TCS Daily


In Search of a Dollar Policy

By Desmond Lachman - November 21, 2007 12:00 AM

Among the few constants in life seems to be the US Administration's tired and stale dollar policy. For over the past thirteen years, every time that the dollar has weakened unduly, the US Treasury Secretary has been rolled out to pronounce his unwavering belief in a strong dollar policy. He has done so in the hope that mouthing that well worn mantra would work as it did as of old to calm foreign exchange market fears.

By now, one would have thought that the efficacy of "a strong dollar policy" would be seriously questioned. For since reaching its peak in 2002, the dollar has depreciated by around 30 percent against a currency basket and by over 40 percent against the Euro. More disturbing still is the recent marked pick-up in the pace of the dollar's decline, which raises real concerns that the dollar might now be in freefall.

Underlying the recent pick up in the pace of the dollar's decline is a growing perception that the US housing market's troubles are far from over and that those troubles are almost certain to spill over to the rest of the economy. Were that to occur, the Federal Reserve would be forced to continue cutting interest rates, which would reduce the relative attractiveness of holding US dollar assets. At the same time, the US banking system turmoil would worsen, which would only reinforce foreigners' wariness about holding US dollar paper.

The perception of a weakening US economy would not be of the greatest concern if the US had a reasonable balance of payment position. Sadly, this is palpably nowhere nearly the case. Despite some improvement over the past year, the US is still running an external current account deficit of around US$700 billion, or almost 5 ½ percent of GDP. That large a deficit means that the US still needs to borrow from abroad a staggering US$2 billion a day. And the US is hoping that such a pace of inflows will continue to occur smoothly despite the fact that foreigners are already stuffed with a surfeit of US dollar holdings.

From a US perspective, an orderly and gradual decline of the US dollar is something to be welcomed. For a lower dollar has to be part of the necessary adjustment process of the large US external deficit. A lower dollar also has the desirable effect of making the country's exports more competitive, thereby providing the economy at least a partial offset to the country's housing market related woes.

A disorderly dollar decline—where the dollar falls at too rapid a pace that could have snowball effects—is quite a different matter. For an excessively rapid pace of dollar depreciation runs the very real risk of stoking underlying US inflationary pressures. It also runs the risk of destabilizing already unsettled financial markets by raising the prospect that foreigners would want to exit en masse the US equity and bond markets. Needless to say, both rising inflation and a troubled US bond market would highly constrain Mr. Bernanke's room to cut interest rates to soften the fallout from the US housing market bust.

On his recent visit to Washington, President Sarkozy focused attention on yet a more ominous risk from too rapidly a declining US currency. Recalling the experience of the 1930s, he suggested that disorderly dollar movements raised the very real risk of "economic war". By this he meant that countries might be tempted to revert to beggar-my-neighbor policies that could intensify protectionist pressures and that could threaten the very foundations of a globalized economy.

Confronted with the very real risks that a dollar rout would pose to both the US and the global economies, one has to wonder whether simply having the US Treasury Secretary periodically mouth support for the dollar is an adequate response to very serious economic and financial market problems. Might not a more appropriate US policy response be that of considering how the country's budget, tax, and credit policies might be adapted to improve the country's dismal savings performance? For after all, it is the country's abysmally low savings level that underlies the dollar's basic vulnerability.

One might also ask whether the US should not be making a greater effort to seek a coordinated policy response to what is a global rather than simply a US economic problem. Such coordination should not be limited to foreign exchange intervention exercises aimed at restoring a two-way market for the dollar. Nor should it be confined to exerting real pressure on China to adopt a very much more flexible currency policy and to bear its fair share of the adjustment process.

Rather, one would think that such policy coordination should also be aimed at forging a common monetary policy approach among the Federal Reserve, the ECB, and the Bank of Japan. It should do so both with a view to reducing the risk of disorderly dollar movements as well as to ensure that the world has an appropriate level of aggregate demand.

It would hardly be an exaggeration to say that today's risks to the global economy are at unusually elevated levels. Such times would seem to cry out for very much more imaginative policies from the United Sates than merely uttering empty mantras and praying that markets do not fall apart.


The author is resident fellow at the American Enterprise Institute.
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3 Comments

Rather weak
as the author doesn't go near one of the chronic causes of the dollar's losses, namely the massive rising deficit of the US federal government. Until the US achieves something resembling balanced budgets, there will be no solution to the dollar decline. Every currency collapse in history has been the result of governments outspending their credit, and this one is no different.

a radical dollar policy
Instead of all this orderly devaluation etc. what about the really radical idea of not having fiat money, but actual money based on something istead? The only people that this would be bad for would be the federal government; the very guys who brought in the FED by steal way back then, so that they could embark on the policy of fiat money; they love it and so does Paul Krugman, Roy, and Naomi Klein as per her stupid new book.

deficits have nothing to do with this
the 'massive' US government deficit is falling and has been for five years running now. Furthermore, what matters is the government's deficit as percentage of GDP, not total dollar denominations of it. When looked at that way, it has fallen even further.

Or, are you confused as this author is about the current account 'deficit'? Thats a totally bogus figure that doesn't count ROI for US investments held outside the country and does a thoroughly ****-poor job of adequately counting the revenue we get from services, which dominate our economy today.

Our trade is balanced. We get hard goods and services from foreigners and the foreigners take in exchange these pretty much worthless things called 'greenbacks'.
But, they can use the greenbacks to trade with other nations for other hard goods (like oil) and services. If the value of the dollar falls, we have to pay more dollars, that is true. But its the same game. If we didn't have de facto balanced trade, we wouldn't have as much (cheap) goodies at Wal-Mart, that's all. And if foreigners want to use their dollars to buy US Treasuries, who cares? We were going to issue that debt anyway, regardless of who ended up buying it.

They day may come when foreigners stop accepting dollars. Fine, we just won't be able to buy their stuff. But, since that means shutting down China and India Inc., I doubt that Chicken Little's sky is going to fall on us any time soon, despite the empty threats made by certain Chinese officials to the contrary.

The problem -- and the sole cause of the problem -- concerning the dollars plummeting value is that the Fed created way too much currency relative to current demand for it and needs to reverse course by taking enough out of circulation to do so. This is why the price of gold is pushing $1000/oz. Of course, that would be deflationary and quite a few special interests won't like that (the already beleaguered housing & mortgage industries for example). But, hey...if you live by the fiat currency, you die by the fiat currency.

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