Submitted by Jeffrey Snider – Alhambra Investment Partners
The finance ministers and representatives of central banks from the world’s ten largest “capitalist” economies gathered in Bonn, West Germany on November 20, 1968. The global financial system was then enthralled by a third major currency crisis of the past year or so and there was great angst and disagreement as to what to do about it. While sterling had become something of a recurring devaluation tendency and francs perpetually, it seemed, in disarray, this time it was the Deutsche mark that was the great object of conjecture and anger. What happened at that meeting, a discussion that lasted thirty-two hours, depends upon which source material you choose to dissect it. From the point of view of the Germans, it was a convivial exchange of ideas from among partners; the Americans and British, a sometimes testy and perhaps heated debate about clearly divergent merits; the French were just outraged.
The communique issued at the end of the “conference” only said, “The ministers and governors had a comprehensive and thorough exchange of views on the basic problems of balance-of-payments disequilibria and on the recent speculative capital movements.” In reality, none of them truly cared about the former except as may be controlled by the latter. These “speculative capital movements” became the target of focused energy which would not restore balance and stability but ultimately see the end of the global monetary system.
Some background is needed before jumping into West Germany’s financial energy. The gold exchange standard under the Bretton Woods framework had appeared to have lasted as far as this monetary conference, but it had ended in practicality long before. In the late 1950’s, central banks, the Federal Reserve primary among them, had rendered gold especially and increasingly irrelevant in settling the world’s trade finance.
It took almost a decade, but Bretton Woods was mostly gone by 1968 when gold started trading at a two-tiered price. In reality, functionally, Bretton Woods ended not long after October 20, 1960, in the formation of what would become known as the London Gold Pool – a consortium of government and central bank allocations that would actively supply gold when needed to “hold” its price and enforce the official price. By the standards of Bretton Woods, to have a foreign pool established in order to maintain the convertibility of the dollar alone was breaking the rules.
That fact occurred almost immediately after gold flirted with $40. In fact, on October 27, 1960, the Bank of England was called upon to work closely with the Fed to supply gold in an attempt to calm that market (though there is little paper trail, you know there were gold swaps flying the Atlantic from that point). It was the initial formation of the Gold Pool, and had some success in at least keeping further “devaluation” from rapidly destabilizing global affairs, financial and economic.
The Gold Pool invoked but temporary calm and obviously failed. By 1967, sterling “had” to be devalued once more (from $2.80 to $2.40) and it kicked off an age that was fomented by chronic instability, or what we now call the Great Inflation. For the Gold Pool, the imbalance had grown so large that it was forced to cease operations in March 1968, having sold a massive, almost unthinkable $3 billion in gold in just the four months prior to its end – $400 million on March 14, 1968, alone (it bears emphasizing that these were just huge amounts even though in today’s inflationary context they seem quite quaint; and that is the point of comparison and devaluation where once $1 billion meant something but today we need trillions to merit any attention at all, but how we got to that point is a story nobody seems to appreciate in its relevant comprehensiveness). Of the $3 billion, the United States official reserves accounted for $2.2 billion, or an 18% drop. From that point forward, gold would trade on a two-tiered basis; the official exchange rates would be maintained but there would also be a separate price for the private market.
If you were a European bank in early 1968 and had accumulated dollars, there wasn’t really much you could do with them without bearing currency and inflationary risk. The Bretton Woods system had been designed, intentionally, to be funneled through official channels, as that was what economists wanted (proclaiming their own enlightenment the key to fomenting permanent stability; markets = mess). Thus, any bank holding dollars wishing to exchange them at the official rate had to turn them over to their national central bank for payment in local currency. But that wasn’t as straightforward as it sounded, either.
In truth, with gold no longer providing a satisfactory monetary anchor anywhere, banks proficient in global finance found themselves increasingly devoted to currency “speculation.” It had been a specialist trade dating back to the late 1950’s, but this Merchant’s Bank market, as it was first known, began to marry fund flows including those plying interest rate differentials and inflation risks among the world’s great currencies. Central banks, too, were active in this Merchant’s market finding it often a means to express monetary policy without having to resort to drastic and direct action.
The object of desire in November 1968 among the world’s “great” economic policymakers was to get Bundesbank to support the mark. It had shown far too great a tendency toward devaluation even though Germany had become a standard of stability in both economic and financial terms. At first, Germany had refused the offer but, as disorder rose, before long Buba had acted.
In the last two weeks of December 1968, Buba delivered some $400 million to the “market” and an additional $850 million in the first week of January in both spot and swap operations. Over the next two weeks, Bundesbank had grossed up its operations to a total of $650 million in spot exchange and an enormous $1.05 billion in swaps. By the end of January, the operations in support of the mark against the dollar had reached $2 billion.
The February 4, 1968, FOMC meeting Memorandum of Discussion (the MOD, a detailed summary in lieu of verbatim transcripts) tells us what happened next:
The drain on German reserves had actually reached the point at which they were running low on cash and were becoming concerned about the continuation of the losses. Consequently, the German Federal Bank raised its rates on swaps to make them less attractive to the commercial banks, and at the same time it permitted the spot rate to fall well below par. [emphasis added]
Even though Germany’s reserves were counted as 33.7 billion Deutsche marks worth of deposit account balances with the world’s other central banks and commercial banks, physical currency and Federal gold holdings, barely one full cycle of intervention had run to its limit. Consequently, Bundesbank was forced to shorten up its maturities even while still intervening supposedly against the dollar. By March, as that original batch of swaps and forwards started to mature, Buba was still intervening heavily in forex but getting nowhere for the trouble. For the month, the German Federal Bank had issued another $1 billion in currency swaps and sold another $250 million dollars in spot interventions, but the reserve position of West Germany hadn’t changed. The maturing swaps had delivered back to Buba an almost equivalent amount of dollars, “sterilizing” the whole regime.
The effort was doomed from the start by its very nature. It was nothing more than an attempt to buy time so that whatever imbalance causing general stress and disorder could by itself dissipate. That was the Keynesian handbook even at that time, to focus only upon the short run so that a steady state may once more present itself with but that minimal boost. Except in early 1969 the imbalance was more than a minor disturbance, it was a general and serialized decay.
It only got worse from that point on since reserves under these circumstances of swaps and forward liabilities are never what they seem to be (because accounting, as policy, is taken from only the short run perspective). Just six months later, in September 1969, the Bundesbank had no choice but to allow the D-mark temporarily float; a month later, it was officially revalued from $0.25 to $0.273. In other words, despite the gigantic impression left by impressive-sounding numbers and the arcane and complex programs meant to present them in conclusive fashion, the German central bank was helpless to withstand what was already transforming the global financial landscape. Worse, the fact that the world’s other economies had come crawling to Bonn to try to force Buba’s hand to do it in the first place was no position of strength but rather another indication they were just as powerless if not more so.
The Bundesbank’s monthly report from December 1969 makes this very plain, despite all that it had done (and other central banks) over the prior year.
The domestic money market has in fact been tighter than ever in the last few weeks. Money-market rates reached unprecedented heights, both in absolute terms (day-to-day money on 4 December, the last day before the advance rate was raised, stood at 8 ¾ to 9%) and in relation to the advance rate, which, exceptionally, was substantially exceeded at times by the day-to-day money rate. The decisive factor behind this strain was the massive exodus of foreign exchange, which was partly due to the fact that funds placed in Germany before the revaluation flowed out again and partly to the fact that the other external transactions also ran large deficits.
It was the “other” that was most troubling. Because of the float and revaluation, Bundesbank’s reserves had fallen by 16 billion D-marks, an amount so large that it reveals the nature of what was taking place. This was no convoy of armored trucks moving huge piles of cash across international borders, it was exchange accounts and liability settling among the modern currency regimes. What was different about 1968 and 1969 was how far that new system had penetrated. Again, Buba’s December 1969 report:
In contrast to the situation during the preceding period of speculative money inflows into Germany, when the banks considerably stepped up their monetary investment abroad with the concurrence and at times the active assistance of the Bundesbank, the efflux of foreign exchange between the end of September and early December came solely out of central money reserves; indeed, there were calls on the reserves over and above this, as the banks continued to export funds even after the revaluation.
In other words, currency intervention is always a losing proposition because it amounts to handing your own banking system the tools for your undoing. This was very much unexpected and had not been the case historically. What changed? Bundesbank was supposedly delivering dollars in support of the mark, and further getting German banks to aid in the effort (by handing out preferential swap rates), but where were all those dollars going? It is typically believed they were loosed upon the “market” in some generic and nonspecific conception, but forex of this kind in the late 1960’s was more and more concentrated in that Merchant’s market – the EURODOLLAR market.
With these money exports – and with their capital exports, which were also at a very high level – the banks exploited the interest differential between Germany and the Euro-money market or the Euro-capital market. However, prior to revaluation, the capital exports ultimately did not affect the banks’ liquidity position since the latter were, so to speak, only re-exporting speculative inflows. Now, though, the capital exports made additional inroads into the banks’ liquidity cushions, which were already depleted by the reflux of foreign funds referred to above.
We would recognize this last paragraph in today’s terms as the “dollar short.” In fact, you can practically exchange Germany for China and 2015(16) for 1968(69) in all of the above, leaving an eerie and thus tragic near replay of everything. That includes, relevant to our current Chinese fixation, the fact that swaps, over the intermediate term, are your ultimate enemy. However, the mark example in 1969 was not unique, as it was also the case for many, many other global currency connections just as yuan is but the most visible example of currency degradation now (real, ruble, lira, rand, etc.). The eurodollar had suddenly become not just a manner in which global trade could be accounted and settled but rather, owing to its “short” and therefore lack of actual convertibility, a central mechanism of global monetary conditions for which there was no control.