Jeffrey Garten on Forestalling a Dollar Rout

Yale Professor Jeffrey Garten has long argued that letting the dollar fall will do little to remedy America’s chronic balance of payments deficit. In a recent Newsweek article that picks up on themes he presented in a 2004 New York Times op-ed, namely, that America is so addicted to imports that a big fall in the dollar will increase inflation rather than do much to lower the trade deficit:

One of Washington’s fundamental assumptions about a declining dollar is wrong. As the figures show, just because a cheaper greenback might make imports more expensive, it doesn’t mean Americans will significantly cut back on their purchases of foreign goods. Reason: the nation has become hooked on imports, not just for finished products that are no longer made in the United States, such as many machine tools, but also on parts essential for the finished goods themselves, such as the electronic components for computers. Thus, a weak dollar leads not to less imports, but to higher prices and inflation.

In addition, the dollar cannot sink far enough to do what Bush needs without creating a panic. For example, while a softer greenback has benefited exporters, almost no conceivable dollar depreciation would be enough to significantly narrow the trade gap, simply because the value of imports is twice that of exports.

In a comment in today’s Financial Times, Garten continues his ruminations on the dollar and focuses this time on the possibility of a dollar panic and what might be done to avert it.

Yet what is disconcerting in reading Garten’s four recommendations is they are inadequate for the magnitude of the problem he sets forth. He really has only two remedies (selective central bank intervention to punish speculators and holding off on pressuring China over the value of the yuan); the other two are longer-term measures that won’t counteract a rapid, destabilizing slide.

Garten has been thinking about this problem for quite a while. The paucity of his solutions reveals that that governments and regulators are pretty powerless in the face of sustained currency moves.

From the Financial Times:

Leaders are behaving like deer caught in the headlights. Yet some action is crucial now because the dollar’s orderly retreat could at any time change into a chaotic rout, given the uncertainties and anxieties in today’s markets. The danger is enhanced as every sign – financial, economic and political – points to a dollar that will continue to drop, making a bet on a weaker dollar nearly a risk-free proposition.

Moreover, while the Bush administration exalts the export stimulus from a weakening dollar, the overall effect of continuous devaluation will be highly detrimental to America. It will be inflationary, because it will raise the price of imports, including oil and other commodities. At a time when the US needs to borrow $2bn (€1.4m) (£979m) a day to finance its current account deficits, a depreciating dollar will act as a disincentive to foreign investment in US government securities unless American interest rates are raised. A weakened greenback will also expose US industries to foreign takeovers at bargain basement prices. Admittedly, conflicting interests among countries make any grand scheme, such as the Plaza Accord that realigned and stabilised currencies in 1985, a non-starter. There are, however, at least four moves that finance ministers and central bankers should make soon.

At an opportune moment, they could make a sharp and powerful co-ordinated intervention in the currency markets to buy dollars. This surprise move would not change long-term trends, but it would show speculators that shorting the dollar is not always without consequence. The intervention could therefore bolster prospects for an orderly dollar decline and demonstrate that the US and the European Union are capable of jointly using powerful policy levers.

Next, the US could temporarily turn off its relentless pressure on Beijing to revalue the renminbi (and thereby further weaken the dollar). Over the long term, a floating Chinese currency is important, but for now a stronger renminbi adds petrol to a raging fire. Instead, discussions with the Middle Kingdom need to focus on something else: what stabilising role should China play if there were a major currency crisis?

Third, the US needs to be prepared for a large increase in foreign acquisitions. While protectionism would be a disaster, allowing many of the new, cash-laden foreign government investors in the Persian Gulf and Asia to use America as a bargain basement would itself result in a nasty nationalistic reaction. US Treasury officials should be confidentially talking now to the big sovereign wealth funds to develop a mutual understanding of some US rules concerning transparency, maximum ownership percentages and sectoral sensitivities. The aim: to facilitate investment in a highly charged political environment.

None of these measures deals with important longer-term questions. That is why the Bank for International Settlements ought quietly to undertake a thorough examination of the future of the dollar in the international economy. With the growing power of the euro, the escalating importance of London as a global financial centre, the inevitability of the renminbi becoming a big global currency and the long-term deficits and foreign debts America faces in financing a burgeoning social safety net and massive military burdens, it is unlikely that the dollar will remain as central to global commerce as it has been for more than half a century. It is too late for the lame-duck Bush team to care about this, but in 2009 a new US administration – not to mention the rest of the world – should have great interest in the results of this project.