Wednesday, August 18, 2010

A brief history of the dollar


Here, in a nutshell, is my version of the history of the dollar's history, with a focus on its major turning points. As a point of reference, I'm using the Fed's Real Broad Dollar Index (chart above), which measures the dollar's value against a large basket of trade-weighted currencies, all adjusted for changes in relative inflation. It's arguably the best measure of the dollar's true value against other currencies. I've marked 6 key turning points in the dollar, and I explain here the key events occurring around the time of each turning point. I also opine on the future of the dollar.

A: Most measures of the dollar's value only go back to 1973. That's unfortunate, since the modern history of the dollar begins in August 1971, when Nixon ended the dollar's convertibility into gold. Prior to that point, the dollar had been fixed to gold at $35/oz. since 1934, and most of the world's currencies were pegged in some fashion to the dollar. Nixon's decision to abandon the gold standard was the catalyst for what would eventually prove to be a major devaluation of the dollar. The underlying cause of the dollar's collapse, however, was the Fed's decision to ease monetary policy in support of Great Society spending programs. The Fed's easy money policy started in the mid-1960s, and it was reflected in a steadily increasing outflow of gold. The Fed was holding interest rates at artificially low levels, and this was undermining the world's confidence in the dollar. Central banks began demanding gold in exchange for their dollar holdings, until Nixon's decision put an end to that. That decision effectively relieved the Fed of the need to raise interest rates significantly, which in turn exposed the fact that there was a huge excess supply of dollars in the world.

By early 1973, when this chart begins, the dollar had lost about 10% of its value. Despite the Fed's repeated attempts to tighten monetary policy by raising interest rates throughout most of the 1970s, the Fed's efforts were on balance "too little too late." The dollar collapsed, and investors scrambled to sell the dollar and buy gold, commodities, and real estate. Inflation soared to double digits.

B: By early 1979, the collapsing dollar, double-digit inflation and the feckless Carter administration had combined to create a deeply pessimistic outlook for the U.S. It's no wonder that the dollar fell to an all-time low against other major currencies around this time. Then in August 1979, Carter had the foresight to appoint Paul Volcker to head up the Fed with a mandate to stop inflation. Over the next few years, Volcker slammed on the monetary brakes, causing interest rates to soar. When tight money combined with the confidence-boosting Reagan tax cuts in the early 1980s, the dollar began to take off.

C: The dollar reached an all-time high against other currencies in early 1985. It was benefiting from a powerful combination of tight money, high real interest rates, falling inflation, low taxes and strong economic growth. It's hard to imagine a better combination of forces. Sadly, however, it soon became fashionable among politicians and pundits to complain that the strong dollar was too strong—too much of a good thing was not welcome, especially among industrialists that were having trouble exporting because of the dollar's strength. So it was that the Plaza Accord was signed in September 1985, in which the world's major governments agreed to lower the dollar's value. Volcker did his part to weaken the dollar by expanding bank reserves by more than 30% in the space of just 18 months.

Alan Greenspan took over the Fed in August 1987 at an inauspicious time. The dollar had lost almost one-fourth of its value in just over two years, and the Reagan administration was faltering, having agreed to a 40% hike in the capital gains tax. Confusion abounded, confidence faltered, and the stock market cratered in October. Greenspan successfully navigated the storm, eventually tightening policy enough to halt the rise in inflation that followed in the wake of the dollar's collapse—the CPI rose from a low of 1.1% in late 1986 to a high of 6.3% in late 1990.

D: By early 1995 the dollar hit an all-time low, burdened by the high inflation of the late 1980s, the weak presidency of Bush I, the disappointing recovery following the 1990-91 recession, the tax hikes in the early years of the Clinton administration, the threat of HillaryCare, and the Fed's surprise tightening of monetary policy in 1994 (the CPI was a relatively low 2.5% when the Fed stunned the bond market in early 1994 with a tightening).

Despite the dismal state of affairs that prevailed as 1994 drew to a close—recall the Orange County bankruptcy and the Mexican peso devaluation of December '94—things began to improve shortly thereafter. The Republicans, led and inspired by Newt Gingrich's Contract with America, took charge of Congress in early 1995, and Clinton saw the wisdom of triangulation. The economy began to boom, and federal spending was held in check. Confidence rose as the capital gains tax was reduced in 1997 and the housing market began to elevate, boosted by Clinton's decision to exempt most homeowners from paying capital gains on the sale of their house. Meanwhile, the Fed kept real interest rates high from 1995 through 2000, worried that the economy was "overheating." The dollar received a major boost in 1997, as a wave of S.E. Asian currency devaluations sharply boosted the demand for dollars.

E: The dollar hit a high note in early 2002, supported largely by the view that the U.S. economy was likely to outperform other major economies, even though the recovery from the 2001 recession was modest. Plus, fears of a global deflation/depression were running high at the time, as commodity prices and gold hit lows in late 2001 and early 2002, and corporate defaults soared.

Things turned around as the Fed embarked in earnest on an easing campaign which eventually took the Fed funds rate down to 1% in mid-2003, where it stayed for one year even though the Bush tax cuts helped the economy boom in the latter half of 2003. That was followed by a very cautious and gradual rise in the funds rate, in a manner reminiscent of the 1970s. The Fed seemed always to be raising rates by too little, too late. The CPI rose from a low of 1.1% in mid-2002 to a high of 5.6% in mid-2008. The final phase of the dollar's weakness came in 2006-8, as the U.S. housing market began to implode, eventually culminating in the subprime mortgage crisis, the failure of Lehman Bros., and the deepest recession since the early 1980s.

F: The thing that turned the dollar around after it plumbed fearsome lows in early 2008 was the global panic-driven demand for dollars that developed as economies began collapsing. This didn't last long, however, since the dollar reversed course starting in March of last year as it gradually became apparent that a global deflation/depression was not in the works as so many had feared. Fed policy helped accentuate the dollar's ups and downs, because the Fed was slow to accommodate the intense dollar demand that developed in the latter half of 2008, and then reluctant to tighten policy as dollar demand fell and the economy recovered in mid-2009.

The future: The value of a currency can be strongly influenced by demand for that currency, and that demand can in turn be driven by factors affecting the prospects for economic growth. Politics can also influence the value of a currency. Ultimately, however, the central bank has the final word. Thus, the dollar's future value is critically dependent on what the Fed does over the next year or two, especially given the enormous and unprecedented expansion of the Fed's balance sheet over the past two years.

Today the dollar is only 4-5% above its all-time lows relative to other currencies, and the dollar—along with almost every other currency on the planet—is at all-time lows against gold and most commodity prices. The dollar is still benefiting from safe-haven demand to some extent, but fundamentally it is very weak. The prospects for the U.S. economy are not very bright (many in fact are calling for another painful recession), and Obama's and Congress' approval ratings are abysmally low. Taxes are going to rise after the end of this year, unless the Congress votes to extend the Bush tax cuts. States and municipalities are reeling from their fiscal burdens. The Fed is promising to be massively accommodative for as far as the eye can see. Washington is pounding the table for the Chinese to weaken their currency, which is a polite way of saying they'd like to see a weaker dollar. The news is seemingly bad on all fronts, with almost no hope for any improvement.

This is where my contrarian instincts kick in. The news is bad, the fundamentals are horrible, and fiscal policy and politics are absymal. No wonder the dollar is close to an all-time low. But for the dollar to get weaker, things have to deteriorate even more than they already have.

If instead of deteriorating, things just improve a little, the dollar could hold these levels and perhaps improve with time. If things began to change for the better in a big way, it's difficult to imagine how strong the dollar might be several years from now. What if the Fed manages to pull off a reversal of its quantitative easing in time to avoid a massive overhang of dollars and an eventual hyperinflation? What if Congress votes to extend the Bush tax cuts? What if the November elections result in a massive shift in the balance of Congressional power, and a new wave of Tea Party-inspired politicians rescind ObamaCare and the remainder of the failed stimulus package?

Call me an incurable optimist (as so many here have), but I think there's a decent chance that the fundamentals behind the dollar can improve. Things are so bad now that the future could easily be less awful—and maybe even much brighter—than the market seems to believe.

Full disclosure: I am very long the dollar at the time of this writing.

19 comments:

Benjamin said...

This is a fascinating write-up of the dollar's exhange rate.

A couple notes:

Grannis writes of the 1970s: "The underlying cause of the dollar's collapse, however, was the Fed's decision to ease monetary policy in support of Great Society spending programs. The Fed's easy money policy started in the mid-1960s..."

Hmmm. I seem to recall a minor tempest in the 1960s called "Vietnam." Something about 560,000 US troops there, and horrific expenditures and losses, and ultimate defeat, during the Nixon Presidency (although he inherited an awful mess). Was it financed by federal spending? That was my recollection.

That said, I never understood the affection for a strong dolla, and attribute it to international travelers or US-based companies wishing to expand foreign operations cheaply.

Why not a "weak" dollar? It would help US industries, and they need the help.

Is it the language that confuses people? Should we call a "weak" dollar instead an "export-boosting" dollar, or "trade-enhancing" dollar?

This one has long puzzled me.

C+I+G (X-M)= GDP. Why not boost exports?

Dr William J McKibbin said...

I think a better way to go would be for the Federal government to continue to use Federal Reserve Dollars for payments to its employees, contractors, the military, and pensioners, while the private sector departs from the dollar in favor of an alternative foreign currency or perhaps some form of corporate scrip. The dollar is going to have a rough road ahead in terms of valuation. The good news is that equities will provide a good hedge from dollar declines. Basically, I am advocating that Federal Reserve Dollars become a form of Federal "funny money" to be used for entitlements, Federal worker pay, contractors, and pensions, and that the private sector begin now to detach their treasuries from what has become a politicized and distorted dollar. As the dollar value continues to erode, it's very easy for private enterprise to move instead to "hard" currencies. Conversely, the Federal government would find it almost impossible to move from the dollar. By the way, keep your ears open for words like "capital flight laws" in the near future in Congress...

Benjamin said...

Dr. McKibben:

I haver to say, you have novel ideas.

Jeff said...

OR...those seeking a "safer" haven in the dollar continue to exit, massive tax increased DO go in effect in 2011, health care is not repealed despite huge GOP (read Tea Party) gains, stimulas spending continues (we just threw another $30 billion to the unions...I mean States), another stimulas is negotiated prior to 2011 (remember Bush's two $300 billion stimulus in the form of checks...I'm still waiting for mine. And that was with GOP majorities!), and finally, even more tax increases and spending.

Why more taxes?

Becuase after the GOP gains in Novemember, the next crisis is going to rise up which is currently being ignored by the Dems and the media. The "coming" debt crisis will overwhelm us in the media. So much so, that the nation will be convinced (like during Reagan and Papa Bush) that the only way to solve the crisis is with big tax increases.

The crisis is coming. And I don't think we have the numbers to stop it.

I'm still bearish on the dollar.

Scott Grannis said...

wjmk: What you are proposing is akin to a sizeable default on federal government obligations. The value of the Federal Reserve Dollar would surely fall considerably relative to the emergent private currency. There have been numerous cases of provincial governments around the world printing their own currency for use to pay bills, and the currency is invariably discounted by the private sector in order to accept it. I'm not saying this can't happen, I'm just saying that it is essentially a form of default.

John said...

The instant the market believes the government is intentionally defaulting its currency obligations there would be a virtually instant price collapse.

It is why I argued back in May that Greece would not leave the Euro (they havn't). Why issue a currency for the primary reason of debasing it? The market would kill it within days/hours.

Scott,

Very, very good economic history here. It should be read and re-read. Thank you.

Public Library said...

Great post Scott. The end is debatable but the body is awesome.

I believe Dr W is spot on.

The private sector is far better off determining the medium of exchange. In fact, society is always better off deciding the medium of exchange.

What Scott soundly describes is the complete mismanagement of paper money. As I mentioned in another post, central banks assume they can outsmart human nature with their policy decisions when this fallacy of hope is proven wrong time and time again.

We are 'lucky' all of the worlds paper money is currently called into question or the dollar collapse would already be history.

However, I think the world is starting to seriously question the ability of ALL central banks to manage seriously under collateralized paper.

Public Library said...

John,

Have you seen Greece spreads? They are defaulting anyway. You either die a slow death or take the pain and move on. However, the result is the same either way.

The US will never payoff its debts. Everyone knows it. We can either slowly sink into the sea like Japan, or do something to right the ship in the longer term.

Time to neutralize the Fed.

John said...

Pub,

I never said Greece would not need to restructure their debts (restructure is a form of default). What I said would not happen is an exit from the Euro as a currency, replacing it with their own. It would be done for the primary purpose of paying their debts with depreciating currency. The market would take it behind the woodshed and shoot it without a blindfold.

Germany tried it in the 1920s to escape the WW1 debt England and France loaded them with. We all recall seeing the wheelbarrows of 'notes' required to buy everyday groceries. It eventually all became worthless because the government and the people of Germany abandoned it.

A currency derives its value from the committment of it's people to accept it in payment of goods and services they produce. It is thus related to a country's ability to produce goods and services at competitive prices and its willingness to sell them.

Many people believe the US Dollar will someday become worthless. It could happen...IF the American people allow it to. It is in our hands to decide.

Dr William J McKibbin said...

Scott, I agree with you that printing regional or provincial currencies would essentially be "akin to a sizeable default on federal government obligations." However, I am starting to see that this might happen sooner than we all might think, and where it might start is in California, though only time will tell. In the mean time, equities are looking finer than ever as a hedge against currency degradation.

As for my last comment, I maintain that we should all watch out for capital flight laws.

John said...

Doc McKibb,

Why would the US Government care about 'capital flight' laws? The US Dollar is the world's reserve currency. Our Federal Reserve engages in routine currency swaps with its global counterparts on whatever scale is necessary to maintain orderly markets. The global economy is conducted largely in US dollars. What on earth would cause the US government to suddenly say "you cannot convert your property (US Dollars) to any other currency for any reason"? I don't think there is a court in the country that would uphold such a thing.

John said...

Pub,

You said, "the US will never pay off its debt and everyone knows it".

I agree.

However it is not necessary that we do so. Your statement implies an equivalence of the US Government to an individual or some other entity with a finite lifespan. The government is not limited in that respect. What is necessary is that an acceptance of responsibility to perform our required obligations be maintained in the minds of our creditors through time. As long as that confidence is intact, the currency has relative value. As that confidence erodes, it loses value.

The eventual full repayment of all debt that results in a debt free society is not required for a currency to have and maintain value.

Scott, please correct me here if you disagree.

Public Library said...

John,

We are talking about irresponsible money printing central banks. This calamity really set sail when Nixon broke with gold. The incentives to print and destroy will not change until the central bank structure and authority changes.

Default almost seems assured in our lifetime. Americans wanted to believe we could have everything and never sacrifice our standard of living or way of life.

Fight $T wars on loan, float the auto, banking, agriculture, and housing industries, provide health care for all, export our jobs while redirecting the remaining capital into unproductive and over-invested sectors, and save nothing for a rainy day whilst hoping it will all work out just dandy.

Sorry, I am a realist, and we certainly do not live in Kansas anymore...

Dr William J McKibbin said...

Hi John, good question about why capital flight laws might become a concern. The reason would be any indication that the US dollar might lose its status as the world's preferred reserve currency. Said another way, as the US dollar's status as a reserve currency erodes, capital flight into alternative or diversified reserve holdings would motivate capital flight. Thanks for the question.

Scott Grannis said...

wjmk: You've got something of a circular argument going on the dollar and capital flight. If the US were to impose restrictions on capital outflows, then the dollar would surely collapse, since the dollar would lose much of its appeal. If the dollar were to lose much of its appeal, then it would surely collapse, and while that might provoke some politician to impose capital flight restrictions, there is nothing that could be done to prevent its collapse. In the end, the dollar finds support only to the extent that policy fundamentals remain healthy.

Bill Luby said...

Scott,

Just a quick note to say that I have been a loyal reader here since the week you launched the blog and have enjoyed your frequently provocative and often contrarian takes, such as this one on the dollar.

Thanks for putting this all in the public domain and for keeping the wheels turning in my head.

Cheers,

-Bill

Scott Grannis said...

Many thanks, Bill!

Jeff said...

We already have capital flight laws in this country. If I want to give up my citizenship and leave the country I CANNOT take all my money with me. I must pay an "exit tax" of 30% of my wealth (over $2 million)!!

This is the equivalant of an economic Berlin Wall. This is what totalitarian governments do. When people try to flea their policies, they need to put up walls.

Scott, we already have an economic Berlin wall to prevent capital flight!!

Benjamin said...

As I look at this interesting post again, I see something: The 1990s, perhaps America's best economic decade ever (low inflation, terrific growth, booming Dow, federal surpluses) happened during a "weak" dollar.

Read that again: Arguably, our best decade ever, and the dollar was weak.

So, why again is a weak dollar bad?