Monday, January 11, 2010

The Dollar: Our currency, your problem

What to do about the weak dollar? The world is unhappy with us. Even though our currency is the bedrock of their international reserve positions, they have no leverage over us. And anyway, if the Fed started raising interest rates to support the dollar, the consequences for global growth would be awful. It's not an option.

No, the solution goes in the opposite direction: they need to engage in competitive devaluation, target a desired exchange rate, and start buying dollars until they get there. Not only can they stem the appreciation of their currencies, but also they can prevent deflation and negative nominal GDP growth in the bargain. (One of the false lessons of the Depression was that the "beggar thy neighbor" devaluations were somehow bad. To the contrary, they were the engine by which deflation was reversed and nominal growth resumed.)

Given the contradictory roles that the dollar plays as an unanchored national currency and as the global de facto reserve currency, and given the US's large role in international trade, it is very hard for other countries to ignore the dollar value of their currencies. The yen has appreciated from 360 in 1971 to 92 today. This is highly deflationary.

Any country with a strong currency and large dollar reserves can peg to the dollar and prevent further appreciation by buying dollars with the country's unlimited supply of its own currency. The BoJ and the ECB have an unlimited ability to buy dollars with their currencies until the targeted relationship is achieved. This is what HK and China have been doing for years, and which has served them well.

The problem with the 1949-1971 Bretton Woods system was that it sought to discipline the hegemonic currency by allowing surplus countries to exchange their unwanted dollars for gold. This was intended to force the hegemon (us) to raise interest rates, which Nixon was unwilling to do.So Nixon said "enough!" and ended convertibility.

Under a Bretton Woods 2.0, the dollar is not freely convertible into gold or anything else. If you're in surplus and you want to avoid inflation, revalue. Like Japan, the ECB can't allow the euro to steadily appreciate; they will have to intervene, resulting in higher eurozone inflation, which is desperately needed anyway (especially in the south).

None of this addresses the lack of discipline on the hegemonic currency issuer. But it does address the problem of undesired appreciation. Unfortunately, such a policy in not within the power of the affected to governments to implement. This is because they (Japan, Europe) have placed their monetary sovereignty into a blind trust known as the "independent central bank". Prime ministers and finance ministers can whine, but they have no monetary power--because they have given it away. The lesson of the Great Inflation was that governments should keep their hands off of the monetary faucet. The lesson of the recent past suggests that, left to their own devices, central banks are very conservative institutions, more concerned with their own prestige than with growth policies.

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