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The War against Terrorism: Implications for the International Financial System

Brief Questions and Proposals regarding U.S. Measures
to improve National and International Economy


B. With the strong dollar policy in mind, imagine that Secretary O'Neill advisers are considering the following possible measures:

  • If the terrorist attacks should continue, capital flight from the United States could weaken the dollar and the economy. If that occurs, the U.S. government could impose controls on outgoing foreign investment.

  • To restore confidence in the economy, the Treasury Department should order the Federal Reserve Board to expand the money supply.

Indeed this possible consequence of the terrorist attacks might bring capital flight from the U.S., causing various negative effects on domestic economy.

What is likely to occur right know is that several private persons, national and international companies, governments and other investors could take their capital out of the U.S. because of the uncertainty within the local market, which translates into economic instability, moving them to take their money to foreign markets with strong currencies, where they can have better interest rates, such as in the case of the "euro" in Europe. This extreme action could easily create an aggressive devaluation, lethal effect for the U.S. currency. This attitude confirms the fact that lowering interest rates, as is currently happening in the U.S., can surely help the domestic market but can affect international markets; another direct effect would be, for instance, on bonds.

We consider that these measures the U.S. government could impose to control outgoing foreign investment are perfectly legal within the U.S. economic system. Of course, these actions should be temporary until adjustments are done, until confidence in the economy is restored.

The U.S. Treasury (Treasure Department) and the Federal Reserve (FED) can take whatever measures are necessary to prevent those actions that could weaken the dollar and the economy. Some moves that are been already taken by the FED include the lowering of the interest rates and the expansion of the money supply. This last action consists basically in the extension of credit by the banking system. In this particular case, if the supply of dollars increases, its value tends to decrease or fall, unless more demand is introduce. That's why the U.S. authorities should pool together diverse policies to make their currency stronger, encourage demand among its citizens by providing lending facilities and revive economy.

Some other legal measures already undertaken by the Congress and the Bush administration are (1) approval of substantial increases in government spending and (2) approval of a second round of tax cuts.

Regarding the implications of the "strong dollar policy" in the international arena, we consider it's perfectly allowed by international law. In this way, Article VI, Section 3, of the Articles of Agreement of the IMF allows governments to restrict capital movements as they see fit, that is, as they consider it necessary for their economical purposes and adjustments. In this case, the U.S. is imposing controls on outgoing foreign investments, forcing for instance U.S.-based corporations and investment funds (mutual funds, retirement funds, etc.) to apply to the Treasury for a license in order to be permitted to transfer capital abroad. The IMF is flexible in these situations, but they impose a requirement, which is to approve any restriction on the making of payments and transfers for current international transactions (these include exports and imports of goods and services). This IMF guideline confirms one of its principal functions, which is "to promote a liberal regime of international payments".


2. One of the dangers of the current crisis involves the uncertainties that exist over the possibility of future terrorist attacks. In financial markets, uncertainty generally translates into market volatility; even the most hardened economic decision - makers can react emotionally to events such as these, and once investors lose confidence in a currency, the decline in value of the currency can be unstoppable. Concentrating on the foreign exchange markets, what can the United States and its allies do to prevent, as much as possible, exaggerated swings in the foreign exchange markets? What means can they use to accomplish this?

As we mentioned before, measures like the Swap Agreement between the U.S. Federal Reserve Board and the European Central Bank (ECB), adopted on September 13, 2001, immediately after the attacks, are the ones necessary to stabilize international exchange markets. This important step was taken to provide liquidity and facilitate the functioning of international banks. Thus, both systems exchanged $50 Billion of dollars per the same amount in Euros, so that the ECB could provide national banks of the Euro system with necessary amounts in dollars to respond to their diverse U.S. operations.

One of the huge problems during uncertainty periods caused by specific conflicts within countries is instability it causes on exchange markets. Nations are obliged to work together on these matters in order to avoid serious financial crisis all over the world. After the incidents on past September, there have been multiple proves of support for the United States and world economy, the commitment of the IMF to maintain a stable exchange market after the attacks, monitoring the situation, assuring the membership that it will stand ready to assist its member countries as appropriate. They also stated that despite the human tragedy, these terrible events would have only a limited impact on global economy and the international financial system.

As we saw under Article IV of the amended Articles of Agreement, states are free to adopt any exchange regime they choose, as long as it its notified to the IMF, so that they can follow certain surveillance over these states, in order to keep stable foreign exchange markets. A good example of past measures adopted by the U.S. to support its currency was President Carter's actions back on 1978, when several problems arose regarding the dollar, making it very unstable. Therefore, it began devaluating after diverse factors and the U.S. government, very criticized both at home and abroad because of their weak moves to avoid possible swings in the foreign exchange markets, directly affected in this case, announced a change in their policy and a massive intervention in both the foreign exchange market and to support the dollar.

Several drastic measures were done, such as:

  • Usage of a package of 3 Billion dollars worth of marks, yen and Swiss francs drawn from the IMF, plus the proceeds of the sale of 2 billion dollars worth of IMF SDR´S;

  • The federal rediscount rate was raised by a full point, form 8.5 to 9.5 percent;

  • The U.S. issued 10 billion dollars worth of securities denominated in foreign currencies, known as Carter Bonds.

These measures undertaken by this former administration were clear signs that the U.S. had the determination and the resources to support its currency, also playing a decisive role in foreign exchange markets.

Other important mean used back in the 1970´s crisis, and that could be use to accomplish this prevention of exaggerated swings in the foreign exchange markets, was the purchase of dollars in the New York market by the Federal Reserve, in coordination with purchases of dollars by the central banks of West Germany, Switzerland, and Japan in their home markets, and also in New York. What its really relevant here is that buying dollars can effectively lower the dollar supply all over the world and raise its value significantly, contributing directly to the dollar's strengthening.

Its interesting to consider that, other measures such as higher interest rates and tight money, despite exclusive U.S. policies, could likely help to strengthen the international position of the dollar, and therefore, the exchange markets, but it could have the adverse consequence of unemployment in the U.S. That's why these measures should be implemented carefully, trying to keep a fair balance on its effects.

The Group of Seven (G-7) also constitutes a great tool by which the U.S. and its allies can prevent exaggerated swings in the foreign markets. This important body was created in 1975, and it's considered the only group of most industrialized nations concerned with global financial stability. Presidents of these nations meet each year to discuss financial stability issues and their resolutions have a great political weight.

After several meetings, the G-7 proposed the creation of a special body with the specific intention to improve co-ordination and the exchange of information between the various authorities responsible for financial stability, the so-called Financial Stability Forum (FSF), established in 1999. Through these institutions the most important objective should be to standardize capital controls, definitively a adequate measure to bring stability to foreign markets.

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