Stephen King: US must face the choice of hitting creditors where it hurts

The last refuge of a desperate policy maker is a currency devaluation

"America's exporting its deflation to Europe!" It's easy to see why this accusation is now being made. The collapse in the dollar against the euro over the last two years could be the ideal way for the US economy to stage a recovery. The Federal Reserve has slashed interest rates - with perhaps more to come in a few days' time - and the Bush Administration has loosened fiscal policy, yet the results have been disappointing. The last refuge of a desperate policy maker is a currency devaluation. With the dollar heading down, the US could be hoping to unload its post-bubble burdens on an unsuspecting European public.

Let's think about how this might work. The US fears deflation. We know this because the Fed has said so. Deflation is scary when there's lots of debt swishing around. Deflation raises real debt levels but, if interest rates are already close to zero, the central bank finds it difficult - if not impossible - to offset the rise in real debt levels through a reduction in debt service costs, or interest rates. With America up to its eyeballs in debt, deflation has to be avoided at all costs.

When it comes to dealing with deflation, you may need to redistribute income away from creditors towards debtors. Debtors are more likely to spend than creditors - who, after all, are savers - so if you want a recovery in the economy, you have to make the hard political choice of hitting creditors where it hurts to make sure that debtors lift the level of demand and return the economy to sweetness and light.

In America's case, however, policy makers may be hoping to avoid a hard political choice. At the national level, all Americans are debtors. They've been consistently borrowing from the rest of the world for decades and, over that time, they've built up a huge amount of debt.

In these circumstances, a dollar devaluation seems rather attractive. America's creditors - in other words, mostly Europeans - get hit because the value of our dollar holdings goes down in sterling or euro terms. Americans, meanwhile, suddenly find themselves with lower real debt levels as their inflation rate picks up as a result of the dollar devaluation. For President Bush, this sounds very attractive indeed: the economy gets bailed out with no real damage to any of the voting public.

I think, though, that this argument is too good (or bad, depending on your point of view) to be true. One problem is the extent to which the dollar can actually fall. The left-hand chart shows the extent of the dollar's decline since its peak against a broad basket of other currencies at the beginning of 2002. Since then it has fallen by only 10 per cent.

Our European standpoint intensifies the dollar's decline. According to the chart, the dollar has declined against the euro not by 10, but by 25 per cent over the same period while it has moved hardly an inch against the majority of Asian countries and, as a result, the brunt of any dollar depreciation policy is being felt in Europe. So long as Asian countries continue with pegged or managed exchange rate regimes against the dollar, the US currency itself will never be able to fall very far overall, even if it goes down a long way against the euro.

I did a few calculations last year in an attempt to work out how far the dollar would have to fall to bring America's balance of payments position back to balance - one possible measure of the adjustment required following a period of debt indigestion. I argued that if the dollar were to be used to correct the current account balance it would have to fall to $1.40 against the euro and the yen would have to rise to ¥60 against the dollar. As things stand today, the yen is still at around ¥117 having scarcely budged at all so if the euro is having to do all the work it might eventually have to go up to $1.80. Ouch. This wouldn't do Europe any good at all.

A second problem is the extent to which a devaluation policy can actually work. Remember that the idea is to avoid deflation. Devaluation reduces the chances of deflation primarily by placing upward pressure on prices: both import prices and export prices will be able to rise in domestic currency terms, potentially triggering a pick-up in inflationary expectations and, as a result, a reduced real debt burden.

This is all very well so long as inflation picks up but is there any particular reason to think that it will? After all, a fall in the currency merely reflects a change in relative prices: if your currency falls against another country's either your inflation rate goes up or the other country's inflation rate goes down - or, perhaps, a bit of both. The danger with the current situation - from both an American and a global perspective - is that a dollar depreciation creates deflationary pressures elsewhere without getting rid of deflationary pressures at home.

A controversial point, perhaps, but not necessarily wide of the mark. Since the beginning of the 1990s, exchange rate falls have had surprisingly little impact on the domestic inflation rate. Fears - or nowadays, hopes - that an exchange rate decline will raise the domestic inflation rate have, for the most part, proved inaccurate. A good example is the UK experience in the aftermath of sterling's departure from the exchange rate mechanism in 1992. The right-hand chart shows what subsequently happened to both sterling and to UK inflation. Sterling fell a long way - as we all know - but inflation simply did not pick up. With the economy already very weak, there simply wasn't any pricing power.

The US experience in recent years has not been dissimilar: the dollar began to fall against the euro in the summer of 2001 yet, since then, US inflation has edged ever lower. Dollar depreciation has, to date, had no impact whatsoever on raising the inflation rate in the US. Instead, it has heightened concerns about deflation in Europe, particularly within Germany.

Who should be blamed for this state of affairs? For the Americans, it's Europe's fault. From a Washington perspective, the dollar's decline is simply a reflection of US attempts to get the domestic economy going. According to this view, it's up to Europe to decide whether to offset the impact of the rise in the euro by either cutting interest rates aggressively or loosening fiscal policy. From a European perspective, however, the dollar's fall could be regarded as a blatant last-ditch attempt to try to secure recovery from the ashes of a post-bubble crisis and represents no more than a "beggar-thy-neighbour" policy approach. Sadly, these two different views suggest that, whilst the arguments continue, the global economy will inch one step closer to a deflationary impasse.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com