Sunday, January 30, 2005
Sinking dollar could put the whole world in a skid
Posted by David Smith at 03:00 PM
Category: David Smith's other articles

In the rarefied atmosphere of Davos, amid the snow-covered Swiss mountains and the distant sound of yodelling and alpenhorn, it is easy to lose sight of more down-to-earth issues. True, the focus here tends to be on grand visions for tackling the problems of world poverty, global warming (which I shall look at soon), Aids and Africa. And, true, there has been a lot of optimism on show from politicians and business leaders on these matters. We have, however, seen plenty of occasions when words have not converted into actions.

On a down-to-earth level, there is a pressing economic question, which can be summarised, Sound of Music like, as: What shall we do with a problem like the dollar? This week’s G7 meeting of finance ministers and central bankers in London, which will be attended by the Chinese, will examine the issue. It is unlikely, however, to offer a solution.

The question was anticipated in a speech last week by Kate Barker of the Bank of England’s monetary policy committee. She has become the MPC’s resident expert on housing, having produced a report for the Treasury on the supply of new houses. But she believes that the dollar represents a bigger risk to Britain’s economic stability than events in the housing market.

The extraordinary run of economic growth in Britain, confirmed with last week’s release of figures showing a 0.7% rise in gross domestic product in the fourth quarter of last year (the fiftieth rise in a row), could in other words be blown away not by home-grown problems but by a dollar crisis. The Bank, to a certain extent, would say this. But figures from Nationwide last week, showing a small rise in house prices this month, supported Barker’s argument. And there has been plenty of backing for the dollar crisis risk at the Davos world economic forum.

Fred Bergsten of the Washington-based Institute of International Economics argues, as do others, that America’s reluctance to confront its budget and trade deficits is the big danger facing the world economy. Bergsten said: “The US deficits are unsustainable in domestic-political and trade-policy terms, as well as in international financial terms.”

Stephen Roach at Morgan Stanley, who admittedly has built a reputation for being the most bearish analyst of the American economy, agrees — and more. The dollar’s fall, on its own, will not be enough to curb America’s current account deficit — now running at an annual rate of more than $700 billion (£370 billion). Austerity, caused by a sharper rise in interest rates than the markets are assuming, will be needed. American consumers, who have raised their spending to the equivalent of 71% of GDP against a long-term average of 67%, will have to cut back. So will the Bush administration, which last week added $80 billion to its Iraq spending and $855 billion to its projected budget deficits over the next decade.

Bergsten sees the possibility of a dollar crisis “within weeks”: a combination of dollar selling by the foreign-exchange markets, coupled with the abandonment by leading central banks of their policy of accumulating dollars. Who, after all, wants to hold a declining asset? A dollar crisis, a sudden drop of 20%, 30% or 40%, could force American interest rates up sharply — the Federal Reserve being unable to ignore the inflationary consequences. This, in turn, would reinforce the risks to US growth underlined by Roach.

That’s all very relevant for America, but why should it concern us? The usual way of analysing the dollar’s decline has been in terms of its impact on Britain’s exports. Sterling has indeed risen against the dollar, if not quite to $2 to £1, and this has had an effect on exports, as the CBI noted last week. The impact of a further downward lurch for the dollar would, however, be elsewhere. A combination of a dollar crisis and sharply rising American interest rates would, for a start, hit global stock markets hard. Investors are betting on the gradualism of the Federal Reserve — a quarter-point rise every six weeks — continuing. Any change in that pattern would go down like a lead balloon.

The second big effect would be on Europe. At about $1.30, the euro is near the limit of what can be absorbed by Europe’s economies. As it is, euroland growth may be only about 1.5% this year. A dollar slide that pushed the euro to $1.50 or $1.70 would guarantee a recession in the eurozone. Britain has come through such recessions before during the 50-quarter run of growth, but a recession on your doorstep is never pleasant. The European Central Bank can — and probably would — cut interest rates from the present 2% to try and compensate, but this might not be enough.

A third effect will be on trade more generally. Currency turbulence is never good for world trade, which has been enjoying a good recovery. A dollar crisis would not only undermine that but would put at risk the important World Trade Organisation Doha trade round, on which progress needs to be made this year.

Fourth, a sharp dollar-related rise in American interest rates would change the global interest-rate climate. It would raise the spectre of inflation. There is no automatic read-across from the Fed to the Bank, but a rise in inflationary expectations would affect everybody. A sharp dollar decline, after all, marked the start of the great inflation of the 1970s.

Will it happen? For all the Davos doom about the dollar, one thing also stands out. Nobody, except perhaps the speculators, has anything to gain from a dollar crisis. Other governments do not, or central banks, or investors, or businesses.

America has become like an errant child, spending beyond its means and running up huge debts, to the despair of its parents. But confronting that might be worse than letting it carry on, at least for a while. The errant child could go badly off the rails, bringing the whole family down with it, or it could be quietly persuaded to change its ways. We have to hope for the latter.

PS: At events like the world economic forum you can see why the desire to lead burns so powerfully among politicians, like our own Gordon Brown. Tony Blair can fill a hall with 2,000 senior business people and their spouses (although I did notice a few slipping away before the end) and get flattered by Klaus Schwab, head of the forum, for his “visions, values and compassion”.

The chancellor would probably get the flattery, but he would struggle to fill the hall. Business folk understand this well. Blair is the equivalent of the chief executive, Brown is the finance director — the money man, the accountant.

It goes further. Some people at Davos probably had a vague idea that the British economy has been doing pretty well but probably most associate Britain with other things: Iraq, the war on terror, the special relationship with George Bush, and Blair himself. Many, I suspect, lump Britain together with Europe’s unsuccessful large economies.

You would have struggled, for example, to find news of Britain’s record 50th successive quarter of economic growth in the international edition of the Financial Times. Without that economic record, however, the New Labour story would have been very different and domestic policy would have been a constant struggle. Brown’s success in managing the economy, while still disputed by some readers, has given this government prolonged political life. Without it, ironically for the chancellor, Blair would be much less of a figure on the international stage.

From The Sunday Times, January 30 2005

Comments

The dollar may be about to fall off a cliff but that prompts the question: Why now?

The US trade deficit has been worsening since 1992. But the US dollar was rising against other currencies until 2002. So trade and the dollar are not directly linked. What has changed?

Between 1992 and 2002 there were a series of international problems - the Mexican peso crisis, the Asian currency crisis, The Russian Bond crisis, LTCM and 9/11. In each case the US dollar was a safe-haven currency.

But 2002 brought Enron, WorldCom, other business scandals, the bursting of the US stockmarket bubble and eventually the invasion of Iraq. Now America is the problem.

A lower dollar is hardly going to help US exports when the US has a reputation for aggressive business practice and an extremely aggressive international policy.

Although it may suit other countries to stop the dollar plummeting, the US can hardly expect further help from countries it has gone out of its way to offend. If the G7 meeting tells Secretary Snow that people won’t buy US goods because they don’t like US behaviour, no matter how low the dollar (as seen since 2002), maybe that’s the quietly persuasive message that even President Bush can understand.

Posted by: David Sandiford at January 31, 2005 07:35 AM

David - if your thesis is true, then why did investment in tUS increase last quarter?

I'd also think the G7 is kind of irrelevant since the main player in the dollar crisis is China - which isn't a member of the G7.

The reason for the why not question is simply that China now holds about a trillion dollars of US debt and there has to be some limit on how long it can sensibly keep buying up US treasuries. The dollars decline is mainly the market saying - not much longer methinks.

Posted by: giles at February 2, 2005 11:39 PM

Giles - My thesis boils down to: the trade-weighted exchange rate of the dollar isn't strongly correlated with the US trade deficit.

Therefore (a) a falling dollar won't necessarily improve the trade deficit and (b) a crisis elsewhere in the world could make the dollar rise in spite of the deficit.

However the US (or possibly the UK) looks like prime candidate for a crisis at the moment - because of its need to borrow so much from abroad.

The crisis could come from China suddenly withdrawing lending or from other 'events'.

On the other hand if there's no crisis then the deficit can continue to grow and the dollar can continue to fall for a long time. But that just makes the US more vulnerable to a sudden withdrawal of lending.

Either way, the US needs to reduce the trade deficit so that it does not depend so much on borrowing from abroad. That means exporting more and importing less.

Unfortunately the US government has not realised that exporting requires making yourself look attractive abroad. Germany's Schroder has visited China six times. How about Bush and Blair?

But America's main problem is that US consumers are borrowing excessively to spend on imports, not investment. Indeed, US companies have restored their balance sheets (apparently) and they are investing to feed these consumers - the spoilt children.

But if Alan Greenspan doesn’t reduce excess consumption soon, you’re right, the markets probably will.

Posted by: David Sandiford at February 3, 2005 10:58 AM

David, theres a good article by Kaltesky in the Times today that worth reading. Who's the sucker?

The US real trade weighted exchange rate has not fallen much recently because of the Asian currency peggs so any corection in the US deficit is going to come at the exepnse of the unpegged currency - the Euro zone which has appreciated substantialy against the dollar.

But lets think about what really going on here:- in effect China has out sourced fiscal policy to the US - they lend the US money which the US uses to buy goods from China. Neither side here seems much concerned about this for simple economic reasons - the US gets cheap goods at low interest rates and China gets to stimulates its industrial demand and thereby speed development. When/if this ends with a dollar crisis, the US simply looses a free lunch and China looses perhaps 500 billion on its treasury holdings - but since this is just book value, it may not have any direct effect on the real economy - just as Norman Lamonts loss of the UK's reserves didnt have any real economy affects.

The EUzone by contrast is likely to find itself in a bit of a pincer - the Chinese by then have developed manaufacutreing industry that can compete with Europe while the devalued US manufacturers can compete on price.

So as Anatole argues, there are the sucker is looking more and more like Europe, and its hard to see how they can get out - buy dollars? Fix the Euro to the Yuan? I dont know.

Posted by: Giles at February 3, 2005 06:04 PM

Giles, I did read Anatole's article and Europeans do appear to be in a difficult position. But which Europeans? The 90% that are in jobs have a high standard of living, low personal debts and a strong currency because of their trade surplus. It's the 10% without jobs that are suffering - although not that much because it suits the 90% to give them good benefits to avoid political unrest.

But this is a bubble situation - the arrangement isn't sustainable because of the rising cost of the benefits. However the politicians can't fix the problem by increasing employment because that would mean increased competition and lower wages for the 90%. The 90% will vote against it.

It's like the UK property bubble. Central government could fix the shortage of property by allowing some building on green land. But the house-owning majority will vote against new building, not to protect the environment but to protect their monopoly. Ironically these are the same people that thought Thatcher did a wonderful job of breaking union monopoly.

In both cases it will take a crisis before the problem can be fixed - a recession in Europe or a house price crash in the UK.

But the US is not getting or potentially getting a free lunch from China. They're buying on credit and the bill will have to be paid. If the US were borrowing to invest in advanced technology products and services that would be one thing. But they're consuming this lunch and charging it.

Of course the US can sustain some level of debt but it just keeps growing.

They can't resort to inflation because Greenspan or his successor appointed by a right-wing government will prevent it.

The hope is that by raising interest rates at a measured pace they can achieve a soft landing - a stable dollar and less borrowing.

I don't think it will work. The US won't increase exports enough or slow consumption enough and they'll just go deeper into debt.

China remains a creditor rather than a debtor and if a US dollar crisis pushed up interest rates and causes a recession in the US they can buy US assets at distressed prices.

Unless the US can increase productivity or innovate their way out of this mess, it's the end of a superpower.

Posted by: David Sandiford at February 4, 2005 04:22 AM

P.S. And the real suckers are the idiots that voted for Bush. Let's hope we don't make the same mistake with Blair. Otherwise it could be Banano Republico for us too.

Posted by: David Sandiford at February 4, 2005 09:09 AM

They're buying on credit and the bill will have to be paid.

US debt is dollar denominated so the more the dollar depreciates, the less they have to repay and they issue the debt so they set the rate - that, I think, is why there is only a limited sense of urgency about the matter from the US side. And in extremis, the point about international debt is that no it doesnt have to be repaid.

Unless the US can increase productivity or innovate their way out of this mess, it's the end of a superpower.

No I think that is a mistake: even if the dollar halves in value, the US will still account for about 25% of world GDP,5% of world population and have one of the highest levels of productivity in the world. In that respect it will continue to be a world price setter and "super power". In fact I think this is the wishful thinking that allows the ECB to keep its head in the sand. There is no quantity theory of Growth or Productivity - a depression in the US will not produce a boom in Europe, the loss of USeconmic power will not increase Europes, the loss of reserve currency status for the dollar does not mean the euro replaces it.

Secondly a trade deficit is produced simply by consuming more than you produce; the easiest way out is simply to cut consumption - changes in productivity have very little to do with it.

Finnally the real reason why I think the suckers are the ECB is that I have seen alot of articles and thought from american and asians about how this might unravel and who'll loose most. I've seen very little from the ECB, which I why I think they havent thought seriously about the matter and are most likely to be the loosers.

Posted by: giles at February 4, 2005 05:45 PM

Thanks for a lot of fascinating comments. What has struck me most in recent days is that the Chinese mean it when they say they won't be pushed to revalue. The last thing Europe needs is a further currency rise but vanity ("a strong euro is a good euro") appears to have taken over.

Posted by: David Smith at February 4, 2005 06:06 PM

The other dog that isn’t barking is that the US seems to have given up on trying to persuade the Chinese to revalue; neither the president, treasury secretary or fed have said much about it in the last six months.

I suspect that they have reached tacit agreement; the Chinese have, in effect, told the US that they intend to use domestic inflation to revalue their currency. But this also means they’ll have to keep lapping up US debt until domestic prices make the necessary adjustment.

The US has accepted this position since, in the long term, it revalues the Chinese currency and thereby (hopefully) corrects the trade imbalance while in the short term it obviously helps them fund the domestic deficit without raising interest rates too far.

While there are risks for both parties to this “deal”, most of the risk is being cast on Europe. In the short term, the risk is that the undervalued dollar and yuan will crush European industry in a pincer movement; they will be unable to compete on price at high end of the market with the US and at low end because of the undervalued Asian currencies.

In the long term the danger is that the Chinese inflation policy and US low interest rates could produce a bout of global inflation. Global inflation however tends to help international debtors (i.e.. the US) while harming creditors. Most European countries are currently running international credit positions – in part because their aging populations are saving for retirement. Global inflation could wipe these savings out at a time when Europe’s productive capacity is at its weakest. This is what the ECB should be worrying about instead of gloating about 1.3 euros to the dollar.

Posted by: giles at February 4, 2005 11:32 PM

I think Alan Greenspan had some interesting things to say on this subject at the G7 meeting on Friday.

But just to put the currency situation in context I’ve posted graphs of the traded-weighted exchange rates for major currencies here:
http://www.graphicinvestor.com/econo/US/DOLLAR/ExchangeRates.htm
(Data mostly from BoE database.)

In spite of the huffing and puffing about the euro, all that’s happened is that it has returned to the middle of its long-term range.

Sterling has been even more serene since it’s post-ERM fall and return to grace.

But you can see why the Japanese resort to intervention.

Now, how about the US dollar dancing on the cliff edge? Although it’s been falling for three years it has now reached a record low. The next move could be a vertical drop – couldn’t it?

Well, no. The final graph shows the dollar versus a broad range of currencies, as opposed to the major currencies in the graph above. On this basis the dollar seems to be heading for its level in June 1997, just before the Asian currency crisis. What goes around comes around.

Posted by: David Sandiford at February 5, 2005 04:40 AM

Alan Greenspan's speech, "Current Account", is here:
http://www.federalreserve.gov/boarddocs/speeches/2005/20050204/default.htm

Posted by: David Sandiford at February 5, 2005 05:59 AM

Thanks for the graphs but given that the Euros' only been around for a few years I'm not sure if anyone knows what its “long term” value is. And if you're going back in time, in the 70 and 80s productivity grew much faster in Europe than the US. Hence it could sustain a higher exchange rate. But now, looking at your charts tells me that the Euro has appreciated by 20% in the last couple of years - which is a large increase if you're effectively in a recession, while the dollars 20% depreciation is useful if you’re coming out of a recession. I think the better point about why it may not matter is that the Eurozone is effectively a closed economy – most of European countries trade is with other European countries.

Interesting article from Greenspan – money quote is :-

“One is the effect of Asian official purchases of dollars in support of their currencies. Such intervention may be supporting the dollar and U.S. Treasury bond prices somewhat, but the effect is difficult to pin down.”

I wouldn’t have thought that the effect was at all difficult to pin down – he knows who buying what, what effect that’s having on treasury and dollar prices etc. So in acting fairly ambivalently about the currency fixing in Asia and whether its good or bad for the US (how can it be good?) suggests to me that there’s some sort of tacit agreement between the US and china along the lines that you buy our debt and we wont kick up a fuss about currency fixing.

Posted by: giles at February 5, 2005 09:09 PM

Giles, I know what you mean about the ‘historical’ data for the euro but we’ll have to assume the BoE gave it their best guess. Although the euro has risen by 20% since 2002 the world economy has also recovered since then, so that helps. Also the trade-weighted euro is now at almost exactly the level it started on EMU day in Jan. ‘99. If the Europeans don’t like it, it’s their fault. And as you say, effectively, there’s a lot they could do to stimulate internal activity if they wanted to.

As for the US and China; the US does seem to be crying all the way to Wal-Mart. Equally, you can see that the Chinese wouldn’t want their currency behaving like the Japanese Yen over the last few years.

But what amuses me is the statement that the Chinese will adjust their currency when everyone else stops talking about it. We’ve probably put the revaluation back for weeks just discussing it here. Don’t mention the r-e-n-m-i-n-b-i. ;)

Posted by: David Sandiford at February 6, 2005 05:03 AM

"If the G7 meeting tells Secretary Snow that people won’t buy US goods because they don’t like US behaviour"

But in reality most people do not give a damn about "US behaviour" (by which of course you mean US GOVERNMENT behaviour). I do not like French government behaviour (such as supporting fascism in Iraq and Yugoslavia) but I still bought French wines because I rather doubt the wine producers had shares in Elf Aquitaine or had much say in the kick-back based policy stances that come out of Paris. The idea 'people' (other than a minority of irrelevent Guardianistas) are going to avoid US products based on any issues beyond price and quality is laughable.

Posted by: Perry de Havilland at February 21, 2005 04:47 PM

Gile, David et al,

Terrific and civil discourse, the both of you. I and hardly anyone I know voted for the imperialist in the White House, who claims to be a conservative. "Conservative" in American politics signified 'balanced budget' for 200 years, until this Harvard MBA arrived in Wash DC.
Unfortunately, Greenspan is not much better, as he told George to cut taxes (arguably necessary after the recession of 2000-2001, but they should of been followed in 2002-2003 by an increase in taxes and a reduction of federal expenditures thereafter) to rid the government of the 'peoples money'. Now, with the same mouth he says deficits are unsustainable ? Quickly forgetting what he advised merely three years earlier.
George and Dick truly believe in the free lunch principle, as Dick eluded to in a recent interview ("Reagan proved deficits don't matter"), as well as the foolish notion that a devaluation of the dollar will lead to a rebound in the manufacturing sector, as if the US can compete on the world stage in ALL forms of manufacturing, which at her stage of economic development is little more than wishful thinking.

Our greatest strength and contemporeaneously our greatest weakeness is a complete and utter lack of collective memory.

William

Posted by: William Woodruff at March 12, 2005 03:59 AM

is us really concerned about fall in dollar value?why did china all of a sudden showed the liberty to float the currency and malaysia did the same thing mean time. i think there is more reasons to this. if any one of you can hlep me, please clear my doubts

Posted by: Aminath Sudha at July 26, 2005 05:44 PM
Post a comment









Remember personal info?








    •