Europe's force de frappe (The consequences of a weak U.S. dollar)

The US now owes France and Germany no favours. It may not be openly vindictive but it is not going to help them

The dollar is going to get weaker. What then? To say the dollar's present slide has some way further to go is hardly controversial, for it is the mainstream view of the financial markets. Whether this will turn out to be right or not is, of course, another matter, but let's assume for the time being that it is so. A typical profile for this decline, at least against the euro, is shown in the first graph above. This suggests that the fall of the dollar will carry it beyond its €1.15 (80p) level at the beginning of 1999, when the euro was launched, to something like €1.25 by the middle of next year.

If that turns out to be right – and once financial markets get their teeth into an idea, they tend to push it onwards for a long time – there will be a string of consequences for the rest of the world.

First, and most obviously, a super-competitive dollar will be bad news for the eurozone. It may also be bad-ish news for the UK, though that depends on the extent to which sterling can maintain a mid-Atlantic status, moving some of the way with the dollar but not all.

For the eurozone, and particularly for Germany, the situation would be very grave. The fringe eurozone countries could still manage to maintain growth. This is partly because several of them (such as Ireland and Spain) entered the eurozone with an undervalued currency and partly because they can generate domestic growth. But Germany (and to a lesser extent France and Italy) find it hard to boost domestic demand, leaving them open to price competition in export markets. Last year, the only part of the German economy that delivered growth was exports – domestic demand actually fell – so a more competitive dollar would be serious indeed.

But this is only a first order effect. There is every likelihood that this will be another year when US demand rises faster than European or Japanese demand. The likely result of that is the US current account deficit, far from narrowing, may actually widen further. HSBC estimates that it might reach 6 per cent of GDP (see next graph). Were that to happen there would be a danger of the slide becoming very serious indeed. I don't think you need to predict a crisis of confidence in the entire US economy to be aware that it would lead to global trade disruption.

When the dollar rose to unsustainable levels in 1985 and world trade was threatened, such fears led to the Plaza Pact, so-called because it was signed at the Plaza Hotel in New York, between the G5 nations (as they were in those days). Their main central banks agreed to intervene to curb the rise. But it would be hard today to assemble a similar coalition of those willing to support the dollar, were it to fall too low. For a start, global economic co-operation is going to be harder in the wake of the Iraq bust-up. And in any case it would suit the US administration, whatever it might say, to have a more competitive currency. Fears of inflation have given way to fears of deflation. While it is far too early to think in terms of a series of competitive devaluations, as took place in the 1930s, the fact remains that in a period of slow global growth, it helps to be able to corner a few more exports by being able to undercut competitors.

Remember that the general concern about devaluation – that it leads to imported inflation – becomes much less significant in a time of global price stability, even deflation. Meanwhile, the already low inflation in Germany (third graph) could quickly slip into deflation.

This leads to a more general concern. International co-operation is going to be much tougher to orchestrate in the coming months. Self-interest would suggest that we should all continue with the multilateral approach that has governed international trade and payments since the Second World War. But that has been sustained by mutual concessions.

The US now owes France and Germany no favours and while I cannot see it being openly vindictive in its trading relations, it is not going to help countries that have behaved in this way. There will be an economic price to pay; it is naïve to think otherwise. The weaker dollar has to be seen in this context.

So what will happen to sterling? The problem there is that the whole debate is stalled until the result of the Treasury's five tests are published. Assuming they produce a "not yet" verdict, the markets will have to decide whether sterling is fundamentally part of the dollar bloc or the euro bloc. Past performance suggests that it tends to be halfway between, sometimes siding with one, sometimes with the other. On balance over the past two decades it probably has inclined a bit more towards the dollar, but in recent months we have been closer to the euro. A "not yet" decision would push us back towards the dollar.

If this is right you could see quite a weak pound against the euro. We would go back to having holidays in Florida because it was cheaper than Spain. The Eurostar trains to Paris would be even emptier than they are now. Our exports to Europe would become much more competitive and there would start to be European opposition to sterling joining the euro.

Currencies overshoot. In a rational world they would move in much narrower bands and we would create ways of resisting their wilder fluctuations. But we do not live in a rational world. I personally do not think the dollar fall will get out of hand but if it were to fall to €1.25 or beyond, it would do grave damage to the European recovery. And I do not see the Americans worrying much about that.

The oil market is competitive. If it cheaper for foreigners to buy dollars, they will be willing to pay more for oil.

I have been in the petrochemical industry for over 20 years. That makes absolutely no sense to me. The market price is just that -- the market price. It varies from day to day based on fundamentals -- like supply vs. demand. From one contract to another, regardless of the buyer or supplier involved, the price does not vary and stays within a slim margin. (Unless there is a longer term contract were future price has been guaranteed or in a case where a country was giving illegally low prices such as was the case to Saddam to Syria). The only time someone is "willing" to pay more is when the supply gets tight, and in that case the whole market moves up in response to the new price and that is what everyone ends up paying.

Natural gas can replace oil in many applications, so as the price of oil increases, the demand for natural gas increases, and so the price.

Yes, the technology exists for natural gas to replace oil in many applications, but there are very few places where we have the technology IN PLACE and the infrastructure to handle that. If we decided to do that today, it would take several years to have our current petrochemical facilities and the infrastructure for such converted. We just aren't ready, so we really aren't able to switch at this moment. Aside from that, natural gas is at an very high historical prices, so nobody in their right mind would advocate moving toward natural gas and away from crude oil. Oil is still a much better bargain. That will not turn around any time soon, either. While the price of oil has been high (and has been coming down), natural gas will be in short supply and at a high price historically for some time to come. We don't even have a good supply situation for natural gas to cover the CURRENT demand for natural gas, so we can't even consider converting crude oil technologies toward natural gas. Natural gas as a raw material just wouldn't be available. I hope that changes.

I'm not sure we can count on the Chinese to continue the same exchange rate if the US dollar drops too much.

Heck, we can't count on the Chinese for anything, but let's just explore what happens when the Yuan is pegged to the USD and the USD weakens (and therefore the Yuan Renmenbi weakens).

Since the Asian currency crisis of 1997, all of the other Asian nations' curencies were weakened vs. the USD. These countries, most notably Japan, have been pleading with China to let their currency float and stengthen or weaken along with the other Asian currencies because they were losing their ability to compete vs. China. China refused. They have been ingnoring the request for years. Now, that the USD is weakening, and they are pegged to the USD, why would they want to strengthen now? Not only will they maintain their US market, but with the strengthening of the euro, their products will be even more competitive in European market.

The Chinese are cut-throat. They are not going to lose this opportunity to get a larger market share in Europe. Just think of it: The price that their goods are sold for in Europe can stay the same, while the amount of local currency they recieve for the sale will increase. But, more likely, they are only going to try to get the same price in their local currency, which means that in Euroland the price of their goods will decrease. Not so good for European manufacturers of similar products. But, no different here in the US for consumers since, because they are pegged to the dollar the price won't change (but they already have a commanding presence anway).

Our local prices from Chinese goods won't change, but the Chinese might cut their prices in Euroland. I don't know, but I have a feeling, that the goods we sell to Europe and the goods China sells to Europe don't overlap so much. If they did, I would think that would also happen in the US and that apparently isn't the case because we have already pretty much given up too much of our small goods consumer market to China -- but that is another discussion altogether.

"The substantial swings we have experienced in dollar valuation since the dollar was floated against gold and other currencies have been very burdensome to the economy, and ought to be ended"

In theory the idea of floating currencies should be the best system as it should reward the most disciplined Governments with a higher currency value. In practice it has been a disaster as Governments attepmt to manipulate their currency for political reasons.

I now advocate an implied Gold standard wherein the Fed would transparently use a price rule to add or subtract liquidity from the banking system based upon this rule. This system would work much better than current system and transactions costs associated with financing would fall across the broad. We still do not have adequate cooperation with our main trading partners, however, in order to full utilize such a system.

The ECB is pursuing a tight mentary policy even through the French, German and other EU economies are choking. The Japanese are still clinging to their export led economic model which demands an artificially low Yen value; the Chinese are pursuing a similar strategy with their currency. It is not sustainable for the US to be the only buyer.

The current deflationary pressures in the world economy are a result of Government subsidized over investment in a number of export industries. The South Koreans have the way out the current mess by liquidating some of their redundant capacity and stimulating internal consumer demand in order to replace sales from exports. The other Asian countries should be looking to South Korea for a solution to their problems.

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