Alan Ruskin of RBS Greenwich capital makes an important point in the Financial Times. The US has effectively outsourced its strong dollar policy to the emerging world.
It isn't even clear that the US Treasury really wants a stronger dollar right now, let alone a strong dollar. The US certainly isn't prepared to intervene to support the dollar. But it doesn’t really need to so long as the emerging world’s central banks are so willing to prop the dollar up on their own.
“The US has been tolerant of dollar weakness, and neglected building reserves, precisely because it knows that its trading partners could suffer more than the US from a dollar collapse and would do something about it.
So far, this implicit US assumption that the dollar is “too big to fail” has been correct. The latest IMF data show global reserves in the 12 months through the second quarter up $1,100bn, indicative of global policy makers indirectly bailing out the dollar on an ever expanding scale.”
Ruskin is absolutely right to note the ever-expanding scale of emerging market intervention required to support the dollar; my own calculations suggest that emerging market reserve dollar growth is now about equal to the US current account deficit. If emerging market central banks were lending funds to the US to allow the US to intervene to support the dollar rather than intervening themselves to keep their currencies from rising, their lending could be considered the world’s largest currency bailout.
This intervention hasn’t been conditional on any policy action on the part of the US – and it hasn’t been supported by formal coordination among those countries now working collectively to prop the dollar up either. But so long as a host of Asian countries are reluctant to let their currencies appreciate against the RMB, and so long as the gulf countries (setting Kuwait aside) insist on moving together and the Saudis aren’t willing to move, explicit coordination doesn’t seem to be necessary. At least not so long as the key players are willing to allow a few smaller players – Qatar, for instance – to free ride.
Concern about appreciating v China prompts a host of Asian countries to intervene when the dollar comes under pressure even in the absence of any formal coordination. They don't talk, but they all stilll end up adding to their dollar reserves. And so long as countries like the Emirates aren’t willing to abandon their dollar pegs unilaterally, the GCC’s policy is determined by the preferences of Saudi Arabia. This matters: the UAE’s reserve growth in 2007 (roughly $15b in the first half of the year) isn’t impressive compared to China, but it is quite large relative to the UAE’s own small economy.
As a result, it wouldn’t take a Plaza for the dollar to start to depreciate against much of the world – central banks and policy makers don’t need to send a signal to the market that they want a weaker dollar. All it would take is a simple decision on the part of a few key emerging economies to spend a bit less money propping the dollar up.
The US doesn’t currently have a strong dollar policy so much as China has a weak RMB policy – and the Saudis have a weak riyal policy.
This arrangement is not without its advantages for the US, even if – as Dean Baker likes to remind us -- a stronger-than-it-otherwise-would-be dollar has important distributional consequences. Among other things, it lets the Fed set US interest rates without worrying (too much) about the dollar, even though the US now not only has a substantial stock of external debt that it has to rollover but also relies on many hurt by a falling dollar for the ongoing financing needed to sustain its still large external deficit.
But this arrangement also implies that the decisions that determine the dollar’s value are increasingly made in Beijing and Riyadh, not in Washington.
Berkeley professor Barry Eichengreen argued back in 2004 that the dollar financing cartel was subject to collective action problems, as every country would prefer that another country assume the costs associated with financing the US. So far, though, such coordination problems haven’t materialized in a big way: some countries diversified, but others stepped up their dollar purchases. Total dollar reserve growth just keeps on rising. The commitment of key regional players – and particularly China – to the system has, in various ways, made defection from the dollar financing cartel costly.
I increasingly wonder whether aspects of the current situation more closely resemble another classic of game theory, the game of chicken. The US continues to direct its domestic monetary policy solely toward domestic conditions, no matter how its decisions impact on the dollar and its creditors. And it effectively dares those governments now intervening heavily to hold their currencies down -- action which has the effect of keeping the dollar up -- to do something other than intervene more in response.
This hardly seems like a long-term recipe for international economic and financial stability. But so far it has been – and it is likely that the best bet is that it will continue to be. It still makes me nervous that global financial stability hinges on the continued willingness of a few governments to lose large sums of money in the foreign exchange market.
UPDATE: Bernardo Aito must have stayed up light attempting to formalize my analogy to the game of chicken. Commentator t (of imperial college?) has produced an interesting payoff matrix as well. I though am constantly reminded of how hard it is to model a country as a unitary actor.
Chinese exporters (and foreign firms that produce in China) win so long as China pegs to the dollar, a policy that leads Chinese taxpayers to use the central bank balance sheet to subsidize Chinese exports. They actually do better with low US rates and a weak dollar than with higher US rates and a stronger dollar. Chinese taxpayers, on the other hand, have a lot to loose from dollar weakness. Different groups in the US also have different interests. Most Americans gain if Chinese (and Gulf intervention) allows the US to conduct a monetary policy geared toward domestic conditions even though it relies on ongoing foreign inflows to finance a still large deficit, but workers in the US tradables sector do not.
UPDATE 2: Apologies of the initial misspelling of Ruskin's name.