Executive Summary: Secretary Jim Baker's G-5 initiative on monetary policy ended the floating era of "benign neglect." The Jack Kemp, Bill Bradley "congressional summit" on exchange rates and the dollar has made it socially acceptable to discuss global monetary reform and even a gold standard. Three distinct levels of reform proposals emerged: Target zones of exchange rates; anchored target zones; and gold-anchored target zones. Mundell proposes an immediate set of policies that capture the current market values, $325 gold, 190-to-210 yen, 2.4-to-2.6 D-Mark, as a transition in determining the optimum price of worldwide gold monetary reserves. There's little support for returning to a dollar-centered Bretton Woods arrangement, politically unstable. Supply-siders divide over alternatives, a multilateral standard of gold convertibility or an IMF-centered system of "paper gold," with a "collective exercise of sovereignty." There's a sense of fairly rapid change on the horizon.
The Kemp-Bradley Monetary Conference
The Kemp-Bradley international monetary conference of Nov. 11-13, at Washington, D.C.'s National Academy of Sciences, came to no conclusions and changed no policies. But taken together with the September 22 Group of Five meeting of finance ministers and central bankers at New York's Plaza Hotel, the event was of immense importance.
We can say of G-5 that it ended a generation of U.S. "benign neglect" of the effects its dollar policies have on the rest of the world. It brought to a close the experiment with floating exchange rates begun in 1971 with President Nixon's closing of the gold window. And it dramatically turned the dangerous forces of protectionism swiftly gathering in the world into the positive channels of monetary reform.
The monetary conference co-sponsored by Rep. Jack Kemp and Sen. Bill Bradley, coming fortuitously in the wake of G-5, turned into a celebration of its occurrence and meaning. Treasury Secretary James Baker III, who addressed the 150 participants and as many guests and press, was the man of the hour. There were the expected wide and sharp disagreements in the two long days of discussion and debate. But Jim Baker and his G-5 initiative were almost unanimously hailed for having ended an era of monetary nationalism and reviving discussion of international reform. "The significance of this conference," observed Robert Bartley, editor of The Wall Street Journal, "is that it ends discussion of whether there will be international monetary reform and poses the question 'How?'"
In the Sunday New York Times of Nov. 17, a few days later, an article on the central economic policymakers of the Reagan Administration hints at the pregnancy of this idea. Timesman Peter T. Kilborn writes:
They could now be planning to jettison the world's 12-year old system of "floating" currencies, moving back in the direction of the gold standard, toward a system of tighter control, to thwart another big rise of the dollar, or what Mr. Volcker fears more, a big fall. "The President is receptive to new ideas in the monetary realm, I think," said Patrick J. Buchanan, the White House communications director. "He's attracted to the idea of a standard for the currencies."
Robert Hormats of Goldman Sachs, an international economist who served in both the Carter and Reagan administrations, shrewdly noted that the conference reopened discussion that had been suspended a dozen years ago when floating began. The difference now is that floating has been experienced, and no longer can be advertised as the easy solution. There were of course several defenders of the float who argued that it enabled the world to withstand the "oil shocks" of the 1970s. (Althrough a surprising number took the once heretical view that the float invited the oil shocks, Phillip Braverman of Irving Trust being the most cogent.) But even most of the usual defenders, including former Rep. Henry Reuss — one of the architects of the float — seemed receptive to proposals for greater fixity.
There were plenty of press people, generally amazed, not only that a Kemp and a Bradley would host a "U.S. Congressional Summit on Exchange Rates and the U.S. Dollar," which is what it was called, but also that so many bigshots came from around the world — parliamentarians, government officials, bankers and financiers, and world renowned economists. They couldn't imagine something like this happening, say 18 months ago, and getting anywhere near the attention. "Why now?" I was asked repeatedly.
One thought that struck me at the opening session was that the constituency for floating currencies had been systematically reduced over the years. At the beginning, in 1971, Nixon's closing of the gold window was cheered so widely by the establishment's opinionmakers and policymakers — left, right and center — that it seemed a decision made forever. In the inflation that followed, creditors took their lumps, but a good number of these were foreigners left holding a bag of dollar bonds. Dollar debtors reveled in this new inflationary freedom and celebrated the float. The float turned in 1980, though, and now debtors felt the crush.
In the last 18 months the squeeze has not been as horrific as in 1982, during the first deflationary wave, but it has been persuasive. Floating has few remaining fans, even among many of those who seem to profit from calling the turns. The West Germans were most conspicuous in support of continued floating, but then they are the dominant players in the fixed exchange rates of the European Monetary System. And if they are so much in support of a floating dollar-Deutschemark relationship, Bob Mundell asked, why do they continue to hold, buy and sell such large volumes of dollar assets — the antithesis of floating?
The most notable convert was Alan Greenspan, the moderator of several panels at the conference, who came out for a gold standard. Chairman of President Nixon's Council of Economic Advisors in the early days of the float, Greenspan has insisted over the years (perhaps taking his cue from Arthur Burns) that a gold standard wouldn't work unless inflation were under control. And if inflation were brought under control, he's said, a gold standard would be superfluous. His reasons for changing his mind were garbled, but his willingness to publicly identify himself with Kemp and the gold bloc was generally taken as a straw in the wind.
As expected, the gold bloc was a distinct minority, mostly gathered around Kemp, and of course Mundell. But it is now a socially acceptable minority. When Henry Reuss wryly observed that "Jack Kemp is the only populist I know of who can run with a cross of gold for a touchdown" it was with not a little political admiration. Jim Baker and Dick Darman were careful to remain above specifics. But when Darman told Leonard Silk of the Times that he and Baker were prepared to listen to "all respectable and respect-worthy views" it was obvious the co-sponsor of the conference would be included in that range. Kemp read with pleasure Jim Baker's statement on why Treasury wouldn't sell gold to alleviate the debt-limit problem, because "The President and I are not prepared to take that step because it would undercut confidence here and abroad based on the widespread belief that the gold reserve is the foundation of our financial system."
The common thread that ran through the discussions was the desire for stability of exchange rates, however. The three distinct groups with ideas on how to achieve such stability were: 1) The "Target Zone" advocates, the group associated with the Democratic economists of the Institute for International Economics in Washington — Senator Bradley aligned himself here; 2) The "anchored" Target Zone advocates, a relatively new group that will fix exchange rates around anything but gold per se; 3) The gold-anchored Target Zone advocates, a group divided over secondary details that are critical to the ultimate shape of the international monetary regime.
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1) Target Zones. The IIE in Washington has made these supposedly optimum exchange rate areas (also called "reference zones" by the IIE's John Williamson) a fashionable idea among Democrats. These are would-be managers of the major exchange rates ("managed floating," as Senator Bradley put it), whose objective in the exercise is a balance of trade. Robert Roosa, a partner of Brown Brothers Harriman and chairman of The Brookings Institution, was at the conference and shoulder-to-shoulder with Williamson in support of this idea.
The economic theory underlying these proposals is what sold President Nixon on closing the gold window in the first place, that a "weaker dollar" relative to the D-mark or Yen would decrease U.S. imports by making them more expensive and increase U.S. exports by reducing their price abroad. The Target Zones are those which their advocates believe would bring about these altered trade flows — 180 Yen to the dollar, for example — but without any permanence. Global money would be managed on a day-to-day basis the way the Federal Reserve now manages the domestic dollar around M-1 "zones" or GNP "zones." Leonard Silk noted Richard Darman's interest in the idea:
Mr. Darman indicated support for publicly announced "target zones" for exchange rates among the major currencies. Specifically, he expressed interest in the proposal of John Williamson, a senior fellow of the Washington-based Institute of International Economics, for target-zones of perhaps plus-or-minus 10 percent, with "soft margins," rather than an absolute commitment to prevent rates from straying outside target zones.
In that context, the assumption is that central bankers could decide on when to ease or tighten domestic policies in order to remain in this global "paper snake." There's no specific guide beyond the collective wisdom and judgment of the bankers, except for the emphasis on trade flows. One embodiment of this idea is Senator Bradley's Strategic Capital Reserve Act of 1985, a proposal that would require the Federal Reserve to devalue the dollar by injecting bank reserves whenever the trade deficit exceeded $50 billion. This assumes exchange rate changes will automatically alter trade flows, an idea that is popular but which has no statistical support. In the current milieu of $150 billion U.S. trade deficits, one can easily imagine this "trade-account" monetary standard yielding triple-digit hyperinflation.
Williamson, by the way, correctly observed that whether they realized it or not the Group of Five finance ministers had made "the essential intellectual jump" in moving from uncoordinated floating to a target zone system. But this simply points up the problem of simple target zones. The Japanese wound up interpreting the Plaza agreement as requiring them to raise interest rates, thereby not only weakening their economy but also reducing their demand for U.S. notes and bonds. Several participants clucked about the perversity of this development.
If there is no objective reference point outside the target zone, Alan Reynolds observed, the situation could develop where the Bank of England raises interest rates to stay in the zone. And the Fed, observing the dollar weakening against the pound, raises interest rates to strengthen it. The result is competitive appreciations that invite global recession. This is the flip side of the situation Harvard's Jeffrey Sachs described in the 1971-73 period, when the West attempted a fixed exchange rate system without an "anchor" or reference point. With the Fed leading the way, the central banks jointly inflated, ignoring the quadrupling of the gold price in this period as if it no longer mattered.
More immediately, Reynolds noted in commenting on the Williamson-Roosa target zones that Paul Volcker early this year was asked why he could not stabilize the dollar-DM rate; Volcker asked how to decide whether the Fed should ease or the Bundesbank tighten. "Proposals that do not answer this central question are useless and should be dismissed out of hand," he said.
2) Anchored Target Zones. One of the most significant intellectual shifts displayed at the conference came from Ronald McKinnon of Stanford University, heretofore the most renowned advocate of Target Zones sans anchor or reference point. The main difference between McKinnon and the ME economists has always been his refusal to accept their assertion that trade flows will change in response to exchange rate changes. But until the Kemp-Bradley event, he had spent a decade writing and lecturing on behalf of a fixed rate system guided by central bank judgment. At the conference, his presentation concluded with a recommendation that a basket of primary commodities serve as a guide to central bank intervention in the target zones. Given McKinnon's leadership in this area, this was far more significant than simply a straw in the wind. It raised eyebrows among the cogniscenti, being the intellectual equivalent of a Unitarian conversion to Catholicism.
Harvard's Jeffrey Sachs had derided the 1971-73 experiment with fixed, unanchored exchange rates, but nevertheless endorsed the Williamson target zones. Democratic economists stick together. But privately he acknowledged that of course any fixed system required an anchor. Any but gold!
Perhaps the most elegant presentation of a fixed regime with an anchor was by Alexander Swoboda, of the Institut Universitaire de Hautes Etudes Internationales in Geneva. If the monetary authority fixes exchange rates, he said, domestic prices have to adjust; if domestic policy dominates, exchange rates must be free to fluctuate. But as with McKinnon and Mundell, trade flows do not respond to monetary policy in his model. Still, Swoboda stuck to his longtime proposal of having central banks anchor on the Fed's targeting of M-1, as if he had not heard of its demise. So he was alone.
McKinnon's idea of a commodity basket as anchor is more of a milestone than a serious contender for a permanent solution. As Mundell points out, world central banks hold 1.1 billion ounces of gold as monetary reserves, and no other commodities, primary or otherwise. Serious reform proposals must deal with the gold question, he insists. The reserves must either be utilized or in some way disposed of. It is not practical for economists to suggest reforms that ask governments to simply forget the gold.
3) Gold-anchored Target Zones. If we think of a Target Zone as simply a band of exchange rate values, we realize the Gold Bloc has much in common with the other fixed rate proponents. The difference is that the center of the Target Zone or "band" of each exchange rate is the dollar/gold price that provides the anchor. At the conference, Mundell was the only panelist who offered a specific policy action vis a vis target zones. He suggested the Administration immediately buy or sell limited quantities of gold at $325, the current price, and that the Fed help the Bank of Japan maintain the Yen/dollar rate at between 190 and 210 and help the Bundesbank maintain the DM/dollar rate at between 2.4 and 2.6.
The proposal seems deceptively simple because the values are all more or less current, which means nothing extraordinary need take place. Yet because the Deutschemark is the dominant currency in the fixed-system of the EMS, and because almost all currencies of the West are pegged to either the dollar, the Yen or the European currencies of the EMS, the Mundell proposal would mean an immediate gold-anchored system of target zones for the world's currencies. Close your eyes and open them again and it's done.
The fact that gold has been trading at $325, give or take a dollar or so, since the G-5 meeting Sept. 22 suggests that it has become the floor of the Fed's deflation. It can't go down by much or the anguish would be felt immediately in Tokyo with even higher real interest rates. To go higher requires an explicit easing by the Fed, and any easing will not be so pronounced that it sends the dollar into the kind of "precipitous fall" that Volcker fears.
This is why Mundell suggests only "limited" U.S. purchases and sales of gold at $325, to give the central banks a feel for the system. Caution is required because the current situation may be different from the past, when restoring gold convertibility meant tying into an existing system. During a transition period, the dollar must play a central role because it now gives stability to gold, not vice versa. It's important to note shifts in the world gold stocks during this transition in determining the optimum price of the gold monetary reserves. "We don't want to buy all the world's gold and we don't want to sell all our gold either," says Mundell.
Thus, if in this transition period the Treasury would find itself adding to its gold stocks it would be able to confidently gather the $325 was too high a price. Selling from its stocks would indicate a too low price. It's important the optimum price is at least approached if the gold stocks held by the central banks of the world are to be utilized, exchanged as a final-settlement asset instead of sitting dormant in vaults. Mundell's expectation is that $350 — exactly ten times the old Bretton Woods price — would be in the appropriate range.
It's difficult to imagine a monetary reform that would begin differently than this Mundell scenario; if there were an easier way, one assumes he would have thought of it, since he has thought of little else in this realm for the last dozen years. But this is far from being a complete reform.
It was clear at the conference that the Europeans have little stomach for a revival of "Bretton Woods," by which is meant a system with the dollar at the epicenter and all other currencies required to peg their currencies to the dollar. At the conference, Helmut Schlesinger of the Bundesbank made it clear he wasn't going to go through that again: Acquiring $15 billion of dollar bonds at 3.6 DM to the dollar, under his Bretton Woods obligations, and then having the United States — in control at the center — devaluing the dollar and handling the Bundesbank a huge capital loss. Georg Rich of the Swiss National Bank also fretted about returning to a fixed system that might prove to have less discipline than he prefers.
Supply-siders have been debating and discussing this problem for years, generally agreeing that the Bretton Woods type of gold-exchange standard is at least politically unstable and perhaps economically unsound as well. It simply becomes too tempting for the nation that runs it to manipulate it for national advantages, as the U.S. did in 1971-73. This was the "exorbitant privilege" that Charles de Gaulle complained about. This was the "deficit without tears" that his finance minister, Jacques Rueff, described in the late Sixties. Unlike Helmut Schlesinger's Bundesbank, which swallowed U.S. bonds as reserve assets, France demanded U.S. gold for the dollars Frenchman were accumulating.
If the United States is not going to be at the center of a reformed system, there are two conceptual alternatives: a multilateral gold standard and a world central bank.
The multilateral gold standard would replicate the classical gold standard, with gold at the center of the system and individual central banks committing themselves to the convertibility of their respective currencies. The leading advocate of this system is Lewis Lehrman, who made such a proposal at the conference.* I call this the "Rueffian" school, after Jacques Rueff, a Lehrman mentor, who observed from Paris that it was the dollar's reserve-currency status that was undermining Bretton Woods. Under the Lehrman proposal of multilateral convertibility, the major central banks would agree not to hold each other's financial assets as reserves. The U.S. would fund existing dollar reserves, buying them back over time, at the equivalent of $400 to $500 gold.
The idea of a world central bank picks up where the debate on monetary reform was suspended in 1973, where international economists and bureaucrats pondered the weaknesses of Bretton Woods — including the De Gaulle complaint. The International Monetary Fund would be assigned the task of maintaining the gold weight of its independent "unit of account/' the SDR (for "Special Drawing Rights"). The SDR would thus be "paper gold." If all major currencies committed to convertibility of their currencies to the SDR, they would essentially be convertible to gold. The IMF could not change the gold weight of the SDR without the 85 percent weighted vote of the members, and governments that wanted to inflate would be free to opt out of the system. At the conference, Renato Ruggiero of the Italian Ministry of Foreign Affairs used a phrase, "the collective exercise of sovereignty," that seems appropriate here.
My tendency is to think along these lines, rather than the Rueffian approach of Lehrman's. It seems to go with the flow of history instead of against it. But both seem technically sound. And it isn't necessary to decide on one or the other right away; it will be a few years at least before the shape of a "permanent" monetary regime evolves — one we could hope would last for several decades.
At the moment, though, there's a sense we're on the threshhold of the transition period and may have already slipped into it. Where the movement toward reform experienced in recent years has been painfully slow, it has picked up dramatically since the Plaza G-5, and the Kemp-Bradley conference left a few of the important participants feeling that rapid change, even exponential change, is on the horizon.
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*The Lehrman paper, "Protectionism, Inflation, or Monetary Reform: The Case for Fixed Exchange Rates and a Modernized Gold Standard," has been published this month by Morgan Stanley & Co.