Fear Not the Falling Dollar!

Scott Mather The U.S. dollar has fallen in value vs. most other currencies for most of the last nine months and is now flirting with multi-year lows. More U.S. dollar weakness should be expected but not necessarily feared. Contrary to many proclamations from official and private sources, a “strong” dollar is not necessarily in the U.S. or collective global economic interest. Attempts to prevent a continued orderly dollar decline may further perpetuate global imbalances, slow U.S. economic recovery and prevent a stabilization in the U.S. debt dynamic that is badly needed. While one can hypothesize alongside doomsayers about the possibility of a cataclysmic selloff in the U.S. dollar that would drag the U.S. economy into depression, the more likely case is a continued orderly decline in the dollar. A decline in the U.S. dollar is likely inevitable, but its pace of decline will very much be determined by policy. What is often overlooked is that an orderly U.S. dollar decline may in fact be desirable. In contrast to what many alarmists would contend, a weaker U.S. dollar is not synonymous with a loss of reserve currency status or unavoidable hyperinflation. To the contrary, a weaker dollar can go a long way toward facilitating a much-needed rebalancing of the U.S. and world economy: The U.S. needs to save and produce more, much of the rest of the world needs to consume more and become less reliant on exports. “King Dollar?” Looking at just one currency vs. the U.S. currency can be misleading (for instance looking just at values of the euro or the Japanese yen). The changing levels of a single currency pair reflect the relative price changes between just two countries and may not always capture more significant shifts in currency valuation. A better measure is the Real Broad Traded Weighted Exchange Rate. This type of currency measure is constructed to look at the value of a basket of currencies weighted by their respective importance in trade and adjusted for inflation differentials (see Chart 1). By this measure, the dollar is back to the low levels touched a few times before in the last 30 years. Note that the dollar has only just now given up the gains it “achieved” during the intensification of the financial crisis in the so-called “flight to quality trade.” Putting aside for the moment the important debate about whether the “quality” associated with the U.S. dollar is justified or not, it is important to acknowledge that the dollar does tend to temporarily appreciate vs. other currencies during times of crisis for a host of reasons. In this context, the current weakening of the dollar is really a continuation of the broader weakening trend in place since 2002. So in that sense, it is really not surprising to see the trend reassert itself after the peak of the financial crisis. But it is important to note that much has changed since the dollar was last at these relatively weak levels of valuation. We shouldn’t expect to see – nor would it be economically helpful to see – the dollar regain its previous levels of valuation. Indeed, there are many reasons to expect the dollar to continue its weakening trend. Should we fear economic calamity? Will the dollar lose reserve currency status and collapse in value leading to hyperinflation? Will the dollar extend its losses to create the next Weimar Republic or follow in the footsteps of the more recent example of Zimbabwe? To be sure, these are important albeit somewhat sensationalist questions. It is important to consider the primary reasons for dollar weakness. The Fundamental Problem: Borrow and Spend, Invest Poorly The U.S. has gone on a multi-decade-long spending binge that has been financed by foreign borrowing. As a country, the U.S. has spent continuously more than it has earned through economic activity and as a result, has had to import savings from abroad to finance the resulting deficit. The current account balance is a measure of how much of this has taken place. As shown in Chart 2 below, the amounts accelerated continuously up until the economic collapse. The amount of borrowing made necessary by the current account deficit is truly staggering: the accumulation of deficits since 1990 totals $6.8 trillion. That’s equal to 50% of annual U.S. GDP. Or, in more relevant terms, $22,000 for every man, woman and child alive in the U.S. today. As with most types of borrowing, there are legitimate and good economic reasons for temporary indebtedness. But ever-increasing debt levels cannot be sustained indefinitely. We all intuitively know this to be the case for individuals, households, and businesses. Yet it seems to be a very difficult idea for nations to coalesce around, much less manage to do something about. The ongoing discussion in political circles about the root causes of the current crisis and possible solutions rarely start with an accurate analysis of this very important fundamental fact. If borrowing is used to finance productive investment, it carries far fewer worrisome consequences than otherwise. Unfortunately, much of what was borrowed and spent in the U.S. was for consumption. That which was borrowed and “invested” mostly went into creating excess housing stock – a poor investment indeed. For much of the past decade, the predominant share of excess borrowing came from the private sector. But now, in an attempt to soften the blow from economic meltdown, the federal government is increasingly taking on the role of borrower/spender of last resort. The result is an ever-increasing load of “twin” fiscal and trade deficits which must be financed. In aggregate, the borrowers and spenders shifted within the economy, but fundamental imbalances and sources of economic vulnerability remain. Foreign providers of capital to the U.S. are increasingly demanding better pricing in the form of a cheaper dollar relative their home currency. Although there are lags, the multi-year trend in dollar weakness has not yet been significant enough to sufficiently stimulate U.S. exports, discourage debt financed imports and arrest the negative current account balance. This is one of the primary reasons we can expect further dollar weakness ahead. There are other powerful forces contributing to dollar weakness as well. As the Federal Reserve has lowered the policy rate to zero and further promised to keep abnormally low rates for an extended period, the dollar has taken on the role of global funding currency. Borrowing in low-yielding U.S. dollars to invest in higher-yielding alternatives is increasingly attractive. Given that the U.S. is at the epicenter of the economic crisis and has some of the most severe structural problems to contend with, many investors are betting that the Fed will be among the last to raise rates. This further encourages flows out of near-zero-yielding U.S. assets into more generous yields offered elsewhere. As with Japan earlier in the decade, the commitment to maintain zero interest rates coupled with quantitative easing measures (such as the Fed’s purchase of Treasury, mortgage-backed securities and Agency securities) acts as a powerful invitation for those looking to engage in the so-called “carry trade” by borrowing short-term in U.S. dollars and investing in higher-yielding securities denominated in other currencies. This version of selling dollars carries special risks but further acts to depreciate the currency. Since the dollar is burdened with a bad set of fundamentals and has low prospects for returning to high-yielding status anytime soon, some large holders of dollar assets (foreign central banks and sovereign wealth funds) find themselves uncomfortably overweight low-yielding dollar investments. Their diversification out of dollar assets adds further pressure to weaken the dollar. But What About the “Strong Dollar Policy?” The U.S. has officially pursued a “Strong Dollar Policy” since the mid 1990s. In practice, this policy has been little more than rhetoric. The U.S. has intervened in the currency markets only twice in the intervening period, and both times it was to WEAKEN the U.S. dollar. For the most part, the policy consisted of what can be called “open mouth operations” (or “jawboning”). More recently, U.S. policymakers have been conducting fewer open mouth operations in support of the dollar. This is leading many to conclude that the unofficial dollar policy has in fact shifted to one of “benign neglect.” Whether or not there has been an unannounced policy change reflective of new thinking, or simply a realization of the inevitable need for the dollar to adjust downward we do not know. But it does seem increasingly apparent that a weaker dollar is one of the least painful ways to both stimulate the U.S. economy and rebalance the global economy. It is only the fear of turning what has so far been an orderly decline in the U.S. dollar into a more tumultuous decline that is preventing a more honest and open policy dialogue. But surely the benefits of a weaker U.S. dollar are not lost on the U.S. Treasury or the Federal Reserve. There are many very vocal advocates of a strong U.S. dollar. Many reminisce about the halcyon days of the U.S. bubble economy when the feel-good factor of borrowing and spending masked the unsustainable reality. Too many arguments in favor of a renewed strong dollar policy are based on outdated economic assumptions or patriotic emotions about what status should be conferred on the dollar rather than a sober assessment of economic reality. Arguments for a renewed commitment to a strong U.S. dollar are equivalent to suggesting that the imbalances that helped bring about the economic crisis should be further encouraged and that U.S. indebtedness should continue to expand. This would further promote an economy based on consumption and unsustainable indebtedness rather than one balanced with an appropriate amount of production and saving. One wonders if the many vocal advocates of a renewed strong dollar policy ever ask themselves the following questions: Why it is that virtually no other country in the world is promoting strength in their own domestic currencies, if it’s such a good thing for economic growth? In fact, many countries are openly intervening in the currency markets to try to prevent or slow the appreciation of their currencies vs. the U.S. dollar. If a strong currency is so good for the U.S., why isn’t a strong domestic currency a desirable policy objective for every other country in the world? There is clearly more at work than altruistic feelings about the U.S. currency. In reality, most other countries prefer to keep their currencies weak relative to the U.S. dollar to gain competitive advantage in export markets and to prevent current account deficits from accumulating. In varying degrees, this means pursuing policies to weaken their currencies relative to the dollar in an attempt to enjoy more export demand vs. other countries. Such policies are the backbone of many Asian mercantilist growth models. Europe and Japan are feeling increasingly uncomfortable about the strength of their currencies vs. the U.S. dollar. They too have become vocal supporters for a reinvigorated “strong dollar policy.” If you follow daily statements from policymakers around the world, you would almost begin to feel that that the strong dollar policy is not so much a U.S. policy as it is a European and Asian desire. It is hard to think of any other U.S. economic policy that is as strongly supported outside the U.S. as the outdated “strong dollar policy.” Clearly, this is about more than just their export markets to the U.S. Europe’s and Japan’s competitiveness concerns are much broader, since much of the rest of the world operates with pegged or quasi-pegged currencies to the U.S. dollar. This means that countries operating with a dollar peg are also devaluing their currencies alongside the dollar regardless of whether it is warranted by their domestic fundamentals. This presents clear problems for the world’s major free- floating currencies. But verbal resistance and occasional market intervention have thus far been unable to overcome the more powerful forces acting to weaken the dollar. But What About Inflation? One argument suggests that the fall in the U.S. dollar may exacerbate inflation as the cost of imported goods increases. And while it’s true that with all things equal, a fall in the U.S. dollar will raise the cost of imports, the passthrough to overall U.S. inflation has been very muted. Most studies have shown the historical passthrough to U.S. inflation from currency depreciation is very low and is falling over time. A 10% devaluation of the U.S. dollar may only result in a small inflationary impulse of between ¼% and ½% in overall U.S. inflation. In addition, the U.S. is currently operating with record amounts of spare human and industrial capacity. Deflation is therefore a bigger near-term threat than inflation. In such a context, an inflationary impulse from currency devaluation may be desirable to help move the U.S. inflation rate further away from a dangerously low level that could trigger a debt deflation trap similar to the Japanese experience. For these reasons, we shouldn’t expect that imported inflation from a falling dollar will be much of a threat unless the currency falls very much further and faster from this point forward. U.S. policymakers may even breathe a sigh of relief at more currency weakness since the associated inflationary impulse will likely help move the U.S. economy further away from the deflationary abyss. What Will a Weaker U.S. Dollar Mean For Reserve Currency Status? It is very unlikely that an orderly dollar decline will lessen its near term role as the world’s reserve currency for one simple reason: There are few viable alternatives. In the short term, no other currency offers the size and liquidity – not to mention the political and legal stability – necessary to match the dollar as reserve currency of choice. In the longer term, U.S. dollar reserve dominance may be challenged by other currencies that will likely rise in importance. But for now, an orderly decline that helps the U.S. economy rebalance into a sustainable growth and debt dynamic may help prolong its importance as a reserve currency. In addition, it's worth considering that while the benefits of being the world’s reserve currency are presumably abundant, they are difficult to quantify. One of the chief benefits of reserve status is presumably a reduction in borrowing costs. And while it is unlikely the U.S. would lose reserve status from a continued orderly dollar depreciation, there is the possibility that interest rates would rise marginally with the perceived loss of reserve credibility. But to the extent the dollar depreciation helps stabilize the U.S. twin deficits, there would be less need for debt issuance to be sold to foreigners. This offset would mean that the fundamentals of inflation and growth would continue to dominate the level of interest rates for the U.S. economy. It may well be that a falling fiscal risk premium would be enough to offset any rise in rates resulting from a change in perceived reserve currency status. Reorienting the U.S. economy to a more balanced state based less on debt and consumption and more on production and saving will take much more time. Acknowledging the need for more currency weakness is an important step along the way. Fortunately, it looks like U.S. policymakers, although not yet willing to officially abandon the “Strong Dollar Policy,” are at least operating differently than in the past. They have awoken to the inevitability as well as the possible benefits of a continued fall in the dollar. A gradually weakening dollar may help heal the U.S. economy, stimulate U.S. job creation and help reverse the build-up of global imbalances that are at the root of today’s economic crisis. Investors should expect and position for further U.S. dollar weakness ahead.