Financial firms have so far announced losses totaling around $160 billion, and UBS feels there could be a total of $600 billion in losses triggered by the subprime collapse. There is more bad news to come, and central bankers know it. If UBS is correct, we've only seen the tip of the subprime iceberg, and central bankers will have to remain flexibile to effectively deal with upcoming challenges. I don't doubt that the dollar's long term trend is down, but I argue here that coordinated intervention to give the U.S. dollar a short-term (2-5 years) lift may be an interesting idea for central banks to consider.
"The already undervalued dollar won't stop falling until it is stopped via coordinated intervention," said Morgan Stanley's Stephen Jen in a note published in December. "While the preconditions for such an action have not yet been met, uncoordinated verbal intervention has clearly commenced, validating the notion that the costs of a weaker dollar are quickly catching up to the benefits for most countries in the world."
Coordinated central bank intervention to save the dollar might sound like a crazy idea, but it's worth pointing out that in the past 30 years, coordinated intervention caused all but one of the changes to the dollar's long-term trend. Morgan Stanley said in November that the Fed, European Central Bank [ECB] and the Bank of Japan [BoJ] may coordinate efforts and intervene once Euro hits $1.50 or if the Yen goes to 100. The analysts suggested that coordinated intervention becomes more likely once the Fed ends cutting rates and the ECB ends hiking rates, and it's probably fair to say we are fast approaching such a condition.
The Morgan Stanley report points out that trade and investment flows rarely offset large currency moves, which implies that the "natural economic mechanisms that should, in theory, have helped halt the greenback sell-off were not, in fact, usually strong enough. This is why multilateral interventions were usually required to facilitate the re-alignments of exchange rates."
Central bank credibility can go down the tubes if they fail to boost the dollar in a coordinated intervention attempt. How long will the Fed's $67 billion of reserves (including $42 billion in foreign currency) last before it's absorbed by a forex market that trades $3,000 billion a day? The Fed will need the help of other central banks to take on the massive foreign exchange market. Assuming central banks can successfully pull off a coordinated intervention, here follows five reasons why saving the dollar makes sense:
1) Record oil prices pose a major risk to the industrialized world, and a higher dollar will probably knock down oil prices and reduce inflation
OPEC is refusing to boost production when the rest of the global economy is faltering, and it's time for central banks to get creative. Lower oil prices, as a result of coordinated intervention to save the dollar, will help to cool inflationary pressures, giving central banks some room to adjust monetary policy. For example, many analysts believe the ECB is behind the curve, especially after recent economic releases that disappointed. Lower oil prices may reduce inflation expectations in Europe, which may allow the ECB to cut interest rates and deal with the economic slowdown and credit troubles.
2) A stronger dollar will boost the buying power of the weakening U.S. consumer
The U.S. remains a consumer nation, and central bankers need to find ways to resuscitate the U.S. consumer. After all, the U.S. consumer has been the driver of growth in many parts of the world. By boosting the value of the dollar, through coordinated intervention, U.S. consumers remain protected from inflationary pressures by boosting their buying power.
3) Japanese exporters need to remain competitive
"Recession is a clear and present danger in Japan," said Tetsufumi Yamakawa, chief Japan economist for Goldman Sachs. "The leading indicators are deteriorating very sharply. Inventory is piling up at a rapid pace. There are clear signs of deceleration in exports of steel and semi-conductors to China," he said. Japanese exporters will have to remain competitive if Japan is going to recover from the current slowdown. Coordinated intervention to lift the dollar will push down the yen, helping Japanese exporters.
4) Coordinated solutions will be more effective than isolated solutions
If countries act in isolation, I doubt they can produce meaningful solutions. A perfect example of this idea is the Fed's recently announced rescue package that will probably benefit the Chinese more than the United States. "Americans will use the rebates to buy Chinese imports offered at Wal-Mart and the $150 billion will then wind its way inevitably back to Asian coffers," says PIMCO's Bill Gross in a recent note. Some might say this is far-fetched, but it illustrates an important point: Global economies are tightly connected, and contagion effects are likely to undermine the impact of domestic policy action. This is a global problem, and it has to be solved by global, coordinated solutions. "Preventing a global downturn is too big a job to be left just to American policymakers," says the headline in a recent article published by The Economist.
5) The timing of the U.S. elections
The world can't always rely on America to save the day, and other nations will have to come to the table and offer solutions. Due to the political transition in the U.S. it might take time to implement policies that will be effective. After all, the $150 billion rescue package has been labeled as "temporary" solution to avoid widespread damage to the economy in an election year, and much work still has to be done to arrive at a permanent solution. Quoting PIMCO's Bill Gross again: "When private demand falters, it becomes the responsibility of the government to fill the breach. Because it likely will not do so effectively until after a new Administration is elected in late 2008, the U.S. economy and its somewhat coupled global companion will sleep walk for some time and a resumption of prosperity as we knew it will be dependent on reforms of monetary and fiscal policy resembling the 1930s more than our past decade."
There are numerous arguments against intervention to save the dollar. Exports have turned into the main driver of US growth, offsetting the housing slowdown and credit crisis. It doesn't make sense to disturb an area of growth, especially when we don't know if U.S. consumption will continue to hold up. A weakening dollar is also helping the adjustment of the U.S. trade deficit, a process that U.S. officials wouldn't want to disturb. Politics may also delay coordinated central bank intervention. The G7 demands currency flexibility in the emerging world, and for that reason any coordinated intervention from G7 central banks will contradict those demands. Some analysts suggest that a more realistic scenario would involve the Europeans undertake some sort of coordinated intervention that would spread the burden of adjustment more evenly between the euro and some Asian currencies.
Coordinated intervention to boost the dollar is not an ideal solution, but the foundation of the idea is simple: we need coordinated solutions. "If the world leaves the Fed to provide risk insurance for everyone, America's interest rates will almost certainly be too loose for too long-just as they were in 2001-04," says The Economist. "Excessively low American rates would raise the odds of new asset bubbles and impede the rebalancing of the global economy."