The Rotten Fruits Of America

The Rotten Fruits Of America's Strong Dollar Policy

Marshall Auerback

"It's hard for me to live in a world where you can't tell the truth because somebody will stick a javelin in your heart for doing it." undefined Former Treasury Secretary Paul O'Neill

Over the long run, trends in real exchange rates are a function of current account equilibriums and productivity differentials. The U.S. is the closest of all countries in the world to the global technological frontier today. Even with its vast increases in standard of living, emerging Asia, including China, India, etc., remains still at some distance, but the rapid deepening of Asia's human capital is allowing it to advance on this frontier at a fast pace. On a trend basis, Asian productivity will continue to outstrip that of America, which economic theory suggests should also produce a trend of appreciating currencies against the dollar.

Despite the logic behind the theory, it is a fact that the dollar has remained strong on a trade-weighted basis over the past several years, particularly against these very same emerging economies. It is said that the impending change in President Bush's economics team following on from last Friday's resignations of Treasury Secretary Paul O'Neill and chief economic adviser Lawrence Lindsey will presage a change to a weak dollar policy, thereby eliminating this anomaly. But those who expect an improvement in the U.S. external imbalance should the dollar weaken might find their hopes cruelly dashed in light of the recent strong performance of Asia's export sector, whose competitive position has improved massively at the expense of the U.S. as a consequence of their respective currency depreciations against the dollar in 1997/98.

China's economy has the highest rate of growth of productivity in tradables of any economy in the world today. At a constant remnimbi-dollar exchange rate, Chinese competitiveness has also improved by leaps and bounds. That means that the swing that we are now witnessing in Asian trade balances toward greater and greater surpluses will largely come at the expense of U.S. trade. For all of the current discussion about deflation, and China's alleged role in exporting it, a longer-term perspective would see such deflationary pressures as a direct consequence of an ill-conceived effort to sustain a dollar exchange rate well above what long-term fundamentals would have otherwise justified. In perversely pursuing this strong dollar policy since the days of Robert Rubin's tenure as Treasury Secretary, the U.S. has unwittingly catalyzed its own economic demise and hastened the rise of Asia's ascendancy, notably China.

Throughout history, we have seen how high economic growth has been due to some countries catching up with the most advanced economies. The growth of the latter remains slow, because it is restrained by the slow place of technological progress. After its initial burst of industrialization, Great Britain, then the most advanced economy in the world, grew very slowly after the mid-18^th century. Growth in America exploded in the late 19^th century as the U.S. finally caught up to Britain. It then too fell close to the British growth rate. The countries in continental Europe and Japan followed, particularly in the two decades following World War II. The highest growth was achieved by Japan and Italy, the two most underdeveloped of the G-7 economies at the war's end.

In this cycle, one of the most noteworthy features has been the rise in the real value of the dollar against the emerging world undefined particularly emerging Asia. This is in sharp contrast with the past, when higher domestic inflation plus a fixed real exchange rate caused these countries to experience an ongoing real appreciation of their currencies against the dollar. This real appreciation partially offset their rapidly improving abilities to compete with the U.S. in more and more markets.

By contrast, in this cycle, despite continued productivity increases in tradables relative to the U.S., these countries have undergone massive devaluations against the dollar. Even with the strong economic recoveries from the crisis-induced lows of 1998, these countries' currencies still linger well below levels sustained throughout most of the early 1990s. We have always believed that this huge departure from the trend path of these currencies would create the potential for quantum increases in competitiveness at the expense of the U.S. Such gains in potential competitiveness extend even to countries like China; even though there has been no devaluation of the Chinese currency, the combination of significant domestic price deflation in tradables and expanding export subsidies have reduced prices of manufactured exports relative to the cost of their production in the U.S.

All this has occurred during a time of incredible vulnerability for the U.S. economy. For two and a half decades the dollar has eroded amidst repeated balance of payment crises. This time conditions are far worse. The dollar's ascent since 1995 started with a current account deficit to GDP ratio that was higher than it was prior to the dollar bubble of 1984-85. We are now looking to an all-time record in the current account deficit relative to GDP. But in the past, in the case of each previous dollar crisis, the U.S. was a net creditor nation. This time it is a huge debtor nation to the tune of 27-28% of GDP. Its room to maneuver is limited, yet the Asian economic export juggernaut continues unabated.

China remains the new economic locus of Asia. The country's large current account surplus has also continued to grow against a backdrop of steadily deteriorating global growth. The impact of dock lockout of the U.S. West Coast on China's external trade has been much smaller than previously thought. Exports still rose 31.5% y-o-y to US$29.95bn last month. The growth was only modestly slower than the 33.1% rise in September and was faster than the 28.7% growth in 3Q02. One consequence of this is that the remnimbi, in contrast to the dollar, has been under persistent appreciation pressure in the past couple of years; if anyone could proclaim a strong currency policy with a maximum of credibility, it would be China's monetary authorities, given the US$100bn jump in the country's foreign exchange reserves since end-2000, to US$265.5bn in October.

The strengthening trend of emerging Asia's exports this year is evident throughout the region; it is largely structural, rather than just cyclical. This is not simply a dumping policy; the root causes can be traced to Rubin's strong dollar policy initiated when he succeeded Lloyd Bentsen as Treasury Secretary in 1995.

In fairness to the former Treasury Secretary, Rubin initiated the change in policy when the dollar was a mere 79 to the yen. At that time, the dollar was deeply undervalued, and U.S. trade was beginning to improve relative to Japan. Trade improvement implies an inflow of foreign exchange, which is supportive to the exchange rate. Under such circumstances, it was felt that U.S. assets would become cheaper relative to assets in Japan. The cost of production of goods in the U.S. would also fall relative to Japan, raising returns to investment in the U.S. at the expense of Japan. Such considerations, Rubin calculated, should draw in long-term capital and thereby foreign exchange. Therefore, under such conditions, the dollar would fall only if the flow of short-term speculative capital undefined which chases price momentum rather than long-run returns undefined outweighed the exchange inflow from the trade account and the long-term capital account. The key was that Rubin was at the time developing a policy designed to encourage stable, long-term flows into the U.S. economy.

Encouraging strength in the dollar that is too low is constructive in that it reverses the flow of speculative short-term capital in a fashion that restores long-run equilibrium to the exchange rate. This is what coordinated intervention is all about when it is on the "right side of the fundamentals". This may have been appropriate on the dollar's rise from its 1995 low at 79 yen. However, once the dollar began to rise appreciably, well beyond what might be implied in terms of trade competitiveness (and, hence, long-term flows), such encouragement of trend following speculative short-term capital became questionable. In fact, we would argue that it became destabilizing, causing a speculative overshoot in the direction of extreme overvaluation, which has persisted to this day.

The foolish consequences of pursuing a policy that encouraged the short-run speculative trend following of capital inflows are a rising current account deficit and a growing net debtor position. The capital markets are becoming increasingly hostage to capricious overseas inflows, which may cut and run at the first sign of serious dollar depreciation. Moreover, it is becoming increasingly apparent that it will be difficult for the U.S. to reduce its trade and current account deficits for the foreseeable future, which in turn will exacerbate underlying imbalances in the economy and give policy makers much less room for future maneuvers.

Perhaps Fed governor Bernanke sensed this problem when he pulled back from publicly advocating a deep dollar devaluation in his speech of November 21, notwithstanding that this was the inevitable corollary of his public pledge to crank up the currency printing presses to prevent the onset of deflation. Over one-third of U.S. Treasuries are now held by foreigners, who may not take kindly to a hinted policy of explicit devaluation and who may, therefore, move to counteract the effectiveness of the measures introduced by the Fed (e.g. by demanding a higher long-term interest rate to compensate for the resultant capital loss that would stem from a dollar devaluation).

Truly, the country is now reaping the horrible consequences of Robert Rubin's strong dollar policy, unthinkingly upheld by successive Treasury Secretaries as America's trade imbalances piled up. (Ironically, it was Paul O'Neill's occasional tendency undefined in brief, unscripted moments of clarity as revealed at the top of this page undefined to recognize the folly in mechanistically parroting the "strong dollar" mantra, which may have partly contributed to his demise last week.) The U.S. has become hooked on short-term global speculative capital that has gone on for too long and that has gone too far. In the end, relative prices will matter. Too rich an exchange rate will erode profits of U.S. multinationals. Too rich a stock market valuation will create unusual market vulnerability. Too high an exchange rate will create current account deficits that may more than offset short-term capital inflows, which will in turn risk a sustained retracement of the dollar and a massive withdrawal of short-term speculative international capital.

There may be no way out. A sustained high exchange rate may lower earnings relative to unrealistic expectations and imperil stocks. A move to lower the exchange rate may pull the support of large cumulative speculative global capital flows. America's sustained courting of short-run global speculative capital at the expense of almost all else has placed the U.S. economy in a box: a sustained high exchange rate appears to have hurt too much and for too long, eroding the current account, profits, and ultimately stock and bond prices. A declining exchange rate may cause withdrawal of critical mobile global capital flows, which in turn may also undermine the U.S. capital markets, as well as complicating recently proclaimed Fed pledges to avert deflation by all means possible undefined conventional or otherwise.

The only real beneficiary of such inept and short-sighted policy making has been Asia, which has recovered faster than anybody thought possible a few years ago. Despite some short-term compromise, Asia did not fundamentally reform "Western style" as some arrogant market commentators and institutions such as the IMF advocated so strongly back in 1998 at the height of the region's financial crisis. Its governments are increasingly dominated again, not by Western, IMF-approved technocrats, but policy makers who recognize that Asia's "Alliance capitalism" is simply not compatible with volatile international capital flows and Hobbesian Western market behavior.

Above all, China has proved resistant to Western ways. Its relatively closed borders to volatile Western leveraged capital (notwithstanding the pleas of Wall Street) enabled it to emerge from the regional crisis of 1997/98 relatively unscathed. As the recent data suggests, it is now well prepared for growth on its own terms (which is why one should not expect imminent capital account liberalization and a corresponding revaluation of the currency). It will be the economic leader in the global recovery. Asian development strategies will continue to deepen further as China's regional economic dominance expands. China is not the source of the world's current problems; it is not, as is commonly argued, "exporting deflation." Rather, it has been the persistent refusal of the American government to conduct economic policy with an eye toward preventing a loss of U.S. competitiveness, and a corresponding rise in huge external imbalances, that has caused the relative shift in economic fortunes in regard to America and Asia. The source of potential U.S. deflation, and today's quandary for American monetary and financial officials, is very much home-grown.

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