The IMF Fiddles while the Dollar Burns

AEI
Among the more surrealistic spectacles of the IMF's recently concluded Spring Meetings was the IMF, the supposed guardian of the international financial system, assuring the world that there was little to fear from today's unparalleled global payment imbalances. For the IMF made this assurance at the very time that the dollar's decline appears to be gathering pace, as suggested by its plumbing almost daily new lows against the Australian dollar, the British pound, and the Euro. It also made these assurances at the same time that the key global surplus countries, China and Japan, show no sign of adjusting policies to share at least some of the burden of the dollar's decline.

The IMF's apparent equanimity about global payment imbalances is rooted in its remarkably sanguine world economic outlook. For notwithstanding the gathering clouds in the US housing market, the IMF persists in the view that the US will have the softest of soft landings. In the face of all historic evidence to the contrary, the IMF also takes the view that, even were there to be a hard US economic landing, the rest of the world would somehow make up for any lost momentum in the US economy.

The most immediate risk to the IMF's rosy global economic outlook is that the US housing market is far from bottoming out and that falling home prices will prove to be a continuing drag on the US economy. After all, between 2000 and 2006, US home prices were supported by a host of unusually accommodating factors that fueled a spectacular and unprecedented 80 percent increase in home prices at the national level. This rise in housing prices, coupled with a veritable explosion in Mortgage Equity Withdrawals, provided the underpinning for US households to run down their saving rate from 7 percent of household income in 2000 to virtually zero today.

The IMF now chooses to turn a blind eye to the growing evidence that the US housing market bubble has burst and that housing prices have started to fall. It also chooses to overlook the growing evidence that the factors that had earlier fueled that bubble are now beginning to work in reverse. Indeed, the IMF seems oblivious to the fact that the Federal Reserve has now normalized interest rates after a long period of unusually accommodative interest rates and that the orgy of sub-prime mortgage lending has been stopped in its tracks. Compounding the housing market's present sea of troubles, overall mortgage lending standards are being tightened, while the resetting of Adjustable Rate Mortgages threatens to further crimp housing demand.

A significant US housing-led economic slowdown must carry the threat that the pace of the dollar's decline accelerates, especially given the United States' record need for foreign financing. For a start, the relative interest rate differential that presently favors the US dollar will be eroded as the Federal Reserve is forced to cut interest rates to support a flagging US economy. More important still, the dollar would be hit by the fact that, in any housing-led downturn, US financial assets, including equities and mortgage backed securities, would likely lose their appeal to foreign investors.

Any disorderly decline in the US dollar could intensify protectionist pressures and could pose a serious threat to global financial markets by disrupting the US bond market. This would be all the more so the case should the Asian countries continue to shirk from bearing their share of the burden of a falling dollar and should that burden continue to fall disproportionately on regions like Australia, the Euro area, and the United Kingdom.

Seemingly oblivious to the mounting risks of a disorderly unwinding of global payment imbalances, the IMF had little to offer at its Spring Meetings by way of leadership towards a coordinated policy response to those risks. In its supposed exercise of multilateral exchange rate surveillance, the IMF cobbled together well-worn policy plans from its bilateral consultations over the past year with the United States, Europe, Japan, China and Saudi Arabia. Aside from being at the most general of levels, those policy plans offered virtually nothing new by the way of policy initiatives.

Equally disconcerting is the IMF's virtual silence on the exchange rate manipulation that is so much in evidence in Asia's major economies. Judging by today's Asian economies, it would seem as if each country is free to do as it likes with its exchange rate without raising real objections from the IMF. Indeed, China massively and persistently intervenes in its exchange market to the tune of US$250 billion a year to prevent any meaningful appreciation of its currency. And it does so without incurring the IMF's wrath. For its part, Japan persists with a policy mix of a tightening fiscal policy and extraordinarily low interest rates that ensures a continued weakening in the Japanese yen.

This all has to leave one wondering how far the IMF has strayed from its original mandate as the guardian of the international exchange rate system. It also has to leave one wondering whether the IMF's periodic gatherings still serve much purpose.