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The dollar - the case for benign neglect Samuel Brittan: The Financial Times 30/01/04 Ever since I have been in short trousers there has been a supposed problem about the dollar. A dollar shortage was the cry when I was being taught by Milton Friedman during his sabbatical in Cambridge. "Sure", he said. "Europeans suffer from a dollar shortage just like American citizens. They would both like to have more dollars." This time the "problem" is the weakness of the dollar. When the Group of Seven finance ministers and central bankers meet in Florida on February 6 and 7 they will be under pressure from European business interests to "do something" about it, as they fear it will slow down the modest European recovery. The foreign exchange markets are indeed prone to overshoot. The real effective dollar exchange rate rose by nearly 50 per cent between the late 1970s and 1985, only to lose all the ground that it had gained within the next couple of years. It then recovered to a halfway point in the late 1990s only to fall back again more recently to where it started. The difficulty is that, as we do not know the equilibrium exchange rate, overshooting can only be recognised after the event. There is no agreement today about whether the dollar has fallen too far or not far enough. The most sensible recent remark about the dollar comes from Alan Greenspan of the US Fed: "To my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin." According to conventional wisdom the weakness of the dollar reflects an excessive US current account deficit of 5½ per cent of GDP. This conventional wisdom reflects an outdated preoccupation with the current account which ignores offsetting capital movements. The financial firm, Smithers, suggests however that the deficit is too low rather than too high because of the greater likely return on capital in the US than Europe or Japan*. On modest assumptions about differential economic growth, it argues, the proportion of US assets owned by foreigners would only be 15 per cent five years from now and never rise above one third, even if such a deficit had to be financed indefinitely. Suppose, nevertheless that the G7 authorities agreed to halt or slow down the fall in the dollar how would they go about it? It is generally accepted that intervention has to be concerted if it has to have a remote chance of success. Not only would the euro area have to buy dollars, but the US authorities would have to sell euros. But that is only the beginning. There is an account of the last attempt at concerted G7 exchange rate in Nigel Lawson's The View from Number 11 (Corgi, 1993, chapter 43). The Louvre agreement of February 1987 for a time succeeded in stabilising the dollar within "soft" and "hard" margins against both the D. Mark and the yen. Although Lawson was a supporter of the Louvre system -- as I admit I was myself -- he highlights its weaknesses. If intervention is to have a chance of success it has to be supported by domestic monetary policy moves. In the present context either US monetary policy would need to be tightened or ECB monetary policy loosened. There was no agreement at the Louvre or afterwards on which way round it should be. Lawson adds that such agreement would have required a common view on whether the world faced a greater danger of recession or inflation -- in other words there would have to be a concerted nominal demand policy for the main industrial countries. If these conditions could not be met in 1987, there is even less chance of their being met today. The Americans would of course be delighted if the ECB were to relax. But they would be adamantly opposed to tightening policy and risk slowing down their economy in the run-up to an election for the sake of international exchange rate management. In the end the Louvre system collapsed when the Bundesbank followed a US increase in interest rates by raising its own rates, despite the slippage of the dollar below the agreed range. Not only did this burst apart the exchange rate framework, but it contributed to the undermining of market confidence which came to a head in the Wall Street crash of October 1987. Since then not only have the footloose funds available to speculate against exchange rates increased massively. More important: the numerous breakdowns of currency pegs and currency boards has made market operators extremely cynical about any future attempts falling short of full currency fusion on the lines of the euro itself. The Europeans and the Americans are agreed on one point. This is that the Chinese and other east Asian countries should abandon their pegs against the dollar and allow their own currencies to appreciate. This reflects the US hankering after still more "competitiveness" against Asia and the European desire that the downward pressures on the dollar should be shared by other regions and not concentrated on themselves. Even here benign neglect is the best policy. Another recent remark of Alan Greenspan is that the rapid growth in the Chinese money supply will at some point cause the Chinese economy to overheat or at least force the Chinese authorities to stop intervening to buy dollar assets. Premature US pressure on the Chinese to stop accumulating dollar assets is playing with fire. If the Chinese really took the Americans at their word and stopped accumulating dollar assets here and now ahead of natural developments, there could be a sharper fall in the dollar than anyone has bargained for. This in turn could trigger off a rise in American long-term interest rates which would more than offset any economic stimulus from a lower dollar. Central bankers have tried to evade the above difficulties by focussing not on the dollar's level but its rate of change. In quiet times exchange rate movements might be limited to those necessary to offset interest rate differentials such as the one per cent gap between euro and dollar rates today. But as soon as there is a change of sentiment the most placid financial operator will want to move quickly rather than at the stately pace preferred by the central banks. Can one really expect financial markets to move by small reassuring amounts like cats by the fireside? Surely finance ministers and central bankers should have learnt that by far the best policy is to say nothing what ever about the desirable movement of their own or other people's currencies. I would guess that more US Treasury Secretaries have lost their jobs from unfortunate remarks about exchange rates than any other cause. Nothing will prevent jerky readjustments in the real world; but inevitable fluctuations are made a great deal worse by the efforts of governments to orchestrate the pace of change. * The US current account: Too small rather than too large? Smithers & Co. Ltd., 20 St. Dunstan's Hill, London EC3R 8HL.
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