What Constitutes a Currency Crisis?
October 5, 2009
The Lonely Trader posted the following recent comment: “Given your experiences of the last USD freefall back in 1978, I’ll be looking forward to more of your insights on the next one.” I prefer “crisis” to free-fall, because it is an easier term to define. The dollar has fallen sharply several times in the last 35 or so years. Not every sharp decline of the dollar constituted a crisis, however. The drop in 1985-87, for instance, was promoted by the G-5 governments and saw the dollar’s value slashed in half from DEM 3.478 in February 1985 to DEM 1.576 at end-1987. Dollar/yen dropped to 120 from 263. Other infamous dollar declines included a drop from DEM 2.90 in March 1973 to DEM 2.20 in fewer than four months, a 25% decline against the yen in the final nine months of 1980, a 40% loss against the euro between October 2000 and December 2004, a 27.5% decline against the euro from its 2005 high to its 2008 low, and a 37% drop against the yen from just before the Clinton presidency began to the Japanese currency’s all-time high of 79.85 on April 19, 1995. Then there is my personal favorite, the drop of 29% from DEM 2.4058 at the time of the Carter inaugural on January 20, 1977 to DEM 1.7030 on November 1, 1978. This wasn’t the largest decline either in total or in percent depreciation per month, but it evolved unquestionably into a full-blown currency crisis.
A currency crisis is defined by the collateral damage it produces. Ask these questions. Do domestic long-term interest rates rise as a result? Is inflation impacted in an unfavorable way? Does the functionality of the foreign exchange market break down under the weight of increasingly one-way trading? Does the crisis continue despite escalating policy efforts to stop it? How aggressive is the policy counter-attack eventually? Several features stand out from the 1978 crisis. Dollar depreciation and domestic inflation mutually fed one another, becoming the biggest economic problem of the time. U.S. authorities in concert with other central banks intervened repeatedly during the period, without lasting effect. Most conspicuously, the Fed raised its discount rate by 100 basis points on November 1, 1978. That move was unprecedented both in size and from the standpoint that it was motivated principally by currency market developments, not domestic circumstances. Indeed, announcement of the rate increase was made by the White House, not the Fed, and included in a list of other dollar rescue measures such as more resources for intervention and the planned issuance of Carter Bonds.
Dollar declines in 1973 created a crisis, resulting in the Nixon Administration’s agreement to intervene. The dollar drop in 1994-95 can be called a crisis too, getting the attention of Treasury Secretary Rubin, who repeatedly insisted that “a strong dollar is in the best interest of the United States because it holds down inflation and interest rates and promotes the inflow of foreign capital.”
The dollar’s recent losses do not constitute a crisis — at least not yet. Dollar depreciation is a weapon against deflation. Countries whose currencies have been relatively weak reap comparatively better growth prospects when inflation is not a risk. This was a lesson from sterling’s ignominious exit for the European Exchange Rate Mechanism in September 1992. Asian currencies are the most undervalued in the world according to purchasing power parity comparisons, but those economies are now ahead of all others in leading the world out of recession. That is especially true of China, and the U.S. too is expected to grow faster next year than Japan or Euroland. Recent dollar trading does not exhibit a lack of depth, breath or resilience. The market is working.
The United States government nevertheless has to be careful in its handling of the dollar. Because of the greenback’s reserve currency hegemony, the United States can fund its current account deficit without having to incur an exchange rate exposure by borrowing in currencies other than the dollar. U.S. long-term interest rates are lower as a result. Major foreign creditors of U.S. debt have complained about dollar depreciation and threatened to diversify since the oil producers during the 1970’s. A mass exodus has never occurred, however. That doesn’t preclude the future possibility that the dollar might eventually relinquish to unique position among currencies. One need only look at sterling, which used to be the king of reserve currencies before being replaced by the dollar. Who before the Second World War would ever have imagined Britain going to the IMF in 1976 for an aid bailout? Gold’s advance above $1000 also serves as warning that the advantages the U.S. now enjoys from having a reserve currency mustn’t be taken for granted by officials. But nobody can predict for sure when or how abruptly that special status will end.
Copyright Larry Greenberg 2009. All rights reserved. No secondary distribution without express permission.
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