An unannounced but evidently coordinated effort to arrest or at least slow the fall of the dollar is underway. The Financial Times indicated that Asian central banks were aggressive dollar buyers on Thursday, but the information came via currency traders rather than an official pronouncement. Thailand, Malaysia and Taiwan made substantial purchases; Hong Kong and Singapore also intervened today. The action may also have a secondary objective of rejiggering their currency values versus China’s, since China repegged the renminbi against the dollar.
However, these efforts were seen by traders as merely an attempt to control the fall in the dollar rather than halt it. And other markets responded to the dollar weakness. Oil prices rose nearly $3 today, gold hit a new high in dollar terms, and copper and tin spiked upward. The dollar is strengthening overnight on Bernanke’s empty promise that the central bank will raise rates when the economy recovers.
The dollar’s weakness exposes a series of dilemmas and a lack of obvious remedies. Normally, a country experiencing a financial crisis takes measures to depreciate its currency so it can use an export boom to help pull itself out of its economic mess. However, Paul Krugman, among others, have pointed out that trade has collapsed, so even if one were to break glass and trash currency, it isn’t as effective a solution as it would normally be. And even if that approach might work, with so many countries affected by the crisis, it’s too easy for currency depreciation to lead to beggar-thy-neighbor competitive devaulations.
Although the US keeps mouthing its “strong dollar” assurances, many observers believe that the Obama Administration is content to let the dollar slide because the resulting inflation will help erode the value of debt and more robust exports will help growth. But that seems a trifle optimistic. First, some economists, such as Jim Hamilton, argue that it was the commodity price runup of early 2008 that pushed over-indebted consumers over the edge. Commodities inflation, when it inures to the benefit of foreign producers, is not a boon to the US. Second, the US has ceded a lot of manufacturing industries. How long would the dollar have to stay weak for the US to repatriate significant amount of, say, furniture and shoe fabrication? These are two industries where some incumbents insist the US could remained competitive in high-end and even some mid-level manufacturing (offshoring was driven not just by cost savings but also by a desire to please Wall Street analysts). It takes time to establish operations and hire and train staff. No one is going to make investments like that unless they are confident the dollar will remain comparatively weak.
Third, rising inflation is not a panacea. While it reduces the value of debt currently outstanding, it also makes it costly to sell new debt (unless the borrower is convinced inflation will rise even higher). Even if the principal will be paid back in depreciating dollars, the cost of debt service rises with higher interest. And having lived through the inflation-ridden bond markets of the early 1980s, no one wanted to be borrowing then. Reasonable credit quality companies were facing 15+% coupons.
Even before we get to anything resembling that level of interest rate, the Fed and Treasury have a big bind. Higher domestic inflation means higher interest rates. Higher interest rates mean higher mortgage rates. That kills housing. Higher interest rates also means all those private equity owned companies that are stuffed up to their eyeballs in debt and need to refi between now and 2013 find it more costly. Many will not survive higher debt service. Big bankruptcies and related job losses are not too good for economic recovery. The Treasury has also gotten addicted to super low interest rates (and if my correspondents are correct and the average maturity of Treasury debt has shortened, the US is more exposed to interest rate increases than it might otherwise be). In other words, even a modest increase in rates could have a much nastier economic impact than conventional wisdom assumes.
And we have another possibility. At the G20, the US started to take up the “we want to be an exporter when we grow up” theme. Ahem, so who is going to be the net consumer if the US gives up that role? Now I will be the first to concede that having a world where more countries had robust consumer sectors and were less export dependent would be a much better arrangement, but getting there is at least a 10 year, probably more like a 20 year transition. Yet the powers that be here are acting as if the US can beef up its exports and get to a net neutral or a net exporter position much sooner. So was that unannounced Asian intervention benign, or was it a bit of a warning shot, that the rest of the world reluctantly accepts that the dollar probably needs to be cheaper, but will only let that go so far?