gold stock. This point was reached and passed in 1964, by which time the U.S. payments deficit stemmed entirely from foreign military spending, mainly for the Vietnam War.
It would have required a change in national consciousness to reverse the military programs that had come to involve the United States in massive commitments abroad. America seemed to be succumbing to a European-style imperial syndrome, and was in danger of losing its dominant world position in much the way that Britain and other imperial powers had done, weighed down by the cost of maintaining its worldwide empire. And just as World Wars I and II had bankrupted Europe, so the Vietnam War threatened to bankrupt the United States.
If the United States had followed the creditor-oriented rules to which European governments had adhered after World Wars I and II, it would have sacrificed its world position. Its gold would have flowed out and Americans would have been obliged to sell off their international investments to pay for military activities abroad. This was what U.S. officials had demanded of their allies in World Wars I and II, but the United States was unwilling to abide by such rules itself. Unlike earlier nations in a similar position, it continued to spend abroad, and at home as well, without regard for the balance-of-payments consequences.
One result was a run on gold, whose momentum rose in keeping with sagging military fortunes in Vietnam. Foreign central banks, especially those of France and Germany, cashed in their surplus dollars for U.S. gold reserves almost on a monthly basis.
Official reserves were sold to meet private demand so as to hold down the price of gold. For a number of years the United States had joined other governments to finance the London Gold Pool. But by March 1968, after a six-month run, America’s gold stock fell to the $10 billion floor beyond which the Treasury had let it be known that it would suspend further gold sales. The London Gold Pool was disbanded and informal agreement (i.e., diplomatic arm-twisting) was reached among the world’s central banks to stop converting their dollar inflows into gold.
This broke the link between the dollar and the market price of gold. Two prices for gold emerged, a rising open-market price and the lower “official” price of $35 an ounce at which the world’s central banks continued to value their monetary reserves.
Three years later, in August 1971, President Nixon made the gold embargo official. The key-currency standard based on the dollar’s convertibility into gold was dead. The U.S. Treasury bill standard – that is, the dollar-debt standard based on dollar inconvertibility – was inaugurated. Instead of being able to use their dollars to buy American gold, foreign governments found themselves able to purchase only U.S. Treasury obligations (and, to a much lesser extent, U.S. corporate stocks and bonds).
As foreign central banks received dollars from their exporters and commercial banks that preferred domestic currency, they had little choice but to lend these dollars to the U.S. Government. Running a dollar surplus in their balance of payments became synonymous with lending this surplus to the U.S. Treasury. The world’s richest nation was enabled to borrow automatically from foreign central banks simply by running a payments deficit. The larger the U.S. payments deficit grew, the more dollars ended up in foreign central banks, which then lent them to the U.S. Government by investing them in Treasury obligations of varying degrees of liquidity and marketability.
The U.S. federal budget moved deeper into deficit in response to the guns-and-butter economy, inflating a domestic spending stream that spilled over to be spent on more imports and foreign investment and yet more foreign military spending to maintain the hegemonic system. But instead of U.S. citizens and companies being taxed or U.S. capital markets being obliged to finance the rising federal deficit, foreign economies were obliged to buy the new Treasury bonds being issued. America’s Cold War spending thus became a tax on foreigners. It was their central banks who financed the costs of the war in Southeast Asia.
There was no real check to how far this circular flow could go. For understandable reasons foreign central banks did not wish to go into the U.S. stock market and buy Chrysler, Penn Central or other corporate securities. This would have posed the kind of risk that central bankers are not supposed to take. Nor was real estate any more attractive. What central banks need are liquidity and security for their official reserves. This is why they traditionally had held gold, as a means of settling their own deficits. To the extent that they began to accumulate surplus dollars, there was little alternative but to hold them in the form of U.S. Treasury bills and notes without limit.
This shift from asset money (gold) to debt money (U.S. Government bonds) inverted the traditional relationships between the balance of payments and domestic monetary adjustment. Conventional wisdom prior to 1968 held that countries that ran deficits were obliged to part with their gold until they stemmed their payments outflows by increasing interest rates so as to borrow more abroad, cutting back government spending and restricting domestic income growth. This is what Britain did in its stop–go policies of the 1960s. When its economy boomed, people bought more imports and spent more abroad. To save the value of sterling from declining, the Bank of England raised interest rates. This deterred new construction and other investment, slowing the economy down. At the government level, Britain was obliged to give up its dreams of empire, as it was unable to generate a large enough private sector trade and investment surplus to pay the costs of being a major world military and political power.
But now the world’s major deficit nation, the United States, flouted this adjustment mechanism. It announced that it would not let its domestic policies be “dictated by foreigners.” This go-it-alone policy had led it to refrain from joining the League of Nations after World War I, or to play the international economic game according to the rules that bound other nations. It had joined the World Bank and IMF only on the condition that it was granted unique veto power, which it also enjoyed as a member of the United Nations Security Council. This meant that no economic rules could be imposed that U.S. diplomats judged did not serve American interests.
These rules meant that, unlike Britain, the United States was able to pursue its Cold War spending in Asia and elsewhere in the world without constraint, as well as social welfare spending at home. This was just the reverse of Britain’s stop–go policies or the austerity programs that the IMF imposed on Third World debtors when their balance of payments fell into deficit.
Thanks to the $50 billion cumulative U.S. payments deficit between April 1968 and March 1973, foreign central banks found themselves obliged to buy all of the $50 billion increase in U.S. federal debt during this period. In effect, the United States was financing its domestic budget deficit by running an international payments deficit. As the St. Louis Federal Reserve Bank described the situation, foreign central banks were obliged “to acquire increasing amounts of dollars as they attempted to maintain relatively fixed parities in exchange rates.”7 Failure to absorb these dollars would have led the dollar’s value to fall vis-à-vis foreign currencies, as the supply of dollars greatly exceeded the demand. A depreciating dollar would have provided U.S. exporters with a competitive devaluation, and also would have reduced the domestic currency value of foreign dollar holdings.
Foreign governments had little desire to place their own exporters at a competitive disadvantage, so they kept on buying dollars to support the exchange rate – and hence, the export prices – of Dollar Area economies. “The greatly increased demand for short-term U.S. Government securities by these foreign institutions resulted in lower market yields on these securities relative to other marketable securities than had previously been the case,” explained the St. Louis Federal Reserve Bank. “This development occurred in spite of the large U.S. Government deficits that prevailed in the period.” Thanks to the extraordinary demand by central banks for government dollar-debt instruments, yields on U.S. Government bonds fell relative to those of corporate securities, which central banks did not buy.
This inverted the classical balance-of-payments adjustment mechanism, which for centuries had obliged nations to raise interest rates to attract foreign capital to finance their deficits. In America’s case it was the balance-of-payments deficit that supplied the “foreign” capital, as foreign central banks recycled the dollar outflows – that is, their own dollar inflows – into Treasury securities. U.S. interest rates fell precisely because of the balance-of-payments deficit, not in spite of it. The larger the balance-of-payments deficit, the more dollars