The Countdown to the Last US 'Default' - 1 August 2011
Forty years ago, US Dollar holders knew what their currency was worth. They could swap it for gold at $35 an ounce. Then along came Richard Nixon...
ADRIAN ASH of BullionVault takes a trip to the archives, and looks at the days leading up to the last great US 'default' – when President Richard Nixon ended the convertibility of Dollars to gold in 1971...
Tuesday, 3 August 1971 – Treasury secretary John Connally yesterday urged US banks not to follow the Bank of Michigan, the Financial Times reported, after the small bank raised its key lending rate from 6% to 6.5%.
Instead, US banks should look to "hold prime rate down", said Connally, adding that "Further unjustified increases in interest rates, already historically high, might well jeopardize the strength of business recovery."
Faced with recession, the Federal Reserve had slashed its key interest rate to a 7-year low of 3.7% at the start of the year. But after slipping negative, real US interest rates – allowing for the rate of inflation – had turned higher. That meant tighter credit for US households and business. But what looked (only a little) like strong money at home was doing nothing to support the Dollar, or reduce volatility, on the foreign exchanges.
Dollars continued to pour out of Washington into foreign-reserve accounts overseas. So also on the Monday, Germany's Bundesbank had set a 6% trading band on the Deutsche Mark versus the Dollar, selling the US currency at DM3.46 even as Deutsche Bank analysts forecast a rise in the Dollar to the previous parity of DM3.66.
Currency confusion was hitting commodities too, where the Financial Times said firm cocoa prices were "even attributed to Dollar weakness" by traders – as if weak money could possibly wind up in high prices. Rubber had meantime fallen to its lowest price since 1949. While sugar prices had turned higher in early August, they'd been falling all year with "no scarcity" reported.
Closer to home for FT readers, and thanks to that ongoing flood of Dollars out of Washington, the United Kingdom was meantime enjoying its fastest foreign-reserves growth in 5 years, with gold and foreign-exchange reserves reaching $3.8 billion – a 20-year high (if you allowed for the effect of devaluation) – thanks to higher-still interest rates attracting foreign capital.
Moreover, new capital controls on British money, plus import tariffs, meant that food-price inflation in the UK, which had forced retail prices over 10% higher from summer 1970, "would soon abate" claimed the Financial Times. Such policies worked, apparently. Just the kind of policies US president Nixon had campaigned against – and abolished – during his first campaign for the White House.
Thursday, 5 August 1971 – "Nixon softens attitudes to prices and incomes policy," announced the FT, reporting from Washington on Wednesday that "President Nixon startled everyone this morning [with an] impromptu press conference."
Nixon "declared an 'open mind'...a far cry from the obduracy shown...for the previous two and a half years." But would domestic price caps and wage controls help the Dollar recover? "Pressure on Dollar follows French currency curbs" said the FT's front-page, reporting how Paris had banned its commercial banks from growing their overseas debts in either Francs or foreign currency.
France had also bought $50 million in gold from the US Treasury that Wednesday, delivering it to the International Monetary Fund as part-payment of the $609m still owing from the Franc devaluation of 1969. France had now taken $250m in gold off the United States in the "last few months". Its foreign-exchange reserves had swollen by some $500m.
"The effects of the moves spilled over into the gold market," said the FT, "always a centre of attention at times of currency upheaval." Gold traded in London had hit a two-year high of $42.50 per ounce.
The United States Treasury still obliged itself to swap gold for $35 per ounce, but only to its major central bank counterparts, all of whom had promised not to demand metal for paper.
Monday, 9 August 1971 – Alongside the round-up of IRA supporters in Ulster and a trades-union strike over rising Metro fares in Paris, "US Treasury rejects a call for devaluation" said the Financial Times, quoting a weekend statement from Nixon's Treasury spokesmen, after the Reuss subcommittee in Congress had called for the United States to follow Britain and France in formally cutting its currency's exchange rate.
"That the Treasury felt obliged to issue a formal 'denial' statement to the conclusions (not unanimous) of a dim and more or less powerless Congressional subcommittee is proof of the altered condition of the Dollar.
"This will be in evidence this week, when the US gold stock will drop to just over $10,000 million, the lowest point since the early 1930s...There has naturally been a revival of the traditional theory that when the gold stock hit $10,000m, the US would simply close the gold window.
"There is no evidence that the Nixon Administration plans such action."
Washington was busy in foreign exchange, however, buying $862m worth of Belgian Francs and Dutch Guilders from the IMF to better suit their governments' preference for guaranteed credits at the central-banks' central bank. Reports of French gold buying continued, with the FT noting the "orthodox position" that Paris would only take gold to pay off its IMF debts, rather than build its own central-bank gold hoard. "[But] some commentators here [in Paris] openly suggest it should do so and thus increase pressure on the Americans to put their own house in order."
Three-month US Treasury bills fell, pushing interest rates in the open market up to 5.37%.
Tuesday, 10 August 1971 – "Pressure on Dollar – new D-Mark peak" announced the FT's headline writer, never dreaming that one day a cut-and-paste function would enable him to repeat such disasters at the click of a button.
"The Dollar crisis intensified yesterday," said the paper, "with strong speculative pressure once again centred on the D-Mark and the Swiss Franc." Gold had hit highest price since the collapse of the London Gold Pool – the ill-fated cartel in which the US, Germany, UK and France sold gold into the open market, trying to suppress its price near the official peg of $35 per ounce – in March 1968.
"Confusion in N.York," the Financial Times went on inside, noting that although "the Nixon Administration maintained its customary silence on the difficulties of the Dollar", what the paper called "well-founded rumours" said the New York Fed would make an announcement concerning its Dollar swap-line agreements with other central banks. Because after heavy use throughout 1970, "a number of foreign Governments were no longer prepared to accumulate Dollars, with the Fed's assistance, in order to pay off their international indebtedness," according to an un-named New York Fed official.
What to do amid the confusion? Switzerland banned what the FT called "speculative flows" into the safe-haven Swiss Franc – itself "already revalued to a new fixed parity". The Swiss National Bank would now only take US Dollars deposited against corresponding deposits of Swiss Francs on "blocked accounts". The UK Government meantime continued implementing official controls and tariffs on imports, while business chiefs' lobby the Confederation of British Industry that day called on some 200 companies not to raise their prices by more than 5% for the next 12 months.
But in Washington? "Problems of a parity change," explained John Graham, US editor for the FT, meant that even doubling the official price of gold to $70 per ounce might leave foreign-exchange rates untouched, creating no net depreciation for US exporters, nor a devaluation in all those Dollars piled up overseas.
There was another solution for Nixon's White House, however – "more ingenious and less improbable...The gold content of the Dollar is guaranteed only because the US Treasury accepted an option in the late 1940s to buy and sell gold at $35 an ounce," Graham told his readers. "The acceptance of this offer is contained in a letter" from the then Treasury Secretary, clearly as keen to support America's historic gold hoard as to support the post-War fixed-exchange system agreed at Bretton Woods in 1944. Down in the detail, and alongside all those governments not obliged to buy or sell gold, the Treasury had to hold the Dollar inside a 1% parity band. Because "The [International Monetary Fund] rules that a country has an obligation regarding exchange stability, and that a country whose authorities 'in fact freely buy and sell gold within the limits prescribed' is fulfilling that obligation.
"[But] the US does not 'in fact freely' buy and sell gold, except in a narrow technical sense. It is true that no monetary authority which has insisted on Buying Gold [from the US] has ever been refused, but pressure of all sorts has been applied to reduce the likelihood of such insistence."
Ergo, said Graham, revealing what seemed a little-known solution, the US could disoblige itself of the gold clause, but still stick within the Bretton Woods' rules by moving solely to currency-to-currency parities instead.
Friday, 13 August 1971 – The headline writer said it all once more: "Dollar under pressure again...US seeking study of wider currency bands...Gold active."
Reports in Germany said Thursday that the Bundesbank wouldn't let the Deutsche Mark rise above 3.33 to the Dollar – "a revaluation of virtually 10%" from the agreed fixed-exchange rate parity. Indeed, for the first time since the Deutsche Mark had been floated off its Dollar-parity in mid-May, the Bundesbank had bought "a noticeable amount of spot Dollars, reliably reported at $39m" in the open market.
"This helped to steady the market," said the FT, but "Gold again attracted attention in fairly active dealings. The metal ended the day at $43.30, a rise of 40c on the previous day."
Over in Washington, Nixon's Treasury secretary – John Connally – had on Thursday asked the IMF board "to study seriously the possibility of widening the official bands around currency parities. A 3% margin has been suggested." Currency traders weren't waiting for the politicians and central bankers to agree, however, and "The New York foreign exchange market went wild again this morning," said one of the Financial Times' US correspondents.
"The only thing that hasn't moved is the Pound," the FT quoted a dealer at a major bank, who described the session as "crazy".
"Although key European currencies rose sharply in value against the Dollar, there was no sign the New York Federal Bank, acting as the agent of the US Government, had intervened in the market." But Washington was intervening at the political level, however, and with good reason.
"US warns Japan to speed removal of trade barriers," said the FT – pointing to what one historian, writing 35 years later, noted as a plain but little-recognized fact of the 1971 Dollar crisis: "Japan had [already] replaced Western Europe as the target of America's economic complaints." Its go-go economy was hoovering up foreign exchange so fast, the Yen's fixed parity rates couldn't hold. Tokyo added $4 billion to its reserves inside two weeks that month, trying to maintain the ¥360-Dollar rate. But by the end of August, Tokyo caved in. Another FT article that Friday reckoned there was "No hidden magic in Japanese management" techniques. But its export boom continued regardless, and the Nixon White House saw trade tariffs as the culprit.
In contrast to the turmoil elsewhere, "France reacts calmly to US currency margins bid" the FT went on elsewhere. Because "The rounds of anti-speculative measures taken last week has had the effect of putting France a little outside the mainstream of the monetary crisis, as was the authorities' intention...Dealings in foreign currencies have remained restricted to bona fide commercial transactions." Exchange controls worked was the lesson, or so the US was to claim that coming Sunday.
And the stock market? "Dow jumps 12.6 with volume up 4.5m" reported the FT. Whatever chaos was hitting the Dollar, equity buyers must have judged it good news for risk.
Saturday, 14 August 1971 – "Dollar ends week still under pressure...From Switzerland came confirmation of the moves agreed with the banks to control hot money flows...100% minimum reserves...In Frankfurt the Dollar again reached new lows...The gold market, however, was fairly quiet after a nervous start [with] a fall of 25c on the day."
"The $ under pressure" added a headline on page 12, just after the FT's weekly How to Spend It pages, aimed then as now at City bankers looking for fine wines and watches. "No one doubts that the objective must be to produce a more realistic exchange relationship between the Dollar and America's chief economic partners," said the editorial piece below. "Either the Dollar changes its relationship to gold or all the strong currencies float or revalue upwards against the Dollar. But for the present both routes are barred."
Raising the Dollar Gold Price "has always been resisted [by the US] on the grounds that it is a haphazard way of increasing world liquidity, that it would reward America's enemies (particularly the Russians) and penalise her friends." With pressure eased by the post-Gold Pool two-tier market – one private, one for central banks – and as the Congressional sub-committee had said, why not let gold float a little – say 10 or 15%...? It needn't cause "massive disruption to the international system.
"But the chances of the US administration submitting to this blow to its prestige in a pre-election year is so remote as to be virtually non-existent."
Oh yeah? You can read what happened next here...
Adrian Ash runs the research desk at BullionVault, the physical gold and silver market for private investors online. Formerly head of editorial at London's top publisher of private-investment advice, Adrian Ash was City correspondent for The Daily Reckoning from 2003 to 2008, and is now a regular contributor to many leading analysis sites including Forbes and a regular guest on BBC national and international radio and television news. Adrian's views on the gold market have been sought by the Financial Times and Economist magazine in London; CNBC, Bloomberg and TheStreet.com in New York; Germany's Der Stern and FT Deutschland; Italy's Il Sole 24 Ore, and many other respected finance publications.