The mighty dollar Washington is sending mixed signals about its currency policy, say Gerard Baker and Peronet Despeignes Published: July 27 2001 19:01GMT | Last Updated: July 27 2001 19:06GMT
Ever on the lookout for the slightest evidence of changed verbal nuances in policy formulations, foreign currency traders had a somewhat frenetic time this week trying to figure out whether the US administration was shifting its dollar policy.
For months Paul O'Neill, the Treasury secretary, has done his best to reiterate the administration's commitment to the so-called "strong dollar" policy adopted by the Clinton administration. But on his trip to Europe for the Group of Eight summit last weekend, President George W. Bush threw some uncertainty into the mix with an observation that it was markets that really determine the value of currencies.
That may not sound like a big change but to the carefully tuned ear, it was potentially revolutionary. It was seized on by foreign currency traders as an indication that the US was not all that committed to maintaining the dollar's strength after all and the US currency slipped in the markets.
In London a few days later Mr O'Neill quickly reiterated the strong dollar position and made it clear he was in charge of exchange rate policy. But by Thursday there was just the slightest hint of further uncertainty. Asked who was responsible for dollar policy, Ari Fleischer, White House spokesman, said: "I think what the secretary is saying is accurate that the Department of Treasury has jurisdiction over matters monetary about the dollar. But obviously the secretary is not speaking for the president when he says there is only one spokesman."
For financial markets this diverting side-show provided a reason to sell the US currency. By Friday, the dollar had weakened against the euro to just under 88 cents, its lowest level for two months.
The strength of the dollar has been one of the abiding features of the global economy for the past six years. Since early 1995, it has risen against a broad basket of currencies by 25 per cent; against the euro it is up by about the same amount since the European currency's introduction in 1999. For most of that time the US currency's strength has probably been a positive for the rest of the world: it helped keep inflation in check when the US was growing at super-charged growth rates until a year ago; and it helped both Europe's and Japan's export sectors.
But there are growing fears that the dollar's virility is both undermining the country's capacity to recover - by hurting battered American exporters - and posing an increasing threat to global financial stability through the risk that an eventual dollar correction could be painful.
The week's events in Washington prompt two questions for international investors. Is the Bush administration consciously seeking to back away from support for the strong dollar policy of the last few years or was it all just inter-departmental line-crossing? And, in the end, does it matter what the administration's policy is, or will the dollar simply be pushed by much more powerful economic forces?
The mixed signals fuelled suspicions again that the "strong dollar mantra" of the Robert Rubin/Larry Summers era has been abandoned. As growth has slumped in the last year the administration has faced increasingly vocal demands from manufacturers, unions and farmers for a devaluation of the dollar. There is also a feeling in some quarters that the administration might be trying to engineer a depreciation.
After that, the official line from the US Treasury was that "absolutely nothing has changed" with regard to dollar policy. Officials everywhere seem eager to draw a line under the week's events. But the uncertainty does appear to reflect a broader debate within Washington that has gone on since Mr Bush and his team took office about what the policy should be.
In its early, somewhat faltering, efforts to secure credibility in financial markets, the Bush administration was to some extent pressured by currency markets into restating the Rubin/ Summers line that a strong dollar is in the US interest. But support for a strong dollar was both appropriate and relatively easy to pursue when the US economy was far outperforming the rest of the world. "Under Rubin and Summers we had a strong dollar policy and we had a strong economy," says Robert Hormats, vice-chairman of Goldman Sachs International. "Now we have a weaker economy but the administration has simply inherited the strong dollar policy."
In fact, some policymakers within the Bush administration have questioned whether simple devotion to the strong dollar formula makes any sense if market pressures are pushing the other way. No one within the administration appears to be pressing for an abandonment of the policy but nor is there much support for intervention - of either a verbal or currency market nature - to buck the market.
The problem is that any abandonment of the dollar policy could result in a sharp reaction in markets, which would have severe consequences for the US and the global economy. Furthermore, there is no real agreement on what leaving it to the markets would really mean for the dollar.
To some economists, the most important issue is whether the dollar's strength can be sustained in the face of the nation's huge annual current account deficit - now a record $450bn, or 4.5 per cent of economic output. The widening deficit means that the US relies to an increasing extent on foreign capital to sustain the value of its currency.
In testimony to congressional lawmakers this week, Robert Rubin himself and Paul Volcker, former Federal Reserve chairman, called the deficit's upward trend of the past few years "unsustainable". To be sustainable, "we would eventually have to absorb all the capital in the world and it's just not going to happen", Mr Volcker said. "We cannot assume that Japan and Europe will not enjoy stronger growth in the future and will not be happy to employ more of their own savings at home."
But others demur. A former high-level Treasury official points out that as long as economic growth and savings rates abroad exceed those of the US, the deficit could widen indefinitely without provoking a dollar collapse.
"If the US is a good place to invest, there's no reason why the rest of the world shouldn't be investing here for a very long time," says Gregory Mankiw, a professor of economics at Harvard university. "Some economists are worried that people are eventually going to stop investing here in such large amounts - there may be diminishing returns to the investment - but there's no immediate need for it to end."
Ultimately, if the US economy's current weakness is as fleeting as some economists suspect and if Europe and Japan fail to show much sign of either short-term dynamism or longer-term structural improvement in their economies, the dollar may continue to look like a good bet.
But to sceptics the arguments offered in defence of the strong dollar and the deficit's sustainability sound eerily similar to the increasingly tortured rationalisations during the US stock market's sharp, five-year run-up before its long slide early last year. Confidence in a quick US rebound from its current woes is ebbing. Indeed, the growth figures published provide further evidence of how close the economy is skirting recession; the equity market has resumed its descent toward two-year lows as corporate profitability remains under strain; and doubts are growing about the authenticity of the much-vaunted "productivity miracle".
All these concerns would have to dissipate soon to justify the dollar's value, whatever Mr O'Neill, Mr Bush or even Alan Greenspan have to say about it. One senior international monetary official neatly captured the debate about the dollar this week: "Is the dollar's strength sustainable? Probably not. Is it desirable? Probably not. Is there anything policymakers can do about it? Probably not."