Reforming the World Monetary System

Fritz Machlup and the Bellagio Group

Carol M Connell

• Publisher: Routledge
• Year: 2015
• Edition: 1
• eBook ISBN:
  9781317320401
• Topic: Economics
• Subtopic: Economic History
• Index: Economics

Focusing on Fritz Machlup, Connell presents the story of the Bellagio Group and its contribution to modern finance. Initiated by Machlup the Bellagio Group was made up of thirty-two non-government academic economists. During the years between 1964 and 1977 the Group met eighteen times and made a series of recommendations for policymakers.

1 A CRISIS IN CONFIDENCE

Introduction

Nearly a half-century before the financial crisis of 2008–9, there was another time (conservatively, from 1959, when Triffin first presented his analysis to a Congressional committee, to 1977, the end of the Bellagio Group conferences, which is the period covered in this book) when reforming the world monetary system was on everyone’s lips. Many academics and policymakers were formulating plans for its reconstruction before illiquidity, speculation and loss of confidence brought the system to a predicted ruin. Not since the Great Depression was the fear of a total financial meltdown so real.

In his statement before the US Congress, economist Robert Triffin articulated the problem that would become known as the ‘Triffin Paradox’. That is to say, as the global economy expanded, the United States – as the marginal supplier of the world’s reserve currency – could continue to supply reserve assets to foreigners by running a current account deficit and issuing dollar-denominated obligations to fund it. If the United States ever stopped running balance of payments deficits and supplying reserves, the resulting shortage of liquidity would pull the global economy into a contracting spiral. Nevertheless, Triffin warned that if the deficits continued, excess global liquidity risked fuelling inflation. Moreover, the build-up in dollar-denominated liabilities might cause foreigners to doubt whether the United States could maintain gold convertibility or might be forced to devalue, thus undermining confidence in both the dollar and the monetary system depending on the dollar. Triffin would call for a radical reform of the system in Gold and the Dollar Crisis.¹ US President John F. Kennedy would urge members of his cabinet to act on Triffin’s proposals.² Fred Bergsten of the US National Security Council and the Brookings Institution would call Gold and the Dollar Crisis ‘the most influential book ever written on the international monetary system’.³

We know in the end that flexible exchange rates prevailed and that the underlying system was not reformed. We know also that Triffin believed that the outcome was the result of Fritz Machlup’s influence on influential policymakers and academics who had strong policymaking ties – policymakers like Otmar Emminger of Germany, Robert Roosa of the United States and Andre de Lattre and Giscard d’Estaing of France.⁴ Contemporary literature, much of it written by insiders to the reform debates, supports Triffin’s perspective on Machlup’s influence and that of the group he led, the thirty-two non-governmental economists. This group would become known as the Bellagio Group, for the Rockefeller resort on Lake Como where members frequently convened. This brand name, as it were, is also given to a series of conferences that included the original Bellagio Group members but also finance and treasury officials from the industrialized nations, corporate economists and strategists and private bankers. In an age before television programmes needed academic experts to interpret current events, how did Machlup and the Bellagio Group develop their outreach and exert an influence on the monetary system of today? Former historian of the International Monetary Fund Margaret DeVries wrote, ‘In 1963–64, a group of 32 academic economists and public officials identified three basic problems of the Bretton Woods system: liquidity, adjustment and confidence in reserve media. For the next decade, discussions of the system’s shortcomings centred around these three problems’.⁵ In the economic literature, liquidity and confidence were and are two related, even intertwined factors, influencing how economists and policymakers felt about the third factor – the likelihood and speed of payments adjustment.

This chapter reviews the critical balance of payments problems facing the world after World War II. Then, using 2012 as an example, it discusses surpluses and deficits in balance of payments in terms of the impact on trade and employment. Perceived in this context, the contributions of trade economists to new thinking about balance of payments theory, comparative advantage, effective tariff and protection theory, optimum policy combinations and exchange rate regimes are discussed. Finally, the chapter puts the Bellagio Group in context and summarizes monetary system events and actions through the Jamaica Accord of 1976.

Balance of Payments Problems in the 1960s

From 1946 to 1973, exchange rate policy was dominated by the Bretton Woods system. It differed from the prior period’s gold-exchange standard in three ways. Instead of pegged exchange rates, Bretton Woods established adjustable exchange rates to eliminate balance of payments deficits, subject to the existence of what was known as ‘fundamental disequilibrium’ (although the term was associated with crisis and countries sought to avoid sending a message of crisis to their trading partners). Capital controls were permitted in order to curb potentially volatile international capital flows. The International Monetary Fund was created with the mandate to monitor national economic policies, extend balance of payments financing to countries at risk, sanction governments responsible for policies that destabilized the international system, and compensate countries that were adversely affected.⁶ In practice, despite the adjustable peg, parity changes were rare. Exchange controls substituted for the absence of an adjustment mechanism until the restoration of current account convertibility in 1958.

Under the Bretton Woods system, the universally accepted reserve asset for international payments was gold, but gold supplies were limited and new gold stores were under the control of countries (fundamentally South Africa and Russia) where gold was mined. Hence, US dollars and British pounds sterling (the latter only after 1958) were established by the Bretton Woods Agreement as substitute currencies for international payments, although convertible to gold upon request. The dollar was also a medium for the financing of foreign trade through the Eurodollar market, which permitted high interest-bearing US dollar-denominated short-term deposits at foreign banks or foreign branches of American banks that were not subject to US bank reserve requirements. The Eurodollar market was actively promoted in Britain as a way to continue Britain’s international financial leadership role. According to Gianni Toniolo, most central banks at this point (early 1960s) took a positive attitude towards the Eurocurrency market because it provided them with a flexible, high-yield investment outlet and temporary cover for liquidity imbalances, and they used the Eurocurrency market (Bank for International Settlements, Bank of Italy) for this purpose.⁷ The central banks’ attitude of benign neglect of the Eurodollar market began to change in 1967–8 following international monetary events that accelerated the pace of short-term capital flows – the 1967 War in the Middle East, the sterling devaluation of 1967, the gold crisis of March 1968 and the French franc crisis later in the same year. Having grown to a huge size, the Eurocurrency market was heavily dependent on monetary policies in the USA, as concern spread about the War in Vietnam and President Lyndon Johnson’s Great Society programme.

From 1958 to 1968, a whole series of agreements, regimes rules and institutions were needed to ensure the Bretton Woods financial system worked. Institutions included the International Monetary Fund, Working Party 3 of the Organisation for Economic Co-operation and Development, and the Bank for International Settlements, which was tasked with problems of money and exchange. Agreements and regime rules included swap agreements between central banks; the London gold pool; the General Arrangements to Borrow; and the institution of special drawing rights in the IMF. The London gold pool (consisting of the United States, Germany, United Kingdom, France, Italy, Belgium, Netherlands and Switzerland) was created to regulate and protect the price of gold on world markets. The gold pool broke down under the outflow of gold reserves and France withdrew from the agreement. The devaluation of the British pound, followed by a run on gold and an attack on the pound sterling, led to the March 1968 gold crisis, which Charles Coombs of the New York Federal Reserve Bank said to Federal Reserve Chairman William McChesney Martin was ‘a crisis more dangerous than any since 1931’. Thereafter a two-tiered market system was enforced, calling for an official exchange standard of $35, along with open market transactions. While the USA pledged to suspend gold sales to governments to trade in private markets, and gold pool members said they would not sell to private persons, some participants converted currency reserves into gold and sold it at higher rates. The system proved unsustainable and would collapse in 1971, when West Germany left the Bretton Woods system, and the United States abolished direct convertibility of the dollar.

Nevertheless, maintaining the system’s viability for as long as possible was highly desirable given the high rate of growth in international trade. To support such trade required the creation of increasing international liquidity, primarily in the form of central bank reserves. Insufficient means of international payments would obviously reduce trade and therefore output growth and therefore employment. Full employment and growth required trade liberalization. Individual countries would proceed with a programme of trade liberalization only if they felt comfortable with a level of reserves believed to be capable of cushioning the domestic economy from international monetary shocks.⁸ Hence, the provision of international liquidity largely depended on the US balance of payments deficit, although managing the size of those deficits was critical to confidence in the international currency. This had not been a problem given the dollar shortage that prevailed through much of the 1950s, when the USA ran balance of payments surpluses. The problem began to manifest when US purchases from Japan and Western Europe, as well as the country’s overseas investments and military expenditures, led to larger US balance of payments deficits.⁹

The USA and Europe shared a common fear: the balance of payments effects of short-term money flows (increasingly those through the Eurodollar market, as well as the ability of central bankers to cash in dollars for gold at any time). Both sides of the Atlantic feared that the ratio of dollar liabilities to American-held gold might one day increase to a level that causes a loss of foreign confidence in the dollar and a run to the US Treasury gold window.

American policymakers saw loss of confidence as a threat to national economic well-being and foreign policy. Presidents Dwight Eisenhower, John F. Kennedy and Lyndon Johnson considered US payments deficits a problem as critical to US security as the nuclear threat. Kennedy calculated that the US payments deficit in 1962 was equal to the cost of maintaining US troops in Europe, and weighed the advantages of eliminating the deficit by recalling the troops or by negotiating with the French as the USA had done with Germany to pay for the troops via US armaments purchases, thus allowing the USA to use the cash received to retire the deficit.¹⁰ Cold War Presidents were concerned that the Soviet Union might pursue an alliance with Germany or that France might pursue an alliance with Germany, pushing the USA out of European affairs.

European policymakers feared restrictions on or termination of all sales of gold by the US monetary authorities; restrictions on international payments through the introduction of foreign exchange controls and prohibitions of capital transfers; import restrictions of all sorts; the blocking of deposits of foreign nationals; the end of convertibility; elimination of key currencies from the official reserves of central banks and consequently a drastic reduction in ‘liquidity’ everywhere; and, ultimately, reductions in production and employment resulting from import restrictions and export reduction. Many high-level French officials believed that the international monetary system was rigged in favour of the Americans. Charles de Gaulle criticized America’s ‘exorbitant privilege’ and threatened to liquidate the French government’s dollar balance. France was at that time a large creditor of the US Treasury.¹¹ France’s ambassador to the USA Hervé Alphand had told de Gaulle that Kennedy was receiving all kinds of dangerous advice on monetary policy from his advisers. Controls and a gold embargo were being considered. Europe was already deeply engaged in building an external monetary policy to end dependency on the USA and the US dollar as the pivotal international currency, which involved reforming the international monetary system to base it on a neutral, non-dollar standard.¹²

For all practical purposes, fixing Bretton Woods without actually reforming it would boost confidence and enhance trade. Hence the plethora of minimalist, exchange rate-oriented approaches and, ultimately, the victory of floating rates. As Barry Eichengreen and Harold James have argued, ‘a consensus on the need for monetary and financial reform is likely to develop when such reform is seen as essential for the defence of the global tr...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• Acknowledgements
• List of Figures and Tables
• Introduction
• 1 A Crisis in Confidence
• 2 Fritz Machlup, his Research and Methodology
• 3 Robert Triffin and the Triffin Plan
• 4 William Fellner and the Intersection of Macro and Microeconomics
• 5 Why Economists Disagree: The Role of Framing in Consensus Building
• 6 ‘Assuring the Free World’s Liquidity’ Through Multiple Reserve Currencies
• 7 Milton Friedman and the Arguments for Flexible Versus Fixed Exchange Rates
• 8 Collaboration with the Group of Ten
• 9 Adjustment Policies and Special Drawing Rights: Joint Meetings of Officials and Academics
• 10 From the Bellagio Group to the Bürgenstock Conferences
• 11 From The Bellagio Group and Joint Conferences of Officials and Academics to the Group of Thirty
• 12 Reassessing the Bellagio Group’s Impact on International Monetary Reform
• 13 The Impact of the Bellagio Group on International Trade and Finance Scholarship from the 1960s to the Present
• Conclusion
• Notes
• Works Cited
• Index