Reading Stephen Roach's Friday post on the dollar, and keeping my recent post on the same topic in mind, I realise that there could be a problem of dynamic inconsistency here. Stephen is saying that the likely future direction of dollar/euro is down. I agree. The difference between us lies, I think, in what we see as the mid-term consquences of this. He sees the 'correction' as a trigger for structural reform and change in Europe and Japan. I am not at all optimistic on this front. Paul describes me as a 'deep institutionalist'. I think I accept the mantle. Reform and change in Europe and Japan needs to go down a much more difficult road, one which passes through a much more deep-seated, and sensitive, series of problems in the forefront of which is the problem of identity. Without this collective process of self-questioning my fear is that the only consequence of upward currency pressure will be more of the same in Japan, and the definitive entry of the German economy into the rigor-mortis of the deflationary cycle. This being the case, mid-term the currency 'correction' becomes unsustainable, the relevant central banks get serious about 'springing the trap', and back we go the other way. remember, if the dollar is heading south right now this is in part because the the US Treasury and the Fed, being more 'wised up' to the deflation problem, want it that way. We Europeans, as usual, arrive late for the party, we are still busy revelling in our new found 'wealth'. Much as I admire his courage, Stephen is playing the moralist here: unfortunately between what should be and what is lies all too often the giant gap of reality.
In the murky realm of foreign exchange analytics there is no guarantee that what has worked in the past will work in the future. In my 30 years as a macro practitioner, I’ve seen a host of currency theories fall in and out of favor -- from swings in relative interest rates and inflation differentials to growth comparisons and currency reserves. And now a new bogey appears to have emerged -- external financing imbalances; on this count, I am in close agreement with the work of our currency economist, Stephen Li Jen (see his dispatch in today’s Forum, “Our Dollar Smile Returns”). The problem is the gap between nations with current-account deficits (mainly the US) and surpluses (mainly Asia but also Europe) has never been larger. And for a saving-short US economy, a dramatic deterioration of America’s fiscal position points to an ever-wider current account deficit over the next few years -- moving from a record 5.2% of GDP in late 2002 into the 6.5% to 7.0% range by late 2004. Meanwhile, with growth stymied in the rest of the world, non-US external imbalances could well be moving into ever-wider surpluses -- leading to a highly unstable disequilibrium between deficit and surplus regions. This is a recipe for a significant currency realignment. The only question in my mind is whether the dollar falls quickly or gradually. There are good cases that can be made for either outcome.......
Europe and Japan show little or no inclination to voluntarily alter these deeply entrenched approaches. So, in my view, it seems entirely appropriate to put pressure on both economies to change. The currency lever is the most effective means to accomplish this objective. If the dollar stayed strong and the world held to its course of US-centric growth, Europe and Japan would have no incentive to change. A weaker dollar would leave them with no other choice. Plagued by unprecedented external imbalances, the world simply cannot afford to stay the course of US-centric growth. A lopsided global economy needs a shift in relative prices to find a new and more stable equilibrium. The dollar -- the world’s most important relative price -- has to fall. Such a decline may now be under way. And the world will have no choice other than to figure out how to cope with the imperatives of global rebalancing
Source: Morgan Stanley Global Economic Forum
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