from Follow the Money

Danish honesty (on the no-longer-strong dollar)

November 25, 2007

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Teis Knuthsen of Danske Bank:

“Secretary Paulson claims the strong dollar policy remains in place but also that FX rates should be set in the markets, a combination that is currency inconsistent.”

Sounds about right.   Martin Wolf makes essentially the same point, citing the work of Wynn Godley and others at the Levy institute.

As Wynne Godley of Cambridge university and co-authors point out, a sustained improvement in US net trade will offset at least a part of the likely sluggishness in domestic demand.* This is why the US authorities talk about a strong dollar, but do not mean it. They want a retreating dollar, but one that does not turn into a rout.

US policy makers are caught in a dilemma.   

On one hand, essentially no one believes that the US actually has a strong dollar policy.   The reiteration of the existing US policy therefore has almost no impact.

And – it should be noted – the “strong dollar” policy has never meant that the US would direct its monetary policy toward maintaining the dollar’s external value rather than stabilizing the domestic economy.   Right now, former Secretary Summers believes stabilizing the domestic economy requires putting emphasis on supporting demand growth

“Maintaining demand must be the over-arching macro-economic priority. That means the Fed has to get ahead of the curve and recognise – as the market already has – that levels of the Fed Funds rate that were neutral when the financial system was working normally are quite contractionary today.”

The strong dollar policy – in my view -- was always more a way for the Treasury to talk about the dollar without moving markets than a policy commitment to dollar strength no matter what.  Remember, two of the three Rubin/ Summers interventions were to weaken the then too-strong dollar.  Repeating the same phase avoids sending any new signals to the market, and thus helps the market -- at least in theory -- set the currency's value.

The policy commitment behind the United States' strong dollar policy certainly never matched the policy commitment behind China’s weak RMB policy – a policy that requires that China intervene heavily in the fx market, hold domestic interest rates down and increasingly run a fiscal surplus. 

On the other hand, the rest of the world would be quite upset if the US actually abandoned its current strong dollar policy.  Ending the “strong dollar” mantra could be interpreted as a signal that the US wants an even weaker dollar.   It might push the dollar down further.  It certainly would antagonize a lot of other major players – most of Europe’s political leaders, the ECB, China -- in the world economy.

The result:  US policy makers end up repeating words that almost no one believes have real content.   And the rest of the world spends a lot of effort encouraging the US to keep repeating words that few think have much content. 

But finding a new policy isn’t going to be easy.   The dollar is simultaneously very weak by any historical standard v Europe and quite strong v most of Asia.  And yes, that means European currencies are very, very strong v most Asian currencies.   The result is talk of both a new Louvre (a deal to support the dollar) and a new Plaza (a deal to bring the dollar down in an orderly way).   

I liked Knuthsen’s three pronged analysis of the sources of dollar weakness: 

One, the US is growing more slowly than the world:

“As long as the US performs, or is expected to perform more poorly than comparable economies, then a fall in the dollar is a logical consequence.”

Two, the world has lost confidence in US “financial technology” and thus a lot of the “product” the US was trying to sell the world -- a point that Dani Rodrik has also made.   Knuthsen: “We are currently in the midst of a global financial crisis that has at its epicenter US financial institutions and structured products on US financial instruments.”   CDOS stuffed with US residential mortgage backed securities are even harder to sell than Hummers right now – 

Three a set of oil exporters are – at the margin – purchasing fewer dollars and more euros, yen and Asian currencies.   I am not sure what fraction of the Gulf investment funds’ aggregate portfolio is now in Asia – probably more than 10% but less than 20%.   But there are lots of signs that their Asian portfolio is smaller than they would like and that the Gulf’s dollar portfolio is a bit larger than the key players might like.  One of Dubai's funds wants to put 30% of its portfolio Asia, far more than it has now.

But Gulf to Asian flows have not been allowed to push Asian currencies up.  Asian central banks are intervening to avoid that outcome.  While Gulf to Europe flows, Russian flows to Europe and American flows to Europe have been allowed to push the Euro up.   As Knuthsen notes in a useful analysis of Europe’s basic balance, Euroland is now is attracting huge portfolio inflows in the absence of a Euroland current account deficit.   

Euroland financial institutions use the inflow to finance deficits in Eastern Europe – acting as true global intermediaries.

But the overall result is that the euro is appreciating against dollar – but  most Asian currencies are not.   Not really.  There are some changes recently – the yen has appreciated along with the euro over the past few weeks.   But China, India, Thailand and a host of others are not intervening quite significantly to keep their currencies from appreciating (and, as a result, keeping the dollar from depreciating).   

I am not sure how much longer this pattern can be sustained. 

It implies a pattern of global adjustment that will be driven far more by a rise in Asia’s surplus with Europe than a fall in the United States overall deficit (though both of course will happen).    The “Chimerican” deficit will fall because of a rise in China’s surplus.    And it also implies that the US will become even more dependent on Asian central bank flows (and SWF flows) than it is now.   Asian central banks end up taking an even bigger risk to its balance sheet by taking on an even big share of the burden of financing the US.  

And on the trade side, the entire burden of adjustment has to be absorbed by Europe not by Asia.

In other words: Same old, same old. 

At the same time, the costs of maintaining this constellation are quite obviously rising.

Dooley, Garber and Folkerts-Landau (of Bretton Woods 2 fame) argue that Europe will be forced to intervene to prop up the dollar – and in effect, Europe will join Asia in maintaining a de facto peg to the dollar.   The fall in private demand for US assets associated with the subprime/ structured product crisis will induce even more official support. 

Another possibility is that the costs of absorbing huge quantities of dollars will prove too much for even China to bear – and China (along with the Gulf) will be forced to let its currency adjust.

I tend to think China will allow faster RMB appreciation before the ECB joins the PBoC in propping up the dollar.   But I don’t have a lot of confidence in that view.   By contrast,    I am fairly confident that the status quo is untenable.    Barring a return in private demand for US assets that takes pressure off European, Asian and even American policy makers, something has to give.

Update: Lex on verbal intervention, and the possibility of actual intervention (Lex though seems to have forgotten about Japan's quite large intervention in 2003 and 2004, and for that matter New Zealand's intervention earlier this year.  Developed countries most certainly have intervened since 2001, just not the US and most of Europe) 

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