Sunday, December 8, 2013

1968-1982 Secular Bear Market was Caused by High Inflation, the Fed Tightening Cycle, Currency Crisis ("Nixon Shock"), and Oil Price Shocks

In 1944, the Bretton Woods agreement made the U.S. dollar the world's reserve currency at fixed exchange rates and it was linked to gold at $35 per ounce. But less than three decades later, to deal with a balance-of-payments crisis, trade deficit, and a potential run on the U.S.'s gold with depreciating dollars, President Nixon announced on August 15, 1971 that he was suspending "temporarily the convertibility of the dollar into gold." This event eventually led to the demise of the gold exchange standard in 1973 and created the fiat (paper) monetary system.

First, via Businessweek:
Rampant domestic inflation was mirrored, franc for franc, in markets overseas. Foreign governments intervened to buy dollars to shore up America’s currency (and their export trade). This left their central banks swollen with greenbacks. “Foreigners buying dollars caused a monetary expansion, similar to today,” says Ronald McKinnon, an economist at Stanford University. Meanwhile, America’s gold stock had dwindled to $10 billion, half its 1960 level. The gold standard now existed only in name, for foreign banks held far more dollars than the U.S. held gold. This left the U.S. vulnerable to a run.

President Nixon announced the closing of the gold window and a 10% tax on imports on August 15, 1971 (via American Presidency Project). Watch the video of Nixon's address to the nation here.
The third indispensable element in building the new prosperity is closely related to creating new jobs and halting inflation. We must protect the position of the American dollar as a pillar of monetary stability around the world.

In the past 7 years, there has been an average of one international monetary crisis every year. Now who gains from these crises? Not the workingman; not the investor; not the real producers of wealth. The gainers are the international money speculators. Because they thrive on crises, they help to create them.

In recent weeks, the speculators have been waging an all-out war on the American dollar. The strength of a nation's currency is based on the strength of that nation's economy--and the American economy is by far the strongest in the world. Accordingly, I have directed the Secretary of the Treasury to take the action necessary to defend the dollar against the speculators.

I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States.

Now, what is this action--which is very technical--what does it mean for you?

Let me lay to rest the bugaboo of what is called devaluation.

If you want to buy a foreign car or take a trip abroad, market conditions may cause your dollar to buy slightly less. But if you are among the overwhelming majority of Americans who buy American-made products in America, your dollar will be worth just as much tomorrow as it is today.

The effect of this action, in other words, will be to stabilize the dollar.

Now, this action will not win us any friends among the international money traders. But our primary concern is with the American workers, and with fair competition around the world.

To our friends abroad, including the many responsible members of the international banking community who are dedicated to stability and the flow of trade, I give this assurance: The United States has always been, and will continue to be, a forward-looking and trustworthy trading partner. In full cooperation with the International Monetary Fund and those who trade with us, we will press for the necessary reforms to set up an urgently needed new international monetary system. Stability and equal treatment is in everybody's best interest. I am determined that the American dollar must never again be a hostage in the hands of international speculators.

I am taking one further step to protect the dollar, to improve our balance of payments, and to increase jobs for Americans. As a temporary measure, I am today imposing an additional tax of 10 percent on goods imported into the United States. This is a better solution for international trade than direct controls on the amount of imports.

This import tax is a temporary action. It isn't directed against any other country. It is an action to make certain that American products will not be at a disadvantage because of unfair exchange rates. When the unfair treatment is ended, the import tax will end as well.

As a result of these actions, the product of American labor will be more competitive, and the unfair edge that some of our foreign competition has will be removed. This is a major reason why our trade balance has eroded over the past 15 years.

At the end of World War II the economies of the major industrial nations of Europe and Asia were shattered. To help them get on their feet and to protect their freedom, the United States has provided over the past 25 years $143 billion in foreign aid. That was the right thing for us to do.

Today, largely with our help, they have regained their vitality. They have become our strong competitors, and we welcome their success. But now that other nations are economically strong, the time has come for them to bear their fair share of the burden of defending freedom around the world. The time has come for exchange rates to be set straight and for the major nations to compete as equals. There is no longer any need for the United States to compete with one hand tied behind her back.

The range of actions I have taken and 2 Proclamation 4074. proposed tonight--on the job front, on the inflation front, on the monetary front is the most comprehensive new economic policy to be undertaken in this Nation in four decades.

Here is the Office of the Historian's take on what happened (State Department):
Under the Bretton Woods system, the external values of foreign currencies were fixed in relation to the U.S. dollar, whose value was in turn expressed in gold at the congressionally-set price of $35 per ounce. By the 1960s, a surplus of U.S. dollars caused by foreign aid, military spending, and foreign investment threatened this system, as the United States did not have enough gold to cover the volume of dollars in worldwide circulation at the rate of $35 per ounce; as a result, the dollar was overvalued. Presidents John F. Kennedy and Lyndon B. Johnson adopted a series of measures to support the dollar and sustain Bretton Woods: foreign investment disincentives; restrictions on foreign lending; efforts to stem the official outflow of dollars; international monetary reform; and cooperation with other countries. Nothing worked. Meanwhile, traders in foreign exchange markets, believing that the dollar’s overvaluation would one day compel the U.S. government to devalue it, proved increasingly inclined to sell dollars. This resulted in periodic runs on the dollar.

It was just such a run on the dollar, along with mounting evidence that the overvalued dollar was undermining the nation’s foreign trading position, which prompted President Richard M. Nixon to act.

Below is a chart comparing the year-over-year percent changes in the Monetary Base (green), Money Supply (M2, in blue), Consumer Price Index (inflation, in red), Real GDP (orange dashed line), Gold (black), and Oil (yellow) between 1960 and 1985. You can see that Monetary Base and M2 (money supply) growth kept making higher highs between 1960 and 1973 and remained elevated (with dips during recessions). And the oil price shocks only made the inflationary pressures worse.

I took out gold and oil and added the S&P 500 Index (black) to the chart (right scale).

To kill off the inflation that occurred in the 1970s and early 1980s, the Fed began a tightening cycle that sent the Effective Federal Funds rate to a high of 10.78% in 1973, 12.92% in 1974, 10.03% in 1978, 13.78% in 1979, 18.90% in 1980, 19.10% in 1981, and 14.94% in 1982 (source: St. Louis Federal Reserve).

Here's a chart showing the Effective Federal Funds Rate, the CPI (year-over-year % change) and the S&P between 1960 and 1985. It's pretty clear that the "Nixon Shock", high inflation, the Fed tightening cycle, and the oil price shocks (more inflation) kept the secular bear market going between 1968 and 1982 (black line). The S&P chart looks better in real terms.

Today the federal funds rate is close to 0% because the U.S. is still dealing with deflationary pressures from the previous crisis. And since the Fed can't go lower than 0%, the monetary base and M2 (money supply) have gone parabolic because of the Fed's QE program and deficit spending by the government.

So, going forward, the U.S. will either experience another period of asset price and debt deflation in a new recession (deleveraging the leverage from 2009), or we'll see a period of stagflation that will rhyme with the 1970s (asset price bubbles + deleveraging cycle versus inflated money). A currency crisis or protectionism could also destabilize trade, prices and the global economy.

More from the Office of the Historian:
A success at home, Nixon’s speech shocked many abroad, who saw it as an act of worrisome unilateralism; the assertive manner in which Connally conducted the ensuing exchange rate negotiations with his foreign counterparts did little to allay such concerns. Nevertheless, after months of negotiations, the Group of Ten (G–10) industrialized democracies agreed to a new set of fixed exchange rates centered on a devalued dollar in the December 1971 Smithsonian Agreement. Although characterized by Nixon as “the most significant monetary agreement in the history of the world,” the exchange rates established in the Smithsonian Agreement did not last long. Fifteen months later, in February 1973, speculative market pressure led to a further devaluation of the dollar and another set of exchange parities. Several weeks later, the dollar was yet again subjected to heavy pressure in financial markets; however, this time there would be no attempt to shore up Bretton Woods. In March 1973, the G–10 approved an arrangement wherein six members of the European Community tied their currencies together and jointly floated against the U.S. dollar, a decision that effectively signaled the abandonment of the Bretton Woods fixed exchange rate system in favor of the current system of floating exchange rates.

Finally, here's an important paragraph from that Businessweek article:
"Friedman’s prediction that, left to the market, currencies would regulate themselves with only gradual adjustments proved wildly incorrect. The dollar plunged by a third during the ’70s, and currency volatility has threatened several national economies since; in 1997, Asian and Latin American countries were wrecked by currency runs. To this day, Volcker regrets that Bretton Woods was abandoned. “Nobody’s in charge,” he says. “The Europeans couldn’t live with the uncertainty and made their own currency and now that’s in trouble.”"

This post is somewhat related to this post: PIMCO's Bill Gross Made An Interesting Point About Investing Since The Early 1970s.

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