Is a Weaker Dollar What the Doctor Ordered?

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.

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  1. Nameless

    “the currency stayed super cheap because the yen had become a funding vehicle”

    The currency stayed super cheap because their Central Bank poured a lot of money into U.S. treasuries, artificially depressing the currency. To this date, if I’m not mistaken, BOJ is the second largest holder of U.S. treasuries worldwide, after China.

    1. Yves Smith Post author

      With all due respect, you need to do homework on retail currency speculators. The BoJ, unlike China’s central bank, was not buying Treasuries to keep its currency cheap. Conversely, if you are running a big trade surplus, you wind up holding foreign assets. You have the causality wrong in this case.

  2. Kevin de Bruxelles

    A too-strong Euro is a threat to the continental economic model of balanced consumption and manufacturing. As the Euro rises so does the volume of that giant sucking sound of high quality European manufacturing jobs getting outsourced to America and elsewhere. When it comes down to a choice between inflation and the European way of life, the ECB will have to bend to political pressure to silence that sucking sound by accepting inflation as a necessary evil.

    I do not understand why Munchau is concentrating on the dollar / Euro rates when the real global imbalances are between the US / EU on the one hand and many of the Asian currencies on the other. The fundamental problem is that some economies peg their currencies to the dollar. The US /EU should declare this practise as a breach of free trade and in retaliation set tariffs to force the Asians to float their currencies.

    Munchau also mentions that a weaker dollar would help the US by tending to increase exports. The obvious problem here is that there are not all that many places in the world to export to anymore, given the global economic crisis. The real benefit of a weaker US dollar would be that imports into the US would decline and that domestic production for the US market would increase, thus providing a needed boost to employment. Any slight increase in exports would obviously be welcome but not entirely necessary to help improve US economic prospects.

    1. Vinny G.

      Well, those “high quality European manufacturing jobs” (which hopefully don’t include those producing low quality Renaults, Seats, Fiats, Jaguars, and Peugeots :) ) have been moving to Eastern Europe for some time now. Dropping exchange rates for most Eastern EU members’ currencies versus the Euro, coupled with no trade barriers at all, makes this a much more desirable destination than outsourcing those jobs to the US. Additionally, the high cost of health insurance in the US along with the still rather high American wages (higher than in most EU nations) will not make the US an attractive outsourcing destination for some time.

      FYI, except for German auto makers, the US market is completely closed to most European industrial products. For instance, the majority of automobiles here are Toyotas, Hondas, Fords, GM, and to a lower extent VW, BMW, and Mercedes. Nissan is the only auto company with a “French connection” that has a presence here. I have yet to see a Fiat, Seat, or a Peugeot on American roads, so it makes no sense to build plants here, when labor is so much cheaper in Eastern Europe.

      And, as far as the high productivity of American workers, similarly high productivity occurs in some Eastern European EU members.

      BMW, Nokia, Phillips, and even some French manufacturers have been building plants in Poland, Romania, Bulgaria, and the Czech Republic like crazy lately, this despite Sarkozy’s and Merkel’s public complaints. Additionally, manufacturing jobs that 10 years ago migrated to places like Spain and Ireland are now also moving over to Eastern Europe.

      I spend a lot of time in Eastern Europe, and this is what I see happening.

      Vinny G.

  3. Brick

    Currency devaluation probably works for small countries but not for larger ones. Firstly you need to think about the impacts to both existing and potentially new exports and imports. Lets take imports first which can be split into consumer goods which probably would see price increases in the shops while component, especially oil would feed through to either lower margins or price increases. The main difference though between a large and smaller country is the impact on exports. Firstly it takes time for new business to build up any momentum with typically 12 months minimum before you see much in the way of pick up in new business. For existing business you should expect your goods to be more competitively priced and therefore gain business straight away, but this may not be sustainable for two reasons. Firstly the types of exports from the US are largely made up of capital goods (machinery, telecommunications equipment, and aircraft) and industrial supplies (chemicals, wood and paper products, metals) with the major recipients being Canada, Mexico, the EU and to a lesser extent China. The point here is that dollar devaluation makes China more competitive which hurts the economies where the US exports to. In effect dollar devaluation exports unemployment to the EU, Canada and Mexico reducing your customers demand. The second reason has to do with the fact that the dollar is currently a reserve currency and is used for pricing of commodities with competitive nations likely to see some pricing drops for there components and raw materials that the US will not see. Basically as raw material prices drop so do the consumer prices for imported goods. Where the UK might get some benefit from devaluation, the US because of its size and the fact that the dollar is the reserve currency will most likely not.

  4. ryan

    If the Fed and the remaining U.S. political leaders choose to trash the dollar, what will the U.S. export? My humble opinion is there is nothing in this country that can’t be produced cheaper in China and Asia-Pacific … except food. The only thing the U.S. has going for it is corn and soybean production still outnumbers the mouths this country needs to feed. We can export food … but only if fertilizer produced from hydocarbons is abundant. It’s not. And that’s the problem.

  5. MarcoPolo

    Agree with Kevin up to, [not many places to export anymore given the economic crisis] and would correct that to read “given protectionist barriers from developing Asian nations” which began in Japan a generation ago. Yves said something just this week about how the Japanese had raised that to an art form. WTO has not changed it. Now we have China, 10 times Japan, and 5 times the US and it still relies on the US in the same way as Japan did. It can’t work. The numbers don’t come out. See Michael Pettis:

    In effect the US imports labor from the east. We have technology to offer in exchange. (And industrial goods, as Brick points out.) Selling technology requires that the creator of technologies be given ownership rights to its development. And you just can’t sell to those who don’t respect that effort. IMO it’s the biggest barrier to balance. Though, not the only one.

    We in the US have been forced to structure our companies to survive in that environment and we’ve worked on it for a generation. Which is why I feel that it would be easier to reposition Chinese manufacturing to domestic markets and away from exports rather than to restructure US companies and rebuild a manufacturing capacity, already over-supplied in those segments, yet again.

    Whatever, a weaker dollar, vs. any basket as opposed to the just the RMB, is not a solution. It only jeopardizes the business model we have spent a generation developing. In that I agree also with Brick. Both US monetary & fiscal policy seem short-sighted to me in that regard.

  6. jake chase

    Our principal export seems to be financial instability. Further weakening of the dollar is unlikely to promote continued government borrowing at laughable interest rates. Consider the effect of a crash in Treasury bonds: ou revoir globalization; bienvenue autarky, fascism, etc.

    Of course, there is no reason to think the idiots in charge won’t risk it. They seem willing to try anything.

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