All eyes, right now, are on the forming Obama administration and the economic plan they are constructing. We get the word that we can expect fiscal deficits in the neighborhood of one trillion dollars and we can expect large deficits for several consecutive years.
The Federal Reserve is doing all it can to push liquidity into the system and has thrown just about everything it can into the market to get banks lending again and the financial markets functioning. The Fed’s balance sheet has ballooned so significantly, one has to wonder how they can ever re-establish monetary discipline within a reasonable time period.
The concern is, of course, an economic recession or worse and the economic dislocation and misery that accompanies such an experience. As a consequence, very little attention is being given to the dollar.
I believe that the value of the dollar is something to watch, even at a time like this. The reason being is that the value of the dollar captures how international financial markets are interpreting the economic policies of the United States government relative to the economic policies of other nations. The importance of this price is underestimated and I continually go back to the statement of Paul Volcker: “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership, (New York: Times Books, 1992), p. 232.)
The Bush 43 administration ignored the value of the dollar for most of its time in office and showed contempt for any fiscal or monetary discipline as the value of the dollar declined by more than 40% against a wide range of important currencies. This decline can be seen in the accompanying chart which presents the value of the dollar relative to the Euro. One can see that from 2001 until August 2008 the value of the dollar fell (represented by upward-moving curve).
Place chart here from St. Louis Federal Reserve Bank.
One can see that once the world financial crises escalated in September 2008 through the fall that the value of the dollar rose (the value of the Euro falls in this chart) as there was a world wide flight to quality…a movement to the United States dollar. Only recently have we seen some decline as the Federal Reserve has let short term interest rates in the United States fall toward zero and has attempted to further push liquidity into banking and financial markets.
The concern is going forward. How are world financial markets going to accept the Obama team and the monetary and fiscal policies that will be implemented by the new administration? With projections for such huge amounts of federal government debt hitting the market and the stance taken by the Federal Reserve system to basically monetize large portions of this debt, there is concern about what will happen to the value of the dollar and the place of the United States dollar as the world’s reserve currency.
Bush 43 was helped considerably by the willingness of the rest of the world…especially China, India, Japan, Middle Eastern countries and others…to finance the huge deficits it created. The Federal Reserve produced negative real rates of interest and private debt soared, much of it placed off-shore. The United States relied on the savings of the rest-of-the-world to pull off its debt binge. But, international investors responded to this debt bubble by selling the dollar.
It seems as if there are three possibilities for the value of the dollar given the projected large federal deficits. These are:
1. Foreign investors will continue to acquire the debt of the United States and will continue to use the dollar as a reserve currency;
2. Foreign investors will avoid, to one degree or another, absorbing the new debt of the United States and will flee the dollar;
3. The Federal Reserve will have to monetize a major portion of the new debt issued by the United States government and this will not be good for the dollar.
One hopes that the first of these alternatives will come to pass. Unfortunately, with the experience of the last eight years, the international financial community does not have too much faith in the ability of the United States government to act with appropriate discipline. Therefore, it is important to keep an eye on the value of the dollar and see how the world community is evaluating the new administration.
I have said nothing here about the potential effectiveness of the forthcoming Obama stimulus plan. There are still many questions that remain about how effective the plan might be. No one knows for sure. And, no one has an idea about when the banks might start lending again and when the financial markets might thaw. One hope that these policies will have some degree of success.
Still, we need to keep an eye on the value of the dollar. Discipline in Washington, D. C. has been absent for the last eight years. And, as I have said many times, once discipline has been lost…decisions makers don’t have any really good options that are left them. Bush 43 acted as if the rest of the world did not matter. The Obama administration, as much as it would like to throw everything it can at the economy, must not lose sight of how the rest of the world is reacting to what it is doing. A continuing decline in the value of the dollar not only will weaken the role of the United States in the world, but it will also place more and more American physical assets on the sales block to be scooped up by foreign interests.
The rest of the world already is saturated with American debt. How it receives the massive amounts it is going to receive is anybody’s guess. I think watching the value of the dollar will give us a clue.