Developments in the Early 1970s

On August 15, 1971, US President Richard Nixon announced a new economic policy that consisted of nine economic measures. The purpose of this policy was three-fold: to curb inflationary pressure, to stimulate economic activities and increase employment opportunities, and to address the balance of payment (BOP). In particular, in connection with BOP policy, the US declared the temporary suspension of the convertibility of the US dollar (USD) to gold. That this is called the “Nixon Shock” in Japan shows how shocked the country was by this announcement and the following sharp appreciation of the Japanese yen.

The suspension of the USD’s convertibility to gold was a natural consequence of several developments that necessitated a defense of the currency. After World War II, the world economy had been primarily led by the US. However, after the mid-1950s, the situation gradually changed. Japan and the European countries started to recover and even catch up with the US. Meanwhile, the US was bogged down with the Vietnam War in the 1960s; the increase in military expenditures put an enormous pressure on the US economy. The US was also suffering from serious labor disputes. The relative international competitiveness of the US economy in relation to Japan and the European nations thus declined, taking with it the people’s confidence in the USD.

Immediately after the US announcement, while European countries closed their foreign exchange markets, Japan kept its market open and tried to maintain a pegged rate system. During the following two weeks, Japan, facing mounting selling pressure of the USD, kept buying dollars, reaching an amount equivalent to 2 trillion yen (or 5.2 billion USD at that time). This amount was also almost equal to the total Bank of Japan lending outstanding to the commercial banks at that time. However, even such large-scale intervention did not achieve the intended goal and in the end major countries including Japan decided to abandon the fixed exchange rate system on August 30. Due to the intervention in the market during these two weeks, the Japanese commercial banks were left with excessive yen liquidity, so the Bank of Japan exceptionally issued promissory notes in the market and tried to absorb the excessive liquidity.

In December 1971, the G-10 Finance Ministers met at the Smithsonian Museum in Washington, DC and agreed to readjust the exchange rates and resume a fixed exchange system. Under the Smithsonian Agreement, the value of gold increased from 35 to 38 USD per ounce, a 7.89 percent increase. At the same time, all of the major currencies appreciated significantly in relation to the USD; in particular the Japanese yen appreciated from the previous fixed rate of 360 yen to 308 yen to the dollar, a 16.88 percent increase. This was the highest among the major currencies. In addition, a more flexible wide band was adopted under the Smithsonian Agreement. Under the past fixed rate regime, currencies were allowed to fluctuate only within a very narrow range of plus or minus 1.5 percent. This range was widened to 2.25 percent each way under the Smithsonian Agreement.

However, even after the agreement at the Smithsonian, the confidence in the USD was not fully restored: speculation on the possibility of further readjustment prevailed in the market and the selling pressure on the USD continued. Finally, in February and March 1973, Japan and other European nations decided to give up the fixed rate system and eventually the fixed rate regime completely came to an end. As of early 1973, the Japanese yen had appreciated to around 260 yen per dollar.

Japan’s economy had been experiencing a relatively long period of buoyancy since the mid-1960s. To avoid overheating the economy, the Japanese monetary authority started to adopt a tight monetary policy in 1969. With the slowdown of the Japanese economy, the trade surplus increased. In addition, low interest rates in the US led to an increase in capital inflow to Japan through foreign investment in Japanese securities. The short-term volatile capital inflow to Japan also contributed to widening Japan’s BOP imbalance and accumulating foreign reserves.

In early 1971 Japan’s economy had shown signs of recovery, but the “Nixon Shock” and the following Smithsonian Agreement completely reversed entrepreneurs’ sentiments from optimism to pessimism and significantly cut down exports. The Economic White Paper of the Japanese Government at that time correctly mentioned that the radical adjustment of foreign exchange rates in the early 1970s would provide Japan with an important turning point to change its economic growth path. In other words, Japan was no longer able to rely solely on the increase in exports to get out of recession.

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