Don’t look now, but the US dollar is falling.

[G-khan]

Don’t look now, but the US dollar is falling. That’s especially the case against the euro, but there has even been some slippage against the yen. And in recent days the greenback has also begun to edge down against the currencies of a broad basket of America’s trading partners. Could this be the beginning of America’s long-awaited current-account adjustment?

Curiously, the dollar has fallen just as US equity markets have begun to price in a postwar recovery. This seems to have taken many by surprise. Most like to think of currencies as a proxy for an economy’s relative growth potential. America has been strong, goes the logic, and the dollar should mirror that strength. Conversely, Japan and Europe have been weak, so the yen and euro should follow suit. Actually, that hasn’t been a bad framework over the past eight years. After hitting record lows in the spring of 1995, the broad trade-weighted dollar surged some 47% through early 2002 before giving up about 8% of that gain over the past 14 months. Not by coincidence, in my view, this sharp run-up in the dollar was accompanied by an extraordinarily lopsided US-led global growth dynamic. The United States accounted for fully 64% of the cumulative increase in world GDP (at market exchange rates) over the 1995 to 2001 interval -- double its share in the world economy. Currencies and relative growth performance have, indeed, marched to the beat of the same drummer for quite some time. Why shouldn’t that continue, especially if equity and credits markets are now starting to discount another bout of US-led global growth?

The simple reason is that the relative growth paradigm may no longer be applicable in determining currency values. In the murky realm of foreign exchange analytics there is no guarantee that what has worked in the past will work in the future. In my 30 years as a macro practitioner, I’ve seen a host of currency theories fall in and out of favor -- from swings in relative interest rates and inflation differentials to growth comparisons and currency reserves. And now a new bogey appears to have emerged -- external financing imbalances; on this count, I am in close agreement with the work of our currency economist, Stephen Li Jen (see his dispatch in today’s Forum, “Our Dollar Smile Returns”). The problem is the gap between nations with current-account deficits (mainly the US) and surpluses (mainly Asia but also Europe) has never been larger. And for a saving-short US economy, a dramatic deterioration of America’s fiscal position points to an ever-wider current account deficit over the next few years -- moving from a record 5.2% of GDP in late 2002 into the 6.5% to 7.0% range by late 2004. Meanwhile, with growth stymied in the rest of the world, non-US external imbalances could well be moving into ever-wider surpluses -- leading to a highly unstable disequilibrium between deficit and surplus regions. This is a recipe for a significant currency realignment. The only question in my mind is whether the dollar falls quickly or gradually. There are good cases that can be made for either outcome.

Meanwhile, other factors are suddenly coming into play against a long-overvalued dollar. As the Federal Reserve comes closer to deploying non-traditional measures to combat the risk of deflation, “yield-capping” at the long end of the Treasury curve emerges as a leading option. This would bias the yield differential against dollar-denominated assets. The outbreak of SARS may also be a negative for the dollar, in my view. To the extent that it taints China, that would hurt a key member of the so-called dollar bloc -- currencies that are pegged to the dollar, such as the renminbi. That’s most likely a transitory factor, to be sure, but when an asset class comes under attack, it always amazes me how the negatives seem to reinforce each other. That’s an important example of how a virtuous circle can quickly be transformed into a vicious one. For the time being, at least, that seems to be very much the case with respect to the sagging US dollar.

Barring the crash-landing alternative, I continue to believe that a weaker dollar is exactly what a dysfunctional global economy needs. In my view, an unbalanced world is in increasingly desperate need of a rebalancing -- less domestic demand growth in America and more elsewhere around the world. A weaker dollar may well be the only means to achieve such a result. From the American standpoint, currency depreciation should be seen as part and parcel of a classic current-account adjustment process. If that’s the case, dollar weakness should trigger a number of other macro developments in the US economy -- namely higher real interest rates, slower domestic demand growth, and a rebuilding of private sector saving. In effect, a weaker greenback should trigger an important and necessary shift in the mix of aggregate demand in the United States -- away from domestic demand and into external demand. A declining greenback could also be important in America’s battle against deflation -- having the effect of transforming imported deflation into imported inflation.

For the rest of the world, the impacts of weaker dollar will undoubtedly be a good deal tougher to accept. That’s especially the case for Europe and Japan, where anemic growth in recent years has largely been dependent on external demand. Euro and yen appreciation would certainly undermine competitiveness and inhibit export growth, thereby crimping a major source of growth in both regions. Under those circumstances, Europe and Japan would have little choice other than to bite the bullet and embrace long overdue policies of structural reform and countercyclical stimulus in order to stimulate domestic demand. The outcome for both regions would be the mirror image of the shift in aggregate demand likely to occur in the US -- less external support and more domestic demand. And presto-- a rebalancing of the global economy would be under way.

I fully realize all this is easier said than done -- especially the responses of Europe and Japan to further dollar weakness. Japanese authorities have, in fact, been quite adamant recently in maintaining that they would like a much weaker yen to deal with the nation’s persistent deflation. Some European officials have also expressed concerns about the potential impacts of a stronger euro. The burden of currency appreciation would be especially heavy on Germany -- that segment of Euroland, which is currently closest to outright deflation. Indeed, with German inflation currently running at just 1% -- essentially half the pan-European average -- a further significant rise in the euro might well be sufficient to tip the economy into deflation. In the pre-EMU days, Germany would have had the option to depreciate the deutsche mark in these circumstances. The strictures of monetary union have all but closed off that alternative. One thing is certain, however: Irrespective of the wishes of all major regions to have cheaper currencies, the zero-sum paradigm of relative prices underscores the sheer impossibility of such an outcome. History and economic theory tell us that the country with the large external imbalance -- the US, in this instance -- will eventually win any battle of competitive currency devaluation.

But there’s even a deeper significance to dollar depreciation. Largely for political or other institutional reasons, both Europe and Japan have been unwilling or unable to adopt pro-growth policy measures. Japan is fearful of ending the “convoy system” of zombie-like companies; the resulting rise in unemployment is an anathema to a system where social contracts still involve some form of lifetime employment. Europe is constricted by a misguided rules-based system of macro policy determination. Monetary policy is still aimed at fighting inflation in an increasingly deflationary world. And fiscal policy is set by the arbitrary constraints of the Growth and Stability Pact, which did not take cyclical distress into serious consideration. Europe and Japan show little or no inclination to voluntarily alter these deeply entrenched approaches. So, in my view, it seems entirely appropriate to put pressure on both economies to change. The currency lever is the most effective means to accomplish this objective. If the dollar stayed strong and the world held to its course of US-centric growth, Europe and Japan would have no incentive to change. A weaker dollar would leave them with no other choice.

Plagued by unprecedented external imbalances, the world simply cannot afford to stay the course of US-centric growth. A lopsided global economy needs a shift in relative prices to find a new and more stable equilibrium. The dollar -- the world’s most important relative price -- has to fall. Such a decline may now be under way. And the world will have no choice other than to figure out how to cope with the imperatives of global rebalancing.

[Libertarian_Guard]

http://quotes.ino.com/chart/?s=NYBOT_DXY0

[BarnacleBob]

The dollar has nicely back filled the 95 - 95.20 area and is now proceeding lower. I suspect resistance in 93 area and then lots of volatility in the 90 - 92 area. (NIA)

http://quotes.ino.com/chart/?s=NYBOT_DXY0&v=i