The 35% decline in the yen, 25% decline in the Euro relative to the US dollar and the U.S. dollar index up by 25% since 2017, are being rationalized as a response to the Fed’s raising rates to battle inflation. Analysts remind us that such policy is similar to the one Paul Volcker pursued in the 1980s to put an end to the inflation then.
Not so.
The late Paul Volcker’s own take is not the only reminder of what is gravely mistaken with the Fed’s policies and all central banks’ now; the co-ordination with the respective governments as well as the above analyses, but it also shows what would be the lasting, stable solution - not being discussed now.
Volcker noted that between 1980 and 1982, the higher interest rates “attracted more and more foreign funds to help finance our deficits and investments. The adverse repercussions of this policy mix on international markets became obvious – except to members of the administration who interpreted it as a vote of confidence in U.S. policy. [But} the high interest rates and a strongly rising dollar made it harder to deal with the debt crisis [and] the competitive position of our industry; and markets began to be seriously undermined.”
This is similar to the scenario unfolding now before our eyes, as the wildly gyrating exchange rates show. Dollar-indebted countries’ currencies such as India’s, Chile’s, all depreciated this year, and Sri Lanka defaulted on its overseas bonds in May. Their central banks have been spending reserves and raising rates to mitigate their currencies’ fall (and to prevent default) without success.
Meanwhile the ECB as well as central banks in Norway, Sweden, Switzerland, UK, Indonesia, Philippines, Taiwan and Turkey are pursuing tightening. The fact that an estimated 40% of the $28.5 trillion in annual global trade is priced in US dollars alongside estimates of global dollar debts of $13 trillion, all suggest that a debt crisis is looming – as it did during the 1980s.
Volcker added that though he anticipated the Mexican debt crisis before it materialized in 1982, he did not think that lowering rates by 1-2 percent in 1981 would have prevented it. However, by July 1982 he changed his mind, and eased monetary policy. The weakening of the American industry because of the strong US dollar contributed to the change in policy. Though Volcker thought that it was “strange and paradoxical” that the dollar continued rising until 1985. However, he did anticipate that a “sickening fall in the dollar would come”- which it indeed did between 1985 and 1987; the dollar index plunging 50 percent.
He noted too that to be successful, central banks’ monetary tools were not enough to lower inflation quickly: To absorb the liquidity that led to the high inflation on the late 1970s, early 1980s, reducing the budget deficit should have complemented the Fed’s policies. Volcker added that this “would have relieved the pressures on our own money and capital markets and our dependence on foreign capital; effective effort to restore budget balance could [have] reinforced what we were trying to do.”
Apparently UK Prime Minister, Liz Truss and her cabinet are not familiar with Volcker’s testimonies, summarized in his Changing Fortunes: The World’s Money and the threat to American Leadership (1992, co-authored with Toyoo Gyothen, former Chairman of the Bank of Tokyo). The upheaval against her planned fiscal policy happened not so much because of proposed changes in a marginal tax rate, but more because announcing an additional deficit of 45 billion pounds to be financed by borrowing, exactly when UK’s Central Bank planned selling gilts from its balance sheet. The reaction forced the Central Bank to make a U-turn, and buy 65 billion of bonds.
Back in the 1980s, It took time for the co-ordination between the easing of monetary policy in 1982 and the changes in fiscal and regulatory policies to stabilize the U.S. economy and lower the inflation rate to 5% in 1984, and to 4% in 1987, the year of Volcker’s departure, with 30-yearFixed Rate mortgages still hovering around 10 percent.
As to the dollar: in 1985, the U.S. dollar index was at 160, up from 80 in 1980. This led to Volcker’s observation that “Increases of 50 percent and declines of 25 percent in the value of the dollar or any important currency over a relatively brief span of time … are a symptom of a system in disarray.” The disarray led to the Plaza and Louvre accords (1985, 1987) – following which the dollar index dropped from 160 back to 80, its level in 1980.
U.S. industries restored their strength during these upheavals helped by both President Reagan’s fiscal and regulatory policies and the large increase in hedging instruments developed in the financial market – now standing at hundreds of trillions in notional value. The latter allowed U.S. companies to stay in their lines of business and mitigate the impact of volatile exchange rates.
However, currency hedging is not just costly, in some countries it is prohibitively so; preventing companies’ access to credit. The expansion of the financial sector in a floating world brings a misallocation of talent and capital, using more brains and capital, less being allocated to “Main Street,” and less scarce brains flowing to science and politics too.
Briefly, many countries did not manage exchange rate gyrations well. Their experiences, Japan being prominent, show how accurate Volcker was in his statements that there are strong limits to what monetary policies can achieve on their own without coordination with fiscal policies, and what disarray a lack of exchange rate stability brings about.
Japan is again prominent. The yen was up 184% to the US dollar ten years after the Plaza 1985 accord. It has been up and down 50% or more since 1995, the last decade down by some 70 percent, down 6% just in April 2022. The share of revenues of Japanese companies’ subsidiaries relocated abroad increased from eight to 30 percent from 1997 to 2014. To deal with the massive exchange rate fluctuations, Japanese companies had the option to either hedge financially (which became expensive) or relocate to the U.S. They did both. The relocation brought about the hollowing of Japan's manufacturing sector, having long-lasting impact on domestic opportunities – something that no central bank can remedy.
History rhymes: The Federal Reserve now pursues policies to reduce inflation; the higher interest rate can correlate with a stronger dollar. With roughly $4 trillion - 30% of the revenue of S&P 500 Index firms coming from outside of the United States per year – U.S. stock markets are impacted too, as not all such revenues are hedged. Perhaps a debt crisis is looming. But history does not repeat itself: fiscal and regulatory policies of the early 1980s helped the Fed to absorb unwanted liquidity, but this is not the case now. Also, in contrast to the 1980s, it is not only emerging countries that have debt crises looming; so do the U.S., Western European countries and Japan too. Bond vigilantes appeared out of the shadows during recent UK events, with the CDS almost doubling the last few days and up almost 400 since last November.
A revised Bretton-Woods agreement among governments would be the long-term stable solution. However, the agreement must include two clauses left out of the original: One is to allow for occasional devaluations when identifying “fundamental disequilibrium”; Two, penalizing for accumulating excess reserves (the latter being a sign of major implicit and explicit mercantilist policies).
Washington could initiate such agreement subject to firm answers to two questions Volcker raised too: “Can we have a stable [financial] system without a dominant country that is itself extraordinarily stable? And was the United States any longer able to play that role?”
The answer to the first question is “no” – the maze of institutions backing contracts must be stable. As to the second question, the answer is yes. Capital is still flowing to the U.S. (and not only because of interest rates); Debts around the world are underwritten in U.S. dollars; both the Euro and the yen failed to become reserve currencies; a communist regime, with institutions not committed to transition to a commercial society backs the yuan. The U.S. can thus play the role once it manages simultaneously to lower inflation and coordinates it with both proper fiscal and regulatory policies and steps to stabilize exchange rates.
