Reviewing Bretton Woods Jude Wanniski July 11, 1994

An op-ed in Friday's Wall Street Journal, "Redeem Us With a Cross of Gold," presents the case for an international gold standard. It is authored by Lewis Lehrman and John Mueller, old friends who are partners in a competitive firm, whose arguments are largely helpful, at least in the gold ballpark. Their central argument, though, is as misguided now as it was when first advanced in Europe more than 30 years ago by Jacques Rueff and Robert Triffin. Inasmuch as I believe we are on the threshold of another gold debate, it is important that we understand why Rueff and Triffin were misguided in their belief that the fatal flaw of the Bretton Woods gold-exchange standard was the use of foreign exchange, along with gold, as international reserves. It has been several years since I have gone through this exercise in a client letter, so it bears repeating now. 

The 1944 Bretton Woods monetary system blew up on August 15, 1971, when President Nixon announced the closing of the gold window at the U.S. Treasury. This meant that foreign central banks could no longer present dollars that they had collected abroad and in return demand gold from our sizeable, but dwindling reserves stored at the New York Fed and at Fort Knox, Ky. The action was meant to end the currency crisis that had convulsed the U.S. and Europe during that year, as wave after wave of dollars swept into Europe from U.S. banks. Then, as now, the dollar crisis was thought to be related to the U.S. trade deficit. The solution, said the Keynesians then surrounding President Nixon, was a devaluation of the dollar against the DM and yen. Then, as now, the crisis was actually the result of the monetary policies of the Federal Reserve. Chairman Arthur F. Burns, appointed by Nixon, who wanted an easy money policy to expand the economy prior to the 1972 elections, embarked in early 1971 on an aggressive program of monetary ease that ran smack into Bretton Woods. Under its fixed-rate regime, the United States was obliged to maintain the dollar price of gold at $35. Participant nations were obliged to keep their currencies fixed to the gold dollar. A critical fact: U.S. citizens were barred from owning serious amounts of gold, the result of a 1934 law intended to force citizens to invest in productive enterprises instead of hoarding gold; under the terms of Bretton Woods, the U.S. was obliged to redeem dollars presented by foreign central banks with bullion, at the $35 rate.

The mechanism used to put the Nixon-Burns policy of monetary ease into effect was the purchase of government bonds from the banks by the Fed in the open market. The Fed would "pay" for the bonds with "ink money," in effect retiring interest-bearing debt of the government by replacing it with non-interest-bearing cash. The theory was the banks would lend this extra cash to borrowers who would spend it, thereby generating "aggregate demand" and economic expansion. The unwitting accomplice to this inflationary binge was the 30-year-old chief economist at the Budget Bureau, Arthur B. Laffer, who had been brought to Washington from the University of Chicago by the Budget Bureau director, George P. Shultz. In helping prepare for the 1971 budget, Laffer had drawn up a table to show that various levels of money increases would translate into corresponding levels of nominal GNP. The Nixon team essentially picked the level of GNP it wanted, plugged it into the budget, and lit a fire under Arthur Burns to supply the money. Here's what happened:

The Fed would instruct the open-market desk at 11 a.m. to buy $100 million in government securities from the banks. At noon, the Fed would have the securities and the banks would have the cash. But instead of calling in borrowers who had previously been turned away as bad risks with insufficient collateral, the banks would wire the $100 million to their European branches. Upon arrival in Frankfurt, the $100 million would be exchanged for DM 400 million, at the 4-to-1 exchange rate. American investors would then be able to buy German assets worth DM 400 million, essentially paying for them with this "ink money." Germans, on the other hand, possessed $100 million in dollars, which would be presented at the Bundesbank for DM 400 million. The Bundesbank was obliged to make the exchange, in accordance with Bretton Woods. To unload the dollars, it would then wire a request to the U.S. Treasury for gold, and the Treasury would advise the Bundesbank that it would rather redeem the non-interest-bearing dollars for interest-bearing debt -- special bonds the Bundesbank could put into its portfolio as reserves. With the speed of electronic banking, all this would take place in a few hours, and at the end of the day, all that had transpired was that: 1) Americans now owned $100 million worth of income-earning assets in Germany and 2) Germans owned $100 million worth of income-earning assets in the U.S. (government bonds). The U.S. banks had not made any new domestic loans to bum risks and no new economic activity transpired. On the other hand, the Bretton Woods gold mechanism had successfully contained the inflation implications of the Nixon-Burns attempt to lift the U.S. economy with printing-press money.

A review of the financial press of the era will today show that nobody understood the process as I have just outlined it. Day after day, the Fed bought bonds in the morning and the Treasury sold bonds in the afternoon. American economists warned of a "dollar overhang" in Europe that would one day crash down upon us. European economists, like Rueff and Triffin, complained that the United States was buying up Europe with fiat money, "a deficit without tears." In retrospect, it might seem comical, except that the same mindlessness still afflicts the Clinton Administration and its Keynesian economic team, who believe the weakness of the dollar is a result of a trade deficit with Japan, not the surplus dollars produced by the Greenspan Fed since last September (as evidenced by the 10% rise in the price of gold).

Why were Rueff and Triffin wrong? Why are Lewis Lehrman and John Mueller in the gold ballpark, but off base? It is because they argue that Bretton Woods blew up as foreign central banks, like Germany, could hold dollar bonds in their portfolios. If a new agreement prohibited use of foreign exchange as reserve assets, they say, a new international gold standard would work like a charm. My counter argument, which I have been making for 15 years, is now that American citizens can once again own gold bullion, the Rueff-Triffin complaint is irrelevant. That is, if Arthur Burns had been buying $100 million in U.S. bonds in 1971 and the banks could call the Treasury and ask for $100 million in gold, which is how it all worked prior to 1934, surplus dollar liquidity would not leak out to foreign central banks the way it did in 1971. If foreign central banks want to hold dollar bonds, they should be allowed to do so, even encouraged to do so. The U.S. government with $4.5 trillion in debt should want all the happy creditors it can find. But the central banks should have to buy the U.S. debt in the open market, alongside the private buyers. It should not be forced upon them by a U.S. Treasury reneging on its gold promises. 

We are on the threshold of another great debate regarding the role of gold in the monetary regime. Unless and until it is resolved, the U.S. economy will not go anywhere, and the financial markets will remain as lethargic as they are today. Without a gold guarantee by the Treasury, surplus dollars created by the Fed can show up anyplace in the world. To be sure, the only good reason for the Fed to create dollars is for their use as a circulating medium, "cash money" that pays no interest. Tens of billions of dollars circulate in foreign countries and are used by citizens who distrust their own national currencies; in the Fed statistics, most of the dollars created this year are for this purpose. Any fresh dollars pushed into the banks in an attempt to finance new private investment are expected to show up as domestic bank deposits and as the "money supply." Yet they may just as easily show up as dollar deposits and money supply in foreign commercial banks which take dollar deposits and make dollar loans. 

A surplus dollar in the system of international dollar financial assets has to intersect somewhere with the market for real goods. The intersection is assumed to be in the gold market, gold being the commodity with the most monetary properties. The surplus dollar can appear for a multitude of reasons. It is useless to guess why, when there are so many possibilities. We need only know that a rise in the dollar price of gold can result from someone, somewhere in the world, bidding for gold with a surplus dollar, possibly one deposited at a local bank to earn interest and then loaned against the gold as collateral. From that step onto the slippery slope, the inflation process proceeds inexorably to a rise in the general price level. It is a process we see underway once again as the Fed watched the gold price rise by 10% and tried to counter the incipient inflation by slowing the economy with higher interest rates. If, instead, the Fed was taking surplus dollars out of the system, it would increase the value of the dollar and thereby increase the world's demand for them. There is nobody around President Clinton who understands this, so he worsens the dollar's problems as he tries to fix them. The question we are all pondering: How bad do things have to get before someone at the Fed tells him what he has to know to fix the dollar with gold?