Political Economist

Global consequences Ⅰ – in the name of ‘glory’ of the strong dollar

Until now, we focused on Reagan and Volcker’s policies and their domestic impacts. However, it would be much more interesting to see that the Fed had played a significant role in international financial market even before the term “globalization” became one of the most buzz words in our ordinary lives.

First of all, it would not be so difficult to understand that the world economy has started to enter into the same economic recession due to the Fed’s contractionary money policy. The underlying logic was simple: once the richest market in the world declined, exporters around the world started to lose their customers. When the ordinary wage earners in the North America started to suffer from their losses of jobs and reduced incomes due to higher interest rates, it was natural for export-driven “developmental economies” in the Third World to suffer from losses of their consumers. The global economy was sinking into recession too, large nations and small ones alike, due to the same economic reason.

Even in these circumstances, however, central banks of other industrial nations had no other options but to raise their interest rates too allowing the depression of their own domestic markets. If they resisted raising interest rates in their own countries whatever the reasons, huge amount of money invested on their domestic capital account would flight into the U.S financial market for the short term arbitrage causing abrupt withdrawal and financial disorder in the domestic financial market.

It is not purely theoretical; newly elected socialist president of France, Francois Mitterrand, for instance, tried for a time to boost its economy through expansionary monetary policy in early 1980s. However, as soon as the French central bank lowered the interest rates, capital fled from French enterprises in search for higher returns available overseas. Instead of investing their assets, French capitalist sought for short term interest premium. Instead of lending their financial assets to domestic entrepreneurs, French financial asset holders withdrew their money from domestic capital account and invested on the US market. Due to this capital flight, France was depreciated rapidly. Instead of faster growth and full employment, the Mitterrand government had to face stagnation.

Secondly, there was another aspect the Fed’s monetary policy had. It was more indirect process but surely exacerbated by the Fed’s high interest rate policy. The higher interest rates available in the US attracted more and more foreign wealth to dollar-denominated financial assets. The worldwide demand for dollars was increasing, but the supply of dollars was still held tight by the Fed, so naturally the international price for dollars – the foreign exchange rate at which other currencies were converted into US dollars – started to go up.

From then on, an international bank or a corporations or private investor who wished to buy dollar assets would have to pay with more francs or pounds or yen. “From July 1980 to September 1981, the dollar appreciated by 36 percent in its international exchange value with the German mark. In 1979, the yen had traded at less than 200 yen to the dollar. By 1983 the ratio was 235 yen to the dollar.”(414)

This rapid appreciation of the dollars in turn “drove away foreign buyers of American products, just as high interest rates drove away the domestic customers from goods and services. It made US exports more expensive for overseas customers proportionately, and at the same time made foreign imports cheaper in American marketplace.”

In extreme case, for example, American farmers who have previously produced their grains and corn much more cheaply in Iowa and Kansas and have sold them on overseas markets would lose their price competitiveness in foreign markets accordingly. “The machine tools produced in Germany and Japan would drive away American competitors from Cincinnati and take away customers in their own domestic market.” “American grain farmers lost more than a third of their share of the global market from 1981 to 1983 as the export price of their wheat and corn practically doubled.”(415)

In the meantime, “foreign producers of auto, steel, machine tools, computer chips and a long list of other manufactured products grabbed a larger and larger share of the American domestic market. US import of manufactured goods rose by 66 percent over four years’ time and US exports declined by 16 percent.” (593)

In a sense, this process can be described as an exploitation of producers for the interest of consumers, which every mainstream economic textbook cites as an example of the benefits of free trade. However, since American consumers are consisted of owners of farms and agricultural workers, owners of small scale of factories and industrial workers, the process of cost and benefit analysis will be highly complicated; Those who were engaged in farming and middle scale manufacture industries would lose their lands, factories and jobs due to expensive money borrowing. Those who barely succeeded in maintaining their factories and farm would now finally lose their lands and factories due to the rapid appreciation of their national currency.

During these periods, “hundreds of thousands, perhaps millions of US jobs were extinguished by the strong dollar. The Reagan administration celebrated the stronger dollar as a sign of America’s restored vigor, but in international trade, the advantage flowed to the weakening currencies of Europe and Asia. By 1983, the estimated losses exceed 1.5 million American jobs, most of them high-wage, unionized jobs in manufacturing.”(593)

But what damaged American production was rewarding for American finance, especially for the major banks active in international markets. The rising dollars meant that the value of their overseas dollars was rising too. It also meant that market demand was growing for the commodity that American financial institutions traded – US financial assets. “As long as the Fed held interest rates high – higher than competing returns in foreign countries – capital naturally flowed across boundaries, seeking the higher returns available in American financial institutions. And as the demand for dollars increased, the dollar would naturally get harder and harder in foreign exchange. In other words, the stronger dollar was good for business – if your business was finance.”(416)

Admittedly, the Reagan administration had the power to intervene with the Fed’s policy through Treasury ministry. “The dollar’s international value was one of the few areas of monetary policy where both law and tradition gave higher authority than the Fed to the executive branch. The Treasury Secretary was responsible for US dollar policy, and if it wished he could advise the Fed to adjust its domestic interest rates accordingly. Or Treasury could coordinate interventions in foreign exchange markets – buying or selling dollars by both Treasury and the Fed to push the price of the dollar up or bring it down. But it did not use this power.” (416-417)

Given this unique balance of power controlling the international value of the dollar, it is still mysterious why the then US Treasury did not intervene with international exchange market, allowing the rapid appreciation of the dollars. The author of the book, William Greider estimated that it might be because the Reagan administration truly believed that laissez-faire policy would bring about economic recovery. But it also might be because the officials at the administration were so ignorant that they could not know their legal executive power of balancing the terms of international currency.

Global consequences Ⅱ - the Third World debt crisis

However, the most serious impacts of the Fed’s economic policy on global economy were on the less developed countries (LDCs) in the Third World, whose economies largely depended on the US market.

First of all, their economic output and real incomes fell disastrously as much as 10 percent in some instances, as their export markets dried up and the price of raw material commodity such as copper and rubber price began to fall sharply. “What was to become a severe recession for Americans was catastrophe for the citizens of these poorer countries in Africa and Latin America and Asia.”(415)

At the same time, the debt burdens of the LDCs expanded dangerously. The worldwide spike in interest rates had raised the cost of the debt, the hundreds of billions in outstanding loans previously borrowed from the banks of Europe and America. As interest rates rose, the LDCs found themselves surrounded by rising cost of interest payment. They could not even have short time to think of the payment of original loan. “Both government and businesses in the struggling nations were compelled to borrow more and more, simply to keep up the payment of interest on their old loans.” (415)

In a sense, the debt crisis had its origins in the Fed’s policy failure itself. In the late 70s and early 80s, the Fed and other US governmental regulators had failed to impose prudent limits on the money center banks and their competitive lending to the Third World. They had issued mild warnings occasionally, but they had not tried to prevent the risky lending. Then starting in 1979, Volcker launched his aggressive campaign to break inflation, rationing money tightly and imposing a stern discipline on the world currency market.

The Fed’s failures of regulation are now turning its direction to the US domestic financial market like returning boomerang. If some Latin American countries declare the default, this would result in huge amount of losses in commercial banks in the US. If this detrimental effect were not prevented from happening in advance, the whole US banking system and economic order would be collapsed.

The first challenge originated from Mexico. “The United States and Mexico were economically intertwined by trade, labor supply and finance. If Mexico declared default, it would influence most of American banks. At the early 1980s, Mexico owed $80 billion to the major American banks such as Citibank and Continental Illinois.”(485)

Paul Volcker and the Mexican finance minister agreed that Mexico should borrow money from the International Monetary Fund in the near future. However, the Fed’s chairman decided to lend huge short-term loans from the Fed reserves in order to prevent Mexico’s abrupt default declaration before the Mexican government went to the IMF. “The Fed, in addition to its other roles, was authorized to play lender of last resort to other nations. On April 30, it lent Mexico the $600 million, the first in a series of short term multimillion dollar loans called ‘currency swap.’”(485)

In theory at least, the debt crisis might have been avoided if the Fed had not chosen such an abrupt approach to decelerating price inflation. The LDCs were heavily dependent on credit. But the Fed had drastically raised the cost of their borrowing while simultaneously depressed their sales and incomes. “If the world economy had not been pushed down so far, if interest rates had not been forced so high, these debtor nations might have survived the contraction. As it was, they had no time to adjust and really no alternative but to keep borrowing more, just as weakened American corporations had to increase their borrowing to survive the recession.”(521)

In this respect, whether there were no alternative to the Fed’s aggressive anti-inflation policy seemed to be relevant. The Fed tightened money to curb the inflation. “The general public agreed that double-digit inflation must be curbed somehow, but if the question was examined carefully, it was not at all clear that a deep recession induced by the Fed’s monetary policy was the best way. The 1981 inflation, for instance, was driven by escalating prices in oil and agriculture. In this case, the price inflation might have been contained by temporal price controls and other aggressive government policies.”(394)