EURO INTERVENTION: HAS THE US OPENED A PANDORAS BOX?

by Marshall Auerback

26 September 2000 Pandora was modelled by Hephaestus in the likeness of Aphrodite. Athena breathed life into her and dressed her in elegant garments. Aphrodite decked her with jewels and fixed her red mouth in a winning smile. Into the mind of this beautiful creature, Zeus put insatiable curiosity, and then he gave her a sealed jar and warned her never to open itBut Pandora was not perfectly happy, for she did not know what was in the jar that Zeus had given her. It was not long before her curiosity got the better of her and she had to take a quick peek. The moment she opened the lid, out swarmed a horde of miseries: Greed, Vanity, Slander, Envy, and all of the evils that until then had been unknown to mankind. Horrified at what she had done, Pandora clapped the lid on, just in time to keep Hope from flying away too. Zeus had put Hope at the bottom of the jar, and the unleashed miseries would quickly have put an end to it. They stung and bit the mortals as Zeus had planned, but their sufferings made them wicked instead of good, as Zeus had hoped. They lied, they stole, and they killed each other and became so evil that Zeus in disgust decided to drown them in a flood. Pandoras Box, DAulaires Book of Greek Myths

They have finally done it. Coming on the heels of the exhortation by the new IMF managing director, Horst Koehler, for less talk and more co-ordination, the worlds leading central banks surprised currency markets last Friday with joint intervention to support Europes ailing currency. This was followed up by the weekends G-7 communiqui suggesting that it would continue to cooperate in exchange markets as appropriate, using code words implying further intervention if needed. The early success of the buying spree on behalf of the euro was largely attributed to the unexpected co-operation of the US monetary authorities. Thus far, most of the market comment pertaining to the intervention has focused on the risks posed to the euro and the credibility of the European Central Bank (ECB) by marshalling the worlds main central banks, including the Federal Reserve in support of the currency. These commentators have argued (in the words of the Financial Times), The operation simply has to succeed if global foreign exchange markets are to regain their faith. Sentiment has deteriorated so sharply in recent months that failure could even provoke questions about the future of the European monetary union. Less attention, however, has focussed on the risks posed to the dollar if the intervention is too successful and the US currency begins to lurch violently southwards. Financial markets had hitherto assumed that American policy makers would not risk a dollar devaluation in the politically sensitive period preceding a Presidential election, given the attendant inflationary risks and corresponding need to boost interest rates in an economy still rife with unprecedented levels of private sector debt and consequent financial fragility. Reflecting the fine line that the US authorities must tread, Treasury Secretary Summers followed up his countrys intervention in favour of the euro with a reiteration of Americas longstanding strong dollar policy. This ambiguous statement somewhat undercut the initial effectiveness of the intervention, perhaps reflecting a realisation on the part of the American monetary authorities of the potential risks undertaken by acceding to the longstanding ECB request for co-ordinated support of the euro. Given that intervention on behalf of the euro by its very nature implies a weaker dollar, has Mr. Summers, albeit reluctantly, in fact opened up a dangerous Pandoras box?

For months, US policy makers had blithely viewed the declining euro as a uniquely European problem in much the same way as they saw the early stages of the Asian financial fall-out of 1997 as a problem best left alone to the Asians. This was certainly the signal conveyed to the foreign exchange markets, which were shocked by the apparent abandonment of a long-standing strong dollar policy. But perhaps the about-face is less surprising than it seems; historically, when overseas problems have threatened to impinge on Americas shores, this has often generated policy shifts. In both the case of Asia and the declining euro, a change of heart was prompted only when events threatened to impact negatively on US financial markets. Just last week, Michael Mussa, the IMFs chief economist, argued: I used to say [the weak euro] is more of an embarrassment than a problem. But I think recently it has become more of a problem that is a source of concern going forward in all the major currency areas.

Seemingly validating this concern, Colgate Palmolive, Ingersoll-Rand, HJ Heinz and Gillette, amongst several prominent multinationals, have all issued euro-related profit warnings in the last few weeks, thereby refocusing the markets attention on the threats to these firms international competitiveness posed by a weak euro and strong dollar. This was followed up by Intels shocking warning of slower-than-expected European sales (perhaps in part a function of slower growth as a consequence of six ECB interest rate rises since last November in the euro-zone). Furthermore, Merrill Lynch estimated that the currency translation effect could cut one per cent from the operating earnings of S&P 500 companies this year. Taken in aggregate, these concerns essentially forced the Americans hand reluctantly particularly after the stock market came perilously close to breaching important technical support levels.

Why such reluctance? After all, one would have thought a somewhat weaker dollar would be just the policy tonic required for the American economy, given the continued record deterioration in the US current account deficit (now running at better than $1 billion a day on current trends)? In fact, with a current account deficit in excess of 4 per cent of GDP and rising, the US is now threatened with debt trap dynamics, as its external indebtedness continues to mount at a very rapid pace. The country needs to export more and import much less in order to service these rising debts. Secretary of Treasury Summers was a professor at Harvard and the chief economist at the World Bank during a period in which the risks posed by debt trap dynamics were of paramount importance to the markets. No doubt he is aware that a persistently rising current account deficit poses big long-term problems for the American economy.

Perhaps now would be as good as any time to reverse the inherited dollar policy of his predecessor?

The other side of this coin is that both Treasury Secretary Summers and his predecessor, Robert Rubin, have long recognised the risks posed by a rapidly declining dollar. Rubin in particular felt that prolonged weakness in the greenback would reverse such capital flows that could (in the former Treasury Secretarys own words), "drive investors out of American stocks, bonds and Treasury debt". The potential risks posed from destabilizing capital flows out of US stocks and bonds, in the view of Rubin and, more latterly, Summers, appear to outweigh the problems arising from a strong dollar policy: a loss of competitiveness, a rising current account deficit, and a growing net debtor position. To be fair to the former Treasury Secretary, when the exchange rate was overshooting to the downside, (as it did back in 1995 when the dollar plunged to 79 against the Japanese yen), policies designed to strengthen the greenback were more understandable in that context in that they helped to minimise the effects of destabilizing short term capital outflows, and facilitated the restoration of long run equilibrium in the currency markets. But the repudiation of a dollar devaluation policy was subsequently pushed to an opposite extreme, thereby fostering a new set of disequilibria. The continued emphasis on a strong dollar policy since 1995 has engendered a loss of trade competitiveness and propelled asset markets ever higher with unstable fuel from inflows of short-term global speculative capital. And the maintenance of this policy by Summers has continued to send an already unprecedented overvalued stock market ever higher, as well as beginning to destabilise all of the worlds major currency blocs, as the IMFs chief economist noted last week.

Consequently, the Treasury Secretarys continued courting of short run global speculative capital at the expense of almost all else has placed him in a box: a sustained high exchange rate is clearly exerting terrible damage on the economy, as a lengthening list of companies have begun to report shockingly disappointing earnings, the current account continues to erode, and debt levels compound relentlessly higher. Yet the alternative is equally problematic.

If overseas investors begin to believe that their profits on US assets are likely to be reduced or wiped out by the threat of dollar devaluation, global speculative capital might refuse to continue to finance these large deficits and flee en masse, as was the case in emerging Asia. This is why the US is loath to encourage too much euro strength against the dollar. The very capital flows which have done so much to weaken the former are also the essential lifeblood of the latter, like Siamese twins battling over a single set of vital organs. Sonja Hellemann, currency strategist at Dresdner Kleinwort Benson, notes that Fridays intervention may have scared off any speculators who might have been tempted to start selling the euro. But essentially, they will have to soak up the capital outflows from the euro-zone. This requires a lot of money. But this is also money required to continue to finance Americas private sector deficit, now running at around 6 per cent of GDP. To the extent, therefore, that the US authorities continue to co-operate in this joint intervention, therefore, they put their own capital markets at risk.

This is one potential way out of this box, but it risks a massive expansion of the now pervasive problem of moral hazard: direct intervention in support of the stock market should a dollar devaluation precipitate widespread capital outflows from the US market. Coming in the context of a week of a co-ordinated effort to support the euro, concurrent with a Presidential authorisation to release 30 million barrels out of the US Strategic Petroleum Reserve in order to dampen the price of crude oil, it is no longer fanciful to envisage circumstances in which a similar intervention on behalf of stock prices might be deemed necessary by policy makers to offset the impact of a rising euro and a steadily weakening dollar if such a reversal of capital flows ultimately propagated further financial instability in the United States. Is this the ultimate quid pro quo for continued American co-operation on the euro? If such intervention were framed as a short-term measure designed to avert the potential collapse of the European Monetary Union and a global recession brought on by a worldwide stock market crash, perhaps there would exist sufficient political support to undertake this drastic step. But a drastic step it would certainly be, and not without its own significant risks. Speculative excesses could intensify in a scenario in which investors came to believe that their investments were effectively underwritten by the American authorities, even if such support were cast as a temporary expedient much like a currency intervention or resort to the emergency oil reserves to curb a short-term market anomaly in the price of crude. As an example of the risks posed, the belief in implicit government guarantees of the baht peg against the dollar did much to trigger even greater speculative inflows into Thailands overheated economy, rather than alleviating such imbalances. Could not the same occur again? We are not asserting that any such stock market intervention has in fact taken place, but raising the possibility of it occurring at some point makes clear our belief that the stakes have now been raised massively. According to ancient Greek mythology, when Pandora opened her box, out swarmed a horde of miseries that ultimately led to the earths destruction. Without extending the apocalyptic metaphor too far, lets hope that myth is not even partially transformed into reality. http://216.46.231.211/international.htm

-- Carl Jenkins (Somewherepress@aol.com), September 28, 2000

Answers

Most interesting. When Summers seemed to be dragging his feet so distinctly over this whole thing, I figured his worry over the ultimate effects on the U.S. Stock Market dominated his thinking.

-- Billiver (billiver@aol.com), September 28, 2000.