Johnson Restricts Direct Foreign Investment

Date January 1, 1968

President Lyndon B. Johnson imposed restrictions on direct foreign investment by U.S. corporations in response to a worsening balance-of-payments deficit. Any benefits of the restrictions, however, proved short-lived, as the deficit continued to increase in the long term.

Locale Washington, D.C.

Key Figures

• Lyndon B. Johnson (1908-1973), president of the United States, 1963-1969
• Henry H. Fouler (1908-2000), U.S. secretary of the Treasury, 1965-1969
• William McChesney Martin (1906-1998), chair of the U.S. Federal Reserve’s Board of Governors, 1950-1970
• Gardner Ackley (1915-1998), chair of the President’s Council of Economic Advisors, 1964-1968

Summary of Event

In a crisis atmosphere, on New Year’s Day, 1968, President Lyndon B. Johnson announced the imposition of strict, mandatory curbs on capital outflows from the United States. These capital outflows were created by corporations in order to finance direct foreign investment, or purchases of machinery and factory facilities in other countries. These new restrictions were necessitated by a dramatic worsening of the nation’s balance of payments in 1967. The U.S. balance of payments, an accounting system that measures flows over time and records the nation’s real (exported and imported goods) and financial transactions with the rest of the world, had been recording accelerating deficits since the beginning of the decade.

In his message to the nation, Johnson indicated that the 1967 deficit in the U.S. balance of payments was estimated to be between $3.5 and $4.0 billion. He noted, moreover, that deficits of this magnitude were unsustainable and threatened not only the future prosperity of the United States but also the stability of the international financial system and the future prosperity of the free world.

The decision to restrict direct foreign investment was made secretly over the Christmas weekend. The gravity of the situation was clearly demonstrated by the unpopularity of the proposed restrictions. Nevertheless, the government saw a need to act because of nervousness in foreign-exchange markets following the recent devaluation of the British pound sterling and the recurring purchase of gold reserves with currency. These developments indicated that the world’s financial markets saw problems with the U.S. balance of payments.

U.S. corporations were forbidden to create capital outflows to finance direct foreign investment in Western Europe and most other developed nations. They were permitted to invest up to 35 percent of their average investment during 1965 and 1966. The funds to finance this investment could come from reinvestment of earnings from foreign countries. All earnings on direct foreign investment that were greater than 35 percent of the average investment in 1965 and 1966 had to be repatriated.

In order to maintain the economic growth and financial stability of Canada, Japan, Australia, and oil-exporting countries, these countries were exempted from restrictions. U.S. corporations were permitted to invest in developing nations up to 110 percent of their average investment there during 1965 and 1966. Funds to finance this investment could come either from the United States or from reinvested earnings. In general, U.S. corporations had to reduce bank accounts and holdings of other short-term assets to the levels during 1965 and 1966 and had to repatriate the same percentage of earnings from each of these three sectors as in 1965 and 1966.

Balance-of-payments problems, for which the restrictions on investment were proposed as a cure, resulted in part from the structure of the world financial system. Although the currencies of major European nations had not become convertible, as defined by the International Monetary Fund, until February of 1961, they became externally convertible de facto at the end of 1958. Under the Bretton Woods Agreement of 1944, which provided the institutions and organization for the post-World War II international financial system, general convertibility was to have been achieved in 1949.

The U.S. balance of payments had registered deficits, at first slight and then growing, from 1950 onward, following devaluations of the French franc and the British pound sterling in 1949. The U.S. balance on official reserve transactions, a summary account used at the time to measure the general overall balance of payments, averaged a deficit of $0.9 billion during the 1950-1959 period and a deficit of $1.7 billion during the 1958-1968 period.

The great concern at the time was the “dollar shortage.” The so-called dollar shortage reflected the idea that there was a fundamental long-term imbalance in the international payments system in favor of the United States. The idea of a dollar shortage was a theoretical concept that took on a life of its own, despite underlying structural changes taking place in the international economy. An entire literature developed around the concept of a dollar shortage, and some writers forecast that the dollar shortage would be a permanent feature of the post-World War II international economy.

By the end of 1959, almost simultaneous with the de facto convertibility of major European currencies, large deficits in the U.S. balance of payments began to appear. A redistribution of world monetary gold and the accumulation by other countries of reserves in the form of dollars had already begun and soon would accelerate. The concern over the dollar shortage quickly turned to a concern over a dollar glut.

A permanent dollar shortage would have meant slower economic growth, poor allocation of world resources, and a retarding of the trend toward international integration. A dollar glut, on the other hand, would prove to be much more dangerous and would ultimately result in a collapse of the gold exchange standard that was established with the Bretton Woods Agreement. The gold exchange standard was a system of fixed exchange rates for currencies. It was also a compromise, attempting to capture the automatic adjustment mechanism of the nineteenth century gold standard, in which all major currencies could be converted into gold, while permitting a nation to devalue its currency in relation to others, so that the currency would buy less of the currencies of other nations. Devaluation allowed a country to avoid a painful drop in the prices of its products when it found that its imports exceeded its exports.

Under the Bretton Woods system, the U.S. dollar and the British pound sterling became “reserve currencies.” Monetary reserves—a country’s holdings of assets to support the value of its currency—could be kept either in a reserve currency or in gold. After the 1967 devaluation of the British pound sterling, the U.S. dollar became the world’s premier reserve currency.

The value of the U.S. dollar was defined in terms of gold by the Bretton Woods Agreement. One ounce of monetary gold was equal to $35. All other nations defined the “par” values of their currencies in terms of the U.S. dollar. Each nation was required to keep the value of its currency within 1 percent of the currency’s par value. This would be accomplished by buying or selling currency in exchange for gold or reserve currencies. Selling gold in exchange for a currency, for example, would raise the value of that currency by taking some of the currency out of world circulation.

Monetary reserves, and particularly the U.S. dollar as a reserve currency, played a key role in the Bretton Woods system. When a nation ran down its monetary reserves in attempts to keep the value of its currency above the minimum allowed, pressure would develop for the nation to devalue its currency, or reduce its par value, relative to the U.S. dollar.

The U.S. dollar had a unique role and responsibility. To the extent that other nations were willing to hold additional U.S. dollars as monetary reserves and that their citizens were willing to hold additional U.S. dollar assets as investments, the United States could continue to run a deficit in its balance of payments. That is, the United States could send its currency abroad without a devaluation since other countries used it as a reserve currency.

The unique feature of the Bretton Woods system was that as long as the rest of the world was willing to accept more U.S. dollars, the United States could collect a “seigniorage,” consuming and investing more than it produced. It could finance this consumption and investment with creation of additional U.S. dollars. The downside of the unique role the U.S. dollar played in the Bretton Woods system was that when the U.S. dollar was overvalued relative to other currencies, in terms of the goods and services that could be purchased with it, the United States government could not devalue the U.S. dollar or change its par value relative to other currencies.

The United States had been losing gold reserves for a number of years by the time the balance of payments crisis developed in 1968. Foreign holders of U.S. dollars had claimed gold in exchange for their dollars. In June of 1967, foreign U.S. dollar claims against the United States stood at 226 percent of the total U.S. holdings of gold reserves, meaning that the United States could redeem less than half of the dollars held in foreign countries.

Significance

The restrictions on direct investment by U.S. corporations affected a number of institutions, markets, and financial practices. The impact on the U.S. balance of payments, while initially positive, proved to be transitory. By the third quarter of 1968, exports were growing faster than imports, and the balance of payments (seasonally adjusted) recorded a surplus. The return to large deficits in the balance of payments and a run on the U.S. dollar in the early 1970’s, however, would ultimately cause the collapse of fixed exchange rates and the Bretton Woods system.

The restrictions on direct foreign investment by U.S. corporations did not represent a basic change in the U.S. government’s policy of promoting economic development in developing nations. The restriction on investments there of 110 percent of the average in 1965 and 1966 was considered to be lenient. The policy of restricting direct foreign investment essentially was aimed at Western Europe and more specifically at the strong German mark and Germany’s growing balance of payments surplus.

The major impacts of these restrictions seem to have been on the way that U.S. corporations financed their foreign activities and on the development of the Eurobond market. Eurobonds are international debt issues denominated in U.S. dollars. They are distributed in more than one country (in which the U.S. dollar is not the national currency), and the borrower is foreign. Eurobonds may be denominated in other major currencies if these bonds meet the other requirements.

The restrictions on direct foreign investment virtually forced all U.S. corporations that wanted to continue their foreign commitments and activities to participate in the expansion of the Eurobond market. The Eurobond market at the time was at a critical stage in its development. The expanded volume provided by new securities issued by U.S. corporations and the development of secondary markets made possible the participation of international institutional investors in the Eurobond market.

Institutional investors, which have come to play an important role in the development of financial markets, had been largely absent from the Eurobond market prior to the mandatory restrictions on direct foreign investment by U.S. corporations. The increased demand for funds in the Eurobond market by U.S. corporations acted as an integrative force in world financial markets. Because financial markets were more integrated, interest rates became closer together and tended more to move together. In addition, one country’s economic problems became more likely to be transmitted to other countries.

Participation in the Eurobond market by U.S. corporations represented a willingness to experiment with innovative financing techniques as well as enhancing their true multinational characters. Eurobond market financing also represented a willingness to separate the investment decision from the financing decision: A company could invest in a country without having to borrow money there. It could obtain the country’s currency, if needed, in the international financial market.

The restrictions on direct foreign investment ended six years after they had begun, with the exception that such investment still had to be reported. The Bretton Woods system ended in 1972, eliminating some of the concerns about the dollar as a reserve currency. Currencies were allowed to “float” against one another, although in practice governments chose to intervene to maintain currency values. Seeing no need to continue the restrictions, the U.S. government ended them on January 29, 1974.

Bibliography

Cohen, Benjamin J., ed. International Monetary Relations in the New Global Economy. 2 vols. Northhampton, Mass.: Edward Elgar, 2004. Extremely comprehensive account of the theory and practice of international finance.

Foster, Susan B. “Impact of Direct Investment Abroad by United States Multinational Companies on the Balance of Payments.” Monthly Review Federal Reserve Bank of New York 54 (July, 1972): 166-177. Foster attempts to estimate the impact of the 1968 restrictions on direct foreign investment, using existing statistical data. This article contains a detailed discussion of the concepts and the difficulties that are involved in such a measurement as well as how one might undertake such a measurement. Foster emphasizes that available data were inadequate to estimate the impact. This article is rather technical in nature though not particularly difficult to read.

Scammell, W. M. International Monetary Policy. 2d ed. New York: St. Martin’s Press, 1965. An excellent book for someone interested in the Bretton Woods system. Well written and easy to understand, with many interesting insights. Explains the development of the Bretton Woods system and the role the International Monetary Fund played up to the early 1960’s.

‗‗‗‗‗‗‗. International Monetary Policy: Bretton Woods and After. New York: John Wiley & Sons, 1975. An excellent book, well written and easy to understand. Examines the development of the Bretton Woods system, changes in the international environment, and the role the International Monetary Fund played up to 1973. Contains a good discussion of the merits and shortcomings of both the Bretton Woods system and the International Monetary Fund.

Solomon, Robert. The International Monetary System, 1945-1981. New York: Harper & Row, 1982. Excellent, well written, and easy to understand. Solomon spent many years with the U.S. Federal Reserve System and offers an insider’s perspective.

Stanley, Marjorie T., and John D. Stanley. “The Impact of U.S. Regulation of Foreign Investment.” California Management Review 15 (Winter, 1972): 56-64. The authors attempt, through use of a questionnaire, to determine whether and how the 1968 restrictions influenced the way multinational corporations financed their foreign subsidiaries. This article is not particularly difficult and contains some detailed, interesting comments on how chief corporate financial officers make decisions.

Yeager, Leland B. International Monetary Relations: Theory, History, and Policy. 2d ed. New York: Harper & Row, 1976. Excellent source for anyone interested in international finance. Contains a wealth of information.