Bottom dollar begins its ascent
Sunday 20 August 1995
It is a relief in a personal sense for, having predicted a higher dollar this year, it felt a bit uncomfortable to see the thing whizzing down. But of course it is a relief in the vastly more substantial sense that the undervaluation of the dollar had become so great as to threaten the world recovery.
Assuming that the turning point has been reached, there is every prospect of a cyclical dollar recovery over the next two to three years. The path of the dollar against the mark, the yen and sterling since the fixed-rate system broke up in the early 1970s, plus a projection beyond 2000, was charted last month by NatWest Markets. The recovery has come more quickly than the currencies team predicted, but the rationale behind their outlook is unchanged, and the projections deserve a wider audience. NatWest's view, however, is that we will simply see a cyclical recovery: the long- term trend in the dollar versus the mark and the yen remains down. And the long-term trend of sterling against the dollar also remains down: the dollar will remain weak, but the pound will be weaker.
The cyclical pattern is a function of relative points on the economic and interest-rate cycles, plus investment fashion, and spiced with policy errors and the financial markets' habitual tendency to overshoot. But what about those long-term trends? Cyclical swings will always be with us, but long-term trends do change. The NatWest thesis is that the downtrend is set, so that we are only talking of a two- to three-year recovery, and thereafter the decline of the dollar will continue. That may be right, but it is worth exploring the alternative view, that the long decline of the dollar (and for that matter, the pound) is nearing its end.
Long-term trends in currencies are a function of two main features: the structural and political climate in which a country's inflation rate is determined; and the relative economic performance and comparative advantage.
Thus while the US has had an institutional structure that ought to give it a sound currency - a pretty independent central banking system - it also has a political structure which has tended to generate lax fiscal policy. Add an erosion of comparative advantage for much of the post-war period, but heavy overseas commitments in military spending, and a decline of the currency is hardly surprising.
By contrast, Germany has had a strong social commitment to low inflation and reasonably restrained fiscal policy, plus a structure for its central bank that encourages it to lean hard against inflation. It has benefited from having much of its industry in growing areas and has further gained from having its external security guaranteed and partly paid for by the US, plus a contribution from Britain. Result: a trend for stronger currency.
Japan has not any political or institutional arrangements that hold down inflation and in the 1950s and 1960s suffered large price rises. But it does have a social structure that leans against imports, and devotes resources to exports. The result was that when its comparative advantage improved with the fall in commodity prices (it has always been a heavy importer) it began to run a large structural current account surplus and became the world's largest owner of net overseas assets. Further, like Germany, it has had its external security guaranteed by the US. So its currency has climbed.
Finally, we here have had the worst of every world: an institutional and political structure which has favoured inflation; an economy overdependent on sectors where we had little comparative advantage; and a continuing drain across the exchanges from military commitments overseas. Given that, it would have been astounding had the pound been an inherently strong currency. Now apply this test. How many of these features seem likely to change over the 20 years?
Let's start with the US. It is hard to see any significant change taking place in the position of the Federal Reserve, but there will surely be some change in the way fiscal policy is set. Whether this takes the form of a requirement for a balanced budget, or whether the change takes place in the next three years or is delayed into the next century is less important than the fact that there is a clear commitment to change. Maybe, just maybe, there will also be social changes that will increase the preparedness to save, at present one of the weakest features of US economic behaviour.
Next, the competitive position: there has been a clear improvement since the early 1980s. This showsin terms of share of world exports, but more importantly in the structure of US foreign earnings. These come increasingly from intellectual property, from entertainment, and from financial and other services. These are also areas that seem less likely to be challenged by the new low-wage contenders in world manufacturing. By contrast, Germany and Japan both find themselves being undercut.
Finally the US role as global policeman is drawing to an end. Defence spending is shrinking in real terms and spending on, for example, troops in Germany is likely to fall faster.
Now compare this with Germany and Japan. Germany's structural support for sound money will continue, and support for sound fiscal policy has survived the pressures of unification. Sound money should also survive the pressures of monetary union, if that should occur. The German traditional strength on medium and upper-medium technologies seems as secure as ever. But there is less evidence of strength in the new "soft" technologies, the ones in which the US is particularly strong, and Germany has been slow to reform crucial areas like telecommunications.
Many of the same points apply to Japan, which despite its vast trade surpluses, is actually the only large developed country that exports a smaller proportion of GDP now than in 1960 and which also has been slow at developing "soft" industries. The institutional structure of government will change during the next 20 years, which may or may not change attitudes to inflation. But for Japan, the key economic influence will be demography, for it will become the oldest nation on earth: it will have the highest proportion of over-65s. In theory at least that should change its savings habits: Japan will have to run down its overseas assets to help pay for support of its retired folk.
And us? I think the closest parallel is with the US. We are considering structural changes, such as an independent Bank of England, which should result in sounder monetary policies. Our comparative disadvantage in manufacturing is largely a thing of the past; our labour market has been reformed; and we have great strength in software, education and entertainment. Our residual role in keeping troops overseas will surely wither away, so that drain on resources seems likely to end. These may not be conditions for a strong sterling recovery, but the continued decline need not continue.
Is this convincing? Anyone who tries to "call' a turning point in trends that have been established for more than 30 years is liable to be proved spectacularly wrong. I think we will look back on this period as a great turning point for both the dollar and sterling. But I would be the first to hang a large health warning on that projection.
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