Speculation and the dollar in the 1980s.

Author:Quinn, Stephen F.

With the end of Bretton Woods in the early 1970s, the market for foreign currency grew rapidly in both size and instability. The liberalization of capital flows that followed the adoption of floating exchange rates brought vastly larger flows of capital between nations. Though reliable market-specific data are difficult to find, if the explosion of the Eurocurrency market over the period is indicative, monthly Eurodollars issued to U.S. addresses alone rose sixfold from $8.2 billion in January 1975 to $52.2 billion in January 1980.(1) Five years later, the total was up to $95.9 billion. By 1989, the average daily value of foreign currency transactions (based on April of that year and on net of double counting) was around $640 billion, sufficient to finance world trade more than 35 times [BIS 1990, 208-211].(2)

Our goal is to identify the lasting effects of this transformation of the exchange market. In particular, we consider the impact on three areas: social provisioning, U.S. public policy, and economic theory.(3) We conclude that though the first two were affected, it was really in terms of revisions to neoclassical explanations of currency price determination that the events of the 1980s still manifest themselves. Because theory dictates the nature of choices available to policymakers, we view this development as particularly significant.

Exchange Rates and International Capital Markets in the 1980s

The adoption of floating currencies and the relaxation of capital controls in the 1970s and 1980s led to an increased variance in exchange rates. This volatility was not simply of the hourly and daily variety, but occurred over months and years. The end of Bretton Woods did not bring a new plateau of consistent long-term exchange rate variance; rather, the volatility itself was volatile [ILLUSTRATION FOR FIGURES 1 AND 2 OMITTED].(4) The most important factor in bringing about this instability was the increasing size of the international asset market. Beginning in the 1970s, the dominant international transaction became a volatile movement of portfolio capital, rather than more staid trade or direct investment [Walter 1991, 197].

The increased importance of international portfolio capital was promoted by increasing demand, increasing supply, and policy changes. On the demand side, the general slowdown in world growth rates caused funds to move out of the real sector in search of higher returns [Walter 1991, 202]. This process accelerated when the OPEC oil embargoes generated unprecedented wealth in search of international returns [Sarver 1988, 24-28; Johnston 1982, 20-21; Walter 1991, 202]. And when flows of OPEC funds receded in the 1980s, the United States became a large consumer of European and Japanese investment [BIS 1986, 7-8]. Adding to this was the spread of multinational corporations [Park and Zwick 1985, 16-17].

On the supply side, major innovations reduced the cost of many international transactions by more than 90 percent from the 1960s to the 1980s [BIS 1986, 4]. Advances in telecommunications greatly reduced the cost of international commerce and so expanded the scope of global financial markets. Similarly, rising computing power increased the ability to design, price, and monitor derivative instruments [BIS 1986, 181]. Clearinghouse-based exchange markets, like the Chicago Board of Trade and the London International Financial Futures and Options Exchange, lowered the transaction costs of currency derivatives by standardizing contractual forms and offering liquidity-enhancing offsets.(5)

Finally, government liberalization of markets also contributed to the growth of international capital flows. Interestingly, this process actually started during the Bretton Woods era [Harvey 1995]. Although Reagan/Thatcher policies certainly contributed to the events of the 1980s, they were largely an extension of earlier trends.

Social Provisioning

When studying economic phenomena, institutionalists are drawn to ask whether an institution encourages social provisioning or predation. As suggested in the previous section, the majority of exchange market activities in the 1980s was oriented toward portfolio capital management. While international trade and direct foreign investment tend to lead to increases in employment and output, the effect of short-term capital flows is not clear.(6) The issue at hand, then, is whether the massive growth in short-term portfolio capital flows, which was both cause and effect of the exchange market transformation in the...

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