TCS Daily

Who is Minding the Dollar?

By Desmond Lachman - December 17, 2004 12:00 AM

International leadership is woefully lacking in dealing with the vexing problem of the U.S. dollar's chronic weakness. In the absence of effective leadership by either the US Treasury or the International Monetary Fund, there is every prospect that the dollar's recent steady decline will soon turn into a rout. That could have very untoward consequences for global financial markets. And as painful experience has shown, turbulent market conditions can be destructive of international economic prosperity.

Among international financial leaders, a state of confusion reigns. John Snow, the U.S. Treasury Secretary, chooses to point fingers at the Europeans for failing to stimulate their economies, without acknowledging that the US budget deficit might be an important part of the problem. At the same time, Chinese officials have had the temerity to call attention to the US budget problem, while buying massive amounts of dollars in order to keep their own currency cheap, their aim being to keep their export machine running smoothly.

As if to add to this confusion, the IMF is conspicuous by its silence on the dollar issue, while Jean Claude Trichet, the President of the European Central Bank limits himself to fulminating against the "brutal" moves of the dollar against the euro. He does so while refusing to cut European interest rates in a manner that might stimulate Europe's anemic economic recovery and slow the decline in the dollar.

The stakes would appear far too high for the global economy for a continuation of finger pointing and name-calling. For the last thing that the world economy needs now is a disorderly decline in the dollar that could lead to a melt down in equity and bond markets as well as to a relapse to the damaging protectionist policies of the past. Rather, the time would seem long overdue for agreement among the major countries on a coordinated solution to the dollar problem.

Any hope for a coordinated international solution to the dollar problem must start with the recognition that there are multiple reasons for the dollar's present weakness. Such recognition will quickly lead to the conclusion that there is much blame to go around for today's unprecedented global payment imbalances and that there is urgent need for coordinated international action.

Among the more fundamental reasons for the dollar's recent decline is the abysmal lack of US savings. In particular, a gaping US budget deficit and a record low US household savings rate. This is reflected in an external current account deficit that is presently by far the largest on historic record and that is now worrying Alan Greenspan as to how long we can expect foreigners to continue financing it.

It must be emphasized, however, that the large US budget deficit is not the only culprit for the dollar's weakness. Rather, also contributing to the dollar problem is the inability of either the Europeans or the Japanese to generate sufficient domestic demand to stimulate their economies. Instead, they choose to remain overly reliant on US growth to prop up their economies, which makes it exceedingly difficult for the US to export its way out of its external deficit problem.

Similarly, unhelpful to solving the US dollar problem is stubborn Asian resistance, particularly by Japan and China, to allow their currencies to strengthen. They do so in order to keep their exports cheap in international markets. However, by so doing, they unfairly place almost the entire burden of the dollar's adjustment on the Europeans, who at some point must also be expected to react by manipulating their own currency.

A coordinated approach to the dollar problem involving the US, Europe, Japan, and China, could be done along the lines of the 1985 Plaza agreement, which successfully facilitated an orderly depreciation of the dollar by a similar amount to that which is required today. Under a modern day Plaza Agreement, the United States might credibly commit to halving its budget deficit over the next few years. In return, the Europeans and the Japanese might credibly commit to a very much more activist monetary policy to stimulate domestic demand, while the Asian countries as a whole might commit to allowing their currencies to appreciate.

Sadly, a US Treasury that seems to be in denial does not hold out much hope for such a coordinated solution to the problem anytime soon. Nor does an IMF that has been virtually silent on this issue despite the fact that this was the very reason for its being set up in 1945. One must be left wondering whether a hard landing of the global economy is what it will take to focus the minds of those who should be leading us out of this problem. That would be a great shame. For by then it would be too late.


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