The U.S. and many other major economies remain stuck in sluggish growth, despite bloated central-bank balance sheets and enormous debts accumulated by national governments. To get back to economic vitality will require a fundamentally different approach.
The financial crisis of 2008 — caused by tight monetary conditions — made the U.S. dollar overvalued relative to other major currencies. Now, whenever the U.S. Federal Reserve stops monetary easing, the dollar appreciates, which causes financial conditions to tighten, growth to slow, and, at the margin, risk-taking in the economy to decline.
This cycle has bedeviled policy makers as economic growth and wages have stagnated, capital expenditures and productivity remain weak, and, in economic terms, monetary velocity — that is, the speed with which money circulates through the economy — has remained at recession levels, despite ultra-low interest rates and three cycles of easing.
To change the game, monetary authorities must break market expectations that the dollar will appreciate, via an international agreement like the Plaza Accord, which was negotiated by the Reagan administration in 1985.
While the U.S. is not the unrivaled economic behemoth it was in the half-century after World War II — China and the eurozone today are comparable in size — its currency still dominates global finance and trade. When the dollar sneezes, the world catches cold.
As in the 1970s, when the dollar’s large depreciation relative to other major currencies created an international inflation problem, today the dollar’s tendency to rise sharply has created deflationary headwinds in the U.S. and the world, with attendant anemic growth.
Japan has been stuck in a similar, though deeper, rut since the 1990s, so its example is instructive. In the late 1980s, responding to U.S. pressure to raise the yen, Japan tightened its monetary policy. Higher interest rates created a large inflow of speculative capital, so-called “hot money,” and Japan’s currency soared from 240 to the dollar in 1985 up to 80 to the dollar in 1995, a threefold appreciation.
The result of that enormous currency appreciation was a chronically overvalued exchange rate and two decades of deflation in Japan. Whenever its central bank stops easing, the yen appreciates again and conditions once again tighten. Markets anticipate this future appreciation, so they hold more cash, spending and investing less. Temporary monetary easing or Keynesian spending stimulus will not fix the problem, as Japan has proven for almost three decades.
Today, the U.S. is in a similar bind, and it is affecting the world.
How did we get here?
In summer 2008, after several years of excessively easy monetary policy, as indicated by a depreciating dollar, swelling commodity and asset prices, and elevated inflation — the Consumer Price Index hit 5.5 percent annualized in May — U.S. monetary authorities signaled that they planned to tighten.
“Inflation Now Enemy No. 1 for Fed,” reported the Wall Street Journal on June 19, 2008. The Fed stopped cutting its target rate and the European Central Bank, which had been moving in tandem with the U.S., actually raised its target rate by a quarter point in July, suggesting similar policy to come from the Fed.
Startled markets, which had anticipated a longer period of easy money to offset the subprime crisis — already in progress for more than a year — scrambled for cash. Capital flows out of America reversed abruptly. Though interest rates remained unchanged, demand for dollars soared causing monetary conditions to tighten sharply.
In the roughly 90 days from August 1 through October 28, 2008, the Fed and the U.S. Treasury allowed the dollar to appreciate by 25 percent, a monumental error.
In the roughly 90 days from August 1 through October 28, the Fed and the U.S. Treasury allowed the dollar to appreciate by 25 percent, a monumental error. The soaring dollar collapsed asset prices far beyond subprime mortgages: Prime and commercial real-estate prices plunged, as did equities and commodities, while oil collapsed by 70 percent. Credit markets froze, bankruptcies mounted, and unemployment soared. The CPI inflation rate plummeted from 5.5 percent in May to 0 percent in December to negative 2 percent in March 2009, the first outright deflation in 60 years.
It was the biggest monetary fiasco since the Great Depression, according to Nobel laureate Robert Mundell.
“All the major crises in banking history have always come from some deflationary tendency — either appreciation of a currency or through deflation, falling prices,” he said in a 2008 speech. “And that’s always been caused by some kind of excess demand for money or excess supply of commodities. It would be very strange to see a big bank collapse without an appreciation.”
Mundell, who was central to the supply-side economics revolution of the Reagan era, later drew a parallel from the deflation of 2008–09 to the disinflation of the early 1980s:
When Ronald Reagan was elected president in 1980, the inflation rate in the United State was 13 percent — 11 percent in 1979, 13 percent in 1980, and 11 percent again in 1981. But in 1984, the inflation rate was 4 percent. Why? How could monetary policy operate that quickly, to bring about — in the largest economy in the world — the price level coming down so quickly?
The disinflation came about “because the dollar doubled against the Deutsche mark and other currencies,” Mundell said. And that exchange-rate appreciation was the “mechanism of adjustment.”
But “after a disinflation policy like this, you have to have a quick and dirty devaluation, because the exchange rate is overvalued,” he explained. “And in 1984–85, that’s what America did — America had the Plaza Accord. The Plaza Accord of September 22, 1985, was designed to get the dollar down.”
Today the U.S. is stuck in a rut similar to what Mundell described about the 1980s. The tight-money blunder of 2008 squashed incipient inflation but wildly overshot and has left the U.S. dollar overvalued and tending to soar.
Markets expect that the dollar will appreciate, so they hold more cash and spend and invest less in the future. Who wants to take on new debt or buy an income stream today if prices are likely to fall tomorrow? The result has been weak private-sector economic activity and an anemic recovery.
To break the expectation of appreciation requires putting an upper limit on the dollar-euro rate, perhaps around $1.20, followed by a stability pact. The U.S. and the eurozone would agree to buy each other’s currency to keep the exchange rate in an agreed-upon band of, say, 10 percent. The Fed and the European Central Bank would need to align inflation rates, which has already basically occurred.
Long-term exchange-rate stability will break the expectation of appreciation and, with good fiscal policy, will restore economic health on both sides of the Atlantic. A more stable dollar would also ameliorate the stress on China’s exchange-rate peg, reducing the threat of a major devaluation this year.
The dollar-euro-yuan bloc would then be the core of a stable international monetary system, which would facilitate trade and productive capital flows and end the era of exchange-rate-driven crises.
The question now is, Will the Trump administration’s Treasury Department follow the lessons of the Plaza Accord and act?
— Sean Rushton is the director of the Project on Exchange Rates and the Dollar at the Jack Kemp Foundation.