Chapter 1

CHAPTER ONE

Nearly forty years after their climax, the ‘Sixties’ continue to represent the celebration of youth, optimism, protest and explosions in art, music and pop culture and symbolise the campaign for the liberation of the races and sexes.  The cultural explosion, which cut across the lines of class and race and most crucially divided society itself by age, came from a deep but unfocused unrest in society, usually felt in the general rebelliousness of youth.  What was counter-culture in the ‘Sixties’ is now often accepted as mainstream culture and the years of unprecedented prosperity and consumerism is now nearly mythical?   Interpretations often focus on the colourful aspects of the times revealing a great deal about the sex, drugs and rock music rather than the underlying values that led people to embrace the different cultural forms.  The majority of young rebels in the sixties believed the decay of present civilisation was not caused by its failures but by its achievements; the arid materialistic utopia of communism and capitalism alike.  But, as the counter-cultural ‘youth’ worldwide were revolting against a civilisation and a culture they regarded as morally and intellectually bankrupt, the United States of America was on the verge of economic failure, the circumstances dangerous and intractable and action on a global scale was crucial to prevent disaster.

If we are to understand the actions of President Richard Nixon, who history remembers best for the Watergate debacle and his unprecedented resignation, we need to think back to the state of the world economy in the early 1970’s.  The United States had turned away from the fiscal orthodoxy of balanced budgets in favour of providing constant stimulus to the domestic economy, social welfare programme, financing the Cold War, the military conflict in Vietnam and the American space missions in the form of government spending leaving the United States $75 billion in debt.  The impact of military conflict in Vietnam provided for increased government borrowing from individuals, commercial banks and other governments.  Government debt obligations were purchased by individuals and commercial banks and the funds injected back into the economy. In 1971, the volume of world trade using United States dollars as the medium of exchange finally exceeded the ability of the United States to support its currency with gold. Whereas the Treasury was not really sure how many paper dollars were actually in circulation, they did know there was not enough gold in Fort Knox to back them.    If demand were placed upon the United States Treasury at any one time to exchange all the Eurodollars for gold, the United States Treasury would have had to default, thereby effectively bankrupting the United States government.

The problem was exacerbated by the fact the United States Treasury was not the only institution aware of this fact.  All the G-10 countries were well informed.   France, the United Kingdom, Germany and Japan were concerned about their substantial holdings in United States dollars.   “The dollar” said John Bowden Connally, Treasury Secretary to President Richard Nixon, addressing a delegation of Europeans worried about exchange rate fluctuations, “is our currency, but your problem.” 

On August 9, 1971 the United Kingdom quietly initiated a formal demand at a meeting between its Ambassador to the United States, the former Governor of the Bank of England, George Baring, the third Earl of Cromer, with John Connally and Paul Volcker ,the then Under-Secretary of the Treasury. The Ambassador demanded $3 billion of the Bank of England reserves be exchanged for gold.   Connally listened to the ambassador and said, “I will answer you tomorrow” 1.

Nixon, Connally and Volcker, in an ultra-secret weekend meeting with the brightest of the nation’s bankers and economists gathered to ponder “tomorrow’s” answer.  Honouring the demand meant certain death to the United States as an economic super power.  Not meeting the demand would have catastrophic results.  Was there a way out?  Nixon and his advisors viewed the dilemma in terms of two mutually-exclusive alternatives; increasing the value of United States gold reserves and maintaining a gold-backed economy, or considering the repercussions to the world’s economies if the United States dollar were no longer backed by gold. To resolve the crisis, the United States needed to unilaterally abandon efforts to maintain the official price of gold at an artificial level. 

Although governments had been issuing paper currencies for centuries, they were all theoretically linked, except in periods of war or extreme crisis, to gold, silver or some other “natural” store of value, or to another currency, such as the dollar or pound sterling, that was itself linked to gold. After 1945 the need to re-establish a link to gold for the world economy was met by creating a monetary system in which the pound and other international currencies were all linked to the United States dollar but, crucially, the value of the dollar was itself legally fixed at $35 per ounce of gold.

The Bretton Woods agreements of 1944 were the most ambitious and far-reaching monetary agreements among sovereign states in history. American and British financial officials, led by Harry Dexter White and John Maynard Keynes, hoped to set up a system that would maintain stable exchange rates, allow nations' currencies to be converted into an asset over which they had no issuing control, and provide an effective mechanism to adjust exchange rates in the event that a fundamental balance-of-payments disequilibrium did emerge. In the case of non-fundamental deficits that normally arose in international transactions, the deficit country would pay with a reserve asset, gold or a key currency convertible into gold, or seek short-term financing from the International Monetary Fund2. This system differed greatly from a traditional gold standard, in which the domestic money supply, hence the domestic price level, was directly determined by the national gold stock. Under the gold standard, a balance-of-payments deficit would be paid for through the export of gold, resulting in a decrease in the domestic money base and a deflation of prices. The decreased purchasing power would lower that country's imports, and the increased international demand for that country's lower-priced goods would increase exports, naturally correcting the balance-of-payments deficit. Conversely, an influx of gold, by increasing the domestic monetary base and domestic prices, had the opposite effect of boosting imports and discouraging exports, thereby eliminating a payments surplus. According to standard market theory, any disequilibrium would be adjusted more or less automatically, eliminating the need for government interference. In reality, the gold standard worked as well as it did before World War I because capital flows from London and to a lesser extent Paris, kept the system functioning smoothly.

The rules and institutions established at Bretton Woods subordinated market speculation and national self-interest to the higher goal of international cooperation through a stable exchange-rate regime monitored and enforced by the rules of the International Monetary Fund (IMF). The authors of the plan wanted a system that would "avoid competitive devaluations among currencies; the fund would stabilize foreign-exchange rates, encourage the flow of productive capital among participating nations, help stabilize price levels, promote sound credit practices and reduce barriers to foreign trade." 3  The basic framework laid out in the  Bretton Woods approach  for a global financial system were for fixed exchange rates among national currencies anchored by a government commitment to redeem in gold 4 .

However, there are many arguments for and against the system.  Those who consider the system flawed say, firstly, it was not driven by some grand idealistic purpose on the part of its founders but by considerations of national interest. The British especially saw in the agreements a chance to immunize their planned social programs from international balance-of-payments pressures and to acquire generous amounts of American aid without political concessions. Secondly, the Bretton Woods agreements did not create financial stability, economic interdependence, and international cooperation. In fact, the plan to abolish exchange controls while at the same time establishing fixed exchange rates, full convertibility, free trade, and domestic autonomy was unworkable from the start. What emerged after the war was an ad hoc system plagued by non-convertibility, trade restrictions, and capital controls. These flaws were largely hidden through generous allotments of American aid. When the major European currencies were made convertible in late 1958, the system promptly began to break down. For the next ten years, monetary relations were marked by a chaos and instability that strained relations among the Western allies. Indeed, the internal contradictions of the Bretton Woods system virtually guaranteed contentious balance-of-payments issues that, absent an effective adjustment mechanism, could only be resolved politically. Keynes and White were convinced that international economic cooperation would provide a new foundation of hope for a world all too prone to violence. “If we can continue,” Keynes observed, “this nightmare will be over. The brotherhood of man will have become more than a phrase.” 5

The Americans rejected the currency union plan as too radical but the British came up with a substitute in the so called “scarce-currency” clause which permitted extensive currency controls and trade discrimination against major surplus countries. Both Keynes and R.F. Harrod, a Treasury official, suggested that the scarce-currency clause not be discussed in public for fear that the United States Congress might figure out its true implications. As Harrod said, "In view of the need for 'good handling' the less public lucidity there is on this matter the better." And Keynes responded, "The monetary fund, in particular, has the great advantage that to the average Congressman it is extremely boring." 6 The clause was included in the agreements, but the Americans interpreted it very narrowly, a fact that created much bitterness in Britain. In later years, the British government blamed many of its economic woes on the narrow interpretation of Article VII by the Americans. The British had little to complain about, however, because the larger political goal of promoting European reconstruction and eventual union led the United States to permit extensive dollar discrimination while furnishing billions of dollars of aid.

The Bretton Woods system gave an unusual advantage to currency traders who could easily discern what currencies were in need of revaluation and could simply put pressure on a vulnerable currency until its government exhausted its reserves and lost its will to defend the old exchange rate. Speculators made fortunes when sterling was devalued in 1949 and 1967. The only way to avoid such devaluations was to impose capital controls which every major country, including the United States, had to install at some point during the Bretton Woods era in order to maintain its exchange rate.

Another issue was the method of providing liquidity in the Bretton Woods system. Liquidity is simply another word used to describe reserve assets that are transferred from debtor countries to cover their payments gap. In order to offset a negative balance of payments and maintain a fixed exchange rate, nations have to supply some universally accepted asset over which they have no issuing control. Until 1914, that asset was gold. Because planners believed that there was not enough gold to supply world liquidity needs, key currencies, such as the dollar and sterling, would be used to supplement or replace gold to settle international transactions. That brought up a larger question; how stable and cooperative would a system be that required the world's largest economy to run persistent balance-of-payments deficits? The dollar, fixed against gold at $35 an ounce, had to do double duty under the Bretton Woods system; first, as a national currency; secondly, as an international reserve asset. But sooner or later, the amount of dollar liabilities held for this reserve purpose was bound to become larger than the value of the gold stock backing its value.

The Bretton Woods agreement became problematic as more and more liquidity was needed to maintain fixed exchange rates in the growing international economy. But, because the worldwide gold stock was limited, most of the liquidity was supplied by the American payments deficit. As this deficit increased, doubts arose everywhere as to the ratio of dollars to the gold backing them up. America's promise to sell gold at a fixed price, a promise that was the foundation of all international monetary rules, thus became a magic money machine for overseas holders of dollar liabilities. The reasons that gold had been bid up included the tensions over Berlin, the burgeoning American payments deficit and the fear of loose monetary and fiscal policies under a Kennedy presidency. But, instead of recognizing the flaws in the system, American policymakers wrongly blamed the market

By any measure, the United States during the 1960s possessed overwhelming economic strength, commanding a larger share of the world's wealth than any modem nation in history. That wealth was convincingly exhibited by the American ability to dispense billions of dollars in aid to its allies and station hundreds of thousands of troops in foreign countries. Yet the United States whole foreign policy, including the global containment of communism, was absurdly endangered by movements in the price of gold in London. After the gold crisis of 1960, it seemed logical to policymakers to blame the United States payments imbalance and shortage of gold on two factors; speculators operating in a free market and American overseas commitments. After all, the United States still consistently maintained a sizable current-account surplus (positive balance of trade) throughout this period. So a fierce debate raged within the Eisenhower, Kennedy, and Johnson administrations over the impact that vital United States foreign-policy commitments were having on the balance of payments and price of gold. Dwight D. Eisenhower and his top aides feared that unless United States commitments were reduced, the payments balance would deteriorate, the gold outflow would worsen, and the international monetary system would be destroyed. The resulting economic collapse might well fracture the NATO alliance and hand the Soviet Union a victory in the cold war without a shot being fired. Of course, that never happened and it is arguable whether it could have happened but the important point is the fact that concerns over the dollar and the international monetary system had a major impact on foreign-policy decisions.

All three administrations met the crisis with policies that antagonized alliance relations. Although, American troop reductions in Europe, were never fully carried out, mere discussion of the issue damaged confidence in the United States commitment to defend Western Europe. Ultimately, West Germany, Japan, and others "agreed" to offset the full balance-of-payments cost of the American troops. The president of the Bundesbank also promised to hold American dollars and not turn them in for gold. Both the offset agreement and the gold guarantee created great tensions in the American-German relationship. Attempts to get Charles de Gaulle's France to cooperate on monetary matters failed miserably, worsening an already strained alliance. During his press conference on 4th February 1965, President Charles de Gaulle had openly challenged the United States dollar’s “exorbitant privilege” under Bretton Woods order, “…Any workable and acceptable international monetary system must not bear the stamp or control of any one country in particular.  Truly it is hard to imagine any standard other than gold.  Yes, gold, whose nature does not alter, which may be poured equally well into ingots, bars or coins, which has no nationality, and which has eternally and universally, been regarded as the unaltered currency par excellence…..”

Neither these nor any other measures could repair the fundamental problems of the Bretton Woods system. Throughout the 1960s, policymakers and outside observers produced dozens of plans to reform the international monetary system but reached no consensus. The task became urgent when Britain, in the face of massive speculation on the currency markets, was forced to devalue sterling again in November 1967. Johnson administration officials feared that speculators would attack the dollar next. The payments deficit, which had been brought under control in 1965, ballooned during the next two years, primarily because of the cost of the Vietnam War.

The Johnson administration announced a program on January 1, 1968, that included border taxes and export subsidies, steep travel taxes, increased offset payments from allies, limits on overseas lending by American banks, and mandatory controls on capital investment abroad. The program had enormous political costs, especially in an election year. Overseas, especially in continental Europe, the plan provoked an outcry. The Atlantic Alliance, strained to the breaking point in 1966 and 1967 by internal crises, was pressured further by the administration's plan. Worse still, the plan reversed a cardinal tenet of post-war American foreign economic policy: to promote open markets and free trade around the world.

To compound matters, the harsh balance-of-payments program was completely ineffective. By March 1968, the Johnson administration was forced to call an emergency meeting of the world's finance ministers, and finally to ask the British government to close its gold market. Under enormous political pressure from the United States, it was agreed that a two-tiered gold market would be established; a private market in which the price of gold would be determined by supply and demand, and an intergovernmental market where the price would remain at $35 per ounce. Of course, the finance ministers had also to agree not to buy or sell gold on the open market. That meant the United States could exert enormous political pressure on world bankers to hold their dollars without fear of being overwhelmed by the private market. What ‘replaced’ it was the current system of sometimes free, sometimes managed exchange rates called the "dirty float."

To resolve the crisis and imminent bankruptcy, the United States needed to unilaterally abandon efforts to maintain the official price of gold at an artificial level of $35 per ounce, the same price that existed in 1933.  Gold in 1971 had a market value of approximately $350 to $400 per ounce. But on Sunday 15 August 1971 however, President Nixon and the Federal Reserve suddenly closed the gold window, taking the world by surprise and suspended the legal convertibility of the dollar into gold. The value of money was no longer linked to any objective standard of value, be it gold, silver or cowrie shells. For the first time the whole world was operating what economists call ‘pure fiat money’? The Bretton Woods system was dead, a victim of its own contradictions.

Pure paper money was one of those previously unimaginable and irreversible 20th-century inventions that changed the world forever. It finally broke the dependence of economic activity on arbitrary natural phenomena, such as the discovery of new gold mines. Fiat money thus severed one of the most durable links between man and nature and gave governments, and the central bankers whom they appointed, the freedom to manage their economies without regard to external forces and to create standards of value that philosophers and economists had previously ascribed to God.

Historians who study the late 20th century will devote far more attention to the changes wrought in the world economy by President Nixon’s administration and the Federal Reserve than any other singular or significant man made event. The wars, the acts of terrorism and even the defeat of Communism, will one day pale into insignificance beside the extraordinary and unprecedented transformation that has occurred in the world’s monetary system in the past three decades; the replacement of gold, silver, salt, precious stones and all other standards of monetary value that had underpinned economic activity since the dawn of civilisation, with a system of pure paper money that represents nothing more or less than an edict by the issuing government or its central bank.

When historians try to understand the transformation from the solid golden world of Midas and Mammon to the modern global economy, where completely worthless bits of paper and coded electronic signals are sufficient to represent all material dreams and aspirations and keep billions of people permanently in their thrall, they need an understanding of the apparently disparate and unrelated events which are really part of the single historical stream.  Fundamentally, they need to comprehend a ‘Bond’ is primary to any sequence of events