Wednesday, March 2, 2011

The Bear and the United States Dollar

I continue to be a long-term bear on the United States Dollar.

The credit inflation that is looming on the horizon in the United States over the next decade is daunting. Financial leverage is going to increase once again and financial innovation, spurred on by advances in information technology, is going to this future.

This is what people do in a period of strong credit inflation.

Chairman Bernanke says he doesn’t see any signs of a buildup of inflationary expectations.

This analysis comes from a man who has been late for every economic event during his ten-years of leadership in Washington, D. C.

Inflationary expectations may not be showing up significantly in bond yields, but inflationary expectations continue to dominate the markets for the U. S. Dollar.

Inflationary expectations are not showing up to any extent in the government bond market because of the pressure kept on this market by the Fed’s quantitative easing efforts. The Fed, given the magnitude of its actions, can keep even long term interest rates lower than they would be otherwise.

The Federal Reserve cannot achieve the same success in the foreign exchange market, especially if it is flooding the financial markets with liquidity.

Foreign exchange markets look for governments that are “out of control” in terms of their fiscal affairs. Large deficits and growing levels of debt contribute to an environment of credit inflation. That is, not only does the government debt increase in such an environment, but the incentives are established by the government so that private debt levels also increase. If such credit inflations are observed by foreign exchange markets to be excessive relative to what is occurring in other countries, the value of the currency in the country that is least disciplined will decline relative to these other countries.

The last time the foreign exchange markets appeared to believe that the United States government was managing its budget in a relatively prudent way was in the late 1990s. Beginning in early 1995 when the Clinton administration began bringing the fiscal deficits of the country under control, the value of the dollar against major currencies (Federal Reserve series) rose by almost a third until January 2001 when Bush 43 took over as President.

The value of the dollar reached its near term peak in February 2002, just after 9/11, after the “flight –to-quality bid up the currency during this uncertain time. However, the budget policies of the Bush 43 administration became clearer to foreign exchange markets as the spring of 2002 progressed and the value of the dollar began to decline.

The credit inflation begun during the Bush 43 presidency continued into the Obama administration. From February 2002 through February 2011, the value of the dollar declined by almost 36%!

Some recovery took place in the value of the dollar last year as a result of the turmoil in the sovereign debt markets in Europe. However, to me, when United States credit inflation surfaced again in the late summer of 2010, it was very obvious that the focus of foreign exchange markets turned almost immediately toward selling the dollar.

The event of the late summer was the speech by Chairman Bernanke which introduced the forthcoming QE2, the second round of quantitative easing. The value of the dollar has fallen since then, indicating that the attention of foreign exchange markets was still on the lack of fiscal and monetary discipline in the United States government.

Since the summer of 2010, the value of the dollar against major currencies has declined by about 9%.

Furthermore, foreign exchange markets are showing no confidence in the fights now taking place in the United States Congress concerning the “battle-over-the-budget.”

To me, foreign exchange markets are saying that there is no leadership on fiscal matters (or monetary matters) in the United States government. Everything is the same as it has been for the last fifty years. And, we see no evidence that anything will be changed in the foreseeable future.

In addition, the rise in the price of oil due to the turmoil in the Middle East seems to raise further questions about the United States economy and this is adding to the downward pressure on the value of the dollar.

How much more will the dollar have to fall?

Barry Eichengreen, an expert of the international monetary system, gives us his estimate in the Wall Street Journal this morning. He argues that “the dollar will have to fall by roughly 20%.” The time frame seems to be over the next five years or so. (See

Given this scenario, Eichengreen also sees the role of the United States dollar as the world’s primary reserve currency declining. Besides the lack of fiscal discipline in the United States and the proliferation of financial innovation in the world, he argues that there are now some legitimate alternatives to the dollar in global trade. The euro and the Chinese yuan are being used more and more in world trade and given the further decline in the value of the dollar this trend for the euro and the yuan will continue.

This outlines the picture that I am working with when I take my bearish position with respect to the long-run value of the United States dollar. In a world where capital flows very fluidly throughout the world, even a country as powerful as the United States, a country that possesses the globe’s reserve currency, cannot operate as if the rest of the world doesn’t exist.

Yet, that seems to be the view of the leaders of the United States and I don’t see that attitude changing anytime soon. Thus, the value of the dollar will continue to decline.

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