Is a landslide about to begin? The immediate effect of last weekend's Group of Seven statement calling for more flexible exchange rates was to hit the dollar.
That is certainly the right direction for it to go. I don't think many people believe that it is too high, given the size of the current account deficit, which, if you believe the figures, is heading towards 5 per cent of GDP. But what we cannot yet know is whether the G7 words will have a modest medium-term effect, perhaps pushing the dollar down a bit earlier than might otherwise have been the case, a dramatic impact leading to a serious and excessive decline - or maybe no lasting impact at all.
History helps a bit. We know for sure that when politicians try to talk up weak currencies they get a kick in the backside from the markets. Successive bouts of sterling weakness have demonstrated that. We also know that when a number of finance ministers and central bankers get together and make a joint statement about currencies they are liable to influence the markets - particularly when they back their words with intervention on the exchanges.
The Plaza Pact and Louvre Accord in the 1980s, the first checking the rise of the dollar against the yen and the second stabilising its decline, seemed at the time to be great success stories. But with hindsight they were successful probably because they validated market movements that were already starting to happen. Subsequent efforts to hold the major currencies within unpublished bands - the idea of the Louvre Accord - were not very successful and were eventually abandoned.
The G7 statement is, in one respect, similar to Plaza, though in this case the country that is using a low exchange rate to boost exports to the US is China, not Japan. If the US wants to ward off protectionist pressures it has to do something about the level of the renminbi.
But there are three substantial differences. One is that there is no central bank intervention on the exchanges, perhaps because it is not needed but also because there is no consensus among the other G7 members that the dollar should be lower. Neither the Europeans nor the Japanese want that.
The second is that the US problem is not so much that the dollar is generally too high - it may be a bit high but not excessively so - but that demand in the US remains strong while demand elsewhere remains weak. This sort of imbalance does not easily lend itself to correction by exchange rate movements - or rather the scale of dollar devaluation would be so great as to be highly disruptive to the world economy.
And third, China is not a member of the G7, so it is not party to the statement. Japan was a member of the G5, as it then was, at Plaza.
So what can sensibly be said? There is no doubt of the bearish mood of the exchanges. The left-hand graph shows the movement of the dollar over the past five years, and the annual rate of change. It is also clear why the dollar has not fallen further already. The reason has been the flood of foreign funds into US Treasury securities, with non-nationals now holding 20 per cent of the total stock of official debt.
But before you conclude that this cannot continue and the dollar must fall sharply, remember that it is not in the self-interest of anyone outside the US to see that happen. Not Europe, already teetering on the edge of recession; not Japan, at last managing a little growth; and certainly not China.
In any case there are other reasons for non-US nationals to invest in the US. American corporate profitability is recovering, thanks to a huge surge in productivity. That surge has an important side-effect: businesses elsewhere need to know how the US does it and accordingly need to maintain their investment in the US. Portfolio investment, too, may recover, as it becomes almost certain that the bottom of the present equity cycle was last October. Cheaper oil will help a lot (right hand graph).
Besides, if you don't like the dollar, where else do you go? The euro would be the obvious candidate and in the short term it may well strengthen somewhat. But that may push the European Central Bank into another cut and may push the eurozone's nascent modest recovery back into stagnation. The yen? Well, yes, but there are big risks there that the artificially low long-term rates may rise sharply.
Sterling? That will, if past performance is any guide, trade between the dollar and the euro, so it is not really much of a hedge. East Asian currencies, including the renminbi? Can't get into them as the markets are too small.
Put all this together and the balance of probability is that there will be some shading down of the dollar over the next couple of years. There is a small danger of an over-rapid decline, which, were it to happen, would be deeply dangerous to world trade.
To avoid any such danger two things have to happen. One is that Europe and Japan follow growth-oriented policies. The other is that countries with large trade surpluses in the US, most notably China, realise both that there are limits to American patience and that it is not in their long-term self-interest to be so dependent on exporting to the States.
And the chances of these? It is hard to be very optimistic about European growth. There is a disturbing lack of urgency and humility in the eurozone: leaders don't like admitting that the euro might actually be part of the problem, despite the fact that large parts of the Continent self-evidently have the wrong exchange rate.
It would be a good reality check were the euro to rise sharply and export growth be choked off, for it might force European leaders to take seriously the notion that domestic demand has to be encouraged.
As for China, expect nothing except polite words and you will not be disappointed. My concern is that the leadership has so many problems to wrestle with that it is not able to devote sufficient space of mind to the problems of a trade surplus with America.
If all these US companies come and build plants in China, where, they might ask, does America expect the products to go? The difficulty is that individual corporate decisions to cut production costs by sourcing from China have a collective impact on the US, which those businesses cannot take into consideration.
None of this means that there is disaster ahead. But there is a possibility of serious trouble and things will not feel more comfortable until the US current account starts heading back a little way towards the black again.Reuse content