The U.S. Treasury must lead
The world has suffered a decade of financial bubble, crash, and anemic economic growth, driven in part by large swings in the value of the dollar in relation to other major currencies. To raise economic growth requires restoring confidence that going forward, the dollar’s exchange rate with other top economies will be more stable.
Ending currency volatility will require leadership from the U.S. Treasury, which has responsibility for the dollar’s international value. This is a key opportunity for Treasury Secretary Steve Mnuchin and his team to improve economic growth and financial stability.
Three areas unaddressed by recent presidential administrations cry for attention:
1.) The world’s two largest currency issuers, the United States and the euro area, together represent about 40 per cent of world GDP. Many other nations — China, the Persian Gulf states, Hong Kong, parts of Eastern Europe and Africa — fix their currencies to one of these titans, creating extended dollar and euro blocs that represent at least two-thirds of global output.
For this reason, the dollar-euro exchange rate is the most important price in the world, says Nobel Prize-winning economist Robert Mundell. It strongly influences global asset prices, financial conditions, and trade flows. Along with prices for key commodities like oil, the dollar-euro price is an essential, real-time market signal of monetary conditions.
Over the last decade, the dollar-euro rate has been highly unstable, seesawing by about 20% eight times since 2007. When the U.S. Federal Reserve eases, the dollar depreciates, when it stops, the dollar springs back up, pushing down prices and slowing the economy.
As a result, market expectations of dollar appreciation have meant a weak recovery. Who can make long-term capital expenditures or investment in such conditions? Is it any wonder monetary velocity — the speed with which currency moves through the economy — remains at crisis level, despite enormous efforts at monetary easing?
Just as President Reagan’s Treasury Secretary James Baker announced the Plaza Accord to realign and stabilize the dollar relative to the German and Japanese currencies in 1985, the current Treasury Department should stabilize the world monetary system by announcing a dollar-euro stability pact, as soon as possible.
2.) The relationship between the dollar and the Chinese yuan likewise needs attention.
Beijing was wise more than 20 years ago to peg its currency to the U.S. dollar. Lacking a deep financial system of its own, it recognized that its best bet to avoid destabilizing speculative attacks was to delegate its monetary policy to the Federal Reserve. By joining the dollar bloc, China has achieved internal financial stability that has allowed it to grow rapidly for two decades, alleviating grinding poverty and turning it into an economic powerhouse.
China’s dollar peg has also been a significant source of global financial stability, as past Treasury secretaries have recognized.
But, the China-U.S. currency bloc is now at risk, for two reasons.
First, the dollar appreciated sharply versus the euro and other major currencies beginning in late 2014. That translated into tighter monetary policy for China and some loss of competitiveness by Chinese exporters.
Second, the People’s Bank of China (PBOC) has used domestic monetary policy more actively in recent years. Independent monetary policy and a stable exchange rate cannot coexist for long, and China has sought to staunch the outflow from the yuan with capital controls and by buying up its own currency, spending almost $1 trillion of its foreign exchange reserves last year.
If history teaches anything — George Soros breaking the Bank of England in 1992, the collapse of Argentina’s faux currency board in 2001 — it is that pegged exchange rates cannot survive if a central bank also conducts an activist domestic monetary policy.
Markets are now betting that the yuan will depreciate significantly, perhaps after the Communist Party’s twice-per-decade national conference this fall. A major yuan decline could lead to a financial crisis in Asia or spark a trade war with the U.S.
So, will the Treasury Department address this issue before it becomes a crisis? Specifically, will the U.S. encourage the PBOC to recommit to a stable exchange rate with the U.S. if the dollar-euro rate has been stabilized?
3.) The world’s fourth largest economy, Japan, has been pummeled by its overvalued exchange rate for 25 years. In the 1980s, Japan agreed to tighten monetary policy and raise the yen versus the dollar. But it wildly overshot, and the yen soared from 240 per dollar in 1985 to 80 in 1995 — a three-fold increase. The result of this huge appreciation was two decades of falling prices, ultralow interest rates, and economic malaise.
Japan’s case demonstrates that neither fiscal stimulus nor temporary monetary easing can fundamentally realign an overvalued exchange rate. The only way out is to permanently break market expectations of appreciation, by realigning the yen down to a healthy level versus the dollar, followed by long-term stability.
Once there is a currency stability pact — a new Plaza Accord — among the U.S., eurozone, and China, why not roll in Japan as well?
Exchange rate stability with a low, common rate of inflation among the major economies would end a decade of volatility, crisis, and malaise. It would help inaugurate a new era of optimal capital flows, open trade, and strong growth for the U.S.
The question is, will the Treasury Department take the lead?