The Way of the Dollar

external value of the currency has to halve to preserve the competitive equilibrium, or purchasing power parity (PPP) as it came to be called. If there are 10 pesos to the US dollar, you can’t have a pair of shoes costing 100 pesos at one moment and 200 pesos six months later with the dollar still standing at 10 pesos: if you do, shoe

exporters will go bankrupt and the republic of Banania will be flooded with imported shoes. The ppp* theory, that currencies will tend towards their competitive equilibrium values, is based on common sense, though its literal application was to lead pundits into treacherous seas in the 1985. Before 1971 currency speculation was child’s play-like taking candy from a baby central bank. All you had to do was keep tabs on relative inflation rates and watch for the moment when a country would run into payments

difficulties. Then you would sell it forward against the central bank, which would see it as its duty to defend the currency until it became indefensible, and had to be devalued. Then you would buy back and clean up.

In this way, bank traders would make fortunes at the expense of the central banks. And to this day, taking on the central banks is something bank traders cannot resist.

The Great American Inflation

During the 19605, America flooded the world with dollars, which were lent and re-lent in the so called Eurodollar* market –the market in dollars outside America. The result was an oversupply of dollars around the world, at a time when the “economic miracles” were happening in continental Europe and Japan. While the American economy ambled forward, weighed down by the burden of the Vietnam war, between bouts of balance of payments trouble, the countries of the German-zone* and Japan surged ahead on a wave of export-led growth. This put remorseless pressure on the dollar, which was forced off the gold standard in 1971.

The key event of the 1970s was that US inflation got out of hand. At the start of the decade, the greenback had been on a pedestal. For a start, America’s record over inflation had been second to none for decades –not least during the 1960s, when it returned to the 1-2% area, after backsliding briefly at the time of the Korean War, in the early 1950s. So when US inflation soared into double figures after the first oil crisis in 1973, it was a cause of sharp disillusionment; and the dollar suffered accordingly. Bu t during the second oil crisis at the end of the decade, US inflation deteriorated even further (reaching 15% in 1980), whereas in every other major country the inflationary peak was lower than in 1974-5.

So at the end of the 1970s, the dollar was a pariah among currencies. It had been falling for 10 years, but despite this, the current account was in deficit and the currency not evidently competitive. It was death. It gave you cancer. The place to be was in D-Marks and Swissies – if not in gold, diamonds, paintings, wine, baked beans or other inflation hedges. That was the background when Paul Volcker was appointed chairman of the Fed in 1979, by President Carter.

The Volcker Shock.

Volcker’s medicine was tight money, along with whatever level of interest rates might result. His aim was to turn the tide of US inflation. He succeeded, and in the process most of the conventional wisdom of the currency markets was turned upside down, as the experts were to discover.

The first Volcker shock came in 1980 when US interest rates blipped up to 20% –only to slide back down again to 8% in time for November’s presidential elections, which saw Ronald Reagan take over from Jimmy Carter. The dollar rode up and down again on the back of US interest rates, like the Grand Old Duke of York.

Of course there was nothing new about the idea that hefty shifts in interest rates could move currency rates. Interest rates and currency rates have always been intimately related –often in a threesome including inflation rates. In Latin America, there has been a long tradition whereby interest rates were officially administered in line with inflation rates or alternatively bank deposits were indexed to inflation while the exchange rate was similarly indexed inversely to inflation and interest rates.

By the same token, if interest rates on the world’ s reserve currency –or any other major currency –made a sudden quantum leap, said currency was suddenly much more attractive to hold and very unattractive to borrow or to sell short (they amount to the same thing). The trouble, for the gamblers, was that you cannot forecast interest rates. As casual observers, we often think we can forecast interest rates. But full– timers know better. Anyone who could do so reliably would soon be very rich and would have no need to forecast currencies or anything else, since they would be living the life of Riley, cutting bond coupons in the South of France. The roller-coaster ride in US interest rates and the dollar in 1980 could not be forecast; and it gave the currency punting fraternity its first taste of what was to become staple fare over the next half-decade – remorseless financial bereavement.

But there was nothing in the performance of the dollar in 1980 to undermine any of the conventional wisdom of the currency markets. Sure, interest rates could dominate the dollar and make life difficult for the punters. But that was a case of “win some, lose some”. And come 1981, the punters were feeling more at home as US inflation began to come down and the US trade balance took a turn for the better. So when US interest rates took off skyward again in that year, closely followed by the greenback, many “pros” were quite quick to get on board. Though few were ready for the extent of the rise in the dollar during 1981, when it soared over DM 2.50 from the 1980 low near DM 1.80.

When the dollar backed down sharply from its highs in 1981 that was as it should be. The trouble came in 1982. The big event in 1982 was the distress of Mexico. It took Paul Volcker some time to see that his policy of very high interest rates was causing impossible strains in the world at large –south of the Rio Grande in particular. Anyway, US interest rates started coming down in mid-1982. And then things went wrong. Instead of turning down with US interest rates, the dollar carried on up. And this was the beginning of the big trouble for forex observers.

The world’s money

The more flexible among them had expected the dollar to fall with US interest rates and were confounded when it didn’t. The rest were near unanimous in deeming the greenback overvalued and bound to crash in the face of an inexorable rise in the US trade deficit. How could it defy the proven rules of currency behaviour –rules that had been valid throughout the experience of all participants?

It could and did. To see how, we might start by looking at what happens to dollars that pile up in the hands of foreigners as a result of a growing US trade deficit. The dollar is not just any old currency; it is the world’s money. When you get paid dollars, you don’t just automatically trade it in for your domestic currency. If you are happy with prospects for the dollar you’re likely to hang onto them. In other words, you see the dollar as a store of value, or as an investment, and judge it as you would any other investment.

This was the great discovery of the punters in the mid-1980s. The currency markets –or rather the dollar and all its main parities, DM, Yen, pound and SF – did not move in response to trade flows but to portfolio flows. It didn’t matter that it was “uncompetitive”, or “overvalued”. It didn’t matter that America’s trade account was in ruins. Investors knew all that. But what mattered to them was that it was rising, and offered the highest yields around. Just as important, America’s inflation had plunged from one of the highest