The Free Market 13, no. 5 (May 1995)
The events of March 1995 could be a watershed in international monetary affairs. Beginning with the Bretton Woods agreement 50 years ago, the Federal Reserve system has been the global monetary regulator. The collapse of the dollar is a no-confidence vote that may have brought this role to an end.
In a system of freely-floating fiat paper currencies, each currency has a foreign exchange value determined by the "law of one price." This law states that the price of any good must be the same in every location, net of transportation costs. If this uniformity does not exist, arbitragers can make profits by buying where it is cheap and selling where it is dear.
When applied to currencies, this law is called the purchasing-power-parity (PPP) theory. Let's say 100 dollars buys more goods in Germany when exchanged for marks than it does in the United States. Then currency traders eliminate arbitrage profit by exchanging dollars for marks. They will do this until the dollar is devalued enough to bring the currencies in line. That's why some currencies appreciate or depreciate against others.
Can central bank interventions prevent these changes? Not at all. They don't eliminate market forces; they dam them up. Consider a case where PPP requires a devaluation of the dollar vis-à-vis the mark. The Fed intervenes to halt it by buying—or, better yet, pressuring the Bundesbank to buy—dollars that arbitragers are supplying in exchange for marks.
Since this intervention does nothing to relieve the underlying disparity, it does not stop the arbitraging. Furthermore, intervention not only requires intervening central banks to have large stocks of foreign currencies, but it imposes on them huge arbitrage losses at the point when the intervention is overwhelmed by market forces and traders devalue the dollar.
Central bank buying of dollars with marks cannot continue indefinitely. The purchasing-power disparity can be fixed by an exchange-rate fluctuation. Or it can be fixed by reducing the money stock of dollars relative to the money stock of marks. To do this, the Fed can reduce its inflation of the dollar or it can induce the Bundesbank to increase its inflation of the mark.
If the Fed has domestic policy reasons for wanting to continue inflating the dollar, then it must become embroiled in international tussles. Its cajoling and threatening work much better when backed up by military superpower status.
After World War I, Britain employed these tools to prevent a devaluation of the pound. The Bank of England had inflated the pound much more than the Fed had inflated the dollar during the war. Instead of allowing the pound to devalue (by redefining the pound in terms of the dollar and thus, reducing its gold content), the Bank of England convinced the Fed to inflate the dollar.
Unfortunately for the British, this merely emboldened the Bank of England to continue its rapid inflation and to press for the Fed to inflate even more. Great Britain lost its international preeminence in no small part because of its monetary policy and the programs it funded. The Bank of England can no longer cajole or threaten the Fed.
Bretton Woods was the changing of the guard in international monetary affairs. Since then the Fed has been in the preeminent position and the dollar has served as the world's reserve currency. But in the 1960s Fed inflation was called upon to fund a growing welfare-warfare state. As monetary inflation accelerated into the early 1970s, the United States faced a test of its monetary leadership. Countries with less inflationary currencies, especially France, began to ask the U.S. to exchange the dollar (now devalued) for gold at the rate agreed to at Bretton Woods: $35 per ounce.
Unwilling to slow Fed inflation and unable to accelerate inflation in other countries, President Nixon "closed the gold window" and devalued the dollar to $42.22 per ounce. This event marked the beginning of the decline in American economic strength. The 1970s was the worst decade of American economic performance since the Great Depression, which was also the product of Fed inflation.
Other countries had followed the Fed's lead and inflated heavily through the decade. Because these countries suffered dismal economic times as well, America's relative position changed little.
In the 1980s, things were different. The Fed began a massive monetary inflation after the recession of 1981 that, unlike the 1970s inflation, did not cause much domestic price inflation. Instead, the dollars were exported to foreign markets in the expansion of global trade and for use in underground markets. The Fed successfully kept them there by convincing central banks to buy and hold.
A central bank's inflation is emboldened when there are no noticeably detrimental effects, either in domestic price inflation or dollar devaluation. Britain speeded up its own inflation in the 1920s with the Fed's cooperation, and the United States did so after its inflation in the 1980s. And just as market forces eventually caused devaluation of the dollar in the early 1970s, those same forces built to devalue the dollar in the 1990s. The only factor lacking was a triggering event.
The Mexican bailout broke the dam the Fed built against a market devaluation. When President Clinton—at the urging of the Republican leadership—raided the Emergency Stabilization Fund of $20 billion as a down payment on the bailout, it reduced the $35 billion fund to zero (it already had $15 billion in liabilities). The bankruptcy of the ESF was a symbol to the world that nothing stood behind the dollar except the Fed's printing press.
The treatment of Mexico demonstrated the commitment of the U.S. to its North American dependencies in the trading bloc established by NAFTA. Since other banana republics south of Mexico are clamoring to join the bloc to receive similar doses of Fed inflation, currency traders quite reasonably predicted that the Fed had gone too far.
As the sell-off of the dollar began, the Fed frantically tried to coordinate central bank efforts to prevent the devaluation. When their massive dollar purchases failed to even slow the dollar's plunge, the Fed threatened the Bundesbank to inflate the mark to halt the dollar's slide.
Then Fed Chairman Alan Greenspan and Treasury Secretary Robert Rubin tried to talk the dollar back up (a "strong dollar" is in the "national interest"). Then the central banks intervened again. Far from creating confidence in the Fed, a stop-and-start policy makes it appear frantic.
The Fed has reason to be frantic. There is a dictum in foreign exchange analysis that currency devaluations precede domestic inflation. When the Fed inflates the money stock, newly-created money is spent by one person, received by another and then spent by him. This process bids up domestic prices. But foreign currency traders profit by anticipating the end state of domestic price inflation, and they can act to bring about the entire devaluation of the dollar against other currencies all at once.
The anticipation of domestic price inflation has been heightened beyond the level expected from recent Fed monetary inflation. If the Fed fails to maintain the dollar as the world's reserve currency, central banks and other foreign concerns that hold dollars out of fear of the U. S. will disgorge them. If the dollar continues to devalue, the incentive to do so increases. Once disgorged, these dollars will eventually be spent in the U.S., bidding up domestic prices.
The Fed will be helpless to stop the resulting increase in interest rates, stock and bond market crashes, and recession. What the Fed rightly fears, and is frantic to stop, is the 1970s all over again.
Beyond domestic problems, the Fed has reason to worry about its international preeminence. The alignment of countries into the world's three trading blocks, Nafta, the European Community, and the Pacific rim is seen in currency movements. The dollar devaluation is reported studiously against the mark and the yen. The media seem not to care how the dollar is faring against traditionally stable currencies like the Swiss franc.
We are told to be reassured because the dollar appreciated against the Mexican peso and the Canadian dollar. But why should we be reassured when all the currencies in our trading bloc are collapsing against the major currencies of the European and Pacific rim blocs? It is more reasonable to be dismayed that the Clinton administration has allied us in Nafta with international losers, and burdened us with solving their problems.
This mistake may be the last that the U.S. makes as the leader of international monetary affairs. The world is turning to the mark and looking to the Bundesbank to provide a more solid reserve currency. The failure of the EC to implement its own currency has left the D-mark as the de facto reserve currency of Europe. Given this new status, if the dollar collapse continues, how long will the Bundesbank let the Fed dictate its policy?
