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The Boston Globe: Perils of a weak dollar

February 17, 2008

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On Saturday, the Boston Globe published an oped that I wrote. It is the first oped that I have ever had published.

The headline on the oped though is a little bit misleading.

I focus more on the perils of pegging to a weak dollar rather than the perils of a weak dollar per se.

One of the strange features of today’s global economy is that many countries with strong economies have weak currencies by virtue of their link to the dollar. That discrepancy distorts the global economy in a number of ways:

-- It keeps the US trade and current account deficits larger than it otherwise would be.

-- It means the adjustment against the dollar is unbalanced. There is a difference between a world where the Euro rises against the US and Asia and a world where the Euro and most Asian currencies rise against the dollar.

-- It requires a ton of government intervention in the foreign exchange market, a fact that necessarily will lead to rising government ownership of a host of financial assets.

-- And it has led a number of countries that peg to the dollar/ manage their currencies against the dollar to adopt wildly pro-cyclical macroeconomic policies.

As a result, the weak dollar is much more of a problem in the countries that tie their currencies to the dollar than in the US. I agree with Dr. Krugman: right now, the US benefits from a weak dollar. Exports are helping to support the US economy and reduce the trade deficit. In the oped, I argued:

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 Gulf and China though have many alternatives other than continuing to manage their currencies against the dollar and as a result import US monetary policy -- a policy that will be directed at stabilizing the US economy, not stabilizing their economies.

The problems dollar weakness is creating in the Gulf are now quite visible.

The Saudis are cutting interest rates like mad at a time when inflation is rising. Negative real interest rates are pro-cyclical. They are already fueling a real estate boom in Qatar and the UAE.

Curbing inflation - in the absence of currency appreciation or monetary autonomy - requires cutting back government spending and investment.  Gene Leon of the IMF:

In recent statements, the IMF said Gulf states also need to trim spending and tighten money supply within stricter fiscal policy to curb inflation.  "Fiscal policy is the only effective instrument to control inflation in Gulf Co-operation Council states," said Gene Leon, deputy chief of the GCC division.

But it is kind of hard to explain why government spending, including government wages, should be cut in the face of rising domestic prices when oil is high and the government has plenty of cash. As a result, most countries are increasing spending to offset rising prices ...

Michael Pettis has busy documenting the macroeconomic difficulties China is now facing as a result of RMB weakness - especially in the face of rising commodity prices and associated inflationary pressures. Keeping lending growth from exploding is an ongoing battle. The tightening of the fall seems to have given away to concerns about growth. Lending certainly increased significantly in January.

And - at least if the January data is indicative - China may not have shifted away from export led growth. Not yet. The pace of export growth picked up in January - rising back to the 25-30% y/y range (26.7% to be precise). Given that China exported $1220b in 2007, that implies a huge rise in China’s exports. Think of a $300 to $360b increase in China’s exports over the course of the year.

I doubt that kind of growth can be sustained.

But the fact that China’s overall trade surplus is up from last January even though oil is now around $90 and oil was a lot closer to $50 than $60 last January is really quite impressive. Especially in a global context where the US non-oil deficit is down. China has taken market share from other suppliers to the US, and increased its surplus with the world ex-oil ex-US dramatically.

Doing so has required enormous intervention in the foreign exchange market: some visible, some hidden. Buying depreciating foreign assets likely will result in significant financial losses - though the precise meaning of exchange rate losses at a central bank is still debated.

The weakest part of the oped, in my view, is the conclusion - which hints at the need for coordination to help manage a transition off dollar pegs and central bank financing of the US but doesn’t really spell out what that might entail.

That reflects space limitations. But it also reflects two deeper analytical issues.

The first - highlighted by Martin Wolf - is that adjustment requires a reduction in US aggregate demand (i.e. less US consumption) and an increase in global aggregate demand. Yet right now US policy is directed at trying to avoid a too-sharp and too-sudden a fall in US demand.

I think that is appropriate: Too fast a fall in US demand would just lead to less global growth, not a shift in the basis of global growth. But as Martin Wolf notes, applying stimulus in the deficit country but not the surplus economies risks sustaining imbalances. The key will be to shift away from stimulus as soon as the US economy stabilizes. It would be a mistake for the US to shift from a real estate fueled consumption boom to an equity fueled consumption boom, one reinforced by a surge in SWF demand for US equities.

The US - and the world - need to find a new basis for growth. US consumption cannot continue to rise relative to US GDP, helping to absorb the rest of the world’s high level of savings.

That though requires a bit more willingness on the part of other countries to adopt policies to support aggregate demand rather than maintaining policies that support export growth. Basically, there will be a need to shift from policies designed to avoid too sharp a fall in activity in the US to policies designed to support demand outside the US.

Europe’s reaction to Strauss-Kahn’s proposals wasn’t all that encouraging.

The second is that I have lost confidence in the "consensus’ policy recommendations made to address imbalances back in 2004 - policy recommendations enshrined in the disappointing end-result of the IMF’s multilateral consultations. The basic approach was threefold -

Fiscal consolidation in the US

More growth in Europe, whether from structural reforms (consensus view) or policies to support demand (my view)

Exchange rate adjustment in Asia, along with domestic policies to support an internal rebalancing.

From 2005 to 2007 two of the three actually happened. European growth picked up smartly. And the US fiscal deficit fell.

However two of three wasn’t enough. I think the 2005 to 2007 period will be remembered as a period when an opportunity for much deeper adjustment was missed, in part because China opted for a pace of RMB appreciation that was way too slow. Especially in a global context where the dollar was sliding against a host of currencies.

I also suspect that a couple of key policies were left out of the old three pronged approach -

Energy policy for one. The role of the oil-exporters in the world’s imbalances is now hard to ignore. If oil stays around $90, the US "petroleum" deficit will be close to $400b. That deficit in turn has created a glut of savings in the oil exporting economies -- the Gulf is throwing one nice party for itself (and its real estate companies) and still has plenty of money left over. Here US and Chinese interests are aligned -

Some broader changes in the institutions for global economic coordination that recognize the growing importance of the emerging world for another. The G-7 doesn’t cut it. This though would require change not just in the G-7 countries but in China as well. From what I gather, China isn’t sure it wants the responsibilities that might come with membership in a group like the G-7.

And perhaps reserve management. It strikes me as likely that orderly adjustment will require that some key central banks refrain from aggressively diversifying their reserves as they move off the dollar. The delicate issue though is that the US needs enough central bank financing to sustain a gradual adjustment but not so much that the US avoids all pressure to adjust. A massive SWF bid for US equities that pushes equity prices up in the say that central banks pushed bond (and housing) prices up and creates a new wealth effect wouldn’t help.

I am not sure I quite see the potential bargain. Not yet.

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