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.

There is nothing very new about a decline in currency of a country running a large current account deficit and whose economy is softening. But in important respects the situation of the dollar is almost without precedent.

The vast majority of the US current account deficit is now being funded by central banks accumulating reserves as they seek to avoid appreciation of their home currencies. While the US dollar is usually viewed as a floating rate currency, substantial and critical parts of the world economy operate with currencies pegged to dollar parities or at least managed with them in mind.

This suggests the need for rethinking traditional approaches to dollar policy at a time when the global economy is more vulnerable than it has been since 1998.

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. But it is insufficient in the current world, where the dollar’s trade-weighted exchange rate is to an important extent managed abroad. Some means of engagement must be found with those who have yoked their currencies and so their financial policies to that of the US.

The US has responded in an ad hoc way by carrying on a “strategic dialogue” with China – by far the largest economy with an exchange rate linked to the dollar – backed by congressional threats to address exchange rate issues using the tools of trade policy and references to communiqués from the Group of Seven leading industrial nations. In reality the dialogue is anything but strategic. Like so much of American international policy in recent years, it seems to confuse the firm statement of legitimate desire with the serious conduct of diplomacy.

Think of the questions Chinese policymakers must ask themselves. What is the highest US priority – global financial stability or market access for well-connected US firms? Can the US take yes for an answer or is it a certainty that a new president will insist in 18 months on a new set of economic diplomacy accomplishments with China? In which areas, if any, is the US prepared to adjust its policies in response to global interests? Given that the Chinese authorities have presided over nearly double-digit annual growth for a generation, do US officials who make assertions about what is in China’s interest have the experience and knowledge of China that should cause their views to be taken seriously? Why is China being singled out? How could China – even if it wished to – act in ways that the US prefers without appearing to yield to international pressure?

Maintaining global financial stability and the role of the dollar requires a more strategic approach – a task that, given the political calendar, is likely to fall to the next US administration.

The G7 process has lost its focus on exchange rate issues over the years as its member governments stopped trying to manage their rates. In any event, the G7 is something of an anachronism in the current international context.

It needs to be radically reinvented, starting with a change in its composition. Yet its history – particularly in its early years, when it focused heavily on macroeconomic and exchange rate policies – is instructive. Two principles stand out.

First, any new approach must be premised on the desirability of a strong, integrated global economy that benefits the citizens of all countries, not on the idea that economists or politicians can calculate “fair” exchange rates.

The right and potentially effective 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.

Second, multilateralism is better politics and economics than unilateralism but it must not become an excuse for inertia. Any new group should be as large as necessary and no larger, should meet with some frequency and should include central bankers. It should be analytically informed but everyone should know that key decisions will ultimately be taken by senior officials in the national interest, not by international organisations.

The stakes are high. Well-managed finance cannot on its own make a country stable and prosperous, let alone the world. But history tells us that poorly managed finance foments instability and economic insecurity.

Rosy forecasts carry economic health warning

Small earthquake: few hurt. This is what the International Monetary Fund is saying in its latest World Economic Outlook: world output grew 5.4 per cent last year and will grow 5.2 per cent this year and 4.8 per cent in 2008, only 0.4 percentage points less than expected last July. What conclusion, then, are we to draw? Is a substantial financial shock at the core of the world economy nigh on irrelevant? The answer is: maybe so, but there are also appreciable risks.

According to the IMF, the world is in the midst of a period of growth unrivalled since the early 1970s. Between 2004 and 2008, it forecasts, global growth will average 5.1 per cent a year and the rate of growth of world output per head will average 4 per cent (see chart). The driver of global growth has been emerging economies in general and Asian emerging economies in particular. Between 2004 and 2008, says the IMF, growth of emerging economies will average 7.8 per cent a year, while high-income countries will average only 2.7 per cent. Never before has world growth been so much higher than that of high-income countries.

These figures are computed at so-called “purchasing power parity (PPP)” exchange rates, which greatly increase the weights of large and poor emerging economies, such as China and India. They give a correct picture of the rise of economic welfare, but a misleading one of expenditures around the world. At market exchange rates, world economic growth is forecast to average only 3.6 per cent a year between 2004 and 2008. The gap between growth at market and PPP exchange rates has also never been so big.

Fundamental, however, is the IMF’s optimism about emerging economies, despite its caution about the US, whose economy is forecast to grow at 1.9 per cent this year and next. The IMF expects demand in the rest of the world to be largely decoupled from weakness in the US.

Inevitably, this rosy forecast comes with health warnings. The World Economic Outlook stresses financial conditions and domestic demand in the US, Europe and Japan as bigger threats now than in forecasts in April and July. Correspondingly, downside risks from inflation and the oil market are smaller than before, while the risks posed by global imbalances are much the same in magnitude.

All this is plausible. The impact of the “credit squeeze” and downturn in the US housing market could be anywhere between mild and severe. An analysis of the financial squeeze concludes, for example, that “recent financial turbulence has not been unusually large compared with previous episodes”. But it notes three reasons why the outcome might be worse than this suggests: links with the housing market; loss of confidence in securitised credit markets; and impacts on the health of the banking system. As Ken Lewis, boss of Bank of America, recently remarked: “I’ve had all of the fun I can stand in investment banking at the moment.” So, indeed, have most of us.

Further adding to the downside risks is the vulnerability of housing markets in high-income countries. The IMF’s analysis suggests that France, Ireland, the Netherlands, Spain and the UK may be particularly vulnerable. But even Germany would be affected by a housing-led downturn in its European partners.

In emerging markets, happily, demand risks are seen as being to the upside. One reason for this is the impact on money, credit and asset prices of their huge accumulations of foreign currency reserves. In the long term, these may threaten an upsurge in inflation. In the short term, however, they are an additional stimulus to domestic demand.

At the global level, the IMF is less worried about inflation than in earlier forecasts. Today’s short-term inflation pressures are related to tight commodity markets and may be exacerbated by weak productivity growth in the US. The modest forecast slowdown should be a help, then, so long as central bank easing does not undermine their longer-term credibility. Oil markets are particularly tight. Given prospective trends in demand, they are likely to remain so. But, again, weaker growth will reduce the pressure.

The IMF also rightly picks out global imbalances and the management of capital inflows into emerging economies as sources of risk. These phenomena are closely related, since the world’s private sector is trying to put money into the emerging economies that the latter are then recycling outwards as official reserves. In 2007, for example, the IMF forecasts a current account surplus for all emerging economies of $690bn and another $495bn in private net capital inflows. This is then offset by government outflows, via reserve accumulations, of an almost incredible $1,085bn (see chart).

Yet, encouragingly, the global imbalances are now expected to shrink a little, as a share of world GDP. The counterpart of the decline in the US deficit is expected to be increased spending by oil exporters, while Asian emerging economies will export ever more capital in relation to global output (see chart). China, with a current account surplus expected to be close to $400bn this year (12 per cent of gross domestic product), is the new giant of this massive recycling.

The broad picture, then, is of continued strong growth with downside risks. It is at least a plausible one, so long as the dynamic of the “great convergence” is sustained, alongside the stability of the “great moderation”.

Ultimately, this happy outcome depends on sustained openness and monetary stability. But this combination can no longer be ensured by developed countries alone. Emerging markets have now become big players. They will have to accelerate domestic demand, reduce accumulations of currency reserves, allow exchange rate adjustment, open markets and, in short, be “responsible stakeholders”, if the growth dynamic is to be sustained in the years ahead.

For what is now happening is an historic shift in economic weight. How well will the world handle this challenge? In truth, it has gone better than one might have feared even a few years ago. Yet the ability of the international institutions – and particularly of the IMF – to help is limited. Partly because of the iron determination of the Europeans to hold on to their privileged position, the IMF, like the Group of Seven leading high-income countries, is now largely an observer of events. But, thanks to the work displayed in the World Economic Outlook, it is at the very least better informed and so, as a result, are the rest of us.