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Comment: The devaluation delusion revisited

By Brigitte Granville



“The dollar is our currency and your problem.” So Ame-rica’s Treasury Secret-ary quipped before President Nixon pulled the plug on the Bretton Woods system three decades ago. What John Connolly’s bluntness reflected was America’s ability-and willingness-to export its economic problems by driving down the dollar’s value while scapegoating countries opposed to that strategy. President George W. Bush seems hell-bent on repeating Nixon’s misbegotten policy. Like the Nixon/Connolly team, the Bush administration is responding to America’s massive budget and trade deficits by letting the dollar fall-and hard-while it also tries to distract attention from its responsibility by pointing an accusing finger at China as the cause for both US joblessness and deflationary pressures. This strategy, however, is likely to prove as ineffective now as it was for Nixon, who succeeded only in ushering in an era of stagnation.

Bush’s policy is doomed to fail because, as in the 1970’s, America’s economic problems are homegrown. They are not imported and cannot be fixed merely by changing the dollar’s value. The world’s reliance on the US as the one source of growth in global demand buttresses America’s currency power play, but at the cost of aggravating vast global imbalances. Since 2000, America’s excess productive capacity has outstripped the Euro area and Japan combined, its economy growing far more slowly than its 3.5 percent to 4 percent annual potential, with US unemployment rising. This pitiful performance incites angry cries that American jobs are disappearing abroad, and that low-cost exports may result in deflation. Sadly, America is not alone in viewing devaluation as a panacea for domestic problems. Too timid to undertake serious reforms at home, Japanese authorities fight to keep the yen’s value as low as possible against the dollar and rival Asian currencies. Similarly, the European Union created the euro to give its members increased currency stability. When the euro was down, wounded pride forced EU governments to try talking it up. Now that the euro is up, those same governments are trying to talk it down.

The euro’s dizzying trade-weighted ascent over the past year is, indeed, exacerbating near-term pressures within the EU. But the Union’s finance ministers would be better off pushing the internal reforms Europe needs, rather than following the Bush example and pressing the European Central Bank to force a strong currency down to earth. Yet America’s currency strategy is the most reckless-another mighty error in an economic policy so wayward that it is hard to know where to begin listing the mistakes. Perhaps the best place to start is with the speedy deterioration in America’s federal budget in the past two years. From a surplus of 1.4 percent of GDP in 2000, the Bush administration has delivered a deficit of 4.6 percent of GDP this year. US budget deficits may have spared America and the world economy even worse performances over the past two years, but fixing what ails the US is now far more difficult. Tightening fiscal policy would go a long way towards boosting confidence in the US. It might also help push the rest of the world into moving away from its reliance on America as the sole engine of growth. Growth elsewhere might help America export more.

But this won’t provide the quick fix that the Bush administration yearns for, because a declining dollar need not bring about an equivalent rise in the price of US imports. This is partly because the final price of an imported good reflects numerous costs such as distribution and marketing, which are unaffected by the exchange rate. Indeed, many countries that export to the US-especially Japan and China-price their goods in dollars. Because these countries are keen to maintain their share in the world’s biggest market, they often absorb the effect of a drop in the dollar by cutting their profits rather than raise prices. As a recent study by J.P. Morgan’s Chief Economist John Lipsky shows, the link between exchange rates and trade is weakening. What makes US strategy reckless is that the Bush administration is attacking China at the very moment that America’s dependence on Chinese purchases of US government bonds is growing. Without these purchases, the US might face a rise in domestic interest rates that could threaten both its economic recovery and the global economy.

Moreover, if China decided to sell its dollar holdings, the bond market would discount US government securities, raising US long-term interest rates and canceling much (perhaps all) of whatever stimulus has been provided by the dollar’s depreciation. Luckily, China’s government knows that America’s advice to let the renminbi float right now is dangerous-both to China and for the world economy. Policies intended to benefit one country’s economy at the expense of another, such as competitive devaluations, were widespread during the Great Depression of the 1930’s. For most of the postwar era, governments appeared to have learned the lesson of that time. So it is bizarre that, today, leaders in the world’s strongest economies are dabbling in such dangerous nonsense again.

To fix its domestic problems, America must tighten its budget, not drive down the dollar’s value. But with presidential elections looming, no US government would cut spending or raise taxes. So forget about the economically illiterate Bush administration daring to do either. The silver lining here is that this failure may revive the realization that no country-not even mighty America-can devalue its way out of trouble.

Brigitte Granville is Professor of Business Management at the Centre of Business Management, Queen Mary College, University of London. —Daily Times—PS

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