Enter the era of dollar devaluation

By Jim Saft

NEW YORK,  (Reuters) - We’ve entered a new era in global financial markets: the U.S. is intentionally devaluing the dollar.

For the U.S., which has long espoused a strong dollar but in reality had a policy of benign neglect, this is the equivalent of pushing the big red eject button in the jet cockpit: something big is going to happen and we will have to see how it will work out.

The Federal Reserve on Wednesday moved to open a second round of quantitative easing, pledging to purchase a total of $600 billion of longer-dated Treasuries between now and the end of the second quarter of next year. As well, the Fed will reinvest $250-300 billion in the same period, meaning that the central bank will be buying up $110 billion a month in Treasuries and creating a like amount of new money out of the ether.

Perhaps the principal way QE will boost the economy, the Fed hopes, is by lowering effective interest rates, enticing investors to move into riskier assets, some of which may generate inflation and jobs. As well there is the wealth effect; the old canard of spending more because your retirement account and house have gone up in nominal terms.

The bald fact, though, is that by turning on the printing presses the Fed will drive down the value of the dollar absent a similar move in another currency. Much of the new investment created by QE will be made not in the U.S. but will be money borrowed in the U.S., exchanged into a foreign currency, probably an emerging markets one, and invested overseas. That will drive the dollar down, which will help to make U.S. industry more competitive.

There you have it; competitive devaluation, a beggar-thy-neighbor policy. It is not much of a lever, but it is one of the few which the Fed has left to pull.

Don’t expect anyone from the Fed or the Treasury to tell you this in simple declarative sentences, but it’s true nonetheless.

“Devaluation is the intention, and devaluation is what is going to happen,” Avinash Persaud, Chairman of Elara Capital told the Forex Forum conference in New York on Tuesday.

We can surely expect the U.S. to deny this, as Treasury Secretary Timothy Geithner did in October, but the truth will be seen in the foreign exchange markets, where the dollar has been falling and will fall further as the year winds down.

GETTING THE GENIE BACK INTO THE BOTTLE

It is most certainly in the power of the U.S. to begin a period of competitive devaluation. The U.S. dollar is a global reserve currency and the marginal cost to Bernanke of printing more is very low indeed. Less certain are the reactions of the rest of the world.

While the U.S. will surely have prepared the way for QE2 with its major trading partners (and in fact may be deliberately ticking off the Chinese) there remains a strong chance that a falling dollar sets off a range of tit-for-tat reactions. Already Korea and Brazil are moving to stem the appreciation of their own currency. Look too for the possibility of other countries joining in to QE, in part so that the Japanese yen, to name just one, does not rise too much against the dollar.

A currency war blossoming into a trade war has to be one of the outside but significant risks of 2011. If global growth can recover significantly this may be averted, but this is far from promised.

The second and maybe more important risk is that the U.S., having lost control over its own monetary policy many years ago due to recycling of capital by the Chinese, now loses control of its currency. Like going broke, this can happen little by little and then all of a sudden.

On the Fed’s reckoning it will go like this; QE2 and very low rates go on for an extended period, but almost as a matter of mechanics, when the Fed begins to tighten, the dollar recovers.

 The Fed has used the dollar lever to ease and then uses it to help to tighten. The dollar remains the principal global reserve currency and investors respond to the Fed’s incentives.

The alternative is that QE is not terribly successful in improving U.S. growth but does touch off a round of speculative investment elsewhere, investments that make returns in a shrinking dollar look worse day by day. When the time comes that the Fed, perhaps hurrying to prove its control, decides to stop QE2, bond investors want compensation for holding U.S. debt -- a lot of compensation. U.S. equities, which have been held aloft by QE, duly fall sharply, as does the dollar, while yields spike. This is not a central case, but it is a possibility, and as it would be a disaster, one that needs to be watched closely.

Extraordinary times surely call for extraordinary measures, but those measures sometimes bring extraordinary results, and not always the ones we hope for.

Obama’s Asia frustrations raise protectionist risks

• China’s resistance to quick fixes “does not bode well”
• Obama returns home to angry voters, hostile congress
• Tea Party pressure could encourage defensive trade approach

YOKOHAMA, Japan, (Reuters) - The risks of a wave of protectionist sentiment on Capitol Hill just got higher after President Barack Obama struggled to win over wary leaders of export-driven Asian economies.

Obama’s message to trade surplus nations during his 10-day swing through Asia was unwavering: the path to global prosperity is not “simply paved with exports to America”.

But if he was heard, he is not being heeded.

“The failure of movement of the Chinese does not bode well for heading off new trade restrictions (in Congress),” said Fred Bergsten, director of the Peterson Institute for International Economics in Washington.

“If we can’t get the two sides to tango, this is going to cause continued problems for world growth and potential future crises, and in the short run for potential protectionist outbreaks.”

Even before last week’s G20 summit, China and Germany had quashed Washington’s proposal to set numerical targets for current account imbalances that risk destabilizing the global economy. When the leaders of the group -- whose economies account for more than 80 percent of global output -- met in Seoul, there was no agreement even on how to identify such imbalances.

Chinese President Hu Jintao told an Asia-Pacific summit in Japan on Sunday that the global recovery is neither well established nor balanced and that protectionism is on the rise.

But there was no sense that Beijing sees eye to eye with Washington on how to go about achieving the rebalancing needed to avert the risk of a trade war.

China cried foul over the Federal Reserve’s easy money steps to boost the U.S. economy and ruled out a sharp rise in the yuan, which would suck in imports and boost domestic demand.

U.S. lawmakers assert that China keeps its currency undervalued by as much as 40 percent, giving its manufacturers an unfair advantage against imports and making Chinese exports cheaper. Bergsten’s institute reckons the yuan is 17 percent undervalued against a basket of currencies.



Unbridged rifts, domestic pressure

In short, Obama returned to Washington on Sunday with little to show voters who, angry about high unemployment, handed control of the House of Representatives back to Republicans on Nov. 2 after an election campaign marked by anger over China and the loss of U.S. jobs to cheap imports.

The president failed to clinch even a bilateral victory on the sidelines of the G20 summit: the conclusion of a long-stalled free trade pact with South Korea. The U.S. Chamber of Commerce has warned that 340,000 U.S. jobs are at risk if the pact falls through.

“It is hard to imagine how the summit could have gone any worse for the U.S. Treasury and the president,” said Simon Johnson, a former IMF chief economist. “The Chinese are digging in hard on their exchange rate; this is headed towards a mutually destructive trade war.”

So far predictions of a descent into a 1930s-style tariff barrier war have been proved wrong. And the rhetoric is pulling the other way: the communiques of both the G20 and APEC summits resounded with pledges to refrain from competitive devaluations, maintain open markets and fight protectionism.

However, it may be too early to sigh in relief. The summiteers parted with rifts unbridged and Obama returns home to pressure from voters to do something about a stubbornly sluggish economy.

“This strong language is reassuring, but does not preclude a trade war from breaking out if the U.S. economy in particular remains weak and China moves too slowly,” said Julian Jessop, chief international economist for Global Economics. A new Congress takes charge in January, with trade sanctions against China already passed by the House of Representatives and waiting for approval in the Senate.

The new Congress will include a number of freshly elected conservative Tea Party members who may not share the Republican Party’s traditional enthusiasm for trade, promoting isolationist sentiment that is normally kept on the fringe of U.S. politics.

“The shift in the balance of power (in Congress) is likely to cause a more protectionist approach to foreign economic policy,” said Tony Twine, senior economist at research group Econometrix.