Wednesday, July 28, 2010

Looking at the Dollar Again

As European financial markets seem to be stabilizing, it is time to look again at the value of the dollar. After the heat over the sovereign debt crisis cooled somewhat the value of the dollar, once more, headed south. Over the past two years or so, global markets have seemed to be saying, if the financial world is going to fall apart today, I want to be holding some kind of dollar assets. However, if I am to bet on the value of the dollar over an extended period of time, then I want to hold assets denominated in other currencies.

As one can see from this chart showing a trade-weighted index of the United States dollar against the major currencies of the world, the general drift of the value of the dollar since the early 1970s has been downward. There are two major upswings. The first relates to the tightening of credit by the Federal Reserve under the leadership of Paul Volcker. This is the upswing that goes from about 1980 to 1986. The second upswing came during the federal budget tightening led by Treasury Secretary Robert Rubin which eventually resulted in a budget surplus and lasted from about 1995 into 2001.
During the last two years or so, there have been two minor upward movements in the value of the dollar. These minor swings came during the fall of 2008 into 2009 and in the spring of 2010 connected with the sovereign debt crisis in Europe. This last upswing seems to have peaked as the dollar, once again, heads downward.
Although the rise in the value of the dollar during the first of these movements was “across the board”, the primary reason for the rise in the value of the dollar in the latter period was the movement of money out of the euro. But, given the actions of the European Union and given the results of the “stress tests” applied to European banks, confidence seems to be returning to the Euro.
So, the long-run trend in the value of the dollar still seems to be downwards.
To me, the price of a nation’s currency is still the most important price in that nation. The fact that the long-run trend of the dollar is down highlights the fact that the international financial community continues to believe that there are still structural problems in the United States that must be dealt with. And, one can add, that these structural problems are not connected with one political party or the other. Both parties have contributed to these structural problems and, until there is a major change in the way Americans think, these structural problems will not go away. Hence, the bet is still on a falling value of the dollar.
What are the major structural problems?
Let’s start with just three. First, is the federal government deficit. Again, this is not a problem that has just occurred. The gross federal debt of the United States has increased at a compound rate of about 7% from 1961 through 2009. “Official” estimates of the deficit over the next ten years are for the deficit to increase by $8 to $10 trillion. I have been a little more pessimistic, arguing that the deficits will be more like $15 trillion. The lower estimate will still keep the growth rate of the debt above 7% a year.
Second, the commercial banking system has over $1.0 in excess reserves! The Federal Reserve is planning an “exit” strategy to remove these reserves from the banking system as the economic recovery picks up steam. However, there is little evidence provided over the past fifty years or so that the Fed can or will be able to keep these reserves from getting into the spending stream especially given the amount of the federal debt that is going to have to be financed over the next ten years.
Third, there are major dislocations in terms of the allocation of corporate assets, of corporate capital, both physical and human, in the United States. (See my post To correct these dislocations will take a lengthy period of time which indicates that the country will not recover as rapidly as it would if these dislocations did not exist. This will just exacerbate the problems caused by the two situations mentioned above. Again, this is seen as a negative in terms of pricing the dollar in foreign exchange markets.
I have been a dollar “bear” for a long time. The reason is that the general thinking about economic policy in the United States has been wrong since the early 1960s. International financial markets seem to support this assessment. And, this thinking appears in both the Republican and the Democratic leadership. I had hopes that changes were taking place when Paul Volcker was Chairman of the Board of Governors of the Federal Reserve System. I had similar hopes when Treasury Secretary Robert Rubin led the charge to reduce the federal deficits in the 1990s. In each case, “the dark side” eventually prevailed.
There is nothing I see in the future to make me think that the value of the dollar will rise except in times of global financial crisis where there is a “flight to quality”. But, these will eventually run out if nothing is done to resolve the longer-run issues. As far as I can see, there certainly is no leader on the present stage that can bring about the changes that are needed. Therefore, I remain “bearish”.

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