Life beyond the dollar

When a mighty currency falls, it is only natural that the earth around it shakes a little

The dollar is our currency, but your problem,” US treasury secretary John Connolly had told his European counterparts in 1971.

This was when the US was mired in an expensive foreign war in Vietnam; its fiscal and external deficits were high; and there was growing international uneasiness about the dollar. It was a situation quite like the one we see today.

The dollar, then as now, was the cornerstone of the global economy. Though most major currencies then were valued in terms of a fixed weight in gold, there was not enough yellow metal in the non-US central bank vaults to back the paper. These central banks pegged their currencies to the US dollar, and the US government promised to redeem these dollars with gold whenever required. Banks outside the US held dollars because they could be exchanged for gold.
But as the pressure to convert dollar holdings into gold grew, the US government decided to close this option in 1971. The dollar fell in value. The world economy went into a bout of turmoil.
While inflation and slow growth were already on the horizon, the dollar crisis in the early 1970s pushed the world economy towards stagflation— the then-unexpected combination of stagnant growth and high inflation.

Cut to 1985. Once again, it was the same basic problem: high US deficits. Officials from five countries—the US, Japan, Germany, France and the UK—met at the Plaza Hotel in the September of that year. There was wide agreement that the dollar was overvalued and had to fall against the major currencies. The Plaza deal was a comprehensive plan for price-fixing. The dollar would be eased down against the other major currencies, and especially the Japanese yen.
That is precisely what happened, but with unintended consequences. The rising yen threw sand in Japan’s export engine and threatened growth there. Japan’s finance ministry was forced to react because of the outcry from domestic lobbies. It asked the central bank to slash interest rates to negate the effects of a strong yen.

Japan’s central bank released a flood of yen into its domestic economy, lifting equity and real estate prices to unheard-of highs. It was the Japanese bubble. When it eventually burst in 1990, the banking system was nearly wrecked and the economy went into a deflationary spiral.

Another unintended consequence of the rising yen: Japanese manufacturers had to tweak their strategies. A lot of work could be done offshore in cheaper countries in Asia. So, to cut costs, Japanese investments flowed into places such as Malaysia, Thailand and the Philippines. This movement of money fed the bubble in these countries. It popped in 1997, to devastating effect.
There is a point to this little excursion into financial history. Connolly was right in 1971: the dollar may be the US currency but it is our problem. The greenback has been so central to the world economy that its gyrations can rock economies in the most unlikely corners of the earth.
Look at the line-up of challenges the US has today: high deficits, an expensive foreign war and a weak currency (among other things). These are creating problems in other countries. In India, exporters are under huge pressure. In China, there are worries that its trillion dollar plus foreign exchange hoard will lose value. In West Asia, where currencies are pegged to the US dollar and, hence, independent monetary policy has been abandoned, the falling dollar has pushed up inflation and sparked off labour protests.

What happened in 1971 and 1985 shows that these tremors are not unexpected. To paraphrase Rajiv Gandhi’s unfortunate statement in 1984, after his mother’s assassination: when a mighty currency falls, it is only natural that the earth around it shakes a little.

Is there a way out? Should a world economy that is now less dependent on the US than before be so hopelessly dependent on the dollar to conduct its trade and hold its foreign assets?

These are not new questions. In 1945, as the world came out of World War II, John Maynard Keynes had vehemently argued for a new global currency to displace the British pound. It would be managed by a global central bank. Keynes called this currency the bancor. Others such as the great monetary economist Robert Mundell, have been passionate supporters of a single international currency because, as former US Federal Reserve chairman Paul Volcker once said, a global economy needs a global currency.

On the other hand, Austrian economists such as F.A. Hayek have backed a free-market plan to have private currencies that will compete against one another, free of central bank intervention. Money would be denationalized. And then there are the more immediate possibilities, such as the euro replacing the dollar as the world’s reserve currency.
The debates could resurface if the dollar’s decline is not a smooth one.