This week, successive comments by the US Treasury Secretary, John Snow, that might have been intended to calm markets only succeeded in raising new doubts about what the dollar policy of the second Bush administration will turn out to be. Foreign exchange markets were alternately relieved, rattled, and ultimately confused by widely publicized remarks that seemed contradictory. Snows comment on January 7 that US officials want to do things to sustain the strength of the dollar, appeared to suggest that they now believe the dollars nearly three year-old slide has gone far enough. It triggered a sharp rally for the dollar against most foreign currencies, especially the euro. But that was followed by a television interview three days later in which Snow repeated the familiar line that exchange rates are best set by markets. Currency traders and portfolio managers have come to interpret that language as shorthand for signaling a US Government preference for a decline in the value in the dollar in order to help arrest the persisting rise in the already huge US trade and current-account deficits. So the dollar set back. Whats going on? many market professionals are asking.
In fact, there is mounting evidence that an intense, and so far inconclusive, debate is in progress among Republican politicians and their economic advisers over the issue of whether the current-account deficit is a serious problem for the United States and if so what should be done about it. The latest data, a record $60.2 billion deficit for November, came out Wednesday. The current-account deficit is running about $5 billion a month higher. Incidentally, Democrats are more unifiedthey want the trade deficit to go down and favor a sharp drop in the value of the dollar to help bring about that adjustment. But they are essentially out of power these days, so their opinions dont count for much.
One camp in the Republican internal debate is led by the Wall Street Journals influential editorial page, supported by a handful of prominent market economists and several key members of the Bush administration. They maintain that trade and current-account deficits do not matter. US consumers and firms are optimistic about the future, enjoy rising incomes and wealth, and are justified in taking advantage of bargains allowed by open markets. To the extent that trade and current-account deficits ensue, these are readily financed by inflows of foreign capital, both private and official. Whats more, trying to do anything about the deficits is bound to do more harm than good. Suppressing demand risks stunting growth or, worse, causing a recession. Depreciation of the dollar risks bringing in higher inflation and higher interest rates, which would certainly harm the housing market and could damage business investment, too. Conversely, they argue that in other major countries bad economic policies stifle incentives, suppress business investment, and discourage consumers, who become fearful of losing their jobs. Exports to the US tend to go up, but imports are held back, with the result that current-account surpluses develop. But so do outflows of capital to the US and elsewhere.
A second camp within the Republican establishment, including a number of Cabinet and sub-Cabinet officials, supported by many business executives, views the US external deficit as mainly a reflection of what they see as unfair trade barriers erected by the governments of trading partners. The controversy over Airbus subsidies is one example. (Europeans counter that Boeing gets subsidies, as well, through its defense contracts, but Americans are not ready to concede that just yet.) Another is restriction on agricultural imports that are believed to disadvantage US farm exports. In this view, the answer to the trade deficit is not found in the area of exchange rate policy, because even a large depreciation of the dollar would not do much good if US exports continue to be discriminated against. And it could prompt higher US interest rates, which would be bad for business. So the recommendation is a tougher negotiating stance in bilateral and global trade talks, coupled with threats of US retaliatory measures if others are unwilling to compromise. An example from the first Bush administration was the imposition of steel tariffs. That policy measure, however, split the administration (eventually leading to the dismissal of the leading critic, then-Treasury Secretary Paul ONeill). The business community was also divided, since users of steel complained they were badly hurt by the measure. It was quietly withdrawn, but not without weakening the administrations reputation as a supporter of free trade.
A third camp is centered in the White House, but includes a number of prominent Republicans in the Congress. It is basically agnostic on whether or not the current-account deficit is a good thing or a bad thing and whether a depreciation of the dollar is essential for lowering the deficit. But it is tolerant of trade deficits with countries that support President Bushs foreign policies, whether the Iraq war or its position with respect to trouble spots such as North Korea. So trade and dollar policy is seen as just another tool of overall geo-political relations.
However, this position is overlaid with a set of pragmatic concerns about the consequences of the large trade deficits for specific industries and firms. Most significant are the problems of the US motor vehicle industry. There are also serious concerns about bankruptcies in the airlines industry and financial difficulties within some parts of the high-tech sector. There is a relatively sophisticated understanding that these various problems are not primarily caused by foreign exchange rate misalignment. But in the short-run they are exacerbated by the dollars past strength. And it is felt that a further decline in the value of the dollar, especially against Asian currencies, could buy time for remedial actions to take effect. That could forestall having to go to Congress to authorize a bailout of troubled firms.
How will this debate be resolved or will it be resolved? There is no doubt that the Federal Reserve, which has no formal decision-making authority over exchange rate policy but certainly weighs in with advice on this important matter, favors an orderly decline in the value of the dollar as part of an overall adjustment mechanism for the external deficit. This argument carries some weight within the Bush administration. But the Fed also favors lower federal government budget deficits. The administration pays lip service to that goal but is dead set against doing much about it if it means reversing the Bush tax cuts or lowering defense spending.
The decision will probably turn on whether the financing of a current-account deficit approaching 6% of GDP, with no end in sight, becomes far more difficult than it has up to now. What are the key facts?
First, the US has run large and rising current-account deficits for a long time. Since the mid-1990s, there was a long period when higher deficits were accompanied by a rising dollar, essentially from 1995 through March 2002. The past three years have produced a rising current-account deficit with a falling dollar.
Financing US Current Account Deficits
|$ billion, annual averages||1995-2001|
|Net direct investment||23.4||-87.8|
|Private net acquisition of securities||252.8||361.2|
|Banks, money markets, and |
Second, the main financing source for the entire ten-year period was private portfolio investments. The great majority of those reflected acquisition of bonds, equally divided between US Treasuries and other bonds, notably mortgage-backed securities.
Third, during the first seven years of the period, the deficit was partly financed by net inflows of foreign direct investment into the US. During the more recent period, however, net foreign direct investment has been consistently negative. That is because US corporations have increased investment abroad at a faster pace than foreign companies have invested in the US.
Fourth, during the first period, the private sector financed the US current-account deficit. In the recent period, the bulk of the financing has come from official purchases of dollar assets as part of foreign exchange intervention operations by Asian governments and central banks designed to curb or stop the appreciation of their currencies.
Fifth, years ago a major swing factor in balance-of-payments financing was often hot money flows through the banking system or through the money markets. But that hasnt been a factor at all throughout the last ten years. Instead, in the new financial world of securitized, globalized, highly leveraged financial markets, virtually the whole spectrum of financial assets, including bonds, equities, and increasingly important, financial derivatives, are available to both domestic and foreign investors.
This transformation has been frequently stressed by Fed Chairman Greenspan, along with the dangers associated with it. Financing of the US current-account deficit has gone more smoothly than many economists were predicting just a few years ago, when the deficits started to mount rapidly. But that does not mean that market stability can be taken for granted forever.
In the end, the Bush administration is likely to coalesce around the dollar policy that seemed to be evolving over the past year, at least until Secretary Snows confusing statements of the past week. A lower dollar, especially against Asian currencies, will be welcomed but not overtly sought. Occasional rallies for the dollar will be frowned upon but not overtly resisted. Asian official foreign currency intervention will be tolerated, but only up to some as-yet undefined point. And the reality that a large current-account deficit will persist for many years to come, almost regardless of what happens to the dollar, will be quietly acknowledged.
What will the foreign exchange markets make of it? The consensus will almost always predict a medium-term fall in the dollar. But traders will recognize opportunities for short, sharp, sudden rallies that will punctuate an otherwise orderly decline.
The implication is clear: volatility in the foreign currency markets is going to increase irregularly and that will likely spill over onto bond and stock markets in the year ahead.