Date The Headline
Today, we have three headlines of relevance. The first one comes from BusinessWeek as of October 9, "Finance Chiefs Warn Currency ‘War’ Is Risk to Growth" in which we read: "As the International Monetary Fund’s annual meeting began in Washington, policy makers warned that efforts to boost exports by embracing weaker currencies threatened to provoke protectionism and trade imbalances at a time when economic growth is already slowing. China was again the target of criticism as foreign officials called the yuan undervalued and pushed for its appreciation to be accelerated." This was promptly followed by the Telegraph's "IMF fails to strike deal over currency frictions", in which we learn part two of the weekend's key festivities: "The International Monetary Fund on Saturday night failed to reach agreement on tackling mounting global "frictions" over exchange rate policies despite US calls to deal with the issue more forcefully." Which brings us to today's game of 'date the headline', which comes, somewhere in time, from the New York Times: "US said to allow decline of dollar against the mark" in which we read a paraphrase of a quote by then Treasury Secretary James Baker III, together with some additional commentary: "'I think if you look at the underlying economic fundamentals in this country, they're very, very good,' he said. But he added that the stock market appeared to be reacting to prospects of tax increases by Congress, the enactment of protectionist legislation to reduce foreign imports, and to fears of rising interest rates and inflation. He also said growth of computer-generated ''program trading'' of securities had contributed to the size of the daily sell-offs." Oddly enough, the situation described in the New York Times was identical, if not better, to what is transpiring right about now. As to what happened 24 hours after the original NYT article appeared, well, we all know that...
More form the New York Times article of choice:
For American tourists, a cheaper dollar means that their dollars buy fewer German marks.
There is the risk, however, that the stock market, which has already plunged 17.5 percent since its high in August, might erode further with a falling dollar. Foreign investors have been a major reason for the market's big move this year. That was due, in part, to their confidence that when they wanted to repatriate their funds, they would not suffer in a currency exchange. If the dollar falls further, their funds would be worth less in their own currencies.
A decline in the dollar ''could reinforce weakness in the stock market,'' said Felix Rohatyn, a senior partner of Lazard Freres & Company. ''Foreign holders will bail out of stocks to bail out of our currency. You have to look at the dollar, not just in the context of the trade market, but in the context of the capital markets as well.''
A decline is also risky because it can lead to accelerated inflation from the higher prices Americans pay for imports. In part because of the 40 percent decline of the dollar from its peak in February 1985, inflation has already picked up a bit, and fears of still higher inflation, and higher interest rates to accommodate the rise in inflation, underlie much of the stock market's nervousness.
The sense of turbulence in the markets has not spread to the Administration. Mr. Baker said that the Dow had undergone ''major correction,'' but that ''we do not see this as a panic situation.'' He is proceeding with plans, made some months ago, to depart Sunday on a visit with economic officials in Denmark and Sweden, a Treasury official said.
Comments on Interest Rates
But Mr. Baker flatly rejected speculation that the Government will do anything to cause a rise in interest rates, in particular, an orchestrated increase by the Federal Reserve. Higher rates and recent anticipation of further increases in the United States have been major reasons for the stock market decline. Higher rates are ''an assumption that's not warranted,'' he said.
''That came across loud and clear,'' said Neal M. Soss, an economist at the First Boston Corporation and a former Federal Reserve official. ''There's no tightening imminently.'' In Bonn, officials have expressed dismay over Mr. Baker's comments beginning with a White House news conference on Thursday. They maintain that the rate increases are miniscule - they add up to less than a percentage point - and that they are driven by forces in the markets, not by the Government.
A decline in the dollar against the mark ''would certainly bring a decline of other European currencies,'' said John Williamson, an economist at the Institute for International Economics, ''and it would bring a lot of pressure against the Japanese yen.''
Tolerating a decline of the dollar is different from actively provoking a decline, which governments do by moving into the markets and buying and selling currencies. But when governments say they will tolerate a decline, it can become a self-fulfilling prophesy.
Such a passive policy can also fail, however, if the markets determine that economic forces dictate a stable dollar or a rise. The dollar has been unusually stable for months despite the turmoil in stock and bond markets.
''Suppose the dollar doesn't want to go down?'' Mr. Soss asked. At that point the Administration would have to consider a more active policy - saying it wants a lower dollar and selling dollars from the Treasury's reserves in the markets.
In Paris in February, the leading industrial countries agreed at the French Finance Ministry offices in the Louvre palace that they would alter their domestic economic policies to speed world growth while keeping inflation in check and their currencies at roughly the prevailing levels. Raising interest rates, Mr. Baker says, violate the growth objective of the agreement because they tend to slow economies down. Germany worries the Administration most because its economy is already soft.
The implication of Mr. Baker's remarks today is a lower ''reference range'' for the dollar and the mark, or a lower level at which the countries would try to let currencies trade before they ''intervene'' in the markets to keep them from drifting out of the range. The current range for the mark has never been disclosed, but traders presume it is between 1.80 and 1.90 marks to the dollar.
Mr. Baker and the Treasury emphasize that the adjustment can be made within the context of the agreement, which, beyond specifying exchange rates and changes in national policies, set the framework under which the countries will try to coordinate their economic policies in the future.
Once before, last April, the accord accommodated a currency adjustment - a lowering of the exchange rate of the dollar for the yen. ''There was a new level established then,'' the other Administration official said.
Although he did not mention the dollar, it was apparent from Mr. Baker's remarks that a lower dollar was the best tool available to help him try to discourage further German rate increases and to enforce the growth goals quickly.
He said that the German rate increases violated earlier agreements, that he had ruled out pushing up American interest rates, and that the agreements were flexible enough to accommodate adjustments in exchange rates. And by adding that such an adjustment had been made earlier, and that the agreements needed reexamination, he left only one trigger-quick alternative - a lower dollar.
For those who are still unsure, the original article can be found here, and the original date is October 18, 1987. And this time is not different. Well, maybe with one small difference: the Fed. Unlike in 1987, the Fed is now the primary driver in the market, and has to neutralize not only such mundane issues as constant domestic outflows from the capital market, but an increasing outflow by foreigners, which just like in 1987, are accelerating with each day that the dollar keeps trading lower and lower.
In 1987, the market took its medicine quickly, and even though it was painful, manifesting in the form of October 19, 1987's Black Monday, in which stocks lost almost 25% of their value in one day, this time no such market crash is assured, primarily due to the FRBNY's dominance of the stock markets. Yet, in addition to death and taxes, the third sure thing is that no matter what, central banks will always, on a long enough timeline, lose to the market.
With the recent addition of the foreclosure scandal, it is now certain that the Fed is juggling one ball too many. Throw in global protectionism and all out currency war and the already stretched equilibrium fails. All it would take for a global reset, now that there is no backer to a consolidated central bank failure, is for one person to demonstrate Soros' courage and tenacity from another Black day, this time Wednesday, and to call the Fed on its bluff. Whether one will ever emerge, is a different story.
h/t Geoffrey Batt