What's Next

WHAT'S NEXT?

Research and Opinion by
Henry CK Liu

"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."

"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." — See last 2 paragraphs this presentation.

The Fed and the strong dollar policy
By Henry C K Liu

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 of 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 US$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, 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 exhausted its initial dollar resources.

In establishing the Bretton Woods system, the Articles of Agreement of the 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 IMF SDRs 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.

Imports surcharge

President Richard 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 0.5 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 Jimmy 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 US reserve position at the IMF by the Treasury; and issuance of Carter Bonds. 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.

Plaza Accord

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 Greenspan, 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 Bill 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 Ernesto Zedillo to reverse the tight money policy of the former administration of Carlos Salinas de Gortari. 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 The Tequila Trap, Asia Times Online, November 6, 2004).

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.

Blatant circumvention of procedures

Senator Robert Bennett, a freshman Republican from Utah, took Angell's proposal to Fed chairman 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 would 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 1998 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, 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 is not exclusive to Asia.

Liu cont. Earlier Blog Reply Archive HOME