HOW far will the dollar fall and how much damage will it do to the world economy? These questions will not be answered in Washington, London or Wall Street. Instead, the outlook for currencies and their impact on the world economy now depends largely on the policies of the European Central Bank.
Although the mantra of Europe and Asia is that America “must do something” to stabilise the dollar and curb deficit spending, this is just hot air. Nobody who matters in Washington cares about the deficit, and following President Bush’s re-election, taxes will probably be cut yet again under the pretext of “social security reform”. But Washington’s refusal to worry about deficits is not just a matter of politics.
There is no good economic reason for US policymakers to worry about either the budget or trade deficit, as long as there is no sign of the nasty consequences that these supposedly produce, namely high interest rates and rising inflation.
If inflation or interest rates were to start climbing steeply, as they did in comparable circumstances during the late 1970s, an abrupt change in US economic policies would certainly come. But until then, President Bush is doing US citizens a favour by borrowing as much as he can at just 4 per cent from gullible foreign investors and then devaluing the dollar before he repays these debts. By devaluing the dollar ever since he became President (see graphic) Mr Bush has also helped American businesses to sell more at the expense of foreign competitors. At some point inflation may, of course, accelerate and US policy will then have to change very abruptly to avert a 1960s-style spiral of rising prices, wages and import costs. But until inflation does accelerate or the bond market panics at the profligacy of the US Government we can forget about action to support the dollar from the US.
What about does this mean for the rest of the world? Must we just grin and bear it, or maybe even enjoy the devaluing dollar by taking cheap holidays to Disney World? Or can someone else act to stabilise the dollar even if Washington defaults?
For Britain, because it is quite close to full employment, the falling dollar is actually quite welcome, since it reduces inflationary pressures and allows the Bank of England to refrain from any further increase in rates. In fact, given the relatively high level of interest rates in Britain, and the very flexible monetary management practised by the Bank, a rate cut could soon be on the cards if the pound goes on rising against the dollar.
Luckily for Britain, the recognition of this is likely to discourage the market from bidding the pound much higher, now that most investors have reached targets of about $1.90.
The other major economy with a fairly clear policy on exchange rates is China. China has stated repeatedly that it will keep its currency, the yuan, firmly linked to the dollar, at least for the time being. At some point, the Chinese may move to a more flexible exchange rate, but they will not do this under foreign pressure or in the midst of a market crisis. While the Chinese recognise the benefits of currency flexibility, they are understandably reluctant to add to financial uncertainty at a time when their domestic economy is going through a shakeout.
In any case, there is not much evidence that China’s currency is badly misaligned. China’s global current account surplus is only $20 billion (£10.6 billion), at least according to official figures. The huge acquisition of dollar reserves by the Chinese Government has been driven by inward capital flows, not by huge trade surpluses. This means the yuan could even fall, instead of rising, once the currency began to float — and capital could then flee the country. This is a risk the Chinese want to avoid at all costs, making policy changes from China almost as unlikely as moves in the US.
Turning to Japan, its top priority is to pull the economy out of a “lost decade” of stagnation. Japan is determined to avoid repeating the mistake of 1995, when a rampantly strong yen stifled a promising economic recovery . To avoid another destructive currency appreciation Japan has sold trillions of yen to the markets and bought $840 billion of US bonds.
Buying all these overvalued bonds might seem like a staggeringly stupid investment, but it has served Japan’s perceived national interests. By buying dollars, Japan (along with China, Singapore, Korea, Taiwan and other Asian countries) prevented the dollar-yen exchange rate from rising too abruptly.
Secondly, by reinvesting their reserves in US bonds, Asia helped to keep US interest rates extremely low and thus ensured that Washington’s borrowing and spending sprees could continue at zero cost. This, of course, helped the market for Asian exports.
Finally, by preventing the yen from rising much against the dollar — and by occasionally punishing speculators with aggressive and unpredictable foreign exchange intervention — Japan has also managed to divert most of the unwelcome inflows of hot money away from its own economy and the rest of Asia and into Europe, where the speculators could play into an open goal.
By diverting so much money into euros, Japan has caused the euro to rise not only against the dollar but also against the yen. As a result, Japanese manufacturers have been able to steal a march on their European rivals — a very beneficial by-product of the dollar’s uneven devaluation, since in many industries Japan’s main competitors are not in America but in Europe.The European Central Bank is the one monetary authority totally unwilling to defend its economy against the falling dollar. As a result, the eurozone has become the fall guy in the currency manipulation practised by Asia and the US. This will continue until there is some kind of policy change.
We have already established that policy changes in the US or China are out of the question. A shift in Japanese currency policy might be just conceivable if Europe and America applied concerted pressure on Tokyo to stop manipulating the yen. But it is far from clear that Washington would want to do this, since Asian currency manipulation helps to keep US rates and inflation down.
Realistically, the only plausible policy response to the falling dollar must come from Europe itself. Not only could Europe intervene in the foreign exchanges as aggressively as the Japanese, which would at least level the playing field between the euro and yen. But Europe has another more potent weapon, not available to Tokyo: it could cut interest rates.
An ECB rate cut would have an electrifying effect on markets where most investors already believe that the euro is dangerously overvalued and buy it only because it is the one major currency not defended by its central bank. An aggressive ECB move would therefore send an avalanche of money out of the euro into both the dollar and the yen. A rate cut would also rekindle the recovery in house prices and consumption which was gaining momentum before the summer, but fizzled out largely because of a collapse in exports.
By boosting European consumption as well as exports, an ECB rate cut would rebalance the global economy. It would be warmly welcomed not only by Europeans but also by Americans, Japanese, British and the Chinese. In the absence of policy change, global currency misalignments will become even more extreme. At some point, the euro will become so overvalued that it becomes the currency of a continent going bankrupt. It will then collapse. If the ECB sticks to present policies, this point may be quite close.
