The Return of King Dollar
In reaction to the gradual demise of Bretton Woods, the major Western European nations embarked on a thirty-year odyssey of currency convergence, culminating with the European Union and the euro, which was finally launched in 1999. As Europe moved fitfully toward currency stability, the former twin anchors of the world monetary system, the dollar and gold, were far from stable. Despite the expectations of growth and higher employment coming from the dollar devaluations, the United States suffered three recessions from 1973 to 1981. In all, there was a 50 percent decline in the purchasing power of the dollar from 1977 to 1981. Oil prices quadrupled during the 1973–1975 recession and doubled again from that new, higher level in 1979. The average annual price of gold went from $40.80 per ounce in 1971 to $612.56 per ounce in 1980, including a short-term superspike to $850 per ounce in January 1980.
In the eyes of many, it was a world gone mad. A new term, “stagflation,” was used to describe the unprecedented combination of high inflation and stagnant growth happening in the United States. The economic nightmare of 1973 to 1981 was the exact opposite of the export-led growth that dollar devaluation was meant to achieve. The proponents of devaluation could not have been more wrong.
With faith in the dollar near the breaking point, new leadership and new policies were desperately needed. The United States found both with the appointment of Paul Volcker as chairman of the Federal Reserve Board by President Jimmy Carter in August 1979 and the election of Ronald Reagan as president of the United States in November 1980.
Volcker had been undersecretary of the Treasury from 1969 to 1974 and had been intimately involved in the decisions to break with gold and float the dollar in 1971–1973. He was now living with the consequences of those decisions, but his experience left him extremely well prepared to use the levers of interest rates, open market operations and swap lines to reverse the dollar crisis just as he and Arthur Burns had done during the sterling crisis of 1972.
As for inflation, Volcker applied a tourniquet and twisted it hard. He raised the federal funds rate to a peak of 20 percent in June 1981, and the shock therapy worked. Partly because of Volcker, annual inflation collapsed from
12.5 percent in 1980 to 1.1 percent in 1986. Gold followed suit, falling from an average price of $612.56 in 1980 to $317.26 by 1985. Inflation had been defeated and gold had been subdued. King Dollar was back.
Although Volcker’s efforts were heroic, he was not the sole cause of declining inflation and a stronger dollar. Equal credit was due to the low-tax and deregulatory policies of Ronald Reagan. The new president entered office in January 1981 at a time when American economic confidence had been shattered by the recessions, inflation and oil shocks of the Nixon-Carter years. Although the Fed was independent of the White House, Reagan and Volcker together constructed a strong dollar, implemented a low-tax policy that proved to be a tonic for the U.S. economy and launched the United States on one of its strongest periods of growth in history. Volcker’s hard-money policies combined with Reagan’s tax cuts helped gross domestic product achieve cumulative real growth of 16.6 percent in the three-year span from 1983 to 1985. The U.S. economy has not seen such levels of growth in any three-year period since.
The strong dollar, far from hurting growth, seemed to encourage it when combined with other progrowth policies. However, unemployment remained high for years after the last of the three recessions ended in 1982. The trade deficits with Germany and Japan were growing as the stronger dollar sent Americans shopping for German cars and Japanese electronics, among other goods.
By early 1985, the combination of U.S. industries seeking protection from imports and Americans looking for jobs led to the usual cries from unions and industrial-state politicians for devaluation of the dollar to promote exports and discourage imports. The fact that this policy had failed spectacularly in 1973 did not deter the weak-dollar crowd. The allure of a quick fix for industries in decline and those with structural inadequacies is politically irresistible. So, under the guidance of another Treasury secretary from Texas, James A. Baker, a worthy successor to John Connally, the United States made another demand on the world for a cheap dollar.
This time the method of devaluation was different. There were no longer any fixed exchange rates or gold conversion ratios to break. Currencies traded freely against one another and exchange rates were set by the foreign exchange market, consisting mostly of large international banks and their corporate customers. Part of the dollar’s strength in the early 1980s stemmed from the fact that foreign investors wanted dollars to invest in the United States because of its strong economic growth. The strong dollar was a vote of confidence in the United States, not a problem to be solved. However, domestic politics dictated another fate for the dollar, a recurring theme in the currency wars. Because the market was pushing the dollar higher, it would require government intervention in the exchange markets on a massive scale if the dollar was to be devalued. This kind of massive intervention required agreement and coordination by the major governments involved.
Western Europe and Japan had no appetite for dollar devaluation; however, memories of the Nixon Shock were still fresh and no one could be sure that Baker would not resort to import surtaxes just as Connally had in 1971. Moreover, Western Europe and Japan were just as dependent on the United States for their defense and national security against the communist bloc as they had been in the 1970s. On the whole, it seemed better to negotiate with the United States on a dollar devaluation than be taken by surprise again.
The Plaza Accord of September 1985 was the culmination of this multilateral effort to drive the dollar down. Finance ministers from West Germany, Japan, France and the United Kingdom met with the U.S. Treasury secretary at the Plaza Hotel in New York City to work out a plan of dollar devaluation, principally against the yen and the mark. Central banks committed over $10 billion to the exercise, which worked as planned over several years. From 1985 to 1988, the dollar declined over 40 percent against the French franc, 50 percent against the Japanese yen and 20 percent against the German mark.
The Plaza Accord was a success if measured solely as an exercise in devaluation, but the economic results were disappointing. U.S. unemployment remained high, at 7.0 percent in 1986, while growth slowed considerably to only 3.2 percent in 1987. Once again, the quick fix had proved chimerical and, once again, there was a high price to pay in the form of inflation, which took off with a lag after the Plaza Accord, shooting back up to 6.1 percent in 1990. Devaluation and currency wars never produce either the growth or the jobs that are promised, but they reliably produce inflation.
The Plaza Accord was deemed too successful by the parties and occasioned one last adjustment to put the brakes on the dollar’s rapid decline from the heights of 1985. The G7, consisting of the Plaza Accord parties plus Canada and Italy, met at the Louvre in Paris in early 1987 to sign the Louvre Accord, meant to stabilize the dollar at the new, lower level. With the Louvre Accord, Currency War II ended, as the G7 finance ministers decided that, after twenty years of turmoil, enough was enough.
By 1987, gold was gone from international finance, the dollar had been devalued, the yen and mark were ascendant, sterling had faltered, the euro was in prospect and China had not yet taken its own place on the stage. For now, there was relative peace in international monetary matters, yet this peace rested on nothing more substantial than faith in the dollar as a store of value based on a growing U.S. economy and stable monetary policy by the Fed. These conditions largely prevailed through the 1990s and into the early twenty-first century, notwithstanding two mild recessions along the way. The currency crises that did arise were nondollar crises, such as the sterling crisis of 1992, the Mexican peso crisis of 1994 and the Asia-Russia financial crisis of 1997–1998. None of these crises threatened the dollar—in fact, the dollar was typically a safe haven when they arose. It seemed as though it would take either a collapse in growth or the rise of a competing economic power—or both—to threaten the supremacy of the dollar. When these factors finally did converge, in 2010, the result would be the international monetary equivalent of a tsunami.
