March 30, 2010

Fear of falling: Why the dollar is (thankfully) destined to fall further

Posted in Macroeconomics at 11:06 am by Eamon Aghdasi

Recently I’ve heard people lamenting the weakness of the dollar, and fondly reminiscing about the good-old-days in the 1990s, when the dollar was historically strong against other currencies. I have to admit that even I wish I could go back to just a few years ago when I would drive up to visit my girlfriend (now fiancé) in Montreal, and get a huge plate of Lebanese food for about seven bucks. When your life is largely motivated by the search for cheap delicious food, the weaker dollar has made tourism a serious drag.

Within the past two years the dollar’s value has taken us for a particularly curious ride. Through much of 2008 it actually appreciated, as global investors fled to the safety of the dollar amid financial crisis (one of the few times in history, I imagine, that a country went through a financial crisis and demand for its currency actually increased). Then dating back to about 12 months ago it started a steep decline, and that’s when the exchange rate panickers came out again in full force.

When it comes to public perceptions, exchange rates constitute one of the worst-understood topics in economics. Many bright people fall into the trap of thinking “strong dollar: good; weak dollar: bad”. The simple truth is that weak can be as good or better than strong, depending on what you want or what you need . If you want to buy lots of foreign goods, then strong dollar: good. If you want to sell more of your goods and services to foreigners, then it’s actually weak dollar: good. In reality, a free market does a great job of getting you to a not-too-strong, not-too-weak equilibrium of the value of a country’s currency. (Of course, if you’re a small developing country with an inflation problem, then there are other factors at play.)

Despite the decline in the value of the dollar against most currencies over the past ten years or so, I personally believe there is still no way to go but down from here for the next ten. The rest of this blog is about explaining a) why I feel that way, and b) why this is actually a good thing.

There are a handful of interconnected reasons why the dollar must weaken in the coming years. The first and most important of these is the US current account deficit, the other mega-gigantic global imbalance that has been overshadowed by the 2008 financial crisis and the worst recession in 70 years, not to mention the deterioration in public balance sheets for pretty much all of the OECD countries. Part of the reason people don’t take this as seriously as they used to, I think, is the fact that the current account deficit has effectively been cut in half in the past few years. (Back in Q3 2006 it was about 6.4% of GDP, while in Q4 2009 it was 3.2%.)

But the decline in the size of the current account deficit shouldn’t be interpreted as a sign that we’ve escaped disaster. The reality is that much of the closing of the deficit had to do with a dampening in the country’s voracious appetite for imports, not regained export strength. After exports collapsed at a faster rate than imports starting in late 2008, the last two quarters have seen imports recover faster than exports, a discouraging sign to those focused on the current account. The reality is that, barring a surge in global demand for American exports, over the next few years the current account deficit isn’t going anywhere. Does this necessarily mean we’re destined for a hard landing? No, but it doesn’t matter. Whether the gap closes quickly or slowly, the reality is that at some point foreigners will be unable or unwilling to finance the American trade deficit.

So how do you increase exports to close the gap? There are microeconomic levers, for sure. National governments can provide tax breaks and other incentives to exporters (within the rules of the WTO), for instance. Monetary policy plays a role too, though it’s tough to argue that the Fed’s stance can or should be more accommodating than it is at present. The real mechanism, of course, the big hammer in the toolbox, is the exchange rate. Just take a look at the relationship of the strength of the dollar and the current account deficit over the past decade. It’s not surprising that the two are very closely (negatively) correlated.

The problem is, of course, that the US doesn’t fix the value of the dollar, so you can’t quickly intervene and devalue as if you were on a fixed exchange rate regime. But there are things you can do. One is being pushed somewhat aggressively these days (as it has been at various points in the past), which is putting pressure on China to revalue. This is obviously sticky territory; push too hard, and the issue will be even more linked to national sovereignty and pride than it is already, and Chinese leaders will be even less inclined to accept a cut in the value of their dollar reserves. But the world in general wants this to happen, not just the US. Given the slow pace of global recovery from a horribly deep recession, a great untapped source of global demand is the Chinese consumer, whose consumption most would say is being artificially restrained by the cheap yuan. My feeling is, given the mesh of issues on the table between China and the West – most notably Iran and climate change, but also other issues like Sudan – the chance for a compromise in the next few months, featuring a modest appreciation of the yuan, is possible.

But China is small potatoes compared to a much more significant factor, which is the dollar’s role as a global reserve currency. Check out another chart, showing a very clear connection between dollar strength and its share in global reserves. Part of this relationship of course occurs because the fluctuation in the dollar’s value directly affects its collective share of the value of total reserves. But another component of the issue is how the demand for dollars as a reserve currency artificially props up its value. If you’re like my roommate, a brilliant private equity brain who understands global markets as well as anyone I know, you’d nonetheless defend the dollar’s role as the world’s premier reserve for this very purpose. You can’t let the value of individuals’ assets plummet! he likes to argue. But this is exactly the point. The dollar should be gradually taken off the pedestal as the world’s reserve of choice, such that a collapse from foreigners’ dumping dollars all at once is a less likely doomsday scenario. While the idea of a world reserve currency, recently promoted by some heavyweight political and economic personalities, is tough at present from an implementation point of view, it is less crazy than it sounds, and it may be the only thing to calmly bring the dollar from off the ledge.

But what about higher prices? Wouldn’t a depreciation trigger a cycle of inflation? I’m quite surprised how much attention inflation gets these days. I don’t mean to say that inflation is never going to be an issue in the United States. I’m young enough practically to never witness real inflation. When I was born in 1980 the inflation rate was 13.5 percent. The following year it was 10.4 percent, and after that it was 6.2 percent. Since then, over a 26-year period, the highest it has been is just 5.4 percent (in 1990), and in the past twenty years it’s averaged (arithmetically) 2.6 percent. That’s just incredibly low for any country for any stretch of time.

So some would say that people of my generation are naïve about the dangers of inflation. Perhaps. But I also know that the IMF forecasts inflation to be 2.3 percent or below for the next five years. That sounds entirely reasonable to me, with unemployment still hovering around ten percent, and nearly every macroeconomist anticipating a sluggish, perhaps decade-long return to employment normalcy. Given these facts, do you really prefer to guard against inflation via a strong dollar, at the expense of regaining international competitiveness?

The big trump card here is government debt. To this point I’ve paid pretty much no attention to countries’ governance and fiscal situations, a major topic in recent months given the enormous stress that the financial crisis and recession have put on public balance sheets. It is tempting to look at the Greek fiscal crisis, the threat of contagion to other vulnerable Euro members, and the shaky European response as evidence of poor governance, and take a short position on the Euro in response (the recent EU-IMF deal, of course, cooled some of the anxiety). But the problem is, does the American governance situation really make you more comfortable? Never mind the share of debt to GDP; had this been the only factor in this conversation, Japan would have been underwater a decade ago. What I see in the US – and I admit that I have only a limited basis to compare to other countries or other American generations – is partisan and corporate strangulation of federal policymaking. When you have the worst financial crisis in eight decades and basically nothing has changed from a regulatory perspective more than a year later, this makes me somewhat skeptical that the two parties will successfully work together to avert the coming fiscal reckoning.

So if not the dollar nor the Euro, what’s left? I know there has been some talk lately about the Scandinavian currencies as a safe haven. But it also might be a golden opportunity for smart investors to reconsider a basket of emerging market and developing country currencies in the medium term. Particularly intriguing are the “pre-EM” countries, as I would call them, the ones at the lower stages of economic and financial development, some of which are exhibiting responsible policies, stability, and healthy flows of FDI (though there are some logistical problems here). Smartly diversified, these currencies could prove a smart choice if investors make a move for the next frontier of value.


1 Comment »

  1. David Wozney said,

    If the stated value, of “Federal” Reserve notes, declines enough with respect to copper and nickel, the 1946-2009 nickels, composed of cupronickel alloy, could completely disappear from mass circulation.

    According to the “United States Circulating Coinage Intrinsic Value Table” available at, the March 30th metal value of these nickels is “$0.0595636” or 119.12% of face value.

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