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Snow, the US Treasury secretary, effectively abandoned the previous administration's strong dollar policy over the weekend by issuing his own definition of what constitutes a strong currency. It does not include market prices.
David Hale Financial Times May 20, 2003

The circumstances now confronting the US economy are unique in the modern era. The Federal Reserve has warned about the risk of deflation after a year in which the US dollar has fallen by nearly 30 per cent against many leading currencies. Despite the weakness of the currency, US Treasury bond yields have fallen to 45-year lows and are 37 basis points under the yields of German government debt.

The dollar's decline has been painless for US financial markets because investors are complacent about inflation. The failure of bond yields to rise has also produced a policy of benign neglect in Washington. Federal Reserve officials say the falling dollar is a European problem, not a US one. John Snow, the US Treasury secretary, effectively abandoned the previous administration's strong dollar policy over the weekend by issuing his own definition of what constitutes a strong currency. It does not include market prices.

The dollar began to weaken more than a year ago but its decline has accelerated during recent weeks for three reasons. First, the markets are concerned that the Bush administration's fiscal policy could boost the federal budget deficit to $400bn-$500bn (£250bn-£310bn) and create a domestic savings imbalance that will expand the current account deficit to $600bn.

Second, the markets are alarmed that the US is embarking upon an imperialist foreign policy that will have unknown consequences for its fiscal position, foreign trade and relationships with other countries. In the heyday of empire, the UK ran large current account surpluses. There is no precedent for a country playing the role of global superpower with a large external payments deficit.

During the cold war, the US was able to finance its defence spending in part through offset programmes with other countries. The Bundesbank, for example, stockpiled dollars as a quid pro quo for US defence spending in Germany. During the 1991 Gulf war the US received large subsidies from Japan, Saudi Arabia and other countries. With the US pursuing a more unilateralist foreign policy it will have to absorb all of the costs without help from traditional allies.

Last, the markets perceive a vacuum at the centre of US economic policymaking. In this administration power is highly centralised at the White House. The only highly visible cabinet ministers are at the departments of state and defence. The Treasury's stature and influence declined during the tenure of Paul O'Neill because of his caustic comments about many issues and his poor relationship with Congress.

Mr Snow has worked hard to improve ties with Congress but the markets see him as a salesman, not an architect of policy. Larry Lindsey and Glenn Hubbard, the people who created the administration's economic policy, have resigned.

The other institutions of economic policy are also weak. The new director of the national economic policy council is focused on internal administration rather than influencing markets. Mitch Daniels, director of the Office of Management and Budget, is leaving to pursue a political career in Indiana. The Council of Economic Advisors is being evicted from the White House.

Economic policy appears to be under the control of White House political advisers, not the traditional institutions of government. In fact, the White House will not be able to encourage a dollar rally until /George W. Bush's chief strategist/ Karl Rove holds a press conference on the subject.

As Mr Snow's recent comments have made clear, Washington will do nothing to stabilise the dollar until there is a big correction in bond prices that might jeopardise the boom in the US housing market. But in the absence of a threat to the US housing market, the burden of adjustment will fall elsewhere.

Asia will resist dollar depreciation through large-scale market intervention. China's foreign exchange reserves will expand from $280bn to $330bn this year. Japan's foreign exchange reserves will mushroom from $500bn to $600bn this year and reach $1,000bn by 2008.

If Asia is able to stabilise its exchange rates, the US will have to reduce its current account deficit through larger devaluations against other currencies. This pressure for devaluation will set in motion a process of competitive monetary reflation with the eurozone, Britain, Canada, South Africa and other countries with variable exchange rates. These countries will be compelled to cut interest rates to prevent their currencies from appreciating against the dollar.

The Bush administration is prepared to pursue aggressive fiscal and monetary policies to ensure a healthy recovery in the run-up to the 2004 presidential election. Its new weak dollar policy is designed to put pressure on other countries to reinforce this domestic growth agenda.

During the late 1980s Japan created a bubble economy with rocketing prices for land and equities by pursuing a monetary policy designed to stabilise the dollar. The coming round of competitive monetary reflation is also likely to force central banks to pursue far more aggressive interest rate cuts than they expect. If it does, President George W. Bush will not win re-election. There could be Bush bubbles in many asset markets during late 2004 and 2005.

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