Hamish McRae: The decline of the dollar may hurt Europeans more than Americans
Thursday 24 April 2003
What if the dollar does continue to decline?
What if the dollar does continue to decline?
The latest forecasts for economic growth for this year and next suggest that the United States will have another 18 months when it is likely to grow more quickly than the eurozone or Japan.
There is no particular surprise there. But it will not be particularly rapid growth because the American consumer seems to be starting to borrow just a little less and the US business community is not anxious to borrow much more. Meanwhile the US seems to have become a much less attractive region for foreign investors, in part perhaps because of the myth of dollar invincibility has been punctured.
Besides, once markets get going in one direction they tend to overshoot. So there is at least a reasonable possibility that the recent fall of the currency will go much further. Suddenly the markets are talking about a rate of €1.15, which is pretty much where the euro came in.
Is it plausible? Have a look at the long-term trend of the dollar, as shown in the first graph. It is plotted there on the usual trade-weighted package against major currencies but also against a broader range, including the currencies of the fast-growing economies of East Asia. On a near 30-year view, the dollar looks OK against major currencies. The most recent peak was not as marked as that of the middle 1980s, so while the dollar is still higher than it was during the early 1990s, it does not feel wildly out of hand.
If, however, you look at the value of the dollar against a wider range of currencies, it has made a steady climb. Now, that is partly because some of those currencies, the Latin American crop for example, have been pretty dreadful. But it also reflects a continuing under-valuation of the currencies of the East Asian "tiger" economies. The widening US trade gap is largely against these, as indeed is the UK gap.
So it is perfectly plausible that the dollar will fall back a bit more against the major currencies, largely because European investors are scaling back their purchases of dollar assets, but the dollar will retain its past pattern of climbing against a wider basket. Intuitively, that feels right. If it is, what are the consequences?
An obvious one is that the faster US growth will be reinforced. At the margin price still matters. The US has been an uncompetitive producer vis-à-vis Europe for several years, except in products such as software, where it has a strong comparative advantage. At the margin European exporters will be at a disadvantage in the US and a bit will be knocked off European growth.
This could be quite serious for some eurozone countries, in particular Germany, which has been overwhelmingly dependent on export markets to create any additional demand at all. Indeed the eurozone would be the largest single casualty of a weaker dollar.
There need not, however, be such a shift against other regions, which may continue to nudge down their currencies against the dollar. Do not expect a "cure" to the US current account deficit.
Might a fall in the dollar recreate inflation in the US? I think that danger is small because the general danger is one of global deflation, not inflation. The price of goods in the US year on year is now negative; the only reason prices are positive is the rise in the price of services and the rate of increase there is falling too (see next graph).
Indeed in a deflationary world it is rather helpful to have a weaker currency as it gives the policymakers a little more leeway – just as having a strong currency is useful in an inflationary world. Remember how the fall of sterling, after the pound was kicked out of the European exchange rate mechanism, was expected to lead to a bounce in inflation. It didn't because competitive pressures were strong enough to hold inflation down. Expect a similar outcome in the US.
A nearer-home consequence is the position of the pound. As a useful rule-of-thumb sterling usually behaves like a mid-Atlantic currency, moving halfway between the dollar and the euro. Of late, it has tended to stay closer to the dollar, with the result that the pound is now at a four-year low against the euro and at a rate that is generally accepted as acceptable were the pound to join.
Without getting into the whole business of whether entry would be a good idea, note that were the dollar to fall much further, and to take sterling with it, another objection would start to arise. This would be that the pound, far from being too high, was too low and was putting UK exporters at an unfair advantage.
This possibility should not be dismissed. There is no particular reason to fret about the UK current account deficit, which was last year less than 1 per cent of GDP. But while we don't need a lower exchange rate, we might get one as a result of backwash from the dollar. We would then have the possibility or rebalancing the economy, replacing domestic demand with export demand and import substitution.
Indeed it would be quite a neat way of engineering a soft landing for the economy, though at the cost of upsetting relations with our European competitors. Having a weakish currency makes a lot of sense if there is to be a prolonged period of slow growth.
That possibility was suggested by HSBC in a recent paper and you can see the outlook sketched in the third graph. We regard the 1990s as normal because that decade encompassed the most recent economic cycle, but it is perfectly possible that it was unusual – a boom sustained beyond its natural life by enthusiasm for the communications revolution.
It is equally plausible that the cycle we have just begun will be more muted – that the trend growth of the 2000 to 2010 period will be lower than that of the 1990s. There are several reasons why this might be so, including the still-to-be-eliminated excesses of the dot.com boom. The most over-riding reason, though, is the threat of deflation. If it is going to be a slow growth decade, with a flirting experience of deflation in several major economies, then the US (and the UK) may continue to perform quite well relative to the core eurozone and Japan.
All this, of course, is predicated on the assumption that the dollar will get weaker. Viewed globally it may not. But it may against the euro, which will exacerbate all the internal tensions already evident in the eurozone. If the Americans have reason to feel a little twitchy about the weakening dollar, the Europeans have reason to be really concerned.
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