Tuesday, January 18, 2005

How to Stabilize the Dollar

Barry Eichengreen has written a nice piece that argues a new "plaza accord" will not help to stabilize the dollar. Through recent history , intervention in the currency markets has not been effective unless supported by policies that go with the grain of the intervention (he focuses on the 1980's, but intervention attempts during the 1970's also show the same thing). He also lists what true "coordinated intervention" would look like. Fat chance...
...if the U.S. takes steps to address its budget deficit, the rest of the world needs to support global demand. In Europe, where the ever-higher euro will soon be putting downward pressure on inflation, there is room for the ECB to cut interest rates. In Asian countries with low debts and deficits, there is room for cutting taxes. Korea’s deficit, for example, is only 1 per cent of GDP. Its government has already committed to applying a small dose of fiscal stimulus, but it could go further. Japan, with much larger debts and deficits, is preparing to raising taxes. While it will have to undertake fiscal consolidation eventually, it should put those measures on hold for now. Asia can also take some of the pressure off Europe by allowing its currencies to rise against the dollar, but doing so will slow its economies, making strong fiscal expansion all the more important.

So here we have the outlines of a grand bargain: fiscal consolidation in the U.S., fiscal expansion in Asia, and monetary stimulus in Europe. Everyone will be better off with this adjustment in the policy mix. Budgetary adjustment in the U.S. will strengthen the dollar and put the U.S. back on a sustainable fiscal path. Monetary stimulus by the ECB will cap the rise in the euro and encourage the investment that Europe needs. And looser fiscal policy in Asia will sustain global growth and help the continent to recover from its tsunami.

Unfortunately, none of the three regions seems ready to do its part. The ECB is still preoccupied by the nonexistent specter of inflation when the real risk in Europe is deflation due to the falling prices of imports not just from China but now from America as well. It is engaged in a death struggle with national governments, refusing to cut interest rates until the latter first rein in their excessive deficits. And with the collapse of the Stability and Growth Pact and the breakdown of fiscal discipline in France and Germany, no end to this gridlock is in sight.


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