Stephen King: US policymakers playing with fire as the dollar continues to tumble
A dollar collapse would be a disaster all round. It would drive up the cost of borrowing in the US
Monday 12 October 2009
It's no great surprise that, in Britain, the collapse of the dollar has gone largely unnoticed. Sterling has fallen even further. Since those heady days in 2007 when a pound could buy you more than two dollars, and eager British teenagers queued outside the Fifth Avenue branch of Abercrombie and Fitch, Sterling's purchasing power has imploded. A trip to the other side of the Atlantic is now 20 per cent more expensive than it was back then.
The pound's problems may be considerable but, from a global perspective, the dollar's difficulties are much more relevant. The dollar's fall from grace has had a much longer gestation. Its last really big peak was in 2002, at least when measured against a basket of currencies representing America's major trading partners.
Then, the US economy bounced back remarkably quickly from the stock-market crash, the very modest recession which followed and the traumas of the Twin Towers. Investors believed the US had, once again, demonstrated the success of the so-called "Anglo-Saxon" model. No one wanted euros or yen because both Europe and Japan continued to be buried in economic stodge.
Funnily enough, Europe and Japan are still looking rather stodgy. Their economies, like their populations, are increasingly old and infirm. Their currencies, dosed up with financial Viagra, have nevertheless been extraordinarily virile. At $1.47, the euro has been flexing its muscles in front of an increasingly weedy dollar. The yen's performance has been even more remarkable. A dollar will now buy only JPY88 whereas, back in 2002, a dollar would buy JPY134 (for those with an interest in longer-term history, in the early-1970s, a dollar would buy JPY380: against the yen, at least, the dollar's decline has been a multi-decade phenomenon.)
Movements in currencies are, of course, all about relativities. The yen and euro may recently have risen in value against both the dollar and sterling but this could just as easily reflect yen and euro strength as opposed to dollar and sterling weakness. On the whole, it is more likely to be the latter. After all, with low interest rates and weak growth, neither the eurozone nor Japan offers the cyclical attractions which typically get currency investors excited.
A useful cross-check is to see how currencies perform against gold. Even in today's world of fiat money systems, gold is regarded by many as an alternative currency, despite its high storage costs and its limited circulation (try getting gold out of an ATM). The evidence is unequivocal. Having blasted through $1,000/oz, gold may be a soft metal but it is very much a hard currency. Investors are increasingly happy to hold it because they don't want to hold dollars.
Disillusion with currencies often stems from inflationary fears. If inflation is about to take off, it makes sense to get out of cash and invest in something else which might provide some degree of inflation "protection". Yet most of the usual anti-inflation suspects are, themselves, rather weak. Residential property prices have risen a bit but still remain at very depressed levels. Commercial real estate is under heavy downward pressure. Equities have shown a strong rally but only from a very low base. Bond yields are very low by historic standards.
And inflation in the US is, if anything, too well-behaved: including all items, prices fell 1.5 per cent in the 12 months to August; excluding the volatile food and energy components, prices rose a rather modest 1.4 per cent.
If inflation isn't a problem, why are investors turning their backs on the dollar? The answer, I think, relates to increased frustration with the dollar's role as the world's reserve currency. Reserve currencies become reserve currencies for good reason. They're trusted and universally acceptable.
Sometimes, trust slips away, particularly if the nation issuing the reserve currency has an incentive to abuse its reserve currency status. Today, the US absolutely has that incentive. Following the credit crunch, the US now has a very large budget deficit which, in turn, is driving up the level of government debt rapidly. Many years ago, before the era of open cross-border capital markets, governments mostly borrowed from their own citizens. If the state borrowed too much, it could always print money to pay people back. The rise in inflation that followed effectively reduced the government's debts in real terms. The creditors were, in effect, cheated out of their savings. They got their money back but the money was worth less than they had expected.
In our modern world of huge international capital flows, the US doesn't borrow so much from its own citizens. Instead, it borrows from foreigners. China, Russia and Saudi Arabia are among the countries which have been major creditors to the US in recent years. They have mostly chosen to lend to the US in dollars.
If the US adopts a policy of benign neglect towards the dollar – through low interest rates, a large budget deficit and the gentle hum of the printing press – the risk for these creditor countries is a fall in the dollar which would leave them nursing losses on their huge dollar assets, mostly held in the form of foreign exchange reserves. For the US, this would mark a convenient shift in the pain of economic adjustment from domestic debtors to foreign creditors.
US policymakers will doubtless shrug their shoulders and say, "So what?" After all, other countries had the option of holding fewer dollar assets. Indeed, the US argues that China's holdings of dollar assets are a direct consequence of its desire to hold its exchange rate at a super- competitive level, thereby boosting Chinese exports at the expense of American jobs.
Yet the US has also gained. Without those creditor nations, US interest rates would be a lot higher, debt levels a lot lower and consumer spending a lot softer than they've been in recent years.
Put another way, the willingness of foreigners to hold dollar assets as opposed to, say, euro assets has allowed American citizens to consume beyond their means for many years. Of course, it wasn't just the Chinese and the Russians who were lending to the US. Others did so via their purchases of US mortgage-backed securities (MBS). But if the collapse in the MBS market exposed the first chink in American economic armour, a rejection of the dollar as the world's reserve currency could expose an even bigger hole. If other nations begin to believe the US is happy to allow its currency to plummet, they may all head to the exit at the same time.
A dollar collapse would be a disaster all round. It would drive up the cost of borrowing in the US. It would leave the international monetary system short of stability and long of fear. It would unleash economic upheavals on a similar scale to those seen in the 1970s. And, as the dust settled, the world would be scrambling for a new beacon of stability.
For Asia, the Middle East, Africa and, perhaps, parts of Latin America, that beacon may eventually prove to be the renminbi yuan. After all, China now has an important, and growing, role as a major trading partner for other nations, particularly in the emerging world. By standing to one side as the dollar comes down, the US is not just playing with monetary fire: it may also, inadvertently, be encouraging an epochal shift in the world financial order.
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