TCS Daily


Mr. Trichet Sleeps as the Dollar Sinks

By Desmond Lachman - October 4, 2007 12:00 AM

In 1972, John Connolly, Richard Nixon's Treasury Secretary, famously remarked to his European counterparts that the dollar might be the United States' currency but it was Europe's problem. While somewhat of an exaggeration, Mr. Connolly's remark contains an enduring kernel of truth. And as the US dollar is once again very much on the ropes and likely to stay there, it is at his peril that European Central Bank President Mr. Trichet risks ignoring Mr. Connolly's insightful observation.

The dollar's recent plumbing of new all-time lows should hardly come as a surprise. After all, for almost a decade now, the United States has been living increasingly beyond its means. The net upshot has been the ballooning of the US external current account deficit to its present level of US$800 billion, or the equivalent of a staggering 6 percentage points of GDP.

Worse still, the United States' profligacy has long since moved the US from being the world's largest creditor nation to being the world's largest debtor nation. Indeed, the US now owes a net US$3.5 trillion to both foreign central banks and private sector investors. As a result, not only does the United States now need in excess of an additional US$2 billion a day in external financing, but it also needs the rest of the world to continuously add to its already outsized dollar asset holdings.

The market response to Mr. Bernanke's September 18 surprise 50 basis point interest rate cut hardly bodes well for the dollar. In the two weeks following that cut, the dollar plunged by more that 2 percentage points to take the dollar to an all time low. At the same time, rather than decline as Mr. Bernanke had intended, US long-term interest rates rose as investors feared that an easier monetary policy stance risked re-igniting inflation, not least because of a weakening dollar.

The dollar's extreme vulnerability highly complicates Mr. Bernanke's task of dealing with the United States' worst housing bust since the Great Depression. Mr. Bernanke is all too aware that US monetary policy will need to be eased aggressively in the months ahead to cushion the rest of the US economy from the fallout of the ongoing housing market bust. However, he also knows that the US dollar is still probably overvalued by around 20 percent and that any further reduction in interest rates risks tipping the dollar into freefall.

A plunging US dollar would make it all but impossible for the Federal Reserve to achieve its dual mandate of promoting satisfactory economic growth and keeping inflation in check. For a weaker dollar would rapidly feed through to US domestic inflation as import costs soared. A weaker dollar would also likely result in a further significant backing up of US long-term interest rates as a declining dollar hastened foreign investors' exit from the US Treasury market. Such a backup in interest rates would only deepen the US housing market malaise.

While a declining US dollar will certainly complicate US economic policymaking, it would seem to pose at least an equal challenge to European policymakers by seriously undermining Europe's export prospects. Especially so in the context of today's world, in which all too many Asian countries manipulate their currencies for competitive advantage, causing the Euro to bear the brunt of the dollar's decline.

As the dollar's fall gathers pace, one already hears the predictable chorus of European policymakers calling upon the United States to do something about its falling currency. They do so oblivious to the fact that, even were it inclined to do something, there is little that the Federal Reserve can realistically do to support the dollar at the time that the housing market bust is in full train. They also make their call in total disregard of Mr. Connolly's reminder that the dollar is in the end Europe's problem and that any prospect of slowing its decline will require the close co-ordination of European and US monetary policy.

At a time that a declining dollar, coupled with a weakening US economy and a global credit crunch, seriously threatens the European economic recovery, it is difficult to understand the ECB's still hawkish monetary policy stance. One has to wonder what lesson Mr. Trichet might be drawing from the dollar's recent swoon in the immediate aftermath of the Fed's recent interest rate cut. One must also wonder whether a forward looking ECB would not be anticipating future Fed rate cuts to support the ailing US economy and would not see that matching those interest rate cuts offered the only real hope of preventing the dollar from going into free fall.

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11 Comments

"worst housing bust since the Great Depression" - really????
Are we really in the worst housing bust since the Depression? Where are the facts to back up this powerful claim? Maybe it is true, but what info backs up this statement?

Absolutely the housing market is in bad shape, and home builders, mortgage companies and other companies in this industry are in bad shape. People also got into houses that they couldn't afford thru the sub-prime mortgages. While each one of them is an individual sad story, how many in total are we talking about compared to the overall housing market?

Also, we have around 4.5% to 5% unemployment, not 20% like in the Depression. The EC would kill for those unemployment figures. Also our GDP growth, while slowing is still around 1.5%-2.0%. Isn't that reduced number still higher than the EC?

How much did housing prices drop in the Depression? Currently aren't we seeing about 2-5% median price decline?

"worst housing bust since the Great Depression"
Agree, what does this mean?

Too much supply, not enough demand?

Lenders providing loans at 125% of market value?



Mr. Trichet Sleeps as the Dollar Sinks
This article is of generally poor quality, with some claims similar to those made by any street corner 'prophet-of-doom'.

But first, about housing slump: yes, by one measure, it is worst since the great depression. The nationwide house prices have not declined in nominal terms (before inflation), since the 1930s.

But the claims like “Americans have been living beyond their means for years” are nonsensical: we have open financial markets. If foreigners choose to buy our bonds for their own reasons (because they are looking for a safe place to park their money, or because they have chosen mercantilist economic policy), what are we going to do with the proceeds? We buy their goods. Thence the trade deficit and debt.

“the US dollar is still probably overvalued by around 20 percent” – where does this number come from, I have no idea. In purchasing power parity, $ is undervalued against major developed world currencies (read the stories on shopping bargains in the US for Canadian, British and EU turists).

Ned

sinking just as predicted by the Austrian economists
They also correctly predicted the great depression back then. No, Austrian economics is not some new fad of a school, but has been around for ages, but ignored because of politicians who like to intervene in and distort the economy; thus they prefer Keynsianism. Had the US remainded on the real gold standard and not used fiat money, it wouldn't have all these problems.

All this and more spending
The line up of Demcratic candidates are propsing huge increases in social spending. That should help the dollar value.

Get ready for Jimmy Carter IV

Why do you say that?
"But the claims like “Americans have been living beyond their means for years” are nonsensical: we have open financial markets."

Open markets are irrelevant. The conclusion about living beyond means comes from personal debt and savings rates. Americans are the highest in the first and lowest in the latter of all OECD nations.

"If foreigners choose to buy our bonds for their own reasons (because they are looking for a safe place to park their money..."

It must come as a surprise to you then that we're now in the second year of development capital draining out of US markets. Second, it's not all that safe as the current subprime mortgages collapse is showing.

"“the US dollar is still probably overvalued by around 20 percent” – where does this number come from, I have no idea."

Oh please, the decline in the US dollar is fueled by two phenomena: runaway government fiscal deficits and a rising trade deficit. The dollar has declined directly as US finances have moved from surplus to deficit.

"If foreigners choose to buy our bonds for their own reasons"

Try again. The part you are missing is why were the bonds issued in the first place. To cover the budget deficit. At some point, and the subprime mortgage-commercial paper fiasco may have set it off, the value of US assets comes into question. So, I'll spell it out for you. If the US keeps issuing bonds to cover deficits (it's called printing money) sooner or later the asset value to backstop that debt becomes devalued. At that time you have two choices, jack up the interest rate, thus triggering a recession, or face a liquidity crisis.

The current fiscal mess is certainly not the end of the world, but your views of "what me worry" would have us all over the cliff, blinded by our rose-colored glasses.

Desmond, Desmond...Desmond...
Consider for a moment that the dollar is actually flat...and that it only appears to be weakening because the currencies it is being compared with are simply strengthening.

We are talking about the value of money relative to alternative assets...including other currencies.

Within our own economy a weakening dollar against our own US assets would be (by definition) inflationary. If this was real yet we experienced little domestic inflation then the market counter balance would be a "strengthening" of the dollar against foreign currencies...in a sense weakening their money and exporting our own inflationary pressures into their economies. Clearly that is not happening. Quite the opposite.

Similarly, a market induced (rather than something done by the authorities) weakening of the dollar should counter underlying deflationary pressures, if we do not simultaneously measure domestic inflation. Again, we see no evidence that there is (or concern that there might be) significant deflationary risk in our economy, today. It follows that the dollar is not weakening to hold off domestic deflation.

Consider the phenomenon of healthy inflation in a growing economy. The real value of an economy's income producing assets must be increased in terms of the buying power of its domestic currency while the money itself does not lose value against other hard currencies. We see this today in the Philippines. As their economy develops its sustainable rate of inflation is enhanced by a strengthening of the peso. Assets in the Philippines are worth more money (dollars) today than two years ago because, as the Philippine economy enters the global arena, those assets are able to produce greater earnings.

Alternatively, the Japanese economy has substantially recovered...but its rate of growth is about flat. Its domestic asset values are not improving against the yen and a further strengthening of the yen would be deflationary. It is better for the Japanese if the yen weakens somewhat against the euro and does not stregthen agains the dollar just now...and that is precisely what is happening.

The Chinese economy is going great guns and they are absorbing their internal, upward, asset revaluation (without strengthening the yuan) through domestic inflation that must soon spill over into substantial wage increases (following the 2008 Olympics) and thereafter, indeed, as a stronger yuan after all.

The euro is strengthening relative to the dollar because the European economy is experiencing robust expansion (finally) and much of that inflationary pressure is being released into the expanding global economy...that is fully able to absorb it.

Through all this the dollar has remained flat. The dollar is the global benchmark regarding the value of money. That role might shift onto another currency some day...but insofar as currency revaluation is useful for rapidly changing economies (other than our own) the Central Banks of the world should be quite happy to let us do the heavy lifting.

Why have Europe jump on a sinking ship!!!!
The USS Inflation is sinking and you want the continent of Europe to jump on board. This whole mess was caused by easy credit in the first place and the Sub Prime meltdown was caused by the Fed trying to stop the easy credit flow.

If the Europeans are smart, they will keep their inflation (Increasing the money supply) LOW (Note not zero which it should be.) and buy all this cheap US stuff like CAPITAL ASSETS and technology to help thier productive capabilities.

If the US insists on making its citizens poorer then why should Europe do the same?

Finally, Deflating money biases exporters at the EXPENSE of domestic producers. This is horrible long term economics as those with capital see better investments abroad.

Cause of dollar decline
Colin H--

In my opinion, the dollar is declining because (a) our interest rates are so low, (b) Treasury is not supporting it, and (c)(the point of the article)neither is anyone else.

Also, keep in mind the point made by some of the other posts: the dollar's decline is steep relative to the Pound Sterling and the Euro, but not so much against Western Hemisphere and Asian currencies. Travel to Europe is not affordable (darn it!), but South America and Asia are still travel bargains relative even to the U.S.

Quite right
about the reason for the dollar decline, particularly when you add in trade and fiscal deficits. Decline against western currencies? It's declined by over a third compared to the Canadian dollar, and the Swiss franc and.... I could go on, but fact is it's declined heavily against all OECD currencies except perhaps for the yen.

The real point of my post was the original poster's comments about no evidence for overvalue. Utter foolishness, the dollar's decline is evidence of overvalue, and the absence of change in any background conditions that produced it mean that decline will continue.

Quite right about the lack of interest rate support. However, the interest rate required to stabilize the dollar at its current level means a recession. Given the absence of political appetite for that, the dollar's decline will continue, and everyone in the US will effectively take a pay cut by the amount of that decline.

It's worse than that, though, Otterman. If you were a foreign investor over the past eight years of economic growth, all of your gain on investment would have been wiped out by the decline in the dollar. Now, maybe we should think about the long term implications of that.

What Lending Crisis?!
I'm also tired of hearing about how sub-prime mortgages hurt anyone. Please!! I want one of those loans!!

I know of NO ONE being foreclosed upon who couldn't afford the payments... if they'd give up the cars, the boats, the games, the vacations, the lattes, and the lunches out. Do you?

Please, do NOT wreck my chances of getting a great loan deal for the abuse of a few, silly losers who can't manage their finances. (Do not even think about forcing me to bail anyone out, either!!)


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