I'm catching a lot of flack at the moment for my attempts to put a different 'spin' on the dollar decline situation, and on the inactivity of the G7. Today it's Joerg's turn to try to wrong foot me:
regarding the "argument about the absence of a currency policy instrument": Please explain what you consider to be the correct stance for a central bank to take. The Mexicans are selling incoming dollars off at a daily auction. They are playing the game according to the rules of a true floating-exchange-rate regime. In my view, they are the "best practices"-model of behavior the larger banks need to ultimately emulate. If they do not, a well-managed fixed-rate regime would be preferable to what might ensue from attempts at running a "beggar-thy-neighbour-strategy" with manipulated, flexible pseudo-floating rates. Note also that the choice the central banks are confronted with is structurally similar to the menu of options available during the 1920s and 1930s in regard to the maintenance of the gold standard. The rules for that game had been laid down by Ricardo, but they were not fully implemented at the time. There was a tendency to add to the gold reserves - which lengthened the list of causes contributing to the plunge into and the persistence of the depression. It may seem to be difficult to mismanage all four variables - trade, money, taxes and budgets - that were apparently misadjusted at one point or another of the evolving Great Depression, but considering the fact that there is no need to get them all wrong at the same time I would think there is a a fair chance of history repeating itself.
..............I cannot see how this points in any other direction but that of a repeat performance of historical mistakes. I would also like to point out that it is not "money" itself that is at fault here. Money is a technology that comes with a users´ manual. Unfortunately, central banks currently seem to use a new release of the tool - the floating-exchange-rate version originally launched by Milton Friedman many decades ago and now in widespread use all over the world - in conjunction with the old manuals that are detailing how to operate a fixed- or semi-fixed exchange-rate system. If the instructions in the new manuals were already being followed, it would be clear to everybody that the monetary instrument does not allow for such a thing as a currency policy. Playing an updated game according to the old rules, however, will certainly wreak havoc. There is always the option to return to the older system - which we can be sure will ultimately not be exercised -, but unfortunately a mix-and-match style of operation is a recipe for disaster.
My first observation is that I am not especially comfortable in the role of having to try and explain a 'correct' central bank strategy since I do not consider myself to be in any way qualified to set myself up as a 'currency theorist'. I find myself being lead into this minefield by the need to try and make some coherent sense out of what is happening on the global economy front, and finding that in order to do this I need to take account of the strategy being adopted by the US treasury. Also, by way of parenthesis, I should note that in principal I have difficulty with the term 'correct' here, and would prefer to speak of 'possible' strategies. One of the great problems with being pragmatic is that the simplicity of the extremes is not available, and at the same time it is often difficult to give the kind of clear and precise answers which may be offered by the more dogmatic orthodoxies. So I can say quite happily that I think neither fixed nor floating exchange rates, offer, in and of themselves, a way forward. This is like asking if you believe in free markets, well yes, and no. I believe in regulated 'free' markets. And I believe in 'regulated' floating exchange rates - and in no case fixed rates (this explains my reasoning on the Euro, and I guess I'm going to have to explain this more another day, since Frans, at least, is still waiting for an explanation). Of course, in both cases, the issue turns on what you mean by 'regulated'.
In the modern world things aren't so simple as when Friedman started writing. In particular we've discovered 'expectations', and this means that the principal players are constantly 'intervening' in the markets by what they do and say, whether or not this is supported by any classic currency measures. In other words I am saying that absence of intervention (or saying you are comfortable with a process) is itself a form of intervention. Currency strategy is a game of constant guessing. The question is to know whether anyone is about to get the 'big hammer' out. So the central banks - or the Treasury Departments according to country - try to ride the wave. They try to steer the markets by the use of gesture and intonation, politics is, after all the pursuit of war by other means, and non-intervention is the pursuit of intervention by other means.
So my starting point here is that I am comfortable with this tendency to 'guide' and 'steer' the markets. Where I am not comfortable, is with the kind of guidance that is currently being given. Perhaps part of the problem is that I am not happy with the point of departure: I am not convinced that the dollar was anything like as over-valued as was being suggested. Over-valued, implies that something else is under-valued. So over-valued with respect to what? And what exactly was undervalued - the euro, the yen - I am not convinced? My fear is that the dollar is being allowed to fall to pursue two objectives (and yes, this is currency policy at work). Firstly to try to put a gun to the heads of the Europeans and the Japanese, to try to force through reforms by placing survival in danger: a very dangerous game this one. And, secondly, in case the first ploy doesn't work, to try and buy some anti-deflation insurance for the US. I am not convinced on either count. I think what is needed is a change of course, globally. Back to the days of Plaza and Louvre, to a more managed world where we tried to work in cooperative fashion to resolve our collective problems. In economics one winner doesn't need another loser: we could all sink or swim together.
The circumstances now confronting the US economy are unique in the modern era. The Federal Reserve has warned about the risk of deflation after a year in which the US dollar has fallen by nearly 30 per cent against many leading currencies. Despite the weakness of the currency, US Treasury bond yields have fallen to 45-year lows and are 37 basis points under the yields of German government debt. The dollar's decline has been painless for US financial markets because investors are complacent about inflation. The failure of bond yields to rise has also produced a policy of benign neglect in Washington. Federal Reserve officials say the falling dollar is a European problem, not a US one. John Snow, the US Treasury secretary, effectively abandoned the previous administration's strong dollar policy over the weekend by issuing his own definition of what constitutes a strong currency. It does not include market prices.
The dollar began to weaken more than a year ago but its decline has accelerated during recent weeks for three reasons. First, the markets are concerned that the Bush administration's fiscal policy could boost the federal budget deficit to $400bn-$500bn and create a domestic savings imbalance that will expand the current account deficit to $600bn. Second, the markets are alarmed that the US is embarking upon an imperialist foreign policy that will have unknown consequences for its fiscal position, foreign trade and relationships with other countries. In the heyday of empire, the UK ran large current account surpluses. There is no precedent for a country playing the role of global superpower with a large external payments deficit. During the cold war, the US was able to finance its defence spending in part through offset programmes with other countries. The Bundesbank, for example, stockpiled dollars as a quid pro quo for US defence spending in Germany. During the 1991 Gulf war the US received large subsidies from Japan, Saudi Arabia and other countries. With the US pursuing a more unilateralist foreign policy it will have to absorb all of the costs without help from traditional allies.
Last, the markets perceive a vacuum at the centre of US economic policymaking. In this administration power is highly centralised at the White House. The only highly visible cabinet ministers are at the departments of state and defence. The Treasury's stature and influence declined during the tenure of Paul O'Neill because of his caustic comments about many issues and his poor relationship with Congress. Mr Snow has worked hard to improve ties with Congress but the markets see him as a salesman, not an architect of policy. Larry Lindsey and Glenn Hubbard, the people who created the administration's economic policy, have resigned. The other institutions of economic policy are also weak. The new director of the national economic policy council is focused on internal administration rather than influencing markets. Mitch Daniels, director of the Office of Management and Budget, is leaving to pursue a political career in Indiana. The Council of Economic Advisors is being evicted from the White House. Economic policy appears to be under the control of White House political advisers, not the traditional institutions of government. In fact, the White House will not be able to encourage a dollar rally until Karl Rove holds a press conference on the subject.
As Mr Snow's recent comments have made clear, Washington will do nothing to stabilise the dollar until there is a big correction in bond prices that might jeopardise the boom in the US housing market. But in the absence of a threat to the US housing market, the burden of adjustment will fall elsewhere. Asia will resist dollar depreciation through large-scale market intervention. China's foreign exchange reserves will expand from $280bn to $330bn this year. Japan's foreign exchange reserves will mushroom from $500bn to $600bn this year and reach $1,000bn by 2008. If Asia is able to stabilise its exchange rates, the US will have to reduce its current account deficit through larger devaluations against other currencies. This pressure for devaluation will set in motion a process of competitive monetary reflation with the eurozone, Britain, Canada, South Africa and other countries with variable exchange rates. These countries will be compelled to cut interest rates to prevent their currencies from appreciating against the dollar.
The Bush administration is prepared to pursue aggressive fiscal and monetary policies to ensure a healthy recovery in the run-up to the 2004 presidential election. Its new weak dollar policy is designed to put pressure on other countries to reinforce this domestic growth agenda. During the late 1980s Japan created a bubble economy with rocketing prices for land and equities by pursuing a monetary policy designed to stabilise the dollar. The coming round of competitive monetary reflation is also likely to force central banks to pursue far more aggressive interest rate cuts than they expect. If it does, President George W. Bush will not win re-election. There could be Bush bubbles in many asset markets during late 2004 and 2005.
Source: Financial Times