Brenner vindicated?

From: Rakesh Bhandari (rakeshb@STANFORD.EDU)
Date: Sun May 25 2003 - 00:27:06 EDT

Is Snow encouraging the devaluation as a beggar-thy-neighbor policy
or as immunization against debt deflation or both?

US declares war on the euro

America's policy of competitive deflation poses a real threat to the
Eurozone, writes William Keegan

Sunday May 25, 2003
The Observer

Although the current political and economic debate in Britain is dominated
by the relationship between the pound and the euro, the more imminent
problem is the relationship between the euro and the dollar.

The crux of the matter is that, while the US economy was booming and the
dollar was strong, the Eurozone enjoyed not so much a free lunch as an
easy ride, which served to disguise its underlying macro-economic problem.
That problem, put quite simply, is that there is a deficiency of what
economists call 'aggregate demand' in the Eurozone. Economic policy - both
budgetary and monetary - has been too restrictive, but as long as the US
was happy to serve as 'importer of last resort' to the rest of the world
the magnitude of the potential crisis was not appreciated.

In the second half of the 1990s the US economy expanded by some 4 per cent
per annum in real terms. In 2001 and 2002 its average growth rate more
than halved to 1.3 per cent. Successive efforts to talk the economy up
have had meagre results. History suggests that, after an investment boom
on the scale experienced in the US in the late 1990s, it can take years
for confidence to revive.

This is why President George W Bush, desperate to achieve the re-election
that eluded his father, is throwing everything into a desperate attempt to
revive the economy. The ending of the Iraq war has not triggered a serious
revival of economic confidence. So Bush is trying to buttress the Fed's
cheap money policy (the key Fed funds interest rate is down to 1.25 per
cent) with tax cuts, and US Treasury Secretary John Snow has effectively
declared the outbreak of 'currency war' with the rest of the world in
general and the Eurozone in particular.

While the dollar was strong and the euro weak, the Eurozone was protected
from the full disinflationary impact of its own policies. Thus, having
been at around $1.17 when launched in 1999, the euro declined to a point
where it averaged $0.85 in June 2001. It was still $0.89 in 2001 on
average, and $0.94 in 2002. But it strengthened over last year to $1.02 in
December, and leapt to $1.15 by the middle of this month. It has recently
hit its inaugural $1.17 level.

While the period of the 'weak euro' was considered politically and
presentationally unfortunate, it was extremely good news for Eurozone
companies, whether they were exporting or competing in domestic markets
with foreign companies. Now they are feeling the pinch of an uncompetitive
currency. Yet the adjustment in the dollar is rightly regarded as
necessary to correct a major disequilibrium in the world economy. The US
may have accounted for two thirds of global economic growth since the
mid-1990s, but it has been feeding its consumption habit by borrowing $1.5
billion a day from the rest of the world.

There is something very odd about the world's mightiest economy borrowing
on such a scale. Many economists have acknowledged for some years that a
major realignment of the dollar against other currencies was necessary to
correct this imbalance. And last year the currency fell 14 per cent
against a weighted average of other major currencies. Some currencies,
such as the Chinese renminbi, are rigidly tied to the dollar; and the
Japanese, with massive economic problems of their own, have been doing
their best to resist a rise in the yen against the dollar.

It is the euro that has borne the brunt of the impact of the dollar
devaluation. The rise in the euro has recently brought squeals of pain
from French and German exporters at a time when the German economy is in
recession and the French economy perilously close.

But if Treasury Secretary Snow has his way, this will not be the end of
the story. Last weekend, on the occasion of a meeting of the Group of
Seven leading finance Ministers in Deauville, France, Snow departed from
the traditional Washington 'strong dollar' policy, saying that its
devaluation had been 'helpful to US exporters' and that so far there had
only been 'a modest realignment'. The danger is that, while an adjustment
was necessary, Snow's statement is tantamount to a declaration of currency
wars. As John Llewellyn and Russell Jones say in the latest Global Letter
from Lehman Brothers: 'The industrial economies are awash with excess
capacity, most are experiencing disinflation, and some are threatened by
outright deflation. With unfortunate echoes of the 1930s, policy-makers
are being tempted to use exchange rates to maximise their share of
manifestly inadequate global demand.'

The US declaration of a 'beggar my neighbour' policy of competitive
devaluation arises from frustration with the demand-management policies,
or lack of them, in Europe. Snow says: 'A healthy global economy needs
multiple engines of growth. Our G7 partners [half of whom are in the
Eurozone] must immediately take their own steps, appropriate to their own
circumstances, to spur growth, create jobs and contribute to global

While Snow referred to 'structural reforms' (supply-side policies to make
labour markets more flexible) they were not his real targets. The obvious
bone of contention is the way the Stability and Growth Pact constrains the
fiscal policies of European governments, and the European Central Bank
remains obsessed with fighting the last inflationary war.

Even the International Monetary Fund has warned that Germany is on the
verge of outright deflation, a probability that would become a certainty
if the markets push the euro much higher. The economists at Lehman
Brothers warn: 'We are concerned that the rapidly rising euro could
consign the Eurozone to an extended period of stagnation.'

While not wishing to push the parallels with the 1930s too far, Llewellyn
and Jones make the point that 'during a period of competitive currency
depreciations, the first country to devalue gains an initial advantage.
But this will prove temporary, as others follow suit.' They say that 'the
mechanism through which successive devaluations are achieved - typically
looser monetary stances - can lead to broad-based reflation and recovery.
It is just a roundabout way of reaching that end. Coordinated expansion in
the face of a slowdown would appear a more sensible policy prescription.'

But with the dollar and sterling depreciating against the euro, and the
Japanese and Chinese doing their best to avoid a rise in their currencies
against the dollar, the euro stands out as the one that is being made too
strong for its own good.

The situation is potentially so serious that Eurozone policy-makers may be
forced to make the changes to their macro-economic policies that would
suit a British Government contemplating joining the euro. But for the
moment it would be difficult to sell the Eurozone economy to the British

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