Thursday, December 11, 2008

Competitive Devaluation of the U.S. Dollar on the Way?

The U.S. dollar has moved to multi-week lows vs. the euro (top chart) and is challenging longer-term lows vs. the yen (middle chart). Meanwhile, this morning, gold (bottom chart) is also challenging multi-week highs. This dollar weakness has breathed a bit of life into commodity prices this week.

A recent report suggested that China is keeping the yuan undervalued as part of a "beggar thy neighbor" policy of competitive devaluation. We're also seeing aggressive devaluation of the ruble, amidst warnings that high tariffs and competitive devaluations were instrumental in turning recession into depression in the 1930s.

But might the U.S. seek a policy of beggaring its neighbors? Let's go back to Federal Reserve chief Bernanke's famous speech, in which he outlined how the U.S. could extricate itself from a future deflation. He emphasized that, "a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition...A central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero."

How is a central bank to expand demand and economic activity in a deflationary, zero-interest rate world? "By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so," Bernanke asserts, "the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

"Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today," Bernanke assures listeners, "it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly."

Thus far, Bernanke's speech has been an accurate blueprint of the government's actions during this financial crisis, as we've seen efforts to drive interest rates to zero and stimulate the economy. With recent U.S. dollar weakness, we may be seeing the start of the use of exchange rate devaluations as a "weapon against deflation".