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By BarryEichengreen (chinadaily.com.cn)
BERKELEY - The dollar hashad its ups and downs, but the downs have clearly dominated of late. Thegreenback has lost more than a quarter of its value against other currencies,adjusted for inflation, over the last decade. It is down by nearly 5% since thebeginning of 2011, matching the lowest level plumbed since the Bretton WoodsSystem of pegged exchange rates collapsed in 1973.
Anobvious explanation for this weakness is the United States Federal Reserve'snear-zero interest-rate policy, which encourages investors to shift fromdollars to higher-yielding foreign assets. Predictably, the Fed's critics are up in arms. Thecentral bank, they complain, is debasing thedollar. It is eroding the currency's purchasing power and, with it, Americans'living standards.
Even worse, theFed is playing with fire. Its failure to defend the dollar, the critics warn,could ignite a crisis of confidence. At some point, the Fed's tolerance of aweak dollar would be taken as a lack of commitment to price stability.Frustrated investors would then dump their US Treasury securities. Bond yieldswould shoot up. The dollar would plummet. There would be financial distress anda deep recession.
Scarystories sell newspapers, but in truth all of this sniping at the Fed isoverdone. Historically, a 10%fall in the dollar translates into only a one-percentage-point rise ininflation. This means that the dollar's 5% fall so far this year will add onlyhalf a percentage point to the inflation rate.
And it is not asif USinflation were out of control. Food and fuel prices may be up, but labor costsremain firmly anchored – not surprisingly, given the country's 9% unemploymentrate. In this environment, the Fed can well afford to maintain its stance ofbenign neglect toward the dollar.
While Fed ChairmanBen Bernanke paid obeisance at his recent press conference to the talisman of a"strong dollar," the Fed is probably quite happy to see the greenbacktrending down. With domestic demand still weak, more export demand is just whatthe doctor ordered for an anemic economy. And a weaker dollar is one way ofdelivering foreign markets.
Moreover, thosewho warn that the Fed might fail to raise interest rates if inflation picks updon't understand that the Fed's culture of inflation targeting is deeplyingrained. Indeed, the very fact that the Fed is under such intense politicalscrutiny makes it all but certain that it will take the first opportunity toreestablish its price-stability bona fides.
If thereis a threat to the dollar, it stems not from monetary policy, but from thefiscal side. What is mostlikely to precipitate a dollar crash is evidence that US budgets are not beingmade by responsible adults. A US Congress engaged in political grandstandingmight fail to raise the debt ceiling, triggering a technical default. Evidencethat the inmates were running the asylum would almost certainly precipitate thewholesale liquidation of US Treasury bonds by foreign investors.
And even if thisimmediate hurdle is overcome, the US will still have only limitedtime to get its fiscal house in order. Financial crises almost always occuraround the time of elections. The US has a big one coming at the endof 2012.
Some criticsobject that a collapse of US Treasuries and a dollar crash are not the same.The dollar, they observe, is the funding currency for banks around the world.When banks borrow on the wholesale money market to finance their investments,they borrow in dollars. Thus, when volatility spikes and liquidity dries up,those same banks scramble for dollars. Indeed, even when problems originate inthe US,the dollar strengthens. We saw this in the summer of 2007, when the subprimecrisis erupted, and again in 2008, following the collapse of Lehman Brothers.
In the short run,then, a US Treasury market crisis might lead to some knee-jerk appreciation ofthe dollar. But with evidence of deep problems in US financial markets, globalbanks would start looking for other ways to finance themselves. The period ofdollar strength would be brief.
The result wouldbe the Fed's worst nightmare. With Treasury yieldsspiking and economic activity collapsing, the Fed would want to cut interestrates and flood the markets with liquidity.
Buta sharply lower dollar would, at the same time, mean sharply higher inflation,requiring it to tighten policy. Caught on the horns of this dilemma, theFed could do nothing to solve America'sproblems.
Bernanke regularlywarns of the dire consequences of not facing the country's fiscal problemshead-on. Congress, indeed everyone in America, should take him seriously.
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