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Friday, May 16, 2003

Blowing Sunshine

I'm posting some feedback I've received from Kevin. He is obviously right that the US has no declared dollar policy in the conventional sense of the term. But let me suggest this: market participants act on expectations, so part of the 'guess' is what will be the reaction and response of the US Treasury. The US has just won a war, and many people speak of a global hegemon. Now, does anyone doubt that the US could defend the dollar level it wanted, if it wanted. So not having an explicit fx policy is in itself a policy. At the moment I don't buy the dollar correction argument based on the external deficit argument. I don't buy this because of the absence of alternative growth engines argument. Investors may be disenchanted with the US, but realistically, where else do they go? So if they are testing the dollar downwards it is because it senses that the administration will not react against.

Now the BoJ does 'spend' lots of money, but what does this spending involve, selling yen and buying dollars, if the yen long term goes weak, this 'spending' could look like an investment. Now the sterilisation argument is another country: because what is being proposed by Bernanke and others (with due allowance made for the requisite denial of intention) may well be an implicit fx 'policy:

The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar.

Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.

The sterilisation argument is also highly contested. Bernanke and other criticise the BOJ interventions precisely because they are sterilised. Among the proposals for 'unconventional' measures is one that would make such interventions unsterilised. Bottom line, I think the foolproof path isn't 'foolproof' because of the generalised deflation argument and not because, analytically and in principle, you can't separate fx from monetary policy. Obviously, in the final analysis all policies are one, but the nuances may be important. Now Kevin:

I don't really get this notion of an fx policy separate from monetary policy. The press and analysts like Medley have a stake in going on about fx policy it gives them something to talk about, thus a way to make money from readers and clients. That doesn't mean any of it is true. ("If understanding fx policy were easy, anybody could do it.") Of course, Japan has an fx policy. The BoJ spends great gobs of yen in service of that policy. As far as I can tell, though, Japan still sterilizes its fx interventions and the last time I cracked open an economics text on the subject of sterilized intervention well, you know. The US does not intervene nearly as much, not at all under Bush II. This lack of support for the dollar is part of the "dollar policy" story if the US Treasury won't back up strong dollar talk with cash, then the Treasury must really support - or "be happy with" as it is often reported a softer dollar. That isn't a policy, other than in the negative sense that the Treasury has a determined policy of doing nothing to disturb market pricing of the dollar. Similarly, Snow's (and O'Neill's before him) taking Japan to task over fx intervention is really a demand that Japan not have an fx policy.

Let me offer an alternative explanation for US officials' behavior regarding the dollar. Lately, there have been several mentions from US officials of the benefits to exports from a weaker currency. That has been taken, mistakenly, I think, as support for a weaker dollar. It is no more than an acknowledgement of the facts. Why bring it up? Doesn't mentioning it at all suggest policy makers are taking an interest? Well, of course they take an interest, but often the choice to raise the issue lies with a reporter, not the public official. A reasonable rule of thumb for elected officials and their representatives is when confronted, blow sunshine. The US supports a strong dollar. Then isn't a weak dollar a policy failure? Why, no! It supports exports! (No bad news, no policy failures thank you. Not on my watch.) Nobody ever won an election based on their fx policy.

Pegging is still practiced, but not by the US, Europe or Japan (though Japan sometimes seems to have a target band, not so different from a peg). Doesn't pegging a foreign exchange rate simply make monetary policy the slave of fx rates, instead of the other way around? To a lesser extend, doesn't having an fx policy imply that, to some extent, you are pursuing multiple goals with a single monetary policy instrument (again, reference to the textbook suggests* well, you know.) The "foolproof
path" seems (oh, I'm gonna hate myself) a bit of a fantasy, pretending there are two policy instruments when there is only one.

In sum: What mechanism for pursuing fx policy, other than monetary policy, is there? What real evidence is there that the US is pursuing any particular fx
policy, rather than (as O'Neill and now Snow have both said) that the US is pursuing policies which are likely to foster growth and attract investment, which will incidentally support a strong dollar? How can a "foolproof path" that involves currency manipulation work, when deflation risks are general, rather than limited to a single economy? How can it do more than monetary policy, when there is only one instrument?

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