Tuesday, March 31, 2009
This article takes up where the first part left off: the dismantling of the London Gold Pool in March 1968. The US authority's fight to keep gold pegged at $35 had by no means ended with the Pool's demise. Instead it shifted to a new front. That same month a massive gold embargo against South Africa, the world's largest gold producer, was initiated by the US, a battle that would last till early 1970.
The US led embargo against South Africa, backed implicitly by the largest military in the world, highlights the gradual but steady tendency for authorities to back the failing $35 peg by forceful means. This is the inevitable route taken by any state-run financial system experiencing difficulty. Whereas in a free banking system mistakes are fixed through market discipline, competition, and failures, the state's mistakes in banking are maintained as long as its monopoly on force can keep these mistakes from destroying the system.
To recap, the Bretton Woods Agreement negotiated after World War II set the value of the dollar at 0.81 grams. This value was backed by the United States Federal Reserve's promise to convert all dollars into gold at the stipulated ratio of 0.81 grams, the more well known ratio being $35 dollars to one ounce. This promise was further enhanced by the fact that the Fed held some 21,000 tonnes of the metal, more gold than all other central banks combined. Dollar's convertibility was limited to foreign governments and central banks — private citizens in both the US and overseas who owned dollars held what was essentially inconvertible paper money.
Bretton Woods vs. Free Banking
To understand this system, it helps to compare it to a hypothetical world of private banks issuing currency in a free market. In such a system, the option that currency holders have to exercise gold convertibility forces discipline on individual banks. A bank that issues more of its branded money than the market is willing to support, say by lowering its own interest rate on loans below the market's rate, will soon face a wave of its own currency returning to it for conversion. The irresponsible bank's gold reserves will decline and it will be forced to call in loans to rebuild reserves, or increase interest rates back to at least the market rate to attract gold deposits.
In a free banking system, customers are free to choose the notes of whatever banks offer the most reserves to back up their issue, further disciplining banks that might wish to expand beyond a reserve ratio that customers prefer. At the extreme, transgressing banks are punished by run which may lead to bank failure. In that case, remaining assets are taken over by competitors, restoring balance to the system.
The US Federal Reserve operating under Bretton Woods was by no means exempt from the same pressures that individual banks in a free banking system would be subject to. As my first article pointed out, a massive US balance of payments deficit began to appear in the 1950s, driven in part by government spending overseas including military expenditures and foreign aid to a rebuilding Europe. To fund these expenditures, the Federal government issued bonds which were bought by the Fed with newly printed dollars. By 1951 the Fed held more treasury bonds on it's balance sheet than gold.
As happens in a free banking system, once the mass of dollars created by the Fed exceeded demand they began to be returned to the US for conversion into gold by foreign central banks. This process began in earnest in 1958, when US reserves plummeted by 9%. A free bank would have been forced by competitive forces to reduce money creation, call in loans, increase interest rates, and rebuild reserves. Here is where the comparison between the Fed under Bretton Woods and free banks end, because the Fed and its partner the US government have one other policy option that the free banks don't; they can resort to their monopoly on force.
Thus began the constantly escalating attempts through the 1950s and 60s to prevent the same market forces that exercise discipline on free banks from exercising discipline on the US. The monetary authority's goal was to forcibly stem the flow of US dollars overseas, reduce the gold price, and plug the rising number of conversion claims for dollars to gold on the part of foreign governments.
For instance, in 1959 Eisenhower made it illegal for Americans to buy gold overseas — extending Roosevelt's 1933 ban on American domestic holdings of gold. In 1964 a new tax was imposed by President Kennedy on foreign currency deposits to prevent Americans from investing overseas — the Interest Equalization Tax. In August 1970 President Nixon was given discretionary authority to impose wage and price controls on citizens.
Soft nanny state campaigns by the state to discourage tourism and therefore dollar outflows, including Lyndon B Johnson's comments that "We may have to forego the pleasures of Europe for a while," and "I am asking the American people to defer for the next two years all non-essential travel outside the western hemisphere," became common. In 1968 Johnson would also forbid all American investment in Europe and impose limits on investments elsewhere.
All this is terribly ironic as Kennedy, Johnson, and Nixon were clamping down on American economic freedoms at the same time that they were waging a war of aggression in Vietnam. By forcing the American public to spend less overseas, Kennedy and Johnson realized they would free up more room for their own overseas campaigns.
There are umpteen examples of forceful means being used to reduce the freedom of individuals in order to save the $35 peg from that era. One by one they failed, including the London Gold Pool, only to be replaced by even stronger forms of coercion. The last and probably the most overtly aggressive of these was the South Africa embargo.
The Embargo of 1968-69
Leaving off from the last article, central banks asked for the London gold market to be closed and dismantled the gold pool on March 15, 1968. Without price suppression from pool sales, the market price of gold immediately vaulted to $39 upon the market's reopening. That same day, in what became to be called the Washington accord, western central banks led by US Treasury Secretary Robert Fowler announced that the world's monetary reserves were "sufficient" and no subsequent purchases or sales by central banks in any market would be necessary.
This last seemingly innocuous statement had large repercussions. If central banks ceased buying gold, monetary demand for the metal would dry-up. South Africa, producer of some 75% of the world's gold, would suddenly find no outlet for a bulk of its new gold. After all, the lion's share of world gold demand was by central banks.
Fowler hoped that the boycott would force South Africa to funnel gold sales into the relatively small London market, dominated by jewellers, speculators, and other private parties, depressing the market price from $39 back to the official one at $35. This amounted to substituting the London gold pool, active from 1961-68, and its dampening influence on the gold price, with South African sales, the latter without South Africa's permission. Letters were sent to 95 central banks asking them to desist from all gold purchases. The boycott had started.
South Africa Gains the Upper Hand
From the beginning the boycott was a failure. Rather than falling the gold price steadily rose from $38 to $42. The 20% price differential between the official price of $35 and the market price put a mockery to the whole managed Bretton Woods system. In essence, the market was saying it didn't believe that the US dollar was worth the gold value that the authorities claimed. Rather than a dollar being convertible into 0.81 grams, the market was betting that, once the chips were down, the dollar was likely only convertible into just 0.67 grams.
At the same time, the price differential provided a tremendous arbitrage opportunity to central banks. To make an easy profit, all they had to do was bring their dollars to the Federal Reserve, convert them to gold at $35, ship their horde to London, and sell it for $42, further exacerbating the US's already significant gold outflows.
Despite the pressure on South Africa to sell in London, the London gold price never caved. Rather than selling gold on the market, the Reserve Bank of South Africa skirted the boycott by purchasing the gold produced by mining firms and hoarding it. By the end of 1968, South African gold reserves at the central bank had doubled from an opening balance of about $600 million to $1.2 billion.
While this kept gold off the London market and prices high, it meant that the nation could no longer send its main export product overseas to pay for imports. Luckily, South Africa had been running a significant capital account surplus since early 1965. World equity markets had been rising since the last bear market bottomed in 1966. Foreign investors, bullish on South Africa, were flooding South Africa with foreign currency, and for the time being there was no need to sell gold.
The boycott amounted to a game of chicken between the US and South Africa. At some point the flow of investment capital into South Africa could dry up and the nation's gold reserves would have to be sold in the open market to fund imports. But before that, the differential between gold's market price and the official price could stretch even wider, weakening the resolve of the participants in the American led boycott to the point where central banks, in particular those in Europe, might start buying gold again.
Many South Africans hoped to see an official devaluation of the dollar, i.e., a rise in the official price of gold, South Africa's main source of income. With the market price of gold at $42, arbitrage profits might get so tempting that the world's central banks would converge on the US en masse to convert dollars to gold. US reserves would plummet, and a devaluation would be forced. In this game of chicken, it was a question of what happened first: South Africa being forced to sell its gold or a run on the US forcing it to give up $35 gold.
South Africa actively tried to sell some of its hoard by targeting potential boycott breakers with cheap gold prices. Portugal broke the blockade in late 1968 when its central bank bought some $150 million in gold from South Africa. They would buy another $120 million in 1969. Rumours persisted that other European central banks had crossed the picket line too.
The International Monetary Fund was also a potential sop for South African gold. IMF rules stipulated that the fund was required to buy all gold offered up to it by members. This, at least, was the opinion of IMF head Pierre-Paul Schweitzer and most IMF officials. Treasury Secretary Fowler held the rather convenient opinion that the IMF had no obligation to buy anyone's gold, in particular South Africa's.
Rather than accepting a South African request to buy 1 million ounces of gold in May 1968, the IMF board of directors deferred any decision on the legality of gold purchases, thereby giving South Africa the cold shoulder. The US, with 25% of board votes, had no small part in determining this policy. This closed yet another avenue for South African gold.
Through most of 1968 South Africa would funnel small tester sales into the London market to determine the resiliency of prices. Prices fell to $38, but by year's end would be back at $42. In late 1968 three private Swiss banks agreed to buy $200-400 million worth of gold from South Africa, selling this gold on the market. The South Africans were unwilling to deal with their traditional agents the Bank of England, reportedly because the Bank's close relationship with the Fed would compromise the secrecy of South Africa's sales.
With price still far above $35 in October 1968 and South Africa able to sell some of their gold, the monetary boycott was an all out failure. Henry Fowler decided to offer South Africa a compromise. He would allow the South Africans to resume monetary gold sales, but only to the IMF, not central banks. Furthermore, sales could only be made when the market price of gold was below $35 or South Africa was experiencing a capital account deficit.
This plan would set a floor for the gold price at $35. Since all South African gold would flow to the IMF once price fell below $35, the market would no longer be absorbing this rather considerable lode of metal, and price would stabilize. As they were still running a capital account surplus and the price of gold remained high, confident South African officials ignored the offer.
The Boycott Succeeds
Around the world, the bull market in equities that had begun in 1966 was ending as markets began a downwards spiral into the 1969-70 bear market. South Africa, once attractive to investors, began to lose its shine. By the second quarter of 1969, South Africa's capital account revealed a deficit, its first in three years. Net inflows of private capital amounted to a paltry £11.7 million for the first half of 1969, down from £218 million the year prior.
The pillar that had been allowing South Africa to avoid open market gold sales had cracked. To fund imports, South Africa began to sell its gold in earnest. Reserves, which had hit a peak of $1.4 billion at the end of May 1969, fell to $1.2 billion by July and $1.1 billion by August. The gold price in London fell from $43.50 to $41. According to estimates, all new South African gold production, about 20 tonnes a week, was now hitting the market.
The sell off turned into a bloodbath in late October. Prices broke below $40. Through November gold continued to plummet, falling into the $35 range at the end of the month. On January 16, 1970 prices touched $34.80, the lowest level since the London gold market had reopened in 1954.
At prices significantly below $35, it made sense for central banks to arbitrage gold, but no longer by drawing on US reserves. Rather, banks could buy in London at $34.80, ship the gold to the US for 10¢, and have the Fed issue dollars for gold at $35, after taking a 7.5¢ commission. This promised a sure 2.5¢ per ounce profit. The effect was that the US was now accumulating reserves. The tables had turned, and Fowler's plan had worked. The $35 peg seemed to have been saved, though at the expense of freedoms lost by everyone caught up in the endeavour.
With gold at $35, in December 1969 South Africa agreed to the US compromise offered more than a year before. Its freedom to sell monetary gold was still drastically limited — it could still only sell to the IMF, and at prices below $35 — but this was better than nothing, and at least a floor had been set below the gold price.
Newspapers and magazines were filled with fawning accounts of the US's victory. A January op-ed in the New York Times noted that: "Gold's power to disrupt the international monetary mechanism has now been greatly reduced, and possibly ended. Under Secretary of the Treasury Paul A. Volcker has voiced the hope that this latest move will dispose of gold as a 'contentious monetary problem'."
This celebration would be short-lived. Even with South Africa selling most of its gold in London, the gold price steadily rose through 1970, ending the year at $37.50. By August 1971 it would be trading in the free market at $43.50, again 20% above the official price. In spring of 1971 a run on the US dollar began. Central banks lined up at the Fed's doors in ever increasing numbers to demand their gold. On August 9, the British economic representative asked to convert an astonishing $3 billion into gold, or about 2,500 tons. The South Africa gamble had been the last trick up the US's sleeve, and on August 15, 1971 President Nixon officially abandoned the dollar's $35 peg when he ended convertibility of dollars into gold.
Comparing 1968-69 to present day
The 1968-69 South African gold embargo is not just an interesting historical quirk. It also provides a mirror to understand the means by which governments will combat the present failure of the financial system. Like the $35 gold and Bretton Woods, much of the world's financial architecture has been designed by government technocrats. Fannie Mae, Freddie Mac and their foreign equivalents like the Canadian Mortgage and Housing Corporation dominate much of the home lending markets. The Federal Reserve and other central banks control the supply and quality of money, and agencies like the SEC, Fed, and OFHEO have monopolies on regulation.
This architecture is crumbling. In a free market, housing lenders and banks who fail at their task are taken over by more able competitors. Private regulators who do a poor job as watchdogs have their reputations crushed, to be succeeded by regulators who better understand their domain. Charities that bail out those who don't deserve help will lose funding at the expense of charities that better target aid. In this way failed architecture is renewed.
Much like the US's decision to save Bretton woods by coercing South African gold sales, today's governments will resort to ever more authoritarian measures rather than allowing their pet institutions to fail. Already the legislation governing central banks has vastly expanded in scope, federal housing agencies have had their mandates dramatically increased, and government regulators who fell asleep at the wheel are being given ever greater powers.
While this may work temporarily, much like South Africa's forced sales saved the $35 peg for one more year, the financial architecture's endemic problems will still exist. Instead of being purged, they will only crop up further down the road, more serious than ever. And when this happens you can be sure our elected officials will again try to save their pet institutions by taking away our liberties.
 The Economist, January 6, 1968.
 New York Times, January 4, 1969.
 New York Times, July 13, 1969.
 Time, July 25 1969.
 New York Times, June 16, 1968.
 New York Times, Jun 28, 1968.
 New York Times, Jul 26, 1969.
 The Economist, Aug 30, 1969.
 New York Times , July 13, 1969.
 New York Times, Aug 15, 1969.
 The Economist, Nov 22, 1969.
 New York Times, Jan 5, 1970.
 Peter Bernstein, The Power of Gold. Pg. 351.