WALTER S. SALANT Brookings Institution

The Post-De valuation Weakness of the Dollar

BETWEEN THE MIDDLE OF MAY and early July of 1973,the price of the dollarin the foreignexchange market fell sharply.The amountof the de- cline was greatlyexaggerated by some reporters,who cited figuresof 25 percentor more, whichreally measured only the dramaticdecline against the Germanmark, the Swissfranc, or an averageof a few Europeancur- rencies.The fall against an averageof the currenciesof the major U.S. tradingpartners was much less-6.3 percent,when each country is weighted in proportionto its bilateraltrade with the United States.The dollarre- mained stable againstthe currenciesof our two major tradingpartners, Canadaand Japan, and also againstthose of the United Kingdomand Italy. Even this smalleraverage decline, however, presents something of a mystery,coming as it did afterthe dollarhad been devaluedon February 12, 1973, for the second time in fourteenmonths, and when people who follow these mattersgenerally held that it was, if anything,already below its long-runequilibrium value.

ExplanationsSuggested by Others

Many explanationsof this weaknesshave been offered.Nobody knows theirrelative importance or even whethersome have any importanceat all, but a catalogueof plausiblereasons may be of interest. At the outset, it may be pointed out that, contraryto a widely held 481 482 Brookings Papers on Economic Activity, 2:1973 opinion,the declineof the dollar,like the fall of any otherprice, does not necessarilyimply that net privatesales of dollarssubstantially increased or that purchasesother than by monetaryauthorities dropped. If would-be buyersand would-besellers of the dollar(or anythingelse) simultaneously change their opinionsas to what it is worth, its price can change in the absenceof any transaction.Such a change is commonlyreferred to as a "markingup" or "markingdown." While it is very unlikelyin practice, somethingapproaching it may occur when everyonehears of an event simultaneouslyand interpretsits significancefor the commodityin ques- tion in the sameway. Somethinglike that evidentlyoperated in the case of the dollar,for therewas apparentlyno net outflowof privatecapital during the second quarterof 1973.The preliminaryfigures, in fact, indicatethat the net flow was inward. In view of the widespreadopinion that the dollar was "undervalued" after the Februarydevaluation, its subsequentweakness in the foreign exchangemarket requires explanation, for the usual meaningof "under- valuation"is that the commodityin questionis likely to rise in price, so that people who believeit to be undervaluedwould presumablybuy it in anticipationof that rise, therebybringing the rise about.I shall reviewthe manyreasons given for the dollar'sdecline from early May to July,and try to reconcilethat declinewith the belief that the dollarwas alreadyunder- valuedbefore that declinebegan. 1. One of the most commonexplanations is that pricerises in the United Statesaccelerated rapidly after the beginningof 1973.Price increases not causedby increasesin foreigndemand always tend to weakenthe value of a currencyin the foreignexchange market, especially if theyare more rapid than thosein competingcountries, because they are likelyto foreshadowa loss of exportsand an increaseof imports.The accelerationof the U.S. pricerise during the winterand spring of 1973was not limitedto exportable farm productsand would probablyhave weakenedthe foreign exchange valueof the dollareven hadit not beenmore rapid than that abroad,if only becauseit reverseda previousslowing of the inflationarymovement and therebysuggested a weakeningin effectivecontrol by the governmentand the possibilityof furtheracceleration. 2. Simultaneouslywith the accelerationin the rate of price rise in the United States, monetarypolicies in some Europeancountries, notably Germany,were tightened and interestrates in most of themrose. Although one might arguethat the Germancontrols against capital inflows would Walter S. Salant 483 Table 1. Relation of German and U.S. Interest Rates, March-August 1973 Percent

Representativemoney market rates Domesticcorporate bond yields

At or Excess of Excess of near end United Germani United German of month Germany States rates Germany States yields

March 9.50 7.10 2.40 8.83 7.60 1.23 April 12.50 7.22 5.28 9.26 7.50 1.76 May 12.63 7.75 4.88 10.45 7.64 2.81 June 14.00 8.54 5.46 9.82 7.90 1.92 July 14.50 10.13 4.37 10.99 8.42 2.57 August 13.75 10.93 2.82 10.28 8.13 2.15

Source: Morgan Guaranty Trust Company of New York, WorldFinancial Markets, September 18, 1973, pp. 17, 20. insulatethe deutschemark from this development,these controls can at best restrainsuch inflows.For one thing, they do not preventGermans who have investedabroad from bringingtheir capital home. Second,they do not preventincreases of commercialcredits in the form of the so-called leads and lags-that is, increasinglyearly paymentsfor Germanexports and increasinglydelayed payments by Germansfor their imports,which, on given expectationsabout futurechanges in the mark,are influencedto some degreeby the differencebetween interest rates in Germanyand other countries. The relationbetween interest rates in the United States and Germany before and duringthe months of 1973 in questionis shown in Table 1. 3. Furthermore,Germany showed its determinationto suppressits price rise to the maximumextent possible by adoptinga tighterfiscal policy. On May 9, it announcedincreases in taxation,curtailment of plannedgovern- mentexpenditures, and othermeasures to reinforcethe restrictivemonetary policy adopted in February.Other countriesalso intensifiedtheir anti- inflationarymonetary and fiscalpolicies, which may havebeen expectedto checkboth theirdemand for importsand the deteriorationof the competi- tive position of theirexports. 4. The sensationalrevelations precipitated by the Watergatebreak-in and the publicitygiven to other actionsassociated with the White House raisedserious questions in the minds of manyasset holders about the abil- ity of the administrationto governand, more specifically,to initiate and 484 Brookings Papers on Economic Activity, 2:1973 carryout effectivepolicies to combatinflation. This was unquestionablyan influence,and continuesto be. 5. Relatedto this influencebut also partlyindependent of it is a fear that, underany circumstances,the recentrapid rise of pricesin the United Stateswill end in a severecredit squeeze followed by a recession.A reces- sion wouldnormally be regardedas strengtheningthe net U.S. tradeposi- tion, both by restrainingbusiness activity and therebyU.S. importsand by restrainingdomestic demand for exportablegoods and thereby en- couragingexports, but it also tends to make investmentin the United States,especially in commonstocks, much less attractiveto foreigners. 6. Also tendingto weakenthe dollarwas the fact thatjust when a huge increasein foreigndemand for U.S. agriculturalproducts was contributing greatlyto an improvementin the tradebalance, the United Stateslimited exportsof soybeans,cottonseed, and relatedproducts, and also of scrap metals.The impositionof the first exportcontrols was regardedas a set- backfor tradeimprovement, and the subsequentcontrols-made necessary by shifts of foreigndemand into commoditiessubstitutable for those sub- ject to the firstset-clouded still furtherthe prospectfor improvementand consequentlyfor an increasein the demandfor dollars. 7. Anotheradverse factor in the long-runoutlook for the dollarwas the suddenlyemerging and much publicizedprospect that the United States wouldhave to expandvastly its importsof oil and gas. Increasesfrom some $5 billion in 1972 to between$11 billion and $15 billion by 1975, and to $25 billion-even $35 billion-by 1985,have been talkedabout. 8. During May and June, the Japanesemonetary authorities sold over $1.6 billion of foreignexchange reserves to keep the yen up in the face of theirpayments deficit. These sales, however, were smaller than those made duringMarch and April, which amountedto about $2.3 billion. 9. Superimposedon theseconsiderations was the risein the priceof gold in privatemarkets. If this rise had been no greaterthan that in some aver- age of the pricesof foreigncurrencies, it would have reflectedmerely the declinein the valueof the dollar.But the pricerose in foreigncurrencies as well. In general,a rise in the price of gold is morelikely to be an effectof distrustof the dollarthan a cause,but it is to some extentalso a cause.It has been attributedto a distrustof all currencies,resulting in a movement from assetsdenominated in currenciesinto gold itself(where its ownership is permitted),and to a revivalof speculationthat gold mightbe restoredto a centralmonetary role afterall. It mightbe supposedthat a generalmove- WalterS. Salant 485 ment out of currenciesinto gold, whileraising the priceof gold in relation to all currencies,could not affectthe relationbetween the dollarand other currencies.This is not the case, however.Even if asset holderswanted to convertinto gold the samepercentage of assetsheld in everycurrency, the absolutequantity of assetsdenominated in dollarsis so much largerthan that in othercurrencies that the volumeof dollarsoffered might be greater than the volume of other currencies.Even apartfrom this consideration, the relative,as well as the absolute,movement out of dollarsclearly would be greatestof all the currencies.One reasonis that the recentexperience of dollarholders has been less happythan that of holdersof othercurrencies. In this connection,it is hard to avoid the conclusion,even if only in retrospect,that the seconddevaluation of the dollarwas verydamaging to the desireto hold dollars.Because it was quiteunexpected, it mustinevita- bly have raisedthe fear that it could happenagain, especiallysince it was medicinethat the U.S. Treasuryappeared to enjoy taking.One investment adviserwho believedthat the dollarwas undervaluedexplained that he did not recommendpurchase of dollars because, having thought the dollar alreadycheap before the seconddevaluation and havingpersuaded clients to buy dollar-denominatedassets, he had madea mistakethat provedvery costly to them. Althoughhis convictionthat the dollar was undervalued waseven stronger after the seconddevaluation than before it, his confidence in his ownjudgment was naturallyshaken. Many othersmust have felt the same way. The second devaluationappeared to be quite arbitrary;if the dollarcould be devaluedarbitrarily once, it could be again.This response to it, moreover,was reinforcedby the U.S. government'sdeclaration at the sametime that it intendedto end the controlsover the outflowof cap- ital and to refrainfrom marketsupport of the dollar, and by its implied intentionto imposeonly moderaterestraint on demand. This is an impressivelist of reasonsfor the dollar'sweakness. All of them have some, and severalhave much, plausibility.Nevertheless, it is hard to reconcileany but the last one with the widespreadview that the dollaris undervalued.With one-yearmoney availablein some European countriesat 7 percentto primeborrowers and probably8 percentto other good borrowers,one would supposethat anyoneconfident that the dollar would rise in the courseof a year would have borrowedforeign currency, bought dollars,and investedin U.S. Treasurybills at the then available yield of 7 '/: or 8 percent,expecting to be ableto pay off his loan a yearlater by buyingback the foreigncurrency at a lower price.More generally,one 486 Brookings Papers on Economic Activity, 2:1973 wouldhave expecteda movementof capitalinto the United Statesso long as the expectedrise in the price of the dollarwas greaterthan any excess of foreigninterest rates to borrowersover the interestrates obtainable by lendersin the United States.Since that excesswas no morethan 2 percent in any Europeancountry except Germanyand by late springthe dollar appearedto have been widely regardedas undervaluedby significantly more than that amount,the absenceof a flow of capitalinto the United States is hard to reconcile with the belief in a substantialundervalua- tion. Oneexplanation is thatthe fall of the dollarhas been greatlyexaggerated by the publicitygiven to its movementin relationto the majorEuropean currencies.As I havenoted above, the dollarfell littleduring the May-July periodin relationto the Canadiandollar and did not fall at all in relation to the Japaneseyen-and Canadaand Japantogether account for some40 percentof U.S. trade. It fell by only about 4 percentagainst the pound sterling. Given these facts, an interpretationsuggesting that the seven Europeancurrencies participating in the joint float rose againstthe rest of the worldappears more accuratethan one that suggeststhat the dollar fell in relationto all other currencieswhen it and many other currencies of major tradersfell in relationto the seven. This point was forcefully made by the Morgan GuarantyTrust Companyin its WorldFinancial Markets(issue of June 19, 1973, p. 2), which concluded, "The recent exchange-marketevents shouldnot be describedas a run on the dollar." Measuringthe declineof the dollar againstan averageof the major cur- rencies,with each currency weighted by bilateraltrade of the issuingcoun- try with the United States,the MorganGuaranty Trust Company calcu- lated that the dollar declinedby about 3 percentduring May. The total declineagainst this averageof foreigncurrencies, from early May to the low point in early July, was approximately6.3 percent,according to their calculations. Eventhough the fall of the dollarwas less severethan the headlinesdur- ing the springsuggested, it was substantial.Moreover, the view that the dollarwas undervaluedwas certainlywidespread by the beginningof June, if not before,yet it continuedto fall. SinceJuly, there has been a recovery, but as of mid-Augustit accountedfor only abouthalf of the May-Julyloss. Moreover,as was announcedin September,the dollar was supportedin July by approximately$575 million of purchasesby the FederalReserve Systemand the GermanBundesbank, indicating that even this partialre- WalterS. Salant 487 coverywas not accomplishedby privatemarket forces, at least not alone. In short,something remains to be explained.

AnotherPossible Explanation

I suggestthat the conceptof undervaluationis beingused in two different senses,and that theseare associatedwith two differentconcepts of the bal- anceof payments.In one sense,the dollaris undervaluedbecause its present priceis sufficientto strengthennot only the net merchandisebalance but the entirenet balance on goods and servicesand perhapsalso the basic balance(that is, the combinedbalance on goods, services,unilateral trans- fers,and long-term capital) to a degreethat will bringone, two, or all three of thesebalances into surplusin the next few years.It may be notedthat all but one of the foregoingexplanations of the dollar'sweakness invoked influencesthat could be expectedto be relevantonly over, at most, two or threeyears; the sole exceptionis the fearedincrease in importsof oil and gas. Probably,however, another factor is at work.There is evidentlya wide- spreadbelief that overthe longerfuture the dollarwill be a muchless secure currencyin which to hold assetsthan it was in the past, and that a wise investor should reduce the dollar-denominatedproportion of his total portfolio.Even if this beliefwere confined to foreignersand involvedonly theirdollar-denominated liquid assets and, among them, only those held in the United States,it would have affectedassets totaling approximately $90 billion at the end of March(nearly $20 billion held by privatefor- eigners,and $70 billion held by foreignofficial agencies). In additionto theseliquid liabilities of the United States,foreigners held long-termand nonliquidshort-term assets in the United Statesconsisting of some $66 bil- lion at the end of 1972,and acquired more in the firstquarter of 1973.They, togetherwith Americans,also held assets denominatedin dollarsbut lo- cated in other countries,which Morgan Guarantyestimated at approxi- mately$95 billion at the end of March.1Although these are not liabilities 1. See WorldFinancial Markets, July 26, 1973, p. 8. Accordingto this source, these estimates"differ significantly from those publishedby the Bank for InternationalSettle- ments(BIS) in its recent annual report.The estimatesgiven here take into account to a much greaterextent than those of the BIS the rapid growth and proliferationof Euro- currencybanking outside traditionalEuropean centers," including Canada, Japan, the Bahamas,Singapore, and Panama. 488 Brookings Papers on Economic Activity, 2:1973 of American residents-at least not directly-an effort to sell them would weaken the dollar in the foreign exchange market. An attempt by investors to substitute other assets for some of the dollar-denominated assets in their portfolios would be a transitory phenomenon in the sense that once the shift was made, there would be no further attempt to sell dollars; but this portfolio adjustment, even if pursued for a relatively long time, would in- volve enormous amounts of money, since dollar-denominated assets of foreigners evidently amount to at least $250 billion. Although this hypothesis appears straightforwardenough, further con- sideration of it reveals a number of possible motivations for such asset shifting. It also reveals some interesting questions, different answers to which would have different implications for the exchange value of the dollar. First, suppose that there is a reduction in the desired proportion of dollar-denominated assets but none in the total amount of financial assets that people want to hold; they want merely to shift a portion of their financial assets denominated in dollars into assets denominated in other currencies. That implies a shift out of dollars into other currencies and would certainly tend to lower the price of the dollar in the foreign exchange market relative to the desired currencies. In contrast to that development, consider, second, a general movement out of currencies into goods in fear of continued inflation-a common explanation of recent events. The effect of this kind of shift is less clear. As was noted in the discussion of gold purchases, the volume of financial assets denominated in dollars is larger than the volume denominated in any other currency. If all holders of financial assets wanted to reduce their holdings by the same proportion and convert them into real assets, there- fore, the absolute volume of dollar-denominated assets offered would ex- ceed that in any other currency. But this supply would not be offered-at least in the first instance-in the foreign exchange market; it would be offered first in the market for real assets. Whether the dollar would be weakened by a shift out of financial assets of the same proportion for assets denominated in each currency evidently depends on the currency de- manded by the sellers of the real assets, as well as on the currency denomi- nation of the financial assets people wish to dispose of. Suppose, to take an extreme and hypothetical example, that 60 percent of all financial assets are held in dollar-denominated form and 40 percent in other currencies, Walter S. Salant 489 and that all holders wish to reduce their holdings in each currency by the same percentage. But suppose also that these would-be sellers want to con- vert 75 percent of the assets to be disposed of into real assets owned or cur- rently produced by sellers who, whether American or not, want to be paid in dollars. Even though a flight from dollar-denominated financial assets exceeds in absolute amount the flight from assets in other currencies, it could raise the price of dollars in the foreign exchange market because there would be a net increase in the demand for dollars, at least initially. If the real assets purchased were not currently producible and the sellers were content to hold dollar-denominated financial assets at their now reduced prices, that would be the end of the story. But suppose that the initial holders wanted to hold currently producible durable goods-say, Cadillacs or metals produced primarily in the United States-or invest in U.S. housing developments or office buildings. On a large enough scale, such a movement could raise the costs of producing exportable and import- competing goods enough to affect the U.S. trade balance adversely. Thus, even in this case of a portfolio shift into real assets sold for dollars, the initial favorable effect on the foreign exchange value of the dollar might be offset. There is no need to spell out further complications. The main point is that a general flight from financial into real assets would not depress the dollar merely because there are more dollar-denominated assets to escape from than there are assets in other currencies. The effect on foreign ex- change rates depends not only on the relative quantities of financial assets denominated in various currencies that holders wish to dispose of but also, in the first instance, on what currencies have to be bought to pay for the real assets into which they want to shift. Note also that the countries of residence of the buyers and sellers are relevant only insofar as they influence the currencies offered and demanded. A third possible cause of a shift out of dollar-denominated financial assets relates to holdings of monetary authorities. Even if a reservecurrency were in equilibrium under a regime of fixed exchange rates, a mere shift to a system of floating rates, or even of very flexible rates, would put the dollar under pressure if that system were expected to be permanent. Under such systems, foreign monetary authorities presumablywould have a lower stock demand for total international reserves, including foreign currencies, than they have under a fixed-rate system, and would want to dispose of some of 490 Brookings Papers on Economic Activity, 2:1937 theirdollars if they becameconvinced that the moreflexible system was the wave of the future,even if theirprevious holdings had been no largerthan they wanted.2 Finally, some reductionin the stock demandfor dollarsshould be ex- pectedto resultfrom the arrangementsamong members of the European Communityto limit the fluctuationsin exchangerates betweentheir cur- rencies.And a furtherreduction should result from the plannedmonetary unificationamong the EC members,to the extentthat assetholders expect the plan to be carriedout. The existingarrangement to limit fluctuations amongsome of the members(France, Germany, Belgium-Luxembourg, the Netherlands,and Denmark)and two nonmembers(Norway and Sweden) providesthat the jointnessof their "jointfloat" shouldbe maintainedby interventionin their own currencies.The countrieswhose currenciesare supportedare supposedto repaythe supportingcountries only partlyin dollarsand neednot do so until the end of the monthfollowing the month of intervention.The rule that settlementis to be only partlyin dollarshas been breachedrepeatedly, but futureadherence to it, in contrastwith the earliermethod of day-to-dayintervention in dollars,would permit a reduc- tion in the necessaryholdings of officialreserves in thesecountries that may not be insignificant.If it is believedthat unificationis makingprogress, a much largerreduction in both the officialand privatestock demandfor dollarsis likely.There are severalreasons why Europeanmonetary unifica- tion may be expectedto have that effectbut limitationof space prevents discussingthem here.3

2. It may also be noted that in any system that permittedmonetary authorities to intervenein the foreign exchange market-the only kind that can realisticallybe con- templated-the U.S. authorities would probably want larger reserves of foreign cur- renciesthan underthe gold-dollarsystem. Any such addition to the U.S. stock demand for foreign currencieswould depressthe dollar while the shift occurred.This, however, was probablynot an elementin the weaknessof the dollar duringthe springof 1973. 3. They are fully discussedin my paper,"Implications for InternationalReserves," in Lawrence B. Krause and Walter S. Salant (eds.), EuropeanMonetary Unificationand Its Meaningfor the UnitedStates (BrookingsInstitution, 1973), especially pp. 225-27; in the comments on that paper by Peter B. Kenen, especially pp. 245-47; and in the paper by Richard N. Cooper, especially pp. 253-54 and 259-62. While Cooper thinks Europeanmonetary unification would in itself have no substantiallong-run effect on the world economy, his qualificationsof that conclusion envisage a reductionin the stock demandfor dollars,at least for a numberof years. See also Cooper's"The Futureof the Dollar," and the comments on it by Peter M. Oppenheimer,Pascal Salin, and Motoo Kaji, in ForeignPolicy, No. 11 (Summer1973), pp. 1-32. On the relation among the various roles of an internationalcurrency, see also Benja- WalterS. Salant 491 This hypothesisof a reductionin the desiredstock of dollarassets does not implythat the dollarhas ceasedto be the preferredcurrency in which to denominatetransactions or to hold assets. It implies only that the strengthof the preferencefor dollarsis diminishing.Such an implication would sufficeto accountfor the dollar'sremaining below the value con- sistentwith eliminationof the deficitin the basic balance. This conclusionmay be supportedby some illustrativefigures. Suppose, for example,that foreignasset holders wished to reducethe dollar-denomi- natedproportion of theirliquid assets only, and by only 20 percent(which would be a much smallerpercentage of their total financialassets), and werewilling to do it over a periodof threeyears. On the assumptionthat these assetsamount to $180 billion, this would involveliquidation of $12 billion a year. For the United States to financethat outflow at present exchangerates without officialintervention to supportthe dollar would requirethat its net balanceof paymentson the official-settlementsdefinition not be in deficit.This, in turn, would requirethe basic balanceto be in surplusby at least $12 billiona year,compared with deficits of $9.8 billion in 1972and of estimatedannual rates of $3.8 billion and $3.1 billion, re- spectively,in the firsttwo quartersof 1973.Then a portfolioadjustment of $12billion a yearconfined to foreigners,and further confined to theirshort- termholdings of dollarassets, would require,under a floatingdollar with no interventionand the consequentzero official-reserve-transactionsbal- ance, that the U.S. basicbalance improve by about $22 billion a year over the 1972figure, by about $16billion over the annualrate of the firstquarter of 1973,and by about $15 billion over that of the secondquarter. On the assumptionsof this illustrativecase, these figuresoverstate the necessary improvementin that theyignore the growthof total portfoliosthat maybe expectedin a growing(and inflationary)world economy,but they under- stateit insofaras foreignersalso wishto reducethe proportionof theirnon- liquiddollar holdings and insofaras U.S. residentsalso wish to reducethe proportionof theirfinancial assets denominated in dollars. Thesefigures are enoughto indicatethat even a reductionin the desired min J. Cohen, The Futureof Sterling as an InternationalCurrency (St. Martin's, 1971); AlexanderK. Swoboda, "Vehicle Currenciesand the Foreign Exchange Market: The Case of the Dollar," in Robert Z. Aliber (ed.), The InternationalMarket for Foreign Exchange (Praeger, 1969); and C. Fred Bergsten'sforthcoming book, tentatively en- titled, TheInternational Roles of the Dollar and U.S. InternationalMonetary Policy (New York: Council on Foreign Relations). 492 Brookings Papers on Economic Activity, 2:1973 proportionof dollar-denominatedassets that was relativelymoderate and that was carriedout in equalamounts over, say, threeyears, would require a seriesof largebasic surpluses. After this adjustmentof portfolioshad been accomplished,such surpluseswould no longer be necessary.One could thenexpect the dollarto appreciateand the mainelements of the basicbal- ance to relapsethrough the mechanismof the strengtheneddollar toward an approximatelyeven position,or to a smalldeficit offset by an inflowof liquid capital correspondingto long-run growth of portfolios having a stablecurrency composition. On this view,the dollarwould continue to be weakfor sometime. While it would make a comebackwhen these portfolioadjustments were com- pleted,that would take severalyears. If whathas beenhappening reflects such a changeof viewsabout the long run, it is no wonderthat the initial decline that began in May was not counteractedby short-termspeculative support. The apparentlygeneral view that the dollarhas been undervaluedmay be correctin the sensethat the dollarhas been cheaperthan it need be to restorebalance in the U.S. merchandisetrade account, goods and servicesaccount, or basic balance. But even if this view is correct-and I believeit is-it does not implythat the dollar will rise in the foreign exchangemarket during the period in whichthose deficitsare eliminated. Regardingthe relationbetween the strengthof the dollarand the balance of payments,the improvementin the U.S. balance of paymentson the official-reserve-transactionsdefinition in the second quarterof 1973 in itself has no significancefor the futurestrength of the dollar.It was not only foreseeablebut unavoidable.Given that the dollar was floating in relationto most currenciesduring the whole of the second quarter,with relativelylittle officialintervention, the balanceon that definitionhad to be somethingbetween a small deficitand a small surplus,depending on the amount of officialintervention in the exchangemarkets. (A surplusoc- curredmainly because the Japaneseauthorities sold $2.9billion of reserves duringthe quarterto preventthe yen from falling.)Since the U.S. deficit had been enormousin the firstquarter-an annualrate of $42 billion,sea- sonallyadjusted-it couldnot havefailed to improvein the secondquarter. This improvementmeans merely that ex post purchasesand sales other than by monetaryauthorities were nearlyequal in the second quarter.It did not imply,therefore, that the dollarwould necessarilystrengthen, al- thoughthat has happened.To drawconclusions about whether nonofficial Walter S. Salant 493 supplyand demandforces have changedso as to strengthenthe dollarre- quiresknowing what forcesreduced the firstquarter's excess of sales over purchasesand their relativeimportance. Was the changeindependent of the May-Julydecline or did it resultfrom that decline?This questionin- volvesmerely the rudimentarydistinction between increases in purchases, decreasesin sales, or both that resulton the one hand, from a movement of the demandcurve, the supplycurve, or both, and, on the other hand, frommovement along the existingcurves when a pricefloor that has been set abovethe equilibriumlevel is removed.Since the floorunder the dollar (and also the ceilingover it) was removedalmost entirely, there is no way of telling whetherthe previousexcess of sales over purchasesof dollars other than by monetaryauthorities disappeared because the demandand supplycurves moved or becausethe pricewas permittedto fall. Moresignificant for the futurestrength of the dollarthan the simpleim- provementof the official-reserve-transactionsbalance is its composition. While by far the largestpart of it stemmedfrom terminationof the first quarter'shuge outflowof liquidand othershort-term capital, an improve- ment also occurredin the basic balance, particularlyin the goods and servicescomponent (see Table 2). This could not have resultedfrom the declineof the dollarduring May, June, and earlyJuly. Also, less than half of the absoluteimprovement in the merchandisebal- ance sincethe fourthquarter of 1972(the last one unaffectedby the second devaluation)was attributableto the increasein agriculturalexports spurred by the world grain shortage.The substantialincrease in nonagricultural exportsand the dampeningof the growthin importssuggest that the de- cline in the dollar that had alreadyoccurred before May was having its conventionallyexpected effect, although it was also supportedby the boom abroad.

A Judgmentabout Portfolio Shifts

WhatI have said aboutthe possibilitythat a desireto readjustthe com- position of portfoliosaccounts for the May-Julyweakness of the dollar was intendedto put forwarda hypothesis,not to expressa commitmentto it. My personaljudgment is that such shiftsare occurringto some degree. That view is strengthened,as noted above, by the recentlyannounced in- formationthat in Julythe FederalReserve System had sold the equivalent 494 Brookings Papers on Economic Activity, 2:1973 Table2. Summaryof U.S. InternationalTransactions, Selected Periods, 1972 and 1973 Billions of dollars Change, 1972:4 to 1972 1972:4 1973:1 1973:2 1973:2 Transaction Year (seasonallyadjusted annual rates) Merchandiseexports, totala 48.77 52.85 61.28 66.99 14.14 Agriculturalgoods 9.49 10.75 15.28 16.65 5.90 Nonagriculturalgoods 39.28 42.10 46.00 50.34 8.24 Merchandiseimportsa -55.68 -59.83 -65.12 -67.91 -8.08 Merchandisebalances -6.91 -6.98 -3.84 -0.92 6.06 Services,total 2.30 3.50 4.44 3.38 -0.11 Investmentincome, netb 7.86 8.93 9.24 8.28 -0.64 Othere -5.56 -5.43 -4.80 -4.90 0.53 Balanceon goods and services -4.61 -3.48 0.60 2.46 5.94 Remittances,pensions, and other transfers -1.57 -1.72 -1.59 -1.52 0.19 U.S. governmentgrants, excluding military -2.17 -1.81 -1.38 -2.20 -0.39 U.S. governmentcapital flows, net -1.34 -2.34 -1.34 0.38 2.72 Privatelong-term capital flows, net -0.15 3.12 -0.08 -2.25 -5.37 Balance on currentaccount andlong-term capital -9.84 -6.22 -3.79 -3.13 3.10 Nonliquid privateshort- term capital flows, net -1.64 -3.93 -7.17 -4.22 -0.29 Allocations of special drawingrights 0.71 0.71 0 0 -0.71 Errorsand omissions, net -3.11 -5.96 -15.68 0.92 6.88 Liquid privatecapital flows, net 3.54 9.47 -15.35 7.93 -1.54 Balanceon officialreserve transactions -10.34 -5.94 -42.00 1.50 7.44 Means of financing Decreasein official reserveassets 0.03 -0.44 0.88 0.07 0.51 Increasein liabilities to foreign officialagencies 10.31 6.38 41.12 -1.57 -7.95

Source: Survey of CurrentBusiness, Vol. 53 (September 1973), Tables BI and 1, pp. 38, 41. Component figures may not add exactly to totals because of rounding. a. Excludes exports under U.S. military agency sales contracts and imports of U.S. military agencies. b. Includes fees and royalties received and paid on direct investment. c. Includes military transactions. Walter S. Salant 495 of $273 million in foreignexchange to supportthe dollar and that these effortswere "strongly reinforced by coordinatedBundesbank purchases ... totalingsomewhat more than $300million."4 That intervention shows that autonomouschanges in private supply and demandconditions did not alone end the declineof the dollarin July and cause the partialrecovery sincethen. Furthermore,they did not do so with the unsupportedhelp of privateresponses to the narrowingof differencesin interestrates between the United Statesand Germany,although those must have been a factor. Some adjustmentof portfoliosis probablyinevitable, for there is little doubt that the relativeeconomic and politicaldominance of the United Statesin the worldhas diminished.In this sense, those who think that the long-runshrinkage of U.S. hegemonysuffices to explainthe deterioration in the priceof the dollarare probablyright, even though they almostnever establishthe connectionbetween this generalizedcause and the mundane movementsin the foreignexchange market. Because general recognition of this long-runchange appears to back up projectionsof past lossesby hold- ers of dollars,I assumethat a desireto makelong-term shifts out of dollars is a force now at work. Nevertheless,I also doubt that decisionsinvolving massive amountsof dollarshave been irrevocably taken. It is farfrom clear (to me, at least)that the decreasein U.S. powerwill be greatenough to inducea massivelong- run reductionin the proportionof assetsheld in dollars.What currencies, afterall, arelong-run competitors? I doubtthat any singlecountry outside the communistbloc will succeed to a predominantposition in the near future.The United Statesstill providesthe most competitivecapital and financialmarkets, and that fact contributedto the demandfor dollarsas a currencyin which to conduct transactionsand to hold wealth in liquid forms.This advantagewas gravelydamaged by the second traumaticde- valuation,but probablycan be largely, if not wholly, regainedin time. Althoughsome regardGermany as a strongcandidate, an equallylikely competitor,in my view, is an aggregationof countries-the European Communityled by Germany;but the conflictswithin the communityand the continentaldislike of keen competitionamong financialinstitutions makeit doubtfulthat any of its currencies,including the still hypothetical

4. See CharlesA. Coombs, "Treasuryand FederalReserve Foreign Exchange Opera- tions," FederalReserve Bank of New York, MonthlyReview, Vol. 55 (September1973), p. 217. 496 Brookings Papers on Economic Activity, 2:1973 unifiedcommunity currency, will succeedto the positionformerly held by the dollar. I conclude,therefore, that althoughsome shiftingout of dollarsis in- evitable,the size of the shifts still hangs in the balance, and will depend heavily on unfoldingevents, includingpolicy decisionsby the U.S. au- thorities. Discussion

LAWRENCE KRAUSE EXPRESSED doubts that the expertswere agreedin February1973 that the dollarwas undervalued.Nor did he believethat the case for such a verdicthad been compelling.Enormous uncertainties sur- round any estimatesof the long-runequilibrium value of the dollar. The exchangemarkets in recentmonths have reflectedthese uncertainties;and Krausethought that it was verydifficult to second-guessthe market.While FrancoModigliani agreed with Krausethat the exchangemarket provides a measureof the "warrantedchange" in a currency'svaluation, he under- lined the possibilityof destabilizingspeculation in the short run. He felt that the sharpnessboth of the declinein the dollar'svalue during the spring and of its subsequentrebound implied that such forceshad been at work. He pointedto the desirabilityof interventionby centralbanks in exchange marketsto containthe impactof suchspeculation in the future.Modigliani felt that a limitedamount of suchintervention could help a systemof float- ing exchangerates work more effectively. WilliamBranson expressed basic agreementwith Salant'sviews on port- folio shifts. It seemed quite plausiblethat world traderswould want to diversifytheir portfolios into a widerrange of currenciesbecause of greater uncertaintyabout exchangerates. But he was skepticalthat such adjust- ments would take anywherenear the three years Salantimplied, in view of earlierstudies of his own that had found fairlyshort lags in the flow of liquid capital.Alan Greenspanadded that portfolio adjustmentsmay al- readyhave passedtheir peak as an influenceon exchangerates. Much of the overhanghad been createdthrough massive interventionby central banksacting to supportthe dollarin the past. He felt it was importantthat suchmistakes not be repeatedin the event of some temporaryweakness of the dollarin the future.Barring such mistakes, he felt the worstmight well be over in termsof shifts away from the dollar. WalterS. Salant 497 Modiglianipointed out that any expected appreciationof the dollar would add to the total expectedreturn from dollar holding,thus slowing down the dishoardingof dollars.He and Fred Bergstenstressed the possi- bility of consolidatingexcess dollar holdings (for example,in the Inter- national MonetaryFund) as a way of both containingdownward pres- sureson the dollarand increasingstability in exchangemarkets. Severalparticipants mentioned other factorsthat might operateto hold downthe internationalvalue of the dollar.Branson noted that a declinein U.S. interestrates relative to those abroadcould have importanteffects in that directionduring the monthsahead. David Fand suggestedthat expec- tationsthat U.S. investmentcontrols might be relaxedand that American citizensmight be allowedto hold gold could be exertingdownward pres- sureon the dollar'sexchange rate. Bergstenstressed the greatand growing competitionof the deutschemark with the dollar as a majortransactions and reservecurrency. He noted that the markhad surpassedsterling as the secondleading reserve currency and now absorbedover one-fourthof the transactionsin the Eurocurrencymarket. Moreover, German exports now exceed U.S. exports.He concludedthat the mark was a "dominantnew force" in internationalfinance, and that shifts into it were likely to gen- eratecontinuing downward pressure on the dollar. A numberof participantscommented on the relationshipbetween ex- changerates and domesticinflation. William Poole wonderedwhether ex- changemarkets were reflectinga belief abroadthat, in view of its record sincethe mid-sixties,the United Statesis unlikelyto containinflation in the years ahead. Modiglianiand Bransonemphasized that the United States has not been more inflationarythan its trading partners,although, as WilliamFellner pointed out, U.S. export prices have risen more rapidly than those of Germanyand Japan.Murray Weidenbaum suggested that inflationmight be more tolerableto the public in countrieswith rapidly risingreal incomesthan it was in maturecountries like the United States. He felt that a growingreaction against inflation has recentlybeen revealed in the politicalprocess and that that reactionmight exert more influence on U.S. policiesin the future.