How Japan's savings could stave off recession

Could the dollar be about to experience another amazing free-fall? And if so, how would the world be affected?

Forecasting the demise of the dollar has been pretty much a mug's game over the last few years. So reaching big conclusions from the dollar's recent decline may be a bit premature. After all, there have been plenty of previous interruptions to the dollar's onward march and, each time, they have come to nothing. The dollar fell back during the Russian crisis and the LTCM hedge fund affair. It fell back at the end of 2000 as the first signs of domestic US economic problems came through. Yet, on each occasion, the dollar picked itself up, dusted itself down and carried on as normal. Indeed, the dollar reached new cycle highs in the first half of this year.

Never the less, it is worth thinking about life with a weaker dollar. All bull runs eventually come to an end. And now is as good a time as any to be worrying about a weaker dollar. Put simply, financial markets have lately become more and more gloomy about the US economic outlook. As they have done so, they have become increasingly disinclined to hold dollars and dollar assets.

First, the good news. Most dollar declines have been fairly limited in scope. Measuring the dollar's value against a basket of other currencies, the dollar has typically fallen by around 10 per cent during correction phases. This pattern has held reasonably well over the last 30 years. If this kind of decline happens again, there could be good news in store for the global economy.

A modest dollar decline would boost the competitiveness of US companies, reducing the pressure for domestic cost cutting. A dollar decline would not be so helpful for European exporters. However, the impact on Europe would not stop there. A weaker dollar – and, hence, stronger euro – would make it a lot easier for the European Central Bank (ECB) to cut rates aggressively. Indeed, the earlier period of dollar strength may have been a key factor behind the ECB's reluctance to lower interest rates, despite signs of severe domestic weakness in, for example, Germany.

My estimates suggest that a combination of a modestly lower US dollar, more cuts in US interest rates and a more aggressive approach to monetary policy from the ECB would be a net plus for the world economy over the next 12 months. On this basis, the authorities should surely welcome a weaker dollar.

Unfortunately, there are a number of key risks with this view. Every dollar decline over the last 30 years has been associated with weakness not just against the European currencies, but also against the yen. A weaker dollar might, eventually, do wonders for transatlantic relations. But Japan hardly needs a stronger yen. Indeed, there are already indications that Japanese officials are frantically returning from their holidays early to ward off speculative upward pressure on the yen. Moreover, there are no guarantees that the ECB is in the mood to cut rates aggressively. On that basis, the potential benefits of a dollar decline might not be fully realised.

Now on to the bad news. The 1985-88 dollar decline is the exception to the general rule of only modest corrections. Then, the dollar fell against its currency basket by roughly 40 per cent over a three-year period. Then, as now, the dollar's decline followed a multi-year period of strong appreciation. And, like the last few years, the US had seen a massive increase in its current account deficit. Could it be that the dollar is about to experience another amazing free-fall? And, if so, how would the world economy be affected?

The dollar's collapse in the mid to late 1980s was a reflection of good, rather than bad, things. Indeed, the dollar's decline could be seen as a precursor to the late 1980s boom. The key to understanding this situation lies in the reasons for the dollar's climb in the first place. The dollar's rise in the early 1980s was based on a combination of excessively tight monetary policy and excessively loose fiscal policy. The resulting very high interest rates allowed the US public sector to suck capital away from the private sector, both in the US and elsewhere. As a result, the widening budget deficit was accompanied by a widening current account deficit (left-hand chart).

The multi-year decline in the dollar was sustained partly by the earlier reductions in US inflation – which allowed the Fed to ease the monetary brakes – and partly because of the renewed commitment to budget deficit reduction. This led to a dramatic reduction in real interest rates which proved to be a huge benefit not just to the US economy but also to the rest of the world. Thus, Germany, Japan and the UK all boomed in the late 1980s, despite seeing their currencies rise rapidly against the dollar.

Unfortunately, these arguments do not apply today. America has not been sucking in capital from around the world to fund its public sector. Rather, America's demand for global savings has come from its private sector. The hopes of the late 1990s – built on a seductive mix of low inflation, low interest rates and new technology – allowed the US to go on a spending binge, with both consumers and companies pushing the boat out in a major way.

For a while, all of this supported the hopes of the "new paradigmers". However, declining equity prices and collapsing profits now suggest that many of these hopes were skating across very thin ice (right-hand chart). Under these new circumstances, a rapid dollar fall would reflect a collapse in expected future returns for the US private sector, not for the public sector. In other words, a collapsing dollar now would reflect heightened fears of US – and, hence, global – recession. In addition, it would be a quick way of exporting America's problems to both Europe and the Japan.

So how can we be sure that a dollar decline will be a modest, orderly affair rather than a disorderly collapse? There is a fine line to be drawn between the two. History lies on the side of the modest decline. But fundamentals suggest the risk of something far worse. To ensure the former, and ward off the latter, maybe now is the time for greater policy co-ordination between the world's major economies.

There is an opportunity for action. A substantial dollar decline would imply a shortage of savings to support the US economy and, hence, would heighten risks of recession. At the same time, however, Japan has an excess of private savings which, to date, have been languishing in the Japanese bond market. Even with the collapse in US returns in recent months, it is still the case that most US assets yield higher returns than their equivalents in Japan. So if a mechanism could be found to shift Japanese savings abroad, there could be benefits for both countries.

How could this be achieved? A number of radical steps would have to be taken. The Japanese would have to deliver a much larger current account surplus, through aggressive fiscal tightening. The Japanese and Americans, in combination, would have to "draw a line in the sand" on yen appreciation, with the threat of concerted bilateral intervention to push the yen lower, thereby supporting Japanese exporters. The falling yen would remove the currency risk from Japanese investors who, in the past, have had their fingers burnt as a result of foreign adventures. Meanwhile, the Europeans, Japanese and Americans would agree on a unilateral appreciation of the euro in exchange for aggressive rate cuts from the ECB.

Sounds fanciful? Perhaps, but the global allocation of capital would be improved, returns for Japanese investors would be higher, the Americans would avoid a complete dollar collapse and the Europeans would contribute to a much looser global monetary environment. Maybe it is worth a try.

The writer is managing director of economics at HSBC.