naked capitalism

Wolfgang Munchau, in today’s Financial Times, makes the case that a certain amount of dollar weakness is a good thing and consistent with global rebalancing. On one level, this is a sensible and defensible view. But this view is implicitly based on the idea that the dollar will somehow find its “correct” level, more or less.

But currencies are known for their propensity to overshoot and stay for long periods at levels not warranted by fundamentals. The yen is a prime example. Even with Japan’s lousy domestic economy, its large (until recently) trade surpluses would have argued for an appreciation of the yen. However, the currency stayed super cheap because the yen had become a funding vehicle. It was only when the carry trade unwound and domestic currency speculators exited their foreign bets that the yen rallied, and is now at levels that seem similarly unwarranted by the fundamentals. To his credit, Munchau does not see some welcome weakness of the dollar as a long-term solution; he highlights the need for structural reforms.

So Munchau is correct, there could be a happy ending here, but I’d be loath to bet on it. For instance, some took cheer that the US trade deficit narrowed. But that was due largely to oil imports contracting due to price increases. $70ish a barrel oil is hardly expensive by recent standards. If a recovery to that level can lead to a fall in demand, it says the economy is more fragile than most want to admit.

From the Financial Times:

Imagine a world with a small current account deficit in the US, a somewhat larger deficit in the eurozone and a not too excessive Asian surplus. In such a world, economic commentators would no longer bang on about global imbalances and would have to find a different subject.

In the long run, such a world would require significant reform of the international monetary system. In the short term, a fall in the dollar’s exchange rate would help get us there. And I note with some satisfaction that it is happening.

A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ….a strong dollar is the last thing the US economy needs right now.

There are two further factors that support a weaker dollar. The first is, of course, the double-digit public sector deficit, which has already unnerved investors and which is not going to come down with any haste. The second is monetary policy….

The latest published comments from Bill Dudley, president of the New York Fed, confirmed my suspicion about the Fed’s asymmetric bias when he said he was more concerned about deflation than inflation and that interest rates would stay low for a long time. This is 2003 and 2004 all over again, except this time the chances are higher that it will end in inflation rather than in a housing and credit bubble.

What about the rest of the world? Would the Europeans, for example, not fight tooth and nail against a weakening dollar? Not necessarily. Just look at the situation from the perspective of the European Central Bank. Ideally, it would like to exit early by withdrawing liquidity support and raising interest rates, but it is severely constrained because many European banks are still dependent on low interest rates and ECB life support operations for their survival.

Fiscal policy is also extremely loose and likely to remain so. From the ECB’s point of view, a strong euro is probably the most effective insurance against resurgent inflation, at a time when interest rate policy remains constrained.

A strong euro would nicely take care of Germany’s persistent current account surplus. The surplus countries will never adopt policies to get rid of their surpluses. The exchange rate will have to do the job for them. Last week’s announcement of a surprise fall in German exports during August tells me that the hopes of another export-led recovery, as in 2006, are unrealistic. I expect a much reduced current account surplus for Germany in the next few years and, for the eurozone, a sizeable, probably not excessive, current account deficit.

The sensible goal of a more balanced world economy is entirely consistent with a weaker dollar and a stronger euro. I am not trying to make a short-term prediction. Foreign exchange markets are crazy, and I have been wrong too many times. But what persuades me that the dollar has further to devalue is the observation that, for once, politics and economics are pushing in the same direction.

Exchange rates cannot solve the problem of global imbalances…. Reform of the global monetary system is necessary for sustained balance. I agree with the views of Fred Bergsten, director of the Peterson Institute for International Economics in Washington, that the world will ultimately have to move to maximum targets for current account imbalances.

In a forthcoming article in Foreign Policy, he proposes a current account deficit ceiling of 3 per cent of gross domestic product for the US. He also argues that a reduced international role for the dollar would be in the best strategic interests of the US as continued imbalances would end up producing intolerable instability, no matter whether they are financed or not….

It is important not to confuse the international role of a currency and its exchange rate at any particular time. But in the case of the dollar, there is a link. A fall in the dollar’s exchange rate would be a very useful contribution to global balance. A reform of the global monetary system is needed to ensure that imbalances do not return. We are not there yet, not even close. But some of the parameters are slowly falling into place.