Page 4 of 4 The Fed and the strong dollar policy
By Henry C K Liu
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 a
White House where voodoo economics of a strong dollar being sustainable by
persistent Federal deficits reigned, went back to Harvard to continue his quest
for truth in economics after serving two years with Reagan.
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.
Fed and Treasury in conflict
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 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 the
same year. 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 rates were 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 considerations
dominated the Fed's monetary policy deliberations in 1985, as they did under
Benjamin Strong after World War I to help Britain maintain the gold standard,
contributing 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
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.
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 exports, condemning them to permanent economic
servitude to the fiat dollar.
China joins export game
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 regarding the North American Free Trade Agreement
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 are not automatically inflationary but are needed to boost demand
to restore the current supply-demand imbalance.
Henry C K Liu is chairman of a New York-based private investment group.
His website is at http://www.henryckliu.com.
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