I would like to set out what I think are the ways in which the strength of the US dollar could be harming the global economy, but also the ways in which there may be both underlying, sensible reasons why the dollar is where it is, and also how it may actually be doing the global economy some good.
Clearly, the principal losers from the strong dollar are US manufacturers. They’re already under pressure from relatively weakening demand in the US, rising oil prices, rising energy prices more generally, and of course, financial problems in the equity markets. Probably the last thing that US manufacturers need to see is the kind of appreciation of the dollar that we’ve seen over the past year. But of course, that has simply added to their woes and it is very clear now that the US has been in a manufacturing recession for the best part of a year.
Manufacturing reached a peak last September and is substantially below that level now. The question is how much of a recovery we can expect this year in the world economy if US manufacturers - or US economy more generally - is driven lower.
The situation in Britain at the moment is very striking. There is a sharp manufacturing recession, but the rest of the economy is actually showing signs of overcapacity. So how important is it that the obvious pain being felt by US manufacturing is a huge problem for the global economy? Can the global economy really can recover unless there is some significant improvement in prospects for US manufacturers?
Second, the way in which the dollar is possibly harming the world economy is by diminishing the Federal Reserve’s attempts to stimulate the US economy. Traditionally, monetary policy, easing of the sort that we’ve seen in the past six months by the Fed, works through a number of channels - through lower interest rates directly, obviously short-term interest rates and long-term interest rates indirectly through easier financial conditions in equity markets, and of course, easier financial conditions through the currency.
None of those three has been happening for the past six months. And so the dollar is clearly dampening the effect of the Federal Reserve’s policies, which have been very important and, indeed, very dramatic historically in terms of trying to revive the US economy.
Third is the risks for emerging markets here. We’ve already seen deep domestic problems in Argentina but they are clearly exacerbated by the strength of the dollar when you have a currency tied to the dollar as the peso is. And it’s inevitable that the pressures we’ve seen in Argentina over the past couple of years will intensify, and that’s also a danger. The situation is much better than it was in 1998 because there are fewer pegged currencies or currencies that are directly tied to the dollar as there were in Asia in ’98. But I think the strength of the dollar at the moment is clearly a cloud over emerging markets and is something that threatens the prospects for global recovery.
Fourth, if we go through periods of overshooting and undershooting in free markets, and if the dollar has significantly overshot in the past year or two, then if there is a reversion to something like what economists would regard as a level more justified by the fundamentals, then the higher the dollar goes, as it has done over the last year, the greater the potential damage.
Most economists would probably believe that a country that is operating a current account deficit of the sort the U.S. is at the moment will eventually experience a sharp depreciation of the currency. If the dollar goes higher and we have a much greater height from which to fall - thus the potential danger, the instability that could follow in financial markets from a sharp turnaround in the dollar is, of course, much greater.
On the positive side, it’s clear that while the strong dollar has vitiated the Federal Reserve’s attempts to stimulate the US economy, though it has undoubtedly helped on US inflation, which a few months ago was starting even though the weakness in the US economy was dampening those inflationary pressures. There were still some strong signs of inflationary pressures, by simply a combination of energy prices and some domestic wage pressures, and the dollar has clearly helped to depress those. That’s actually made the Federal Reserve’s task somewhat easier. They’ve probably been able to be more aggressive than they would perhaps otherwise have been if the dollar had been weakening.
And that’s another danger: if the dollar is sharply overvalued and corrects suddenly, that is going to complicate the Federal Reserve’s policy, if it feels that it has to adjust to deal with inflationary consequences.
Second, and this is controversial for US manufacturers, a stronger dollar, particularly against the yen and the euro, is clearly going to help manufacturers - especially exporters in Japan in Europe that are strapped. So it’s not quite a zero-sum game but it’s clearly the case that the performance of European and Japanese exporters over the past few years has been much stronger than it otherwise would have been.
Third, the implications for US financial markets of the strong dollar have been, to some extent, a kind of mutually reinforcing process whereby the confidence that investors have in US companies and the US financial markets more generally has helped the dollar and the strength of the dollar has made those investments return even more. And that process has gone on.
So it’s probably been one of the factors, again, that’s been very positive for US financial markets. I leave others to weigh up the pros and cons, but I think that, in sort of crude and simple terms, summarises it.
This is an edited version of the first of five speeches given to the Economic Strategy Institute – Derivatives Study Center forum: "Is the value of the dollar harming the global economy?" at the National Press Club on Thursday, July 26, 2001. Click here for the full transcript.