Currency turmoil in an unbalanced world economy

The world is once again under threat of currency turmoil ignited by a vigorous appreciation of the dollar against all other currencies. This is the harbinger of another long cycle which has been the pattern of exchange rates since the fall of the Bretton Woods system in 1971. Because dollar cycles are driven by momentum dynamics disconnected from fundamentals, they are likely to distort real effective exchange rates between major currencies. The dollar appreciation phase may also wreak havoc in the financial systems of emerging countries that are heavily indebted in dollars. In the present state of the world economy, the prospect of a new dollar cycle is particularly worrisome since most countries, far from deleveraging after the financial crisis, have massively increased their debt relative to GDP in the non-financial sectors. The rise in dollar debt is due to subpar income growth in the world economy which has precluded deleveraging of the already high level of debt reached in 2007 on the one hand, and to the status of the dollar as the de facto exclusive supplier of international liquidity on the other hand. Because US monetary policy is not bound by any international rules, it has supplied liquidity on its own terms, flooding the world with cheap money in order to revive domestic consumption in the US. The catalyst for renewed dollar appreciation has been the divergence in monetary policy between the US on the one side, Japan until early 2013, and the euro area until late 2014 on the other. Monetary policies in these latter countries, working counter to the US before a recent change in course, have created deflation risks that the new trend of dollar appreciation compounded with the slump in the price of oil is expected to correct, spreading the recovery worldwide. However, this is the benign scenario. History would suggest the possibility of a much more unpleasant outcome. Misalignment in exchange rates is a repeated feature of dollar cycles, as much as unsustainable imbalances in the balance of payments. Currently, the gap between US long term interest rates and similar rates in the euro area and Japan is large and expected to widen. Nevertheless, the market’s expectations of future short-term interest rates up to end-2017 are much lower than the Fed’s. If the market expectations are right, this means that the US recovery will be hurt by the dollar turning from being cheap to expensive. If the US recovery stalls, this will mean that secular stagnation will be with us for an indefinite time.