Economic Powers at Cross-Purposes

As the United States struggles out of its recessionary hole, Japan and West Germany are still roaring ahead - temporarily decoupled from the global economy.

Action by the Federal Reserve has prompted a sustained acceleration in U.S. monetary growth. Officials in Tokyo and Frankfurt are still trying to slow things down.

The Pushmi-Pullu pattern among the world's three largest economies accounts for much of the tension in world financial markets today. It helps explain the persistent strength of the dollar in the face of a sharp decline in U.S. short-term rates relative to rates in Japan and Germany.

Addressing Tension in London

This tension is the principal reason that finance ministers and central bankers of the seven largest industrial democracies were closeted in London the other day, rather than celebrating the arrival of summer at the seashore.

These crosscurrents in global finance have created attractive investment opportunities. Prices of high-grade U.S. dollar bonds have dropped in recent weeks, despite a favorable domestic environment. Credit demand is at a postwar low. Inflationary forces are receding.

The problem is overseas. The perception of high real returns on German bonds has acted like a magnet, pulling U.S. rates up and pushing U.S. bond prices down.

Inflation Foreseen in Germany

However, this may soon change. Karl Otto Poehl, the departing president of the German Bundesbank, said recently that inflation in Germany would accelerate in coming months.

Investors should heed Mr. Poehl's warning. The German mark is down; capacity use is high, and wage increases are running at 5% to 7% in western Germany and 20% to 30% in the former East Germany.

As prices in Germany pick up, the perceived real return on German debt will naturally fall. That could clear the way for a rally in U.S. Treasury securities.

The powerful surge in the U.S. dollar in relation to the German mark (up 23% since early February) triggered the recent meeting in London. Its purpose, despite a lot of double-talk from its participants, was clearly to cap the dollar's rise.

As French Finance Minister Pierre Beregovoy put it, the present level of the dollar is appropriate. "It should not go any further," he said.

Warning from a German

Helmut Schlesinger, who will take over as Bundesbank president at the beginning of August, made much the same point:

"I hope that exchange rate considerations do not force us into a corner," he warned. This means that Germany is prepared to raise interest rates to defend the mark, even if that were to put unwelcome pressure, say, on the French, who already appear uncomfortably close to recession.

Market players professed disappointment that the meeting did not come up with a definitive statement on the dollar.

Central Banks' Powerlessness

One London trader said, "People want nothing less than a strong defense of the yen and mark, or it will be an excuse to buy the dollar again."

This statement was understandable but mistaken. While it is always easier to trade a currency if you know the limits of your risk, central banks cannot overcome market forces to push a major currency up or down.

Indeed, attempts of this sort are fraught with danger. Intervention by central banks in foreign exchange markets can easily draw monetary policy far away from intended goals.

There are two types of foreign exchange intervention: sterilized and unsterilized. In sterilized trades - typical of most official currency dealing - central banks offset purchases or sales of currencies with the opposite transactions in their domestic markets.

Sterilized Intervention

If the Fed buys marks in the morning, it will sell Treasury bills in the afternoon. Numerous studies have shown that such sterilized intervention in foreign exchange has no lasting effect on currency values.

In unsterilized trades, foreign exchange trades are not offset, which means that central banks directly influence the rate of growth of their domestic money supplies by buying or selling foreign currencies.

Indeed, as a practical matter, monetary policy - not intervention in the foreign exchange market - determines the value of one currency in relation to others.

In fact, exchange rate trends are not a result of central bank intervention. Rather, they are due to changes in monetary growth rates and other economic fundamentals.

As a rule of thumb, if monetary authorities pursue domestic monetary policies that are not inflationary, foreign exchange intervention is not needed. If they don't, then intervention is futile.

In the wake of the London meeting, the focus of commentary was on the politics - who "won" and who "lost."

Such fun and games may make good reading, but they are largely irrelevant. Market forces set currency values, just as they determine prices for other goods and services.

The Bundesbank, traditionaly a strong supporter of official meddling in foreign exchange, admitted the limits of such efforts in an essay in its 1990 annual report (good reading despite the turgid style):

"International cooperation among the three largest industrial countries has adjusted to the changed environment to an ever-increasing extent.

Bundesbank's View

"In view of the divergences in levels of business activity and the resulting differences in interest rate policies, any attempts to stabilize the U.S. dollar exchange rate - for instance, by means of intervention contrary to market trends - would have little chance of success, even though central bank intervention can sometimes help to stabilize and smooth out rates."

Amen.

Mr. Heinemann is chief economist of Ladenburg, Thalmann & Co., investment bankers in New York.

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