October 29, 2007
How America must handle the falling dollar
By Lawrence Summers
The falling dollar generates anxiety almost everywhere. Americans and those dependent on American growth worry about the proverbial "hard landing" as inflation and interest rates rise with a weakening dollar, causing asset prices and output to fall. Europeans and others with currencies that float freely against the dollar worry that their currencies will bear a disproportionate share of the dollar’s decline and appreciate too far, leading to competitiveness problems. The falling dollar risks rising inflation, asset bubbles and the loss of macroeconomic control in countries that have tied their currencies to the dollar’s sagging mast.
The dollar’s decline may provoke anxiety but it should not be a surprise to anyone who has followed the global economy in recent years. History suggests that periods when a country’s economy turns down, short-term interest rates are declining and financial strains are increasing are likely to be periods when a nation’s currency depreciates. Moreover the US current account has for years now been financing consumption rather than investment, with the financing coming increasingly from debt rather than equity and shorter rather than longer-term debt.
The remainder of this column can be read here. Debate from our guest economists appears below.
The writer is the Charles W. Eliot professor at Harvard University.
Robert Wade: Larry says that “the G7 is something of an anachronism in the current international context … [and] it needs to be radically invented, starting with a change in its composition”. But he doesn’t spell out how its composition should be changed, beyond “any new group should be as large as necessary and no larger”.
I agree that the G7 is an anachronism. Including as it does Canada and Italy but not China, it is in the position of the captain of a ship who turns the steering wheel this way and that way - but with no effect because the wheel is disconnected from the rudder. The G7 should be
slimmed down to the G4: the US, the eurozone, Japan, and China. This is the group which is as large as necessary and no larger. The problem, of course, is Britain, outside the eurozone but home to the first or second financial centre in the world. Perhaps, then, the G5. Or (in the spirit of the present formula for expanding the G8 heads of government summit, known as the G8 Plus the Outreach 5 [China, India, et al.], whereby the
heads of the Outreach 5 governments are invited to fly halfway around the world to have lunch with the G8 leaders) perhaps the G4 could undertake “outreach” to Britain and invite the British finance minister and central bank governor to fly half way around the world to join the
others for lunch. We could call this the G4 Plus One. The G4 or G4Plus One could be supplemented with beefed up meetings of the existing group of G20 finance ministers.
Larry talks about what a new group of finance ministers and central bankers should do. He is too elliptical by half when he avows “The right … case for adjustments in the current alignment of exchange rates relies on their unsustainability and the distortions they induce in macroeconomic policies, not on ideas of fairness to workers”. I wonder who or what his target is. Does it have something to do with the following news story, from August 2007?
“The U.S. Treasury took two years to persuade the International Monetary Fund to police global currency markets - and just two months to trash the initiative once the IMF adopted it.
“Treasury officials recruited the fund to be a currency regulator as China and other countries tried to gain a trade advantage with exchange rates. Instead, the fund took aim at the dollar, calling it overvalued in an Aug. 1 report. The Treasury objected, and on Aug. 2 an aide to
Treasury Secretary Henry Paulson Jr told Congress that it was impossible to measure a currency’s fair value.
“‘The U.S. Treasury has cut the legs from under the IMF before it even started the race’, said Michael Mussa, chief economist at the Fund from 1991 to 2001… ‘This was foolish and unnecessary when they could have just said nothing’.” (Christopher Swann, “U.S. currency push on IMF backfires”, International Herald Tribune, 24 Aug 2007).
On the face of it, this appears to be yet another case of the Bush administration’s hostility to multilateralism whenever the multilateral process yields a result not to its liking. Does Larry imply agreement or disagreement with the Treasury’s August 2 response?
Posted by: Robert Wade | October 30th, 2007 at 5:32 pm | Report this commentRichard Portes: Robert Wade and Mike Mussa are of course right to say that the US Treasury undermined the IMF-led multilateral surveillance exercise. But that is not surprising and has nothing in particular to do with ‘hostility to multilateralism’ when its outcome is inconvenient: all governments behave that way, and the only issue there is whether the institutional structures and incentives underlying multilateralism can override that natural response.
The Treasury’s ’strong dollar’ mantra has for many years been inconsistent with its simultaneous efforts to achieve dollar depreciation with respect to the RMB and other currencies that are closely managed or pegged to the dollar. Larry says ‘a strong dollar based on strong fundamentals’ was a highly successful policy. Well…the US current account deficit already exceeded 4% of GDP by the time he left office (despite the commendable move into fiscal surplus). It depends, perhaps, on what he means by ‘fundamentals’ and ’success’.
As for undermining the multilateral surveillance process, the Managing Director of the Fund did that even better (worse) than the Treasury, when he flip-flopped from one day to the next on whether the dollar is undervalued or overvalued. It wasn’t clear whether that was politically motivated or just a reflection of ignorance. The IMF’s Chief Economist says ‘while no single method for assessing exchange rates is perfect, we have a nice balance across the three most plausible methods. I really don’t think there is generally much disagreement among the reasonable approaches to this issue.’
Well…the reasonable approaches applied in the Fund’s paper setting out their methodology give very different answers: ‘In a few instances, there can be significant differences between misalignment estimates according to the different methodologies. For example, in the case of China and the United States, the ERER methodology points to a much lower misalignment than the MB or the ES.’ Indeed. Never mind the details. We might think this an important case. The Goldman Sachs GSDEER (Dynamic Equilibrium Exchange Rate) model put USD/CNY ‘equilibrium’ on 25 October at 7.32 versus a spot rate of 7.49 - a negligible bilateral misalignment of 2.2%. So perhaps we should be sympathetic to the Fund if it seems unable to decide about the dollar, the RMB, or whatever. It may not make much difference.
Whatever we think about the dollar or the feasibility, desirability and effectiveness of IMF multilateral surveillance, Robert and Larry are right to argue for a very different configuration of the machinery of international economic and financial cooperation. The proposal for a G4 (same composition as Robert’s) to discuss exchange rates was first made three years ago in a CEPR Report by Kenen, Shafer, Wicks and Wyplosz on ‘International Economic and Financial Cooperation’, where they also proposed an ‘agenda-setting body’ of no more than 15 countries. These and other recommendations were based on extensive analysis of economic cooperation, balance of payments adjustment, etc., since Bretton Woods. I commend the Report to our readers.
Posted by: Richard Portes | October 31st, 2007 at 1:41 pm | Report this commentMartin Wolf: I think this was an interesting column that has evoked equally interesting responses. I would like to add just four comments.
First, I disagree with Larry’s statement: “The Clinton administration approach of asserting the desirability of a strong dollar based on strong fundamentals while allowing its value to be set on foreign exchange markets was highly successful in its time and has largely been followed by the Bush Treasury.” I think it was a mistake, for three reasons. First, it disguised the fact that this was an aspiration without a policy and, as such, had next to no operational meaning. Second, it did not mean much analytically, since, by definition, whether or not the fundamentals were strong would be decided by the foreign exchange markets and the foreign exchange markets alone. Third, to the extent that the markets did believe it meant something, it encouraged them to go along with an ever-widening US current account deficit, until it finally became obvious that the strong dollar was indeed inconsistent with the fundamentals, which is where we have been for the past few years.
Second, I agree with Robert and Richard that the right way to go is via a G4. I have made this argument myself. But we also need a stronger IMF, to do the surveillance.
Third, I love the way the US Treasury is simultaneously arguing that it is impossible to determine a currency’s fair value, while believing that the renminbi needs to appreciate.
Finally, to eliminate the dancing on the pin of estimates of under- or overvaluation of a currency, I suggest that surveillance focus on the scale of currency intervention. There could (should) be a simple rule that any large-scale, long-term and open-ended currency intervention is a prima facie indication of fundamental disequilibrium. In such cases, the country undertaking the interventions should be required to produce a cogent justification for the policy. Should it fail to do even this, it should explain how it intends to remedy the situation. (This might not necessitate a currency appreciation: there are alternatives.) If it failed to do this either, its trading partners should have the right (though no obligation) to impose tariffs against its exports until intervention fell to lower levels. Of course, there should be a credible multilateral procedure to assess such actions.
I do understand that this last suggestion would put a few large cats among the IMF and WTO pigeons. Certainly, I do not expect it to be agreed. But I fear that the result will not be business as usual, but rather unilateral and brutal action, probably by the US. Historians will also remember that this topic takes us back to the debates that occurred at the time of the invention of the IMF, including its “scarce currency” clause.
Posted by: Martin Wolf | October 31st, 2007 at 4:53 pm | Report this commentBrad DeLong: I think Larry has the rhetoric slightly wrong. I think the right things for reality-based political economists to be saying right now are:
To the US Congress: a rapidly-growing China that views the US as a helping friend rather than an enemy is an enormous source of strength and wealth; the overall US unemployment rate is set on the Mall in the Eccles Building by the Federal Reserve rather than in Beijing. Yes, China’s economic policies have transferred wealth from America’s manufacturers and manufacturing workers to construction workers, contractors, and to coastal homeowners - but dealing with that transfer is an internal matter for us.
To the government of China: the longer China delays rebalancing - delays shifting from export-led development driven by an undervalued currency to development driven by domestic demand - the greater the likelihood of a major crash someday, the greater the magnitude of that crash should it come, and the higher the chances that China’s economic development will suffer a severe check and that the cadres of the CCP will wind up in the garbage dump of history.
Posted by: Brad DeLong | October 31st, 2007 at 6:56 pm | Report this commentLarry Summers: The comments here raise a number of important issues. To take up several of the most important.
1) I think there is general agreement on the need for a new forum for discussing exchange rate policy that includes the new powers. The G-4 may be just the right idea though I think this needs careful thought and possibly some expansion.
2) I think Martin and others are too tough on the Clinton administration policy “strong dollar policy”. It does not seem to me that believing in a stong currency is not to deny the possibility that particular other currencies are too weak. It also seemed to us and nothing has changed my view that the “strong dollar” mantra was helpful in combatting suspicions that devaluing a country’s way to prosperity was a viable strategy. I think it, in conjunction with the strong visible respect for the fed’s independence contributed to the low inflation, low risk premium environment that prevailed during the Clinton years. It is not my sense that approaches with more interesting rhetorical variation have over time been very effective.
3) I have not reread carefully what the Treasury did or did not say last summer. On the one hand, the point that there is no justification for multilateralism only when it comes out on your side is clearly right. On the other hand, I can easily as Martin suggests imagine a nuanced position that assigned much greater presumption to appropriateness of market exchange rates relative to those managed with heavy intervention.
4) I am not sure I understand Brad’s point but I think a key aspect of making any strategy with China work is making it easy for them to say yes. And that means holding off threats based on merchantilist arguments and instead stressing China’s macro interests.
Posted by: Larry Summers | November 5th, 2007 at 3:55 am | Report this comment