Executive Summary: The European participants to the June 4-6 summit meeting in Versailles are hoping to draw the Reagan Administration into an agreement to stabilize international exchange rates. Volcker and other powerful Americans seem to be encouraging such a move, at the expense of the monetarists who oppose the idea. The proposed system, though, seems akin to the plan advanced by Volcker in 1973, but rejected in Europe, based on a fiscal approach to the balance of payments. A review of the pre-floating period suggests a monetary illusion at the Fed. Post-1973 academic research seems conclusive that exchange-rate changes do not affect trade flows. But Beryl Sprinkel will be at Versailles, trying to thwart agreement. There's always a chance the pressures from Europe and a spark of leadership will invite policy change, but chances seem small this trip.
The Versailles Summit
On June 4 in Versailles, the heads of state of the United States, France, West Germany, Britain, Canada, Japan, Italy and Belgium will stage another in their series of economic summit meetings. At their last session in Ottawa last summer nothing much happened, except for the European complaints about U.S. high interest rates, which were alleged to be causing economic distress in Europe. And, President Reagan asked for patience, because he was just getting his fiscal program into place and it would take a bit before interest rates would come down.
This trip, we learn from Paul Lewis of The New York Times, writing from Paris on May 18, a deal is in the works: "The United States and other major industrial countries are near a monetary agreement that would stabilize the dollar's value in currency markets and provide for tighter coordination of economic policies, officials close to the negotiations said today." We are also told that George P. Shultz, former United States Treasury Secretary (1970-73), is involved in the discussions as President Reagan's special envoy to Europe to prepare fqr the Versailles summit. In the May 10 Wall Street Journal we had previously learned that the Group of 30, supposedly the world's most illustrious informal club of commercial and central bankers, publicly urged that the "time has come for the U.S., in both its own and the common interest, to pay more attention to exchange-rate considerations in framing its domestic policies and in particular, to avoid an unbalanced mix of monetary and fiscal policies."
One of the Group of 30, supporting this view, is Robert V. Roosa, of Brown Brothers, Harriman & Co., who was President Kennedy's Treasury Undersecretary for Monetary Affairs and also Paul Volcker's mentor. Volcker, as President Nixon's Undersecretary for Monetary Affairs devoted two years of his life, 1971-73, attempting to swing a deal of the kind that is supposedly cooking once again at Versailles. The Volcker attempts of 1971-73 were fruitless because the French would not agree to the system that the U.S. and U.K. had arranged to deal with the instability of exchange rates.
Whatever the reason they gave, the French were fundamentally correct in rejecting the system that Volcker had negotiated and his boss, George Shultz, tried to peddle. It was based on the Keynesian, or fiscal, approach to the balance of payments, and resembled a Rube Goldberg mechanical device.
The assumption was that a currency "weakens" when the nation behind it imports more than it exports. The assumption was so false as to be worthy of ridicule — the United States ran a trade deficit almost every year from 1800 to 1914 and its currency was as good as gold. But very big and powerful men have a way of creating disaster out of ridiculous assumptions, and this was the idea of the time, most closely associated with the Yale school. Nobel Laureate James Tobin, C. Fred Bergsten, Richard Cooper, Henry Wallich, all big guns out of Yale, gave respectability to the idea with the Yale brand of international Keynesianism.
The system built to deal with this false assumption would permit, perhaps even force, a nation with a weakening currency to take steps to import less and export more. A Britain with a weakening pound, for example, would be permitted to violate the General Agreement on Tariffs and Trade by either putting up its tariff wall or directly controlling capital outflows. Or, it could be asked to deflate internally, inducing a recession by reducing aggregate demand (raising taxes, cutting spending) so it wouldn't buy as much abroad and would sell off its recession goods at cut rates abroad. This would allegedly cause a strengthening of the currency and stabilization of exchange rates. We could even open the gold window again, Volcker presumed, at least to resume convertibility among foreign central banks, because the system would alleviate the foreign demands for U.S. gold. As early as 1968, Robert Roosa was despairing of keeping the foreign demands on U.S. gold from increasing. Why weren't they buying American goods with their dollars instead of demanding gold? This was the logic of the day.
The second part of the 1973 system that never came into being was aimed at the surplus nations, those with "strong currencies" resulting from big trade surpluses. It would be the responsibility of a Japan or a West Germany to try to weaken its currency by exporting less and importing more. They could lower tariff barriers or they could lower interest rates by printing more money. Surplus countries as well as deficit countries, then, would have an obligation, a responsibility to coordinate their domestic fiscal and monetary policies so that exchange rates would be stable and nobody would be in a position to ask anybody else for a final settlement asset, the yellow stuff. If the system were in place today, for example, the United States would have to take steps to weaken the dollar. Interest rates, of course, would have to come down, and everyone knows the interest rates are caused by the high deficits, which can be closed by raising taxes and reducing outlays. Professor Tobin and his Yale colleagues are also suggesting devaluation of the dollar directly, or, in combination with a tighter fiscal policy, monetary ease to bring down interest rates — which also weakens the currency.
This is what is afoot in Versailles. The wise men will gather as "Nations Aim to Stabilize Dollar and Economies," as the Times headline put it.
What has changed in the last decade that should give us confidence that we can maintain the dollar price of gold absent such a Rube Goldbergian mechanism — which of course would only impoverish the world economy anyway? The supply-side answer is that we should have learned that the Keynesian approach to the balance of payments is as ridiculous as its starting assumption. The monetary approach is all that is needed to stabilize exchange rates and prevent international monetary crises of the kind that decorated the early 1970s.
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Five days before President Nixon closed the gold window on August 15, 1971, The New York Times reported on its business page that the Federal Reserve Board's open market committee had voted, six weeks previously, to ease the money supply. The news item is a cause for amusement, as are all the other news items of Fed policymaking in that period. The very idea that the Fed could tighten or loosen the money supply while the gold window was open was a joke in itself, a joke on the Fed and its members. For how many years did the distinguished Board of Governors assemble, light their cigars, and solemnly contemplate the economic and political scene before solemnly balloting for or against monetary ease. It was all an illusion, a self-delusion. Here's what would happen:
After the Board would vote monetary ease, an increase in the money supply, the open-market desk in New York would be so advised, and on a certain Tuesday morning at 10 a.m. the desk would purchase $100 million of Treasury securities from the commercial banks, creating $100 million in greenbacks out of thin air. The decision to turn over $100 million in income-earning assets, bonds, to the Fed in exchange for non-interest earning assets, cash, was not made by the banks or its customers. They wanted interest-bearing assets, we can be quite sure, and would quickly look to get out of cash back into interest-earning assets.
The sudden appearance of all this extra cash would tend to be inflationary, putting pressure on all prices except the government's official gold price of $35 which is guaranteed. But it is only guaranteed to foreign central banks, not to the American banks and their customers who now hold this unwanted $100 million cash. The $100 million would be wired to West Germany and exchanged for 250 million Deutschemarks in the private currency markets. The Americans, with 250 million DM to spend and wanting interest-bearing assets, would buy up stocks, bonds or capital assets in ways that would approximate the income stream given up to the Fed.
The Germans who had given up 250 million DM in exchange for $100 million U.S. could now go to the Bundesbank and, under the terms of the Bretton Woods agreement, the Bundesbank would be required to take the $100 million and produce 250 million DM. The Bundesbank, in turn, could call the Treasury and ask for gold in exchange for the $100 million now in its hands. But it would be reminded by Treasury that the United States was reluctant to further run down its gold stocks and was offering, instead of gold, special Treasury bonds bearing interest. The Bundesbank would shrug and allow that this would be acceptable, wire the $100 million back to the Treasury and have credited to its account the $100 million bond.
Given the speed of modern, electronic banking and the efficiency of international arbitrage, it is not unlikely that the lag between the Fed's 10 a.m. purchase of $100 million in bonds would be so short that before lunch the Treasury would be selling the $100 million bond to the Bundesbank.
At the end of this process, we observe that nothing much has happened. There has been an open market purchase and sale of $100 million in bonds within a matter of hours, if not minutes. All that has really occurred is that Americans now own $100 million more of European financial assets and Europeans own $100 million more of American financial assets.
All through the 1950s and 1960s and 1970s the Federal Reserve actually believed it was "managing the money supply" and all it was doing was spinning its wheels. Financial assets were being shuffled around internationally, but the net effect was close to zero. Americans owning more European assets only caused alarm in Europe and the outcry that we were buying them up with our balance of payments deficit, "a deficit without tears," as DeGaulle put it. But at the same time Americans were horrified at the enormous dollar assets that began piling up in foreign central banks — the dollar "overhang" as it has been called. The fear was that the "overhang" would crack off and swamp the United States with claims on U.S. assets and goods in some unspecified but nevertheless terrible fashion.
The confusions, which played into the hands of the demand-side economists and led to the suspension of convertibility altogether, would have been avoided if Americans could have converted dollars into gold all along. Instead of having to transfer surplus currency abroad to have it offset by a foreign central bank, Americans would have gone directly to the gold window and turned the unwanted $100 million into gold — and if the Treasury did not wish to give up gold from its stocks, it would have to persuade the Fed to sell a $100 million bond on the open market — to reclaim the non-interest bearing cash and its claim on gold.
On March 2, 1973, I wrote a lead editorial for The Wall Street Journal describing the so-called "financial crisis" then besetting the world in general and the U.S. in particular. The editorial, titled "Rethinking the Dollar Problem," said in part:
In the current turbulence, we observe the curious phenomenon of yields dropping on short-term federal securities. Lenders here are well aware that the West German central bank will be rechanneling the dollars it is mopping up into short-term U.S. federal securities. At the same time, we suspect speculators are dipping into the money supply here, borrowing to finance their speculations abroad.
The capital flow is circular, with the direction determined by the speculators. The Fed, though, might be able to reverse the direction of the flow. A sharp tightening of the money supply, along with an announcement that it is intended as a temporary blow against the speculators, would do more than give the speculators pause. Dollars would still be needed for any number of projects, and fewer of them would be available domestically. American banks and multi-national corporations would have to borrow marks, yen, etc., and cash them in for dollars to put to work in tasks where dollars are needed.
The editorial, written off the Mundell-Laffer monetary approach to the balance of payments, simply suggested that the attack against the dollar be countered by the U.S. monetary authorities — selling bonds in New York, reducing the liquidity of the system until it was uneconomic for the "attack" to continue. There were, of course, no "speculators" causing the problem. It was all along the Fed's inability to match the demand for dollars with the precise supply needed at a fixed price — there no longer being a price to shoot at. Of the mainstream economists, only Professor Charles Kindleberger of MIT supported the editorial line I had advanced at the Journal. When the decision was made in the Nixon Administration to "float" the dollar instead of defending it, the Journal also dropped the editorial line, suspending comment on international money altogether while watching the float.
What was being watched in this experiment was the Keynesian proposition that a devaluation of the currency would produce an improvement in the balance of trade in the short run. This, after all, was the only reason President Nixon was driven to suspending convertibility in 1971 and the main reason he floated the dollar in 1973, on the advice of George Shultz and Milton Friedman. Devaluation would increase competitiveness and jobs. In the Mundell-Laffer classical model, the terms of trade would not change simply by changing the unit of account even in the short run. If a bottle of wine traded for a loaf of bread when the unit is $1, it will still trade at the same terms if the unit is changed to $2, with no lag in the marketplace. The only effect of a devaluation would be negative, a reward to debtors at the expense of creditors that would reveal itself in the financial marketplace as a rise in interest rates.
The three principal studies in the years that followed were done by Laffer, Cooper and Salant.
Laffer studied 15 postwar devaluations and found that on average the trade balance tended to worsen. In each case the trade balance was charted for the three pre-devaluation years and the three post-devaluation years and the year of devaluation itself. Ten of the 15 countries have the largest deficit of the seven-year period in the three years following devaluation.
Cooper, arguing that Laffer's study was statistically biased, examined 24 devaluations carried out by 19 countries from 1959-1966. Cooper studied the trade balance from the year of devaluation to the year after devaluation and found improvement in 15 cases. Marc Miles, a Laffer student now at Rutgers, pointed out the shortcomings of the Cooper study, observing that, on average, the "improvement" in the post devaluation year was less than the deterioration in the devaluation year itself. That is, the net effect of devaluation might still be adverse to the trade balance even in Coopers own study.
Michael Salant then examined 101 devaluations, examining the three-year prior and three-year post averages in the trade balance. He charted improvements 46 percent of the time, a worsening 54 percent of the time and no change in one case.
In all studies, the balance of payments tends to temporarily improve with devaluation, but this is simply an accounting phenemenon involving adjustments in the flow of money and bonds, with no effect on the flow of goods and services. Insofar as economics pretends to be a science, Salant's work would seem to be conclusive. But economists seldom permit evidence to get in the way of a hypothesis. When confronted with the Salant evidence on April 2 (at a debate I had with him at North Texas State University), Bergsten asserted that he never said devaluation in and of itself would have positive effects on the trade balance, but would have to be supported by appropriate domestic policies. He cited the recent Mexico devaluation of its peso by 40 percent and said the government, in permitting Mexico's workers a 40 percent wage increase, offset the benefits of the devaluation. Of course, workers will not permit their terms of trade to be altered by the government's change of the unit of account. Bergsten, who was assistant secretary of Treasury for international affairs in the Carter years, is essentially arguing that he can turn water into chicken soup, but by the way, he has to have a chicken.
This is a matter of profound importance and relevance to the Versailles summit meeting. A decade has been spent in demonstrating the simple truth that the terms of trade can not change by changing the unit of account. The foreign central banks and heads of state are ready and eager to stabilize exchange rates. But most of them are still trapped in the fiscal approach to exchange-rate stability and would have the United States relegate domestic tax and spending policy to that end. It's an improbable, outlandish idea. It is offensive to hear Otto Po'hl, head of the German central bank, instructing the United States to lower its federal deficit. An international accord that would give him direct influence over U.S. fiscal policy would be intolerable.
An international accord to stabilize exchange rates through a coordination of monetary policy is not as offensive to supply-siders because of the firm conviction that such a step would lead to an anchored system, which would prevent the Giant Currency Snake from inflating or deflating as a unit. The monetarists are wildly opposed to such an accord for the same reason. They know the United States could not for long intervene in the foreign exchange markets to support a floating snake without an anchor, a common reference point, the price of gold or a commodity price index, a gold SDR. They know the Fed cannot pretend to control the quantity of money if it is committed to stabilize its price. Treasury Undersecretary Beryl Sprinkel will of course be in Versailles, Milton Friedman's representative, to make sure nothing comes of the exchange-rate discussions. The New York Times of May 30 carried a vague report of a U.S.-French "agreement" on exchange rates. But, this will almost surely prove to be a rhetorical flourish and nothing more.
To suggest that something concrete will come out of Versailles, given the dominance of the monetarists in the Reagan Administration, would be stretching. The participants haven't given any indication that they have a greater understanding of why they got the world into its current mess than they did a decade ago. Their propensity to yap about domestic fiscal policy seems almost as great as ever. And there is no single leader who seems to know what he is doing, least of all the Ronald Reagan of June, 1982.
Yet there is in the wind blowing from Europe, a wind that always seems to have an intoxicating effect on our Eastern Establishment, a definite yearning for change. And there seems to be a common groping back to the spring of 1973, when the floating began, for signs of how things could have been made to work if only everyone had tried a bit harder. In this kind of environment, with President Reagan exposed to ideas that have been sealed out of his Stockmanite, Friedmanite world of late, it would take only a spark to ignite a policy change. We can only be certain that the spark will not come from the American delegation, unless it is from the President himself.
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