Larry Summers on How to Manage the Dollar’s Decline

Whoever wrote the headline to former Treasury Secretary, now Harvard professor Larry Summers’ latest comment in the Financial Times did him a disservice. The lead-in, “How American must handle the falling dollar,” implies that Summers has a specific, hard-headed program. Instead, the piece offers a succinct and subtle analysis of what is wrong with our current approach but offers little in the way of a prescription.

Summers’ main observation is that America is adhering to a posture that worked when the facts on the ground were different, namely, we had solid growth prospects and our trading partners had floating currencies. Now, we have a deteriorating economy and quite a few countries peg their currency to the dollar. The one shift is that we are focusing our energies on getting China to float its currency, which Summers argues isn’t the best way to go about things. The problem is clearly greater than China and putting China on the spot has the perverse effect of making it more difficult for them to go along.

Not surprisingly, Summers advocates taking a multilateral approach with a new group larger than the G-7. He also urges shifting the focus of policy away from the impact on workers toward:

….. the desirability of a strong, integrated global economy that benefits the citizens of all countries, not on the idea that economists or politicians can calculate “fair” exchange rates.

That is a nice-sounding ideal, but I wonder if it can be made to work in practice. The sands are shifting on the question of when and to what degree free trade is beneficial. Dani Rodrik has argued that widely touted figures that claim to come up with large per capita benefits are dubious at best, and more rigorous calculations come up with modest gains. A vocal minority, including Paul Samuelson and Alan Blinder, believes that more open trade can be detrimental to workers in high-wage countries. More recently, Thomas Palley has added an interesting wrinkle, arguing that the problem lie in the fact that large companies increasingly make productivity-enhancing investments in low-wage countries.

I’m not sure how you can neatly decouple overall economic impact from the effect on workers if large numbers of workers are affected. I am also not certain that we are not close to an efficient frontier on the trade front. Further integration of markets raises issues of national sovereignty. Further liberalization may also do more to redistribute income and wealth within a country than to create average gains.

Mind you, I am not saying these reservations are correct, but they are becoming more widespread. The advocates of greater liberalization are going to have to do a better job of making their case than in the past, and in particular, marshaling empirical data rather than theory. As the wide-ranging debate with China illustrates, currency and trade policies are interdependent.

From the Financial Times:

The dollar’s decline may provoke anxiety but it should not be a surprise to anyone who has followed the global economy in recent years. History suggests that periods when a country’s economy turns down, short-term interest rates are declining and financial strains are increasing are likely to be periods when a nation’s currency depreciates. Moreover the US current account has for years now been financing consumption rather than investment, with the financing coming increasingly from debt rather than equity and shorter rather than longer-term debt.

There is nothing very new about a decline in currency of a country running a large current account deficit and whose economy is softening. But in important respects the situation of the dollar is almost without precedent.

The vast majority of the US current account deficit is now being funded by central banks accumulating reserves as they seek to avoid appreciation of their home currencies. While the US dollar is usually viewed as a floating rate currency, substantial and critical parts of the world economy operate with currencies pegged to dollar parities or at least managed with them in mind.

This suggests the need for rethinking traditional approaches to dollar policy at a time when the global economy is more vulnerable than it has been since 1998.

The Clinton administration approach of asserting the desirability of a strong dollar based on strong fundamentals while allowing its value to be set on foreign exchange markets was highly successful in its time and has largely been followed by the Bush Treasury. But it is insufficient in the current world, where the dollar’s trade-weighted exchange rate is to an important extent managed abroad. Some means of engagement must be found with those who have yolked their currencies and so their financial policies to that of the US.

The US has responded in an ad hoc way by carrying on a “strategic dialogue” with China – by far the largest economy with an exchange rate linked to the dollar – backed by congressional threats to address exchange rate issues using the tools of trade policy and references to communiqués from the Group of Seven leading industrial nations. In reality the dialogue is anything but strategic. Like so much of American international policy in recent years, it seems to confuse the firm statement of legitimate desire with the serious conduct of diplomacy.

Think of the questions Chinese policymakers must ask themselves. What is the highest US priority – global financial stability or market access for well-connected US firms? Can the US take yes for an answer or is it a certainty that a new president will insist in 18 months on a new set of economic diplomacy accomplishments with China? In which areas, if any, is the US prepared to adjust its policies in response to global interests? Given that the Chinese authorities have presided over nearly double digit annual growth for a generation, do US officials who make assertions about what is in China’s interest have the experience and knowledge of China that should cause their views to be taken seriously? Why is China being singled out? How could China – even if it wished to – act in ways that the US prefers without appearing to yield to international pressure?

Maintaining global financial stability and the role of the dollar requires a more strategic approach – a task that, given the political calendar, is likely to fall to the next US administration.

The G7 process has lost its focus on exchange rate issues over the years as its member governments stopped trying to manage their rates. In any event, the G7 is something of an anachronism in the current international context.

It needs to be radically reinvented, starting with a change in its composition. Yet its history – particularly in its early years, when it focused heavily on macroeconomic and exchange rate policies – is instructive. Two principles stand out.

First, any new approach must be premised on the desirability of a strong, integrated global economy that benefits the citizens of all countries, not on the idea that economists or politicians can calculate “fair” exchange rates.

The right and potentially effective case for adjustments in the current alignment of exchange rates relies on their unsustainability and the distortions they induce in macroeconomic policies, not on ideas of fairness to workers.

Second, multilateralism is better politics and economics than unilateralism but it must not become an excuse for inertia. Any new group should be as large as necessary and no larger, should meet with some frequency and should include central bankers. It should be analytically informed but everyone should know that key decisions will ultimately be taken by senior officials in the national interest, not by international organisations.

The stakes are high. Well-managed finance cannot on its own make a country stable and prosperous, let alone the world. But history tells us that poorly managed finance foments instability and economic insecurity.