“I think the biggest obstacles [to international coordination of monetary policy] are that it sounds good in theory, but when the exchange rate target appears to conflict with domestic urgency, domestic urgency wins. It is politically very difficult to appear to subordinate domestic policy to international exchange rate stability, even though this may be desirable in the long term.” — Paul Volcker
The Federal Reserve’s aggressive monetary tightening is on a scale the world has not seen because the early Eighties. Over the past 12 months, U.S. securities markets have suffered significant losses, however the U.S. economy and economic system remain on reasonably solid ground. The situation abroad is more precarious. Higher U.S. rates of interest and a robust dollar are disrupting cross-border capital flows and straining the funds of nations that hold large amounts of dollar debt.
The impact of Fed policy on the worldwide economic system is one other feature of the COVID-19 pandemic that has surprised investors. But very similar to post-pandemic inflation, it’s hardly unprecedented. Since the top of World War I, U.S. monetary policy has shaped cross-border capital flows, central bank policy, and the sustainability of debt service world wide. This is an influence that the United States assumed when it became the world’s largest creditor after World War I and the world’s top issuer of reserve currencies after World War II.
The Fed’s policies will undoubtedly shock the world again in the approaching months. Indeed, the United Nations Conference on Trade and Development released an ominous report earlier this month warning of doubtless serious consequences for among the most vulnerable countries. Beyond these generalities, nevertheless, it’s difficult to predict how Fed policy will play out globally. But one query is value pondering: Will the Fed adjust its policy within the interests of world financial stability?
There are two scenarios from history which may help answer this query.
Ben Strong and the Roaring 20s
The Fed aggressively tightened monetary policy in 1920 for a well known reason: to curb inflation. This led to a severe but relatively short depression. The economy recovered in 1922, but overheated within the mid-Nineteen Twenties. This put the Fed in a difficult position. The Fed chiefs, who were partly blamed for the Depression of 1920-21, feared a repeat of their mistake and refused to boost rates of interest early. Making matters worse, the Fed was under intense pressure from European central bankers to maintain rates of interest low. Why? Because if the Fed raised rates of interest, gold would flow from Europe to the United States as investors sought higher returns on capital. This would jeopardize post-war reconstruction by reducing the European money supply and forcing European central banks to boost rates of interest to stem the outflow of gold.
The Fed’s commitment to rebuilding Europe was first tested within the United Kingdom in 1925. After the First World War, the pound sterling had largely lost its reserve currency status to the US dollar. But Britain’s political leadership wanted to revive it. Faced with demands from leaders of the Bank of England and his Conservative Party to revive the gold standard, Winston Churchill, who served as finance minister, caved to the pressure. He announced that the pound would return to the pre-war fixed exchange rate of $4.86. This significantly overvalued the pound, making British exports immediately uncompetitive. This increased gold shipments from the United Kingdom to the United States, causing problems for each countries: the United Kingdom suffered a painful recession, while the U.S. money supply experienced a rapid and undesirable expansion.
In the spring of 1927, central bankers from the United Kingdom, Germany, and France traveled to the United States to advocate for loose monetary policy, fearing that the Fed would raise rates of interest again within the face of rising inflation and speculation. Ben Strong, governor of the New York Federal Reserve Bank, helped persuade his Fed colleagues to accede to the Europeans’ demands. But they went one step further: as an alternative of keeping rates of interest stable, they lowered them. The Federal Reserve Bank of New York cut the rediscount rate from 4.0% to three.5%. The cut was approved only by one dissenter, Adolph C. Miller, whose words proved prescient. He described the choice as “The largest, boldest operation the Federal Reserve System has ever undertaken, and . . . One of the most costly mistakes made by this or any other banking system in the last 75 years!”
That wasn’t an exaggeration. The Fed’s overly expansionary monetary policy fueled rampant speculation within the late Nineteen Twenties. This ended with the catastrophic crash in October 1929 that triggered the Great Depression. The Depression, in turn, created the cruel economic conditions that enabled the rise of the Nazi Party and the Japanese militarists.
Paul Volcker and the Great Inflation
Fed Chairman Paul Volcker announced his famous monetary tightening program on October 6, 1979. Volcker knew it will have enormous consequences outside the United States. But he didn’t let this affect his political decisions. His priority was first to contain US inflation after which to take care of the resulting consequences at home and abroad.
Volcker’s monetary tightening continued for nearly two years. As inflation slowed and the U.S. economy could now not sustain austerity measures, the Fed began cutting rates of interest in July 1981. The United States slowly emerged from the severe recession of 1981-82, and subsequent price stability contributed to just about 20 years of prosperity.
Other nations didn’t fare so well. The situation in Latin America was particularly painful. In fact, the Eighties are sometimes viewed as Latin America’s lost decade. The sharp and sudden rise in U.S. rates of interest caused the dollar to understand significantly against many foreign exchange. Many Latin American countries had gathered U.S. dollar-denominated debt, often with floating rates of interest, within the Seventies. Now they’d to pay higher interest payments in dollars while their very own currencies fell in value. Mexico was hit particularly hard, because it was unable to service its foreign debt in August 1982.
Although the Fed provided significant aid to Mexico, amongst other countries, the international problems didn’t deter Volcker from his course. Domestic concerns within the US clearly took precedence. This element of Volcker’s philosophy most distinguishes it from Strong’s.
What does this mean outside the United States?
The extent to which the Fed will adjust and recalibrate its policies based on their global impact is unclear. However, we expect the Fed to follow Volcker’s model quite than Strong’s. The current political atmosphere within the United States is targeted on domestic issues. All else being equal, the Fed will likely reflect the attitude of the American people.
So in relation to U.S. monetary policy, foreign governments could be sensible to arrange for loads of Volcker and hope for slightly Strong.
If you enjoyed this post, do not forget to subscribe.
Photo credit: ©Getty Images/Douglas Rissing
