In 1972, John Connolly, Richard Nixon's Treasury Secretary, famously remarked to his European counterparts that the dollar might be the United States' currency but it was Europe's problem. While somewhat of an exaggeration, Mr. Connolly's remark contains an enduring kernel of truth. And as the US dollar is once again very much on the ropes and likely to stay there, it is at his peril that European Central Bank President Mr. Trichet risks ignoring Mr. Connolly's insightful observation.
The dollar's recent plumbing of new all-time lows should hardly come as a surprise. After all, for almost a decade now, the United States has been living increasingly beyond its means. The net upshot has been the ballooning of the US external current account deficit to its present level of US$800 billion, or the equivalent of a staggering 6 percentage points of GDP.
Worse still, the United States' profligacy has long since moved the US from being the world's largest creditor nation to being the world's largest debtor nation. Indeed, the US now owes a net US$3.5 trillion to both foreign central banks and private sector investors. As a result, not only does the United States now need in excess of an additional US$2 billion a day in external financing, but it also needs the rest of the world to continuously add to its already outsized dollar asset holdings.
The market response to Mr. Bernanke's September 18 surprise 50 basis point interest rate cut hardly bodes well for the dollar. In the two weeks following that cut, the dollar plunged by more that 2 percentage points to take the dollar to an all time low. At the same time, rather than decline as Mr. Bernanke had intended, US long-term interest rates rose as investors feared that an easier monetary policy stance risked re-igniting inflation, not least because of a weakening dollar.
The dollar's extreme vulnerability highly complicates Mr. Bernanke's task of dealing with the United States' worst housing bust since the Great Depression. Mr. Bernanke is all too aware that US monetary policy will need to be eased aggressively in the months ahead to cushion the rest of the US economy from the fallout of the ongoing housing market bust. However, he also knows that the US dollar is still probably overvalued by around 20 percent and that any further reduction in interest rates risks tipping the dollar into freefall.
A plunging US dollar would make it all but impossible for the Federal Reserve to achieve its dual mandate of promoting satisfactory economic growth and keeping inflation in check. For a weaker dollar would rapidly feed through to US domestic inflation as import costs soared. A weaker dollar would also likely result in a further significant backing up of US long-term interest rates as a declining dollar hastened foreign investors' exit from the US Treasury market. Such a backup in interest rates would only deepen the US housing market malaise.
While a declining US dollar will certainly complicate US economic policymaking, it would seem to pose at least an equal challenge to European policymakers by seriously undermining Europe's export prospects. Especially so in the context of today's world, in which all too many Asian countries manipulate their currencies for competitive advantage, causing the Euro to bear the brunt of the dollar's decline.
As the dollar's fall gathers pace, one already hears the predictable chorus of European policymakers calling upon the United States to do something about its falling currency. They do so oblivious to the fact that, even were it inclined to do something, there is little that the Federal Reserve can realistically do to support the dollar at the time that the housing market bust is in full train. They also make their call in total disregard of Mr. Connolly's reminder that the dollar is in the end Europe's problem and that any prospect of slowing its decline will require the close co-ordination of European and US monetary policy.
At a time that a declining dollar, coupled with a weakening US economy and a global credit crunch, seriously threatens the European economic recovery, it is difficult to understand the ECB's still hawkish monetary policy stance. One has to wonder what lesson Mr. Trichet might be drawing from the dollar's recent swoon in the immediate aftermath of the Fed's recent interest rate cut. One must also wonder whether a forward looking ECB would not be anticipating future Fed rate cuts to support the ailing US economy and would not see that matching those interest rate cuts offered the only real hope of preventing the dollar from going into free fall.