The Decline of the Dollar (1977-78)

Case Analysis: The Decline of the Dollar

            The central issue facing the Carter administration in 1977-78 was how to stop the rapidly depreciating U.S. dollar, without hurting domestic employment.  The run on the dollar was primarily a function of high (relative) inflation, increased deficits in the current account, and a lack of confidence in the administration. The theory behind floating exchange rates was that the currencies would self-regulate and provide market based corrections to eliminate deficits and surpluses in the balance of payments.  However, this adjustment often took place gradually, as it took time for policy makers to develop a suitable plan to increase confidence in the currency.  Additionally, the support for the dollar creates a paradox as policymakers must choose between a stronger currency (implying high interest rate strategy) and easy monetary policy to promote the domestic economy.

The era of the mid to early 1970s was characterized by increased deficits in the balance of payments, high inflation and obstructionist policies regarding free trade.  The Bretton Woods system of fixed exchange rates was implemented shortly after WWII and allowed countries to adjust the exchange rate to reflect structural defects in the balance of payments.  In 1971, the Nixon administration reached a deficit in the BOP of $30 billion and dollar liabilities of greater than $50 billion.  In anticipation of large quantities of dollar exchanges (fixed at $35 per ounce of gold), Nixon devalued the dollar by 10% and removed the U.S. from the gold standard.  The Smithsonian accords led to a temporary bounded exchange rate, with a range of 2.25%. The quasi-floating exchange rate was pressured as Nixon relaxed wage and price controls and speculators anticipated inflation.  By March of 1973, the industrialized countries of the West held floating exchange rate systems.

The policy of a fixed exchange rate was difficult to maintain and relied on a proactive government to constantly buy and sell currency to maintain a fixed market price.  In the event that a country such as France or Britain would run a large deficit, speculators would sell that country’s currency and buy stronger ones.  Speculators played an active role in promoting market based pricing, constraining the government’s ability to maintain a fixed rate.  Speculators often had more access to capital than governments, forcing devaluations by buying and selling large quantities of currency. Other constraints included inflation and U.S. demand for foreign goods (oil).  The result was reflected in the large deficit in the U.S. current account.   The current account balance went from a surplus of $4.3 billion in 1976 to a deficit of $15.3 billion in 1977, followed by consecutive negative balances in each quarter of 1978.  Meanwhile, Germany and Japan managed current account surpluses, while the United Kingdom broke even.  The theory behind the floating exchange rate system was currencies would self-regulate.  

President Carter’s first policy move was to obtain swap lines of credit with various central banks. According to the supplement, aggregated swap lines were approximately $30 billion.  The purpose of this policy was to use borrowed money to buy dollars (and sell foreign currency), stabilizing the value of the dollar.  This policy provided direct access for intervention in capital markets, much like a fixed exchange rate system.  This policy did not address underlying causes of the declining value of the dollar – appetite for foreign products (oil), current account deficits and inflation. The effect of this policy is shown in Exhibit 9, as net dollar support approached $2 billion.

President Carter’s administration also announced they would sell gold and reduce the size of the federal deficit.  Selling gold would imply devaluation relative to gold – using proceeds from gold sales to prop up demand for the dollar.  The effects from BOP deficits and inflation outweighed the ability of the administration to intervene in gold markets.  The attempt at reducing the federal deficit did little to quell market expectations for the future of dollar because neither addressed the root cause.  Current account surpluses from Germany and Japan also hindered Carter’s strategy.  The strong currency of Germany and Japan did not adjust ‘automatically’ as the theory suggested.  The countries with the strongest currency maintained surpluses in 1977-78 as the dollar declined dramatically.  U.S. consumers had a strong demand for foreign products.  The ability of Japanese and German to exporters to produce quality goods supported the value of their currency, even with higher prices for their exports.

            The Federal Reserve conducted monetary policy by raising interest rates (discount and fed funds rate) and increasing reserve requirements for banks, therefore increasing the amount of leakage in the system.  The policy was a direct response to inflation—higher leakage in the system would imply a tighter supply of money and reduce the multiplier effect of money.  Inevitably, the interest rate policy would provide confidence and support for the dollar by attracting foreign capital.  Inflation in the U.S. was running about 8-10% annual growth in the CPI in 1978.  The discount rate was increased to 9.5%. Fed Chairman Paul Volker was largely credited with breaking inflationary cycle and restoring faith in the dollar. 

            The policy of high interest rates and an independent Federal Reserve System allowed the U.S. to implement a strategy for contesting the market devaluation of the dollar.  The unique independence of the Fed was vital to restoring confidence.  Inevitably, devaluation of currency implies that imports become more expensive and exports will increase due to the relative affordability.  As interest rates rise, foreign capital flows into the domestic economy and increases the demand for dollars.  Currency speculators played a large role in the decline of the dollar, as did the strength of Japanese and German exports.  The market often takes time to adjust to new policies and can act rationally or irrationally in the short run. The long run effect of supporting the dollar was shown through a stronger currency and stronger domestic economy.  Ultimately, the Carter administration was troubled by the paradox of choosing between a strong dollar and a strong domestic economy.