Page 2 of 4 The Fed and the strong dollar policy
By Henry C K Liu
Subsequently, in coordinated operations with other central banks, US
authorities sold about $650 million between January and March 1985.
Plaza Accord
Although the dollar had started to decline by late February 1985 due to US
fiscal deficit, that decline had yet to reduce the US trade deficit, causing
protectionist sentiment in the US to mount as the trade deficit swelled to an
annual rate of $120 billion in the summer of 1985. In part to deflect
protectionist legislation, US officials arranged a meeting of G-5 officials at
the Plaza Hotel in New York on September 22, 1985, with the purpose of
ratifying an initiative to bring about an orderly decline in the dollar,
observing that "recent shifts in fundamental economic conditions among
their countries, together with policy commitments for the future, have not been
fully reflected in exchange markets," and concluded that "further orderly
appreciation of the main non-dollar currencies against the dollar is
desirable," and that the G5 members "stand ready to cooperate more closely to
encourage this."
During the seven weeks following the Plaza Accord, G-5 authorities sold nearly
$9 billion, of which the US sold $3.3 billion for other currencies, while
speculators profited by shorting the dollar.
The dollar had declined to seven-year lows in early 1987 amid signs of weakness
in the US economy while the US trade deficit continued to grow. Public
statements by US Administration officials were interpreted in exchange markets
as indicating a lack of official concern about the ramifications of further
declines in the dollar.
On February 22, 1987, officials of the G5 plus Canada and Italy met at the
Louvre in Paris to announce that the dollar had fallen enough. But despite
heavy intervention purchases of dollars following the Louvre Accord, the dollar
continued to decline, particularly against the yen. Market participants
perceived delays in the implementation of expansionary fiscal measures in Japan
expected after the Louvre Accord and talks of trade sanctions on some Japanese
products heightened concern about tension in US-Japanese trade relations.
Following the Louvre Accord, the G-7 authorities intervened heavily in support
of the dollar throughout the episodes of dollar weakness in 1987, and sold
dollars on several occasions when the dollar strengthened significantly. Net
official dollar purchases by the G-7 and other major central banks effectively
financed more than two-thirds of the $144 billion US current account deficit in
1987. The US share of these purchases was $8.5 billion, and the share of the
other G-7 countries was $82 billion, since the non-dollar expert-dependent
governments wanted desperately to halt the appreciation of their currencies.
Record US trade deficits and market perceptions that the G-7 authorities were
pursuing monetary measures best suited to their own separate domestic economic
objectives soon sparked a further sell-off of the dollar. This contributed to a
worldwide collapse of equity prices, which had risen to levels unsupported by
fundamentals.
The dollar's decline gathered new momentum when the Federal Reserve under its
new chairman, Alan Greenspan, moved more aggressively than its foreign
counterparts to supply liquidity in the aftermath of the 1987 stock market
crash, which had been triggered by program trading on portfolio insurance
derivatives arbitraging on macroeconomic instability in exchange rates and
interest rates.
The Federal Reserve's actions in 1987 led market participants to believe that
it would emphasize domestic objectives, if necessary at the cost of a further
decline in the dollar. By year-end, the dollar's value had fallen 21% against
the yen and 14% against the mark from its levels at the time of the Louvre
Accord while Greenspan, the wizard of bubble-land, was on his way to being
hailed as the greatest central banker in history.
The ESF was the conduit used by the Bill Clinton administration to provide
assistance to Mexico to avoid default in the peso crisis of 1994 to prevent
huge losses to US lenders after Congress rejected the proposed Mexican
Stabilization Act. The crisis was triggered by an abrupt devaluation of the
Mexican peso by newly installed president Ernesto Zedillo to reverse the tight
money policy of the former administration of Carlos Salinas de Gortari. Salinas
had issued the Tesobonos, a type of sovereign debt instrument denominated in
pesos but indexed to dollars, fatally increasing Mexico's exposure to foreign
exchange risk. (See The
Tequila Trap, Asia Times Online, November 6, 2004).
Bear Stearns chief economist Wayne Angell, a former Fed governor and advisor to
then Senate majority leader Bob Dole, first came up with the idea of using ESF
funds to prop up the collapsing Mexican peso. Bear Stearns had significant
exposure to peso debts that would cause significant losses in the event of a
peso collapse.
Blatant cirumvention of procedures
Senator Robert Bennett, a freshman Republican from Utah, took Angell's proposal
to Fed chairman Greenspan and Treasury Secretary Robert Rubin, both of whom
rejected the idea at first, shocked at the blatant circumvention of
constitutional procedures that this strategy represented, which would invite
certain reprisal from Congress. Congress had implicitly rejected a rescue
package in the form of Mexican Stabilization Act earlier that January, when the
initial proposal of extending Mexico $40 billion in loan guarantees could not
get enough favorable votes. Greenspan advised Bennett that the idea would only
work if Congressional silence could be guaranteed. Bennett went to Dole and
convinced him that the scheme would work if the majority leader would simply
block all efforts to bring this use of taxpayers’ money to a vote. It would all
happen by executive fiat.
The next step was to persuade Dole's counterpart in the House, Speaker Newt
Gingrich. The two congressional leaders consulted several state governors,
notably then Texas governor George W Bush, who enthusiastically endorsed the
idea of a bailout to subsidize the border region in his state. Greenspan, who
historically opposed bailouts of the private sector for fear of incurring moral
hazard, was clearly in a position to stop this one. Instead, he used his
considerable independent power and congressional influence to help the process
along when key players balked. The controversial 2008 bailout of Bear Stearns
by the Fed was not the first.
The 1994 peso bailout would lead to a subsequent series of similar situations
in which influential private financial institutions would knowingly get
themselves into future trouble in order to maximize their short-term profit,
vindicating the moral hazard principle that market participants will take undue
risks with the expectation of government bailout guarantees.
Eventually, the US Treasury actually made a $500 million profit on the $50
billion loan to Mexico, but the global economy lost trillions down the road. As
Thailand, Indonesia, Malaysia, South Korea, Brazil, Argentina, Turkey, Russia
and other countries stumbled into financial crises, culminating in the 1998
collapse of hedge fund giant Long-Term Capital Management (LTCM), which played
key roles in precipitating the crises to begin with, Greenspan moved to inject
liquidity to support the distressed bond markets. At the helm of LTCM was yet
another former member of the Fed board, ex-vice chairman David Mullins, who
pleaded for help from his former colleagues with Fed-speak that they
understood.
When New York Fed president William McDonough helped coordinate a bailout of
LTCM at his offices, Greenspan defended McDonough before a congressional
oversight committee. Reflecting on all the corporate welfare being doled out to
prop up bad private-sector investments worldwide, Clinton appointee Alice
Rivlin, the able former congressional budget director, observed that "the Fed
was in a sense acting as the central banker of the world". During Clinton's
first term, Greenspan had handed the president a "pro-incumbent-type economy"
and was rewarded with a seat next to the First Lady in Clinton's televised
second-term State of the Union address and a third-term appointment as Fed
chairman. Crony capitalism is not exclusive to Asia.
Deterring outflows
Treasury policy during 1961-71 focused on deterring capital outflows from the
US and on giving major foreign central banks an incentive to hold dollar
reserves rather than demand gold from the US gold stock. The ESF resumed
intervention operations in the foreign exchange market in March of 1961 (for
the first time since the mid-1930s), but it soon became apparent that the
resources of the ESF alone were too small to sustain transactions of the
magnitude necessary.
At the invitation of the Treasury, the Federal Reserve joined in foreign
exchange operations in February 1962, entering into a network of swap
agreements with other central banks in order to obtain foreign currencies for
short-term periods for use in absorbing forward sales of dollars by foreign
central banks hedging exchange risk on their dollar holdings. To provide
foreign currency to repay the Fed’s swap drawings, the Treasury during the
1960s issued non-marketable foreign currency-denominated medium-term securities
known as Roosa bonds, named after then Undersecretary of the Treasury Robert V
Roosa, designed to be attractive to foreign monetary authorities as an
alternative to converting dollars into gold, and sold the proceeds to the Fed.
Part of the foreign currency proceeds from Roosa bonds was used to extinguish
swap debt that otherwise would have lingered beyond the one-year limit set by
the Fed Open Market Committee (FOMC) on such drawings. In August 1971, the
United States ceased conducting gold transactions with foreign monetary
authorities, and the need to moderate the drain on the US gold stock was
eliminated.
In December 1974, ESF turned over, in a sale at par value, a gold balance of
2.02 million ounces (valued at $85 million) to the Treasury General Account.
This gold had been acquired prior to August 1971 through gold transactions that
the ESF engaged in
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