Currency Wars: The Making of the Next Global Crisis

by James Rickards

  International response to the 1971 Nixon gambit was not long in arriving. By late August, Japan had announced that it would allow the yen to float freely against the dollar. To no one’s surprise, the yen immediately rose 7 percent against the dollar. Combined with the 10 percent surtax, this amounted to a 17 percent increase in the U.S. dollar price of Japanese imports to the United States, which was welcome news to U.S. car and steel producers. Switzerland created “negative interest rates,” in the form of fees charged on Swiss franc bank deposits, to discourage capital inflows and help prop up the dollar.

  In late September, the council of the General Agreement on Tariffs and Trade (GATT) met to consider whether the U.S. import surtax was a violation of free trade rules. There was no justification for the surtax and U.S. deputy undersecretary of state Nathaniel Samuels made almost no effort to defend it, other than to suggest that the surtax would be lifted when the U.S. balance of payments improved. Under the GATT rules, retaliation would likely have been justified. However, the U.S. trading partners had no stomach for a trade war. Memories of the 1930s were still too fresh and the role of the United States as a superpower balance to the Soviet Union and military protector of Japan and Western Europe was too important to risk a major confrontation over trade. Japan and Western Europe would simply have to suffer a weaker dollar; the question was to what extent and on whose terms.

  An international conference in London was organized under the auspices of the so-called Group of Ten, or G10, in late September. These were the wealthiest nations in the world at the time, which importantly included Switzerland, even though it was not then an IMF member. Connally put on a performance worthy of his Texas pedigree. He told the delegates that the United States demanded an immediate $13 billion swing in its trade balance, from a $5 billion deficit to an $8 billion surplus, and that this demand was nonnegotiable. He then refused to engage in discussions about how this might be achieved; he told the delegates it was up to them to formulate a plan, and upon his review he would let them know whether they had been successful. The nine other members of the G10 were left to mutter among themselves about Connally’s arrogance and to think about what kind of swing in the U.S. trade balance they might be willing to orchestrate.

  Two weeks later, in early October, the key players met again in Washington at the annual meeting of the IMF. Little progress had been made since the London conference, but the implications of Nixon’s 10 percent surtax were beginning to sink in. The Canadian trade minister, Jean-Luc Pépin, estimated that the surtax would destroy ninety thousand Canadian jobs in its first year. Some dollar devaluation had already taken place on the foreign exchange markets, where more countries had begun to float their currencies against the dollar and where immediate gains of 3 percent to 9 percent had occurred in various currencies. But Nixon and Connally were seeking total devaluation more in the 12 percent to 15 percent range, along with some assurance that those levels would stick and not be reversed by the markets. The IMF, not surprisingly given its research-dominated staff, began vetting a number of technical solutions. These included wider trading “bands” within which currencies could fluctuate before requesting formal devaluation, and possibly the expanded use of SDRs and the creation of a world central bank. These debates were irrelevant to Connally. He wanted an immediate response to the immediate problem and would use the blunt instrument of the surtax to force the issue for as long as it took. However, he did soften his views slightly at the IMF meeting by indicating that the surtax might be lifted if the U.S. trade balance moved in the right direction even if its ultimate goals had not yet been achieved.

  There was one other issue on which the United States seemed willing to show some flexibility and on which the Europeans were quite focused. While the United States had announced it would no longer redeem dollars for gold, it had not officially changed the dollar-gold parity; it still regarded the dollar as worth one thirty-fifth of an ounce of gold, even in its nonconvertible state. An increase in the price of gold would be just as much of a devaluation of the dollar as an upward revaluation of the other currencies. This was symbolically important to the Europeans and would be seen by them as a defeat for the United States in the currency war despite U.S. indifference. The Germans and French would also benefit because they held large gold hoards and an increase in the dollar price of gold would mean an increase in the dollar value of their gold reserves.

  Nixon and Connally did not really seem to care; having closed the gold window, the price of gold seemed somewhat irrelevant, and devaluation by whatever method was all just a means to an end. By the end of the IMF meeting, it seemed that some combination of continued upward revaluation of most currencies against the dollar on foreign exchange markets, some flexibility on timing of trade deficit reduction by the United States and a U.S. willingness to explicitly raise the dollar price of gold might form the basis of a lasting currency realignment consistent with Nixon’s goals.

  By early December, the endgame had begun with another G10 meeting, convened at the ornate Palazzo Corsini in Rome. This time, Connally was ready to deal. He proposed an average revaluation of foreign currencies of 11 percent and a devaluation of the dollar against gold of 10 percent. The combination of the two meant an effective increase of over 20 percent in the dollar price of foreign exports into the United States. In exchange, the United States would drop the 10 percent surtax.

  The Europeans and Japanese were in shock: a total swing of perhaps 12 percent to 15 percent might have been acceptable, but 20 percent was too much to bear all at once. Moreover, the members of G10 began to position themselves against one another. A 20 percent swing against the dollar would be one thing if all countries did it at once, but if, for example, the UK revalued only 15 percent while Germany did the full 20 percent, then Germany would be disadvantaged against the UK and the United States. France wanted to limit the size of the dollar devaluation against gold so that more of the adjustment would be pushed onto a German revaluation in which France would not fully participate. And so it went.

  By now the negotiations were almost nonstop. A few days after the Rome meeting, President Nixon met one-on-one with President Georges Pompidou of France in the Azores, where Pompidou pressed the case for an increase in the dollar price of gold as part of a package deal. Nixon conducted the negotiations in a sleep-deprived state because he had stayed up most of the night to follow a Washington Redskins football game in local time. In the end, Nixon agreed to the French demands and Pompidou returned to France a hero for having humbled the Americans in the delicate matter of the dollar and gold. Still, Nixon did not leave empty-handed, because Pompidou agreed to push for significant reductions in the stiff tariffs on U.S. imports imposed by the European Common Market.

  The tentative agreements reached at Palazzo Corsini and in the Azores were ratified two weeks later by the G10 in a meeting held in the historic red castle of the Smithsonian Institution, adjacent to the National Mall in Washington, D.C. The venue gave its name to the resulting Smithsonian Agreement. The dollar was devalued about 9 percent against gold, and the major currencies were revalued upward between 3 percent and 8 percent against the dollar—a total adjustment of between 11 percent and 17 percent, depending on the currency. Important exceptions were England and France, which did not revalue but still went up about 9 percent relative to the dollar because of the devaluation against gold. The Japanese suffered the largest total adjustment, 17 percent—even more than the Germans—but they drew the least sympathy from Connally since their economy was growing at over 5 percent per year. The signatories agreed to maintain these new parities in a trading band of 2.25 percent up or down—a 4.5 percent band in total—and the United States agreed to remove the despised 10 percent import surtax; it had served its purpose. No provision for a return to the convertible gold standard was made, although technically gold had not yet been abandoned. As one writer observed, “Instead of refusing to sell gold for $35 an ounce, the Treasury will simply refuse to sell . . . for $3
8 an ounce.”

  The Smithsonian Agreement, like the Nixon Shock four months earlier, was extremely popular in the United States and led to a significant rally in stocks as investors contemplated higher dollar profits in steel, autos, aircraft, movies and other sectors that would benefit from either increased exports or fewer imports, or both. Presidential aide Peter G. Peterson estimated that the dollar devaluation would create at least five hundred thousand new jobs over the next two years.

  Unfortunately, these euphoric expectations were soon crushed. Less than two years later, the United States found itself in its worst recession since World War II, with collapsing GDP, skyrocketing unemployment, an oil crisis, a crashing stock market and runaway inflation. The lesson that a nation cannot devalue its way to prosperity eluded Nixon, Connally, Peterson and the stock market in late 1971 as it had their predecessors during the Great Depression. It seemed a hard lesson to learn.

  As with the grand international monetary conferences of the 1920s and 1930s, the benefits of the Smithsonian Agreement, such as they were, proved short-lived. Sterling devalued again on June 23, 1972, this time in the form of a float instead of adherence to the Smithsonian parities. The pound immediately fell 6 percent and was down 10 percent by the end of 1972. There was also great concern about the contagion effect of the sterling devaluation on the Italian lira. Nixon’s chief of staff briefed him on this new European monetary crisis. Nixon’s immortal response, captured on tape, was: “I don’t care. Nothing we can do about it.... I don’t give a shit about the lira.”

  On June 29, 1972, Germany imposed capital controls in an attempt to halt the panic buying of the mark. By July 3, both the Swiss franc and the Canadian dollar had joined the float. What had started as a sterling devaluation had turned into a rout of the dollar as investors sought the relative safety of German marks and Swiss francs. In June 1972, John Connally resigned as Treasury secretary, so the new secretary, George P. Shultz, was thrown into this developing dollar crisis almost immediately upon taking office. With the help of Paul Volcker, also at Treasury, and Fed chairman Arthur Burns, Shultz was able to activate swap lines, which are basically short-term currency lending facilities, between the Fed and the European central banks, and started intervening in markets to tame the dollar panic. By now, all of the “bands,” “dirty floats,” “crawling pegs” and other devices invented to maintain some semblance of the Bretton Woods system had failed. There was nothing left for it but to move all of the major currencies to a floating rate system. Finally, in 1973, the IMF declared the Bretton Woods system dead, officially ended the role of gold in international finance and left currency values to fluctuate against one another at whatever level governments or the markets desired. One currency era had ended and another had now begun, but the currency war was far from over.

  The age of floating exchange rates, beginning in 1973, combined with the demise of the dollar link to gold put a temporary end to the devaluation dramas that had occupied international monetary affairs since the 1920s. No longer would central bankers and finance ministries anguish over breaking a parity or abandoning gold. Now markets moved currencies up or down on a daily basis as they saw fit. Governments did intervene in markets from time to time to offset what they saw as excesses or disorderly conditions, but this was usually of limited and temporary effect.

  The Return of King Dollar

  In reaction to the gradual demise of Bretton Woods, the major Western European nations embarked on a thirty-year odyssey of currency convergence, culminating with the European Union and the euro, which was finally launched in 1999. As Europe moved fitfully toward currency stability, the former twin anchors of the world monetary system, the dollar and gold, were far from stable. Despite the expectations of growth and higher employment coming from the dollar devaluations, the United States suffered three recessions from 1973 to 1981. In all, there was a 50 percent decline in the purchasing power of the dollar from 1977 to 1981. Oil prices quadrupled during the 1973–1975 recession and doubled again from that new, higher level in 1979. The average annual price of gold went from $40.80 per ounce in 1971 to $612.56 per ounce in 1980, including a short-term superspike to $850 per ounce in January 1980.

  In the eyes of many, it was a world gone mad. A new term, “stagflation,” was used to describe the unprecedented combination of high inflation and stagnant growth happening in the United States. The economic nightmare of 1973 to 1981 was the exact opposite of the export-led growth that dollar devaluation was meant to achieve. The proponents of devaluation could not have been more wrong.

  With faith in the dollar near the breaking point, new leadership and new policies were desperately needed. The United States found both with the appointment of Paul Volcker as chairman of the Federal Reserve Board by President Jimmy Carter in August 1979 and the election of Ronald Reagan as president of the United States in November 1980.

  Volcker had been undersecretary of the Treasury from 1969 to 1974 and had been intimately involved in the decisions to break with gold and float the dollar in 1971–1973. He was now living with the consequences of those decisions, but his experience left him extremely well prepared to use the levers of interest rates, open market operations and swap lines to reverse the dollar crisis just as he and Arthur Burns had done during the sterling crisis of 1972.

  As for inflation, Volcker applied a tourniquet and twisted it hard. He raised the federal funds rate to a peak of 20 percent in June 1981, and the shock therapy worked. Partly because of Volcker, annual inflation collapsed from 12.5 percent in 1980 to 1.1 percent in 1986. Gold followed suit, falling from an average price of $612.56 in 1980 to $317.26 by 1985. Inflation had been defeated and gold had been subdued. King Dollar was back.

  Although Volcker’s efforts were heroic, he was not the sole cause of declining inflation and a stronger dollar. Equal credit was due to the low-tax and deregulatory policies of Ronald Reagan. The new president entered office in January 1981 at a time when American economic confidence had been shattered by the recessions, inflation and oil shocks of the Nixon-Carter years. Although the Fed was independent of the White House, Reagan and Volcker together constructed a strong dollar, implemented a low-tax policy that proved to be a tonic for the U.S. economy and launched the United States on one of its strongest periods of growth in history. Volcker’s hard-money policies combined with Reagan’s tax cuts helped gross domestic product achieve cumulative real growth of 16.6 percent in the three-year span from 1983 to 1985. The U.S. economy has not seen such levels of growth in any three-year period since.

  The strong dollar, far from hurting growth, seemed to encourage it when combined with other progrowth policies. However, unemployment remained high for years after the last of the three recessions ended in 1982. The trade deficits with Germany and Japan were growing as the stronger dollar sent Americans shopping for German cars and Japanese electronics, among other goods.

  By early 1985, the combination of U.S. industries seeking protection from imports and Americans looking for jobs led to the usual cries from unions and industrial-state politicians for devaluation of the dollar to promote exports and discourage imports. The fact that this policy had failed spectacularly in 1973 did not deter the weak-dollar crowd. The allure of a quick fix for industries in decline and those with structural inadequacies is politically irresistible. So, under the guidance of another Treasury secretary from Texas, James A. Baker, a worthy successor to John Connally, the United States made another demand on the world for a cheap dollar.

  This time the method of devaluation was different. There were no longer any fixed exchange rates or gold conversion ratios to break. Currencies traded freely against one another and exchange rates were set by the foreign exchange market, consisting mostly of large international banks and their corporate customers. Part of the dollar’s strength in the early 1980s stemmed from the fact that foreign investors wanted dollars to invest in the United States because of its strong economic growth. The strong dollar was a vote of confidence in
the United States, not a problem to be solved. However, domestic politics dictated another fate for the dollar, a recurring theme in the currency wars. Because the market was pushing the dollar higher, it would require government intervention in the exchange markets on a massive scale if the dollar was to be devalued. This kind of massive intervention required agreement and coordination by the major governments involved.

  Western Europe and Japan had no appetite for dollar devaluation; however, memories of the Nixon Shock were still fresh and no one could be sure that Baker would not resort to import surtaxes just as Connally had in 1971. Moreover, Western Europe and Japan were just as dependent on the United States for their defense and national security against the communist bloc as they had been in the 1970s. On the whole, it seemed better to negotiate with the United States on a dollar devaluation than be taken by surprise again.

  The Plaza Accord of September 1985 was the culmination of this multilateral effort to drive the dollar down. Finance ministers from West Germany, Japan, France and the United Kingdom met with the U.S. Treasury secretary at the Plaza Hotel in New York City to work out a plan of dollar devaluation, principally against the yen and the mark. Central banks committed over $10 billion to the exercise, which worked as planned over several years. From 1985 to 1988, the dollar declined over 40 percent against the French franc, 50 percent against the Japanese yen and 20 percent against the German mark.