The best recent policy response to the financial crisis didn't come from the G20 but from the foreign exchange market. This week the dollar fell aggressively against many currencies, driven by an Australian rate increase and a report claiming Arabs, Chinese, and Russians were conspiring to stop pricing oil in dollars. But the dollar was set to depreciate anyway due to an increasing debt and a dovish Federal Reserve. A weak dollar will have a positive effect on normalizing trade imbalances, if it lasts.
A falling dollar is a great stimulus to the US manufacturing base. Historically, manufacturing profits are inversely related to the value of the dollar.
From 1990 to 1995, the dollar stayed around the same level. But in 1995, the dollar started rising steadily, eventually peaking in 2002 after rising 51%. During this time, exports decreased by half:
During this period, exports in China and Japan surged. China's reserves quadrupled and Japan's reserves almost tripled. (For more information, see Robert Blecker's paper, "The Benefits of a Weak Dollar" at the Economic Policy Institute.) The strong dollar also had a large effect on jobs. See this figure on the effect of China's artificially low currency on employment and trade:
The map below shows the damage per state (see Robert Scott's paper here). Note that politically sensitive states such as Ohio, Michigan, and Florida have suffered some of the biggest losses.
Simon Johnson from MIT wrote a recent article arguing the weaker dollar is a part of Obama's plan to win the midterm elections by stimulating the manufacturing industry. Simon says NY Fed President William Dudley's recent comment that interest rates would stay low for the foreseeable comment was timed to send the dollar lower after the Australian rate hike. If rates stay low in the US for longer than other countries, there is an opportunity for a carry trade between the dollar and a currency that is likely to increase rates sooner (e.g. Korea, Australia, China or Switzerland).
Fundamentally, the dollar has nowhere to go but down. With high fiscal debt, loose monetary policy, and trade deficits, the dollar is fundamentally unattractive. Furthermore, there is likely to be significantly less demand for dollars in the future. The second largest holder of US debt, Japan, is highly indebted (debt to GDP of 170%) and aging. The savings rate has been steadily decreasing and will continue to reduce demand. Furthermore, the number one holder of US debt, China, is actively (and publicly) trying to diversify from the dollar.
But while the dollar may go down and start to normalize trade in the short-term, there is reason to be skeptical that this will occur for longer periods of time. Asian nations will not let the dollar get too low. Already we have seen Asian countries respond to the falling dollar. Yesterday, the FT reported Asian central banks aggressively bought the dollar on Thursday. Thailand, Malaysia, Taiwan, Hong Kong, and Singapore made substantial purchases, though they merely slowed the dollar's decline. A key aspect of this intervention was that it was coordinated.
The Asian countries that intervened likely did so primarily to stay competitive with China, which re-pegged the renminbi to the dollar in July 2009. This re-pegging of the renminbi means that whenever the dollar significantly weakens, a large number of central banks must intervene if they want to compete with China. This could mean a floor for the dollar. It could also be a bullish indicator for US treasuries, as foreign central banks may buy treasuries to push the dollar higher.
