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The financial crisis has been raging for 15 months. One shoe that has yet to drop has been the dollar. Against major currencies the greenback has declined on balance only 4 percent since June 2007 though it dipped 11 percent through April before coming back until recently.1 The risk is that if the US authorities are not perceived to have their act together, a renewed rapid decline in the dollar will open up a new front in the crisis. At a minimum, it is more than likely that the Bush administration will be defending the dollar before it leaves office on January 20, 2009, and it should be open to doing so.
Despite the largely unjustified finger pointing at the United States by some foreign officials in response to what is truly a global financial crisis, the foreign exchange value of the dollar has been largely unaffected. One reason is that the turmoil also has affected most other industrial countries directly or indirectly via their financial systems or real linkages to the US economy and financial system. A second reason is the unprecedented degree of cooperation among central banks in the provision of dollar liquidity to their financial systems. With the announcement of four more swap arrangements on September 23, the total number of Federal Reserve partners has reached 10 for a total of $382 billion, about ten times the size of the network when the bulk of it was dismantled a decade ago.2
Two recent actions by the US authorities have undercut this cooperative spirit. First, they mishandled the decision to make foreign financial institutions under the Troubled Asset Relief Program (TARP) and in the process created the impression that other countries would establish parallel programs. That expectation was dashed by the G-7 on Monday.
Second, by looking to the Exchange Stabilization Fund (ESF) to provide insurance to money-market mutual funds (MMMFs), the administration created confusion. As pointed out by Randy Henning, the move itself is questionable in terms of the spirit of the relevant statute, and it calls into question the willingness and ability of the US Treasury to support the dollar. (Sure, the foreign exchange in the ESF cannot easily be used to guaranty the MMMFs, but the average market participant does not know this.) The Treasury, in effect, called into question whether it understands the important role of the dollar in the international financial system.
To remedy this situation, the legislation authorizing the TARP should include $50 billion for the MMMF guaranty fund and the ESF should be relieved of this burden. Beyond that US authorities must be prepared to use the substantial though limited foreign exchange resources of the ESF and the Federal Reserve to defend the dollar if it goes into freefall. As I pointed out more than three years ago, there is something odd about a country reducing interest rates when its currency is declining.3 The Federal Reserve has been living on borrowed time even as the US economy has been living on borrowed money, and the chickens may soon come home to roost.
Notes
1. Federal Reserve Board staff index of the foreign exchange value of the dollar in nominal terms against major currencies, monthly.
2. Reciprocal currency or swap arrangements temporally provide other central banks with US dollars in exchange for balances of their currencies. They are typically reversed in 90 days. The totals of 10 partners and $382 billion include the standing arrangements with the central banks of Mexico and Canada; the Bank of Canada now has a special arrangement as well.
3. Postponing Global Adjustment: An Analysis of the Pending Adjustment of Global Imbalances, Peterson Institute Working Papers 05-06, July, 2005.
