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R E V . N O V E M B E R 0 7 , 2 0 0 1
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Research Associate Daniel Pope prepared this case under the supervision of Professor Michael G. Rukstad. HBS cases are developed solely as the
basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective
management.
Copyright © 1984 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
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M I C H A E L G . R U K S T A D
The Decline of the Dollar: 1978
In 1976, after almost four years of experience with floating rates of exchange among the major
industrial nations, the International Monetary Fund sounded an optimistic note about the functioning
of the world monetary system:
[T]he floating among major currencies has been characterized by some reduction in the
amplitude of exchange-rate movements. . . . [This reflects] in part the fact that the disturbances
in the global pattern of payments have been less severe than during the early period of floating
rates; in part, however, they may represent an improvement in the ability of the market
mechanism and official policies to cope with the realities of a more flexible exchange rate
system.i
By early 1978, however, a depreciating dollar seemed to threaten that stability. From early 1977
until October 1978, the effective exchange rate (a weighted average of the exchange rates between the
dollar and other currencies) declined by almost 13%. (See Exhibit 6.) Although news of the dollar’s
decline initially could be found only on the financial pages, not in the headlines, it was, in the words
of one Carter administration official, “a very grim business.”ii Policy makers were keenly aware of
their limited experience with floating exchange rates. There were two questions they needed to
answer if they were going to make the system work. First, why had the U.S. exchange rate declined?
And second, what should the government do about it? The answers to these questions depended on
the interpretation of the world’s experience since the fixed rate system had first been established at
the Bretton Woods, New Hampshire conference of 1944.
Bretton Woods and Its Demise: 1944-1973
Under the Bretton Woods system of fixed exchange rates, which prevailed from 1944 through
March 1973, crises had mounted from the early 1960s onward. The provisions of the Bretton Woods
system allowed countries to devalue or revalue their currencies in order to correct “fundamental
imbalances” in their external payments. Great Britain, for example, after several years of emergency
measures to defend the pound sterling at $2.80 in the face of serious payments deficits, devalued
sterling by 14.3% to $2.40 on November 18, 1967. In the next two years, speculators and investors
sold French francs and bought German marks in large quantities, forcing France to devalue the franc
in August 1969 by 11.1% and the Germans to follow suit with an upward revaluation of the mark by
9.2% two months later. (All devaluations and revaluations under Bretton Woods were relative to the
dollar.)
384-116 The Decline of the Dollar: 1978
2
The United States also took an active role in controlling the exchange rate of its currency. Faced
with accelerating inflation, a balance of payments deficit which was to reach $30 billion in 1971 and
outstanding dollar liabilities to foreign governments and central banks of more than $50 billion,
President Richard Nixon took decisive action on August 15, 1971. Fearing that foreign holders of
dollars would demand gold at the fixed price of $35 an ounce, he announced that the United States
would no longer allow foreign central banks and treasuries to trade their dollars for gold. This action
directly undermined one of the basic principles of the Bretton Woods system. At the same time,
Nixon also imposed a 10% surcharge on dutiable American imports (approximately half of total
imports). This was akin to a partial devaluation of the dollar, because it raised the price of American
purchases from abroad by 10%. Finally, the president instituted a 90-day wage and price freeze and
subsequent controls aimed at slowing domestic inflation and improving international
competitiveness of U.S. goods and services.
In the early 1970s, world economic leaders recognized the need for new international monetary
arrangements; but they did not, for the most part, wish to abolish fixed exchange rates. In 1969,
Undersecretary of the Treasury for Monetary Affairs Paul Volcker had described floating rates as
popular “in academic circles, and that’s where they can stay.”iii Even the crisis of 1971 had not
altered this opinion. Memories of the 1930s, when the fixed rates of the gold-exchange standard had
fallen apart, haunted central bankers, finance ministers, and International Monetary Fund officials.
In the 1930s, nations had competed in devaluing their currencies in order to take export markets from
their competitors. At the same time, they had raised tariffs and other trade barriers, and these steps
had stifled international trade and damaged the world economy. Between 1929 and 1933, the goldexchange
standard had been abandoned by 35 nations, including the U.K. and Japan in 1931 and the
United States in 1933. Many other countries had imposed severe restraints on convertibility of their
currencies.
The Nixon announcement of August 15, 1971 provoked fears that some of the travails of the 1930s
might be repeated. Within days of Nixon’s speech, Pierre-Paul Schweitzer, managing director of the
IMF, warned, “Unless prompt action is taken, the prospects before us is one of disorder and
discrimination in currency and trade relationships which will seriously disrupt trade and undermine
the system which served the world well . . . for a quarter of a century.”iv
Thus, in December 1971, finance ministers and central bank officials of the major industrial
nations (the so-called Group of Ten) convened at the old Smithsonian Institution building in
Washington, D.C. to work out the new exchange rate parities that almost all believed were needed.
The conferees agreed that the United States would raise the dollar price of gold from $35 to $38 an
ounce, which effectively devalued the dollar in terms of gold. Since a dollar would now purchase
less gold, the existing gold reserves would cover more dollar liabilities. Japan, Germany and
Switzerland consented to revalue their currencies significantly upward (which meant lowering the
price of the dollar, and hence gold, in terms of their monies) while the British pound sterling and the
French franc remained unchanged. Temporarily, the nations agreed to let currencies trade on
financial markets at rates as much as 2.25% above and below the newly established parities.
Fluctuations beyond that band would require government intervention. This would take the form of
the central bank’s selling a currency which had appreciated too much or buying one which had fallen
too far in value. President Nixon told the television cameras that the Smithsonian accord was “the
most significant monetary agreement in the history of the world.”v
Despite the president’s hopes, the Smithsonian agreements lasted little more than a year. In
January 1973, Nixon relaxed wage and price controls, and international monetary traders, fearing
more rapid inflation in the United States, sold dollars and put their funds into nations with “strong”
currencies—Japan, Germany, Switzerland and the Netherlands. During early February, in the space
The Decline of the Dollar: 1978 384-116
3
of less than one week, the German Bundesbank purchased over $5 billion to keep the dollar-mark
relationship within the Smithsonian limits. Other nations’ currency parities were also threatened by
speculative flows. Recognizing that the Smithsonian parities were coming unglued, the Nixon
administration sent Paul Volcker around the world to consult with finance ministers. Upon Volcker’s
return on February 12, 1973, Treasury Secretary George Shultz announced a 10% devaluation of the
dollar. Meanwhile, most other members of the Group of Ten, led by Switzerland and Germany, gave
up their efforts to maintain fixed exchange rates. They allowed their currencies to float, as Canada
and the U.K. had already done during the previous year.
During this crisis, exchange markets became disorderly and were closed from March 1 through
March 18, 1973. When they reopened on March 19, the non-Communist world’s major currencies
were all floating. Although most smaller nations continued to peg their currency either to the
currency of their largest trading partner or to a weighted average of leading currencies, the majority
of the world’s trade was now carried on among nations with floating exchange rates. (See Exhibit 1
for exchange rate practices.)
Economists in both the Keynesian and monetarist camps looked on floating rates as intrinsically
healthy for the world’s economy. Under a fixed rate system, they contended, nations had to
subordinate domestic monetary policies to the maintenance of the pegged rates. Countries with
payments deficits would find their monetary reserves shrinking, and surplus nations would face an
influx of funds which might prove inflationary. A payments deficit might also require higher real
interest rates at home to attract capital inflows, to cut back on demand for imports, and to lower the
price of exports.* With flexible rates, the academics said, the price of a nation’s currency would adjust
to eliminate surpluses and deficits on the international accounts, so that nations could, as they saw fit,
employ discretionary monetary and fiscal policy to deal primarily with domestic concerns. Thus, it
was believed that flexible rates could help to insulate a country from foreign economic shocks.
Academics might like floating rates. But for most policy makers in the early 1970s, such rates
were “an inevitable evil for the time being,” in the words of the French finance minister. They were
necessary because national governments and central banks were unable to preserve fixed rates in the
face of massive flows of speculative capital from one currency to another. From the 1950s onward,
European nations had removed barriers to capital mobility. Meanwhile, the growth of the
Eurocurrency market (which may have reached as much as $150 billion by 1971) and of multinational
corporations meant that large amounts of “hot money” were available to seek the currency of the
nation where the highest return was available.
Policy makers viewed floating not as a permanent solution but rather as a temporary expedient.
From 1972 through 1974, foreign ministers, central bank officials and their deputies met in the IMF
Committee of Twenty to reconstitute the world’s monetary system. Even as floating rates became the
norm in the industrial world, the Committee of Twenty continued to assume that fixed rates were the
goal of reform. Although “floating rates could provide a useful technique in particular situations,”
the “Committee recognized that exchange rates must be a matter for international concern and
consultation and that in the reformed system, the exchange rate regime should remain based on
stable but adjustable par values.”vi
* See the earlier BGIE case, The U.K. and the Gold Standard: 1925.
384-116 The Decline of the Dollar: 1978
4
1973-1976: The Initial Performance of Floating Rates
The economic experience of the mid-1970s was paradoxical. On the one hand, forces quite
independent of the world monetary system made these years a stormy era. On the other, the
experience of floating rates persuaded even some of the most steadfast proponents of fixed rates that
the float was the best way to handle the shocks the world was undergoing. Summarizing the
experience, Thomas D. Willett, director of international monetary research at the Treasury
Department, concluded: “Under extremely trying circumstances, generalized floating has proven
itself to be a sound foundation on which to base the future evolution of the international monetary
system.”vii
The shocks to the world economy during these years were many and disparate. Clearly, the
single most important blow was the impact of petroleum shortages and the OPEC cartel. The
fourfold rise in petroleum prices in late 1973 boosted consumer prices in oil-importing countries and
functioned as a “tax” that reduced aggregate demand in these nations. If the industrialized world
were to escape recession in the years following the OPEC price hikes of 1973, some means of
restoring aggregate demand would have to be found. At the same time, the economies of the industrialized
nations suffered a rapid rise in agricultural and raw material prices, which could be blamed
on causes as varied as the disappearance of the anchovy from the Pacific Coast of South America
(since these fish were used in high-protein animal feed) and the sale of large quantities of American
wheat to the Soviet Union at below-market prices.
These “supply shocks” meant simultaneous pressures towards inflation and stagnation. With
inflation in the final quarter of 1973 raging at 12% in the capitalist industrialized nations, few leaders
were eager to pursue expansionary fiscal and monetary policies. By early 1974, real GNP in these
nations had begun to slip, and by the spring of 1975 the world was experiencing the worst economic
slump since the 1930s.
Despite these woes, the floating exchange rate system seemed to be performing reasonably well.
Earlier fears of competitive depreciation of currencies and the imposition of protectionist measures
proved largely unfounded. The OPEC financial surplus was recycled into investments in the oilimporting
nations especially the developing nations. The trend in the mid-seventies seemed to be
toward exchange rate stability. In particular, the dollar’s behavior appeared reasonably satisfactory.
The dollar did dip sharply in the summer of 1973, a time of rapid American inflation, uncertainty
about the Watergate affair, and fears that the dollar was still overvalued. The United States and other
nations intervened to support the dollar by purchasing it with other currencies, and its foreign
exchange value rose markedly during the second half of 1973. It dipped and rose again in 1974 and
1975, but from late 1975 through the autumn 1977, its effective exchange rate remained in a narrow
range, within a few percentage points of the level that had been set at the 1971 Smithsonian accords.
(See Exhibit 6.) When corrected for relative price changes, to give “real” effective exchange rates (a
measure of the competitiveness of American goods and services in export markets), the dollar
appeared to be even more stable. According to some calculations, the real effective exchange rate at
the end of 1977 was the same as it had been in March 1973.viii (Compare this with the real exchange
rates in Exhibit 4.) Major improvements in the U.S. balance of payments had accompanied exchange
rate calm. Less reliant on imported energy than its industrialized competitors, the United States
actually attained a current account surplus each year from 1973 through 1976. (See Exhibit 3).
Although the pound sterling had declined in value very rapidly in 1976, necessitating a large loan
to the U.K. from the International Monetary Fund, the experience of most industrialized nations had
been reasonably favorable. Fluctuations in exchange rates were becoming more moderate and were
apparently fulfilling their prescribed function. When a nation’s currency depreciated, its
The Decline of the Dollar: 1978 384-116
5
international competitive position generally improved and its payments deficit shrank. Similarly, as
strong currencies rose in value, their payments surpluses tended to diminish.
Nevertheless, some disquieting problems remained. The industrialized nations had plunged into
the recession almost simultaneously, but they climbed out at different rates. The recovery in the
United States was more vigorous than in Germany and Japan. American industrial production rose
at a 6.9% annual rate between the fourth quarter of 1976 and the third quarter of 1977. Germany’s
industrial production increased at a rate of 1.2% during the same period. Japan’s rate was also 1.2%.
Indeed, the United States was the only major industrial nation to achieve its forecast rate of real GNP
growth during 1977. (See Exhibit 5.) At the same time, American prices began to rise more rapidly
(6.1% for the U.S. producer price index compared to 1.8% for German wholesale industrial prices
and only 0.1% for Japan’s wholesale price index).
Rapid American growth took its toll on the U.S. balance of payments. On the current account,
imports increased faster than exports. The nation spent $45 billion on imported petroleum in 1977;
combined with a declining surplus on trade in manufactured goods, the oil bill helped put the
current account $15.3 billion in deficit. Almost equally important to the overall payments deficit was
the negative flow of $13.4 billion in private funds on the capital account as private investors and
speculators transferred investments and deposits from dollars to other currencies. In order to finance
this deficit, German, Japanese and OPEC official dollar holdings increased dramatically. (See
Exhibits 2 and 3.)
1977-1978: The Decline of the Dollar
A. Onset: “Benign Neglect”
The depreciation of the dollar at the beginning of the new Carter administration in 1977 was at
first rather gradual. Until late 1977, the effective exchange rate of the dollar remained near or even
above the level it had reached when generalized floating began in March 1973. The decline was not
equal against all currencies. For example, the dollar appreciated 9.4% against the Canadian dollar
and 34.8% against the pound sterling between March 1973 and the end of 1977. The decline of the
dollar was, properly speaking, its decline against several currencies, notably the German mark, the
Japanese yen and the Swiss franc. The dollar depreciated 25.5% against the mark, 10.5% against the
yen and 37.9% against the Swiss franc from March 1973 to December 1977. (See Exhibits 6 and 4.)
To most American policy makers in 1977 and early 1978, this dollar decline was part of the
solution, not the problem. Nevertheless, depreciation was not the administration’s preferred
response to sluggish world growth and the American payments imbalance. The favored method was
known as the locomotive theory. First espoused by economists at the Brookings Institution and the
Organization for Economic Cooperation and Development, the doctrine held that the world’s strong
economies (notably the United States, Germany and Japan) should adopt expansionary policies that
would raise their growth rates and increase their demand for imports. This would, in turn, stimulate
the weaker economies and accelerate world growth, pulling the world economy like a locomotive
pulls a train. According to this account, the unwillingness of Japan and Germany to shoulder the
burden of pulling the world economic train by stimulating their domestic spending was keeping their
imports low, their current accounts in surplus and their currencies strong. If they continued to refuse
to pull, the next best solution was to be found in exchange rate readjustment. A depreciating dollar
would at least make American products more competitive in the world market; and more expensive
marks and yen would correct the German and Japanese payments surpluses.
384-116 The Decline of the Dollar: 1978
6
The Carter administration feared that Japanese officials were hindering the adjustment process by
engaging in a “dirty” float. They were said to be intervening in foreign exchange markets: selling yen
and buying dollars in order to keep the yen’s value from rising too far. They were doing this, said
many critics, in order to protect Japanese export competitiveness. (See Exhibit 3.) Vice President
Walter Mondale headed a trade delegation to Japan in January 1977 and allegedly complained about
the dirty float. “We knew what the Japanese were doing, and we told them to knock it off,” said C.
Fred Bergsten, an economist who accompanied Mondale.ix At a Paris meeting of the Organization for
Economic Cooperation and Development (OECD) in June 1977, Secretary of the Treasury Michael
Blumenthal announced that exchange rate adjustments should “play their appropriate role” in
restoring economic equilibrium.
Statements like these in 1977 persuaded foreign exchange dealers that Blumenthal, on behalf of
the Carter administration, was “talking down the dollar.” Europeans complained of the secretary’s
“open mouth policy.” The top international money trader at the New York Federal Reserve later put
it pungently: “Every few days some dumb bastard from Treasury would get up and say that the
United States would not intervene to fix the value of the dollar, only to counter disorderly markets.
When people heard that, the cry went up: ‘Sell the bucks,’”x Was Secretary Blumenthal really trying
to drive the dollar down? (After he left office, Blumenthal protested that his words had been
misinterpreted. All he had meant to say was that the United States favored flexible rates and would
not intervene in currency markets in order to peg the dollar at a given level. “I never said that I
wanted the dollar to decline,” he insisted.xi
As the dollar’s decline commenced, Federal Reserve Chairman Arthur F. Burns pledged to a
House banking subcommittee that the United States would protect the integrity of its currency, both
domestically and internationally. A brief rally followed Chairman Burns’ pronouncement in August
1977, but the dollar continued to decline. During the second half of 1977, the dollar lost 10.0% against
the mark, 10.3% against the yen and 18.7% against the Swiss franc. But some officials and economists
responded that these figures were misleading, since they measured not only the decline of the dollar,
but also the general appreciation of these strong currencies. Looked at in another light, the dollar’s
decline was less alarming. The “effective exchange rate” (a weighted average) dropped by only
about 5% in the second half of 1977. (See Exhibit 6.)
In any case, the declining dollar did little to improve the U.S. balance of payments in the short
term. The fourth quarter 1977 deficit on the current account was (seasonally adjusted) nearly $7
billion, or close to half the entire year’s $15.3 billion deficit. To advocates of the locomotive doctrine,
it was galling that German and Japanese current account surpluses in 1977 almost matched the U.S.
deficit. In the first quarter of 1978, the American current account was again in deficit by $6.9 billion.
(See Exhibit 3.)
Several reasons were offered to explain the failure of the current account balance to respond well
to depreciation. As William Nordhaus of the Council of Economic Advisers told a Senate committee
in June 1978, “Unfortunately, things got worse before they got better. This is the well-known ‘Jcurve’
effect.” In the short run, import and export commitments are frequently unchangeable. With
depreciation, it will take more dollars to pay for the same volume of imports while export revenues
remain stable for the time being.xii Second, many American exports, especially to Japan, were
foodstuffs and raw materials. Demand for these goods, officials pointed out, was often inelastic, so
that declining prices in strong currency countries did not greatly stimulate sales. At the same time,
Americans who bought Japanese cars, cameras or electronics equipment often had strong brand
preferences. Even the rapid rise of the yen did not prevent Japanese auto sales in the United States
from rising by 1%.xiii
The Decline of the Dollar: 1978 384-116
7
Finally, as foreign bankers and officials repeatedly pointed out, the U.S. economy was
overheated. U.S. growth rates outstripped those of its industrial trading partners, but so did
inflation rates. For the United States, consumer prices increased at 6.6% from March 1977 to March
1978; the corresponding figures for Japan and Germany were 4.3% and 3.2%.
B. A Move Toward Activism
In its January 1978 report to President Carter, the Council of Economic Advisers restated the
administration’s belief that flexible rates had worked well: “In summary, while exchange rate
fluctuations sometimes have been undesirably large and are often unpleasant reminders about
unsatisfactory aspects of underlying economic conditions, the evolution of the system of marketdetermined
exchange rates has been a major achievement of this decade.”xiv Moreover, the council
argued, official intervention to alter exchange rates was ineffective and undesirable. Private traders,
including many of the world’s largest commercial banks, have far more foreign exchange at their
disposal than do official agencies. When central banks intervene to counteract market trends, they
rarely can do more than slow down—at a high cost—the underlying movement. Moreover,
intervention to eliminate trends would generally be unwise, because it would retard the process of
restoring payments balances that result from exchange rate adjustments.xv Intervention was proper to
counteract short-run, “disorderly market conditions,” not longer-term trends.
Yet even before the Council of Economic Advisers’ cautions appeared in print, the Carter
administration moved to a more active defense of the dollar’s value. On January 4, 1978, the
Treasury Department announced that it had obtained an $2 billion “swap line” from the German
Bundesbank. The new swap arrangement complemented over $20 billion of existing swap lines
between the Federal Reserve and other central banks. Under swap arrangements, nations have
stand-by lines of credit in their partners’ currencies. They can support their own currency by
borrowing foreign money on these lines of credit and then selling the foreign exchange to purchase
their own money.
That very afternoon of January 4, the Treasury, the Fed and foreign central banks jointly
intervened to support the value of the dollar. (See Exhibit 9.) Even before the Fed could execute the
intervention, the announcement itself had lowered the value of the mark by about four percent
against the dollar. The dollar gained a full six percent against the Swiss franc. One American
commercial bank official described the intervention as a “fundamental change in exchange policy,”
but a European official perceived it as merely a “bluff.”xvi
Two days after the interventions began, the Federal Reserve raised its discount rate from 6% to
6.5% because, “The recent disorder in foreign exchange markets constitutes a threat to orderly
expansion of the domestic and international economy.” The increase would, it was hoped, cool off
domestic inflation and improve the capital account of the balance of payments by attracting funds
from abroad. But some observers worried that the cure was worse than the disease and that tighter
money might mean economic recession at home. Arthur Okun, a respected economic adviser to
Democratic presidents, said he was “surprised, disappointed, and very concerned” by the Fed’s
step.xvii
In foreign exchange markets such statements and reports of discord within the administration
heightened doubts that the dollar’s fall was over. Despite frequent official support during January,
the dollar fell back somewhat from the levels it had reached on January 5, directly after the initial
intervention. The decline continued during February and the first part of March 1978.
As the spring of 1978 approached, however, there was a wave of optimism. President Carter and
Chancellor Helmut Schmidt both assserted that their nations’ economic policies were being
384-116 The Decline of the Dollar: 1978
8
harmonized. On March 13, the German Bundesbank placed another $2 billion dollars worth of marks
in the Fed’s swap line, and the U.S. Treasury announced that it was prepared to acquire dollar
support funds from the International Monetary Fund as well. In April, President Carter announced
that the United States would sell 300,000 ounces of gold each month for the next year. Putting this
gold on the market was designed to raise the value of dollars in terms of gold and, it was hoped,
other currencies. The next month, the Fed tightened domestic credit another notch by raising the
discount rate from 61/2 % to 7%. In June, G. William Miller, who had recently been appointed
chairman of the Fed’s Board of Governors, addressed a businessmen’s group in Zurich; he predicted
that the worst of the dollar’s troubles were past. Newspapers reported a generally favorable
response from the audience. A few days later, the International Monetary Fund issued an optimistic
forecast of the American balance of payments. Figures later showed that the second quarter’s current
account deficit was already shrinking. It was $3.3 billion, less than half the first quarter’s deficit. (See
Exhibit 3.)
Nevertheless, in June 1978 the dollar slipped again from its springtime plateau. The weakening
was particularly severe against the yen, whose price in dollars rose by more than eight percent in
June alone. The economic summit meeting in Bonn in July was no help. Shortly before it convened,
the head of Japan’s Economic Planning Agency told reporters that there was “great disappointment
that President Carter seems to be going to Bonn empty-handed,” unwilling to offer assurances that
the United States would reduce energy imports and lower inflation rates.xviii Americans pointed to a
forecast that the Japanese current account surplus for 1978 would be a whopping $18 billion, three
times the official Japanese estimate. At the Bonn gatherings, the Germans pledged to introduce
proposals in Parliament that would increase government spending to stimulate the economy. Japan
promised to reduce its trade surplus within a year by increasing domestic demand and voluntarily
restraining exports. But Prime Minister Fukuda, “stern-faced and tight-lipped,” at a press
conference, refused to say that these measures would really solve the surplus problem.xix Carter, for
his part, could offer little; from a peak of 8.8 million barrels a day in 1977, the United States vowed to
reduce daily oil imports by 2.5 million barrels by 1985. Foreign exchange markets reacted to the Bonn
summit with disdain and the dollar continued to slide down.
By mid-August, 1978 signs of distress were mounting. Congressman Henry Reuss, chairman of
the Joint Economic Committee, was grimly warning, “We must not panic.”xx The influential Reuss, an
unwavering supporter of floating rates since the early 1970s, was a voice who could not go unheeded.
The next day, when President Carter expressed concern about the decline of the dollar during his
news conference, one banker commented, “I thought he said nothing and he said it badly.”xxi
Accompanying the president’s words, however, were actions to support the dollar. Official gold
sales were tripled. The Fed raised the discount rate in July and boosted it again in August to 73/4 %
“in view of recent disorderly conditions in foreign exchange markets.”xxii Both the Bundesbank and
the Fed intervened several times in August to support the dollar and hold down the value of the
mark. (See Exhibit 9.) Nevertheless, throughout the second half of the month the mark cost more
than 50¢, an important symbol of the weakening dollar.
American policy makers in the late summer found the situation frustrating. U.S. interest rates
were up, forecasts of vigorous growth had been abandoned, and the real growth rate was predicted
at a modest 3 to 31/2 %. The Senate passed an energy program in September. Carter and Blumenthal
were discussing ways to hold the federal budget deficit down. What else could they do? According
to the Wall Street Journal, the solution was simple and obvious:
. . . [S]urely the price of the dollar depends on the supply and demand for the dollar. It
declines because the Federal Reserve supplies more dollars than are demanded. For all the talk
of swap networks, gold sales and so on, the only way the decline will be reversed is for the Fed
to constrict the supply of dollars.xxiii (Compare Exhibit 3.)
The Decline of the Dollar: 1978 384-116
9
The Economist, however, saw things differently. Too much monetary tightening could bring on an
American recession, “a remedy as primitive as chopping off a foot to deal with an ingrown
toenail.”xxiv
When governors of the International Monetary Fund and the World Bank convened in late
September for their annual meeting in Washington their anger and distress were visible.
Administration spokesmen had leaked word of the components of a new anti-inflation program, to
be announced the next month, but this news failed to move the IMF and World Bank officials. Nor
did the Fed’s increase of the discount rate to 8% on September 22 impress them. (The rate rose to
81/2% on October 10.)
President Carter had adamantly opposed compulsory wage-price controls and had often pledged
not to fight inflation by increasing unemployment. Indeed the Administration had succeeded in
reducing unemployment from its record post-Depression high of 9% in March 1975 to 6% in October
1978. This was particularly remarkable since the growth rate of the labor force during 1977 and 1978
had been 3.1%—far above the 2.4% rate of the previous decade—forcing the Administration either to
create an additional 1.4 million jobs or suffer an increase in the unemployment rate of 1.3%. The
entry of the “baby-boom” generation and the increased participation by women in the labor force
accounted for the increased number of job seekers.
The IMF and World Bank governors doubted Carter’s will or ability to control rising prices
without drastic measures that would undoubtedly raise unemployment. “If you do only what we’ve
read about,” one banker reportedly told Secretary Blumenthal, “the dollar will explode”—that is, it
would depreciate violently.xxv
C. October 1978: The Dollar Crisis
Soon after the IMF conference, Secretary Blumenthal instructed Anthony Solomon, undersecretary
for monetary affairs, to list all options for defending the dollar. Blumenthal wanted a
“strong package to really turn this thing around.”xxvi Blumenthal then worked to pressure President
Carter to include in his anti-inflation plan a pledge to limit the federal deficit in the fiscal year 1980
budget to $30 billion or less. Not until five hours before Carter went on television with his proposals
on October 24 did the president accept this recommendation.
Faced with the unpalatable options of contractionary monetary and fiscal policies and mandatory
controls, President Carter in his October 24 speech chose neither. The deficit-cutting pledge won
mild applause from business circles, but other proposals—notably voluntary wage-price guidelines
and regulatory reform—failed to impress the markets. The next day the stock market continued a
steady downturn that saw it lose $110 billion on paper during the last 12 trading days in October. On
the international currency market, the dollar started to fall in Tokyo trading even before the end of
Carter’s speech. The Fed and other central banks intervened with dollar purchases of $2 billion, but
the mark rose 1.8% and the yen 1.7% against the dollar in one day. (See Exhibit 9.) The Carter
administration was now facing an inescapable dilemma. Having tried a series of moderate measures
and seen each fail one by one, the administration now had to decide which goal was more important:
a strong dollar, or a robust domestic economy. But it remained unclear under just what were the
proportions of this trade-off. How badly might the domestic economy be injured by measures taken to
strengthen the dollar?
384-116 The Decline of the Dollar: 1978
10
Exhibit 1xxxExchange Rate Regimes of I.M.F. Members
Industrialized Developing
Floating 16 Floating 36
Fixed 4 Fixed in terms of:
Dollars 38
French francs 14
Other 36
Exhibit 2 Measures of International Interdependence
(A) Size of Exports in GNP (%)
1958 1963 1968 1973 1978
United States 4.5 4.7 4.9 6.6 8.1
Germany 22.8 19.4 22.9 23.3 27.0
Japan 11.3 9.6 10.4 10.8 11.9
United Kingdom 20.3 19.1 20.4 22.9 29.0
(B) Holdings of Financial Assets by Foreigners
1958 1963 1968 1973 1978
% of U.S. government debt 3.0 5.0 4.5 16.1 22.3
$ Billions 6.9 12.6 12.5 54.7 137.8
(C) Size of Eurocurrency Market
1968 1973 1975 1976 1977 1978
Gross Eurocurrency liabilities ($ billions) 50 305 485 595 740 950
Eurodollars as % of total gross liabilities in
all Eurocurrencies NA NA 78 80 76 74
Source: Parts A and B are calculated by author from IMF, International Financial Statistics, 1982; Part C is from Board of
Governors of the Federal Reserve System and Morgan Guaranty Trust Company.
NA = not available.
The Decline of the Dollar: 1978 384-116
11
Exhibit 3 Selected Performance Indicators
Real GNP CPI M-1
Current
Account
Balance
Change in
Reserves
Year/Quarter Annual %
Growth
Annual %
Growth
Annual %
Growth
(billions of dollars in
year or quarter)
United States
1974 -3.5 12.1 5.1 1.7 -1.05
1975 2.4 7.2 4.6 18.4 -0.35
1976 4.6 5.0 5.8 4.3 -2.05
1977 5.5 6.7 7.9 -15.3 -0.24
1978:1 -0.1 8.0 6.3 -6.9 0.25
1978:2 8.7 10.6 10.3 -3.3 0.34
1978:3 2.6 8.3 7.9 -3.7 0.25
Germany
1974 -1.7 6.5 10.6 9.8 0.25
1975 1.5 5.6 15.1 4.0 1.22
1976 4.9 3.8 6.5 3.8 -3.93
1977 2.6 3.7 10.4 3.8 -4.04
1978:1 -0.6 2.9 25.3 1.4 -2.33
1978:2 8.8 1.8 6.5 1.8 1.69
1978:3 2.3 2.9 10.5 2.5 -3.31
Japan
1974 -0.2 24.4 11.1 -4.7 -1.26
1975 3.3 8.6 10.8 -0.7 0.66
1976 5.2 9.3 14.7 3.7 -3.08
1977 5.7 6.1 6.1 11.0 -6.53
1978:1 9.4 1.7 9.7 5.5 -6.31
1978:2 4.0 5.4 13.2 4.8 1.88
1978:3 3.9 7.1 17.2 4.5 -1.80
United Kingdom
1974 -0.3 18.2 11.0 -8.3 0.45
1975 -2.0 25.3 19.0 -3.7 1.44
1976 4.9 15.0 10.3 -1.6 3.02
1977 -0.6 13.2 21.9 0.3 -14.08
1978:1 3.2 5.8 27.9 -0.6 0.09
1978:2 5.4 5.5 5.7 0.4 2.79
1978:3 4.6 12.5 20.4 -0.1 -0.15
Sources: Columns 1, 2, and 3, Federal Reserve Bank of St. Louis, International Economics, Conditions; Column 4,
January 10, 1979, U.S. Department of Commerce, International Economic Indicators; Column 5, IMF,
International Financial Statistics. All quarterly percentages are compound annual rates of change from the
previous quarter, seasonally adjusted. Negative sign in “Change in Reserves” indicates an addition to
reserves.
384-116 The Decline of the Dollar: 1978
12
Exhibit 4 Derivation of Real Exchange Rates
1972 1973 1974 1975 1976 1977
November
1978
Nominal Exchange Rates (End of period index)
$/DM 100.0 118.6 133.0 122.1 135.6 152.2 159.6
$/¥ 100.0 107.8 100.3 99.1 103.3 126.0 156.8
$/£ 100.0 98.9 100.0 86.1 72.5 81.2 82.3
Ratio of Domestic Prices to Foreign Prices (End of period index)
P$/PDM 100.0 99.4 103.1 106.2 107.7 110.7 115.8
P$/P¥ 100.0 95.1 84.8 82.8 80.1 78.8 81.8
P$/P£ 100.0 97.4 93.1 81.9 74.3 68.3 67.8
Real Exchange Rates (End of period index)
Real $/Dm
a
100.0 119.3 129.1 115.0 125.8 137.5 137.8
Real $/¥ 100.0 113.4 118.2 119.7 128.9 159.6 191.7
Real $/£ 100.0 101.5 93.1 105.2 97.5 118.9 121.3
Source: IMF, International Financial Statistics, 1982 Yearbook, indexes calculated by author
a
Real $/DM = $/DM • PDM/P$ i.e., the real exchange rate is the nominal exchange rate times the ratio of foreign prices over
domestic prices.
Note: If the purchasing power parity condition holds, then the changes in the nominal exchange rate will be equal to the
changes in the ratio of domestic prices to foreign prices.
Exhibit 5xxxNational Forecasts and Realized Real GNP Growth for 1977
Country Change From Early 1977 Forecast Realized
United States Fourth quarter to fourth quarter 5.75-6 5.75
Canada Year to year 3-4 2.25
France Year to year 4.6 2.75
West Germany Year to year 4.5-5 2.50
Italy Year to year 2.6 2.00
Japan Fiscal year to fiscal year 6.7 5.00
United Kingdom Year to year 1.2 0.50
Source: Economic Report of the President, 1978, p. 107
The Decline of the Dollar: 1978 384-116
13
Exhibit 6xxxMovements in Exchange Rates: 1971-1978
Effective exchange rate changes are an indicator of the extent to which the external value of a
country’s currency has moved relative to other currencies. Effective exchange rate changes are
computed as an index, combining the exchange rates between the currency in question and 20 other
major currencies with weights derived from the international monetary fund’s multilateral exchange
rate model. Each weight represents the model’s estimate of the effect on trade balance of the country
in question of a change of one percent in the domestic currency price of one of the other currencies.
The weights, therefore, take account of the size of trade flows as well as the relevant price elasticities
and the feedback effects of exchange rate changes on domestic costs and prices. The measure is
expressed as an index based on the par values in May 1970.
Prepared by Federal Reserve Bank of St. Louis
384-116 The Decline of the Dollar: 1978
14
Exhibit 7xxxRelative Rates of Inflation
a:
1971-1978
a
Comparision of rates of change in consumer price index over corresponding four-quarter periods. Example: The United
States-Belgium inflation differential for January 1977 is computed by subtracting the percentage change in the Belgian CPI
over the January 1976-January 1977 period from the percentage change in the United States CPI over the same four-quarter
period. Data are seasonally adjusted.
Exhibit 8xxxShort-Term Interest Rates—International Comparisons: 1974-1978
Source: International Monetary Fund
The Decline of the Dollar: 1978 384-116
15
Exhibit 9xxxFederal Reserve and Treasury Department Intervention in Foreign Exchange Markets
Period
Sale of Foreign
Currencies
a
Purchases of Foreign
Currencies
b
Net Support for
Dollar
c
February 1974 - July 1974 $527.0 $317.1 $209.9
August 1974 - January 1975 742.3 208.4 533.9
February 1975 - July 1975 1,045.0 1,260.5 -215.5
August 1975 - January 1976 106.5 240.4 -133.9
February 1976 - July 1976 270.4 288.6 -18.2
August 1976 - January 1977 175.6 205.0 -29.4
February 1977 - July 1977 212.4 150.7 61.7
August 1977 - January 1978 1,736.8 35.4 1,701.4
February 1978 - July 1978 NA NA 1,511.0
Source: Calculated by author from “Treasury and Federal Reserve Foreign Exchange Operations,” Federal Reserve
Bulletin, September 1974 - September 1978 and March 1975 - March 1979.
a
Support for dollar through intervention sales of foreign currencies. Figures equal millions of dollar equivalents.
b
Purchases of foreign currencies either to support foreign currency values or to repay obligations from pervious dollar
support interventions. Figures equal millions of dollar equivalents.
c
Sales-purchases. Positive values imply net support for dollar during period.
Note: Figures do not include purchases of Swiss Francs and Belgian francs to repay debts incurred before August
1971.
NA = Not available.
384-116 The Decline of the Dollar: 1978
16
Endnotes
i
IMF Annual Report, 1976, p. 32.
ii
Wall Street Journal, November 1, 1978, p. 1.
iii
Cited in Gerald M. Meier, Problems of a World Monetary Order, 2d ed., Oxford University Press,
1982, p. 129.
iv
Ibid., p. 126.
v
Cited in Robert Solomon, The International Monetary System: 1945-1981, Harper & Row, 1981, p.
208.
vi
Ibid., p. 248
vii
Thomas D. Willett, Floating Exchange Rates and International Monetary Reform, American Enterprise
Institute Studies, No. 172, 1977, p. 67.
viii
“Summary Measures of the Dollar’s Foreign Exchange Value,” Federal Reserve Bulletin, October
1978, p. 788.
ix
Quoted in Michael Moffitt, The World’s Money, p. 134.
x
Ibid., pp. 114-115.
xi
Solomon, p. 346.
xii
U.S. House Hearings, Decline of the Dollar, 1978, p. 49.
xiii
Ward’s Automotive Yearbook, 1979. (Figures are for the five best-selling Japanese brands.)
xiv
Economic Report of the President, 1978, p. 134.
xv
Ibid., pp. 121-122.
xvi
New York Times, January 5, 1978, p. D7.
xvii
New York Times, January 13, 1978, p. D1.
xviii
New York Times, July 9, 1978, p. A1.
xix
New York Times, July 18, 1978, p. D13.
xx
New York Times, August 16, 1978, p. 145.
xxi
Solomon, p. 348.
xxii
Federal Reserve Bulletin, September 1978, p. 777.
xxiii
Wall Street Journal, August 30, 1978.
The Decline of the Dollar: 1978 384-116
17
xxiv
The Economist, August 26, 1978, p. 9
xxv
Fortune, December 4, 1978, p. 41.
xxvi
Ibid., p. 41.