Last week the world learnt that economic “decoupling” from America is a myth. The next lesson to relearn is that the US Federal Reserve’s monetary mistakes have global consequences, and that one result of the Fed’s great dollar miscalculation this decade has been a dangerous breakdown in world monetary cooperation.
Look no further than the European Central Bank (ECB), which was notably absent when the Fed made its emergency rate cut amid falling global stocks last Tuesday. In testimony before the European Parliament, ECB president Jean-Claude Trichet came about as close as a member of the brotherhood ever will to calling out a fellow central banker: “In...times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility in already highly volatile markets.” If we can interpret Trichet further, he thinks the Fed helped to create the current financial mess by going on a bender in the late Alan Greenspan era, and is again running dangerous inflation risks by cutting rates too soon in the face of Wall Street pressure. He’s also unhappy as the dollar’s fall against the euro has raised political pressure on ECB to ease as well. So, now that the Fed wants his help to avoid a further dollar decline against the euro, he’s in no mood to oblige.
Trichet has a point, and for that matter so do all the Davos-types chortling about US credit woes. Europeans and many Asians love to see the Yanks humbled, and the sight of America’s banking giants going hat in hand to Abu Dhabi, Singapore and China is too much Schadenfreude to pass up. One irony is that the cause of all this Yankee humiliation isn’t the familiar Euro-gripe about the “trade deficit” or tax cuts. It is monetary policy. But they’ll enjoy it whatever the cause. They shouldn’t get carried away, as their own stock markets have shown what could happen to European and Asian economies if the US heads into recession. The $7 billion fraud at Société Générale and the mess at Britain’s Northern Rock mortgage lender also make clear that American bankers don’t have a monopoly on bad judgement.
The currency reserves and sovereign wealth funds that many countries have been piling up are in substantial part the result of that same Fed mistake. So, they can vanish as fast as they arose if commodity prices fall again and the dollar rises. Recall the Texas oil patch, circa 1983, as Paul Volcker’s Fed corrected the inflation of the 1970s.
Trichet also has an advantage over Fed chairman Ben Bernanke in that his mandate is to focus solely on the price level. Under Humphrey-Hawkins, the Fed must target the price level and employment. Trichet is right to keep his eye on a stable euro, but we also wish he and the Fed weren’t so obvious about their mutual discord. The other great casualty of the Fed’s blunder has been the global dollar bloc. This had been building for years, as nations adopted either formal (such as a currency board) or informal dollar links to their currencies. A stable exchange rate creates economic and trading efficiencies, while a formal dollar link means a country can reduce political uncertainty by delegating its monetary policies to the Fed. This made sense as long as the dollar was stable. But as the dollar has fallen, these countries have imported inflation and some are now severing their dollar links. The Gulf Cooperation Council is mulling a link to a euro-dominated basket of currencies, and even China is slowly revaluing the yuan against the dollar—less due to US political pressure than out of its interest to control internal inflation.
This world of greater exchange rate volatility is dangerous. The extreme movements of the euro versus the dollar over the last decade have created enormous uncertainty for business, while distorting trade and investment flows. They also contribute to economic anxiety and a populist trade backlash. The collapse of the dollar bloc, if it continues, will add to this exchange rate volatility and in the worst case make it easier for beggar-thy-neighbour currency manipulation. The world needs more monetary cooperation, not less. As the world’s most important central bank, the Fed must take the lead. The way to start is by sending a message that its decisions will be based on a renewed determination to protect the dollar and its role as a reserve currency.
The Wall Street Journal
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