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Thursday, May 29, 2003

Of Water Pistols and a Rhinoceros

Some sound sense from another FT writer on the currency situation. Perhaps the most heartening comment is this one:"But every time in the past couple of decades that there has been a genuinely co-ordinated attempt to shift the currency markets, it has worked." This was my feeling, but its nice to see the picture confirmed from the people who have all the data at their fingertips. What is needed is a decision, and a determination to make it stick. And the real problem lies here (and not in the supposed will of the markets). We are far, far away from consensus. Indeed what consensus there is probably leans towards the idea that punishing Germany and Japan will be long-term beneficial. As the FT writer notes "As of now, the prospect of building such a consensus to arrest the euro's rise seems remote." Of course, he also makes a distinction between a 'fundamentals' driven correction and the turning point". I base my argument on the idea that this whole correction is perceptions rather than fundamentals driven - this is especially true in the context of the 'reserve currency' ingredient. There is a perceived 'overvaluation' of the dollar, so there is a correction. This perception is based on the supplementary evidence of the trade deficit. But the trade deficit is the result of a structural problem US-Asia, and by-and-large this will not be affected by the dollar fall, since many of the key players are falling with the dollar. To swallow the fundamentals driven story I would have top be convinced that the whole 'new economy' story of the late ninetees was a sham. That there was a bubble: period.

The problem is, I am not convinced. Sure, there was a bubble in IT investment. Sure the 'new economy' idea was exaggerated. Underlying this there was a massive re-organisation in the US corporate mentality. There was a change of dynamic. Powerful software which enabled flexible and decentralised organisational structures came on the scene. There was the 'death of distance' and the 'weightless economy'. All of this was real. Amazon, Yahoo and Google were born, Wal-Mart came of age (forget WebVan that was always a diversion - or at least it was too much, too soon). Then we have the internat, and the 'externality' of the English language. The productivity benefits of the ICT revolution reached longest and furthest in the US and other English speaking countries. Sure the other players are now getting some of the benefits. But this process isn't slowing down, it's accelerating. So the gap remains, or is increasing. The US economy is 'weak' precisely because productivity is rising fast, while consumption is much more laggard, due, in part to the weakness of cap-ex in a global oversupply context.

In fact growth and productivity improvements in both Germany and Japan are slower and lower than in the US. The deflation danger is either already present or greater. And the resolve and vision of those responsible for policy making is weaker and more confused. So what exactly are the fundamentals we are talking about here? Of course, Stephen Roach (and to a lesser extent Paul Krugman) has it easier here: he never did believe in the 'new economy', so there is nothing special to justify the US dollar premium. He also doesn't understand just what the probem is going to be trying to 'kick-start' Germany and Japan. I'm sure they will receive the kick, it's the start bit that may be a problem. Meantime, to give an idea of where I think the fundamentals are, I reckon that if we want to see any turn round in the growth situation, we would need to be looking at a yen at around 140-150 to the dollar, and a euro in the 0.90 - 0.95 region. But to make this stick we'd need to recognise that ageing is a problem, that international labour migration forms a key to easing the situation, that the biggest structural imbalance is the North-South one, and that co-operation rather than fueding is a better platform to work from. I seem to be talking about another planet. Oh, never mind.

Intervention in thecurrency markets is notoriously pointless - like shooting a water pistol at a rhinoceros, according to one description. But as the euro surges past successive landmarks, policymakers are beginning to worry about how they might be able to bring it down: and the water pistol is all they have. The good news is that it is not quite as useless as is sometimes supposed. The overwhelming weight of evidence is that in currency markets where turnover is in the region of $1,000bn a day, policymakers cannot spend a few billion to shift exchange rates at will. But every time in the past couple of decades that there has been a genuinely co-ordinated attempt to shift the currency markets, it has worked. "When you look at the tops and bottoms of exchange rates, they are marked by policy changes," says Avinash Persaud, global head of research at State Street. "Economic fundamentals can determine the trend in a currency, but policy determines the turning points." The concerted intervention instigated by the European Central Bank to support the euro in September 2000 was widely derided: after a brief recovery the euro slipped from a little over $0.85 before the intervention to an all-time low of a little over $0.82 the following month.

But with the benefit of hindsight, European policymakers think, it was a success, because it established a floor below which the euro would not sink. Similarly, the previous trough in the dollar, in which it fell below the equivalent of $1.40 to the euro, prompted the Group of Seven developed countries to call for an "orderly reversal". The US and other countries had been intervening to support the dollar for a year with little success, the effort undermined by international bickering. The G7 communiqué initially seemed equally ineffectual, but it later became clear that the dollar had turned the corner. Such statements and intervention can work by conveying information about policymakers' intentions: the September 2000 intervention, for example, gave advance warning that the ECB was going to take a tough line on inflation, and was reinforced by a rate rise from the ECB the following month.But policy can also simply provide the markets with an anchor for their opinions.

People tend to think the right value for anything is what it is at the moment, plus or minus a little. If the ECB and the US Treasury can manage to agree that the dollar needs to rise, for example, they will send a very strong signal to the markets that it will not keep falling indefinitely. As of now, the prospect of building such a consensus to arrest the euro's rise seems remote. John Snow, the US Treasury secretary, has several times reiterated his view that "interventions [should be] kept to a minimum". While the rising euro is setting off alarm bells in Europe, it is seen as an unalloyed boon in the US. However, the fall in the dollar in 1987 was one of the triggers for that year's crash in bond and equity prices. If the dollar's decline accelerates, the US may decide it needs to reach for the water pistol after all.
Source: Financial Times

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