The Wall Street Journal-20080123-The Dollar and the Market Mess
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The Dollar and the Market Mess
Lenin was surely right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.
-- John Maynard Keynes
Currency debauchment is a choice. Most governments don't want to debauch their currency -- it's just that they don't want to take the actions that might prevent it, because those actions are perceived to be intolerably painful. Thus it was that last fall, the Federal Reserve, the world's central bank, decided to "let the dollar go" because staying the course on interest rates might threaten the world's financial system (or so the argument goes).
Meanwhile oil prices are high, inflation is considerably above the Fed's own stated long-term targets, and the dollar is in danger of losing its reserve currency status. Should we care? Are saving the dollar and saving the global financial system mutually exclusive alternatives? And isn't a dollar decline necessary for "rebalancing" the U.S.'s external deficits? The answer to the first question is a resounding yes, and to the last two questions, resounding nos.
Why is a weak dollar bad for America? First of all, it directly pushes up oil and other commodity prices by paying the producers with a depreciating piece of paper (thus removing the incentive to increase production), while lowering local currency oil prices for the rest of the world (thus increasing oil demand at the margin). It is no coincidence that the world's two great oil shocks in 1972-73 and 2004- 2007 both came after long periods of off-balance-sheet global monetary expansion and subsequent dollar weakness -- the growth of the eurodollar market in the late 1960s and 1970s, and the SIV and CDO expansion of the last several years.
Oil traders know this, and it is why the immediate consequence of the Fed's earlier 50-basis-point cut was to take the dollar down and oil prices up. One could write a separate essay on what a lower dollar and higher oil prices do to our strategic interests, such as propping up regimes like those in Iran and Russia.
Second, a lower dollar reduces the wealth of the U.S. consumer in global terms, immediately through the dollar's lower purchasing power, and longer term through the erosive impact of inflation. It hits retirees and those on fixed incomes particularly hard, and is a totally counterproductive policy for a potentially weak consumer.
Third, the weaker dollar accelerates the growth of our competitors. China may be growing at 11% or more in yuan terms, but their growth in U.S. dollars in 2007 was greater than 17%, and it is their dollar growth rate that is relevant for the rate of their rise in the world's economic hierarchy. Using Europe as another example, in 2002 U.S. nominal GDP was nearly 10% larger than that of the Eurozone 15. Today it is 14.3% smaller. Although Europe has been growing more slowly, its global economic power has been rising more rapidly than that of the U.S. because of our falling greenback.
Finally, if America were to lose its reserve currency status because of a continued loss of confidence in the dollar, the cost in terms of jobs and growth would be significant. The real economic benefit conveyed by the right to print the accepted global currency is called seignorage, which results in part from the lower capital cost we derive from foreigners' willingness to hold dollar cash. This country has taken for granted the benefits of our global seignorage for many years, and it is one of the reasons the U.S. has maintained a higher growth rate than the world's other mature economies.
But don't we need a lower dollar to "correct" our large trade and current account deficits? In the first place, our accounting deficits are largely with our own overseas subsidiaries (more than 50% of world trade is intra-company trade) and reflect an increasingly globalized world economy. Second, America is the shopping mall for the world. Because our distribution system is the world's most efficient, retail prices for the world's goods are lower here, and we have been the shopping destination for the world's consumers even before the dollar began its recent fall. These foreign purchases prop up retail sales (helping to explain the resilience of the U.S. consumer), depress our measured savings rate, and result in an underreporting of U.S. exports and an exaggerated measure of our imports (some significant share of our imports are actually bought by foreigners).
The ability of currency moves to correct trade deficits or surpluses depends on the elasticity of demand and supply. Because of increasingly specialized world trade, the elasticity associated with our exports and imports are very low. Thus a falling dollar is likely to increase the dollar amount of our imports (the infamous J-curve), and force the bulk of the adjustment to currency moves into the "income effect" that results from our higher bills (witness the impact of higher oil prices on the U.S. consumer). Moreover, our current account deficit for a year is equal to only a fraction of the dollar's foreign-exchange trades for a day. To say that one is either the cause or consequence of the other is almost laughable.
Our external deficits are largely measures of Federal Reserve and banking-system liquidity creation, just as the dollar's exchange rate is a function of foreign trust in holding dollar cash or near-cash balances as a monetary store of value (these balances are the lion's share of our so-called foreign debt). Thus, our deficits will only be ameliorated by a slowdown in liquidity creation itself. Just such a slowdown is likely now underway as a result of the mortgage crisis as we enter 2008, but any attempt by the Fed to ease at the expense of further dollar declines will likely snatch defeat from the jaws of victory, and risk a global inflation of significant proportions over the next several years.
Doesn't a failure to respond aggressively to the credit crisis by cutting rates too slowly risk a recession, or a Japan-like breakdown of the world's financial system? Unfortunately the recession risk is high, but not because of high interest rates (which are currently negative in real, after-tax terms). The recession risk is high because of a breakdown in the absurd system that developed for the packaging and underwriting of debt, and the excess liquidity that developed from the combination of that system and a highly stimulative monetary policy.
The Fed took a gamble on inflation to ward off what was perceived as a deflationary threat in 2001-02. The inflationary consequences of that gamble are now here, with the petrodollar monetary merry-go-round fueled by the weaker dollar. Those consequences will be much easier to deal with now, rather than later. Unlike Japan, where the capital- markets risk was concentrated in a handful of thinly capitalized large banks, the very growth of the credit-derivatives market that is the source of the current crisis in the U.S. has also resulted in a wide dispersion of risk in the financial system, and any recession will likely be mild and short.
While we might see a number of hedge funds and some isolated banks fail, the pool of distressed asset buyers waiting in the wings would result in a needed consolidation of the financial-services industry, without systemic failure. In the meantime, the systemic risk posed by the failure of one or more of these institutions is minimal compared to the moral hazard and longer-term inflation risks we incur from their bailout.
Sadly, the dimensions of the Fed's great dilemma would be much less acute had the Fed and Treasury officials not taken such a cavalier approach to the U.S. dollar over the past eight years. Our "strong dollar" (wink, wink) policy has never been articulated by either institution with any real conviction, and markets have rightly sensed that maintaining employment, growth and stock-market happiness has begun to take precedence over maintaining the value of money. In a world of fiat currencies, where trust is your most powerful policy tool, dollar strength is a far better indicator as to the appropriate stance of monetary policy than "core" inflation.
Any further loss of confidence in the U.S. currency will cost us dearly in terms of both price stability and jobs in the long run, as it will imply a higher level of interest rates to maintain a given monetary stance. A convincing elevation of the dollar in the policy priority list for both the Fed and the Treasury would be the single greatest step that either institution could take in restoring health to the financial system.
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Mr. Wilby is a former head of equities at OppenheimerFunds.
