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 they aremore 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