Last month’s G7 finance ministers’ meeting in Dubai prompted a sharp fall in the dollar. I reckon this is a turning point in the fortunes of the currency since its peak in February 2002.
To get the US economy going, the administration has already incurred huge deficits and started issuing limitless, costless dough. Now it has ditched the “strong dollar” policy.
The consensus view is that this is good news. A weaker dollar, this argument goes, will help reduce the huge US trade deficit, and Europe and Japan will be forced into economic reform to revive their economies. And a weaker dollar will help reflate global prices.
Deflation compounded I don’t agree. A weaker dollar is another deflationary burden on the world, which is already weighed down by overcapacity and weak consumer demand outside the US and high consumer debt inside it.
The US plan won’t work because the world is unbalanced and dollar devaluation will have uneven effects. The US sees cheap Asian exports as depriving US manufacturers of market share. That makes it hard for US industry to stage the sort of recovery that delivers jobs.
So the US has put the squeeze on Japan (and other Asian countries) to alter the policy of currency intervention to keep their exports booming. At the G7 meeting, Japan gave in and agreed to curtail intervention.
But the real target for the US is China. It is China’s peg to the dollar that is making it impossible for the US currency to depreciate sufficiently and so correct trade imbalances. The G7 has upped the ante in order to get the Chinese to revalue the renminbi.
But China will probably make no more than a minor gesture of little economic significance, introducing a trading band for its currency peg with the dollar that will shift the value of the renminbi up by 2% to 3%. China’s exports are so competitive that they won’t be affected by such a tiny adjustment. The impact on the US trade deficit will be non-existent.
So with China not shifting and Latin American currencies following the dollar down, the burden of dollar weakness will fall on the euro and, to a lesser extent, the yen. That will boost, not reduce, deflationary pressures throughout the rest of the world.
After all, Japan has not overcome deflation. Core inflation in Germany is below 1% and some Asian countries are deflating already. And dollar weakness has not translated into more US inflation – core CPI inflation in August was at its lowest since 1966.
It’s Europe that will suffer the most. The euro has already gained 29% against the dollar since its low. In the past, Europe’s social contract involved corporations employing unproductive workers on the understanding that they could recoup profits by overcharging for their products within small, politically segmented national markets where competition was minimized. That contract risks being blown away with any further euro appreciation. If that were to happen, Europe’s labour-cost bubble would burst, weakening wage incomes and domestic demand.
The other danger is to the US itself. Foreign investors are already overloaded with US treasuries. Once the dollar begins to tumble, they won’t want more dollar assets and are more likely to dump existing holdings. If foreigners shun dollar assets, long-term bond yields (and mortgage rates) will rise. That could burst the US housing bubble and bring the debt burden down on consumers’ heads.
If the US angers the Chinese with threats of protectionism or pressure on North Korea, Asian central banks will dump the dollar and US treasuries. So trying to improve the US current account deficit by dollar depreciation could weaken the very ability to finance it.
Endeavouring to correct US excesses by getting others to assume the burden is more likely to drive the world to deflationary death than prompt reflation. It works like this. The dollar dives. That drives other countries’ (mainly European) corporations into the red. They fire people and invest less. Global credit contracts.
This hits the US financial sector, shrinking it. And global consumers won’t buy more US exports because the impact on their incomes of an appreciating currency will outweigh the positive impact of cheaper US goods.
Dollar weakness won’t engender reflation in the US either. Global deflationary forces are just too big for that. No devaluation of the dollar will compensate for China’s huge comparative advantage in the cost of labour and capital. So dollar devaluation will shrink the foreign appetite for US financial assets faster than its current account deficit.
Until the US government reins in its spending and American households start saving, there can be no sustained global recovery and world growth will stay below par.
| US current account deficit as % share of the rest of the world’s annual savings |
