Two Threats: The “Gold Drain” and Speculation

The growing international supply of dollars led to a feeling that the dollar was overvalued. As Barry Eichengreen explains,

The problem was less that the dollar was fundamentally overvalued relative to the yen and the European currencies; it was more that the dollar was increasingly overvalued relative to gold, reflecting the inelasticity of monetary gold supplies and the growing overhang of foreign dollar balances.8

bill rates, which in the summer of 1960 was 3.1 percent with the United Kingdom offering a rate of 5.5 percent while the United States sat at 2.4 percent, see Financial Times 1960.

  • 7. De Vries 1987, p. 25. This reserve accumulation was, in part, due to US overseas military spending and foreign aid transfers. But it was also a consequence of the dollar’s role as the world’s top currency. Since most trade was settled in dollars, countries running current account surpluses naturally found their dollar reserves increasing as a result of their involvement in international trade.
  • 8. Eichengreen 2000, p. 5.

This was especially problematic because the currency was convertible into gold at 1/35th an ounce per $1. By the end of 1957, foreign countries had invested their excess dollars into $13.6 billion of liquid assets in the United States. Of that sum, $7.9 billion were "official” assets: predominantly short-term US treasury securities that could be converted into gold on demand. The remaining $5.7 billion was privately held in the form of US bank deposits. At that time, the United States maintained a total of $22.9 billion in gold holdings compared to the rest of the "free world,” which possessed only $14.8 billion in gold.[1] It became apparent that if the countries of Western Europe continued to grow and increase their dollar reserves and subsequently their dollar-denominated assets, they might begin to convert some of these assets into gold. A modest redistribution of gold from the United States to its allies abroad was not viewed as a serious threat to the US economy or the international financial system. However, what was unfolding was not a modest redistribution. The rate at which gold was flowing to Europe was alarming to US officials. As a result of foreign dollar-gold conversions, from 1957 through 1960, US gold holdings fell to $17.8 billion. In just five years, the United States had lost nearly a quarter of its bullion.[2] [3]

The United States had a vicious cycle on its hands as it related to gold conversions. As foreign economies amassed billions of dollars in US treasury bonds, they began to worry that the United States might one day not have sufficient gold reserves to back its growing obligations to foreign creditors. Suspicion was building that the United States might have to devalue the dollar by increasing the dollar price of gold in order to stop the drain.11 This suspicion, in turn, increased the incentive of foreign governments to convert at least a portion of their dollar-denominated assets into gold as a way of protecting themselves from experiencing losses if the dollar were devalued. As one scholar writing on the subject has put it, "Around 1960 it became clear that the [gold] reserves in Fort Knox were not adequate to cover foreign liabilities.[4]

The dollar also faced a second threat from private capital holders. The development of European financial markets in the early 1960s meant that

US and foreign investors alike had many new investment opportunities in currencies other than the dollar. Fears about dollar devaluation generated concerns among private market participants as well. A devalued dollar would mean investments in the currency would lose value when converted into foreign currency. If investors believed a devaluation was inevitable, they had incentives to move their money into foreign currency- denominated assets. However, such a move meant that these foreign investors would be effectively selling dollars to foreign central banks (in exchange for foreign currency) already flush with dollar reserves. Such a move would just increase the pressure on European monetary authorities to continue converting dollars into gold. The mere anticipation that the United States might be forced to devalue the dollar could create a selffulfilling speculative flight from the dollar. Hence, the United States was vulnerable to the threat of a "bank-run-like crisis. If private investors converted their claims on the [United States] into foreign currencies en masse, the dollar would come tumbling down.”[5] The United States needed the help of an ILLR to protect its gold stock and increase global confidence in the dollar-gold peg.

  • [1] For added perspective, in 1945, US gold holdings totaled $29 billion. Distributionof gold holdings among major economies was as follows: Germany, $2.5 billion; UnitedKingdom, $2.3 billion; France, $0.6 billion; Italy, $0.5 billion. See Knipe 1965, p. 158.
  • [2] Ibid., pp. 159-61.
  • [3] Bremner 2004, p. 166. See also Naftali 2001, p. 385. These concerns were not limited to foreign finance ministries, either. For instance, in an interview with the New YorkTimes in the spring of 1959, an economist and former research director of the IMF, EdwardBernstein, stressed the need for the United States to deal with the international dollar glutbefore the dollar became a "weak” currency; see NYT 1959a.
  • [4] Zimmermann 2002, p. 111.
  • [5] Eichengreen 2000, p. 33. For more on these two threats to the dollar, see Gavin 2004, pp. 33-88.
 
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