5. OVERVALUATION AND INTERVENTION

If the dollar is significantly overvalued - perhaps by as much as 20 percent - the interesting question is surely why there have not been more decisive speculative attacks? It is surely a fact that there are no compensating interest differentials that would support rationally holding U.S. assets. This is a hard question which a more prudent writer might avoid. The probable answer lies not in irrationality but rather in the short horizon of speculation.

Asset markets are dominated by speculators who are limited in their ability to provide long-term stabilizing speculation. Regulatory reporting requirements and above all quarterly performance competition prevent financial institutions and corporations from engaging in long-term speculation if the short-term uncertainty is too high. Thus, even though there may be a consensus that over a two year period the dollar will undergo a 30 percent depreciation, few institutions take a long-term position and sit out that depreciation. The reason is that a short run adverse trend is seen as much more costly than the ultimate, almost certain, profit. Of course, there is some long-term speculation. But there is also some central bank intervention, in fact an extraordinary amount. But more than the magnitude of intervention counts the willingness of central banks to stop one way speculation by creating sufficient uncertainty about the near term pace of depreciation. That means depreciation occurs in chunks, with irregular intervals of stability or even partial reversal in between.

Looking back one observes that a massive dollar depreciation has taken place without any significant influence on U.S. interest rates or on inflationary expectations. Looking forward it seems hard to believe that another 30 percent is possible without speculators catching on. But small action on interest rates is enough to check speculation. Moreover, the further the depreciation is carried the more diffuse are expectations about the magnitude and timing of any remaining depreciation and hence the easier the task of destabilizing the speculators.

A further argument in this direction is frequently made: continuing dollar depreciation in the near term would imply that the J-curve is persistently at work. Further depreciation, with its adverse effects on valuation, keeps dominating the quantity adjustments and hence current account improvement simply does not come into sight. The failure, of current account improvement to emerge tests the patience of speculators who take an excessively pessimistic view of the currency and might stage a run that costs control. Hence the need to space out depreciation to allow volume adjustments to become significant and thus elicit stabilizing speculation.

This interpretation of foreign exchange markets in the past half year assumes that central banks agree on the need for much further dollar depreciation but chose to bring it about in a controlled fashion. If so, there must presumably also be an idea of how Europe and Japan absorb the gain in U.S. competitiveness. The alternative explanation is that the U.S. accepts that the dollar has gone far enough and is simply helping to demonstrate to the market the new equilibrium rate, if necessary with increased interest rates. Of course, it might also be a much more shortsighted policy pursued for the convenience of an election year and motivated by concern about increasing U.S. inflation in the next 12 months. Whichever the motivation, defending an overvalued exchange rate is a dead-end street. The costs in terms of disruptive high interest rates and ultimate collapse are extremely high. There is no conceivable merit for the U.S. or the trading partners in perpetuating the overvaluation, other than as a policy of a controlled dollar decline.

There remain two questions: First, in the long run, where will the real exchange rate of the dollar go? Second, what are the scenarios for U.S. adjustment in the next two years?