President Clinton and his economic team will be in Italy Friday for the annual G-7 economic summit. It is to be hoped that the seven heads of state do nothing but pass the time, as it is not evident that any of them know enough to do any good about the topic at hand, the weak dollar. Only the Fed can fix the dollar and Alan Greenspan won't be in Naples. At least the Fed yesterday decided against another interest-rate boost, giving up, we hope, on this approach to propping up the dollar. The most serious problem in Naples will be the absence of institutional memory. Currencies have been floating up and down against each other since 1971-73, with the end of the Bretton Woods system that fixed currencies to the dollar, which itself was fixed to gold at $35 an ounce. The float, which officially began in March of 1973, was supposed to end various problems thought to be caused by fixity, including trade imbalances, undesirable capital flows, even unemployment. The G-7 have been talking to each other ever since, trying to coordinate economic policies in an attempt to keep their currencies from floating too far away from each other -- the term for which, "dirty floating," was coined in 1973. Since heads of state and their financial advisors come and go, the cast of characters forever changes, and to those of us who have been watching all this while, it becomes déjà vu all over again. Neither President Clinton, 46, nor Larry Summers, 40, the Treasury Undersecretary for International Affairs, was paying much attention when the currency float began. In March of 1973, I was writing "Rethinking the Dollar Problem," the lead editorial of the March 2 Wall Street Journal, amidst the "dollar crisis" of the day -- which followed the February 23 dollar devaluation that was supposed to have ended the crisis.
The devaluation theoretically was supposed to do the trick by increasing the global demand for dollars. If you have so many dollars in the world, and on February 23 announce that they are worth 10% less, any job that previously took $1 will now need about $1.10. Previously unwanted dollars that put pressure on exchange rates will be soaked up in this new demand. Unfortunately, the devaluation also reduces global confidence in the dollar as a stable currency, and people who had been willing to previously hold dollars because of this mystique become less sure of their position and turn to other currencies and precious metals.
Somehow, then, a way has to be found to increase the global demand for dollars without tarnishing confidence in them. For one thing, it would seem advisable that central bankers stop talking about maybe another 2% or 3% doing the trick. Treasury Secretary George Shultz did not help matters when he said he hoped for a bit more devaluation against the yen. West German Finance Minister [Helmut] Schmidt does no good by speculating about a common European float in the near future.
I suggested a thought, "which at first might seem drastic," for the Fed to tighten up on the money supply, arguing that surplus dollars were being channeled into European investments, then mopped up by the Bundesbank and converted into U.S. Treasury securities.
The capital flow is circular, with the direction determined by the speculators. The Fed, though, might be able to reverse the direction of the flow. A sharp tightening of the money supply, along with an announcement that it is intended as a temporary blow against the speculators, would do more than give the speculators pause. Dollars would still be needed for any number of projects, and fewer of them would be needed domestically. American banks and multinational corporations would have to borrow marks, yen, etc., and cash them in for dollars to put to work in tasks where dollars are needed.
The editorial, written as Art Laffer was whispering in my ear, caused sufficient controversy in academic and political circles to prevent me from writing the dollar editorials for many months. If the Fed had done as the editorial suggested, though, the dollar crisis would have ended instantly, its floating would have been avoided, the inflation that followed would not have occurred, and President Nixon probably would not have been impeached. Alas, the world was not ready for the strange idea that if you wish to increase the demand for dollars, you might try making them scarce at their source.
From the looks of the G-7 gathering, it still isn't clear the world is ready for this strange idea. The U.S. position, voiced by Undersecretary Summers, is that the dollar is weak because the yen and Deutschemark are strong, and if Japan and Germany would lower interest rates, their economies would get stronger, which means they would buy more from us, their currencies would get weak too and we would look stronger. Why are U.S. interest rates so high? Because, says Dr. Summers, our economy is so strong, which is why the dollar is so weak. Why were U.S. interest rates so low last year? Because the bond market reflected confidence in the strength of the economy. Arrrgh.
We are happy to hear that Bob Rubin at the National Economic Council and Laura Tyson, the CEA chair, are arguing against taking action on the exchange-rate front. To further encourage them, we suggest they read our 1973 editorial, and contemplate the figures below, representing fixed and floating currency systems. Note that if each central bank targets gold, it automatically becomes a fixed-rate system, with low interest rates for all. (Alan Greenspan can take a peek too.)