The dollar is up, and the pound sterling is down. But only one of these shifts is significant for the world economy. The decline in the value of the pound doesn’t matter much. The United Kingdom no longer has a currency peg to defend, as it did in other times of crisis, such as 1931, 1949, 1967, and 1992. Its floating exchange rate can do what it is designed to do, namely, float. The British government borrows in its own currency, and nearly three-quarters of its debt is held at home. Spiking interest rates are mainly of concern to British homeowners with variable-rate mortgages and aspiring homebuyers who must watch as their banks withdraw from the mortgage market. Rising rates are also of concern to British pension funds that hold bonds issued by the British government to match, at least in part, their long-term liabilities. As their investments lose value, such funds are forced to sell those bonds into a falling market. In response, the Bank of England felt obliged to step in and support the government bond market in the name of financial stability.
The pound’s weakness has undermined confidence in Prime Minister Liz Truss. But at the end of the day, these are just parochial British problems. The United Kingdom accounts for just three percent of global GDP. The pound, notwithstanding its history, accounts for less than five percent of the identified foreign exchange reserves of central banks worldwide. Those central banks may now replace the sterling with more reliable currencies. This pervasive doubt is a problem for the United Kingdom because it augurs a still-weaker currency and even higher borrowing costs. But it is not a problem for the United States and the rest of the world. If the United Kingdom’s financial tribulations provide a timely and important reminder that there may also be financial problems festering in other countries’ pension funds and mortgage markets, then all the better.
The dollar, on the other hand, is everyone’s problem, to paraphrase an aphorism from John Connally, the former U.S. Treasury secretary. The dollar’s rise compounds excruciating problems of debt sustainability for scores of low- and middle-income countries. Much of the corporate debt of such countries in the hands of foreign investors is denominated in dollars. This debt becomes more expensive to service and repay when the dollar is strong. Even when external debt is in local currency, a fall in the exchange rate against the dollar can cause problems. U.S. financial firms, seeing themselves exposed to losses on those foreign investments, withdraw from emerging-market assets, putting yet additional downward pressure on the value of foreign currencies in a vicious circle.
Moreover, because global commodity prices are denominated in dollars, the cost of imports rises when local currencies depreciate. That dynamic leads to inflation, which is the last thing governments currently need. It is why a growing number of central banks are intervening in the foreign exchange market, using their dollar reserves to buy, and therefore support, the local currency. But most of the U.S. Treasury bonds they sell end up being dumped into U.S. financial markets, which only adds to the excess supply of U.S. Treasuries, pushing up yields and perversely strengthening the dollar. Moreover, interventions in the foreign exchange market by emerging-market central banks are often taken as a sign of weakness, making them a recipe for more economic and financial turbulence.
The Federal Reserve, for its part, is not going to abandon its anti-inflationary program of interest-rate hikes because it adversely impacts the rest of the world. It can activate the swap lines through which it provides dollars to foreign central banks, and negotiate new ones. But those swap lines are small potatoes relative to the scale of global financial markets. And if foreign central banks use them to conduct more exchange-market intervention, the dollars provided will just flow back to the United States.
A coordinated intervention such as the 1985 Plaza Accord, in which the United States and other governments agreed to simultaneously sell dollars against foreign currencies to depreciate the greenback, is not in the cards. It took years of diplomacy back then to get the United States, the United Kingdom, France, Germany, and Japan on the same page. Today, the relevant collection of countries that would have to participate in this kind of intervention is much larger. An effective sequel to the accord would require cooperation between the United States and China at a time when the two countries are at loggerheads. And implementing such an agreement would require the Federal Reserve to cut interest rates. Given the importance that the Federal Reserve and the U.S. Treasury attach to subduing inflation, the United States is not prepared to countenance such cuts.
Nor can this problem be addressed by the International Monetary Fund. The fund is rolling out additional programs for countries in financial distress, as it should. It has firepower left. But it lends for extended periods to countries with deep debt and structural problems, not to finance intervention in the foreign exchange market. Its rules require it to lend only when it has a high assurance of being repaid. Were the dollars it lends spent on futile intervention in the foreign exchange market, it would not likely be paid back.
It follows that the only reliable way for countries to support their currencies against the dollar is by raising interest rates, which encourages inflows to their asset markets. This move, of course, is uncomfortable under present circumstances, when interest rates are rising and economic growth is weak. Many central banks in emerging markets were quick off the mark: they had begun raising rates before the Federal Reserve did and were thus hopeful that the tightening cycle had come to an end. Unfortunately, this no longer looks to be true. Theirs is a case of virtue unrewarded.
In the longer run, the solution is for central banks to diversify their reserves and for countries to diversify their transactions away from the dollar and toward the currencies of the eurozone, China, and smaller economies. Doing so would leave countries less exposed to the decisions of one central bank. It is past due time, after more than half a century, for them to take John Connally’s aphorism to heart.
