FDITOR'S BOTE

1 have spent a lifetime as a journalist observing many of the events in this

book, and it has been an illumination for me to hear them described from
the inside by two of the men who made them. Nothing quite like it exists
anywhere else: the distinct voices of two successful economic statesmen
reviewing their often tumultuous careers, justifiably proud of their
achievements but admitting with refreshing candor that they were
sometimes surprised by events and the results of their own policies, and that
they might have done things differently, or even better. Their book should
be read as a counterpoint between established and rising powers by two
men who held similar positions on different, although not necessarily
opposing, sides. In the current heated climate it also shows the value of
civilized conversation between the United States and Japan.

Both authors count Princeton as their alma mater, but with quite different
experiences. Paul Volcker was at Princeton as an undergraduate right after
World War II, and about a decade later Toyoo Gyohten was the first of a
long series of young staff members at the Japanese Ministry of Finance who
completed their graduate education at the Woodrow Wilson School. They
first met when Gyohten was special assistant to the Japanese minister of
finance during the difficult and rancorous negotiations leading to the
Smithsonian agreement. Their responsibilities continued to intersect as
Gyohten rose through the ranks of the ministry, eventually becoming vice
minister for international affairs in 1986.

EDITOR S NOTE

Although Volcker entered investment banking after retiring as chairman of

the Federal Reserve Board in 1987, he spends part of each year teaching at
the Woodrow Wilson School. Gyohten spent a year in residence there after
retiring from government service, and thus they collaborated on a seminar,
passing on some of the lessons of their lives in public service.

Everything here is the authors' own in a framework of their own devising,

fortified by their frank and considerate responses to their students, who
were often their most pungent questioners. A remarkable team of young
research scholars at Princeton has also provided a chronology, glossary,
bibliography, and some worthwhile charts and statistics, which all those
involved in this project hope will support their principal aim: to raise public
consciousness and make the book a standard in a field that is too important
to remain the arcane property of economists.

Lawrence Malkin

AUTHORS* MOTt

1 his book grew, rather spontaneously, out of a series of informal lectures at

the Woodrow Wilson School at Princeton University, which is first of all a
place for learning about the arts of government and public policy. To that
end, its faculty is replete with distinguished economists, political scientists,
sociologists, scientists, and demographers. But the educational effort, if it is
to be successful at all, has to be more than the sum of those individual parts.
It has to capture something of the way in which a combination of the
school's disciplines can be brought to bear in dealing with complex issues
of national and international policy. And something more is at stake.
Talented young people need some sense of the challenge and excitement
that work in government can bring to them. Only that can encourage them
to commit a large part of their working lives to public service.

To further those aims we were asked, as practitioners in world financial

affairs throughout our careers, to conduct a joint seminar during the spring
of 1991 on developments in international monetary affairs over the past half
century.

One or the other of us—and usually both—personally participated in most

of the events we describe. Our vantage points and, as it sometimes turned
out, our understandings were quite different. Our reflections illustrate how
different national points of view, intellectual backgrounds, and political and
bureaucratic constraints influence events and complicate negotiations.

AUTHORS NOTE

For all of that, what may be more striking are our fundamental areas of
agreement as we review the management and the decline of the Bretton
Woods system of fixed exchange rates, the great oil shocks of the 1970s, the
effort to come to grips with inflation, the international debt crisis in the
1980s, and the renewed attempts at the Plaza and the Louvre to deal with
the instability of exchange rates.

What this experience suggests for the evolution of the world monetary
system we leave to our ruminations in the final chapter. What we do feel
confident about is that the firsthand experience of those of us who are
familiar with the challenges, the paradoxes and dilemmas, the achievements
and the failures of the system in the past are not irrelevant for the future.
That is why we have turned our experience into a book.

Mechanically, this book took form from the transcription of seminars at the
Woodrow Wilson School. But those bare mechanics required a great deal of
creative human intervention, accompanied at times by almost inhuman
patience on the part of our collaborators.

We were indeed fortunate in the choice of Lawrence Malkin as editor. To

say he clarified language, rearranged passages, eliminated redundancies (at
least some of them), asked the right questions, and proposed relevant
additions is all accurate. It is also inadequate. The simple fact is there would
be no book without his enthusiasm for the project, without his insistence
that it was all worthwhile, and without his production of an edited draft of
the transcripts from which we could work. We have long been aware of him
as a first-rate professional reporting and writing in the field of economics
and international finance. We now proudly count him as a friend and
colleague.

Our seminar lectures were chaired with cool efficiency by Atish Ghosh of
the Princeton economics faculty, who saw to it that we addressed relevant
questions and that our students actually learned something useful.
Throughout the preparations for the lectures, we were also assisted by three
exceptionally able Princeton graduate students. William Grimes and Daniel
Granirer are young North American political scientists with an intense
interest in the growing role of Japan in world affairs; both are fluent in
Japanese and the field of political economy. Rami Amir brought his interest
in economic policy and research training to the job of tracking down some
elusive facts and preparing statistical materials. Michael and Elizabeth
Friedberg were diligent in transcribing tape recordings into coherent
typescripts quickly and efficiently.

Marianne Donath, our secretary at Princeton, did an amazing job of

vin

AUTHORS NOTE

translating the unintelligible into a readable draft. Michael Bradfield, Sam

Cross, Robert Solomon, and Edwin Truman, all of them old colleagues at
the Federal Reserve, volunteered to read parts of the draft and to run down
some facts to make sure our memories were anchored in reality. Anke
Dening in New York cheerfully coordinated much of the work flow while
prodding one of the authors to get it all done.

One of the authors has a special debt to Frederick H. Schultz for many
reasons, one of which is that he now is the first Frederick H. Schultz
Professor of International Economics at Princeton. More important, Fred
Schultz served as vice chairman of the Federal Reserve Board during a
crucial period from 1979 to 1982 and provided enormous support to the
chairman in the process of serving his country.

Without the persistent interest of two outstanding professionals in the world

of publishing, there never would have been a book. Robert Bamett from his
law offices in Washington brought his counsel and enthusiasm to bear on
overcoming our inertia. He insisted that we pass through the door first
opened years earlier by Alberto Vitale, who was convinced from the start
that practitioners in monetary and international economic policy had
something worthwhile to say.

More broadly, we are both conscious of the enormous number of dedicated

men and women with whom we have worked in our respective governments
over the years who are not mentioned in this book. They are living
affirmation of the intelligence and energy that many able people bring to the
challenge of public service. What neither of us can properly do is to thank
all of those who were our mentors, our colleagues, and our staffs as we
progressed through the ranks. Some of them are mentioned, however
inadequately, in the pages that follow. Many more could not be. Suffice it to
say, without them there would have been no occasion to write this book.
What is much more important is our conviction, growing out of our
association with them, that the challenge of government can, and should,
both bring out the best in talented men and women and provide them with
great personal satisfaction.

The substance and responsibility for what is said in these pages are, of
course, ours.

Paul Volcker Toyoo Gyohten February 1992

INTRODUCTION

PAUL VOLCKER

I he world is certainly a very different place from the one that existed when
Toyoo Gyohten and I began our careers in the 1950s. After the turmoil of
depression and war, both on a scale without parallel, there was a sense of
renewed confidence, stability, and promise symbolized in the international
economy by the Bretton Woods system.

Neither of us is at all satisfied with the current state of affairs, but neither do
we see much hope that some great new economic and monetary conference,
or a series of them, can set out a new framework for an agreed system as
happened at the end of World War II. Too much has changed since the
victorious Allies, appalled by what had gone before, in a burst of energy
and inspiration over a few years set out the framework for a new world
system that lay the base for a generation of economic progress and
cooperation. For half a century, that system was nurtured by the efforts of
the United States to promote political democracy, human freedom, and a
market economy. Paradoxically, with that vision now seemingly triumphant,
the United States somehow finds itself in a doubting mood, questioning its
capacity to sustain the burdens of leadership.

The new circumstances are epitomized by the enormous thrust of Japan. It

has moved from a poor and defeated enemy to a strong eco-

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INTRODUCTION

nomic power, capable of generating much larger savings than it can use at
home. Heavily dependent on open markets elsewhere to absorb its exports
of goods and capital, it still seems unsure of what it should do to sustain and
manage the liberal international system within which it has prospered.
Europe, meanwhile, may be finding renewed strength and sense of purpose
in its greater unity and the opening to the East. At the same time, the
sustained attention needed to meet those regional challenges can easily
dilute the energy needed to confront issues of intercontinental character.

One of my old friends from abroad once told me—I think he meant it as an
ironic compliment—that he thought of my career as a long saga of trying to
make the decline of the United States in the world respectable and orderly.
The implication was that we had not quite succeeded. That remark struck a
nerve with me as I reviewed those episodes in postwar monetary history in
which I played a role. Increasingly, the United States has found itself on the
defensive in managing its monetary affairs and the dollar.

We had set up the postwar Bretton Woods system of fixed exchange rates
and freer trade, but no sooner did it start working as planned than the
monetary agreements started to come under pressure. We improvised
brilliantly in the 1960s to defend and strengthen the system, and attempted
to introduce more fundamental reforms. But stopgaps were not enough, and
partly under the pressure of the Vietnam inflation, the Bretton Woods
system finally broke down in 1973. On the way, Richard Nixon and his
secretary of the Treasury, John Connally, attempted to make the devaluation
of the dollar into a political triumph, which was no mean feat. But in a
longer perspective, it was a reflection of something else. A decline in the
value of any currency, especially when repeated, is typically a signal that
something is wrong.

By the early 1970s, many economists and some people in authority, such as
George Shultz, who succeeded Connally as secretary of the Treasury,
wanted to move the world toward floating exchange rates because they
believed in them. Most simply accepted them for lack of anything better
and as expedient at the time. By standards other than expedience, the early
experience with floating rates could hardly be termed entirely satisfactory.
There was much volatility, and under Jimmy Carter in 1978, the defense of
the dollar eventually became an important element in domestic policy. That
all merged into the war on inflation at home, where I had been drafted to
play a role at the Federal Reserve.

INTRODUCTION
One cost of that war was the highest interest rates we had ever seen, a good
lesson in why we shouldn't let inflation get the upper hand. The fight
against inflation complicated the Latin American debt crisis that came to a
head in Mexico in 1982 and later contributed to a strong rise in international
value of the dollar. The debt crisis and the problems of exchange rate
volatility led to remarkable episodes of cooperation among international
monetary authorities. But Latin American debt management and the Plaza
and Louvre agreements, however necessary, constructive, and dramatic they
may have been under the circumstances, were essentially defensive.

A great deal in this book is about exchange rates, and that grows a bit
complex. Economists sometimes take the view that exchange rates are all a
technical matter, and that after taking account of really important things like
differences in inflation, productivity, and interest rates, shifts in exchange
rates are a kind of residual, balancing adjustment. I may be old-fashioned
about this, but I have never been able to shake the feeling that a strong
currency is generally a good thing, and that it is typically a sign of vigor
and strength and competitiveness. Of course, that idea can be overdone.
During the presidency of Ronald Reagan, some of his acolytes trumpeted
the strength of the dollar in those terms, at times to the point of becoming
boastful and abrasive. It all turned out to be temporary, but their instinct
was right.

Certainly a depreciating currency ordinarily means that imports cost more

and that exports earn less foreign currency. In other words, the nation is
poorer, not richer, and that's not something to jump with joy about. Look at
this span of history: In the 1950s the dollar started out very strong, but with
some notable exceptions it has been going in the opposite direction ever
since, to the point where it now is worth about a third what it was against
the yen in the 1950s and about 40 percent against the mark. That alone tells
you something about the changing role of the United States in the world.

I cite all this not to be doleful but challenging. The position of the United
States after World War II was entirely abnormal and unsustainable. We
came through the war unscathed. Our industrial power actually
strengthened, while our potential competitors were substantially destroyed
and needed our help to rebuild themselves. Our subsequent decline (if that
is the right word) has not been absolute but only relative to others. It has
been both natural and desirable for others to catch up to us from a very
depressed start. The postwar growth of our trading partners was in fact
encouraged as a deliberate act of American policy.

INTRODUCTION

Moreover, we still have the highest standard of living and an unmatched

capacity for leadership. The plain lesson of the war in the Gulf was that
when our vital interests and those of our friends are at stake, the United
States is able to respond with coherence and vision; we are able to marshal
allies and maintain cooperation in ways not possible for any other nation. In
a much longer time perspective, the dramatic new opportunities to build
democracies, to protect the human spirit, and to achieve strong market
economies in Eastern Europe, in the former Soviet Union, and around the
world, in a very large sense reflect the strength of American conviction and
the success of American policy.

What remains at issue is whether and how the United States and its partners
build on those opportunities. The way the United States felt compelled to
pass the hat among its allies to pay for the Gulf War was symbolic of the
change in American attitudes and the American economic position over a
generation. There are other, and to me more ominous, signs of a reduced
capacity to lead. Somehow, despite all the depreciation of the dollar and
reduction in trade barriers abroad, we have come to doubt our competitive
strength. We may still be the most open of the large world economies, but
more and more we find ourselves fighting protectionist forces at home. In
our relations with international financial institutions, we have become much
more preoccupied with short-term political or economic interests. Within
these institutions and outside, we want to cut back on our financial
contributions while retaining the strongest and even a predominant
influence; it is obvious that over time these objectives are incompatible.
Conversely other nations, Japan especially, are in a much stronger
economic position. But none of them is so uniquely strong as was the
United States, nor is it yet clear that they have the kind of strong vision of a
new world order that can command broad support.
All of which brings me to the questions we address in this book. How much
of the relative decline of the United States was natural, how much of it was
desirable, and how much came from self-inflicted wounds? Should we, with
the help of the Japanese, have worked harder to maintain the Bretton Woods
system and the stability in exchange rates it provided? Has the breakdown
of that system been partly responsible for the slower world growth and the
greater instability in the past two decades? Where do we go from here
without so dominant and enlightened a leader as the United States was at
the end of World War II?

As I write, there is a sense that the recession that started in the United

INTRODUCTION

States and other Anglo-Saxon countries in 1990 may be lingering and

spreading. Prospects over the next year or more for anything better than a
muted recovery, here or elsewhere, seem dim. Even though objective
measures of economic activity do not indicate that the recession has been
particularly deep, the public mood in the United States, and to some degree
elsewhere, is plainly one of deep concern about the long-run economic
outlook, perhaps more so than at any time in my experience. At the same
time, we in the United States are in the midst of a presidential election
campaign. All that provides unusual opportunities and temptations: an
opportunity on the one hand for focused debate on where we are as a nation
and a society and where we want to be; temptations on the other to think
and act for the moment, to seek the quick fix and the jump-start without
much concern beyond the next election. This book is not a campaign
document or a political platform. All we can reasonably hope is that it casts
some light on the economic choices faced by the United States, by Japan,
and by other nations as we seek that everlasting goal of a prosperous and
harmonious world order.

TOYOO GYOHTEN

When I look back on the history of negotiations between the United States
and Japan, in which I myself played a role, I cannot help experiencing a
certain sense of emotion, the kind of emotion that reminds me of our
changing fortunes. Forty-five years ago, no American or Japanese could
have predicted where we would stand in the world. In the early 1950s,
President Harry Truman and Prime Minister Shigeru Yoshida forged an
alliance between a hegemonic superpower and a fledgling democracy
struggling to grow out of a war of devastation. Nevertheless, it was truly
remarkable that the alliance was not only successfully maintained but
developed into one of the most important bilateral relationships in the world
today.

When we talk about the increasing sore feelings and deterioration of this
alliance, it is important for both of us to reflect upon the fundamental
character of the alliance. In my view, it was built upon inseparable pillars.
One was Japan's acceptance of U.S. leadership in global affairs. The other
was U.S. acquiescence to Japan's free entry to the world

INTRODUCTION

market, and that included the U.S. market. This alliance worked beautifully.
The United States could count on Japan as a faithful and obedient follower,
and thus as a supporter of American global strategy. Japan had a free hand,
thanks to the stability imparted to the world by American power, to expand
its exports while securing the stable import of oil, foodstuffs, and raw
materials.

During the early years of the postwar period, the United States firmly
established its national ethos of being the warden of the world. It was
backed by the self-confidence of the strongest power on earth and a sense of
duty as the guardian of the free world against the evil empire of
communism. Japan was the most studious pupil of its American tutor. Not
only out of gratitude for postwar American assistance, but also out of a
genuine aspiration to attain the affluence, efficiency, and freedom enjoyed
by America, Japan made the most strenuous effort among all the countries
that took the United States as a model and followed its leadership.

The alliance was a historic success. In a way it was too successful: Both
sides took it for granted even when the fundamental situation changed. The
United States, while performing the role of the free world's guardian
gallantly and with pride, kept oozing away its economic sap into military,
social security, and private spending. Japan for its part quickly rose to the
status of a global economic power by the ingenuity and hard work of its
people while taking full advantage of the economic security provided by the
alliance with the United States. At the same time, the European
Community, led by Germany and France, awoke to the serious need to
become more competitive against Japan and the United States. The
Community's progress toward economic integration has been impressive,
and it has firmly secured the status of a major economic power.

Against this changing background, the alliance between the United States
and Japan was fundamentally altered. It is no longer an alliance between the
hegemonic superpower and a fragile economy in the Far East, but an
alliance between two of the world's three major economies; together Japan
and the United States account for 40 percent of the world's output.

The sources of the problems that have irritated the alliance in recent years
seem to be found in the gap of perception between the two countries over
the nature of the alliance itself. Both recognize a great value in the alliance.
However, Japan wants to retain its economic free

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INTRODUCTION

hand while it becomes increasingly reluctant to remain a political

subordinate. The United States, on the other hand, wants to remain the
world's warden, but does not want to allow Japan to continue its economic
onslaught. In other words, both the United States and Japan want to
maintain the one pillar that suits their own interest but remove the other
because it has gotten in the way. This common selfishness has led them to
forget that the two pillars were inseparable.

But the global order today is fundamentally different from the one that
existed in the 1950s. Although the United States is still the strongest
economy in the world and is still trying to perform the role of world
policeman, the fact remains that it no longer can be the hegemon who
single-handedly plays the leader's role. The United States, the European
Community, and Japan share the role of managing the world economy. This
tripolar setup will most likely remain for at least a few more decades.
Beyond that, it might be possible to imagine a more diversified power
structure in which countries like Russia and China may play a greater role.
But in the early part of the twenty-first century, international relations, and
the world itself, may well be governed by the fluid combination of
confrontation, cooperation, and competition among several major countries.
But even in this situation, it is my firm belief that the alliance between the
United States and Japan will remain the most important bilateral relation for
both, because of their high degree of interdependence and the vast potential
of the Asia-Pacific region that links them together.

In order to fortify the alliance while adapting to the new global

environment, both the United States and Japan have urgent tasks to
accomplish. The United States must fully recognize that its relationship
with Japan is interdependent. It must also accept its share of the burden of
correcting its own economic excesses. Japan must open its market in the
same way the United States has and recognize that its very survival depends
on devising domestic policies that are compatible with those of the rest of
the world, of which it now is a full member and no longer the isolated
island culture of bygone centuries.

CHA

FORTUNES

THE NEW MID ORDER, POST-WORLD WAR II STYLE

PAUL VOLCKER

OVERVIEW

The economic planning and international institution building that took place
around the end of World War II were without precedent in their scope and
vision. In the midst of war—war conducted on a scale never before waged
—and during a difficult peacetime transition, agreement was reached on the
character of the International Monetary Fund and the International Bank for
Reconstruction and Development (these were the Bretton Woods
institutions) and the General Agreement on Trade and Tariffs (the GATT).
Taken together, those agreements set out the intellectual and institutional
base for a new international order. That order was to be marked by a
commitment to stable exchange rates, nondiscriminatory trading relations in
which no nation would be specially favored, rapid reconstruction of
devastated economies, and the goal of economic development of the poor.
In a fundamental sense, it all rested on the idea of a market-oriented, liberal
economic system, which is why the major Communist powers of the Soviet
Union and China opted out.

The vision gained sustenance from the policies of the one large country, the
United States, that had both the capacity and interest for

CHANGING FORTUNES

leadership. America had emerged from the war with its industry intact, its
economy operating at high levels, and unquestioned military and
technological superiority. In contrast to the end of World War I, most war
debts were promptly forgiven. The large Anglo-American loan of 1946—
equivalent to about $25 billion in today's dollars—helped the United
States's principal wartime ally restore a degree of economic stability. A few
years later, the European Recovery Program, the Marshall Plan, promoted
effective cooperation in European recovery and provided the margin of
resources, amounting for a time to about 2 percent of the U.S. gross
national product, that was needed to implement those plans.

Nothing like that burst of intellectual energy, institution building, and

transfer of money and resources in the interest of international economic
cooperation has been seen before or since. It was driven by a scries of
extraordinary circumstances.

There was a general conviction that the peace process a generation earlier,
after World War I, with its demands for reparations and unman-ageable debt
repayments, had been badly botched, leaving in its wake political
antagonism and economic instability. The Great Depression of the 1930s
seemed to challenge the very survival of capitalism, and in any event was
accompanied by a wave of protectionism, instability, and a sharp
contraction in trade. Amid the destruction of a second great war that
followed, governments were receptive to new ideas, and they could, in
effect, write their plans on a clean sheet of paper. Accounting for something
like 40 percent of the world's output in 1945, one government was both
sufficiently strong and farsighted enough to provide a driving force in
pursuing those ideas, and that was the United States.

The negotiation process was enormously simplified by the fact that there
were only two effective participants: the two victorious wartime allies, the
United States and Great Britain. And when they disagreed there was little
doubt about which was the senior partner. Even so, it took more than a
decade for postwar recovery to be firmly grounded in Europe so that the
new trading and financial arrangements would work as intended. But the
sense of progress, cooperation, and growing confidence was soon palpable,
and it quickly came to encompass the defeated nations of Germany and
Japan as well.

THE NEW WORLD ORDER

HOW IT BEGAN

All this took place before the authors of this book personally participated in
international financial affairs. The creation of the Bretton Woods system
was something we had studied (in part at the Woodrow Wilson School!). Its
management provided a framework for our first work as Treasury officials
in the United States and Japan, and we came to accept its operation as the
way things quite naturally worked in a properly functioning world
economic order. My active involvement with the world of international
monetary affairs began when I went to Washington to join the Treasury at
the beginning of 1962. But obviously, as it says on the Archives Building in
Washington, past is prologue, and 1 first want to put myself back in that
vanished world of the 1950s.

I took my first job as a junior economist and then as a government

securities trader at the federal Reserve Bank of New York. I learned a lot
there about the economy and monetary policy and, just as important, about
bureaucracies as well as financial markets. Certainly, the Reserve Bank in
those days was a very bureaucratic institution. Some of the things I wrote 1
wasn't supposed to read, because I wasn't on the restricted circulation list.
When you wrote a memorandum to respond to a question of the president of
the bank, it went to your superior, and he would put some notes on it and it
went to his superior, and then to the vice president, until it finally got
through the chain to the top. And if the president had a comment, it would
come back to you the same tortuous way. Allan Sproul, the president of the
New York Fed, was at that time perhaps the most influential central banker
of the day, so however rigid the bureaucracy, it seemed worthwhile. I also
assumed that was the way all big organizations worked.

Then I went to Chase Manhattan Bank, and with a much smaller economics
staff, it was assumed I was more or less expert on everything labeled
"financial." I remember one incident vividly, and with some embarrassment,
that was unlike any experience at the Fed. Early in 1958, I was summoned
to the office of the president, George Champion. After dealing with some
routine question he said, "Sit down a minute. I'm worried about our trade
position. It seems to me we are getting less competitive, and it could affect
the dollar. What do you think?" Well, international trade and finance was
not yet my field, so I managed to respond with what was then the standard
economist's answer: "There is

CHANGING FORTUNES

nothing to worry about. The more we spend dollars to increase our imports,
the more other countries will want to take those dollars and increase their
imports from the United States. The United States has no balance of
payments problem."
Those times represented the intellectual heyday of the theories of the
"dollar shortage." At the beginning of the 1950s, I can remember a graduate
course at Harvard during which my distinguished professor set out the basic
thesis. The idea was that the United States, with abundant resources and
energy, and free of wartime devastation, was going to be more or less
perpetually on the leading edge of technology and production efficiency. As
a result, our rate of productivity would inherently increase more rapidly
than the rates of other countries; thus we would tend to maintain a strong
trade position. Others argued as a corollary that we would be able to spend
pretty much what we wanted abroad, and it would be in our interest to do
so. Looking back at the Depression years, they reckoned that the prosperous
United States inevitably would never find a place to invest all its savings at
home. Consequently, we could usefully provide a high level of official
assistance and eventually private investment abroad so that other countries
could afford to buy our exports and keep our industry employed. Otherwise
we would not be able to sell what we were able to produce because there
would be what economists began to call a "dollar shortage." A little present-
day research in the Index of Economic Articles turns up a classification
with that title. The Index for 1940 to 1949 listed ten articles, and from 1950
to 1954 there were thirty-three. An influential book titled The Dollar
Problem was published in 1957.

I recall being skeptical about all that theorizing, and I would have been
better off reflecting that skepticism when I answered George Champion.
Within a few months of his question, our balance of payments turned
adverse, and by the end of the year we had lost $2.3 billion in gold from our
reserves. There came a few faint glimmerings that confidence in the dollar
was not impregnable. It was all a good lesson for me: If you can't
understand what the professor is saying, don't dismiss the possibility that he
might be wrong. And practical men dealing in markets sometimes are far
quicker to sense a change in trend than economists immersed in past data.
In fact, the Index of Economic Articles cited only one piece on the dollar
shortage during the 1960s; I presume it was a retrospective article
explaining why all the earlier ones were wrong.

THE NEW WORLD ORDER

American policymakers and American economists are often accused these
days of not paying enough attention to the international consequences of
supposedly domestic economic policy, but it was much more true then.
Imports, exports, and international investment were very much a sideshow.
Virtually all of what was taught in general economics courses about
economic managment was domestic. One reason was that thinking about
economic policy was dominated by memories of the Depression and
problems of how to achieve and maintain full employment at home. For the
United States that meant domestic policy, with the emphasis on government
spending and taxation, or what is known as fiscal policy. But there was one
lesson for international monetary arrangements as well. Financial
instability, not just domestic panics and bank failures but international
financial instability as well, was thought to have contributed greatly to trade
protectionism between the wars and the depth of the Depression. There was
a sense that every government had gone its own way internationally in an
effort to save itself domestically at the expense of enormous fluctuations in
exchange rates and high tariffs.

From 1929 to 1932, which was the pit of the Great Depression, world trade
declined 60 percent. That was an enormous contraction, and people
associated it very clearly with the idea of a breakdown of the international
monetary system. That system had been built on the gold standard and fixed
exchange rates, and to many people those characteristics implied a
monetary universe as orderly as that of the Newtonian laws of physics.

By contrast, floating exchange rates, which prevailed in the 1930s, were

associated with monetary disorder and impaired trade; at worst, the absence
of rules offered temptations to manipulate exchange rates to produce unfair
trading advantages known as "beggar-thy-neighbor" policies. The general
idea was to depreciate your currency as much as you could to make your
exports cheaper in world markets, and to increase the price of imports. The
net result, if everything worked out as planned, would be to increase your
own production, create more jobs, and in the context of the 1930s, escape
the rigors of the Depression. Some countries seemed to be relatively
successful in doing just that for a while. But the result was to hurt other
countries, who lost production because their goods were priced out of
foreign markets. As they retaliated, everyone was hurt. One great fear of
those who built the postwar world was that repeated attempts at so-called
competitive devaluations

CHANGING FORTUNES

would persist in an effort to support the growth of one country's exports at

the expense of its neighbors.

I think there is some doubt among revisionist scholars that competitive

devaluations were really as important before the war as was then believed.
Economists as well as other scholars like to reexamine history every
generation, and perhaps it's about time to rewrite the history of competitive
devaluations. But there isn't much doubt in my mind that the two big
devaluations in the 1930s—Britain in 1931 and the United States in 1933—
did place large pressures on their trading partners, deliberately or not, and
set off further rounds of instability.

In using the term "beggar-thy-neighbor," once very common, I realize it has

hardly been heard in policy discussion for a decade or two. One thing that
has changed is that there is more fear a depreciated currency will bring
inflation by raising import prices. That wasn't a worry in the Great
Depression, when the main concern was falling prices. Indeed, the purpose
of the U.S. devaluation in 1933 was to raise commodity prices in general
and agricultural prices in particular to reverse the rural depression that had
begun during the 1920s. The purpose was sought by buying gold in the
markets at progressively higher prices, a process that was stopped when the
gold price reached $35 an ounce, up from $20.67. What good it did in the
end, and why President Roosevelt stopped the process at $35, is not clear to
this day. But arbitrary or not, gold at $3 5 an ounce was accepted as one of
the anchors of the postwar system; the price lasted for nearly forty years.
And for most of those years, gold was worth as much as $35 only because
the United States said it was, and was willing to back up that policy by
purchases from whoever wanted to sell. It was only when the balance of
buying and selling went the other way in the 1960s, and when for an
extended period the United States lost gold, that the postwar monetary
system began to unravel.
The final negotiations to create the new monetary system had taken place in
the summer of 1944, before the war was over, at a grand turn-of-the-century
resort hotel in the White Mountains at Bretton Woods, New Hampshire. (If
you visit it now, you'll find a memorial plaque to the conference displayed
prominently at the hotel, which has been restored at great cost to outlive the
system to which it gave its name.) There was one great advantage to
holding the discussions in the midst of the war, when international markets
were effectively shut down. It's hard to conceive of such a detailed
agreement, completely

THE NEW WORLD ORDER

reorganizing the world monetary system, being accomplished at any time

except when there wasn't any system operating at all and when the
enormous burdens of war effectively silenced more parochial concerns.

There wasn't much question about the objective. The planners wanted to
avoid the monetary disturbances that had characterized and contributed to
the Great Depression. To that end, they wanted a fixed exchange rate
system under international surveillance and guidance. They wanted to end
controls on international trade and services. They were willing to
countenance exchange rate changes only in exceptional circumstances,
which they defined as a "fundamental disequilibrium" of a country's
international accounts. And to achieve these purposes, they established an
international institution with its own staff, the International Monetary Fund,
and the new International Bank for Reconstruction and Development, the
"World Bank," to provide funds for postwar reconstruction.

There was, of course, a lot of discussion on how to implement those ideas,

and some of the arguments keep reappearing. The plan proposed on behalf
of the United Kingdom by John Maynard Keynes—the leading economist
of his generation—was grandiose and oriented toward economic expansion.
It contemplated the creation of a new synthetic international money apart
from the gold that countries already held in their reserves; his proposed
name for it, bancor, combined the word for bank with the French word for
gold. Keynes wanted the supply of national reserves to be large and
potentially expandable so that governments could promote and conduct full
employment policies at home without quickly running out of money to
finance the trade deficit that might result. Years earlier, he had dismissed
gold as "a barbarous relic," and did not want the world in general and
Britain in particular to be constrained by an international monetary system
resting only on a limited amount of gold to finance payments deficits.

Looking back at all that from the standpoint of an American, one of the
interesting things was Keynes's concern that a productive and prosperous
United States would be in chronic payments surplus absorbing reserves—in
other words, the feared dollar shortage. He felt there had to be something in
the system to discipline chronic surplus countries: to encourage them to
expand, to liberalize imports, to make investments overseas, or to provide
aid so that other countries would not be drained of their reserves. Under the
gold standard, or for that matter any monetary system with fixed exchange
rates, countries that fall into deficit are

CHANGING FORTUNES

disciplined more or less automatically. Their lack of competitiveness, low

interest rates, and inflationary economic policies will cause them to lose
reserves to countries with higher interest rates and policies of more stability
or slower growth. And when they lose enough reserves, they have to
respond; typically they raise interest rates, which slows their economic
growth. Keynes was worried from the standpoint of the world, and more
specifically from the standpoint of Britain, that there would be too much
bias toward economic restraint.

He had two solutions. First was his idea of making available a larger supply
of reserves. Second, he wanted to set up some automatic schemes for
penalizing countries that piled up too many reserves by running large and
prolonged trade surpluses. As finally adopted, the IMF agreement permitted
the trading partners of extreme surplus countries deemed to have "scarce
currencies" to penalize them by limiting purchases of their exports,
potentially a severe penalty. But from the early days, the Americans resisted
any suggestion of putting that clause into effect, and it became a dead letter.
Ironically, as we shall see, Keynes's concerns in 1944 became American
concerns thirty years later when Germany and Japan built up huge
surpluses, but the problem has never been satisfactorily resolved.
The competing plan, advanced by a senior U.S. Treasury official named
Harry Dexter White, shared many characteristics with the Keynes Plan,
notably a system of fixed exchange rates with surveillance by an
international body. It was, however, notably less expansive. White's concern
was that deficit countries should not receive too much easy financing at the
automatic expense of the world's major surplus country, which of course
was then the United States. A generation later, when the Americans fell into
deficit, White's concerns were mirrored by the Europeans. While Keynes
proposed the creation of $35 billion worth of international reserves by the
new IMF, White proposed only $5 billion, largely by pooling existing
reserves. The eventual compromise on an $8.8 billion revolving fund was
much closer to the U.S. proposal, which says something about the balance
of power between the Americans and the British.

In fact, to start up the Bretton Woods system, the United States had to prime
the pump with far more money than White or the Treasury had ever
envisioned. The first important step was a long-term low-interest loan to the
British of $3.75 billion in 1946 by the United States and Canada to rebuild
its reserves and make the British pound usable

THE NEW WORLD ORDER

internationally. That was a huge sum for that day, but confidence in the
pound sterling was so low the money didn't last long. The Marshall Plan,
which was designed to tide over all of Western Europe as it rebuilt, was
much more successful. Its commitment of 2 percent of our gross national
product for two or three years was the equivalent in today's money to
almost $100 billion a year. But the money was paid out only as the
Europeans, under our surveillance, jointly developed plans for its effective
use by rebuilding their basic industries and transport structure in a way that
would promote trade and economic cooperation among themselves. The
program was carried out with great skill and effectiveness, no doubt greatly
assisted by the cooperation bred in wartime experience and a common
commitment to the objective of developing a bulwark against communism.
Even so, as the Europeans, and later the Japanese, restored their economies,
their controls on imports and on lending abroad were relaxed only
gradually. For years, the United States tolerated discrimination against
American exports, and for all practical purposes international borrowers
had to come to our markets.

Despite the direct costs to the United States, budgetary and otherwise, there
was never much question about the balance of advantages, either in terms of
the world order or to the United States itself The experience of depression
and war was too fresh, and the evident strength and prosperity of the
American economy too evident to engender concern about the costs. To the
contrary, among the elites (and that wasn't such a bad label in those days)
there was a strong sense of mission and of the need for leadership. Both
labor and business, confident of America's competitiveness, had a stake in
open markets and strong economies abroad.

THE RULES OF THE GAME

The new rules of international economic good conduct were set out boldly
in a few relatively short founding documents. They called for cooperation
on monetary affairs, for a market-oriented trading system, and for
collaboration in speeding economic development at a time when none of
those things could be taken for granted. It is no coincidence that China
opted out after the Communists took power, and the Soviet Union never
joined, nor would it allow its satellites to maintain membership. The
Chinese returned only when they began their economic reforms. The
Eastern European states were able to apply for membership

CHANGING FORTUNES

only as the sway of Moscow lessened. Now. applications to the World Bank
and the IMF from the old Soviet republics have become a matter of priority.

The mechanics of the Bretton Woods system were a little complicated Each
member country was obligated to set a "par value"' for its currency, which
was determined by setting its price in terms of gold or another currency that
could be converted into gold. In practice, for nearly all countries except the
United States, that other currency was the U.S. dollar. It thus played a
critical role at the center of the system, although there was nothing specially
said about the dollar in the IMF Articles of Agreement.
Countries fullv participating in the system had to stand ready to exchange
their own currency for gold or a convertible currency on demand by the
monetary authorities of other countries that held their currency. The
exchange would take place at their declared par value, plus or minus a small
margin ot no more than I percent. The practical effect was to maintain
national currencies in a fixed relationship in the market, within narrow
margins. After an initial period, those fixed currency rates could only be
devalued or revalued with the approval of the executive board of the IMF.

As the world's dominant economic and financial power, the United States
was the only country that was prepared to exchange its currency into gold at
the request of foreign governments and central banks—that is. to maintain
gold convertibility. 1 It was also the only one that feasibly could have done
so as the new system started up. Of 96s million ounces in the official
reserves of all countries at the end of 1945, the United States had s~4
million, with $20.1 billion at the price of $35 an ounce. In the
circumstances, most other countries were quite content to keep a portion of
their limited reserves, typically the great bulk ot them, in dollars that could
earn interest rather than in sterile gold. That added an element ot flexibility
to the system.

The new system also had other features to deal with what were perceived as
the shortcomings and undue rigidities ot the classical gold standard. Most
important, the IMF could provide credit to its member countries from that
$8.8 billion fund. These were called "drawing

'Even the United States would not accept a commitment to sell gold to
private individuals. including its own citizens, except tor industrial
purposes. In the midst ot* the Depression. U.S. citizens were required to
turn in their gold to the Treasury to bolster its reserves and inhibit
speculation. That policy was maintained until the 1970s.

THE NEW WORLD ORDER

rights," and their amounts were derived from a formula reflecting the
economic size and trading importance of the member countries. Access to
that credit was designed to become progressively more difficult as the
amounts grew larger, an important element of discipline in the system. For
countries seeking to borrow substantial amounts, the Fund's staff eventually
developed what it called "conditionality" criteria. This meant elaborate
procedures of surveillance to monitor the performance of a country in
progressively reducing its trade and budget deficits, its rate of inflation, and
other targets that had to be reached for the IMF to release successive
amounts of credit.

Exchange rate changes did not in themselves violate the rules, but they were
supposed to be undertaken only as a kind of last resort when other efforts to
restore balance in trade and foreign payments were inadequate or would be
counterproductive. The founders of the IMF clearly recognized that
member countries would need the means to sustain growth. If their policies
proved basically inconsistent with their exchange rate, a devaluation was
considered preferable to forcing chronic unemployment on the country.
Countries were also to be strongly discouraged from controls on trade,
tourism, foreign aid, and other current account spending. Controls on the
movement of capital in times of difficulty were viewed more benignly,
partly in recognition of the role that huge speculative movements of money
had played in the 1920s and 1930s in undermining currency stability.

Most of the critical operational questions about the IMF were left to
subsequent judgment and experience. Plainly, the founders were intent on
permitting more flexibility in reserve creation, in financing, and in
exchange rate changes than was possible in a strict gold standard. But the
emphasis differed among countries and among individuals from the start.
The fundamental question of how much "adjustment" of economic policies
and performance should be done to end imbalances, and how much
"financing" should be made available to bridge those imbalances, is as old
as the judgments of Florentine bankers in lending to European princes and
as current as the debate about financial assistance to the new East European
states and the successor states of the former Soviet Union. It is a question
that will recur throughout this narrative, from the reform efforts in the
1960s and 1970s to the debt crisis of the 1980s.

At least as frustrating has been the difficulty of reaching agreement on how

much flexibility there should be in exchange rates. Clearly, the founders of
the Fund were unable to devise any hard-and-fast rules
CHANGING FORTUNES

about when a country was justified in devaluing—when, in the Fund jargon,

it was in "fundamental disequilibrium." Per Jacobssen, who became IMF
managing director in the early 1960s after a long career in European central
banking, said he could no more define equilibrium than he could define "a
pretty girl, but you can recognize one when you meet one." (He spoke
before the feminist revolution.)

Well, like individual tastes in women, one man's opinion, however

respected, could hardly settle the issue. But in fact devaluations by
important countries did not happen very often in the first quarter century of
the IMF. After a round of large European realignments early in the postwar
adjustment period, there was only Britain in 1967, and France in a two-step
adjustment in 1957 and 1958 and again in 1969, among the important
trading nations. Canada resorted to a float on two occasions, although that
was outside the rules. Germany, equally exceptionally, upvalued the mark in
1961 and again in 1969. The yen-dollar rate was set at 360 in 1949 with
American advice as to an appropriately competitive rate, and there it stayed
until the Bretton Woods system crumbled. The simple fact was that, quite
apart from the letter of international agreements, the possibility of discrete
exchange rate changes was to markets psychologically unsettling and to
governments a political defeat. For the United States dollar, the monetary
linchpin of the system, such a change as the new IMF got under way was
simply unthinkable.

For a decade or more, the formal rules of the IMF were much less critical
for achieving stability and growth than the financial resources, the open
markets, and the overarching security commitments provided by the United
States. The widespread acceptance and use of the dollar was a natural
reflection of those realities; it was something that the postwar planners and
markets around the world took for granted, not an artificial construct of an
international agreement.

Only later did it come to be clearly recognized that the special role of the
dollar implied both privileges and burdens incompatible with the long-term
operation of the system as spelled out at Bretton Woods. Specifically, the
use of the dollar as a reserve currency meant that the United States, unlike
other countries, could run a balance of payments deficit without giving up
its own reserves of gold or without borrowing foreign currencies for as long
as other countries were willing to add to the dollars they already held in
their reserves. In effect, increased foreign dollar holdings financed the
American deficits at relatively low U.S.

THE NEW WORLD ORDER

interest rates in the 1950s and 1960s, and without exchange rate risk to the
United States. At the same time, those increased dollar holdings provided
an important source for new reserves and liquidity for other countries.

All of that seemed reasonable enough so long as the dollars were willingly
held. This was true as long as the dollar was considered not only just as
good as gold but better. But, of course, there was a flip side to that
proposition. If that basic equation between gold and the dollar were called
into question—or more broadly, the willingness of the United States to
sustain the stability of its own prices and its economy and the openness of
its markets—then the foundation of the system's stability would be shaken.
That, in fact, is what began to happen during the 1960s, but for most of the
1950s the United States was gaining gold, the American economy remained
way out in front of the rest of the world, and its prices were relatively
stable. Within the postwar economic system and behind the shield of the
mutual defense, a shattered Europe and Japan experienced a remarkable
recovery.

TOYOO GYOHTEN

Paul Volcker and I came to know each other twenty years ago. At that time,
he was already a major player sitting prominently at the negotiating table. I
myself was just a junior official who was carrying his boss's briefcase,
sitting in a back row, and watching rather uneasily his boss's performance in
international negotiations. So, you see, there is a huge gap between him and
me, to say nothing of the difference in our physical size, but I am proud to
say that somehow we have developed a strong mutual friendship and trust.

When the international monetary system was being formed at Bret-ton

Woods in 1944, Japan was still fighting a desperate war. All of the major
cities were totally destroyed by bombing, and when finally the end came in
1945, Japan had lost one quarter of her national wealth during the preceding
decade. The Japanese gross national product at the end of the war was 60
percent of what it had been ten years before. Industrial production was only
30 percent of what it had been in the mid-i930s.

CHANGING FORTUNES

I joined the Japanese Ministry of Finance in 1955, ten years after the war.
And I still recall that my first monthly salary was $20 at the exchange rate
prevailing at that time. Japanese per capita income was about $200, roughly
one tenth of that of the United States at that time. In 1956, I came to
Princeton to do graduate work on a Fulbright scholarship awarded by the
U.S. State Department. It took three weeks to cross the Pacific by ship;
landfall was at Seattle for my first visit to the United States.

Before I left Japan, one of my friends who had recently returned from the
United States offered me some advice on how to eat a healthy meal at the
lowest cost. He assured me that I could survive handily on a ham-and-
lettuce sandwich with a chocolate malted. With this in mind, I took my first
lunch, climbing up nervously on a stool at the counter. The waitress was a
black woman. I ordered my ham-and-lettuce sandwich, trying my best to
pronounce the L correctly, since it is a sound that does not exist in Japanese.
Without so much as a glance at me, the waitress asked in a most
businesslike manner: "Dark or white?"

Instantly, I feared that my order had not gone through, because to trie, her
question sounded totally irrelevant. I repeated "Ham-and-lettuce sandwich,"
taking the utmost care to pronounce the words slowly and clearly. This time
she looked at me and repeated firmly: "Dark. Or. White." A thought struck
me. Before I left Japan, I had been briefed about racial segregation in the
United States, and that included the information that blacks were not
allowed to sit in some places reserved for whites. She must be asking me
my race! I panicked. I felt I was being put to a test of conscience. After a
moment of frantic soul-searching, I decided I had to be honest. With some
pride, I replied: "Yellow." The waitress was merely irritated. In one hand
she held up a slice of white bread and in the other a slice of rye, and
shouted: "Dark or white?"
The difficulty of communication across cultures on any level is a fact of
international life that should never be ignored. After Princeton, I returned
home and until 1990 remained in the Finance Ministry, where I was
privileged to watch the evolution of international monetary relations
through a Japanese window, so to speak, and participated in Japan's
constantly increasing involvement. Certainly, the development of the
Japanese economy during my thirty-five years in the ministry was quite
outstanding. When I look back at those days, it seems just like a series of
frames of a slow-motion picture of a pole-vaulter. A bar is set that

THE NEW WORLD ORDER

seems too high to pass over, and you are sure that he can't make it. And
when he starts jumping, the pole bends so dangerously, and you are sure
that the pole wiU break. But, frame after frame, you see that the man
somehow makes the jump and clears the bar. That was the bright side of our
history.

At the same time I have to admit that for most of this period Japan's posture
in dealing with those international monetary issues was dominated by very
strong features. One was clear passivity, in the sense that Japan was quite
reluctant to play a role on the main stage. She wanted to mind her own
business at home without being mixed up with others. There was also a
very strong, almost overwhelming, preoccupation with the bilateral
relationship with the United States. And I think these two features certainly
were very strongly influenced by the war, the experience of defeat, and then
the experiences from the immediate aftermath of the war.

As Japan's external assets grew, and the business stakes of Japanese

financial institutions expanded enormously in world markets, they forced
Japan to cast off the spell that we had suffered for so long. At last, in the
1980s, we began our conscious efforts to become a major player in
international financial issues, and we were quite eager to become a
responsible player as well.

IN THE THICKET OF BRETTON WOODS: THE DECADE OF THE

1960s
PAUL VOLCKER

OVERVIEW

Looking back, the performance of the world economy in the first twenty-
five years after Bretton Woods was exceptional. Growth in the United
States itself averaged about 3 percent a year, a historically extraordinary
performance that was punctuated by only short and mild recessions. Indeed,
as the 1960s ended, the country had enjoyed a record of almost nine years
of expansion, and some exuberant economists were prematurely ready to
declare victory over the business cycle. In Europe, which started from a
much lower level, growth was even stronger. The recovery from war and
the subsequent expansion were led by the Federal Republic of Germany,
which became Europe's strongest economic power. The German miracle,
however, was outdone by Japan. By the end of the 1960s, that country, on
the strength of a compound growth rate of some 12 percent over the decade,
had plainly become a modern industrial power. Its economy had enormous
momentum and competitive strength, although Japanese thinking was still
colored by the image of recurrent balance of payments difficulties and
financial vulnerability suitable to the earlier postwar period. Meanwhile, a
number of developing countries, benefitting in part from the strength of
world markets and

18

IN THE THICKET OF BRETTON WOODS

the availability of foreign finance, began a period of economic "takeoff"

that in some cases approached Japanese-style growth rates.

All that was achieved in a context of relatively good price performance by

the nations of the industrialized world. Japan and Germany were both
sensitized to the dangers of inflation by the collapse of their currencies after
their wartime defeat. They did best among the major countries, and their
prices generally rose very little in the 1960s, especially those of
manufactured goods. The United States, with an average consumer price
increase of 2.3 percent over the decade as a whole, at first did a bit better
than most European countries. But as the decade wore on, the financial and
price pressures associated with the Vietnam War led to increased restiveness
among foreign dollar holders as well as in the United States.

By the end of the 1960s, the United States' share of the world output had
declined to about 27 percent from 35 percent in 1950. While a substantial
part of that change reflected a kind of natural catch-up by others after the
destruction of war, the growing strength and confidence of European
countries made them more assertive partners in discussions and decisions
about the monetary and economic system. Although it was not the intent,
the creation of the European Economic Community by the Treaty of Rome
in 1957 in itself implied discrimination against the exports of the United
States and other countries outside the region. The historical antipathy of the
United States toward such trading preferences was blunted, however, both
by its strong support of the political purposes of the Common Market and
by the substantial multilateral reductions in tariffs achieved in two rounds
of GATT negotiations.

It was in this period that the Bretton Woods monetary arrangements, in

spirit and substance, came into full bloom. Convertibility of currencies was
restored, exchange controls in Europe were relaxed, exchange rate changes
among industrialized countries were limited in number and, by prewar
standards, relatively small. In that benign setting, expanded trade became
the cutting edge of economic growth, increasing by an average of 6 percent
in real terms.

But the story has another side, and it is a side with which we are
particularly concerned. No sooner did the new monetary arrangements
become fully operational than intimations of mortality appeared—first
small, scattered, and manageable, but increasingly threatening as the decade
ended. New ground was broken in consultation and cooperation among
countries and men dedicated to preserving and strengthening the

CHANGING FORTUNES

system. Nonetheless the doubts became stronger, and the dikes gave way
early in the 1970s. It is an interesting question whether, with different and
stronger policies at critical points, the Bretton Woods system could have
been prolonged and even saved. It is even more interesting to ponder
whether the distinctly poorer economic performance of the world generally
since the early 1970s—slower growth, deeper imbalances, and greater
inflation—is related to the breakdown of the Bretton Woods system.

THE VIEW FROM THE TREASURY

To pick a single year to start the story, Bretton Woods turned from symbol
to substance in 1958. It was only then that the system began to function as it
had been designed, with substantial freedom in trading important
currencies. The countries of Europe had recovered sufficiently from the war
to become competitive industrially. Reflecting newfound confidence, they
began the process of declaring their currencies convertible. At first,
foreigners could freely convert their blocked balances of European
currencies, and by 1961, citizens of European countries could freely acquire
foreign currencies to buy goods abroad. No special license was needed from
their exchange-control authorities anymore for most transactions, even
though restrictions on travel and capital transactions remained in place quite
a while longer in some countries.

Bretton Woods was then, and for many remains, a kind of a wonderful
totem, representing stability of exchange rates, freedom of payments, and
less tangibly, a spirit of international cooperation. The irony is that no
sooner did it become mechanically operative than worries about its
sustainability began. Nor was it purely a coincidence that the first signs of
stress appeared about the same time the system began to blossom. In 1958,
the United States experienced a sizable deficit in its overall balance of
payments (including foreign investment, aid, military costs, and other
flows, not just trade). That meant foreign central banks were adding sizable
amounts of dollars to their reserves.

During the autumn and winter of 1957 and 1958, we had a rather short but
sharp recession. Short-term interest rates dropped to about 2.5 percent. With
their higher dollar holdings receiving lower interest rates, foreign monetary
authorities had an incentive to buy gold, and it was entirely within the rules
of the Bretton Woods system to do so. The United States had started 1958
with its gold holdings at about $23 billion;

IN THE THICKET OF BRETTON WOODS

they were near their peak and still almost 60 percent of all official gold
stocks. But in the course of 1958 it lost $2.25 billion, about 10 percent and
clearly enough to catch the eye of markets.

Still, there was no cause for real concern. The growing strength of the
Europeans was surely welcome; it was evidenced in part by the fact that
they had enough reserves to begin to make their currencies convertible. We
seemed to have more than enough gold to meet any possible demands. The
recession soon ended and interest rates rose, reducing the incentive to
exchange dollars for gold.

Nonetheless, the United States did continue to lose gold during the next
couple of years, although in much smaller amounts. The psychological
shock came late in October of i960, just before the presidential election.
John Kennedy was a young man of unknown financial credentials—and he
was a Democrat. The combination apparently contributed to a certain
suspicion about whether his administration would be "responsible"—as the
expression went—in defending the dollar. Against this background, we
began losing more gold.

What I don't fully understand to this day is why the gold price suddenly
shot up so far in the market. Americans were not permitted to buy gold
freely then, but in many countries people could. Ordinarily, however, there
was more than enough newly mined gold to meet the demand for jewelry,
dentistry, and hoarding, so central banks tended to buy gold, keeping the
price close to $35 an ounce. That's not what happened on October 30, i960.
I remember very well sitting in my Chase Manhattan office when somebody
came in and excitedly said, "The gold price is forty dollars." I said, "That
can't be, you mean thirty-five dollars and forty cents." Even that would have
been unprecedented, so we checked the news ticker. My visitor had it right,
and even if the implications were not well understood, it created a sense of
uncertainty and concern, which quickly reached Kennedy's political
entourage.

An old mentor of mine at the Federal Reserve Bank of New York, Robert
Roosa, was widely and rightly considered the foremost American expert on
international monetary affairs. One of the very few experts who in those
days bridged the worlds of academe and banking, he commanded the
respect of theoreticians and practitioners alike. Roosa was asked by the
Kennedy campaign party what to do. No doubt they gave weight to his
advice. Kennedy's statement the next day was to the point: "If elected, I
shall not devalue the dollar." Only a few days later

c: HANGING FORTUNES

he was elected, and the new young president was committed in his
campaign statement to a clear policy of sustaining and defending the price
of gold. The market price quickly receded to close to S3 >. but
psychologically a seed of doubt and concern had been planted.

Government policy began to be affected even before the new administration

took office. President Eisenhower's outgoing secretary of the Treasury,
Robert Anderson, and Douglas Dillon, who was under-secietar) ot state,
were dispatched on a mission to Germany to ask that country to assume a
share of the costs of stationing L'.S. troops on its soil, thus reducing the
outflow of dollars. They w ere rebuffed, perhaps partly because of the
suddenness of the request. Hut it was more than a minor diplomatic defeat.
It was the first time that the United States felt it had to ask tor foreign
support to offset the cost of its defense ^or any of its Other) commitments
overseas. The pattern has since become a familiar One, dramatically SO
during the Gulf War, when the concern was more fol the budget than the
balance of payments.

The Anderson-Dillon mission was the first of such political initiatives. 50 it

attracted attention. Suddenly, after all these years of an impregnable dollar,
the balance of payments of the United States and its commitment to a fixed
price for gold became a constraint on policy

A year later. 1 became part of the Kennedy administration working under

Bob PvOOSa, w ho had been put in charge of monetary affairs at the
Treasury. No doubt 1 am prejudiced, but it was a remarkable Treasury team
within an administration marked by extraordinary economic talent. Dillon
came from the influential Dillon. Read investment banking firm founded by
his father, .md carried impeccable credentials in the financial and
diplomatic communities. He was a Republican and conservative, not
necessarily in that order, had been ambassador to France, knew a lot about
the world, and was perfecth at ease with presidents and prime ministers.
Kennedy was obviously looking for a reassuring symbol of financial
rectitude, and he made a calming, bipartisan choice. As 1 came to know \
cr\ well, the president got a man of great competence, and a master of detail
who still maintained a strong sense of the larger issues at stake.

How things change: In those days working breakfasts at 7:30 a.m. were
almost unknown in Washington, and you could respectably get to work at
9:00, or even a bit after. 1 still can vividly recall Dillon's big black
limousine passing me b\ occasionally while 1 was driving my old ford dow
n Rock Creek Rirkw a\. 1 le w ould be sitting in the back reading the

IN THE THICKET OF BRETTON WOODS

newspaper, and I knew that by the time I got to the office there would be a
half dozen things he would want me to check up on. I'd spend most of the
day trying to find answers and writing memoranda, and they would be
placed on his desk by six or so in the evening. He would go through them in
about two minutes and ask for this or that additional piece of information.
His ability to recall economic statistics never failed to dazzle at
congressional hearings, and he combined that with a willingness to look at
new ideas.

Bob Roosa held a unique position in the United States government as

undersecretary for monetary affairs, then the number-three position at the
Treasury. Henry "Joe" Fowler, the senior undersecretary in protocol, was a
wise and experienced public official whose advice, political and otherwise,
carried great weight. But when it came to monetary and financial policy,
domestic or international, Secretary Dillon and the administration looked to
Roosa, who was in turn ably assisted by Dewey Daane, who had also grown
up in the Federal Reserve. I later succeeded Dewey, when he was appointed
a governor of the Fed. Then and later, I worked closely with him because he
was the board's international specialist, and we became lifelong friends,
although I lagged a continent behind his reputation as a bon vivant on the
numerous trips he made to Europe and elsewhere for international meetings.

The position of undersecretary for monetary affairs had been invented a few
years earlier, largely, as I understand it, to fit the desire of the first
incumbent, who had been a distinguished banker. It is a position that I held
later in the Nixon administration, so I know something about it, and I grew
to love it. It has since been changed, in my opinion at significant cost to
sensible policy.

The undersecretary for monetary affairs was the one official in the United
States government, other than the secretary of the Treasury himself, who
had substantial direct operating responsibility for both domestic and
international policy. Most governments divide up these responsibilities. But,
so long as the position existed, no budget or tax proposal, no debt flotation,
no comment on monetary policy—essentially, nothing important
concerning domestic economic policy— would clear the Treasury without
at least some consideration of the implications for the dollar and for the
impact abroad. Nor, conversely, could international financial policy be
isolated from its domestic implications.

CHANGING FORTUNES

As markets become increasingly globalized, it is even more important to

have such institutionalized links inside the government. However, when
James Baker became secretary of the Treasury in 1985, he dropped the
position despite my urging to the contrary. I suspect his principal deputy,
Richard Darman, wanted to have a strong hand in international affairs,
which would have made it difficult for another undersecretary to have
parallel responsibilities. But that was an unusual situation, and 1 think
something has been lost by institutionalizing the idea of a separate domestic
financial undersecretary and an international undersecretary.

In the days of Dillon and Roosa, the government of the United States,
indeed the country as a whole, did not have many people with experience
and expertise in internationa] finance. Economists and offi-cials were
interested in foreign aid and the problems of economic development. Trade
policy had always been a large issue. But for two decades or more, external
finance had not been a real worry; until then, the dollar was strong and the
balance of payments in order. External financial constraints were something
that ordinary countries had to worry about, not the unquestioned leader oi
the tree world, whose currency everyone wanted. Policy officials had no
need to follow balance of payments numbers closely, analytic resources
were thin, and few knew foreign financial officials at all well.

Bob R.OOS3 was the exception. In his role at the New York Fed, which
handled the government's operational contacts with foreign central banks,
he had become a budge to the foreign central banking and treasury
community. 1 le was an intellect with a substantial body of writing on
domestic monetary policy, but he was also very much a doer with a richly
inventive mind capable of spewing out ingenious technical approaches to
strengthen and protect the monetary system.

In the State 1 )epartment, his natural counterpart and frequent intellectual

antagonist was George Ball, who, as undersecretary for economic affairs,
naturally c-haled at the need to rein in international initiatives for the sake
of the dollar. At the Council of Economic Advisers, which was the other
major player in the formulation of economic policy, Walter Heller was an
activist chairman supported by a strong team, including James Tobin, who
has since won a Nobel Prize. They imbedded Keyne-sian economic
thinking into U.S. government policy, with apparent success at the time.

There was a great contest for influence in economic policy among

IN THE THICKET OF BRETTON WOODS

that talented group. Fortunes would rise or fall on particular issues,

including the president's key policy initiatives tor tax reduction and reform.
But I don't think there was much question that international economic
policy, certainly international financial policy, was dominated by the
Treasury. And the Treasury was in no mood for radical experimentation. It
was foursquare for the Bretton Woods system, for the sanctity of the $35
gold price, and for fixed exchange rates.

All that was greatly strengthened by the basic instincts ot President

Kennedy, which apparently were reinforced or even implanted by his father.
Presidential assistants sometimes bridled under that yoke. They told how
the president, on taking office after the gold scare, had been warned by his
lather that protecting the balance ot payments and the Stability of the dollar
should be among his first priorities because a strong currency was essential
to a successful administration. That strikes me as good advice to this day; in
any event, when the stability of the dollar was at issue in the debates within
the administration, the Treasury in the last analysis could usually count the
president on its side.

It's hard now. after all the changes m exchange rates and disturbances in
financial markets, to recapture the strength ot the emotional and intellectual
commitment to the international stability ot the dollar and the fixed gold
price. Certainly, the idea that a devaluation of the dollar might be needed or
that we might initiate a change in the gold price was not a respectable
matter for discussion in the halls of the Treasury, and not much outside.
That view was plainly more than a matter of technical economics.
Defending the dollar was less a burden than a badge ot honor that went to
the prestige and to the sense of international leadership and responsibility of
the nation.

Within a few weeks of Kennedy's inauguration, the new administration set

out the first ot what became a series ot balance ot payments messages that
had a common theme. The specific elements were broadly accepted then,
even if they sound dated now: the importance of keeping our international
payments in balance and of maintaining the exchange rate of the dollar and
the "immutable" gold price. When the dollar was threatened, the
administration even became prepared to put controls on foreign capital
outflows of private citizens and companies, something that was permitted
by the IMF agreements.

Then as now, the more important questions concerned the implications for
monetary and fiscal policy. The United States had just been through two
recessions, in 1958 and i960, and the key element of the

CHANGING FORTUNES

president's election campaign had been his pledge to "get the country
moving again." The recessions had left a legacy of near price stability, and
there was a natural urge for action to expand the economy. However,
monetary policy had already been eased, and there seemed to be limits as to
how far that could be carried without raising serious questions about our
commitment to dollar stability. The principal sensitivity internationally was
found in short-term interest rates, while long-term rates were felt to be far
more significant domestically. Largely at the prodding of Bob Roosa, a
coordinated effort was undertaken by the Federal Reserve and the Treasury
to "twist" the yield curve by concentrating new financing in the short-term
markets and buying back long-term Treasury securities. The success of that
effort in actually changing yield relationships was subsequently strongly
debated; most economists later found the effects were quite limited, a
conclusion with which I agree. But within the administration the activist
approach relieved some of the pressure for greater monetary ease and
reduced concern over the modest tightening steps taken by the Federal
Reserve as the economy picked up some momentum.

Fiscal policy, specifically the reduction of taxes, was in any event

considered the more promising tool to stimulate the economy. In its first
year, before I went to the Treasury, the new administration had already
taken initiatives to stimulate investment by inventing an investment tax
credit and by permitting accelerated depreciation of new equipment. What
raised concern in the Treasury was a strong push from Walter Heller and
others for an early and large reduction in income taxes, particularly when
the economy seemed in danger of stalling in 1962. At that time, I was
responsible for economic forecasting in the Treasury, and took the position
within the department and with my colleagues at the Council of Economic
Advisers and the Budget Bureau that a downturn was unlikely. Secretary
Dillon, in any event, resisted early action partly because he thought it both
politically and economically wise to combine tax reduction with substantial
tax reforms, which would take some time to formulate.

At the same time, the Treasury certainly preferred that stimulus be provided
by means of fiscal rather than monetary policy and lower income taxes
rather than increased expenditures. Today, the arguments have become
familiar: Lower* interest rates would jeopardize the external value of the
dollar, while lower taxes would help spur investment and efficiency. I spent
a good deal of time in the fall of 1962 working with

IN THE THICKET OF BRETTON WOODS

Joe Fowler preparing material for the congressional presentation used in

public defense of the tax-reduction program. In my enthusiasm, my
arguments paralleled many of the points made by the incoming Reagan
administration almost twenty years later, although they were couched in
Keynesian terms. In some of the drafts, I even suggested the possibility that,
in the particular circumstances then prevailing, most or all of the revenues
lost by lower tax rates could be recovered as a result of triggering greater
investment and growth. Grayer and wiser heads decided that thought was
too radical to be credible to Congress and the public, and the matter was
dropped.

There indeed may be particular circumstances, especially when an economy

is mired in stagnation, when some tax reductions may, as their advocates
argue, "pay for themselves," at least in substantial part. But I later came to
realize how dangerous it could be to give that impression as a normal or
expected consequence of reducing taxes. Pushed very far, the result is the
large and intractable deficits we have today.

The program presented to the president for approval in the fall of 1963 by
the Treasury Department included large enough reductions in tax rates and
projected revenues to satisfy the expansionist wing of the administration.
But despite the strong administration position, the program was not enacted
until almost a year later, and only after the assassination of the president.
Then and now considered highly successful, it was a textbook example of
effective fiscal action. The budget soon returned close to balance. But
Congress and public opinion were not ready to countenance easily such a
deliberate departure from the doctrine of annually balanced budgets, a
discipline now lost.

In the early 1960s a second great period of international institution building

took place, all with the purpose of defending and supporting the Bretton
Woods system. In early 1962, in response to a Treasury initiative, the ten
most important financial powers joined together in agreeing to backstop the
International Monetary Fund with a credit line of $6 billion; that credit
could be made available in the event that its own resources would be
insufficient to help support one of the participants' currencies. The
mechanism was called the General Arrangements to Borrow.

For the United States, this had two advantages. While there was no clear
intention of an American draw on the IMF, the new agreements
demonstrated that substantial funds could be marshaled to meet a
speculative attack on the dollar without forcing the United States to sell
large

CHANGING FORTUNES

amounts of gold. We also did not want other countries to find themselves
suddenly short of liquidity and forced into devaluations, .which would
undercut our competitive position.

Six billion dollars was big money then, but the General Arrangements to
Borrow was significant apart from the money pledged by the United States
and the other nine countries. Japan was invited for the first time to be a
member of the club of countries that had assumed special responsibilities
for the system; in addition to the United States, the others were Canada,
Britain, Germany, France, Italy, Belgium, the Netherlands, and Sweden.
The size of their commitments is an interesting reflection of each country's
relative financial influence at the time. The U.S. obligation, at $2 billion,
was naturally by far the largest. Germany, the defeated European nation,
had clearly become the largest economy on the Continent with the strongest
external position. It committed the second largest credit line, $1 billion.
Britain, with its heritage as a major financial power, also agreed to $1
billion. The newcomer, Japan, committed only $250 million—not quite the
proportion that would be arranged today!

The GAB was the origin of something called the Group of Ten. (Later
Switzerland was associated with it, but the name colloquially remained the
G-10). That group was the precursor of all the various groupings—the G-5,
the G-7, the G-24, and the C-20—that during the next twenty years came to
populate the landscape of official international finance. The special area of
competence assumed by the G-10 was the structure of the international
monetary system, IMF operations, and all the rest. Its legitimacy rested only
in the fact that the countries involved had formally agreed to provide
resources to the Fund under certain conditions that it alone would decide.
Inevitably, it came to be looked upon by others as a closed club of rich
countries. But for some years it served effectively as an active forum for
serious and confidential discussions of international monetary matters,
including proposals for reform of the system.
In 1961, the Organization for European Economic Cooperation (OEEC) in
Paris, which was a group of European countries formed to coordinate
Marshall Plan disbursements, was turned into the Organization for
Economic Cooperation and Development, or the OECD. Significantly, the
membership was broadened to include the United States and Canada, with
Japan invited to join in 1964. The OECD had a sizable staff of economic
experts and was designed to promote research

IN THE THICKET OF BRETTON WOODS

and discussion among the industrialized countries about common problems

of economic policy, development assistance, business regulations and
practice, and the like. Its Economic Policy Committee provided a broad
forum for discussion of economic policy among the senior officials of all
member nations, large and small. It was initially chaired by Walter Heller,
and the custom of U.S. chairmanship has persisted to this day. But the
committee, for all its broad mandate, met infrequently and was without
operational responsibility.

Far more important and active at the time was another group, a
subcommittee innocuously named Working Party Three, or WP3 for short.
The membership of this group was by no coincidence limited to the same
countries as those of the G-10. Participation by other than finance ministry
officials and central bankers was discouraged, although the U.S. Council of
Economic Advisers regularly sent one of its members. The idea was to
provide an intimate setting where senior officials with responsibility for
their governments' policies would frankly review economic and financial
developments within their countries, consider the implications for
international markets, explain their own policies, and even hint at
forthcoming policy plans. Despite the burden of travel for the more distant
members, WP3 met quite frequently—for some years as often as every six
or eight weeks. Bob Roosa decided to attend regularly to represent the
United States, reflecting the importance he attached to the international
discussions and their relevance to domestic policy making. With that
example, other countries sent men or women of equivalent rank.

It is hard today to reconstruct the atmosphere. The participants saw

themselves as carrying a very special and important, if arcane,
responsibility to protect the stability of the international monetary system.
Like high priests, or perhaps stateless princes, they were schooled in arts
with which few were familiar, arts that required both a certain amount of
secrecy and a high degree of mutual confidence. A few of them had
personally participated, at least at the margins, at the Bretton Woods
conference and saw themselves as disciples of the founders, who would
keep their vision intact. As men with vivid memories of depression and war,
they sensed the stakes were high.

Emile van Lennep, who held a job equivalent to Roosa's in the Dutch
Treasury, served as the first and very active chairman of the WP3. He was a
prime example of the talent and dedication the Dutch have traditionally
supplied to international organizations, and he later became

CHANGING FORTUNES

head of the OECD. Otmar Emminger from Germany later served as

chairman of the WP3 and eventually became head of the Bundesbank. Fritz
Leutweiler of the Swiss National Bank, later its president; Rinaldo Ossola
of the Bank of Italy, a wonderfully warm man personally and an extremely
effective mediator; and Andre de Lattre, who provoked General de Gaulle's
wrath by being too cooperative with the Americans, helped round out the
core group. The Japanese, invited a little later, were rather less passive than
in most organizations. That reflected the competence of Yusuke Kashiwagi,
who had lived in Brooklyn as a child and combined fluency in English with
considerable experience in international finance. He became the first vice
minister in the Japanese Treasury with responsibility for international
affairs and later served as president and chairman of the Bank of Tokyo, for
many years Japan's leading bank in the international arena.

Some time after I joined the Treasury, I occasionally attended WP3 in a

staff capacity. There was no mistaking the sense of mission and camaraderie
among the regulars. These people were not politicians; they mainly had
long careers in government. They all had an unusual sense of commitment
and common purpose, and they built up a reserve of mutual trust that paid
off later in an ability to reach quick decisions. Occasionally they would go
well beyond commenting informally on each other's policies and prepare a
formal letter for transmission to one government or another, typically in
support of appropriately restrictive policies that might be politically
unpalatable. It would be written in close consultation with the officials from
the recipient country, who felt it would be useful at home to have a message
of international concern and support delivered to the head of their
government.

Those communications were exceptional, and as far as I know none was

ever sent to the United States. It was not for want of growing concern about
U.S. policies as the decade wore on. There was at least one instance in the
debate about raising taxes to finance the Vietnam War when Secretary
Fowler encouraged foreign officials to communicate their concerns directly
to congressional leaders.

Much more important as an incentive to restraint in those days was the

threat, or indeed the actuality, of pressures on a country's exchange rate in
the marketplace. Normally, except for the United States, a sizable balance
of payments deficit would be paid for by a loss in a nation's gold and
foreign currency reserves, which for most countries would be reported at
least monthly and often weekly in the regular statistics. A loss

IN THE THICKET OF BRETTON WOODS

of reserves always carried the risk of undermining confidence and

encouraging speculation in a country's currency. If large amounts of money
had to be borrowed from the IMF to replace those reserves and help
stabilize the currency, then the question of "conditionality" would arise
quite directly. In other words, the IMF would make the loan conditional on
the borrowing country's taking measures the IMF deemed appropriate, and
that usually meant some form of domestic austerity such as tightening
money, raising taxes, cutting expenditures, or all three.

Those practices and attitudes are greatly altered now. With exchange rates
floating and no official par values to defend, declines in a currency and
losses of reserves carry a sense of emergency only in extreme cases. Under
the current floating regime, the consultative efforts came to be carried on
mainly in the Group of Five (now enlarged to the Group of Seven), and the
finance ministers and central bank governors of the United States, Britain,
France, Germany, Japan, Canada, and Italy publish communiques instead of
writing letters to each other. International telephone communication is
incomparably easier than it was in the 1960s, so informal contacts are much
more frequent.

In general, I suspect finance ministers are better informed about

international questions today, and they come to meetings prepared to debate
strongly with each other. But the debate today is not grounded in preserving
(and possibly amending) a system with agreed rules that loom larger than
the interests of any single country. As a result, the discussions today often
seem to have more of an ad hoc quality and less sense of urgency.

Organizational and institutional development is not, of course, a substitute

for action, and the early Kennedy years saw a lot of technical innovation.
For one thing, the United States began intervening in the foreign exchange
markets, ending the taboo on such operations that had prevailed for many
years. Partly as a means of acquiring resources for intervention, a "swap
network" was established. That was a technique for prearranging short-term
lines of credit among the major central banks and treasuries, enabling them
to borrow each other's currency almost instantaneously in time of need. So-
called Roosa Bonds were invented, enabling the United States to borrow
foreign currencies from other monetary authorities, currencies that could be
used instead of gold when a country 7 wanted to convert unwanted dollars.

With memories of the preelection gold scare, an informal "gold

CHANGING FORTUNES

pool" was reinforced and formalized. This group of countries (including the
United States, Belgium, Britain, France, Germany, Italy, the Neth-erlands,
and Switzerland) undertook to buy or sell gold in the market at a small
margin around the official $35 price. Both purchases and sales were divided
among them by agreed formula. While the pool was designed to protect
against a destabilizing rise in the gold price, in calmer times it would be
expected to be (and for many years was) a net buyer of gold as newly mined
metal reached the market.

Bob Roosa liked to describe all these innovations in official finance in

sophisticated terms drawn from military doctrine: rings of outer and inner
defenses for the dollar and for the system. The plain implication was, of
course, that the dollar needed defending and that the unquestioned faith in
its stability had been undermined. From today's perspective, the deficits in
the American balance of payments in the early 1960s look minuscule, no
more than $2 or $3 billion a year. Moreover, as the government kept
emphasizing, the deficits resulted entirely from outflows of capital from the
United States; our trade remained in surplus, suggesting the basic American
competitive position was still healthy. But the net outflow was enough to
add significantly to foreign central bank holdings of dollars and give rise to
some U.S. gold sales to redeem them, even if at a relatively slow pace. By
1964, foreign official dollar holdings came to exceed the value of the U.S.
gold stock. Even that need not have implied a threat to the dollar so long as
confidence in the policies and performance of the United States was
maintained. Nonetheless, it was symbolic evidence of the importance of
maintaining that confidence.

Under the old gold standard, the orthodox response would simply have been
to raise interest rates and tighten money until the capital flowed back; that
was not, however, something that could be easily contemplated by an
administration dedicated to "getting the country moving again." Short-term
interest rates were permitted to rise gradually by a percent or so, and the
entire thrust of expansionary policy came from reducing taxes. But the
Treasury nevertheless felt compelled to look elsewhere for help and in the
process was even willing to encroach upon other accepted taboos.

In constructing the postwar system, the United States stood squarely for
liberal trade and free capital movements, so any idea of controlling the use
of the dollar in foreign exchange was anathema. Yet, in small ways at first
and then more dramatically in 1963, various restrictions

IN THE THICKET OF BRETTON WOODS

were adopted. More and more development aid was tied to U.S. exports.
Where possible, overseas defense purchases were directed back to the
suppliers in the United States, who could be paid in dollars instead of
foreign currencies. The first steps were taken toward restraining capital
outflows in a bigger way when Bob Roosa's fertile mind seized upon the
idea of taxing them.
The argument ran essentially like this: Our partners are restive about the
dollar and uncertain about our willingness to deal with our balance of
payments deficit. However, our trading accounts are in sizable surplus,
which means there is no reason any question should arise about devaluing
the dollar even if we could, because that would undermine the whole
system. The problem lies with the capital account, particularly in what
seems to be becoming a chronic long-term outflow of dollars. The
traditional way of stopping that is by tightening money, but we certainly
don't want to do that too aggressively while we are still recovering from two
recessions and prices are stable. Moreover, the real reason the capital
outflow is so large is that European capital markets are controlled,
congested, and inefficient; the Europeans and everyone else have to come to
New York to borrow money, but that is an artificial situation reflecting their
own lack of flexible financial markets. We don't want to resort to exchange
controls and we won't. But we can be ingenious and mimic the effects of
higher interest rates without having unduly tight money. We will do that by
taxing capital outflows, specifically by levying a tax on foreign loans in
New York equivalent in amount to an additional i percent interest on their
new bonds or loans.

This provided an interesting lesson to me about government. It seemed an

imaginative and intellectually attractive idea to simulate the market system
without really using it. I was given the job of drafting the Interest
Equalization Tax along with David Tillinghast, the Treasury's able
international tax counselor. Our job was to translate the conceptual vision
into legislative reality. I quickly discovered the enormous gap between
beautiful concept and practical application. From the beginning, it was
decided that short-term capital flows were too numerous and complex and
served too many essential purposes, such as financing exports, to make a
transaction tax feasible, so borrowings under three years were exempt.
Similar reasoning led to an exemption for direct investments such as putting
money into foreign companies, especially the subsidiaries of American
companies abroad. As for taxing the limited amount of loans to developing
countries, that seemed inequitable. But

CHANGING FORTUNES
we decided that everyone else should be treated alike; just like the market,
when interest rates go up, everybody should pay.

That was the way the proposal for the Interest Equalization Tax was
announced. It took about eight hours for a sizable part of the Canadian
government to swoop down on Washington. In essence, they said, "My
God! You can't put a tax on our borrowings. We're dependent upon your
market. The Canadian dollar (and presumably the Canadian economy) will
sink forever. You don't want that to happen. We've always been integrated
with your capital markets. You must exempt us." So they were exempted.
Japan argued it was still economically vulnerable, and a limited exemption
was later provided. When the bill got to Congress, the members were
barraged with requests for more exemptions by constituents, and the
loopholes grew. Every loophole required many more definitions and
restrictions that were often essentially arbitrary. It is not easy, for instance,
to distinguish between portfolio investment and direct investment abroad
when more than a statistic is at stake. Even the exempted borrowers had to
be controlled lest they borrow money and loan it on to those subject to the
tax, which would be a very profitable business if they could get away with
it. Then, in came the Internal Revenue Service with all its experience in
writing complicated rules to avoid evasion. The intellectual concept,
beautiful in its simplicity, was smothered in hundreds of paragraphs of
regulation.

To a neophyte Treasury deputy undersecretary, it was all a very good lesson

about how difficult, messy, and arbitrary controls can be. But that turned
out to be only the beginning. The supposedly temporary tax stayed for more
than a decade; the rates were raised and the coverage extended. In March
1965, the banks were asked "voluntarily" to curtail their overseas lending,
and after a while it wasn't so voluntary. Eventually, in the second half of the
1960s, the process spread to restricting investments overseas by American
corporations. That was much more politically sensitive since it was so
closely related to the business strategies and objectives of our largest
corporations. The controversy increased among economists as well as
businessmen, and the program of controls was seized upon as an issue in
Richard Nixon's 1968 presidential campaign.
With all that effort, did the controls really do much good? Statistically,
capital outflows from the United States diminished. We also know one thing
for sure. Because the market in the United States now was partly closed to
foreigners, the controls greatly encouraged the develop-

IN THE THICKET OF BRETTON WOODS

ment of markets in dollar deposits and dollar securities abroad. American

banks and investment houses in Europe joined institutions already there to
attract dollars and lend the money, circumventing the controls quite legally
in what came to be known as the Eurodollar market, which flourished in
London. Interest rates were a bit higher than in New York, so some dollars
that might otherwise have been deposited or invested in the United States
were induced to stay abroad. Moreover, many lenders and borrowers
enjoyed the relative freedom of the Euromarkets, so much so that they
never returned to Wall Street. I don't think anyone has satisfactorily
answered the question of what was accomplished in terms of the ultimate
balance of payments of the United States or in terms of the competition
between national markets.

At the same time, following the Dillon-Anderson mission to Bonn in i960,

the United States persistently and more aggressively asked its allies and
trading partners for what came to be known as balance of payments
"offsets." It started in the defense area mainly with requests that our allies
direct more of their military purchases to the United States, which often
made a lot of sense merely on grounds of cost. Later, we requested
budgetary support for troop facilities abroad. Eventually, the effort
amounted to little more than window-dressing the statistics. The Treasury
persuaded foreign monetary authorities to place funds in the United States
for more than one year. According to the conventions of the day, they were
counted as long-term capital imports. Accordingly, unlike three- or six- or
nine-month deposits, they were placed "above the line" in balance of
payments accounting as a plus, offsetting outward flows that on balance
produced a deficit even though the reality was unchanged.

My clearest memory of these early negotiations involved a visit of the then

Japanese finance minister, Takeo Fukuda, to Washington, accompanied by
Yusuke Kashiwagi. I was in Secretary Fowler's office just before a lunch
with the Japanese visitors when he got word that Minister Fukuda would be
bringing a gift. The Treasury wasn't prepared for these diplomatic niceties,
but we quickly consulted with the State Department, which promised to
supply a handsome silver frame for the secretary's signed picture. Much of
the lunch was devoted to how Japan might, by various means, "offset" our
defense expenditures in Japan. We didn't make much progress. But the
lunch was pleasant enough, and as the coffee was served, Mr. Fukuda called
for his assistant to bring in a beautifully wrapped package. It was given to
Secretary Fowler with a

CHANGING FORTUNES

flourish and a little speech, and duly unwrapped. Unfortunately, someone

had forgotten to put a picture in what turned out to be an empty frame. The
Japanese delegation sat for a few moments in stunned silence, eventually
broken by Kashiwagi, saying, "Just like offset: nothing there!"

Our balance of payments and the nature of the Bretton Woods system
forced more serious concerns than exchanges of pictures or financial
offsets. In one of his first acts, President Kennedy ordered a review of all
overseas expenditures by the government, and after a while a "Gold
Budget" was set up to provide for cabinet scrutiny of all official spending
that affected the balance of payments. It was that scrutiny that led to the
tying of foreign aid to the purchase of American goods, and probably to less
generosity in aid generally. We eventually did have some success in
encouraging Germany and Japan to pick up costs of American troops
stationed abroad, and there were a series of more trivial and irritating
cutbacks such as reduced duty-free allowances for tourists. All this
occasioned much restiveness, particularly by those who thought our
security or foreign policy interests were being jeopardized by financial
considerations they considered secondary.

There were clearly limits beyond which the administration would not go. I
recall vividly one unhappy meeting of the Balance of Payments Committee
at the Treasury when Secretary Dillon asked me to tell the assembled
cabinet officials that he would be delayed but to proceed without him. The
prospect of a relatively junior Treasury official trying to chair the meeting
didn't brighten the atmosphere, and McGeorge Bundy, then the White
House National Security Adviser, sourly opined that if the purpose of the
meeting was to discuss cutting back on overseas military spending, we
could adjourn because that subject was off-limits as a matter of national
security. Chairman William McChesney Martin of the Federal Reserve
retrieved the situation by commenting that he'd been around a long while
and that the stability of the dollar would be more important to American
security in the end than precisely how many troops we had in Germany. My
emotions were all with the chairman, but of course the issue was never that
stark. The balance of payments cost of a division or two of troops overseas
simply was not large enough to be financially decisive. In my experience,
the idea of a fundamental conflict between our international commitments
and the strength of our economy is seldom borne out; it is a question of our
willingness to pay, not oi-r ability.

IN THE THICKET OF BRETTON WOODS

The issue was joined perhaps as sharply as it ever would be in the financing
of the Vietnam War. The conflict seemed to be intensifying in the second
half of 1965. However, the White House simply refused to permit accurate
spending figures to be released to the public, and so far as I know, even to
its economic advisers, presumably feanng that the information would
strengthen the arguments of those opposed to any escalation.

Chairman Martin happened to be a personal hero of mine, as he was to

many in the financial world. He was also a man of long expenence in the
ways of Washington, with many influential fnends and sound intuition. He
sensed that defense spending was indeed taking off and that the time had
therefore arrived to apply monetary restraint. He broached the idea of
raising the discount rate dunng the early autumn by half a percent, which
was strongly resisted by President Johnson and Secretary Fowler. But
Martin persisted, and I recall a dramatic meeting in the White House when
he was persuaded to hold off—at least long enough for the issue to be
reexamined while the president had his gallbladder removed!

A decision was made to convene a small group of officials, including me, to

examine the issue "objectively." I was sympathetic to raising the discount
rate and had already argued internally for a halfway step of a small, one-
quarter percent increase. It was an odd situation. It was a little difficult to be
professionally objective when your boss (and his boss) had already taken a
strong position against any change. Daniel Brill, the research director of the
Fed, was really queasy about his own chairman's aggressive position.
Arthur Okun from the Council of Economic Advisers, later its chairman
and one of the most distinguished economists of his generation, and Charles
Zwick of the Budget Bureau, argued for waiting until the budget decisions
in the New Year.

After much discussion, we proposed a memo for our superiors pointing out
that we had no hard evidence of accelerating Vietnam expenditures. We
concluded that a decision to tighten money could be deferred until the
budget decisions were made in a few weeks. None of us had any doubt that,
if expenditures were rising as fast as Martin thought, taxes should be
increased. I managed to console mysell by adding a footnote saying that if
Vietnam expenditures were really nsing much faster than foreseen, the
discount rate should be raised nght then, but I have never looked back upon
that exercise as my finest hour.

The Federal Reserve Board voted to increase the discount rate on

CHANGING FORTUNES

December 5, 1965. almost the day I left the Treasury. I did not experience
firsthand the president's explosion when he asked Chairman Martin to visit
him at his ranch in Texas. I do recall reading chat the chairman handled it
all with his usual aplomb, pointing out that there was no disagreement about
objectives! President Johnson went on to reject the advice of his economic
advisers and refused to propose a tax increase m early 1966 to restrain the
increasingly exuberant economy. I recall Secre-

Fowler valiantly defending the decision to those of us who had been urging
such an mcrease; he argued that any such request would have been rebuffed
by the Congress, at great cost to the president's prestige and ability to lead.
Be that as it may. our inability then fand later) to take adequate action to
restrain the economy against the economic stimulus of Vietnam spending
seems to me and many others the beginning of the inflationary process that
plagued us for years. I always have suspected that the president simply did
not want to risk a congressional test on his :nam policy in the form of a tax
to pay for it. The economic policy-lesson was that when the time came to
restrain, we flunked the test. It was not a matter ot ability, but will.

I returned to private life at the Chase Manhattan Bank and recall wrinng a
plaintive note to my old Treasury colleagues arguing that, just as we had
applied fiscal stimulus earlier when it was justified, we now needed to
balance it with fiscal restraint when the need for restraint

ear. Failure to do so would undermine the credibility of the Keynes-

:nne that was the foundation for what the administration had

preached as the New Economics, and that is precisely what happened.

the - : k on bretton woods

In the intemaaonal sphere, an intellectual attack was developing to

challenge the basic assumptions of Bretton Woods. There had alv. been
some academics m favor of floating exchange rates, but they were quite
outside the mainstream of policy* thinking. However, as the effort to
maintain confidence in the dollar and curb the balance of payments deficit
impinged more and more on other objectives, the natural result was a
greater willingness to consider new approach a

The first fundamental challenge to the Bretton Woods system came not
from a radical reformer but from a firm supporter of fixed exchange rates.
Robert Tnrhn was a Belgian-bom economist with practical experience in
developing a workable European payments system after the

IN THE THICKET OF BRETTON WOODS

war who later became an influential teacher of international economics at

Yale. In i960, he published a book titled Gold and the Dollar Crisis, the
basic point of which was that the Bretton Woods system contained an
inherent and potentially fatal flaw in its dependence on the dollar. He
argued that as the volume of trade expanded over time, any fixed exchange
rate system would need an increase in usable reserves, in other words, an
increase in acceptable international money to finance increased trade and
investment. Future gold production at the established price could not be
enough to meet the need, so the source of the international liquidity
necessary to lubricate growth within the Bretton Woods system would have
to be dollars. The only avenue for putting those dollars in the hands of the
rest of the world was the American balance of payments deficit.

What the founders of Bretton Woods had inadvertently done was to ng up a

world monetary system dependent upon American deficits, the very same
deficits that everyone came to decry in the 1960s as destabilizing. If the
U.S. deficits continued, confidence in the dollar and eventually the system
would be undermined, and the result would be instability. But if the U.S.
deficits were eliminated, the rest of the world would be deprived of the
dollars it needed to build up its reserves and finance economic growth. For
countries other than the United States, the question later became stark: hold
more dollars in their reserves or turn them in for more gold from the United
States. The latter course, probably sooner rather than later, would force the
United States to stop selling gold, one of the foundations of the system. The
former course of holding an increasing amount of dollars would inexorably
undermine confidence as the potential demands on our gold stock came to
far exceed the amount available to meet them. Either course contained the
seeds of its own disaster.

This analysis came to be known as the Triflin Dilemma, and it was hard to
escape its implacable logic. But its implications for policymakeis were for
the long term. The efforts of the Kennedy administration to deal with the
American balance of payments deficit seemed reasonably successful, and
the United States still had a huge stock of gold. There were doubts both in
the United States and Europe that sizable needs for more world reserves
were at all imminent. A good record of price stability, plus Bob Roosa's
"inner and outer defenses," provided grounds for confidence in the dollar.
There was ample time, or so it seemed, to avoid being impaled on the horns
of the Triflin Dilemma.

CHANGING FORTUNES

What gradually came to concern American policymakers as much or more

was something economists called the "nth currency problem." The term
sounds like a puzzle in mathematical logic, and it was. The point is that not
every country can independently set its own exchange rate; at least one
must be passive. Suppose there are three countries. Countries A and B set
their exchange rate against Country- C. That will determine, at the same
time, the cross-rate between A and B, and the exchange rate of C. If C does
not like that result, and it tries to change its exchange rate, A and B will be
upset and there will be an unstable, unpredictable result.

For the Bretton Woods system to operate, one country had to be passive
with respect to its exchange rate. That was the United States; the dollar was
the «th currency. The dollar had a gold price, which it set. It had an
exchange rate against the pound, the mark, the franc, the yen, and every
other currency. But the United States did not set those rates; the other
countries did.

That did not seem to be a great problem when we were strong enough,
literally, to take on all comers at the gold vaults in Fort Knox. The potential
lay in a situation in which other countries might prefer to keep their
exchange rates somewhat undervalued, giving their exporters an advantage
in world markets, tending to keep their balance of payments in surplus and
their dollar holdings rising. It was a sophisticated form of the old concern
about competitive devaluations.

It was hard to pin down just how important the problem was, but it seemed
very real to American policymakers as the 1960s wore on. Devaluations by
large countries were not frequent, but when they happened, the decisions
seemed to be biased toward overdoing it to play safe and to convince
markets that it would not be necessary to go through the wrenching exercise
again. There were many more devaluations than revaluations. At least as
important, by the beginning of the 1970s Japanese industry had clearly
become highly efficient and export-minded. The yen exchange rate, set with
American advice right after the war when the country was prostrate, had
come to seem very much undervalued.

All that gave rise to another dilemma. The Bretton Woods system could
work well only if markets had confidence that exchange rates were not
going to change very frequently by sizable amounts and the dollar rate was
not going to change at all. The IMF Articles of Agreement specified that a
country in fundamental disequilibrium could in fact
IN THE THICKET OF BRETTON WOODS

change its exchange rate. But it was pretty quickly realized that making a
change was difficult and potentially destabilizing. Waiting to devalue until
the case was crystal clear and the need was large could unleash strong
speculative forces in the market and create economic distortions. But
frequent changes on less than conclusive evidence risked even more
speculation, making it difficult to maintain a fixed-rate system at all.

The travails of the Labor government elected in Britain in 1964 were

instructive. Markets feared that a Socialist government inheriting a weak
external position might devalue the pound, and they started dumping the
currency. Prime Minister Harold Wilson, acting very much as Kennedy had
done, decided right away that Britain would not devalue. I don't imagine he
made his decision out of an altruistic love for the Bretton Woods system; he
thought it important in domestic terms to reassure the financial community
that Labor would follow disciplined policies. That instinct was strongly
reinforced by the view of the U.S. government, which feared that if sterling
collapsed, the psychological destabilization would bring the dollar itself
into the front line of speculation.

Wilson's quick decision set the stage for a long, grueling effort to protect
sterling. Opposition within as well as outside the party grew on the grounds
that the stability of the currency and of the system was being placed ahead
of the growth of the British economy; the symbol of the pound was being
elevated above the substance of policy.

The Wilson government gave up the long, dreary battle in November of

1967, much to the discomfort of the United States. When the decision was
finally made, the British followed the IMF rules to the letter, notifying the
management of the IMF and awaiting formal Fund approval. That delay of
a day or so involved the loss of hundreds of millions of foreign exchange to
speculators, and a loss as well of credibility by the Chancellor of the
Exchequer, who was forced to dissemble in response to questions in
Parliament.

The whole effort could not but help raise questions. Britain had gone by the
book. The currency was defended for years with tighter monetary and fiscal
policies than the government otherwise would have liked, and with a lot of
controls. But in the end, what was at the time the world's second most
important currency was devalued, and the delay had not avoided substantial
losses to former colonies that were still holding sterling in their reserves. As
the Americans had feared, there was an avalanche of gold buying; a prompt
declaration by President Johnson

CHANGING FORTUNES

that the dollar price of gold would not be changed no longer carried the
force of earlier denials. In very practical political terms, there was a large
question of what the United Kingdom had gained by waiting so long.

In the larger arena of international politics, a strong challenge to Bretton

Woods—and through Bretton Woods to the United States— had already
been launched by President de Gaulle of France. The French had long made
plain their sensitivity to perceived encroachments on their autonomy and a
strong antipathy to what they felt was the economic domination of Europe
by the United States. That defi americain in French eyes was epitomized by
large investments by American companies in the new European Common
Market, investments facilitated, in their eyes, by unduly low U.S. interest
rates. Just as with Japanese investment in the United States in the latter
1980s, the American investment led to a rather diffuse fear and resentment,
even when it was welcomed by the companies and localities benefitting
from the money.

On February 4, 1965, de Gaulle took the opportunity of one of his staged

press conferences to begin an open attack. His basic argument was that the
"dollar system" provided the United States with an "exorbitant privilege.*'
It was able freely to finance itself around the world, because unlike other
countries its balance of payments deficits did not lead to loss of reserves but
could be setded in dollars without limit. The solution would be to go back
to the gold standard, and the language was arresting. The time had come, de
Gaulle said, to establish the international system "on an unquestionable
basis that does not bear the stamp of any one country in particular. On what
basis? Truly it is hard to imagine that it could be any standard other than
gold, yes, gold, whose nature does not alter, which may be formed equally
well into ingots, bars, or coins, which has no nationality and which has,
eternally and universally, been regarded as the unalterable currency par
excellence."

But he did not stop at florid oratory. The words were backed up by a
message that France would buy a substantial amount of gold from the
United States, not all at once, which would have been a kind of monetary
declaration ol war, but spaced out by mutual agreement over a period of
years. His appeal for a return to the gold standard was prompdy rejected as
simply anachronistic, and not just by the United States. But de Gaulle no
doubt had other purposes in mind. By calling attention to the vulnerable
link between the dollar and gold he could attempt to rein in what he saw as
the excesses of American policy working to the detriment of France and
Europe more generally.

IN THE THICKET OF BRETTON WOODS

De Gaulle's press conference took place before the Vietnam War had
seriously escalated. That escalation later engendered much more sympathy
in some European circles for de Gaulle's basic point. His more specific
concern was probably the wave of American investment supposedly buying
up European industry. Whatever his specific complaints—and I suspect he
was essentially objecting to the financial freedom and independence that in
his eyes the United States enjoved— by the end of the decade the gravamen
ot his charge that the United States was escaping international discipline
had become a significant emotional and political issue.

More important than the politics were the perceived economic

consequences. Toward the end of the decade, the belief that the United
States was exporting inflation through the outflow of dollars had become
pronounced, most of all in Germany, which has always been highly
sensitive to price stability and monetary autonomy. Inflation in the Umted
States had in fact begun to rise. Although it was still far below the levels
that were later reached in the 1970s, many Europeans had come to feel that
American policies were unduly expansionary, leading to a growing balance
of payments deficit.

The position of Germany was pivotal as the principal surplus country

politically aligned to the United States. As a measure of their cooperation,
the Germans had long foresworn the option taken by France of buying gold
directly from the United States. In a letter to Chairman Martin in 1967, Karl
Blessing, then president of the Bundesbank, flatly and formally promised
not to spend Germany's dollar reserves to buy gold, citing our heavy
defense costs overseas and specifically in Germany. But the continued
increase in Germany's dollar holdings was a continued source of frustration.
Bundesbank officials came to feel that their control over the domestic
German money supply was undermined by the inflow of dollars,
threatening their country with inflation supposedly exported from the
Umted States. That concern in rime brought the Germans into the vanguard
of those prepared to reform the system, particularly in the direction of more
flexible exchange rates.

The earliest effort at fundamental reform was directed not at exchange rates
but straight at the Tnffin Dilemma by the United States. Henry Fowler, who
had replaced Douglas Dillon as secretary of the Treasury in April 1965, was
not so steeped in financial and monetary lore as his predecessor. He did,
however, have a finely honed sense of the political and negotiating
atmosphere. He realized that the United States

CHANGING FORTUNES

was increasingly on the defensive over the status quo, and that without
some fresh initiative our relations with our allies and the Bretton "Woods
system itself would be in jeopardy. I was the main link with the attitudes
and policies of the previous Treasury administration in the monetary arena,
and we spent hours reviewing the state of play. He talked with others in the
administration who surely were impatient with the Treasury, which they
saw as too cautious. Then Fowler went to his summer house on Cape Cod
for a short vacation. Upon his return, he asked me to come to his office to
discuss some thoughts he had had "on the beach."

These thoughts turned out to be a carefully crafted speech destined for, of

all audiences, the Virginia Bar Association. He wanted to present his fellow
lawyers with an abstruse discussion of monetary affairs, describing the
system with a heavy Triffinite flavor. It was delivered on July 10, 1965, and
the punch line came near the end: He had been authorized by the president
to participate in an international monetary conference if other nations
agreed to hold one and it was adequately prepared.

In my specialized little world, that was a bombshell. An international

monetary conference had not been on the Treasury agenda. I explained
again what he already knew. Any conference with our partners would open
up a can of negotiating worms. It would confuse the market, and the
resulting speculation would put the dollar at risk. Most of all, unrealistic
expectations would be aroused. We reviewed again the work that had
already been under way much more quietly under the auspices of the G-10
experts to examine the issues away from the spotlight. He listened and later
tinkered with the draft, but he quickly got the authority he sought from the
president to call a conference.

The French and the others were strongly suspicious. But Secretary Fowler
hit on the notion of describing what he wanted as a matter of prudent
"contingency planning." It was in that context that the G-10 launched a long
and difficult negotiation for creating a new international reserve asset that,
unlike the dollar, would be subject to collective control and would provide
an alternative to both the dollar and gold. Some Europeans, and particularly
the French, were deeply suspicious of any alternatives to gold. They
wondered whether the Americans weren't looking for a different but still
painless way to finance their balance of payments deficit.

The negotiations were both highly technical and contentious,

IN THE THICKET OF BRETTON WOODS

spreading over almost three years. The final agreement was a personal
triumph for Secretary Fowler. By the persistent exercise of personal
diplomacy and the marshaling of wide intellectual support, he had
succeeded in obtaining agreement on the creation of Special Drawing
Rights, or SDRs, at the annual IMF meeting in Rio de Janeiro in September
of 1967- Great hopes were placed on the imaginative new instrument,
which promptly was labeled "paper gold" but was neither paper nor gold; as
one wit at the IMF said, the SDR was "not minted, not printed." Rather, the
SDR could be found only in the blips on an IMF computer, and many
restrictions were placed on activating the computer.
The fact was that the negotiation never really settled the issue of whether
the SDR truly was international money, to be used as a national holder
wished, or more like a line of credit subject to various covenants on its use.
That ambiguity was reflected in its cumbersome name. The financial
markets viewed it as something of a synthetic creation that was not really as
good as gold or the dollar. Nonetheless, the agreement to create it
demonstrated that the principal financial nations were capable of acting
together to strengthen the system, and that helped bolster confidence.

By any criteria economic performance during the decade of the 1960s had
been enormously encouraging. In the United States, productivity was
growing at close to 3 percent a year until late in the decade, and there were
nine years of unbroken expansion, a record. European economic recovery
was complete, with enormous growth in Germany and most European
countries. Led by confident American corporations, international
investment revived, and trade expanded steadily. Economists themselves
developed new confidence in their ability to manage the economy. But, by
the end of the decade, there was no disguising the fact that, SDRs or not,
the very monetary system that had helped make it all possible had fallen
into jeopardy.

The end was foretold by a unique gold crisis in 1968. The British
devaluation had generated enough uncertainty to spark a heavy demand for
gold. Large volumes of the metal for the first time drained out of official
reserves into private hoards through the gold pool. The French ceased
participation in the pool, and amid great tension in March of 1968,
Chairman Martin called a conference of the remaining participants at the
Federal Reserve. They could find no way out of the crisis other than by
joint refusal to sell official gold to the private market. The $35

CHANGING FORTUNES

price would remain for official settlements between nations, but the private
market would be permitted to go its own way without any official buying or
selling. In the eyes of the market, that decision amounted to a confession
that the central banks collectively no longer had confidence that market
purchases of gold could subsequently be revived at or close to the official
price. The United States plainly indicated it was not willing to maintain the
market price single-handedly. Sensing all that, market demand drove the
price to about $40 an ounce before it fell back.

The emergency decision was presented as kind of a permanent reform, but

it hardly was an elegant one. Two different prices for gold, supposedly the
pillar of the monetary system, inevitably created tensions. The gold
holdings of the system as a whole were effectively frozen, and it became
increasingly difficult for central bankers to justify sales among themselves
at prices below those in the market. With gold becoming available and
unhappiness rising about holding dollars, the system seemed to be
unraveling.

The difficult year ended on a strange and disconcerting note. A speculative

crisis in European markets led to an emergency G-10 meeting in Bonn in
November. The markets looked toward an upvaluation of the mark and a
devaluation of the French franc, which seemed consistent with the
underlying economic situation. But the German government was divided,
with the finance and economic ministers alternately briefing the press with
different views. The French were reluctant, but finally after much acrimony
there seemed to be an understanding that the expected currency shifts would
take place. The meeting adjourned, only to have President de Gaulle
renounce even the idea of a French devaluation as "the worst form of
absurdity." So the Germans refused to move, too, and everyone looked a
little silly.

In that setting, new ideas circulated among economists. Relatively few were
prepared to support fully floating exchange rates, but ingenious designs for
gliding parities, crawling pegs, and wider margins appeared in the hope that
more flexibility in exchange rates would be helpful.

The ideas of free-market economist Milton Friedman, an enormously

effective debater and proponent of floating exchange rates, began to be
taken more seriously. He was an occasional adviser to Republican
presidential candidates, including Richard Nixon. His writings depicted an
idyllic picture of a benign world in which the natural

IN THE THICKET OF BRETT ON WOODS

operation of exchange markets, left unfettered by official efforts Da fix
exchange rates, would automatically correct international disequilib-num.
There would be no need for controls, because the nse and fall of currencies
would work to eliminate imbalances in trade and other international flows.
Domestic policies could go their own w. bifts in exchange rates would take
account oi different national rate^ lnflaaon. He and others left the
impression that it would all happ rather smoothly and painlessly.

To those chafing under controls, that was an attractive doctrine. To

policymakers impatient with the effort to coordinate national poK< and
resistant to the constraints that the balance of payment i to

place on their domestic economic goals, it offered an appealing escape. The

key element in the Friedman argument was that floating exchai rates could
work their magic without wide fluctuations: that, in the end. they would
indeed be more stable than the large and sudden changes that occurred
when fixed exchange rates were forced to adjust. That had not been the
experience of the 1930s, but those had been years ofdep and disorder. The
Friedman hypothesis remained to be tested in the more favorable
circumstances ot the postwar world.

This discussion was taking place in a presidential election year, and during
the campaign Richard Nixon, like Kennedy eight years before. was pressed
for his own thoughts. He resisted whatever temptations may have existed to
throw off the shackles of the old system and proclaim the need for radical
change. But pressed by the bus mmunity, he did

make a campaign commitment to get rid of all those tiresome controls on

capital outflows. All in all. the official dc the academic debate,

the performance of the markets, and the resentment about the restraints on
policy sent a message that the Brettoo \Y tem was in rik

trouble, and to a growing number, not worth saving.

TOYOO GYOHTEN
Tor Japan, the 1950s and 1960s were a period ot rapid recovery and
economic development, simultaneously marking the resumption of her
financial relations with the rest ot the world. Our very quick recovery from
the damage caused bv the war was effected first ot all by the

♦7

CHANGING FORTUNES

government's very active industrial policy. The government encouraged

strategic industry by various administrative measures including tax
preferences and the preferential allocation of scarce resources. For example,
the government actively encouraged coal mining right after the war because
coal was thought to be the crucial material for developing the steel and
fertilizer industries, and those in turn were supposed to boost other
manufacturing industnes and agricultural production. On the whole, these
active industrial policies were quite effective and successful, but by the
early 1960s the private sector had become strong enough to no longer need
such government encouragement. Even more, it came to dislike such quasi
control through the government's industrial strategy.

Matters reached a head in 1963. when the government proposed a

new "Law Concerning the Advancement of Specified Industnes." Its aim

was to empower the government to encourage the rationalization and
merging of private companies in industries where it sought to enhance
international competitiveness. The bill was blocked by private business, and
the incident was a watershed in the postwar history of Japanese industrial
policy. It sent an important message to governments that they could no
longer dictate to private business.

I know all the myths about Japan, Inc., and they are not accurate. The
notion that Japanese industnes are controlled by the government is no
longer valid. Compared to the United States, it is quite true that relations
between business and government have been closer and less confrontational
in Japan. Most ot the time the basic inclination of government has been to
facilitate the development of strategic new industnes and the phasing out of
obsolete sectors. But the government simply does not have the power to
issue orders that business must follow. In spite of Japanese business leaders'
public courtesy to the government, it is not the master of the Japanese
economy, which continues to be dominated by a dynamic and highly
capitalistic private business sector. Although government sometimes acts as
a moderator between conflicting private business interests, its principal role
is to gauge the real condition or the mind-set of the market and try to
accommodate its own policies to it.

Another factor in our quick postwar recovery was the successful control of
inflation. Before 1949. the government had a multiple exchange rate system
under which each major conimodity had a different exchange rate, all of
them weaker than the posted rate. In 1949, there

IN THE THICKET OF BRETTON WOODS

was a drastic stabilization program that was very effective. The

government, following the advice of Joseph Dodge, the economic adviser to
the American occupation authority, imposed a very strict budget balance on
itself, sharply curtailed lending by the Bank of Japan, restricted wage
increases, and established a uniform exchange rate at 360 yen to the dollar.
Consumer price inflation, which was running at 50 percent in 1948, was
reduced to a negative 10 percent in the following year as the result of this
program.

I also should not forget to mention that financial aid from the United States
was very substantial. Although Japan was not covered by the Marshall Plan,
the United States nevertheless provided various forms of financial
assistance, which amounted to more than $2.1 billion from 1946 to 1952,
when Japan legally restored her independence by signing the peace treaty
with the United States. Quite unexpectedly the Korean War broke out in
1950, when U.S. aid was winding down, and U.S. government procurement
for the war injected a very large amount of additional resources into the
Japanese economy, a total of $3.5 billion from 1950 to 1955.

Underlying all this was a fundamental change in the policy of the United
States toward Japan. At first, the main thrust of U.S. occupation policy was
to punish the Japanese and restrict our economy, but as the Cold War
developed, U.S. policy shifted toward encouraging Japan's economic self-
sustenance, and then further toward encouraging the Japanese industrial
recovery so that Japan could become a supplier of various resources to the
free world.

Our recovery proceeded very speedily and was complete in the mid-1950s,
when the Japanese economy regained its prewar level, and continued
expanding right through the end of the 1960s. The annual rate of growth for
Japan's gross national product for almost two decades was quite remarkable,
running as high as 10 percent a year. Very strong domestic investment and
technological development in sectors such as steel, petrochemicals,
automobiles, synthetic fibers, plastics, and electronics supported this rapid
growth. Although the relative importance of agriculture was declining, 40
percent of the work force still was employed on the land, and increasing
agricultural income was a very supportive element in expanding the
domestic economy because it helped manufacturing industry find a growing
market at home.

From this base, the structure of Japanese exports underwent a fundamental

change. The mainstay of Japanese exports shifted from textiles to

CHANGING FORTUNES

various types of machineries. In 1950, textile products accounted for almost

half of our exports and machinery only 10 percent. Twenty years later the
export shares were totally reversed: Textiles were down to 12 percent and
machinery up to 46 percent. Japan had tremendous export competitiveness
in the world market as the marginal supplier of machinery due to cheap
labor, a favorable exchange rate, and improving quality, and demand
expanded very rapidly. So, as the Bretton Woods system was declining at
the end of the 1960s, Japan had more or less reached the status of a major
world industrial and trading power.

Now, let me turn to Japan's reentry into the international financial arena.
This process of course started with trade. It was only in 1947, two years
after the end of World War II, that the Allied occupation authorities allowed
Japan to resume private international trade. Although trade started to
burgeon from then, trade policy was strongly tainted by export promotion
and import restriction. Japan was still suffering from very high
unemployment, and most Japanese manufacturing industries were very
weak and at a rather infantile stage of development, so Japan suffered then
from chronic balance of payments deficits. For all these reasons, it was
believed that trade policy could not be as open as we later desired, so
import restriction was one of the major features of trade policy at that time.
The conditions that justified these policies disappeared by the end of the
1950s.

As Paul Volcker explained, the much-feared dollar shortage turned to a

dollar surplus in the 1960s as the United States started to run an external
deficit, and this became an issue on the international monetary scene. Japan
registered her first bilateral trade surplus with the United States in 1959,
and from that time on I think U.S. policy toward Japan started to change. In
i960, the first year in which the United States came up with the dollar
defense program, one element was a request for import liberalization by
Japan. On the Japanese side, we came to realize that our freer participation
in the world trade system would really be a prerequisite for Japan's further
growth. That meant external pressure supplemented the internal need for
trade liberalization.

So it was quite important that in i960 the government for the first time came
up with a program of trade and exchange liberalization. Over three years, it
was envisaged that 80 percent of Japan's imports by value should be
liberalized so that there would be no more quantitative restrictions. In fact,
our performance was better than we expected, and by August of 1963 less
than three years from the announcement of that

IN THE THICKET OF BRETTON WOODS

program, 92 percent of our imports had been liberalized by the dismantling

of import quotas. Nevertheless, our external balance was converted into a
structure that ran surpluses by the middle of the 1960s, and this was
beginning to become an international issue while the Bretton Woods system
began suffering increasing instability.

Japan's reentry into international financial markets was necessitated by our

recurrent external deficits up until the mid-1960s, and reserves that never
rose above $2 billion until 1968. At that time, Japan imported about $15
billion worth of goods annually, so our reserves covered only about two and
one-half months of imports, which left us quite vulnerable to unexpected
shifts. Our domestic economy was quite dynamic, investment was active,
and our production was growing. But whenever the domestic economy
boomed, imports inevitably increased, because Japanese industry depended
almost entirely on imported energy and key raw materials such as iron ore,
cotton, wool, and soybeans. So a boom always brought with it an external
deficit and the loss of reserves, leading Japan to introduce the classic
measures of tight money and other adjustment measures.

On the whole these adjustment measures were quite effective, but of course
they had to be accompanied by some cash flow from the outside to tide us
over, and for this we depended on borrowing from the International
Monetary Fund. Japan joined the IMF in 1952. In those days, the IMF was
not a very active lender. I think it was only in 1956 after the Suez Crisis,
when there was a large outflow of short-term capital from the United
Kingdom, that Britain became the first major borrower from the Fund
through the arrangement of a standby credit of $1.3 billion. Japan made her
first drawing from the Fund in 1957, when we suffered a serious foreign
deficit of $600 million and borrowed $125 million from the Fund. It sounds
very small by today's standards. And then again in 1961, Japan suffered
another major external deficit. This time we arranged an IMF standby of
$350 million, and the government also borrowed $200 million for one year
from three American banks. The 1961 deficit was considered a crisis
because it was almost $1 billion, or perhaps half the size of our total
reserves. Foreign financing was therefore considered absolutely crucial to
Japan's survival.

I was in Washington that year as a young trainee in the IMF, but I was
called to Vienna to assist the Japanese delegation at the IMF's annual
meeting. The finance minister, Mikio Mizuta, was there to arrange the
$200-million-dollar line of credit from the three American banks, and I

CHANGING FORTUNES

was summoned to assist him. We went to a hotel suite, and there were the
three presidents of the American banks—Bank of America, Chase
Manhattan, First National City Bank of New York—all waiting for the
finance minister. Mizuta was very nervous because he knew how important
it was to conclude this first postwar loan for Japan with foreign banks. But
he was a heavy smoker, even more so when he was nervous. So before we
left our hotel for the meeting. I put packs of cigarettes into every one of his
pockets, so that he would not fumble for cigarettes while talking with those
three presidents.

We began by asking them for S200 million through Japanese private banks.
They agreed but insisted that we leave our short-term deposits with their
banks as collateral, which would be pretty good business for them. We
couldn't do that because we had to keep our reserves liquid, so we ended up
arranging for the credit to the Bank of Japan on a one-year basis. This was
the first time that the central bank had incurred any foreign debt, and it was
not at all happy that its financial credibility might be affected. When the
negotiation was complete and Mizuta returned to his hotel room, he was so
relieved that he gulped down a glass of whiskey and promptly fell asleep
with his suit on. We had to peel it oft" and cany him to bed.

Aside from short-term financing. Japan was also in very strong need of
development capital—long-term, productive capital to build infrastructure
and finance new industry. Our first choice was the New York capital
market, where from 1959 to 1963 the Japanese government sold about Si 76
million of its own bonds and bonds of the institutions that the government
guaranteed such as the Japan Development Bank. We regarded this as a
very substantial amount. But then came the U.S. interest equalization tax,
which, as Paul Volcker has explained, was devised in very much of a hurry.
We certainly were not informed in advance. Robert Roosa blamed it all on a
bureaucratic mistake in the U.S. Embassy in Tokyo, but it was a big shock
nevertheless. Our stock market collapsed, falling by almost s percent in a
single day. We felt that this would really kill us. because until then the
major source of long-term development capital for Japan had been the New
York market.

Like Canada and some ot the developing countnes. the Japanese

government rushed a special delegation to Washington and New York to
negotiate an exemption. Finance Minister Kakuei Tanaka was first asked to
lead the delegation but refused. Then Kiichi Miyazawa. director ot the
Economic Planning Agency, was appointed, but he came down

IN THE THICKET OF BRETTON WOODS

with acute appendicitis. Finally the thankless task was left to our taciturn
foreign minister, Masayoshi Ohira. The appeal didn't work. The United
States Treasury was very tough, very uncompromising. It failed to show
any sign of sympathy. So we had to come back empty-handed. Only in
1965, after eighteen months of pleading and lobbying, was Japan granted an
exemption of $100 million in borrowings each year. By that time, Japan's
balance of payments situation had improved substantially, the economy was
much strengthened, and there was not that large a demand for long-term
borrowing abroad. Only $63 million of this $100 million exemption was
utilized.

One reason we had no great need to pick up the full exemption was that
after our request was first denied, we had no other recourse but to shift
during 1963 and 1964 to the European capital markets that the Treasury
maintained were charging higher prices because they were allegedly so
much more inefficient than New York. The Japanese government and its
agencies raised $118 million in London, Frankfurt, and Zurich. For Japan,
the interest equalization tax certainly did have an impact: It shifted our
sources of capital to Europe and also taught Japanese industry the
advantage of generating its own reserves. And in hindsight it certainly did
major damage to the New York capital market, because Japan was not the
only country to shift to Europe. This became a major factor in the rapid
expansion of Euromarket and the rather volatile movement of international
capital, which contributed to the instability of the Bretton Woods system in
the late 1960s.
We remembered the lesson of the interest equalization tax for a long time,
or at least I did. In 1984, the yen was being weakened by a large outflow of
capital from Japan, especially for investment by insurance companies in
long-term United States Treasury bonds that gave better yields than
Japanese Treasuries and were financing the Reagan administration's
deficits. The trade account was in surplus, and international criticism
naturally arose of this weakening yen as an unfair trade advantage. So
politicians were very much concerned, and they came up with the idea of
capital controls and put strong pressure on the Finance Ministry. I then was
director general of the ministry's International Finance Bureau, and I
resisted, and I think I was right. I somehow managed to avoid the
imposition of capital controls by persuading the politicians with the
argument that Tokyo was just in the process of becoming an international
capital market, and I did not want it to repeat the experience that New York
had suffered in the 1960s. It is easy for

CHANGING FORTUNES

a market to lose its credibility, and restoring it takes a very long time.

In addition to the private markets, between 1956 and 1962 the United States
Export-Import (Exlm; Bank supplied S405 million in long-term finance for
Japan's purchase of agncultural products, aircraft, and much else. But the
major source of long-term capital for Japan was the World Bank, and Japan
was a very heavy borrower in those days. From 1955 through 1966, more
than ten years. Japan borrowed a total of S863 million from the World Bank
at interest rates of between 4.5 and 5.5 percent. The money was used for the
renovation of steel mills, power plants, highways, and railways. Most ot
Japan's postwar infrastructure was built with the financial help of the World
Bank, and in Japan's postwar recovers- and rapid development, the role
played by this institution was really immeasurable. Our final repayment was
made only in February 1990. and when Barber Conable. then the president
of the World Bank, came to help us celebrate, he said, perhaps only half as a
joke, "I really hate to receive this repayment, because now we need good
debtors."
So foreign borrowing was very important in helping the Japanese economy
to recover and grow. We were fortunate to have been able to utilize it
efficiently to enhance our competitiveness and productivity, so that it could
lay the groundwork for accumulation of our domestic capital in later years.

In international monetary negotiation, gold was a focal point of all

discussions. Japan was unique in having an almost negligible amount, only
S23 million, of gold in it at the end of 1957, because when

the war ended Japan had almost no gold left—it had been used up by the
military. So we started almost from scratch as far as gold was concerned.
There were rather strong arguments among politicians and even among
officials for increasing our gold reserves, because it was obvious that unless
you had some gold in your reserves, you really could not participate in
those international discussions because nobody would pay any attention to
you. So we made some efforts to increase our gold reserves, but the
increases didn't materialize. The major reason was that we did not have
much money to buy the gold. When you have only $2 billion in reserves,
you have to maintain them in a very liquid form to use in trade and
international payments, which in those days were made almost exclusively
in dollars.

Since most international transactions were earned out in dollars, there were
strong arguments in the 1950s against converting them into

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gold. This created a sort of unspoken political pressn

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1 matter of tact. I think the size of our gold reserve

our status in international monetary discussions. The tac

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greater role in the system, and that position was mam

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Eke many others did what this argument was all about. It was too techni
anyway were to be abstract, nontracbhle entries in the a members. Among
politicians, there was a generally en SDRs. because they simply assumed
that when SDR Japan's reserves would be in crease d and that would decn

?»R creation became too easy and too arbirrar innanonary bias in the world
economy, so I think at a

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CHANGING FORTUNES

good device for the world economy as a whole.

And in fact, immediately after the SDR was created in 1971, a group of
Japanese politicians visited Washington, and while there they called on the
managing director of the IMF. And after some polite conversation, the
leader of the group asked the managing director, "Could we have a look at
the vault where you keep these SDRs?" And you cannot laugh at him,
because I am sure many people in other countries shared his idea of SDRs
at the time.
With its tremendous growth and prosperity, Japan in the 1960s began
serious efforts to become a member of the inner circle of the world's elite.
Our first step was made in i960, when Japan joined the Development
Assistance Committee (DAC) of the Organization for Economic
Cooperation and Development, even before Japan joined the OECD itself.
There was still a very strong argument in Japan against our participation in
the DAC. Just as in the debate on buying gold, the other industrialized
countries questioned whether a growing country that was still borrowing
ought to join this aid-giving group of countries. But I think that was a very
good step for Japan. In 1962, Prime Minister Hayato Ikeda made his first
European tour and wanted to remind European countries of our
participation in the OECD, which he thought very crucial. He visited many
European capitals, and when he met President de Gaulle in France, he
talked enthusiastically about the development of the Japanese economy and
the progress in Japanese industries. After he left the Elysee Palace, de
Gaulle, in a remark to an aide, is said to have dismissed Ikeda curtly as
acting more like a salesman of transistor radios than a prime minister.

I think Ikeda nevertheless left a very strong impression among European

countries of Japan's economic achievements, and in the same year Japan
pledged the capital to become a founding member of the General
Agreements to Borrow, which supplements the financing available to the
IMF, and thus joined the Group of Ten, the main forum for international
monetary discussions. In 1964, Japan acceded to Article 8 of the IMF by
lifting restrictions on current transactions and making the yen convertible. It
also became a full member of the OECD, where it was immediately invited
to become a member of the inner circle forum, Working Party Three, of
which I served as chairman from 1988 to 1990. Japan also was invited to
join the Bank for International Settlements (BIS) in Basel, which is the
central bankers' bank and another major international financial forum.

IN THE THICKET OF BRETTON WOODS

So by the middle of the 1960s Japan was a full-fledged member of the club
of advanced industrial countries. This progress certainly gave the Japanese
a great sense of satisfaction, but I have to say, it gave them a little bit of a
sense of unease. If you go to the OECD, the delegates meet in a large,
elegant conference room, and there are twenty-four countries around the
table. And when the Japanese delegation for the first time found itself in
that room, it was the only delegation whose members all had straight black
hair, the only non-Caucasians. That situation continues to this day. I went to
the BIS meeting in Basel as an observer in 1967, the year that the Cultural
Revolution was sweeping China. Red Guards were rampaging there, and it
was of high concern to neighboring Asian countries, includingjapan. But at
the BIS meeting, central bankers from all the European countries gathered;
had cocktails, luncheons, and dinners; and talked endlessly about gold, the
dollar, and the pound sterling, switching among English, French, and
German. But there was absolutely no interest shown in the upheavals going
on at that very moment in China. The Vietnam War was at a very critical
stage, but apparently those bankers had very little interest in such events
outside their sphere. I thought uneasily, this is a group of people for whom
the world still stops west of the Dardanelles.

So while Japan became a statutory member of the elite group, we quite

obviously did not become an active member. And the rest of the world, the
United States and Europe, did not expect Japan to play a major role. There
was not yet a Group of Five; Japan was not invited to join the gold pool;
and although revaluation of the deutsche mark and devaluation of the pound
and similar urgent currency issues were discussed in the Working Party
Three and elsewhere, Japan was not in a position to get involved in those
discussions. But we could not complain about that because although we
might have liked the idea of being, on the main stage, we were not ready yet
to be a major player. The experience and still-strong memory of wartime
defeat and total subordination to United States policy during the occupation
period greatly discouraged Japan from taking an active and visible role in
international affairs. In that sense, international relations for Japan consisted
to a great extent simply of our bilateral relationship with the United States.
In those days the Japanese delegations to international conferences were
ridiculed as the "triple S" delegations: smiling, silent, sometimes sleeping.

Such a low posture is not necessarily a bad thing. Domestically,

CHANGING FORTUNES
Japan was making a genuine effort to bring up her own economy and turned
in a splendid performance in managing it; we had no reason to complain
about or challenge the Bretton Woods system. The exchange rate of 360 yen
per dollar was considered overvalued when it was first introduced in 1949
because our major export items were not competitive in price, and indeed
our exports declined briefly afterward. However, Japanese export industries
quickly adjusted to the exchange rate, and in fact 360 yen per dollar soon
became very comfortable for them. At the same time, we in Japan could
enjoy the entire Bretton Woods regime while remaining quite willing to
accept the deficit country's burden of adjustment. Although Japan suffered
recurrent deficits, we complied rigorously with the IMF's conditions for
giving us short-term balance of payments credits. In those days, the
recommendations made by the delegations of IMF officials amounted to
almost a voice from heaven. The experience of the Allied occupation from
1945 to 1952 had made us extremely respectful of foreign authorities.
Furthermore, we were very obedient to the advice of the World Bank and
the IMF because we had to borrow from them. Delegations from these two
institutions were treated like state guests. Irving Friedman, director of the
IMF's Trade and Exchange Restrictions Department, could easily have a
meeting with Prime Minister Ikeda and preach to him on appropriate
economic policy.

Luckily, Japan had no Vietnam, no arms race, no steel strikes, like the
United States. Japan had no colonial problems, no domestic unrest, like the
United Kingdom or France. So when Japan was brought into international
monetary discussions with the United States or European countries, I think
we Japanese had a very naive but genuine sense of puzzlement that they
were making a fuss about international monetary instability without really
putting their own houses in order. I think that was a very genuine, very
naive feeling on the part of some Japanese. However, in this state of rather
complacent aloofness, I'm afraid Japan failed to recognize that the Bretton
Woods system was becoming unsustainable, and more important, that Japan
herself was coming to be viewed as a threat to the system, because of her
apparently selfish aloofness. The gap was widening between Japan's self-
portrait and the important role she had started to play in the world economy.
And in 1970, Japan was forced to face this reality when the Bretton Woods
system began breaking down.
PAUL VOLCKER

OVERVIEW

The divisive experience of Vietnam cast a shadow over much of American

life in the early 1970s, and economic performance was no exception. The
growing inflationary pressures toward the end of the 1960s eventually
produced interest rates that were unusually high by the standards of the day,
and the record-breaking expansion gave way to a relatively shallow and
short recession. But the recession did not really break the back of the
inflation, and concern rose as the consumer price index remained close to 4
percent, around its highest level in twenty years, despite excess capacity
and rising unemployment. That only exacerbated the European fears that
the United States was exporting inflation and led to further doubts about the
underlying competitive position of American industry.

By the beginning of the new decade, the great surge in Japanese production
had overflowed into ever higher exports. Japan had only begun to
accumulate dollars, and was quite content to hold them while building its
international reserves. But the apparent strength of the Japanese competitive
position raised more pointed questions in the minds of many American
businessmen about the desirability of a fixed

CHANGING FORTUNES

dollar exchange rate and the ability of the nation to maintain it. Moreover,
the academic community, at least in the United States and Germany, was
increasingly willing to challenge the dogma of fixed exchange rates.

That was the background to the rearguard action defending the dollar and
the system well into 1971. Shortly after the middle of that year, the dam
broke. On August 15, 1971, the United States declared it would no longer
freely convert official dollar holdings into gold. Convertibility would be
restored only in the context of a thoroughly reformed monetary system and,
by implication, of realigned exchange rates making American companies
more competitive in world trade. That decision provided the focus for the
Nixon administration's New Economic Program, involving a temporary
freeze of wages and prices, a package of tax and expenditure reduction, and
a controversial surcharge on imports that was designed to be bargained
away for a more competitive exchange rate for the dollar. Despite the
growing sense that the Bretton Woods system was unraveling in the
immediately preceding months, the nature and scope of the program was a
surprise. There was a sense of shock abroad, particularly in Japan. At the
same time the sense of relief in the United States was palpable, and at first
stock and bond markets rose sharply.

The bargaining over an exchange rate realignment was prolonged,

contentious, and to some an alarming portent of a breakdown in
international cooperation. Agreement on new exchange rates was finally
reached in December at a meeting in the old Smithsonian Institution castle
on the Mall in Washington. While very little progress had been made
toward fundamental reform of the Bretton Woods system, it also became
apparent that the threat of protectionism and extreme monetary disturbance
had receded.

Indeed, the American economy responded to the new program with a

vigorous expansion and, under the shield of controls, with greater price
stability. In Japan, where the shock was the greatest, the momentum of
growth was scarcely affected. It all provided a strong backdrop to Richard
Nixon's campaign for reelection. But, in the end, it was only one act in the
larger drama of moving toward a very different monetary system.

BREAKDOWN

IN THE NIXON TREASURY

Looking back on the end of the Bretton Woods system, which had become
for me a way of life, still makes me wonder if there was any point at which
it could have been saved. I don't know exactly when the breakdown passed
the point of no return, but it was clear by the time I became Undersecretary
of the Treasury for Monetary Affairs in January of 1969 that its survival
would at best be a close-run thing. In the United States, those with influence
both in and outside government were feeling increasingly constrained in
their economic and political choices. Abroad, we were fighting a war in
Vietnam. One reason the war was badly financed was that no public
consensus had ever been developed in support of it, but whatever the
reason, that added to the pressures already weighing on the dollar.

Presidents—certainly Johnson and Nixon—did not want to hear that their

options were limited by the weakness of the dollar. Consider the issue of
maintaining our troops in Germany and Japan. It would be a gross
oversimplification to boil all that down to a calculation of how many U.S.
divisions abroad were worth how much loss of gold. But those of us on the
financial side certainly thought that the stability and strength of our
currency was important to sustaining the broad role of the United States in
the world, and that consideration had to be cast into the balance of decision
making. Those responsible for security affairs, typically beginning with the
president, were inclined to view the dollar problem as something we should
make go away, presumably painlessly.

Big issues like this seldom are resolved in some grand and lasting
intellectual and political consensus; instead, they nag away at decision
making month after month, year after year. At least that was the case as the
new administration took office, and the lack of resolution contributed to a
sense of unease about the international monetary system. Those responsible
for national security had, as usual, their agenda. What was different was
that some of the prominent economists taking office were ready to
challenge the basic elements of the Bretton Woods system. In particular
they were willing to accept the phrase "benign neglect" as a fair description
of their policy preference of more or less ignoring the problems of the
dollar and the balance of payments.

That phrase had been used years earlier by the administration's in-house
intellectual, Daniel Patrick Moynihan, in a totally different context; he was
appealing for a period of calm and consolidation in civil

CHANGING FORTUNES

rights after the great advances and social upheavals of the 1960s. But
benign neglect became fighting words in the black and civil rights
communities, and its association with U.S. international economic policy by
parts of the press, especially abroad, similarly helped rile relations with our
trading partners.

The fact is the association of the phrase with U.S. international monetary
policy was mistaken. Benign neglect was proposed by some critics of
established policy, including the distinguished professor Gottfried Haberler,
who had first taught me international economics at Harvard twenty years
earlier. Their complaints centered on the growing emphasis the previous
administration had placed on capital controls, on "window-dressing" the
balance of payments data to shore up confidence and, most important, on
the danger seen by some that domestic policy might be tilted too much
toward protecting the dollar. As far as I was concerned, the potential for
controls and financing gimmicks had been pretty well exhausted. But if we
in the Treasury weren't nearly as imaginative as our predecessors in
thinking up new ways to show our concern for the problem, there was no
doubt about my own feeling that the issue of the dollar could not be
neglected. On the contrary, the question was what could be done in a more
fundamental way to strengthen the dollar and preserve the system.

Questions keep recurring to me when I think back to that period. With the
world enjoying the sort of economic expansion that it had never before
experienced, why was there so little sense of commitment to an
international monetary system associated with that performance? Shouldn't
the United States have been more rather than less responsive to the
discipline of the system in shaping domestic policy? Apart from any
concern about the international system, shouldn't we have heeded the
warning signals about inflation and the dollar that the exchange markets
were sending us, if only for our own good?

Surely, there were times when our monetary policy had been influenced by
our commitment to maintain the dollar as the sun of the system. But was it
influenced enough? Specifically, shouldn't the concerns about the system
have been brought to bear more powerfully on decisions about the financing
of the Vietnam War? That was the period when inflation really gained
momentum in the United States and threatened to spread to Europe too, and
if we weren't willing to finance the war properly, then maybe we shouldn't
have fought it at all. To me, the people responsible for an earlier period of
world growth and prosperity,

BREAKDOWN

the Pax Romana, had an appropriate phrase: res ipse loquitur —the thing
speaks for itself.

Of course, with the best will in the world to make it work, the basic design
of the Bretton Woods system might have been so flawed that its breakdown
sooner or later would have been inevitable. For one thing, the postwar
system, like the gold standard before, depended heavily for its practical
operation on one strong country able and willing to take the lead in
managing and protecting the system.

For the United States, there were some real benefits in having the dollar at
the middle of the system. It did accord us flexibility in financing and some
flexibility in policy. But for the system to work, there were real costs, too.
One of these was a special responsibility for maintaining a sound currency
upon which others could depend. Can any fixed-rate system operate without
a dominant world power ready to provide responsible leadership and to
maintain discipline? In the jargon of political scientists such a dominant
nation is called a hegemon, and that was the role the United States had
played reasonably well for more than twenty years.

I suppose what happened in the late 1960s could be interpreted as an

example of what the historian Paul Kennedy calls "imperial overstretch,"
and Vietnam was the point at which we snapped. But it's a nice question
whether the United States had somehow subconsciously decided to abdicate
its responsibilities to the system, or whether any system so heavily
dependent upon one country can last through a period of such profound
change in the economic landscape as the shifts that took place in the relative
position of the United States and its partners in the Bretton Woods system.
When I bemoan what the United States might have done, one of my old
associates at the Treasury, Sam Cross, remarks, "If you postulate a system
that depends upon one country always following the right policies, you will
find sooner or later that no such country exists. The system eventually is
going to break down." There is wisdom in that comment. I am ready to
accept intellectually that, given enough time, any hegemon will become
either tyrannical or just plain fat and sloppy. But as I took office as
undersecretary of the Treasury, I was not prepared then to accept passively
that the breakdown would be inevitable within a single generation, nor do I
believe that today.

The tale we have to tell here is that there is no simple way out of the
burdens of leadership. I had a wonderful vantage point for observing those
difficulties, largely because I was well known to Charls Walker,

CHANGING FORTUNES

who had been designated as undersecretary of the Treasury in the incoming

Nixon administration. Charly loved to play on his Texas "country boy"
background, but he was always deeply interested in public policy, politics,
and banking, in about that order. I had known him for years as a Federal
Reserve economist and later as head of the American Bankers Association
in New York. He suggested my name to David Kennedy, Richard Nixon's
first secretary of the Treasury.

David Kennedy had no connection to the Massachusetts Kennedys; he was

a widely respected banker in his mid-sixties who, in his typical low-key
way, had led the Continental Illinois Bank to a position of solidity and
leadership. (Ironically, long after his retirement, Continental became the
first of the large banks laid low by the excesses of the 1980s, and, as
chairman of the Federal Reserve, I was fated to be the one to call in the
federal rescue team.) Kennedy, with his dignity and snow-white hair, was
the epitome of honesty and openness. At the end of an honored business
career, he had no driving ambition to dominate, and he was used to
delegating responsibility. While I never probed to learn the full story, it
became clear to me later that once he had settled on me as his choice as
Undersecretary for Monetary Affairs, he insisted on it over political
opposition. I was, after all, a Democrat, if not an active one, and Pat
Moynihan and I were the only Democrats at a high level in an
administration suspicious that it had inherited far too many civil servants
sympathetic to the opposition.
i^n inauguration day I sat down in my new office in the Treasury with a fine
view of the parade as it passed by my window. A memorandum arrived
from the White House with, as I recall it, the title of "National Security
Study Memorandum Number Two." I clearly had not been on the list for
Number One but, after all, Number Two was not bad. I didn't really know
what a National Security Study Memorandum was in those days, but since
it was signed by Henry Kissinger on behalf of the president, it was
obviously something to be taken seriously.

The memorandum described administrative and other arrangements for the

conduct of international monetary affairs by the new administration. It
designated the Undersecretary for Monetary Affairs—the position to which
I would be nominated—to chair an interagency committee on the subject.
The previous administration had such a group, so that was no striking new
initiative, but it was nice for me to have my bureaucratic position
confirmed. The memo also said that in that capacity I should report to
Henry Kissinger at the National Security Council. That was unusual news
to me, being in the Treasury Department. I went

BREAKDOWN

running to Secretary Kennedy's office and said, "You'd better take care of
this quick, because it seems to cut you out of the loop." He was not very
close to Mr. Nixon at the time, and I sensed his hesitation about what to do.
I always suspected he just ignored that part of the directive, because that's
certainly what I did. Henry Kissinger had other things to worry about
during those days. Besides, one of his able stable of assistants, Fred
Bergsten, was a member of the interagency group, and I knew he was fully
capable of keeping Henry informed. I never heard another word about it,
and I suspect papers on the intricacies of international monetary affairs
ended up at the bottom of Kissinger's in-tray, assuming they ever got that
far. But it was to me an interesting lesson in bureaucratic one-upmanship.
Kissinger had been designated to his position many weeks earlier, had a
staff in place, access to the president, and an instinct to make good use of
his head start.

I was fortunate in my position for another reason. Thanks to a series of able

and respected predecessors, I had a solid organizational base, well
recognized both in Washington and internationally. But perhaps more
strongly than before, others in the administration thought they had a
mandate of their own in monetary affairs. One or two had served on a
Nixon campaign task force on international monetary affairs; members had
been drawn largely from the academic community and were sympathetic to
a variety of ideas about more flexible exchange rates. Their task force
report never had any official status and was kept secret, presumably because
of radical ideas that would have disturbed the exchange markets. Once in a
while there would be murmurings to me by members of the group that the
report was, in fact, the official doctrine of the administration.

I was never given the document, and I never had reason to think the
president ever saw it or was influenced by it. The relevance of this is only
that strands of opinion in the administration were clearly identified with
favoring exchange rate flexibility, and they were represented most strongly
by Professor Hendrik Houthakker of Harvard, who had been appointed to
the Council of Economic Advisers. In his personal manner, Henk was
unfailingly modest and courteous, but to me he was something of an
unguided missile as he visited his counterparts around the world. Questions
and conversations that would have been unexceptional in the academic
world caused a certain amount of confusion about American objectives
when coming from a proverbial "high administration official."

I was also in the dark about the role of Arthur Burns in this area after

CHANGING FORTUNES

his appointment as counselor to the president. A former chairman of the

Council of Economic Advisers, Arthur had long been the distinguished
chairman of the National Bureau of Economic Research, the leading
authority on business cycles, and a friend and adviser of Mr. Nixon since
his vice presidency. He had made a trip to Europe before the election, and
while he had not previously been known for an interest in international
monetary affairs, somehow the suspicion arose, justifiably or not, that he
was canvassing the possibility of an increase in the gold price. The story
gained a little more credence when Secretary-designate Kennedy, in an
unguarded response to a question at a press briefing in December, said he
wanted to "keep every option open" on the price of gold. He drew back
from that when he realized the implications for the markets of such a
statement by a Treasury secretary, and I never had any sense that the
president came into office with any strong view on the monetary system.
On the contrary, it seemed clear to me that we had to go to work in the
Treasury, and through the interagency "Volcker group," to develop an
approach.

With unemployment low and inflation rising, we were fortunate that

monetary policy became quite tight in the United States during 1969. We
were at the end of the long expansion of the 1960s, and although it doesn't
sound like so much now, the Treasury bill rate went up to 7.25 percent by
December and bond rates were 8 percent, higher than in anybody's memory
at that time. With tight money sucking short-term capital into the United
States, foreign central banks had to sell dollars. Gold, instead of flowing out
because of uncertainty about the dollar and U.S. intentions, actually flowed
toward the United States. As the year wore on, the European complaints
about the United States exporting inflation gave way to complaints that our
monetary squeeze was restraining their economic activity. All that was
temporary, but it gave us valuable breathing room to consider our position
calmly.

By that time, even though the U.S. trade and current account remained in
surplus, it was impossible to dismiss the idea that our balance of payments
problem had become chronic, and that one day a change of some size would
be needed in the exchange rate of the dollar. At the same time, I was far
from wanting to act upon something so important when the outcome was
still quite uncertain. Furthermore, it was clear we could not manage an
abrupt change, maybe any change at all, without undermining the whole
system. One report on a conversation that Henk Houthakker had held with a
European Community official

BREAKDOWN

did help to put the problem of our exchange rate policy in its proper
perspective. Asked what Europe would do if the dollar were devalued, the
Community official replied, "All European currencies would be devalued
by the same percentage on the same day."
The interagency group on international monetary affairs produced a paper
that discussed the situation at exhaustive length, and my summary set forth
options for the president. A change in the gold price, as a means of
achieving an exchange rate change, was included among those options
more, as far as I was concerned, for the sake of completeness than any
sympathy with the idea. We concluded that a "small change" of perhaps
about 10 percent would be destabilizing without any clear prospect of
achieving anything constructive because of the risk that other countries
would simply devalue with us and additional changes would be expected.
That would undercut the willingness of foreign central banks to hold
dollars.

A stronger case might have been made for increasing the dollar price of
gold by a large amount, perhaps even doubling it. However, the effect on
world reserves would have been quite uncertain. One strong possibility was
that dollar holders, who would have suffered an enormous loss relative to
those holding gold, would turn in all their dollars at the new price and
forswear all future dollar holdings. That was the Gaullist view of what
should happen, but it was hard to see any lasting advantages in it for the
United States.

Alternatively, gold holders might be convinced the price had been raised so
much that it would be pointless to speculate on further increases for many
years. As they sold their gold and took their profits, dollar holdings would
increase, resulting in an enormous increase in world liquidity. One thing
was certain: The ultimate result of such a move in terms of exchange rates
and international reserves was highly uncertain. No one pressed the idea.

Of course, more than economics was involved; there were matters both of
equity and prestige. If the price of gold were doubled, who would really be
helped? The two big gold producers, South Africa and the Soviet Union, for
sure, and those who had been buying gold, led by the French, who had been
our negotiating antagonists. And who would be hurt? The Japanese, who
had never bought any gold from us and who depended on the dollar, and
other countries, including most of the developing countries, who took us at
our word in holding dollars.

The paper discussed floating and ways of introducing more flexibil-

CHANGING FORTUNES

ity into the Bretton Woods system. The preferred option appeared under
what I hoped was the seductively attractive label of the "evolutionary
approach." Basically it called for policy continuity, although none of it
would be much welcomed in the G-io discussions.

First, given that Special Drawing Rights had been agreed upon in principle,
we proposed actually to create some—to "activate" the scheme, which
required a strong consensus among IMF members. We believed there was a
clear economic case for increasing world reserves, and doing so by means
other than a U.S. deficit. The case was reinforced by the likely absence of
any flow of new gold into central banks following the creation of the two-
tier gold market. Part of the idea was psychological: to demonstrate we
could work together to strengthen the system. Second, the United States
was to explore quietly the possibility of introducing some new techniques
for putting greater flexibility into the exchange rate system.

Those ideas fell far short of floating or abandoning the gold/dollar system.
Nonetheless, my enthusiasm for the second part of the effort was distinctly
muted. The atmosphere at the time among my European colleagues was
graphically conveyed to me on my first trip to a WP3 meeting in Paris after
I took office. The custom then, as the problems and discussion of them
seemed ever more delicate, was for a core group (which did not include the
Japanese) to retreat for dinner to the suburban home of one of the OECD
ambassadors. Arriving in the dark after a confusing drive, it was to me a
rather mysterious hideaway. My traveling counterparts were surely curious
to know the views of the new administration, and they were at least as
anxious that I learn the depth of their concerns. It was not long before a
European finger was being shaken in my face with this remark: "If all this
talk about flexible exchange rates brings down the system, the blood will be
on your American head."

That remark was extreme, but in fact it would be difficult to talk publicly
about increasing the flexibility of exchange rates without promoting
speculation. The markets would move against the dollar because there was
no doubt that exchange rate flexibility meant depreciation of the dollar and
appreciation of some of the currencies of our trading partners. In
recognition of the danger of destabilizing speculation, most of the schemes
for "crawling pegs" or "gliding parities" that were being spawned in
academe called for quite gradual changes of parity by, say, a small fraction
of a percent a week, or a month. There was great doubt

BREAKDOWN

in my mind that we or others could rely on such small and prolonged

changes to correct our disequilibrium. Once the principle of easy exchange
rate changes, however small, was agreed, it seemed to me that speculative
pressures in the market would make it extremely difficult to resist larger
changes and would probably cause them quickly. It was precisely those
questions and difficulties that plagued the European efforts to fix rates
among themselves later in the 1970s. Experience strongly suggests that a
"flexible fixed-rate" system is more than a verbal oxymoron; it has inherent
contradictions that tend either to tear it apart or to drive it to greater fixity.

While these debates were going on about possible reforms, the real world
experienced a small monetary tremor. Without any forewarning officially or
in the marketplace, and acting in the midst of the August vacation season, a
new French government devalued the franc. Because money was so tight in
the United States, the decision did not pose an immediate threat to the
dollar. Nonetheless, the action was bound to add uncertainty over time, and
when my French counterpart, Rene Larre, called to tell me of the imminent
announcement, he anticipated my discomfort and could not refrain from a
note of irony: He said he hoped the devaluation didn't cause us too much
trouble. Actually, months earlier in our report to President Nixon, I had
written that a French devaluation was probable, so only the precise timing
came as a surprise. What did make an impression was the finesse with
which Valery Giscard d'Estaing, who had returned as finance minister in the
new Pompidou government, had pulled it off. No hints in the market, no
rumors, no gossip; it all seemed so elegant, devaluation without pain!

However neatly done, it was to us more evidence of the bias in the system
that came from leaving the dollar as the "nth" currency, overvalued. The
French move predictably added to speculative pressures on sterling.
Another British devaluation, for all the short-term strength of the dollar,
almost surely would have precipitated a general crisis. I had greatly
admired the skill and determination with which the British government,
with Roy Jenkins as Chancellor of the Exchequer, warded off the market
pressures in the face of a string of monthly trade deficits. I sensed we were
out of danger only when, in the course of a European trip, he invited me to
visit his thatched cottage in the country on a rainy September Saturday.
Over a pre-lunch sherry he told me the latest monthly British trade balance.
It was a surprisingly large figure, he said gravely. Then he added with a
little smile, "Plus, you know."

CHANGING FORTUNES

Instead of a British devaluation, late October brought a much jrnore

welcome German revaluation. In the midst of election uncertainties and the
exchange market sensitivities that seem often to precede annual meetings of
the IMF, speculative flows into the mark had precipitated a decision to float
the currency, awaiting a definitive decision of a new government. In office,
the coalition of Social Democrats and Free Democrats reset the mark parity
upward by 9.39 percent.

So in the space of three months, by independent decisions the French and

German governments had put in place what had proved impossible almost a
year earlier in the Bonn fiasco. General de Gaulle, who had been unable to
reconcile a negotiated French devaluation with his nation's honneur, had left
the field and retired to his country home in April 1969. A self-confident
Karl Schiller, taking office in a new Social Democratic government in
Germany, was able to accomplish the revaluation that had been such a
matter of controversy with his conservative Christian Democratic partners
in the previous "grand" coalition.

Meanwhile, the SDR negotiations were crowned with a considerable

measure of success. Agreement was reached to create the equivalent of $9.5
billion, spread over three years starting January 1, 1970. That was a little
below my highest hopes but a nice number, large enough to provide some
reassurance that governments were not immobilized in finding ways to
manage an orderly increase in reserves.

Nevertheless, concerns about the dollar were about to take center stage
again. With the economy moving into recession at the start of 1970,
monetary policy was relaxed under the new chairman of the board, Arthur
Burns, who had taken office in the autumn of 1969. The short-term capital
flows reversed with a vengeance. Our trade surplus actually increased, but
that was thought to be temporary, related to the recession. The overall
balance of payments moved into deficit, with the total for the year
approaching $10 billion, a multiple of any previous numbers.

More ominous, because it was unrelated to fickle capital flows, was the
clear evidence that the new industrial power of Japan was spilling over into
world markets. The speed of the change was brought home to me while I
was waiting to speak at what was in those days an unusual meeting of
important American and Japanese business executives. Leafing through
some standard State Department briefing material that had been distributed,
the appropriate theme for my remarks became apparent. The official
American government brochure about the Japanese

BREAKDOWN

economy described it as fragile, vulnerable, and prone to recurrent balance

of payments difficulties. That description plainly no longer fit the facts,
although it had probably been written only two or three years earlier.
Certainly, the American businessmen knew it didn't fit what they were
seeing in the marketplace. I was not at all sure, however, that the Japanese
representatives comprehended the complaints all that well.

That was when I came to hate early phone calls, before I left for work. An
able Treasury civil servant, Page Nelson, had the unenviable job of getting
to the office early, checking the exchange markets, and receiving reports on
the latest movements of the dollar. If the phone rang, I could anticipate it
was Page asking for guidance on some request from a foreign central bank
for gold, or if not gold, for a Roosa bond or a swap drawing of some foreign
currency to protect against a devaluation of the dollar. If there was no phone
call, I knew the news was good, and it could wait until I arrived in the
office. But, at the rate dollars were piling up abroad, the telephone bell was
ringing all too often.

As 1970 wore on, the administration was feeling blue for other reasons. The
recession wasn't all that deep or all that long, but the recovery didn't seem
all that vigorous either. Worst of all, consumer prices continued to increase
close to the rate reached in the expansion. The ungainly phrase "stagflation"
seemed to fit the circumstances. By subsequent standards, inflation at about
4 percent doesn't look anywhere near high enough to provoke talk of price
controls, but then it did.

By year end, some were talking of the possibility of "shock treatment" in

the form of a wage-and-price freeze for a few months to jar us back to a
more stable path, and a few of us in the Treasury urged that course on
Secretary Kennedy. Arthur Burns, from his platform at the Federal Reserve,
openly called for a strong incomes policy and controls.

In the middle of all this unhappiness, a significant event occurred for me

and for monetary affairs. David Kennedy resigned, making himself a kind
of token sacrifice for the economic malaise, and John Connall/ from Texas
was appointed secretary of the Treasury. None of us in the Treasury knew
Connally. Charly Walker, from his Texas contacts, reported that all the
evidence was that he was a couth Lyndon Johnson. A protege of Johnson's,
he had been secretary of the navy under John Kennedy, returned home to be
elected governor of Texas, was shot and gravely wounded while riding in
the car with President Kennedy when he was assassinated in Dallas. He was
a man who knew his way around government and had greatly impressed
Nixon with some work he had

CHANGING FORTUNES

done on a commission to reorganize the government. He was a Democrat

but plainly not a despised Establishment liberal, and the president was
attracted by his vibrant, forceful personality, as many of us were later.

One thing he was not: He was not a great figure of international, or even
domestic, finance. None of us knew what to expect, and I know he
surprised me in a number of ways. I assumed that a new man, and this one
was a politician to his fingertips, would surround himself with some of his
old associates. He did not. All of us were asked to stay put. I also thought
we would have difficulty communicating about the mysteries of the
monetary system. We did not.
I still remember the sense of relief I had in my first substantive briefing. He
quickly brushed aside my recital of where we stood on the balance of
payments, crawling pegs, wider margins, the intricacies of the SDR, and
other arcane details. I confessed that I was greatly concerned that sooner or
later we would have to seek a substantial change in exchange rates, that the
adjustment would be strongly resisted, and that there could be large political
as well as economic ramifications. He plainly didn't need any instruction
from me on those points. He had an instinctive grasp of what motivated
men and governments and knew we would be in for tough negotiations.

Late in 1970, with the overall deficit rising and more gold losses, I asked
for something that almost certainly had never been done in the Treasury
before. In today's context of flexible exchange rates it would be perfectly
natural, but then it was a potential bombshell. Deliberately avoiding the
Treasury's large international division, where it would be hard to keep word
of my request from spreading, I asked one of the department's senior
economists, John Auten, to spend a month or two reviewing all the
evidence and literature he could find and tell me whether he thought the
dollar was "fundamentally" overvalued and by how much. John was a shy
ex-professor and worked pretty much alone in those days. I had brought
him into the Treasury a few years earlier and I knew he was well trained in
international economics, had an exceptionally clear mind, and would keep
quiet about the project. A while later, he reported back to me with a fat
memorandum saying that all the different approaches he could test
suggested that the dollar would need to be devalued somewhere between 10
and 15 percent to restore equilibrium, depending upon how many countries
would devalue with us.

Reinforced by that judgment, and more by the evidence of further

BREAKDOWN

deterioration in the current account, I prepared a written analysis for

Connally that reviewed where we stood and the options as I saw them. I had
no interest then in precipitating a decision, but we needed some
contingency plans. Our gold stock was getting down toward $10 billion,
less than half of what it was at the start of the 1960s. There were
psychological and other limits to how low we could permit it to fall. The
trade and liquidity position might not have passed the point of no return, but
the trends were clearly unfavorable. I was pessimistic on prospects for
negotiating a large enough change in parities to deal with the situation in
any circumstances short of a thoroughly reformed system, and I argued that
the negotiations could not be undertaken unless the gold window was
closed. I therefore concluded that, when and if the time came, we should
take the initiative and close off our gold sales as a prelude to a large
exchange rate realignment and necessary reforms in the system. Moreover,
those decisions should be combined with a price freeze and complementary
fiscal and monetary policies at home to restrain inflation.

None of that could have been a big surprise to Connally, but my

contingency memo apparently provided a vehicle for raising the issue with
a few other key officials. The memo remained in draft form and I took care
to have all copies returned to avoid leaks. At about the same time, an
energetic new White House assistant, Peter Peterson, had been assigned the
task of reviewing foreign economic policy. While he stayed out of our
preserve of international monetary policy, he wrote a report widely
circulated within the administration that helped explain and dramatize our
weakening trade and competitive position.

I held on to the hope that a major crisis could be avoided, but that hope
dwindled during the winter and spring of 1971. As the dollar outflows
continued, we learned that among themselves some Europeans had
canvassed the idea of a joint float of their currencies against the dollar.
French opposition and lack of enthusiasm by others made that impossible,
and in any case it would have been quite a feat without considerable
planning. People began dumping dollars for marks in the spring, and the
Germans received a deluge of our unwanted currency in their reserves.
Without a joint float to fall back on, the Germans responded in early May
by unilaterally permitting the mark to float.

That action, taken under heavy market pressure, was consistent with both
the strong free market philosophy of Karl Schiller, who combined the
powerful German finance and economics ministries under his au-

CHANGING FORTUNES
thority, and the deep concern of many in the Bundesbank about how to
protect the independence of their monetary policy. The earlier concerns of
Emminger and others about the inflow of dollars had been strongly
reinforced. The German monetary base would grow so rapidly, they feared,
that the Bundesbank would be unable to maintain a monetary policy
oriented toward price stability. The Germans were in effect saying that they
could no longer reconcile their traditions of autonomy in domestic
monetary policy and freedom for capital movements with the demands
made by fixed exchange rates. While no such sweeping interpretation was
made at the time, the implication was that the world's second largest
economy had decided to opt out of the system.

The German decision was welcomed by many both in the United States
government and outside it. It was, in their view, an important step toward
more flexible exchange rates and offered a path toward effectively
realigning the dollar. I was not so sanguine. It seemed unlikely that the
adjustments we needed could come about through that kind of piecemeal
action without destroying the system, and that further incentives to
speculation would only risk wrenching the initiative from our hands.

DEVALUATION

In May, the new secretary of the Treasury had his introduction to many of
the world's important personalities in high finance at the annual meeting of
the International Monetary Conference in Munich, which brought together
the leading commercial and central bankers. Atypically for a Treasury
secretary, he sat through all the meetings and the elaborate lunches and
dinners, quietly sizing up his audience and their thinking before delivering
the traditional closing address. Most of that speech was a restatement of the
American position, but it was put in a more demanding, forceful way:
Something had to be done; the United States could no longer single-
handedly "underwrite" the financial and trading system; while we wanted to
continue an open system, other countries must share more of the burdens,
joining with us in opening their markets, in providing aid, and in sharing
defense costs.

I had also drafted, as a conclusion, a vague paragraph about the need for
greater exchange rate flexibility. When I next saw the speech, it had a very
different ending, pure Connally in tone: "Helpful to the solution of any
problem is the understanding there are necessarily some unaltera-

BREAKDOWN

ble positions of any participant. Believing this, I want without any

arrogance or defiance to make it abundantly clear that we are not going to
devalue, we are not going to change the price of gold, we are going to
control inflation. ..." I asked him whether he was really sure he wanted to
say all that so strongly. I suggested that, after all, we might have to end up
devaluing before too long. He ended all discussion with words forever
imprinted on my mind: "That's my unalterable position today. I don't know
what it will be this summer."

So he gave the speech, and he delivered it so forcefully the audience sat

back in their chairs. Actually he had a little fever, a touch of the flu, and he
may have spoken even more forcefully than he intended. But there was no
doubt that he made an impression; this new man on the international
financial scene was going to make an impact.

By June it seemed to me Connally had become convinced the time was

approaching to act. Within the administration and the country, one of the
debates about economic policy was taking place that recur during prolonged
periods of unsatisfactory performance. Then (as when I write these words)
the core of the political concern was mainly about a sluggish recovery and a
stubborn inflation. Connally plainly favored a more activist policy,
including a price freeze. He did not, however, carry the day, and at the end
of the month, as chief economic spokesman for the administration, he
proclaimed the then celebrated "four no's": no price controls, no wage-and-
price review board, no tax cut, no increased federal spending.

By that time, working mainly with two trusted colleagues, Assistant

Secretary John Petty and our executive director at the IMF, William Dale, I
had begun to develop some operational plans for suspending gold
payments. We soon had a fat briefing book, and a plan in black and white:
the mechanics of withdrawing our policy of selling gold, an analysis of the
size of the change we needed in the exchange rate of the dollar, what kind
of openings for more trade we should seek from our partners, how we might
later restore some degree of official convertibility, and tentative plans for
monetary reform. There was a certain comfort in putting down in black and
white our plans for what all of us knew would be a leap into the unknown.
As the trade data for the spring months became available, they showed an
alarming deterioration. With the trade balance for the first time moving
sharply into deficit, all the "contingency planning" looked as though it
would soon be operational.

Secretary Connally was of course aware of all this, and he soon began

CHANGING FORTUNES

urging the president to act. He wanted me to supplement the plans in one

important respect and asked for homework on how a special tax or tariff
known as an import surcharge could be placed on goods being brought into
the United States. While there were a few precedents for that kind of action
by countries defending their parities, I was upset by the prospect that the
United States would go in that direction. I argued that it was logically
contradictory to an effort to achieve an exchange rate realignment and could
only be interpreted as antagonistic and protectionist. I hoped I had been
convincing and that Connally's request would go away. But when he
insisted upon seeing a memo soon, I couldn't procrastinate any longer in
seeking some help from legal and trade experts.

At the president's request, Secretary Connally also had undertaken some

briefing of Paul McCracken, the chairman of the Council of Economic
Advisers, and George Shultz, then head of the Office of Management and
Budget. By early August, I was told that the president was convinced of the
need to act, but that he felt he could not take the initiative while Congress
was out of session.

Connally decided to leave for his Texas ranch, but any chance of a tranquil
period for him down there was ended by another burst of speculation
against the dollar, reinforced by a congressional subcommittee report
calling upon the administration to float the dollar. The response I wrote said
basically that we did not think the subcommittee, and by implication its
activist chairman Henry Reuss, spoke for a substantial body of
congressional opinion. That was perfectly true but not exactly a robust
denial of the point. One thing was clear to me. We were on the brink of a
market panic that willy-nilly would force us off gold. If we were going to
take the initiative suspending the convertibility of dollars for gold and
present it as the first step of a considered and constructive reform package,
the decision could not wait until September. I called Connally and told him
so. He immediately decided to call the president and to return to
Washington.

Upon his return, I was told a meeting had been arranged of the principal
economic officials for that weekend at Camp David. Interestingly, no one
was invited from the State Department, by the president's decision. I had
worked well with Nat Samuels, the economic undersecretary at State, but he
was on vacation and could be only elliptically briefed. Henry Kissinger was
also absent, apparently, I later understood, because he was on secret
negotiations on Vietnam.

BREAKDOWN

I knew the odds were very high that we would close the gold window
before the Monday after the meeting, so I called Charles Coombs, who had
been for many years responsible for international affairs at the Federal
Reserve Bank of New York. Coombs had spent most of his working life as a
vital part of the Bretton Woods system, had helped mastermind the defense
of sterling, managed the swap arrangements with the club of central
bankers, and developed close and confidential relationships with his
counterparts abroad. He had been heartsick about the erosion of the system
and was not very happy about what he considered a halfhearted defense by
the administration, and by implication, me. I thought I owed him a last
chance to say his piece, so I called him to say: "The decision is going to be
made this weekend. You get down here, and I assure you I will get you
some time with Secretary Connally if not the president. Make your
argument, because this is the last time you're going to be able to make it."

When he arrived at the Treasury on Friday morning, he took a call outside

my office and returned absolutely crestfallen. The foreign exchange desk in
New York had called to inform him that the British had just asked for
"gold" for their dollar holdings of about S3 billion. If the British, who had
founded the system with us, and who had fought so hard to defend their
own currency, were going to take gold for their dollars, it was clear the
game was indeed over. The message to Coombs apparently had gotten a bit
garbled; I was told later that the request was for some combination of
"cover" to guarantee the value of their dollars, but not necessarily for gold.

One story circulated later that the British request precipitated our decision
to go off gold. That was not true. Demands for gold had been building from
other, smaller countries. The momentum toward the decision was by that
time, in my judgment, unstoppable. There was, however, a sense in which
those last requests for gold and guarantees were helpful; no one could argue
that the United States had reached its decision frivolously.

We arrived at Camp David early Friday afternoon. The president

immediately asked Secretary Connally to explain why we were there and
what the plans were. Connally summed up the situation in the markets, and
with clarity and conviction he laid out the package of measures we had
discussed for so long. While the president did not say much, the way the
meeting was conducted didn't leave any doubt that he was ready to support
Connally's proposals. We all had a chance to

CHANGING FORTUNES

speak our piece, and the only really active debate about the program was
over the import surcharge. As I remember it, the discussion largely was a
matter of the economists against the politicians, and the outcome wasn't
really close. I think the president had been convinced that it was both an
essential negotiating tactic and a way to attract public support.

Arthur Burns spoke forcefully against the heart of the program, the
suspension of gold payments. He argued that we ought to try to negotiate an
exchange rate adjustment "cooperatively," including an offer to devalue
against gold. Only if that didn't work would we be justified in falling back
and suspending the convertibility of gold. I had great sympathy for his
concerns. Of all the people there, he and I had been most committed to
working within the Bretton Woods system and most conscious of the
importance of maintaining a framework for cooperation, both institutional
and personal. But when directly asked, I had to tell the president that I did
not think it was at all a credible option to negotiate a new exchange rate
while keeping the gold window open.

I did not believe, and John Connally certainly did not believe, that we could
go to the Japanese and the Europeans and say, in effect, "Look, contrary to
all we've said for seven years, we want a big realignment of exchange rates.
Let's arrange it this weekend before the markets open on Monday." They
certainly would have refused, even if we had been willing to devalue
against gold. They would also immediately have been placed in an
intolerable position. How could they continue to hold and buy dollars in the
market and not convert them into gold? How could we possibly avoid leaks
of information and enormous speculation? And how would we cope with
that situation—other than to suspend gold payments right away, with the
appearance of defeat and the loss of initiative.

Arthur Burns had personal seniority among all of Mr. Nixon's advisers and
was given the opportunity to present his case more privately to the president
later. I don't know whether new points were made, but the outcome seemed
to me preordained.

I was disappointed on two counts in the decision making at Camp David.

First, I failed to obtain any real endorsement by the group of the appropriate
directions for long-term reform of the monetary system. Second, the
president did not, in his public comments, plan to reaffirm our intent not to
change the official gold price. I consoled myself that there would be plenty
of opportunity to deal with the fundamental reform issues later. Right then,
the gold question seemed more impor-

BREAKDOWN

tant because it would be bound to arise immediately, and we needed a

strong position.

A lot of time was spent at Camp David in dealing with what to me was a
side issue. In his election campaign, the president had promised textile
manufacturers more protection against imports, and he was frustrated and
angry about Japanese intransigence in reaching an agreement that would
effect his pledge. The dramatic New Economic Program seemed to provide
suitable cover for unilateral action. The difficulty was that the only legal
justification the lawyers could find lay in recourse to an old law called the
Trading with the Enemy Act, hardly a felicitous legal rationale for
restricting Japanese imports. But the threat of action under the law did soon
produce an agreement to carry out the campaign pledge that the president
apparently felt more strongly about than gold.

The meeting broke up into small groups. One dealt with price controls, one
with the surcharge and trade matters, and one with monetary changes. I was
fortunate in being able to ask for help from Michael Bradfield, then a young
Treasury lawyer and later general counsel of the Federal Reserve. I had
asked him for some preliminary legal work on both the price controls and
the surcharge, which were the most contentious and legally difficult areas.
With his help, a long press release describing the program and its legal
justification was ready by Sunday morning.

At Connally's request, I had gone up to Camp David with a hurried draft of

the speech in which the president would announce the whole program. I
suppose it was a typical devaluation speech, aimed at calming financial
markets and reassuring central bankers. It included a few of what I thought
were the obligatory mea culpas, along with promises to maintain internal
discipline, deal with inflation, and work cooperatively to reform and
improve the monetary system. Aside from a few of the technical points,
none of it ever saw the light of day.

The speech was clearly something the president would focus on personally,
and he went into seclusion with his chief speechwriter, William Safire. It
was quite a different speech that I saw on Sunday. Lo and behold, the
suspension of gold payments, something I had seen as threatening the very
system that I had spent much of my working life defending, had become a
bold new initiative. The international crisis provided a plausible rationale
for what otherwise might have been criticized as an abrupt and
embarrassing change in domestic policy. Forty-five days earlier, it was said
there would be no price controls; now

CHANGING FORTUNES
there was suddenly to be a freeze followed by a price-review board. It had
been said there would be no tax reduction; now there was to be some tax
reduction. The announcement that we would suspend gold payments came
near the end of the speech; that would hold the speculators at bay, and along
with the surcharge would put us back in command of the situation.

After the speech was delivered, on the night of Sunday, August 15, I
learned a good lesson about what masterful politicians can do. I had feared
that suspension of gold would be seen by Americans as a humiliation: that
the United States had been done in by foreigners, that the dollar that
Americans loved and treasured was being trashed, and that we ought to turn
inward, put up tariffs, cut off aid, and bring back the troops. But Mr.
Nixon's performance, followed up with enormous panache by Secretary
Connally's news conference on Monday, played it all as more of a triumph
and a fresh start. And, as it all worked out at home, it was a fresh start.
Stronger economic growth and reduced inflation made for a powerful
campaign platform in 1972.

Now, twenty years later, I wonder. It was, after all is said and done, in some
ways a defeat. The inflationary pressures that helped bring down the system
did not abate for long; they got much worse as the controls came off and
plagued the country for a decade or more. The monetary system has not
been put back together in a way that really seems to satisfy anyone. And
somehow we are still complaining about unfair military, aid, and trade
burdens.

But that story was still to come. What lay ahead in 1971 was a long and
contentious negotiating process, much longer than I had anticipated at
Camp David. In my naivete, I thought we could wrap up an exchange rate
realignment and start talking about reform in a month or two; say, by the
IMF meeting in late September. Instead, I got a fast lesson in big-league
negotiation. Connally assumed from the start that it would take months to
put the other countries in a mood to accept sufficiently large exchange rate
changes. What we found, even after we shut the gold window, was fierce
resistance by key countries to their currencies floating upward against the
dollar, thus making their goods more expensive in international commerce.
The Japanese, in particular, blocked revaluation of the yen for some days by
buying huge amounts of dollars in the market. One of my Japanese
government colleagues later said they had misunderstood our intentions,
and that is confirmed by Toyoo Gyohten's account in this chapter. The
Japanese assumed we simply

BREAKDOWN

wanted to avoid gold sales. They would have been perfectly happy to buy
and hold dollars; what they did not want was a change in the exchange rate.
But that, of course, was exactly what we had decided was essential. What
we did not really want, and really had forced upon us, was a change in the
official price of gold that a succession of administrations had pledged was
inviolate.

I arrived in London on Monday, August 16, to meet with my counterparts to

explain our approach, including our unwillingness to change the price of
gold. Most of those at the meeting were old friends, and I sensed in their
tone that they did not feel anger as much as anguish that the United States
had not arrived with a prepared solution to save the system. That was in part
deliberate. We had no solution we thought our partners would yet be
prepared to accept.

John Connally, at a later stage, put the point crudely: "The dollar may be
our currency but it's your problem." I cringed at putting it that way; then
and now we do have responsibility for the stability of the dollar. But it was
clear at the time that our trading partners were not prepared to accept what
we thought was required: To stop the outflow of dollars, about which they
were so unhappy, there would have to be a big shift in exchange rates, trade
liberalization by them, and more help on our overseas defense costs as well.

The negotiation really started early in September when I told the G-io
deputies at a Paris meeting how big a shift we thought we needed in our
balance of payments. It would have to move from minus to plus in a swing
of $13 billion over a year or so. In making those estimates, we assumed that
our trade balance was rapidly deteriorating and that the current account
deficit would soon reach $4 billion in the absence of corrective action. We
added to that an estimate of capital exports, which had reached a level of $6
billion or so for some time. We told our partners that we would like to
eliminate all our special controls and restraints on foreign payments and run
a small surplus for a while.

We did not, at that point, talk about exchange rates, but my counterparts
were appalled. They knew immediately that so large a swing in our current
account would imply much larger changes in exchange rates than they had
contemplated. In fact, few of our trading partners really wanted to see any
significant deterioration in their own trade positions, which would be a
necessary counterpart to an improvement in ours. I recall a number of
Europeans turning to the IMF representative, pleading that I wasn't really
listening to their concerns and in effect asking him

CHANGING FORTUNES

to tell me the American calculations were way off base. He replied.that he

did not know that Si3 billion was required, but the IMF's calculations
suggested that the number was a big one. I could have kissed him.

A G-io ministerial meeting in London a little while later turned out to be

more contentious, marked by considerable posturing and leaking to the
press about the outrageous demands of the Americans. The ire was
predictably directed in large part at the surcharge, where we were
vulnerable to the charge of protectionism. On the monetary side, the steady
drumbeat by the others was the need for the United States to devalue
against gold before anything could be done. The tone at the annual IMF
meeting a few weeks later was more constructive. In his speech, Connally
seemed to point the way more clearly toward negotiations and he
specifically offered to remove the hated import surcharge if the others
agreed to a free float as a transitional device to find a new level for the
dollar.

We did not expect that offer to be picked up, given the antipathy to floating,
but there had been a brief but fierce argument about a far more radical
approach. After a draft of Connally's speech had been completed, George
Shultz made a very strong appeal to the secretary to change the whole
emphasis: He wanted to raise the offer for a transitional float into what
could only be interpreted as a unilateral declaration by the United States
that floating currencies should themselves be the basis for the new
international monetary system, period. The evening before the speech was
to be delivered, he tried a hasty rewrite, and I was delegated to talk to him
about it. Talk we did, sitting until early in the morning in a room in the
Sheraton-Park Hotel, where the meetings were held. In my own mind, the
Shultz "bombshell" would plainly not be negotiable, could only further
poison the atmosphere, and was not in any event desirable. The next
morning Connally was given the option of delivering the revised Shultz
draft or essentially the speech we had prepared. He went ahead with the
original, but George Shultz would live to face the issue another day, that
time as secretary of the Treasury. His tactics and approach were very
different, but we ended up with floating rates.

After the IMF meeting, the currency negotiations proceeded slowly.

Connally plainly thought time was on his side in maximizing an exchange
rate adjustment and in reinforcing the American demand for progress in
liberalizing trade by the Europeans and Japanese if a real equilibrium was
to be restored.

BREAKDOWN

I recall one meeting by Working Party Three called to assess our demand
for a shift of $13 billion into the balance of payments and, importantly,
which countries would be willing to accept a corresponding deterioration in
their own payments. The discussion was revealing of the difficulties. The
Germans, in a visibly strong position and usually forthcoming in these
things, said they were prepared to accept an adverse swing of perhaps $2
billion or more. The British argued from their chronic weakness and said
they could not contribute anything significant. The French, pointing to their
earlier devaluation, were resistant. The Dutch and the Belgians, who had
been among the most active in buying gold, on the assumption that they
were small countries whose purchases would not shake the system, likewise
insisted in this context that they were too small to make any significant
difference. The Japanese naturally tried to remain as quiet as possible,
realizing that they would be asked for the largest contribution in raising
their exchange rate.

The secretariat jotted down aU the numbers to draw up a rough balance

sheet, with our $13 billion on one side and the responses of the others on
the other. The latter, as I recall it, amounted to only $3 billion or so, way
below the estimates of the IMF and OECD as to what was needed, as well
as our own. It was a reflection of where the negotiations stood.

In the foreign exchange markets, currencies were already being moved in

the directions that would promote the level of adjustment we needed, but
apart from the resistance by most countries to a large change, there were
increasingly large distortions among individual currencies. Through
exchange controls and currency market intervention, the French in
particular strongly resisted almost any appreciation of the franc. The mark
rose much more freely, jeopardizing Germany's competitive position in
Europe and against Japan, looming even then as the Germans' principal
industrial competitor. There was great anger about the surcharge; to show
that the possibility of retaliation was real, the Danes put on a surcharge of
their own.

Within the United States, increasing concern arose over whether the
Connally hardball tactics were too aggressive, jeopardizing the open trading
system and the prospects for monetary reform. Arthur Burns held that view
and did not keep it hidden. As the autumn passed, I was visited by
colleagues in the administration who repeated the message and asked for
enlightenment as to our negotiating plans. I was in no position really to
satisfy them on the last point. Connally was holding his cards

CHANGING FORTUNES

very closely, and at a crucial point took a lengthy trip to Indonesia, of all
places, returning via Japan, where his reputation as a tough customer
preceded him. The visit inspired great concern among the Japanese, who
were anticipating strong negotiating pressures from Connally. But he was
content not to press the monetary issue. In a typically dramatic press
conference upon leaving, he reminded everyone of his advance billing as
"Typhoon Connally" and said, "I assure you that I came as a gentle spring
breeze."

Finally, Connally as chairman called a promised meeting of the G-io

ministers for the end of November in Rome. There has been a lot of
questioning, particularly in the light of what happened, about the degree to
which he was pushed to this move by the president, who in one version of
the story presumably was responding to the concerns of Kissinger, Burns,
and others about the effect of his tactics on the relations with our allies.
Connally told me later that that was not the case, that his own sense was the
time had come for movement. But no doubt part of that calculation was that
the president was scheduling for other reasons a series of meetings with his
major NATO partners, and they would certainly want to press the issue on
those occasions. With the president typically more concerned with security
and other issues, that would not necessarily be to our negotiating advantage.

On the eve of the Rome meeting, I was still not certain Connally had
changed his "unalterable" position on the gold price. Along with virtually
all American officials working in the area, I felt strongly about the issue.
Beyond all the concerns about prestige (or pure cussedness) of which we
were accused, it was hard to see how an increase in the official gold price
could be anything but destabilizing. Prospects seemed small for a large
enough exchange rate realignment to correct our deficit. Expectations of
further changes in the dollar would be sure to arise, and with them, of
further changes in the gold price. That would make it harder to restore any
form of convertibility by the United States, to avoid speculation in the gold
market, and to design a new monetary system.

Despite the absence of a ringing affirmation of that position at Camp David

or in the president's own speech, Connally held strongly in all his public
statements to his refusal to change the price of gold. Within the Treasury he
did ask another undersecretary, Edwin Cohen, a shrewd lawyer whose
specialty was taxation, to make an independent evaluation of our
negotiating position. Had we not been amicable colleagues with

BREAKDOWN

a great deal of mutual respect, the situation would have been exceedingly
awkward. As it happened, the combination of continuity and a fresh mind
didn't produce any antagonism or a startling new approach.

By the time of the Rome meeting, however, I had reluctantly reconciled

myself to the need for some gesture toward a change in the gold price if the
realignment was to proceed. In response to my question about whether he
thought the time was ripe for settlement, Connally told me he had the
authority to offer a gold price change when he thought it appropriate.
Meanwhile, I would outline our position once again to my foreign
counterparts without mentioning the gold price.

I presented the G-io deputies with a memorandum silent on gold but

indicating for the first time that we wanted an exchange rate change
between the dollar and the currencies of the other industrialized countries
averaging 11 percent on a basis weighted for our trade with each of them.
Even that, we argued, would be inadequate to obtain the $13 billion shift in
payments we wanted, but it would be enough for us to remove the import
surcharge, assuming the Europeans and the Japanese entered into good faith
negotiations on the issues of trade liberalization and sharing security
burdens we had raised.

Finally, it would have to be understood, since the alignment would be

inadequate, that we would not reopen the gold window. What seemed to
shock the group particularly was that I said we would release the
memorandum after the meeting. I was promptly accused of torpedoing
international monetary cooperation, and the strength of their reaction
convinced me to call Connally and suggest that we withhold the
memorandum. But predictably, I was not long out of the meeting before I
discovered that much of the substance had already been leaked—and not by
the American side.

After some preliminary reports, the G-10 meeting went into executive
session, excluding all but principals, with no aides. Thus began what was to
me the most interesting international meeting of my career. By an accident
of alphabetical rotation, Connally had become chairman of the G-10, which
implied a certain neutral status. It was left to me to be the principal
American spokesman, but sitting within a foot of Chairman Connally. The
discussion began with the other finance ministers declaring that there was
nothing to discuss unless the United States was prepared to make a
"contribution," as they termed it, by devaluing the dollar in terms of gold—
that is, by raising the $35 gold price.

It was a familiar chorus, and finally, with Connally's whispered

CHANGING FORTUNES

agreement that I could raise the subject, I asked: "Well, suppose, just
hypothetically, we were willing to discuss the price of gold. How would
you respond if we increased the price by ten or by fifteen percent?"
Apparently Connally thought 15 percent was overreaching, because he
immediately responded: "All right, the issue has been raised. Let's assume
ten percent. What will you people do?"

There was no answer, no discussion, no attempt to change the subject, no

call for recess; for almost an hour, there was just silence. Some smoked,
some whispered a little to their colleagues, some just fidgeted, but no one
wanted to take the lead in addressing the meeting.

Finally, it was Karl Schiller who spoke. Germany, given its concern about
inflation and the strength of its external position, had long been the most
flexible of our trading partners on exchange rate policy. Schiller said
Germany could live with a 10 percent dollar devaluation, "and would
probably add some percentage to it." He was immediately asked: "What do
you mean by 'some'?" He replied, "In the German language, 'some' does not
mean 'one.' It means 'two.' "

We all had a language lesson and learned that Germany would accept a
realignment of 12 percent. That didn't seem nearly enough to us to bring the
overall result we wanted, but clearly the real negotiation was under way.
The Germans put their European partners on the spot. The British and the
Italians protested their inability to participate in any significant realignment.
The French remained quiet.

Then there were recesses, and caucuses, and telephone calls to various
capitals, most significantly, we all presumed, to Prime Minister Pompidou.
It all took hours. As it became evident that no agreement on exchange rates
was likely the next day, Connally reminded the group that trade issues
remained outstanding. All the participants had been asked to bring trade
officials to the meeting, but the Europeans generally did not, arguing that
was a matter for the European Community, not individual countries.
Raymond Barre, later prime minister of France during Valery Giscard
d'Estaing's presidency, was sitting outside the meeting room in his capacity
as the Community's trade commissioner. When Connally learned of that, he
insisted that Barre be brought in. But Barre maintained he had no authority
unless he was given it by a meeting of the Community's Council of
Ministers—the ministers of the member countries meeting as a decision-
making body. The Community's finance ministers were all sitting right
there, and Connally at one point suggested the G-10 recess so its European
ministers could could act as

BREAKDOWN

a Council. They were not, of course, about to take such an extraordinary

step on the spot, so all that could be done was to reach an understanding
that trade remained on the agenda and trade representatives would meet in
coming days.

For all the recesses and hesitations, there was a common feeling that, after
months of impasse, an agreement was in reach. John Connally was at his
best. For all the intense criticism in the press of his "cowboy"
aggressiveness, much of it no doubt fed by the officials who were his
negotiating antagonists, there was a certain sneaking admiration among
some of his fellow ministers, who themselves also were very much political
animals. There was no doubt that he made an impact on them at the official
dinner during the conference, held at a Renaissance palazzo atop one of
Rome's seven hills. Apparently extemporaneously and certainly without
notes, the cowboy from Texas recalled the civilizing mission of the Roman
leaders, presumably often gathered at the very spot where we were dining,
and their legacy of law and learning and a common currency. Somehow, he
placed the mundane challenge before the ministers into the sweep of
Western civilization, going back at least two thousand years!

It was a mark of confidence at the end of a long and tiring meeting that
when no one could decide what to say in a communique, the ministers
agreed that Connally should brief the press alone, trusting him to present a
fair sense of movement without prejudicing anyone's position. It was not an
easy assignment, but he managed it with great style, first hoisting himself
atop a massive Italian table to get everyone's attention in an ornate palazzo
room crowded with press and microphones. The discussion about gold was
reported as hypothetical, but few of the financial journalists were left in any
doubt as to where the negotiations were heading. (One of those reporters,
who currently happens to be the editor of this book, promptly filed a story
that he headed "The Coming Devaluation of the Dollar.")

The next G-io meeting was scheduled for Washington the week before
Christmas. However, the crucial negotiation did not take place in the United
States, but at a meeting scheduled earlier between Pompidou and Nixon in
the Azores. For years, the French had been the principal antagonists of the
United States in monetary and most other international negotiations. (There
were times when I would daydream about presenting a U.S. position
opposite to what we really wanted, so I could then "gracefully" accede to
French objections.) Mr. Pompidou

CHANGING FORTUNES

might not have had all the prestige of General de Gaulle but, as a former
Rothschild banker, he took a strong interest in monetary affairs. If
concessions were to be made to the American view, the agreement would
have a French imprint. And from our standpoint, we felt sure that
agreement with the French would bring agreement more generally.

Monetary issues were not close to President Nixon's heart, and I was told
later that Mr. Pompidou dominated their discussion at the start with a
Gaullist lecture on gold and the evils of the dollar standard. While Nixon
patiently heard him out, waiting to get to the problems of mutual defense
and security that were his concern, Connally, Giscard d'Estaing, and I sat in
another room developing an outline of an agreement covering nearly all the
issues.

The key question, the size of the dollar devaluation, was left to the two
presidents the next day, and given the relative intensity of the French views
on the subject, I knew that would leave us at a disadvantage. Given the
great symbolic importance of our concession on gold, and the French
emphasis on the need for adjustment, it seemed to me Pompidou ought to
concede that 10 percent was a reasonable figure. But the argument with the
president didn't last long. Pompidou finally conceded that the gold price
might go up from $35 to S38 an ounce, or 8.5 percent, on the basis that $38
was a round number appropriate to such a key figure in the monetary
system. My attempt to point out that the price would not translate into a
round number in French francs carried no weight, which was symptomatic
that even the French recognized the central importance of the dollar. Mr.
Nixon clearly wanted to be done with it, and off I went to find the wife of
an army sergeant at our Azores military base who had been assigned to us
to type the agreement.

That agreement in hand, we prepared for the final G-10 negotiating session
at the main building of the Smithsonian Institution in Washington. It was
(and is) a modest-sized, ornate brick building from the Victorian era, set
right on the Mall and now crowded among the modern mass of the Air and
Space Museum and the cylindrical block of the Hirshhorn Museum.
Perhaps the Smithsonian, with its collection of historic artifacts, dedication
to culture and preservation, and interest in scientific inquiry, was considered
appropriate to rebuilding the monetary system. In any event, the old brick
castle, as it is called, was equipped with a lot of small rooms suitable for
informal meetings.

One of those rooms was used to thrash out one of the critical

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remaining problems. Both the Americans and the Europeans had a common
interest in obtaining as large as possible an appreciation of the exchange
rate for the yen. Not only had the exceptional strength of the Japanese trade
position become apparent, but, as a negotiating matter, it was evident that
the size of the yen's appreciation would affect the willingness of the other
countries, and especially Germany, to accept a large realignment of their
currencies.

For all our efforts, Mikio Mizuta, the Japanese finance minister, effectively
resisted an actual appreciation of 17 percent or more. (Toyoo Gyohten
reports the story in vivid detail, and I am chagrined to learn, twenty years
too late, that another 3 percent might have been possible.) Germany in the
end exceeded Schiller's offer at Rome, agreeing to an appreciation of 13.57
percent against the dollar. Some of the European countries nevertheless
continued to fight over a percent or so. In an effort to ease the concerns of
some of those countries, we had developed calculations of weighted
average exchange rate changes. The purpose was to evaluate the amount of
a realignment not simply against the dollar, a habit of thinking bred by the
gold/dollar Bretton Woods system, but against all major trading partners.
We were able to demonstrate that, taking account of the appreciation of the
yen and the mark, some smaller countries would have achieved a small
effective depreciation simply by maintaining their existing gold parity. But,
in the end, the Italians and Swedes insisted upon devaluing against gold, by
1 percent.

The new gold price had, of course, been agreed at the Azores with the
French, and after a little play-acting between us, it was readily agreed by
all. That pretty much determined how large an exchange rate realignment
we could negotiate generally. The adamant refusal of the Canadians to give
up the floating rate they had adopted earlier effectively meant that we
would achieve no realignment at all against our largest single trading
partner.

The choice of weights in determining average effective exchange rate

changes has arbitrary elements. At the end of the day, we calculated that
against all OECD countries, the trade-weighted depreciation of the dollar
amounted to a little under 8 percent, or somewhat over half of what the
Auten calculations nine months earlier had suggested. Without Canada,
which had a heavy weight, the figure was 12 percent, which we emphasized
in our announcements. Either way, it was well short of what we felt we
needed to restore a solid equilibrium in our external payments, even if we
had succeeded in opening Japanese and European

CHANGING FORTUNES

markets in trade talks. But the stonewalling of the Common Market and
Japan had been effective. With the exchange rate realignment settled and
the import surcharge removed, we had little negotiating leverage. The trade
openings negotiated over the next weeks were limited primarily to some
citrus fruits, which was politically important because the U.S. lobby was
vociferous, but not large in the context of the balance of payments.

One reform introduced at the Smithsonian lives on in intra-European

monetary arrangements today. The margin for exchange rate fluctuations
around the new panties (or "central rates," as they were termed by most
countries) was set at plus or minus 2.25 percent, over twice the Bretton
Woods range of 1 percent. That was a French concession to our demand for
3 percent.

Amidst aU the wrangling over exchange rates, just as at Camp David, little
energy was expended on questions of long-term reform. Those arguments
would come later. At the time, it was generally (if not happily) understood
that the Umted States would not be prepared to defend the new exchange
rates with its own gold or by borrowing foreign currencies. What had been
agreed for the time being was effectively a dollar standard—Bretton Woods
without the gold.

Toward the end of the negotiation, President Nixon came over from the
White House to praise the outcome. Finance ministers, central bankers, and
their retinues were herded into the old Air and Space Museum to face the
press under the suspended airplanes of the Wright brothers and Charles
Lindbergh. The president proclaimed the meeting had reached "the greatest
monetary agreement in the history of the world."

That remark has often been repeated with a scornful laugh, but it was, so far
as I know, in fact unprecedented to have so many countries agree on a set of
exchange rates at one time. What was lacking was the sense of commitment
necessary to make it all work. One of my associates reminds me that, upon
hearing the president's remark, I turned to him and said, "I hope it lasts
three months." Well, it lasted longer than that. It was six months before the
British floated the pound and President Nixon, informed that Italy might be
next to unhitch from its Smithsonian parity, confided to his White House
staff, "I don't give a [expletive deleted] about the lira."

The end of the Bretton Woods system was approaching.

BREAKDOWN

TOYOO GYOHTEN

1 he events of 1971 sent a very strong and enlightening message to Japan.

They told us that the Japanese economy had become closely intertwined
with the world, and that the insulated economic management we had been
pursuing was no longer possible. We of course knew that the international
monetary system had been growing increasingly unstable, but in our view,
the major cause was the intractable deterioration of the United States's basic
balance during the 1960s, which was caused by its shrinking trade surplus
and by the growing outflow of long-term capital. This deterioration
produced the large increase in the United States's short-term liabilities; in
other words, the large amount of dollars held by foreigners.

Official short-term liabilities of the United States exceeded the U.S. gold
holdings for the first time in 1964. In the unlikely event that all those
official holders of dollars panicked and exercised their right to turn them in
for gold, the U.S. gold reserves upon which the Bretton Woods system
depended theoretically would have been exhausted. The situation continued
to deteriorate rapidly, and by 1971 the gold reserve had fallen to $11 billion,
while official short-term liabilities of about $25 billion stood at more than
twice that. In other words, dollars in the hands of foreign governments and
central banks were only 44 percent secured by gold. So there was a rapid
deterioration in the dollar's credibility.

That was not the only factor behind this instability. Interest rate and
inflation differentials reflected the unsynchronized economic cycles among
the major economic powers, creating very large and volatile capital flows,
particularly through the Euromarket. A strong impression was growing
meanwhile that the incoming Nixon administration had shifted the
economic priorities of the United States from external adjustment to
ensuring full employment and increasing corporate profits. This policy
change was called "benign neglect," and I think it gave the coup de grace to
international stability.

On the Japanese side, we now realize in hindsight that the underlying

structure of our balance of payments had become very solid by the middle
of i960, although we were still subject to fluctuations and in fact ran a
rather serious current account deficit in 1967. We therefore still believed
ourselves to be very vulnerable, and when our external accounts started
yielding large surpluses in 1970 and 1971, we thought it

CHANGING FORTUNES
was the result of the cyclical domestic slowdown during those years.
Corporate profits were deteriorating, stock prices were falling, and
production was very stagnant. The shift to a policy of domestic expansion
in the United States raised a strong demand for our exports, while peculiar
factors such as a long dock strike in the United States blocked American
exports while Japanese textile producers were rushing shipments to the
United States in anticipation of the voluntary export restraints.

With the underlying situation thus disguised, we thought the appropriate

countermeasure was not to revalue the yen, because that only would have
aggravated our domestic slowdown. We preferred to boost the domestic
economy by expansionary fiscal and monetary policy, and to liberalize
imports further. I frankly suspect this argument did not reflect a genuine
belief on the part of the Japanese and was to some extent a bargaining tactic
against outside pressure to revalue the yen. Nevertheless, a majority of
Japanese lacked confidence in our balance of payments structure and feared
that revaluation would dampen the economy. Only a few economists or
businessmen dissented, and their voices were not loud enough. When the
United States and the Europeans began criticizing Japan's surplus and its
undervalued yen, we therefore did not realize how serious the situation had
become and believed we could still fend off our critics by taking domestic
measures to boost our economy.

President Nixon's announcement of his New Economic Policy came on

August 16 at 10:00 a.m., Japan time, with the market already open. The
financial attache at the U.S. Embassy in Tokyo sent an advance warning of
sorts to me and to the Bank of Japan. I was special assistant to Takahashi
Hosomi, the Vice Minister for International Affairs. He telephoned and
said, "At ten o'clock, Tokyo time, President Nixon will be making a very
important speech." I said, "What?" He replied, "I don't know. You had better
listen to it." There was no Cable News Network at the time, so I asked
where I might hear it broadcast. He said the Voice of America would carry
it. The Voice of America was broadcast only by shortwave, so I told my
secretary to find a shortwave radio fast. Fortunately, she did, and I listened
to the speech, and the minister was right, it certainly was an important one.
I think there was one very friendly call from the undersecretary of the
Treasury, Paul Volcker, to his counterpart, Yusuke Kashiwagi, senior
adviser to the minister of finance, warning him what was going to happen.
It was a

BREAKDOWN

good gesture and evidence of the importance of personal friendship and

trust at a time of emergency for us.

We called this the "Nixon Shock." All of Japan was caught by surprise, and
it was a big one. The market was inundated by dollar sales. The Ministry of
Finance hurriedly convened a meeting, which disclosed a sharp internal
split. Heated arguments raged between those who wanted to close the
markets immediately and stop buying dollars, and those who wanted to stay
open. The first group said that U.S. and European markets were closing and
asked why Japan's should remain open to buy dollars, which would leave
the government with a large loss when they were devalued, as they surely
would be. But the others countered that if Japan closed its markets, it would
have no other choice but to float or to revalue when they reopened, and that
was precisely what we did not want to do. Furthermore, they advanced a
strong argument for protecting the banks. They had large amounts of dollar
assets on their books, which they had taken on under strong persuasion by
the Ministry of Finance and the Bank of Japan. If the markets were closed,
they would be unable to sell them and would suffer huge losses. Those who
wanted to keep the markets open were confident that our system of
exchange controls was so perfect that few dollars would be sold.

So, those who argued for keeping the market open prevailed, and we kept
buying dollars at the rate of 360 yen. There certainly was a serious
misjudgment on the part of the Japanese about the real intentions of the
U.S. Treasury and the U.S. government as a whole. The Japanese were too
naive in believing President Johnson and President Nixon when they
repeatedly pledged that the United States would not devalue the dollar.
Secretary Connally had reiterated that pledge just a few months before. So
we thought that the real U.S. objective was not to devalue the dollar but to
free it from gold and try to stabilize its value as quickly as possible.
Supporting the dollar at the parity of 360 yen, we believed, would meet the
interests of the United States and be taken as an act of cooperation. So the
Bank ofjapan went right on buying dollars at 360 yen per dollar, and after
two weeks it had purchased some $4 billion. Japan had started the month
with official reserves of less than $8 billion, so that meant we had increased
them by almost 50 percent. On August 28 we finally gave up and reopened
the market to let the yen float.

How large was this amount? Four billion dollars at the exchange rate

CHANGING FORTUNES

of 360 yen was equivalent to about 1.5 trillion yen. At that time, Japan's
money supply on an Mi basis of cash in circulation and checking accounts
was about 24 trillion yen, so it is not hard to imagine the importance of an
intervention purchase of this size by the Central Bank. Not surprisingly, the
Bank of Japan and the Ministry of Finance were criticized very harshly in
the serious debates that followed. The critics argued that these huge dollar
purchases so increased the supply of yen in the economy that they prepared
the way for the inflation of 1973 and

1974.

I do not believe that the intervention directly caused the inflation. It is true
that the money supply was substantially increased by about one quarter
from the previous year, through the second half of 1971 and into the first
quarter of 1972, but inflation did not really catch hold until a year later, in
the second quarter of 1973. As for the Ministry of Finance and the Bank of
Japan, they certainly suffered a large accounting loss, because the $4 billion
we bought at 360 yen was devalued to 308 yen just four months later. Our
critics argued that the government had rescued those private banks at the
sacrifice of the taxpayers' money. I find this argument not too well
grounded in theory because central banks do not have to settle their foreign
exchange accounts on any certain date. The account is ongoing, and makes
neither profit nor loss in local currency because it holds its foreign currency
reserves to pay them out abroad when needed. You might argue that the
additional $4 billion in reserves was very useful two years later when the
first oil crisis hit, and Japan had to pay out large amounts of dollars to buy
much more expensive imported oil. They had been acquired while the
Japanese market was still open after the Nixon Shock.
We learned later that Japanese banks and trading firms had borrowed
dollars abroad after August 15 and sold them in Tokyo. The Japanese
authorities had grossly underestimated their financing power abroad. One
very valuable lesson we learned was that our exchange controls were far
from perfect. This was a shock to those bureaucrats and the central bankers
who until that moment believed they held tight control over the private
banks and their exchange transactions.

After the Nixon Shock, the economy was in a turmoil. The stock market
index fell very sharply, from 202 at the end of July to 176 in October, more
than 10 percent. But exports did not fall, and although the situation was still
uncertain, the Ministry of Finance realized that it was no longer possible to
defend the old value of 360 yen to the dollar.

BREAKDOWN

But at the same time, there was very strong resistance to a large revaluation
of the yen because of strong fears that it would have a disastrous impact on
the economy. The ministry tried to float up the yen gradually to avoid sharp
criticism from businessmen and politicians. So we kept intervening in the
market and the yen crept up gradually from August 28. By October 1 the
rate was 333 yen to the dollar; by November, 329; and on December 18, the
day before the Smithsonian Agreement, the rate was 320. That represented
a 12.3 percent revaluation from the old gold parity.

We were not sure what Americans were really aiming at in the currency
realignment. The Ministry of Finance had made its own studies and we
knew that we would have to join this multilateral currency realignment in
one way or another. On November 15 the Ministry of Finance, at its senior
staff meeting, decided to accept the scenario for the dollar to be devalued by
6 percent against gold, with West Germany revaluing by 3 percent and
Japan by 6 percent, which would mean a total increase of about 12 percent
in the value of the yen against the dollar. We calculated this would produce
a swing in the U.S. current account balance of about $6.5 billion, or half of
what the Americans were seeking. The reason we proposed a 12 percent
revaluation was that the market had already revalued the yen by about 10
percent, and we further calculated that the impact of the 10 percent import
surcharge was roughly equivalent to an additional 2.2 percent revaluation of
the yen.

But we knew that we would have to bargain with the Americans and the
Europeans, and the American demand was really exorbitant. We tried to
make an alliance with the French, and then with the Germans, and both
failed. We were left with the impression that Japan's situation was so special
that nobody would form alliances with us in opposing the strong pressure of
the United States. That was rather a disappointing discovery, and we later
found that the United States was forming alliances with the Europeans to
gang up against us. But instead of examining the situation and trying to
discover why we were so isolated, we adopted a very defensive position.
The Smithsonian thus became a rather unfortunate watershed in the
development of Japanese attitudes, and bureaucrats at least have been left
with a very strong sense of isolation.

The Smithsonian bargaining should be placed in the broader context of our

relationship with the United States. Beyond the economic issues that are
usually the most prominent aspects of that relationship, a series

CHANGING FORTUNES

of events in 1971 placed a considerable strain on the stability of what until

the mid-1960s had been an alliance probably best described as that of a big
brother with a little brother. A serious concern for Japan at the time was the
emergence of Communist China as a major economic and military power.
Japan remained allied with the United States against too rapid an entry by
China onto the world political and economic scene. However, on July 15,
one month before President Nixon's economic statement, he gave the
Japanese the first shock when he announced his plans to visit China. In
October, when the United States and Japan were cosponsoring a resolution
at the United Nations to block the expulsion of Taiwan from the United
Nations, Henry Kissinger made a secret trip to China. On October 15, Japan
concluded very difficult negotiations agreeing to voluntary restraints on
textile exports to the United States, which left us with a strong sense of
defeat.
That was about the time that the United States started to view us as an
economic competitor and decided to get tough with Japan. I believe the
Nixon administration was thinking about the possibility of using
Communist China as a counterweight to Japan in post-Vietnam Asia. To us
there seemed to be a meeting of minds on this subject between I lenry
Kissinger and John Connally, which made us feel that the United States had
pulled the rug out from under Japan. The United States was playing a kind
of China card to Japan. When Connally visited Japan early in November to
negotiate about exchange rates, he apologized for the bad timing of
Kissinger's visit to China, but at the same time he stressed that the European
Community was strengthening itself as a very exclusive and discriminatory
bloc, the Soviet Union and Communist China were growing into very
important powers, and Japan would find itself in a very difficult position
unless it cooperated much more closely with the United States.

Connally asked for a 24 percent revaluation of the yen, an 18 percent

revaluation of the deutsche mark, and no change at aU for the dollar. Three
weeks later, at the Group of Ten meeting in Rome, the United States
reduced that request to 20 percent for the yen and 15 percent for the
deutsche mark, proposing for the first time a 10 percent devaluation of the
dollar. On December 17, the first day of the Smithsonian negotiation, the
United States request came down a bit farther to a revaluation of 19.2
percent for the yen and 14 percent for the deutsche mark, and an 8.25
percent devaluation for the dollar.

The United States finally settled with Japan for 16.9 percent. Why

BREAKDOWN

such an odd figure? At the Smithsonian, Connally had insisted on 18

percent in his last bilateral negotiation with his Japanese counterpart, our
finance minister, Mikio Mizuta. Like Connally, Mizuta was no bureaucrat
and was a born politician. He was a Socialist when he was a student, had
been arrested for his beliefs several times by the police of Japan's prewar
militarist government, and later became a conservative politician. He served
as finance minister three times at very critical junctures in the Japanese
postwar financial development, and one of these was at the Smithsonian.
The final negotiating session between Connally and Mizuta took place
dunng a short break in the plenary session; I was special assistant to the
Vice Minister for International Affairs and was acting as Mizuta's
interpreter. We were in a very small room in the Smithsonian that seemed to
be used for keeping the Institution's specimens; funny things were pickled
in all manner of bottles and jars that were lined up on the shelves. Ignoring
the background, Connally insisted that Japan revalue by 18 percent.
Impossible, said Mizuta. He absolutely had to settle below 17 percent.
Connally asked why.

Mizuta replied: "Because 17 percent is a very, very ominous number for

Japan. Back in 1930 when Japan returned to the gold standard, the yen
appreciated, and the magnitude was 17 percent. The economy was thrown
into a depression. The finance minister who decided upon this return to the
gold standard was assassinated."

I don't know whether Connally was impressed by that argument in view of

his experience when President Kennedy was assassinated in Dallas, or
whether he was thinking of it at all, but he quickly replied, "Okay, how
much can you go?"

"Three hundred and eight yen," said Mizuta, which worked out to a
devaluation of 16.88 percent.

"Let's make a deal," Connally replied, and that settled it.

Connally had been very tough in his negotiations with Japan, but he also
recognized Japan's importance when the United States turned to deal with
the Europeans, and he never pushed Japan to the point of humiliation. He
was really a superb negotiator, a magnificent deal maker, and he enjoyed his
job tremendously.

But I must put in a word for Mizuta's shrewdness as well. After the
Smithsonian, he confided that even before he left Tokyo for Washington, he
secured from the prime minister, Eisaku Sato, his approval for a revaluation
of up to 20 percent. I cannot vouch for the truth of this

CHANGING FORTUNES
because both men are dead now, but Mizuta was afraid that even after he
struck the deal with Connally, Karl Schiller of Germany would try to block
it. Schiller had insisted that the yen must be revalued by at least 4 percent
more than the deutsche mark, but Mizuta's deal with Connally left a
difference of only 3.3 percent. Mizuta was worried that Schiller might
object. He waited until Schiller made his final proposal at the last session
on the afternoon of December 18, and only then did Mizuta publicly
announce his acceptance of the 16.9 percent revaluation. Connally said,
"Thank you very much, Mr. Minister." That was the first and List tunc I
heard those words from Connally throughout this whole scries of
negotiations. The meeting was adjourned, and Mizuta quickly disappeared
from the room. He went into hiding in the Japanese delegation's room in the
Smithsonian and did not come to the drafting session of the communique
lest the agreement come undone at the last moment.

( ionnally and Mizuta established a very good personal friendship and

exchanged personal gifts. Mizuta gave C Connally a beautifully carved and
lacquered wooden mask of a Japanese demon. "This is the demon who is
supposed to protect ladies. So if you keep it in your house, Mrs. Connally
and your daughters will always be safe,' 1 he said as he presented it.
Connally riposted, "Oh, is that so? I thought it was an economic annual who
came to devour the American economy." In return, Connally gave Mi/uta a
pair of custom-made Texas cowboy boots, and for that he hat! to measure
Mizuta's foot. He asked Mizuta to take off his shoes and stand on a sheet of
paper, while the secretary of the Treasury himself traced Mizuta's foot with
a pencil. Mizuta was a bit shy, and he said, "In Japan there is a saying that a
man with a big foot has a small brain." And Connally said, "No, no, you
shouldn't worry about that. On the contrary, in my country there is a saying
that a man with a big foot is liked by the ladies."

But amongjapanese bureaucrats, most of whom had no idea of how the deal
was concluded, the Smithsonian agreement was viewed as a serious defeat.
They had believed they could fend offa request for a large appreciation of
the yen and genuinely believed the final figure was too large. The Japanese
media, which seem to have a tendency toward masochism by taking
pleasure in humiliating their own country, accused the bureaucrats of failing
to bargain more shrewdly and claimed we had suffered a terrible diplomatic
defeat. But business in fact welcomed the settlement, not because it wanted
to revalue, but because it was far more

BREAKDOWN

concerned by the prolonged instability in the exchange market. Of course, it

would have preferred a smaller revaluation, but it did not regard 16.9
percent as excessive. Even as early as October of 1971, I was told
afterward, big Japanese corporations were already using the exchange rate
of 310 yen per dollar in their internal calculations and planning, almost
exactly where we finally came out, at 308 yen. They were trying to make a
very quick adjustment to a higher value for the yen even before it had been
formally negotiated, and were hardly upset by it. As for the general public,
the change in the exchange rate was not really a serious matter in their daily
lives. The economy as a whole rebounded quickly after hitting a trough in
the last quarter of 1971, and the stock market hit a historic high on January
13, 1972.

But despite our domestic recovery, the trade surplus was not reduced, which
would help lead to a further revaluation soon. At that time, we thought that
after this realignment, we might possibly rebuild the fixed-parity system on
a dollar standard. Gold had already ceased to be the cornerstone of the
international monetary system when the two-tier gold price system was
introduced in 1968. In spite of all the grand events of 1971, what happened
after the Smithsonian agreement was probably only a mere alteration of the
intervention points. All the countries in the negotiation (apart from Canada)
hoped to return to a fixed-rate regime based on the rates they had
negotiated. But it was unrealistic to hope for a return to a fixed-rate system
based on the dollar, because the dollar did not recover its credibility.
Furthermore, the Smithsonian negotiations never touched on fundamental
questions because everybody in that negotiating room was engaged in some
kind of bargaining without taking much cognizance of the implications to
the system itself Things might have developed differently if the
Smithsonian discussions had assumed the serious theoretical and
intellectual character of a discussion of the system, but unfortunately they
did not. All these things made floating almost inevitable.
In the end, the crisis of 1971 taught Japan many lessons. First of all, it
demonstrated Japan's serious underestimation, even ignorance, of the
strength of its own country's economy, and of the irresistible power of
market forces. It also left a strong impression among Japanese that we were
under very severe international pressure, particularly from the United
States, and unfortunately, this impression fortified our defensive posture,
which remained fixed for years afterwards. The unfolding of all these
events failed to give Japan the encouragement it badly needed to

CHANGING FORTUNES

play a positive and forward-looking international role at a time when the

Bretton Woods system evidently lacked adequate mechanisms for economic
adjustment and exchange rate realignment. The international monetary
situation was therefore heading toward more trouble.

PAUL VOLCKER

OVERVIEW

The two years after the Smithsonian agreement were the most economically
turbulent of the postwar period up to that point.

In the United States, the program of August 15, 1971, whatever its ultimate
consequences for the monetary system, combined with an accommodative
monetary policy to produce the strongest kind of electoral platform for Mr.
Nixon: rapidly rising production and a clearly reduced rate of inflation.
Internationally, there was a sense of relief that monetary and trade disputes
had been patched up and exchange rates stabilized.

But beneath the surface, ominous forces were building up. The American
trade and current account position continued to deteriorate, and there was a
flood of short-term capital exports. Far more rapid increases in dollar
holdings built up in foreign central banks than in the period leading up to
the closing of the gold window. Stoked by the American domestic
expansion and by the explosion in international liquidity, a strongly
synchronized boom lifted the industrial nations.

It couldn't last long. Inflationary pressures were building, especially under

the lid of price controls in the United States. The mandatory

101

CHANGING FORTUNES

controls were largely ended in early 1973 and, as it happened, the pressure
from the boom coincided with worldwide crop shortages. The result was
rates of inflation far greater than those that had provoked the controls in
mid-1971.

Just as the price pressures were heating up, the Smithsonian "central rates"
came under renewed pressure in Europe, and the United States decided to
negotiate a new, and larger, exchange rate realignment in February of 1973.
In sharp contrast to the experience in 1971, negotiating success was
achieved essentially over a single weekend. But the markets showed no
respect for the negotiating artistry, and renewed exchange rate pressures
ushered in an agreement by the major countries to permit their currencies to
float as a kind of last resort, while comprehensive reform would be pursued.
So it was, but it never achieved what had been intended.

Reform negotiations actually extended over almost two years. They were
aimed at restoring a structured system of exchange rate parities and
convertibility, but with important new elements of flexibility. It was an
important educational process for all of us involved but, as a practical
matter, was abandoned late in 1973. By that time high rates of inflation had
appeared, and the rates differed among the major nations, helping to make
exchange rates much more volatile. The first oil crisis was under way.
Conventional wisdom was that no fixed-rate system could be successful
amid such shocks and imbalances. In fact, the United States and the world
were headed for what turned out to be the most severe recession so far in
the postwar period. In the process, for better or worse, the sense of fixed
structure, stability, and order that for a while had characterized the world
economy in the context of the Bretton Woods system seemed to disappear.
We are left with interesting questions. Was the Bretton Woods sense of
monetary order and structure simply a passing reflection of unusual
circumstances, summed up in the dominance of the United States? Or,
conversely, did it fail for lack of a stronger sense of rules and systemic
discipline? Was the effort to construct a new system modeled on Bretton
Woods only an unrealistic dream in a world of broadly dispersed political
power and close economic integration? Or, conversely, is it the absence of a
sense of greater structure and discipline in the international monetary
system that has somehow contributed to the world's poorer economic
performance after the system broke down in 1971?

FLOATING AND DRIFTING

THE PRESSURE OF EVENTS

Perhaps the most important lesson of the Smithsonian agreement, and of the
traumatic events leading up to it, was an almost subconscious one: The
world didn't come apart. Currencies had floated for several months. The
changes in exchange rates that were ultimately agreed on were larger than
most countries had anticipated. During the protracted negotiations, trade
restrictions were threatened, and considerable antagonism arose among
governments. Yet stock and bond markets performed well, trade continued
to expand, and business in general prospered in the ensuing year. While
there were inevitable distortions and uncertainties, neither the world
economy nor its trading system seemed so sensitive to monetary
disturbances as had been feared by those of us raised in the Bretton Woods
system and dedicated to protect it.

The other side of that coin was a lack of commitment to the fixed-rate
"Smithsonian system." For the United States, that was symbolized by our
refusal to convert dollars into any other reserve asset. More important,
governments in general did very little to defend the new "central rates" (as
the new parities were mostly called) by raising or lowering interest rates or
other appropriate domestic policies.

The United States had imposed a temporary price freeze and introduced a
system of wage-and-price controls when it suspended convertibility in
1971. Our prices in fact stabilized for a while. But keeping controls for any
length of time would be impossible in the kind of open economic and
political system we want in the United States. They are not at any rate an
effective substitute for the restrictive monetary and fiscal policies that
typically accompany devaluation. In the event, U.S. monetary policy was
actually eased in early 1972, reflecting the sense that the economy was still
operating well below full employment but hardly a signal of concern about
protecting the new exchange rates.

Arthur Burns, who was Richard Nixon's choice as chairman of the Federal
Reserve Board when William McChesney Martin's term expired early in
1970, had been the main proponent of some kind of wage-and-price
controls, irritating the White House in the process. Once the controls were
adopted, Burns was saddled with the uncomfortable responsibility of
exercising surveillance over the commercial banks' pnme rate, a politically
volatile matter when wages had been frozen. As I came to know later, in
reconciling his various responsibilities, Burns (and I suspect most of his
board) was extremely sensitive to

CHANGING FORTUNES

charges that international considerations were influencing domestic interest

rates. Hence, despite his enthusiastic support of fixed exchange rates, he
seemed to me to have a kind of blind spot when it came to supporting them
with concrete policies.

Certainly, I saw no evidence that the White House was any more committed
to preserving the Smithsonian exchange rates. President Nixon, like most of
his predecessors, was absorbed in international affairs from the very
different perspective of the political leadership and mutual security of the
free world. Successive Treasuries under successive presidents came to view
with apprehension presidential trips abroad and meetings with foreign heads
of state; to any president, economic advantage was a bargaining chip for a
political concession. Typically, it seemed to us foreign leaders had precisely
the opposite priority; they prized a concession on trade, or aid, or
(particularly in Pompidou's case) monetary affairs.

Nixon, like most presidents, resented the idea that his freedom of action
might be limited by monetary difficulties. The only objective I heard him
state about a reformed monetary system, and I heard him say it more than
once, was that he just didn't want "any more crises." That made me
distinctly uneasy. I didn't know how to design a system that would be
guaranteed against crisis, irrespective of our domestic policies. The
proponents of floating did purport to have the answer: Individual countries
could conduct their affairs as they wished without worrying about the
balance of payments, losing reserves, or raising interest rates to defend a
parity, because floating exchange rates would adjust smoothly and
effectively to international disturbances.

Intellectual acceptance of the idea of floating was much less advanced

abroad, but we were not the only nation that could be accused of neglecting
the discipline of a fixed exchange rate. In May of 1971 West Germany, then
the world's second largest trading nation, had already clearly demonstrated
that it was willing to depart from a fixed exchange rate if that conflicted
seriously with its domestic priority of fighting inflation.

Just before midyear in 1972, speculation turned against the British pound.
The British trade balance had turned adverse, but speculation was strongly
reinforced by a comment of the Chancellor of the Exchequer, Anthony
Barber, to the effect that recent monetary developments had taught him a
lesson: A country should not wait too long to change an exchange rate if
balance of payments trends were adverse and the ex-

FLOATING AND DRIFTING

change rate came under pressure. That comment encapsulated the general
change in attitude. In the mid-1960s, a British Labour government fought
speculative pressures for three years before devaluing and avoided
devaluation altogether under renewed pressure in 1969. Now, a
Conservative British government withstood the pressure for only about a
week before floating the pound on June 23, 1972.

I remember the incident well. Just the day before, I had been asked about
the pound in Congress. In support of what I had understood to be the
position of the British government, I replied that I saw no reason for it to be
devalued. The British Treasury's Washington representative seemed more
than a little contrite when he reported the decision to me. Meanwhile,
Arthur Burns told the White House he was worried that floating the pound
could lead to speculation against the lira. Against my advice, a White
House assistant reported these concerns directly to Nixon, giving rise to his
notorious remark about the lira, which was recorded on a Watergate tape. I
have always had sympathy for this display of annoyance in the midst of a
trying day. Absent the Bretton Woods disciplines and sense of commitment
to the system, there was in fact nothing we could do to deal with such
sudden currency upheavals in Europe, a point I later learned from the tape
that Nixon himself had made.

The British float was the first formal break in the Smithsonian central rates.
It provoked more consideration of a joint float by continental Europeans
against the dollar, but eventually markets settled down. The atmosphere was
calmed in part by increased price stability and the strength of the business
expansion in the United States, which eventually surpassed 6 percent for the
year. Economic performance was also very strong in Japan and in Europe as
well.

One thing that had not turned around for the United States was the current
account deficit. Even allowing for normal lags and for the strength of the
recovery, that seemed to me to confirm our earlier judgment that we would
need another exchange rate alignment. It would be an exaggeration to say
that I wanted to find or provoke a reason to devalue, but, like Tony Barber
in June, we had become psychologically prepared to act, and we thought we
had more reason.

Early in 1973, that occasion arose. The stage was set in part by what
seemed to me a sudden and rather imprudent decision to abandon the
mandatory price-and-wage controls in one fell swoop at the start of Nixon's
second term. Politically, the timing was understandable, given

CHANGING FORTUNES

the philosophical aversion of the administration to controls and the

complaints of business and labor. That aversion was strongly shared by
George Shultz personally; he had replaced the pragmatic John Connally as
secretary of the Treasury. Moreover, the process of relaxing the controls had
actually begun earlier, and the longer they remained, the more the
distortions and the more difficult it was to administer them fairly and
effectively. My concern was a practical one. Inflationary pressures were
clearly mounting, and the unanticipated lifting of controls across the board
would send a signal of indifference to both the domestic and international
audiences. With a more restrictive monetary policy, there would have been
less concern, but that was slow in coming.

Shortly thereafter, for entirely unrelated reasons, there was a burst o{

speculation arising out of Italian political uncertainties; worried Italians
dumped lire in exchange for Swiss francs. In a few days the Swiss
responded by floating their currency. That set off a new speculative surge
against the dollar. I wrote a short memorandum to Secretary Shultz
advocating that we take the initiative by negotiating a further exchange rate
realignment, ensuring this time that it would be fully adequate. Because we
had already established the precedent of changing the gold price, I felt it
would be useless to resist doing so again. Instead, I urged a more
conventional approach. We would devalue against gold by 10 percent
provided that Japan revalued by 10 percent against gold. This would be
equivalent to an appreciation of 20 percent against the dollar. The other
major countries would then have to agree to stand still, thus in effect
appreciating by 10 percent against the dollar.

Simple and effective, or so I hoped. All our analysis suggested that so large
a change ought to deal with our basic balance of payments problem, thereby
providing a solid base for confidence in the foreign exchange markets. A
large Japanese realignment seemed justified by the evident and growing
size of the Japanese trade surplus despite the yen's sizable increase against
other currencies in the Smithsonian realignment. In any event, I sensed that
the Europeans would demand another large Japanese revaluation if they
were to agree to a standstill of their own currencies. My own views were
reinforced when I received a confidential personal message from Otmar
Emminger at the Bundesbank, suggesting essentially the same course of
action.

My approach quickly won support within the United States government,

with two provisos. One I thought was particularly important. Two dollar
devaluations in a little more than a year raised the risk of
FLOATING AND DRIFTING

renewed speculation in the gold market and problems of regaining market

confidence. A higher market price for gold would not directly affect the
official price of gold or market exchange rates, but a large speculative
demand for gold seemed sure to cast doubts on the stability of the dollar.
Consequently, I obtained agreement within the government, not necessarily
with enormous enthusiasm, that our willingness to devalue against gold
depended on others' being willing to join with us in selling gold in the
market if that proved necessary to dampen speculation.

The second proviso was that other countries accept that we would remove
all our remaining controls on capital outflows—the interest equalization
tax, the direct investment restraints, and all the rest. Shultz and others in the
administration had long chafed under maintaining at least some of the
controls on capital outflows inherited from previous Democratic
administrations. Even apart from market ideology, which was as important
if not quite so pressing as in the subsequent Reagan administration, there
were the practical facts that the effectiveness of the controls was becoming
more limited, and they had become an important irritant for international
business. After all, relaxation and elimination of controls had been a
campaign pledge by Mr. Nixon all the way back in 1968. I was reluctant to
move so quickly, fearing that sudden removal would undercut confidence in
the new exchange rates, but that concern was not widely shared in the U.S.
government.

Even after those provisos, I realized there still was an obvious gap in our
strategy. No move or announcement with respect to monetary policy would
accompany the devaluation. By that time, after a year of strong growth and
with price pressures rising, it seemed to me a clear case could be made on
domestic grounds alone. But the Fed was not ready, and no one except me
seemed at all eager to press the point.

To the best of my recollection, during the internal discussions no one even

raised the question of restoring some degree of convertibility into other
reserve assets for the huge dollar holdings of other countries. By that time,
we had already embarked on formal international negotiations about a new
monetary system, and we had begun to set out terms and conditions under
which the United States might resume some form of convertibility. It
seemed inconceivable that we would prejudice that carefully developed
position by an ad hoc decision to resume any type of convertibility without
the safeguards and understanding that we felt were necessary to sustain
such a commitment. In cruder terms, converti-

CHANGING FORTUNES

bility was known to be our hole card in the negotiations, and our
negotiating partners had ceased pressing for an early decision.

The upshot was that I went off to fly around the world with Sam Cross, an
able and experienced Treasury civil servant who soon became our executive
director at the IMF and later moved to the Federal Reserve Bank of New
York, where he ran foreign exchange operations in the 1980s. We had at our
disposal a windowless government transport that had been designed as a
refueling jet. I left for Tokyo on Wednesday afternoon, February 7,
immediately after testifying before Congress, all the while hoping that I
would not be pressed about our response to conditions in the exchange
market. While I was in the air, the Japanese government was notified that I
was coming via a message sent over the president's name. It urgently
requested a meeting with the finance minister or the prime minister on the
very evening of my arrival (which would be Thursday, Tokyo time). Upon
arrival at our embassy, I was directed straight to the private home of the
then finance minister, Kiichi Aichi. We went right at it for a couple of
hours. The contrast could hardly have been more striking to the five months
of haggling and strained feelings that preceded the Smithsonian.

I had a simple message: Given the pressures in the exchange market,

something had to be done. We had a constructive approach that would meet
everyone's needs better than any alternative. I informed Aichi that we were
ready to devalue the dollar by 10 percent against gold and that I was
prepared to fly immediately to Europe to insist that they stand still.
However, Japan had to agree to revalue the yen; that would certainly be a
condition we Americans and the Europeans would require. In our judgment,
a 10 percent revaluation of the yen was appropriate. If we could not reach
an agreement, there was no point in my going on to Europe. I would instead
go home, and we would see what happened next.
Clearly, the implicit threat was that the speculative pressures would force
general floating of all currencies, which risked substantial disorder and
mutual antagonism. The Japanese could not have had much time to consider
how they would respond, but by the end of our two-hour conversation,
Aichi came close to meeting our conditions, although he did not want to
take responsibility for a fixed revaluation. He was prepared instead to
permit the yen to float freely in the market, without quite agreeing to an
effective appreciation against the dollar of 20 percent. I interpreted his
position to be that the yen could reach close to

FLOATING AND DRIFTING

that level in the market without governmental resistance. Since I felt

confident that if left alone the market would carry the yen to the level we
sought, or at least close to it, we seemed near to a mutual understanding
without forcing an explicit decision.

I was much impressed by Minister Aichi. He always seemed open and

straightforward in his contacts with us, perhaps at the expense of being
considered too pro-American for his political good. In the few hours before
my arrival, there must have been an opportunity to consult with the prime
minister and others who would certainly have anticipated some of what was
on my mind. But I sensed that the decision lay in his hands as he heard me
give the specifics of our proposal.

It seemed to me I had heard enough in Tokyo to present the plan to our

European counterparts, and I wanted to begin with Finance Minister Helmut
Schmidt and the Germans, expecting them to be the most sympathetic.
Schmidt had not been finance minister very long, but we had come to know
him as straightforward and pragmatic in his dealings with the United States
government from his years as defense minister. We thought he would be
strongly inclined to cooperate rather than risk the monetary frictions
between the United States and Europe that might result from more
unilateral, uncoordinated actions. And I knew he would consult with the
Bundesbank's Otmar Emminger, who supported the approach we were
proposing. In substance, Germany, after all, had a great deal to gain
competitively from a large yen revaluation.
The best-laid plans can go awry. In those days, jet transports had to refuel at
Anchorage to fly to Japan from Washington, and I could only fly on to
Europe via Anchorage, and then over the North Pole. When I returned to
the plane, which was parked at a United States military airport near Tokyo,
I was eager to get started because I knew the Germans were being asked to
receive me on Friday evening. To my consternation, the pilot said he
couldn't leave for eight hours because the military rules required a rest
period after the flight from Anchorage. When I inquired about the extra
crew that I thought had been brought along for just that contingency, I
discovered they had been left at Anchorage.

I called Washington to explain the fix in which I found myself. I am told

that the secretary of defense eventually had to be roused from bed to
override the normal limits on flying time. All that took several hours, and
when I finally arrived at the Bonn-Cologne airport around eight

CHANGING FORTUNES

o'clock on Friday evening, I was informed by the Treasury attache meeting

me that he had just seen Helmut Schmidt boarding a German government
plane. In fact, Schmidt took off for Paris as I landed, having decided to
consult with his French counterpart, Valery Giscard d'Estaing, before he
talked to me. That worried me somewhat because I wanted the opportunity
to present our proposals to him fresh, as it were, in the hope he might join
us in convincing the French. In effect, I wanted to reverse our Smithsonian
negotiating strategy.

I had the chance to present our approach to Schmidt the next morning in
Bonn, and as expected he was joined by Emminger. As I recall it, he
responded rather cautiously, clearly not rejecting the idea but wanting to
consult further with his European colleagues. I then flew to London and that
evening found the British supportive. Next on my list was Giscard
d'Estaing, our old colleague from the Azores. We anticipated he would be
the most difficult to convince because of the size of the devaluation we
proposed. At the same time, however, we were offering a solution
consistent with his desire for fixed exchange rates and were willing to take
whatever opprobrium would be associated with devaluation. After hearing
me out on Sunday morning, Giscard proposed that we meet late that
evening with Helmut Schmidt and Tony Barber at his Paris apartment to try
to resolve the matter. (Meanwhile, the Italian government got wind of my
travels and urgently requested a briefing. I flew to Rome and, somewhat to
Giscard's discomfort, brought back with me Minister Giovanni Malagodi of
the Italian Treasury, judging he would be supportive.) The Europeans all
accepted that our approach was more promising than any alternative they
had considered. Conceptually, a joint float of European currencies against
the dollar was an option, but it would in effect constitute a declaration of
monetary independence from the United States. I felt they doubted they had
either the political cohesion or the technical ability to manage it
successfully.

Most of the discussion late that night was about our proviso that gold would
be sold into the market if necessary to dampen speculation. It became clear
that the French were extremely reluctant to sell gold even as a limited
participant in a joint effort; the proposal plainly touched a political nerve in
a country historically populated with gold hoarders. To my disappointment,
French opposition was much stronger than their concern about removal of
our capital controls, even though that seemed to me and others a
psychological threat to the success of the exchange

no

FLOATING AND DRIFTING

rate realignment. The arguments, theoretical and practical, went back and
forth, but in the end, lacking vigorous support from others in the room,
agreement on gold eluded me.
What was clear was our agreement on the nature of the exchange rate
realignment, provided that an adequate understanding with the Japanese
would be pinned down. By that time, the Japanese had dispatched the Vice
Minister of Finance for International Affairs, Takashi Hosomi, to Europe to
monitor the negotiations firsthand. I met him in Bonn the next day while we
awaited the final decisions in Washington, Tokyo, and the European
capitals.

During the course of the day, I agreed with Hosomi on a form of words that
papered over our small remaining differences about the extent of the
Japanese appreciation. In effect, the Japanese committed themselves to
permit a free float to a rate of 264 yen to the dollar, an appreciation of 17
percent; I made clear my understanding on behalf of the Europeans and the
United States that if market pressures so indicated, Japan would permit the
yen to rise to 257, a 20 percent appreciation. Meanwhile, in consultation
with George Shultz in Washington, we decided we could not press any
further on gold. At my urging, however, Shultz was willing to soften our
announcement about the removal of controls by deferring the action into the
future. That part of the plan was only fully implemented early in 1974.

With those understandings, the deal was done. The negotiation had run only
from Thursday night in Japan to late on Monday in Europe. The effective
exchange rate change was larger than had been achieved at the Smithsonian
after five months of controversy. Plainly, there had been a massive shift in
attitude by all parties in their sensitivity to changing their exchange rates,
and there was a strong sense of constructive cooperation.

The agreement was met with effusive acclaim from commentators on

international financial affairs, from those concerned with the political
relationships among Europe, Japan, and the United States, and from
virtually all editorial writers. The response that counted much more, in the
markets, was more ambiguous.

When I got back to the United States, the deep-seated skepticism was
reflected in a barrage of questions from the press centering on whether and
when the United States would resume some degree of convertibility for
gold as an earnest of its commitment to the new exchange rates. In
unspoken deference to the reform discussions and our

CHANGING FORTUNES

negotiating position in them, that question had not been raised in my

weekend trip around the world. But intellectual praise for reform plans and
negotiating nuances don't count for much when speculators' money is at
stake. Some of them, at least, wanted to see us "put our money where our
mouth was" before betting too much on the dollar.

As expected, the announcement of the large exchange rate realignment

brought a sizable inflow of funds into the dollar for several days, but it fell
short of what we would have liked. More ominously, as I had feared, the
gold price soon began rising sharply, reaching about S90 an ounce, or more
than twice the new official price of S42.22. That knocked the psychological
props out from under the dollar. Within a week or two, dollars were again
pouring into European central banks. They felt they had no recourse but to
close their official exchange markets on March 2.

That had a specific meaning. Market operators could continue to negotiate

trades among themseleves at whatever price could be agreed, but
governments would not intervene to stabilize their currencies. In practice,
currencies were therefore free to float. The danger was that without a sense
of official direction and support, trading conditions could be quite chaotic,
volumes limited, and currency relationships among third countries
distorted.

The European Community's finance ministers quickly caucused and

decided to invite us and the Japanese to an emergency meeting on March 9
in Paris. Although the players were mostly the same, the tone was quite
unlike the disputatious and hectoring atmosphere of the meetings in 1971.
There was a clear sense of a common problem and little finger-pointing; the
United States had, after all, seemed to play by the rules in initiating the
second devaluation. Moreover, the Europeans and Japanese were facing a
quite different and, at that point, little-known personality in George Shultz.
In his reserved demeanor and soft-spoken manner, the surface contrast to
John Connally could not have been more striking.
The Europeans, in fact, knew little of Shultz's substantive views. Rather
tentatively, it seemed to me, they suggested that they would have to attempt
to arrange a joint float. That posed questions about whether the United
States would be willing, by one device or another, to mop up dollars from
the market and also bring the unregulated Eurodollar market under better
control, always a particular concern of Helmut Schmidt. Shultz sat silently
through it all until shortly before lunch,

FLOATING AND DRIFTING

when he was pressed for a response. It was short: An agreed move to

floating was something he was prepared to consider sympathetically. He
would be willing to discuss technical measures that might be taken to
absorb some of the Eurodollars, but no hope was held out for convertibility.

During the lunch break at the American Embassy, Shultz and I had an
interesting discussion with Arthur Burns. Although Shultz's brief remarks at
the meeting had done little to reveal his intellectual attitudes to the
Europeans, he had long been strongly sympathetic to floating. But Burns,
whom Shultz had admired enormously ever since he'd served on Burns's
staff as an economist at the Council of Economic Advisers twenty years
earlier, feared floating with a passion. The chairman of the Federal Reserve
Board made one last appeal to turn the tide. To me, it simply seemed too
late, and with some exasperation I said to him, "Arthur, if you want a par
value system, you better go home right away and tighten money." With a
great sigh, he replied, "I would even do that."

He was not put to the test. When the meeting resumed, it turned to more
technical preparations for a joint float. The deputies were sent off to
Brussels to discuss ways and means for cooperating to tame the Eurodollar
market. A week later, the ministers met again and formally agreed to permit
their currencies to float for an indefinite period. The ongoing reform
discussions were being conducted under the assumption that some kind of
par value system would be restored, so the assumption was that the
generalized floating would be temporary.

Shultz gave a press conference at the American Embassy, and I recall only
one point. Burns stood on the podium with Shultz, and a reporter asked
what seemed to me an appropriate question: "Mr. Secretary, what does this
all mean for American monetary 7 policy?" Burns, always conscious of the
prerogatives of an independent Federal Reserve chairman, reached over and
took the microphone from Shultz and pronounced in his most authoritarian
tone, "American monetary policy is not made in Paris; it is made in
Washington."

It seemed to me at the time, and it seems to me now, that we were at one of

those points in economic history when Burns's sensitivity (and many
others') about the legitimacy of international considerations in conducting
what is thought of as merely domestic monetary policy was misplaced. In
the particular circumstances early in I973> price increases were already
beginning to accelerate in the United States. Within only

CHANGING FORTUNES

a few weeks, monetary policy was tightened and the discount rate was
raised. But it was all too late; too late to save the dollar exchange rate, and
far too late to head off an incipient inflation that, amplified by repeated rises
in world oil prices, soon reached an intensity beyond any seen in the life of
the American republic. It presented me with my main challenge when I
eventually assumed the position that Arthur Burns then held. I've often
wondered whether the economy might not be stronger today if monetary
policy in those days had not always carried the label "Made in Washington"
and if the United States had responded to the international pressures on the
dollar in the early 1970s with the vigorous monetary restraint that in any
case was needed by the domestic economy.

THE REFORM TRACK

Paralleling all these practical decisions, a more intellectual, forward-

looking process was at work. A group of us from around the world, mostly
deputy finance ministers and central bankers, were thinking about how to
rebuild a structured monetary system. We wanted to improve on the Bretton
Woods model. But we were also conscious that we had to do it in real time
against the background of discordant events in the market and in an
environment in which no one or two countries could practically dictate the
results.
After the suspension of convertibility in 1971, and even before, there was
talk about the need for monetary reform to go far beyond the agreement that
created Special Drawing Rights. Before the Smithsonian and after, every
official speech and every international communique about monetary affairs
included obligatory paragraphs about the need to proceed on reforming the
system. But the fact of the matter was that, for a time, the United States was
not interested in pursuing the matter aggressively.

There were several reasons. As the discussions at Camp David and later in
the Azores revealed, it was not a matter that captured the president's
personal interest and imagination. Moreover, there was a split within the
United States government between the Bretton Woods veterans and those in
the Nixon administration representing newer schools of thought. The latter
were sympathetic to more radical approaches, particularly those
emphasizing more flexible exchange rates. To some extent, the differences
paralleled a broader intellectual and ideological

FLOATING AND DRIFTING

cleavage even within the Republican party between the internationalists of

the eastern establishment and those who believed they were more deeply
dedicated to advancing free market concepts and more suspicious of foreign
economic entanglements.

Although those differences existed, in my judgment it would be a mistake

to attach central importance to them. The officials most involved in
international monetary matters generally approached problems rather
pragmatically; that was certainly true of John Connally. His principal
concern in early 1972 was that a concerted reform effort was premature for
the simple reason that an adequate agreement was not possible. I came to
agree fully. We were convinced that European thinking was trapped in
channels that were far too conventional. With few exceptions, the
Europeans plainly felt strongly about the virtues of a par value system,
strong limits on exchange rate flexibility, and full convertibility of dollars
into agreed international assets (presumably some combination of the SDR
and gold). From their standpoint, the major flaw in the Bretton Woods
system was the unconstrained use of the dollar as a reserve currency,
making it impossible to force the United States to take strong action to
adjust its balance of payments deficit. The central thrust of their thinking on
reform was to make the system tighter, more like the classic gold standard
with tougher adjustment disciplines for the United States.

Our preoccupations were quite different. We, too, were concerned with
asymmetries in the system, particularly with the relative ease with which
other smaller countries could adjust their exchange rates, seek and maintain
trade surpluses, and leave us, as the residual "«th country," in a chronically
weak position. We, like Keynes before us, felt the disciplines of the system
had fallen primarily on the debtors. We recognized that any new system
would need to come to grips with the Triffin Dilemma. But we were not
willing to rule out use of the dollar as a reserve currency or restore full
convertibility until the underlying asymmetries were resolved. And if they
realistically could not be, then there would need to be adequate elements of
flexibility both in reserves and in exchange rates. All this was technically
complicated and part of it politically quite subde. We were not convinced
then, or even later, that the Europeans really understood our concerns or
how strongly we felt them.

Finally, we did not like the G-10 forum as a locus for the reform
discussions. It was dominated by the Common Market countries and

CHANGING FORTUNES

Switzerland, all of which basically shared the philosophy of a tight system

with full convertibility. The Japanese position was more enigmatic,
certainly less aggressive than the Europeans' about the dollar, but unlikely
to be counted on as a strong force for liberalism and flexibility. While
Britain, Canada, and Sweden might be more sympathetic on some points,
the G-io as a whole seemed much too much stacked with the most
conservative European views.

More broadly, the G-io was seen as too much of a rich man's club to
provide legitimacy for fundamental reform of the international monetary
system. For other reasons, the more representative group of twenty
executive directors of the IMF also seemed inappropriate. Experienced and
able as they were, these men seemed too far removed from the policy-
making processes in their own governments, and too much committed to
the Bretton Woods framework, to offer a reasonable chance for negotiating
success. We thought the optimum arrangement would be a relatively small
number of finance ministers (including several from the developing world),
with their deputies as a working group to prepare the decisions. The G-io
and executive board were definitely unhappy, but the logic was compelling.

As it turned out, the only practical way to achieve agreement on which

countries were to be represented was to duplicate the twenty members of
the IMF's executive board, but at the level of ministers. In practice, the
Committee of Twenty—or the C-20, as it came to be known—ended up as a
rather unwieldy forty at the working level of deputy ministers. Each
member of the C-20 produced two representatives: one official from the
finance ministry and one from the central bank for the leading countries.
Each one of them was backed by staff people, so there were perhaps a
hundred and fifty people in the room every time the Committee of Twenty
deputies had a meeting. There were even more when the ministers met.

All that history is worth mentioning because the C-20, which remains as the
IMF's Interim Committee, is the only part of the reform effort that left a
concrete legacy. Although it still has never been given formal status, the
Interim Committee, along with its companion, the Development
Committee, meets at least twice a year and provides the only forum in
which finance ministers can hold regular discussions of monetary issues
and economic developments outside of the inner circle of industrialized
countries. Important decisions affecting the IMF and the World Bank must
pass through these groups.

FLOATING AND DRIFTING

The differing perspectives on monetary reform were rather dramatically, if

inadvertently, exposed at the annual International Monetary Conference of
commercial bankers in Montreal in May of 1972. Chairman Burns was on a
panel discussing reform plans, and while his ideas were deliberately
sketchy, they conveyed a tone of urgency. If you want a speech to have
some impact, you must always enumerate a nice round number of points
and place them at the end. Burns had ten of them, and among them he
included the need to restore par values and convertibility of the dollar. He
had courteously permitted me to comment on a draft of the speech
beforehand, and I did not believe it would be read as breaking new ground.
But the press promptly interpreted his remarks as a clear change in the U.S.
position, moving closer to European views. By sheer accident, I had a press
conference scheduled very shortly after Burns spoke, and aggressive
questions were posed about "the Burns plan." I replied that Burns was not
speaking for the United States government, which was certainly true, and
that in any case we had no plan to present.

In fact, my main function at the conference in the absence of Secretary

Connally was to give the keynote speech laying out the prerequisites we felt
necessary to put in place even before useful negotiations could begin. The
next day, front-page headlines pictured me as deliberately squelching
Burns, with the result that Connally had calls from Nixon lieutenants
congratulating us for "taking on" Chairman Burns. Only later did I discover
there was a vendetta of sorts among White House staff to press Burns to
maintain easy money during an election year, something I would have
wanted no part of.

Shortly thereafter, there was a surprising change in secretaries of the

Treasury, which raised the age-old question of how much difference
personality makes in the formulation of policy. John Connally, without
providing any inkling in advance, abruptly resigned as secretary of the
Treasury; he simply called me into his office along with a few others, told
us he was leaving, and in a day or two, he was gone. I had a strong sense of
loss. Some of the views he was fond of expressing in private about foreign
policy and particularly about Vietnam alarmed me. Certainly, he did not put
great store on continuity and predictability, qualities normally favored by
financial officials. He was in some respects hard to work for, at times
secretive and with a Texas-sized ego. He certainly demanded loyalty. But in
turn, he strongly supported his subordinates and, without in any way
involving me in his more political activities,

CHANGING FORTUNES

taught me a great deal about the ways of power in Washington.

George Shultz, who was then director of the Office of Management and
Budget and had earlier been Nixon's secretary of labor, was promptly
appointed secretary of the Treasury. Shultz's notably calm and stolid
persona has since become quite familiar due to his tenure as secretary of
state in the Reagan administration. His public image of integrity reflects a
strong and genuine sense of right and wrong. Unbeknownst to the rest of us
at the time, he successfully stonewalled White House requests for
confidential information about individual tax returns during the Watergate
years.

What is less well known is the strength of his ideological views on some
subjects. Shultz was a Princeton man and a Ph.D. economist from the
Massachusetts Institute of Technology. But his real intellectual home had
come to be the University of Chicago, where he had become dean of the
business school. Milton Friedman, for many years a professor at Chicago,
had a pervasive influence on the intellectual life of that school. In many
areas—including monetarism and its international corollary of floating
exchange rates—Shultz was among those captivated, and in terms of
ideology there was no question as to who was the teacher and who was the
student.

I knew from experience that Shultz had no hesitation in expressing

monetarist views forcefully during policy debates within the administration.
But I soon came to know another side to George Shultz, which later became
evident to a great many people when he served President Reagan as
secretary of state. Much of his private professional experience was as a
labor negotiator. I found that when he assumed full responsibility for a
problem, what came to the fore was the side of his background that marked
him as a conciliator and consensus builder, rather than an ideologue. Time
and again, he would work with almost inhuman patience to bring a group
into agreement upon a decision that all could support, at times submerging
his own preferences.

Not long after Shultz became secretary, he asked me about our plans for
monetary reform. I had to confess they did not exist, at least not in the sense
of a considered position paper that had been internally debated and adopted.
The fact was that John Connally had not encouraged much reform
discussion, thinking it premature. Arriving at an agreed intragov-ernment
position, amid the conflicting attitudes, would also be difficult. I had asked
a small interagency group to work under my deputy at the time, Jack
Bennett, to see if they could develop some agreed views, but

FLOATING AND DRIFTING

without expectation of much progress. There would have to be more

concerted pressure from higher authority to make progress, and George
Shultz provided it.

The annual IMF meeting in September 1972 was the logical place for a
public initiative, so we did not have a lot of time. Within a few weeks, I
organized my own thinking into a fairly comprehensive outline of a
reformed system. Shultz liked it well enough to use it as the base for
discussion among all the relevant agencies, including the State Department,
which had been left out of Camp David. Moreover, he somehow managed
to keep the attention of his fellow cabinet-rank officials for a series of
meetings to discuss what was, after all, highly technical stuff.

The plan that was developed in the summer of 1972—well before the
breakdown of the Smithsonian agreement—accepted that the center of
gravity of the new arrangement should be a par value system supported by
official convertibility of dollar balances. We would be willing to consider
the conversion of a large portion of existing official dollar balances into a
new account at the IMF (to be called a "substitution account"), but we
thought some use of the dollar and other reserve currencies would remain a
necessary part of the system, providing an element of needed flexibility. We
also wanted to permit a wider range of fluctuation for currencies around
their par values. Importantly, we felt that in some circumstances a country
should be able to float its currency, something that was technically against
the Bretton Woods rules.

The problem that haunted us was how to deal with the asymmetries that we
felt had plagued the Bretton Woods system. They tended to keep the United
States's external payments under pressure and more generally focused
adjustment pressures on deficit countries while taking pressures off surplus
countries. My way out of the thicket was a conceptually simple but
operationally difficult system. The general idea was that a country
experiencing disproportionate gains or losses of reserves, to be measured
against a "norm" established for each country, would be expected to initiate
adjustment, possibly by changing its exchange rate but when possible by
adjusting other policies.

In the Bretton Woods system, a loss of reserves would eventually force

adjustment by a deficit country, but there was no comparable pressure on
surplus countries such as Japan or Germany. The key to the reform plan was
that a surplus country unwilling or unable to adjust would eventually lose
its right to convert its currency reserves into gold or SDRs, relieving the
pressures on the system and particularly the

CHANGING FORTUNES

reserve center. Moreover, an option for a government to float its currency

would provide an escape valve for either deficit or surplus countries that
was not legally available under Bretton Woods rules.

I was rather proud of the indicator approach, only soon to be reminded, in

this area like others, there is nothing really new under the sun. I had not
done my homework by rereading the debates leading up to Bretton Woods.
A more scholarly Federal Reserve colleague, Robert Solomon, who headed
the Fed's international division and later wrote the most comprehensive and
authoritative study of postwar international monetary developments, soon
pointed out to me close similarities to some of Keynes's early reform
proposals prior to the Bretton Woods conference. The fact of the matter was
we were writing from broadly similar perspectives; Britain was a reserve
currency country with a deficit, and Keynes didn't want all the adjustment
pressures to converge on sterling. The United States, then the chronic
surplus country, resisted Keynes's ideas, just as the European countries
would resist the U.S. reform plan thirty years later.

With Secretary Shultz's careful nurturing, the United States had a reform
plan that commanded support right across the spectrum of U.S. government
opinion. I was nonetheless concerned when he asked Milton Friedman to
review the plan as incorporated in an early draft of his IMF speech. With
the addition of some useful rhetorical flourishes, it somehow passed muster.
At the start of the autumn IMF meeting, the United States was placed very
much on the defensive. Not only had we been portrayed as the reluctant
dragons on the reform issue, but just before the meeting the story was
leaked that the United States would block the reappointment of Pierre-Paul
Schweitzer as the Fund's managing director. That decision had been taken
when Schweitzer refused the option of gracefully retiring in a year or two
and was the culmination of a long series of perceived frustrations,
frustrations not confined to the United States. Other countries had, in fact,
been consulted about the matter, although they did not want responsibility
for the decision. Notwithstanding all that, Schweitzer was a man of stature
and considerable repute. Among other things he was a French resistance
hero, and rightfully popular among smaller member countries. The United
States was easily portrayed as an international bully by a press already
sensitized by John Connally's aggressive approach. When Schweitzer was
introduced to speak at the start of the meeting, competing rounds of
applause filled the

FLOATING AND DRIFTING

huge auditorium in support of the martyr, providing a convenient outlet for

resentment of the United States.

That mood changed dramatically as George Shultz spoke later. Here was the
United States at last setting out an integrated and comprehensive vision of a
new monetary system. Like it or not, there was at least a constructive plan
on the table that could provide a base for negotiation.

At no time did any other participant in the negotiations provide a similarly

comprehensive vision of a new system, and that seemed to me symptomatic
of a certain reality. After all that had happened to the dollar, and all the
criticism of the United States's negotiating approach, no other country
seemed able to set out a view of a new monetary and trading system that
would really attempt to take account of the needs of all the countries that
would participate in it. Perhaps my impression is merely self-serving and
naive, but I believed at the time that it was characteristic of American
positions on important matters to take account of the international interest
as well as our national interest. It is not really a matter of altruism. When a
large, powerful country acts, it is forced to take account of feedback effects
—the anticipated reactions of others in the system—because it knows its
actions will affect them. That does not come so naturally to small countries
or those on the periphery. After all, a small country can run surpluses or
deficits, devalue or revalue, buy gold or hold dollars, open markets or close
them, tighten money or ease it, without much fear of reprisal or of having
an appreciable effect on the system as a whole. A large country has much
more influence on the shape of events and the nature of the system itself.
But it also lacks the luxury of acting (or even thinking aloud!) without
sending shock waves around the world.

Whatever the sense of relief that we had taken an initiative, however broad
our vision and ingenious our proposals, there was no reason to expect easy
agreement. For some, the whole scheme seemed too far away from the tight
asset settlement system most Europeans wanted. Suspicions persisted that
our plan would permit the United States too many escape hatches from
internal financial discipline, leaving the rest of the world still dependent on
an unstable dollar. Some cynically concluded the whole proposal might be a
complicated smoke screen, shielding our preferred desire to have no
agreement at all. Even more sympathetic participants were concerned that
the plan would automatically force frequent currency alignments,
undercutting the stability sought in a par value system.

CHANGING FORTUNES

That was a tough criticism to meet. It was not literally true that the indicator
system would force a country to adjust its external position by changing the
value of its currency or by some other action that would automatically take
place. If a nation was in deficit, for instance, just as under the Bretton
Woods system, a government could choose to tighten monetary or fiscal
policy, to borrow for a time, or even to resort to controls temporarily,
although we insisted controls were not to be a preferred or mandatory
option. When in surplus, controls could be removed, markets opened,
money eased, or foreign aid increased. But it was also true that, once a
country found itself in a sizable external disequilibrium, a change in the
exchange rate might well appear the most effective and plausible way of
dealing with the situation. That posed a political problem. Fixing an
exchange rate is considered a fundamental part of national sovereignty. In
some circumstances, governments may yield that aspect of sovereignty to
gain a larger objective, as members of the European Community have
agreed to do before the turn of the century. But the appearance of being
pressed to make a decision by a mechanical indicator was hard to swallow.
In fact, it turned out to be harder for governments to do that than simply to
abdicate the decision to the impersonal forces of the market, which is what
they essentially agreed to do in floating their exchange rates.

No consensus was ever reached on the structure of a new system. At oik

point, in the summer of 1973, the talented and energetic C-20 secretariat—
led by Jeremy Morse, who had taken leave from his responsibilities as
executive director of the Bank of England, and ably supported by Bob
Solomon, Hideo Suzuki of Japan, and others—attempted to break the
impasse. It set out a proposed framework for agreement combining
elements of our proposals with a tighter asset settlement system for a core
of industrialized countries. Some hope was stirred when the French
conceded there was some point to American concerns about the need for
symmetry, and made a helpful gesture toward accepting a modified form of
our indicators approach.

The French were, of course, considered the principal protagonists of the

"hard line" European view. But more than any other minister involved,
Giscard d'Estaing had a strong intellectual interest in the monetary system,
gave personal attention to the problem, and was, I thought, genuinely
concerned to negotiate solutions. Nevertheless, It was difficult to have a full
meeting of minds. Claude Pierre Brossolette, the principal French deputy,
once aptly described the difficulty: In

FLOATING AND DRIFTING

approaching the monetary system, Giscard as a good Frenchman thought in

terms of a formal garden, completely symmetrical, with everything in its
place; Anglo-Saxon monetary designs, like English gardens, came from a
different tradition of informality and improvisation.

I went to a key deputies' meeting in Paris in September 1973, ready to

accept the secretariat's draft as a basis for discussion despite the need, as we
saw it, for some key changes. (The draft did contain large elements of a
French garden.) It soon became apparent, however, that the Europeans were
in no mood to settle; by prearrangement or otherwise, one by one, they
rejected the secretariat's outline. Without the possibility of strong support
from Japan or even Canada, both relatively passive participants, the whole
effort began to look hopeless, and I said so.

Nonetheless, I was a little surprised when later, at the IMF meeting in

Nairobi, Giscard himself took the initiative and proposed that the
negotiations be set aside for a year. By that time, the decision to float had
already been taken as an interim measure. But certainly the French had not
become covert floaters intellectually, and I was never clear why Giscard
wanted to set the negotiations aside at that stage. The formal decision to
wind up the negotiation was taken at a C-20 meeting in Rome in January
1974. By that time, both the spreading oil crisis and the pervasiveness of
inflationary pressures provided a plausible excuse. To most participants, the
practical possibility of actually installing a highly structured system had
come to seem increasingly remote. My personal disappointment that we had
failed to create a new Bretton Woods amidst all the turmoil was not widely
shared in the United States government. Those content with floating
currencies felt no urge to keep the negotiations alive.

Our proposal sharpened the basic question of whether really meaningful

elements of exchange rate flexibility can be introduced into a par value
system without that system's shaking apart sooner or later. The very purpose
of making exchange rates more flexible is to minimize the need for controls
and to reduce potential conflicts between monetary policies that seem
appropriate for domestic needs and the need to defend a currency in the
exchange markets. But at the same time, the mere expectation that exchange
rates might change sends huge sums of liquid capital rattling through
international markets seeking speculative gains, in the process making it
impossible either to maintain par values or to avoid mobilizing monetary
policy to stabilize the currency.

CHANGING FORTUNES

This was not just some theoretical matter to the negotiators; they could see
it happening before their very eyes and as a result of their own decisions.
The resort to floating in early 1973 was not taken out of any general
conviction that it was a preferred system. It was simply a last resort when,
by general assent, the effort to maintain par values or central rates seemed
too difficult in the face of speculative movements of capital across the
world's exchanges.

The next stage was to reinforce the legal and institutional framework for
floating, but in the meanwhile, the Europeans were developing a par value,
fixed exchange rate system for use among themselves. Ever since the
breakdown of the Bretton Woods system, they had been experimenting with
arrangements to maintain more stable exchange rates among European
currencies, avoiding distortions in trade within Europe and in the process
reducing the unsettling effects of the fluctuations of the dollar.

I will not rehash all the many steps in that process. Suffice it to say that,
although over the years there have been many setbacks to the system and
temporary dropout countries, the effort never flagged for long. There have
also been many skeptics, but the version of the European monetary system
that was established in 1979 has held together for more than a decade.
Within the system, there were for a while a number of revaluations and
devaluations, but all were relatively small and offered very limited, if any,
gains to speculators. Management of the system has probably been eased by
use of the wider margins introduced at the Smithsonian. Capital controls
have been dismantled, matching the progress in freeing the European
Community's internal market for goods and services.

The trend is clear: The intra-European system has moved strongly in the
direction of fixed exchange rates. While in concept small exchange rate
realignments have been tolerated, in practice, as the system moved into its
second decade, they became rare. The tendency toward greater "fixity" was
underscored by the political decision of the European heads of government
at Maastricht, in the Netherlands, in December of 1991. The agreed goal is
to attain not just fixed exchange rates but a common currency before the
year 2000 among all European Community countries that have
demonstrated an ability to reach certain measures of financial stability.

Plainly, this progress toward monetary integration seems to be telling us

something about the basic requirements for running a par value
FLOATING AND DRIFTING

system, and doing so consistent with the liberal ideal of open markets for
goods, services, and money. One thing has been clear, and it is relevant to
the more general questions of what is feasible on a world level. The
Europeans have a dominant currency. The German mark is dominant partly
because Germany has Europe's largest and strongest economy, but at least
as important is the mark's stability. Other European countries have
concluded that it is in their interest to maintain a high degree of price
stability, and maintaining an exchange rate that is fixed to the mark
advances that goal. That can only be achieved at the expense of largely
forgoing the independence of their national monetary policies. Apparently
that has been a price most of the other nations of the Community think is
worth paying as long as the dominant currency continues to deliver the
stability they seek.

The sad fact is that the dollar had stopped delivering that stability by the
early 1970s. After two devaluations, the United States found its currency
continuing to float downwards for several months. President Pompidou was
a less than gracious host when he sarcastically commented to the press
when entering the 1973 International Monetary Conference in Paris, "Now I
see we have the third dollar devaluation." Nonetheless, his remark caught
something of the mixture of concern and satisfaction with which many
Europeans viewed the fall of the dollar from its Bretton Woods pedestal.

Any glee in that respect was premature. By the summer and fall, as signs of
an improved U.S. trade position appeared, and later, as the Mideast War and
the oil crisis worried markets, traders and investors were reminded that the
United States, after all, was still a relative bastion of strength and stability
and the dollar a safe haven in troubled times. With short-term capital
flowing toward New York, the dollar rose almost as sharply as it had fallen.
Early in 1974 I had the pleasure of writing the press release announcing the
end of capital controls, noting that under existing circumstances access to
the New York capital markets for foreign countries could be useful. It was,
in fact, even important to the Japanese, as Toyoo Gyohten explains.

It is an interesting question whether any national currency can realistically

be expected to be a solid anchor for a fixed-rate system decade after decade.
The abstruse questions we faced in the reform effort of the early 1970s were
often posed in excruciating detail, and I do not believe we ever arrived at
fully satisfactory answers. But the basic issues were not technical. Again
and again the question was posed: Can we

CHANGING FORTUNES

have a stable system without a dominant country that is itself

extraordinarily stable? And was the United States any longer able to play
that role?

At one of the C-20 meetings I remember sitting next to Claude Brossolette.

Our minds wandered as the speeches droned on. At one point, my French
colleague drew a little triangle on a piece of paper to illustrate what he
considered the three ways of designing a monetary system. On one side of
the triangle he wrote "Dominant Country" or "Hegemonic Power"—I don't
remember the precise phrase. Underneath it he wrote "tyrant." He said, "We
don't want that." On another side of the triangle he wrote "Dispersed
Power," and underneath that he wrote "chaos." "We don't want that." And
that left only the base of the triangle, where he also wrote "Dominant
Power." But underneath that he wrote "benign."

I think he meant the United States had been relatively benign, and the
system had worked, which wasn't exactly the official French posture at the
time. But, taking his point, could the world return to that position? Was the
United States still relatively strong enough? And would the French, of all
countries, find it agreeable? It was a very simple analysis, but I've always
remembered it because it seemed to sum up the problem we had.

The questions seem even more relevant today. We are much closer to an
economic and monetary balance of power as the European Community and
Japan approach greater parity with the United States. Without so dominant a
power as the United States in the 1950s and 1960s, can we reaDy manage
an open system and maintain its stability?

We do not have the conclusive answer to that question yet, but we have had
by now a good deal of experience in developing what potentially could be a
kind of collective directorate. Its foundations were really laid by George
Shultz, although I doubt he fully realized at the time that his modest
initiative would be so fruitful in institution building. In the spring of 1973,
with the monetary system in disarray, with the reform discussions moving
slowly at best, with inflation accelerating, and with everyone unaware that
the first oil crisis was approaching, Shultz invited his French, German, and
British counterparts to an informal meeting in the library on the ground
floor of the White House. The locale was meant to emphasize his intent to
engage in quiet, confidential, and significant discussion.

I do not recall any profound conclusions of substance reached at that

FLOATING AND DRIFTING

meeting of finance ministers, but there was a common understanding that it

would be worthwhile to maintain the informal contact. Giscard volunteered
to host a meeting in France in the fall, and the Japanese were later invited to
attend through a deft diplomatic tactic that Toyoo Gyohten relates. Arthur
Burns was also insistent that he, too, must be included, and Shultz,
recognizing the relevance of central banking input and in deference to an
old mentor, included him at the meeting at the Chateau d'Artigny near
Tours. That set a precedent for central bank governors to accompany their
finance minister colleagues, and the framework was set for the Group of
Five.

Schmidt of Germany and Giscard of France, two of the original participants

in Shultz's Library Group, soon rose to the top of their governments, which
itself says something about the importance European countries attach to
international economic matters. It became a natural thing later, when an
important agreement was reached on amending the IMF Articles of
Agreement to legalize and rationalize floating exchange rates, for members
of Shultz's Library Group to meet at the level of heads of government.
Thus, with the addition of Italy and Canada, was born the Group of Seven
and the annual economic summits as we know them today.

In terms of press attention and publicity, the summit meetings in particular

have strayed far from the kind of quiet intimacy sought at the White House
library to facilitate decisions. Perhaps the escalation in attention has been
inevitable, but I see no reason to believe it has improved the quality of the
decision making. As a personal footnote to all of that, Karl Otto Pohl and I
attended the first meeting in the White House as deputy finance ministers.
Then we had years together as the heads of our two central banks. Together
and individually, I am confident that we hold the record for attendance at
ministerial G-5 and G-7 meetings by a wide margin, but central bankers,
quite happily from my perspective, were never invited to the economic
summits, where politics and publicity have come to loom large.

The existence of all these institutional trappings for the conduct of world
economic and monetary affairs belies the innocent promise of floating: that
it would by itself tend to stabilize and make economic adjustment relatively
painless. In the real world of markets, trade, and financial flows, the actual
experience of floating was not a very happy one, certainly not initially. The
exchange rate swings certainly seemed extreme, even accepting the point
that no system could have worked

CHANGING FORTUNES

well under the pressures of rising inflation and economic crisis. At the same
time, the proponents of floating could argue that it had helped the world
economy to survive the crisis and, in any event, that it was all a learning
experience.

At the time, not many voices were raised to argue that the weakness in the
dollar and the surge in world inflation were themselves among the causes of
the sudden quadrupling of oil prices, and that those economic upheaveals
could be traced further to the collapse of Bretton Woods. Subsequent events
would help cast new light on whether international money could manage
itself.

TOYOO GYOHTEN

1 he period from the Smithsonian agreement in 1971 to the installation of

the regime of floating rates in 1973 was a period of trial and error. We all
groped for the right exchange rate levels, and we all tried to maintain
stability in the new and very unfamiliar environment. Right after the
Smithsonian agreement, the world tried for a while to support the new
parity relationship, which was called "central rates." But this time the
system lacked the essential cornerstone of the gold-backed dollar. As it
became increasingly apparent that the divergence of economic
fundamentals among major economies was not disappearing, the effort to
restore a regime of fixed parities, central rates, or whatever they were
called, was in fact doomed to failure. The new forum of the C-20 made a
genuine effort to reconstruct a sustainable exchange rate regime, but
conflicting national interests shattered any hope of an early agreement. In
the autumn of 1973, the first oil crisis changed the global flows of money,
and the world came to realize that there was no alternative to the floating-
rate regime as a fact of life, and no hope of a return to fixed rates in the
foreseeable future.

Japan feared that the large Smithsonian revaluation of the yen would throw
the economy into recession, but the economy revived, the current account
surplus grew, and the United States stepped up its demands for us to import
more American products. Many bilateral negotiations took place, including
the well-known one in Hawaii between Prime Minister Kakuei Tanaka and
President Nixon in September 1972. This

FLOATING AND DRIFTING

meeting was rather an ominous one for Tanaka because he agreed to

purchase Lockheed aircraft from the United States to help correct the trade
imbalance, and during the process of finalizing the deal he was accused of
accepting kickbacks. He was indicted and the continuing scandal blighted
his political life.

Trade pressure increased, and so did international pressure for further

revaluation of the yen. We in Japan frankly did not accept that revaluation
was really necessary. We thought that the 1972 surplus would disappear in
due course, and in any case Tanaka opposed revaluation, enthusiastically
pursuing expansionist policies. He wanted to rebuild the Japanese
archipelago and planned to construct twenty or thirty medium-sized cities
all over the country, connecting them with highspeed highway and bullet
train networks. Tanaka was the first and probably the last prime minister in
Japan who really came from nowhere. He was born in the poor farm
country of Niigata and he was a truly self-made man: no higher education,
but an almost animal instinct, and he was very sharp, very quick, and very
bold; too bold, I'm afraid, at last. He was full of new ideas and had the
energy and guts to try to realize them. He was far more occupied with his
grandiose plan to remodel Japan than any questions of the further
revaluation of the yen.

The Ministry of Finance unfortunately had a rather weak minister at that

time, Koshiro Ueki. He had no leadership or initiative and could not have
had any view on the currency issue during his tenure, which lasted only five
months. I certainly sympathize with him, because he was physically weak,
under medication for diabetes. So Japan really had no other policy but to
intervene in support of the central rate of 308 yen to the dollar, but the
upward pressure remained relentless. During all of 1972 we bought some
$7 billion, to no avail. International instability increased, and by February
1973 only three currencies had managed to hold their Smithsonian central
rates: the yen, the deutsche mark, and the Dutch guilder.

On the eighth of February, Ninja Volcker's secret mission commenced. On

that day, Tokyo time, the prime minister's office received a cable from
President Nixon telling us that Undersecretary Volcker was on his way to
Japan, and would arrive in Tokyo that same evening. Volcker does not
exactly cut an inconspicuous figure, and it was not easy to conceal this
secret mission from the press, but we managed somehow: His plane landed
at a military air base in a suburb of Tokyo and he was driven to the U.S.
Embassy in a limousine with smoked-glass windows.

CHANGING FORTUNES

He was bringing a "ten to ten" proposal. That is, the United States would
devalue 10 percent from its SDR parity, Japan would revalue 10 percent,
and Europe would stand still. That meant $42.22 for one ounce of gold, and
257 yen per dollar, effectively a 20 percent appreciation of the yen from its
Smithsonian central rate.

We had a new finance minister for less than two months, Kiichi Aichi, one
of the most intelligent finance ministers we ever had. Perhaps I should say
it was pure coincidence that he was a former official of the Ministry of
Finance, but he resisted a formal revaluation for rather practical as well as
political reasons. Since it was February, our budget bill was before the Diet,
and if we changed the central rate while the budget was still being discussed
by our legislature, we would have had to revise some of the yen figures that
had been calculated on the basis of the central rate. We agreed to accept a
float, but. not one that would revalue the yen by 20 percent. We told
Volcker we might be able to go as high as 15 percent. Half satisfied, half
disappointed, he left Japan for Europe, but he was in such a rush he left his
hat behind at Aichi's residence. I think we sent it to him later. Negotiations
continued in Bonn. Takashi Hosomi, his then-counterpart, and I flew to
Bonn, where wc met with the Germans and then with Volcker again. To our
great dismay, we found ourselves totally isolated once again. Volcker had
skillfully organized the Europeans into a gang against us. We went to see
Helmut Schmidt, the West German finance minister, who we thought was
our last hope of obtaining help, or at least some sympathy. That was a
totally wrong move. Schmidt told us very politely, "If you don't accept this,
there will be economic war between the United States and Japan." At that
stage, Helmut Schmidt sounded more like Helmut Connally.

Agreement was reached for Japan to float in a range of between 257 and
264 yen, implying an appreciation of 17 to 20 percent against the United
States dollar. Even at that stage, we wanted to repeg the yen before the
budget bill passed to avoid a cumbersome debate in the Diet. We still
thought that floating was a temporary phenomenon, and that there was a
strong enough consensus in the world for a return to a parity regime. In the
United States, we detected a clear split between the Treasury and the Fed.
Early in March, Arthur Burns told us he thought floating would surely bring
misery to mankind, and that once begun, floating would be hard to end and
could last anywhere from a few years to a century. He urged Japan to repeg
as soon as possible. But in Europe, the confusion and turmoil were
mounting and the deutsche mark and

FLOATING AND DRIFTING

Dutch guilder, two strong currencies, came under heavy attack. On March I,
1973, the Bundesbank bought $2.7 billion in a single day, the largest
intervention by any central bank in history. They finally closed their
markets on March 2, and when they reopened on March 19 there was de
facto floating everywhere.
Our decision to float was accomplished much more quickly and smoothly
than in August 1971. From that episode we had learned the lesson that it
was useless to try to maintain a fixed rate by intervening in the market
when there was overwhelming pressure in one direction. In 1973, the
economy was in an upturn, there were dangerous signs of inflation, and
there was less domestic opposition to revaluation. Remarkable stability
followed, until the oil shock in October; the yen/ dollar rate fluctuated
between 264 and 266, almost as if we had a fixed parity. The economic
environment reversed rather dramatically, the current account turned to
deficit because of the overheating economy, inflation increased, and there
was a large long-term capital outflow. We had downward pressure on the
yen, which we resisted by buying more than $5 billion to support our
currency. We resisted the depreciation of the yen because we thought we
still had a structural surplus, and we also feared a depreciating currency
would aggravate inflation. At least that was the polite explanation. In fact,
we were like a child who had burned his lips with very hot soup and then
tried to cool them off with ice cream. Our reaction to the new situation was
biased by our previous experience.

After the oil shock, our inflation accelerated and the economy went into a
long recession. The yen slumped and we successively lowered our
intervention point from 265 yen per dollar to 275, then 285; finally, when it
reached 300 we thought the slide must be stopped. We launched a massive
intervention to defend the rate at 300. Starting from the oil shock in
October, we sold almost $7 billion until finally in January of 1974 the
United States announced the total suspension of capital control and the
interest equalization tax, and the dollar started to weaken. The quadrupling
of oil prices quadrupled our oil bill from $4.5 billion in 1972 to $21.2
billion in 1974, and we worried that we would be unable to finance the huge
cost of our energy imports until we could bring our economy and our
payments back into balance. Our anxiety increased with the turmoil in the
Euromarkets, and the failures of the Franklin National Bank in the United
States and the Herstatt Bank in Germany. So in August of 1974 we
borrowed $1 billion from Saudi Arabia for five

CHANGING FORTUNES
years but kept it a secret for fear any publicity might make Japan look
financially weak and therefore more vulnerable. The oil shock dealt a
severe and unexpected blow to the Japanese economy, which was
unprepared because it was totally dependent on imported oil. Instantly, the
economy was thrown into simultaneous inflation and stagnation. The
Japanese suddenly discovered their vulnerability, and so did foreigners.

In general, however, the recycling of the huge OPEC surplus was carried
out smoothly, facilitated by the floating exchange rate regime, which helped
absorb the strains on the monetary system. Rates fluctuated according to the
supply and demand for currencies, gold was no longer the key international
monetary asset, and although the oil-producing countries held big surpluses,
they could not monopolize the supply of key international monetary assets.
That surplus was held largely as deposit currencies in banks in New York or
the Euromarket, which recycled by simply changing the names of the
owners on their books. The operation of this neutral market removed most
of the financial fears created by the oil shock; from the standpoint of
important and creditworthy borrowers like Japan, which would have
suffered serve economic deprivation if credit had not been available, the
easy availability of short-term financing put a quick end to the early panic
and confusion. The lesson we learned was that, having been overwhelmed
by a sense of panic, we had failed to understand and to trust the price
mechanism of the floating-rate regime.

Nevertheless, examination of monetary reform plans went on at a highly

sophisticated level in the C-20 from July 1972 through June 1974; it was
Japan's first experience in a really substantive role in this international
work. Japan participated actively thanks to both its position on the steering
group and the high caliber of the representative it sent. The secretariat was
headed by Jeremy Morse of the Bank of England, who had four vice
chairmen: Robert Solomon of the Federal Reserve, Alexandre Kafka of
Brazil, Jonathan Frimpong-Ansah of Ghana, and Hideo Suzuki of Japan,
who was Japan's representative at the IMF as an executive director at the
time.

The reform exercise faced two main issues: timely adjustment of currency
values and the settlement of external imbalances. We thought that the
collapse of the Bretton Woods system was due to the delay in the
adjustment of currency parities, especially the difficulty for the United
States in changing the value of its currency without everyone else changing,
too. In principle, Europe and Japan preferred fixed pari-

FLOATING AND DRIFTING

ties and were ready to accept floating as an exception. We opposed any

automatic mechanisms for currency adjustment for fear of losing our
national autonomy in economic policy. Another cause of the collapse of
Bretton Woods was the uncontrolled increase of the amount of dollars in the
hands of foreigners. Europeans, particularly the French, argued against the
privilege of the United States in financing its foreign deficits with its own
currency, and we joined them in insisting that the United States accept the
obligation of settling its accounts with other assets— either gold, SDRs, or
foreign currencies—just like any other country. The United States insisted
on using a system of reserve indicators, and the argument persisted.

At the working level, discussions of these issues were highly technical and
virtually free from political interference and pressure. But from the start,
like most major questions in international monetary affairs, these two issues
were not subject to mere technical solutions because they represented
fundamental political problems, and that made solutions impossible,
certainly at least at that level. The value of a currency was considered a
matter of national sovereignty, and countries were not prepared to surrender
such sovereign decisions to the working of an automatic indicator based on
reserves or whatever. The problem of asset settlement really boiled down to
whether the rest of the world was really going to depnve the United States
of its privileges as the key currency country. For the political reason of the
broader role of the United States in the world, this issue also was
impossible to solve. But there also were practical reasons: Most
international transactions were conducted in dollars and the national
custodians of the deutsche mark and the yen were not at that time prepared
to let them take its place and share its burdens.

Floating rates would resolve these issues through the apolitical market rules
of supply and demand. No one would have to surrender his national
prerogative to pick an exchange rate. Since a country also would be under
no obligation to intervene to support its currency, the problem of
settlements would be avoided because the market would force economic
adjustment. It remained only to legalize the floating regime under the IMF
Articles of Agreement. Gold had to be freed from the constraint of its
official price, and an institutional mechanism of international surveillance
had to be built into the IMF to prevent the floating system from being
abused to gain unfair competitive advantage. This was done in a second
amendment to the articles in 1976.

CHANGING FORTUNES

Attempts to use multilateral surveillance did not really materialize for about
another decade. In the meanwhile it became clear that as floating became
established, the international system, such as it was, would not be run by
formal rules but increasingly in meetings of powerful ministers that soon
became the summits, with their own bureaucratic dependencies. Although
Japan was included in this inner club, it had not been at the start. This was
evident from the organization of informal Library Group meetings in the
White House in the spring of 1973, when George Shultz invited the finance
ministers of Britain, France, and Germany. Japan's finance minister became
quite jealous when he heard about this secret meeting and was determined
not to be excluded again.

As Paul Volcker noted when describing how he negotiated the second

devaluation in Tokyo, Kiichi Aichi was a man who spoke his mind and did
things on his own initiative. At the annual meeting of the IMF, which was
held in Kenya that September, he came up with a very ingenious idea. He
invited the four Library Group ministers—Shultz, Barber, Giscard, and
Schmidt—to the Japanese ambassador's residence in Nairobi. He asked
them to bring along their undersecretaries. The whole group had dinner,
with some sake after the meal, and then Aichi asked everybody except the
five ministers to leave the room. There the five remained, supposedly
discussing very important matters, but really not very much of substance, as
I later learned. The most important thing to Aiichi was that the five agreed
to continue the forum. The Library Group, which at its formation was a G-
4, had become the G-5, and Giscard invited the group to meet next in
France.
The tragedy of all this was that Aichi could not attend when the first formal
G-5 convened two months later, in November, because he died just before
the meeting. We held the final preparatory meeting in his office just before
our departure to Paris. He complained that he was not feeling well, so we
called off the meeting, and a few hours later we were told that he had been
hospitalized with a high fever. We prepared letters of regret to the other four
ministers, and he signed them in a weak, trembling hand. The vice minister,
Koichi Inamura, and I carried the letters, and when we changed planes at
Amsterdam, there was a man from the Japanese Embassy at the airport to
tell us that Aichi was dead. When the meeting convened at the Chateau
d'Artigny near Tours, his fellow ministers observed a moment of silence for
him.

Inamura was surprised to discover that Arthur Burns was attending. He

understood the gathering was to be limited to finance ministers, so

FLOATING AND DRIFTING

he asked Anthony Barber, the British Chancellor of the Exchequer, "Am I

right that I was not asked to bring the governor of the Bank of Japan? How
about you?" Barber replied, "I was not asked to bring the governor of the
Bank of England." So Inamura was relieved and asked George Shultz why
Arthur Burns was there. Shultz explained that under U.S. law the chairman
of the Federal Reserve was considered the equal of a cabinet member. Paul
Volcker tells me that the real reason was that Burns wanted to come, and
Shultz, who regarded himself as a student of Burns's and revered him,
although they disagreed on practically everything, didn't have the heart to
say no. Well, as you can imagine, when the other central bank governors
heard about that, it was impossible to keep them away from the next
meeting, and they became regular participants. But as Paul Volcker reminds
me from his more recent central banking perspective, Federal Reserve
Board chairmen are not just equal to but better than American cabinet
ministers, and on that note I had better conclude before I become too deeply
entangled in the inscrutable hierarchy of United States government.

EXPERIMENTS IN COORDINATION
PAUL VOLCKER

O VER V IE W

The combination of accelerating inflation and the oil shock late in J 973
went a long way toward establishing floating currencies as the operational
international monetary system. By mid-decade, they were sanctified by
amendment of the Articles of Agreement of the International Monetary
Fund. By the end of the decade they were so imbedded in academic
thought, in government policy, and in banking practice, that those still
longing for fixed rates on more than a regional or highly selective basis
were relegated to the fringes of debate.

But that progression wasn't paralleled by any sense of growing satisfaction

with actual performance. On the contrary, the mid-1970s were marked by
what was then the most serious of the postwar recessions and by a pattern
of inflation rates racheting ominously higher. Although the pace was
uneven, all the monetary indicators were giving off ominous signals: strong
volatility of exchange rates, rapid growth in world reserves and national
money supplies, and a high level of interest rates. The oft-expressed
expectation that both exchange rates and economies would stabilize as the
world gained experience with floating began to look more like forlorn hope
than reality.

EXPERIMENTS IN COORDINATION

All of that called forth new efforts to coordinate policy internationally,

drawing upon the new and presumably more adaptable institutional
apparatus of the seven-nation economic summit meetings, the Group of
Five finance ministers, and the Interim Committee of the IMF.

One focus of that effort was dealing with the real and financial
consequences of the drastic change in oil prices. Another and still more
ambitious approach was to achieve appropriately complementary economic
policies to sustain and reinforce growth, an effort that reached its apex at
the Bonn summit in the summer of 1978. Later in that same year, there was
a quite-different coordination effort, and it had to be arranged not over a
period of months but within days. It focused on defense of the dollar with
the classic tools of tightened monetary policy and aggressive intervention,
just the sort of thing that some countries had felt compelled to do while the
world operated in the Bretton Woods system. Plainly, the naive impression
that had been created by some that a floating regime would do away with
crises was misplaced.

The emergency program succeeded in its immediate objective of stabilizing

the dollar, but it hardly changed the broad direction of developments. As the
decade drew to a close, the dollar was again under recurrent attack, inflation
in the United States was reaching historic highs, international debts were
dangerously mounting, and the world was caught up in a renewed oil crisis.

THE OIL SHOCK

The first oil crisis was a profound shock in several dimensions. The small
group of rich countries that had come to dominate the world economy
suddenly saw their economic destinies threatened by loss of control over the
supply and cost of oil, which was the single most important commodity to
their well-being and the one that was by far the most widely traded in
international markets. Even the United States, which had only recently lost
energy self-sufficiency, could not escape the direct effects and even less the
indirect ones. The economies of the oil importers were torn in conflicting
directions: They faced deflation as purchasing power was siphoned away
from them to the oil producers and exporters, and simultaneously they were
threatened by inflation as the sharply higher oil prices rippled through the
economy. Financially, this produced a massive reshuffling of international
reserves, with tens of billions of dollars flowing toward a small group of
Middle Eastern states

CHANGING FORTUNES

that had been peripheral to the world economy in all respects except oil
production until that moment.

It was all quite unprecedented for people who had spent their lives studying
and making economic policy. But one thing seemed evident: The
implications for monetary reform (as for much else) would be murky at
best, and most probably adverse. It all seemed to confirm the wisdom of
pushing off, to the indefinite future, resolution of the most difficult issues
before the C-20.

Secretary Shultz capsulized the sense of impotence when he reported to the

C-20 meeting in Rome in January of 1974 that he had just come from an
audience with Pope Paul VI. The pope told him that, in arranging for a
warm winter in Europe, God had managed a more constructive response to
the oil crisis than all the assembled finance ministers and central bankers
together. Actually, Shultz was not unhappy to put the complicated and
difficult reform issues aside, and no doubt he was joined in that sentiment
by others for a variety of their own reasons. What couldn't be escaped so
easily was cooperative planning to deal with the economic and financial
consequences of the oil crisis.

Right from the start, the implication was clear that enormous amounts of
dollars would be drained from oil importers both in the industrialized
countries and in the developing world, ending up in the hands of a half
dozen or so major oil producers, the majority of whom could not possibly
use the money to buy the equivalent amount of goods for their small
populations. Those funds would have to be "recycled" into international
financial markets if a massive contraction in economic activity was to be
avoided. But even if placed in international markets, there was reason to
doubt that the funds would flow to the points of greatest need. In particular,
many developing countries were caught in a financial squeeze by high
prices for imported oil, and it seemed unlikely that they would be able to
borrow on terms and conditions they could afford.

We in the United States Treasury immediately went back to our financial

drawing boards. Assistant Secretary Jack Hennessey, who later turned his
energies and talents to investment banking and the leadership of the First
Boston Corporation, soon presented some preliminary outlines of new
institutions with shared management and financial guarantees by the oil-
consuming countries and the Organization of Petroleum Exporting
Countries (the OPEC of the headlines). It all taxed our imagination, and it
was perfectly obvious that there would be enormous

EXPERIMENTS IN COORDINATION
problems of encroaching on national sovereignty, of delegating decision
making, and of organization. Moreover, the financial problem, however
important, was only one facet of a crisis that would affect the balance of
economic power and political influence more broadly.

Henry Kissinger, who had just become secretary of state, moved to take
control of the decision-making process within the American bureaucracy. It
was my first opportunity to see Kissinger dealing intensively with others on
a substantive matter over an extended period. Certainly the atmosphere in
his meetings was quite different from that in the much more collegial
Treasury, and we weren't quite used to having everything recorded by note-
takers. There was, blessedly, no strong sense of protecting turf. The State
Department focus did mean, however, that instead of using the existing
international forums so familiar to finance ministries and central banks, the
United States convened a special and highly publicized Energy Conference
in February 1975 to bring together both foreign and finance ministry
representatives from the leading oil-importing countries.

It really didn't work. Most of the ad hoc meeting was taken up by

procedural wrangling among the foreign ministers, while Shultz, Schmidt,
and Giscard waited impatiently or consulted informally about the financial
questions they had studied. Michel Jobert, the aggressive French foreign
minister, seemed to protest the legitimacy of the meeting and especially the
leadership of the United States in setting the agenda. Substantive progress
doubtless would have been limited in any event, given the inherent
difficulty of these new issues and the consequent lack of familiarity with
them. Nonetheless, the whole incident reinforced in my mind the basic
prejudice of financial officials around the world: Substantive agreement on
difficult financial issues is best sought in quiet negotiations among finance
ministers and central bankers. Central bankers, I later came to understand,
would not be averse to dropping finance ministers out of the equation when
it came to dealing with monetary policy!

Despite intense efforts, political and substantive issues continued to dog

negotiations for a "financial safety net" long after I left Washington. In the
end, an agreement was signed, but the U.S. Congress never ratified it
because the intensity of the concern greatly diminished.
What happened was that international banking markets, acting on their own,
seemed to be doing an effective job of recycling the surpluses of the oil
countries, which soon came to be known as Petrodollars. The

CHANGING FORTUNES

mechanism was simplicity itself. The major oil exporters found it

convenient to place large parts of their dollar accumulations in the big,
well-known international banks, particularly in the form of short-dated
Eurodollars, which are dollars deposited in banking offices outside the
United States, including the London branches of American banks. The
banks, now awash with liquidity, found willing borrowers for these huge
sums in Latin America and elsewhere, particularly among those
governments whose external payments fell into deep deficit as the oil price
mounted. The ultimate lenders—the OPEC countries—were satisfied that
they had found a safe haven for their money and that they could retrieve the
funds almost immediately from their banks when they were ready to spend
them. The ultimate borrowers in Latin America and elsewhere paid
relatively low interest rates on loans that typically would tide them over
several years.

There were those like David Rockefeller at the Chase Bank who expressed
uneasiness about the process, which indeed was unorthodox from a banking
standpoint. But others, including the aggressive and articulate Walter
Wriston, the chairman of Chase's archrival, Citicorp, were enthusiastic
about the apparent ease and efficiency of the market processes. Bankers and
government officials engaged in a good deal of mutual congratulation over
what they saw as a striking example of Adam Smith's "hidden hand" at
work, smoothly reconciling in the marketplace problems that seemed
otherwise unmanageable. What Wriston and the others in their enthusiasm
apparently forgot, or perhaps never had read, were those interesting
passages in Smith's Wealth of Nations that specifically warned of the
dangers of leaving the management of banking (as distinct from other
industries) entirely to the self-interest of bankers.

The unfolding of that story must await chapter 7. The immediate

significance of the oil crisis and the adjustments to it was to reinforce in the
minds of officials and observers alike, in the United States and elsewhere,
the virtues of market-determined exchange rates in reconciling international
imbalances and adjusting to the huge flows of capital.

THE NEW RULES OF THE GAME

Changes in the leadership of the Treasury during 1974 gave added impetus
to that market view and moved the official American position toward
advocating it outright. William Simon, who took George Shultz's place as
Treasury secretary in May 1974, came from the world

EXPERIMENTS IN COORDINATION

of bond trading, and his experience and free market ideology were of one
piece. Jack Bennett, who took my place around midyear, and his successor a
year later, Edwin Yeo, were convinced currency floaters. Working together
and within a more receptive negotiating environment, they pushed to deal
with some practical matters that needed to be resolved in a way that would
not prejudice the monetary system against floating rates. These matters
included the official role for gold, the definition of the SDR, larger IMF
quotas, and a special "oil facility" set up within the IMF for countries
thrown into deficit by high oil prices. It was a remarkably active period in
those respects.

Then an opportunity arose to settle the exchange rate controversy itself, at

least formally and legally. An understanding developed in the G-s that if
France and the United States, the principal protagonists in the debate over
fixed versus floating rates, could agree on an amendment to the IMF
Articles, then others would also accept it. In a burst of negotiating energy
over a few weeks in the fall of 1975, the new undersecretary, Ed Yeo,
hammered out an agreement with his French counterpart, Jacques de
Larosiere, who then held the prestigious position of directeur du tresor and
was the senior civil servant in the French Ministry of Finance. They settled
on a few paragraphs that provided a legal basis for floating exchange rates.
While there were vague allusions to a return to a general par value system,
it was clear that in practice the United States could veto any such decision
by the members of the Fund. The rest of the new amendment was short on
specifics, but the philosophical base was unmistakable: Stability in
exchange rates, while devoutly to be desired, would have to emerge from
"orderly underlying economic and financial conditions" rather than from
any specific government decision to determine an appropriate rate. Nations
were to avoid "manipulating" exchange rates, and the IMF itself was to
exercise firm surveillance efforts so that efforts to distort the market
through intervention or otherwise would be discouraged.

It was for the specific purpose of pronouncing a blessing on the Fund

amendments that the first economic summit was held on November 15
through 17, 1975, at the Chateau de Rambouillet, well removed from Paris.
It was, in fact, a G-6, with Italy included by virtue of the precedent
established by its presence in Giscard's apartment when the last dollar
devaluation was agreed. Canada was invited to join later to help balance
things, thus creating a G-7. I recently went back and read the first summit
communique. Apart from endorsing the Franco-American

CHANGING FORTUNES

"rapprochement" on the exchange rate regime, it emphasized the need to

assure recovery without inflation, to avoid trade restrictions, to accelerate
the then-current Tokyo round of GATT negotiations, to reduce dependence
on imported oil, and to develop effective energy programs. These same
points have been the grist for countless communiques over the years, and by
now finance ministry officials around the world can reproduce the language
in their sleep.

I was not involved in that meeting or subsequent summit meetings since

central bankers have never been invited at that level. I was, however, glad
to see them happen. For one thing, it seemed to me a good idea to expose
American presidents more directly and regularly to the problems of
international economic policy, to which their counterparts abroad typically
have given a much higher priority. Perhaps Gerald Ford was less
preoccupied with a grand strategic vision than the president he had replaced
more than a year earlier, but even he could not bring to the table the
experience of three of the other participants at Rambouillet: Schmidt of
Germany, Giscard of France, and James Callaghan of Britain had all served
as their countries' finance ministers. More important, I think it is harder for
presidents and prime ministers to bow to protectionist pressures when they
know they will have to justify policies of economic nationalism face-to-face
against their peers, with the world looking on. Routine as many of the
statements in the communique have become, they do help remind the
leaders of the importance of promoting the objectives to which they have
attached their names.

At Rambouillet, the rest of the world and its representatives in the press had
to look on from a distance; their headquarters were in Paris, twenty-five
miles away. During the preceding weeks, personal representatives of the
heads of government had prepared the meeting; they soon became known as
sherpas after the Nepalese guides who conduct mountaineers to the
Himalayan summits. George Shultz, who had established a warm personal
relationship with both Schmidt and Giscard when he served as Treasury
secretary, was drafted back from private life to serve as the American
sherpa. The whole affair seemed to have retained some of the sense of
intimacy and informality associated with the Library Group. That's not a
bad way to conduct business, but we have gone a long way from it. The
kind of massive media attention given today and the compelling need to
make news can often detract from the essential purpose of the meeting: to
understand and reconcile conflicting views. Moreover, the ease of
communication and transportation these

EXPERIMENTS IN COORDINATION

days means there are more frequent opportunities for heads of state to meet,
bilaterally or otherwise. For all their difficulties, however, the annual
summits still afford a certain prophylaxis against purely domestic political
pressures.

A broad question was raised by the new agreement on floating. The call for
close collaboration to achieve the "orderly underlying conditions ... for
financial and economic stability" did not offer any real guidance as to how
the requisite cooperation would be achieved. The seemingly simple
injunction that the IMF should exercise surveillance over the policies of its
member countries could hardly be a full answer. It raised further issues we
had to confront into the 1980s and that remain today: What do we mean by
surveillance? By cooperation? By coordination? Defining these terms is no
easy matter.
The Bretton Woods system had in practice answered these questions, in part
by specifying certain rules of the game; it had laid down which policies
would be appropriate and which would not in response to signals flowing
from exchange rate pressures and gains or losses of national reserves. Even
then, the practice had developed of substantial consultation by the Fund
with its members, one by one, and that consultation grew teeth if the
country wanted to borrow from the Fund. But the process clearly had its
frustrations and its limitations. As the distinguished finance minister of a
large developing country put it to me during the reform discussions,
cynically but not entirely inaccurately, "When the Fund consults with a poor
and weak country, the country gets in line. When it consults with a big and
strong country, the Fund gets in line. When the big countries are in conflict,
the Fund gets out of the line of fire."

The mechanisms of the G-10, the G-5, and the WP3 had developed to
facilitate consultation and cooperation directly among the leading financial
powers. Within the context of the Bretton Woods rules, some rather clearly
defined functions developed. First there was the simple matter of full
exchange of information about national developments and policies and,
going a big step beyond, providing candid information to other countries of
the intentions behind a government's policy. This information can be a
significant ingredient in everyone's policymaking. By helping to understand
the intentions and probable reactions of others, governments minimize
uncomfortable surprises and avoid unnecessary frictions. Beyond that,
cooperative arrangements could be developed ad hoc to deal with exchange
market emergencies through mutual inter-

CHANGING FORTUNES

vention, "swaps" or other credits, and the like. The various, forums,
supplemented by the C-20 and its successor, the IMF interim committee,
facilitated longer-term reform discussions.

But none of those groups had moved very far from those activities that fall
under the general rubric of international cooperation to ones in the more
ambitious area of coordination. To my mind, coordination connotes a
willingness to shape or alter domestic policies on the basis of international
agreements and understandings, and these understandings will also bear on
the policies of others.

I don't know how many speeches and toasts my counterparts and I delivered
over the 1960s and 1970s to the god of international cooperation, but
coordination was another matter. The reluctance of Arthur Burns to admit
that Federal Reserve policy might take account of external influences was
only one symptom of the political sensitivity to even a hint of yielding
national autonomy. Presidents, prime ministers, and maybe even more,
legislators, are typicaDy interested in maximizing national freedom of
action, and not in tying their hands by international understandings.

Of course, the Bretton Woods system did enforce a kind of coordination, at

least on deficit countries. Strong intervention into domestic policy
decisions, even for some of the largest member countries, became
transparently obvious when the Fund learned how to attach detailed
conditions to its financial advances. The British sterling crises in the 1960s,
and again in 1976, provided striking and politically controversial
illustrations of domestic austerity policies tied to the need for IMF approval
of finance to tide them over. These took place in the context of specific
emergencies, typically involving the defense of a currency. Countries were
willing to act—say, by tightening money or cutting expenditures—because
officials and the public alike could perceive something important at stake.
Failure to respond would risk inflation, dislocations, lack of cooperation,
even possible retaliation. The process would need to be more subtle, and the
judgments more difficult, when the agreed rules of the system became, to
put it charitably, less obvious after the Bretton Woods breakdown. Except in
extreme cases, such as the collapse of sterling in 1976, a floating exchange
rate system did not send off alarm bells demanding a response.

Instead of responding to crisis, the whole philosophy of the new approach

would be to work together to avoid crisis and promote stability. But to be
meaningful, that would imply that national fiscal and

EXPERIMENTS IN COORDINATION

monetary policies, plus national energy policies during the oil shocks of the
1970s and other regulatory policies, all would be legitimate matters for
international consultation and understanding. It is rarely stated that baldly,
but when it is, the domestic political implications are daunting. Moreover,
there is enormous room for differences in judgment among countries,
whether politically or intellectually inspired, and ample opportunity for
reaching different conclusions in any given situation.

Put plainly, coordination commits a government to take actions on the basis

of international consultation that are different from those it might otherwise
have taken, often in conjunction with decisions other countries are making
that they might not otherwise have made. The timing, degree, and substance
of the decision will be influenced by what other countries are prepared to
do, and vice versa. The rationale is that, in the end, all countries will be
better off in reaching both domestic and international objectives if their
actions complement each other. For example, if monetary policies are being
coordinated in an effort to stabilize the dollar, the United States will not
raise or lower its discount rate independent of what other central banks are
willing to do. And the action by the others may reduce any conflict,
perceived or real, with domestic needs.

That is a fairly simple example. Coordination becomes much more

complicated when it moves into broad questions of trying to manage
different economies at different rates of growth, or of influencing tax policy
or energy policy. To a politician, that all implies some loss of sovereignty.
Academics can dance around that philosophically in emphasizing quite
correctly that participation in an open world economy necessarily implies a
loss of autonomy, and that external influences on policy are bound to
become larger as the volume of international trade and investment
increases. Nonetheless, to those politically responsible for decision making
in the real world, the idea of coordination invades very sensitive political
territory.

LOCOMOTIVES AND THE DOLLAR

As things happened, it would be a new administration that would test the

limits of coordination. Jimmy Carter's appointments to the main economic
posts in the Treasury, the Council of Economic Advisers, and the State
Department were of a quite different breed from the monetarists
predominant during the later Nixon-Ford years, who profoundly
CHANGING FORTUNES

believed that, as with most economic problems, markets could be relied

upon to achieve any needed coordination. The Carter people all had
professional training in economics and had seen substantial governmental
service in the 1960s. They supported floating exchange rates but by instinct
and experience were policy activists with the Keynesian faith in the ability
of governments to maximize the performance of the economy and indeed of
the market itself. From my perspective as president of the Federal Reserve
Bank of New York, a post I assumed in 1975 after a year at Princeton away
from government service, there was only one possible question about their
qualifications: a relative absence of the particular sensitivities that become
ingrained in those who have been actively involved in financial markets.

There was no doubt, however, that the new economic team recognized from
the start that it lived in a world in which the success of American policies
would be dependent on the complementary policies of others. As they took
office, they seemed to have a clear view of what the situation required. Part
of their program was sketched out by Lawrence Klein of the University of
Pennsylvania, who won the Nobel Prize in economics for his mathematical
models of the United States and the world economy. He laid out the general
thinking in public testimony before the Joint Economic Committee of
Congress, and even before that he had presented it in 1976 at a conference
in Washington at the Brookings Institution, a research center where a
number of the Carter activists were associated before being recalled to
government. Klein endorsed domestic fiscal stimulus to counteract high
unemployment lingering from the last recession. He also pointed to growing
international imbalances that were helping to destabilize exchange rates.
His solution was straightforward: To maximize success and avoid a massive
imbalance in an already growing American trade deficit, the surplus
countries should be persuaded to expand their economies, particularly the
powerful potential "locomotives" of Japan and Germany, as they were cast
in this strategy.

As time passed, the Carter team's desire for an appreciation of the yen and
the mark to help make the strategy work by increasing U.S. trade
competitiveness became increasingly explicit; it was widely interpreted in
financial markets as a certain insouciance about the fate of the dollar. That
sense was reinforced later by less guarded comments by Michael
Blumenthal, the Treasury secretary. The subsequent declines in the dollar,
as the trade balance deteriorated and inflation began to accelerate from
already advanced levels, were an important element under-

EXPERIMENTS IN COORDINATION

mining any sense of coherence in the administration's economic policies as

its term wore on.

But at the start, enthusiasm and conviction were high, and the
administration was not many weeks old in 1977 when it launched a
prolonged effort to achieve appropriate coordination of international
policies. The story of the Bonn summit has become a case study in the
world of political scientists. From my perch in New York, I could observe it
only from a distance, and partly through the eyes of some of my foreign
counterparts who were feeling the pressure. In essence, the message was
simple. The oil exporters had huge surpluses; the counterpart deficits should
not fall entirely on the developing countries or the United States. Germany
and Japan had restrained their economies to deal with the inflationary
consequences of the oil crisis, and their external payment positions were
strong. Hence, in their own interest, as well as the world's, they should
expand. Specific targets were set out.

It all had a certain inherent logic, and the general outlines came to be
supported in the reports of the IMF and even the Bank of International
Settlements, the citadel of central bankers. At the London summit in 1977,
resistance by Japan abated and it "took the pledge" to achieve a rapid
growth target. Germany took longer to convince. Helmut Schmidt might
have been the leader of the Social Democratic party on Germany's Left, but
he was first of all a German, and for him stability counted above all. He no
doubt felt fully capable of making up his own mind about economic policy
and increasingly resented the brash American demands to stimulate an
economy already recovering from recession. Moreover, Schmidt, like
Europeans generally, had become annoyed by the profligate use of energy
of the United States. I know that has become a familiar story, but I am
talking about 1978, when in economic terms our energy policies were
particularly hard to defend.

Virtually all the other industrialized countries had permitted their gasoline
and other energy prices to rise in step with world oil prices, sometimes
adding a stiff gas tax increase. Their imports of oil were declining in
response to conservation in industry and transportation. The United States,
in contrast, maintained price controls on domestic producers and refused to
permit the rising world prices fully to feed through to domestic markets.
Looked at from abroad, the politically inspired resistance to letting the
market work was not only an ideological anomaly but affected the world
balance of supply and demand to other consuming countries' disadvantage.

So the making of a deal existed. Germany would join Japan in taking

CHANGING FORTUNES

measures to expand its economy while the United States would decontrol
oil prices. From a negotiating standpoint, the appearance of a balanced
international bargain was seen as a way to dampen domestic political
resistance.

The negotiations continued over many months and meetings. In the end, the
summit countries, meeting in Schmidt's home base of Bonn, came to more
explicit agreement about the management of "domestic" economic policies
than at any time before or since. The Germans, by adjusting taxes and
spending, would aim to add i percent more to GNP. The Japanese, having
fallen short of the previous target, would reinforce their program of public
works, and other smaller countries would be asked to take comparable
measures. For its part the United States, over the strong opposition of
Carter's political advisers, pledged to speed oil decontrol and thereby lower
oil imports.

No doubt there was genuine give and take, and most scholars agree that
there was a significant impact on policy. In the American case, the insiders
on the deal insist that only the fact that the president had made an
international commitment enabled him to overcome the argument of his
political advisers that he was courting electoral suicide. Schmidt was never
happy about the agreement, bitterly asserting for years that the extra
expansionary measures agreed to by Germany left it vulnerable to renewed
inflation when the second oil crisis exploded only about half a year after the
deal was done at Bonn.

With the benefit of hindsight, the whole locomotive strategy is easily

questioned. The idea seemed reasonable enough in its conception. But it
took a long time to explain, develop, and negotiate. By the time it was
implemented, there had been a change in the "underlying economic and
financial conditions," to borrow a phrase from the new IMF Articles. Most
governments were caught with active expansionary programs, budget
deficits, and loose monetary policies just as oil prices doubled and even
trebled and inflationary pressures took on tremendous force.

Some, led by Helmut Schmidt, have argued that the locomotive strategy
was a mistake, a classic example of international pressures to coordinate
overcoming the better informed instincts of a government on how to best
manage its own economy. Even with a more forgiving interpretation, the
episode emphasized the inevitable hazards of a planning and negotiating
process that must extend over many months, or even a year or more, before
its decisions can be implemented. During

EXPERIMENTS IN COORDINATION

the 1970s unexpected events were particularly pronounced: oil shocks, bad
economic forecasts, political and legislative rigidities, regional wars and
revolutions, and profound shifts in market psychology. But they are always
a risk of economic life, and that simple fact counsels against placing too
much faith in elaborate coordination efforts that cannot be easily adjusted to
new circumstances. Judging by the absence of such an ambitious and
politically prominent coordinating effort since 1978, that lesson may have
been absorbed.

Even from an American standpoint, any success from the Bonn summit,
apart from faster oil decontrol, was undercut by the performance of the
exchange markets in ensuing months. The administration was soon forced
into a coordination effort quite different from the elaborate, stage-managed
Bonn summit. It was, in fact, an impromptu defense of the dollar much
along the lines of what Britain and others had to do in defending their
currencies under the Bretton Woods system.

During late 1977 and into 1978, the dollar had been under recurrent
downward pressure, although this was interrupted by occasional rallies.
Foreigners sensed that for the Carter administration a stable dollar was a
much lower priority than growth and jobs. At the start of 1978, some
gestures were made toward supporting the dollar through intervention in
cooperation with other countries, but there was little follow-through.
Economic expansion helped keep the current account deficit growing. Most
important, without a firm response by monetary policy as the year wore on,
inflation kept rising. Cries of "benign neglect" or worse from our trading
partners again were common, and as often happens, both the psychological
and market pressures seemed to mount around the time of the annual IMF
meeting in September, which threw thousands of the world's financial
officials and bankers into close proximity at receptions and dinners as well
as at business meetings. The Treasury had already valiantly tried to change
its image of indifference to the dollar, but it was not until after the IMF
meeting that obvious public and market uneasiness about inflation and the
dollar forced the administration to reconsider its policy.

The first fruits of that reconsideration, consisting almost entirely of some

limited fiscal tightening, were announced with some fanfare in late October.
The administration also had approached the Federal Reserve Board to urge
tighter money, an unusual move for any government. But in the markets'
judgment, these moves fell into the well-populated category of too little, too
late. About $6 billion was spent to support the

CHANGING FORTUNES

dollar by the United States and others in the last week of October, yet the
fall continued. By the end of the month, the dollar had lost nearly a quarter
of its value from the beginning of the year, and the inflation rate had moved
to almost 9 percent.

All pretense of insouciance was gone. Anthony Solomon, who had my old
job at the Treasury, went to work to organize a good old-fashioned rescue
program, calling Toyoo Gyohten among others to an emergency
consultation in Washington. Drawing on his long experience and personal
credibility, Solomon achieved quick agreement on plans to mass resources
to support the dollar, plans that in sheer volume would dwarf any previous
package: augmenting swap lines by $7.6 billion with the German, Japanese,
and Swiss central banks to a total of $15 billion; borrowing $10 billion in
foreign currencies through "Carter bonds," use of $2 billion in SDRs, and a
drawing of $3 billion on the IMF. Apart from its massive size, the program
was built on approaches familiar to Treasury and central bank officials, but
to our foreign partners there was special satisfaction that the United States
had overcome its long-standing aversion to borrowing in foreign currencies
in private markets abroad. What the foreigners did not know at the time,
and what I only learned a day before the proposed announcement, was that
the Federal Reserve Board in Washington, which had been resistant to
strong monetary restraint, would approve a 1 percent increase in the
discount rate as part of the package. In order for the board to take this
action, it had to be requested formally by a Federal Reserve Bank. I was
only too happy to call a special telephone meeting of my board in New
York so that we could oblige. Thus the Carter administration had come full
circle from seeming indifference to the dollar to a willingness both to
borrow from the IMF and to use classic domestic policy instruments to deal
with a run on the currency. It would not be for the last time.

As publicly announced, the package was worth an unprecedented $30

billion. It is a moot point whether the full amount would ever have been
spent, or even been made available by our partners if conditions
deteriorated so much that all the money would have been needed. The
simple announcement that funds are available does not make it easy
actually to draw on a credit line up to the maximum, or to sell off reserves.
In the end, debts have to be paid back, and if they are denominated in
foreign currencies, those currencies will need to be earned in the market.

That's what made Tony Solomon nervous. The dollar strengthened

EXPERIMENTS IN COORDINATION

against the yen. But after an uneven start, we had to sell foreign currencies
fairly steadily to keep the dollar on an even keel against the European
currencies. With the equivalent of $6.7 billion spent during the last two
months of 1978, Solomon wondered aloud to me how long it was worth
keeping up. Fortunately, the New Year's blues were cleared away by a
spontaneous strengthening of the dollar in January 1979. As the dollar
improved early in the year, the swaps could be unwound, the debts repaid,
and the Treasury was happy to accumulate some foreign currencies.

Five years earlier, the argument that had clinched the victory of floating
exchange rates in many minds was that domestic economic priorities would
not need to be sacrificed to what was really a kind of icon, a fixed exchange
rate that no one could be quite sure was at an economically optimal level.
Indeed, in a changing world, it seemed to be hard to fix any right exchange
rate for long. But here we were, back to "defending" an exchange rate, with
a more vigorous (if quite tardy) use of monetary policy than had ever been
invoked under Bretton Woods.

Again the insistent question arises whether it would have been more
appropriate to have paid attention much earlier to the warning signal sent by
a falling exchange rate. That may not have been so intellectually elegant as
extended negotiations leading to highly publicized summits, but we had
learned one thing for sure. That day at Camp David in 1971, Mr. Nixon had
set in train a reform of the monetary system. Mr. Ford, in the first of all the
economic summits in 1975, helped preside over the triumph of floating
rates. Mr. Carter, in the fall of 1978, discovered that none of it was proof
against crisis.

TOYOO GYOHTEN

fcven without the oil shock, I doubt that the Smithsonian system could have
been saved. The divergence of economic fundamentals was already so great
in 1973 that the world economy could not have survived with the parity
system. In hindsight, the argument for floating rates was very much
strengthened by our experience of the oil crisis. Whether that crisis was
necessary or unavoidable is another question, but even if it had

CHANGING FORTUNES

been somehow avoided, the basic trend in the monetary situation would
have been unchanged.
During the latter half of the 1970s, the world began a serious reappraisal of
the floating exchange rate regime, which had been accepted reluctantly and
at first with great fear. But we realized that the flexibility of floating rates
allowed us to absorb the severe shock created by the oil crisis. Although the
floating-rate regime attracted considerable support, international
disequilibrium aggravated the volatility of exchange rates, and that
worsened toward the end of the decade. Suspicions arose again about the
effectiveness of the equilibrating mechanism of the floating-rate regime.

Supporters of floating rates had strongly expected that rate changes would
produce a better balance of international payments. But we found that the
mechanism did not work quickly enough to shift trade flows and help bring
equilibrium, and therefore a certain disillusionment arose about this
function of the regime. As a result, attention shifted, or rather expanded, to
demand management policy and especially its multilateral coordination at
summits.

This was also the period when international discussion on the monetary
system moved into a new phase, because the world was convinced that it
was no longer possible to return to the gold exchange standard and fixed
exchange rates. And we were also scared of the almost intractable increase
in dollar liabilities outside of the United States caused by the huge dollar
deposits of the oil-exporting countries, which we called a "dollar glut."
Various efforts were made to explore the possibility of replacing the dollar
with either the SDR or some kind of a multicurrency reserve system.
Growing concern was expressed about volatility under the floating-rate
regime, and as a result various forms of managed floating were proposed to
modify it. These were the main issues of the period.

From the Japanese point of view, this was the period when markedly
increased global attention was focused on our economy. This time, it was
not only the level of our current account surplus or the exchange rate of yen
that attracted global attention, but the structural strengths and the
uniqueness of the Japanese economy when in the second quarter of IQ 75 w
e were among the first in the world to begin our recovery from the damage
of the oil crisis. This rather early success was due mainly to the effective
control of inflation. The Japanese wholesale price index, which rose by 23
percent in 1973 and another 23 percent in 1974,

EXPERIMENTS IN COORDINATION

decelerated very sharply in 1975 to an increase of only 2 percent. This was

due to a very tight monetary policy that left domestic private demand very
stagnant. Manufacturing production fell very sharply. Indeed, the industrial
production index did not recover its precrisis level until as late as April
1978, more than four years after the first oil shock. We put the economy
through a severe deflation. Although the operating rates of many factories
were very low, the low inflation rate substantially strengthened the price
competitiveness of Japanese products. Imports stagnated, and a strong
export drive dramatically reversed Japan's current account balance from a
$500 million deficit in 1975 to a surplus of almost $17 billion in 1978.

This export-led recovery attracted quite strong international criticism.

Upward pressure on the yen mounted throughout 1977. The Japanese
authorities tried to slow down the rise by intervening in the currency market
and selling yen for dollars, to no avail. In 1977 we purchased almost $6
billion in conducting what other countries called a "dirty float" to prevent
our currency from rising even higher, although we were not the only ones
doing this, but the yen rose from 291 to 241 to the dollar. Put another way,
at the start of the year it cost a Japanese 291 yen to buy a dollar. By the end
he could buy a dollar for only 241 yen, an increase in our exchange rate of
about 20 percent. The pattern repeated itself in 1978. Against the
background of Japan's large trade surplus and the prospect of its
continuation, there was a greater supply than demand for dollars in the
market. In spite of our efforts to sop up the excess, the dollar weakened and
the yen strengthened. The phenomenon suddenly generated a big debate,
with strong complaints mainly from exporters, whose overseas orders were
badly hurt by the strong yen. They brought politicians into their camp, who
urged the Ministry of Finance and the Bank of Japan to step up intervention
in the market to stem the appreciation. So there was quite a sharp conflict
between our domestic views and the strong international criticism of Japan's
surplus and a so-called dirty float.
This international criticism became most vociferous between May and
September of 1977. It became genuinely uncomfortable for those of us who
had to sit through those international meetings, because everybody
complained about Japan's performance as if the Japanese economy was a
cancer in the world economy. That was how the argument for international
pressure on our domestic policy developed into the locomotive theory and a
parallel campaign for selective appreciation of

CHANGING FORTUNES

currencies against the dollar. That argument was first made openly to
Congress in February of 1977 by Lawrence Klein of the University of
Pennsylvania, who proposed that the two surplus countries step up their
growth, and that the Japanese yen and German deutsche mark be revalued
by about 10 percent.

In May 1977, the world economic summit met in London. Japan agreed
informally to aim at a growth rate of 6.7 percent in our gross national
product for the coming year, which we failed to achieve. We heard even
stronger criticism of the Japanese surplus and demands for the surplus
countries to expand their domestic economies in hopes they would bring in
imports from the deficit countries. In the same month, Secretary of the
Treasury Michael Blumenthal came to Japan for the International Monetary
Conference of commercial bankers and repeated his very strong demand for
Japan to share the balance of payments deficit created by the increased oil
import bill instead of increasing its trade surplus.

At one point he argued that Japan should not keep the interest earned on its
investment in U.S. Treasury bills. Since Japan kept the bulk of her official
reserves in the form of U.S. Treasury bills, and they naturally earned
interest in dollars, which further increased our reserves, Blumenthal said
Japan should sell those additional dollars in the market. If we did not, he
argued, Japan was in effect conducting a dirty float by increasing its official
reserves, because accepting the Treasury's interest in dollars was
tantamount to buying dollars for the purpose of intervening in the currency
markets to depress the yen. This type of tortuous argument became fairly
common, attracting much attention at home and abroad. The surplus
nevertheless increased, and in July 1977, we announced a record surplus for
a single month of $1.5 billion. That led to demands focusing on the yen in
particular to appreciate against the dollar. Charles Coombs of the New York
Federal Reserve wrote an article to that effect in August. United States
pressure intensified for Japan to reduce her surplus by increasing imports
from the States; this was the message of a high-level meeting we had in
September with a delegation led by Richard Cooper of the State Department
and C. Fred Bergsten of the Treasury, who also raised many outstanding
trade issues between the two countries. Later in the month, at the annual
meeting of the IMF, Denis Healey, Britain's Chancellor of the Exchequer,
singled out Japan and accused us of distorting the equilibrium of the entire
world economy.

EXPERIMENTS IN COORDINATION

Despite this concerted criticism, the yen continued to appreciate against the
dollar. It gained more than 10 percent in October and November. By that
time, there was a growing resignation that with such a strong imbalance, the
appreciation of the yen could not be prevented, and inside the ministry we
began arguing that we should stop intervening in the market to slow the
rise. But domestic political demands for us to resist the yen's appreciation
remained very strong. Prime Minister Fukuda, who was quite an
enlightened man on international monetary matters, maintained his strong
position that the authorities must continue to check the rise of the yen.

In November of 1977, Robert Roosa, who had returned to Wall Street, in

the private sector, testified before the Senate Banking Committee in
Washington and presented his long-cherished idea of a currency target zone.
He proposed that the major currency countries cooperate to maintain the
exchange rate relationships among their currencies in a range that could be
agreed upon by them as a target zone. He was talking about a long-term
regime, but when his testimony was reported in the press, many Japanese
welcomed his speech and thought Bob Roosa was in favor of stabilizing the
yen. When the report of Roosa's testimony appeared in Tokyo, the yen
promptly weakened, and I was later told that he was embarrassed by the
misunderstanding of his testimony in Japan.

To appease their critics, the cabinet decided in December that in the

following year Japan would aim at 7 percent growth for 1978. This message
was conveyed to Robert Strauss, the U.S. Special Trade Representative,
who visited Japan in January 1978. This visit prompted intense and
extended debates between the United States and Japan on the exchange rate
and also on trade issues. The Japanese countered that the United States also
should take domestic economic measures, particularly to control inflation
and cut its rising oil imports. The Carter administration was already
preparing an energy bill to put substantial controls on oil imports, and I
vividly recall Bob Strauss telling our finance minister, Tatsuo Murayama,
that he was very confident that the energy bill would be cleared by
Congress within ninety days. That was January, and in fact a very weakened
energy bill was passed by the United States Congress in October. This sort
of thing aggravated the mutual mistrust between the United States and
Japan. But one very positive by-product of this debate was that Japan began
opening up its market. In January of 1978, Fukuda instructed us to overhaul
our restrictive foreign exchange con-

CHANGING FORTUNES

trol laws. When this was completed in 1980, there was a substantial
liberalization of capital transactions facilitating Japanese business in
investing abroad, foreigners in setting up business in Japan, and both
foreigners and Japanese in borrowing and lending.

In spite of all this harsh debate, by November of 1977 the United States
Treasury and Federal Reserve Board realized that the further decline of the
dollar—or the further appreciation of the mark and the yen—would not help
reduce America's foreign trade deficit, and that domestic economic policy
was equally important. From 1973 through 1978, the net savings by the
household sector of the United States declined sharply while net investment
by the corporate sector increased sharply from 1975 on. Although the
government sector's net deficit declined quite conspicuously, the decline
was not big enough to offset the decline of household savings, which
traditionally finance the deficit of government and industry. As a result the
external deficit increased very rapidly as a percentage of GNP. In other
words, Americans had to borrow foreign savings to replace their own. The
situation in Japan was the reverse. Households saved at very high levels,
but the corporate sector's net investment declined sharply. And although the
government also increased its net investment, that was not enough to offset
the deflationary impact in the private sector, and as a result Japan's external
surplus increased very sharply.

By the end of 1978, policy requirements in those two countries were quite
clear. Fiscal policy in each country was moving in the right direction; Japan
was loosening, the United States was tightening. The problem was, there
was a very divergent movement in the private sector. In America private
individuals were spending too much and saving too little, while in Japan the
situation was exactly the reverse. Under the circumstances, appropriate
monetary policy was very important. Late in 1977 the United States
changed its policy to defend the dollar against a further decline rather than
talking it down. But in its official statements, the Treasury continued to
argue that it was impossible for the United States to depress its economy, to
impose exchange controls, to issue bonds in foreign currencies, or to place
an import surcharge on oil.

Without any fundamental policy change, the decline of the dollar continued,
and finally, in January of 1978, the Treasury and the Federal Reserve issued
a joint statement announcing they were prepared to intervene in the market
to defend the dollar and were raising the discount rate from 6 to 6.5 percent.
The United States and Germany

EXPERIMENTS IN COORDINATION

came to a swap agreement for the United States, for the first time, to sell
$600 million of its SDRs for deutsche marks to support the dollar in the
market. This created turmoil in Japan because our press took it as evidence
that the Finance Ministry's poor diplomacy had left Japan isolated, and that,
as one newspaper, the Nikkei Shimbun, said, the deutsche mark and the yen
were in the same room but not in the same bed.

But still the dollar did not stop falling, and a new and severe attack took
place in March 1978—so severe that we had to halt our intervention as
useless after buying more than $5.5 billion in one month and still watching
the yen gain so that it moved from a price of 240 to the dollar up to 231.
The intervention stopped on the order of our finance minister, Tatsuo
Murayama, on the advice of the bureaucrats. We were afraid he would
refuse it because of domestic political pressure against a strong yen, but
were surprised and encouraged when he accepted our advice. He was a tax
expert and had very little experience in international finance, but he had a
strong market instinct. He knew that in a very volatile market like this one,
traders were speculating with great fear that anything could happen.
Murayama told us, "Those speculators are also under very strong stress,
nervous stress. When you are gambling, a good strategy is reverse your
strategy completely and unexpectedly, and pull the rug from under those
speculators."

We stopped our intervention completely, and his strategy succeeded. The

yen stopped rising at 218 to the dollar and started to weaken in April and
May. That was a kind of turning point in our exchange rate policy. We
realized that intervention would not be very effective against a strong
market, and the view was growing in press and business circles that a strong
yen might not be all that bad. After resisting appreciation of the yen,
businessmen discovered that a stronger yen has some benefits. Businesses
depending on imported energy and raw materials discovered that a strong
yen meant lower costs. Those who were forced by high export prices to cut
costs by streamlining their businesses discovered the benefits of
rationalization. The learning process, however, was not complete. As we
shall see later, after the Plaza accord in 1985, when the yen appreciated
rapidly, strong opposition again arose among politicians and some
businessmen. It was only in 1988 that the benefits of a strong currency were
generally recognized in Japan.

At the same time, there was a growing sense of resentment in Japan against
international criticism, which we came to know as Japan-bashing

CHANGING FORTUNES

in those days. Japanese argued that their country was trying hard to boost its
economy, but Germany was dragging its feet and worrying more about
fighting inflation than encouraging growth, and the Umted States went right
on talking down the dollar and not taking efTective measures to control its
oil imports. Resentment mounted at home, and at one cabinet meeting a
minister proposed that Japan use its huge accumulation of dollar reserves to
buy gold as a demonstration of its financial clout while reducing the
nominal trade surplus. A few ministers thought that might be a good idea.
That made no sense. It would simply have inflated the market price of gold
and subjected us to internaoonal criticism. Even so. the Ministry of Finance
was left in an increasingly difficult situation because criticism persisted
anyway while chauvinism mounted at home. The one positive development,
however, was that Japan did use its reserves to announce a doubling of our
official development aid in two \ ears and joined in expanding the resources
of the African and Asian development banks.

The Dollar Defense Package finally came in November 1978. because of

growing concern about high inflation in the Umted States. We did not know
what was it'oot until Takehiro Sagami. the vice minister for international
affairs, received a telephone call from his counterpart. Anthony Solomon,
the undersecretarv of the Treasury, on October :v which was a Saturday. He
invited us to Washington to discuss the exchange rate situation with
German and Swiss officials. Sagami; Haruo Mayekawa. the deputv
governor of the Bank of Japan: Masaru Hayami, of the Bank of Japan: and I
decided to go to Washington. Because it was Saturday, the treasurer's office
at the ministry was closed, and I could not get an advance to purchase my
ticket. I had to pay for my ticket with my credit card, and I was a bit
worried that if the negotiation did not succeed, the treasurer's office would
not refund my money.

We four flew to Washington, and it was still the weekend when we arrived.
We went to Solomon's residence in Washington and had a small, informal
meeting. He explained that the United States had been taking a series ot
fundamental measures, including the increase in the discount rate and an
anti-inflation program that had just been announced, but the market did not
appreciate their significance and the dollar was stall falling. Solomon was
afraid that the fall of the dollar might negate the effects of these policies and
said the Umted States therefore needed bridging finance to cover the lag
between the policy and the market's appreciation of it. We quickly agreed.
The package consisted

EXPERIMENTS IN COORDINATION

of a $30 billion war chest for intervention by the United States, Japan,
Germany, and Switzerland. The United States prepared its credit lines by
borrowing $3 billion from the IMF, selling $2 billion in SDRs, expanding
its swap arrangement with the other three to a limit of $15 billion, and
issuing up to $10 billion in foreign currency bonds. Domestically, the
Federal Reserve planned another increase in the discount rate, by one full
percentage point to 9.5 percent, an increase in the banks' reserve
requirements, and an increase in the Treasury's gold sale in December from
the previous month's sale of 750,000 ounces to 1.5 million ounces to help
mop up dollars.

The package was a big success on most global markets in the period
immediately following the announcement. The yen had risen to 176 against
the dollar before the package, but by the end of November it had declined to
200. One of the most important reasons the package worked was that the
dollar had overshot. Everyone in the market felt that the yen rate of 176 to
the dollar was far too much. We had been calculating the optimum rate
between the dollar and the yen using the formulas based on purchasing
power in both countries and we came up with a rate of about 230. The
market was already in a very precarious state, with everybody on edge
because they knew that the dollar was too weak and that a turnaround could
come at any time. But no one would dare to move against the trend. It was a
classic case of the bandwagon phenomenon in the exchange markets. Once
the authorities seized the initiative and made a strong announcement, the
entire mood in the market changed, because everyone was ready to buy
dollars. When the turnaround finally came, it was very dramatic.

Other reasons for success were that the package was comprehensive, large,
and concerted. The Treasury had taken many measures to defend the dollar
during 1978, but they were announced piecemeal and in a halfhearted way,
and therefore never succeeded in influencing the market psychology. In
fact, a check of the market movements confirms that every time the
Treasury announced one of these piecemeal measures, the dollar dropped
some more. As for size, a S30 billion war chest was a big amount in those
days, and the fact that it was backed by the United States, Japan, Germany,
and Switzerland impressed the market and changed the entire climate.

The very next month, December of 1978, the Iranian revolution began and
the oil price started to rise. The second oil crisis promptly sent Japan's
external account into deficit in the first quarter of 1979, and the

CHANGING FORTUNES

yen started to weaken. But this time Japan succeeded in quickly countering
the crisis by tightening monetary policy very substantially. The Bank of
Japan raised the discount rate four times in ten months—in April, July, and
November 1979, and again in February 1980—from 3.5 percent to 7.25
percent, or more than double in ten months. The private sector moved with
determination to conserve energy in general and oil in particular, partly
because the government did not control imports or prices and let the price
increase pass quickly through to domestic consumers. Wholesale price
inflation stopped as early as the third quarter of 1980, and although we ran
an external deficit throughout the year, the stringent measures restored
international confidence in the yen quickly, capital started flowing in, and
the decline of the yen was halted by April 1980.

Discussions began on the dollar glut. Serious efforts were made to

substitute SDRs for dollars, or to replace the dollar that now was the
standard with a multicurrency reserve system. Undersecretary Solomon was
quite enthusiastic in pursuing this idea of a substitution account for dollars;
it was amazing that the United States was for the first time officially
exploring methods to reduce the dollar's role as a key currency. He even
organized a working group of senior officials from G-j countries (I was one
of them), and we had a series of meetings looking for feasible methods. But
of course it could not be the Treasury's formal position to yield the dollar's
role, and when the Reagan administration took office in 1981, all these
studies were just ignored.

Various efforts were made to find some form of managed floating. In

addition to Roosa's target zones, I must also cite an impressive speech by
my colleague Paul Volcker at Warwick University in England. The speech
was given in memory of the economist Fred Hirsch, and was worthy of
Hirsch's style of original thinking. Volcker advocated "quiet, mutual
contingency planning" to achieve stability in the exchange market. What he
was implying was a more realistic and practical approach than Roosa's by
trying to aim at an international arrangement under which the key currency
countries would cooperate to avoid exchange rates' straying into areas
considered far out of range—as had just happened. In other words, a sort of
negative target zone, although he never used those words.

One important lesson of the period, particularly for Japan, was that under
the floating-rate regime, monetary authorities could not manipulate the
exchange rate by simply intervening against an underlying mar-

EXPERIMENTS IN COORDINATION

ket trend. That lesson cost us billions to learn. We also learned that a change
in exchange rates by itself will not have a quick effect on most countries'
balance of payments. That was certainly obvious from the performance of
the Japanese and United States economies.

Factors that market practitioners take into consideration certainly have

changed over time, and on the whole they have multiplied almost beyond
our calculation. In the early days of the floating regime, we thought that
medium- and long-term elements such as purchasing power parities and
balance of payments adjustments would still have a major influence. But
then short-term capital flows and interest rate differentials became very
important. But aside from that, there was the explosion of information
technology, which promoted quick shifts of focus. One moment the market
will be focusing on interest rates, the next on balance of payments data, and
then on political developments. So it is difficult to pinpoint the decisive
factors in short-term movements. Recently I was talking to one of Japan's
best foreign exchange dealers, and I asked him to name the factors he
considers in buying and selling. He said, "Many factors, sometimes very
short-term, and some medium, and some long-term." I became very
interested when he said he considered the long term and asked him what he
meant by that time frame. He paused a few seconds and replied with
genuine seriousness, "Probably ten minutes." That is the way the market is
moving these days.

We also learned, from the intense international planning and discussion of

the locomotive approach at two successive economic summits in London
and Bonn, that an international effort that tries to dictate a national
macroeconomic policy targeted to specific growth rates or external balances
simply does not work. The problem of the Bonn summit was that the
countries had no clear and common objective of what they were really
aiming at and what instruments they would utilize. It is easy to discuss
coordination, but when there is no common vision of the desired order of
the world economy, it becomes a very difficult task to achieve. The
essential mistake at Bonn, and at all those exercises throughout the years,
was an obsession with a fine-tuning approach. The United States thought it
was feasible to set up certain quantitative goals and target our
macroeconomic performance. It was a fundamental mistake, for example,
for Japan to accept such a precise target as growth of 6.7 percent. In any
objective state of mind, how could anyone make a commitment that an
economy of 120 million

CHANGING FORTUNES

people can be fine-tuned to such a precise rate of growth? The mentality of

those days was totally wrong in trying to gear the performance of national
economies to that kind of quantitative target. I'm afraid the same applies to
the use of economic indicators to monitor the performance of national
economic policies in later years. This is really amazing in a world of
market-oriented, capitalist economies, to talk as if national economic
performance can be fine-tuned to that extent.

The most important achievement of those informal, top-level discussions

among policymakers is a sort of mutually enlightening effect. Each finance
minister learns how his counterparts view the current economic situation
and what kind of policy directions they plan to follow. Beyond that stage of
mutual enlightenment, perhaps a common objective will emerge, but we
have not reached that second stage yet. We are, I think, somewhere between
the two stages.

One way we know that policies have become discredited is that they
become easy targets of jokes. In financial circles at that time, there was a
joke about three locomotives. One locomotive simply didn't run; that was
Germany. The second locomotive ran, but it ran in the wrong direction; that
was Japan, which grew by increasing its exports instead of its domestic
demand. The third locomotive also ran, but it polluted the air; that was the
American locomotive, burning too much oil and leaving a trail of dollars
behind.
All in all, this period witnessed a budding awareness of the need for
international policy coordination. But the failure of the locomotive
approach, the inability to control the volatility of rates, and the shock of the
second oil crisis discouraged the world from pursuing coordination further.
Instead, the major economics drifted apart in pursuit of their national or
regional objectives. The European Community formed the European
Monetary System in 1979 to protect its members from the volatility of the
dollar; that began their move toward a single European currency bloc. In the
United States, under the new Reagan administration, policy aimed at a
strong America and a strong dollar. In Japan, we fortified our industrial and
market structure to further strengthen our external competitiveness. So the
world moved into a period of uncoordinated policies against the looming
problem of high interest rates and Third World debt.

PAUL VOLCKER

1 his book is a series of reflections on international monetary affairs, not a

personal memoir or a treatise on monetary policy. But all those things
intersect, and that was no more true than in the period after I took office as
chairman of the Federal Reserve. 1

It all came about quite unexpectedly. With oil prices and inflation rising, the
economy looking stagnant and administration credibility low, Jimmy Carter
had gone up to his Camp David mountain to think things out. There he fired
some of his cabinet, including his secretary of the Treasury, and came down
again to give what came to be known as his "malaise" speech. That seemed
to me a pretty good description of the mood of the country, but he was
widely criticized for failing to provide a fresh sense of direction. To the
people who cared about such things, the change that moved Fed chairman
G. William Miller into the job of Treasury secretary left a vacancy at the top
of the agency that would have to do something about inflation, if anybody
could.

I was a little surprised when I got a call in New York from Bill Miller
asking me to see the president. He didn't give a reason, but of course I
'This chapter is not based on the lectures that underlie this book but grew
out of responses to questions in the class discussion.

163

CHANGING FORTUNES

could guess. I had never met Mr. Carter or any of his immediate White
House entourage, and in any event I didn't think of the chairmanship of the
Fed as something to campaign for. So I went to Washington without any
particular expectation, mainly concerned that the president not be under any
misunderstanding of my own concern about the importance of an
independent central bank and the need for tighter money—tighter than Bill
Miller had wanted. As I recall it, I did most of the talking. I remember
dining with some close friends in New York later that evening and relating
to them with a certain sense of relief that, after my performance, I surely
wouldn't be asked to pull up stakes to return to Washington and disrupt the
family at an awkward time.

A couple of days later, a ringing telephone woke me at seven-thirty in the

morning and Mr. Carter asked me to become chairman. (I later wondered a
little whether, had he known I was still in bed that morning, he would have
thought me suitably qualified.) For someone who had made a career in
finance and central banking, the president's request was not one to be
refused. Bill Miller and I were sworn into our new positions together on
August 6, 1979, at the White House. Not so long ago, I happened to see a
tape of the East Room ceremony, and there I was with a rather long face
decrying the fact that inflation had permeated our national consciousness as
never before and that we as a people had "lost the euphoria that we had
fifteen years ago, that we had all the answers" about achieving growth and
stability. It wasn't quite the malaise speech, but it bore a family
resemblance!

Inflation had, as the earlier chapters relate, been picking up since the
Vietnam War period. It plainly had become firmly embedded in popular
expectations. Those were the days when not just fine art but almost any
category of collectible had become a prime investment medium. The
intensity of the inflation of course had something to do with the intensity of
the two oil crises. But it also was certainly connected with a feeling that
things were out of control and with the international instability of the dollar.
Before I took office, the dollar was in another of its all too familiar sinking
spells in the foreign exchange markets. I couldn't resist a little pride that the
announcement of my appointment sent the markets up, but that didn't last
long.

Now, one can argue about just why all the problems had piled up, but one
thing was clear-to me at the time. If all the difficulties growing out of
inflation were going to be dealt with at all, it would have to be through
monetary policy. It was not just that other policies seemed to

TAKING ON INFLATION

be caught in a sort of political paralysis, but that no other approach could be

successful without a convincing demonstration that monetary restraint
would be maintained.

The immediate situation was complicated by considerable concern, shared

by the Fed staff, that a recession was imminent and perhaps had even
begun. Economists, I know, are not very good at predicting turning points,
and this time they were predicting a downward turn that didn't happen—at
least it didn't happen for quite a while. (There is a prudent maxim of the
economic forecasters' trade that is too often ignored: Pick a number or pick
a date, but never both.)

Those concerns had naturally led to a certain hesitation about tightening

money very much, however serious the inflationary situation had become.
Some tightening had been undertaken in July, including an increase in the
discount rate, and there was further tightening in August after I officially
assumed my new office. A much more important event, as it turned out, was
the Federal Reserve Board's decision to approve a further increase in the
discount rate by half a percent in mid-September, the second increase in
only four weeks. The significance lay not in the change itself but in the way
it was interpreted.

The discount rate is changed by a majority vote of the seven members of

the board of governors in Washington, agreeing to a proposal by one of the
twelve Reserve banks. The vote is always immediately announced. That
time the vote, after some considerable discussion, was four to three.
Ordinarily, I might have been reluctant to move with such a split board, but
I knew from the discussion the four votes were solid—including, besides
myself, Henry Wallich and Philip Caldwell, the two established anti-
inflation "hawks," and the new vice chairman, Fred Schultz, with whom I
was working closely. There was no reason for me to believe that further
steps to tighten could not be taken when and if I was prepared to make the
case for them. But the press and the market didn't see it that way. To them,
the split vote spelled hesitation and left the impression that this would be
the board's last move to tighten money. The whole maneuver was therefore
counterproductive in seeming to send a message that inflation could not be,
or would not be, dealt with very strongly.

That made a large impression on me because it was further confirmation of

what I had long sensed. After years of failed or prematurely truncated
efforts to deal with inflation, markets had developed a high degree of
cynicism about the willingness of what they dismissed as

CHANGING FORTUNES

"Washington" in general, or the Federal Reserve in particular, to stand firm.

In market talk, we always seemed to be "behind the curve," reacting too
slowly and too mildly only after the evidence was abundantly clear, which
by definition was too late.

Part of the difficulty, I had come to believe, lay in the Fed's operating
techniques. Every six months our objectives were laid out in terms of
desired growth in certain measures of the money supply, as a law passed a
few years earlier required us to do. But the actual operational target, day by
day, week by week, from one federal Open Market Committee meeting to
another, was the short-term rate of interest. Specifically, it was the federal
funds rate, in effect the "wholesale" market price for overnight loans among
banks and their largest customers.

In that focus on interest rates lay a psychological trap, and the implications
became worse as the inflationary momentum grew. With the best staff in the
world and all the computing power we could give them, there could never
be any certainty about just the right level of the federal funds rate to keep
the money supply on the right path and to regulate economic activity. The
art of central banking lies in large part in approaching the right answer from
a sense of experience and successive approximation. But it is also a
psychological fact of life that the risks almost always seem greater in
raising interest rates than in lowering them. After all, no one likes to risk
recession, and that is when the political flak ordinarily hits. The corollary is
that there is a tendency to make moves, and especially moves to tighten
money, only in small increments to "test the waters." That may be all fine
and prudent when the prices and expectations are relatively stable. But in
the midst of accelerating inflation, what the Fed might think of as prudent
probing looked to the rest of the world like ineffectual baby steps.

In September 1979, the markets seemed to be confident of only one thing:

Bet on inflation. Even if the cost of borrowing to do so was rising, that cost
lagged inflation, and there always seemed to be enough money to finance
whatever you wanted to buy. That situation forced me to think hard about
how we could be more effective. I knew that for years some in the Federal
Reserve had wanted to put more emphasis on more directly controlling
some measure of the money supply, whether Mi, which included cash in
circulation and in checking accounts, or M2 or M3, which added savings
accounts and other highly liquid funds to the Mi measures. A few of the
regional Reserve Bank presidents who served

TAKING ON INFLATION

on the Open Market Committee had been particularly eager to control the
money supply by focusing on bank reserves to determine our day-to-day
and week-to-week operations. In effect, our emphasis would shift from
controlling the price of money to its quantity.

That was philosophically in line with the monetarist school of thought that
Milton Friedman had done so much to popularize. I was as skeptical of the
extreme claims of that school about the virtues of constant money growth as
I had been about the efficacy of floating exchange rates in escaping our
external constraints. But shorn of some of those extreme claims, the
approaches that had been debated (and half forgotten) within the Fed
seemed worth looking at again. In fact, I had made a rather long and turgid
speech at the annual American Finance Association meeting more than a
year earlier suggesting the advantages of focusing, in the inflationary
circumstances, more heavily on growth in money.

Certainly we had to be conscious of the warnings of recession. But I, at

least, was convinced that possibility could not be allowed to dominate our
decision making. The idea associated with Keynesians of a so-called
Phillips Curve trade-off between unemployment and inflation did not seem
to be working well. What was plainly happening over a period of time, as
the monetarists emphasized, was that both unemployment and inflation
were rising, and further delay in dealing with inflation would only
ultimately make things worse, including the risk that any recession would
be large.

In my own mind, I had about concluded that we could achieve several

things by a change in our approach. Among the most important would be to
discipline ourselves. Once the Federal Reserve put more emphasis on the
money supply, not just by publicly announcing the target but by actually
changing its operating techniques to increase the chances of actually hitting
it, we would find it difficult to back off even if our decisions led to
painfully high interest rates. More focus on the money supply also would be
a way of telling the public that we meant business. People don't need an
advanced course in economics to understand that inflation has something to
do with too much money; if we could get out the message that when we say
we're going to control money, we mean we're going to deal with inflation,
then we would have a chance of affecting ordinary people's behavior.
I had begun trying out the approach with my Washington colleagues before
I flew to Belgrade late in September for the annual meeting of the

CHANGING FORTUNES

International Monetary Fund. Staff work was under way on the

technicalities, and I sensed that there was a good chance for a consensus in
the board. The regional bank presidents who were members of the Open
Market Committee had not been briefed, but I knew some of them would be
enthusiastic.

The flight to Europe gave me a chance to fill in the secretary of the

Treasury and Charles Schultze, the chairman of the Council of Economic
Advisers, as to what I was thinking. They were not enthused. But I got
some psychological reinforcement when we stopped ofF at Hamburg,
hometown of Helmut Schmidt, who had become chancellor of the West
German Republic. We spent part of the day with him and Otmar Emminger,
who had become president of the Bundesbank.

Schmidt was at his irascible worst—or best, depending upon one's point of
view. He dominated the conversation and left no doubt that his patience
with what he saw as American neglect and irresolution about the dollar had
run out. His remarks had special force because, whatever his evident
irritation with Mr. Carter on other grounds, no one could really doubt his
good will toward America and Americans over a number of years. Nor
could his experience and that of Emminger in the international monetary
area be questioned.

Their arguments only reinforced my belief that the time had come to act,
and that we faced a large challenge in being credible to the international
audience as well as to our domestic constituency. I suspect the force of the
German concern had an impact on the thinking of Miller and Schultze as
well, perhaps moderating their concern about my plans. I found time amid
all the other meetings at Belgrade to talk privately to a couple of my central
bank colleagues whose judgment I most trusted, including in particular
Emminger. In hinting to them about what I had in mind, I found a favorable
response.
In the press at the time and in some later histories of the period, a great deal
was made of the fact that I went home from Belgrade while the IMF
meeting was still under way, the presumption being that I was convinced by
the sour atmosphere at the meeting that we faced an emergency. The more
prosaic fact is that I went home because there was nothing more for me to
do in Belgrade. The flood of preliminary meetings of the G-5, the G-10, and
the interim and development committees, was over. I had no role to play in
the formal plenary, where Bill Miller would read a speech defending U.S.
policy. Instead of staying bored and itchy, I decided to go home a day or
two early and get a head start on changing policy.

TAKING ON INFLATION

As near as I could judge when I returned, both the technical work and board
thinking were on track, and I began planning for a special meeting by the
weekend of the Open Market Committee, which would have to make the
decision. But of course administration support or at least acquiescence
would also be critically important if the new approach was to be
convincing. When Miller and Schultze returned, they consulted with their
own experts, who included Lyle Gramley, then a member of Schultze's
Council of Economic Advisers but formerly a senior and thoroughly
respected Fed staff economist. (He was shortly thereafter appointed to the
board and became an enormously valuable and loyal colleague.) Their
concerns persisted, in part on the reasonable ground that so unfamiliar a
course would have highly unpredictable results. They urged that we instead
take strong but more orthodox action, which might even include an increase
in the discount rate by as much as 2 percent. No doubt they urged that view
on the president; they reported to me that he was of the same mind. But it
was significant to me that the president did not ask to see me directly. My
reading of the situation was that while the president would strongly prefer
that we not move in the way we proposed, with all its uncertainties, he was
not going to insist on that judgment in an unfamiliar field over the opinion
of his newly appointed Federal Reserve chairman. From his position as
Undersecretary of the Treasury for Monetary Affairs, Tony Solomon, who
had to carry the burden of trying to stabilize the dollar, quietly advised me
to go ahead if I really felt strongly, and that advice was also helpful.
So I decided to go ahead, calling a secret meeting of the Open Market
Committee for Saturday, October 6. As anticipated, several of the regional
bank presidents were eager to proceed, and I spent a good part of the
meeting insisting that before we voted the consequences must be fully
understood—including the possibility of much higher interest rates in the
short run. In theory, and as it turned out in practice and in spades,
concentrating on direct control of bank reserves and the money supply
would produce much more volatile interest rates, and in the short run,
before inflation came under control and confidence was restored, the whole
level of interest rates would rise. Then and later, the volatility of interest
rates bothered me more than many of the members of the Open Market
Committee. The majority insisted that we not place any really effective
limits on the extent to which interest rates might move, although the
decisions of the committee did set out rather wide ranges that, if exceeded,
might call for us to reconsider our policy.

CHANGING FORTUNES

The announcement of our change in operating approach that Saturday

evening was accompanied by several other changes that could be more
easily understood: another jump in the discount rate of f percent, special
reserve requirements on the growth of commercial bank time deposits, and
an appeal to the banks to stop lending for speculative purposes. I had a
speech scheduled a few days later at the annual convention of the American
Bankers Association, which afforded an opportunity to explain the policy in
more meaningful and colorful language than a Federal Reserve
announcement. But the basic message we tried to convey was simplicity
itself: We meant to slay the inflationary dragon. And the president, when
questioned, was remarkably supportive of what we had done.

We soon learned that any dreams we might have had of changing public
expectations by the force of our own convictions were just that—dreams.
One telltale sign of our difficulties was that when short-term interest rates
rose, as anticipated, long-term rates did, too. If the markets were convinced
that inflation would be coming down, presumably that would not have
happened, at least not for long. Moreover, the general level of interest rates
reached higher levels than I or my colleagues had really anticipated. That,
in a perverse way, was one benefit of the new technique; assuming that
those levels of interest were necessary to manage the money supply, I
would not have had support for deliberately raising short-term rates that
much. More important, even with interest rates so high and volatile, it was
hard to say we had achieved much constructive uncertainty in the markets
of the kind that I thought we needed to slow down lending or speculation.
Most disconcerting of all, while the money supply behaved more or less as
we had intended for the rest of the year, the inflationary momentum actually
had increased by early 1980. With consumer prices rising at an annual rate
of around 15 percent for a few months, there was a palpable sense of
growing political panic as well as economic distress.

The time for submitting the annual federal budget was at hand, so in
textbook terms there was an opportunity for the president to take a
constructive lead with a strong fiscal policy. No doubt he did what he
thought he could, but politically there didn't seem to be much room for
maneuvering, either on taxes or spending. Against the background of
ensuing steep jumps in- producer and consumer prices, the budget was
viewed with enormous disdain in financial markets. The adverse reaction
seemed excessive to me. But what clearly had happened over a

TAKING ON INFLATION

period of time is that a concern I had expressed a year earlier in the annual
report of the Federal Reserve Bank of New York about "the credibility and
coherence of U.S. economic policy" for all holders of dollars had come
home to roost.

Interest rates moved still higher, with the commercial banks' prime lending
rate reaching the unheard-of level of 15.25 percent in early February. But
the monthly inflation rate was almost as high, 14.9 percent, and the dollar,
which had stabilized for a while, was looking wobbly again. We at the Fed
saw no alternative to tightening again, not only by raising the discount rate
but by reinforcing our "moral suasion" about excessive growth in bank
lending with much more specific numerical guidelines. The administration
did not object in principle. We were urged, however, to delay until a revised
budget could be submitted, reinforcing the impact by placing all the new
measures, both our monetary decisions and their fiscal proposals, in a
comprehensive package.

The president thought it crucially important to bring his message home to

the proverbial average American. To help do that, he wanted to impose
direct controls on the use of consumer credit. That didn't make a lot of sense
to us in the Federal Reserve. While the economy had been expanding right
through the end of the year despite the extremely high interest rates and the
earlier forecasts of recession, credit-financed consumption was at best
sluggish, and the idea of getting involved in the administrative morass of
direct controls on millions of consumer credit transactions had no appeal to
us for economic or practical reasons. But it was not so easy to avoid.
Congress had put a peculiar law on the books a while before. It was
designed to embarrass President Nixon by giving him the power to
authorize consumer credit controls at a time when he was resisting them.
The Federal Reserve in turn was given the authority to administer the
controls. Theoretically, the Fed could refuse to implement what the
president had authorized, but that was hardly an attractive option.

I repeatedly conveyed our concerns to the president and his staff. In the end,
however, I found it impossible to resist the implied argument that, at a time
when the president had publicly supported our risky and unprecedented
monetary policy, and when he was responding to our urging that he take
tough steps to tighten the budget, we in the Federal Reserve ought to
respect his political judgment that consumer credit controls were needed to
convey the right sense of urgency. After all, we

CHANGING FORTUNES

were by no means ideologically pure: Consistent with the slower growth in

the money supply that we were trying to achieve, we were preparing to
introduce administrative, if nominally voluntary, restraints on bank lending.
So in the end I persuaded a reluctant board, on the understanding that the
controls on consumer credit would be as mild and as impersonally
administered as we could reasonably devise.

At the president's request, I was spending a lot of time with Secretary Miller
and other administration people as they consulted with Congress about
budget cutting, and then with the president and his inner economic circle as
he made the programmatic budget decisions. I had little or nothing to
contribute to these detailed decisions, but the exercise provided an
interesting insight for me into the practical problems of one president trying
to do his best to achieve a coherent budget policy amid strong political
pressures pulling in a different direction. Day after day, what I seemed to be
seeing before my eyes was a president with basically conservative instincts
finding his preliminary decisions challenged by advisers sensitive both to
particular interests and to the more liberal traditions of his party. In the end,
the compromise decisions really satisfied no one, and the image the
president instinctively wanted to convey was blurred. Without being too
grandiose about it, that budget struggle seemed to me to represent much of
the difficulty President Carter had in conveying a strong and consistent
image of his administration to the American people, despite the strength of
his personal character and convictions.

On March 14, 1980, the whole package was unwrapped at a big White
House ceremony: the new budget, the credit controls, the further Federal
Reserve tightening. The economy promptly went into a nosedive. Through
all the interest rate increases of the previous six months, the economy had
continued to grow. Now the bottom just fell out, literally within a matter of
days.

Things are always clearer in retrospect. The self-appointed experts of the

National Bureau of Economic Research later dated the recession as
beginning in February of that year. Be that as it may, when we were able to
go back and look closely at the data, what jumped out was that, all of a
sudden after the president's announcements, consumers stopped spending.
No one had ever seen anything like it. The consumer credit controls we had
decided upon were not intended to bite hard. Mechanically, they did not.
Credit was exempted for autos and things related to housing, which are the
principal uses for consumer credit; the effect

Toyoo Gyohten as a

graduate student at

Princeton University in
front of Nassau Hall, 1956.

Paul Volcker at his desk in the Treasury, 1963

AP/WIDE WORLD

Paul Volcker with William McChesney

Martin, chairman of the Federal

Reserve Board, testifying before

Congress in 1969.

upi/bettmann
Toyoo Gyohten (upper left) at the U.S. Treasury in Washington in 1973
with (front row from left) Kiichi Aichi, Japanese finance minister; John
Petty, assistant secretary for international affairs; and Henry Fowler,
secretary of the Treasury. Japanese official at upper right is unidentified.

Treasury Secretary John Connally

in full flight at press conference

after Group of Ten meeting in

Rome, 1971.

AP/WIDE WORLD
Connally emerging from ministerial meeting at Rome, with Volcker and
Federal Reserve Chairman Arthur Burns in the background.

AP/WIDE WORLD
With the president at Camp David for the meeting of August 1971. Seated
from left: Peter Peterson, assistant to the president; Arthur Burns, chairman
of the Federal Reserve Board; John Connally, secretary of the Treasury;
Richard Nixon; George Shultz, director of the Office of Management and
Budget; Paul McCracken, chairman, Council of Economic Advisers;
Herbert Stein, member, Council of Economic Advisers; Paul Volcker;
Caspar Weinberger, deputy director, OMB. Standing, from left, Michael
Bradfield, assistant legal counsel, U.S. Treasury; William Safire,
presidential speechwriter; Arnold Weber, associate director, OMB; Kenneth
Dam, assistant director, OMB; John Erlichman, assistant to the president for
domestic affairs; Robert Haldeman, White House chief of start.

THE NATIONAL ARCHIVES NIXON PROJECT

"American monetary policy is not made in Paris, it is made in Washington."
Federal Reserve Chairman Arthur Burns seizes the microphone at a press
conference at the U.S. embassy in Paris in March 1973 as Treasury
Secretary George Shultz smiles, Paul Volcker frowns, and Burns's patron,
Richard Nixon, smiles down from an official photo (see Chapter 4).

Toyoo Gyohten with Prime Minister Kakuei Tanaka flying to the United
States in 1972.
The first summit meeting at Chateau de Rambouillet. From left: Aldo Moro,
Italy; Harold Wilson, Bntain; Gerald Ford, United States; Valery Giscard
d'Estaing, France; Helmut Schmidt, Germany; Takeo Miki, Japan.
keystone/sycma
Behind the Federal Reserve Board chairman's traditional smokscreen,
Arthur Burns testifies before Congress in 1975, and Paul Volcker in 1983.

With Ronald Reagan in the Oval Office, 1981

AP/WIDE WORLD

'It's Paul Volcker—he put me on hold!'

■*.'.',

yy^^fflga^p

With Treasury Secretary Donald Regan at the IMF meeting in Washington,

1983.

Jacques de Larosiere,

managing director of

the International Monetary Fund,

at closing session in 1983.

upi/bettmann
Toyoo Gyohten serving as master of tea ceremony in his home in
Yokohama, 1984.

Finance Minister Kiichi Miyazawa

and Treasury Secretary James Baker

outside the Treasury building

in Washington, 1987.

AP/WIDE WORLD

Pushing the reluctant central banker out front at the press conference after
the Plaza agreement on September 22, 1985 (see Chapter 8). The five
finance ministers behind him are, from left, Gerhard Stoltenberg, Germany;
Pierre Beregovoy, France; James Baker, United States (grasping Volcker's
arms); Nigel Lawson, Britain; Noburu Takeshita, Japan. upi/bettmann
Toyoo Gyohten (front row, second from left) at Group of Seven meeting in
Berlin, 1988. Alan Greenspan, Volcker's successor as Federal Reserve
Board chairman, stands second from left in the back row.

TAKING ON INFLATION

therefore should have been limited to credit card purchases and general-
purpose installment loans. Even then, our special new reserve requirement
would only apply to increases in loans and was designed only to raise the
cost of credit moderately. But the president was interpreted as saying that
the country was in a national emergency and that consumer spending should
be restrained. So a lot of consumers stopped spending. They certainly
stopped using credit cards, some cutting up their cards into little pieces and
sending them to the White House. "Mr. President," the letters said, "we will
cooperate."

After aD the trouble we had had trying to stop the money supply from
increasing, it suddenly dropped precipitously. We could only catch up with
that, like the decline in the economy itself, when we got the statistics a few
weeks later. As soon as the magnitude of the drop became apparent, money
was eased. But there was a lot of criticism from economists, monetarists
and Keynesians alike that we hadn't moved fast enough; we were willing to
put the country through the agony of high interest rates when inflation was
raging, but we weren't doing enough to prevent a crash.

Even so, we eased a lot. The federal funds rate went from about 20 percent
to 8 percent in only three months. We removed the consumer controls at the
beginning of July, as soon as I felt we decently could. Interest rates soon
stabilized, and the money supply shortly began increasing again, although
for a while it was still far below the target range we set out at the beginning
of the year. Only later did we or anyone else realize that the economy was
rebounding almost as fast as it had declined.

It is all recorded in the books as a recession, but in retrospect it was an odd,

almost accidental occurrence. There was a sharp decline in production, but
it only lasted about four months. What seems to have happened is that many
consumers decided to pay off debt, so both spending and cash balances (that
is, the money supply) fell suddenly. As the fright about an economic
emergency dissipated and the credit controls were removed, spending (and
the money supply) picked up rapidly.

The net result might not have been much of a recession, but there wasn't
much progress against inflation either. It continued running at double-digit
levels, and with the money supply rising strongly again we were in the
uncomfortable position of tightening money and raising the discount rate
only a few weeks before the election. It was small comfort that Ronald
Reagan, as a candidate, criticized the Federal Reserve for being too easy!

CHANGING FORTUNES

All of that detail may seem something of a diversion from international

finance, but there was a basic connection. The priority given to the fight on
inflation by monetary policy after the fall of 1979 helped stabilize sentiment
in the exchange markets even though consumer prices continued to rise
sharply for a while. Moreover, our current account, benefitting in part from
the past dollar depreciation that made American exports cheaper abroad,
was close to balance. The stage was set for the strengthening of the dollar
that eventually went way beyond expectations.
By the time Ronald Reagan took office in January 1981, monetary policy
was again fully engaged in restraint; our money supply targets had been
reduced a little and commercial bank interest rates were back at a peak of
over 21 percent. Relations with the new administration were cautious, to
choose the right word carefully. To me, its economic officials were a rather
odd mixture of hard-boiled monetarists and what came to be popularized as
"supply siders," mixed in with a few pragma-tists like the new chairman of
the Council of Economic Advisers, Murray Weidcnbaum. As Assistant
Secretary of the Treasury for Economic Policy a decade earlier, Murray had
reported to me, so we could talk comfortably and candidly. I suppose that
Donald Regan, the new secretary of the Treasury, could also be put among
the pragmatists, but it soon became plain that he would be pulled in
different directions by the strong and often conflicting ideological
commitments among his own staff in the Treasury and the administration
generally.

What all those schools had in common was the idea that monetary policy
was absolutely critical to the success of the new administration, even if they
differed on how it should be conducted. I knew from Arthur Burns that at
the start some advisers, led by Milton Friedman and the extreme
monetarists, who had long carried on an intellectual crusade against the
Federal Reserve, would have liked to have ended our independence, if not
the institution itself. Burns was apoplectic about it. We were indeed
fortunate that even in his retirement, his intellectual stature, his public
standing, and his old friendships were brought to bear to keep the wilder
views of some of his Republican friends at bay.

Reflecting the importance attached to monetary policy, the White House

staff proposed that the president himself visit with me at an early date in my
official home, the handsome quarters of the Federal Reserve on
Constitution Avenue. That would have been without precedent, and I sensed
that, however well intentioned, the gesture would raise endless

TAKING ON INFLATION

questions about our independence. The normal arrangement, I pointed out,

would be for me to visit the president in his office.
We compromised on lunch at the Treasury, and the president walked across
the street from the White House with much of his economic team. It was the
first time we met, and the whole thing seemed to me a bit contrived, with
press and cameras. But I was delighted when the president started off, with
the press still present, by saying that it would be important for the gold
price to decline in the market as an indication that inflation was under
control.

In early policy statements, some of the new people of the administration

wanted to write very specifically about monetary policy; for example, one
favored formulation was that money growth should be "predictably and
assuredly" reduced by I percent a year for several years. I knew that such
precision would be impossible to achieve in the real world, and achievable
or not, it would look like the administration was trying to order the Fed. I
somehow succeeded in talking them out of that kind of language on the
basis that they would only invite conflict and antagonism on matters that,
after all, the law made amply clear were for us to decide. Certainly, we got
lots of advice from the administration. Later on, much of the advice was
passed on via the press, sometimes by unidentified White House officials
with vaguely ominous threats, often more openly by Donald Regan, who
would recurrently refer to mysterious studies of the independence of the
Federal Reserve.

Some of that was natural, I suppose, in the face of the really serious
recession that developed in mid-1981, that briefly carried the
unemployment rate by the end of 1982 to a postwar high of over 11 percent
and that lasted well over a year, and into a congressional election year at
that. President Reagan must have received lots of advice to take on the Fed
himself, but he never really did despite plenty of invitations at press
conferences or otherwise. I never saw him often, as I had Mr. Carter, nor
did I ever feel able to develop much personal rapport or indeed much
influence with him. He was unfailingly courteous, but he plainly had no
inclination either to get into really substantive discussions of monetary
policy or, conversely, to seek my advice in other areas. But I had the sense
that, unlike some of his predecessors, he had a strong visceral aversion to
inflation and an instinct that, whatever some of his advisers might have
thought, it wasn't a good idea to tamper with the independence of the
Federal Reseive, which, after all was said and done, was trying to restore
stability.

CHANGING FORTUNES

Certainly, the administration generally supported our efforts to restrain

money growth in 1981, even at the expense of ferociously high interest
rates. I recall particularly the delight with which Secretary Regan received
the news that we were about to raise the discount rate in May to help deal
with a bulge in the money supply even though, as it had turned out, that was
very close to the peak of business activity. The fact is, from my own
admittedly partial and prejudiced perspective, there was substantial support
in the country for a tough stand against inflation, for all the real pain and
personal dislocation that seemed to imply. I don't mean that we would have
won any popularity contest, but there was a deep-seated sense that
something was wrong and we were trying to do something about it. At one
point in the darkest days of the Carter administration when Soviet divisions
invaded Afghanistan, the lack of confidence was symbolized by the gold
price's soaring above $800 an ounce and by wild speculation in the silver
market. Occasionally, there were demonstrations around the Fed
headquarters, and for a while my office was deluged with sawed-off
wooden two-by-fours in a campaign organized by homebuilders to lower
interest rates and stimulate their business. But even a few of the messages
scrawled on the boards suggested we were making a point. They said things
like: "Keep the money supply down to reduce interest rates" or "Stop
printing money to cover the national debt."

In the end, there is only one excuse for pursuing such strongly restrictive
monetary policies. That is the simple conviction that over time the economy
will work better, more efficiently, and more fairly, with better prospects and
more saving, in an environment of reasonable price stability.

In a speech in San Francisco in December of 1983, I defined "reasonable

price stability" as a situation in which ordinary people do not feel they have
to take expectations of price increases into account in making their
investment plans or running their lives. After the Great Depression, a lot of
economists thought it was a good thing to have a slight bias toward
inflation; it would pep things up a bit, encouraging spending and new
investment. The trouble is that when everyone expects inflation, and
interest rates go up in anticipation, the temptation always remains to speed
up the inflation a little more, if not deliberately then for fear that restraint
will cause a recession. In the end, there will all too likely be a still bigger
recession, and more agony in restoring stability. That was the situation at
the start of the 1980s.

TAKING ON INFLATION

It may be hard to prove this point with the rigorous mathematical reasoning
and statistical techniques used by modern economists. But there are real
doubts that those techniques can ever capture all the complexities that drive
human behavior. By and large, the world's governments, in the most
developed nations and some of the least developed countries alike, seem
now to have come to the conclusion that price stability is a prime priority,
and obtaining it is worth a lot of transitional agony.

We are all perfectionists. Looking back, there is a certain amount of second-

guessing, including that by many experts sympathetic to the dilemmas faced
by the Federal Reserve, about whether we weren't too slow to ease in 1982.
Maybe, they say, the recession could have been ended a few months earlier.
Perhaps that is true, but those arguments do not impress me very much. It's
not that our policies were perfection but that the far greater error at that
point would have been to fail to follow through long enough to affect
fundamental attitudes and really put inflationary expectations to rest. Those
policies cannot really be fine-tuned, and even after all we went through the
objective was not fully achieved. We did, I think, lay the essential base for
the longest peacetime expansion in history in the 1980s, and it has been
greatly reassuring to see members of the present Federal Reserve Board
attaching the priority they do to finishing the job of achieving price
stability.

What was more important than the precise timing of our moves was the
broader mix of policies in the 1980s. The Reagan administration's 1981 tax-
reduction bill, which was the centerpiece of its supply-side program, turned
out to initiate a process of much larger tax cuts and budget deficits than
anyone really intended. We in the Federal Reserve could only watch from
the sidelines as the Democrats and Republicans alike engaged in a political
competition to see who could reduce taxes further. I could plead to the
Congress that all that tax cutting should be paralleled by expenditure
reduction, but nobody much wanted to listen.

The more starry-eyed Reaganauts argued that reducing taxes would provide
a kind of magic elixir for the economy that would make the deficits go
away, or at least not matter. This was an extreme version of what I had
argued as a young official in the Treasury in 1963- But some of their
arguments made me wonder why we bothered to collect taxes at all. The
more realistic advisers (everything is relative) apparently thought the risk of
a ballooning deficit was a reasonable price to pay for passing their radical
program; any damage could be repaired later, helped

CHANGING FORTUNES

by a novel theory that the way to keep spending down was not by insisting
taxes be adequate to pay for it but by scaring the Congress and the
American people with deficits.

Later repair efforts recouped some of the extreme tax reductions in 1981;
but we ended up with a big built-in deficit. I lost no opportunity to
emphasize that the result was to keep interest rates higher than they would
otherwise be, a point that seemed self-evident to most of us, although it was
denied by some enthusiastic Treasury supply-siders. So much for that
institutional citadel of conservatism with which I had long been associated.

By the nature of our responsibilities, I saw a lot of Don Regan and his
successor as secretary of the Treasury, James Baker. By long and useful
tradition, we would try to breakfast together every week, and we frequently
needed to meet in order to deal with particular matters. They knew my
concern about the deficits and would often bemoan the difficulties in
keeping spending in check. But all that made no real difference to the
conduct of fiscal policy, which had been effectively frozen by large political
and ideological forces. Successive Treasury secretaries no doubt felt they
had comparably little effect on the course of monetary policy. During
Reagan's first term particularly, I would often pick up the newspaper to read
how poorly we were conducting things, even though little was said directly.
The huge deficits, however reasonable in the midst of recession and
tolerable in the early stages of recovery, did not serve the country at all well
once the economy resumed forward momentum. That seemed to me evident
on domestic grounds alone because the deficit effectively ate up a lot of our
private savings, which were awfully low to start with by world standards
and even by our own past performance. That meant, in turn, that the
environment for domestic investment was not as good as it should have
been. We had the longest peacetime expansion in history, but it was not
exceptional for either its increases in productivity or for new investment in
plants and equipment, particularly after allowing for the necessarily rapid
depreciation of the large computer purchases that loomed so large in the
investment spending that did take place. Those trends of low investment
and low productivity growth seemed to be related and present a major
challenge for economic policy today.

As time passed, the shortage of domestic savings was compensated in

substantial part by an enormous inflow of mainly borrowed capital from
abroad. That inflow was at one point running at a greater rate than all

TAKING ON INFLATION

the personal savings in the United States and turned out to be far larger than
I had thought possible. I remember, with some embarrassment, chiding the
Fed staff for making a presentation sometime around 1983 that suggested
the capital inflow might need to reach and even exceed $75 billion a year in
order to cover a growing current account deficit. I reminded them that little
more than a decade earlier flows of $20 or $30 billion into or out of the
dollar were extreme and sent currency values careening. In fact, in the peak
year of 1985, the recorded net capital inflow was $103 billion.

For a while—in 1980, 1981, and 1982—the somewhat stronger dollar that
accompanied the high interest rates provided a welcome respite for
everyone from the exchange market crises of the 1970s. But as time passed
and high interest rates helped attract more and more foreign funds from
abroad to help finance our deficits and investments, the adverse
repercussions of this policy mix on international markets became obvious.
More correctly, it seemed an obvious problem except to some dedicated
members of the administration team who interpreted it all as a vote of
confidence in U.S. policy.

For one thing, both the high interest rates and a strongly rising dollar made
it harder to deal with the debt crisis that is the subject of the next chapter.
Then, as the dollar moved sharply upward in 1983 in response to foreign
purchases of U.S. securities, the competitive position of our industry in
international markets began to be seriously undermined. The rise was
almost explosive in 1984, and by early 1985 the dollar had appreciated by
about 45 percent above 1980 levels against the mark. And eventually the
strength of the business recovery petered out in the face of a huge trade
deficit. In those circumstances, the question naturally arose as to whether
we might back off from our tough monetary targets and attempt to
ameliorate the situation by lowering interest rates. The answer always
seemed pretty clear: Such an approach would only jeopardize larger goals.

We had sensed the possibility of a Mexican debt crisis for some time before
it materialized in August of 1982. But it hardly seemed possible that easing
interest rates by a point or two in late 1981 or in the first part of 1982 would
have made a significant difference. Even so relatively small a change, when
the money supply was higher than our targets, would have been hard to
explain. Should we have announced, in effect, that we were willing to live
with more inflation in an attempt to ease the debts of a foreign country,
particularly when the effort almost

CHANGING FORTUNES

certainly would not have been big enough to have made much difference
anyway?

The question answers itself. The debt crisis was on an express train of its
own, and by late 1981 or 1982 there was not much anyone could do to head
it off. Actually, by the summer of 1982 the financial fabric of the United
States itself was showing clear signs of strain. Against the background of
the spreading problems of the savings and loan industry and some well-
publicized failures of marginal government securities dealers, the
bankruptcy of the high-flying but obscure Penn Square National Bank in
Oklahoma exposed that billions of dollars of oil loans that it had originated
were virtually worthless. Some very large and well-known banks were
involved; the proud Continental Illinois Bank, largest in the Midwest, was
shaken to its foundations. All that contributed to the timing of our decision
to ease policy in July 1982. That was done, however, against the
background of disappointing business news and evidence that the money
supply was well under control. There was not, in other words, a clear
conflict with the central fight on inflation.

Later on, as the dollar rose so strongly, interest rates had already declined
markedly, although they remained high in any longer historical perspective.
To me, it was a strange, paradoxical situation. Up to a point, the strength of
the dollar was helping to dampen inflation by keeping import prices low
and competitive with American products. But plainly, over time it had gone
from something constructive to a potential catastrophe. The competitive
position of our industry was being undermined in a way that might do
lasting damage. Sooner or later, I thought, there would all too likely be a
sickening fall in the dollar, undermining confidence, as had happened so
often in the 1970s. Yet there was an administration that simply didn't seem
to care. From time to time Japanese and European officials would argue that
we ought to join them in showing our concern in the most direct and
simplest way, by selling dollars in the foreign exchange market. But those
overtures were rejected by the Treasury as a matter of principle. Instead, the
strength of the dollar came to be cited by some officials as a kind of Good
Housekeeping Seal of Approval provided by the market, honoring sound
Reagan economic policies.

For the Federal Reserve to flout the views of the Treasury by using its
independent authority to intervene seemed to me more a theoretical than a
practical possibility at that point. The efficacy of intervention alone to deal
with the situation was very much in doubt, especially if the

TAKING ON INFLATION

government was not unified on the point. For the Federal Reserve to go it
alone would plainly have set off a distracting and entirely counterproductive
political debate risking support for our basic policy. The federal Open
Market Committee, a number of whose members were always skeptical of
the value of intervention, would certainly not have agreed, even if their
chairman had been so misguided as to have seriously raised the issue.

What would have been substantively a much more important step would
have been actually to have eased money more than we perceived consistent
with domestic requirements and with the fight on inflation. That too would
have seemed odd when the administration was cheering on the dollar. And
by late 1984 and at the start of 1985, when the dollar soared on its own
momentum into a kind of monetary stratosphere beyond any sense of
competitive reality, it seemed beyond any predictable influence by
intervention or even monetary policy.

To the best of my recollection, the Federal Reserve was not really under
attack for neglecting the external dimension of policy. The administration,
as indicated, didn't seem to be concerned about the dollar. Our counterparts
abroad in central banks and finance ministries basically supported our
efforts to deal with inflation, and most of them said so publicly. They
recognized the larger issue at stake; to some degree I sensed they saw the
Federal Reserve fighting a battle for all central banks even though some of
the side effects were troublesome. I would wince when I read of bitter
complaints by Helmut Schmidt, who had helped provide a big push toward
our new policies during the Hamburg stopover in 1979, citing "the highest
real interest rates since the birth of Christ." But it was amply clear that he
regarded loose American fiscal policy as the main villain of the piece.

The plain logic of the situation to me and most economists was to reduce
the budget deficit, which at about $200 billion was running more than ten
times the much maligned Carter budget proposal of early 1980. Reducing
the deficit would have relieved the pressures on our money and capital
markets and our dependence on foreign capital without jeopardizing the
credibility of the fight on inflation; in fact, effective effort to restore budget
balance could only reinforce what we were trying to do.

I had plenty of occasions for making that point to the Congress. Although it
was never pressed, sometimes there were intimations of a deal; if the
Federal Reserve would commit itself to reducing interest

CHANGING FORTUNES
rates, that would provide political lubrication for some combination of
spending cuts and a tax increase to cut the deficit. History taught me to be
cautious about that. Once before, in the late 1960s during the debate over an
income tax increase to pay Vietnam War costs, the Fed eased in anticipation
of fiscal tightening. I don't know how much the decision to ease was meant
as a political gesture as well as being economically appropriate. But it had
become part of Fed lore that it was all a big mistake; the tax increase never
had the restraining effect anticipated, the Federal Reserve was for months
politically locked into inappropriate policy, and the momentum of inflation
speeded up.

In the context of the 1980s, it was not even plausible to think Congress
could deliver its end of the hypothetical deal—not over administration
opposition. I know in the real world of electoral politics, "cover" for a tough
vote is important, and a congressman naturally would want to point to some
easily identifiable thing he had won from an increase in tax rates or
cutbacks in spending. But I remain convinced that the larger wisdom of
Congress is reflected in its judgment, ever since the Federal Reserve was
created in 1913, that the central bank should be insulated from the pressures
ot electoral politics. To put the point another way, even good and
responsible fiscal policies are not an adequate excuse for a bad monetary
policy.

I realize that there were two schools of thought at the time as to whether a
tore etui budget program, however desirable over time, would actually have
had the effect ot reducing the high dollar exchange rate. The standard
Kevnesian analysis was straightforward: Other things being equal, a
reduced deficit would release more U.S. savings for other needs, interest
rates would drop, less capital would be attracted from abroad, the dollar
would stop rising or decline, and we would end up with more exports and
fewer imports. Martin Feldstein, a distinguished member of the Harvard
economics faculty who had become chairman of the Council of Economic
Advisers, forcefully expounded that view publicly, to the dismay and
irritation of many administration colleagues.

Others argued that a budget program seen as "more responsible" would only
send the dollar still higher in the exchange markets because it would
increase confidence in United States economic policy and in the future of
the American economy, thus encouraging still more capital flows to the
United States. In the short run at least, that was not a foolish view limited to
administration apologists. I once put the problem to a small group of highly
respected academic economists who had gathered

TAKING ON INFLATION

at Basel for a dialogue with central bankers. What did they think would be
the effect of a reduced deficit on the direction of the dollar? Half said it
would go up, and half said it would go down.

Perhaps the right answer would have been that it would go up a little at first
for psychological reasons, and then down for more lasting reasons.
Unhappily, we never got the chance to test that hypothesis. All such
sophisticated argument was probably irrelevant in the face of the entrenched
administration opposition to a budgetary fix that would necessitate
compromises on spending and taxes with the Congress. The opposition
remained solid even when Republican congressional leaders seemed
prepared to consider it. The classic and irrefutable answer to my entreaties
to administration officials was that, however sensible a bipartisan program
might be, it was simply not on politically; in his campaign for reelection,
President Reagan had pledged no new taxes, and that was that. Indeed he
had, but I was always left with the nagging question of which advisers had
encouraged the strength of that pledge, or had at least not objected to it, in a
walk-over election.

All of that made the administration look pretty insular to our foreign
counterparts. The low point, psychologically, was probably at an interim
committee meeting near the end of Don Regan's tenure at the Treasury. His
Irish blood was up after listening to the litany of criticism focusing on our
budget deficits. He aggressively delivered a speech telling his foreign
counterparts that they had it wrong and we had it right; that they should be
emulating our policies, not criticizing them; that the proof was that it was
the United States that was growing fast, not Europe and Japan. I happened
to walk into the room at the middle of it all, with Regan in full flight,
almost shouting. It was immediately apparent that this was not a high point
for the niceties of international diplomacy. Nor—to my mind, and much
less to the foreign audience—was there any convincing rationale for the
fiscal policy he was defending.

But Regan did have an important point. Both Europe and Japan were in a
period of low growth; those were the days when the term "Eurosclerosis"
was coined. Their economies and those of the rest of the world were being
substantially buoyed by the United States, quite directly by our rapidly
expanding imports. The administration might in foreign eyes have seemed
totally ideological in its tax, its budget, and its exchange rate policies (or, as
they saw it, lack thereof). But that same ideology was doggedly resisting
protectionism and promoting more open markets around the world in the
common interest. And it was also

CHANGING FORTUNES

true that it would have been wrong to take many risks with the growth of
the American economy before momentum picked up in Japan and Europe.

The second Reagan administration would soon take the lead in attempting
to achieve better coordination. That is the subject of a later chapter. But as
the middle of the decade approached, international policy problems were
returning front and center, even as there was evident progress in dissipating
inflation and the economy grew vigorously.

TOYOO GYOHTEN

JVly memories of these events begin in 1980, just after the Federal Reserve
adopted its new policies. At first we did not perceive the change as very
dramatic because nothing really happened for a while. Then interest rates
started to shoot up. We in Japan started to wonder whether this was a
sustainable, viable policy, especially when the United States economy
started to decline. How long could the Federal Reserve stay tough? Then
Paul Volcker came to visit us, and Finance Minister Ippei Kancko gave a
dinner for him at the Okura Hotel. After dinner we sat around over brandy,
and Volcker asked, "If you were the Fed chairman, would you still continue
with this tight monetary policy?" He asked each of the half dozen senior
officials around the table to answer the question one by one, and we all said
yes. I don't know whether he was encouraged by our response, but I
remember the incident well.

During the early years of the first Reagan administration, the Treasury was
dominated by free marketers. You might have thought that the persistently
high interest rates and resulting strong dollar would have caused some
reflection within the administration and prompted a change in policy, but
not among the free marketers then in charge. They never doubted the
wisdom of their policies, were quite happy to see the dollar rising, and
cared nothing about the deepening current account deficit, because money
flew in to earn a high interest rate, and they argued that this was a symbol
of the strength of the American economy.

We started to feel very nervous. When the rising dollar became a subject for
discussion everywhere in 1983, we repeatedly questioned the

TAKING ON INFLATION

wisdom of United States policy, even though a strong dollar helped

Japanese exports penetrate U.S. markets. We did not criticize monetary
policy, which we considered a victim of excessively expansionary fiscal
policy. We criticized the budget deficit because we thought it soaked up
available funds while simultaneously feeding inflation. The administration
had no ears to listen. We argued that the high interest rates were certainly
exacerbating the Third World debt problem and calculated that if U.S.
interest rates declined by I percent, Latin America's burden of debt service
would be reduced by $4 billion a year. We got no response in Washington
and felt we were really talking to deaf ears in those days.

Certainly the original intention of the Reagan fiscal policy was not that bad.
The problem was that it did not work as intended. They expected that their
policy would boost domestic savings, but it did precisely the opposite. This
was clear to everyone else, but it took so long for the administration to
recognize the ineffectiveness of its policy that it could not change course
quickly enough.

The first half of that decade was certainly a most remarkable period,
distinguished by a serious lack of preparedness and willingness to discuss
domestic economic policies at the international level. All fiscal and
monetary authorities tend to be. in Paul Volcker's words, very parochial and
insular, and we Japanese were too obsessed by the need for the United
States to maneuver itself into a better fiscal position and by the awareness
that Umted States policy was leading toward a very serious international
disequilibrium. But we. too. lacked even the willingness to study the
international compatibility of our different domestic policies. At the time
there was a strong consensus that U.S. fiscal policy was to blame, and if
other countries had tried to accommodate by loosening their own fiscal
policies, global pnee stability would have been endangered. What I regret
most is that, although we would have been willing to enter into intense
dialogue on such questions, dialogue was totally nonexistent at that time.

But it is also true that none of us. including Japan and Germany, had the
guts to speak up. It seemed all right for us to blame the United States, but
there was always a fear that the Umted States would reply that the world
was in need of a stimulus for growth, and if the United States were to cut its
deficit and slow its economy, who would replace it as the engine of growth?
At that point, the obvious implications of that ques-tion for our economy
would have dampened our courage to continue the argument. So let me say
that there was a certain amount of mutual

CHANGING FORTUNES

acquiescence in the crimes of another, because we were all sinners to some

extent. This situation has not changed appreciably. It is one major source of
frustration on the part of the United States and it is an almost continuous
source of frustration and discontent in any coordination effort that we now
undertake.

HUH CRISIS

PAUL VOLCKER

OVERVIEW
The Latin American debt crisis was more than five years in the making, and
it came to a head in a few weeks during the summer of [982. Treasuries and
centra] banks of ereditor eountries, the IMF, the commercial bank lenders,
and—critically important—the borrowing countries themselves mounted a
remarkable cooperative effort. Together, they defused and diffused a
situation that had the potential for upsetting the financial stability of the
industrialized world and undercutting prospects for growth, not only in
Latin America but the world generally. Even a decade later, the wounds in
Latin America itself have not fully healed. For some oi those countries (and
for those similarly affected in Africa), the [980s was a lost decade in terms
of growth and price stability.

Yet, for all the pain, the implications were not entirely negative. At the start
of the 1990s, a number of important countries were poised for progress:
Mexico, Chile, Colombia, Venezuela, and even Argentina, where the
shortfall from potential has been most glaring. Their governing
philosophies, their economic policies, and even their political systems were
fundamentally revamped from the stultifying approaches

187

CHANGING FORTUNES

entrenched for decades. They no longer crouched behind high walls of

protection, sheltering their national monopolies or cartels, seeking comfort
and security in widespread government ownership and control of business,
and rejecting foreign ownership of enterprises and the equity and energy
that could bring.

To a substantial degree all that has been abandoned. Instead, tariffs and
other import restrictions have been drastically reduced, in some instances
pretty well eliminated. Dramatic steps have been taken to sell off previously
sacrosanct government enterprises such as airlines, telephone companies—
even some banks. (The largest Mexican banks turned out to be worth more
in the market than some larger and better known institutions in the United
States.) Subsidies for favored manufacturers have been cut back and more
modern capital markets have begun developing. It has become easier for
foreign investors and companies to participate in joint ventures, even
occasionally in the particularly sensitive areas of petrochemicals and oil
exploration.

Perhaps the most telling evidence of a profound change in attitudes and

approach emerged in a broader concept. Unthinkable only a few years ago,
free trade agreements among Latin American countries, and potentially
most important, with the United States became a part of the everyday
political dialogue.

Those are observable facts. What is not provable, but what I think seems
evident to most experienced observers, is that the agony of the debt crisis
provided the jolt necessary for Latin American leaders to rethink their old
approaches and set off in fresh and much more promising directions.

Ot course, success is not assured. There have been false dawns before in
one country or another as they worked their way through their debt
problems. Brazil is the largest of all the Latin American countries and is
historically the most dynamic—speciaUy blessed, they used to say, by God.
After a decade of battling debt, it seemed in danger of losing its way,
bogged down in inflation, stagnation, and an unnatural pessimism.

No doubt there are lessons here for the nations of Eastern Europe and the
new republics of the old Soviet Union as they struggle to modernize their
economies. The parallels are certainly not exact. The typical debt load of a
former Communist country, and certainly of the former Soviet Union, is
relatively lighter and potentially easier to carry. At the same time, the nee-d
for adjustment has been thrust upon them with even less preparation. The
Latin American countries have long had

MANAGING THE LATIN AMERICAN DEBT CRISIS

institutions, legal systems, and habits of mind broadly compatible with a

capitalistic market system. Effort at reform has been under way for years in
Chile, Mexico, and Argentina.

The most relevant lesson may be just that. Fundamentally reshaping an

economy takes time, taxing the patience of populations and politicians
alike. But the Latin American experience also suggests that that difficult
process need not be incompatible with greater democracy and political
freedom.

THE GENESIS OF THE CRISIS

Memories are short and now we tend to think of the Latin American debt
crisis of the 1980s as a problem for the Third World. But when it broke, it
was just as much of a problem for the first world, which found its banking
system suddenly threatened with collapse. No doubt the emergency efforts
in i9cS2, and the tortuous process that ensued to coordinate the efforts of a
dozen countries, hundreds of banks, and several international institutions
was energized by that most important of all instincts—that of self-
preservation.

We probably would be better off if we had a longer collective memory in

another respect: International debt crises, and particularly Latin American
debt crises, are nothing new. The amount of "cross border" lending that took
place in the 1970s and 1980s was immense, and we tend to think of it as a
function of more developed markets and modern communication. But the
amounts of lending a century and more ago, relative to the size of banks in
those days, might have been just as large.

There was a long lapse from the last important episode, the brief spurt in
international lending during the late 1920s that quickly collapsed in the
early 1930s. When we went through the trauma of world depression, the
problems of international debt were centered in Europe even more than in
Latin America, and they certainly were a complicating factor in the
financial and economic collapse of the time. But two generations is an
eternity in the minds of financial operators, and all of that was out of sight
and out of mind in the world of the 1970s.

I was introduced to the problem a quarter century earlier as a student of

economics after World War II, but we didn't dwell on it. The problem of the
day was not excessive debt but a reluctance to lend after all the dislocation
of war. I do recall, at a seminar at the London School

CHANGING FORTUNES
of Economics when I was a graduate student, being exposed to the then-
conventional wisdom: If international loans are to be made in any volume
by private lenders for purposes other than short-term trade financing, which
was considered a questionable proposition to start with, it should be done
by banks. In the 1920s and 1930s, international credit had been extended
mainly by selling foreign bonds in the market, and the lesson of that
experience was that no quick and effective way existed to organize a
coordinated "workout" in time of crisis among the widely dispersed
bondholders to preserve values and stabilize markets. It was a matter of
everyone for himself, saving what he could at the expense of other lenders,
the borrowers, and ultimately himself.

That lesson was drilled into my mind: Large-scale international lending, if it

is done at all, should be done through syndicates of banks that would be
able to assess risks expertly and carefully and, if worse came to worst, work
together to organize debt restructurings in the common interest. What I
learned not as a student but as a central banker was that it was impossible to
count on the first of those precepts—that banks would assess risks carefully
and with prudent foresight. But I do think it was fortunate, when
international lending did revive in the postwar world, that it was in fact
done very largely by banks. Perhaps ironically, the bondholders in the
1980s ended up better off than the banks, but that was essentially because
the amounts of the bonds were so relatively small, the debt could be
serviced with regular interest payments.

Apart from trade financing, there was relatively little international bank
lending before the first oil shock, and what there was was highly
concentrated among the most internationally minded banks. At the end of
1974, the foreign loans of all banks to developing countries totaled S44
billion; about one third had been made by American banks that were then
leading the wave of internationalization in all areas of banking. Outstanding
loans to Eastern Europe, which could be put more or less into the same
category as developing countries, came to about $14 billion, almost all by
European banks. A sizable part of that lending was guaranteed by their
governments.
That rather restrained lending activity took place in the context of rapid
growth by the borrowing developing countries. Beginning in the 1960s,
growth rates of 6 and 7 percent, year after year, were quite common in Latin
American and some Asian countries. It was a remarkable performance by
any historical standard and fueled what the Ameri-

MANAGING THE LATIN AMERICAN DEBT CRISIS

can politician Adlai Stevenson called "the revolution of rising

expectations." Sustainable or not, efforts to maintain that growth became a
political imperative for leaders in Latin America and elsewhere. By the
latter part of the 1970s, there was also a sense of opening in some countries
of Eastern Europe, nothing nearly so dramatic as what happened from 1990
onward, but enough to stir a little optimism that a growth process was also
starting in the Communist countries. All of that led to a greater willingness
both to borrow and to lend.

The requirement of many countries to pay much larger oil bills after 1974
greatly increased potential needs. At the same time the oil producers were
sending the banks large deposits, which the bankers wanted to put to work.
By the end of 1979, just as the second oil crisis broke, loans to developing
countries reached $233 billion, almost five times as much as five years
previously. While the American share remained at about 35 percent, its $82
billion in outstanding loans to developing countries was also five times as
much as at the end of 1974. With very little American participation, total
loans to Eastern Europe went up even faster, from $14 billion to $64 billion,
as some Western European governments wanted to encourage an opening to
the East.

This burst in lending began to involve a large number of banks beyond the
core group of traditional international lenders. Many regional banks in the
United States were drawn in, as were all the large Japanese banks and, as
we later learned, rather obscure institutions scattered through Europe and
the Middle East. But the banks setting the pace, and by their activity
reassuring the others, were twenty-five to fifty American, European, and
Japanese banks with international experience and ambitions. Those were
precisely the institutions with whom the newly rich oil producers wanted to
deal; to Middle Eastern potentates they were familiar bastions of stability
and continuity, just as they were to the largest Western corporations. Quite
by coincidence, however, the banks were beginning to lose their
competitive edge in lending to those traditional corporate clients. The major
American companies were discovering they could raise short-term money
in the market by floating notes (known as commercial paper) in their own
names, thus bypassing the banks. Some of the banks had been badly burned
by going into the business of real estate lending. So, loaded with deposits,
they were amenable to finding new ways to lend large amounts of money
quickly.

Of course, transforming the potentially volatile short-term deposits of the

oil producers into loans with maturities extending over years to

CHANGING FORTUNES

financially needy developing countries involved risks for the banks. There
were risks that market interest rates would increase, and they would have to
pay more to their short-term depositors. That risk was almost always
pushed off on the borrower by making the loans at "floating" interest rates
—interest rates that carried a margin above the Eurodollar deposit rates
(called LIBOR in the jargon, which is short for London Interbank Offering
Rate). There was a liquidity risk that the bank might lose its deposits. But
for big, strong, proud banks that risk didn't seem so great; the market for
deposits was enormous, and the banks assumed they could always raise
money if they were willing to pay the interest rate. Then there was the
credit risk that the sovereign borrower might not be able or willing to repay.
That was not so easy to shrug off, and the credit judgment required
technique and experience quite different from assessing a corporate balance
sheet and income statement. But at first, the loans were not so large relative
to the resources of the borrowing countries. Their economies were growing
fast, and their repayment records were good.

The oil producers themselves were not so casual about those risks to their
money. The only important exceptions took place when they made direct
loans on religious or political grounds to Moslem countries in Africa or
elsewhere, or when Venezuela loaned money to small and poor Central
American neighbors. That predictable reluctance of the oil-producing
countries to lend directly is what led to concern at the time of the first oil
crisis that a bottleneck would develop in the process of recycling money
from the surplus to the deficit countries. The Washington Energy
Conference in early 1974 certainly didn't succeed in finding a solution, and
as it turned out, no official action was ever necessary.

At the time the new secretary of the Treasury, Bill Simon, and his
colleagues were strongly disinclined to favor government intervention. As
important as ideology, I suspect, was the fact that industrial countries did
not want to assume risk and that the public sector is seldom fast on its feet
in any event. That is all the more true when the cooperation of a lot of
countries is required in a new and complex area like this one. And lo and
behold, the banking markets soon seemed to be doing the job on their own
with great efficiency.

They had both the money and willing borrowers—probably all the more
willing because, the banks, unlike the IMF or the World Bank, were not
inclined to fuss much about attaching policy conditions

MANAGING THE LATIN AMERICAN DEBT CRISIS

to their loans. And in any case it would be invidious for private lenders to
make demands on sovereign countries in today's world. Contrary to
traditional banking practice, the loans increasingly came to be general-
purpose loans to tide countries over balance of payments and budget
deficits. The loans were mainly denominated in dollars, removing the banks
from the risk that their borrowers would be able to repay in their own
depreciating currencies.

What might have been less well understood was that, while a sovereign
country might have means of raising funds at home, there could be no
assurance of its finding the hard foreign currency needed to repay loans in
dollars. That would depend on its ability to generate export surpluses and
maintain confidence, which was not something that should have been taken
for granted.

Traditionally, bankers had been trained to lend for limited periods of less
than a year to facilitate trade. If they extended longer-term loans
internationally at all, it would be for specific business or development
projects whose profitability could be analyzed. That analysis forced a
certain useful discipline on the lending process. But the number of really
sound projects was limited, and the needs for covering balance of payments
deficits were soaring. The temptation to ease those old criteria could not be
resisted.

The opposing views were personified by the two principal rivals for
commercial banking leadership in the United States at the time. David
Rockefeller was personally a strong internationalist and had pushed the
worldwide expansion of the Chase Manhattan Bank. But the bank had also
been a relatively cautious lender; Rockefeller was concerned that banks
would be asked to take on too much risk in recycling the oil billions, or
would volunteer to do it. Walter Wriston had led Citicorp into aggressive
international lending and earnings growth, and it had taken a big lead in
size among American banks. He was in no way fazed by the challenge of
recycling, and vigorously maintained that governments should keep hands
off because the markets could do the job.

Within a couple of years, the facts seemed to have decided the argument.
Recycling was proceeding with surprising ease through the private banking
markets, accompanied by a certain amount of cheerlead-ing by the United
States government itself. The process actually seemed to gain momentum
over time. Money to lend seemed easily available to reputable banks in the
international markets, loan losses were negligible, and bankers and
regulators came to tolerate more leverage of bank

CHANGING FORTUNES

capital. No doubt the modern management techniques being pressed upon

hidebound banks by aggressive consultants played a part as well. The big
balance of payments loans carried large fees up front for the originating
banks, and lending officers were able to earn sizable bonuses (and
promotions) as those revenues came in. It was all a lot easier, and more
exciting, than worrying about shipments of cotton that secured a traditional
trade loan, or analyzing the balance sheet of a domestic manufacturer.

Moreover, in the latter part of the 1970s, there seemed to be reasonable

grounds for thinking it was all working out very well. By 1977 and 1978
many of the oil-importing countries, such as Brazil, had begun working
down their balance of payments deficits, their rapid internal growth had
resumed, and the oil-producing countries themselves were spending most of
their revenues on vast new modernization projects. That, after all, was the
way the adjustment process was supposed to work, and mutual
congratulation was in order. In the particular case of Mexico, which later
became the focus for the debt crisis, there had been enormous oil
discoveries, and it was difficult—indeed, almost impossible—to restrain
enthusiasm about that country's potential. Certainly, the new oil was a
solvent for worries about Mexico's debt burden.

Overall, the data themselves seemed reassuring. Measured as a percentage

of bank capital the simplest measure of a bank's ability to absorb losses,
loans to developing countries had leveled off toward the end of the 1970s.
By the end of 1977, for the 150 or so U.S. banks with significant loans to
the developing world, those loans totaled 150 percent of capital, much
higher than at any time in memory. By 1979 the ratio had increased slightly
to 165 percent. The nub of any potential problem lay in a much smaller
number of the largest so-called money center banks. The nine institutions
grouped in that category for statistical purposes had the equivalent of about
250 percent of their capital committed to loans to developing countries by
the end of the 1970s. But even in those instances, the ratios seemed to be
leveling off.

What might not have been realized was the extent to which inflation, the
classic balm of the debtor, was disguising potential strains. The great bulk
of the loans were denominated in dollars, and inflation rates in the United
States had risen above Libor, the basic Eurodollar interest rate. The
practical effect was that in real, inflation-adjusted terms, the borrowers were
paying very little or no interest at all.

Debt burdens of a borrowing country are often judged by compar-

MANAGING THE LATIN AMERICAN DEBT CRISIS

ing annual interest payments to the money the country earns from its
exports of raw materials, or agricultural products, or whatever. In 1977, that
ratio stood at 10.5 percent for Latin American countries, higher than five
years earlier but hardly ominous. More disturbing to anyone who bothered
to sit down and think about it was what would happen if inflation went
down and real interest rates rose.

It is a fair question to ask where the supervisory authorities were while all
this was going on. Were any alarm bells ringing, and if not, why not? As
best I can recall the atmosphere, the good, gray, cautious Federal Reserve
did not share the blithe lack of concern of some in government about what
was going on. While 1 wasn't present to vouch for the story, Arthur Burns
once recalled that he summoned a group of leading bankers to Washington
in 1976 to warn them about the risk of repeating in foreign lands their
recent excesses in real estate lending. What he got for his trouble was a
response that they knew more about banking than he did. That w as without
doubt true, but it could not substitute for the long perspective of the wise
Dr. Burns, who had lived through the Great Depression and had spent his
life studying business cycles.

Like the banks themselves, the regulators found reassurance in the tendency
of the banks' lending exposure and risk relative to capital to Stabilize as the
yean passed. Moreover, we were all looking at the other side oi the equation
as well—the desirability of growth in Latin America and the danger implicit
m any abrupt cutoff of new lending. Because of a long-established
regulators- rule, precisely that risk seemed to arise for the largest borrowers
—Mexico, Brazil, and potentially others. Most of the largest U.S. banks are
chartered by the federal government, and the National Banking Act for
many years contained a specific provision that loans to a sizable borrower
could not exceed 10 percent of a bank's capital. By the late 1970s those
limits were being reached, and the biggest lenders were faced with the
prospect of cutting off new credit to their biggest country customers.

Diplomatic demarches were made by the borrowers, alarms were sounded

by the State Department, and protests were lodged by the banks. All argued
the overriding interest of sustaining Latin American order and growth, and
none of us could be oblivious to that. Faced with the clear language of the
statute (including criminal penalties for violations), the Comptroller of the
Currency at the time, John Heimann, had to call upon all his ingenuity.
After talking with me, among others, he reached a Solomon-like judgment:
If a governmental organization—say,

CHANGING FORTUNES

Pemex, Mexico's state-owned oil company—had an independent source of

finance at home, U.S. banks could consider that organization a separate
borrower for the purposes of their 10 percent Mexican limit, even if its
borrowings were guaranteed by the central government. That relieved the
pressure; suddenly Mexico and Brazil could divide up their borrowing from
American banks among several entities to avoid the limit.

Was it a wise decision? I thought it reasonable at the time, and it is

interesting that years later the single borrower limit was eased by Congress
(at the urging of the Reagan administration) for quite other reasons. But,
when one surveys the problems of the savings and loan industry in the
1980s, one has more sympathy for setting out and enforcing a few key
limits on risk taking, crude and arbitrary as they may be in particular
instances.

A bit earlier, Burns had agreed that I should attempt to devise a much more
sophisticated apparatus to guide our examiners and banks in the area of
foreign lending. The idea was to achieve some progressive restraint as the
exposure of banks increased but without abruptly halting lending or
pointing our finger at any particular country as not worthy of credit, except
in the most extreme circumstances. What it amounted to was a conceptually
ingenious system of cross-classification, taking into account both the
economic strength of a borrowing country and the exposure of the bank.
Green, amber, or in extreme cases, red signals were supposed to flash
depending on a combination of the economic position of the country, the
strength of the bank, and the amount of its exposures in loans. We began
doing a lot of country analysis to back up our warning system, just as some
of the commercial banks were doing to support their lending judgments.

I personally spent a long time working on the framework, but after it was
put in place over the next few years we found it did little to slow down the
lending. The whole process was deliberately nuanced, apparently too
nuanced for bank examiners in the field to manage or banks to respond
effectively. More than a decade later I read about the controversy over
whether bank examiners are too tough or too easy on domestic real estate
loans, and I am reminded of our multicolored warning chart. Bureaucracies
respond best to nice bright red or green signals; trying to flash subtle shades
in between is almost as hard as squaring a circle.

Unfortunately, commercial banking bureaucracies are not really any

MANAGING THE LATIN AMERICAN DEBT CRISIS

easier to direct in that respect than public bureaucracies. In the late 1970s
and early 1980s, all systems seemed to be "go." Many country analysts
were hired, but whatever the formal review process, the lending officers
knew that there had been no sizable losses on foreign loans, certainly not in
Latin America. As Walter Wriston kept stressing, they looked on the record
like the safest category of loans in the bank. Of course, as the loans came
due, they were typically "rolled over," or replaced with new loans. But
wasn't that true, after all, even of loans to the U.S. government?

The second relevant fact to the lending officers was that the fees for these
loans were large. The competition became so fierce as more and more
banks entered the game that the ordinary lending spreads—the difference
between the Libor wholesale rate for money and the rate the banks charged
the Third World borrowers—sometimes dropped to .5 percent or less,
hardly enough to provide a reasonable return on the bank's capital. But big
money market banks that put the loans together and led the syndicates, and
the bank officers who did that business, could do well from the added fees
they charged. So the planes to Latin America were filled with young men
with lending agreements at the ready.

As for the borrowers, it was an age-old story. It is human nature to like and
demand growth. If credit is so freely available that it is in fact thrust upon
you, you are likely to use it, sometimes even against your more considered
judgment. To a Third World president or finance minister, international
banking in the 1970s came to be in its own way like receiving a credit card
in the mail—with three or four more zeros on the size of the credit line.
And it was an unfortunate fact that military needs and even a little local
corruption in pushing projects provided added incentives for taking the
money.

One sad story was related to me by Mexican officials after the crisis broke.
Sometime in 1980 or early 1981, senior Mexican financial officials became
deeply concerned about the speed with which Mexico was increasing its
debts. Courageously, they went to President Lopez Portillo and urged him
to cut back, slowing the breakneck pace of economic growth in the process.
He said he would think about it. Then he asked the opinion of a few friends,
who, most significantly, consulted some banks about whether they shared
the concerns about Mexican indebtedness. The banks did not. The president
then told his financial officials that he was rejecting their advice.

Mexico proceeded to add $15 billion to its indebtedness in 1981

CHANGING FORTUNES

alone, increasing the amount outstanding by almost 35 percent. The lending

spreads actually declined, bearing out the bankers' lack of concern. As the
crisis approached, the officials who had delivered the warning were fired.
Such is the reward for sounding an alarm too soon.

For most Latin American countries, the second oil crisis in 1979, and not
the first, triggered the new burst of borrowing that left them so vulnerable.
Not long thereafter, the Federal Reserve introduced its new monetary
policies, and the days of negative real interest rates were over. Ironically,
the crisis came to a head in a country that had itself become an oil exporter
when it developed new oil resources after the first oil shock. Mexico had
overreached. Bankers who would eagerly have loaned in February of 1982
pulled back by June in the face of uncontrolled expansion, accelerating
inflation, and rising imports that began to outpace oil revenues once world
prices had receded from their peaks.

It wasn't hard to see the crisis coming even though the actual data lagged by
six months or more. Bank loans to developing countries had increased more
than 50 percent in three years to more than $362 billion at the end of 1982,
one third of which was held by American banks. Mexico's outstanding
indebtedness to foreign banks was about $60 billion, equal to approximately
40 percent of its annual gross national product. For the nine U.S. money
center banks, loans to Mexico alone averaged about 45 percent of their
capital. Loans to all of Latin America averaged close to twice their capital.

The question through the first half of 1982 was not whether Mexico was
approaching crisis but what to do about it. A populist government had
refused time and again to trim its economic sails; its easy access to bank
credit meant it saw no need to do so. Lopez Portillo, under attack for
personal as well as policy excesses, was in the last year of his six-year term
and plainly did not want to confess error. The market sounded a clear
warning during February of 1982 in the form of a run on the peso. That
provoked a devaluation and a limited austerity program. Neither action was
really convincing, but the mini-crisis had one fortunate effect. A new
finance team of Jesus Silva Herzog as minister of finance and Miguel
Mancera as director general of the Banco de Mexico was installed, and they
were absolutely first-rate. Both men had started their professional careers in
the central bank years earlier. So had Miguel de la Madrid, with whom they
were closely associated and who, in the Mexican fashion, had already been
designated as the next president by the ruling Party of Revolutionary
Institutions.

MANAGING THE LATIN AMERICAN DEBT CRISIS

Silva EieiZOg and Mane era began visiting Washington about once a month
to inform the IMF. the World Bank, the Treasury, and me of the
deteriorating situation. (The Federal Reserve visits were indelibly
associated in Silva Herzog's mind with lemon meringue pie. which was on
the regular Friday menu of the Fed cafeteria and was a favorite of mine.)
Our advice, predictably, was to apply to the Fund for a loan, introduce a
really effective program to reform the domestic economy, and on that basis
reduce the hemorrhage ot Mexican capital that was fleeing the country for a
safe haven m the United States and elsewhere. Their answer w as as simple
as the reply 1 would later receive from American secretaries ot the Treasury
when 1 pleaded for closing our budget deficit: Their president would not
accept it. Lopez Portillo had come into office some six years earlier when
Mexico was first under the tutelage ot a tough and unpopular IMF program.
He was not about to repeat the experience at the end ot his term. Any
possibility would have to await the new president, who would not be
elected until July and would not actually take office formally until five
months later.

So. U was a matter of buying time. In an effort to hold things together

psychologically, we agreed with considerable unease to extend overnight
swap credits once or twice to the Bank of Mexico to bolster the month-end
figures for their dollar reserves. We would transfer the money each month
on the day before the reserves were added up. and take it back the next day.
Our unease did not arise from any fear of financial loss, but because the
"window dressing" disguised the full extent of the pressures on Mexico
from the bank lenders and from the Mexicans themselves. 1 justified the
actions to the Open Market Committee, with Treasury acquiescence, on the
basis that Silva Herzog was willing to give us his personal assurance that
Mexico would seek an IMF program as soon as the new president had the
freedom of action to bring it about. That could not be before September i.
when Lopez Portillo would make the traditional valedictory ot\\n outgoing
president. It was a long interregnum—too long.

With new bank lending finally drying up. the Federal Reserve agreed after
the July election to activate the swap arrangement that had long existed
between the United States and Mexico in an amount of %*) to million. That
was a real loan, not overnight window dressing, and it was intended to tide
Mexico over the summer while its officials began quiet discussions with the
Fund. We understood that any announcement of a Fund loan accompanied
by a forceful new program would not be

CHANGING FORTUNES

possible until September or later. There was one little difficulty in the best
laid plans: Confidence was gone. Money that was supposed to last a month
or two drained right out of Mexico's foreign exchange reserves, swept out
by a mass flight of money abroad.

THE CRISIS

The crisis landed on our doorstep—or, more literally for me, at a fishing
ranch in Wyoming—early in the week of August 9. That morning, I had
great difficulty catching anything. That afternoon, I was visited by the
chairman of the Continental Illinois Bank, who flew out to tell me the bank
was in so much trouble that it would need Federal Reserve support. The
next day my office called to tell me Mexico was about out of money, so I
headed back to Washington almost fishless. By Friday, Jesus Silva Herzog
and his indefatigable debt-management associate, Angel Gurria, were in my
office sorting out the situation and figuring out what to do. (Silva Herzog,
known to everyone by his nickname, Chucho, later told a roomful of very
worried bankers they could rest easy about their Mexican debt; after all,
Jesus and Angel were in charge.)

With any possibility of new bank loans gone on any terms, it was clear
Mexico could not pay off any amount of maturing debt. The banks would
have to be told that as soon as possible. Meanwhile, there was a possibility
that short-term emergency credit could be obtained from the United States
and from other central banks, provided there was a sense that Mexico had
some coherent program in train and was willing to go to the Fund for help.
It would make no sense to use official money to repay private commercial
banks, or in the vernacular, to bail them out. Instead, the official money
would need to be short-term bridging credits that would be repaid from IMF
medium-term loans and fresh bank credits as soon as they could be
arranged.

U.S. Treasury officials later received a certain amount of criticism for

failing to realize the dimensions and implications of the debt crisis before it
broke. But there was little they could do then, and there was no doubt they
put their shoulder to the wheel once the crisis was no longer a contingency
but a reality. At Don Regan's direction, his deputy, Tim McNamar, was hard
at work in the crucial weekend of August 14 developing and coordinating
U.S. government resources.

Agricultural credits of size were relatively easy to come by; existing

MANAGING THE LATIN AMERICAN DEBT CRISIS

PL-480 programs designed to aid farm exports provided a ready vehicle, as

they had on a number of earlier occasions. A more significant breakthrough
was gaining the necessary approvals for an advance payment of $1 billion
to Mexico for its subsequent sales of petroleum to the strategic oil reserve.
That involved many technical problems and an implied interest rate that
was egregiously high, reflecting the need to satisfy the Yankee trading
instincts of Budget Bureau and Energy Department officials far removed
from any sense of the larger issues at stake and more than slightly sensitive
to the possibility of subsequent political criticism. The Mexican oil
officials, who would have to pay, quite understandably were furious. For
about a day, the whole package seemed to falter until the effective interest
rate was cut in half by the American negotiators.

The Treasury was willing to join the Federal Reserve in adding to "swap"
facilities for Mexico, and I called some of my foreign counterparts to
develop an international package of central bank credits. In the end it
amounted to $1.85 billion, actually a little higher than the $1.5 billion for
which we had aimed, with half from the United States. Gordon Richardson
at the Bank of England and Fritz Leutwiler of the Swiss National Bank,
who also happened to be serving as president of the central bankers' own
preferred meeting place, the Bank for International Settlements in Basel,
instinctively understood what was at stake. With their experience and
goodwill, they immediately pitched in to help us seek participation of the
leading European central banks to join in the bridging credit. The governor
of the Bank of Japan, Haruo "Mike" Mayekawa, who had long been an
active and trusted participant at the BIS and other central banking meetings,
promptly obtained the approval of the Japanese government to participate
on a scale second only to the United States. It all fell into place by the end
of the weekend and was ready to be announced in principle, even though
many difficult questions remained to be sorted out. Most pressing was
satisfactory security for the central banks' bridging finance so they would
have some recourse if the IMF credits fell through.

All in all, it was a remarkable example of international financial

cooperation. For all the subsequent reinforcement, the agreements really
rested on mutual trust among financial officials and perhaps most
particularly among central bankers. By virtue of experience, tenure, and
training, they are almost uniquely able to deal with each other on a basis of
close understanding and frankness. Certainly, we didn't have to spend a lot
of time explaining to each other the nature of this emergency. The
CHANGING FORTUNES

threat to our national banking systems might have varied in degree, but the
linkages among the banks were such that no important country could feel
insulated. But there was more than that. Even countries that felt removed
from the financial crisis could recognize the plight of Mexico as well as
what was at stake for its development and for all of Latin America.
Fortunately, the new Mexican financial officials also were themselves
known quantities to some of us and shared our concerns.

With the short-term bridging loans and other credits agreed in principle, we
decided to invite the heads of several hundred leading commercial banks
from around the world to a meeting at the Federal Reserve Bank of New
York on August 20. The setting, the timing, and the language were all
important. I spent the evening at the New York Fed with the Mexican
officials, with Tony Solomon (whom I had persuaded to become president
of the New York Fed after he left the Treasury), and with Tim McNamar
and two key Federal Reserve staffers, Ted Truman and Sam Cross, who
were destined to become absorbed in Latin American debt problems for
years. Even during dinner we had to deal with more bad news about the
crumbling of Mexico's external finances and a few surprises, such as the
discovery that the same oil shipments had been used to secure more than
one credit to Mexico, and that at least one credit line, which was in the form
of bankers' acceptances, probably did not meet Fed regulations.

We decided that Solomon would introduce Silva Herzog, indicating in that

way our official concern and interest, and a few other countries had lower
level official observers. We also decided that the banks ought to be asked to
agree to a "standstill"—a less frightening and aggressive term than a
"moratorium" or a "default," which would have technically triggered legal
action forcing banks to foreclose.

It all went pretty quickly, and on the whole smoothly. While I was not at the
meeting in New York, Silva Herzog and Gurria apparently gave a clear
explanation of the impasse that had been reached, and impressed the banks
with their understanding. They were as reassuring about Mexican intentions
as they could be, emphasizing their intent to seek a Fund credit. The
somewhat stunned bankers asked few questions, and no one specifically
objected to the request for a standstill on their payments. Silva Herzog
immediately and adroitly interpreted that to the press as acquiescence. No
bank challenged that interpretation, and subsequent meetings were set to
work out a mutually agreeable approach. Of course, the banks really had no
other practical choice. But right then,

MANAGING THE LATIN AMERICAN DEBT CRISIS

it was set that agreements would be reached through voluntary negotiations

with a committee of banks, a pattern that was followed in country after
country as the crisis widened.

I say it all went reasonably smoothly, but no few paragraphs can convey the
complexities and frustrations—legal, banking, and human— in resolving
the difficulties over the next few days and weeks. I was personally fortunate
in being able to rely on Solomon and Cross in New York and, in
Washington, on Mike Bradfield, whom I had acquired as Fed general
counsel, and Ted Truman, who, better than anyone else, could pull the facts
together as head of international research. Later, Gerald Corrigan, who
replaced Solomon at the New York Reserve Bank and had earlier been my
assistant in Washington and president of the Federal Reserve Bank of
Minneapolis, became immersed in the process, as he has remained to this
day. Among the private bankers, William Rhodes of Citibank, who is fluent
in Spanish and had served in Latin America, played an enormous role then
and for years to come in organizing and coordinating the private
commercial banks. For long and often frustrating years, he somehow
cajoled banks and borrowers alike into seeing their interest in negotiated
financial settlements instead of forcing a default.

I have touched upon the role of the Treasury in the United States, and of my
central banking colleagues abroad, largely coordinated by Gordon (now
Lord) Richardson and the Bank for International Settlements. The official
involvement then and later was critical. It broadly conformed to what an
elementary economics textbook explains is a principal function of a central
bank: to act as a "lender of last resort" for its national banking system. The
idea is that when unwillingness to lend threatens a financial panic, the
central bank can fill the vacuum, creating money for the purpose if that is
necessary. In effect, that is what we collectively were doing on an
international scale, which complicates things a lot. But the central question
presented to a lender of last resort is the same, whether it's done nationally
or internationally, and the answer always requires judgment.

The familiar textbook dictum was laid down by the nineteenth-century

British financial writer Walter Bagehot: Lend freely (at a high rate of
interest, he said) to restore liquidity but not at all if the problem is one of
solvency. In plain English, if the bank is just short of cash, lend all it needs,
but lend not a penny if it is fundamentally unsound—if its assets are less
than its debts.

In assessing the debt crisis in ensuing years, there was a lot of

CHANGING FORTUNES

discussion about whether the Latin American countries faced a liquidity

problem or a solvency problem, implying that a quite different response
would be indicated for each. Of course, the concept of national solvency is
more than a little elusive; Walter Wriston in his more exuberant moments
used to say a country could not go bankrupt. That does not accord with
experience, in the sense that there have been many official defaults through
the years. But it is certainly true that countries do not have businesslike
balance sheets, and except in the most extreme circumstances, what matters
is a government's willingness to pay, not its ability. But even apart from the
political issue, the distinction between insolvency and lack of liquidity is
easier to make in a textbook than in the real world. After serving a while as
a central banker, I'm not sure I've ever seen a pure liquidity problem.
Typically, significant liquidity problems arise because there is some
question of solvency, or there would be no lack of willing lenders. Put
plain, if your credit is unassailable, you can nearly always raise money and
stay afloat.

In this case, we had faith in the future of Mexico and its willingness to pay,
but I must confess that faith was jolted somewhat on the eve of the IMF
meetings in Toronto at the beginning of September. Fighting for his tattered
reputation, Lopez Portillo, instead of gracefully accepting the need for an
IMF agreement, aggressively vented his populist instincts in his final
itifomie, the speech that summed up his presidency. The Mexican banks
would be nationalized because they had supposedly provoked and aided the
capital flight. Exchange controls would be invoked. That was all too much
for Miguel Mancera, who resigned. Silva Herzog, in Toronto at the IMF
meeting and with no warning of the speech, was left wondering if he should
do the same. Understandably, the run on the dollar deposits in the foreign
offices of the Mexican banks intensified. At one point, the inability of
Mexican banks to meet depositors' demands for dollars at the end of a
working day brought the complex and automated international clearing
machinery to the edge of breakdown, threatening confidence in the entire
system.

My fellow central bankers left to my judgment how much of the agreed

bridging finance might be used to help maintain the dollar liquidity of the
Mexican banks even though not every i had been dotted or t crossed in the
lending agreement. Cooped up in a hotel room in Toronto, I agreed to
release enough of the funds to clear the payments system. Subsequently,
money was spoon-fed to the Mexican banks only if their dollar depositors—
who were mostly other banks and not in-

MANAGING THE LATIN AMERICAN DEBT CRISIS

dividuals—agreed to maintain the basic deposit relationship more or less

intact and not rend the system by pulling out their money. The intensity of
the persuasion among Mexican banks and their depositors can only be
imagined, but the pressures eventually subsided, and a few weeks later a
team of incoming president Miguel de la Madrid's advisers, led by one
Carlos Salinas de Gortari, were able to begin negotiations with the IMF. We
had no reason then to expect that, six years later, Senor Salinas, then a
thirty-five-year-old technocrat at the Ministry of Planning and Budget,
would be tapped to follow de la Madrid as the next president of Mexico.

Jacques de Larosiere had become managing director of the IMF in 1979, an

appointment no doubt facilitated by the favorable impression he had made
as directeur du tresor in France, especially in the negotiations with Ed Yeo
to amend the IMF agreement in 1975. I did not know him at all well at the
time; he was a bit younger and had been a step down the bureaucratic
ladder when I was undersecretary of the U.S. Treasury. In dealing with the
debt crisis, we were thrown together, and I soon came to recognize not just
his personal qualities of courage and good sense, but what a substantive
impact those qualities could have when applied to the international financial
problems of the day. The IMF was at the very center of those dealing with
the crisis then and as it spread throughout Latin America and beyond. De
Larosiere's role between the debtor countries and the banks resembled in a
way that of a bankruptcy judge on a grand international scale. But it was an
area in which there was no settled law or practice, so he had to work out
new rules as he went along. He did so with great skill and persistence.

Many elements in the adjustment program developed with Mexico were,

difficult as they might be in their specifics, more or less IMF standard
remedies: sharply cutting the budget deficit, raising taxes and cutting
subsidies, restraining wages, strongly cutting back the money supply. What
was different was the understanding that none of it could work without
enough financing to cover the inevitable current account deficit until
Mexico got back on its feet. That demanded more financing than the IMF
itself or other official lenders could or would find it appropriate to supply.
The banks in their own self-interest would have to supply the rest. If they
failed to do so, then the prospects for interest on their existing loans, much
less the chances of repayment, would go a-glimmering.

Conceptually, that was plain enough. The problem was to persuade

CHANGING FORTUNES

individual banks to recognize the common interest and not opt out of the
new loan package. Many smaller banks might be tempted to do so if they
thought they could obtain a free ride—that is, earn regular interest on their
loans and even have some of them repaid out of funds advanced to Mexico
by the IMF and by larger and more exposed banks. Less aggressively, a
bank might simply feel its own exposure was so small that, instead of
providing any fresh money, it would be willing to take the loss and retreat
from its ill-advised venture into the realm of international finance. The large
banks, with large loans out to Mexico, would be inclined to lend to avoid
losing a great deal if Mexico defaulted, but not merely to bail out their
competitors.
In dealing with the potential impasse, de Larosiere did something that had
not been done before, and something that set the basic financing framework
for dealing with the debt crisis. He insisted that no Fund program or loan
for Mexico would be approved without the commercial banks first
committing to a "critical mass" of the needed bank financing, which was set
at 90 percent of the total loans that commercial banks would be expected to
produce (and some $5 billion in that first Mexican program). The effect was
to force a high degree of solidarity among the lending banks. They launched
lengthy negotiations over how the new loans should be fairly shared among
themselves, and the negotiations among them often seemed as difficult as
the ones they had with the Mexicans. From time to time de Larosiere or I
(sometimes both) would meet with some of the lending banks to ensure that
issues could be aired, that communication was clear, and that the
importance of reaching agreement was understood. It took months, but
finally, early in 1983, after de la Madrid was in office, it all moved forward.

That long recital is justified only because the first Mexican program set the
pattern for many that followed; one Latin American debtor after another
(and others from Africa and Asia) found the loan market closed, and they
had to return to the Fund time and again. Very few Latin American
countries—Uruguay and Colombia were the principal exceptions—scraped
by without a formal Fund program. Even then the pattern with the banks
was similar.

All of this had implications far beyond the normal responsibilities and
authority of a central bank. After the original Mexican crisis broke, I was
concerned lest the administration fail to understand and support the
initiatives that had been and would need to be taken. I pieced together a
memorandum with Tim McNamar, emphasizing that the

MANAGING THE LATIN AMERICAN DEBT CRISIS

Mexican crisis was sure to be followed by others. James Baker was then
White House Chief of Staff and called the relevant officials from all parts of
the administration together. There really was not much discussion; the case
for helping to coordinate rescue efforts seemed clear enough on foreign
policy and economic grounds as well as financial ones.
AFTERMATH

Of all the many individual programs that were set in motion over the next
few years for large debtor countries and small, the most intriguing to me
was the one in Argentina in 1984 because of its implications for others.
Argentine economic policy had been in shambles for decades amid alternate
demagogic and military dictatorships. The nation was blessed with
resources, agricultural abundance, and an educated, talented people. On the
eve of World War II, it had been one of the world's richest countries, with
per capita income and resources very similar to Canada's. All that was
squandered under the Peronist regime. Without coherent and consistent
economic policies, the country dropped back toward the status of a
developing country, with recurrent high inflation and very low productivity.
In the early 1980s, the bitter divisions and political unsettlement that
surrounded a military government and the failure to reclaim the Falkland
Islands made things still more difficult. Then, a democratic election in 1983
brought a new opportunity. Raul Alfonsin, a member of the old urban
Radical party, which had vaguely leftist leanings, became president.
Economically, his administration floundered for a while, with his
economics minister taking an aggressive posture against the "reactionary"
foreign influences embodied in the IMF and the commercial banks.

In 1984, a new, able, and imaginative team of economic officials was

appointed. They appreciated the need for an austere program with foreign
financial support, which meant they had to go to the Fund. They devised a
striking new centerpiece for the program, symbolically and substantively.
They would replace the hyperinflated peso with a brand-new currency, the
austral. While that change involved some complicated technical problems,
the rest of the program, while radical in scope and intent, had more
precedents.

For all its orthodox elements, the whole thing bore the stamp of "Made in
Argentina," and I was among those urging the Fund to act promptly when
there was a chance for maximum effect and impact. De

CHANGING FORTUNES
Larosiere was able to push it through quickly. The initial response was
highly favorable. I accepted an invitation to visit Argentina in November,
partly out of curiosity but also in the hope that I could provide moral
support. No one in Argentina could be confident about anything after forty
years of extreme instability, but even brief visits with business, banking,
and labor groups (supplemented by an afternoon chatting with unsuspecting
Argentinians who had gone to a park to relax) suggested a real sense of
hope and possibly pride returning.

Juan Sourrouille, an economics professor of Basque extraction, was the

principal architect of the program as minister of the economy. In manner
and style he was the antithesis of a charismatic politician: reserved, austere
in lifestyle as well as policy, but highly intelligent and tenacious in pursuit
of his program. I think President Alfonsin was convinced of the substance
of the program, but of course he was very much a politician caught up in
the difficult challenge of nurturing democratic institutions and habits in
Argentina amidst constant threats of military interference. The economic
program lost momentum when he hesitated much too long about taking the
next necessary steps to reinforce the stability of the austral, perhaps because
midterm congressional elections did not result in the sweeping Radical
majority he had sought. In the end, the necessary budget restraint eluded
him; he faced enormous inefficiency of the tax-collecting process and the
political hostages inherent in long years of big subsidies. Industrial leaders
themselves, living in a protected world, were less than enthusiastic about
opening the economy to more competition. The hopes of privatizing the
bloated nationalized industries, or at least improving their efficiency,
foundered on vested bureaucratic interests, most notably in YPF, the
monopoly state oil company.

A year or two later, the program that had started with so much promise was
in full retreat. One of the great opportunities for dramatic progress had been
lost, falling into an all too familiar Latin American pattern. Others who
tried to emulate Sourrouille's approach, usually with more attention to the
cosmetics than the hard budgetary and credit core, were no more successful
in achieving a quick success.
A few years later, progress in many areas of Latin America was much
clearer. What had seemed impossible in the mid-1980s became politically
acceptable and almost unquestioned in direction. By the early 1990s
Argentina and Mexico were well along in privatization. Import barriers
were way down. Argentina re-fixed its currency to the dollar and Mexico
had almost stabilized its peso. Chile was further advanced in

MANAGING THE LATIN AMERICAN DEBT CRISIS

liberalizing the economy, and Venezuela was not so far behind. Virtually
uniformly those in charge were justly praised in the domestic and
international business communities; at the same time, they emphasized that
their success was built on the earlier efforts that, for all the false starts,
provided the political education and institution building that was necessary.

One intriguing aspect of all this was the sustained trend toward more
democracy, toward more openness politically as well as economically, and
toward better relations with the industrial world and the United States in
particular. That had naturally been a worry of those concerned with political
reform and human rights as real wages and standards of living collapsed in
the crisis of the 1980s. Those worries helped spawn a myriad of plans for
multilateral negotiation of debt relief. While they differed in detail, those
proposals from academe, from the Congress, and later from Wall Street
itself, had common elements. Peter Kenen at Princeton published the first
well-articulated ideas. These plans set out some trade-offs that are simple in
concept but hard to execute. There would be significant concessions by
lenders, reducing principal or interest (or both) on their loans. There would
also be some kind of official guarantee by the industrial countries for the
remainder of the debt. Debt relief would be granted only to countries that
agreed to stabilization and adjustment programs and carried them out.

All that seemed to raise almost insoluble difficulties over which countries
would be entitled to relief and which would not. For instance, would those
effectively managing big debt burdens in Korea or Indonesia be entitled to
write down their debt? It seemed farfetched that the legislatures of
industrialized countries would agree to the necessary guarantees that would
in effect partially bail out private lenders. The sheer complexity of the
negotiations required would have been forbidding, and in the end the risk of
failure, bitter disappointment, and an adverse political reaction was high.

At least it seemed that way to me, both then and now. We can't rerun the
clock, but the fact is that in most countries, new Latin American political
leadership proved up to the challenge of nurturing democracy in the face of
economic adversity. We dealt with each country individually in the light of
its own particular situation, and I would like to think this case-by-case
approach, which characterized our debt strategy, in fact helped to promote a
sense of political realism and self-reliance.

The borrowers themselves never resorted to organizing a debtors'

CHANGING FORTUNES

cartel, threatening to bring down the financial house by collective default if

demands for debt relief were not met. There was, to be sure, enormous
sensitivity toward obtaining concessions provided another country, but the
Latin American countries always rejected the idea of forming themselves
into a hard negotiating bloc. I think they saw it in their individual interest,
looking toward the future, to cooperate with their creditors as far as
possible. No doubt chronic mutual suspicions and rivalries among many of
the Latin American countries also worked against their coordinating
positions. Moreover, by good fortune or otherwise, there always seemed to
be one important country that was doing fairly well and sensed it had a lot
to lose from joining others in a strong confrontation with their creditors.

A couple of exceptions proved the rule. Peru adopted a confrontational

approach in 1985 under a new left-wing president, Alan Garcia. He
promptly and unilaterally declared he would devote no more than 10
percent of Peru's export earnings to paying interest on the loans (and
seldom reached even that level). For a little while that, arguably, helped
Peru and Garcia. He certainly hoped it would be a model for other debtors.
But Garcia's politics and reportedly overbearing personal manner limited
his appeal to his Latin American counterparts. Neither commercial banks
nor creditor governments wanted to dramatize the issue by demanding legal
redress for the default; that would have raised endless questions for
everyone. But long before the end of Garcia's term, Peru's economy was in
ruins, an example no one wanted to emulate. Alberto Fujimori, who
followed in July 1990, was of totally different ideological and political
persuasion and introduced more orthodox policies at home and abroad.

The Brazilians also once had a particularly feisty finance minister, Dilson
Funaro, whose negotiating style was to make threats, not to pay interest. For
a while in 1987, he actually did suspend interest payments, only to discover
that more Brazilian capital was leaving the country through the back door
than he was able to save up front by withholding interest payments. The
difficulty with his approach is that failure to respect the rights of foreign
creditors sends a chill down the spine of a country's own affluent citizens,
of which Brazil had many. They started wondering whether their own
financial assets might be next on the list for confiscation. That particular
experiment soon ended, but Brazil has been left as the laggard among the
main Latin American debtor countries of Mexico, Brazil, and Argentina
(once referred to by The Economist of

MANAGING THE LATIN AMERICAN DEBT CRISIS

London as the MBA countries, in sly reference to the young bank officers
who had so freely lent them money).

The Latin American countries, large and small, almost uniformly had an
inherited sense of great antipathy toward the Fund. As the designated
worldwide institution for monetary cooperation, the IMF had both moral
authority and experience in devising and overseeing stabilization programs.
But perhaps inevitably, it also presented the image of a martinet, enforcing
sacrifice and restraint. I think we can all be faulted for not having brought
the World Bank and the regional development banks actively into the
process much earlier, for they would have symbolized the need to restore
growth and development as the ultimate objective.

Part of the difficulty, it seemed to me, lay in staff rivalries. Adjustment was
the bureaucratic turf of the IMF, and its officials were not eager to invite
World Bank officers to join their missions or make independent analyses at
the risk of undercutting the clarity of their own message of macroeconomic
adjustment and austerity. Moreover, many of us outside those institutions
wondered whether the IMF staff did not work within an unduly narrow
frame of reference. The IMF adjustment model was clear: Devalue to make
exports competitive, control the money supply to deal with inflation, move
the national budget out of deficit to make room for private investment,
restrain wages to speed the transition to stability—and that's about it. These
requirements were tied to highly specific "performance criteria" so that loan
disbursements quarter by quarter were determined by whether the IMF
client was meeting its adjustment targets. The process was bound to seem
intrusive and even a little arbitrary to the borrowers, who felt the
peculiarities of their particular political and economic situations were not
being adequately recognized. Some of us who had undergone the
experience of trying to hit our own self-imposed targets for monetary and
budgetary performance could sympathize with their concerns. But intrusive
or not, the Fund people would remind us fuzzy-minded idealists of their
own hard-earned experience: that regular surveillance with teeth was
essential lest "errors" in one quarter or two be permitted to cumulate over
the course of a year or so into ineffective policy. I had to admit they had a
point. And so eventually did most of the borrowing countries, which did
not, in any event, have other means of getting the kind of endorsement they
needed. And the Fund provided not only moral endorsement but hard cash,
both through its own lending and by its influence on bank behavior.

CHANGING FORTUNES

The larger commercial bankers generally quickly realized that they had
better hang together if they were to save the value of their loans. It was all
made quite explicit by the approach the Fund had taken: No stabilization
program would be approved, or IMF loan advanced,' until the creditor
banks that had so much to gain—or lose—put up enough new money to see
their borrowing clients through the difficult period of adjustment.

All that raised the issue of whether the banks were being asked to violate
the old maxim of not throwing good money after bad. It was clear to me,
however, that in virtually every case the banks would receive more money
in interest than they were offering in new loans. If they wanted to be really
conservative they could have provided the new loans, accepted the interest
payments, and placed part of them in reserves. Then they would be better
off from every perspective than if they had received no interest at all. Some
foreign banks did something like that and more. Perhaps we should have
insisted on that for U.S. banks.

What I did say, on behalf of the Federal Reserve, was that in instances
where the new loans were part of an adjustment process approved by the
Fund, and therefore reasonably offered the prospect of strengthening
outstanding credits, those new loans would not be criticized as imprudent.
That was analogous to the difficult judgment a bank must often make as to
whether to advance fresh credit to a troubled corporation or individual to
see him through a difficult period. But one important difference in
international sovereign lending is that there is no ultimate recourse to an
international bankruptcy court to sort out different creditors' claims. De
Larosiere couldn't go that far!

A lot of programs proceeded under those arrangements, and a lot of new

lending was agreed. But by the middle of the decade, it was obvious that the
fundamental problems from the borrowers' perspective had not been
resolved and a certain fatigue had set in among the lenders. Politically, there
was a sense that the burdens were greater for the borrowers than for the
lenders, who, after all, had imprudently risked their money in the first place.
The banks might be kicking and screaming at the bargaining table, but they
were in the end getting more cash back in interest than they were lending.
Most American banks were slow to put aside reserves against the risks
because that would directly hurt profits, so they seemed to be escaping the
normal consequences of imprudent lending. Even so, while cooperating in
the new lending programs, some American banks in particular seemed to be
finding ways to limit their

MANAGING THE LATIN AMERICAN DEBT CRISIS

exposures, and friction increased among individual banks or national

groups of banks. Increasingly, a few of the more aggressive banks
attempted a sort of discreet (or not so discreet) blackmail, threatening to
pull out of one new lending package or another unless some special
complaint or objective with respect to the borrowing country was resolved.

It was all very frustrating. The logic of the situation seemed to require that
the banks at least volunteer some significant concessions on interest rates
while building their reserves. But as regulators, we did not feel that we
could in effect impose losses on the banks by forcing below-market interest
rates or large reserves without jeopardizing their willingness to lend. As
time passed, the banks did reduce their interest rate margins but it seemed to
me then, as now, that the success of the whole would have been enhanced
if, at an earlier stage, the banks had volunteered greater concessions.
Instead, the negotiations always seemed to turn into a game of hardball in
an attempt to squeeze out the last eighth of a percent or a year or two of
shorter maturity on restructured loans, at the risk of undermining the
cooperation of borrowers. In the end, Jacques de Larosiere or I, or both of
us, would have to sit down with the banks to encourage them to agree.

James Baker raised all those questions with me after he swapped his place
as White House Chief of Staff with Donald Regan at the beginning of 1985
and became secretary of the Treasury in the second term of the Reagan
administration. In the family tradition, he had been a director of a large
Texas bank, but I suspect it was more his political than his banking instinct
that led him to say, "You know, this doesn't look right. The banks ought to
be taking some loss here." But as he thought about it, he no more than I was
able to devise a way to force limited losses on the banks while expecting
them to advance new money to support their borrowers' return to health.
Nor did he see any promise in the more grandiose approaches that were
being argued by some in the Congress for the reasons I suggested earlier.
But there was no escaping the sense of fatigue and frustration, and the more
important fact that growth and development were languishing. If we didn't
like the more grandiose plans, we couldn't beat something with nothing. So
we put our heads together.

The starting point for me was that all our analyses suggested that under
reasonable assumptions of world growth, open markets, and restrained
inflation and interest rates, enough private and public financing

CHANGING FORTUNES

ought to be available to support a resumption of growth in Latin America

without straining the capacity of either the banks or the official institutions.
This conclusion seemed to be broadly shared outside the Fed by the IMF
and the World Bank and by private analysts. Faith that that would actually
happen was. however, eroding. The banks were tiring of the endless
negotiations to stretch out the debt and reschedule payments on less onerous
terms. Their borrowers were growing at least as frustrated, on further seeing
that the prospects for enough new credits to finance economic growth were
fading.

That was the setting for the new secretary of the Treasury's speech to the
IMF meeting in Seoul in October 1985, outlining a new "Program for
Sustained Growth"—the so-called Baker Plan. The rhetoric was literally
drafted on the plane to Korea, but the shift in approach was more
evolutionary. The purpose was to bring front and center the need to assure
enough financing to support recovery and growth in Latin America.

We had worked out the numbers in Washington with the World Bank and
the Inter-American Development Bank. They were willing to become more
active in extending long-term development credits, backed by their
expertise in the economic evaluation of reform programs. The commercial
banks were to be asked to commit money for longer periods, provided, of
course, suitable programs were approved by the IMF. The IMF itself would
be encouraged to work more closely with the World Bank in developing
programs.

The Baker Plan was well received on all sides, including the commercial
banks. But when it came to moving beyond moral support to making actual
commitments, the latter were not so eager. The Treasury and Fed explored
with them various approaches toward making appropriate pledges, but they
ended up more as general statements of intent than anything vers' hard.

The continuing difficulties were well illustrated during important talks in

1986 between Mexico and its bankers to provide some fresh credit and to
renegotiate the loans made after the 1982 crisis. The whole program had
involved most difficult negotiations beginning in the spnng: at one point I
was asked on short notice to visit with President de la Madrid personally to
help head off a complete breakdown. The uncertainty and disputes within
the Mexican government were highlighted by the sudden resignation of
Silva Herzog. who was replaced by Gustavo Petricioli. now ambassador to
the Umted States. At the time of
MANAGING THE LATIN AMERICAN DEBT CRISIS

the Fund-Bank meetings, the bank financing was still undecided. I finally
decided to join with Barber Conable, the newly appointed president of the
Bank, and de Larosiere of the IMF to hear the banks' side of the story from
the chairmen of the dozen or so largest banks in the world.

It soon became clear they had a dispute among themselves. One or two had
idiosyncratic proposals and were refusing at that late date a package
acceptable to the Mexicans. When the quantity and form of the lending
package were resolved under the pressure of a deadline, the only question
remaining was the interest rate to be charged by the banks for the new
credits. We returned to a room at the hotel where the IMF meeting was
under way and tried to determine if the issue could be settled. It seemed to
me insignificantly small after all the months of difficulty. Petricioli, waiting
in his room, wanted a spread of Vi percent over Libor; the banks wanted 7
A percent, a difference of Vs percent. In dollars, the difference was about
$10 million a year on $6 billion of credits, and that $10 million would be
spread over hundreds of banks.

The bank chairmen sat there, and they sat there some more, but they could
not agree. Finally, there was really only one holdout to the obvious
compromise of splitting the difference. To avoid too clear a precedent, the
loan package could be divided up, depending upon the term of the particular
credit, part at a spread of three quarters and the rest at seven eighths. The
Mexican and bank technicians were asked to work out the details. But the
atmosphere had been so poisoned that no agreement could be reached by
the subordinates as to which part of the package would receive which rate.
Finally everyone unhappily accepted thirteen sixteenths for the entire loan,
a degree of price refinement that had to the best of my knowledge never
been reached before in a loan agreement and that became, deservedly, a
matter of some derision. But derided or not, it became an almost ironclad
precedent for future rescheduling agreements. It was, of course, the very
prospect that every agreement would become a precedent that helped
account for the intransigence at the negotiating table.

The Baker Plan was already in trouble by the spring of 1987; any sense of
enthusiasm was pretty much gone. The coup de grace symbolically took
place at that time when John Reed, the young and rather brash new
chairman of Citicorp, decided to seize the initiative and separate himself
from the old regime. In technical banking jargon, in one fell swoop he
"provisioned," or reserved, $3 billion against Citibank's

CHANGING FORTUNES

Third World debt, 20 percent of the total. That meant an enormous "hit" to
the bank's bottom line, and it ended the year with a loss unprecedented in
American banking. The logic, as Reed explained it to me and later to his
unhappy counterparts in other banks, was to demonstrate that the bank
could absorb the potential losses, remove the overhang of concern from the
marketplace, and clear the decks for record profits in later years. It was hard
to avoid the impression that it was also his way of putting his stamp of
leadership on American banking.

In the community of bank analysts and investors the move was widely
applauded as realistically facing facts. No doubt most of my fellow
regulators felt the same way. The stock market reacted enthusiastically,
sending up the price of Citicorp stock. Other banks felt forced to emulate
Reed's initiative. I could not, as Reed no doubt suspected, criticize what
appeared to be so prudent a step. But more significant to me was what
happened to Latin American loans in the secondary markets, where they
were being bought and sold at less than their face value. Their prices went
down. The reasoning was quite logical. If the banks themselves, led by the
biggest of all, thought the loans were worth only seventy-five cents on the
dollar, then how could they be expected to make new loans? If the banks
stopped lending, their debtors would not be able to keep paying interest,
and they would have little incentive to do so with their creditworthiness
already undermined. The value of the loans would drop still further. Soon,
instead of making record profits, the banks would need to do still more
reserving of bad loans and writing them off.

I left the Federal Reserve a few months later, but I didn't find it surprising
that new lending to Latin America nearly dried up over the next year or
two. There was a period of considerable experimentation with debt-equity
swaps, exit bonds, and other techniques that in some cases involved
voluntarily writing off at least part of the debt. Then, early in 1989, under
the banner of a new administration, Secretary of the Treasury Nicholas
Brady pronounced his benediction on the approach launched in 1982 with
the Mexican crisis and carried forward in the Baker Plan. Of course, Brady
didn't put it quite that way. What he said was that the time had come to
emphasize debt service reduction—that is, for the commercial banks to start
forgiving principal or interest instead of providing new loans. Agreements
would still be case by case, and Fund approval of adjustment programs
would still be the key to legitimizing the write-downs. But no longer would
those official agreements

MANAGING THE LATIN AMERICAN DEBT CRISIS

rest on financing programs agreed by the banks. Moreover, the Brady Plan
built up and amplified thinking that had already been advanced by Japanese
Finance Minister Miyazawa and others.

In substantial part, that was indeed a recognition of reality. I had some

personal doubts about enthusiastic endorsement by government officials of
debt forgiveness, not by official lenders but by private banks, partly because
I was concerned that countries that still had adequate means to pay would
demand similar treatment. Nevertheless, by that time Brady's instinct was
that officials no longer had to act as mother hens to the banks in the
financing negotiations, and events bore that out.

As of early 1992, Brady Plan programs had been negotiated with two
sizable Latin American countries and the Philippines. Mexico had been in
the midst of Baker Plan negotiations when the new initiative was
announced, and modifications were quickly made in the light of those ideas.
No doubt, the amount of debt and interest rate reduction negotiated was
larger than it otherwise would have been; only a handful of banks,
interestingly enough including Citibank, broadly preferred to extend new
loans rather than write down old. The total amount of Mexican debt fell
some instead of rising. That was politically important at the time, but it is
doubtful that the difference was the key to the economic success of the
Mexican program. In Venezuela, the economic case for debt reduction was
always weak as long as oil prices were not particularly depressed.
What mattered much more in both countries was that both had come a very
long way toward restoring confidence in their economic management, their
stability, and their prospects. They once again became able to draw on the
most important source of capital for any country, the savings of its own
people. That capital began returning in volume from New York, Miami,
Zurich, or more exotic locales. Mexico even began to take some small but
highly significant steps toward borrowing in the international bond markets,
where it had never missed a payment throughout the worst years of the debt
crisis.

By the early 1990s, most banks had reserved against all but their short-term
trade loans to Latin America by 50 to 100 percent, far exceeding the
dramatic move by Citicorp in 1987. The thousands and thousands of high-
priced negotiating hours in the 1980s, in which Bill Rhodes of Citibank
played an indispensable role, were in fact successful in defusing the
potential for an international banking crisis. If banks were under strong
pressure at the start of the next decade—and they were—it

CHANGING FORTUNES

was because of excesses in domestic lending during the 1980s, not the
pressure of the Latin American debt.

I'd like to think that all those thousands of hours spent by Jacques de
Larosiere and his people at the Fund, and by Tom Clausen and Barber
Conable and Ernie Stern at the Bank, and by Ed Yeo, who returned to
government service as a Fed adviser and provided indispensable liaison
with Latin American nations, have contributed to the new sense of progress
and hope in Latin America. I know that some talented and liberal-minded
new leaders in Latin America have been thrust to the fore. The remarkable
youthful duo in Mexico of President Carlos Salinas and his finance
minister, Pedro Aspe, were teamed with Miguel Man-cera, who has been a
rock of stability and sense since he was induced to return to the central
bank, and with the energetic Angel Gurria in the Finance Ministry, who by
now must hold all records for length of service in managing international
debt. As a group of economic officials, they match any in the world for
understanding, continuity, and courage. Domingo Cavallo in Argentina,
Pedro Tinoco in Venezuela, and Andres Bianchi in Chile came later on the
scene but made their own strong marks. And the list could be much longer.

Economic and debt crises have a way of recurring, and the spotlight later
shifted to Eastern Europe and to Russia and the new Commonwealth.
Familiar battle flags were raised; to pay or not to pay once again became a
subject of vigorous debate. Poland, at an early stage of its new program, put
great priority on debt relief and got it from official creditors who hold the
bulk of its debt. But international credit markets were nevertheless closed to
it at that time. Hungary, with a higher level of debt in relative terms,
decided to p;ace priority on continuity, on paying, on access to credit
markets, and indeed continued to raise fresh money abroad.

Which approach is more promising? Particular circumstances differ in

important detail, but it is clear where my sympathies lie. Inability to pay is
understood; deferrals and restructuring of debt when necessary will
typically be met with understanding provided a legitimate effort is under
way for economic reform. But to insist upon debt cancellation as a kind of
preferred form of assistance, or to refuse to pay, seems to me all too likely
to be counterproductive.

Within the boundaries of the old Soviet Union, interruption in debt service
is a fact of life, as it generally is for new countries in economic turmoil. But
those debts, estimated at some $60 to $80 billion in 1992,

MANAGING THE LATIN AMERICAN DEBT CRISIS

are potentially manageable in relation to economic potential. Per capita they

represent only a fifth or less the size of the Latin American debt burden, and
the new republics have enormous human and physical resources.

The key to their success will be to release those resources, to restore some
sense of stability, and to improve efficiency and productivity. At the margin,
fresh credits official and private, new investment from abroad, and even
outright aid will no doubt be needed to provide impetus for that process. In
those areas, I suspect their leaders can learn as much or more from the
experience of Latin America as they can from the industrial world. 1
TOYOO GYOHTEN

1 he debt crisis was the first phase of a global issue that will stay with us for
years to come. It is complex because it is closely linked to many important
issues: development strategy, the function of the international financial
market, the role of international financial institutions, and the behavior and
regulation of banks. The major lesson we learned was that we now live in a
world of globalized and interdependent economies. The experience
reminded us how the developed and the developing, the creditor and the
debtor, and markets throughout the world, are all linked together. In groping
for a viable solution, we had some successes, but not the ultimate one.

In concentrating on solutions, at least the partial ones in which I had a hand,

most of the work took place in the second half of the decade. The first half,
which Paul Volcker has described, was a time of emergency that severely
tested financial authorities from day to day in maintaining the viability of
the international banking and financial system. In 1985, it became obvious
that this essential financial firefighting was not enough because the
situation started to deteriorate again. Primary commodity prices, upon
which many of the debtor countries made their living, began to decline, and
so did economic growth in the major

'Highlights of a seminar session given by three experts on Third World debt

will be found in the Appendix.

CHANGING FORTUNES

countries—the United States, Japan, and Germany—which were the

markets for the Third World. The creditor banks became very reluctant to
expand their lending to Latin America and thus help their Third World
clients through hard times. The big American regional banks in particular
were already suffering from the collapse and even bankruptcies of their own
oil and agricultural clients and had to try to save as many of them as
possible. The European banks, especially in Germany and Switzerland, also
turned cautious toward Latin America. The private banks' net lending to the
fifteen major debtor countries declined by $4 billion in 1985 and then
another $1.8 billion in 1986.
This further squeezed the debtor countries. Between 1984 and 1986, the
current account deficit of the heavily indebted developing countries
increased from $31 billion to $49 billion. Their debt service ratio increased
from 24 to 27 percent during these three years, which means that roughly
one quarter of what they earned each year from their exports was
mortgaged to meeting their annual interest payments to their creditors,
mainly in the industrial world. The ratio of their total outstanding debt to
their annual exports rose from 165 percent to 204 percent, or just about the
percentage that is considered the danger level for a country. To meet these
obligations to their creditors, they actually paid out more capital than they
received for much-needed development. The net outflow of capital from
debtor countries amounted to $10 billion in 1984 and more than doubled to
$24 billion in 1986.

This was the background of the Baker Plan announced by the secretary of
the Treasury of the United States in October 1985. It had a growth-oriented
and reformist approach toward the debtors, but it also asked commercial
banks to add $20 billion of new money for three years, and international
financial institutions like the World Bank to increase their lending by 50
percent over the same period. Unfortunately it did not achieve the results
that many of us hoped it would. Private banks simply refused to expand
their credits to those countries. There was no role for the creditor
governments, which was a serious drawback of the Baker Plan. The result
of all this was a rather serious deterioration in the psychology of both
debtors and creditors.

In July 1987, the new and very aggressive president of Peru, Alan Garcia,
said Peru would limit debt service payments to 10 percent of its exports and
challenged other debtor countries to join him, but none did. The situation in
Mexico again deteriorated, with a federal budget deficit in 1986 equal to
almost 13 percent of GNP. Government subsidies

MANAGING THE LATIN AMERICAN DEBT CRISIS

soared to faltering government enterprises, and austerity was ruled out

because thirteen states had gubernatorial elections in the summer of 1986.
Finance Minister Jesus Silva Herzog was replaced. His successor, Gustavo
Petricioli, stressed domestic considerations and alarmed us a bit when he
defiantly reminded his creditors that dead men cannot repay their debts.
Great efforts were made, and finally, in July of 1986, Mexico agreed to an
economic reform program, and the IMF agreed to provide a $1.5 billion
credit. In October, lending banks from the United States, Japan, and Europe
agreed to provide $6 billion of new money to Mexico, which averted
another crisis.

But that was not the end of the story. In February of 1987, Brazil abruptly
announced that it would suspend interest payments on its $90 billion
outstanding debt because its trade surplus was shrinking and its reserves
were dwindling. But the most significant surprise was the announcement by
John Reed of Citibank that S3 billion was being put in the bank's loan loss
reserves for Latin America. A new relationship between the banks and the
debtor countries had arrived: For the first time, the banks were no longer
confident of their debtors' future, and instead of expanding their loans to
keep their clients afloat, turned to protect their own financial viability. A
new approach was clearly necessary.

Senator Bill Bradley had already proposed a debt program that featured a 3
percent reduction of the interest rates and an annual cancellation of 3
percent of the outstanding debt. Other specialists, including Professor
Jeffrey Sachs of Harvard and Representative Charles Schumer of the House
Banking Committee, advanced ideas that included some element of debt
cancellation. The United States Treasury at that point very much opposed
debt cancellation. It was concerned about the potential loss in taxes as the
banks charged off their losses. But it also quite legitimately feared that
cancellation would create a serious moral hazard by encouraging other
debtors not to repay. How could governments then not countenance requests
from beleaguered farmers and mortgage holders? In fact, the moral
contamination did not spread. Domestic borrowers simply did not equate
their position with that of foreign borrowers, and the stockholders of the
banks acquiesced in the banks' policies.

In order to avoid that dangerous path while providing a new type of

approach, Secretary Baker came up with a new approach at the Venice
summit meeting in 1987. He suggested that banks and debtors

CHANGING FORTUNES
should work together on a case-by-case basis and choose from a menu of
different approaches: swaps of debt for equity, investment notes, exit bonds,
new money, capitalizing interest, and much else involving considerable
financial ingenuity. Some of these ideas achieved results, especially the
famous Mexican deal in 1988, in which Mexico auctioned off some of its
old debt at a discount for new Mexican government bonds fully guaranteed
by zero coupon bonds issued by the U.S. Treasury. But on the whole, this
menu approach provided only a marginal supply of new resources and did
not succeed in providing a very large amount of new money to the debtor
countries. Many of the banks were still reluctant to incur a large loss on
their books by cancelling part of the debt, preferring instead to keep it on
their books as long as they could obtain the interest.
Japanese banks began playing a very conspicuous role in the autumn of
1986. In the total bank exposure to Latin America, U.S. banks held 37
percent, Japanese banks 15 percent, British 14, French 10, German 9,
Canadian 8, and Swiss 3. As a group, Japanese banks had become very
important players. Of their $37 billion in credit outstanding to Latin
American countries, $11 billion was to Mexico, $9 billion to Brazil, $5
billion to Argentina, and $4 billion to Panama. And while banks in most
other countries were retrenching, only Japanese banks increased their
lending in Latin America. The Japanese banks' exposure increased from $29
billion in 1984 to $37 billion in 1986. They did it partly because Japan's
large trade surplus gave them liquidity from the increased deposits of their
corporate clients, and that helped turn them into aggressive competitors on
the international playing field. The appreciation of the yen against the dollar
inflated the dollar amount of their credits.

In May of 1987, leaders of America's major banks came to Tokyo: John

Reed of Citibank, Willard Butcher of Chase, Lewis Preston of Morgan, and
Tom Clausen of the Bank of America. They met with our finance minister
and the governor of the central bank, and they urged more positive
cooperation by Japanese banks. The big American banks were caught in the
dilemma of their Latin American debt. On the one hand, they had to suffer
the losses caused in part by their own overlend-ing, which meant they could
not continue being exposed to new loans to Latin America. On the other
hand, they were unable to jettison Latin America, which was for them an
important market. So it became critically important for them to persuade
Japanese banks to cooperate with them and share the burdens of the debtor
countries.

MANAGING THE LATIN AMERICAN DEBT CRISIS

The Finance Ministry argued that the most important thing was to keep
productive capital flowing to Latin America. To achieve that, we thought it
was crucial to encourage the banks to cooperate with their debtors, the
international lending institutions, and their own governments. The Japanese
government, through the Finance Ministry, started looking for a new
approach to the debt problem, and the result was the so-called Miyazawa
Plan, named after our finance minister. The gist of that plan was to
introduce or increase participation by the international financial institutions
and the creditor governments, while the debtors would be asked to
undertake genuine adjustment programs. The international and national
agencies would provide financing so the debtors could provide a stronger
guarantee. The banks would be asked to choose between providing new
money to the countries or reducing their debt service by lowering their
interest rate. We proposed this plan at the Toronto summit meeting in July
1988 and at the Berlin IMF meeting in September of the same year. To our
great disappointment, there were very strong objections from other G-j
countries, particularly the United States, the United Kingdom, and
Germany, on the ground that the increased involvement of public
institutions, either multilateral or national, would produce a serious transfer
of risk from the private to the public sector. Canada maintained an open
position, and France came up with its own idea, which was the creation of
new SDRs and their preferential allocation to the debtor countries. Informal
discussions made it clear that neither of these ideas for helping the Third
World debtors would fly. I was deeply involved in the discussions with
other representatives of G-7, and I was really surprised by the very strong,
almost acrimonious feeling of the politicians against private banks. I recall
vividly that at one of these meetings a finance minister said, "The banks
created this whole problem, so why don't we let them take the hit?" I think
that was the general feeling among politicians in those days.

By the winter of 1988, the situation had not improved at all, and that by that
time even the United States Treasury realized that something new and bold
was needed. It came up with a new idea that was an important departure
from traditional thinking. It was very straightforward and was almost totally
concentrated on debt reduction. Under the Treasury plan, banks would
cancel part of the debt but would not provide any new money. That was up
to the borrowers, who would return to the international capital market, or,
most important, adjust their domestic programs, laws, and regulations to
attract home the huge

CHANGING FORTUNES

amount of flight capital their citizens held abroad. That seemed highly
legitimate but hardly realistic.
So we started to work on various ideas, American, Japanese, and others. We
officials, especially those of the G-j countries, spent about a month
perfecting them and negotiating heavily with the international financial
institutions and the private banks. We came up with a plan that was
officially agreed at the G-7 meeting in April of 1989. It is called the "new
debt strategy" and incorporates major ingredients of the Japanese plan. It is
a collaborative scheme among the four major players: the debtors, the
banks, the creditor governments, and the international financial institutions.
First, the debtor countries had to negotiate with the IMF on a medium-term
adjustment program to control inflation, reduce the budget deficit, privatize
public enterprises, and repatriate flight capital. The IMF would monitor the
progress of the program, and in return, the international financial
institutions, including the IMF and the World Bank, would make new loans
to create a fund in the debtor country that would work as a kind of
collateral. In effect, as Paul Volcker puts it, the IMF acts as a sort of
combined bankruptcy judge and credit agency, and the very fact that it was
guaranteeing the new credit would give confidence to other new lenders.
The banks were given three options: debt cancellation, debt service
reduction, or new money. The creditor governments were also expected to
provide financing to debtor countries, mostly through their public agencies
like Export-Import Bank. Creditor governments were also expected to
remove their impediments in accounting procedures or in tax regulations to
facilitate the banks in writing off the debt.

As of this writing, Mexico, the Philippines, Costa Rica, Venezuela,

Morocco, and Uruguay have already agreed to medium-term adjustment
programs with the IMF. The most significant achievement was the deal
made with Mexico in February of 1990 after long and laborious
negotiations among all four players. The most interesting point of the deal
concerned the banks. Once they were given the choice of how to treat their
Third World debt, about 50 percent chose debt service reduction by
accepting lower interest rates, 40 percent agreed to cancel part of their debt,
and only 10 percent chose to provide new money.

Looking back on this process of renegotiating debt, it is clear that both

debtor and creditor have to bear a major part of the responsibility. There is
no doubt that the debtors' original development strategy was either wrongly
planned or wTongly implemented. Most of the borrowed

MANAGING THE LATIN AMERICAN DEBT CRISIS

money was not utilized to enhance their export competitiveness. Put plain,
the projects into which they put the money did not generate enough foreign
exchange earnings; in fact, most of them lost money. As for the lenders,
many of the banks, for whatever reasons, were too much obsessed by their
own short-term business benefits to pay proper attention to the capacity and
ability of their borrowers to absorb the monev and use it beneficially over
the medium and long term. The lending was certainly encouraged by their
governments, particularly after the oil crisis, but some of their lending
policies were geared simply toward increasing their profits. Lending was
done mostly in dollars, which left the borrowers totally exposed to the
monetary policies of the lending countries; it was no coincidence that the
debt crisis exploded when dollar interest rates reached record levels. As we
have heard from Paul Volcker, the quality ot foreign credit was not his first
priority when battling the worst domestic inflation in memory. We can also
blame our regulatory authorities in being too lenient in permitting the
unlimited expansion of the Euromarket. Up to 1980 there was considerable
caution about expanding the Euromarket, but with the second oil shock all
of us became quite lenient and permitted it to operate in almost laissez-faire
fashion. This was the market that launched all those syndicated loans, a
technique that was instrumental in sharply expanding bank lending.

In unwinding the debt problem afterward, we also came to realize the

danger of a kind of general moral hazard: '"debt fatigue," which afflicted
both borrowers and lenders. Borrowers asked themselves why they should
sacrifice their economic growth just to feed the greed of lenders. The
lenders felt frustrated that they had to continue lending to the debtor
countries while the quality of their credits kept deteriorating year after year.
This debt fatigue was one reason why all of us came to accept that some
kind of debt reduction was not only inevitable but even desirable and
necessary.

But there are three ways, and I think only three ways, to reduce debt stock.
One is, of course, to repay the debt. That is the most classical and in fact the
normal way. but m this case it was not feasible. The second is to convert the
debt into some form of investment that does not require repayment. There
were various ideas for this, such as swapping debt for equity in privatized
corporations. This is of great importance because it can reduce the debt
without jeopardizing the possibility of new money flowing into the country-
that makes the swap, but it needs to be accompanied by prudent monetary
policy.

CHANGING FORTUNES

The third method is debt cancellation, which is a simple and important

concept of debt reduction but also poses a dilemma. The debtor countries
need new capital, but there is an inherent incompatibility in cancelling the
debts of someone who turns around and borrows again. Cancellation means
that the old credit was so bad that it had to be canceled. If that happens,
how can the lender be convinced that the new credit is sound? This can be
reconciled only when lenders are convinced that their new credit and the
remaining old credit will together be of better quality than the old, cancelled
credit. The most traditional way for the borrower to enhance his credibility
is by the good performance of his economy and by demonstrating a firm
commitment to adjustment efforts at home. I think the credit market will
appreciate that kind of demonstration and feel that loans made to such a
borrower have a better chance of being repaid.

At the same time, it is also obvious that these countries need continued
injections of capital for their economic restructuring and development. How
can they obtain it? First, by exporting more than they import and piling up a
trade surplus. They can attract direct investment from overseas investors.
They can also obtain new credit from banks. Finally, they can also acquire
investment funds by retrieving the capital of their own citizens that fled
their feckless policies. In fact, debtors need to use all four methods.

But complex financial techniques alone will never be able to solve the
problem. Paul Volcker stressed that the final answer must come from the
borrowers themselves, but I must add that all four players—debtors,
creditor governments, creditor banks, and international financial institutions
—must share the cost and the risks. There was and still is a very strong
government reluctance to transfer of risk from a private to a public lender. I
certainly understand this concern, but we have to look at reality. In 1984,
public lenders held 38 percent of all Third World debt and private lenders
held 62 percent. In 1990, the share had tilted to fifty-fifty. Whether you like
it or not, there already has been a constant transfer of risk from private to
public lenders, and simply to oppose that trend will not really solve the
problem.

The entire process of cooperation toward the common goal of working

down the debt steadily without bankrupting a country or crippling the world
financial system is bound to continue. Several countries such as Mexico,
Chile, and Venezuela are really making heroic efforts and real progress, but
others are not doing well and this mixed

MANAGING THE LATIN AMERICAN DEBT CRISIS

picture will continue for some time. Latin America is not the only area
where this problem will arise; all the lessons we learned will be both
applicable and equally important when similar problems arise in other
regions, particularly in Eastern Europe.

BRINGINC DOWN SUPERDOLL/VR

PAUL VOLCKER

OVERVIEW

By 1984 and early 1985, the Reagan administration's pride in the economy
was palpable. The recession was long over, the economy had raced ahead,
and there was an enormous election victory to celebrate. The stratospheric
levels of the dollar in the exchange market were provoking complaints by
exporters and some of our trading partners were uneasy. But to the
enthusiasts, all that seemed minor carping against what could be seen as a
symbol of market approbation; and to true-blue Reaganauts, approval from
the economic marketplace was at least as important as the electoral results.

The irony was that the United States was becoming dependent on foreign
capital to supplement its own meager savings; the richest and strongest
nation the world had ever seen was also about to become its largest debtor.
With our budget deficit so large and our domestic savings so low, we could
put the foreign capital to good use. But we didn't like the other side of the
coin, trade and current account deficits that were reaching and exceeding
the previously unimaginable total of $100 billion a year.

The exchange rate of the dollar had plainly become so high as to be

228

BRINGING DOWN SUPERDOLLAR

deeply troublesome, whether or not the administration wanted to recognize

it. Surely, it did not look sustainable either on economic or political
grounds. The yen and the mark, relative to the dollar, had been driven by
the end of 1984 back to their 1973 levels or below, and their car, machinery,
and electronic manufacturers were finding the lush American market easy
pickings. Strong protectionist pressures were building in the Congress.

The new Treasury team of James Baker and Richard Darman was clearly
sensitive to those pressures and problems, and probably intrigued as well by
the challenge of making a mark on the world stage from their new outposts.
Upon taking office, they readily joined efforts already begun at the initiative
of the other G-5 countries to restrain the appreciation of the dollar. A
substantial slide down the exchange rate roller coaster began. When the
dollar rallied for a while during the late summer, the new Treasury team
triggered a joint, aggressive, and open effort to push it lower in what came
to be known as the Plaza agreement because it was sealed at the Plaza Hotel
in New York in September of 1985. Among other things, the agreement was
remarkable for the cooperation of the Japanese in sharply raising the price
of the yen, which in earlier years had been strongly resisted.

The whole episode represented the most aggressive and persistent effort to
guide exchange rates on both a transatlantic and transpacific scale since
floating had begun more than a decade earlier. In a way, it was a mirror
image of the emergency dollar defense package of November 1978. That
was also an American initiative for coordinated intervention, suddenly
reversing previous attitudes toward the dollar and exchange market
management. Both required the active cooperation of other leading
financial powers, and both were consciously related to complementary
domestic policies. Each responded, in its own way, to a perceived need to
assert leadership and control in order to deal with large, urgent economic
problems that had come to have a large political content. In 1978, it had
been a loss of confidence in policy generally; in 1985, the threat of losing
control over trade policy to protectionist forces in the Congress and the
country.

But the two episodes differed in an important respect, apart from the
obvious point that the first was designed to support the dollar and the
second to depress it. The Plaza agreement raised the large question of how
profoundly American attitudes had changed, whether the Plaza would be a
first step toward a more managed system of exchange rates,

CHANGING FORTUNES

and whether, in support of that effort, the governments of the world were
ready to devote any real effort to the systematic coordination of their
economic policies on a continuing basis. That is the fundamental question
we address in the rest of this book. And the answer, I fear, was not really.
Or at least, not yet.

GOVERNMENTS AND MARKETS

Since the advent of floating rates, the principal and sometimes

instantaneous transmission belt for reactions to government economic
policies has been the foreign exchange market. It had grown exponentially
since the early 1970s during a period when all international markets were
spreading rapidly. Consideration of its volatile judgments could never be
entirely excluded in the shaping of policy, but it could also be a very fickle
master.

Even at the start in the early 1970s, there began to be just a germ of a vested
private interest in instability in the exchange markets. Up to that time, all
the big international commercial banks ran foreign exchange departments
essentially as a service to their customers. There was not a lot of money to
be made operating within the Bretton Woods margins of less than 1 percent,
and with parity changes taking place only at long intervals. But when
exchange rates were freed, bank traders soon found out they were very good
at making money from the fluctuations. They could run with a very brief
trend, because they could see it develop and react more promptly to it than
anyone else.

By the start of the 1980s, these back room service departments had become
important bank profit centers—$50 million, $100 million, even $200
million a year, depending upon the size of the bank. There have been some
losses upon occasion, but what is interesting is how significant and how
rather consistent the profit from foreign exchange has been for many active
trading banks. Somebody must be losing, but it has not been the foreign
exchange dealers, and it seems obvious why the financial community has
been such a great supporter of floating exchange rates.

These exchange markets are enormous, buying and selling hundreds of

billions every day. This market is essentially made up of a few hundred
traders with open telephone lines. In front of them is a screen with rate
quotations, and alongside is one or two screens showing the latest news and
computer-driven analyses of exchange rate relationships. The traders

BRINGING DOWN SUPERDOLLAR

make much of their money by trying to stay ahead of what they detect as a
trend. What they mean by a trend is not a year, not a month, but perhaps
only a day or two, or even a few minutes.

Because most of their bosses tell them to square their positions at the end of
the day and insist on limits to their trading positions during the day to limit
the bank's risk, traders have to be fast on their feet to make big money. So
they care little about basic economic trends, they do not pretend to be
thoughtful economists, and in fact they do not especially want to associate
with them.

What interests them is the current fashion in the market, or what they think
is motivating their counterparts in other banks and their customers to buy or
sell currencies. Suppose they think interest rates are important (as indeed
they often should). As the traders follow the business news on their screens,
they may catch predictions by economists working for the large banks and
brokerage houses that, say, payroll employment is expected to fall by
100,000, a figure that will be published by the government first thing in the
morning. If the number of jobs actually declines by 150,000, the market
figures that the Fed is more likely to cut interest rates and that some
customers and other traders will sell dollars. So some will rush to be the
first, initially depressing the value of the dollar. And if it looks like a trend,
then others will follow, and the shift in exchange rates may end up far out
of proportion to the significance of any particular item of economic news.

Changes in exchange rates influence the prices of imports and exports, and
changes in prices of course eventually affect their volume. In general, a
decline in the value of a currency will therefore reduce a trade deficit by
making imports more expensive; a rise produces the reverse effect. But the
actual flow of funds in the market these days is not dominated by
transactions in trade but in huge movements of capital chasing higher
investment income, and the exchange rate therefore reacts more sharply to
those capital flows. And those flows may be influenced by something as
straightforward as a higher rate of interest or as unpredictable as a change in
a country's politics.

From the viewpoint of the policymaker interested in bringing trade and

other balance of payments flows into equilibrium, expectational and
"bandwagon" effects that occur when traders try to ride a trend can create
wide currency swings far out of keeping with a reasonable balance in
trading patterns. What seems to have happened as floating rates continued
was that the market lost any real sense of what exchange rates

CHANGING FORTUNES

were appropriate and sustainable over time; as economists put it, there was
no "anchor" to tether the expectations of the traders and to induce them to
operate against a trend before it went too far. All of that matters because a
nation's exchange rate is the single most important price in its economy; it
will influence the entire range of individual prices, imports and exports, and
even the level of economic activity. So it is hard for any government to
ignore large swings in its exchange rate, even though that is what the
Reagan administration did for some years.
The Plaza agreement represented an attempt to regain at least some official
control over changes in exchange rates. The prime mover was not the
Federal Reserve but the Treasury. In such questions the two branches of
government have independent legal authority and quite possibly different
perspectives. But if the exchange rate is to be managed, the different views
must be reconciled. Like partners in a three-legged race, it is awkward but
doable.

The Treasury, which is part of the executive branch, thinks of itself as

mainly responsible for something called international monetary policy. I
used to be the undersecretary for monetary affairs, and apart from the
domestic responsibilities for economic analysis and financing the
government and its agencies, that position was the focal point for financial
relations bilaterally with other nations or multilaterally through
international organizations such as the IMF. From that perspective, I was
intimately concerned with exchange rate questions and international
monetary reform.

The Federal Reserve, which is deliberately designed to be independent from

the executive branch, reports directly to Congress, which was given the
power by the Constitution to "coin Money, regulate the Value thereof, and
of foreign Coin." The Federal Reserve is responsible for monetary policy
pure and simple, no adjectives. Some might like to describe it as domestic
monetary policy, but what the Fed does in regulating U.S. money and credit
inevitably affects exchange rates, and even the world money supply.
Domestic and international, it's a seamless web, so there is an institutional
overlap.

Operationally the Plaza agreement is mostly about official intervention in

currency markets, and that is the one area in which the overlap is
particularly pronounced and often aggravating. By intervention I mean
official buying or. selling of foreign currencies for dollars in the market in
an effort to influence or stabilize the exchange rate of the dollar. A coherent
intervention policy must be reasonably integrated

BRINGING DOWN SUPERDOLLAR

with other policies, and especially with domestic monetary policy, which
mainly works through interest rates, the province of the Federal Reserve
alone. Indeed, I think all authorities would agree that, at the end of the day,
monetary policy will be a more powerful influence on exchange rates than
intervention, which tells you where the final balance of power lies.

It may be worth diverting briefly from the narrative to clarify, out of my

own experience, how intervention policy is actually decided. After a lapse
of a generation, the idea of the United States again intervening in the
exchange markets started when I was at the Treasury in the early 1960s.
Later, as undersecretary, I was the man in the Treasury most directly
concerned with exchange rate policy. I then served as president of the
Federal Reserve Bank in New York, which actually conducts the
intervention by buying and selling foreign currencies in the market. I ended
up in the Federal Reserve in Washington, which formulates the monetary
policies that affect exchange rates. In Washington one of my principal tasks
was to chair the federal Open Market Committee, the body within the
Federal Reserve that, paralleling Treasury authority, directs intervention
activity that is carried out by the New York Fed.

As a matter of law, the Federal Reserve's authority to intervene is entirely

independent of the Treasury's, and it is not too explicit, to put it mildly.
Specifically, the Federal Reserve has built its intervention practice and the
whole swap network on language in the Federal Reserve Act of 1913 that
says the Federal Reserve can buy and sell in the open market, at home or
abroad, bankers' acceptances, bills of exchange and "cable transfers." In
those days, money was traded internationally by cable, and a cable transfer
usually meant a foreign exchange transaction.

The explicit authority for the Treasury, and it too is a bit hazy about
objectives, came later in emergency legislation in 1933 when the United
States went off gold for a while. However, when Treasury intervention
started in the early 1960s, the Treasury's own resources for intervention
were interpreted as limited to the capital in the Exchange Stabilization Fund
(funded in 1934 from the profits of the rise in the price of the government's
gold holdings). To assure adequate capacity, Douglas Dillon and Bob Roosa
wanted the Federal Reserve to join in, and it was all explained to and
understood by the relevant congressional committees. The Federal Reserve
Bank of New York, which had the needed facilities and market contacts,
acted as agent for both the Treasury and the Federal Reserve, using its
trading room right off Wall Street. That

CHANGING FORTUNES

has been the basic legal and institutional pattern for thirty years.

The Treasury can and does point to language in the emergency legislation in
the 1930s when Congress delegated authority to deal in gold to the
president, and through him to the secretary of the Treasury, that refers to the
secretary's responsibilities for international monetary policy. That language
and subsequent tradition, as well as the sense of political responsibility, has
given the Treasury a certain pride of place in exchange rate and intervention
policy. It certainly can instruct the Federal Reserve Bank of New York,
wearing its hat as agent of the Treasury, to use Treasury money to buy or
sell dollars, or marks, or yen, to affect the relationship between our
currency and the currencies of other nations. What it does not have
authority to do is to instruct the Federal Reserve to spend its own money
and take the attendant risks.

Obviously, for the two agencies to operate at cross-purposes in the market

would surely look odd and, more important, would entirely undermine any
coherent policy objective. So there is a constant need for coordination in the
orders sent to the trading desk in New York. Certainly, the Federal Reserve
would be extremely reluctant to intervene for its own account against the
expressed desire of the Treasury. Not only could that provoke a public
controversy and challenge to political authority, but the very existence of
the disagreement would impair the effectiveness of an operation that
depends for its success on affecting expectations of the holders of
currencies. Members of the Open Market Committee usually want the
comfort of knowing they have administration support in authorizing what,
for them, are operations entailing questions and risks outside their regular
responsibilities for domestic monetary policy.

Conversely, in my experience, the Treasury will be reluctant to intervene

over the strong objections of the Federal Reserve, with its market
experience, cash, and ultimate responsibility for the trump card of interest
rates. The net result is a kind of mutual veto that in practice gives the last
word to the agency that is the most reluctant to intervene. Historically, that
typically has been the Treasury.

Different administrations have blown hot and cold on intervention. The first
Reagan administration was certainly at the cold end of the spectrum. The
people in the New York Reserve Bank, who are the agents, traditionally
tend to be activists. They often feel direct pressure to cooperate with foreign
central banks. They also see themselves, quite rightly, out in the trenches
where the market battles must be fought;

BRINGING DOWN SUPERDOLLAR

they want to keep their expertise and tools in fighting trim. The Federal
Reserve chairman also is often more interested than most of the Open
Market Committee because he follows international problems more closely.
But he nevertheless must persuade his colleagues, and usually the secretary
of the Treasury as well.

All this often leads, I must confess, to rather inefficient stop-and-start

operations. The staff on both sides is suspicious that their own bosses' views
are not adequately respected; during operations, an inordinate amount of
time is taken to reconcile differences in operational judgment. The
bureaucratic problems are not unique to the United States government and
are apt to arise in any country where the authority to act is shared. But this
is one of those areas where our system of checks and balances often works
against effective results. Within broad guidelines, the people actually doing
the intervention need enough authority and flexibility to react to market
conditions as they occur, not after an ad hoc conference in Washington.

The Plaza agreement set exchange rate policy and supported it with
intervention. It clearly could not have taken place without Treasury support,
and in that instance leadership. But once such an agreement is made, it is
not likely to be successful if it runs against the grain of monetary policy.
More important over time than the technical authority to conduct
intervention, changes in domestic interest rates will normally have a potent
effect on whether people want to buy or sell their own or foreign currencies.
Because of its influence on money market interest rates and confidence,
fiscal policy can also be very important, as certainly was the case in the
United States in the 1980s. But fiscal policy is notoriously inflexible; as an
operating matter, week to week, month to month, quarter to quarter, it is
likely to be monetary policy that counts among the instruments available to
government.

All that was rehashed in an international study during 1982 and the first part
of 1983. Internationally, the hands-off policy toward the dollar and
intervention pursued by the Treasury under Don Regan were matters of
considerable debate. Not unexpectedly, the French were most annoyed,
resenting the instability in exchange markets at a time of speculation against
the franc. President Francois Mitterrand chaired the economic summit
meeting at the Palace of Versailles in June of 1982 and coaxed an
agreement from the other six nations for a joint study of the uses of
intervention and whether it had actually worked in the past. The United
States Treasury could hardly object to a study, and even agreed

CHANGING FORTUNES

for it to be chaired by Philippe Jurgensen, a senior and respected civil

servant in the French Treasury. Toyoo Gyohten represented Japan. The
Federal Reserve international staff, under Edwin Truman, did yeoman work
in organizing material and developing sophisticated econometric analyses
for the group, just as it had been enormously helpful in keeping track of the
international debt situation. Ted Truman for many years has been one of
those unsung civil servants who bring experience, high professional stature,
and endless dedication to the informing and advising of policy officials in a
way that makes a critical contribution to policy itself.

The Jurgensen report dwelled at length on the distinction economists make

between "sterilized" and "unsterilized" intervention. Un-sterilized
intervention means that a central bank, when buying or selling a foreign
currency, permits the resulting change in its assets to work its way through
to a change in the money supply and interest rates. Just as the textbooks say,
if the Fed created dollars to buy marks, those dollars would, like any open
market purchase, increase bank reserves and ultimately the amount of
money in circulation by some multiple of that reserve increase; interest
rates would tend to decline, other things being equal. That was what was
supposed to happen in the classic gold standard when a central bank bought
gold; it forced a change in monetary policy. Conversely, intervention is
"sterilized" if the initial purchase of foreign currency is offset by the central
bank by the sale of another asset, say a Treasury bill, so that monetary
reserves and monetary policy remain unchanged.

This is not the place to review all the technical debates among economists
about how to measure whether intervention is sterilized. But I can testify to
an important fact: Central bankers don't ordinarily think that way in
conducting their operations. Almost every central bank has its own
objectives for monetary policy, and they are not framed in terms of the
amount of its foreign exchange intervention. If that intervention either
enlarges or contracts the monetary base, the natural instinct is to offset it by
domestic monetary actions. In other words, they automatically sterilize
intervention to the extent they can. That is the way the Federal Reserve
behaves, and so does practically every central bank in countries with a well-
enough-developed money market to permit large offsetting operations.

That is not to say that conditions in the exchange market do not or should
not influence decisions on monetary policy; they do. A particu-

BRINGING DOWN SUPERDOLLAR

larly clear example was the tightening by the Federal Reserve in November
1978 when it was also selling foreign currency holdings to support the
dollar. But in the minds of central bankers, the decision to ease or tighten is
a separate one: It will be made on the basis of broader economic
considerations, not because of the mechanical effects of intervention.

The technicians who wrote the Jurgensen report, including the Federal
Reserve experts, failed to find much statistical evidence of the effectiveness
of sterilized intervention, and for lack of such evidence did not display great
enthusiasm about intervention in the report they submitted on April 29,
1983. The policy officials from most European countries (supported by the
Fed) made sure that the conclusions were not totally negative. But much
emphasis was correctly placed on the need for consistency with monetary
policy, which would be similar in concept to unsterilized intervention, and
for coordinated international action to give an appropriately strong signal of
intentions. Because the report had been commissioned by the seven summit
nations, the Group of Seven finance ministers met to consider it with staffs
present, rather than the much more informal, no-staff setting of the G-5. A
formal communique was issued that is worth repeating because it sums up
the collective wisdom on the subject: "Under present circumstances, the
role of intervention can only be limited. Intervention can be useful to
counter disorderly market conditions and to reduce short-term volatility.
Intervention may also on occasion express an attitude toward exchange
markets. Intervention will normally be useful only when complementing
and supporting other policies"—by which it meant mainly monetary
policies. After a certain amount of grumbling by the U.S. Treasury, the
communique concluded that the Seven "... while retaining our freedom to
operate independently, are willing to undertake coordinated intervention in
instances where it is agreed that such intervention would be helpful."

That all sounds reasonably forthcoming, but Secretary Regan went to a

press conference immediately afterward and said in effect that he could
hardly imagine a situation where intervention would in fact be helpful. That
seemed to me totally inconsistent with the spirit of the communique. But it
had the virtue, I suppose, of making it clear there would be no change in the
hands-off policy of the United States. In the exchange markets, the dollar
continued the rise that had really begun in 1981.

CHANGING FORTUNES

Coming on top of the economic recovery, the dollar was already high
enough to produce a surge in imports, and by 1984 the trade deficit moved
above $100 billion for the first time. But the dollar-rose still higher,
particularly against the European currencies. Those currencies were
psychologically bogged down by sluggish growth and talk of
"Eurosclerosis," which was the shorthand phrase invented by the Europeans
themselves for a psychology of too much regulation and government and
too little initiative and enterprise. There was a transatlantic sense of genuine
alarm: in Europe because of an eroding self-confidence, and in the United
States because the trade balance was deteriorating sharply and the economy
seemed to be losing some of its expansionary thrust. By midsummer of
1984, the mark had lost almost 50 percent of the value it had reached
against the dollar in 1978 and the yen about one third. We were headed
toward $150 billion trade and current account deficits within a year or two,
but still the United States did not move. It agreed to only nominal (and
ineffective) intervention in early September.

Without notice to us or anyone, Germany reacted suddenly and unilaterally.

The Bundesbank entered the market in a most aggressive way to buy a very
large amount of marks (then estimated at $1.3 billion) while its president
was flying off to the annual meeting of the IMF. That stopped the market in
its tracks for a while as some speculators against the mark licked their
wounds. But soon the relentless rise in the dollar started once again.

The attitude of many of us at the Federal Reserve had already been

encapsulated in a draft note prepared early in 1984 with Ted Truman's help
by Sam Cross, who was in charge of Federal Reserve foreign operations in
New York, including the foreign exchange trading desk. Like me, Sam
knew the problem from both sides, having been one of the Treasury's finest
civil servants during most of the postwar period before moving over to the
Fed, from which he retired at the end of 1991. The staff urged me to send
the note off to Secretary Regan, and it is worth quoting:

I am increasingly concerned about the continued rise of the dollar and the
implications of the dollar's appreciation for our domestic and international
economy. As you know, I do not in general favor heavy exchange market
intervention. In most circumstances, intervention is likely to be ineffective
unless sup-

BRINGING DOWN SUPERDOLLAR

ported by changes in other, more fundamental policies. Nonetheless, under

present economic circumstances, particularly in the light of the volatility
and deterioration of market conditions recently, I believe we should
consider a fresh approach. Specifically, we ought to be intervening. . . .

Then, after describing the concerns of our trading partners, it continued

with a point that would concern me for years:
We have reached a rather uncertain equilibrium with a large budget deficit
and a large current account deficit, both financed in large part by borrowing
overseas. Two elements of the triad, the budget deficit and a large current
account deficit, are not easily changed, but the third, the capital inflow, can
shift very quickly if confidence in the dollar should diminish. Such a loss of
confidence in the dollar could be triggered for example by fear of the re-
emergence of U.S. inflation or a shift in the preferences of fickle investors.

I cite this document of the period not because I sent it to the Treasury,
because I didn't. It was indeed an accurate reflection of my own concerns at
the time, and they recurred during the next year or two, but I didn't see
much to be gained in putting in the written record what I already was urging
on the Treasury orally and privately.

The concern in the draft note about our dependence on foreign capital was
strongly reflected in my public statements at the time. The United States
was running a budget deficit of more than 5 percent of its gross national
product. We had to sell securities somewhere to finance that deficit. The
American people simply were not saving enough money to buy all the
Treasury bonds as well as to buy new homes and invest on their own. So we
were forced as a country to rely on foreign lenders, and to do that we had to
maintain their confidence as a place to keep their money.

The Japanese, in particular, seemed eager to lend; one reason the yen had
not risen against the dollar nearly as much as the mark is that the Treasury
had pulled in tens of billions of dollars from Japan for long-term bonds,
especially from Japanese insurance companies and pension funds. They
plainly did not feel there were equally attractive alternatives in Tokyo. We
were dependent on the money, but there was also something ironic in the
fact that Japanese workers producing all those

CHANGING FORTUNES

exports for the U.S. market would be supported in their old age by interest
payments on thirty-year U.S. Treasury bonds.

By the autumn of 1984, when the economy was less ebullient, interest rates
in the United States came down, and the discount rate was reduced in
November and again in December. But it didn't seem to make any
difference. The dollar continued rising. The final upward push took place at
the beginning of 1985 and coincided with an attack on the pound sterling.
The sterling rate slipped only a few pennies away from the unprecedented
and, to many British, humiliating rate of one pound for one dollar. (Part of
the immediate cause was an unfortunately phrased remark by Prime
Minister Thatcher's press spokesman, hinting that her government was not
unduly concerned about the value of sterling. Shades of some previous U.S.
Treasury secretaries!) In a panicky market setting, Mrs. Thatcher
telephoned President Reagan just before a meeting of the G-5 finance
ministers in Washington to urge intervention in support of the pound
sterling, as well as intervention more generally. However ideologically
reluctant the administration might still have been to intervene, that was one
request it could not reject. Margaret Thatcher was a staunch ally in much of
what the United States was trying to do in the world; she was personally
close to the president and had warm relations with a number of us. The G-5
communique gained Treasury assent by using essentially the tepid language
of earlier meetings that agreed to intervention "when it would be helpful."
The European ministers went home and decided that intervention would in
fact be helpful and began intervening on a large scale. By early March, the
Bundesbank alone had sold $4.8 billion and for once the United States
joined in. The amount of $660 million, while much smaller than the
European numbers, nonetheless represented more than a token. And,
presumably, that heavy intervention, which amounted to about $10 billion
during the first two months of the year, had something to do with the
dollar's finally receding from its peak just around the end of February. Once
the decline started, it picked up speed.

NEW MEASURES, NEW MEN

These changes took place at the time of the important personnel changes at
the top of the Treasury when the second Reagan administration began in
1985. James Baker had been an effective and respected Chief of Staff for
the president but presumably found attractive the

BRINGING DOWN SUPERDOLLAR

prospect of more room for personal initiative and public exposure as
Treasury secretary. He switched jobs with Donald Regan, who probably
was attracted by the power of the White House and by his compatibility
with his Irish soulmate, the president. Baker's White House assistant,
Richard Darman, became deputy secretary of the Treasury and essentially
took over the international portfolio that had been held by the
Undersecretary for Monetary Affairs, Beryl Sprinkel. Sprinkel, who had
stonewalled exchange market intervention and was cool toward most other
forms of active international coordination, moved in turn to the Council of
Economic Advisers as chairman but out of the direct policymaking chain.

So we now had a pragmatic political team in the Treasury. From the start, it
was obvious that Baker and Darman were more concerned about the dollar
than their predecessors had been. While they had no specialized background
in finance, domestic or international, they were highly intelligent and had a
good sense of the main issues. Most of all, they were old Washington hands,
with finely honed political antennae and instincts. And among the things
worrying them at the time was the degree of protectionist pressure in
Congress and in the United States generally. They didn't need to be Ph.D.
economists to relate that pressure to the strength of the dollar, which in their
new positions they actually might be able to do something about.

At some point, they also seemed to become intrigued by the idea of longer-
term international monetary reform, which was one area where a Treasury
secretary could potentially make a lasting impact. A vague allusion to an
international monetary conference in President Reagan's State of the Union
Message in late January 1985 was most likely Baker's doing. The new
Treasury team was not at all open in confiding their thoughts in that area to
a central bank governor they did not know too well, but without being
explicit they let it be known in private conversations with me, as with
others, that they were carefully examining the idea of target zones for
exchange rates.

That idea traced back at least to the late 1970s and came in various
versions. Essentially, the idea was that governments should agree on some
range within which exchange rates should be confined, probably a fairly
broad one. Those ranges would then be defended and enforced by
intervention and if necessary by monetary policy or other measures. The
firmness of the defense that was envisioned depended upon which
particular proposal was under study. Whatever the precise terminology

CHANGING FORTUNES

or specifications, the goal was to find some practical middle ground

between freely floating and narrowly fixed currencies. As Toyoo Gyohten
points out, eight years earlier I had set out a mild versionof the same idea in
a lecture. By the mid-1980s Bob Roosa, the group of activist economists
grouped around Fred Bergsten's new Institute for International Economics
in Washington, and others were actively propagating the idea. Darman in
particular was an active reader and listener.

Indicative of the new drift in thinking in the administration was a speech

about international economic policy made on April 11 by George Shultz, an
old tiger, at Princeton. It was notable for several reasons. As secretary of
state in the Reagan administration, Shultz had until that moment
punctiliously stayed away from public comment in the area that had
occupied his time more than ten years earlier as secretary of the Treasury. It
was no secret that he had been a strong advocate of floating, and that as a
committed monetarist he tended to look to the market as the solution for
economic problems. But this particular speech was different in tone—and it
was a tone, by coincidence or otherwise, that had a great deal in common
with what I had been trying to say. He emphasized the importance of
reducing the budget deficit as a necessary part of a program to regain
international equilibrium. He expressed great concern about the strong
dollar. Most significant, given his past views, he conveyed a strong sense
that something ought to be done about it. While he made no direct call for
intervention, his speech seemed to me symptomatic of a constructive
change in the administration's attitudes and perceptions.

Meanwhile, industry was also busy organizing itself through the Business
Council, the Roundtable, and all the other organs it had to focus intellectual
and political attention on the trade problem and the exchange rate.

All these forces coalesced in the Plaza agreement in September. I was not in
on the ground floor. Sometime during the summer, Treasury officials were
talking tentatively with their G-5 counterparts about a possible meeting and
communique to emphasize coordinated approaches on economic policy. I
was brought into the discussions only in August, when the ideas were
becoming more operational. One trigger was a rebound in the dollar after
sharp declines approaching 20 percent during the spring and early summer.
I was pretty well convinced by then as a matter of market judgment that the
basic direction of the dollar was

BRINGING DOWN SUPERDOLLAR

lower. Certainly, the growth of the U.S. economy seemed to be losing

momentum, and if there was to be any change in monetary policy it would
likely be toward greater ease and lower interest rates. But the prospects for
a lower dollar were not so clear to others as the dollar rebounded.

Baker explained to me his idea of a G-5 meeting to coordinate intervention

to reduce the value of the dollar. He also said he was aware the whole thing
would be undercut if monetary policy were tightened, and he did not want
to proceed against that possibility. I replied, as any Fed chairman should,
that I was not in a position to give anyone commitments about monetary
policy over any substantial period of time. Nonetheless, I was personally
convinced that, quite independent of any policy he might adopt toward the
dollar, there was not a serious risk that monetary policy would need to be
tightened during the next few weeks or months. I pointed out that the
economy was slowing and inflation was declining to the lowest level in
years. That seemed to satisfy him. We discussed his plans for joint
intervention, and he said he might as well go ahead with them.

I recall asking how he was going to get all this past Regan and Sprinkel in
the White House, and ultimately President Reagan. He quite properly told
me that was his problem, not mine. I was later told he did not notify the
White House until a day or two before the Plaza meeting, and he did it by
using his close relationship with the president to inform him directly and in
the most general terms. I suppose Don Regan's mind was elsewhere by that
time, but it was never clear that he felt as strongly opposed to intervention
as Beryl Sprinkel.
As we began planning the Plaza strategy in detail, I quite frankly expressed
the concerns that had appeared in the Cross/Truman memo. I had lived
through almost two decades of dollar depreciation, and had seen the
ensuing difficulties, both economic and in terms of our influence, when it
got out of hand. More than once before, the Treasury had fallen into the
market trap of seeming to promote depreciation of the dollar as an elixir for
our problems. Getting the dollar down from its extreme heights in 1985
made sense, but I didn't want to end up with so abrupt and disturbing a
decline that worries about inflation would reappear, followed by higher
interest rates. I suppose these were all good, traditional central banking
views, but we had before us the specific example of what had happened to
Margaret Thatcher and Britain earlier in the year.

CHANGING FORTUNES

In its specifics, the discussion among us centered on the kind of guidelines

that we should give for intervention to the Federal Reserve Bank of New
York, and how the sales of dollars would be spread among the participating
countries. Given that I was pretty well convinced that the dollar was going
to continue declining on its own, I didn't want to wake up one day and find
we had pushed it right off the cliff. Instead of pushing hard on the days that
the dollar was declining anyway, intervention should be mainly
concentrated on leaning against any tendency for the dollar to rise on
particular days, in effect smoothing out some upward blips. After
considerable discussion, we also agreed that we ought to aim at a decline of
10 or 12 percent over a period of time, and then the whole thing could be
reconsidered. We also discussed at great length how much money should be
committed to the intervention, by us and by others. That was of much less
interest to me. I knew it would be hard to anticipate those needs in advance,
and even harder to decide how much should be done in which locale, given
the vagaries of the exchange markets. All of that was summed up on a piece
of paper that could be used in talking with the rest of the G-5. There was no
discussion of monetary policy beyond my initial conversation with Baker.

The meeting was actually set up on only a few days' notice before it
convened on a Sunday at the Plaza Hotel in New York. That choice of place
was interesting in itself. I had suggested that the logical place in New York
would be at the Wall Street fortress of the Federal Reserve Bank, which
could offer facilities and security. But it was obvious that a nice quiet
meeting with a discreet announcement, and on Federal Reserve turf, was
not exactly what Baker had in mind. A lot of groundwork had already been
done by the Treasury staff and its G-5 counterparts on material that could be
incorporated in a long communique suggesting convergence on basic
economic policies. While there was really nothing new in substance, the
point was to suggest the intervention was consistent with economic
fundamentals.

Inside the meeting itself, the most startling thing to me was that Noboru
Takeshita, then the Japanese finance minister and afterwards prime minister,
volunteered to permit the yen to fall by more than 10 percent. He was far
more forthcoming than we had expected him to be; Toyoo Gyohten explains
that the Japanese were alarmed by growing protectionist pressures in the
United States and were ready to accept a huge appreciation of the yen in the
hope that those pressures would be diverted. Takeshita's attitude I'm sure
surprised others as well, and it was

BRINGING DOWN SUPERDOLLAR

a very important influence on the success of the meeting. A primary

concern of the Europeans was not their exchange rate against the dollar,
which they recognized as being way overvalued, but against the yen. The
larger the appreciation of the yen, the more relaxed they were about their
own competitive position.

There was essentially no discussion at the Plaza about monetary policy.

That absence was consistent with the natural reticence of central bankers to
engage in such discussions in front of finance ministers, if indeed they are
to discuss them at international meetings at all. As central bankers see it,
they face the danger in such discussions that, deliberately or otherwise, they
will be locked into what are essentially political commitments. Except for a
recitation in the long communique of what each country was willing to say
about its own policies, there was also very little discussion of more general
economic policies. The finance ministers were caught in a familiar box.
Individually, they had little control over the main policy instruments, and
politically, countries are unwilling to take the difficult steps involved in
changing tax and spending patterns short of a generally recognized
emergency, even to help correct a problem as evident as a serious
misalignment of the world's major currencies. To the best of my knowledge,
no budget, trade, or structural policy was changed as a result of the Plaza.

It was, however, useful to emphasize that existing policies were compatible

with a declining dollar. The urgent tone of the concern about protectionism
in the United States and other countries was a familiar theme, but
particularly apt.

The operational part of the communique simply read: "The Ministers and
[central bank] Governors agreed that exchange rates should play a role in
adjusting external imbalances. In order to do this, exchange rates should
better reflect fundamental economic conditions than has been the case.
They believe that agreed policy actions must be implemented and
reinforced to improve the fundamentals." Then came the object of the
whole exercise: "Some further orderly appreciation of the main non-dollar
currencies against the dollar is desirable. They stand ready to cooperate
more closely to encourage this when to do so would be helpful."

That final sentence was close to the communique language used in

approving the Jurgensen report at the January G-5 meeting. But that
communique had not been issued like this one was, at the Plaza with press
specially invited and television cameras at the ready. The call for

CHANGING FORTUNES

realignment was clear. The words "when . . . helpful" were quite rightly
read to mean tomorrow.

Actually, the dollar declined very sharply without any immediate

intervention; the intent was clear enough. There was some heavy
intervention in the ensuing weeks to make sure the trend continued, and by
the end of October, after more than $3 billion of intervention by the United
States alone, the dollar had fallen by more than 12 percent against the yen
and close to 9 percent against European currencies. Then the dollar
continued to decline without much additional intervention, and by January
1986 it stood on average a full 25 percent below the peak it had hit about
one year before.

Increases of 50 percent and declines of 25 percent in the value of the dollar

or any important currency over a relatively brief span of time raise
fundamental questions about the functioning of the exchange rate system.
What can an exchange rate really mean, in terms of everything a textbook
teaches about rational economic decision making, when it changes by 30
percent or more in the space of twelve months only to reverse itselt? What
kind of signals does that send about where a businessman should
intelligently invest his capital for long-term profitability? In the grand
scheme of economic life first described by Adam Smith, in which nations
like individuals should concentrate on the things they do best, how can
anyone decide which country produces what most efficiently when the
prices change so fast? The answer, to me, must be that such large swings
are a symptom of a system in disarray. And that the Plaza was fated to be
just one more episode in the saga of reacting to exchange market
emergencies, unless the agreement became the harbinger of a different and
more persistent effort to achieve greater stability.

That is the issue examined in the next chapter, about the Louvre agreement.
But first a few loose ends about monetary policy are worth clearing up.
When the rise in the value of the yen stalled and then actually dropped a
little, the Bank of Japan tightened monetary policy late in October without
any prior discussion. The decision was obviously designed to strengthen the
yen, and possibly the Japanese authorities thought they were responding to
U.S. Treasury pressures. To me, it was a mistake. The underlying problem, I
thought, was that the Japanese economy was expanding too slowly, not too
fast. A move toward monetary restraint for exceedingly short-term benefits
on the exchange rate seemed wrongheaded, and I made no secret of my
view. Fortunately, the tightening was soon reversed and did no real damage.

BRINGING DOWN SUPERDOLLAR

If the long-run fundamentals called for more Japanese growth and lower
interest rates, the conventional wisdom of the market was that the very
existence of the Plaza agreement reduced the likelihood that the Federal
Reserve would tighten policy, and instead would point toward a reduction
in the discount and other interest rates. There was also some theorizing that
the Plaza was all part of a Machiavellian Treasury plot to control monetary
policy indirectly by committing the Federal Reserve to lower interest rates
to depreciate the dollar. Of course, nobody ever said anything to me about
that, and it is hardly unusual for secretaries of the Treasury to want an
easier monetary policy; from that viewpoint there would have been nothing
new in the Plaza agreement. But the real effect, at the margin, was to reduce
the size and likelihood of any easing of monetary policy.

During that autumn, there was some sentiment within the Federal Reserve
in favor of easing on purely domestic grounds. The board in Washington
received repeated requests from some Federal Reserve banks to lower the
discount rate, and some members of the board of governors held that view.
But with the dollar already declining so sharply, the balance of the
argument to me and most of my colleagues was the other way. Without
clearer evidence that the expansion had petered out, easing money in the
face of rapid decline in the dollar seemed too much like pouring Federal
Reserve oil on a fire already burning that I wanted to keep under control.
Those concerns were reinforced in the absence of a willingness by others to
coordinate a rate reduction when their economies seemed to be growing
more slowly.

Around the fringes of a G-5 meeting in London in January 1986, there was
some talk about a coordinated move to reduce interest rates to spur the
world economy. The Japanese, who had recently increased their rate,
indicated some interest and soon moved appropriately on their own. The
time was not ripe for the Bundesbank or the Federal Reserve. Certainly
there was no urgency from the standpoint of the exchange markets, where
the dollar was continuing to fall. Under the circumstances, the priority to
me was for ease in Germany and Japan, where the economic slack was
pronounced, not for the United States.

That was essentially the end of the Plaza episode. But plainly there was
unfinished business for both monetary and exchange rate policy.

CHANGING FORTUNES

TOYOO GYOHTEN
1 here are three different angles from which to examine the period from
1985 to 1988, which we are doing in this chapter and the next, and which
takes in most of Ronald Reagan's second term as president. First, from the
point of view of American economic policy, where Reaga-nomics had
entered a deadlock. Second, through the recognition of the increased
importance of exchange rate policy in adjusting the balance of payments,
especiaUy by concerted intervention by the major authorities. Third,
through the international effort to systematize the coordination of national
economic policies. Let me examine these three in turn.

Kcaganomics was initiated in 1981. It had four major elements: the

reduction of federal spending, the reduction of personal income taxes
combined with tax incentives for business investment, the deregulation of
business, and an anti-inflationary monetary policy. Supply-side economics,
which provided the supposed theoretical basis for this economic policy,
stressed the importance of the after-tax return on income and savings. Its
advocates encouraged reductions in income and corporation taxes so as to
encourage savings and investment, and thereby stimulate growth and
increase employment. If there was to be a budget deficit as the result of all
this, the supply-siders claimed that the economy would literally grow its
way out of it. In hindsight, we can see two miscalculations. The income tax
cut failed to increase savings and increased consumption instead. And it
proved impossible to cut federal spending because of increased defense
outlays and increased social welfare expenditures, mainly Social Security,
Medicare, and other congressionally mandated entitlement programs for the
middle class and the elderly. Until 1980, the savings and investment balance
of the private sector and the deficit of the government sector had moved
more or less in parallel, offsetting each other and thus maintaining the
external accounts more or less in balance. In other words, the savings of
Americans were enough to finance their government's overspending, and it
was not necessary to borrow from foreigners to finance the budget deficit.
But after 1980, the balance between savings and investment of the private
sector deteriorated, and the federal deficit increased further. The
combination of these developments contributed to a higher interest rate, a
stronger dollar, and a large external deficit. The deficit turned the United
States from a creditor in 1981 with net assets abroad of $141 billion to a
debtor
BRINGING DOWN SUPERDOLLAR

with net liabilities in 1985 of $111 billion, a swing of $250 billion in just
four years.

Academics soon began predicting that foreigners, especially the Japanese,

would stop lending their money to the United States by buying its bonds out
of fear for the future of the American economy. American interest rates
would therefore be forced up in order to continue to attract foreign capital.
At some point, predicted Stephen Marris of the Institute for International
Economics, the dollar would crash in a "hard landing," bringing down the
United States economy with it, and foreign lending would stop. This
scenario did not work out because the majority of Japanese investors
maintained their long-term confidence in the American economy, and U.S.
Treasury bonds remained their best available investment in terms of yield
and liquidity. But the large trade deficit was nevertheless real enough and
prompted a rise of protectionist sentiment in Congress. According to one
report, during 1985 alone four hundred bills were introduced to protect
American products, including the famous import surcharge proposed by
leading Democrats. Japan bore the brunt of the criticism because of our
surplus with the United States, and in September 1985, President Reagan
invoked for the first time Section 301 of the Trade Act, basing his decision
on Japan's restrictions on tobacco imports and giving the administration the
authority to retaliate. On the Japanese side there was growing concern, and
the government tried to increase imports and reduce the surplus by
whatever means possible. Prime Minister Nakasone came up with the
interesting suggestion that every Japanese should buy $100 worth of
imported goods. Accompanied by a television crew, he visited a department
store and bought two or three very fancy neckties. Unfortunately, the
neckties were made in France.

From the point of view of exchange rate policy, I believe many people in
the United States welcomed the strong dollar after the volatility of the
1970s, and after the frustrations of a weak dollar under the Carter
administration. This was very much fortified by the monetarist approach
predominant in the United States Treasury, which held that exchange rates
could be misaligned only when the market was imperfect and not
functioning properly. This theory counseled them to stay out of the market
and intervene only in the most disorderly conditions. When the yen
remained weak despite Japan's large trade surplus, they concluded that the
cause really was the many impediments and distortions that were to be
found in Japanese financial markets.

CHANGING FORTUNES

Donald Regan, as Treasury secretary, came to Japan and proposed to

Finance Minister Noboru Takeshita a "yen-dollar committee" to examine
the problem. In the spring of 1984 it produced a report proposing various
measures to open up Japanese financial markets, including very importantly
the rapid development of a Euroyen market. Beryl Sprinkel, the Treasury
undersecretary and a committed monetarist, headed the American team, and
he tried to persuade us to deregulate our financial markets as quickly as
possible. We wanted to move step by step, but his approach might best be
described as leap by leap. Back in his hometown in Missouri, he said, they
used to cut off a sheepdog's tail "in one stroke, just like that," so as not to
hurt the dog by cutting it off in small pieces. He insisted that our
deregulation must proceed in the same way. Financial deregulation was
ordered, and the Euroyen market developed very quickly. Unfortunately for
monetarist theory, the yen still did not strengthen.

This was a period when international capital flows were increasing

tremendously and the exchange market became very sensitive to the interest
rate, probably more so than to economic fundamentals. For example, news
of a possible increase in the United States budget deficit, which should be
bad economic news, nevertheless pushed up the value of the dollar. Why?
The market took it as an indication that interest rates would have to remain
firm to finance a larger deficit. That, in my view, was the real distortion in
the market: too much emphasis on interest rates rather than on economic
fundamentals. With these continued high rates and other factors, the dollar
strengthened and eventually hurt the international competitiveness of
American industry. This continued to enlarge the deficit and encourage
protectionism. So there was a growing recognition of the importance of
exchange rates to balance a nation's foreign payments, and this led to policy
measures in the second Reagan administration under Treasury Secretary
James Baker to correct the exchange rate. This, of course, was totally
different from the monetarist approach.

The third element, policy coordination, was not a new concept. But
previous coordination efforts in the late 1970s occurred more or less on an
ad hoc basis as a countermeasure to a crisis. After the failure of the
locomotive strategy in 1979, there was, particularly in the early part of the
1980s, a rather serious miscoordination of the major economies. The United
States on one hand, and Japan and Germany on the other, pursued poorly
coordinated macroeconomic policies. The United

250

BRINGING DOWN SUPERDOJ.LAR

States, in spite of a large deficit, continued a lax fiscal policy, while Japan
and Germany, in spite of large surpluses, maintained stringent fiscal
policies. When it became obvious that this was creating a problem not only
for the United States but for the global economy as a whole, there was a
growing feeling that policy coordination needed to be reactivated in a
systematic manner. Baker and his principal deputy, Richard Dar-man, were
instrumental in formulating and promoting this and proposed utilizing the
Group of Seven as a forum, with economic indicators to track the
effectiveness of policy coordination.

During that period, there were steady and constant efforts originating
mainly in the United States Treasury to promote coordination. But the
objective of the exercise shifted over time. At the Plaza, the focus was
almost entirely on exchange rate policy. But after discovering that a weaker
dollar and a new set of exchange rates did not produce the quick adjustment
in the balance of payments that they desired, they shifted the focus to
macroeconomic policy at the Tokyo summit in May 1986 and then at the
Louvre meeting in February 1987. But even those macroeconomic policy
changes did not produce sufficient and quick enough adjustment in the
balance of payments, so the objective shifted again, from 1988 onward, to
microeconomic policy and the structural reform of such things as Japan's
marketing and distribution systems and America's lack of export
competitiveness and the way its business practices are oriented toward the
short term. In the view of most Japanese, the budget deficit in the United
States was the single most important cause of the external imbalance. This
meant there was hardly any strong inclination on the part of the Japanese to
take the initiative on an expansionary budget policy of their own, especially
when it meant sacrificing reform of our own budget, which politicians, the
finance ministry, and many conservative business leaders felt had too big a
deficit to start with.

The Plaza accord was drawn up against this background. The first initiative
came from the Treasury in June 1985, when Baker visited Tokyo for the
Group of Ten ministers meeting. In a talk with Takeshita, he presented the
idea of a package containing action on exchange rates and macroeconomic
policy. Both were born politicians and superb dealmakers and apparently
discovered quickly the common talent they shared. Bilateral discussion
continued in July in Paris and again in August in Hawaii, and then finally in
mid-September at a meeting of the G-5 deputies in London, where they
reached broad agreement on the frame-

CHANGING FORTUNES

work of this package. It was concentrated on exchange rates, with very little
on the macroeconomic side because no one was willing to initiate a bold
change in his macroeconomic policy. The deputies had great difficulty
agreeing on the communique, especially the section on exchange rates, and
many passages were left blank or with various alternatives for ministers to
decide.

The meeting was set for the Plaza Hotel in New York on Sunday,
September 22, and its existence was originally intended to be secret, as the
G-5 meetings always were. This is a problem for Japan because a cabinet
minister must obtain approval to leave the country from the cabinet, and
even the Parliament when it is in session. Takeshita met with Nakasone, and
the two worked out a special deal for the prime minister to serve as acting
finance minister during his absence. Takeshita then arranged to play golf at
a course near Narita Airport, left his house with his golf shoes and clubs,
and put his suitcase in the trunk of his car. He went to the golf course and
played nine holes, but then, without playing the back nine, he rushed to the
airport and flew to New York on Pan American to avoid being recognized
by Japanese executives, who usually flew Japan Air Lines. He was
accompanied by the Vice Minister for International Affairs, Tomomitsu
Oba. I was already in New York, and I remember giving a luncheon speech
to American businessmen and bankers at the Japan Society just before the
meeting, on Friday, September 20. During the question-and-answer session
there were many questions about exchange rates, and I was almost scared
out of my wits when Joan Spero of American Express asked me: "Don't you
think there should be a Group of Five meeting to do something about
exchange rates?" I don't know whether or not her firm had bought any yen
on that day, but as far as I was concerned, that was a very uncomfortable
situation.

And then, suddenly it was decided that the existence of the meeting should
be made public. The press was told at eleven a.m. Saturday that there would
be an important meeting the next day. The G-5 met on Sunday morning at
eleven o'clock at the Plaza Hotel, and Baker was rather late, because he was
flying in from Chicago and his plane was delayed by fog. Finance ministers
and central bank governors of the G-5 countries attended, each
accompanied by his deputy. From Japan, Takeshita, Satoshi Sumita, the
governor of the Bank of Japan, and Oba were in the meeting room. I was in
an adjacent room with David Mulford of the U.S. Treasury and others. The
meeting did not last too long—about

BRINGING DOWN SUPERDOLLAR

five hours—and when it was over at about four-thirty p.m., there was a
press conference and photo session. It was held in a very small and crowded
room, made terribly hot by the television lights. Everybody was perspiring,
and on the stage, where five finance ministers and five central governors
were crowded together, there was general confusion over who should stand
in the front row. Baker was trying to push Paul Volcker from the rear to the
front, and the chairman of the Federal Reserve Board resisted and tried to
hide, but to the amusement of all he was pushed onstage.

There was a communique, now a very famous one, and although there were
lengthy prescriptions for the domestic policies to be pursued by each
government, I have to confess that there was not much substance in them.
There were virtually no new measures or commitments to fiscal or
monetary policies by anybody. The single most important paragraph was on
exchange rates, and it contained several points of importance. It is worth
examining these points, and others in the background papers that we
received, to show how such meetings turn on very subtle points of language
that can point to very important differences in the policy that is finally
carried out.

First, the communique said that "some further orderly appreciation of the
main non-dollar currencies against the dollar is desired. Ministers and
governors stand ready to cooperate more closely to encourage this when to
do so would be helpful." During the discussion, several changes had been
made, and one of these was the phrase "some further orderly appreciation."
Takeshita proposed deleting the word "some" because he wanted the
message to be clear. But this was not accepted because the deletion might
make the statement too outright.

The word "orderly" did not exist in the first draft. It was inserted on the
strong insistence of the chairman of the Federal Reserve Board. In the
original draft, two alternatives had been proposed for the word "desired":
"wanted" or "justified." Takeshita argued for the communique to use the
word "justified" because, once again, he was seeking language that would
be as strong as possible, but the majority favored staying with the word
"desirable." The deputies could not agree on the last phrase—"when to do
so would be helpful"—so it appeared in brackets when their draft was
presented to the ministers. Again, the Japanese minister wanted to delete it,
but this dilutive phrase remained.

At the meeting itself, an informal paper was distributed by the G-$ deputies.
It was titled "List of Points for Discussion on Intervention."

CHANGING FORTUNES

It stated that "a ten to twelve percent downward adjustment of the dollar
from present levels would be manageable over the near term. Following
such movement, participants would be relieved of the obligation to
intervene." No such figures ever appeared in the communique, but this
shows that the participants had a general idea of what size dollar
depreciation was envisaged. It also said the meeting did "not seek sharp
downward movement" of the dollar. This was parallel with the idea of an
orderly depreciation. The paper stipulated: "it will be desirable to avoid
major distortion in yen/European currency relationships." This made clear
that the entire purpose of the operation was to achieve the dollar's
depreciation, not an overall realignment of exchange rates. But it also said,
"basic strategy is to resist a dollar rise," which meant there was no intention
of forcefully pushing the dollar down by massive intervention. Rather, the
idea was to effect a kind of ratcheting intervention and peg each downward
bounce of the dollar. As to the amount of intervention, the paper envisioned
that up to $18 billion might be necessary for a period of six weeks. The last
interesting point was contained in the final paragraph, which was headed
"Implications for Interest Rates." All that followed this heading was a short,
bracketed phrase: "To be discussed." But there was not much discussion
about interest rates at the meeting. There was no effort to seek a clear
endorsement or agreement on the points raised in the paper. The Germans,
for instance, insisted that they would not take it as an obligation to push
down the dollar by the full 10 to 12 percent. There was broad acquiescence
in their position. Japan was most forthcoming as far as the appreciation of
the non-dollar currencies was concerned. Finance Minister Takeshita made
it clear that he could accept an appreciation of the yen from 10 to 20
percent. As for the United States Treasury, for domestic political reasons it
remained very wary of giving any public impression that United States
exchange rate policy had changed. In the Treasury's prepared press
guidance, there was a question asking whether the Plaza accord represented
a fundamental change in the exchange rate intervention policy. The answer
said, "it does not represent a fundamental change in the U.S. policy of
intervention" and maintained that it was "only a continuation of the 1983
Williamsburg summit agreement on intervention," which of course had
been much more limited and affirmed the importance of concerted action in
the foreign exchange market mainly to counter disorderly market
conditions. In the Plaza communique there was no word about intervention,
nor did the Group of Five publicly say it was setting out

BRINGING DOWN SUPERDOLLAR

to weaken or drive down the dollar. Instead, the communique saw the
operation in terms of "appreciation of the non-dollar currencies" and
certainly not as a depreciation of the dollar.

In hindsight, it is quite interesting that most of the participants at the Plaza

meeting mistakenly thought that the dollar was still potentially strong, and
that chances were that it would rise again. They therefore were not so
confident of the success of the operation. It is my impression that the
Treasury was even trying to hedge against failure; as events unfolded it
became clear that the participants at the meeting could not really read the
market's underlying sentiment very accurately. Paul Volcker was an
exception. He was already worried about the possibility of a steep and
uncontrollable fall of the dollar in the coming months, but that was not the
majority view at that time.

During the first seven days after the Plaza accord, from September 23 to
October 1, the G-5 countries sold $2.7 billion, and Japan intervened the
most heavily with $1.25 billion. Surprisingly the French sold $635 million.
The United States sold $408 million, Germany $247 million, and Britain
$174 million. And at the end of the first week, the Japanese yen had already
appreciated by 11.8 percent, the deutsche mark by 7.8 percent, the French
franc by 7.6 percent, and the pound sterling by 2.9 percent against the
dollar. During the six weeks to the end of October, which was the period to
which the countries had committed themselves, intervention by Group of
Ten countries totaled $10.2 billion, or considerably less than the $18 billion
that had been envisaged. The United States accounted for S3.2 billion;
Japan, S3 billion; Germany, France, and Britain combined, S2 billion, and
the remaining G-10 countries, $2 billion.

There were many explanations why the Plaza operation was successful, but
the most convincing was that the dollar was already overvalued. As a matter
of fact, it had been on a declining trend for half a year. It had reached its
peak against the yen in February at the exchange rate of 263, and stood at
238 the day before the Plaza. So the dollar had already declined more than
10 percent and the speculative bubble had already burst. Another argument
was that interest rate differentials were already narrowing very rapidly from
the huge spreads of the first half of the decade. Real long-term dollar
interest rates hit a peak of about 10 percent in the middle of 1984 and
declined steadily thereafter to as low as 3.5 percent at the end of 1986. By
contrast, the real long-term rate of the yen stayed around 5 percent during
1985 and even rose somewhat

CHANGING FORTUNES

in 1986, and deutsche mark rates showed a similar trend. That meant the
interest rate differential between the dollar and non-dollar currencies
narrowed very rapidly after the latter half of 1984, and became almost
negative in the middle of 1986. So it was quite obvious that if the
authorities set out to do so, the dollar could be weakened very rapidly. The
Plaza agreement clearly forced a change in market perception by giving a
very strong announcement. The market read a clear change in United States
policy toward its currency and was also very much impressed by the
demonstration of a concerted effort of the Group of Five.

Not everyone shared this assessment. Those who had always favored
nonintervention in the foreign exchange market argued that the agreement
was unnecessary or even harmful because it triggered a very sharp fall of
the dollar in the following month. But in fact the majority view was that the
dollar was still very strong and could rebound at any moment. What the
Plaza accord did was to deliver a coup de grace similar to that of the dollar
defense package in October 1978. It also was a very successful political
show and gave the market a very strong impression of the real clout of the
G-5. But in doing so, it also put an end to the Group of Five. Until that day,
it had been a secret organization. Nobody outside a very tight official circle
knew exactly where and when the five ministers met, what they discussed,
and what they agreed. This was the first time a G-5 meeting was announced
in advance and a communique was issued afterward. This of course
immediately triggered demands for membership from Italy and Canada, and
then other countries as well. Eventually the G-5, if not exacdy superseded,
was overlapped by the G-7 finance ministers and summits, and its
traditional function of private and informal exchange was very much
weakened.

As the dollar continued to fall, we started to feel a backlash because the

external imbalances got worse rather than better. In Japan, this generated a
difficult domestic political situation. Within about half a year, about March
of 1986, arguments were raging in Japan that the Plaza accord had been a
mistake or even a failure, because it had started an unstoppable,
uncontrollable fall of the dollar, or in other words, an uncontrollable rise of
the yen. Export industries, particularly the small and medium-sized firms,
started to complain about the rapid appreciation of the yen, because it
became increasingly difficult for them to do business. This soon translated
into very complex infighting within the ruling Liberal Democratic party.
Prime Minister Nakasone and Finance Minister Takeshita, who were
considered the Plaza's major architects,

BRINGING DOWN SUPERDOLLAR

came under very severe attack from their own colleagues within the party.
Kiichi Miyazawa, who became finance minister in July of that year, was
one of the critics against the government's inability to cope with the
appreciation of the yen, and Nakasone and Takeshita sent letters to Reagan
and Baker asking their help in stopping further appreciation of the yen. But
they politely declined and reported that protectionism in Congress was so
strong that without some tangible improvement in the external balance, the
administration could not shift its exchange rate policy again.

The exchange rate was discussed with the Americans at the Tokyo summit
in May of 1986, to no avail. The dollar continued declining to 171 at the
end of May, 165 in June, and 154 in July. Domestic political criticism
mounted even as parliamentary elections approached in early July. Right
after the summit meeting, I told Prime Minister Nakasone I thought that the
market was still not convinced the dollar had fallen sufficiently, and that we
had better wait, let the dollar slide somewhat more, and then hit the market
with a massive, surprise intervention. Nakasone sounded very
understanding and said, "I know you experts know much better than I do
about the exchange rate." But then he added, "You have to restore it to one
hundred and seventy yen before the election." So we intervened but with
not much success. Then the United States began talking down the dollar,
although Baker tried to help at one point when he told Congress that the
dollar's fall had already offset its previous rise against the yen. That had at
least a temporary impact on the market. But in the meanwhile, although the
strong yen, or endaka, increasingly obsessed the politicians, the bureaucrats,
and the mass media, business was quickly adjusting and once again focused
not on the level of the yen but on obtaining some measure of stability and
predictability about the exchange rate.

For me, it was quite a frustrating situation knowing that business and the
public were not really worried about the yen, but the opinion-forming
classes were still going on with their usual fuss, just as they had in 1971. I
felt rather dismal about this, because it showed Japan's allergy to the endaka
had not changed between 1971 and 1986. In the election of July 6, the
Liberal Democratic party won a landslide victory despite severe criticism of
the strong yen. I think I was right in assessing public sentiment as less
concerned about the rise of the yen, but the debate persisted nevertheless.
Probably only late in 1986 did the hysteria start to abate as a growing
number of people in government finally began to

CHANGING FORTUNES

realize that a stronger yen was proving a greater benefit than a disadvantage
to the Japanese economy in lower import prices, more consumer
satisfaction, investment opportunities abroad, and a stronger incentive for
business rationalization. The change came rather dramatically in the
autumn, but it had been a slow process for all sectors, including politicians
and mass media, to realize these benefits of a strong currency.

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LOUVRE

PAUL VOLCKER

OVERVIEW

By the beginning of 1986, the organized effort to realign currency values

that took place at the Plaza in the previous autumn had run its course. The
dollar had depreciated by an average of 25 percent from its peak a year
earlier. Coordinated international efforts to encourage depreciation through
intervention in currency markets or otherwise had ceased.

What had not ended were the attempts of the leading industrial powers to
achieve better policy coordination. Nor did the end of the Plaza
understandings mean that the dollar had stabilized in the exchange markets,
although changes would not be nearly so sharp.

In 1986, attention focused on the need to sustain the upward momentum in

the world economy. The strong forward thrust of the American economy
had been the main expansionary force for several years, but it subsided in
1985. Growth in both Japan and Germany remained sluggish, with high
levels of unemployment almost throughout Europe. Despite the decline in
the dollar, the huge American trade and current account deficits continued
to rise into 1986.

The logic of the situation seemed clear to American policymakers:

CHANGING FORTUNES

more expansionary policies by our principal trading partners, in their own

interest as well as that of better balance in international trading patterns and
currency markets. That point was pressed in a series of meetings and a
variety of forums—at the G-5 and the interim committee of the IMF, at the
Tokyo summit in May, at the central bankers' meetings in Basel, and toward
the end of the year particularly, in bilateral Japanese-United States meetings
(promptly christened the G-2). All that was paralleled by renewed interest
in the question of international monetary reform, particularly on the part of
the Baker-Darman team at the United States Treasury.

Through all of that effort, fiscal policy in the United States remained frozen.
It was largely the central banks that achieved what limited coordination
there was. At critical points it might have helped prevent more precipitous
declines in the value of the dollar. That was a sensitive matter partly
because, to the concern of America's trading partners and the discomfort of
its own central bank, the secretary of the Treasury at times seemed to be
inviting further dollar depreciation. Whether that reflected frustration over
the inability or unwillingness of Germany and Japan to take more
aggressive expansionary action, or was an aggressive means of attempting
to force such a response, was never really clear to me. In any case, by the
middle of 1986 and early in 1987, the limits to this approach seemed
increasingly evident.
The growing common interest in greater exchange market stability was
dramatically manifested at the G-5 meeting of finance ministers at the
Louvre Palace in Paris in February of 1987. The understandings reached
there set rather precise ranges around agreed but never publicly
acknowledged exchange rate levels between the dollar and other G-5
currencies; those ranges would be "defended" by intervention and
potentially by other measures. It was all very much in line with ideas about
target zones or reference ranges that had long been discussed unofficially
and promoted by a few governments. Until the Baker Treasury, however,
those ideas had been anathema to the Reagan administration and to U.S.
administrations during most of the 1970s as well.

The agreed ranges needed to be adjusted, first with respect to the yen, and
more generally after the stock market crash in October of 1987. By the end
of the decade, with a new American administration and Treasury, the
interest in monetary reform and in coordinated exchange rate management
seemed to have faded once again amid the distraction of the Mideast War
and concern about recession.

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One thing that had become unmistakably evident in the closing years of the
1980s will not fade away. Just two decades after it had first been invited to
join the OECD and the G-10 as an emerging industrial force, Japan had
plainly become a dominant performer on the playing field of international
monetary affairs. Its key financial position was undergirded by the
competitive strength of its industry and its propensity to save even more
than required to meet the large investment programs of its own industry.
The combination of that industrial strength and high savings rate was
reflected in enormous trade surpluses with both the United States and (to a
somewhat lesser extent) Europe, even in the face of a strongly appreciated
yen. The mirror image of the Japanese current account surpluses has been a
flood of Japanese money reaching world capital markets. The need for
capital was particularly marked in the United States, which, after years of
economic expansion, was still running record budget deficits amounting to
$200 billion or more a year.
Toward the end of the 1980s Japanese banks, insurance companies, and
industrial firms had become prime sources for financing our budget deficit,
our booming market for commercial real estate, and even our industrial
investment. At one point, between 1987 and 1989, the United States
actually drew upon a larger amount of savings from abroad than the total
amount of personal savings generated by Americans themselves. That
dependence on foreign capital, and what it meant in terms of the loss of
economic power, was driven into the American psyche by the Japanese
purchase of cultural icons ranging all the way from Rockefeller Center in
New York to motion picture studios in Los Angeles. As this is being
written, there is a Japanese bid for that most American of all institutions, a
major-league baseball franchise, which like too many American enterprises
is under financial stress.

As the last decade of the century began, exchange rates, while still volatile,
seemed to have settled down from the extreme fluctuations of the mid-
1980s. Apart from the huge Japanese surpluses, trade flows seemed better
balanced than for some years, and there were encouraging signs that much
of Latin America was emerging from a lost decade dominated by the
pressures of debt. But it was equally clear that enormous challenges and
uncertainties lay ahead in the management of the world economy, and they
would need to be dealt with before the promise of a New World Order could
be realized.

CHAN G I N G FORTUNE S

TOYOO GYOHTEN

1 he economic summit was held in Tokyo in Man of 1986, 2nd it marked a

significant advance in the effort to coordinate economic policy. The Group
of Seven finance ministers was formally created, and the coordination
process was focused bevond exchange rates and the balance of pavments
toward an international dimension in achieving such obj aves as growth and
emplovment that traditionally had been considered targets purely for
domestic policy. Economic indicators were introduced and accepted, and
there were some efforts, particularly from the American side, to introduce a
certain amount of automaticitv in this policy coordination—targets would
be set. and if actual economic performance deviated significantly, a
government would have to act to trv to meet its goals of growth, inflation,
or whatever.

Thus began for us a trving period, during which we made sec efforts at
coordinating policies among ourselves in order to attack the manv problems
surrounding us. We tried to arrest the fall of the dollar and stabilize the
exchange rate, and to aenvate fiscal and moneta: in surplus countries in
order to reduce their intractable balance of payments disequilibna and resist
protectionism. We also tried to establish a more institutionalized mechanism
to coordinate policies among the G-7 countries. This involved heavy
bilateral bargaining and some political animosity between the United States
and Japan, and the Unite: s : and Germany, and at times the pi cess was
more political than economic. One of our most fundamental problems was
the tame lag between putting a policy into effect and seeing the results. This
delay generated difficult political problems because the political clock
generally ticks more urgently than the economic clock, but meanwhile
economic events generally have strong political reper. nod of proposals,
counterproposals, and compromises among countries no exception. In the
negotiations over who would adopt what policy, for example, the United
States askedjapan and Germany to cut taxes and reduce interest rates in
order to stimulate domestic demand. Japan and Germany asked the United
States to cut its budget deficit as a step to reducing its trade deficit. In most
ca se was no reached, and even when officials managed to do so, political
complications often delayed or diluted its actual implementation.
Nevertheless, the value of the experience wall not be lost, and what
happened arter-

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ward demonstrated the need to build on what we learned. The marked

improvement in the international imbalances from 1988 to 1990 was one of
the results of our efforts to coordinate our policies.

But the episodes of those years left many lessons. The initiative taken by
the United States to institutionalize coordination and align exchange rates
was a very positive and an almost historic step. But at the same time the
process was dominated too heavily by American efforts to make a political
deal rather than to reach an economically viable conclusion. From the
Japanese and German viewpoints, the whole process was frustrating
because we thought that the United States was trying to gain political
concessions from the surplus countries of Japan and Germany by using the
threat of talking down the dollar and the threat of protectionism, knowing
that both could really damage the economies of the surplus countries. This
was in stark contrast to the economic situation under the Bretton Woods
system, when the world order was supported by a credible dollar and an
open market. Instead, the credible dollar and the open market were
transformed into threats. As a result the surplus countries were obsessed by
a deep suspicion that in introducing policy coordination and exchange rate
management, the United States was trying to impose upon them a system
that would benefit only itself. Our response therefore was defensive and
displayed a lack of willingness to contribute positively to the global
economic benefit. In other words, regrettably, there was a serious lack of
mutual trust among the three major countries.

The most immediate problem was what to do about the dollar. Although its
effective exchange rate did in fact drop in the two years following the Plaza
meeting, just as the accord had envisioned, this steady devaluation did not
appear to correct the imbalances in the world's payments. The United States
deficit and Japanese surplus both continued to rise for a time, and to make
the situation worse, the Japanese economy began slowing down. This was
due in part to the normal business cycle but also to the very sharp rise in the
value of the yen, which impeded Japan's export industries. Japan's industrial
production stood below the previous year's level through the last nine
months of 1986, and early in 1987 the unemployment rate exceeded 3
percent, which is very high by Japanese standards.

In 1986, Kiichi Miyazawa was appointed finance minister. He had been a

strong critic of the sharp rise of the yen under his predecessor, Noburu
Takeshita, and Prime Minister Yasuhiro Nakasone. This criti-

CHANGING FORTUNES

cism put him on the spot to achieve something to advance his own political
career. The United States Treasury, which was put in an increasingly
difficult situation by the continuing trade deficit and mounting pressure for
trade protection, tried to talk down the dollar. This raised concern at the
Federal Reserve, which feared that a weaker dollar would bring more
inflation. So the Treasury, faced by the Fed's criticism and the refusal of
Germany and Japan to reflate their economies, organized direct
international negotiations.

Miyazawa preferred a top-down process of decision making, in contrast to

his predecessors, who had depended on developing consensus from the
bottom up to gain the support of their bureaucratic subordinates. When
Baker planned a secret trip to Japan for talks with Nakasone and Miyazawa,
they thought they might do a deal without letting the bureaucrats know
what they were cooking up. This turned out to be unrealistic. Baker
telephoned Mike Mansfield, the U.S. ambassador in Tokyo, to set up a
meeting late in August, but as soon as the bureaucracy learned about it
several days later, the story leaked out and the meeting collapsed.

Then we arranged for the two finance ministers to meet in San Francisco on
September 6, and we made stringent efforts to keep it secret. We were not
sure that we could reach an agreement and we feared that prior publicity
would simply exacerbate speculation in the market. I managed to leave the
country secretly and met in Paris with David Mulford, the Treasury's
assistant secretary for international affairs. We took Concorde together from
Paris to New York and changed planes to cross the continent; both of us
were tired, and fortunately the plane was empty, so we stretched out across
the seats and slept through the flight. It was not so lucky for Miyazawa. He
managed to leave the country unnoticed, but the horrified press soon
discovered that he had given them the slip and flown to San Francisco,
although they did not know where he was staying. One desperate Japanese
reporter ordered a bouquet of flowers with a card addressed to Miyazawa
sent to all the city's major hotels, but his broadside never hit its target,
thanks to our clever consul general in San Francisco. He suspected what
would happen, so he deliberately picked out a very nice, small, and not too
well known hotel, the Majestic.

The meeting itself was held at the penthouse of the Fairmont, which had the
advantage of a private elevator. On the table there was a package that
included a Japanese fiscal stimulus of 3 trillion yen, including some

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tax cuts; the United States was to agree to stop talking down the dollar and
would support this by issuing Treasury bonds denominated in yen.
Miyazawa was anxious to establish close ties with Baker, and I think Baker
himself wanted to create a strong bilateral relationship, particularly with
Miyazawa. With his proficiency in English and vast knowledge of
economics, Miyazawa was the first Japanese finance minister who could
speak to his Treasury counterpart with no help whatsoever from an
interpreter. Baker looked quite surprised when Miyazawa used the
notorious phrase "voodoo economics."

They were nevertheless unable to agree at the San Francisco meeting,

although they tried to set a deadline of tying up the package before the U.S.
congressional elections in November. They also hoped that if they could
come to a deal on exchange rates and macroeconomic policies, this would
put strong pressure on Germany and eventually the rest of the Ci-7
countries for an agreement coordinating the economic policy of all seven.
The following two months were spent preparing a communique with terms
of a formal agreement, and it was an irritating period. There was strong
objection in the Ministry of Finance to implementing any substantive fiscal
measures. The Bank of Japan at first was reluctant to cut interest rates. Both
withheld substantive proposals from the draft communique; in other words,
Miyazawa was being undercut by the central bank and his own bureaucracy.
Gradually he gained influence over them, but it was a very- grueling time
for him, politically and diplomatically, before he could demonstrate to
Baker and to his own domestic constituency that he could master his own
territory and deliver the goods, which he finally did after the Louvre
meeting that winter with a stimulus package.

It took two full months to reach agreement on the first package that had
been proposed at San Francisco. On October 31, the communique was
finally released. The Bank of Japan cut its discount rate from 3.5 percent to
3 percent. A week before, the Japanese government had submitted a
supplementary budget to spend 3.6 trillion yen, mosdy on public works. It
was essentially cosmetic because much of the money was in the process of
being spent anyway. The government also indicated it planned to cut taxes
but made no firm commitment. It also stated that the rate for the yen against
the dollar was moving in line with economic fundamentals, which was
important because no such statement had ever been issued before. Reactions
were mixed, and some said the only decision of substance was the Bank of
Japan's cut in the discount

CHANGING FORTUNES

rate. Although there was no firm commitment by either country to support

the exchange rate, the market reacted favorably and the rate stabilized for
the rest of the year.

Throughout the year, Japan strongly resisted fiscal expansion because it felt
that its fiscal position had deteriorated steadily since it took the coordinated
expansionist measures agreed at the Bonn summit of 1978. By 1985 the
national government deficit reached almost 22 percent of the budget. The
total outstanding public debt was equivalent to 42 percent of GNP. These
figures were among the highest of the G-j countries. Although the
government had attempted to eliminate deficit financing of current spending
by 1984, it could not reach its target until 1990.

A strong theoretical argument against expansion also was launched by the

Japanese Economic Planning Agency. Using its World Link model, it
reckoned that if the United States cut spending by one percentage point of
GNP, that would improve its trade balance by one quarter to one third of a
percent of GNP, whereas if Japan expanded its GNP by one percentage
point through the same method, it would help reduce the U.S. trade deficit
by only two to three hundredths of a percentage point. Instead of Japan
expanding, which the agency argued would have virtually no effect on the
U.S. deficit, the proper course therefore was for the United States to throttle
back on expansion by cutting its fiscal deficit. Fiscal stringency is not a
popular policy in any country, but the Planning Agency's argument only
reinforced a strong desire to improve Japan's fiscal situation among our
politicians and among some business leaders who feared that delay would
only increase both the eventual tax increase and the level of inflation that
would have to be brought under control. Nakasone was a strong supporter
of fiscal reform, which was, of course, led by the Finance Ministry. So
Japan stubbornly resisted fiscal expansion, while in Washington the
Planning Agency's argument was, of course, ignored.
Nevertheless, I believe the October agreement between Baker and
Miyazawa did have some impact on other G-7 member countries; they
finally agreed to meet in February at the wing of the Louvre Palace in Paris
that then housed the French Finance Ministry, across from the famous art
museum. Deputies of the finance ministers prepared extensively for the
meeting. The principal issues were the new macro-economic policies that
might be developed to reduce international imbalances, the extent to which
we could accommodate the U.S. wish

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to formalize the mechanism for coordinating our policies, and what

common position we should all adopt on the exchange rate.

After the meeting, the communique for the first time admitted that U.S.
foreign imbalances could not continue. Based on that recognition, they
acknowledged the need to change the balance between savings and
investment in both surplus and deficit countries—which translated as more
government spending in Japan and a lower budget deficit in the United
States. They also agreed on a new mechanism of surveillance, which meant
that each country would make a medium-term projection, and economic
indicators would be used to monitor whether it was on track. These
indicators included, among others, growth, inflation, interest rates, and the
balance of payments. If they showed a country's economy was heading off
the track to the target, all agreed they would then discuss their individual
situation with the rest of the G-j.

Germany committed itself to increase a tax cut already proposed for 1988
but did not say by how much. The Bank of Japan again cut the discount
rate, this time from 3 percent to 2.5 percent. But the communique contained
a rather obvious contradiction. On one hand, it endorsed the exchange rates
then prevailing as broadly in line with economic fundamentals. But at the
same time, the Seven recognized that their external payments were badly
out of balance and conceded that this imbalance was unsustainable. But if a
payments situation is unsustainable, the exchange rate cannot really be in
line with economic fundamentals. The only way these mutually
contradictory statements could be reconciled would be for each country to
take the steps it promised, and this would bring its economic fundamentals
in line with the existing exchange rate regime. This was indeed a very
hopeful interpretation.

On the exchange rates themselves, although it was not spelled out in the
communique, the Seven tried to devise something now called a target zone.
In the original draft worked out by the deputies, the Seven would have
committed themselves to "seek to maintain exchange rates within agreed
ranges until the next meeting in early April." At the Louvre meeting itself,
they would agree only to "seek to maintain exchange rates around current
levels for the time being." The commitment was watered down because all
agreed that too specific a public commitment on our exchange rates might
provide too tempting a target for speculators. But even though negotiations
had diluted the original, the fact remained that the Seven talked about
arrangements to try to contain the exchange rate fluctuations in a certain
range around the

CHANGING FORTUNES

current level. On that day, the yen was at 153.50 to the dollar, the deutsche
mark at 1.825. What they broadly agreed was to try to maintain the
exchange rate within a 5 percent band—2.5 percent on either side. If the
rate went beyond that, countries were expected to launch concerted market
intervention, and if the market rate diverged by 5 percent in either direction,
we would consult on the possibility of changing the range. To defend the
rates, the Seven pledged that a total of $12 billion would be made available
until the next meeting in the spring.

But although all this was discussed at the Louvre, there was no clear and
firm agreement, and no paper indicating the figures by precise percentages.
The exchange rate discussion took place over dinner, while all the
participants were quite busy cutting their meat and sipping their wine. No
effort was made to formalize the agreement and obtain firm commitments
to the figures from the finance ministers. That left a rather ambiguous,
blurred agreement. The Germans felt they had made no clear commitment,
and while the Japanese were quite willing to stop the rise of the yen, they
were quite reluctant to support it from falling. I think nevertheless there was
a broad consensus that they would intervene to try to stabilize the exchange
rate and maintain the broad targets.
All this may help explain why the target rates were never published or even
officially confirmed by governments, even after the market guessed them
fairly accurately. In any event, they were soon overwhelmed by the market,
and the dollar kept falling. By the end of March the yen rose to 145, and by
the end of April 1987 it had risen farther to 138. There was considerable
disappointment that the Louvre agreement did not work as envisioned to
halt the dollar's fall, and one of its principal architects, Richard Darman, left
the administration in April. Paul Volcker left the Federal Reserve in August.

The period following the Louvre was frustrating as instability increased in

the market. To the news media it seemed evident that policy coordination
was not working. The rift deepened between the United States and
Germany on monetary policy, with Secretary Baker repeatedly goading the
German authorities to loosen, which they declined to do. Finally the
markets revolted, and stock prices collapsed on Wall Street and throughout
the world on October 19, Black Monday. The crash drew forth a multitude
of explanations, but I am convinced that one fundamental cause was the
failure to achieve real results in coordinating the macroeconomic policies of
the seven major economic powers. In August of that year, the United States
Congress had amended the

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Graham-Rudman-Hollings Act to postpone the target year for balancing the

federal budget from 1991 to 1993. The budget deficit was actually
declining, but it was improving far more slowly than the market hoped. The
external accounts of the United States, Japan, and Germany did not improve
at all, and the American external deficit even increased in 1987.

After Black Monday, the G-7 countries again tried to save the situation, but
they dared not call a meeting for fear that if it failed to produce anything
tangible the market might collapse again. So we decided to issue a
communique without a meeting. It was called the Christmas Communique
because it was issued on December 23. It contained little substance except a
sentence declaring that any further decline of the dollar would be
counterproductive. This was a new and stabilizing phrase, essentially a
change in emphasis from the Plaza's original objective of weakening the
dollar and the Louvre's declaration that rates were in alignment with
fundamentals.

This marked the end of a somewhat confused three-year process, the results
of which were not very satisfactory, at least at that time, because all our
efforts in aligning exchange rates and coordinating macroeco-nomic policy
had failed to produce tangible, clear results. The external imbalances among
major countries—especially the Japanese trade surplus and the American
deficit, the two-sided political irritant that had started the whole exercise—
did not improve despite the major changes in exchange rate relationships.
One important reason was the J-curve, which moves the trade balance
perversely downward in the shape of a J during an initial period after a
devaluation because prices in a country's foreign trade have changed but the
quantities of imports and exports have not yet reacted to the new price
structure. In other words, the fall of the dollar at first increased the United
States deficit instead of reducing it. And since the exchange rate continued
to change month after month, as happened in 1986 and 1987, the effects of
this J-curve simply accumulated because the dollar never paused long
enough for the accounts to show any improvement. Furthermore, the actual
change in the dollar's real effective exchange rate might not have been as
large as believed. The dollar's nominal rate against the yen depreciated
about 41 percent in the two years following the Plaza. But the dollar's real
rate, which is weighted by its foreign trade flows around the world,
declined by only 32 percent, about three quarters of the nominal change,
because many developing countries simply pegged their currencies to the
dollar. And

CHANGING FORTUNES

in domestic policy, the budget deficit declined much less slowly than
foreseen, and the household savings ratio actually declined, implying that
consumption sucked in imports unchecked.

Another explanation is what economists call hysteresis. The strong dollar

earlier in the 1980s caused fundamental changes in the import patterns
affecting U.S. industry, and these changes could not be reversed quickly,
even after the dollar started to weaken. The same could be said of the
Japanese side: The very weak yen in the first half of the 1980s brought a
fundamental change in the orientation of Japanese industry toward
increased exports, which could not be reversed even after the yen started to
rise. This phenomenon is known as hysteresis. Although there is not yet
enough empirical evidence to support the analysis, it is plausible that there
is a considerable time lag between a shift in the exchange rate and industry's
response to it.

Policy coordination went through several stages. At the Tokyo summit

meeting in May 1986, there was a basic agreement on how coordination
should be carried out. At the Louvre in February 1987, a more
institutionalized framework was agreed, and at the Venice summit meeting
in May 1987, the political leaders of the G-7 countries endorsed the
framework. But although there was certainly progress in building this
mechanism, there were constant disputes about how to operate it, and they
were always focused on two issues: how automatically countries would
agree to accept the surveillance that meant yielding sovereignty over their
economic decision making, and a serious asymmetry between surplus and
deficit countries, with each side deeply suspicious of the other. But even
though the surveillance mechanism itself is not working fully, we do have
one single important achievement. That is the very much intensified, frank,
and informal dialogues among policymakers of the G-7 countries at which
peer pressure certainly influences their policies.

There are four conditions necessary for successful policy coordination. The
first is a close and interdependent relationship among the participant
countries. The second is a common understanding that the coordination of
certain macroeconomic policies will yield agreed results. Third, the process
for coordination must be established and maintained. And finally, there
must be a strong recognition among participants that coordination will bring
greater benefit to all of them than if they had done nothing. In other words,
everybody has to agree that policy coordination will not be a zero-sum
game in which one participant benefits

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at the expense of others. During this period of the late 1980s, I have to
admit that only the first of these four conditions existed, and the other three
remained to be achieved.
After the Louvre agreement, Japan became less reluctant to take
expansionary fiscal measures and began to realize the importance of a
macroeconomic policy shift. In addition to setting the discount rate at a
historic low of 2.5 percent, the government announced a fiscal stimulus
package of 6 billion yen. The actual stimulus was not great because
economic expansion simultaneously increased tax revenues, but it exerted a
strong psychological impact on the Japanese economy. Growth was
stimulated to 4.9 percent in 1987, compared to 2.6 percent in 1986. More
important, domestic demand contributed 6 percent of the increase, and the
foreign account actually represented a drag of 1 percent. So the Japanese
growth pattern clearly shifted from being led by exports to being led by
domestic demand.

The Japanese policymaking process certainly was very much influenced by

the external pressures mounted in the coordination exercise. Indeed, such
pressure is so often used by the Japanese themselves as a pretext for taking
action that we even have a word for it, gaiatsu. But just because it happens
that the Japanese political system can move more quickly under external
political pressure, this does not mean the United States should have
attempted to take advantage of the situation and concentrate its efforts to
maximize that kind of pressure on Japan.

Most of the measures that Japan put in place under the pressure of gaiatsu
turned out to be beneficial for us, whether they were expansionary policies
or deregulation of various sectors of the economy. In that sense, Japan
cannot complain about what happened. But I am forced to argue that the
pattern of policymaking did corrupt the fundamental, long-term relationship
between Japan and the United States. On the Japanese side, the
policymakers, both politicians and bureaucrats, acquired the habit of
abusing gaiatsu; they used foreign pressure to implement difficult but
inevitable reforms, without at the same time making the difficult and
essential effort to create a positive willingness in the country to accept what
was often a bitter pill of economic reform. On the American side,
policymakers came to believe that the best and only way to deal with Japan
was to apply pressure; they used the blackmail of dollar depreciation and
the threat of protectionism, while ignoring that part of the problem resided
in the failure of the United States to do what it was supposed to do to
correct its own fiscal excesses. This

CHANGING FORTUNES

frequent recourse to gaiatsu has unfortunately contaminated the national

psychology in both countries. Instead of creating mutual trust and
willingness to cooperate, it has generated an ugly mood of frustration and
distrust.

I have no intention of painting a totally bleak picture of policy coordination,

because I can testify that the negotiators of the participating countries made
a sincere and genuine effort to achieve tangible results, which they believed
would benefit the world economy. And in fact they did achieve many
successes. But policy coordination can be ensured lasting success only
when the United States and Japan mutually recognize the global importance
of their own domestic policies and start their efforts at home.

PAUL VOLCKER

1 he further efforts toward coordination that resumed in 1986 were no doubt

encouraged by the seeming success of the Plaza agreement in achieving a
substantial depreciation of the dollar without adverse effects on interest
rates or a psychological sense of a free-fall of the dollar. From the
American point of view, there was still a great deal to do. The American
recovery had progressively slowed after the first two years of vigorous
expansion. At the same time, the Japanese and even more clearly the
European economies had not shown much life, with unemployment in
Europe still averaging about 10 percent after several years of tepid
expansion. If the huge American trade deficit were to decline and the dollar
were to stabilize, then it would be important for Europe and Japan to
expand domestically rather than rely on external stimulus derived from the
strong American demand for their goods.

As part of that process, I urged the leaders of the Japanese and German
central banks as strongly as I could at our meetings in Basel and elsewhere
to take the initiative in easing monetary policy. The Germans were
particularly reluctant, as were the Europeans generally. In the
circumstances, I thought it entirely inappropriate for the United States to
move unilaterally, if at all. That is where things stood at the time of the
short G-5 meeting in London in late January of 1986.

Looking back on it, that rather brief meeting was notable not because there
was a lot of discussion of monetary policy but because there

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was very little of it. In a communique proposed by the U.S. Treasury, the
significance of which I might have underestimated at the time, there was an
effort to include a few words about monetary policy that, to my sensitive
ears at least, suggested that monetary policy should or would be eased. The
wording was rejected by Karl Otto Pohl of the Bundesbank as well as
myself because we felt it would only encourage unwanted speculation. We
ended up with yet another motherhood statement in favor of expansion and
stability.

Pohl and I, two veterans of the G-5 process, would have strongly preferred
reverting to the practice of no communique at all unless there was indeed
something important to announce. But whatever the reservations of central
bankers, after the publicity and seeming glory surrounding the Plaza
agreement, there would be no turning back from the practice of issuing a
communique after every G-5 meeting. That seems to me to have taken away
some useful flexibility in scheduling meetings; it also sometimes leads to
excessive expectations. One problem from the standpoint of independent
central banks clearly was that an assemblage of finance ministers would be
tempted to use these occasions to bring pressure on their central banking
colleagues in an effort to meet what they saw as their political requirement
to say something encouraging, particularly when they had little else to offer.
But at least within my experience, the finance ministers never really pressed
decisions or commitments on central banks that seemed inappropriate to the
central bankers themselves.

Central bankers tend to resist reaching decisions on monetary policy at

ministerial meetings whose time and place are set by others and which may
be politically motivated. This resistance has sometimes been interpreted as
resistance to the whole idea of international coordination of economic
policy decisions by them and others. In my experience, that suspicion is
unjustified. I do not suggest that central bankers themselves have
consistently been able to achieve the kind of coordinated and
complementary action that ideally would be desirable. That inability is
demonstrable even within the European Monetary System, where mutual
dependence is much greater than among Europe, Japan, and the United
States. One of the difficulties, apparent within Europe as well as outside, is
that gross misalignments in fiscal policy cannot be corrected by monetary
policy, a situation that prevailed in mid-1992, when divergent monetary and
fiscal policies forced the realignment of European exchange rates that had
been fixed within the System for almost half a decade. Misalignment of
policies was certainly a principal source of

CHANGING FORTUNES

difficulty in the 1980s when the United States persisted in running

inappropriately large deficits. But it nevertheless seems to me demonstrable
that monetary policy has from time to time been able to achieve a degree of
useful coordination. Early 1986 was a case in point.

I had resisted easing monetary policy through the fall of 1985 in the midst
of the sharp dollar depreciation. Within the Federal Reserve system, the
debate about whether to ease had subsided early in 1986 when the economy
looked a little stronger, but the composition of the Federal Reserve Board
had also changed significantly with two new Reagan administration
appointees. While only one or two Reserve banks were any longer initiating
requests to reduce the discount rate, much to my surprise and for motives I
still do not fully comprehend, a sudden vote was forced in the board to
approve such a reduction by a four-to-three majority on February 24, 1986.
A unilateral cut at that time was entirely unacceptable to me; if the Federal
Reserve was to reduce interest rates at all, my plain preference was that the
lead should come from Germany and Japan to provide some assurance
against weakening of the dollar. The board vote was reconsidered that same
day on the understanding that coordinated discount rate cuts would be
preferable if they could in fact be achieved in a limited time. On that basis, I
initiated further discussions with my colleagues at the Bundesbank and the
Bank of Japan, reaching agreement that the Bundesbank would initiate
action at its next regular council meeting in early March, followed almost
immediately by the Bank of Japan, which had already reduced its rate in
January, and by the Federal Reserve.

The exchange market, as hoped, took the action in stride without

depreciating the dollar, and the success in coordinating policy was soured
only a little by the Treasury's claim to credit. With economic expansion
remaining sluggish, and particularly with the inflation rate dropping away
in the face of sharply lower oil prices, the Federal Reserve subsequently cut
its discount rate twice through the spring and summer, the first time
coordinated with Japan and thereafter alone.

Those partly coordinated moves on monetary policy could not, however,

deal at all adequately with the problem that continued to preoccupy all of us
on the American side. The period when a strong domestic expansion in the
United States could carry the world economy clearly seemed over. No
longer could others look to an expansion in American imports to transmit
our prosperity abroad. Japan and Europe would have to rely instead on
homemade expansionary forces. If carried

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out with vigor, the result ought to be more exports from the United States, a
reduction in our enormous trade deficit, and less pressure on the dollar.

I recall on more than one occasion traveling to the monthly Basel meetings
armed with relevant statistics to demonstrate these points; I urged my
central banking colleagues to act more aggressively. To me, it was a time of
opportunity but also of great concern. Our own inflation rate dropped to
little more than i percent in 1986 as the oil price collapsed, something that
hadn't been seen for twenty years or more. The depreciation of the dollar
didn't seem to have as great an impact on import and domestic prices as I
had anticipated. All of that made possible the easing of monetary policy
through the summer. But without more expansionary action abroad, I was
afraid the momentum of world expansion would falter, that the trade and
current account would remain in deep deficit, and that the dollar would
eventually and unnecessarily weaken further.
Much of the concept underlying that analysis was accepted by our trading
partners. That was the time when Haruo Mayekawa, the widely respected
retired governor of the Bank of Japan known in the West by his nickname,
Mike, wrote a report calling for a basic reorientation of Japanese economic
policy toward growth generated by internal demand. The Mayekawa report,
which was widely read, emphasized the opportunity to meet Japan's sizable
social and infrastructure needs. He argued that the huge trade surpluses
justified a large increase in domestic demand and reduction in formal and
informal barriers to imports. His broad conclusions are as relevant today as
they were five years ago. But it also remains true that translation of those
concepts into reality is a slow and frustrating process.

Both Germany and Japan had worked hard to achieve budgetary discipline
and a high degree of price stability during the mid-1980s, and they had no
intention of jeopardizing either of those policy accomplishments for what
must have seemed more abstract international advantages. Both took a more
optimistic view of their own economic prospects than we did, and they no
doubt looked at the American demands as an effort to shift the burden of
adjustment onto them and away from the clear need for the United States to
consider the beam in its own eye instead of the mote in its neighbors'.

Toyoo Gyohten speaks more authoritatively to those views, and I could only
sympathize with the frustration of our partners over our

CHANGING FORTUNES

inability to deal with our budget deficits. But more generally, the different
perceptions in 1986 were symptoms of a fundamental problem in
coordinating international policies. Different countries inevitably view the
world through different lenses, colored by different cultures, experiences,
methods of governance, and priorities. There is no conclusive, objective
way of resolving the differences that always emerge in analysis and
judgment. Even men of goodwill from friendly countries find it difficult to
reconcile their views, and when the need for action runs up against
domestic political imperatives, the obstacles to coordination become close
to being impassable.
I could sense some of the frustration in the Baker-Darman Treasury team as
they became involved in the G-5 and summit process. By the mid-1980s no
Treasury secretary, not even one so politically adroit and close to his
president as Jim Baker, was able to exercise command over many of the
important tools of economic policy. Fiscal policy was mired in high (and
low) congressional politics. The central bank was independent. Even debt
management, very much the Treasury's province, offered little opportunity
with deficits so large and markets so fluid. But by strong tradition the
secretary is the principal American spokesman in the area of international
finance and economic policy. That platform offers him the opportunity to
exert leverage within the administration, on the Congress, and—as some
may see it—on the central bank as well. That was true, for instance, when
Joe Fowler in 1968 argued that the stability of the dollar required a tax
increase to help finance the Vietnam War. It was true in a dramatic way
when John Connally used the dollar crisis in 1971 to bring the president and
the country behind a sweeping change in a whole range of economic
policies. In 1978, Mike Blumen-thal and his deputy, Tony Solomon, were
able to bring along the Federal Reserve in finally combatting an alarming
slump in the dollar by tightening money.

But that kind of leverage is hard to obtain when there is no sense of

domestic crisis or dependable international consensus on what should be
done. When the dollar was so high in 1985 and American industry became
alarmed about its competitive position, the sense of urgency was great
enough to permit a 180-degree reversal in the government's firm opposition
to intervention. But even then, progress was much more elusive in more
politically intractable areas, most notably fiscal policy.

The G-5 process itself was not very disciplined, despite all the experience
and sophistication of the participants. National representa-

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tives came prepared to articulate their own policies and to describe their
individual circumstances. Differences and even inconsistencies in analysis
were not at all unusual, and it was always relatively easy to avoid
reconciling them. There was no generally agreed conceptual framework to
guide the discussion. There was no way of effectively challenging different
projections and forecasts, and nothing to force a decision or a conclusion,
barring, of course, a crisis on the doorstep. There were almost always
operational questions about the management of the international system that
needed to be resolved: the handling of the debt crisis, IMF quotas, World
Bank policies, and much more. But they were not usually politically
sensitive or matters of high economic policy.

An attempt has been made to address those difficulties by inviting the

managing director of the IMF to provide his independent analysis of the
world economic situation at the beginning of G-5 (now G-7) meetings,
focusing on the implications for the policies of each of the countries at the
table. That helped set out a common framework for discussion and not so
incidentally helped provide a certain political legitimacy to the whole G-5
process, which, you may recall, had no grounding in any formal
international agreement. But even with a managing director as strong and
respected as Jacques de Larosiere, the problem remained. While he can
present the projections and analysis of his staff, he essentially is there in a
personal capacity, without authority to arbitrate differences. The managing
director of the IMF also has to remain sensitive to the need to avoid
appearing to take sides too obviously for or against any of the principal
member countries that, after all, control the fate of his institution. In fact,
the managing director was usually excused from the meeting after his
presentation and some preliminary discussion, but well before any policy
judgments would be reached.

To illustrate the process more specifically, let me give an abbreviated and

schematic idea of what happened in 1986. The American representatives
persistently argued, on the basis of available data and reasonable
projections, that the world economy was slowing down. They warned that
without more stimulus from the European and Japanese economies, which
had been sluggish for several years, the world might tip into recession. With
the U.S. trade and budget deficit, there could be no case for fiscal stimulus
in the United States, and the Federal Reserve was already easing monetary
policy. A pretty convincing argument to us, but the European reply went
like this: "You've got it wrong. The statistics may have been bad before, but
the latest reports on our economy are
CHANGING FORTUNES

more optimistic. Besides, we don't want to take any risks with inflation.
You are stuck on fiscal policy, and we don't want to get in that boat." That
ended the conversation, because there was really no way to reconcile the
opposing views.

All this was a source of no little frustration to intelligent and activist

politicians like Baker and Darman. Their response took two directions. On
the more intellectual level, looking toward reform, they developed a
concept of using a variety of agreed economic indicators to discipline the
process. The general idea was that the main countries, working with the
IMF, would develop a number of supposedly objective statistical indicators
of performance—real growth, inflation, the current account, budget
expenditures and deficits, the money supply, the exchange rate, and others.
Goals or targets for some of those indicators, certainly including growth,
would be set for individual countries and then reviewed to make sure they
were consistent. Progress toward those goals would be monitored together.
If policy adjustments were needed to ensure that everyone would meet his
targets, they could be coordinated at the meetings. A country that failed to
meet the agreed targets for growth or the balance of payments would be
asked to take corrective action.

But, of course, in practice it would never be that simple. The data would
always be late, subject both to revision and of course to each country's own
interpretation. Some key balance of payments data is not even statistically
compatible among major trading partners, providing fruitful ground for
extended debate. And even when the figures were solid and up-to-date, the
large variety of indicators and objectives often would send conflicting
signals for policy.

Nor were the difficulties all technical. There was strong resistance to the
idea that supposedly objective statistical indicators could substitute for
informed policy judgment or could in any event overcome political
resistance. Inserting the IMF into the process might be helpful but could
hardly solve the problem. It would be too much to ask the managing
director to adjudicate the matter; the United States would surely be the first
to object if the Fund spoke out against its deeply felt views, and barring
situations of real alarm, the Fund's support could hardly overcome the
clinching argument for inaction—domestic political constraints. I had
personal experience in developing a far simpler indicator proposal as part of
the more organized and comprehensive reform discussion in the Committee
of Twenty in the 1970s. As a consequence, I had some sense of what the
Treasury was trying to accomplish and

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sympathized with its frustration. But I had no faith in the workability of the
proposals as I understood them, and I was delighted not to be asked to
defend them.

The preliminary work on this indicator system was closely held within the
small group of deputy finance ministers and their aides. Neither the Federal
Reserve nor other central bankers so far as I know were ever drawn
significantly into the discussion. At American urging, the Tokyo summit did
endorse the concept with some fanfare in May of 1986, delegating the
development of the ideas to the finance ministers. One lasting by-product
was to bring Italy and Canada, as G-7 countries, into the exclusive club of
the G-5, but so far as I know, the effort to develop the indicator approach
more fully has pretty much been abandoned.

I was much more concerned at the time with what seemed to be emerging as
the second and more operational negotiating tactic of the Treasury—talking
down the dollar. My concern about an excessive depreciation of the dollar
has been amply reflected in these pages. In 1986, after the sharp fall in
1985, the first priority seemed to me to achieve more stimulation of the
European and Japanese economies, helping in that way to speed the
narrowing of our trade deficit without the potentially disturbing
consequences of further dollar declines on confidence, on inflation, and
potentially, on economic growth itself. It was true that the potentially
inflationary effects of the 1985 depreciation had been held in check. The
sharp decline in oil prices helped offset what impact there was. Another
important factor also seemed to be the aggressiveness of Japanese and other
exporters in maintaining their share of the American market by minimizing
increases in their dollar prices, even at the expense of their profits.
All of that justified a somewhat easier American monetary policy, but I was
never quite comfortable when the dollar continued to decline, even though
it did so much more irregularly than in 1985- As Toyoo Gyohten suggests, I
was much more uncomfortable when the secretary of the Treasury seemed
to signal that he was, at the very least, entirely relaxed about further dollar
depreciation. In his more aggressive mode, Baker almost seemed willing to
forecast a decline in the dollar, with its implicit threat to Japanese or
European exporters, as a means of spurring more aggressive policies of
expansion on our trading partners. By midsummer of 1986, with the dollar
at historic lows against the yen and heading there against the deutsche mark
and the currencies of most of
CHANGING FORTUNES

our major trading partners, there were reasonable expectations that our trade
balance might soon be improving. I became more outspoken, in testifying
before Congress or otherwise, that the dollar had fallen enough. In my
judgment, the uncertainties associated with further sizable declines would
be in no one's interest.

Although the contrast of my views to the comments of the secretary of the

Treasury, sometimes before the same committees, did not escape notice, it
actually was not a matter of great dispute between us at that time. Baker
could plausibly argue that he was simply making the point that, if expansion
in other important countries was too limited to absorb increased American
exports, then the dollar might have to continue its decline, however
undesirable that might be. And I was encouraged that the secretary was
indeed becoming concerned over excessive depreciation. At the very least,
he wanted to tone down the rhetoric about depreciation. In that context, my
clear opposition to further depreciation probably provided some protection
against the market's turning too bearish on the dollar.

Unbeknownst to me at the time, Baker soon undertook a series of bilateral

conversations with the Japanese finance minister, Kiichi Miyazawa, who
became prime minister in 1991. On earlier occasions, I had found that
discussion with Miyazawa was eased by his fluency in English and, more
important, by his personal understanding of the force and logic of the
American position. That position was, after all, fully consistent with the
then-famous Mayekawa report. Whatever Miyazawa's personal sympathies,
however, fiscal stimulus was frustrated by strong political resistance in
Japan. That resistance seemed ironically to be centered in the powerful and
domestically oriented bureaucracy of Miyazawa's own Finance Ministry; it
had long labored to balance the Japanese budget and did not want to see the
hard-won gains reversed. Miyazawa and Baker nevertheless were able to
announce at the end of October a kind of mutual accommodation: The
Japanese would provide a significant fiscal stimulus and further monetary
ease, while the Americans would accept that the exchange rate between the
dollar and the yen was "broadly consistent with the present underlying
fundamentals."
The agreement with Japan did not specify any substantive economic policy
initiatives by the United States, or even an obligation to intervene in the
exchange markets. Nor did the Japanese intentions on fiscal policy seem to
add much to what they were otherwise doing. I was therefore rather
surprised by the intensity of the concerns over the significance of

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this "G-2" initiative among some of my European central banking

colleagues, which presumably was matched in European finance ministries.
The idea that the United States might have reached a clear understanding
about stabilizing the yen/dollar rate without equivalent understandings in
Europe seemed to leave their industries vulnerable to strong competition if
their own currencies appreciated against both the dollar and the yen. There
were also broader concerns, more vague but nonetheless evident, that the
agreement might indicate a more general tendency in America to turn its
attention toward the Pacific and away from Europe.

All that, by design or otherwise, seemed to help Baker's interest in spurring

more expansionary action in Europe, and particularly in Germany. I learned
later that conversations with the German authorities were renewed in
December on the possibility of modifying and speeding German proposals
for tax reform in a way that would provide some net fiscal stimulus. As in
the case of Japan, there would then be an opportunity for affirming both the
desirability and the practicality of greater exchange rate stability. From my
point of view it was all positive. Instead of using the threat of depreciation
as a kind of weapon to provoke the desired policy response, greater
exchange rate stability would appropriately become the reward for action.

Those practical policy and negotiating concerns could then be melded into
an experiment of potentially more lasting significance. The Treasury, at
least at the most senior level, had quietly been continuing its thinking about
target zones, or "reference ranges," as they had been rechristened in a report
prepared inside the French Treasury. The strong French interest both in
encouraging German expansionary measures and in promoting agreement
on a reference range scheme made France a strong potential ally in a
meeting that could build on the experience of the Plaza. The decision to
seek another meeting seems to have been precipitated or reinforced by a
sinking spell of the dollar at the start of 1987. Doubts about German
willingness to take significant fiscal action raised a large question in Baker's
mind as to whether actually to proceed with a G-5 meeting that had been
tentatively arranged. But with my support as well as that of his own staff, he
finally decided to proceed on the basis that the greater risk, both to the
exchange markets and to the outlook for policy, would be to let the
opportunity pass.

We all arrived at the offices of the French Finance Ministry in the Louvre
on the weekend of February 21-22. The substantive discussion

CHANGING FORTUNES

was delayed for hours by a sensitive political issue. The Italian finance
minister, on behalf of his government, was insisting that he attend the
meeting from the start. Arrangements had already been made that he, and
his Canadian colleague, would join the G-5 the next day; any decision
reached would formally be set forth in the name of the G-7. Those
arrangements conformed to a rather contorted compromise that had been
reached following the summit meeting the previous year. It attempted to
reconcile the practical existence of the Group of Five finance ministers with
the fact that seven countries participated in the summit discussions. The
trouble was that the Italian government quite correctly realized that
essential decisions would be reached first among the G-5, and they found
that politically unacceptable. In the end, Giovanni Goria, the Italian
minister, was denied his request and he left for Rome. So, when the
Canadian joined the next day, for the first and only time a communique was
issued in the name of the G-6. The awkwardness of this split has evolved
into the G-7 grouping's becoming the main forum for substantive discussion
in recent years.

The substance of the decisions at the Louvre was reached more easily than
the dispute over who would attend. The decisions evolved around the
mechanism of establishing reference ranges that, while unannounced,
would be "defended" by cooperative intervention. Toyoo Gyohten describes
the specifics and the nature of the understandings about intervention. He is
certainly right that some members of the group, most surely the Germans,
resisted any mechanical interpretations of the agreed guidelines. Moreover,
there was no fixed limit to the amount a currency might move; in the jargon
of economists interested in target zones, the margins would be "soft." If
good faith efforts to defend the outer margin of plus or minus 5 percent
around the agreed central point proved inadequate, then the reference range
would be reviewed and possibly changed. Presumably strong pressure on
the agreed ranges would imply a reappraisal of monetary policy, but there
was no commitment, implied or otherwise, that monetary policies would
necessarily be changed. (In Germany and the United States, such decisions
would be in the hands of independent boards, not just the people sitting at
the table at the Louvre.) What was clear in the discussions was that neither
the central points nor the ranges were to be set in concrete; the
understandings would be reviewed at the next meeting. It added up to the
mildest possible form of exchange rate targeting— limited, temporary, and
unacknowledged. All the communique said on

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that point was that the six nations had agreed "to cooperate closely to foster
stability of exchange rates around current levels." That, of course, was
taken to imply a readiness to intervene.

There was little to be announced about underlying economic policies that

was new. The assertion that currencies were "within ranges broadly
consistent with underlying economic fundamentals" was fully in line with
what I had been preaching for months, but it had to stand more as a
statement of faith than something that could be proven. The German
government did indicate that it would "propose to increase the size of the
tax reduction already enacted for 1988," but in practice, that was well short
of a firm commitment to get it through parliament. The Japanese were not
able to go beyond their earlier expressions of intent.

But what was most disheartening to me in terms of obtaining genuine

changes in policy was the American "contribution" to the agreement: our
pledge that the United States would reduce the fiscal 1988 deficit to 2.3
percent of GNP. I recall questioning Baker on the appropriateness and
indeed the candor of this pledge when that goal seemed far out of reach. His
response was that, realistic or not, he had to reaffirm the position in the
president's budget, which was only a few weeks old. True enough, but that
was hardly a solid base from which to take a highly critical posture vis-a-vis
other countries paralyzed by political problems of their own. In the end, our
fiscal 1988 deficit was 3.2 percent of GNP; the Germans managed only a
small fiscal stimulus and their GNP grew by only 1.6 percent. Only Japan
accomplished a significant, if still limited, fiscal shift later in the spring.

I can only accept the reality of Toyoo Gyohten's critique of the Louvre
agreement. The conceptual analysis of appropriate economic policies to
enhance prospects for growth and stability was essentially American and
reflected our dominant concerns. That analysis seemed to me then and now
broadly correct. But we were, at the same time, incapable of matching our
action to our own analysis, and not for the first time. It seemed to me useful
nonetheless to articulate and restate the analytic case for coordination. One
could only hope that a consensus on that point would, over time, enhance
the possibility of reaching a true international agreement and gathering the
necessary political support for it. Perhaps that is wishful thinking. Certainly
it is not dramatic. But I am afraid it is a fair summary of where the art of
international policy coordination stood in 1987. I see no evidence that it has
advanced much in the subsequent years. Indeed, I sense some retreat.

CHANGING FORTUNES

As it worked out, a lot of intervention was required to maintain the agreed

Louvre ranges in the ensuing weeks. The yen nevertheless appreciated
persistently, and by the time of the next scheduled G-7 meeting in early
April it had broken through the agreed Louvre range. That was not an
auspicious start, but the change was accepted passively by rebasing the yen
range while generally reaffirming the Louvre language.

Later in April and May, with the American economy seemingly on a firmer
footing, further weakness of the dollar significantly contributed to a
decision to tighten American monetary policy slightly. That decision was
more significant for the direction than for the force of the change. To my
subsequent regret, I resisted the idea of raising the discount rate at the time,
preferring to hold that stronger signal in reserve if the dollar's weakness
continued. Instead, the pressure subsided for a while. Only after I had left
the board early in August at the expiration of my second term as chairman
was the discount rate raised. In retrospect, that was certainly later than
would have been ideal on domestic grounds alone. The confidence of
financial markets that the Federal Reserve would resist any resurgence of
inflationary pressures in the face of continuing economic expansion and
budget deficits might have ebbed a bit.

There has been a certain amount of commentary that the rise in the discount
rate was a factor precipitating the stock market crash two months later. That
is surely a misreading. The rather sharp increase in interest rates, and
particularly long-term rates over the summer, was no doubt unsettling. But
that predated the change in the discount rate and reflected disappointment
over the budget and concern that inflation might be increasing once again.
In moving to tighten money a little, the Federal Reserve wanted to make
clear that a tendency toward rising prices would be firmly resisted.

To the extent that the record drop in the stock market could be traced to
policy concerns, the more relevant factor seemed to me the feeling that the
promising efforts toward coordination of economic and exchange rate
policies were breaking down. Just one day before Black Monday, the press
published an only slightly veiled threat by Secretary Baker himself that the
United States would not resist a dollar decline if the German government
did not agree to stimulate its own and the world economy. Perhaps that
sharpened the broader concern about economic policy, but it has always
seemed to me that the stock market was already vulnerable for more
fundamental reasons.

MORE EXPERIMENTS IN ECONOMIC MANAGEMENT

A broader question has been pressed by a number of mainstream

economists, perhaps most notably at the time by Martin Feldstein, who had
served as an exceptionally outspoken chairman of the Council of Economic
Advisers late in the first Reagan administration. From his chair as Professor
of Economics at Harvard and his position as president of the prestigious
National Bureau of Economic Research, Feldstein has been a persistent
critic of the entire effort to stabilize exchange rates. Most immediately in
1987 and 1988, he repeatedly expressed concern that a further substantial
depreciation of the dollar would be needed to achieve a reasonable
equilibrium in international trade. But more generally, he has attacked the
whole intellectual basis for seeking coordination of international policies.
Whatever the theoretical benefits of coordination in achieving greater
growth and stability, Feldstein and others questioned whether those benefits
could practicably be achieved in a world characterized by so much
uncertainty. Forecasts about economic activity in particular countries
inevitably are not very reliable. There is too little consensus about the way
the world really works to provide solid underpinning for decisions to
coordinate policy. (An apt case in point is my informal poll of economists,
mentioned in an earlier chapter, who split fifty-fifty on the probable
direction of the dollar if the budget deficit were to be cut.) And inevitably,
as we have seen, there would be enormous political obstacles to timely and
effective action. Better, in that view, for countries to concentrate on what
seems most urgent and what they know most about—their own needs—
permitting the exchange rate to fluctuate as it will to accommodate
imbalances. In fact, the argument ran, efforts to coordinate might too easily
divert attention and political effort from what needed to be done at home.

My impression of the years since I left government is that, whether because

of intellectual conviction, frustration with what could be achieved, or
simply change in the main personalities involved, the ambitious American
attempts to improve coordination that characterized the period from 1955 to
1987 have subsided. The prompt actions taken by the monetary authorities
to counter the potentially depressing effects of the stock market crash surely
benefitted to some degree from international consultation and coordination,
but important as it was, it was a limited and one-time effort.

Across the Atlantic, we see before our eyes the strongest kind of effort to
coordinate policies of the twelve member countries of the

CHANGING FORTUNES

European Community, and it seems destined to encompass a good many

more nations in the years ahead. Those efforts have their focus in a strong
commitment to fixed exchange rates among themselves, and eventually a
common currency.

There is no question where my sympathies lie: with the effort to achieve

greater stability and more effective coordination. The results are far more
likely than not to produce greater prosperity and stability for the United
States and other countries. But plainly that goal is easier to state than to
achieve.

We live in a vastly different world from that of Bretton Woods. Toyoo

Gyohten has recalled from his particular perspective—as a young citizen of
a defeated Japan—the image of a dominant but rather benign United States,
bringing to all the world the benefits of a stable currency and open markets.
After two decades of slow productivity growth, a declining dollar,
enormous volatility in exchange rates, and an evident resurgence of
protectionist pressures, that would not be an accurate description of the role
of the United States today. Other nations, and most conspicuously Japan,
have approached the per capita wealth of the United States, and a united
Europe will be larger in total economic mass.

Power and influence are irretrievably much more dispersed in today's

world. At the same time, it is a world of wealth undreamed of half a century
ago and a world in which human rights, democracy, and free and open
markets are respected more widely than ever before. In large measure, those
are the fruits of enlightened American policies— economic, military, and
political—initiated years ago. Now, for all the benefits, we also live in a
world in which the difficulties of effective economic management seem
ever greater. It is to meeting that challenge that a new generation, for which
the postwar world can only be a memory, now must turn its attention.

A ill WORLD ORDER OR A NEW NATIONALISM

PAUL VOLCKER

Almost a year has passed since Toyoo Gyohten and I ended our Princeton
seminar. Much has happened in that time, all of it reinforcing the sense of
changing fortunes that has characterized our lives, and we now review our
thoughts and look toward the future.

In these pages, we have recorded some of the false starts, the

misunderstandings, the genuine political and economic strains that have
recurred in international monetary affairs, and in our economic life more
broadly, since World War II. The mechanics of the Bretton Woods system
broke down. Oil crises unsettled our sense of economic security. The United
States faced the most serious inflationary threat in its history. Huge burdens
of debt have come to be a drag on growth in many countries, including the
United States. There have been enormous fluctuations in exchange rates.
Protectionist pressures, after receding for decades, now seem to be growing
stronger.

But for all of that, what stands out so boldly today is how much has been
accomplished. The vision of those men and women who built the postwar
world has been largely realized. The sudden end of the Cold War is a
stunning fact of life. That is surely a tribute to the steadfastness of the
United States and its allies in maintaining their military defenses, a matter
beyond the scope of this book. But it is equally true that that

287

CHANGING FORTUNES

effort could not have been sustained, and that victory won, without the
success of the postwar economic order. Never have so many nations and so
many people—in North America, in Europe, and in East Asia— enjoyed
such an increase in prosperity and personal freedom as during the past
forty-five years.

The triad of fundamental ideas supporting that achievement—political

democracy, respect for human rights, and reliance on a market system with
private property—is ascendent almost everywhere. Now, in Latin America,
in Eastern Europe, and most significantly, within the borders of the old
USSR itself, there are enormous new opportunities for replicating the
success of the highly developed trilateral world. Even in China and Africa,
stirrings of constructive change and progress are apparent.

As an American, I take it almost as an article of faith (a faith that in this

case can be backed by facts) that the United States, as the dominant world
power after World War II and for decades afterwards, was the driving force
toward a liberal trading order and the freedom of international investment.
At critical points it provided the margin of official assistance that underlay
much of our collective success. All that seemed relatively simple and
straightforward to those of us coming of age after years of depression and
war. The United States, after all, produced most of the steel in the world and
most of the cars. We had invented television and the computer. We probably
also invented business schools; certainly they prospered mightily in the
United States, and carried the image of being at the leading edge of
management science.

When I was starting out on my career, productivity teams from other

countries were ubiquitous in the United States. I recall first meeting
Japanese in the 1950s when they seemed to descend on us in waves, barely
speaking English, but determined to learn about the American banking and
financial system. And it was American professors, we now know, who first
taught the Japanese how to develop and maintain quality in the products of
their industries.

Now, the picture looks quite different. In purely statistical terms, the
Germans, the Japanese, and several other countries have higher average
incomes than the Americans at current exchange rates. Those statistics are
no doubt misleading; taking account of the relatively low cost of food and
housing here, the average American still enjoys the highest standard of
living of any large national group. Moreover, the recovery and growth of
other, poorer countries was after all a conscious object of

A NEW WORLD ORDER

American policy after the devastation of World War II. This is therefore a
measure of policy success rather than defeat.

Nonetheless, it seems plain that the United States is not doing all it can and
should to maintain the strength of its own economy. Perhaps it is inevitable
and desirable that others who have started so far below us have had faster
productivity growth than the United States. But we cannot be satisfied that
for twenty years our own productivity, overall, has been growing at little
more than i percent a year, less than half that of the earlier postwar period.
Our business schools still seem to be thriving, as they concentrate on
teaching more and more rarefied techniques of financial manipulation, but
our manufacturing industries are not. We used to think there was an
insatiable demand for American goods, limited only by everyone else's
power to buy them. Now, we wonder whether we can compete in world
markets. In one respect the tables have turned more or less completely:
Now it is we who look to Japan, curious about its management techniques,
about quality circles, and about the merits of a long view in business and
government decision making. We are more humble—or should be—about
setting out our financial system as a model of stability and efficiency.

The size and persistence of our trade deficit and our chronically low savings
rate certainly suggest something is not right. In some recent years, to
finance our investment and government deficits, we have had to borrow
abroad or sell some of our assets in amounts close to the total of all the
personal savings generated in the United States. Even with that borrowing,
the United States has been investing in plant and equipment only about as
much as Japan, a country with a population half that of the United States.
Persuasive arguments can be made that the United States still has
technological leadership; we are certainly ahead in basic research. But it is
also a fact that the United States has fallen well behind both Germany and
Japan (by about a third) in research and development spending relative to
our total output. On recent trends of productivity and growth, the Japanese
economy will actually be larger than that of the United States in twenty or
thirty years.

I don't want to exaggerate the point. Trends like that do not go on forever.
There is room for doubt about whether we are measuring productivity in
our large service industries correctly, and there are bright signs of improved
competitive performance in some manufacturing industries. I, for one, do
not believe in the inexorable economic decline of the United States, relative
or otherwise.

CHANGING FORTUNES

There also is little question that, just at the point of enormous new
opportunities for the world, the mood in the United States has turned
querulous and inward. Some of that may be a passing phase. The absence of
a typically strong recovery from extended recession and the evident and
costly financial strains after years of excessive debt creation have us
psychologically on edge. But it is also true that the sense of frustration and
temptations to turn protectionist have been building for some time and seem
related to our economic performance over a longer term.
One set of statistics, for all the doubts about the precise accuracy of the
data, is particularly telling. Read literally, they say that the real hourly and
weekly earnings of the average production worker in the United States are
lower today than twenty-five years ago. Sophisticated economists can tell
us that the statisticians may not have measured correctly all the
improvements in medical care or the efficiency of computers or other
factors that make life better—but neither do they measure the costs of
increasing crime and greater urban congestion and the evidence of eroding
educational standards. Taken altogether, it's hard to refute the sense that
progress for the average American for almost a generation has been
extremely limited at best.

That, I suspect, goes a long way toward explaining the paradox of why, as a
country, we feel so much more burdened by our international
responsibilities just as they are lightening. Defense costs in recent years
have been a substantially smaller piece of a bigger GNP than during most
postwar years; yet the pressures to cut military spending were intense even
before the breakup of the Soviet Union. For some time, we have, relative to
our size, scored near the bottom of the international league in providing
development assistance. We gripe more about the two tenths of a percent of
GNP we provide in aid today (heavily concentrated in Israel and Egypt)
than we did about the 2 percent of GNP we provided during the peak years
of the Marshall Plan.

Even now, with prospects that defense spending can be prudently cut way
below earlier levels, we seem to be looking to others to carry the bulk of the
load of assisting the new democracies to get on their feet.

To our credit, objective observers still agree that the United States has the
most open markets of any leading countries. But the direction of change is
not so reassuring: Compared to ten or twenty years ago it is our barriers that
have been increasing. Now various estimates suggest up to 30 percent of
our imports are subject to some kind of quantitative restriction. Most other
nations, including Japan, have been moving

A NEW WORLD ORDER

toward more open markets. No doubt it is still enormously difficult for
American as well as Asian and European firms to break into Japanese
markets for manufactured goods even though tariffs and quotas are almost
gone. But if Japanese society and culture remain substantially export driven
and import resistant, I am aware of no evidence that unfair trading practices
have been increasing. As a matter of fact Japanese imports of manufactured
goods have been substantially increasing.

Although more marked here, the pattern of slower growth and protectionist
pressures is not confined to the United States. For nearly two decades,
expansion in the industrialized world has been less robust. Both
unemployment and inflation are larger problems than they were in the
1950s and 1960s. The fact that, after five years of effort, the current, highly
ambitious Uruguay Round of negotiations on further lowering trade barriers
remains in doubt is perhaps symptomatic of a certain broader malaise of
spirit.

The question can legitimately be asked whether all this is related to, and
aggravated by, the breakdown of the disciplines implied by the Bretton
Woods monetary system and the subsequent volatility of exchange rates that
began in the early 1970s. In approaching that question, I have long believed
that the United States, in shaping its "domestic" policy, would have been
well served by paying more attention to the desirability of exchange rate
stability. Certainly in the early stages of the Vietnam War, when serious
inflationary pressures began during the mid-1960s, more attention to
defending the dollar by more restrained fiscal and monetary policies would
have helped stabilize the economy. In retrospect, it is also clear that, had we
done more to defend the dollar abroad before and after the two dollar
devaluations in the early 1970s, we might well have prevented inflation
from becoming so entrenched. Later in that decade, crises in the exchange
markets finally did help precipitate a full-scale attack on inflation.

But that was late in the day, and it took long and difficult years to restore a
sense that inflation had again been brought under at least some measure of
control. Greater confidence in the stability of prices has fortunately
permitted the American monetary authorities a needed degree of flexibility
in dealing with the present sluggishness of business activity. The larger
lesson is that confidence is a valuable thing, and once lost, is hard to regain.

The strongly appreciating dollar was giving a very different sort of signal
through the first half of the 1980s, and the appropriate response

CHANGING FORTUNES

was less clear-cut. As discussed at length in chapter 8, an effort to moderate

the extreme strength of the dollar by greater easing of American monetary
policy seemed potentially self-defeating in terms of other objectives, and in
particular the need to keep inflation at bay. What should have been brought
to bear, in my judgment, was fiscal policy. In the short run we were indeed
uncertain whether fiscal tightening would, by producing lower interest
rates, lower the value of the dollar or, by increasing confidence in the
management of American economic policy, strengthen it further. But, over
time, I believe lower interest rates would have brought the dollar down to a
more realistic value. Smaller budget deficits would have reduced our
dependence on foreign capital, improved the climate for domestic
investment, and reduced the risks in easing monetary policy. Unfortunately,
to this day, that fiscal discipline has not been achieved.

What American experience strongly suggests—and what the experiences oi

a number of other countries confirm—is that whatever its economic merits,
the flexible use ot fiscal policy is politically difficult. This difficulty is what
limits so sharply the potential for the international coordination ot"
economic policies, although there will be occasions when the central banks
can and should act in complementary ways.

In the absence of closer coordination of monetary and fiscal policies,

flexibility in exchange rates has seemed a logical necessity. But in practice
floating exchange rates have not produced anything like the stability and
orderly conditions in exchange markets that its more ardent proponents
envisaged. Until the most recent years, the actual trend was toward more
volatility, not less. Daily changes of a percent or more between the dollar
and other key currencies are not at all unusual. Over a few weeks or
months, the changes sometimes have cumulated to 10 percent or more.
Cyclical changes in the value of the dollar have ranged to 50 percent or
more against the yen and the mark. Such volatility has been especially
disappointing while economic trends in the world's major countries have
actually been converging, and they have shared success in bringing down
inflation.

What is less clear is how the ups and downs of exchange rates have affected
the sum of things we really care about: growth in trade and economic
activity, the level of prices and productivity. By and large, all the statistics
and equations of the most sophisticated econometricians have not been able
to arrive at conclusive results. That does not surprise me too much; in a
world in which so many things are happening at once,

A NEW WORLD ORDER

it is hard to pin down the effects of any one factor. But the logic of the
situation suggests to me that, over a long period of time, the costs in
economic efficiency must be substantial.

The economic case for an open economic order rests, after all, largely on
the idea that the world will be better off if international trade and
investment follow patterns of comparative advantage; that countries and
regions concentrate on producing what they can do relatively efficiently,
taking account of their different resources, the supply and skills of their
labor, and the availability of capital. But it is hard to see how business can
effectively calculate where lasting comparative advantage lies when relative
costs and prices among countries are subject to exchange rate swings of 25
to 50 percent or more. There is no sure or costless way of hedging against
all uncertainties; the only sure beneficiaries are those manning the trading
desks and inventing the myriad of new devices to reduce the risks—or to
facilitate speculation.

But these risks and costs seem to be driving more of the industrial
investment of operating businesses in developed countries toward
producing for local or regional markets. In other words, the decisions in the
real world are often defensive and are designed to escape exchange rate
uncertainties and protectionist pressures rather than to maximize efficiency.
That inevitably leads to diluting some of the important benefits of open
markets, which is maintaining tough competition among the world's
dominant producers.

There cannot be much doubt either that economic management is greatly

complicated by large changes in exchange rates that take place
independently of differences in economic performance, or greatly
exaggerate them. Small countries may be most vulnerable, but large ones
are by no means protected from huge swings. One case in point is the
dislocations suffered by American industry because of the extreme strength
of the dollar during the mid-1980s. Moreover, the sense of irrationality and
helplessness associated in the minds of businessmen with widely fluctuating
exchange rates easily translates into political pressures for protection
against foreign competition.

In sum, the fact that the world has had a mostly unmanaged system of
floating exchange rates over the past twenty years while it also experienced
slower growth, greater inflation, and stronger pressures for protectionism
does not strike me as entirely accidental. No doubt other factors have also
played an important role, notably the oil crises of the 1970s and worldwide
tendencies toward lower savings and less fiscal

CHANGING FORTUNES

discipline. But on the evidence, it is hard to believe that we have found

anything like an optimal set of international monetary arrangements.

American experience over the postwar period illustrates a related point that
now seems generally accepted. While devaluation (or appreciation) of a
currency may be appropriate and even necessary to help deal with the
consequences of past inflation or serious international imbalances, it cannot
be a substitute for more fundamental policies to restore competitiveness, to
enhance productivity and savings, and to maintain stability. Repeated time
and again, devaluations represent in effect a kind of abdication from
necessary policy decisions, and in the end only complicate the job of
maintaining growth and stability.

One of the ironies of the story of this book is that, after repeated
depreciation of the dollar since 1971 to the point where it is 60 percent
lower against the yen and 53 percent lower against the deutsche mark, the
American trade and current account deficits are nevertheless much higher
than anything imagined in the 1960s. Conversely, among the major
industrialized countries, those with the most strongly appreciating
currencies enjoy higher savings rates, stronger productivity, more
competitive industries, and finally, the strongest trade balances.

Taking all this into account and looking ahead, one logical option might
seem to be to restore a system of fixed exchange rates, with specified par
values and rules of the game under the firm control of an international
organization—a modernized Bretton Woods. Essentially, that is what the
Committee of Twenty spent a couple of years discussing in the early 1970s.
I confess to a certain nostalgia for the intellectual coherence and logic
involved in such a highly organized system. But even with that bias, I
cannot come close to convincing myself that such arrangements are a
practical possibility in today's much more complicated world.

Bretton Woods, after all, did not last very long, even with the potential
advantage of a strong, self-confident, stable, and outward-looking nation
providing the reserve currency and dedicated for many years to making the
system work. No doubt the United States could have—and, to my mind, to
its own advantage should have—done more in the late 1960s and early
1970s to protect and sustain the stability of the dollar at the center of the
system. But in the longer frame of history, and given much more even
distribution of economic power among the United States, Japan, and
Europe, it would be unrealistic to rely so heavily on the policies of a single
nation and its currency for the stability of a highly structured system.

A NEW WORLD ORDER

A theoretical alternative to a stable national currency maintained by a

benign and dominant national power would be the creation of a powerful
world central bank, able to issue its own currency and to enforce agreed
rules. In an embryonic way, the International Monetary Fund already can
exercise some of those functions. But it does so in a much more constrained
framework than a true central bank, very much subject to the ability of its
principal members to reach a consensus through cumbersome procedures.
After so much negotiating effort to bring the Special Drawing Rights into
being, their relative disuse illustrates the difficulties. The idea of sovereign
governments delegating so much authority to a supranational world central
bank—or of the markets accepting its liabilities as true and easily usable
international money— simply does not provide today, nor will it for years
to come, a realistic base for planning, however intellectually attractive the
idea may seem.

A different answer may be quite possible within a group of countries

closely tied both politically and economically. The European Community,
against the bulk of skeptical expert opinion, has succeeded in operating
within that area a fixed exchange rate system for more than a decade. It has
done so while almost entirely eliminating controls on capital movements
and in the face of violent fluctuations in interest and exchange rates in the
wider world. For a period of more than three years there have been no
changes at all in official currency values among members of the European
exchange rate mechanism.

That success has been possible because within the area there has, in fact,
been a dominant economic power and a predominant currency— West
Germany and the deutsche mark. With only limited exceptions, the nations
of the Community have, in fact, been willing to nail their currencies to the
strong mast of the DM. They have done so in the conviction that fixed intra-
European currency values are a critical complement to an economically
unified common market, dependent for its operation on large flows of trade
among the members. As long as the German economy has remained strong
and its currency a bastion of stability, the constraints implied for domestic
monetary policy for the other members of the European exchange rate
mechanism have seemed worth the protection against inflation and
instability.

A basic difficulty with that arrangement, as with the Bretton Woods system
in practice, is that it is heavily dependent on the policies, circumstances,
and judgments of one country and one national central bank— the Deutsche
Bundesbank. As I write, the internal pressures on German prices and wages,
on the German budget, and on German interest rates

CHANGING FORTUNES
growing out of the reconstruction of the old East Germany underscore the
point. That is, of course, a historically unique circumstance, and for a time
at least, the other members of the European Community seem fully
prepared to bear the consequences for their own monetary policies of
extraordinarily high German interest rates. But the situation illustrates why
many members of the Community, in a longer-term framework, feel it
necessary and appropriate to move toward collective responsibility for
decisions that affect interest rates, monetary policy, and by extension the
economic direction and indeed the health of the Community as a whole.

The logic of the situation—the desire for fixed exchange rates and the
consequent need for coordinated monetary policy and appropriate political
authority—has driven the Community to accept the concept of a regional
central bank and a common currency before the end of the century. Tough
conditions have been set down. Individual countries cannot adopt the
common currency without meeting strict criteria for the convergence of
their inflation levels, budget deficits, and interest rates. The basic mandate
to be given the European Central Bank has already been carefully spelled
out: It will promote price stability. Furthermore, while the new bank will
draw upon each of the central banks of the Community's member nations to
make up its own governing body and implement its policy decisions, the
whole European central banking system is designed to be remarkably
independent of national or partisan political influence. Indeed, assuming the
European Central Bank goes forward as planned, it is likely to precede any
equally strong focus of political authority and decision making on a
European scale. That, in itself, raises interesting questions of coordinating
largely national fiscal policies with a single regional monetary policy, and
ultimately, of the appropriate form of public and political accountability.

Full resolution of those questions remains for the future. What is not in
doubt is that the world, economically speaking, is drifting into regional
areas. The European Community is by far the most developed. It has
already passed far beyond the simple idea of a common external tariff into a
broader community dealing with problems of competition, financial
regulation, the environment, and much more. Now that the aim of a
common currency has been clearly set out, some members plainly want a
stronger political federation as well.
The United States itself has negotiated a free trade area with Canada, and is
in the process of such negotiations with Mexico. There are hints,

A NEW WORLD ORDER

at least, that the region might be extended through Latin America, where
some much more limited regional arrangements are already being put in
place. And all of that activity has begun to provoke thinking among some
Asian countries that they too, for defensive reasons, should consider an East
Asian trading area despite their historic suspicions of Japan.

These emerging economic and trading areas would have been anathema to
American postwar planners. They had before them the example of the
"imperial preferences" developed by Britain in the interwar years, and the
network of bilateral trading arrangements developed by Germany and
others. All of that was, quite rightly, considered discriminatory and
protectionist, carrying the seeds of political antagonism as well as economic
inefficiency. To be sure, it was not so long after Bretton Woods and the
GATT were negotiated that the United States supported the creation of the
European Common Market. But that was considered a tolerable deviation
from the multilateral norm, justified by the overriding political purpose of
European reconciliation and the creation of a strong Western Europe.

Today, a more general economic rationale for regional trading areas is being
advanced, with increasing intellectual support from both the academic
community and practical politicians. In a world otherwise under
protectionist pressure (and now with the Uruguay Round in jeopardy), the
argument runs that regional free trade areas are the only available path to
freer trade. Because they will likely encompass particularly close trading
partners, they might also provide a natural focus for efforts to stabilize
exchange rates within the area, shielding a substantial amount of world
trade from the vicissitudes of freely floating exchange rates. Neither Canada
nor Mexico, nor for that matter the United States, is at all likely to envisage
a common currency in North America. But the fact is that both of those
neighboring countries, with a very large portion of their trade with the
United States, are already motivated to stabilize their currencies against the
U.S. dollar. If the North American free trade area itself proves durable, I
would not be surprised to see both countries eventually refix their
currencies against the dollar, as the Mexican peso was fixed during most of
the postwar period.

But for all the advantages presented by regional areas, the drift in that
direction leaves me uneasy. By their nature, free trade areas and common
markets are Janus-like. The benign liberal countenance faces inward, to
members of the group. Within the area, barriers are eliminated.

CHANGING FORTUNES

If the practical effect is to head off unilateral protectionist measures, that

would be a clear gain. But the dark side is discrimination against those
outside. That threat need not be serious if—and it is the "if" that is really in
question—the trade, financial, and monetary barriers against others remain
low. But there are those in Europe and America who view these areas as the
means and justification for maintaining barriers against outsiders and even
increasing them. For example, one argument goes that if we in the United
States open our market to cheap Mexican labor, we ought to restrict the
access of the Asians or at least opt out of further multilateral liberalization.
As the reaction of some Asian countries suggests, this implicit threat seems
real. The natural response to one trading area is, as a matter of self-
protection, to build another.

As a practical matter, it is Japan and some smaller countries left out of

regional arrangements that have in the past seemed potentially most
threatened. Today, the greatest risk may be elsewhere. It would be
unfortunate, to state it mildly, if preoccupation with regional areas and the
inevitable internal tensions that arise within them reduce the opportunities
for the emerging Eastern European democracies and the new
Commonwealth republics of the former Soviet Union to find markets in the
established industrialized world. For all the talk of financial and technical
assistance, their reconstruction and eventual prosperity must rest on access
to markets in Europe, North America, and Japan, which will in turn
encourage the new investment and new technology they need.

Quite obviously, the success or failure of the current GATT negotiations

will be vitally important to the prospects for maintaining and enhancing an
open, prosperous world economy. That point is made in every international
seminar, at every summit and G-7 meeting, in every editorial in the
establishment press, here and abroad. Yet the oratory and the ink have not
yet resolved the remaining points at issue, which carry large political
freight, however small they may seem relative to what is at stake for those
not directly involved. The risks of failure are particularly great precisely
because that failure would come in the context of sluggish economic
growth, spreading free trade agreements, and a greater willingness to skirt
the existing rules of international trade. In that environment a failure would
not imply just the maintenance of the status quo, but the clear probability
that protectionist forces would gain the upper hand.

The developments and dilemmas we have reviewed in this book

A NEW WORLD ORDER

require other constructive responses, and they can be shaped at the very
least into a modest agenda.

• The GATT. The existing Article XXIV of the General Agreement on

Tariffs and Trade provides some protections against the aggressive use of
common markets and free trade areas to discriminate against others,
including a prohibition against raising the average level of tariffs to
outsiders. But restraints on nontariff barriers have been less effective in this
context than in others. Consistent with both the spirit of the GATT and the
stated intentions of European and North American leaders, the rules against
nontariff barriers should be clarified, tightened, and enforced. Ideally, any
existing regional quotas and other nontariff barriers should be converted to
tariffs and reduced over time.

• A Pacific Community. More promising than potential rivalries between

American and East Asian trading areas would be the larger concept
embracing both shores of the Pacific. The basin encompasses Japan;
Southeast Asia; the four "tigers" of Hong Kong, Korea, Singapore, and
Taiwan; and Australia and New Zealand, as well as the Americas. That
large area already accounts for more than 40 percent of all world trade, and
it has been the most rapidly growing segment, expanding by about 8.5
percent a year in real terms in the decade of the 1980s. It includes some of
the most open markets in all the world—and also some of the most
protected. It is also beset by recurrent, and now almost continuous, bilateral
conflicts about trade, mutual suspicions, and outright misunderstandings.
The bickering and name-calling between Japanese and Americans is the
most obvious case in point, but it is not the only one.

The region may be too large and diverse to think in terms of a full-scale free
trade agreement. But the bare bones of a political framework already exist
for enhancing regional cooperation. Our mutual dependence on trade with
each other and the growing amounts of direct investment are plain to all.
Surely, those regional concerns provide opportunities for jointly resolving
disputes, resisting protectionist pressures, and reaching common
understandings on the treatment of foreign investment. Concentration on
opportunities to improve the environment and economic development,
which, by their nature, transcend national policies, can help place our often
emotional trade disputes in a broader perspective. And, in time, China could
become a partner.

CHANGING FORTUNES

• Exchange rates and international monetary relations. Within regions we

should aim for progress toward stabilization as the Europeans have done,
although not necessarily in the same way. The regions have different
problems and traditions, but Europe, the Americas, and East Asia each have
important characteristics, including a dominant currency and strong intra-
regional trade patterns, that should facilitate exchange-rate stability.
Regional arrangements—perhaps informal outside of Europe—would fall
far short of a fully articulated international system. It would, however,
provide a base for more effectively reducing exchange rate volatility among
regions. In time, the new Commonwealth of Independent States might also
provide a focus for a currency area.

The kind of coordination I foresee would not require an elaborate

institutional structure. Indeed, the strength of the G-5 or G-7, to my mind,
rests on its informality and flexibility. I am not, as earlier pages made
evident, convinced that elaborate schemes of statistical indicators are
practical or that a special secretariat would be particularly useful. Nor
would I wish to impair the independence and authority of central banks,
undermining the usefulness of the most flexible tool of general economic
policy. Indeed, without some method of insulating central banks from
partisan political pressures and focussing attention on the need for price
stability, efforts to stabilize exchange rates are likely to fail.

What seems to me possible within that framework is the development of

some reasoned and broad judgments about what range of exchange rate
fluctuation among the regions is reasonable and tolerable, and what is not. I
am thinking of ranges significantly broader than the plus or minus 5 percent
that was meant to trigger consultation in the Louvre agreement. At the same
time, unlike the Louvre, governments should stand ready to support a broad
and agreed range by more than just intervention in currency markets. They
would have to be prepared to support their agreements in the short term
with changes in monetary policy, and in the medium and longer term by a
willingness to alter the basic orientation of their fiscal policies as well.
Judgments about which country should move, and by how much and when,
would be taken in the light of the existing economic situation, drawing in
part on the wisdom of international institutions.

For the whole idea to have any meaning, governments would have to accept
that strong pressures on exchange rates would be a prime indicator of the
need for policy action. The agreed ranges would also have to be publicly
known. The official statement of a target zone would

A NEW WORLD ORDER

influence market expectations, helping to stabilize trading activity. That has

certainly been the experience within Europe, where exchange rates are fixed
within a narrow range. But that result will be achieved only if the target
zone for any country or region is in fact taken seriously in the conduct of
monetary policy and in developing general economic policies.

• Finally, for the sake of completeness, I should note the importance of

other matters on the international economic agenda that have not been the
central focus of this book. In the financial area, there is need to broaden and
reinforce the work already done to achieve more consistent capital and
reporting standards for financial institutions and to provide transitional
technical and financial support to the new democracies.
All that has no pretensions to adding up to a new Bretton Woods, neither in
detail nor in the building of institutions. But at the same time, it is rather
straightforward and manageable. Together with the successful completion
of the GATT negotiations, I, for one, would feel a lot more confident that
we would be equipped to seize the enormous opportunities before us.

The danger is that somehow, with Soviet communism collapsed, with the
threat of nuclear disaster reduced if not eliminated, and seemingly secure in
our military might, we will fail to seize those opportunities. We in the
United States are becoming absorbed in our own affairs and preoccupied
with internal pressures and strains—with crime and drugs, with the cost of
health care and our eroding infrastructure, with educational shortcomings
and lingering recession. Our partners in Europe and Japan have
preoccupations of their own.

My point is not that those problems can be neglected. They obviously need
attention and they should get it. But it seems to me entirely wrong to think
that those domestic concerns somehow compete against our international
responsibilities, and that they justify pulling back from a cooperative world
order. On the contrary, international cooperation will more than pay its own
way. The simple fact is that, with the end of the Cold War, the cost of
providing national security is dropping sharply, by amounts that will be
many times larger than the potential costs of assisting in a constructive,
peaceful transition for the emerging democracies of Eastern Europe and the
new Commonwealth of Independent States. It is a safe bet that, in a
cooperative framework, other

CHANGING FORTUNES

countries will provide a larger share of the needed assistance than they did
in past decades, and that Japan in particular would feel its responsibilities
and act upon them.

But the stakes are not simply financial or budgetary. Far more important, a
world of open trade, of greater financial and exchange rate stability, of more
international investment in new and old economies, is important to us as a
nation. It is important to our own economic welfare and standard of living
and important to the kind of world in which we want to live. Of course, we
need to respond to our domestic priorities for their own sake. But we need
to do so as well to provide a foundation of public support for policies that
can look outward, policies that recognize that, in the end, our own success
will be bound up with that of others.

Certainly, we live in a world of more dispersed power, a world in which

Japan and Europe will both have more to say and the resources to back up
what they say. The time may be gone when the United States can pull very
far out in front in insisting upon its own ideas. But the force of leadership
and example will still be decisive. And I don't think it is sheer nostalgia that
suggests a special responsibility still lies with the United States—the
responsibility, more often than not, to set the agenda, to call the meetings, to
provide a spur for action, and, if really necessary, at times even to provide a
large share of the needed resources. That, in a quite different sphere, seems
to me the lesson of what happened so dramatically when Saddam Hussein
threatened the Middle East, and what happened afterward when everyone
looked to the United States as the catalyst of a broader peace in that region.

The days of a simple Pax Americana, to the extent it ever existed, are past.
But neither is there any justification for thinking that somehow we are
drained and exhausted by international responsibilities, by unfair foreign
trading practices, or by domestic problems. On the contrary, we are still the
richest and strongest country in the world. What we need to do is to restore
a sense of confidence in that strength and stability. Then, my sense is that
other nations—old allies and new democracies alike, the now-rich and the
still-struggling—will still welcome a constructive lead from the United
States. To fail in that responsibility would be to jeopardize all the bright
prospects before us. But the simple fact is that, at this time of really
unprecedented opportunity, the challenge lies well within our capacity to
meet it.

A NEW WORLD ORDER

TOYOO GYOHTEN

1 he issue of the international monetary system has been very popular since
the day the Bretton Woods system collapsed, but we have to distinguish
between two interrelated elements of any system. One is the role played by
currency and particularly by reserve currencies. The other is the exchange
rate arrangements among different currencies.

Under the classical gold standard, gold was the only reserve currency, and it
had a fixed exchange rate with all currencies. Under the Bretton Woods
system, both gold and the dollar were reserve currencies, and the rate
between them was fixed at $35 an ounce. The U.S. government guaranteed
the conversion between gold and the dollar. In other words, the U.S.
government made the dollar as good as gold. The exchange rate between
the dollar and the other currencies was a sort of adjustable peg, and
countries could change their currencies' exchange rates against the dollar
only when their payments position was in fundamental disequilibrium and
the IMF approved. In the floating system we have multiple reserve
currencies—the dollar, the yen, and the deutsche mark (with the mark to be
replaced by a single European currency when and if one is created). The
reason we think of a different system is that we complain about the present
one and recall the successes of the gold standard and Bretton Woods in their
heyday. Paul Volcker has argued that it is too much to ask one country to
bear all the responsibilities of maintaining and operating the system, but
that is exactly what did happen when Britain ran the gold standard late in
the nineteenth century and the United States the Bretton Woods system
between the years of 1945 and 1965. In those times, both nations had the
dominant economic, military, and political power to act as hegemon, and
they had a strong external current account position to finance the system
through the normal ups and downs of business and trade cycles. It was not
necessary for the finance to be based only on a surplus of goods; often they
ran a trade deficit that was more than offset by their overseas earnings and
other international profits. Both also maintained appropriate domestic
policies that did not swing too heavily toward inflation or deflation. When
these conditions vanished, the system collapsed.

Our experiences make it absolutely clear that the current system—or non-
system, to be precise—was not the result of anyone's choice. It was
inevitable when the Bretton Woods system became unsustainable. What

CHANGING FORTUNES
is wrong with the current non-system is its lack of stability and
predictability in exchange rates, which seems to hurt the stable growth of
trade and investment. It would be intriguing to analyze technically whether
this really is a theoretically valid correlation, but past performance in the
real world seems to confirm it in practice. Simply consider the Bretton
Woods period from i960 to 1973, and the period of our non-system from
1973 to 1987. During the Bretton Woods period, the average GNP growth
of the OECD countries was 4.8 percent a year; in the second period it
declined to 2.6 percent. Annual inflation accelerated from 4.3 percent to 6.8
percent. The export volume of those countries grew by 8.8 percent annually
under Bretton Woods, but only by 4.2 percent in the second period, while
the annual growth of import volume declined from 9.3 percent to 3.7
percent. Under the present non-system, world economic performance has
certainly been poorer, the volatility of everyone's external accounts has
been aggravated, and the threat of protectionism certainly has increased.

Docs the poor performance of our present non-system argue in favor of a

new one? The system itself is not the ultimate goal. Its sustainability really
depends on whether the countries can take advantage of it to maximize their
national welfare and improve growth, price stability, employment, and so
on. Countries need to be convinced, after considering their economic and
political costs and benefits, that the balance of advantages gives them an
incentive to stay.

In fact, we already are in a system of multicurrency reserves. The dollar, the

mark, and the yen represent the countries with the three largest economies
in today's world. The United States, Germany, and Japan also are different
because they alone maintain autonomous fiscal and monetary policies and
are strong enough economically to let the exchange rates of their currencies
fluctuate. Other, less powerful countries surrender some control over
domestic policy in order to maintain stable exchange rates; this is certainly
the case for all the non-German countries in the European Monetary
System.

One problem in constructing a system based on the United States, Germany,

and Japan is that none of them has the kind of broad, hegemonic power that
Britain and the United States had in the old days. Another problem is that
the relative international roles of the three main currencies do not reflect
their economic fundamentals. For example, the dollar's role is probably
excessive because of noneconomic factors such as the security role of the
United States, the economic role of its large

A NEW WORLD ORDER

and open market, and the historic use of the dollar in the international
banking system. The discrepancy is even more pronounced when the share
of each currency's international reserves is contrasted with figures for the
economy each currency represents. As of 1989, the dollar accounted for 60
percent of world reserves, the mark 19 percent, and the yen 9 percent. But
the U.S. gross national product in 1988 was $4.9 trillion and exports $322
billion, compared to a GNP for Japan of $2.9 trillion and exports of $265
billion, and Germany's $1.2 trillion and $323 billion. This discrepancy
between the currencies' reserve role and the countries' economic
fundamentals is one drawback to achieving a stable relationship among
these currencies upon which to base a new monetary system.

Having said that, I have to admit that there seems no alternative but to
accept the present multicurrency system. To replace the present system with
gold, a new issue of Special Drawing Rights, or any other newly created
asset seems totally unrealistic and could be devastating in generating a new
wave of inflation that could swamp the world's economies. The price of
gold would have to be raised by a very large amount to ensure enough
reserves to replace dollars, marks, and yen. Alternatively, we would have to
create an enormous amount of SDRs, and that would be as politically
unacceptable as it would be economically impractical.

That means the three major currency countries need first of all to increase
their efforts to achieve as much balance as possible in their external
accounts, whether they are in deficit like the United States or in surplus like
Japan. It would of course be unrealistic to expect them all to hit a zero
balance, but their continuing effort to reduce those imbalances would
stabilize the system. They also must continue to make efforts to keep their
capital and financial markets open, efficient, and credible, which will mean
greater efforts by Japan and Germany than the United States. With all these
efforts, a better balance would be created between the international role of
these currencies and the economic fundamentals of the countries issuing
them. Let me make it clear that I am not suggesting three currency regions
or blocs. On the contrary, I think the institutionalization of separate
currency blocs has no global merit, even though there is a trend toward
regionalization in Europe and North America. I would not object to a closer
regional cooperation as long as those regions remain open to the rest of the
world without discriminating against outsiders. But if those two regions try
to become

CHANGING FORTUNES

more solidified as currency or economic blocs, it is inevitable that the Asia-

Pacific region will feel a greater pressure and even a threat, which will
probably tend to strengthen its regional ties. I do not want to see that
happen, because the most important source of dynamism in the Asia-Pacific
region is both its diversity and its openness to the rest of the world.

Working out arrangements to maintain a steady exchange rate relationship

among the three main currencies would be even more difficult and probably
impossible in today's political climate. Although target zones, reference
ranges, and numerous technical ideas are forever being discussed, all of
them are essentially the same, because when the actual exchange rate
reaches its limit, some mechanism presupposes a defense at that limit. So
there really are only two exchange rate arrangements: fixed rates and
floating rates. To create a fixed arrangement among three currencies, many
questions would have to be settled, none of them easy.

Is it possible to discover, let alone agree on, an equilibrium exchange rate

among these three currencies? That rate must not only satisfy their three
separate national interests but also be internationally compatible so that it
can be sustained.

Can the exchange rates also be made flexible enough to adjust to external
shocks and change in economic fundamentals that might affect only one of
the three, such as the effect on the mark of the absorption of East Germany?
When such things happen, exchange rates often must be adjusted. One
lesson of Bretton Woods is that a new system would have to include the
mechanism for doing so smoothly and quickly.
Could the three countries yield autonomy over their own monetary policies
and commit themselves to an unlimited amount of intervention if they had
to do so, in order to defend the parities they had agreed on? For example,
when the United States runs an external deficit and the dollar falls in the
market, Japan and Germany would be obligated to buy dollars to defend the
parities of the three currencies.

Is it possible to agree on a method for settling accounts by trading assets so

that obligatory intervention becomes possible? Unless the United States
agrees to settle its deficits by paying them in foreign currencies, SDRs, or
some other non-dollar asset, Japan and Germany certainly will not commit
themselves to unlimited intervention simply by accumulating depreciating
dollars.

Huge capital flows influence exchange rates, especially in today's

deregulated and globalized market; is it possible to control them? This

A NEW WORLD ORDER

raises one more allied but special problem. Although the exchange rate is
certainly a far more important economic indicator than, for example, the
price of coffee beans or wool, in today's world market currency
nevertheless is traded just as if it were a commodity. As a result, there is an
almost constant danger of overshooting. In the market itself, traders
strongly prefer volatility, because they make more money out of it than
from stability. Businessmen, by contrast, prefer stability because it allows
them to plan ahead.

These problems, which are of fundamental importance but often

excruciatingly technical, would have to be resolved before we could
seriously think of a fixed exchange rate arrangement among three
currencies. So my conclusion is that under the current three-currency
system, we have to stick with floating rates. But they still must be managed
in some way, because the essential problem we face is that while rates may
float, they refuse to stabilize. I therefore think it would be useful to create a
kind of triumvirate of the United States, Japan, and Europe, perhaps with
Germany as the representative of Europe if that is what the Europeans want.
The central banks would of course have to be represented on this
triumvirate because we are dealing with currencies, but the finance
ministries must also be there because they represent elected governments.
They are able to speak about political dynamics but not much else; central
bankers are good at talking about markets but not much else. We would also
need a third representative on each triumvir who would see the situation
from a more objective and even a theoretical point of view, and he might
well be an academic. Of course, if international institutions, particularly the
IMF, can act as truly neutral umpires, their participation would also be quite
useful. The group should meet regularly, and also whenever emergencies
arise.

This triumvirate should try to reach agreement on desirable and sustainable

exchange rates for their currencies under the prevailing situation. From my
personal experience of G-7 meetings, whenever we discussed our exchange
rates, I had the feeling that if the representatives could have discarded the
political constraints imposed upon them by restrictive national interests,
they could have held fairly agreeable discussions using common sense
about the appropriate value of currencies at any given time. (For example,
the rates prevailing as this is written— about 125 yen and 1.50 deutsche
marks to the dollar—would attract broad agreement among such a group.)
When they agreed that prevailing rates were not consistent with economic
fundamentals, they could

CHANGING FORTUNES

agree on measures to rectify the situation. In addition to overseeing the

exchange rate, the triumvirate would engage in regular, mutual peer
pressure about macroeconomic and microeconomic policy with a view to
achieving better international balance and sustainable noninflationary
growth.

In conducting the meetings, I have a bold proposal that would mark a

considerable departure from current practice. I believe it would give greater
legitimacy and force to the triumvirate's decisions if a full account of their
discussions is given to the public. While I agree with Paul Volcker that
informality and confidentiality secure frankness in discussion, the most
frustrating element of all those G-$ and G-7 meetings was that although we
discussed, and discussed, and discussed, when it came down to
implementation, there was no broad support at home for the basic
agreements we reached in our small, closed forum. One way to stimulate
and then mobilize public support is to let the public know what its
representatives have discussed about decisions affecting its own economy.
Although they would not be meeting under the glare of television lights in a
fully open forum, they would know they were speaking on the record. After
the inevitable false starts and misunderstandings of the learning process, I
hope and believe that as the public and the politicians came to know what
their representatives said in these forums, smd what other representatives
said about the policies of each country, a broader basis of support would
develop for what was decided.

In this kind of an open forum, the representatives would certainly be under

a different kind of pressure. Granted, they might be more nationalistic and
play to their home audiences in a demonstration of loyalty to their own
countries. But there would be a crucial difference as they came to realize
that their audience was not only their own countrymen but the world as a
whole. They would know that the force and validity of their arguments
would be judged by a global jury. They also would know that purely selfish
and parochial arguments would not only invite international sneers but also
reprisals that would surely counter their national interests.

Their focus might change from one meeting to another. On one occasion,
the major concern might be global inflation and on another it might be
aggravating international imbalances or global lack of capital. At all
meetings, each representative would also focus on what his country might
do to improve matters, either by shifting the exchange rate or changing
domestic policy. One very crucial condition for all arguments:

A NEW WORLD ORDER

When each representative presented his case to the others, he would have to
explain why his national policy also would be good from a global point of
view. If everybody did that, it would become much easier to evaluate who
was right and who was wrong, and then bring beneficial pressure on all the
countries involved.
Last but not least, governments would have to commit themselves to paying
the highest possible respect to whatever would emerge from the
deliberations of this triumvirate. This would be another difficult issue
because of different constitutional arrangements in each country. Under the
parliamentary democracy of Japan, the government represents the ruling
party in Parliament. As a result, what the government decides has a better
chance of being approved by Parliament. In other words, the government's
commitment in international forums carries greater weight. Under a
presidential system like that of the United States, the independent power of
Congress is much greater and a commitment by the executive branch led by
the president faces a risk of rejection in the legislature. Since the
triumvirate's talks would be government talks, the different constitutional
structures would create a fundamental problem. For example, in my own
experience, either at the G-7 meetings or bilateral meetings between
Japanese and U.S. officials, it became quite tiresome to hear American
representatives tell us that although the government favored measures to
reduce the budget deficit, controlling the deficit was really up to Congress,
and the government could not control Congress. You feel quite hopeless
when your counterpart tells you that he does not know whether his
commitment will remain valid. However, one has to live in the real world.
What we would need to secure is a firm public commitment from
governments that they will make their genuine best efforts to implement the
decisions of the meetings.

Certainly my proposal does involve a considerable amount of idealism. But

none of it is very revolutionary, because I accept the basic structure and
functioning of the system as it exists, and hope to make it somewhat more
smooth and efficient by grounding it in popular consensus. It may not be
easy to find a thoroughly dispassionate set of representatives, but if we try
to move in that direction and learn how to conduct our discussions by trying
to balance national interests and global compatibility, we will make
progress.

For a final moment, however, I would like to dream of something that

would work perfectly in an ideal world. I would envision a situation

CHANGING FORTUNES
in which the three countries agree to remove all restrictions on the use of
their currencies, pledge they will have no exchange controls and no capital
controls—and then agree to make all three currencies common legal tender
in each others' countries. They would not have to surrender their monetary
autonomy, nor intervene to support their currencies, nor commit to any
fixed rate at all. They could, of course, agree to take concerted action in the
exchange market or on their macroeconomic policies whenever they found
it useful. But basically they would leave all that to the market, which would
soon decide the respective rankings, roles, and values of the three
currencies. Under such an arrangement, I believe that the exchange rates
among the three major currencies would tend to be more stable because the
market would react to each fundamental economic change more quickly
and smoothly. For the moment, I concede this is sheer fantasy and I am not
proposing it seriously. But it is comforting to hope that one day our sense of
cooperation and international goodwill might make possible a system that
would help draw us all closer together, not only as economic actors, but
most of all as human beings.

APPEMDiX REMARKS ON THE DEBT CRISIS

I hree specialists who spent much of the 1980s containing the debt crisis
discussed their experiences at the Princeton seminar conducted by the
authors. Here are highlights of their remarks.

WILLIAM R. RHODES, SENIOR EXECUTIVE-INTERNATIONAL,

CITIBANK

From the viewpoint of a commercial banker who has been in the trenches, I
think it is fair to say we had two goals: First and foremost was to prevent
the collapse of the international financial system and the banking system.
Second was to help the countries eventually return to the private capital
markets to finance sustained growth.

If greed often drives people apart, fear often drives them together, and
certainly Mexico in August 1982 was an example of that. There quickly
developed an unusual international working arrangement among competing
commercial banks, bank regulators, international financial institutions,
creditor countries, and many of the borrowing countries. Based on
experiences with early restructurings in the 1970s (for instance, Nicaragua,
Jamaica, and Turkey), the commercial banks organized themselves into
steering committees—or, as we call them, advisory committees—whose
membership was based on the size of

APPENDIX

exposure and geographical representation. These committees were

organized in coordination with each of the debtor countries, and that is
important to remember: They were not put together by the bank's alone;
they were requested by the debtor countries themselves.

A major factor in this working arrangement at the beginning was the

leadership of people like Paul Volcker at the Federal Reserve and Jacques
de Larosiere at the IMF. A balanced and case-by-case approach was
developed, recognizing the fact that each of the restructuring countries had
its own particular and peculiar realities.

In the first phase of the crisis, commercial banks, of necessity, assembled

short-term emergency financing packages. The countries, in turn, began to
adjust their economic policies to reflect, belatedly, the changes that had
been occurring over several years in the international economy.

The second phase looked beyond the countries' immediate needs with
longer-term packages to buy time. What emerged was an agreement that the
IMF would monitor a country's economic performance over a period
substantially longer than normal under standby or extended fund
arrangements, and that this information would be made available to the
commercial banks. This allowed the banks to negotiate restructuring
agreements to stretch out the debt. A more market-based approach also got
its start in 1984, when we negotiated a clause under which banks could
convert debt into equity (the famous debt-equity swaps). This marked the
beginning of the concept of debt reduction.

Phase Three was aimed at shifting the focus from short-term adjustment to
longer-term growth. It reflected the philosophy—I think first expressed by
Jesus Silva Herzog of Mexico—that the only way out of the crisis for the
developing world was to grow out of it. This followed Treasury Secretary
James Baker's decision that the United States Treasury should be more
actively involved in the management of debt than it had been under his
predecessor, Donald Regan. Chief among the points of the Baker Plan was
the emphasis on growth-oriented structural economic reforms by the
borrower countries. In response to the countries' economic adjustments, the
commercial banks were asked to continue to make available a prudent
amount of new loans. Although the Baker Plan is often attacked for not
raising sufficient new money, William Cline of the Institute of International
Economics estimates that banks disbursed over $13. billion in new loans
during the three-year period of the plan, although the $20 billion mark was
not reached. I think that is as much a reflection on the inability of some
countries to

APPENDIX

make the structural adjustments they promised as it is a reflection on the

commercial banks' unwillingness to lend in some cases.

The next event took place in March of 1989 when Secretary Brady
proposed voluntary debt reduction by commercial banks. I would
emphasize commercial banks, because he said nothing in his proposal about
official debt reduction by governments or international institutions. This
reduction of debt by commercial banks became the focus of the debt
strategy in place of new money. The G-7 subsequently met on several
occasions to work out guidelines, and the IMF and World Bank for the first
time agreed to offer resources to back debt-reduction programs for countries
with viable economic programs.

All of this set the stage for the Mexican debt package signed in February
1990. It included most of the debt-reduction techniques used earlier, such as
debt-equity conversions, interest rate reduction, and principal-reduction
bonds, and incorporated many of the new-money techniques, including
bonds, trade finance, and on-lending facilities. Two new techniques were
introduced: collateralized interest for debt-reduction bonds and value
recovery, which were later incorporated in packages for other countries
such as Venezuela and Uruguay.

Let me summarize some of points that I think were crucial after 1982.
First, the banks were often criticized for overlending —by the regulators
and by people at the international financial institutions, saying that we did a
poor job in the two recycling efforts of the 1970s. But where were the G-5
countries and the official sector in general? They wanted no part of the
leadership of it, so the commercial banks picked it up. What would have
happened if the major industrialized countries had decided to step in and
head the recycling effort, among other things, using the international
financial institutions more actively than they did to achieve this goal? I
think the banks did the best they could, which in some cases was not good
enough, but nobody else stepped forward.

Second, a key decision taken early in the crisis was the so-called case-by-
case, or country-by-country, approach, a decision that continues today. The
alternatives were the so-called global solutions, and they have one
drawback: They do not speak to the differing needs of each individual
country, which is why the countries have not backed them. Each country's
situation is different, each requires a tailored solution, and without one the
country might be impeded from returning to the voluntary capital markets.

APPENDIX

Third, the advisory committee system, overall, has functioned well in

serving the interests not only of the creditor banks but also of the borrowing
countries themselves. The committees have served as an informal pipeline
for the borrower governments, who otherwise would find it difficult—if not
impossible—to negotiate with the thousand or so interested banks at any
one time around the world.

Fourth, although the commercial bankers have been criticized for not being
sufficiently supportive, I believe they have generally met the financing
needs of the restructuring countries with either new money or debt
reduction, and certainly have done so for those countries that have instituted
viable economic reform programs. One of the major conceptual errors from
the beginning of the debt crisis was the idea that the countries were in a
short-term liquidity squeeze, and all that was needed was short-term
stabilization programs of eighteen to twenty-four months. The results of this
view were programs that lasted a maximum of two to two and a half years.
The countries often ignored the need to simultaneously make basic
structural economic reforms, including privatizations, in order to lay the
basis for investment and growth. Many people did not understand the major
point that if the countries did not change basic structures, and open up their
economies and privatize, one Stabilization alter another would end in
failure.

ANGEL GURRIA, UNDERSECRETARY FOR

INTERNATIONAL FINANCIAL AFFAIRS,

MEXICAN FINANCE MINISTRY

For the debtors, the whole question is about net transfers and flows: how
much comes into the country and how much goes out. That is the substance,
the heart of the debt crisis—net transfers, or what we like to call the
"minimax." Put it this way: What is the maximum negative net transfer of
resources that you can allow out of a country to the rest of the world that
will still allow the country to grow at the minimum level that is politically
acceptable? The whole debt crisis is about the capacity to continue to have
investment, to continue to have growth. The problem for us was that an
overhang of debt arose after the positive flows toward the debtor countries
stopped in 1982. Nevertheless we had to continue to pay interest to service
the debt without these inflows of resources to which we had become
accustomed. So a very great negative

APPENDIX

transfer was created, which was unsustainable, because a very large portion
of the savings of the country was not being invested inside the country but
was being sent abroad.

We had accumulated these huge debts for a number of reasons. In the

beginning, debt was used in small amounts as one more tool of economic
policy, mostly to complement domestic savings. But then there was a great
external shock to our economies. The terms of trade deteriorated very
dramatically. Our oil exports lost value vis-a-vis our imports. We borrowed
more to close the gap. Interest rates in the world went up in real as well as
in nominal terms. Developing countries that were counting on the continued
flow of cheap credit to promote growth began to face an additional burden.
At first they chose to alleviate it by more loans. But at high interest rates,
the problem escalated. It finally blew up when the banks, who had loaned
these countries a lot of money because they thought that countries never
could go bankrupt (according to one very famous theory in those days),
suddenly got cold feet and stopped lending. The debtors realized they had to
continue to service the debt without receiving any new money. That led to
the phenomenon of negative net transfers. It meant that countries actually
had to take money out of their pockets and pay back the banks without
getting any new loans.

When that happens, you have to use a lot of the already scarce savings in a
country rather than complement them with external savings. When you use
a lot of your savings to pay the debt instead of using them to invest, the
formation of capital and therefore growth suddenly stops. We in Mexico
have to create one million new jobs every year, and we can't do it if we
don't invest and we don't grow. Growth is the ultimate objective of
economic policy, growth with stability of prices. Without that, not only our
economic programs but the overall political situation would become
untenable.

That is what suddenly brought the debt issue to the fore. We overborrowed,
yes. Why? Because we were not prudent enough. Because we thought
things were going to stay the same forever. Oil-exporting countries like
Mexico thought the oil was going to remain at $36 and then increase to $50
per barrel. We were wrong. We thought interest rates were going to be
negative or at least flat in real terms forever. We were wrong. What
happened was exactly the opposite. The price of oil dropped, as did the
prices of most commodities. Interest rates went up, and we were in a bind.
We were caught. When new loans

APPENDIX

stopped, negative transfers began, capital fled most countries, and the debt
crisis began.

First there wis a "muddling through" strategy. The banks- and the
multilateral financial institutions lent highly indebted countries a fraction of
what they had owed, so that they would continue to make the payments in
full. But that was not quite enough. The problem of net transfers was never
really addressed. The initial goal was to keep the banks going. They lent us
a little bit and we had to produce the rest by putting a big squeeze on our
balance of payments. Debtor countries were thus forced to generate a great
surplus on their trade and current account balances, which would produce
enough to pay the whole interest bill with the little bit of "new money" that
was lent to us. Such enormous sacrifice by the debtors—to keep the banks
going!

The problem was that after some time the ones who were lending us even
these modest amounts of "new money" were no longer banks but
governments. The banks didn't deliver their share. And after two or three
years of this strategy, which was later called the Baker Plan, the
governments started realizing they didn't like it. Public money was going
into debtor countries to pay commercial banks. Politically it was not very
attractive, and from the point of view of public policy it was not very
efficient, given that debtor countries were not growing. Indeed, after some
years of "muddling through" and borrowing some money so that we could
make ends meet, we were not growing at all, given that we were
transferring a lot of money abroad and just getting back a little bit of what
we were paying out in interest. By 1987 the banks were stronger, and
people started saying: "Maybe there is too much debt. Maybe there is really
nothing we can do in terms of keeping this strategy moving, even very
slowly, because it will never work. These developing countries will never
really resume growth, which is the ultimate objective of economic policy,
and will never contribute to increase world trade if we continue along the
same path. Growth will never happen, because the net transfers are too
large. This little bit that we are giving them is not enough to compensate for
what they are putting out of their own pocket, out of their own savings.
Maybe the debt is too large."

As people started thinking like that, Citibank marked down its LDC loan
portfolio by 25 percent, and secondary market quotations for LDC debt
showed increasingly deep discounts. Mexico started looking for ways to
capture the discount for itself. By end of 1987, with the assis-
APPENDIX

tance of J.P. Morgan & Co. and the sympathy of the U.S. Treasury, Mexico
offered to exchange new twenty-year bonds, with the principal
collateralized by U.S. Treasury "zero coupon bonds," in exchange for the
old debt at a discount. That meant we would give seventy cents or eighty
cents of better quality, partially guaranteed bonds in exchange for one dollar
of the old debt. It was the first broadly organized, market-oriented,
voluntary debt-reduction deal for a large debtor country and it proved to be
a true watershed.

The importance of getting relief on the debt has proven, particularly in

Mexico, a very big boost. Why? Because in Mexico we were ready to do
the right things in terms of economic policy but there was a perception that
we had too much debt. We struck a deal with our commercial bank creditors
that reduced the debt somewhat. We went through a long negotiation with
Mr. Rhodes and his bank committee, and we agreed on a formula to reduce
35 percent of Mexico's commercial bank debt or reduce the interest rate by
35 percent, which was more or less the same in terms of cash flow. There
followed an enormous surge in confidence in Mexico's economy from both
foreigners and Mexicans. What we began to hear from the private sector
was this: "That is what we really need. We are ready to sacrifice, we are
ready to do the job, but the debt is too large, and the net transfers are
unbearable. We have to have more domestic savings invested in Mexico.
That's all you really have to do in the government. The rest we're ready to
undertake ourselves."

The government was determined to reach a reasonable agreement in a debt

negotiation, and it did. We agreed to go to the IMF and negotiate a four-
year stabilization program in exchange for a loan of about $4 billion. We
went to the World Bank and negotiated $2 billion worth of loans to stretch
out our debt payments and start structural reforms to our economy over four
to five years. We won commitments of $1 billion per year from the
InterAmerican Development Bank and a modest restructuring of some debt
to official export-credit institutions through the Paris Club, which, more
importantly, gave us assurances that it would continue to finance imports to
Mexico. And then last—but of course not least, because they held 80
percent of Mexico's foreign debt—we went to the commercial banks and
struck a deal with them.

It took more than a year to do all this, but after it was done, the atmosphere
was transformed dramatically. Suddenly, with the announcement that we
had actually renegotiated our debt with the com-

APPENDIX

mercial banks and all the official institutions, the market brought its money
back to invest. Even the bankers started offering new loans to Mexico. And
since then Mexico has been able to place more than $i billion in new bond
issues in the voluntary credit markets. Our lesson is that a bad debt
negotiation is probably not sustainable, but even a "so-so" debt negotiation
is sustainable if it enjoys the company of good economic policies. There is
no substitute for good economic policies. If you make mistakes in your
economic policy, then there is no amount of debt relief that will be enough.
But without the debt relief you cannot get the "virtuous circle" started.

The problem is the conflict between relief on the old debt and new credit
flows, which is what originated the debt problem. When there was a
conflict between forgiving and lending, the banks stopped lending. Now
there is the same conflict with governments. They are presented with the
possibility of giving debt relief to some developing countries and
continuing to lend, and some of them cannot find a way to do both. But it
would seem today that both are absolutely what is required. Just as the
commercial banks have found it possible to give debt relief and in some
cases continue lending on evidence of good economic policies, so must the
official export-credit institutions. In many cases, however, the solution is
not more debt. Debt forgiveness should be complemented by aid, not loans,
given the incapacity of some countries to service debt even at concessional
rates.

The debt overhang continues to be a very important problem in many of the

developing countries. It has been solved to some extent in a few, but only a
handful, and in many it is still the largest unresolved question, not only in
terms of economic policy but in terms of the outlook of their own citizens
and the rest of the world.
MANUEL GUITIAN, ASSOCIATE DIRECTOR, CENTRAL BANKING
DEPARTMENT, INTERNATIONAL MONETARY FUND

The core of the theme I want to stress revolves around the risks of moral
hazard. It should not be surprising that countries that pursued a strict policy
of debt repayment will not be particularly encouraged to maintain it by the
example of other countries that, having been able to obtain debt reductions,
do not have to service their external obligations fully.

APPENDIX

Most of the difficult issues that arise in the context of the international debt
crisis have to do with such risks of moral hazard.

Both creditor and debtor countries are represented in the International

Monetary Fund, and therefore the question of external indebtedness cannot
be seen exclusively from either the debtor's or the creditor's side. An effort
has to be made to focus and build upon aspects common to both. This is
like walking on a razor's edge, but it is also a stimulating challenge. The
complexity of the problem can be brought to the surface by posing the
following question: Why not leave the solution of external debt difficulties
to market forces? Well-known economists have argued in favor of this; for
example, Milton Friedman, who has said that "the solution to the debt
problem is to require the people who make the loans to collect them. If they
can, fine. If they can't, that's their problem."

Why was the market solution not taken? The reason was the perception of
impending systemic danger conveyed by the debt crisis. The large
accumulation of external debt liabilities in the developing world through
1981, followed by the abrupt interruption of capital flows in 1982, carried
the threat of irreparable damage to the international financial system. Rather
than letting the outcome be determined solely by market forces, the
response to the crisis was to devise a strategy for a collective solution to the
debt problem based on contributions from both creditor and debtor
countries, private and official entities, and national and international
institutions. I consider the debt strategy to have been very successful from
this standpoint. Its fundamental aim was to eliminate the systemic risk
posed by the debt crisis, which was achieved in a remarkably effective
fashion.

What remains to be resolved? Rather than a systemic risk, we now have a

relatively widespread disease with many individual countries still facing
severe debt-servicing difficulties. These individual country debt-servicing
problems were not—and could not be—solved by the global debt strategy
alone. Possibly that is important among the reasons behind the lack of
access for many indebted countries to international capital markets and,
more generally, the slow resumption of capital flows. This experience could
not but prompt the various stages of the debt strategy: from adjustment with
austerity to adjustment with growth, and then to adjustment with debt
reduction. These various adaptations were made necessary by the absence
of capital flows, which made the resolution of debt problems of individual
countries particularly arduous.

The Fund's approach was based on an adjustment effort by the

APPENDIX

debtor country. But this was not a sufficient guarantee for the solution of
debt problems. Therefore, a major innovation to Fund policies was
introduced: Creditors were required to commit a large amount ("a critical
mass") of their financial support as a prerequisite to the global strategy. This
action amounted to extending the principle of condition-ality to creditors, so
that from this perspective the strategy was even-handed in its treatment of
borrowers and lenders.

In a relatively short time, debt as a systemic risk disappeared. But it did not
vanish as a constraint on individual countries, and the growth process in
debtor countries did not take off as rapidly as expected. So the emphasis of
the strategy moved toward efficiency and structural reform. Eventually it
also contemplated voluntary debt-reduction packages to help set debtors on
a sound growth path. Thus, the adaptations to the debt strategy responded to
problems as they emerged and allowed for the pursuit of a variety of
objectives (for example, structural reform, growth). Nevertheless, the
adaptations called for efforts from everybody, and they could not please all.
On the one hand, strict linkages between adjustment and financing (that is,
the requirement of "a critical mass" of concerted lending) called for
unprecedented commitments by creditors. On the other hand, a looser link
did not ensure adequate support for adjustment efforts and gave rise to the
specter of arrears. Either approach was unlikely to be universally popular.

Lei me now describe graphically some of the practical difficulties

confronting the Fund in assembling debtor-creditor packages. Many
perceived the role of the institution at the center of the strategy as
equivalent to that of the director of an orchestra. But at times it felt as if
each musician was following a different musical score. And this is
understandable, at least in hindsight. Debtors tended to focus their attention
on the availability of financing to support their adjustment effort. Their
main question was: If there is no assurance of financing how can we adjust?
Creditors, in turn, focused on the adjustment effort undertaken by the
debtors as the key justification for their continued financial assistance. The
question to them was: If there is no assurance of adjustment how can we
finance? The Fund, through its financial arrangements, provided the
instrument to bring together the efforts of both creditors and debtors and
was under constant pressure from both sides. Debtors saw the -institution as
the vehicle to ensure financial support. Creditors saw it as the means to
ensure adjustment. There was only one position for the Fund to adopt in the
circumstances, no matter

APPENDIX

how controversial, and this was to focus not on the conflicting but on the
common aspects of the problem from the vantage point of both creditors
and debtors. In effect, the Fund argued that too much financing with too
little adjustment does not in the end help the debtor, and that too little
financing with too much adjustment does not in the end help the creditor.
The issue is rather one of balance between adjustment and financing. But
how best to attain it?

It is in this context that market solutions appear attractive. This is because

market-determined outcomes are typically perceived as reached by
impersonal, objective forces that are remote from political interference. But
the operation of market forces in conflict situations calls for the existence of
legal and institutional structures (such as bankruptcy procedures) that
although in existence nationally are yet to evolve internationally. In the
absence of these structures, market solutions are less attractive. Instead,
balance must be sought by gathering the consensus for solutions involving
concerted actions by governments, international institutions, and the
sources of private capital flows, admittedly an extremely complex effort.
Some will argue that the burden should be on debtors to adjust; others will
argue that adjustment without financial support is unrealistic, if not
inefficient.

Moral hazard surrounds both these perceptions. Borrowing and lending

decisions carry risks. If a balance is drawn in which debtors perceive that
their risk is unduly small, they will have little incentive in the future for
seeking efficiency in their decisions or avoiding the costs of inefficient
behavior. This argues in favor of the need for extreme care in considering
debt reduction. If, on the contrary, the balance is drawn so that creditors are
the ones that perceive their risk as unduly small, lending decisions will lose
incentives for efficiency. This argues in favor of stressing creditors'
responsibility in supporting adjustment. Balance is obviously required
because complete elimination of moral hazard on the part of debtors, if it
were feasible, would only serve to create moral hazard for the creditors, and
vice versa.

The issue at stake here transcends the scope of debt. It has to do with the
distribution between private risk and public risk. A prominent feature of the
process that gave way to the international debt crisis was the predominance
of private commercial bank loans to sovereign governments. The resulting
interdependence between the governments' ability to service their debts and
the quality of the banks' portfolios tended to blur the distinction between
private and public risks. Moral hazard

APPENDIX

looms behind such blurring, because a cost that was in principle linked to a
particular private creditor-debtor transaction, by bringing in the government
(through, for example, the extension of public guarantees), can become a
cost for taxpayers at large. So firmness in the separation of private from
public risks—or, more broadly, transparency in the role of government—is
critical to prevent the risk of moral hazard.
The sound solution to the problem of debt, of course, lies in fundamentals;
that is, in the adoption of appropriate policies in both creditor and debtor
countries. This is a fundamental area of responsibility for the Fund, which
has a mandate for the surveillance of the policies of its member countries.
Indeed, focusing on fundamentals will help make sure that today's solution
does not become tomorrow's problem. The international debt crisis provides
a good illustration of such a sequence of events. The early 1970s witnessed
the emergence of what might be called a revolt against international
economic interdependence in the form of protectionism and tendencies
toward national economic isolation by means of exchange rate flexibility. A
factor that countered these two fortes was the recycling of international
funds through commercial banks. From this perspective, the flow of capital
helped preserve interdependence. At the same tune, domestic policies in
many countries, including in particular the large ones, allowed inflation to
take off in the world economy and negative real interest rates to emerge
later in the decade. The measures required to solve the inflation problem
were necessary from all perspectives. They were also among the factors that
contributed to arresting the borrowing-lending process. That in truth helped
to translate an element of the solution to an early and mid-1970s difficulty
into a problem that would plague the 1980s. But then, such linkages can
hardly be surprising in the only closed economy—that is, the world.

GLOSSARY

ANGLO-AMERICAN LOAN

The Anglo-American loan was a successor of the wartime Lend-Lease

Program. It was extended to Great Britain by the United States on July 15,
1946, tc encourage reconstruction and speed British return to convertibility.
The loan was for S3.75 billion—an extremely large sum for its time, and
much larger than reconstruction loans made to other countries. The money
was soon exhausted, however, because British investors converted their
pounds to dollars and took their savings out of the country, whose economy
had been exhausted by war.

article 8
This article of the original agreement of the International Monetary Fund
requires members of the Fund to lift all exchange restrictions on payments
for current international transactions, and to refrain from discriminatory
currency arrangements or multiple currency practices without the IMF's
approval. Most important, it requires the maintenance of currency
convertibility with certain exceptions in the case of capital controls. The
agreement was reached on July 22, 1944.

ASSET SETTLEMENT

This concept was developed as a means of reducing or eliminating the use

of reserve currencies, especially the dollar. As an alternative to the building
up

GLOSSARY

of liabilities in a country's currency, a reserve currency country would be

expected to promptly convert any increases in other countries' balances of
that currency. In order to do so, the reserve currency country would use it's
holdings of reserve assets such as gold and Special Drawing Rights (SDRs),
or draw on previously negotiated credit lines with the central banks of the
major industrial countries.

Asset settlement would require reserve currency countries—in particular

the United States—to pay more or less on a current basis for their balance
of payments deficits just as nonreserve currency countries are required to
do. It would thus avoid the instability associated with occasional large
conversions and the privilege (as seen by some Europeans, of whom
President de Gaulle of France was the most vocal) of facilitating financing
of U.S. deficits by having other countries hold its dollars instead of settling
them in gold or other assets.

BAKER PLAN

Officially proposed by U.S. Secretary of the Treasury James A. Baker III as

the "Program for Sustained Growth," the Baker Plan became the official
American strategy toward Third World debtor nations in October 1985. It
emphasized returning debtor countries to "sustainable growth paths" by
combining three elements: IMF-approved reform programs to be initiated
by countries in distress, new money commitments by the commercial
banks, and an increase in official funding of debtor countries through a
World Bank. The Baker Plan represented a shift in American policy from an
emphasis on austerity to one on growth for Latin American countries.

BALANCE OF PAYMENTS

A measure of a country's international flows of funds as the result of its

trade, aid, investment, and other international transactions. In principle, the
inflows and outflows will be equal. That can be achieved only if the
Treasury or central bank offsets flows by the purchase or sale of official
reserve assets or by official borrowing. When a country has to sell or
borrow assets, the country is in deficit. When the inflow is more than the
outflow, the country is in surplus. (See also Current account)

BANCOR

Part of the Keynes Plan of 1942-43, bancor was conceived as the

international currency unit in which national reserves would be
denominated in an international clearing union. Keynes advocated the
clearing union, which would have held all national reserves, as an
alternative to the International Monetary Fund. Asset settlement in his plan
consisted of shifting bancor holdings among national accounts. The plan
would have come close to creating an

GLOSSARY

international central bank with the ability to control the world level of
reserves, hence the amount of money available.

BANK FOR INTERNATIONAL SETTLEMENTS (BIS)

The BIS is a financial institution in Basel, Switzerland, that acts as a

depositary for funds of central banks and in special circumstances may lend
to central banks of the Western industrialized countries when they find
themselves in liquidity squeezes. It was founded to deal with German
reparations after World War I, and its main function in the postwar era has
been to serve as a forum for international discussions among central
bankers. During the debt crises of the early 1980s, it facilitated short-term
emergency loans to debtor countries in Latin America and Eastern Europe.
The United States is not a member, but cooperates actively with it.

BENIGN NEGLECT

"Benign neglect" was the term often used to characterize what some felt
was an attitude of the United States (and sometimes other countries) to
place domestic goals over the need to achieve a balance in international
payments or a strong dollar, and was usually cited as a criticism of U.S.
policy. Some American economists advocated such an approach.

BLESSING LETTER

Sent in 1967 by Bundesbank chairman Karl Blessing to the chairman of the

Federal Reserve Board promising that West Germany would refrain from
converting dollars into gold.

BRADY PLAN

The last phase of the American strategy toward Latin American debt,
following the initial emergency approach of the early 1980s and the Baker
Plan of 1985. Introduced by U.S. Secretary of the Treasury Nicholas F.
Brady on March 10, 1989, the Brady Plan called for a new focus on debt
reduction rather than the provision of new money. It proposed authorizing
the use of IMF and World Bank funds to support debt-reduction
agreements.

BRETTON WOODS

The location of the New Hampshire hotel where in the summer of 1944
financial officials from the United States, Britain, and their soon-to-be-
victorious wartime allies agreed on the rules of the postwar monetary
system embodied in the International Monetary Fund and the International
Bank for Reconstruction and Development. Participants agreed to limit the
movements of their currencies to a maximum of a percentage point in either
direction from the rate
GLOSSARY

they had set against the dollar. The dollar was maintained at the rate of
thirty-five to an ounce of gold. Nations were permitted to change these par
values only after they had informed the directors of the International-
Monetary Fund that their balance of payments was in a state of
"fundamental disequilibrium." The IMF could lend borrowing countries
funds in amounts related to national quotas, which were paid into the IMF
partly in gold and partly in national currencies, providing the basis for a
revolving fund that operated somewhat like a credit union for its member
countries. The member countries were also supposed to adopt policies to
eliminate persistent surpluses, and a "scarce currency clause" existed to
impose sanctions on those who refused to do so, but it was never invoked.
Controls on trade and current account transactions were strongly
discouraged.

This system of "par value" but changeable exchange rates was designed to
undergird an open trading system through which tariffs and other barriers to
world trade were reduced through repeated negotiating rounds conducted
under the auspices of the General Agreement on Tariffs and Trade (GATT).
The second Bretton Woods institution was the International Bank for
Reconstruction and Development, otherwise known as the World Bank,
which at first was concerned with postwar reconstruction but soon focused
its resources on tin* Third World. It is financed by capital contributed by
member countries and borrowings in the market indirectly guaranteed by
member countries. Headquarters of the IMF and World Bank are located in
Washington, D.C., and the GATT secretariat is in Geneva, Switzerland.

CENTRAL RATES

C Vntr.il rates was the term used by most G-io countries in the Smithsonian
agreement of December 17-18, 1971, to characterize their new exchange
rates, replacing the former panties. While central rates were not official
parities under the rules of the IMF, the countries that had negotiated them
committed themselves to maintaining spot exchange rates within maximum
margins of 2.25 percent on either side.

COMMITTEE OF TWENTY (C-20)

The United States initiated the Committee of Twenty in 1972. Its mission
was to lay the groundwork for a new monetary system in response to the
uncertainty that followed the closing of the gold window and the
Smithsonian agreement in 1971. It consisted of representatives from the
main G-10 countries as well as regional groupings of other countries. The
C-20 finance ministers met a total of six times and produced the Outline for
Reform of the International Monetary System in early 1974, advocating
increased cooperation and a "more flexible par value system" based on an
SDR standard rather than a gold or dollar standard. The Outline for Reform,
which was never carried

GLOSSARY

out, was only a shadow of more comprehensive plans that failed because of
disagreements among member countries, the uncertainties of inflation, and
the first oil crisis. The group survived as the interim committee of the IMF,
a twenty-member steering committee of finance ministers that meets twice
a year.

CONDITIONALITY

Conditionality implies that loans to debtor countries by official international

and governmental institutions—the International Monetary Fund in
particular—will be granted only under certain conditions imposed by the
lender, usually involving policies of austerity for the debtor country.

CRAWLING PEGS

Crawling pegs, also known as gliding parities, were one of a number of

plans advanced in the late 1960s to make the fixed parity system more
flexible. The plan called for small changes in par values at frequent
intervals in response to certain criteria with various degrees of automaticity.

CURRENT ACCOUNT

Flows of trade, services, interest, dividends, and other "current" items in the
balance of payments. The capital account includes investment and other
long-term items. Together they influence a country's balance of payments.
DEBT-EQUITY SWAP

One method of debt reduction for developing countries. In a debt-equity

swap, a loan is exchanged for local currency, which is then used to make
equity investments in the debtor country. The currency exchange is
typically handled by the debtor nation's central bank, and the loan is
generally exchanged at an effective discount from its face value.

DOLLAR-DEFENSE PROGRAM

A name applied to a variety of programs, beginning late in the Eisenhower

administration, to reduce balance of payments deficits and to stabilize the
dollar.

DOLLAR SHORTAGE

Starting in the early postwar period, theories abounded that the United
States would chronically run a trade surplus, depriving other countries of
dollars to finance their imports and economic reconstruction. The shortage
of dollars was seen to be the result of chronically high U.S. savings and
rising productivity. Writings by economists on the dollar shortage in the
1950s testify to the prevailing view that the United States would remain by
far the most productive economy in the world and a net exporter of goods.

GLOSSARY

EUROCURRENCIES

Currencies, mainly dollars, left on deposit in banks outside their home

countries and loaned to businesses and governments. Legend has it that at
the height of the Cold War in the 1950s, the London branch of the Moscow
Narodny Bank accumulated a stock of dollars from normal business
operations and did not want to hold them in the United States for fear they
would be confiscated by the U.S. government. Western banks quickly
followed suit for other reasons, including lighter controls. The business of
lending out the dollars on deposit abroad became fully established after the
Interest Equalization Tax and other U.S. controls on foreign bank lending
made Eurodollar business more attractive than loans booked through Wall
Street. American banks expanded their offices in London and were ready to
accept the billions in deposits they and other international banks received
from the Arab oil countries as oil prices exploded from 1973 to 1981. These
petrodollars, as they were called, were recycled in loans of tens and
hundreds of millions to Third World countries whose finances had been
imperiled by rising oil prices. When these currencies .ire Loaned out in the
form of bonds, they are called Eurobonds.

EUROPEAN CURRENCY UNIT (ECU)

The ECU is a currency unit of account used by the European Monetary

System and is composed of a basket of currencies of all the EC countries
according to their economic weight. The proportions have been adjusted
occasionally as additional countries joined the system, but the German
deutsche in.irk has been the dominant currency from the start, with a
weighting of about 30 percent. In December 1991, the twelve countries of
the European Community agreed to make the ECU the model for a
European currency by the end of the century, to be managed by a central
bank.

EUROPEAN MONETARY SYSTEM (EMS)

The European Monetary System was created in 1979 as a means to

establish exchange rate stability among European Community currencies,
since this had proved impossible for the world as a whole. Under the EMS
exchange rate regime, now commonly referred to as the Exchange Rate
Mechanism (ERM), each participant establishes a central rate for its
currency in terms of the ECU. Participants intervene to prevent movement
greater than 2.25 percent above and below these parities. For weaker
European currencies, these margins may be exceeded by a maximum of 6
percent on a temporary basis. Large credit facilities have been created to
finance balance of payments deficits within the system.

EXCHANGE RATE MECHANISM (ERM)

See European Monetary System.

GLOSSARY
FEDERAL FUNDS RATE

The overnight interest rate that banks needing reserves pay for loans made
to them by other banks. Banks that have reserves exceeding the legal
requirements offer these surpluses, on a day-to-day basis, to other member
banks that have a deficit in their reserves. Changes in the federal funds rate
respond to the total supply of bank reserves, which in turn is determined by
the Federal Reserve. The rate itself determines the banks' wholesale cost of
money.

GENERAL ARRANGEMENTS TO BORROW (GAB)

The GAB was created in 1962 to facilitate emergency balance of payments

financing for its ten members—the United States, Germany, Great Britain,
France, Italy, Japan, Canada, the Netherlands, Belgium, and Sweden (with
associate membership for Switzerland). It was conceived as a means of
supplementing the resources available through the International Monetary
Fund at a time when Great Britain in particular was facing the possibility of
serious balance of payments problems. The GAB was capitalized at $6
billion by its members and was criticized by developing countries because
the right to use its resources was limited to its members, all of whom were
developed countries.

GOLD-DOLLAR STANDARD

The gold-dollar standard was a description of the Bretton Woods system.

Under it, most countries accepted an obligation to convert their currencies
into the dollar, and the dollar was in turn convertible into gold at the price
of S3 5 per ounce. The gold-dollar standard in effect permitted the United
States to finance a balance of payments deficit by using dollars, but also
gave it the responsibility of meeting the commitment to convert those
dollars into gold on demand by foreign central banks.

GOLD POOL

The Gold Pool was a gentlemen's agreement made at a meeting of the Bank
for International Settlements in Basel in November 1961 by Belgium,
France, Italy, the Netherlands, Switzerland, West Germany, and Great
Britain. Its purpose was to stabilize the price of gold on the private market.
The member countries agreed to provide half of the gold or currency
needed to maintain the $35-per-ounce parity; the United States would
supply the other half. The Gold Pool broke down in 1968, forcing the
adoption of a two-tier gold market.

GROUP OF FIVE (G-5)

Composed of the finance ministers of the United States, Japan, Germany,

France, and the United Kingdom, the Group of Five was the main arena for
matters of international economic cooperation among the major economic
powers from the 1970s until the late 1980s. Its genesis was in the Library
Group

GLOSSARY

of finance ministers (United States, Britain, France, Germany) convened at

the White House library in 1973 by George Shultz, the U.S. Treasury
secretary, for informal discussions as the Bretton Woods system was
breaking down. Japan became the fifth member of the group the following
year.

GROUP OF SEVEN (G-7)

The Group of Seven consists of the G-5 members plus the finance ministers
of Italy and Canada. It was formalized at the Tokyo summit of 1986. After
the Louvre accord of 1987, the G-7 became increasingly important, finally
superseding the G-5 in setting policies of international cooperation.

GROUP OF TEN (G-IO)

The Group of Ten grew out of the General Arrangements to Borrow (GAB),
and is composed of its original members. In the 1960s and into the 1970s, it
was an important forum for discussion of international monetary issues.
Since the mid-1970s, many of its responsibilities have devolved onto the G-
5 and G-7.

INTEREST EQUALIZATION TAX

This tax was first levied by the U.S. government in 1964 on medium- and
long-term private lending to foreign borrowers. Authority was extended
several times, and did not actually expire until 1974. The tax was designed
to narrow or eliminate the difference between U.S. and world interest rates
in order to discourage heavy capital outflows that were putting pressure on
the dollar at the time. By discouraging international borrowing from the
New York market, it was a major factor in the growth of the Eurocurrency
and Eurobond markets.

INTERIM COMMITTEE

The Interim Committee of the International Monetary Fund is a body of

finance ministers of member countries who meet regularly to oversee broad
questions of Fund policy. Day-to-day management is left to the executive
directors of the IMF. The committee was established in 1974 as a successor
to the Committee of Twenty. The name was related to the fact that it was
originally intended to last only until the world monetary system was
reformed, after which it was to be made a permanent committee.

INTERVENTION

Intervention refers to purchases and sales by official government

institutions (usually the central banks) to affect exchange rates. The usual
procedure is to purchase weak currencies from the market with stronger
ones in order to stabilize the weaker, but occasionally the reverse happens
to push down a strong

GLOSSARY

currency. There are two types of intervention. In the first, called sterilized
intervention, a central bank offsets sales or purchases of its currency with
sales or purchases of domestic assets in order to maintain a constant money
supply. In the second, called unsterilized intervention, the central bank will
allow its purchases or sales of currency to affect the money supply.
Virtually all intervention by large countries with broad money markets is
sterilized.

j-curvE
The J-curve explains why a country's trade balance is expected to worsen
immediately following a devaluation but improve thereafter. It is the
theoretical shape of the path (in rough form of the letter J) of a country's
trade balance over that period, reflecting an increase in the price of imports
before their volume can be reduced by higher prices and the volume of
exports increased by lower prices. It is caused by the fact that it takes two to
three quarters (six to nine months) for prices to have an effect on sales
volume, due to orders already made, negotiations in process, and other lags.

LENDER OF LAST RESORT

The lender of last resort in a market carries the responsibility for supplying
liquidity (credit) during financial crises. Before the creation of central
banks, emergency credit was often supplied by great private banks, which
unlike central banks cannot create money and liquidity for the system as a
whole. In a modern national economy, this function of lender of last resort
is carried out by the government's central bank. In the international context,
it has traditionally been seen, more vaguely, as the responsibility of the
preponderant power (when there is one), or in recent years the IMF, to avert
crisis by lending official credits to other countries or by keeping its money
market open. Economists generally recognize the indispensability of a
lender of last resort during a financial crisis in any market.

LOCOMOTIVE STRATEGY

The locomotive strategy, followed by the major economic powers after the
London summit of 1977 and the Bonn summit of 1978, was a response to
sluggish world economic growth (known as stagflation) that followed the
first oil shock in 1973-74. Germany and Japan, two countries with stable
inflation and low growth rates, were to act as "locomotives" for the world
economy by stimulating their own economic growth; theoretically, their
prosperity would spread through their increased international trade and
investment.

MONEY SUPPLY

This is the amount of money in an economy, which is controlled by the

central bank for its effect on economic variables such as economic growth
and

GLOSSARY

inflation. A variety of aggregate measures are used, labeled M-i, M-2, and
so on, as the definition broadens from cash and checking accounts to less
liquid deposit holdings such as certificates of deposit.

MORAL HAZARD

The dilemma that arises because measures taken to reduce the adverse
consequences of risky behavior tend to make such behavior more likely. For
example, allowing a country to pay off bad debts at discounted prices can
create an incentive for it to take actions that will further reduce the burden
of its debt by reducing its value further at the expense of its creditors.

NIXON SHOCKS

There were two Nixon shocks (known in Japan as the "Nixon shokku")
during the summer of 1971. On July 15, President Nixon announced to the
world that he would visit the People's Republic of China, reversing almost
twenty years of U.S. policy to isolate China after it turned Communist in
1949. On August 15, Nixon suspended the gold convertibility of the U.S.
dollar and imposed a 10 percent import surcharge, setting the stage for the
Smithsonian conference in I )ecember of that year. These drastic
turnarounds in policy were particularly shocking for Japan, which was
directly affected by both.

OBJECTIVE INDICATORS

Specified economic indicators used to determine the need for economic

policy adjustments. One form of such indicators was prominent in U.S.
reform proposals in the early 1970s, and another form was agreed to at the
G-7 summit in Tokyo in May 1986. The onginal proposal of U.S. Treasury
Secretary James Baker required that countries adjust their policies
appropriately if these objective indicators showed a disequilibrium. The
framework actually adopted, which included such indicators as economic
growth rates, exchange rates, interest rates, and fiscal deficits, had little
force in affecting the behavior of nations.

OFFSETS

In the 1960s, a variety of means were used to disguise U.S. balance of

payments deficits. Official U.S. expenditures abroad, such as payments for
troops in Germany, increased foreign countries' dollar reserves, while
counting as current debits for the United States. Purchases of U.S. military
goods, foreign payments for base construction, and investment of some of
the funds received for them back into the United States "offset" the loss to
the U.S. balance of payments. As long as securities purchased by foreign
governments had maturities of over one year, they would be considered
long-term capital flows, rather than dollar reserves, and balance of
payments figures would not be adversely

GLOSSARY

affected. An important source of offset finance was contributions by

Germany to the cost of U.S. and British troops stationed there for defense
against a Soviet attack.

OUTLINE FOR REFORM

The Outline for Reform was the final working document of the Committee
of Twenty and was based partly on a 1972 proposal by the U.S. Treasury
Department. The committee sought to reform the par value (fixed-rate)
system by making it more flexible and less susceptible to shocks.

PARITIES

Parities was the term for the obligations to keep fixed exchange rates under
the Bretton Woods regime until 1971. Except for the United States, the
parities were usually set in terms of dollars.

RECYCLING
Following the first oil crisis of 1973-74, foreign reserves of oil-producing
countries increased greatly. The problem of recycling was how to transfer
these reserves back into a form in which they could finance the needs of the
oil-consuming countries. Although leading countries discussed the
possibility of a public role in recycling, in the end it was carried out through
private sector activities, notably through syndicated Eurocurrency loans to
developing countries.

REFERENCE RANGES

A term used to connote a more flexible form of target zone for currencies
(see below). The ranges would not need to be publicly announced, and there
would be less obligation for countries to intervene in order to maintain
them.

RESERVE ASSETS, RESERVE CURRENCY

A reserve asset or currency is one that is held by a national central bank in

support of its ability to make foreign payments and maintain the value of its
own currency. During the 1950s and 1960s, the dollar and gold were the
principal assets that played this role, although British pounds and rights to
draw on the IMF were significant. In the 1970s and 1980s, there was a trend
toward the use of the German mark, the Japanese yen, and, to a limited
extent, the SDR. While many central banks hold gold in their vaults, it is
seldom used, and the dollar remains the leading reserve currency.

RESERVE INDICATORS

Reserve indicators were a form of objective indicator proposed by U.S.

negotiators at the Committee of Twenty in 1972. In the proposal, changes in

GLOSSARY

reserves would signal fundamental disequilibrium and call for adjustment

policies to be applied relatively automatically.

SPECIAL DRAWING RIGHT (SDR)

The SDR, valued as a basket of major currencies, was created in 1970 by
the International Monetary Fund to address the Triffin Dilemma (see
below). It was meant to serve as a supplementary reserve asset and source
of international liquidity in order to take pressure off the dollar. It has not
functioned as a major substitute for the dollar in countries' foreign reserves,
although it is used to provide needed liquidity from time to time, especially
by developing countries.

s I ERLING AREA

Immediately after World War II, a number of former British colonies such
as Australia and India used the pound sterling as their primary reserve
currency. The scope of the sterling area steadily diminished as a result of
the primary role of the dollar in the rest of the world, but it was still a factor
in British reluctance during the 1960s to devalue the pound, after which the
proportion of sterling in national reserves declined sharply. By general
agreement and because of the weakness ol the British economy, sterling
was largely phased out as a reserve currency in the 1970s.

m BST1 rUTION ACCOUNT

A proposal th.it would allow countries to exchange foreign currency

reserves tor SPRs. The proponents hoped that this substitution would both
Stabilize exchange rates and strengthen the role of the multilaterally
controlled SDR.

SWAP AGREEMENT

In an official swap agreement, a central bank agrees to provide a supply of

its own currency to another central bank for an identical amount of its
currency. Typically, the stronger currency will be drawn to intervene in
support of the weaker. When the pressure comes off the weak currency and
its reserves are rebuilt, the money is repaid, and the swap is thus unwound.
The agreement usually includes guarantees to offset any change in currency
values.

TARGET ZONES
Target zones are one plan for stabilizing floating exchange rates. Countries
would set zones within which currency fluctuation would be considered
acceptable, and if rates moved outside those limits, national authorities
would be expected to intervene in the market or take other measures such as
raising interest rates to stabilize the currency.

GLOSSARY

TRIFFIN DILEMMA

In the early 1960s, Robert TrifTin, a Belgian-born economist and professor

at Yale University, identified a crucial contradiction in the Bretton Woods
fixed exchange rate regime posed by the role of the dollar: Continuing U.S.
balance of payments deficits were necessary to supply dollars for world
liquidity, but such deficits would undermine confidence in the dollar. SDR
creation was an attempt to circumvent the dilemma.

TWO-TIER GOLD MARKET

In response to a major rush to exchange currencies into gold in 1968, the

Gold Pool was dissolved and the major economic powers ceased converting
their currencies into gold for private buyers. In the two-tier system that
developed, private buyers and sellers operated in a market without official
intervention, while official holders would theoretically buy or sell gold
among each other and at the official price, or parity. As the pnvate price
rose, few did.

WORKING PARTY THREE (WP3)

One of several working parties (albeit the only restricted one) in the
Organization for Economic Cooperation and Development (OECD), WP3 is
a subcommittee of the Economic Policy Committee. In the 1960s, it
periodically monitored the economic policies of member countries, and
worked to keep them in line with the needs of maintaining the fixed-rate
system. WP3 exists today as a working-level line of communication among
financial officials.
TIONAL

MONETARY RELATIONS 1944-1989

1944

July 22: Articles of Agreement of the International Monetary Fund and the
International Bank for Reconstruction and Development adopted at Bretton
Woods, New Hampshire, after a conference of the Allied powers to
determine the postwar monetary system. Forty-five countries were
represented.

1945

May 8: War ends in Europe.

September 1: Lend-lease aid terminated by the United States.

September 2: Japan formally surrenders.

December 27: IMF Articles of Agreement enter into effect, and the IMF
and the World Bank open their doors in Washington, D.C. The Articles of
Agreement outlawed discriminatory currency practices and exchange
restrictions, except during a transitional period. They required exchange
rates to be fixed. The United States indicated that it would continue its
prewar policy of converting gold to dollars at $35 an ounce upon demand
by foreign governments, but no obligation to do so was written into the
Articles of Agreement.

1946

July 15: Anglo-American loan agreement is approved, providing a loan of

$3.75 billion to Britain on condition that the pound can be converted to
other currencies.

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1947
March 12: President Truman asks Congress for $400 million special
assistance to Greece and Turkey in addition to $350 million requested
earlier for other countries. The United States thus takes on the leadership of
the West against communism after the British tell the United States that
they cannot afford to carry on in what had been their traditional sphere of
influence.

June 5: Secretary of State George Marshall proposes the European

Recovery Program (the Marshall Plan) in a commencement speech at
Harvard.

July 15: Britain restores convertibility of the pound. In less than a month,
$3.35 billion, or almost all the amount loaned by the United States, flees the
country. Convertibility is suspended August 20.

1948

June 28: President Truman signs a bill appropriating the initial $4 billion for
the European Recovery Program (ERP) and $2 billion for other foreign
assistance, mostly for administration and relief in areas of Europe held by
the Allied Occupation Forces. The military aid programs for Greece and
Turkey receive $225 million, and China $400 million.

1949

September 18-29: Exchange rates of European countries are devalued

against the dollar in amounts ranging from 30.5 percent for the pound
sterling to 12.3 percent for the Belgian franc. Many non-European countries
also devalue.

1950

September 19: Agreement establishing the European Payments Union

(EPU) is signed retroactive to July 1, allowing recipients of ERP assistance
to settle accounts among themselves through a multilateral clearing system
using their own currencies, without using scarce dollars.

1952
August 13: Japan joins the IMF.

1956

October 17: IMF extends France a standby credit of $263 million.

October 29: Israel invades Egypt. Two days later, France and Britain, acting
in collusion, also invade and seize the Suez Canal, which had been
nationalized by President Gamal Abdel Nasser. President Eisenhower
telephones Anthony Eden, his.World War II colleague and now Britain's
prime minister, to warn him that Britain will receive no financial help from
the United States unless it withdraws. Harold Macmillan, Chancellor of the
Ex-

CHRONOLOGY

chequer, warns Eden that Britain does not have the financial resources to
continue.

November 7: Britain and France announce Suez withdrawal.

December 22: Britain borrows $561 million from the IMF and is extended a
standby credit of $739 million.

1957

March 25: France, West Germany, Belgium, the Netherlands, Luxembourg,

and Italy agree to the Treaty of Rome, establishing the European Economic
Community, the common market in goods and services with free mobility
of labor, to be phased in over more than a decade. Britain refused to attend
the founding conference in Messina, Italy, and stood aside.

1958

December 27: Ten European countries (Belgium, Britain, Denmark, France,

West Germany, Italy, Luxembourg, the Netherlands, Norway, and Sweden)
restore currency convertibility for nonresidents and dissolve the European
Payments Union. Five other European countries (Austria, Finland, Greece,
Ireland, and Portugal) soon follow.
1959

September 9: The first general increase in IMF resources becomes effective.

The quotas are raised 50 percent, enlarging the Fund's resources to $14
billion.

i960

October: First gold crisis. The price of gold on the London exchange shoots
out of its narrow range around $35 and touches $40 on October 20 before
receding. This provokes a wave of speculation against the dollar. To
stabilize prices, major governments sell large amounts of gold.

October 31: Presidential candidate John F. Kennedy declares: "If elected

president I shall not devalue the dollar from the present rate."

November: Eight nations (Belgium, Britain, France, Italy, the Netherlands,

Switzerland, Germany, and the United States) begin to sell gold in the
London market. A year later, they set up the London Gold Pool to stabilize
the gold price.

November 16: President Eisenhower issues a directive instituting measures

to reduce the U.S. balance of payments deficit by reducing U.S. spending
abroad by $1 billion, reducing military dependents abroad, and tying U.S.
foreign aid to domestic purchases.

CHRONOLOGY

1961

February 6: A Kennedy administration balance of payments message

expresses an interest in improving the ability of international institutions to
provide increases in international reserves, but avoids major policy changes
on currency rates, foreign investment, or overseas military commitments.

March 6—7: West Germany and the Netherlands revalue their currencies
upward by 5 percent.
February 15: Nine Western European countries accept Article 8 obligations
of the IMF, rendering all the major currencies convertible.

March: The U.S. starts to intervene in foreign-exchange markets to stabilize

the dollar.

September 30: The Organization for Economic Cooperation and

Development, successor to the Marshall Plan coordinating group, formally
comes into existence in Paris.

1962

January 5: Partly because of fears that the United States might need to
borrow from the IMF, its resources are supplemented by General
Arrangements to Borrow (GAB) by ten nations. These major financial
powers become the principal forum, known as the Group of Ten (G-10), for
monetary reform discussions. The participants and their credit
commitments: United States, $2 billion; West Germany, $1 billion; Britain,
$1 billion; France, $550 million; Italy, $550 million; Japan, $250 million;
Canada, $200 million; the Netherlands, $200 million; Belgium, $150
million; and Sweden, $100 million. The GAB went into effect on October
24.

February 13: The Federal Reserve adopts procedures for foreign currency
operations by establishing a swap network, or short-term agreements with
other central banks providing short-term lines of credit to be drawn almost
instantaneously against currency pressure.

1963

July 15: Administrative restrictions on American capital outflows are

announced.

July 16: By a narrow vote of four to three, the Federal Reserve raises the
discount rate from 3 to 3.5 percent to help stem dollar outflow.
July 18: The Kennedy administration proposes the Interest Equalization Tax
(approved September 2, 1964) adding an effective 1 percent to interest rates
for foreign borrowers in U.S. capital markets on securities of more than
three years. These measures were extended in 1965 to cover bank loans and
were intensified in 1967 when the rate was increased to 1.5 percent. They
were finally lifted on January 29, 1974.

October 1963-June 1964: Finance ministers and central bank governors of

CHRONOLOGY

the Group of Ten countries undertake a nine-month study of the

international monetary system and its future needs for liquidity. Robert
Roosa, U.S. Treasury undersecretary for monetary affairs, is named
chairman of the group.

1964

June 30: International study group of thirty-two economists known as the

Bellagio Group under the leadership of Fritz Machlup of Princeton
completes its report, "International Monetary Arrangements: The Problem
of Choice," advocating more flexible exchange rates and reforms in reserve
creation and warning of the instability that could be caused by a sudden,
massive demand for conversion of currency reserves into gold.

October 16: Labour government elected in Britain to widespread suspicion

in financial circles. A run on the pound begins. On October 17, the new
Labour government decides against devaluing the pound. On October 26, it
imposes a 15 percent surcharge on manufactured imports. On November 20,
Britain borrows $1 billion from the General Arrangements to Borrow, the
first use of this facility. On November 23, the Bank of England raises the
bank rate from 5 to 7 percent. On November 25, Britain obtains a $3 billion
credit from major financial powers and the Bank for International
Settlements. Speculation subsides.

1965
January 4: France, which has been converting $35 million a month into
gold, announces that henceforth the Bank of France will convert to gold all
new dollar balances accumulated from the nation's balance of payments
surplus.

February 4: President de Gaulle accuses the United States of an "exorbitant

privilege" by being permitted to settle its foreign accounts in its own
currency under the existing monetary regime and appears to endorse a
return to a full gold standard.

February 10: The Johnson administration announces further measures to

discourage capital outflows by extending restraints to bank loans and
corporate investments abroad. It also requests "voluntary" restraints on
foreign lending by American banks and corporations.

July 10: Secretary of the Treasury Henry Fowler, in a speech at Hot

Springs, Virginia, proposes an international monetary conference to reform
the arrangements for increasing international liquidity. The other major
financial powers decline to endorse the idea, but negotiations nevertheless
proceed in the forum of the Group of Ten.

December 6: The Federal Reserve Board, reacting to the strength in the

economy because of unannounced increases in Vietnam War spending,
tightens monetary policy and raises the discount rate from 4 to 4.5 percent
over the objections of President Johnson.

CHRONOLOGY

1966

July 20: The British government, declaring that its recovery program has
been "blown off course" by a seaman's strike, announces a drastic austerity
program.

September 13: The Federal Reserve and other central banks increase their
credit lines to the Bank of England.

1967
January 10: President Johnson belatedly calls for a temporary income tax
surcharge of 6 percent to help pay Vietnam War costs.

March: In a letter to the chairman of the Federal Reserve from Karl

Blessing, president of the Bundesbank, Germany officially agrees not to
buy gold from the United States. The letter was released to the public May
2.

August 3: President Johnson increases his request for an income tax

surcharge to 10 percent, finally yielding to fears of inflation fueled by
Vietnam War spending.

November 14: The British government announces an October trade deficit

of 107 billion pounds (almost S300 million), the largest monthly figure on
record.

November [8: The pound is devalued by 14.3 percent against the dollar.
President Johnson declares that the $35 price of gold will not be changed.
Rumors arise that the Gold Pool of seven central banks supplying bullion in
London will fall apart. Private gold purchases turn into a stampede. France
later leaves the Gold Pool.

November 26: Central bank governors of active members of the Gold Pool
meet in Frankfurt and agree both to continue pool sales and to support the
existing pattern of exchange rates.

1968

January 1: The Johnson administration announces a major new balance of

payments program, including mandatory controls on the use of dollars
raised in the United States to finance direct investment by corporations in
developed countries.

March 15: Federal Reserve Governor Sherman Maisel argues privately that
the Europeans should be pressed to allow a depreciation of the dollar
against their currencies, and that if they refuse the United States should stop
gold sales and end support for exchange rates. Maisel writes his memo as a
result of having been outvoted when the Federal Reserve authorized an
increase in swap lines of $2.8 billion and borrowing S8.5 billion in foreign
currencies to defend the dollar.

March 16-17: The seven remaining Gold Pool members (the United States,
Italy, West Germany, Britain, the Netherlands, Belgium, and Switzerland)
agree to end sales of gold in the private market, which leads to the

CHRONOLOGY

two-tier gold market, permitting the free market price to rise above the
intergovernmental price. The United States reaffirmed that it stood ready to
buy dollars with gold from other governments at $35 an ounce, but most
governments restricted their conversions because of their fear that such
requests would lead to the end of convertibility.

June 18: In the aftermath of the May student uprising, the French balance of
payments deteriorates and France sells $400 million of gold to the United
States and three European countries.

June 28: The United States enacts an income tax surcharge of 10 percent,
retroactive to April 1 for individuals.

November 20-22: At a tense and highly publicized meeting in Bonn,

finance ministers, including Treasury Secretary Henry Fowler of the United
States, attempt a multilaterally negotiated shift in exchange rates between
France and Germany. The meeting fails, with de Gaulle refusing to devalue,
calling it "the worst form of absurdity," President Johnson supporting de
Gaulle, and the Germans refusing to revalue.

December 17: Secretary of the Treasury-designate David M. Kennedy, in a

statement before Nixon's inauguration, refuses to pledge that the incoming
administration will reject the possibility of a devaluation. He said he wanted
"to keep all options open." This upsets European gold markets.

1969

January 16: The Economic Report of the outgoing Democratic president

includes the first official U.S. discussion of the possibilities of flexible
exchange rates.

April 29: West German Finance Minister Franz Josef Strauss suggests
publicly that Germany might revalue the mark as part of a multilateral
currency alignment. Within the next two days, the Bundesbank takes in $4
billion to hold the exchange rate.

May 9: The German cabinet rejects revaluation "for eternity."

May 12: Germany introduces new controls on inflows of funds, cuts

government spending and revenue, imposes "border fees" amounting to an
export tax and import subsidy, and imposes a temporary 100 percent reserve
requirement for foreign deposits

July 28: The first amendment to the IMF Articles of Agreement becomes
effective, establishing Special Drawing Rights.

August 8: Without either warning or speculative pressure, the French franc

is devalued by 11.1 percent.

September 29: Germany lets the deutsche mark float.

October 24: After German elections, the mark is revalued by 9.3 percent,
unwinding speculative inflows. West German reserves fall by more than $5
billion, including the sale of $500 million in gold to the United States.

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1970

August 15: President Nixon signs an extension of the Defense Production

Act, which incidentally and over his opposition gives him authority to^
impose controls on wages, prices, and rents.

September 13: The IMF publishes a report, "The Role of Exchange Rates in
the Adjustment of International Payments," saying that the par value system
remains the best system and promising to study methods of introducing
flexibility.
1971

February 11: John B. Connally, former Democratic governor of Texas, is

sworn in as secretary of the Treasury in the Nixon administration (he had
been named December 14, 1970).

April 26: West German Economics Minister Schiller proposes a joint float
of European currencies to Hamburg meeting of European Community
finance ministers.

May 5: The Bundesbank takes in Si billion in the first hour and suspends
official operations in the foreign exchange market.

May 8—9: European Community finance ministers meet in Brussels and

again reject West German Economics Minister Karl Schiller's proposal for a
joint float.

May 9: Austria revalues by 5 percent and Switzerland by 7.1 percent.

May 10: West Germany and the Netherlands let their currencies float.

May 28: At a meeting of international bankers in Munich, Connally points

out that net U.S. military expenditures abroad are larger than the underlying
U.S. balance of payments deficit and declares: "No longer does the U.S.
economy dominate the free world. No longer can considerations of
friendship or need or capacity justify the U.S. carrying so heavy a share of
the common burdens. . . . We are not going to devalue. We are not going to
change the price ot gold."

June 4: Japan announces an eight-point program to reduce its balance of

payments surplus, including increased import liberalization, preferential
tariffs for less developed countries, accelerated cuts in tariffs, promotion of
capital investment both inward and outward, reduction of nontariff barriers,
increased foreign economic aid, review of export tax incentives, and
introduction of "orderly marketing," which eventually leads to voluntary
quotas in automobiles and more flexible fiscal and monetary policies.
June 26: President Nixon sends Connally to a press conference to announce
the president's policy of "four no's": no tax reduction, no increased federal
spending, no wage-price controls, and no wage-and-price review board.

Late July and early August: Meetings are held between Nixon and
Connally, and among other high administration officials, to plan for the
possible

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suspension of gold convertibility. Nixon decides to wait until Congress

returns in September to act.

August 6: The Treasury announces that the United States has sustained a
new decline in reserves of more than $i billion. The House Subcommittee
on International Exchange and Payments, led by Representative Henry
Reuss, publishes its "inescapable conclusion" that the dollar must be
devalued or gold sales suspended.

August 9-13: During the week, $3.7 billion moves across the exchanges
into foreign central banks. Paul Volcker urges that the timetable be
advanced to maintain the initiative for an orderly announcement. The
Federal Reserve draws heavily on the swap network to provide devaluation
cover for part of the dollar gains of four central banks. A run on the dollar
into gold is increasingly feared. On Thursday, August 12, the Bank of
England requests unspecified devaluation cover for its dollar reserves of
about S3 billion. The Federal Reserve draws $2.2 billion on its swap lines,
including $750 million for the Bank of England.

August 13-15: President Nixon holds a secret meeting of senior economic

and White House officials at Camp David. Connally outlines the program.
Federal Reserve Chairman Arthur Burns opposes floating the dollar and
suspending convertibility. He recommends sending Volcker to negotiate
with other countries on a realignment of currencies. Long-range reform of
the international monetary system is not discussed.

August 1 5: In what he calls a New Economic Policy, the president uses the
authority provided earlier by Congress to freeze wages and prices. He asks
Congress to cut spending, including foreign aid, and confirm a 10 percent
tax on imports imposed by executive authority. The centerpiece of the
program is the suspension of convertibility of the dollar into gold. Connally
invites IMF Managing Director Pierre-Paul Schweitzer to watch the
president's address on a television set in Connally's office. No consultation
occurred with the IMF prior to the August 15 announcement.

August 16: European governments except France close their foreign

exchange markets for a week, in effect permitting a float. Japan does not
suspend foreign exchange trading, and the Bank of Japan continues to buy
dollars at the 360 rate until August 28, when the yen is permitted to float
upward. Japanese companies and banks unload their large dollar holdings
on the Bank of Japan before the dollar depreciates. The Bank of Japan takes
in $4.5 billion, an amount equal to Japan's entire reserve stock before 1971.

August 19: France reopens its foreign exchange market on a two-tier basis,
with floating rates for capital transactions and fixed rates for trade. All other
European currencies float without the two-tier market. Central banks
intervene separately to control these floats, although all European
currencies rise by varying degrees.

September 3-4: Volcker tells Group of Ten deputies in Paris that the

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United States seeks a swing in its current account of Si 3 billion from what
it would otherwise be in 1972.

September 15: Group of Ten finance ministers meet in London, but the
meeting fails to resolve the dispute. Federal Reserve Chairman Burns then
asks Jelle Zijlstra, president of the Bank for International Settlements and
president of the Dutch Central Bank, to attempt a secret mediation mission.
Connally refuses to cooperate with Zijlstra.

November 30-December 1: At a Group of Ten meeting chaired by Connally

in Rome, Volcker says that the United States will eliminate the surcharge in
return for early decisions on trade concessions, progress in sharing defense
costs, and an average dollar depreciation against OECD currencies of 11
percent. The United States hints that it might devalue the dollar by 10
percent against gold, which helps unblock the negotiation.

I )ecember 13-14: France and the United States strike a deal in the Azores
at a meeting between Presidents Nixon and Pompidou. France accepts an
8.6 percent revaluation of the franc against the dollar, the United States
agrees to raise the dollar-gold price from $35 to $38 an ounce, and
Pompidou implicitly agrees not to insist on an early return to dollar
convertibility.

I )ecember 17-18: In a meeting at the Smithsonian Institution in

Washington, Japan agrees to revalue by 16.9 percent against the dollar,
West Germany 13.6 percent, Britain and France 8.6 percent, Italy 7.48
percent, the Netherlands 1 [.57 percent, and Sweden 7.49 percent. The
Bretton Woods band of permissible currency fluctuation is widened from 2
percent to 4.5 percent. Canada, as it had threatened, does not peg its rate but
floats. The United States removes the import surcharge and the investment
tax credit. Instead of the 11 percent originally requested, Washington
achieves an average depreciation of approximately 8 percent against all
OECD currencies. Convertibility is not resumed, and S3 8 is confirmed as
the new price at which, many commentators remarked, the United States
will not sell gold.

1972

March 7: European Economic Community nations decide to narrow the

margins for fluctuations of their currencies against each other to 2.25
percent to form the EEC "snake."

March 15: Connally calls for formation of the Committee of Twenty in a

speech at the Council on Foreign Relations in which he denies he is a "bul-
lyboy on the manicured playing field of international finance."

May 16: George Shultz succeeds John Connally as secretary of the

Treasury.

June 23: After losing $2.5 billion of reserves in six days, Britain leaves the
EEC snake and floats.
June 26: After closing their exchange markets, EEC finance ministers

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decide to maintain the snake but permit Italy to intervene. Denmark

withdraws from the snake.

June 28-July 14: European central banks and the Bank of Japan purchase $6
billion to maintain Smithsonian exchange rates.

June 29: The West German government, over the objection of Economics
Minister Karl Schiller, bars the sale of German bonds to foreigners to ease
upward pressure on the deutsche mark.

July 2: Schiller resigns and is later succeeded by Helmut Schmidt.

July 19: The Federal Reserve undertakes operations in the foreign exchange
market for the first time since August 15, 1971.

September 26: Secretary Shultz presents to the annual IMF annual meeting
the broad outlines of a U.S. proposal for international monetary reform
known as the Volcker Plan. This was to form the basis for discussions in the
Committee of Twenty. It was an attempt to make the par value system more
flexible, and called for a symmetrical system of adjustment.

November 27: At a Washington meeting, the Committee of Twenty starts

deliberations on a new monetary system.

1973

January 1: Britain, Denmark, and Ireland become full members of the

European Community.

January 11: The Nixon administration ends mandatory price-wage controls

and begins a more voluntary approach to fighting inflation.

February 6: West German Finance Minister Schmidt rules out revaluation of

the deutsche mark, blaming the weakness of the dollar for the crisis. During
the week of February 5-9, the Bundesbank purchases more than $5 billion
in an attempt to hold the exchange rate.

February 7: Undersecretary Volcker leaves on a five-day 31,000-mile trip to

major capitals to negotiate a second devaluation of the dollar.

February 12: The United States announces a 10 percent devaluation of the

dollar. Gold begins to rise. The yen is floated and soon rises.

March 1: European central banks purchase S3.6 billion and close foreign
exchange markets for two weeks.

March 11: EEC ministers announce a joint float of six currencies while
Britain, Italy, and Ireland float independently. Germany revalues the
deutsche mark by 3 percent against other European currencies.

March 16: Group of Ten finance ministers agree to float currencies. Swap
facilities among central banks are enlarged. Sweden and Norway associate
their currencies with the EEC snake.

March 19: Markets reopen and the dollar stabilizes.

March 25: After a meeting of ministers of the Committee of Twenty,

French, German, and British finance ministers meet in the library of the
White

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House at the invitation of Treasury Secretary Shultz. They became known

as the Library Group, and later the Group of Five (when Japan was added).

October 6: Arabs attack Israel in the Yom Kippur War.

October 16: The Organization of Petroleum Exporting Countries (OPEC)

raises the price of crude oil 70 percent, from $3.01 to $5.12 per barrel.

October 20: OPEC imposes an oil embargo on the United States, and later
the Netherlands. Oil companies shuffle shipments to ensure steady supplies.
November 12: Central bank governors, meeting in Basel, terminate the two-
tier gold agreement.

December 23: The oil price is raised again, nearly quadrupling from its
level of early October, to $11.65 a barrel. This forces a continuation of
floating.

1974

January 29: The United States terminates capital controls. The dollar begins
to drop.

January 30: West Germany relaxes controls on capital inflows.

February 11: The Washington energy conference attempts to form a front of

Western consumer countries to counter OPEC. The French refuse to
participate in the new International Energy Agency, which collects data on
the oil market from Western oil companies.

March: The Federal Reserve tightens monetary policy.

May 14: Representatives of the Federal Reserve, the Swiss Central Bank,
and the Bundesbank agree to intervene to support the dollar.

June 14: The Committee of Twenty concludes its work with "Final Outline
of Reform." The main features are (1) rules for a symmetrical adjustment
process based on par values that could be adjusted, (2) cooperation in
dealing with capital flows by official restraint, (3) limited gold
convertibility to settle payments imbalances, (4) international management
of global liquidity with emphasis on the SDR, (5) consistency among
adjustment, convertibility, and global liquidity, and (6) promotion of net
flow of resources to less developed countries. This complex agreement was
overtaken by the oil crisis and resulting world economic instability, and was
never put into practice.

October 3: The new Interim Committee of the IMF, its membership based
on the Committee of Twenty, holds its first meeting. The main topic is
petrodollar recycling. France and Belgium call (unsuccessfully) for stable
exchange rates.

1975

November 15: The first economic summit, held at the Chateau de Ram-
bouillet southwest of Paris. It endorses the compromise worked out in
advance between France and the United States revising the IMF's Article 4
to legalize floating exchange rates. In the new version, IMF members
obligate themselves

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to pursue economic policies conducive to monetary stability under a range

of possible arrangements from floating to a more fixed system on the
emerging model of the European currency snake.

The five, with Italy, also agree to intervene in markets to iron out erratic
fluctuations in exchange rates not caused by underlying economic factors.
A detailed system of consultation is created for this purpose, with central
banks consulting daily and finance ministers meeting quarterly.

1976

January 8: The IMF Interim Committee, meeting in Kingston, Jamaica,

completes an interim monetary reform program, with agreement on IMF
quota increases for industrialized and OPEC nations, and a new exchange
rate system legitimizing floating. One third of IMF gold was to be sold on
private markets over a period of several years, and one sixth was to be
returned to members proportionate to their paid-in gold tranche. The other
one sixth would go into a trust fund, which was an expanded loan facility
for less developed countries (LDCs). The reason for this was that gold had
appreciated up to five times its previous fixed price, and some countries
saw tantalizing capital gains for themselves while conveniently siphoning
some of the profits to helping the LDCs.

June 27-28: Puerto Rico summit. President Ford stresses the need for
cautious fiscal and monetary policies to check a revival of inflation. The
summit endorses the restrictive policies under way in the United States and
Germany, reversing the stimulus introduced the year before. Ford takes this
as an endorsement of his administration's economic policy in an election
year.

October 4-8: At the IMF annual meeting in Manila, Managing Director H.

Johannes Witteveen calls on nations to attempt greater adjustment to
balance of payments problems caused by high oil prices instead of relying
on financing to avoid the strains of adjustment.

1977

January 25: President Carter dispatches Vice President Mondale on a tour of

allied capitals, aiming to impress upon the stronger economies what he sees
as their international responsibility to accelerate growth and reduce their
payments surpluses. In Bonn, Prime Minister Schmidt disparages this
advice and rejects it. (Growth in the G-7 countries declined from an annual
rate of 5.9 percent in the first half of 1976 to 3.4 percent in the second, far
more than bargained for in combating the worldwide effects of inflation
induced by the first oil-price shock. Members of the liberal establishment at
the Trilateral Commission, the Brookings Institution, and elsewhere had
called for Germany and Japan to serve as "locomotives" to help stimulate
the world economy.)

February 2: The new Carter administration announces a $30 billion

domestic stimulus program and appeals to Germany and Japan to follow.

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May 7-8: London economic summit. Germany and Japan confirm they will
allow their currencies to float upward if that proves necessary to reduce
their trade surpluses. Germany succeeds in inserting in the final
communique the statement "Inflation does not reduce unemployment. On
the contrary, it is one of its major causes." The summit countries committed
themselves to economic growth targets although there were no specific
figures in the communique.
May 25: U.S. Treasury Secretary W. Michael Blumenthal, in the first of a
series of comments widely interpreted as an attempt to talk down the dollar,
asserts that Germany and Japan have agreed not to resist market pressures
for the appreciation of their currencies.

November 28: Prime Minister Fukuda reshuffles the Japanese cabinet,

bringing in several expansionists and charging Nobuhiko Ushiba, who filled
the specially created post of minister for external economic affairs, with
seeking an accommodation with the United States, which wanted even
greater domestic stimulus.

1978

January 4: The Treasury and the Federal Reserve issue a joint statement that
the United States will use the $4.7 billion in the Treasury's Exchange
Stabilization Fund and $20.2 billion in central bank swap lines to support
the dollar. The Bundesbank also announces a credit line to the Stabilization
Fund.

January 13: Nobuhiko Ushiba, Japan's minister for external economic

affairs, and Robert Strauss, United States special trade representative, reach
formal agreement on a target of 7 percent for growth in Japan in 1978. In
return, the United States pledges in principle to reduce oil imports and
control inflation.

April 7-8: Heads of government of the European Community meeting at

their regular summit as the European Council endorse in principle a
"concerted action" package aimed at accelerating European recovery. This
puts additional European pressure on Germany for faster growth. At the
same meeting, France and Germany also put forward their proposal for a
new European Monetary System.

April 11: President Carter announces an anti-inflationary program that

means there will be less thrust behind the world economy from the United
States and by implication that more stimulus will be needed from Germany
and Japan.
June 22: President Carter tells a group of congressmen that he is ready
administratively to impose a surcharge on oil imports if the Senate
continues to stall his legislative proposals. Carter sends Senate Majority
Leader Robert Byrd to Bonn to assure the German government that the
president will still be able to deliver on his energy program.

July 16-17: The Bonn summit. Germany agrees to "propose to the legisla-

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tive bodies additional and quantitatively substantial measures up to i

percent of GNP, designed to achieve a significant strengthening of demand
and a higher rate of growth." France agrees to increase its 1978 budget
deficit by 10 billion francs over previous projections. The United States
promises that "by year-end measures will be in effect that will result in oil
import savings of approximately 2.5 million barrels per day by 1985" and
that "the prices paid for oil in the U.S. shall be raised to the world level by
the end of 1980."

(Partly as a result of the summit commitments, policy in the G-7 nations

was expansionary in 1978. This collided with the second oil shock the
following year. After 1978 global inflation rates shot up to an annual peak
of 15.7 percent in 1980, a recession of unprecedented severity ensued. In
Germany and Japan, the macroeconomic coordination of the Bonn summit
came to be regarded as a costly mistake, although neither was running a
particularly stimulative deficit when the second oil shock hit in 1979.)

September 3: Japan adopts an additional public works program. (By the end
of the year, Japanese growth is a full point below Fukuda's 7 percent target,
although domestic demand is high.)

October 15: Congress passes a weakened version of Carter's energy

package. The legislation does not include decontrol of prices, so Carter is
forced to resort to administrative action. The effective date of decontrol is
postponed until after the 1980 presidential election. (Between 1973 and
1978, European Community countries passed OPEC price increases through
to consumers, which spurred conservation and reduced oil imports by
nearly 10 percent in volume. During the same period, despite the rise in
prices, the volume of U.S. oil imports rose by nearly one third.)

November 1: The United States sharply tightens monetary policy and puts
together a package to support the dollar. After falling 6.5 percent in a trade-
weighted basis in October, the dollar rebounded 7 percent against the
deutsche mark and 6 percent against the yen within the first few days.

December 17: OPEC nations start raising oil prices by 14.5 percent as the
Iranian revolution cuts supplies by as much as 5 million barrels a day.

1979

March 13: Formal initiation of the European Monetary System and the
European Currency Unit.

March 27: OPEC raises the base price of oil by 9 percent to $14.54 a barrel,
while allowing members to add surcharges according to what they believe
the market can bear.

June 28-29: The Tokyo summit. Because the second oil crisis has converted
Japan's large external surplus to a deficit, Japan escapes criticism. No
significant monetary agreements occur. There is agreement on numerical oil
import targets through 1985 for each country.

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August 6: Paul Volcker is sworn in as chairman of the board of governors of

the Federal Reserve System.

October 6: In a rare Saturday statement, Chairman Volcker announces that

the Federal Reserve Board will henceforth target the aggregates reporting
the size of the supply of money instead of interest rates in controlling the
availability of credit in the United States.

1980

January 21: Fears of East-West conflict arising from the Soviet invasion of
Afghanistan send gold to a record peak of $875 an ounce in New York,
closing at $830, and $852 in London, closing at $850.

March 14: Carter announces a stiff program against inflation including

budget cuts and controls on consumer credit. The public enthusiastically
complies by cutting spending. Recession ensues.

June 21-23: The Venice summit. The seven nations shift away from a
growth strategy and commit themselves to the priority of fighting inflation
and conserving oil. Helmut Schmidt voices concern at the trend of
international bank lending and commends the idea of a "safety net" for bank
deposits, but no action is taken.

July 2: The Federal Reserve formally ends the credit control program,
which had already been phased out by the end of May. But the central bank
continues its anti-inflationary squeeze on the economy by limiting the
money supply, and by the end of the year, business lending rates are above
20 percent.

September 28: To help finance adjustment to the second oil shock, the IMF
Interim Committee agrees to permit members to draw annually up to twice
their quotas over three years, for a cumulative total of six times their quotas.

1981

January 28: American oil prices are decontrolled.

January: Beryl Sprinkel, the new Reagan administration's undersecretary of

the Treasury, lets it be known through newspaper stories that the United
States will henceforth adopt a hands-oflf approach to the exchange rate of
the dollar and not intervene in world currency markets except in
extraordinary circumstances. The dollar, meanwhile, during six months has
regained 20 percent in value from its previously depressed level because of
the attraction of high U.S. interest rates.

March 30: President Ronald Reagan is shot and gravely wounded. The
Treasury directs the Federal Reserve to intervene in the foreign exchange
markets.
April 17: Secretary of the Treasury Donald Regan formally announces the
United States will not intervene in foreign exchange markets except in
emer-

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gency situations, such as a presidential assassination. In the following

months, this policy is criticized by officials in Germany, Britain, Japan, and
the Bank for International Settlements.

July 20-22: The Ottawa summit. Prime Minister Pierre Trudeau of Canada,
Premier Giovanni Spadolini of Italy, President Francois Mitterrand of
France, and West German Chancellor Helmut Schmidt all sharply criticize
high U.S. interest rates, Schmidt claiming that they had brought Germany
"the highest real interest rates since the birth of Christ." Only Prime
Minister Margaret Thatcher of Britain defends Reagan's policies. Treasury
Secretary Regan declares that the summit required the United States to
make "no change in direction."

1982

January: Record deficits are projected for the U.S. budget. Interest rates and
the dollar climb sharply. Geoffrey Howe, British Chancellor of the
Exchequer, advocates "making plain to the United States our concern about
the level of their prospective budget deficit and its implications for interest
rates around the world."

April 24-25: Preparatory meeting for the Versailles summit. Undersecretary

Sprinkel and Michel Camdessus, director-general of the French Finance
Ministry, have a heated debate. Sprinkel calls for policy convergence
among the major economies as the only way to avoid unstable relations
among currencies. He argues that intervention removes the pressure from
countries to control their domestic inflation by keeping a tight rein on
money growth. Sprinkel and Camdessus agree to a collaborative study on
the effectiveness of past interventions in stabilizing exchange rates. In line
with the American policy of promoting convergent economic policies
among trading partners, the Group of Five finance ministers agree to meet
periodically to conduct "multilateral surveillance" of their economic
policies with the managing director of the IMF.

June 4-6: The Versailles summit makes great efforts to strike a deal to
accommodate American demands for Europe to control its commerce with
the Soviet Union and Eastern Europe, and European, especially French,
demands for the United States to cooperate in stabilizing the value of the
dollar in foreign exchange markets. It commissions a report on the efficacy
of currency intervention by a group of officials under the chairmanship of
Philippe Jurgensen, the French Finance Ministry's deputy director for
international affairs. The summit endorses "multilateral surveillance"
agreed at a preparatory meeting. Europeans agree to limit their credits to the
Communist nations.

Interpretations of the communique are immediately contradictory. President

Francois Mitterrand of France hails the agreement as initiating "reform of
the international monetary system." Treasury Secretary Regan suggests that
Mitterrand "didn't read the fine print," and describes the U.S. position as
"far

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from changed." German Finance Minister Manfred Lahnstein returns to

Bonn and says, "We will continue to work with East European countries
and the Soviet Union as usual."

June 18: The Reagan administration, accusing the Europeans of failing to

honor their commitments to restrict East-West trade, threatens sanctions
against the foreign subsidiaries of U.S. firms that supply a huge East-West
pipeline project under construction to bring Soviet natural gas to Western
Europe. The Europeans are enraged, even Prime Minister Thatcher of
Britain.

July 19: The Federal Reserve votes to relax its tight money policy, setting
off a decline in interest rates that will continue for nearly a year. The
discount rate is lowered from 12 percent to 11.5 percent.
August 12: Mexico's finance minister, Jesus Silva Herzog, informs Treasury
Secretary Regan, Federal Reserve Chairman Volcker, and IMF Managing
Director Jacques de Larosiere that Mexico will not be able to meet the
payments on its debt due on August 15.

August 15: The United States extends Mexico a total of $2 billion in food
credits and advance payments on future oil purchases. A rescue plan for
additional finance is initiated with the IMF, the Bank for International
Settlements, and the commercial banks.

August zy. The commercial banks' advisory committee agrees to grant

Mexico a ninety-day postponement on repayment of principal.

September 7: Heavy withdrawals from Mexican banks' branches in New

York force the Federal Reserve to come up with $70 million from the
money advanced to Mexico from the BIS.

November 10: In an agreement to obtain $1.3 billion in IMF financing, the

Mexican government agrees to cut its budget deficit from an estimated 16.5
percent of GDP in 1981 to 8.5 percent in 1983, cut inflation approximately
in half to 55 percent in 1983, reduce foreign borrowing from $20 billion in
1981 to $5 billion in 1983, and decrease domestic subsidies and wage
increases.

November 16: At a meeting with the major creditor banks, IMF Managing 1
)irector Jacques de Larosiere tells them that the Fund's loan to Mexico
depends on the banks' lending $5 billion in new money by December 15.
The same evening Volcker indicates that regulations will be eased on the
new loans.

December 1: Japan allows Japanese institutional investors to invest abroad.

President Miguel de la Madrid takes office. The new government promises

to comply with the IMF conditions and starts negotiations with the
commercial banks on the terms of the new loans and the rescheduling of
payments on $20 billion in old loans. Agreement with the banks is reached
on December 8.
December 23: De Larosiere announces that a "critical mass" of the required
new money has been raised together with $2 billion of additional credit
from the export agencies of the five major industrialized countries.

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1983

April 18: In a memorandum to President Reagan, David Stockman, director

of the Office of Management and Budget, warns that under existing policies
the United States faces budget deficits of $200 billion a year "as far as the
eye can see."

April 27: Chairman Volcker expresses support for currency intervention

"when exchange rates seem clearly wrong."

April 29: The report of the Working Group on Exchange Market

Intervention, known as the Jurgensen Report, is published, finding limited
effects of intervention on currency values. It found that sterilized
intervention could have short-term effects; long-term effects require
changes in domestic policies.

May 28-30: The Williamsburg summit. The American budget deficit and
high interest rates are sharply criticized by the other leaders. President
Reagan argues that there is no evidence that high interest rates and the
overvalued dollar are caused by budget deficits. The final declaration noted
signs of economic recovery, but the heads of government held their hand
from any action lest they again display the damaging splits that turned the
Versailles summit into a disaster. After studying the Jurgensen Report, the
seven agree to "undertake intervention in the exchange markets as
necessary."

August 23: Mexico repays its $1.85 billion loan to the Bank for
International Settlements, three days before signing an agreement to
restructure $20 billion of its foreign debts.

December: All Mexican arrears to commercial banks are cleared, allowing

an agreement on a new $3.8 billion loan. (Between 1982 and 1983, thirty
agreements are concluded involving twenty-four countries through the IMF.
Over the same period, eighteen nations have concluded twenty-two
agreements to reschedule official debts, mainly through the so-called Paris
Club of government officials, which meets in private to arrange methods for
stretching out repayments for overdue official loans.)

1984

May 30: Bolivia suspends payments on its debts. Ecuador follows on June
4.

June 7-9: The London II summit. The final declaration reaffirmed no

change in "the prudent monetary and budgetary policies . . . that have
brought us so far." President Reagan, heading into an election campaign,
refuses to allow a reference to the U.S. budget deficit in the final
declaration. Contrary to French desires for a more forgiving policy toward
debtor nations, the final declaration endorses the IMF's firm "case-by-case"
approach to debtors, which means no generalized relief, and IMF-approved
austerity policies as the price for financial help.

June 21: The eleven major Latin American debtors meet in Colombia, but
take no joint action against their creditors.

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1985

January 17: An attack on sterling leads to an emergency G-5 meeting in

Washington, which agrees that the dollar is "grossly overvalued" and that
this warrants "concerted action."

February 5: Chairman Volcker expresses concern to Congress that the

world's largest and richest economy might soon become the world's largest
debtor (as does indeed occur in 1986).

February 26: After coordinated intervention by the G-10 led by the

Bundesbank and estimated at $10 billion, the dollar peaks at 263.65 yen and
3.469 deutsche marks and starts falling.
March 5: David Mulford, assistant Treasury secretary for International
Affairs, declares before the House Subcommittee on International
Economic Policy that the February interventions had been "totally
ineffective."

March 7: Before the House Budget Committee, Volcker calls for

depreciation of the dollar but warns of the possibility of a "hard landing" for
the economy in which it might be necessary to raise interest rates to keep
the dollar from falling too low.

March 19: The European Community agrees to participate in a new round

of trade negotiations to apply rules of the General Agreement on Tariffs and
Trade to services and agriculture, but refuses to pick a date. Jacques Attali,
the French representative preparing the Bonn summit, tells his colleagues
that the French will never agree to a date for the GATT round unless the
Americans agree to an international monetary conference as sought by the
French government.

April 11: Secretary of State George Shultz, in a speech at Princeton

University, advocates a plan to rebalance the world economy, including
U.S. budget deficit reduction, European measures to promote innovation
and investment, and action by Japan to admit more imports and open its
capital markets.

April 12: In a signal that U.S. policy has gained flexibility, Secretary Baker
tells OECD ministers in Paris that the United States would consider hosting
a high-level meeting of the major industrial countries on international
monetary reform. Thatcher dismisses more ambitious plans for monetary
reform as "generalized jabberwocky."

May 2-4: The Bonn II summit begins with two central questions unsettled:
the starting date for a new GATT round, and the method for pursuing
monetary reform. Mitterrand does not press his case for a monetary
conference or for an explicit link between trade and monetary negotiations.
No monetary deal is made and no date is set for the next GATT round of
negotiations.
In the final declaration, Reagan says that "a substantial reduction of the
budget deficit" is an American objective, although he had refused any such
reference at London II. Japanese Prime Minister Yasuhiro Nakasone
promises

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to deregulate financial markets and encourage import growth.

September 22: The Group of Five finance ministers meets at the Plaza
Hotel in New York at Secretary Baker's invitation. The G-5 issues its first
public statement, secretly negotiated over the previous three months,
declaring that the dollar is too strong and no longer reflects "fundamental
economic conditions" and calling for "orderly appreciation" of other
currencies against the dollar. The United States agrees to take part in
coordinated exchange market intervention.

September 23: In a single day, the dollar falls by more than 4 percent, the
largest daily drop since floating began.

October 9-11: The IMF and World Bank annual meeting in Seoul. Secretary
Baker suggests a new strategy for the major indebted countries combining
"growth-oriented adjustment" with additional lending by the World Bank
and $20 billion by commercial banks over three years. IMF reform
programs continue to be a condition for loans. Although the Europeans and
Japan endorse the Baker Plan, as it comes to be known, they and the
commercial banks withhold the money that might make it viable.

1986

February 24: Chairman Volcker is outvoted on the Federal Reserve Board

majority seeking a cut in interest rates while he is negotiating to cut rates in
coordination with Germany and Japan. After reconsideration, board
members switch votes and he pursues coordinated rate reductions.

March 18: The Bank of Japan buys dollars for the first time since the Plaza
agreement. The United States Treasury announces it will not cooperate in
the intervention. Germany denies the existence of a secret agreement with
Japan to halt the dollar slide.

April 17: At the annual meeting of OECD finance ministers, Baker declares
that a U.S. trade deficit of Si00 billion is not politically sustainable, and
threatens a further decline in the dollar unless the United States's trading
partners speed up their rate of growth relative to that of the United States.

May 4-6: The Tokyo II summit. Germany and Japan accept the use of
indicators for the international coordination of economic policy, although
with skepticism. The procedure proposed by Baker includes the joint review
of forecasts and objectives for each summit member's economy in the light
of "objective" indicators: GNP growth, inflation, interest rates,
unemployment, budget deficits, trade and current balances, money growth,
reserves, and exchange rates. When significant deviations from the
projected course of the economy take place, as measured by changes in the
indicators, the ministers will try to agree on remedial changes in their
economies, and not just intervene in the foreign exchange market to adjust
currency values.

The summit makes its first major statement on agriculture. The seven agree

CHRONOLOGY

to reorient their policies, limit budgetary costs, restore order to markets, and
reduce international tension in agriculture.

The G-5 is enlarged to the G-7 under pressure from Italy and Canada,
whenever meetings concern "the management or the improvement of the
international monetary system and related economic policy measures."

May 13: Baker testifies to the Senate Finance Committee that the dollar has
fully offset its previous appreciation against the yen, signaling no need for
any further devaluation.

September 30: Baker calls upon the banks to provide a "menu of market-
based options" in order to exchange existing debt claims for new assets with
lower nominal value and lower credit risk. These would include debt-to-
bonds swaps, debt-equity swaps, buybacks, exit bonds, and so forth. The
initiative focuses on the debt problem of fifteen highly indebted countries
(the Baker 15).

(Between 1987 and 1988, Chile puts in place its debt-equity conversion
program, Bolivia repurchases $335 million of commercial debt at an
average price of 1 1 cents on the dollar, and in March of 1988 Mexico
retires $3.67 billion of long-term debt at an average discount of 30 percent
in a debt plan secured by U.S. Treasury bonds, known as the Morgan
agreement for the bank th.it devised it. C Conversions of developing
countries' external debt totaled $8.7 billion in 1987 and $22.4 billion in
1988.)

December 30: The Japanese announce their budget for fiscal year 1987,
which returns to austerity because of domestic political pressure by big
business and conservatives to reduce the central government's budget
deficit. The Americans regard this .is breaching the spirit of the earlier
agreements between Treasury Secretary Baker ami Japanese Finance
Minister Kiichi Miyazawa. When the dollar again comes under pressure,
the United States does not resist its decline.

1987

February 21-22: Meeting of G-7 finance ministers at the Louvre in Paris.

They declare that the dollar has fallen far enough and agree to cooperate in
stabilizing it. In support, each minister commits his country to specific
policies. The United States promised to reduce its government deficit from
3.9 percent of the GNP in 1987 to 2.3 percent in 1988 by cutting public
spending. Germany offered extra tax cuts and promised to keep interest
rates low. Japan promised measures to stimulate domestic demand and
reform taxes. France promised to reduce its government deficit, cut taxes,
privatize industries, and liberalize its financial markets. Canada promised
tax and regulatory reform, and privatization. Italy refused to participate,
claiming the Tokyo understandings were breached in the Louvre accord
because it had been excluded from the discussions of the G-5 ministers.

The number of "objective indicators" is reduced to growth, inflation,

CHRONOLOGY

exchange rate, money supply, trade balance, current account balance, and
budgetary position.

April 30: The United States and Japan agree to coordinate interest rate
policy. Germany follows suit.

September 4: In a signal taken by financial markets to mean that the new

chairman of the Federal Reserve Board, Alan Greenspan, will be as tough
on inflation as his predecessor, the board raises the discount rate from 5.5 to
6 percent.

October 19: Black Monday. The Dow Jones Industrial Average falls 508
points on Wall Street; world stock markets follow. The Fed announces that
it will guarantee liquidity for the financial system; other central banks send
similar signals.

November 5: France, Germany, and Japan cut market interest rates.

December 22: The Ci-7 declares that further change in the value of the
dollar would be counterproductive.

1988

June 21: Two indicators based on commodity prices are created at the
Toronto summit: one oil based and one non-oil based. At Japan's urging
they are denominated in Sl)Ks

November 16: At the London School of Economics, Toyoo Gyohten,

Japan's vice minister of finance for international affairs, argues that the yen
and the European currencies must play a greater role in the international
system in order to reduce instability. He declares Japan willing to open
financial markets further.

1989

March 10: U.S. Treasury Secretary Nicholas F. Brady calls for a new
initiative in the debt strategy focusing on a reduction in the debt stocks
rather than providing new money. He proposes using IMF funds to reduce
debt in what becomes known as the Brady Plan and is the third stage of the
official debt strategy.

May 24-26: Mexico, the Philippines, and Costa Rica sign the first
agreements under the Brady Plan with the IMF, followed by debt-reduction
agreements with their commercial bank creditors.

CHARTS

U.S. TRADE BALANCE

Bretton Woods Era

CQ

1963

1965

1967

TRADE BALANCES, F.O.B.

Billions of U.S. dollars

Source. IFS tape series #7D7AC

U.S. BALANCE OF PAYMENTS

ai

Official settlements basis

OVERALL BALANCE OF PAYMENTS

(Official settlements basis) Billions of U.S. dollars

Source: IFS upe. scries #7D8D

CHANGES IN U.S. GOLD RESERVES

Bretton Woods Era

1954 I9«i6 I9SK 1960 1962 1964 1966 1968 1970 1972 1974

( RANGES IN GOLD RESERVES

Millions of fine troy ounces

Source: IFS tape scries #IAD

OFFICIAL GOLD HOLDINGS

Bretton Woods Era

1956 1958

I960 1962

__u.s.

1966 1968 1970 1972

1974

France

OFFICIAL GOLD HOLDINGS

Millions of fine troy ounces

Source: IFS Upe *ene$ #1AD

U.S. FOREIGN ASSETS AND LIABILITIES

Bretton Woods Era

1950 1952 1954 1956

1962 1964 1966

1972

_♦_ Assets » Liabilities

U.S. FOREIGN ASSETS VS. LIABILITIES

Billions of U.S. dollars

YEAR

RESERVES (NON-GOLD)

GOLD

EXTERNAL CLAIMS

TOTAL ASSETS

EXTERNAL LIABILITIES

BALANCE
1950

1.4455

22.82

1.29

25.5555

8.89

16.6655

1951

1.4256

22.873

1.37

25.6686

8.85

16.8186

1952

1.4619

23.252

1.49

26.2039

10.43
15.7739

1953

1.3671

22.091

1.22

24.6781

11.36

13.3181

1954

1.1852

21.793

1.83

24.8082

12.45

12.3582

1955

1.0442

21.753

2.22

25.0172
13.52

11.4972

1956

1.6076

22.058

2.79

26.4556

15.29

11.1656

1957

1.975

22.857

3.37

28.202

15.82

12.382

1958

1.9577

20.582

3.9
26.4397

16.84

9.5997

1959

1.9975

19.507

4.16

25.6645

19.43

6.2345

I960

1.5548

17.804

5.31

24.6688

21.03

3.6388

1961

1.8059

16.947
6.85

25.6029

22.93

2.6729

1962

1.1634

16.057

7.32

24.5404

24.26

0.2804

1963

1.247

15.596

25.843

26.4

-0.557

1964

1.2014

15.471
12.24

28.9124

29.35

-0.4376

1965

1.385

14.065

12.25

27.7

29.36

-1.86

1966

1.6467

13.235

12.03

26.9117

31.02

-4.1083

1967

2.7652
12.065

12.53

27.3602

35.66

■8.2998

1968

4.8179

10.892

12.28

27.9899

38.47

10.4801^ 16.0064 18.5931

1969

5.1046

11.859

12.93

29.8936

45.9

1970

3.4149
11.072

13.87

28.3569

46.95

1971

1972

1973

2.1086 2.6633

2.726

1O206

10.487 11.652

16.94

29.2546

67.8

■38.5454

20.43

33.5803

82.87

-49.2897

26.58
40.958

92.47

■51.512

Source: IFS upc tenet #D1L. D1AN, D5 AND D6

LONDON MONTHLY GOLD PRICES

Bretton Woods Era

1964 1965 1966 1967 1968 1969 1970 1971 1972 1973

LONDON MONTHLY GOLD PRICES

U.S. dollars per fine troy ounce

Source: IFS upe series #7Z6KR

Note: Prices are of the list trading d»y of the month.

TRADE BALANCES

Post-Bretton Woods Era

03 100
-•-U.S.

Japan

TRADE BALANCES, F.O.B.

Billions of U.S. dollars

Source: IFS tape scries #7D7AC

BALANCES OF PAYMENTS

Post-Bretton Woods Era

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985
1986 1987 1988 1989
_«_ U.S. _♦_ Japan

OVERALL BALANCE OF PAYMENTS

Billions of U.S. dollars

Soorce: IFS upe. series #7D8D

DM-$ MONTHLY AVERAGE EXCHANGE RATES

Post-Bretton Woods Era

1970 1971 1972 I97J 1914 1975 1976 1977 I97g 1979 1980 1981 1982
1983 1984 1985 1986 1987 1988

YEN-$ MONTHLY AVERAGE EXCHANGE RATES

Post-Bretton Woods Era

197(1 1971 W72 1973 1974 1975 1976 1977 1978 1979

1981 1982 1983 1984 1985 1986 1987 1988

UU V5

Si

*>$$ «

cm ci

332

38

co m

CM CM
m cm vp ri <s (^

U.S. CONSUMER INFLATION

..Ml I

1961 1963 1965 1967 1969 1971 1973 1975 1977 1979

II 1983 1985 1987 1989

Annually, December to December

A BRIEF BIBLIOGRAPHY

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Brooks, John. "Annals of the Dollar," parts I and II. The New Yorker,
March 23 and 30, 1968.

Coombs, Charles. Hie Arena of International Finance. New York: Wiley,

1976.

Cooper, Richard N. Tlie International Monetary System: Essays in World

Economics. Cambridge, Mass.: MIT Press, 1987.
Deane, Marjorie, and Pringle, Robert. Economic Cooperation from the
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de Menil, George, and Solomon, Anthony M. Economic Summitry. New

York: Council on Foreign Relations, 1983.

Despres, Emile; Kindleberger, Charles P.; and Salant, Walter S. "The Dollar
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A BRIEF BIBLIOGRAPHY

Dettler, I. M., and Henning, C. Randall. Dollar Politics: Exchange Rate

Policymaking in the United States. Washington, D.C.: Institute for
International Economics, [989.

Devlin, Robert. Debt and Crisis in Latin America: The Supply Side of the
Story. Princeton: Princeton University Press, 1989.

de Vriei, Margaret (iamtsen. Balance of Payments Adjustment, 1943 to

1986. Washington. D.C.: International Monetary Fund, 1987.

. The International Monetary Fund 1966-1971. Washington, D.C.: Inter-

national Monetary Fund, 1976.

. The International Monetary Fund 1972-1978. Washington, D.C.: Inter-

national Monetary Fund, to.

Einzig, Paul. The Euro-Bond Market, 2d cd. London: MacMillan and Co.,
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Fishlow, Albert *I essoin from the Past: Capital Markets During the 19th (
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I unabashi, You hi. Managing the Dollar: From the Plaza to the Louvre.
Washington. DC: Institute tor International Economics, 1988.

Gardner, Richard N. Sterling-Dollar Diplomacy: The Origins and the

Prospects of Out International Economic Order. 2d ed. New York:
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Gilpin, Robert. The Political Economy of International Relations.

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Gyohten, Toyoo. "Internationalization of the Yen: Its Implications for the

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Economy and Business, 1986.

Hajnal, Peter I., ed. The Seven-Power Summit: Documents from the
Summits of Industrialized Countries 1973-1989. New York: Kraus
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Hirsch, Fred. The Pound Sterling: A Polemic. London: Victor Gollancz,

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Horsefield, J. Keith, and de Vnes, Margaret Garritsen, eds. The

International Monetary Fund 1945-1965. Washington, D.C.: International
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Iul.i, Kdstlke. "The Theory and Practice of International Economic Policy

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Kencn, PetCI B., ind I'.uk, Clare. Exchange Rates, Domestic Prices, and the
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Kennedy, Paul The Riu and Pall of the Great Powers. New York: Random

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Keohane, Robert O. After Hege m o ny : Cooperation and Discord in the

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Keynes, John Maynard. The Economu Consequences of Mr. Churchill.

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Kindleberger, (Charles P The Dollar Shortage. Cambridge, Mass.: MIT

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Kraft, Joseph. The Mexican Rescue. New York: Group of Thirty, 1984.

Lincoln, Edward J. Japan: Facino Economic Maturity. Washington, D.C.:

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Milward, Alan S. The Reconstruction of Western Europe 1945-51. London,

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Makin, John. Hie Global Debt Cnsis. New York: Basic Books, 1984.

Malkin, Lawrence. Vie Sational Debt. New York: Henry Holt, 1987.

Marris, Stephen. Deficits and the Dollar: Ttie World Economy at Risk.
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Odell, John S. U.S. International Monetary Policy: Markets, Power, and

Ideas as Sources of Change. Princeton: Princeton University Press, 1982.
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Patrick, Hugh T., and Tachi, Ryuichiro, eds. Japan and the United States
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Pouting, Clive. Breach of Promise: Labour in Power 1964-1970. London:

Hamish Hamilton, 19*

Putnam. Robert I)., and Baync, Nicholas. Hanging Together: Cooperation

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Roosa, Robert V. Tlic United States and Japan in the International Monetary
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Roosa, Robert V., et ad. Reserve Currencies in Transition. New York:

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Servan-Schreiber, J. J. Hie American Challenge, Translated by Ronald

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Solomon, Robert. Ilie International Monetary System, 1945-1981. New

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Tnrfin, Robert. Europe and the Money Muddle: From Bilateralism to Near-
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Volcker, Paul A. "The Political Economy of the Dollar." Fred Hirsch

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Williams, John H. Postwar Monetary Plans and Other Essays. 3rd ed. New
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Williamson, John. Targets and Indicators: A Blueprint for the International

Coordination of Economic Policy. Washington, D.C.: Institute for
International Economics, 1985.

Yoshitomi, Masaru. "Growth Gaps, Exchange Rates and Asymmetry: Is It

Possible to Unwind Current-Account Imbalances Without Fiscal Expansion
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Macroeconomic Policies, and Financial Market Innovations, edited by
Hugh T. Patrick and Ryui-chiro Tachi. New York: Center on Japanese
Economy and Business, 1986.

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Occasional Paper No. 18. New York: Group of Thirty, 1985.

Afghanistan, Soviet invasion of, 176

Aichi, Kiichi, 108-9, 130, 134

Alfonsin, Raul, 207-8

American Express, 252

American Finance Association. 167, 170

Anderson. Robert, 22, 35

Argentina:
debt crisis of, 207-8

privatization in, 208 Aspe, Pedro, 218 austral, 207-8 Auten, John, 72

Bagehot, Walter, 203

Baker, James, 24, 178, 264-66

case-by-case, menu approach to Third World

debt proposed by, 221-22 G-5 process and, 276, 278 and international effort
to systematize

coordination of national policies, 251 international monetary reform and,

260 Latin American debt crisis and, 207, 213-17,

220 Louvre agreement and, 260, 266, 281,

283 Mexican debt crisis and, 207 Miyazawa's bilateral conversations with,

264-65, 280-81 Plaza agreement and, 251-52, 257 and pledge to reduce
budget deficit, 283 and policy for intervening on exchange rate

of dollar, 243-44, 250

and precipitous declines in value of dollar,

260, 279-80 and restraining appreciation of dollar, 229,

241 and rift between U.S. and Germany, 268 secretary of Treasury
appointment of, 240-41 stock market crash and, 284 Baker Plan, 214-17,
220 balance of payments, 6, 161, 194 benign neglect policy on, 61-62
British deficits in, 104-5 and challenges to Bretton Woods system, 39,

42-44 currency appreciations and, 294 defense spending and, 22, 35-38 and
devaluations of dollar, 263 floating exchange rates and, 152 importance of
exchange rate policy in

adjustment of, 248-51 and international effort to systematize

coordination of national policies, 262 international lending and, 193
Japanese deficits in, 50-51, 53, 58 Japanese surpluses in, 91-92, 99, 128-29,

153-54, 156. 158 Kennedy on, 25, 39 locomotive approach and, 146-47 and
market-place pressures on exchange rates,

30 monetary reform and, 119-20, 122 offsets, 35-36 oil crises and, 159-60

balance of payments (cont'd) and revaluations of yen, 99 and taxing foreign

loans, 33-35 U.S. deficits in, 20, 32-39, 42, 44, 66, 70, 81-85, 89-91, 95,
101, 105-6, 115, 133, 146, 156 Ball, George, 24 bancors. 9 Bank for
International Setdcments (BIS), 56-57,

147 banks and banking system, 222-23

achieving consistent capital and reporting

standards for, 301 and Argentine debt c risjs, 207 and Baker Plan, 220
federal regulation of. 195-97

foreign exchange departments of. 230-3 I and G-7 Third World debt
strategy. 224

and I .urn American debt crisis, 1X9-91. [95 207, 209-10, 212-14, 2i«. 220-
23

in lending to Japan. 51-52, 54-55. $8

loan tecs 1 baiged by. 197

loss-absorbing abilities of. 1 04

.Hid Mexican debt crisis, 107-206, 214

rod Miyasawa Plan, 223

mone) > enter, 194, [ofl

non-trade financing politics ot, i<>o— 206,

ind oil t rises, 190 <>.». 1<;K.

in recycling oil-producing aaoona' surpluses,

193 and renegotiating Mexican loans, -r 1 s and ihort-tenn deposits. 101-92

in trade finam mg. 190 i(m tpedf* hmtkt Barber, Anthony, 104-5. no

md. H.| u

Barre, Raymond,

benign neglect, polu \ ot. 6 1 'o, 91 Bennett. |.u k. 1 1 S iu. 141

Bergsten, C bred. f>s, 154. 242

Bum hi. Andres. 2 1 S

Blumenthal, Michael, 146, 1S4, 276 Bradfield, Michael. 79. 203 Bradley,
Bill. 221 Brady. Nicholas, 216-17 Brazil:

in avoiding lending limits of U.S. banks,

196 balance of payments deficits worked down

by. 194 debt crisis of, 188, 210-11, 221 Bretton Woods system, xni-xiv, 8-
15, 18-20, 124-25, 137, 143-44, 294-95, 297, 301 breakdown of, xiv, xvi,
14, 20, 60—61, 63, 68-69, 90, 100, 102-3, !24, 128, 132-33, 144, 287, 291,
303

challenges to, 38-47, 50-51, 53, 55, 58, 60 comparison between current
non-system and,

304 creation of, 5, 8 and defending dollar, 151 exchange rates and, xiv, xvi,
9-10, 12-15,

19-20, 25, 38, 41, 43, 90, 143 international commitment to, 27, 29-30 and
international cooperation and
consultation, 144 Japanese satisfaction with, 58 Keynes and, 9-10 lessons
of, 306 mechanics of, 12-13 monetary reform and, 114-16, 119-20,

122-23 and nth currency problem, 40 in permitting flexibility in reserve

creation,

13 reserve currencies and, 303 sense of confidence, stability, and promise

symbolized in international economy by.

Mil

on trade, xiv, 9-10. 304

U.S. control over, 303

ways of introducing flexibility into, 67-68

White and, 10

worries about sustainabdity of, 20 Brill. Daniel, 37 Brookings Institution,

146 Brossolette, Claude Pierre, 122-23, 1^6 budget deficits, 177-83, 283,
289

benefits in reduction of, 292

Congress and, 178, 181-83, 268-69, 309

cxi hange rate intervention and, 239

and fight against inflation, 181

international lending and, 193

and Japanese fiscal expansion package, 266

Japanese investment in financing of, 261

Japan on, 185, 251

Louvre agreement and, 267

of Mexico, 220—21

and Reagan administration tax cuts, 177-78

Reaganomics and, 248-49

Shultz on, 242

and strength of dollar, 182-83, 228

and threat of worldwide recession, 277

U.S. inability to deal with, 276

U.S. pledge on, 283

and value of dollar, 250, 269—70 Bundy, McGeorge, 36 Bureau of the

Budget, 26 Burns, Arthur, 65-66, 70-71, 83-84, 113-14, 174

and ending convertibility of dollars to gold, 78

380

NDEX

and floating exchange rates, 113, 130

and floating of pound sterling, 105

G-5 and, 134-3 5

and international cooperation and consultation, 144

international lending and, 195-96

monetary reform and, 117, 127

wage-and-pnce controls and, 71, 103-4 Business Council, 242 Business
Roundtable, 242 Butcher, Willard, 222

Caldwell, Philip, 16s Callaghan, James, 142 Canada, 141, 279

currency adjustments of, 14

floating rate adopted by, 8<;

Louvre agreement and, 282

monetary reform and. 116, 123

U.S. loans to, 10-11, 34, 52

U.S. negotiations on tree trade with, 296 Carter, Jimmy:

appointees to economic posts by, 145-46, if .3-64

consumer credit controls and, 170. 173

and decontrolling price of oil, 148

and defending dollar, 149-51

federal budget and, 170, 172. 181

inflation and, xiv, 160-73

malaise speech of, 163-64

Reagan compared with. 175

and Soviet invasion of Afghanistan, 176 Cavallo, Domingo, 218 central

rates, 128-30 Champion, George, 5-6 Chase Manhattan Bank, J, 140, 193
Chile, 208-9 China, People's Republic of. xix, 3

Cultural Revolution in, 57

economic emergence of, 96

and new rules of international economic good conduct, 11 Christmas

Communique, 269 Citibank, Mexican loan renegouated by, 217 Citicorp,
140

international lending and, 193

in provisioning against Third World debt, 215-17, 221 Clausen, Tom, 218,
222 coal mining, Japanese government

encouragement of, 48 Cohen, Edwin, 84 Cold War, end of. 287-88. 301
Committee of Twenty (C-20), 278

on exchange rates, 294

monetary reform and, 116, 122-23, '28, 132, 138

Conable, Barber, 54, 215, 218 Congress, U.S.:

budget deficits and, 178, 181-83, 268-69, 309

consumer credit controls and, 171

and floating of dollar, 76

and floating of pound sterling, 105

and Japanese gold reserves, 55

Joint Economic Committee of, 146

Latin American debt crisis and, 213

oil crises and, 139

Plaza agreement and, 257

and policy for intervening on exchange rate of dollar, 234

and precipitous declines in value of dollar, 280

protectionist pressures in, 229, 241, 249, 257

and Reagan administration tax cuts, 177-78

in regulating international lending, 196

on taxing foreign loans, 34 Connally, John, 71-88, 106, 120, 276

background of, 71-72

on balance of payments, 82

and devaluations of dollar, xiv, 73, 93

and ending convertibility of dollars for gold, 76-78. 80

and exchange rate reform, 80-82

G-10 meetings chaired by, 85-87

on import surcharges, 76

International Monetary Conference speech of. 74-75

Japan visited by, 84, 96

monetary reform and, 118

pragmatism of, 115

resignation of, 117-18

on revaluations of yen, 96—97

Shultz compared with, 112 consumer credit, inflation and, 170-73

Continental Illinois Bank, 64, 180, 200 Coombs, Charles, 77, 154 Cooper,
Richard, 154 Corngan, Gerald, 203 Council of Economic Advisers, 24, 26,
29 crawling pegs, 68-69 Cross, Sam, 63, 108

exchange rate intervention and, 238-39, 243

Latin American debt crisis and, 202-3

Daane, Dewey, 23

Dale, William, 75

Darman, Richard, 24, 229 G-5 process and, 276, 278 and international
effort to systematize

coordination of national policies, 251 international monetary reform and,

260 and restraining appreciation of dollar, 241-42 Treasury appointment of,
241

debt fatigue, 225 deflation:

in Japan, 153

oil ernes and, 137 dc Gaulle. Charles. 56. 70

and challenges to Brctton Woods system, 42-43

1968 gold crisis and, 46

Pompidou compared with, 88 de la Madnd, Miguel, 214

Mexican debt crisis and. 198, 205-6 dcutschc mark (DM). 130-31

appreciations of, 89. 146. 154, 156

and depreciations of dollar, 294

dominance of, 125. 295

floating of. 73-74

Louvre agreement on, 26H

Plaza agreement and. 255

and precipitous declines in value of dollar, 279-80

as reserve currency. 303-7, 310

revaluations of, to, yu, yK

and strength of dollar. 229. 23K Dillon. Douglas. 22-24. 233

on early and large reduction in income taxes.

and U S balance of payments deficits. 35-36

dim Moats. 1 S3"54

discount rates

defense spending and. 37-38

and Japanese fiscal expansion package.

6, 271 Louvre agreement and. 2f>7 and precipitous declines in value of

dollar,

274 rises in. 284 Dodge, |oseph. 49

dollar and dollar.. 20-24. 60-61. I 37-38 benign neglect policy on. r»I-62
and Hrctton Woods system. 12. 39-44. 63.

68, hi and budget deficits. 1*2-83, 228. 250. 269-70 calls tor less pressure
on, 275 Christmas Communique on. 2r>y comparison between gold and. 15
convertibility suspended on. 103. 107. 114 defenses of. 149-51, 156-59
deteriorating credibility of, 91, 99 devaluations of, xiv-xvi, 72-73, 79, 85-
89,

93-96. 106-10. 112. 125, 130, 134, 263,

294 and devaluations of franc, 69 end of convertibility of gold into, 60, 76
—81,

84-85, 88. 93 and exchange rate reform, 80-81 floating of, 76, 82, 125

and floating of DM, 73-74

foreign official holdings in, 14-15, 32, 35, 39,

71, 91, 101, 107, 112, 133 glut, 152, 160 and inflation, 80, 94, 149-50, 158,
164,

180-81, 243. 264, 291-92 and international cooperation and

consultation, 145, 262 international lending in, 193-94 and Japanese fiscal
expansion package, 265,

280-81 and Japanese gold reserves, 54-55 Japanese purchases of. 93-94 and
Latin American debt crisis, xv, 204-5 and locomotive approach, 146, 162
Louvre agreement on. 260, 268 and Mexican debt crisis. 204-5 and
monetary reform, 115-16 and nth currency problem, 40 and oil enscs. 128.
138, 140, 152 and overvaluations of yen, 58 and Plaza agreement. 244-47.
272 policy for intervening on exchange rate of,

31-32. 232-40. 243-46. 249-51. 253-56 precipitous declines in value of, 256
—57,

259-60, 262. 268-69. 274-75. 279-80,

284-86 protecting stability of. 25-26. 32, 38-39, 62 and Rcaganorrucs, 248-
49 reducing its role as key currency, 160 as reserve currency, 14-15, 303-7,
310 restoring convertibility of, 107-8. 115, 117,

119. 125 restraining appreciation of, 229, 240-45.

253-55 and nscs in price of gold. 21. 66-67 setting exchange rate of. 14
shortage of, 5-6, 9, 50 and $6 billion credit line for IMF, 27-28 and
Smithsonian agreement, 95, 97-98 strength of, xv, 180-85, 228-29, 237-38.
240-41. 250. 255-56. 276. 291-93 and trying to counteract upward pressure
on

yen. 153"55. 157 and U.S. balance of payments deficits. 32-33,

35 and Vietnam War, 61 drawing rights, 12-13 Dutch guilder, 131

Eastern Europe:

bank lending to, 190-91 debt load of, 188 free trade areas and, 298 and new
rules of international economic good conduct, 11-13

382

NDEX

Economic Planning Agency, Japanese, 266 Economist, 210-11 Eisenhower,

Dwight I)., 22 Emmingcr, Otto, 30, 74, 109-10

inflation and, 168

and revaluation! of yen, 106, 100 Energy (Co nfe re n ce*, 1 iv BurodoUan
ami Euromarket, 15, 140

regulation ot, 1 12-13

Europe

and devaluations ot dollar, 108-10

domettif preoccu p ations oC 301

and expansion ot U.S imports. [1 and floating exchange rates. 1 1 \

monetary reform and. 115—17, 121-22 post World Wat 11 re c ove r ) o£ is.
it ai,

45
renewed strength and sense ot purpose in. xiv and strength ot doOai

unemployment in European Common Market, 41 European Community,

win ■

in approaching parity with L' s . \z<>

^ reatioo oC 19

e con o m k integration achieved by, xviii

in establishing common currency, 1-4. 161,

273

[ uropean ( lentral Hank o£ European Monet ar y System oC 161

exchange rates and. 124 2s. m: |J, I0J 06,

301 German interest rates and. 2<>(< and international effort to s\ steniati/e

coordination ol national policies, at

trade and.

I S nippori for, 20-

European Raovm Program (Marshall PI

11 exchange markets

deregulation and, 250

governments and, 230-40

international study on uses ot i n te rv e n tion in,

J35-37

stenlized interventions in. 236-37

unstenlized interventi ons in, 236

U.S. policy on interventions in. 31-32,

232-40. 243-46. 149-51. -53-56 exchange rates, xiv-xvi. 302-8

in adjusting balance of payments. 248-51 in adjusting to external shocks.

306 Bretton Woods system and, xiv, xvi, 9-10.

12-15. 19-20, 25. 38. 41. 43. 90. 143 budget deficits and, 179 central rates
and, 128-30 and competitive devaluations, 7-8 and decontrolling price of
oil. 149

and devaluations of dollar, 73

domestic preoccupations and, 302

and ending convertibility of dollars to gold, 78

European Community and, 124, 132-33, 295-96, 301

European Monetary System and, 273

fixed, xiv, xvi, 7, 9-10, 12, 25, 38-39, 41, 60, 63, 69, 99, 103-4, no, 122,
124-25, 131-33. 136, 141-42. 151-52, 242, 273, 294-96, 303, 306

flexibility of, 13-14, 65-69, 74, 102, 114-16, 123, 292

flexible fixed-, 69

floating, xiv, 7, 31. 3**, 46-47. 67-68, 73-74, 76, 8a, 89. 09. 102-6, 108-13,
118-20, 122-25. 127-28, 130-34, 136-37, 141-44, 151-52, 160-61, 230-32,
242, 292-93, 297, 303. 306-7

and German fiscal stimulus, 281 (.-- on, 237, 240, 307-8 how they effect
level of prices and productivity, .292-93

inflation and. 104, 174, 239, 291, 294 influent e of huge capital flows on,
306-7 international cooperation and consultation
on, 1 s>. ic>o, 262-63, 285 and Japanese and German easing monetary
policy, 2-4

lapanese controls on, 155-56 Japanese system o(. 48-49

Keynes on, 9-10

Latin American debt crisis and, xv

locomotive approach and, 146

Louvre agreement on, 267-68, 282-84, 300

and maintaining steady relationship among

three main currencies, 306 making money on fluctuations in, 230—31

market-place pressures on, 30-31 and nth currency problem, 40 oil crises
and, 102, 137, 140, 152 par value, 115, 117, 119, 121-22, 124-25,

132-33 par value, fixed, 151 pinpointing decisive factors in short-term

movements of, 161-62 Plaza agreement and, 232, 245-47, 251-55

protectionism and, 293 and raising pnee of gold, 66-67 in reflecting
fundamental economic

conditions, 245 reforming of, 80-82, 84-85, 88-90, 102,

106-13 regional stability in, 300-301 reserve currencies and, 303-7, 310
Smithsonian agreement and, 90, 102-4, 124,

128-30

exchange rates Uont'd)

■ability of, 3

statistical indicators and, 300 target Bona for, 15s. 160. 241-42. 260. 267
68, afl i ^2. 300-301 Ic and. 231-32. 2M. 2^2-93. 304 and U.S. balance of
payments deficits, 66, /-OO
volatility of, 7, ija,

ingt Stabilization Fund, 133

federal funds rate, inflation and. |66 I <•,)<■!,

Maker Plan and. 2 I 4

budget defu in and. 17J 79, 181

COOBUmet Credtl controls and. i-'O-jz and defending dollar. u<;. I )(

defense spending and.

and developing indicatot system 1

and floating eX4 hange rates, inflation and. l6j

insulation 1 I

international lending and. l«;s I atin Amen, an debt < mis §j in manipulating
interest rai<

nsis tod, 199, SOI < monetarist opposition 1

(M

. ;s

■ ting in hniques ..(

Plaaa igreemcni and. ijj jj, 241

ami poh, \ tor intervening on exchange rate

d dollar, | 44

ami prec i pitoui decbnei m value of dollar.

Reagan's 1 riu< isms of, 171

and renegotiating Mexican loans. 21s

and strength ot doll..

Volcka appointed chairman ot. u

Federal Reserve Ai t. ijj Feidstein, Martin lord. Gerald, 142

appointees to economic posts b\ . floating exchange rates and. 151

foreign aid

purchase ot U.S goods tied to. }J, )6 from U S to Japan. 49

Fowler. Henry "1 176

and balance of payments offsets, 35-36 and challenges to Bretton Woods

system.

43-4S defense spending and. 37-38

franc:

devaluations of, 69—70 Plaza agreement and, 255 France, xvm

and challenges to Bretton Woods system,

42-44 currency adjustments of, 14 and dampening speculative demand for

gold,

110-11 and devaluations of dollar, 88, no exchange rate reform and, 90 on

fixed vs floating rates. 141—4-2 and German fiscal stimulus, 281 monetary
reform and. 122-23

• gold crisis and, 45-46 and raising price of gold. 67 I ' S balance of
payments deficits and. 83, ■33
and world position of US.. 126 Franklin National Bank, failure of. 131 free
trade an

Friedman, Irvine: Friedman, Milton

Oil floating e\( hange rates. 46—47 monctanst school and. 167, i~4
monetary reform and. llK. 120

Frimpong-Anaah, Jonathan, 132 1 ujimori, Alberto, 210

Fukuda, 1 akr... |5, 1 ss;

fundamental disequilibrium. 14

220 (leneral Agreement on Trade and Tanffs

( .A I I , I, 19, 197 99, 301 General Arrangements to Borrow ((iAB).

a?-a -

(.ennanv. .win

average incomes in.

calls for economic expansion of. 146-48, 154,

162, ali, ^

and challenges to Bretton Woods system. 43

costs of stationing troops in. 22, 36, 61

Currency adjustments of. 14

and defending dollar. I 50. 156-57. 159

on devaluations of dollar. 86

and casing monetary policy, 272, 274

and European exchange rate, 295—96

floating exchange rates and. 104

and international effort to systematize

coordination of national policies, 250, 265 Latin American debt crisis and.
220 Louvre agreement and, 267-68, 282-83 network of bilateral trading
arrangements

developed by, 297 1968 gold crisis and, 46

384

oil crises and, 147

Plaza agreement and, 254-55

post-World War II recovery of, I 8-19, 45

relations between U S and, 262-63, 268, 275-76

reeean h .uul development in, 2K9 and revaluation! of yen, toy

and $6 billion credit lino tor IMF, 28

sluggish economk growth in, -s<>. 204, 277

and strength ot dollar. 238

and threat ot worldwide receanon, 277

trade Kuphnei ot, id

and U s balance ot paymenti deficita, B3

11 s budget defit tea and, 1 ^s

and u s initiative to institutionalize

coordination and alignment ot 630 lunge rates, 2M ven-dollar exi lunge rate
and, <;\

mv aba deutat he mark

(.iv ard d'l staing, \'.iK : and. l u

monetary reaocm and. iaj ji. 127

oil 1 rises and. 1 w

Shukl'l Ulnars (.roup and. \2f

abiding ptritift. 61

gold and gold standard, 7-10

ami Bretto ti Wooch lyetem, </ 10, 19 40, 4- 46, I

I ominitment to fixed pru t

4N 46, M

companaon between dollar and, is

dampening speculative demand tor.

IIO-II dei lining (J S holduu-i\\d defending dollar, l s<; and devaluations ot

dofl

IO6-8

end of c on ve rt ibility ot dollars into, 60.

76-^ and exchange rate reform. * 4 -Ss\ 90 treed from orru ul price. 133 and
inflation. Bo, I7J Japanese r tacf v ei in. s4- s s. 67 Keynes on. y and
market-place pressures on exchange rates.
30 1968 crisis in. 45-46 and nth currency problem, 40 as reserve currency,
303. 305 rises in prices of'. 21-22. 25. 31-32. 46,

66-67. 84-86. 88-89. 112 shortcomings and undue rigidities of. 12-13 and
J6 billion credit Line for IMF. 28 and Soviet invasion of Afghanistan. 176
two-tier price system for. 99 and U.S. balance of payments deficits. 32. 36

Gold and the Dollar Crisis (Tnffin), 39 Gona, Giovanni, 282 Gramley, Lyle,
169 Granim-Rudman-Hollings Act, 269 Great Britain:

balance of payments deficits of, 104-5

Hretton Woods system and, 9-11

competitive devaluations and, 8

currency adjustments of, 14

and devaluations of franc, 69—70

and ending convertibility of dollars to gold, 77

c \i lunge rate reform and, 90

gold standard run by, 303

imperial preferences of, 297

monetary reform and. 116, 123

i 068 gold 1 nsis and. 4 s

post World War 11 negotiations between I S and. 4

and S<> billion credit line for IMF, 28

and U S balance of payments deficit, 83

US long-term loss-interest loans to, io-ll 0 pound sterling (.reat Depression.
4. 6—y

Hretton Woods svstem and, 9

financial instability as contributor to, 7

inflation and, 1 76

international lending and, 189 Group of I . 31, 137. 242-43

cooperation and consultation mechanisms of,

U3 developing indicator system for, 278-79 discipline lacked in process of,

276-79 n\d easing m o netar y policy, 247, 272-73

end . •

establishment of, 127, 134-35 ced vs floating rates. 141 frustration in

implementing decisions of, 308 Louvre agreement and, 260, 281 Plaza
agreement and, 244-45, 251-56 and policy for intervening on exchange rate

of dollar. 243 providing political legitimacy to process of,

and restraining appreciation of dollar, 229 and threat of worldwide

recession, 277-78 on trade policy, 260 Group of Seven (G-7). 223-24. 265-
70 Christmas Communique of, 269 establishment of, 127, 141, 262 on
exchange rates, 237, 240, 307-8 frustration in implementing decisions of,
308 G-5 overlapped by finance ministers and

summits of, 256 and international effort to systematize

coordination of national policies, 251, 265,

270

385

(■roup of' Seven (G-7) (cont'd)

louvre agreement and. 266—6X.

Miyazpwa Plan and. 22)

new debt ItMteg) ot. 224

and reducing dollar*, role as kev currency. 160 (.roup ot Si 83

Grou] and challenges to Brettoa Woods lystesn,

44 ( onnaOy'l chairing meeting

tion and consultation mechanisms ot.

"4<

• rm and. Bj |apanese member\hip in. so. 2f>\

monetary reform rod, 11 j

I968 gold . nsis and. 40

Pla/a agreement and. 2SI. 2<s

on revaluations

and I ; S balan :its detu ltv |

( .ult U U ( .urn... Aiu-

Haberl

rd 1 Iruvenic

I leimann, fohn, 1 9

l left 1 *

Hcnii
• Bank, failure o£ 1 \ 1

Hirv hi

1 losomi, I ikashi, <;.'. 11

Hanking ( ommitJ

1 S Houthakker, l lendrik, I I lungar)

1 luMetn, Saddam

hysteresis, .

Ikcd.l. I I.A.ltO. {<

imperial pr e fer e m 1 impoci Miri harges Inamura, Kom hi, income taxes
early and large reductions in. 20-27

and financing Vietnam War. JO, Index of Eamomit Articles, 6 Indonesia,

debt burden ol inflation, 71, IJ6-37, 163-86, 204. 187

and achieving price Stability, 176-77 attacks on, xiv-xv. 181, 2gi~92 under
Bretton Woods system vs. current non-system, 304

294

176.

budget deficits and, 181, 185 and challenges to Bretton Woods system, 43
consumer credit controls and, 170-73 and controlling money supply, 166-
67,

169-71, 173-77. 180-81 and defending dollar. 149-50, 158 exchange rates
and. 104, 174, 239, 291, federal budget and. 170-72 interest rates and. xv,
164-67. 169—74,
I-(/-M. 184, K/4-V5 and international cooperation and

consultation. 144 Japan and. 4';. 94, 1 *4

I atin American debt crisis and, xv, 179-80 lending and. 170-73. 194-95
locomotive approach and, 146 oil c rises and. 12}. 12X. 132. 136, 147. 160,

164 Phillips ( urvc trade-off between

uncmplovment and. 167 and pohi \ tor intervening OO exchange rate

ot dollar. 241 ret essions and. 172-73 and revaluations ot 'yen. Ml and
suspension ot gold payments, 80 Vietnam War and. 19, sg. (>2. I04, 2<;l

wage and price iromroli and. 101-2, 106

Institute tor International bionomics. 242. 240 Inter Ameru an I >e\

elopment Bank. 214 Interest Kiuah/ati interest rates. |6l, 272-73

budget detu its and. 17*-7M. ltt-§2, 250

and controlling nionev supply, 169-70.

i urrctu v trading and. 2} I

and defending dollar. 1 jo, 1 $9

<>t (rermany, 2-2. 274. tgj

inflation and. x\. [64 67, 169 74, 176,

and international cooperation and

consultation. 14s international lending and. 192, I94~95 internationally

coordinated reductions in, 247

a, 274

es and, 10 I atm Anient an debt ensis and. 185, 213

oil c rases and. 160

Plata agreement and. 235, 247, 255-56

and pokey for int e rv e ni ng on exchange rate

of dollar, 243 Reaganomics and. 248-49 recessions and. 136, 166 and
renegotiating Mexican loans, 215 and strength of dollar, 184, 292 on
Treasury bills, 1 54

and U.S. balance of payments deficits, 32-35 volatility of. 169-71

386

wagc-and-pnce controls and, 103-4

see also specific kinds of interest rates Internal Revenue Service (IRS), 34
International Bank for Reconstruction and Development (World Bank). 12

Baker Plan and. 214, 220

establishment of, 3, y

Third World debt strategy and, 224

Japanese borrowing from, 54—55. 58

Latin American debt crisis and. 211. 214

lending polu id ot, iy2~v3

Mexican debt crisis and, lyy

and renegotiating Mexican loans, 215 International Monetary ( 'ontereiues, I

54

Connally's speech at. 74-75 International Monetary fund (IMF). 25, 136-3-',
[61
Argentine debt crisis and, 207

Articles of Agreement ot, 12, 40-41, 127,

IJJ, IJ6, ui. 14I

Brctton Woods svstcm inA, 12-13

in (.ailing for GciBlill and Japanese nonoiUK

expansion, 14-and defending dollar, lay-So. 1 sy Development Committee

oi. 1 I r> establishment ot

unge rates and, 12-14. U3 in nocking function! of WOdd central bank,

floating exchange rates and. 133. 141 (>-\ process and, 17

; bird World debt msgj and, 224

Intenm Committee ot, ltd, i.<^. 144

and international cooperation and

consultation, I 44 Japanese botTOW in g from, s Latin Amcncan countnes'

antipathy toward,

211 Latin Amcncan debt crisis and, if*-, 211-12.

114

lending policies of. 31. iy2-93 Mexican debt ensis and, iyy-202. 204-6
Mexican economic reform program and.

221 monetary reform and, 116. iiy-21. 123 oil crises and. 141

and renegotiating Mexican loans. 215 reserve currencies and. 303 SDRs
and. 45. 55-56. 2ys $6 billion credit line for. 27-28 thrce-cuiTency system
and. 307 trade and. 10, 13. 260
and US balance of payments deficit. 81-83 investment. 288-89

budget deficits and, 178-79 converting debt into forms of, 225

in following patterns of comparative advantage, 293

and lack of stability and predictability in exchange rates, 304

Louvre agreement and, 267

Reaganomics and, 248-49

and strength of yen, 258

in Treasury bills, 154

in Treasury bonds, 53

U.S. as driving force in freedom of international, 288 investment tax

credits, 26 Iranian revolution, 159 Italy, 141, 279, 282

lira and, 105-6

Jacobnen, Per, 14

Japan

attempts to restrict imports from, 79 average incomes in, 288

balance of payments deficits of, 50-51, 53, 58 and balance of payments

offsets, 35-36 balance of payments surpluses of, yi-92, 99,

iit-ao, 153-54. 15ft. 158

calls for econonuc expansion of. 146-48, 154, :C>l-62. 264-66. 271. 280-
81. 283 .nallv's visit to, 84, y6 ,osts of stationing troops in. 36. 61 I)AC
membership of. 56 and defending dollar. 150, 157-59 deflation in, 153
and devaluations of dollar, 93, 108 domestic preoccupations of, 275, 301
and casing monetary policy, 272, 274 economic resurgence of, xin-xiv,
xvni-xix,

16-17. 261 and ending convertibility of dollars to gold,

78. 80-81 exchange rates and. 48-49. 80-81, 13-2—33.

155-56, 160-61, 263, 274 and expansion of U.S. imports, 183-84 free trade
areas and, 298 G-5 and. 134~35 gold reserves of, 54-55, 67 G-7 Third
World debt strategy and, 224 inflation and. 49, 94. 184 and international
cooperation and

consultation. 161-62, 250, 271-72 international criticism of, 155-58 loans

from, 19, 222-23, 239-40 loans to, 51-56, 58, 131-32 Louvre agreement
and, 268, 271, 283 low international posture of, 57—5 8 management
techniques in, 289 meetings of business executives from U.S.

and, 70-71

387

NDEX

Japan (cont'd)

monetary reform and. Il6, 123, 130—32 Oil crises and. 131-32. 147. 151-
52. 150-60 open markets and. 290—91

imunitv and. n?) and parity with U S . 126. parliamentary government of.
309 Pitta agreement and. 2s 1 post World War II r J, lH-19,

and pre< ipitous de( lines in value of doll.

rca, DOfl to NlXOO in

in reentering international financial markets.

SO SI
relation-. between business and government

m. 4*

relations between U.S and, Kvii-xb

d li and drsrlopinent 1: sasmg rate* in. 1 so

■ Shuli/'s I ibrars (.roup and. 11.4 an.) $<"• billion I rrdit line tor IMI
sluggish e. onoini. growth

' strength of dollar. I h j strut tural strengths and uniquem

and threat of WOfidwid and I ' S balan.

i S buds; t ,i.ti, in h

I S trade deti, its an.: ! War II d. I ven I-, urs e lenkinv R>>\ lobert. Mi,
hael. 1 \>) JohttOO, I sndon. -1. D]

and , hallenges to Hretton Woodl vsstem.

41 42. 44 defense spending and. Vietnam War and. 61 Jurgensen, Philippe,

ex, hange rate intervention and. 2,<v |7, 24s

Kafka, Alexandre. 132 Kaneko, lppei. 1S4 Kashiwagi, Yusuke, 30, 35—36,
92 Kennedy, David, 64-00. 71 Kennedy,John F.. 25-27, 41

assassination oC -"• 7ii 97

on balance of payments, 25. 39

and sudden increase in price of gold, 21—22, 25. 31

technical innovation under, 31-32

and U.S. balance of payments deficits, 36 Kennedy. Haul. 63

I,John Maynard, 115. 120

on exchange rates, 9-10 Kissinger. Henry. 64-65, 84

("hma visited by. 96

oil enscs and. 1 39

Vietnam War an Klein. Lawrence. 146. 154 Korea, debt burden of, 209
Korean W.r

I arosicrc. Jacques dc. 141 pcot ess ami I atin American debt ensis and. 205-
X.

2!.

I arre. Rem I atin America

antipathy tow a rd IMF m. 211

220

bank provisioning against debt of, 216

Bead) Pitt •

drying up of new lending to. 216

loan tees , ollec ted from. Illations on bank loans made to, 195-97 sustained
trend toward more democracy in.

U \ negotiations on free trade areas in. 297 .ltm Amcrnan <ountncs

Iatm A merica n debt criaia, 1x7-227

absen, i ol debtors c artel in, 209—10

' 19 Agentina a:u\. I Mra/il and. |M, 2IO-I I, 221

raar by raar approach to, 209

debt fatigue and

get. 200

and gTowth rates, 190-9I

inflation and. xv. 179-80

interest rates and. iXs;. 213

international cooperation and consultation on. 201-2

lessons learned from, 219

liquidity vs solvency problem in, 204

Mexico and, 179, 197-207. 214, 216-17

positive implications of, 187-88

and ways of reducing debt shock, 225-26 Lattrc. Andre de. 30 1 a\s
Concerning the Advancement of Specified

Industries, 48 lending and loans, 189—97

to Britain, 10-11

conditions for. 31. 192-93. 195-97

388

to Eastern European countries, 190—91

and inflation, 170-73, 104-95

from Japan, 191, 222-23. •239-40 10Japan, m (6, s8, 131-32

ami Petrodollar

taxa on. (3-35. $>-53

after World War II. 180-90

m .)/*>> l atin American debt ^nsis I ennep, Emilc van, -v-30 I eutweiler,
Prits, |o, 201

I ibrarv ( .roup, i 26 17, I 14. '4-

lira. 1

lo co mot iv e approach, 146 4 s . >s4. is*. 16] 62

I ondon Interbank C Ufermg Rate 1 IIU >R .

international lending and, 192, 194, 197

LopCI I'ortillo. |osi-. Mexican debt aiMN and.

I ous re agreement, J4C

C liristnias C oininunique ind

and international effort to \\stemati/e

coordination oi national pohoti. 270.

intervention required I

iawci addreawd by. 26

and j a pan ea t fiscal expansion pa> ► ,. t s co sw ri butioa to

Mken. Paul mac hinenes. Japanese export

:iar. I tin. latin American debt crisis and.

Makagodi, Giovanni, no Mancera, Miguel, Manafidd, Mike

Marns, Stephen. 24<;

Martin. William \u (. he\ne\. 103

and challenges to BfCOOU Woods system, 43

defense spending and. .old 1 ri\is and. 4 s

Mayekawa, Homo Mil

in ■void in g lending hi:. I96

budget deficits of. 220-21 debt crisis of. 175 .;4. z\(>~i~

economic reform program of maintaining dollar hquidm of bar-

■ I debt auction of. 212 oil CrisCI ar

oil discoveries in. 1^4 oil sale's of, 201 outstanding indebtedness to foreign
banks 01".

iy^-200 privatization in. 208

in renegotiating loans, 214-15, 217, 224 U.S. negotiations on free trade

with, 296, 298

Mideast War, 125, 260

Miller, G. William:

federal budget and, 172

inflation and, 168-69, 172 and Volcker's appointment to Fed chairmanship,

163-64 Mitter.md. Francois, 235 Miyasawa, Kiichi, 52-53, 217, 263-66 on
appreciation of yen, 257. 263-64 Baker's bilateral conversations with, 264-
65, ll

and Japanese resistance to fiscal stimulus, 280

I ouvrc igreemeni and, 266 Miyasaw 1 Plan. zi\ Miruta, Mikio j 1 $2, ig

and revaluations of ven, >,r-y8 mone\ center banks. [94 mones suppK
inflation and. [66 67, \<») 71. 173—77,

interest rates and. 160-70, 176 recessions and. 167. 176— 77 trade deficits
and. 1 70

|ercm). 1x2, 1 32

Moynihan, Daniel Patrick, 61-62. 64

Mulford. David, 2S2. 204 Murayama, I atsuo, 1 ss. 157

:ie, Yasuhiro, 263-64 and appreciation of" ven, 263 and Japanese fiscal
expansion package, 266 Pla/a agreement and, 252, 256-57 L S trade deficits
and. 249 :.al banking Act. 19s National Bureau ofEconomic Research, 172,

Nelson. Pagl

Richard, 23, 60-01, 84, 101, 103-5, 107 appointees to economic posts by,
63-66,

72, 145-4*5 and challenges to Bretton Woods system,

China visited by, 96

consumer credit controls and, 171

and devaluations of dollar, xiv, 93

and devaluations of franc, 69

and ending convertibility of dollars for gold,

76-80 exchange rate reform and, 90 and floating of pound sterling, 105
foreign policy focus of, 104 Japanese reaction to policies of, 9i~94. 96

389

Nixon, Richard (cont'd)

monetary reform and, 114, 151 Pompidou's negotiations with, 86-87 and
U.S. balance of payments deficits, 34 and U.S.-Japanese trade, 79. 128-29
Vietnam War and. 61 wage-and-pnee controls under, 60. 79-80

Nixon Shock. 93-94

nth currency problem, 40

Oba, Tomorrutsu, 252

Ohira, Masayoshi. 53

oil:

controls on imports of, 148-49, 155, 158 short-term bank deposits by

producers of. 191-92

oil crises. 125. 136-41. 287 cause* of dealing with real and financial
consequences

-7-40 exchange rates and. 102. 137. 14^ inflation and. 123. 12H, 132. 13ft.
U7. 160.

(64 international lending and. 190—94 Japan and. IJI-J2, U" 1 . I < 1-52. I
59-60 Latin Anicruan debt crisis and. 198. 225 monetary reform and. 123
Petrodollars and. 13^-40 recessions and. 131

Okun, Arthur. \-

Organization fot Econocnk t oopendon and

Prvclopnic-.: OK D :*~30 Development Assistance Committer DAG

Japanese membership in. $6-57, 2ft] and US balance of'payments def.

Organization tor European Economic

Organization of Petroleum Exporting Countries

OPB< . 132

oil crises and. 138 Petrodollars and, 140 Onolt, Rinaldo. 30

Pacific Community,'. 299

Paul IV. Pope. 138

Pemex, 19ft

Penn Square National Bank, failure of, 180

Peru, confrontational approach of, 210, 220

peso, devaluations of, 198

Peterson. Peter, 73

Pctncioh, Gustavo, 214-15. 221

Petrodollars, 139-40

Petty, John, 75

Philippines, Brady Plan negonaaons and, 217

Phillips Curve, 167

Plaza agreement, 157, 229-30, 232-33, 235, 242-47, 251-57

agreement on framework of, 251-52

Christmas Communique and, 269

communique language on, 245-46, 253-55

criticisms of, 256-57

end of, 259

exchange rates and, 232, 245-47, 251-55

"Implications for Interest Rates" and, 254

and international effort to systematize coordination of national policies, 272

"List of Points for Discussion on Intervention" and, 253-54

monetary policy- and, 245-47

participants in. 252

planning strategy' for. 243-44

protectionism and, 244-45

and restraining appreciation of dollar, 242-45

success of. 255-56. 263, 272-73 Pohl. Karl Otto. 127, 273 Poland, debt
relief sought by. 218 Pompidou. Georges, 86-88

on devaluations of dollar, 125

n'l negotiations with. 86-87 pound sterling. 144

attacks on. 240. 243

floating of, 104-5

intervention in support of, 240

Plaza agreement and, 255

protecting stabdity of, 41-42 Preston, Lewis. 222 price stability. 176-77.
185. 291

European Central Bank and, 296

exchange rates and. 300

in German •■

in Japan, 275

Latin American debt crisis and, 187

and rises in discount rate, 284 Princeton University, seminar on

developments in international monetary affairs at, vii-vm

quality circles, 289

Reagan, Ronald, 53, 107, 118, 162

appointees to economic posts by, 174-75,

184. 240-41. 274 and attacks on pound sterling, 240 exchange rate swings
and, 232 Fed criticized by, 173, 178 inflation and, 173—75 Louvre
agreement and, 260 Plaza agreement and, 257 and policy for intervening on
exchange rate

of dollar, 234, 243 and strength of dollar, xv, 180, 184-85, 228

390

tax policy of, 27, 177-78, 183, 248 trade deficits and, 249 Reaganonncs,
248-49

recessions, wi-xvn, 20-21, 25-26, 59. 70-71, 102, 166 67 budget deficits
and, 178, 277 and controlling money supply, 167, 176—77

inflation and, 172-73 interest rates and, 1 |6, [66

international inonetarv reform and. 2O0 oil 1 rises .ind, 1 11

unemployment and, 175 wor ld wi de, 17

Reed, )olin. ill

in provisioning against I hud World debt,

J I s If). 22 1

Regan, 1 tonald, 1 :\\

budget dent us and, 1B t Chid of Stad appointment of, *4' exchange rate int
er v en tion and. .

l aim American debt insis and

Keuss. I ieni\

Rhodes. Willuni. JO3, 117

l\K liardson. (fOfdofl

Rot keteller. 1 >a\id. 1 SO, IfftJ

Koine. 1 rear) at, 19

Roosa. Robert, J 1

OH innovations in official finaiut

on international cooperation and

consultation. 1 s\ and polk) lor in ter v eni ng Ott exchange rate

ot dollar

S balance ot payment! deficits, jj

and U S tax OH foreign loan

w P, md Koosa Bonds. 31 Roosevelt, Franklin 1 > . s

Sachs. Jeftey, 221

Satire. William. 75

tajimi. I akehin
Salinas de Gortan. (. arh

Sato, hisak.11. 97

Saudi Arabia, loans to Japan by, 131-32

saving and savings nates

and budget de!.

and currency appreciations. 294 in Japan vs. U.S.. 1 >f> and Louvre
agreement. 167 and Reaganomic

and strength of dollar 228

Schiller. Karl. ~o. 7J-74 and apprcciaaon of DM and devaluations of doll on

revaluations ot yet

Schmidt, Helmut, 100-10, 130, 142

and German economic expansion, 147-48

G-5 and, 134

inflation and, 168, 181

On interest rates, 181

oil crises and, 139

and revaluations of yen, 109

Shultz's Library Group and, 127 Schultz, Fred, [65

Schultze, Charles, inflation and, 168-69 Sc humer, Charles. 221 Schweitzer,

Pierre-Paul, U.S. opposition to, 120-21

Senate. U.S.:
Hanking Committee of, 155 tee else c Congress, l S Shultz, George, 76,
106-7. 112-13, 13«—41 bat kground of, 118 ConnaUy compared with, 112

and dampening speculative demand for gold,

l l I and exchange rate reform. 82 and floating exchange rates, xiv, 113 1 .-s
and. 1 }s

Librar) Group of, 126-27, 134. u-

monetar) reform and, 11S-21. 126, 138 oil crises and, l 39

and restraining appreciation of dollar, 242 wag ea nd-pricc controls and.

106

sd\a Henog, Jesus, 214. 221

Mexican debt aws and. 198-200, 202, 204 Simon. William. 140-41. 192
Smith, Adam, 140, 246

Smithsonian agreement. KK-90, 101-6, 108, IIO-Il collapse of, I SI

hangC rates and. 90, 102-4, 124, 128-30 and floating of pound sterling, 105
lessons ot. 103

monetary reform and. 119

U.S.-Japanese relationship and, 95~99 Solomon. Anthony "Tony," 276

and defending dollar. 150-51, 158

inflation and. 169

Latin American debt crisis and, 202-3

and reducing dollar's role as key currency, 160 Solomon. Robert. 120, 122,
132 Sourrouille. Juan, 208 South Africa. 67 Soviet Union, xix. 3

Afghanistan invaded by. 176

breakup of, 290

collapse of communism in, 301

debt load of new republics of, 188

interruption of debt service in. 218-19

391

NDEX

Soviet Union (cont'd)

and new rules of international economic good conduct, 11-13

and raising price of gold, 67 Special Drawing Rights (SDRs), 45, 68, 70,
114

Japan on, 55-56

relative disuse of, 295

as reserve currency, 305 Spero, Joan, 252 Sprinkle, Beryl:

on deregulating financial markets, 250

and policy for intervening on exchange rate of dollar, 243

Treasury appointment of, 241 Sproul, Allan, s Sutc I Vp.irtmrnt. U S , 24

monetary reform and, 119

oil irises .ind. 1 \i> Kehlized interventions. 2 U> |7 Stern. Lrnie. 218

Stevenson, Adlai. i<;i

stot k market 1 r-ish ,. 284

Str.uiss. Robert. 1 SS
Sumita, Satoahi, 2S2 Suzuki, Hideo, 122. 132 iwan necwocka, \ 1 Sweden,
mo netary reform and, 116 Swiss mux ■ floating o£ 106 Switseriand ind
defending dollar, iso. ism

1 .itm Ainerujn debt tnsis jnd, 220

Takeshita, Noboru jnd appreciation e4 yen, 263

WCChangff ratC intervention and. 250

Plan igreement and, 244-4S. 251-54, 156-57

Tanaka. K.ikuei, S2, 128-29 U\es

on foreign loam, 13—35, 52-53

on gat, 147

German reform on, 281, 283

industrial policy and, 48

and international cooperation and

consultation, 145 and Japanese fiscal expansion package, 265,

271 Reagan on, 27, 177-78, 183, 248 Volcker's call for increase in, 182-83
see also specific kinds of taxes

textiles, Japanese export of, 49—50

Thatcher, Margaret, 240, 243

Tillinghast, David, 33

Tinoco, Pedro, 218

Tobin, James, 24
trade, 13, 24, 290-94

and attempts to restict imports from Japan, 79

bank lending and, 190

beggar-thy-neighbor policies in, 7-8

Bretton Woods system on, xiv, 9-10, 304

current non-system on, 304

and depreciations of dollar, 294

dollar shortage and, 5-6, 9

domestic preoccupations and, 302

European Community and, 19, 89

exchange rates and, 231-32, 263, 292-93, 304

and expansion of U.S. imports, 183-84

in following patterns of comparative advantage, 293

foreign aid tied to, 33, 36

free areas for, 296—98

GATT and, 3, 19, 297-99, 301

during Great Depression, 7

import surcharges and, 76, 78-79, 82

and international cooperation and consultation, 145, 262

of Japan, 10, 49-51, 53, 59-60, 79, 89-90, 96. 128-29, 183-84, 269-70, 275,
290-91, 298-99
and Japanese fiscal expansion package, 271

Keynes and, 10

Latin American debt crisis and, 188, 220

and nth currency problem, 40

m oil. 132, 138, 140, 148-49, 155, 158

open markets and, 3, II, 290-91

and precipitous declines in value of dollar, 260, 270-80

protectionism and, 7, 229, 241, 244-45, 249, 257, 291, 293. 297-98, 304

reducing international barriers to, xvi, 291

Smithsonian agreement on, 89-90

and strength of dollar, xv

and strength of yen, 258, 261

U.S. as driving force in liberal order for, 288

and U.S. balance of payments deficits, 32-33 trade deficits, 75-76, 242, 249,
259, 269-70, 272

calls for reductions in, 275

and controlling money supply, 179

exchange rate intervention and, 239

and Japanese fiscal expansion package, 266

protectionism and, 249, 264

size and persistence of, 289

and strength of dollar, 238

and threat of worldwide recession, 277 Trading with the Enemy Act, 79
Treasury, U.S.:

Baker appointed secretary of, 240-41

Baker Plan and, 214

Balance of Payments Committee at, 36

Bretton Woods system and, 25, 43-44

budget deficits and, 178

debt reduction plan for Third World nations

proposed by, 223-24 and defending dollar, 149-51, 156, 159 on early and
large reduction in income taxes,

26 exchange rate intervention and, 233-39,

243-44, 249 and floating exchange rates, 130 G-5 process and, 276, 278-79
on international economic policy, 22-25 and international effort to
systematize

coordination of national policies, 251 and Japanese gold reserves, 55

Louvre agreement and, 260 in manipulating interest rates. 2f> and Mexican
debt auction, 222 Mexican debt crisis .ind, [00-201, 203 and Nixon's
foreign policy toe us, 104 oil c rises and, i <H \Q

IM.1/.1 agreement and, 2u. :u, 244, 247,

-254-55 pragmatic leadership of, 241

and precipitous declines m v.ilue ol dollar,

279 and reducing dollar's role as key currency.

160 and $f> billion credit line tor IMF, 27 and strength of dollar, 1K0, 1M4
and taxes on foreign loans, j \ tax reduction program

on Third World debt cancellation, 221 and U s balance oi paymenn deficits.

3-2-33

Treasury' bills and bonds

Japanese investment in, 53, 1 S4

yen-denominated, 2f>s

Tnflm, Robert, 38-39 Tnflin Dilemma. 39, 43, 11s Truman, Edwin "Ted":

exchange rate intervention and, 236, 238-39,

*43 Latin American debt crisis and, 202-3 Truman, Harry, xvn two-tier gold
price system, 99

Ueka, Koshiro, 129 unemployment:

domestic fiscal stimulus to counteract, 146

in Europe, 272

Phillips Curve trade-off between inflation and, 167

recessions and, 175 United States:

competitive devaluations and, 8

dependence on foreign capital in, 261

domestic preoccupations of, 301-2

and international effort to systematize

coordination of national policies, 250-51,

271-72 international responsibilities of, 302 Japanese economy encouraged
by, 49 and Japanese gold reserves, 55 Japanese parity with, 126, 286
leadership position of, xiii, xvi-xix, 3-4,

125-26 in maintaining strength of own economy,

289 meetings of business executives from Japan

and, 70-71 pressures to cut military spending in, 290 productivity growth
in, 289 prosperity ot, 6 real hourly and weekly earnings of average

production worker in, 290 relations between business and government

in, 48

relations between Japan and, xvii-xix, 57,

>;s 99, 262-63, -271-72, 275-76 standard of living in, xvi, 288 unstenlized
interventions, 236

Venezuela, 209, 217

Venice sumnut, 270

Vietnam War, 57, 59-63, 76

and breakdown of Bretton Woods system, 63 financing of, 30, 37-38, 61-62,
182, 276 inflation and, 19, 59, 62, 164, 291

wage-and-pnee controls, 60, 71, 79—80, 101—6

abandonment of, 105—6

inflation and, 101-2, 106

under Nixon, 60, 79-80 Walker, Charls, 63-64, 71 Walhch. Henry, 165
Washington Energy Conference, 192 Wealth of Nations (Smith), 140
Wcidenbaum, Murray, 174 White, Harry Dexter, 10 Williamsburg summit
agreement, 254 Wilson, Harold, 41-42 Working Party Three (WP 3 ), 20-
30, 68

cooperation and consultation mechanisms of,

143 Japanese membership in, 56-57 and U.S. balance of payments deficit,
83 World Bank, see International Bank for Reconstruction and
Development world central bank, creation of, 295 World War I, war debts at
end of, 4 World War II:

economic planning and international institution building at end of, 3-4, 8-9

393

World War II (cont'd)

international lending after, 189—90

Japanese defeat in. 1 5

U.S. as dominant world power after. 288-89 Wnston. Walter. 140. 193, J'yT.
204

yen

appreciate: . • nding dollar. I SI. I S9 ami devaluations <>t dollar, v* -04.

exchange rate intervention md and (main lal market deregulation. 250
HoatiiH-jihI fynrtr tibial expansion pa( kage.

I ouvrr agTcrnirnt ami. .' ml < DM

Plaza agreement and. 229. 244-47, 255-57 and precipitous declines in value
of dollar,

279-80 as reserve currency, 303-7, 310. revaluations of. 92, 95-99, 106,
108-9, HI

128-31 vetting exchange rate of. 14 Smithsonian agreement and. 89. 95.
strength of. 25K. 261

Treasury bonds denominated in, 265

trying BO counteract upward pressure on.

undervaluations of, 40

i dwin. 141. 205. . Yovhida. Shigcru. xvn Yl'f . 208

■■

394

ABOUT THE AUTHORS

PAUI A. Volcker, who served as chairman of the Board of Governors of the

Federal Reserve System from 1979 to 1987, divides his time between New
York City and Princeton. He il chairman of J. D. Wolfensohn & Co., in
investment bank, and Frederick H. Schultz Professor of International
Economics at Princeton University.

TOYOO ('Vim N spent his career in the Japanese Ministry of Finance, from
which he retired in 1989 as vice minister tor international affairs. He is
chairman of the board of directors of the Bank of Toyko.

ABOUT THE EDITOR

Lawrence Malkin. author of 77ie Sational Debt, is chief U.S. correspondent

for the International Herald Tribune.
This book made available by the Internet Archive.