In 1909, President William Howard Taft and his Secretary of State, Philander Knox, came up with a rather ingenious foreign policy strategy whereby they tried to garner the support of nations through financial rather than aggressive means.  It was referred to as 'Dollar Diplomacy' inasmuch as they believed that money would achieve national goals rather than bullets.  In the end, it actually failed, but has subsequently been employed by other administrations.  Even President Bush to a certain extent used such a strategy in gaining support for the Iraq War.

With the advent of floating exchange rates, and the current level of globalization facing our economy, it appears that a great—grandson of Dollar Diplomacy has emerged.  In its current iteration, monetary policy and currency valuations appear to have been manipulated to not only affect international trade, but, in the end, possibly foreign policy as well.   

To begin with, the dollar made a new all—time low against the euro last week while continuing its decline against the British pound and the Japanese yen.  Meanwhile, the S&P 500 has rallied to its highest point this year, and is now ahead of where it was before the 9/11 attacks.  Ditto the NASDAQ 100.  And, the Russell 2000 — a broad measure of small—cap stocks — is not only at its highest level of the year, but it has also now surpassed its March 2000 peak.  What, if anything, is this seemingly incongruous divergence in economic indicators telling us?

We now know that the U.S. economy in the third quarter grew by more than what was originally estimated, and that some of that increase is due to higher exports.  As reported on November 30, the Gross Domestic Product (GDP) expanded by 3.9% versus the previous estimate of 3.7%.  Much as in the second quarter, exports led the way growing by 6.3%.  In addition, from a trade deficit standpoint, another bright spot in this report was that imports only rose by 6.0% as compared to 12.6% in the previous quarter.  Certainly, this is likely the lower dollar making foreign products less competitive price—wise.  Moreover, with the dollar's continued decline in the past few weeks, many economists are now raising their GDP forecasts for the fourth quarter as well as for all of 2005.  Without question, as the stock market is a future discounting price mechanism, the falling dollar is resulting in rising stock valuations that are anticipating higher U.S. corporate sales volumes.

By contrast, the economies within the EU have been doing much worse, and are even beginning to show signs of the dreaded stagflation. For those who have thankfully forgotten what this is, stagflation is a period of rising prices during an economic slowdown — the kind of economy that the U.S. had in the mid—70's during the first energy crisis.  With the recent explosion in oil and gasoline prices, the EU, along with its central bank, is quite worried about this occurring again. 

As a result, at its meeting last week, the European Central Bank (ECB) left its overnight lending rate at 2.0% where it has been since June 2003.  Certainly, this was no surprise as the ECB has been fighting a more aggressive monetary policy for several years.  However, what was quite astounding was the revelation that ECB members actually considered raising interest rates at this meeting to stave off any potential for a rekindling of inflation.  Given the paltry performance by the EU's economies in the third quarter — up 0.3% having grown by a similarly soft 0.7% and 0.5% in the two previous quarters — along with an exploding currency that is clearly having a negative impact on GDP growth, one has to truly question the sanity of ECB president Jean—Claude Trichet in even considering the advancement of a tighter monetary policy.

Unfortunately, as absurd as this talk about raising rates might seem to us across the Pond who have been advocating an easier monetary policy to our European brethren, not reducing this lending rate by the ECB seems equally incomprehensible given the current state of the EU's economy and its ever—appreciating currency.  For instance, in practically the same breath that Mr. Trichet was announcing the decision to leave rates unchanged, he also reduced the EU's regional GDP forecast for 2005, placing the mean estimate at a meager 1.9% year—over—year growth rate.  Now, factor in an average 8.9% unemployment rate in the region — with France at 9.9%, Spain at 10.6%, Germany at 10.7%, and Belgium at an amazing 13.2% — and one truly has to wonder what kind of economic cataclysm is going to have to befall this part of the world to get its central bank to understand the urgency for a truly aggressive monetary policy. 

That having been said, is it possible that the ECB's intransigence is quite playing into America's hands, and that our policy makers have likely counted on it?  Let's assume that a weak dollar has been the priority of the Bush Administration and the Federal Reserve since January 2001.  If you recall, that New Year began with quite a shock when the Fed announced on January 3 that it was cutting the federal funds rate a half a percentage point to 6.0%.  At the time, the ECB's corresponding rate was 4.75%, still a full 1.25% below that of the U.S., while the euro was worth about $0.93.  Thus began an unprecedented drop in interest rates in America with federal funds ending the year at 1.75%, and the ECB's rate finishing at 3.25%. 

As a result, in just twelve months, the U.S. went from a roughly 1.75% interest rate premium versus that offered by the ECB to a discount of 1.5%.  As such, it shouldn't be a surprise that the dollar began to plummet — maybe exactly as Mr. Greenspan and the Administration wanted.  In fact, since we commenced our aggressive monetary policy almost four years ago, the euro has gone from $0.93 to its current $1.34.  Clearly, this has been a boon for American multinational companies, and a corresponding detriment to those in Europe. 

Yet, the real problem for the EU — one that we actually share — is the exploding Chinese economy, and how their unfavorable yuan/dollar peg is behaving like a trade 'double whammy' throughout Europe.  First, this peg acts to make European products too expensive in China, and Chinese goods extraordinarily cheap throughout Europe, thereby making trade between the two entities rather one—sided.  As a result, the EU reported a £10.373 billion trade deficit with China in 2002 versus a surplus in 1995.  And, according to the British Telegraph:

The deficit is expected to be much higher in 2004 as the euro reaches historic highs against the Chinese yuan. The yuan is pegged artificially to the dollar. The effect is to give Chinese exporters a massive competitive boost against European firms, a situation that is unlikely to be tolerated much longer as economic growth stalls in Germany and Italy.

However, maybe more important, this peg is also acting to inflate the value of the euro against the dollar, thereby complicating matters further by concurrently exacerbating their trade problems with the U.S. As a result, it is conceivable that the largest impediment to European economic growth today and in the future is actually this artificial yuan/dollar peg.

The good news is that the ECB and the EU appear to be beginning to realize this, and understand that the solution is to force China to end this peg as soon as possible.  This could be accomplished in a variety of ways, including, if necessary, petitioning the World Trade Organization (WTO) to put pressure on China to either float the yuan, or create a new peg to the dollar that is more in line with its current perceived value.  Likely, America would go along with such a request, as it would be in our best interest as well.  The end result would be a reduction in some of the upward pressure on the euro, thereby helping the EU to engage in a more balanced trade policy with both China and the U.S. 

Conceivably, this has been the plan by the Bush Administration and the Federal Reserve since 2001.  In reality, it has been clear for quite some time that the yuan/dollar peg was going to be extremely detrimental to the global economy and specifically the U.S. as the Chinese financial engine took off.  However, America, as the global economic behemoth, was not likely going to either get China to capitulate on this issue on its own, or receive any satisfactory redress from an international organization such as the WTO; just look at how little luck the U.S. has had with the United Nations in recent years. 

As such, by brilliantly orchestrating this dollar decline, America has not only seen its exports explode, but we have also pushed Europe into a corner whereby they are likely now compelled to join us in forcing China to finally revalue their currency and hopefully allow it to float against all foreign exchange rates.  In the end, this might not only allow for a much fairer and stronger trading structure throughout the globe, but could be the beginning of a new American/European Union economic alliance that not only helps all of our economies, but also starts to mend the diplomatic rifts that have separated our nations for years.

Noel Sheppard is a business owner, economist, and writer residing in Northern California.  Noel receives e—mail at slep@danvillebc.com.