The Weak Dollar Policy
One of the many things Robert Rubin has been is a bond salesman. That, I believe, accounts for his "strong dollar policy"--Rubin's promise to people thinking of buying U.S. Treasury and other dollar-denominated bonds that the U.S. government was in the business of trying to keep the value of its securities high, and was not thinking of pursuing a policy of dollar depreciation that would boost exports while eroding the wealth of foreign bondholders.
But this Treasury Secretary is different. Over the weekend, Treasury Secretary John Snow persuaded the G-7 nations to issue a communique largely--and correctly--perceived as calling for a "market-based" rather than a "strong" dollar. In response, the value of the dollar fell. U.S. interest rates jumped. The stock market declined:
Markets Fall on Declining Dollar | Jerry Knight: The stock market skidded, the value of the dollar fell and interest rates today rose as financial markets responded to a weekend meeting of world economic leaders.
At the meeting in Dubai, representatives of leading industrialized countries in the Group of Seven proclaimed that markets rather than governments ought to determine currency values. Such a strategy is usually endorsed by most economists and governments, but the statement aroused concern that the dollar would fall in the future and thus make investments less attractive in American equities and debt markets.
The statement was aimed at China and Japan, which have been keeping the values of their money low because they believe it helps their economies. Japan in particular has been holding down the value of its currency, the yen, so that Japanese goods will be cheaper to buy in the United States and other markets.
When financial markets opened after the meeting, the value of the yen jumped to its highest level compared to the U.S. dollar in three years. Although the call for letting the markets determine the relative values of various nations' currencies was pushed by U.S. Treasury Secretary John Snow -- who believes it will be good for the U.S. economy -- the immediate response of the U.S. markets was negative.
The Dow Jones industrial average dropped 120 points from the opening bell and closed down 109 points at 9,535.41 -- its biggest daily loss in more than a month. The Standard & Poor's 500 stock index fell more than 13 points to 1,022.82. The Nasdaq Stock Market composite index dropped 31 to 1,874.62. In the bond market, interest rates on 10-year Treasury notes jumped by as much 13/100ths of a percentage point in early trading but recovered to end the day up by 8/100ths of a point--still an unusually large one-day move...
What is going on here? That question calls for an answer on two levels, economic and political.
On the economic level, the signals that the U.S. Treasury is no longer in the business of trying to keep foreign holders of U.S. Treasuries from suffering lots of exchange rate risk makes foreigners' investments in U.S. Treasury bonds riskier. As a result, foreigners will invest less in U.S. Treasuries and other dollar-denominate securities. Less money flowing into the U.S. looking for securities to buy means that the supply of capital flowing through U.S. financial markets will fall. Falling supply with constant demand means a rising price. The price of capital flowing through U.S. financial markets jumps--and that price is the interest rate.
Hence U.S. interest rates today rise in anticipation of a smaller flow of capital through U.S. financial markets. The stock market falls for similar reasons: some of the foreign demand for U.S. stocks that was expected to materialize in the future will simply not be there. And this rise in interest rates and reducing in equity values will reduce investment in America by a little bit.
In the long run of three to five years this reduction in investment spending below what it would otherwise have been will have few or no effects on employment. As dollar-denominated securities are perceived as riskier, the price of dollar-denominated securities in terms of other countries' assets falls as well--and that price is the exchange rate. A lower value of the dollar makes U.S. exports more attractive. And in the long run in which the economy settles at full-employment equilibrium, the foreign money that would have been invested in America is diverted and spent buying more of America's exports instead. Fewer jobs in construction and in capital-goods manufacturing. More jobs in export-oriented manufacturing. Employment-wise, it's a wash. Income-wise, it's a loss: America has worse terms of trade, and the lowered level of investment slows the rate of long-run economic growth. Safety-wise, it's a gain: growth in exports reduces America's trade deficit, and reduces the chance that large external debts coupled with domestic policy mistakes will produce a situation like East Asia in 1997 or Mexico in 1994 (or the U.S. in 1873).
The net long-run effect? Hard to say. The prospective boost to exports and reduction in the trade deficit reducing the risk of a future serious crisis is a plus. It would, however, have been much better for the long run if the prospective boost to exports were accompanied by a long-run reduction in consumption rather than investment (but that would require a different administration, one willing to raise taxes when it is in the national interest to do so). The prospective decline in investment and economic growth is an offsetting minus, as are the worsened terms of trade.
For the next two years, however, we live not in the long but in the short run. What are the likely short-run consequences of John Snow's communique? The lower value of the dollar will boost exports eventually, but the links and lags between the value of the exchange rate and the volume of exports are long indeed: it will be twelve to eighteen months before we begin to see the rise in export earnings relative to baseline produced by the communique. The higher interest rates produced by the communique will start to put downward pressure on investment spending in nine months or so--next summer. The likely effect of the shift to a weak dollar policy is to open up a hole in aggregate demand that will raise unemployment between one and two years from now. The Federal Reserve is almost out of the ammunition it could use to offset the effect of the shift to a weak dollar policy on interest rates, and the Bush Administration has used up the political capital that it could have used to persuade Congress to adopt a fiscal policy to boost employment in the short run.
So we see that things are weird. The last thing I would want to do--were I sitting in the Treasury Secretary's chair, or were I sitting in Karl Rove's chair--would be to depress investment spending and thus raise unemployment in the second half of 2004. Yet that's what last weekend's policy move seems tuned to achieve. Now so far the shift in dollar policy is not large. The movements in asset prices are small. The effects on the unemployment rate in September 2040 are small. Only if there are more signals that indicate that last weekend wasn't an ill-considered error but a substantive shift in policy will the movements in asset prices and in future investment become large.
Nevertheless, to push down stock prices when you are hoping for an investment boom to cure your business cycle malaise and to push up long-term interest rates just when the Federal Reserve is jawboning as hard as it can to try to keep them down--this is a very odd thing to do right now.
One possibility is that the Treasury Department--or, at least, the people in the Treasury Department who watch the markets--have been shut out of the decision making. "Let's use John Snow in Dubai to send a signal to Ohio and Michigan that we care and are trying hard to boost foreign demand for their exports," some deputy assistant to the president for political affairs (or equivalent rank) said. And when the appropriate Treasury assistant secretary (or equivalent) learned a week later and said "wait a minute" was told "we can't be nay-sayers: we have to be team players." Strong Treasury Secretaries run roughshod over White House Political Affairs on the grounds that policies that are good for the country are also the best long-run politics. Middling Treasury Secretaries who come from Wall Street and for whom the dance of expectations and the flow of finance are second nature challenge White House Political Affairs, on the grounds that they understand how the markets will react and what the big headlines will be. Weak Treasury Secretaries? Who are not from Wall Street and do not really understand why the financial markets do what they do?
Are there other possibilities? I can't think of any.
--------------------------------------------------------------------------------
UPDATE: Update and expansion here.
Posted by DeLong at 09:23 AM |
