The US dollar
has suffered a steep slide. During the last week of November, the euro rose to
a 19-month high of $1.309, while the sterling stood at are 18-month peak of
$1.933. The euro thus gained about 1.2% while the sterling rose by 0.5% and the
Japanese yen rose by 0.5%. During the last one year, dollar fell in terms of
the euro by more than 10%, while it was 12% against sterling. This all-round
slide in dollar value was attributed mostly to the market expectation that the
US economy would suffer a further slow down.
Some analysts
believe that the rush of the market for alternative reserve
currencies—preferably the euro —was triggerd by what Wu Xiaoling, the Deputy
Governor of the People’s Bank of China, said in an economic paper: “Dollar’s
recent decline increased the depreciation risk for Asian reserve assets.”
Reacting to this news, as the dollar breached 1.30 euro, stop-loss
orders—levels at which traders place their automatic orders to sell—of the global
currency traders were triggered, resulting in the fall of the dollar to its
lowest level since April 2005. The news about the German economy performing
above the forecast level—released by Ifo business climate survey - has only
added fuel to the fire. As usual, the volatility of the currency market
instantaneously impacted the global financial markets. Market pundits are of
the strong opinion that this slide may not reverse, at least, in the immediate
future for, the fundamentals of the US economy—as revealed by its current
account deficit that stood at a record high of $225.6 bn in the third quarter
as against the revised estimate of $217.1 bn for the second quarter—and market
flows are stacked against the US dollar.
What does it all mean?
It means nothing
new! There is an oft-repeated axiom in macroeconomics: sovereigns can never
ever default on their domestic borrowings, the reason being sovereigns only
have the right to print currency as they wish. Now, one may wonder what it has
to do with the current slide in dollar value. If we extend this analogy to the
dollar and its host country’s borrowing, it makes a great revelation. The US
has made up its deficit by borrowing externally, but in its own currency. It is
thus sitting pretty on its borrowings, while its creditors suffer sleepless
nights as the dollar is depreciating. This was so aptly put by one of the US
former treasury secretaries: “The dollar is our currency, but your problem.”
Although
analysts, journalists and even economists from all over the globe sing in
chorus that the long-term health of the global economy rests on a weaker
dollar, and the current decline in dollar is good and is a welcome development,
the problem—in its reality—remains the same as it was in 1970s and 1980s.
History reveals that devaluation of dollar is neither good to the creditors of
the US nor can US benefit in any way from it.
Why then, advocate depreciation?
The prime reason
for advocating dollar devaluation is the unabated rise in the US trade
deficit—a part of which, incidentally, includes the deficit resulting from
trade with US—owned subsidiaries located overseas—that is prone to cause global
imbalances. It is causing great anxiety to the world at large, for many
consider it unsustainable and hence demand its immediate correction. Many of
the theoreticians have immense faith in the so-called “elasticities model of
the balance of trade” and hence believe that if the US—the country suffering
from huge trade deficit—could depreciate its “real” exchange rate, its trade
balance should improve, for it makes its exports less expensive in foreign
currencies, thereby enticing foreigners to buy more of its goods, while its
imports become more expensive in dollar terms, owing to which imports into
America will fall significantly. But there is a flaw in this argument. It could
at most cause random short-term fluctuations, but on the long-term, no one
could be sure of the outcome of depreciation in “real” exchange rates, unless
it is linked to monetary policies, which means, the US has to necessarily link
its dollar depreciation with a monetary policy that allows inflation to creep
into its domestic market. Or, alternatively, the central banks of foreign
countries may have to adopt a policy that leads to deflation in their countries.
Then, and then only there will be room for American exports to soar high and
imports to fall.
Here again, the
outcome—rise in prices in the US and fall in foreign countries—from such a
linkage is known to suffer from the effect of “lags”, which the economists name
in their jargon as “J-curve effect”, according to which, the improvement in the
balance of trade of the US is unlikely. The reasons are not far to seek: one,
following the dollar depreciation, the imports that are already contracted for
and invoiced in a foreign currency, say euro, would cost more to the US
importer in dollar terms. Two, with the temporary depreciation of dollar in
real terms, investment in physical assets of the US is likely to become more
attractive for foreign investors, as their prices look cheap. Should this
happen, it would unwittingly result in the asset-price-rise in such countries
whose currencies have appreciated vis-à-vis the dollar.
This has another
unsought for impact: investment of foreigners in the physical assets of the US
again raises consumerism in the US, which in turn can lead to a rise in
imports. And this phenomenon has also the potential to simultaneously cause a
slump in the overseas markets, which means no increase in the US exports. We
are thus back to square one: the net effect of dollar depreciation on the US
trade balance would be ambiguous, at least for 2 to 3 years to come. Indeed,
history testifies this possibility; at least that is what has happened
following the Plaza Accord of 1985.
So, what then?
Given these
limitations, the world, perhaps, has no option but to adopt the policy of a
“strong dollar”, at least should not clamor for a weak dollar, and for reasons
galore. To better appreciate this, let us take a fresh look at the US current account
deficit—which is expected to reach $900 bn this year— which is nothing but a
reflection of excess expenditure by the US vis-à-vis its relative income. This
poses a question: How anyone can spend more than what he earns? That is the
advantage of the US! As Lawrence H Summers, the former treasury secretary of
the US, once said, the US is perhaps the only overwhelming absorber of global
savings. Or, should we say, the US households are the only “consumers of last
resort” for many of the countries from emerging economies. The real problem
underlying this “credit-driven irrational consumerism” is that it is financed
by countries from the emerging economies. Ironically, the goods are flowing
from less industrialized countries to the industrialized country. In the
process, the current account deficit of the US is funded by the “reserves” of
the countries such as China, India, oil exporting countries etc. So, any
devaluation of dollar in “real” terms would cause great harm to these countries
in two ways: one, capital loss in terms of their domestic currency, and two,
loss of market for their industrial output. If imports into America, as
anticipated under the theory of devaluation of dollar, shrink the production
capacities of countries—particularly Asian countries such as China, Taiwan,
Korea, India, etc.—who are highly dependent on American consumers for their
export-led growth would remain idle. Of course, this can be obviated to a
greater extent, provided other industrialized countries, say European Union countries
and Japan, etc., step into the shoes of the US and run current account deficit
so that they could become the market for the developing countries from Asia,
but for reasons best known to them, they are not prepared for it. It means fall
in export earnings of these countries—a slump in the growth of economy in
developing countries.
So the only
alternative for managing this global economic imbalance is: the US has to
correct its trade deficit by reducing its fiscal deficit. In order to achieve
this, it has to encourage American households to save more—preferably even by
offering tax incentives. And to make this work, the present capital suppliers
of the US—China, Japan, other East Asian countries and oil producing
countries—must simultaneously encourage domestic consumption. The Central Banks
of Asian countries must also realize that their accumulation of huge “reserves”
would only lead to bigger losses at a later date, and therefore, exhibit
flexibility in their currency management policies. Similarly, European Union
countries and Japan must exhibit pragmatism in their interest rate management
policies. This kind of combined-effort alone could minimize the global economic
imbalances. Here again, the attempt of the US to contract consumption domestically
must be gradual; otherwise the aggregate demand of the world would be
insufficient to meet today’s production levels. Such is the “trickiness” and
the “centrality” of the American consumer and his dollar in the global economic
balance.
All this leads
us to conclude—as indeed Ronald McKinnon of Stanford University argued—that it
is time for the US to shift its focus from pressing for revaluation of Chinese
currency to constructively engage the countries from emerging economies to
bring orderliness in the global economics.
(January, 2007)
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