Since we were discussing the dollar, I thought this might be of interest: -----Original Message----- *From:* Malpass, David (Exchange) [mailto: [snip]] *Sent:* Wednesday, November 07, 2007 1:18 AM *To:* Malpass, David (Exchange) *Subject:* Dollar Weakness
Gold has topped $820, reflecting a new run on the dollar. The dollar has also hit new lows relative to the euro and oil. The U.S. is in the odd position of asserting that a currency reflects a country's economic fundamentals even as the dollar continues its six-year plunge. I'm recirculating below my 2004 WSJ article on this topic. It argues that governments and central banks should put more emphasis on currency stability, and that the exchange rate, rather than reflecting a country's fundamentals, itself creates a key fundamental (like tax and regulatory policy). This argues against the current Fed and Treasury neglect of the dollar. We note growing negatives for the U.S. from dollar weakness: - Due to dollar weakness, we think core inflation will be somewhat elevated in coming years. If so, this would probably cause higher real interest rates, a Fed-engineered disinflation process, and a*relatively weak U.S. recovery from the 2008 slowdown*. - Rather than attracting investment and jobs, a weakening currency often discourages them. Investments tend to be momentum plays, especially regarding currencies (which increasingly dominate over other investment considerations). Cheap is assumed to become cheaper when a currency is weakening. Investors more often seek countries with appreciating currencies -- Japan in the 1980s, the U.S. in the 1990s, and Europe and emerging markets now. U.S. equities have severely underperformed foreign equities during the dollar's plunge, the reverse of the 1990s. - As foreign currencies strengthen, wealth abroad is rising faster than U.S. wealth. This has implications for geopolitics, national security, and future U.S. wealth. To the extent that it takes money (capital) to make money, the U.S. is falling behind fast. - While the U.S. trade deficit has declined some over the last year, most of that reflects the U.S. housing bust (home-building is import-intensive) and the foreign economic boom rather than dollar weakness. Wall Street Journal COMMENTARY *February 11, 2004* The Willy-Nilly Dollar By David Malpass Since the 1970s, currency values have been swinging wildly, with immense impact on economies and lives. Just since 1999, the dollar has moved from $1.17 per euro to $0.83 in 2001, and to $1.27 today, matching moves in the dollar's value in terms of gold and commodities. The impact of this volatility on U.S. farmers and manufacturers, developing countries, tourism, and investment flows has been immense and disruptive. At last weekend's G-7 meeting, the powerful group of finance ministers and central bankers accepted this, asserting that exchange rates should be flexible and reflect economic fundamentals. The U.S. hopes the G-7 language will form a lasting consensus and be viewed as a set of long-term currency principles. But there's a hitch: Rather than "reflecting" fundamentals, the exchange rate is itself a key fundamental. It affects capital flows, jobs, inflation, and interest rates. Currency changes harm the relationship between debtors and creditors and dominate the profitability of many companies. Without considering the exchange rate, there is not even a ballpark economic definition of a country's fundamentals -- one can't tell whether monetary policy is tight or loose, or inflation likely to rise or fall.* If the idea is that strong economic fundamentals cause a strong currency -- as the Clinton administration argued -- it is unclear why the Bush administration seems so comfortable with the two-year weakness in the dollar. It surely doesn't agree with the dollar-bears' claim that U.S. fundamentals have deteriorated substantially due to the tax cuts and fiscal deficits.* My view is the opposite. U.S. fundamentals are much better now than in 2000, in large part due to the change in the value of the dollar and the improved tax structure. The fundamentals are reflected in important new records in GDP, total employment according to the household survey, corporate profits, productivity and disposable personal income. The U.S. potential growth rate in coming years is one of the best on record, and hard to explain if the current value of the dollar is thought to "reflect" economic fundamentals. The irony in the fascination with the G-7's exchange-rate language is that the causal relationship from economic fundamentals to currencies works so poorly. The dollar reached its peak value in 2001 after the recession started. Dollar strength wasn't the sole cause -- lax regulation plus high tax rates, interest rates, and oil prices contributed -- but the dollar certainly didn't reflect U.S. fundamentals. Japan's experience also supports this "reverse-fundamentals" view. The yen strengthened in 1990-1995 as Japan created a multi-year stagnation, record unemployment, and a decade-long stock-market downturn. Not only was the yen not reflecting fundamentals, it was the key negative fundamental. At the weekend's G-7 meeting, participants added the idea that excess volatility or disorder in exchange rates was undesirable for economic growth. Good point, except the U.S. put very wide boundaries on the definitions of "excess" and "disorder." It signaled that the euro's movement against the dollar -- up 53% since 2001 -- has not qualified as undesirable, nor did one-month moves of over 5% (September and December) constitute excessive volatility. In the same vein, the U.S. has set very wide boundaries in defining its "strong dollar" policy, asserting that it is still in place even after the dollar has lost 35% of its value. I don't think the G-7's formulation for currency policy -- flexible, reflecting fundamentals -- is good for global growth. As a currency moves, the demand for it moves in the same direction causing momentum to take over. * This momentum nature of currency movements leads to wide, anti-growth swings in exchange rates. A pro-growth stance would be for the G-7 to prefer less currency instability in order to create better economic fundamentals.* The U.S. has shown it can withstand the damage from wide swings in the value of the dollar. The strong dollar reached an extreme in 2000 and 2001 causing crises world-wide, a perfect storm, yet the U.S. recession was milder than normal and unemployment peaked at 6.3%. The U.S. economy is big and flexible, with multinational corporations well positioned for currency chaos. The brunt of the damage from currency volatility falls abroad. Latin America suffered whiplash when the dollar levitated, then crashed, with serious aftershocks still showing up almost daily. Though I'm optimistic about Japan, its years of deflationary yen strength constitute a massive headwind to its recovery. *A better system would be one in which governments and their central banks preferred currency stability over instability and used exchange rates as a useful signal for monetary policy. If the currency is strong and strengthening, it means that monetary policy should be loosened to meet rising demand, and vice versa if the currency is weakening. Currencies would still be flexible and would trade actively. Currency interventions would be unnecessary and unwelcome. For the U.S., the result would be a "strong and stable" dollar and relatively steady interest rates rather than the present willy-nilly dollar and wide swings in interest rates. Europe, Japan and many other countries are yearning for less instability in the dollar, and would grow faster if it occurred.* As one of the least regulated markets, foreign-exchange trading has moved to new peaks of profitability on the uncertainty about future exchange rates. George Soros is famous for making a royal fortune breaking the pound in 1992. But even bigger bucks were made by those who broke the euro in 1999 and 2000 and then broke the dollar in 2002 and 2003. For foreign-exchange markets, the game never stops, there's nothing to go bankrupt, and no pretense of fundamental value. The financial stakes are also high for governments. Japan's Ministry of Finance lost nearly $40 billion after the September G-7 meeting in Dubai when the dollar weakened precipitously and the value of Japan's official dollar holdings shrank. The MOF has been working overtime to make a small fraction of that back through the risky carry trade, lengthening the maturity and raising the yield on its U.S. bond holdings despite the grim outlook for U.S. bonds. *China and its neighbors are enjoying a boom in investment, in large part due to good fundamentals provided by currency stability. Investor logic is that the G-7 wants Asia's currencies to strengthen, so investment in Asia might also gain even more than its fundamentals suggest. Asia will likely reap tens of billions in extra investments if a currency-appreciation cycle builds*, a parallel to Japan in the 1980s. This raises another major currency-related problem for the U.S. If currencies are to reflect economic fundamentals, neighboring Latin America will see itself decapitalized while Asia booms. Rather than Mexico joining China in currency stability and fast growth, recent years have seen investment dollars redirected from Mexico to China in search of China's yuan stability and future strength. Rather than reflecting fundamentals, currencies are causing them. On this page in June 2002, I explained my "Bullish on America1" views after years of concern. I'm still bullish on America, but my latest concern is that we have swapped an overly strong dollar for an overly weak dollar, neglecting its value in both directions. The U.S. can survive these currency swings, but the costs are high and unnecessary. The opportunity to improve the currency system is palpable.* Around the world, countries yearn for less instability, leaving the U.S. government and currency traders the principal advocates of the status quo.* Mr. Malpass is chief global economist at Bear Stearns. <<malpass op-ed.pdf>> -- Amit Varma http://www.indiauncut.com
