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Monday, May 26, 2003

More On the Reasons For the Dollars Strength

Stephen Cecchetti in today's Financial Times, supporting John Snow. The thing is I agree with ninety per cent of what he has to say, it's the other ten per cent that causes the problem. Actually Stephen is only saying what Bonobo's 'currency adviser' - Kevin - has been arguing for a couple of weeks. But I still don't buy it all. We all agree with the the 'textbook' version - isn't it called the Krugman triangle - that if you have free capital movements, you can't control both interest rates and the exchange rate. But wait a minute, isn't there another argument that cuts across this related to the 'reserve currency' question. In other words what may be true for Argentina, Malaysia, Norway.....even (or perhaps especially - watch out the euro vote) for the UK, may not be true in quite the same fashion for Japan, the eurozone and the dollar. Now, Japan is a special case, and so will get a special post. Essentially the surpluses and reserves mean that Japan is much more in control of the 'market' evaluation of its currency than many other players. If factors other than monetary policy and 'economic fundamentals' weren't at work, then why would the yen be rising when interest rates are stuck at zero and the 'fundamentals' seem much weaker than in the US.

So, there may be other factors at work than interest rates and 'fundamentals', since in the former case Europe is likely to be reducing soon (and if the dollar-euro switch were only seen as temporary and disturbing, there would be even more argument for G7 'calming' activity), and in the latter, the US is obviously in healthier shape than the eurozone countries. So what is this other factor? My guess is perceptions. The players are being more influenced right now, by their perceptions of what the other players will do than by anything else. This is one of the hidden, 'dark', secrets of economics. We influence each other. How we do it is more obscure, but this doesn't make it any less true. How do you decide which films to see, by the publicity, the reviews, or what your friends do? Obviously in the case of the thinking person the latter two are more important, and your favoured critic may be considered your 'friend' in this sense. This is one topic you won't find well treated in the economics text books. It is, however, the case that the dollar 'correction' we are watching is as much a product of a received view that the dollar was too high and had to come down. Now the wish has become a reality, for the moment. But how will the world live with this. Stephen Roach, who has been active in propagating the 'dollar correction' view would say we lack alternative growth engines. But in their absence how do we sustain the falling dollar argument? By suggesting that Europe will be forced to reform. Open the flood gates of Creative Destruction: well excuse me if I am extremely skeptical that this play will work (in fact having accompanied Stephen for such a long stretch of the road, I now fear the parting of the ways may be approaching: finding your footing as you slowly scale a steep and craggy rock-face is never easy. Best advice: 'don't look down').

My plea is that the road forward here is global, is collaborative, and is institutional. Enough of 'we cannot do otherwise'. In winding up a thought from Maynard:

This is not a very profound insight that I'm making, nonetheless...I wonder if one of the things that will slow down recovery (and perhaps lead to a repeat of the 30's) is the blinkered ideology of the US. The point of your writing is that how people behave depends on expectations of how every one else behaves. Now if you are ideologically committed to the idea that there is, as Ms Thatcher put it, no such thing as society, that the way to run a country like the US is to have 250 million individuals making completely uncoordinated decisions, then there is no way to create this new expectation. If the US govt believes that the only ideologically acceptable way to compel the population to all head in the same direction is through war, then war we shall have.

And now for Stephen Cecchetti:

The criticisms are unfair. Being in charge of exchange rate policy, the Treasury secretary has little choice but to comment on the dollar. But there is not much the Treasury can actually do about currency fluctuations. Mr Snow's and Mr O'Neill's comments are no more responsible for the fall in the dollar than Mr Rubin's were for its earlier rise. So what should Treasury officials be thinking and saying about the dollar? To answer that question, we must look at what does affect exchange rates. Modern economic textbooks agree on one basic principle: a country cannot be open to international capital flows and control both its exchange rate and its interest rate. This as one of the very few immutable laws of economics - one that has been validated repeatedly in many financial crises.

It is fairly simple to grasp why, in a world of capital mobility, policymakers must choose between controlling interest rates and exchange rates. Open financial markets require investors to be indifferent between the purchase of bonds in different countries, so interest rate differentials must equal expected exchange rate changes. If a country's interest rate is relatively high, its exchange rate is likely to appreciate.

Since central banks such as the US Federal Reserve, the European Central Bank and the Bank of England control domestic interest rates, they have implicitly decided to let their exchange rate fluctuate. The implication is that direct exchange rate interventions will be ineffective: decisions to buy or sell currency that leave domestic interest rates unchanged will have no impact on the exchange rate.

To see why this must be so, consider what intervention does to the central bank's balance sheet. In order to control interest rates, policymakers manipulate the size of their liabilities - the level of reserves in the banking system. Foreign exchange intervention that leaves reserves unchanged affects only the asset side of the balance sheet. Intervention by a modern central bank simply exchanges securities denominated in domestic currency for securities denominated in foreign currency.

Most Fed and Treasury officials know this, and act accordingly. Mr Rubin told anyone who would listen that "a strong dollar is in the interest of the US" but rarely intervened to try to influence its level. After his first year in office, he intervened only once - in June 1998 - and that was to try to weaken the dollar. Since then, the US has intervened only once more, again to weaken the dollar. So Mr Rubin's strong dollar policy did not imply any active attempt at raising its value.

Although interest rate changes have a direct impact on exchange rates, Federal Reserve officials always emphasise that the Treasury secretary has formal responsibility for dollar policy and decides when to intervene. He or she has responsibility without power. But unlike Alan Greenspan and his Fed colleagues, the Treasury secretary cannot refuse to answer questions about the dollar. What should Mr Snow say?

Any answer must be clear that exchange rate policy is designed to achieve two long-run goals: first, keeping the dollar as the pre-eminent global currency; and second, maintaining economic policy that ensures high, stable real economic growth and high, steady investment returns. If these objectives are achieved, it will, in Mr Snow's words, make people confident in the dollar. A stable economy will bring a stable dollar, which is what is wanted.

It is essential that Treasury officials are clear that they are going to let financial markets determine the dollar's day-to-day value. They are unable to do anything about currency trends, even over several years, and intervention in currency markets can be an emergency measure only.

So the next time Mr Snow is asked about the dollar policy - which he will be - this is what he should say: "Day-to-day fluctuations in the value of the dollar are determined in financial markets. Our goal is to implement policies that ensure high and stable growth, so that the US economy continues to be the best place in the world to invest and the dollar remains the pre-eminent currency."

If Mr Snow and Mr O'Neill had been saying this for the past two years, would it have made any difference? Would the dollar still have depreciated by 25 per cent against the euro? The answer is probably yes. The dollar's decline is a result of economics, not rhetoric. Mr Snow is clearly right. What the US needs is a fiscal policy that inspires investor confidence. When the country gets it, it will also get a stable dollar.
Source: Financial Times

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