What's Next Liu page 2

Research and Opinion (continued from first page) by Henry CK Liu
The Fed and the strong dollar policy (CONTINUED) By Henry C K Liu

Deterring outflows

Treasury policy during 1961-71 focused on deterring capital outflows from the US and on giving major foreign central banks an incentive to hold dollar reserves rather than demand gold from the US gold stock. The ESF resumed intervention operations in the foreign exchange market in March of 1961 (for the first time since the mid-1930s), but it soon became apparent that the resources of the ESF alone were too small to sustain transactions of the magnitude necessary.

At the invitation of the Treasury, the Federal Reserve joined in foreign exchange operations in February 1962, entering into a network of swap agreements with other central banks in order to obtain foreign currencies for short-term periods for use in absorbing forward sales of dollars by foreign central banks hedging exchange risk on their dollar holdings. To provide foreign currency to repay the Fed's swap drawings, the Treasury during the 1960s issued non-marketable foreign currency-denominated medium-term securities known as Roosa bonds, named after then Undersecretary of the Treasury Robert V Roosa, designed to be attractive to foreign monetary authorities as an alternative to converting dollars into gold, and sold the proceeds to the Fed.

Part of the foreign currency proceeds from Roosa bonds was used to extinguish swap debt that otherwise would have lingered beyond the one-year limit set by the Fed Open Market Committee (FOMC) on such drawings. In August 1971, the United States ceased conducting gold transactions with foreign monetary authorities, and the need to moderate the drain on the US gold stock was eliminated.

In December 1974, ESF turned over, in a sale at par value, a gold balance of 2.02 million ounces (valued at $85 million) to the Treasury General Account. This gold had been acquired prior to August 1971 through gold transactions that the ESF engaged in with foreign monetary authorities and with the market for the purpose of stabilizing the value of the dollar relative to gold. In a public announcement of this sale of gold by the ESF to the Treasury General Account, the Treasury stated that the sale was made "in view of the likelihood that the Exchange Stabilization Fund [would] not be engaging in further transactions to stabilize the value of the dollar relative to gold". The ESF again had gold on its books for a short period in 1978 as a counterpart to an ESF credit to Portugal.

Later in the 1970s, the US monetary authorities built up foreign currency reserves substantially. For this purpose, the ESF entered into a $1 billion swap agreement with the Bundesbank in January 1978 (which has since been allowed to expire). In connection with the dollar support program announced in November 1978, the Treasury issued foreign currency-denominated securities (Carter bonds) in the Swiss and German capital markets to acquire additional foreign currencies needed for sale in the market through the ESF. The United States also drew on its reserve position in the IMF.

Policy coordination

In the mid-1980s, the major industrial nations embarked on a process of intensified policy coordination. The Group of Five's Plaza Agreement in September 1985 served to reinforce exchange rate adjustments among the major currencies and occasioned substantial coordinated intervention sales of dollars. The G-5 "agreed that exchange rates should play a role in adjusting external imbalances ... should better reflect fundamentals ... and that ... some further orderly appreciation of non-dollar currencies against the dollar is desirable."

In the Louvre Accord of February 1987, the major industrial countries agreed that the exchange rate changes since the Plaza Agreement would "increasingly contribute to reducing external imbalances and ... [had] brought their currencies within ranges broadly consistent with underlying economic fundamentals ... [and] agreed to cooperate closely to foster stability of exchange rates around current levels."

They adopted specific measures and cooperative arrangements reflecting their view that their currencies were broadly consistent with underlying economic fundamentals. This framework for cooperation on exchange rates complemented the broader economic policy coordination efforts to promote growth and external adjustment. In December 1987, the Group of Seven reaffirmed Louvre's basic objectives and policy directions and agreed to intensify their economic policy coordination efforts and to cooperate closely on exchange markets. There was continued active cooperation through late 1989, but such activities became less frequent thereafter. Since the credit crisis of August 2007, because of the dollar's decline, talk of need for coordination has been revived.

In December 2007, as part of the measures to deal with the credit crisis, the FOMC authorized temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB), providing dollars in amounts of up to $20 billion and $4 billion to the ECB and the SNB, respectively, for use in their jurisdictions for a period of up to six months.

Today, in a globalized financial market of free floating exchange rates, the exchange value of the dollar is a legitimate and necessary concern of monetary policy. A hallmark of Fed structure is the inclusion of regional views and sector conditions in formulating monetary policy.

From the beginning of the Fed in 1913, opinions, both economic and political, have differed on the need for, and the location of geographic representation on, the Fed Board of Governors. The debate has continued over the Fed's market participating arm, the FOMC, formed by the Banking Act of 1933, changed in the Banking Act of 1935 to include the Board of Governors to closely resemble the present-day FOMC composition, and amended in 1942 to the current voting structure, which consists of the seven members of the Board of Governors, the president of the New York Fed and four other Fed presidents who serve on a rotating basis. In 1964, congressional hearings were even held to consider the abolition of the FOMC on the argument that Fed open market operations were in violation of free-market principles.

The Federal Reserve controls three tools of monetary policy: open market operations, the discount rate and reserve requirements. The Board of Governors is responsible for setting access qualification to the discount window to borrow at the discount rate, as well as bank reserve requirements. The FOMC is responsible for open market operations. Using the three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions must hold at Federal Reserve Banks and in this way alters the federal funds rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.

Changes in the federal funds rate trigger a chain of market events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services. The job of the FOMC is to set the fed funds rate target and keep the rate at or near the target through open market operations in the repo market. A net increase or decrease in reserves or liquidity in the banking system would also put downward or upward pressure on the federal funds rate respectively.

Currency debasement

The Fed, a central bank, must still maintain a balance sheet that reconciles its assets and liabilities just as any other bank does. While the Fed theoretically commands unlimited credit through its power to print money, its balance sheet is still subject to the same rules as any financial institution. The difference is that instead of facing insolvency as a private bank would, a weak Fed balance sheet causes debasement of the currency, since changes in categories of Fed assets and liabilities are an important way the Fed manipulates the money supply.

The Fed under Bernanke has recently taken action that changed the composition of the Fed balance sheet, absorbing more mortgage bonds and swapping Treasuries for even private-label and commercial mortgage-backed securities, in effect influencing prices of securities tied to housing finance. These actions, together with cuts in the fed funds rate target, have adversely affected the exchange value of the dollar.

The importance and overriding dominance of national policy over regional and sector considerations is now generally accepted. The FOMC is not expected to adjust monetary policy to address economic concerns pertinent to only one geographical district or one economic sector. In recent decades, until August 2008, regional and sector inputs had played increasingly only peripheral roles in the formulation of national monetary policy.

By extension, the Fed as the institutional guardian of the dollar, the world's prime reserve currency for international trade, is obliged to support the Treasury's recent strong-dollar policy as a matter of national economic security, as internationalist dominance in US policy over domestic concerns became institutionalized. In recent decades, the rust belt and the agricultural exporting states were urged to restructure their local economies to better compete in the global market and not to expect a devaluation of the dollar to bail them out of their economic problems. The Fed under Bernanke has deviated from this path of a strong dollar in its response to the credit crisis of 2007. Bernanke's June 3 speech on the dollar merely put the Fed back on track.

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.

Speculators rewarded

Granted, market economists argue that a sound financial market ultimately serves the interest of all. But it is a hard sell to paint a debt-infested economy as sound. The Fed's liquidity joy ride has been to reward speculators rather than investors, and to favor transactions rather than growth. Further, the economy is not homogenous throughout. In reality, some sectors of the economy and segments of the population, through no fault of their own, may not, and often do not, survive the down cycles to enjoy the long-term benefits, and even if they should survive the down turn, they are permanently put in the bottom heap of perpetual depression. Periodically, the Fed has failed to distinguish a healthy growth in the economy from a speculative debt bubble in the financial markets. There are clear signs that this failure has been institutionalized at the Fed on Greenspan's watch. The Bernanke Fed has yet shown no signs of needed reform.

The Reagan administration (1981-89) by its second term, which began in 1985, discovered an escape valve for its unprecedented fiscal deficit from Fed chairman Paul Volcker's independent domestic policy of stable-valued money. In an era of growing international trade among Cold War Western allies, with the quasi-globalization incorporating the emerging economies before the final collapse of the Soviet Bloc, a booming market for foreign exchange had developing since Nixon in 1971 abandoned the Bretton Woods regime of gold-backed fixed exchange rates.

The exchange value of the dollar thus became a matter of national economic security and as such fell within the authority of the Treasury under the president and required the "independent" Fed's support as a patriotic duty. Since that time, the Treasury has been the spokesman for the dollar, a fact repeated only last February by Bernanke in Congressional testimony.

Council of Economic Advisors chairman Martin Feldstein, a highly respected conservative economist from Harvard with a reputation 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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