Wednesday, November 7, 2007

Weak Dollars, Subprime Messes, and Monetary Policy Dilemmas

. Wednesday, November 7, 2007

When does the dollar's depreciation become serious? When Chinese officials start talking in public about shifting its $1.43 trillion of reserve holdings out of dollars and into other currencies. The markets are already a bit skittish; loose talk does not help.

Can the U.S. do anything to bolster the dollar? It appears that the U.S. is caught between the classic rock and hard place. On the one hand, domestic financial difficulties resulting from the subprime mortgage mess has encouraged the Fed to cut rates and inject liquidity to ease market conditions. Rate cuts and extra liquidity, however, weaken the dollar. If the Fed wants a stronger dollar, the required higher rates will squeeze financial institutions. Not much of a choice; bolster the dollar at the short-term cost of worsening the financial crisis; inject liquidity at the short-term cost of a weaker dollar.

The Fed's current dilemma is hardly unique. It is not fundamentally different than the dilemma Thai and Indonesian governments faced in 1997; not fundamentally different than the dilemma Austrian authorities faced in 1931. Not fundamentally different from the dilemmas posed by financial crises throughout history (the 1907 and 1894 panics come to mind as well). In all of these cases, monetary authorities had to choose between actions that saved key domestic financial institutions and actions that stabilized the currency. Yes, the contemporary US is different--no fixed exchange rate as a focal point for speculation; no precious metal reserve constraint--yet still, it must choose between internal and external objectives.

What surprises me is that even those at the Fed who oppose further rate cuts make no mention of the dollar as a reason for their resistance.


Weak Dollars, Subprime Messes, and Monetary Policy Dilemmas




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