Should the United States defend the dollar or let it go?

The US financial crises have raised a series of important economic and political issues. The need for foreign finance has made the US weaken its economic position in the world and has led it to contemplate opening the gates on the ownership and board membership to countries that do not fully run their economies according to the principles of free market capitalism.[1] The recession and the financial crisis themselves may turn the political pendulum towards government intervention and away from free market capitalism as seen in a number of Latin American countries after the recession and financial crisis of the end of the century. And finally the unthinkable has become a real possibility, the risk of a run on the world reserve currency.

Kenneth Rogoff has recently pointed out in a newspaper article, the US is very lucky that the world has shown such confidence in the dollar.[2] But a run on the dollar may not be a complete disaster provided the right monetary policy is in place. For any country that does not enjoy the privilege of issuing the reserve currency, a financial crisis would not erupt without a currency crisis. No economist familiar with emerging-market twin crises would want such a devastating blow to economic activity for any country and hopefully a run on the dollar will not take place. John Plender gives good reasons why this might not happen.[3]

But as long as the possibility exists, the question arises as to whether the Federal Reserve should raise interest rates to combat currency depreciation and capital flight. The policy of increasing interest rates has been blamed for much of the deep emerging market recessions of the end of the century. I myself think that during a currency crisis an emerging market should not defend the currency by increasing interest rates but that it should let the exchange rate depreciate.[4] The rise in the policy interest rate would intensify the recession and would increase the burden of foreign debt. In contrast, a depreciation would raise net exports, offset the recession and decrease foreign debt.

There are advantages to the depreciation option for the US: foreign debt is denominated in US currency so that a depreciation does not cause valuation effects on the stock or the service of the debt, and the economy is relatively closed which considerably mutes the effect of the exchange rate on inflation.

After a depreciation, US assets would seem extraordinarily cheap from a foreign perspective, but current holders of US assets would be wiped out (measured in currencies different from the dollar) and this in itself could discourage them from dumping these assets onto the market.

This is reminiscent of the Plaza Accord. The US dollar depreciated 51% after the agreement and Japan had to afford the fall in the value of its international reserves. Currently, a run on the dollar could inflict a similar loss on China precisely when those savings would serve a better purpose by tackling Chinese own financial sector weaknesses.

Should the United States defend the dollar or let it go?

[1] The Federal Reserve has been said to intend to lift the ban on board representation for minority investors and to raise the maximum stake for a minority investor in bank holding companies, in some instances, from 25 per cent to 33 per cent (see “Fears emerge over $700bn rescue” Financial Times, September 22, 2008).

[2] See “America will need a $1,000bn bail-out.” Financial Times, September 17, 2008.

[3] See Reserve judgement on the dollar, Financial Times, September 23, 2008.

[4] See Capital Flows and Monetary Policy, Banco de la República, Working Paper No. 395, 2007. In particular, see page 29 for the case of a country that borrows abroad in its own currency.

4 Responses to "Should the United States defend the dollar or let it go?"

  1. Gloomy   September 27, 2008 at 12:57 pm

    Great post. The dollar will go as the pain of defending it is too great a price for any politician to own (although depreciation will be no fun either).

  2. Guest   September 28, 2008 at 6:15 am

    If THE NEW WORLD ORDER crowd has their way with the North American Union then the AMERO will be forthcoming.So it’s possible they don’t care about the U.S. dollar.Vote HR 2755 ABOLISH THIS FRB Nationalize the central bank.

  3. Caroline Fawcett   September 28, 2008 at 1:03 pm

    I have simulated this scenario with many political economy classes at American University. The main question relates to our partner countries, and if they would put in place coordination mechanisms to help us defend the dollar (let’s face it by that point we will not be in much of a position to defend it). I agree that something should be negotiated with the Euro…and the Europeans. China is in no position to take a lead ..and the alternative stable currency is the Euro. The question is what would the Europeans extract? This has been the subject of many student-led simulations where they are placing some major conditions on the Treasury boys.

  4. Javier Guillermo Gómez P.   October 1, 2008 at 8:32 am

    Sure, defending the currency by increasing interest rates is a costly pain, unimaginable for the US in this situation, but that is precisely what emerging market countries did during the end-of-the-century crisis.