Currencies: A 1970s Flashback?

Some of what worries people about the recent drift toward currency war is its similarity to an ugly past. The competition among nations to gain advantage by depressing the foreign exchange value of their currencies, coupled with rising fuel prices and easy monetary policies, can, in a certain light, look very much like the run-up to the great inflation and huge real asset price bubble of the 1970s. But before bracing for similar, calamitous events, it is crucial to note the differences between then and now—differences significant enough to render a bubble-prone, inflation-plagued outlook neither an immediate concern nor inevitable.

The picture from the 1970s, however, is far from uplifting. That inflationary decade began with a currency war. On August 15, 1971, then President Richard Nixon brought it into the public eye when he suddenly took the dollar off its long-standing gold peg. He was determined to drive down the dollar's foreign exchange value in order to enhance this country's export prospects. The action shattered the Bretton Woods system of fixed exchange rates that had prevailed since the end of the Second World War. Within six months after Nixon's move, the dollar had lost about 15% opposite both Germany's deutschemark and Japan's yen—a shock after years of complete stability. As each nation then scrambled to enhance its export advantage by pushing down the value of its currency, a generalized depreciation of purchasing power set an inflationary trend. It then received considerable additional momentum when the Federal Reserve, freed from the discipline of the gold peg, pursued an extremely easy monetary policy and when in 1973 the oil-exporting nations, after imposing a brief embargo, pushed up crude oil prices by 70%.1

Nixon's action was actually less precipitous or aggressive than it seems on the surface. It was rather a counterstroke to what could be described as a long-standing, slow-motion offensive against the United States. This earlier aspect of the "war" was an unavoidable result of the rigidity built into the old Bretton Woods system. The fixed exchange rates, adopted right after the Second World War, had set the dollar’s value high, to take account of the tremendous relative strength of the U.S. economy, and set the deutschemark's and yen's value low, to take account of the remarkable weakness of these war-ravaged economies. But with each step toward recovery, Germany's and Japan's economies became more efficient and competitive, making their original, weaker exchange rates less appropriate and increasingly advantageous. The more the United States felt the effects of this competition, the more Washington pressed Germany and Japan to revalue the deutschemark and the yen upward. But these countries so enjoyed the export edge offered by their underpriced currencies, they refused. The events of August 1971 reflected Nixon's and Washington's huge frustration.

Whatever Nixon's reasoning, the effect was, ultimately, wildly inflationary. Competitive currency depreciations prompted a price bubble in real assets and commodities, as investors shifted away from purely financial assets in order to preserve the purchasing power of their wealth. In all likelihood, it was the decline in the dollar's value that prompted oil exporters to push up prices. Oil, after all, was priced in dollars then, as it is now, and the dollar's depreciation hit directly its global purchasing power. Of course, the rising price of fuel then imparted still greater momentum to a global inflation and blew up the bubble in real asset prices still more. The Fed’s aggressively stimulative monetary policy added to the mix, as it accelerated the growth in the broad, M2,2 definition of money, to an annual rate of almost 10.0% in the five years following Nixon's move.

The milieu of a depreciating dollar, rising commodity prices, and a flood of liquidity accelerated the pace of inflation in the United States and globally. Nixon, in an effort to stem that tide, imposed wage-price controls, but they had little effect. Even before the oil price jump, the inflationary pressure had become evident. Consumer prices between 1971 and 1973 rose at an annual rate of 6.1%, more than a third again faster than during the previous five years. The jump no doubt would have been more pronounced had not the wage-price controls been in place. The oil price hikes in 1973 added to that pressure, while the aggressively easy monetary policy drove matters to extremes. Between 1974 and 1977, M2 surged at close to a 12% annual rate. Consumer price inflation kept accelerating, even before a second round of oil price hikes in the late 1970s rocked markets and the economy and set the stage for an even more feverish inflation in the early 1980s.3

But if much is similar to those sad years, much also is different. Critical is the economic slack in both the U.S. and the world economy. In the years after Nixon took the dollar off its gold peg and the Fed began to accelerate money growth, there was no slack to speak of. The unemployment rate in the United States hovered near 5.0% and was sometimes lower. Today, the figure hovers closer to 8.0%, and would be higher had not so many given up the search for work and left the labor force.4 Nor were Europe and Japan in recession back in the early 1970s, as they are today. On the contrary, both were growing rapidly, with low rates of unemployment and high rates of capacity utilization. With so much relative economic slack, the world can expect much less immediate pressure on wages or prices than in the 1970s. What is more, the monetary ease this time has hit the economy less suddenly. Because banks, still wounded by the events of 2007–08, are reluctant to extend credit, much of the expansive Fed policy has yet to flow generally through the system. That difference is apparent in the behavior of the broad money supply, which, despite the 17% yearly growth in Fed-provided reserves since 2008, has expanded at a relatively modest 8–9% yearly rate.

To be sure, the underlying, ultimate inflationary risk remains. But the differences nonetheless promise to delay any effect at the very least. It would in fact take until 2015 at the earliest to bring inflation out of this environment, even if the currency war were to go on and the Fed were to make no effort to moderate the pressure. Meanwhile, this delay buys time for the authorities to implement remedies. The Group of Seven (G-7), composed of major developed economies, has taken a stand against competitive currency devaluations.5 Also, Fed chairman Ben Bernanke has indicated a willingness to pull back from extreme ease when the time is right, perhaps before the huge growth in liquidity even finds its way fully into the economy's money supply. The Fed's Open Market Committee is already discussing such a change. But even if the Fed were to fail, the inflationary effects would take time to hit, so investors would have ample time to adjust their portfolios. In the meantime, especially since there is still a good chance of a policy remedy, such anti-inflationary portfolio twists are, at the very least, premature.

1 Data on oil prices from Bloomberg.

2 M1 consists of currency in the hands of the public, travelers' checks, demand deposits, and other deposits against which checks can be written. M2 includes M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.

3 Data on the M2 from the Federal Reserve website.

4 Data on the unemployment numbers from the Department of Labor website.

5 For information on the G-7 and G-20, see, for example, Richard Barley, "G-7 Lost in the Fog of a Currency War," The Wall Street Journal, February 12, 2013; and Tom Burgis, "Currency Wars: The Battle Lines Explained," Financial Times, February 13, 2013.

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