President George W Bush’s foreign policy is simple: don’t mess with the United States. The same, it appears, applies to economic policy. Last Friday, the dollar fell sharply against the euro following comments by Federal Reserve chairperson Alan Greenspan, which — by his own cryptic standards — were unambiguous.
”It seems persuasive that, given the size of the US current account deficit, a diminished appetite for adding to dollar balances must occur at some point,” Greenspan said.
This came on the eve of a meeting of the G20 — a conclave of developed and developing nations — in Berlin at which the recent fall in the dollar was a hot topic.
It also came three days after John Snow, US Treasury Secretary, poured cold water on the idea that the world’s central banks might arrest the dollar’s fall. ”The history of efforts to impose non-market valuations on currencies is at best unrewarding and chequered,” he said.
Europe got the message. Eurozone policy-makers are growing increasingly alarmed about the fall of the dollar, since it threatens to choke off exports — the one area of growth in the 12-nation single currency zone.
There are two reasons why the Bush administration is not willing to play ball with the Europeans. The first is that it sees a lower dollar as inevitable given that the US current account deficit is running at $50-billion-plus a month. A lower dollar makes US exports cheaper and imports dearer.
According to this interpretation, the Americans are now bowing to the inevitable. Stephen Lewis of Monument Securities says the markets have lost patience with the laxity of Washington towards the twin trade and budget deficits.
”The truth is that the US fiscal and monetary excesses, which have been essential to keeping the global economy afloat in recent years, are no longer tolerated in the foreign exchange markets,” he said.
The second reason is that the Bush administration has neither forgotten nor forgiven France and Germany for the stance they adopted over Iraq. They were not interested in helping the US to topple Saddam Hussein, and now it is payback time.
What is happening in the currency markets is simply American unilateralism in a different guise.
In the short term, therefore, the dollar looks like a one-way bet. Analysts are already talking about it hitting $1,35 against the euro, and given the tendency of financial markets to overshoot, nobody would be that surprised if it fell to $1,40 over the coming months. A smooth and steady decline would do little damage to the US economy, but it would hit Europe hard. With a strong euro, there will be a direct impact on European exporters. A sharp drop in exports could quite easily push the eurozone’s biggest economies back into recession.
Growth forecasts for the eurozone are likely to be scaled down over the next few months, and budget deficits are likely to get bigger.
A fresh downturn could prove the death knell of the stability and growth pact, which would be no bad thing, and higher unemployment would intensify resistance among workers to structural reform of the eurozone economies.
Washington may have another reason, apart from getting its own back, for allowing the Europeans to suffer. The US is desperate for the Chinese to revalue the yuan, but has so far failed. The Chinese are determined to resist American pressure.
Europe — the French, in particular — has influence in China. As one analyst noted last week, China has never been censured by the United Nations Security Council — even over the massacre in Tiananmen Square — because Paris has always vetoed any such moves. France, so the theory goes, might have more success in persuading the Chinese to revalue.
It has to be acknowledged, however, that it would be hard to find a financial analyst who believes Snow is capable of this level of sophistication. After his performance in London last week, one said: ”I would sell the currency of any country of which he was the finance minister.”
The likelihood is that even if the Americans were to use the Europeans as a proxy, the Chinese would still resist. Certainly, all the evidence is that China’s central bank is still intervening aggressively to keep its currency stable. Without that action, the dollar’s fall in recent days would have been even more rapid.
Talking the dollar down is easy enough, but the strategy depends on a smooth descent that boosts US growth without scaring off the overseas investors who fund the twin deficits. Should it turn into a disorderly rout then there would inevitably be a spillover into other markets and into the real economy.
Washington, in other words, is relying on a soft landing for the dollar.
History shows, however, that there is a better than even chance of this process ending in a full-scale crisis, as it did in the mid-1980s, when the weakness of the dollar culminated in the stock market crash of 1987. And that was at a time when the G7 was acting in concert. As Lewis said, the crisis could be triggered by a seemingly minor event, as when the Nigerians precipitated the run on the pound in 1976 by switching into dollars.
The US is happy to go it alone for now, since this is the forex equivalent of the quick push to Baghdad. Life is likely to get tougher later — and when it does, multilateralism will have its attractions. — Â