Lessons of the Cold War: How International Monetary Relations Can Influence Geopolitics

“Those who cannot remember the past are condemned to repeat it.”

-- George Santayana

Economists have been prone to dismiss the “veil of money” as having no lasting influence on the real economy, until a financial crisis like that of 2008 comes along to show that the real and financial sides of the economy are inextricably interlinked. Historians have similarly been inclined to treat the cold war strategies of the Western Allies as separate and distinct from the postwar problems of the international monetary system. A closer look at relations among the Allies, and in particular between the U.S., Germany and France, shows that here too monetary problems and geopolitical security issues were in reality two sides of the same coin.

The geopolitical aspects are well understood. The communist system of the Soviet Union in control of Eastern Europe, a divided Germany, the U.S. committed to preventing Soviet expansion into Western Europe, and after 1950 a tense nuclear standoff between East and West. The monetary aspect is less well understood. It involved an impending breakdown of the international monetary system adopted by the non-communist world at Bretton Woods in 1944, a breakdown that threatened to limit the ability of the U.S. to extend economic assistance and military protection to its allies, and undermine the economic recovery and strength that was the capitalist West’s main advantage in the global competition with the communist East.

The Bretton Woods Agreement

The postwar monetary system was established by 44 nations gathered together in 1944, a year before the war’s end, under auspices of the newly formed United Nations at the Bretton Woods resort in New Hampshire. The participants were determined to avoid the competitive devaluations and “beggar thy neighbor” policies that contributed to the economic disasters of the previous interwar period, planting the seeds of the 2nd World War. The agreement reached at Bretton Woods was based on the conventional wisdom that the peaceful growth of international commerce would be best served by a system of fixed exchange rates and rules of good behavior to be administered by a new institution, the International Monetary Fund (IMF). Harry Dexter White of the U.S. Treasury and John Maynard Keynes leading the British delegation were the main negotiators. Keynes argued for making the IMF a kind of global central bank with the power to create and manage a new international currency that he called “bancor”, but the U.S. at that time accounting for 50% of global production and owning 65% of the world’s gold reserves dominated the proceedings and insisted upon basing the system on the U.S. dollar which was the currency being used for virtually all international transactions. The dollar was at that time the only remaining currency backed by gold and to anchor the system the U.S. agreed to uphold the free convertibility of dollars into gold at a fixed price of $35 per oz..

The new monetary system worked beautifully from the War’s end in 1945 until well into the 50’s. This was a period of postwar reconstruction in which the world was clamoring for dollars with which to buy materials from the U.S.. There was an acute shortage of dollars which the U.S. alleviated with the Marshall Plan and other programs of economic assistance. With currencies pegged at relatively low values vs. the dollar, the major industrial countries of Europe and Japan were able to rapidly expand exports as their economies regained strength.

Meanwhile, as the Soviet threat grew, the U.S. greatly expanded its military commitments around the world, NATO was formed and after largely withdrawing from Europe the U.S. reversed course and built up its troop strength in Europe to a peak of 439,000 in 1957, 244,000 based in West Germany and with substantial deployments in France and Britain as well. Total foreign troop deployments, both ashore and afloat, totaled 927,000, exceeded in the postwar period only by the 1.2 million deployed in 1953 which included 327,000 engaged in the Korean war.    

These U.S. military deployments resulted in a huge outpouring of dollars, welcomed by the rest of the world as further relief from the dollar shortage. As the Marshall Plan came to an end, the flow of dollars from that source was supplanted by the outflow of military spending, an outflow of tourism dollars as Americans rediscovered the pleasure of foreign travel, and a rising outflow of investment dollars as American companies began investing overseas. After 1957, however, the “dollar shortage” was rapidly transformed into a “dollar glut”. Western Europe and Japan were now beginning to earn plenty of dollars from their rapidly recovering export industries, enjoying the additional advantage of having had their currencies pegged at a relatively low value. These recovering industrial countries now began racking up large balance of payments surpluses, piling up a huge amount of dollar reserves, while the U.S. was running larger and larger balance of payments deficits. The dollar liabilities of the U.S., represented by the accumulated dollar reserves of the rest of the world, soared above the level of U.S. gold reserves, and with the Treasury at that time still required to hold sufficient gold to back convertibility of the domestic currency at $35 per oz., the amount of free gold available to back foreign liabilities dwindled to a small fraction of the dollar reserves being accumulated by foreign central banks.

The lack of sufficient gold to cover rising foreign liabilities led to questions being raised about the U.S. ability to honor its pledge of dollar convertibility into gold, and speculation that the dollar would soon have to be devalued relative to gold and other currencies. Despite political pressure to hold dollars, some central banks fearing losses from an eventual devaluation began to convert a part of their dollar holdings into gold, leading to a steady outflow of gold from the U.S. that was bringing closer the inevitable day of reckoning.

The Triffin Dilemma

The balance of payments dilemma faced by the U.S. was brought into sharp focus by the Belgian-American economist, Robert Triffin, who wrote two very influential books on the subject: “Europe and the Money Muddle” (1958), and “Gold and the Dollar Crisis” (1960). Triffen highlighted what became known as the “Triffin Dilemma”:

A. If the United States stopped running balance of payments deficits, there would be a dollar shortage. The international community would lose the supply of liquidity needed to support the rapid growth of international trade and investment. The competition for scarce gold would encourage trade restrictions, beggar-thy-neighbor economic policies, and competitive devaluations. This was precisely the scenario that most economists and policymakers believed had caused and deepened the Great Depression of the 1930s.

B. If the United States continued running balance of payments deficits, an excessive supply of dollars (dollar glut) would erode confidence in the value of the dollar. If the dollar’s value were in doubt, no one would hold it as a reserve asset: they would sell it for a more reliable asset, like gold. But if the dollar no longer supplemented gold as a reserve asset, then a large portion of the world’s liquidity used to finance international trade would be destroyed. There would be pressure for the dollar to be devalued, the fixed exchange rate system would break down, leading to instability and a decline in international trade and investment.

Triffin’s proposed solution was the creation of new reserve units. These units would not depend on gold or currencies, but would add to the world's total liquidity. Creating such a new reserve would allow the United States to reduce its balance of payments deficits, while still allowing for global economic expansion. His solution was partially adopted by the IMF much later in 1968 with the creation of Special Drawing Rights (SDRs) which was a kind of new international currency. It enjoyed limited success.    

Eisenhower and the Anderson-Dillon Mission

The gold outflow became a major issue in President Eisenhower’s second term from 1956 to 1960, and since the size of the balance of payments deficit approximated the cost of maintaining troops abroad, his thoughts went immediately to the idea of troop withdrawals. Eisenhower had always been of the opinion that the U.S. should begin to withdraw its forces from Europe at the earliest opportunity lest the Europeans become overly dependent upon the U.S. and neglect building up their own defense forces. He also had doubts about the value of conventional forces as a deterrent, believing that the real deterrent was America’s nuclear capability.

By 1959, Eisenhower felt that the burgeoning U.S. balance of payments deficit and gold

outflow made U.S. troop withdrawals urgent. He told the NATO commander, General Norstad, that it was time to "put the facts of life before the Europeans concerning the reduction of our forces." The Europeans were "'making a sucker out of Uncle Sam." With the United States paying for the whole strategic deterrent force, all space activities, most of NATO's infrastructure cost, and large naval and air forces, why should it also pay for six U.S. Army divisions, especially when these troops were threatening American financial strength? "Our gold is flowing out and we must not weaken our basic economic strength."

In November 1960 (see the photos from my last posting), just two months before leaving office, Eisenhower made a last desperate attempt to do something about the looming monetary and troop deployment dilemma by dispatching his trusted Secretary of the Treasury, Robert B. Anderson along with the incoming President Kennedy’s Secretary of the Treasury designate Douglas Dillon, to Bonn with the stark message that the Bundesrepublik must fully offset the foreign exchange cost of maintaining U.S. troops in Germany or face the prospect of their eventual withdrawal. To emphasize his resolve Eisenhower ordered a sharp reduction in the number of dependents who would be allowed to accompany U.S. forces in Germany, an order that had a strong negative impact on military morale but was never implemented and immediately rescinded by Kennedy upon taking office.

The last minute Anderson-Dillon mission was an acknowledged failure at the moment the delegation left Bonn. It was an ill conceived mission from the start, hastily prepared by a lame duck President only two months before leaving office, and making extreme demands of the Germans that were bound to fail. The demand was for a direct budgetary offset, a payment mechanism that would have placed the dollars expended in Germany to acquire DM needed by the U.S. military into a special account usable by Germany only for purchase of military equipment in the U.S.. The Germans, of course, were well aware that Eisenhower’s threats to withdraw forces were contradicted by the incoming President’s “Flexible Response” strategy that would require a strengthening of conventional forces in Europe.

The only concession made by Germany was a sharp increase in aid to developing countries, action that had been planned for some time and announced two weeks before arrival of the Anderson-Dillon mission, and the Bundesbank’s promise to reduce interest rates so as to reduce the flow of speculative capital into Germany. The German delegation pointed out that the development assistance would not be tied to German exports. After making the dubious estimate that only about 25% would be spent on German products with “most” of the rest spent on American exports, we were informed that the benefit to the U.S. balance of payments would offset much of U.S. military spending in Germany. They lectured us also on the need to reign in our economy and promote saving so that U.S. exports would be more competitive and the payments deficit reduced.  

The Nuclear Issue and Strategy of Flexible Response

In the closing stage of the Eisenhower presidency a group led by former Truman Secretary of State Dean Acheson, and Korean War commander General Maxwell Taylor, began criticizing  the Eisenhower Administration for its over-reliance upon nuclear weapons. Throughout the 50’s the U.S. had developed and deployed thousands of tactical nuclear weapons capable of being delivered on the battlefield by conventional forces. These small nuclear warheads ranging from less than 1 kiloton of explosive power up to about 15 kilotons (the Hiroshima bomb was 12.5 kilotons, Nagasaki 20 kilotons) were highly mobile and easily concealable, capable of being delivered by mortars, 120 mm to 150 mm artillery, short range missiles, aircraft and surface ships, or laid in mine fields. The smallest, the Davy Crockett, weighed only 76 lbs and had a range of 2.5 miles. The Soviets would later develop and deploy a similar capability, but being about 10 years behind at this time left the U.S. with a tactical nuclear advantage. Eisenhower was therefore untroubled by the Soviet numerical advantage in Europe, secure in the knowledge that he possessed overwhelming “firepower”. He rapidly deployed these tactical nuclear weapons throughout Europe from Norway to Greece and Turkey with elaborate sharing arrangements that would make them available to NATO allies in case of need. Acheson, Taylor and other Kennedy advisers, were appalled by what they saw as an irresponsible reliance on the immediate use of nuclear weapons in even the most limited kind of engagements such as those threatened around Berlin, and were nervous about the sharing arrangements that could weaken U.S. centralized controlled over their use..  

These idea of “Flexible Response” was embraced by the newly elected Kennedy, though Acheson later wrote that “he was never quite sure how completely his [Kennedy’s] mind was sold on it ... the thing that seemed to continually bother the President about this was the continuation of so large a body of American troops in Europe without any plan that they should come home by a specific date.” Acheson believed that for the day to come the Europeans would have to be put in such a state of confidence and growing capability of their own forces that they would no longer feel the need for U.S. troops. “The day will never come if you keep saying,” If you don’t do exactly what we want, we’ll go home”. This is the wrong way to act, but I don’t think he [Kennedy] was ever quite with me on this”.

Kennedy’s ambiguity is not surprising because “Flexible Response”, with its requirement for continuation and even augmentation of American troop strength in Europe was in direct conflict with balance of payments objectives. The balance of payments deficit was no problem before 1958 when the world needed more dollars, but now with the gold outflow accelerating, increasing speculation and pressure on currency values, what made sense militarily no longer coincided with perceived economic necessities. One way to square the circle was to get the Europeans to build up their defense capabilities. Another was to get them to shoulder the foreign exchange costs of maintaining U.S. troops in Europe. Threatening troop withdrawals was an obvious means of exercising leverage, but doing so undermined the credibility of America’s new defense ideas. This dilemma was felt acutely during the intense national security and economic policy discussions of the Kennedy years and beyond.

The entire decade of the 60’s was a period of intense debate and negotiation among the NATO allies over defense strategy and economic relationships, especially nuclear strategy and the international monetary system, with both sets of issues interlinked. Kennedy promoted the idea of “Flexible Response”, increased European conventional forces, maintenance or even augmentation of the U.S. military presence in Europe while tightening U.S. centralized control over the use of nuclear weapons. Europeans, especially Adenauer and de Gaulle, were opposed to the idea of “Flexible Response” believing that it weakened the nuclear deterrent, were unenthusiastic about spending more on defense, fearful that conventional war would lay waste to their territory, and eager to share in nuclear decision making with access to the U.S. inventory of tactical nuclear warheads. At the same time the U.S. pressed for more equitable burden sharing with Europeans spending more for their own defense, offsetting U.S. military foreign exchange costs, expanding aid to developing countries on an untied basis, reducing import restrictions and revaluing their currencies upward to curb balance of payments surpluses while refraining from using their dollar surpluses to buy gold.

The Kennedy Years

The new Kennedy Administration lost no time following up on the failed Anderson-Dillon mission. The President first dispatched a team of economic advisers including famed MIT economist Robert Solow and Francis Bator to talk balance of payments and offsets, but the results were no better than before. The Germans felt they were being lectured and talked down to by these somewhat brash and diplomatically inexperienced economists, and in the end served up a warmed over version of the same unsatisfactory response that they had given to Anderson and Dillon. More visits followed, including one by Walter Heller, Chairman of the President’s Council of Economic Advisers, who was equally ineffective.

Meanwhile a fierce debate had developed within the German government over the rapidly growing balance of payments surplus, with Erhard and the Bundesbank favoring an upward revaluation of the DM and Adenauer and others strenuously objecting. We at the Embassy had privately expressed support for the idea of revaluation while carefully avoiding any public statements that would draw us into this hotly contested issue. In March 1961, the DM was revalued from its peg at DM 4.2 per dollar to a new peg at DM 4.0 per dollar. While we all knew that the revaluation was too small to be effective, the Under Secretary of State, George Ball, made the mistake of saying so publicly which touched off a wave of speculation. Adenauer was then able to blame the U.S. for the perverse increase in German dollar reserves that immediately followed the revaluation.

Some progress was made in lower level talks that were divided into three different working groups and continued through the first half of 1961. In one of the working groups the  Germans raised the issue of vested assets saying they would be prepared to prepay $587 million of postwar debts in exchange for agreement to recognize and compensate owners of German property that had been seized during the war, a sensitive political issue in Germany that had been pursued ever since statehood in 1949. Settlement of the vested assets issue would have required Congressional approval and when it became clear that the Administration was in no way willing to take it up with Congress under present circumstances the Germans relented and went ahead with the debt prepayment anyway, which was helpful because it returned an amount of dollars approximately equal to the speculative flows that surged into Germany following the revaluation.

Other progress was made in stripping out minor issues like allowing more chickens to be imported from the U.S. and increasing other agricultural quotas, as well as referring the whole question of German development aid to the broader OECD forum where efforts were being made to get all European countries to take on a larger share of the development aid burden. This enabled us to narrow the focus to the central issue of obtaining a full offset of U.S. military foreign exchange costs of about $600 million per year.

The working group on defense issues quickly discovered several high priority desires of the powerful Defense Minister, Franz Josef Strauss. First and foremost was his desire to procure delivery systems for tactical nuclear weapons. Acquiring the delivery systems even though the warheads would remain under U.S. control was seen by the Germans as the only means of having direct influence over the possible use of nuclear weapons on its territory. Strauss was telling us in effect that he might find it worthwhile to use Germany’s monetary assets and financial strength if it would enhance their military potential and give them more political influence on vital defense questions. A second desire was for the U.S. government to act as Germany’s purchasing agent for military equipment because of the lack of qualified German personnel to look after their interests. A third request he made was for the joint use of training areas, supply depots, airfields, barracks, etc. Because of Germany’s dense population the development of the Bundeswehr was being held back by the difficulty of acquiring such assets. Other NATO allies were not being very cooperative; Germany had even approached Franco Spain for training areas until international protests forced them to drop the idea.

The possibilities for cooperation were thus expanding, but the huge amount of procurement needed to meet the U.S. demand for a full offset still left a large gap to be filled. All of that changed, however, when the Berlin wall started to go up in August 1961, and the crisis came to a head in the standoff at Checkpoint Charlie in October 1961. Many Germans were unhappy with the way the crisis was handled, and the fact that we had allowed the wall to be built. Feelings of vulnerability grew and there was an increased realization of just how dependent they were on America for their defense.

After much discussion in Washington, and many misgivings about the gold drain, Kennedy announced a 45,000 increase in U.S. troop strength in Germany with an option for more depending on how the situation developed. And in Germany the spigots opened and money began to flow as never before. The German defense budget was increased by $750 million to a total of $4.15 billion. Assurances were given that any increase in U.S. foreign exchange costs resulting from the buildup would be offset by Germany.

Breakthrough to the Offset Agreement

This was the breakthrough needed by the “Offset” negotiations. The working groups in Bonn quickly outlined an agenda that included setting up a cooperative logistics system, provision of procurement services, joint use of facilities and most importantly, agreement to provide advanced weapons systems including short range missiles and tactical nuclear delivery systems. Kennedy quickly followed up, this time sending Under Secretary of Defense, Roswell Gilpatric to Bonn. In a message to Adenauer he said that he expected West Germans to “work out with us arrangements to insure that U.S. military expenditures in Germany do not drain foreign exchange reserves from the United States to Germany.”

The Gilpatric mission was kept secret to avoid disclosing the wide ranging nature of the negotiation. It was agreed ahead of time that none of the matters discussed were to require consultation or agreement with Congress or the German Parliament. Gilpatric came with an outline of the logistics assistance that the Dept of Defense was prepared to offer as well as assurances to provide Germany with the latest missile systems. Gilpatric was accompanied by specialists from Defense and Treasury, while on the German side only the Ministry of Defense participated. The absence of representation from the State Dept and German Ministry of Finance was to create heartburn on both sides, and Strauss told Gilpatric that the British Ambassador would be in his office the next morning to demand equal treatment, but the negotiations proceeded anyway.

Gilpatric’s demand of the Germans was simple: that German military payments of benefit to the U.S. balance of payments be no less than U.S. military expenditures of benefit to the German balance of payments. The initial memorandum of understanding covered two years during which German defense procurement in the U.S. would have to total about  $1.45 billion to offset U.S. costs, meaning that about one-sixth of the German defense budget would have to be spent in the U.S.. Strauss supplemented the understanding with a letter stating that a firm commitment beyond the two years would not be possible, that a similar agreement with any other country would be impossible, and that U.S. political support would be needed if the agreement created problems with other countries.  

After the agreement was signed, hectic talks commenced on a myriad of implementing details, financial and organizational structures needed to implement the arrangement as well as the elements of the cooperative logistical system, while military experts dove into discussions of the many weapons systems that the Bundeswehr would be procuring. The financial framework that I was mostly involved with posed a number of problems that the Finance Ministry, largely excluded from the talks, took issue with at the eleventh hour, but the Finance Ministry intervention had come too late and its objections were brushed aside.

The Offset Agreement continued to operate in one form or another through the entire decade of the 60’s. Further implementation and future extensions were a nitty gritty day-by-day affair involving cadres of experts in various fields. Two names became famous for their frequent trips between Washington and Bonn were Henry Kuss, a Defense Dept procurement expert, and Charles A. Sullivan assigned by Secretary Dillon to lead the Treasury team. The comings and goings of Kuss and Sullivan were a source of constant frustration for the Embassy and State Dept because while these two were deeply embedded in German defense policy it was impossible to keep up with their activities and no one knew for sure what they were up to with their German counterparts.

The military importance of the arrangement is that it linked the military efforts of both countries in Europe on many different levels and helped rationalize their structure. By combining much of the procurement, research and development of both militaries, it increased production levels and reduced unit costs. In 1964 German military procurement made up one-third of all U.S. foreign military sales. This made the Bundeswehr mainly a U.S. equipped army, giving it access to the very latest weapons systems and the high tech systems that it would have been unable to develop on its own. It also stifled any inclination of the U.S. to redeploy elsewhere making it possible for U.S. troop levels to be maintained at a high and steady level in West Germany during the remainder of the cold war.

The financial implications for the U.S. were important also. It was by far the most important measure containing the level of balance of payments deficits during the remainder of the Bretton Woods fixed rate regime. It enabled Kennedy to reduce the balance of payments deficit from an annual rate of $4 billion when he took office to less than $2.5 billion in 1963, giving the Treasury breathing space to erect other defenses, as well as laying to rest ideas of withdrawing from global commitments out of monetary concerns. Kennedy himself said, “It should be understood that under present circumstances military offset agreements enjoy a clear priority over increased development assistance because of the immediate and direct benefits this objective can bring to our balance of payments.”           

My time at the U.S. Embassy in Bonn largely coincided with the Kennedy years. I arrived as a 25 year old junior Treasury staffer assigned as Assistant Financial Attache of the Embassy  in August 1960, just three months before the ill fated Anderson-Dillon mission. I was there assisting the Kennedy “offset” negotiators including economic advisers Robert Solow and Francis Bator, that arrived a few months later to pick up where Anderson-Dillon left off, there when the Berlin wall was built and during the October 1961 tank confrontation at Checkpoint Charlie, and then when Kennedy sent Roswell Gilpatric to Bonn and a real “Offset Agreement” was quietly arranged with West German Defense Minister Franz Josef Strauss.  I was also there in June 1963 when John F. Kennedy made his triumphant visit to West Germany, greeted by huge ecstatic crowds, and culminating with the famous “Ich Bin Ein Berliner” speech before a wildly cheering crowd in West Berlin. Despite German disappointment with the U.S. handling of the 1961 Berlin crisis, and the fact that we allowed the Berlin wall to go up when many Germans agreed with the hero of the 1949 Berlin airlift, General Lucius Clay, that we should have bulldozed it away, the Kennedy visit restored the close U.S.-German relationship as more and more Germans concluded that the wall was probably preferable to war. In 1963 Kennedy’s approval rating in West German polls reached 83%.

On November 22, 1963, President Kennedy was assassinated, and in the Summer of 1964 my tour of duty in Germany ended. The Offset Agreement continued to operate in one form or another throughout the 60’s making an invaluable contribution to the NATO defense posture and the development of the Bundeswehr, while avoiding the monetary catastrophe that had been feared. On August 13, 1971, President Nixon finally broke the last ties between gold and the dollar, closing the window at which foreign official holders could convert dollars to gold at a fixed price of $35 per oz. and ushering in a new Bretton Woods system based on freely fluctuating currency values. Fears of a “gold drain” were finally laid to rest.