The Fed and the Strong Dollar Policy

The Fed and the Strong Dollar Policy

by
Henry C.K. Liu

This article appeared in AToL on June 17, 2008

A misleading impression has been given by recent press reports that the June 3 speech by Federal Reserve Chairman Ben Bernanke marked a Federal Reserve departure from a long tradition of nonintervention on the exchange value of the dollar, in response to the Treasury’s renewed declaration that a strong dollar is in the national interest of the US.

The reality is that the Fed has a long tradition in supporting the lead of the Treasury in intervening on the exchange value of the dollar, albeit not always to keep the dollar strong. The Exchange Stabilization Fund (ESF) was established at the Treasury Department by the Gold Reserve Act of 1934 as part of the New Deal. Section 7 of the Bretton Woods Agreements Act of 1945 as signed by 28 nations obliged members to make subscription payments in gold or equivalent currencies for shares in the International Bank for Reconstruction and Development (World Bank). It required an amendment to the Federal Reserve Bank Act of 1913 to maintain the exchange value of the dollar, making ESF operations permanent.

Since then, the ESF has managed a portfolio of domestic and foreign currencies for the purpose of foreign exchange intervention to allow the US to influence the exchange rate of the dollar without directly affecting the domestic money supply. The ESF holds three types of assets: dollars, foreign currencies, and Special Drawing Rights (SDRs) in the International Monetary Fund (IMF). As of April 30, 2008, the ESF was holding assets totaling $51.2 billion of which $40.8 billion was retained profit.

By law, the Secretary of the Treasury is the chief international monetary policy official of the United States. The Federal Reserve has separate legal authority to engage in foreign exchange operations. Federal Reserve foreign exchange operations are conducted in close and continuous consultation and cooperation with the Treasury Secretary to ensure consistency with US international monetary and financial policy.

The Treasury and the Fed have closely coordinated their foreign exchange operations since early 1962, when the Federal Reserve commenced such operations at the request of the Treasury. Operations are conducted through the Federal Reserve Bank of New York (FRBNY), as fiscal agent of the US and as the operating arm of the Federal Reserve System. Beginning in 1962, the Federal Reserve established a network of reciprocal currency agreements (swap facilities) with major foreign central banks and the Bank for International Settlements. In 1963, the Federal Reserve authorized the “warehousing” of foreign currencies for the ESF. By temporarily selling some of its foreign currency holdings to the Federal Reserve for dollars through warehousing, the ESF was able to continue to purchase foreign currencies even after it had exhausted its initial dollar resources.

In establishing the Bretton Woods system, the Articles of Agreement of the International Monetary Fund (IMF) heavily stressed exchange rate stability. The intent was to discourage the competitive devaluations that were viewed as contributing to economic and financial chaos in the 1920s and 1930s. The Articles formally permitted adjustment of a currency’s par value only if the country’s balance of payments was in “fundamental disequilibrium.” This came to mean that exchange rates would be adjusted only as a last resort and only in conjunction with other policies to redress the disequilibrium.

The expanding post-war world economy generated a secular increase in the demand for international reserves in the form of dollars and gold. That demand had been met through the early 1960s by a buildup of official claims on the US as foreign monetary authorities intervened to maintain the value of their currencies against the dollar. Gold and foreign exchange reserves of the foreign G-10 countries tripled over the Bretton Woods period (1945-71), but this increase was not matched by a rise in the US gold stock. Hence, confidence in the ability of the US to meet calls on its gold stock declined. Thus reliance solely on increases in US liabilities to foreign official institutions for an increase in world reserves was seen to be inconsistent in the long run with maintaining the convertibility of the dollar into gold at a fixed rate.

To relieve this fundamental tension, the US sought to preserve its gold stock and the stability of the Bretton Woods system by creating an elastic reserve asset whose supply could be systematically increased as the world economy expanded. This resulted in an agreement to create SDRs (Special Drawing Rights of the International Monetary Fund) through the First Amendment to the IMF Articles of Agreement, which was adopted in 1968 and became effective the following year. The first allocation of SDRs was made in January 1970.

President Nixon, on August 15, 1971, suspended convertibility of dollars into gold or other reserve assets for foreign monetary authorities. He also announced a temporary 10% surcharge on imports to ensure “that American products will not be at a disadvantage because of unfair exchange rates” and a 10% tax credit to businesses that invested in American-made equipment (the job development credit). Use of the Federal Reserve swap network was suspended after the closing of the gold window. Foreign authorities then had the choice of continuing to pile up dollars in their official reserves that were now inconvertible into gold or allowing their currencies to appreciate. The US no longer intervened in the market to support an overvalued dollar.

By the end of August, all major currencies except the French franc were floating. As selling pressure on the dollar mounted, the US in July 1972 resumed limited sales of foreign currencies and the swap network to defend the dollar’s Smithsonian parities, a system of fixed parities among the currencies of the G-10 countries re-established through a negotiated realignment of exchange rates in the Smithsonian Agreement of December 1971. The dollar was devalued in terms of gold from $35 to $38 per ounce; other currencies generally were revalued against the dollar by varying amounts. These changes in parities resulted in an effective devaluation of the dollar of nearly 10% on average against the other G-10 currencies. But the amount of the devaluation fell short of US government estimates of what would be required to restore the US external position to a sustainable balance. Floating was finally legitimatized at the November 1975 Rambouillet Economic Summit among the major industrial countries.

As the depreciation of the dollar intensified around the turn of the year, the Federal Reserve responded by raising its discount rate in January 1978 to 6.5%, citing developments in foreign exchange markets. However, the pace of US inflation quickened to 9% in 1978, in part reflecting the past depreciation of the dollar; meanwhile, inflation in the other G-10 countries, on average, declined from 5.5% in 1975 to slightly more than 4% in 1978. Efforts to reduce the US trade deficit by curbing oil imports after the crisis of 1973 were unsuccessful. The Federal Reserve engineered further firming in money market conditions through the spring and summer of 1978, but the growth of M1 still exceeded its targeted range and the dollar continued to fall.

Disorderly conditions in exchange markets and a serious US inflation problem forced the Federal Reserve in August 1978 to raise its discount rate 1/2 percentage point further to 7.75%. This move and subsequent increases in the autumn provided only temporary support for the dollar. Between May and October 1978, President Carter announced a series of measures to fight inflation, including delays and reductions in the amount of scheduled tax cuts, budgetary restraints, and voluntary wage-price guidelines. Following the announcement of the last two measures in October, the dollar tumbled still further, hitting on October 30 a record low on the trade-weighted index compiled by the Federal Reserve Board staff. Two days later, a dollar-defense package was announced. It included a further hike in the discount rate by an unprecedented full percentage point, to a then historic high of 9.5%.

In January 1978, the Treasury stated that the ESF would henceforth be used as an active partner in the financing of intervention, and that a new swap line with the Bundesbank had been established. Furthermore, in March, the Federal Reserve’s swap line with the Bundesbank was doubled, and the Treasury sold SDRs to the German central bank for marks. The Treasury also indicated that it was prepared to draw on its reserve position at the IMF to acquire foreign currencies. To further support the dollar, the Treasury announced in May that it would resume auctioning gold to the public. Finally, as part of the November 1, 1978 dollar-defense program, a $30 billion package of foreign currency resources to finance US intervention in cooperation with foreign authorities was put together. It consisted of an increase in Federal Reserve swap lines with the central banks of Germany, Japan, and Switzerland; sales of SDRs; a drawing on the U.S. reserve position at the IMF by the Treasury, and issuance of Carter Bonds in West Germany in order to raise marks for the dollar defense. US energy policy was widely regarded in exchange markets as being in disarray. The subsequent dismissal of his cabinet by Carter raised concerns in exchange markets about political leadership. Under these circumstances, US authorities intervened substantially during the summer of 1979 to resist the dollar’s decline.

In early 1981, the new Reagan Administration decided to move away from what it judged to have been unwise intervention inherited from the previous administration, reflecting the ideological view that exchange rates were the product of national economic policies and that a multinational “convergence” of economic policies was the way to stabilize exchange rates, a view consistent with the Administration’s general desire to minimize government interference in markets. The market was deemed to know best.

As the dollar rose due to complex interactions of divergent policies of different governments, the Reagan Administration in its second term began to reverse its policy of nonintervention in currency markets. Group of Five (G-5) officials, meeting on January 22, 1985, issued a statement paying lip service to their continuing commitment to promote the convergence of national economic policies, to remove structural rigidities, and (as agreed at the Williamsburg Economic Summit of April 1983) to undertake coordinated intervention in exchange markets as necessary. Subsequently, in coordinated operations with other central banks, US authorities sold about $650 million between January and March 1985.

Although the dollar had started to decline by late February, 1985 due to US fiscal deficit, that decline had yet to reduce the US trade deficit, causing protectionist sentiment in the US to mount as the trade deficit swelled to an annual rate of $120 billion in the summer of 1985. In part to deflect protectionist legislation, US officials arranged a meeting of G-5 officials at the Plaza Hotel in New York on September 22, 1985 with the purpose of ratifying an initiative to bring about an orderly decline in the dollar, observing that “recent shifts in fundamental economic conditions among their countries, together with policy commitments for the future, have not been fully reflected in exchange markets,” and concluded that “further orderly appreciation of the main non-dollar currencies against the dollar is desirable,” and that the G5 members “stand ready to cooperate more closely to encourage this.” During the seven weeks following the Plaza Accord, G-5 authorities sold nearly $9 billion, of which the US sold $3.3 billion for other currencies, while speculators profited by shorting the dollar.

The dollar had declined to seven-year lows in early 1987 amid signs of weakness in the US economy while the US trade deficit continued to grow. Public statements by US Administration officials were interpreted in exchange markets as indicating a lack of official concern about the ramifications of further declines in the dollar. On February 22, 1987, officials of the G5 plus Canada and Italy met at the Louvre in Paris to announce that the dollar had fallen enough. But despite heavy intervention purchases of dollars following the Louvre Accord, the dollar continued to decline, particularly against the yen. Market participants perceived delays in the implementation of expansionary fiscal measures in Japan expected after the Louvre Accord and talks of trade sanctions on some Japanese products heightened concern about tension in US-Japanese trade relations.

Following the Louvre Accord, the G-7 authorities intervened heavily in support of the dollar throughout the episodes of dollar weakness in 1987, and sold dollars on several occasions when the dollar strengthened significantly. Net official dollar purchases by the G-7 and other major central banks effectively financed more than two-thirds of the $144 billion US current account deficit in 1987. The US share of these purchases was $8.5 billion, and the share of the other G-7 countries was $82 billion, since the non-dollar expert-dependent governments wanted desperately to halt the appreciation of their currencies.

Record US trade deficits and market perceptions that the G-7 authorities were pursuing monetary measures best suited to their own separate domestic economic objectives soon sparked a further sell-off of the dollar. This contributed to a worldwide collapse of equity prices which had risen to levels unsupported by fundamentals. The dollar’s decline gathered new momentum when the Federal Reserve under its new chairman Alan moved more aggressively than its foreign counterparts to supply liquidity in the aftermath of the 1987 stock market crash which had been triggered by program trading on portfolio insurance derivatives arbitraging on macroeconomic instability in exchange rates and interest rates. The Federal Reserve’s actions in 1987 led market participants to believe that it would emphasize domestic objectives, if necessary at the cost of a further decline in the dollar. By year-end, the dollar's value had fallen 21% against the yen and 14% against the mark from its levels at the time of the Louvre Accord while Greenspan, the wizard of bubble-land was on his way to being hailed as the greatest central banker in history.

The ESF was the conduit used by the Clinton administration to provide assistance to Mexico to avoid default in the peso crisis of 1994 to prevent huge losses to US lenders after Congress rejected the proposed Mexican Stabilization Act. The crisis was triggered by an abrupt devaluation of the Mexican peso by newly installed president Zedillo to reverse the former Salinas administration’s tight money policy. Salinas had issued the Tesobonos, a type of sovereign debt instrument denominated in pesos but indexed to dollars, fatally increasing Mexico’s exposure to foreign exchange risk. See my November 6, 2004 article: The Tequila Trap in AToL.

Bear Stearns chief economist Wayne Angell, a former Fed governor and advisor to then Senate majority leader Bob Dole, first came up with the idea of using ESF funds to prop up the collapsing Mexican peso. Bear Stearns had significant exposure to peso debts that would cause significant losses in the event of a peso collapse.

Senator Robert Bennett, a freshman Republican from Utah, took Angell’s proposal to the Fed Chairman Alan Greenspan and Treasury Secretary Robert Rubin, both of whom rejected the idea at first, shocked at the blatant circumvention of constitutional procedures that this strategy represented, which would invite certain reprisal from Congress. Congress had implicitly rejected a rescue package in the form of Mexican Stabilization Act earlier that January when the initial proposal of extending Mexico $40 billion in loan guarantees could not get enough favorable votes. Greenspan advised Bennett that the idea would only work if Congressional silence could be guaranteed. Bennett went to Dole and convinced him that the scheme would work if the majority leader would simply block all efforts to bring this use of taxpayers’ money to a vote. It would all happen by executive fiat.

The next step was to persuade Dole’s counterpart in the House, Speaker Newt Gingrich. The two congressional leaders consulted several state governors, notably then Texas governor George W Bush, who enthusiastically endorsed the idea of a bailout to subsidize the border region in his state. Greenspan, who historically opposed bailouts of the private sector for fear of incurring moral hazard, was clearly in a position to stop this one. Instead, he used his considerable independent power and congressional influence to help the process along when key players balked. The controversial 2008 bailout of Bear Stearns by the Fed was not the first.

The 1994 peso bailout would lead to a subsequent series of similar situations in which influential private financial institutions will knowingly get themselves into future trouble in order to maximize their short-term profit, vindicating the moral hazard principle that market participants will take undue risks with the expectation of government bailout guarantees. Eventually, the US Treasury actually made a $500 million profit on the $50 billion loan to Mexico, but the global economy lost trillions down the road. As Thailand, Indonesia, Malaysia, South Korea, Brazil, Argentina, Turkey, Russia and other countries stumbled into financial crises, culminating in the collapse of hedge fund giant Long-Term Capital Management (LTCM), which played key roles in precipitating the crises to begin with, Greenspan moved to inject liquidity to support the distressed bond markets. At the helm of LTCM was yet another former member of the Fed board, ex-vice chairman David Mullins who pleaded for help from his former colleagues with Fed-speak that they understood.

When New York Fed president William McDonough helped coordinate a bailout of LTCM at his offices, Greenspan defended McDonough before a congressional oversight committee. Reflecting on all the corporate welfare being doled out to prop up bad private-sector investments worldwide, Bill Clinton appointee Alice Rivlin, the able former congressional budget director, observed that “the Fed was in a sense acting as the central banker of the world.” During Clinton’s first term, Greenspan had handed the president a “pro-incumbent-type economy” and was rewarded with a seat next to the First Lady in Clinton’s televised second-term State of the Union address and a third-term appointment as Fed chairman. Crony capitalism was not exclusive to Asia.

Treasury policy during 1961-71 focused on deterring capital outflows from the US and on giving major foreign central banks an incentive to hold dollar reserves rather than demand gold from the US gold stock. The ESF resumed intervention operations in the foreign exchange market in March of 1961 (for the first time since the mid-1930s), but it soon became apparent that the resources of the ESF alone were too small to sustain transactions of the magnitude necessary. At the invitation of the Treasury, the Federal Reserve joined in foreign exchange operations in February 1962, entering into a network of swap agreements with other central banks in order to obtain foreign currencies for short-term periods for use in absorbing forward sales of dollars by foreign central banks hedging exchange risk on their dollar holdings. To provide foreign currency to repay the Fed’s swap drawings, the Treasury during the 1960s issued non-marketable foreign currency-denominated medium-term securities known as Roosa bonds, named after then Undersecretary of the Treasury Robert V. Roosa, designed to be attractive to foreign monetary authorities as an alternative to converting dollars into gold, and sold the proceeds to the Fed. Part of the foreign currency proceeds from Roosa bonds was used to extinguish swap debt that otherwise would have lingered beyond the one-year limit set by the FOMC on such drawings. In August 1971, the United States ceased conducting gold transactions with foreign monetary authorities, and the need to moderate the drain on the US gold stock was eliminated.

In December 1974, ESF turned over, in a sale at par value, a gold balance of 2.02 million ounces (valued at $85 million) to the Treasury General Account. This gold had been acquired prior to August 1971 through gold transactions that the ESF engaged in with foreign monetary authorities and with the market for the purpose of stabilizing the value of the dollar relative to gold. In a public announcement of this sale of gold by the ESF to the Treasury General Account, the Treasury stated that the sale was made “in view of the likelihood that the Exchange Stabilization Fund [would] not be engaging in further transactions to stabilize the value of the dollar relative to gold.” The ESF again had gold on its books for a short period in 1978 as a counterpart to an ESF credit to Portugal.

Later in the 1970s, the US monetary authorities built up foreign currency reserves substantially. For this purpose, the ESF entered in a $1 billion swap agreement with the Bundesbank in January 1978 (which has since been allowed to expire). In connection with the dollar support program announced in November 1978, the Treasury issued foreign currency-denominated securities (Carter bonds) in the Swiss and German capital markets to acquire additional foreign currencies needed for sale in the market through the ESF. The United States also drew on its reserve position in the IMF.

In the mid-1980s, the major industrial nations embarked on a process of intensified policy coordination. The Group of Five's (G-5) Plaza Agreement in September 1985 served to reinforce exchange rate adjustments among the major currencies and occasioned substantial coordinated intervention sales of dollars. The G-5 “agreed that exchange rates should play a role in adjusting external imbalances … should better reflect fundamentals … and that … some further orderly appreciation of non-dollar currencies against the dollar is desirable.”

In the Louvre Accord of February 1987, the major industrial countries agreed that the exchange rate changes since the Plaza Agreement would “increasingly contribute to reducing external imbalances and … [had] brought their currencies within ranges broadly consistent with underlying economic fundamentals …and agreed to cooperate closely to foster stability of exchange rates around current levels.” They adopted specific measures and cooperative arrangements reflecting their view that their currencies were broadly consistent with underlying economic fundamentals. This framework for cooperation on exchange rates complemented the broader economic policy coordination efforts to promote growth and external adjustment. In December 1987, the Group of Seven (G-7) reaffirmed Louvre's basic objectives and policy directions and agreed to intensify their economic policy coordination efforts and to cooperate closely on exchange markets. There was continued active cooperation through late 1989, but such activities became less frequent thereafter. Since the credit crisis of August 2007, because of the dollar’s decline, talk of need for coordination has bee revived.

In December 2007, as part of the measures to deal with the credit crisis, the Fed Open Market Committee (FOMC) authorized temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB), providing dollars in amounts of up to $20 billion and $4 billion to the ECB and the SNB, respectively, for use in their jurisdictions for a period of up to six months.

Today, in a globalized financial market of free floating exchange rates, the exchange value of the dollar is a legitimate and necessary concern of monetary policy. A hallmark of Fed structure is the inclusion of regional views and sector conditions in formulating monetary policy. From the beginning of the Fed in 1913, opinions, both economic and political, have differed on the need for, and the location of geographic representation on the Fed Board of Governors. The debate has continued over the Fed’s market participating arm, the FOMC, formed by the Banking Act of 1933, changed in the Banking Act of 1935 to include the Board of Governors to closely resemble the present-day FOMC composition, and amended in 1942 to the current voting structure, which consists of the seven members of the Board of Governors, the president of the New York Fed and four other Fed presidents who serve on a rotating basis. In 1964, congressional hearings were even held to consider the abolition of the FOMC on the argument that Fed open market operations were in violation of free market principles.

The Federal Reserve controls three tools of monetary policy: open market operations, the discount rate and reserve requirements. The Board of Governors is responsible for setting access qualification to the discount window to borrow at the discount rate, as well as bank reserve requirements. The Federal Open Market Committee is responsible for open market operations. Using the three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions must hold at Federal Reserve Banks and in this way alters the federal funds rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Changes in the federal funds rate trigger a chain of market events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services. The job of the FOMC is to set the fed funds rate target and keep the rate at or near the target through open market operations in the repo market. A net increase or decrease in reserves or liquidity in the banking system would also put downward or upward pressure on the federal funds rate respectively.

The Fed, a central bank, must still maintain a balance sheet that reconciles its assets and liabilities just as any other bank does. While the Fed theoretically commands unlimited credit through its power to print money, its balance sheet is still subject to the same rules as any financial institution. The difference is that instead of facing insolvency as a private bank would, a weak Fed balance sheet causes debasement of the currency, since changes in categories of Fed assets and liabilities are an important way the Fed manipulates the money supply. The Fed under Bernanke has recently taken action that changed the composition of the Fed balance sheet, absorbing more mortgage bonds, and swapping Treasuries for even private-label and commercial mortgage-backed securities, in effect influencing prices of securities tied to housing finance. These actions, together with cuts in the fed funds rate target, have adversely affected the exchange value of the dollar.

The importance and overriding dominance of national policy over regional and sector considerations is now generally accepted. The FOMC is not expected to adjust monetary policy to address economic concerns pertinent to only one geographical district or one economic sector. In recent decades, until August 2008, regional and sector inputs had played increasingly only peripheral roles in the formulation of national monetary policy.

By extension, the Fed as the institutional guardian of the dollar, the world’s prime reserve currency for international trade, is obliged to support the Treasury’s recent strong-dollar policy as a matter of national economic security, as internationalist dominance in US policy over domestic concerns became institutionalized. In recent decades, the rust belt and the agricultural exporting states were urged to restructure their local economies to better compete in the global market, and not expect a devaluation of the dollar to bail them out of their economic problems. The Fed under Bernanke has deviated from this path of a strong dollar in its response to the credit crisis of 2007. Bernanke’s June 3 speech on the dollar merely put the Fed back on track.

Financial markets are not the real economy but its early dawn shadow. The shape and fidelity of that shadow are affected by the position and intensity of the light source that comes from market sentiments on the future performance of the economy and by the contour of the ground shaped by data on leading economic indicators. Yet the institutional bias of the Fed over past decades has been drifting toward more allegiance to the speculative effects on the financial markets than to the health of the real economy, let alone the net benefit to long-term investors or the welfare of all the people. Unfortunately, bending the shadow to make it look tall does not alter the height of the subject.

Granted, market economists argue that a sound financial market ultimately serves the interest of all. But it is a hard sell to paint a debt-infested economy as sound. The Fed's liquidity joy ride has been to reward speculators rather than investors, and to favor transactions rather than growth. Further, the economy is not homogenous throughout. In reality, some sectors of the economy and segments of the population, through no fault of their own, may not, and often do not, survive the down cycles to enjoy the long-term benefits, and even if they should survive the down turn, they are permanently put in the bottom heap of perpetual depression. Periodically, the Fed has failed to distinguish a healthy growth in the economy from a speculative debt bubble in the financial markets. There are clear signs that this failure has been institutionalized at the Fed on Greenspan’s watch. The Bernanke Fed has yet shown no signs of needed reform.

The Reagan administration (1981-89) by its second term that began in 1985 discovered an escape valve for its unprecedented fiscal deficit from Fed Chairman Paul Volcker’s independent domestic policy of stable-valued money. In an era of growing international trade among Cold War Western allies, with the quasi-globalization incorporating the emerging economies before the final collapse of the Soviet Bloc, a booming market for foreign exchange had developing since Nixon in 1971 abandoned the Bretton Woods regime of gold-backed fixed exchange rates. The exchange value of the dollar thus became a matter of national economic security and as such fell within the authority of the Treasury under the president that required the “independent” Fed’s support as a patriotic duty. Since that time, the Treasury has been the spokesman for the dollar, a fact repeated only last February by Bernanke in Congressional testimony.

Council of Economic Advisors chairman Martin Feldstein, a highly respected conservative economist from Harvard with a reputation for intellectual honesty, had advocated a strong dollar in Reagan’s first term, arguing that the loss suffered by US manufacturing was a fair cost at the sector level for national financial strength, provided the growth trend of fiscal deficit was reversed, especially in boom time, and the spending be focused on domestic development rather than armament. But such rational views were not music to the Reagan White House. Feldstein, given the brush off by the White House, went back to Harvard to continue his quest for truth in economics after serving two years in the Reagan White House, where voodoo economics of a strong dollar being sustainable by persistent Federal deficit reigned.

By Reagan’s second term, it became undeniable that US policy of a strong dollar was doing much damage to the manufacturing sector of the US economy and threatening the Republicans with the loss of political support from key industrial states, not to mention the unions which the Republican Party was trying to woo with a theme of Cold War patriotism. Treasury secretary James Baker and his deputy Richard Darman, with the support of manufacturing corporate interest before the age of cross-border wage arbitrage, then adopted an interventionist exchange-rate policy to push the overvalued dollar down.

But this required the cooperation of the Fed which needed to keep dollar interest rate high to fight domestic inflation. A truce was called between the Volcker Fed and the Baker Treasury, though each continued to quietly work toward opposite policy aims, much like the situation in 2000 on interest rates, with the Fed raising short-term fed funds rate while the Treasury pushed down long-term rates by buying back 30-year bonds, resulting in an inverted rate curve, a classical signal for recession down the road. A reverse situation now causes a conflict between the Bernanke Fed which needs to lower interest rates to stimulate a stalled economy and the Paulson Treasury which needs a strong dollar for geopolitical reasons in dealing with run-away oil prices.

A policy deal was struck in 1985 to allow Fed Chairman Paul Volcker to continue his battle against domestic inflation with high interest rates while the overvalued dollar would be pushed down by the Treasury through the Plaza Accord of 1985. This was accomplished by forcing US trade partners to raise non-dollar interest rates to boost the value of their currencies. The agreement, intended to curb increasing US trade imbalances and to defuse domestic protectionist sentiment and action, aimed at orderly appreciation of the key non-dollar currencies against the dollar.

After Greenspan was appointed by Reagan to replace Volcker at the Fed, dollar interest rate was pushed down by the Fed after the 1987 crash. The resultant global interest rates imbalance led to “carry trade” in which currency arbitrageurs borrowed low interest currencies to invest in high interest currencies that contributed to recurring financial crises. Asia, to attract foreign direct investment denominated in fiat dollars, became victim of this carry trade, by raising local currency interest rates, turning Asia into a region of overvalued currencies subsidized by dollar reserves earned from trade surplus. Unfortunately, the resultant flood of hot money into Asia went to improperly planned projects that could not sustain the required debt service and repayment denominated in volatile dollars. This soon drained the dollar reserves held by Asian central banks. Cross-border contagion exacerbated the problem across the whole region and imploded into the Asian Financial Crisis of 1997.

Notwithstanding the Louvre Accord of 1987 which allowed member nations to intervene unannounced on behalf of their currencies as needed to stabilize the international currency markets and halt the overshoot in the decline of the dollar caused by the Plaza Accord, the cheap-dollar trend did not reverse until 1997 when the Asian Financial Crisis brought about a rise of the dollar by default, through the panic devaluation of many Asian currencies. The paradox was that in order to have a stable-valued dollar domestically, the Fed had to permit a destabilizing appreciation of the foreign-exchange value of the dollar internationally.

For the first time since end of World War II, foreign-exchange consideration dominated the Fed’s monetary policy deliberations in 1985, as the Fed did under Benjamin Strong after World War I to help Britain maintain the gold standard that contributed to the 1929 crash. The net result was the dilution of the Fed’s power to dictate monetary policy to the globalized domestic economy and a blurring of monetary and fiscal policy distinctions. The high foreign-exchange value of the dollar needs to be maintained because too many dollar-denominated assets are held by foreigners. A sustained further fall of the dollar now runs the danger of a sell-off as it did after the Plaza Accord of 1985, which contributed to the 1987 crash.

It was not until Robert Rubin became Special Assistant for Economic Policy to the President Clinton (1993-95) that the US would figure out its strategy of dollar hegemony through the promotion of unregulated globalization of financial markets. Rubin figured out how the US could have its cake and eat it too, by controlling domestic inflation with cheap imports bought with a strong dollar, and having its trade deficit financed by a capital account surplus made possible by the same strong dollar. Thus dollar hegemony was born and a strong dollar became a pillar of the national interest.

The US economy grew at an unprecedented rate with the wholesale and permanent export of US manufacturing jobs from the rust belt, with the added bonus of reining in the unruly domestic labor unions and wages to contain inflation. The Japanese and the German manufacturers, later joined by their counterparts in the Asian tigers and Mexico, were delirious about US willingness to open its domestic market for invasion by foreign products, not realizing until too late that their national wealth was in fact being steadily transferred to the US through their exports, for which they got only fiat dollars of uncertain value that the US could print at will but that foreigners could not spend in their own countries without monetary penalties. By then, the entire structure of their economies was enslaved to export, condemning them to permanent economic servitude to the fiat dollar. The central banks of these countries competed to keep the exchange values of their currencies low in relation to the dollar and to each other so that they could transfer more wealth to the US while the dollars they earned from export had no choice but to go back to the US to finance the restructuring of the US economy toward new modes of finance capitalism and new generations of high-tech research and development through US defense spending. In 1979, China under Deng Xiaoping joined the export game as a path for domestic development to become the world’s biggest exporter of labor-intensive manufactured goods three decades later.

Constrained by residual limitation on rearmament resulting from their defeat in World War II, both Germany and Japan were unable to absorb significant high-tech research funds in their own defense sectors and had to buy weapon systems from the US all through the Cold War. By continuing to provide a defense umbrella over Japan and Germany after the Cold War, the US managed to preserve its leadership in science and technology, with financing coming mostly from the exporting nations’ trade surpluses. The more the export economies earned in their dollar-denominated trade surpluses, the poorer these exporting nations became in real national wealth.

Twenty-first-century neo-liberal market fundamentalism is not the same as 19th-century mercantilism in that trade surpluses in the form of gold would flow back to the exporting economy. Trade surpluses denominated in dollars for US trade partners merely expanded the US economy globally. The sucking sound that Ross Perot warned about the North American Free Trade Agreement (NAFTA) during his 1992 presidential campaign turned out not to be the sound of US jobs migrating to Mexico, but the sound of foreign-held dollars rushing into US equity and debt markets.

International commitment to the Louvre Accord to halt the fall of the dollar eventually waned. Germany raised interest rates in 1990 to combat inflation caused by reunification, while the US repeatedly eased monetary policy to counteract recurring recessions after the 1987 crash, leading to serial credit bubbles, the latest bursting in August 2007. Although the interest-rate differentials between the US and Europe caused several pre-euro European currencies to appreciate, the G-7 did not react in 1990. Nor did it try to halt depreciation of the yen. By 1993, the Louvre Accord was virtually dead, as domestic policy objectives took priority over internationally agreed targets. Political shocks (such as German reunification and the Iraqi invasion of Kuwait) and economic facts (such as the persistence of Japan’s persistent current account surplus in spite of a rising yen) also weakened commitment to the accord. The G-7 approach changed from “high-frequency” to “low-frequency” activism, with ad hoc interventions only in cases of extreme misalignment, and the focus shifted from managing exchange rate levels to managing exchange rate volatility.

Despite the enormous damage the credit crisis of 2007 has done to the US economy, the potential harm of a sustained weak dollar can make the credit crisis look like a minor storm. While the Fed is mandated to support the Treasury’s strong dollar policy, the problem of falling purchasing power of all fiat currencies cannot be solved by Fed interest rate measures alone. The Fed’s effort to foil market self-correction by pumping unneeded liquidity to cure a widespread crisis of insolvency is misguided. A more fundamental solution lies in the need for the Fed to recognize that its conventional wisdom on the causes of inflation is faulty and that in an overcapacity economy, rising wages is not automatically inflationary but is needed to booster demand to restore the current supply-demand imbalance.

June 14, 2008