Volcker on the restoration of Bretton Woods and our present financial problems

Background to 1971 – At the time, the U.S. had unemployment and inflation rates of 6.1% (Aug 1971) and 5.84% (1971), respectively. To combat these issues, President Nixon consulted the advice of Federal Reserve chairman Arthur Burns, incoming Treasury Secretary John Connally, and then undersecretary for international monetary affairs and future Fed Chairman Paul Volcker.

The Nixon Shock
By Roger Lowenstein (BloombergBusinessweek Magazine)
August 04, 2011

Volcker envisioned that once exchange rates were modified, Bretton Woods would be restored, perhaps with a more flexible mechanism for adjusting rates. He tirelessly negotiated with Europe and Japan, but Bretton Woods could not be put back together. The gold window stayed shut. More devaluations followed, and by 1973, currencies were freely floating.

Friedman’s prediction that, left to the market, currencies would regulate themselves with only gradual adjustments proved wildly incorrect. The dollar plunged by a third during the ’70s, and currency volatility has threatened several national economies since; in 1997, Asian and Latin American countries were wrecked by currency runs. To this day, Volcker regrets that Bretton Woods was abandoned. “Nobody’s in charge,” he says. “The Europeans couldn’t live with the uncertainty and made their own currency and now that’s in trouble.” The effect on America’s domestic economy was even worse. As Shultz says, “Price controls gave the illusion of doing something about inflation.” They further liberated Nixon from concern for the normal rules. Late in 1971, he wrote to the Fed chief, “You have given me absolute assurance that money supply growth will be adequate to maintain growth.” Burns scrawled in the margin, “Never gave him absolute assurance. What nonsense!” But Burns, intentionally or not, delivered on Nixon’s demand for an expansionary monetary policy.

Controls had the desired short-term effect; inflation was quiescent through the end of 1972, when Nixon easily won reelection. The controls, however, proved difficult to end. The 90-day freeze begat a more complicated wage and price regime, a Phase II, followed by a Phase III, lasting into ’74. And Burns’s easy money fostered a monetary steam cooker that controls could not suppress. By August ’74, when Nixon resigned, inflation had topped 11 percent. Soon it would go even higher. Expectations of rising prices became embedded in the system.

The Nixon Shock was a central cause of the Great Inflation. It also spelled the end of the fixed relationships that had governed the financial universe. Previously, people took out mortgages for set periods and at fixed rates. They had virtually no options for saving money other than in banks, and the interest rates that banks could pay were capped. Floating currencies unleashed a new world of risk and instability. For the first time, investors could bet on the direction of interest rates or the Swiss franc. New financial instruments, new speculative tools, proliferated. The world gravitated from the certainties of Bretton Woods to the dizzying market cycles we’ve lived with since. Donald Kohn, who joined the Fed in 1970 and retired last year as vice-chairman, thinks Bretton Woods was doomed. But bankers have yet to find as rigorous a standard as gold. And they have become ever more apt to please politicians, deferring recessions at the risk of inflating asset bubbles.

Burns was replaced by Jimmy Carter in 1978. The following year, with inflation rocketing toward 15 percent, Burns delivered a keynote speech, “The Anguish of Central Banking,” in which he argued that central bankers around the world were failing because elected leaders were unwilling to risk displeasing constituents. The new Fed chief, Volcker, did tame inflation; unlike Burns, he had the fortitude to subject the country to a brutal recession. But the dilemma faced by Burns—how to withstand the demands of the public for limitless monetary expansion—did not go away. We see it now in the troubles of nations from Greece to Ireland to the U.S. And the anguish that Burns felt is Ben Bernanke’s unfortunate inheritance.