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Date Posted: 18:43:04 07/06/03 Sun
Author: Naval Vithalani
Subject:

Sinking US dollar 'could drag world under'

Sinking US dollar 'could drag world under'

The Bank of International Settlements fears a deflationary crisis because the global economy is too tied to America. William Keegan reports

Unless the leading industrial countries get their act together and pursue compatible economic policies, the world economy may be threatened by 1930s-style

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competitive devaluation and an outbreak of protectionism.
This warning comes from the Bank for International Settlements (BIS), one of the world's most prestigious international financial institutions.

In its authoritative annual report, the BIS warns that: 'The global economy faces a fundamental dilemma, which is becoming more acute with time. How can imbalances in growth and external accounts across the major economic regions be resolved while maintaining robust global growth overall?'

The bank suggests that the rest of the world has been far too dependent on the economic stimulus provided by the United States and that the ongoing decline in the dollar is going to make life much more difficult for Europe and Japan.

The report warns that unless other countries supplement fashionable 'structural reforms' with 'more expansionary demand management policies' there must be a question mark over 'whether domestic demand will expand elsewhere, notably in continental Europe and Japan, after a long period of weakness'.

Known as 'the central bankers' bank', the BIS, headed by Malcolm Knight, is involved with banking and other financial regulation and has a particular concern about the dangers of systemic weakness in the world economy.

It says that 'the institutional underpinnings of the financial system require further strengthening' and expresses grave concern about the erosion of trust in financial markets. 'If trust in the integrity of the capitalist system is crucial to its proper functioning,' says the BIS, 'then it is important that wrongdoers are punished and are seen to have been punished.'

From its position as a central observer of the regulatory effort, the BIS plainly believes that some financial operators have been getting away with murder. 'Given the flagrant excesses of recent years, it is by no means clear that enough has yet been done to re-establish trust in the system,' it comments.

The central bankers' bank points to the large overhang of industrial excess capacity in the US from the earlier boom, with capacity utilisation at a 20-year low and debt levels still high, and argues that the current level of Wall Street 'can only be justified by expectations of an economic rebound and sharp increase in profits'.

The BIS highlights the fact that, although devaluation of the dollar is a necessary part of the current adjustment process (ie, making American exports more competitive and lessening US dependence on foreign funds to finance its imports) 'about half of the US current account deficit today is concentrated in countries whose currencies have closely tracked the dollar'. The main culprit here is China, which, by maintaining its link with the dollar, has now become supercompetitive in international trade.

The BIS warns that this adds to the upward pressure on the yen and the euro. The implication is that the European Central Bank, and individual European governments, should be doing more to boost domestic demand. In which connection it is noteworthy that the German government is now bringing forward tax cuts originally designated for 2005, and Chancellor Gerhard Schroeder last week dropped heavy hints to the ECB that it should ease further.

It is especially interesting - and disturbing - that the BIS is so concerned about the threat of deflation. Central bankers are traditionally more concerned about inflation, even when it is at comparatively low levels. A schism has now opened up in central banking circles, with the Federal Reserve and the BIS worried about deflation, but Wim Duisenberg, the retiring president of the ECB, still issuing warnings about the 'need' for Germany and other countries to adhere to the Stability Pact.

In this context it was interesting that Sir Edward George, in his recent retirement interview with The Observer, indicated that he thought 'structural reform' was not enough to resolve continental Europe's economic difficulties and that active measures should be taken to expand demand. (George was also, until last week, chairman of the high-powered Group of 10 leading central bankers that meets most months under the auspices of the BIS in Basle.)

The BIS states: 'One of the most daunting challenges faced by central banks in a deflationary environment is the zero lower bound constraint' - the fact that interest rates cannot fall below zero, thereby weakening the effectiveness of monetary policy.

As the BIS concedes: 'There are limits to the effectiveness of monetary policy.' It calls upon central banks 'to explore systematically, along with fiscal and prudential authorities, the set of policy options available to address deflationary forces well in advance of their actual emergence.'

The bank acknowledges that such an approach would involve 'co-ordination of policies across separate institutions' and might raise questions about central bank independence. But it emphasises that the issue is too important to ignore: 'This risk could be worth bearing if the exploration of such options helped to inspire confidence in the ability of the central bank, and policymakers as a group, to fight deflation.'

Implicit in the BIS's remarkably frank admission of its concerns is a historic acknowledgement by the kings of Central banking that the once-fashionable monetarist belief in price stability as the great economic panacea has proved seriously defective.

Referring to 'excessive optimism and credit expansion, asset price and spending bubbles, and balance sheet problems that subsequently rebounded on the financial system' the BIS concludes: 'Clearly, the achievement of price stability, with its unquestioned merits, has not been sufficient to ensure the avoidance of financial instability.'

That, in central bankers' speak, is quite an acknowledgement.

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