By Charles Wyplosz
http://www.ft.com/cms/s/0/5e9f14d6-f039-11dc-ba7c-0000779fd2ac,s01=1.html
In 1971, with the greenback weak and falling, US Treasury secretary John Connally famously told the rest of the world that the US dollar was “our currency and your problem”. Thirty years later, with the dollar strong and still rising, Robert Rubin, his successor, no less famously stated that “a strong dollar is in the interest of the United States”.
These days, because the dollar is weak and falling, we would have expected US officials to return to Connally’s mantra but they unexpectedly chose Rubin’s. On reflection, glorifying a strong dollar when it is so weak means they do not care. Connally without compassion, if you prefer.
Jean-Claude Trichet, president of the European Central Bank, is thereby left bemoaning “excessive exchange rate moves”. This, too, is an extraordinary statement. In the past week the dollar has barely lost 1 per cent vis a vis the euro. That is significant, but “excessive”? Yes, he may be reacting to the 6 per cent dollar depreciation in the past month. Or to the 17 per cent change over the past 12 months. Or perhaps the 31 per cent depreciation since the dollar was last strongish in late November 2005.
Well, currencies float. They are bound to be sometimes overvalued and sometimes undervalued. This is what they do and these numbers are not especially large by historical standards. Margaret Thatcher, former UK prime minister, was right when she said that exchange rates were a matter for markets to decide.
Of course, markets react to monetary policies. As the US economy faces a recession, a weak dollar is in the country’s interests. As inflation exceeds its own definition of price stability, a strong euro is in the interests of the eurozone. End of story? Not quite.
We are witnessing one of those instances when the monetary authorities are not co-operating with each other. Co-ordinated emergency loans – with dubious soothing effects – hit the front lines, but they leave national monetary policies out of the equation. This raises two questions.
First, is one side needlessly creating hardships for the other? If Mr Trichet thinks the US Federal Reserve is overreacting, he has a point. Economic conditions surely call for medicine, but the speed and scope of monetary easing is unheard of.
More worrisome is that it may not be the right medicine. One ill is the bursting of the housing bubble, which is partly the consequence of the subprime folly of past years. Driving the interest rate to the floor will not solve the problem.
Another ill is the continuing difficulty faced by banks as a consequence of reckless lending and poor investment judgment. The rebound of anxiety in the past few days amply demonstrates that massive easing of monetary policy is not working.
The banking problem calls for surgical treatment, not interest rate Band-Aids. Certainly, surgery may result in bank failures. The time for administering painkillers will come after the operation, not before. Right now, the Fed is delaying the day of reckoning and, in the process, exporting the US’s problems by adopting policies that, intentionally or not, weaken the dollar.
The second question is what co-operation could look like in the remote eventuality that it is seriously considered. Should the ECB also lower its interest rates?
A case could be made that Europe will have to support demand for US goods and services anyway. This is currently done by knocking off European competitiveness, in effect spreading recessionary forces across the Atlantic. It would seem much better to lower interest rates in Europe and support the US economy with a strong European economy.
The problem is inflation. Bad luck has it that most primary commodity and food prices have risen at this most inauspicious time. The Fed has obviously chosen to risk letting the inflation genie out of the bottle, and is probably betting on the economic slowdown to keep the cork in place. Should the ECB follow suit?
Assume it does. The hope is that this would restart growth in the eurozone and simultaneously strengthen the dollar. Another scenario is as plausible, however. European banks, too, suffer from their own mistakes, so the lower interest rate may fail to produce the expected boost.
Alternatively the markets, enchanted by a possible resumption of growth in Europe, could push the euro even higher. Thus we would ask the ECB to take the risk of rekindling inflation, or simply of giving the impression that it does not care about inflation, in exchange for highly uncertain results. One does not have to be pathologically prudent to turn down that option.
In the end, exchange rates fluctuate, pretty much as they should under the circumstances, and seem to capture attention while financial institutions wobble but manage to escape the wrath of their supervisors. The authorities should co-operate, yes, but where it matters.
The writer is professor of economics at the Graduate Institute in Geneva
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