Who cares if the dollar sinks?
Sunday 09 April 1995
Well, of course some Americans care. The Federal Reserve certainly cares, but then it is its job to. The US Treasury cares. Quite a few members of the Congress care. But these people are in a minority, as one can see by the way in which a dreadful week for the dollar has been reported in the US media.
The plunge has been making the news bulletins but briefly and a long way down. There will be a mention in the national press of each day's new low against the yen, but that is less prominent than the report of a new high of the Dow Jones index on Wall Street. This is not just a reflection of the competing claims for attention by the OJ Simpson trial and the Republicans' Contract with America, more a reflection of the concerns of ordinary Americans. Many of the commentaries on the dollar point not to the international trade tensions caused by the weakness, but to ways in which US tourists planning to travel abroad can avoid being hit. They are encouraged to go to countries where the currencies have weakened or held steady against the dollar in recent months. These include the two US neighbours: Canada and Mexico.
It so happens that those two neighbours, fellow members of Nafta, are also the largest trading partners of the US. Add the fact that southern European currencies such as the Spanish peseta and the Italian lira are also weak, and it is only really against the German mark and the Japanese yen that the dollar has plunged. Add in other factors such as the small size of international trade relative to the whole US economy, and the fact that many international commodities are denominated in dollars, and it is quite hard to see who in America is directly affected by the fall. Even a buyer of a BMW or a Lexus is protected, for fierce competition holds down the price of German and Japanese imports. If that means that the foreign manufacturers lose money on the deal, well, that's their problem.
Actually, it is also America's problem, for reasons that will be clear in a moment. But that is not at all evident yet in US domestic markets. Thus Wall Street is at an all-time high. Inflation is steady at about 3.5 per cent, with the remarkable thing being how little inflationary pressure there is, despite the weak currency and the fact that the economy is at or close to full capacity. There is little pressure on wages. The bond market is no longer overly frightened, for the US long-bond yield is steady at around 7.3 per cent, with prices having recovered since November.
That last point is important. The US Federal Reserve sees its first duty as being responsible for the internal stability of the dollar - domestic inflation. The external stability - the value of the dollar abroad - is secondary to that. A New York bankerpointed out to me that there had only been one occasion in the last 20 years when the US Federal Reserve raised interest rates because of an external threat. That was in 1979, when the weakness of the dollar was leading to a plunge in bond prices.
The trigger was the meltdown of US markets, even if the ultimate cause was the weak dollar.
The obvious conclusion is that while US domestic markets remain comfortable, there will be no sudden tightening of policy by the Fed. That is not to say that US interest rates will rise no further. Citicorp, the New York bank, expects two further rises in the Fed Funds rate: one after the Open Market Committee meeting on 23 May and another in July. But there is a strong belief in US markets that the Fed's current view is that the key risk is overdoing the tightening.
If that is right, how might the Fed convey the fact that it really is concerned about the value of the dollar? There is an odd paradox in the different response of US and foreign investors. Foreigners are self-evidently terrified of holding dollar assets; Americans are seeing the value of their bonds recovering and their equities at record levels.
The trick would be to transmit the confidence of the US investment community to the foreign one. One possibility would be for the Fed to stop saying "no comment" when asked about policy on inflation. Instead, it should commit itself to a specific inflation target. There are some genuine concerns within the US that the second three months of this year, the quarter we have just begun, will show some rise in the pressure of demand. The first quarter was weak, but if the second quarter rebounds sharply and that does start to feed through into inflation, the markets need to know that the Fed is on the case. An inflation target of, say, 2.5 per cent, would go some way to reassure international investors.
But not far enough. It is simply not in the public mind here that the fall of the dollar has become a threat both to the world economy and to the US.
The danger for the world economy is easily sketched. Last year was a wonderful one for world trade. New Gatt figures show this rose by 9 per cent in volume terms. Further growth of international trade is now at risk. The German economic recovery was export-led. There is now a real danger of a double dip, as export demand is choked off by the strong mark. France is being dragged down by its efforts to hold the franc more or less in line with the mark. The Japanese economy has hardly recovered at all and could easily plunge back into recession. There is a reasonable case for both Germany and Japan to loosen policy further, but in the absence of action within the US, any such loosening is unlikely to be very effective.
If the threat to Germany and Japan is more evident, the threat to the US may ultimately be more grave. This point was put to me by a senior official based here in Washington in these terms. The US has undersaved since the early 1980s. This has shown up in the twin deficits: the current account deficit and the federal deficit. These two deficits may not be that large in relation to GDP, but they are cumulative, and both are used to finance an excess of consumption rather than new investment.
For a long while, this might have been accepted by the financial markets, but something has changed in the last year. Markets have become more critical of what they perceive as policy failure. There has been a relative loss of status of countries such as Canada, Mexico, Sweden and Italy. We have seen the markets force a change in policy in these deficit countries, most dramatically in Mexico.
In each case, though, market adjustment is less than ideal. Not only are markets liable to overshoot, but they correct in an unsatisfactory way. In the case of the US, a run on the currency would transmit to domestic markets and lead to a sharp rise in interest rates.
This would cut investment and bring the saving/spending equation back into balance. But actually the US needs more saving, not less investment. It needs a fiscal correction, not a monetary one.
That is always the extraordinary thing about America. You go to the place and can find the most thoughtful analysis of just about any issue you could find anywhere in the world, in this case the real dangers of dollar weakness. You also find that most people simply do not care. It is spring. The cherry blossom is out. Newt Gingrich has completed his Hundred Days, and we'll holiday in Mexico this year. As the headline in USA Today put it: Dollar plunge no big threat.
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