Our currency and our problem

In 1971, the then US Secretary  of the Treasury, John Connolly told his European counterparts: the dollar is our currency but your problem. So far, Connolly’s statement continues to be true.  Every time the dollar weakens, US exporters and US import-competing industries are gaining competitive advantage and/or increasing their profitability.  The explosive growth of US export volumes (reaching 10 percent per year) is part of the reason that, despite the collapse of US housing construction, the US economy is still expanding at a reasonable albeit declining rate. 

The weaker dollar also improves the US net external investment position, regardless of what it does to the trade balance.  With so much of US external liabilities denominated in dollars, every time the dollar weakens, the world largest debtor feels a little wealthier.  The Chinese authorities, despite moves to diversify their foreign asset holdings, still hold over a trillion dollars worth of external assets in US Treasury bills and bonds and similar securities.  The Japanese authorities have a similar exposure.  Already they have re-confirmed their reputations for being among the world’s worst portfolio investors. If the dollar falls by another twenty or thirty percent, which is certainly possible, the Chinese and Japanese authorities would each be presenting their tax payers with a further $200bn to $300bn capital loss. That’s a heavy price to pay for access to US markets for your exports, especially for a poor country like China (around 40 percent poorer at PPP exchange rates than we thought until recently, once (or if) the latest World Bank GDP revisions are accepted).

I fear, however, that the good news about dollar weakness for the US is about to come to an end.  Sooner rather than later, the weakness of the dollar, and fear of its future weakening, will trigger a large increase in long-term US interest rates, nominal and real.  Today’s papers reported how at the OPEC meeting, the cartel members discussed making a statement to the effect that the weakness of the US dollar meant that higher dollar prices for oil and gas were justified.  The fact that it was Iran and Venezuela pushing for such a statement does not mean that this view is restricted to declared enemies of the US government, or that it has no merit.  Many of the oil exporters continue to be large holders of US government debt.  They want to get out of as much of it as they can, but perceive a steeply downward-sloping demand curve for rapid sales.  Nevertheless, all the incredients for a bond-run are in place, and at some point in the near future, the gradual sale of dollar-denominated securities will become a flood.  The stock of US government debt outstanding can, however, only be reduced  through  US government budget surpluses, and we are unlikely to see many of those.  So when the dust settles, the existing stock of US government debt will continue to be held, but at a much lower price (higher yield) and at a much weaker external value of the US currency.

The further weakening of the US dollar will continue to boost the tradable sectors of the US economy, but any sharp increase in long-term nominal and real interest rates will hit investment spending everywhere, and the non-traded sectors like residential and non-residential construction in particular.  It won’t be pretty.  Expansionary monetary policy measures will be limited because a collapse of the dollar will have non-trivial inflationary consequences.  That ugly word ‘stagflation’, will raise its ugly head.

With US long-term real interest rates now set largely by world markets rather than by domestic monetary and fiscal policy,  the US policy makers  will have to get used to operating in a setting that is quite unlike the closed economy paradigm that they grew up with, and more like like a small open economy.  On the financial side, it has, effectively, already happened.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website