Thursday, December 18, 2008

The Declining Dollar

The decline in the value of the dollar has gotten increasing headlines since the Federal Reserve Board of Governors released its new monetary policy efforts on Tuesday. Many short run reasons are being given for the recent decline in the value of the dollar, especially against the Euro and the Yen.

The most intriguing explanation for the decline, however, is a longer term reason. In this explanation, analysts argue that the decline in the value of the dollar is just a continuation of the trend which began in early 2002 and continued through until early August 2008.

The story that accompanies this explanation is that a series of events in 2001 and 2002 convinced international markets that the United States government had forfeited any discipline it had established over its fiscal and monetary policies. First, there was the huge Bush (43) tax cut that moved the government’s budget from one of surplus to one of deficit. This was followed by the war on terror and the Iraq invasion which exacerbated the amount of the budget deficit.

In addition to this the Greenspan Federal Reserve cut the target Federal Funds rate to very low levels, around 1% or so, for a period of about two years. Mr. Greenspan’s concern, apparently, was fear of an extended recession following the burst of the bubble in the stock market. The result was the creation of the housing bubble as well as smaller bubbles in other areas of the economy, including commodity prices.

As a consequence of these actions, massive amounts of debt were created. Fortunately for the United States…at the time…was that over 50% of this debt…both private and public debt…was financed outside of the United States…large amounts being placed in China, India, and the middle east…although as we found out…banks all over the world acquired huge quantities of mortgage-backed debt.

The interesting thing that was learned from this period is that consumer inflation (as measured by the Consumer Price Index) could be kept in check while inflation ran rapid in asset prices (particularly in housing prices and commodity prices at this time). The monetary authorities concentrated on consumer prices and did nothing with respect to asset prices.

The thing is that “self-reinforcing expectations” can get built into asset prices leading to a massive increase of financial leverage. Consumer credit can be expanded for purchases of the items individuals purchase, but this credit expansion cannot match the possibilities for increase that exist as asset prices go up substantially, year-after-year.

Foreign exchange rates capture the relative expectations of people that operate in these markets. The specific ‘relative expectations’ that are relevant here pertain to how market participants judge how the economies of different countries are expected to perform. Performance in this instance relates to the state of the economy, performance of government’s in terms of their conduct of their economic policies, and expected inflation.

In this respect, Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, has stated that the price of a country’s currency is the most important price in its economy. The value of a country’s currency is, in a real sense, the “grade card” of the country’s economic and monetary policy, relative to the rest of the world.

Thus, as the value of the United States dollar fell more than 40% from early 2002 to August 2008, participants in international financial markets were indicating a belief that the government of the United States was showing little or no discipline over its budget and this was connected with an extremely “loose” monetary policy. To these market participants, the United States would have to “pay the piper”, sooner or later.

As the story continues, when the financial markets fell apart in September, the United States dollar became the “quality” asset in the world and investors flocked to the dollar as they repatriated assets from all over the globe in order to invest in U. S. Treasury securities. As a consequence of this rush to quality the value of the United States dollar rose.

This latter movement has apparently come to an end. There seems to be a number of short-run reasons for the recent decline in the value of the United States dollar…one of them being a move on the part of foreign investors to get back into their own currencies to dress up their year-end balance sheets.

But, there is another reason given for the drop in the value of the dollar and this is connected with the decisions of the Federal Reserve that were announced on Tuesday and the projected rise in the deficit of the federal government. For all intents and purposes, the target Federal Funds rate is now approximately zero. In addition, the Fed said that it would buy financial assets, long term U. S. Treasury issues and mortgage backed bonds and so forth in order to flood the financial markets with liquidity. And, they warned, they will continue to do this for as long as necessary…whatever “necessary” means. On top of this, the Obama team seems to be talking about adding roughly $1.0 trillion in expenditures to the federal budget to get the United States economy going again.

One can easily draw from this the assumption that the world will be flooded with dollars…millions and millions of dollars. How should one react to this in terms of the value of the dollar?

One could argue that this is exactly what world financial markets have been predicting would happen since early in 2002. (They did not, and could not, predict precisely the path of the collapse.) This is exactly the reason why the United States dollar has declined by about 40% since then!

The problem is that there are no “good” decisions left for the United States. This is the dilemma that must be faced when discipline in lost. When one sees the consequences of a lack of discipline, one does what one needs to do in order to get one’s life back in order. Getting discipline back into one’s life is a matter of one step at a time.

In terms of priorities…getting the economy going and avoiding a cumulative collapse is number one. Until this is accomplished, we may just have to see the value of the dollar continue to decline.

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