980 and the prospect of four more years of Carter only heightened the level of anxiety. Everyone had begun to think in terms of worst case scenarios.
Then along came the second oil shock, precipitated by the fall of the Shah of Iran. Fearful of an oil shortage caused by decreased Iranian production, speculators set off a wave of panic buying in the spot oil market. Prices, which had been $14 a barrel in 1978, surged to $30 in 1980 and $40 by 1981. The second oil shock sucked even more dollars out the United States, adding about $40 billion to the Euromarket. The Euromarket is a vast pool (actually more like a sea) of several trillion dollars worth of “stateless money,” dollars circulating outside the United States, which are known as Eurodollars. Foreign bankers found themselves awash in dollars, and didn’t know what to do with them. No one – it seemed – wanted dollars, except third world countries.
Iran took U.S. hostages, and the Soviet Union invaded Afghanistan. Everything seemed out of whack. No one knew what would happen next hyperinflation, Fortune 500 company bankruptcies, bank failures, international economic collapse, recession, depression, social upheaval, war. Possibilities abounded, none of them good.
In October 1979, to dampen inflation, the Federal Reserve increased the discount rate (the rate at which they lend money to banks) from 11 percent to 12 percent an unheard of level. Despite the increase, credit expansion continued unabated. An inflationary mindset gripped America. Borrow as much as you can, buy tangible assets, and repay loans with future cheaper (or worthless) dollars. Corporate borrowing increased because of the fear that the government might impose price controls. Fanners bought land. Stamp dealers hoarded inventory.
Gold rose from $500 to $875, amid new fears of a superpower confrontation over oil in the Middle East, precipitated by events in Iran and Afghanistan. Central banks continued to increase their gold reserves, all of which put enormous pressure on the price of gold. At the same time, the Hunts tried to corner the silver market, driving the price to nearly $50 an ounce, and nearly succeeded.
Interest rates approached 20 percent and began pushing the nation into a recession, while speculation continued unabated, fueling inflation. The federal Reserve was stymied because high interest rates, which traditionally cooled inflation, seemed to have no effect. It seemed as if the disease had finally developed resistance to the drug. People everywhere prepared for the worst.
In November 1979, in response to the seizure of American hostages, Carter froze Iranian assets in U.S. banks and their overseas branches. While this move was applauded by Americans, it sent a new shock wave through the international financial community; they suddenly realized that all foreign deposits in U.S. banks were subject to the whim of a President. Arabs were particularly disturbed. They had been huge buyers of U.S. Treasury securities (helping finance the deficit), bill after Carter froze Iranian assets, they stopped buying treasuries and switched to gold. The wholesale flight of Arab money left the Treasury little choice other than finance the deficit through monetary expansion (creating more dollars), which meant more inflation, a weaker dollar, and so on, and so on.
Dollars poured into the Euromarket, hut what to do with them? Third world countries, which had absorbed so many dollars after the first oil shock, were, by this time, reeling from high interest rates and on the verge of default. The oil shock dampened demand for their exports while increasing their costs. Their revenues plunged, as did their ability to service their loans. Especially troubling was the size of their outstanding debt held by private banks. Bankers worried that default of a Mexico or Brazil could trigger a chain reaction of bank failures and a global financial meltdown. The situation was so bizarre that it confounded even the most seasoned economic thinkers. No one knew what would happen, so they planned for the worst. They bought gold and tangibles. And so did the little guy.
The average American, too, had become infected with uncertainty and started to worry about runaway inflation and its effect on his savings and investments. Stocks were down in the dumps. Yields on CDs (certificates of deposit) and bonds were high—but not in real terms (interest rate minus inflation). Tangibles appeared to offer the best chance of preserving and increasing capital. And that’s why tangibles increased in price so much during the late 1970s.
And now, as they say, for the rest of the story. Carter finally made a smart move. He appointed Paul Volcker, a no-nonsense inflation fighter, chairman of the Federal Reserve. In March 1980, Volcker imposed credit controls and at long last inflation began to ease. Unfortunately, Volcker’s credit controls devastated the building and automobile industries, increased unemployment and set off a wave of bankruptcies. Recession set in. But on the bright side, Volcker’s actions – tight money, high interest rates and credit controls – reassured foreign financiers and restored a modicum of stability to the world financial markets. Unfortunately for Carter, they had painful domestic side effects and terrible political consequences, he lost the election to Ronald Reagan in November 1980. Reagan – like Eisenhower, Kennedy and Johnson before him – reassured nervous markets. Financial decision makers perceived him as an able leader, a man in control of events, and almost overnight speculators began to shift from gold (and other tangibles) to dollar assets, eager to lock in high interest rates. Reagan and Volcker got inflation under control, interest rates down, and the economy humming. Prosperity returned as never before, lasting throughout the 1980s and 1990s. Investors once again gravitated toward financial assets mutual funds, stocks, bonds, annuities. The stock market boomed, IRAs and 431 (k)s swelled, brimming with securities. And in the rush, investors forgot that tangibles ever existed.
The Cold War is over, Germany is reunified, the Soviet Union has disintegrated, Eastern Europe is independent. The world has largely stopped worrying about the old set of problems. They have not given much thought to new ones that still lie hidden beyond the horizon the resurgence of a militant Iran, the festering Middle East, the consequences of instability in Eastern Europe and the Balkans; the growth of the Russian nation; the rise of economic juggernauts in the Far East; the growing European economic hegemony of a united Germany; the consequences of a fragile world burdened with too many people and their effect on climate. Some economic thinkers wonder whether the Euro (the European currency) or the Chinese yuan will eventually replace the dollar as the de facto international currency, and should that happen, what long-term effect it will have on the U.S. economy.
In the meantime, the United States has suffered the bursting of the dotcom bubble, a precursor to the bursting of the larger, more catastrophic housing bubble, its concomitant mortgage industry collapse, and the most serious financial industry crisis in living memory. At this writing, uncountable trillions of dollars are being pumped into the economy in an effort to keep it from collapsing. While unemployment, decreased consumer spending, and business bankruptcies will exert deflationary pressure in the short term, the uncountable trillions injected by the Fed will produce inflation in the long run. And it’s more than likely that, sooner or later, tangibles will once again become all the rage.
source: Stephen R. Datz
