The Dollar adrift

What’s at stake: The dollar hit a one-year low against a raft of regional currencies on Thursday despite verbal intervention by ECB President Jean-Claude Trichet and actual intervention in the foreign exchange markets by a panel of Asian central banks. Meanwhile, the London Independent created a splash with a story that several nations were working secretly to trade oil in currencies other than the dollar. While policy makers on this side of the Atlantic fear that the European economy is bearing a disproportionate burden in the global adjustment that is under way, the recent weakness of the dollar has also turned into a political problem for the Obama administration.

Simon Johnson says that the dollar’s plunge is part of Obama's plan to restart the manufacturing sector and win the midterm elections. If the U.S. were concerned about the dollar weakening – say, because of its impact on inflation – it could counteract all of this by making warning noises about potential intervention in the currency market. But the G-7 met last weekend and made no statement about the dollar because the US administration is not currently afraid of inflation, but rather of deflation. So it doesn’t matter to them if a weaker dollar pushes up prices to some degree. What’s more, if the dollar stays weak or declines further, US car companies, machinery makers, and turbine blade manufacturers will soon be rehiring and we’ll finally get some job growth as part of a sputtering economic recovery.

The Wall Street Journal’s editorial says that the dollar plunge is a global vote of no confidence in the US economy.  The problem for the dollar at the moment is that there is a much larger supply of dollars than there is global demand for them. The solution rests not in Manila, Bangkok or Paris, but in Washington. Even if there is no dollar panic causing a spike in commodity prices and jeopardising the nascent economic recovery, the volatility of currency markets is distorting investment decisions and creating more economic uncertainty. It could also lead to a round of competitive devaluations, as other nations try to placate their own domestic export constituencies. In another piece, David Malpass argues that the dollar weakness is a threat to prosperity as the overall pools of capital will be flowing away from the United States and, as such, people and private corporations will have to pay more to attract capital here in our country.

Paul Krugman says beware of the dollar hawks. The growing clamour to do something about the dollar’s decline has him worried, because it’s part of the groundswell of demands that we begin an exit strategy from loose monetary policy now, even though nothing in the actual economic situation warrants such action. One need to see the Wall Street Journal’s fear of a weak dollar in terms of its long-term gold-bug position which maintains that changes in exchange rates play no useful role and that stable exchange rates are the essence of sound policy. But it’s especially important to understand the wrongness of this view right now as if there’s one overwhelming lesson from the Great Depression, it is that putting a higher priority on stabilising your currency than on domestic recovery is utterly disastrous.

Menzie Chinn founds it puzzling that there's all this talk about the prospects for the dollar as many of the concerns now being voiced have been voiced before. On the dollar decline and rebalancing, it was clear before the G-20 meetings that, regardless of what was said and agreed to, dollar adjustment would occur. The extent to which adjustment would occur was, admittedly, obscure before. But it still remains so, exactly because the trajectories of consumption and potential GDP in the US, Europe, and East Asia remain uncertain. On the dollar as the key reserve currency, if one looks at the breathless commentary about the euro's share rising to new highs, well, that's true, insofar as one looks at known euro reserves and known allocations. The picture looks a lot less clear when one tries to think about total reserves, a large share of which is of unknown composition.

Barry Eichengreen argues that despite a cocktail of structural weaknesses, the global importance of the US dollar hasn't changed as a result of the crisis. The euro is unlikely to replace the dollar as the eurozone lacks the fiscal federalism to develop a unified bond market to rival the market for US treasuries. The suggestions for the SDR to replace the dollar are overblown and China’s capital controls limit the prospects for the renminbi to become a functional reserve currency. Paul Krugman says, further, that the benefits of owning a key global currency are much overrated. Yes, we get a little free financing from it but ultimately, the role of the dollar isn’t very important to American prosperity. After all, when the British pound lost its international role nobody in Britain noticed or cared except a few lost souls in Whitehall.

Jeff Frankel forecasts that we are gradually moving from the dollar standard to a global monetary system that features multiple reserve assets. The usual response to worries that US macroeconomic profligacy will eventually end the dollar’s privileged position as lead international currency has always been that no asset constitutes a credible alternative for central banks to hold in their portfolios.   Frankel has argued that, since 1999, the euro has constituted a credible alternative.  But the euro is not the only alternative to the dollar.  The yen, pound and Swiss franc remain viable alternatives for national authorities to put some of their reserves.  Furthermore, 2009 has seen the resurrection of two international reserve assets that had previously been written off as dead:  the SDR and gold.

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