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Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
Conference of the
"Zeitschrift fuer das Gesamte Kreditwesen"
Frankfurt, Gennany
Friday, November 10, 1978


Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
Conference of the
"Zeitschrift fuer das Gesamte Kreditwesen"
Frankfurt, Germany
Friday, November 10, 1978

The world business cycle is passing through a phase of great
significance for the world economy and the functioning of the inter­
national monetary system.

The growth rates of the U.S. economy on

one side and most industrial countries on the other have been converging
Until not long ago, the United States was expanding at a rate above its
long-run potential, while most other countries were expanding well below
their potential . According to many projections, we are entering a
phase in which the rate of growth of other industrial countries will,
on average, exceed that of the United States.
What we are witnessing is a dissynchronized world business
cycle, a condition, in other words, where national cycles are out of phas
with each other.

Much of the turmoil that we are observing in the world

today can be traced to this dissynchronization.
Before examining what a dissynchronized business cycle has
done to the world, however, we should remember the experience we had
with the previous cycle, culminating in 1973-74, which was almost


perfectly synchronized.

All major countries, at that time, were moving

in step and were then operating at peak capacity.

Widespread shortages

There was no way in which excess demand in one economy could

be compensated by excess supplies in another.

Consequently, competing

buyers drove up prices mercilessly all over the world.

When the bubble

burst, inventories were excessive, orders vanished, and, with the
additional burden of a quadrupled price of oil, a severe recession
became inevitable.

It was then that the thought took hold that if the

world economy were to continue to be cyclical, as it has been for 150
years or more, somewhat less synchronization would be helpful.


and valleys would be smoothed out, shortages in one country could be
overcome by excess supplies elsewhere, the danger of a severe recession
greatly reduced.
That wish has been granted.
selves in a dissynchronized expansion.
them to be?

Five years later, we find our­
Are the results what we expected

Let me begin with the good features, which do not seem to

have attracted a great deal of attention.

The United States, and most

other industrial countries, are now almost four years beyond the trough
of the recession as it was recorded in the United States in early 1975.
Continued*expansion is expected in the United States at about its longrun potential rate of 3 - 3-1/2 per cent.

Other economies, after some

slow starts and a few relapses, are now growing at somewhat faster rates.
Given that historically the length of cyclical expansion, at least in
the United States, has been 2-3 years, the longevity of the present
expansion is a distinct achievement in no small measure probably attributable
to the dissynchronized pattern of the present cycle.



The dissynchronized pattern, however, has not been particularly
favorable to the functioning of the international monetary system.


reason is that dissynchronized behavior produced imbalances of trade
which affected exchange rates.

These, in turn, affected rates of

inflation which reacted back on exchange rates.

Moreover, as the

cycle advanced, the approach to full employment generated inflationary
pressures in some countries while excess capacity still was
pushing down inflation elsewhere.
During the present cycle, it was the United States that was
leading in cyclical phase.

The United States, therefore, found its

imports rising rapidly while its exports were lagging and a large
current account deficit developed.
slowly, had the opposite experience.

Japan and Germany, expanding
Some countries fell in between.

The ensuing divergent pattern of deficits and surpluses set
in motion exchange rate movements which in turn began to influence price

The declining exchange rate contributed to inflation in

the United States.

Rising exchange rates in Germany, Japan, and

Switzerland helped to reduce inflation there.

The inflation differential

further weakened the dollar while the currencies of countries in strong
surplus strengthened.
Meanwhile, as the United States economy began to approach
the full-employment zone, renewed price pressures began to make themselves

Previously, the United States had succeeded in bringing inflation

down from a peak of around 12 per cent in 1974 to the 5 per cent zone
shortly following the 1974-75 recession.

More rapid expansion, however,


and policies supporting this expansion, as well as the institutional
peculiarities of U.S. collective bargaining, kept inflation from
falling further.

A declining dollar and mounting economic activity

caused U.S. inflation to reaccelerate from the 5-6 per cent range
after a period of perhaps two years during which it had remained
relatively constant.
In the countries whose economies were lagging, an opposite
pattern occurred.
down inflation.

Maintenance of substantial slack helped to bring
Policies designed to accomplish this objective were

supported, in the case of Germany, Japan, and Switzerland, by a rise
in exchange rates.

The latter, in turn, responded both to a movement

toward current account surplus and to diminishing inflation.

In this

way, the leading industrial countries developed sharply contrasting

Some countries fell in between, suffering both high inflation

and slow growth.

These eventually found themselves compelled to

restrain their economies in order to remove current account deficits
which threatened further exchange rate depreciation and inflation.
It is noteworthy that during this period of contrasting move­
ments, some features of the separate economies involved came into good
alignment, while others did not.

In the major countries, interest rates

came roughly into alignment with rates of inflation.


countries had low interest rates, countries with higher inflation had
higher rates.

Particularly among the United States, Germany, Switzerland,

and to some extent Japan, differences among rates of inflation were



roughly equal to differences among interest rates.

Real interest rates,

that is, nominal interest rates adjusted for current inflation rates,
were not very different among these countries.

Where nominal interest

rates were high, they nevertheless were, if not negative, at most
barely positive in real terms.
Exchange rates, on the other hand, behaved very differently.
For the most part, their movement failed to reflect nominal interest
rate differentials, frequently exceeding these differentials very sub­

Likewise, exchange rate changes were greater than needed to

reflect the change in purchasing power.

Over prolonged periods, exchange

rates, especially for the dollar, the yen, and the Swiss franc, but
only to a lesser degree for the DMark, very considerably under- and over­
shot exchange relations based on relative price movements.
For the behavior of exchange rates, and the associated behavior
of current account deficits and surpluses, a variety of factors may be
held responsible.

One of them is the well-known J-curve phenomenon.

An exchange rate movement that, over two or three years, may be expected
to bring about greater balance in the current account, may in the short
run produce the opposite effect, or perhaps a delayed effect.


volume of exports and imports does not respond instantaneously to
changing prices and/or exchange rates.
more favorable exchange rate —
less favorable rate
full effect.


It takes some time before the

for the depreciating country —

for the appreciating country —

and the

can have their


A similar J-curve phenomenon may occur in capital markets,
although it has been less clearly demonstrated in that context.


rise in interest rates may be expected to attract capital to the country
where it occurs.

A rise in interest rates, or the expectation thereof,

has an adverse effect upon long-term financial and real assets.


the stock market, and perhaps other assets tend to decline as interest
rates rise.

The capital losses that investors could sustain from such

moves can far exceed any gains that would accrue to others from investing
at the new rates.

While asset markets seek to establish a new base,

therefore, the effect of rising interest rates is not necessarily to
attract capital to the countries where the rise occurs.

If investors

move abroad during this period, the exchange rate may suffer.


an adjustment has taken place, of course, the widened interest
differential may well produce a much enlarged inflow of capital with
attendant consequences for the exchange rate.
All this demonstrates that in a dissynchronized expansion,
considerable pressures are likely to converge upon the international
monetary system.

Exchange rates may undergo movements that do not

necessarily correspond to their values in any long-run equilibrium.
For that reason, it is perhaps not exclusively of historical interest
to inquire how a dissynchronized business cycle would have fitted into
the precepts of the old Bretton Woods system.

That system was exposed

to dissynchronized cycles only rarely and in moderate degree, such as
in 1958-59 and the latter half of the I960*s.

The prevailing view in


-7those days was that "when the United States catches cold, the rest
of the world catches pneumonia."

This implied a cycle led by, and

synchronized with, the United States cycle.

Nevertheless, the

Bretton Woods system had one clear standard that could have been
applied to a dissynchronized cycle:

Under the Bretton Woods code,

only fundamental disequilibrium could justify and require an alteration
in exchange rates.

A cyclical disequilibrium, absent other sources

of imbalance, was to be ridden out.

The ensuing current account

deficit was to be financed and dealt with by other adjustment
measures, but not by exchange rate depreciation.
In recent years, market forces have told us that the Bretton
Woods prescription would probably not have been adhered to had it still
been in effect today.
around rather sharply.

They have told us this by moving exchange rates
The world has fared better under floating rates

because in all probability it has been spared a series of exchange rate
crises that could have provoked counterproductive controls on capital

But the Bretton Woods precepts are not without their lesson.

They remind us that there is a difference between a cyclical and a
fundamental disequilibrium.

That difference, of course, was never

No one would argue that the disequilibrium experienced by

the world today is purely cyclical.

For the United States, it is over­

laid by the problem of oil imports.

For Germany and Japan, it is over­

laid by a variety of structural changes.
for numerous other countries.

Something similar could be said


But the cyclical component is important, and the Bretton
Woods precept that cyclical movements should not give rise to
permanent exchange rate changes should not be altogether forgotten.
Nor does today's floating rate system, to which there appears to be
no practical alternative, relieve us of the need to take adjustment

"Adjustment" was one of the key words of the Bretton Woods


Its successful implementation frequently eluded us, and

the Bretton Woods system came to an end.

But the need for adjustment

has remained under the system of floating exchange rates.
Contrary to the views frequently expressed before floating
began, floating exchange rates do not allow a country to adopt any kind
of domestic policies that it chooses.

A country that were to ignore

the effect of its policies upon inflation and upon its exchange rate
would quickly discover, from the behavior of both, the limits of its
freedom of action.
The United States has been very conscious that the value of
the dollar depends on its domestic policies and that the value of the
dollar is enormously important for its domestic well-being and for its
international economic and political relations.

A number of actions

attest to this.
First, the United States has brought its cyclical expansion
to a soft landing at a rate of growth consistent with its long-term
growth potential.

This was accomplished by a reduction in the budget


deficit which in 1976 stood at $66 billion.

Early this year, the budget

deficit for fiscal year 1979, which began October 1, 1978, was still
projected at $60 billion.

Now the deficit for fiscal year 1979 is

expected to be less than $40 billion.

It is recognized that such a

deficit is still too large for a fully employed economy, and a reduction
to $30 billion is expected for 1980.
Second, the Federal Reserve has tightened monetary policy, by
seeking to limit the growth of the monetary aggregates.

While the target

for Mi (currency and demand deposits) of 4 - 6-1/2 per cent has been
overshot by approximately 1.5 percentage points, it should be recognized
that the M^ target was extremely modest, considering that nominal GNP
was expected to rise at a rate of 11 per cent.

The Federal Reserve is

aware of the need for adequate monetary restraint.

Recent increases

in the discount rate, the latest by a full percentage point to an
unprecedented level of 9-1/2 per cent, as well as in the Federal funds
rate, which is the principal focus of impact of Federal Reserve policy,
attest to this.

So does the increase in reserve requirements on large

time deposits by almost $3 billion; the successful achievement of our
targets for M£ (M^ plus bank time and savings deposits other than large
negotiable CD's) and Mg (M2 plus deposits in thrift institutions) also
is evidence of a policy of restraint.
Third, the United States has instituted a program of wage and
price restraint.

While the program is voluntary, it does not lack

means of enforcement, through the procurement mechanism and through



the action of regulatory agencies that set prices for certain regulated

The use of the tax system to encourage wage restraint,

through a real wage insurance, is also being proposed by President
Fourth, the United States has finally enacted energy legislation.
A great effort in intensifying conservation of energy and developing
substitute sources for oil and gas is still ahead of us.


it should be noted that increases in the price of energy have been
proportionately no less than in most other industrial countries.


have gone less far only because they started from a generally much
lower level.

The response of U.S. consumers and particularly of U.S.

industry to higher energy costs has been about the same as abroad.
Fifth, the United States has also instituted an export promotion

The United States is a relative latecomer to export promotion.

That practice has been employed far more energetically for a long time
by some of its competitor countries, including some that today are
concerned about their own large surpluses and about the U.S. deficit.
These concerns could be eased if more effective agreements could be
arrived at to restrain competition in.export promotion.

The United

States has been trying to promote such agreements.
Finally, to support its policies, especially the President's
wage and price program, the United States also has strengthened its
capacity for intervention in the exchange markets by putting in place
a package of $30 billion of foreign exchange resources, including
sale of SDR, drawings on the International Monetary Fund, sale of



foreign currency obligations by the Treasury, and enlargement of swap
facilities on the part of the Federal Reserve.
sales beginning December was also announced.

An increase in gold
The United States

expressed its determination to intervene, in cooperation with the
governments and central banks of Germany and Japan and the Swiss
National Bank, in a forceful and coordinated manner in the amounts
required to correct the situation in the exchange markets.
Under the impact of these policies and developments, the
U.S. current account deficit today gives promise of substantial reduction
over time.

Econometricians have estimated that the full effect of the

cyclical gap between the United States and the rest of the world accounts
for something like $10-20 billion.

That is to say, if the entire world

were to move to full employment, the U.S. current account, which
amounted to about $20 billion over the last 12 months, would be
reduced by that order of magnitude.

It has also been estimated that

every percentage point of depreciation of the dollar, after adjustment
for inflation, i.e., in real terms, should reduce the deficit by
$750 million to $1 billion over a period of two years.

The dollar

has depreciated, in real terms, about 12-15 per cent over the last
18 months which again would imply a substantial reduction in the

An improvement of 30-40 per cent is a reasonable expectation.
These developments should help the international monetary

system to regain a much greater measure of stability than it has
recently shown.

Universally it is recognized that the stability



of the system can only be attained by greater ¡stability of the fundamentals.
Actions in that direction are now under way in all countries.
In addition, evolution is progressing along two lines.


Europe, action is afoot to create an area of monetary stability among
countries willing to achieve a sufficient convergence of their policies
to be able to sustain among themselves a system of fixed though adjustable
exchange rates.

Within the membership of the International Monetary Fund,

arrangements have been put in place for surveillance of members' policies
with respect to exchange rates and with respect: to domestic policies
affecting the exchange rate system.

The European effort, if designed

properly, can make an important contribution not only toward the
stability among the countries concerned but also toward the strengthening
and stability of the international monetary system and to the central
role of the IMF within that system.
These developments characterize the present state of evolution
of the international monetary system.
gradual change must be expected.

The system cannot be static, and

The system must be capable of dealing

with both synchronized and dissynchronized cyclical developments.


will best be able to accomplish this task, the advantages and
difficulties of which I have tried to set forth here, if evolution
proceeds in an environment of international cooperation and freedom
of movement for goods and capital.