Over the last several months, the US economy has slowed, interest rates have been cut, and global demand for US bonds—setting those from the Treasury aside—has dried up.
Until a few months ago, influential commentators argued that the country’s skill at creating complicated financial securities would help to finance the US trade deficit. But rather than selling the financial equivalent of a Mercedes-Benz, expensive bonds with a reputation for quality engineering, the United States is trying to sell a mix of financial “lemons” and minivans—dolled-up subprime debt and reliable, but boring, Treasury bonds.
In this context, the fall of the dollar is not a surprise. But even as the dollar has fallen significantly against the euro, the pound, and the Canadian dollar, the world’s rapidly growing emerging economies have resisted market pressure for their currencies to rise against the dollar.
The resulting growth in these economies’ foreign-currency reserves has helped finance the US deficit. Too many countries with strong economies now have weak currencies, which puts strain on the world’s economy and financial system.
It is better to produce goods—or financial assets—that can be sold at a premium in the global market than to produce goods and financial assets that must be sold at a discount. On the other hand, a weak dollar should help spur exports at a time when fewer Americans will be employed building and selling homes.
Europeans will start to find the United States an attractive location for factories, not just shopping excursions. German auto firms already are increasing investment in the United States. The alternative to a weak dollar is a US monetary policy aimed at supporting the dollar rather than stabilizing economic activity in the United States—an even less attractive option.
The United States now trades far more with Asia than with Europe and spends far more on imported oil than on imported European luxury goods. However, the central banks in the large emerging Asian economies and the major oil exporters generally have not allowed their currencies to rise by much against the dollar, even though their economies are growing faster than either the European or US economy.
While a weak currency helps these countries’ exports, it is now contributing to a host of other economic problems. Inflation is rising. Real interest rates—the cost of borrowing less the inflation rate—are often now negative.
The fact that the dollar hasn’t fallen against the parts of the world with the fastest growth has put additional pressure on Europe. Europe would be far better positioned to sustain its expansion—helping to offset the US slowdown—if the euro were strong only relative to the dollar, not strong relative to both the dollar and the currencies of most of Asia.
The unwillingness of many key emerging economies to allow their currencies to appreciate against the dollar at a time when private demand for US assets has waned has another consequence: the United States has become more, not less, dependent on financing from China’s central bank and the investment funds of the large oil-exporting economies as the US economy has slowed.
China’s central bank, its new sovereign wealth fund, and its state banks will probably buy close to a half-trillion dollars in 2007 to keep China’s currency from rising at a faster pace. Russia and the large oil-exporting economies in the Gulf will combine to add almost as much to the coffers of their central banks and sovereign wealth funds. The world’s big creditors are now states—and often not democracies. This credit line helps keep US interest rates low as the dollar falls, but it also distorts the global adjustment to the US slowdown. China’s already large trade surplus increased by close to $85 billion this year, more than the US deficit fell.
Global policy makers should start to think seriously about the best way to exit from a system where a number of countries around the world, in very different economic circumstances than the United States, are importing the consequences of the weak dollar. This above all requires a greater willingness on the part of those countries now intervening most heavily in the foreign exchange market to allow their currencies to appreciate. But it also probably requires far more cooperation among the major economies than has been the case recently.
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