- How does the dollar’s fall affect the global economy? How does the euro’s rise influence the European economy?
- The fall of the dollar has had a number of consequences. First, it is making US producers more competitive in terms of price. As a result of the weak dollar, their competitiveness will definitely increase and in time, this will lead to a correction of the US’ unacceptably large imbalance of payment.
Secondly, with time the dollar’s decline will affect the cost of financing. If the dollar will continue to fall, depositors will obviously want a bonus in the form of additional interests on their deposits as a compensation for risk. This, in turn, will increase financing costs for US consumers and investors. The resulting rise in interest rates will weaken consumer demand in the US and reduce the volume of goods imported into the US.
Both factors will have an adverse impact on the economies of exporter countries. They risk losing a certain market share and their sales growth could decline significantly. This is especially urgent for Japan, Europe and, to a considerably lesser extent, China, which to all appearances is headed toward an overheated economy. To withstand these negative consequences, these countries should stimulate their domestic economies via fiscal and monetary policy. However, both Japan and Europe have rather limited room for maneuver. They have practically no room to lower their interest rates and their government budgets are already encumbered with expenditures. Thus, the weakening of the global economy will be the most probable consequence of the dollar’s decline.
- What is the most acceptable dollar exchange rate for the EU? At what level will this become dangerous for the Europeans?
- Based on practical observations, we can say that the optimal exchange rate for Europe is 1.10 dollars to the euro. The current rate ranging from 1.25 to 1.30 is 15-percent overvalued. Given that each 10% the euro is overvalued takes 3% away from annual export (the reaction comes in six months), we can estimate for example that the current overvalued euro will mean GDP growth rates will fall in Germany by 0.5%. Accordingly, if GDP growth rates are expected to be 2% in 2004 and this is the third consecutive year of stagnation, this effect will definitely pose a threat to the German economy. If the dollar/euro exchange rate is consistent at 1.4, this will certainly trigger a recession in Europe.
- How low could the dollar fall?
- Nobody can imagine what the maximum for the euro could be. If we assume that the past thirty years can work as a guide for modeling a situation, then it is possible to say that 30-percent variance from the optimal exchange rate would be the critical point. Thus, the rate of 1.4 is the critical value for the euro versus the dollar. It should be noted, though, that in the past the current imbalance of payment never reached 5% of the US GDP, or $500 billion a year.
- The present situation with the dollar is reminiscent of a similar process that took place in the mid-1980s. Would it possible today to agree to support the US currency in a way similar to the agreement at the Plaza Hotel or the Louvre Agreement on dollar protection?
- The following traditional monetary policy instruments could be employed to prevent undesirable exchange rate variations. First, interest rates in the US could be increased, and secondly, interest rates in Europe and Japan could be lowered. Under present circumstances, it is extremely difficult to do either of these. In the US, the president wants to be re-elected for a second term in 2004, and the robust economic upturn undoubtedly increases his chances for victory. In Japan, the cost of credit is virtually zero and cannot go any lower. In Europe, the repo rate is already 2% p.a., meaning there isn’t much room for reduction.
Mass, or “unsterilized,” intervention on the currency market can be another way to exert influence on the currency rate. However, both the US Federal Reserve and the European Central Bank have an almost religious aversion to this kind of intervention. Even if they do intervene, it would be merely tactical. It would be aimed at supporting the dollar if at some moment it should fall lower than acceptable. In any case, I believe that none of the central banks will undertake any intervention until the exchange rate reaches 1.4. An agreement similar to the one made in the Plaza Hotel would be possible only in the case of a real catastrophe.

Interviewed by Olga Vlasova

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