The American Dollar And The World Economy

In the 1980s Americans faced the problem of an overvalued dollar, which priced many U.S. goods out of international and domestic markets, and widened the U.S. trade deficit.

But an undervalued dollar also has costs for the U.S. economy. The costs became obvious in the late 1960s, during the Vietnam War, when heavy purchases of relatively inexpensive foreign goods -- and increased foreign and military aid -- caused many dollars to flow out of the country. As dollars became readily available, the dollar's value declined significantly on the world's foreign exchange markets. U.S. economists deplored this decline in the purchasing power of the dollar because it tended to exacerbate inflation.

The problem of coping with inflation and variation in the dollar's value, as well as the generally volatile nature of the world economy, has led many observers to call for adjustment or reform of the world monetary and financial system. Concrete efforts at reform began as early as 1944, when most of the world's leading nations sent representatives to a conference at Bretton Woods, New Hampshire. The International Monetary Fund (IMF) was established for the purpose of stabilizing national currencies. It was created with a fund of $8.8 thousand-million, of which the United States contributed approximately 25 percent.

The IMF extends short-term credit to nations that are unable to meet their balance-of-payments debts by conventional means, usually increased exports and long-term loans. The IMF expects to be paid back and can enter into consultations with chronic debtor nations in order to advise them on how best to repay their debts.

The conference at Bretton Woods also resulted in agreement to maintain fixed exchange rates between nations, but this has since been abandoned. In 1971, with the U.S. trade deficit continuing to grow, the United States proposed that Germany and Japan, both with favorable payments balances, appreciate their currencies. But when they acted, it was too little, too late. The fixed value of the dollar was abandoned and allowed to "foat," that is, to fluctuate in relation to other currencies -- with supply and demand determining its value. In the United States, prices and wages were frozen for a time, and a 10-percent surcharge was imposed on imports. The purpose was to persuade Europe and Japan to reduce trade barriers against American products.

A world conference was called at the Smithsonian Institution in Washington, D.C., to try to revive the old system. The dollar was officially devalued, and the Japanese yen and German mark were raised in value. When the U.S. trade position still did not improve enough in 1972, the fall of the dollar was made official, and the world reverted to floating exchange rates.

Some economists argue that more potent methods must be used to correct long-term and deep-seated trade imbalances. Two of the more popular ideas have been the use of somewhat flexible exchange rates and Special Drawing Rights (SDRs). Somewhat flexible exchange rates represent a compromise between the days of rigid (and usually outdated) exchange rates and the post-Smithsonian free-floating situation, where supply and demand can cause extreme fluctuations in a currency's value. One proposal for a system of somewhat flexible exchange rates calls for establishing a "target zone," in which each currency could fluctuate by a certain maximum amount, perhaps 1 percent or 2 percent a year.

Special Drawing Rights (SDRs) are what is known as "paper gold." Limited supplies of gold relative to the world money supply, along with the fall in value of the dollar (which, as the world's strongest currency, had been used in lieu of gold to pay for international transactions), have led to the need to find an alternative. The IMF has responded by agreeing to create paper gold and distribute it to member nations in proportion to the amount of their subscription to IMF funding. Some poorer nations hope that the IMF will allow them a share of SDRs based on need that is out of proportion to their economic size.