Contrasting Views on the US$'s Fate

What we have here are two differing takes on the future of the US dollar that recently appeared in the Financial Times. First up is former US Treasury Secretary George Schultz and former economic advisor to George Bush Sr. John Taylor. According to them, the subprime mess has a "silver lining" in that it is reducing America's deficits by curbing consumer spending as well as investment in housing. As a consequence of these adjustments, they do not foresee the dollar falling much further, though they would prefer it if, you guessed it, the market decided the fate of the US dollar:

The good news is the recent reversal of the steady upward climb in the current account deficit. During the past three quarters for which we have data the deficit has been cut by $119bn, falling from about 6 per cent of gross domestic product to 5 per cent, and the adjustment appears to be continuing.

Why the reversal? One explanation is the implementation of policies that these same international policymakers agreed to at recent past meetings. The basic economic principle that led to these policies is that the US current account deficit is caused by the gap between saving and investment. Accordingly, a three-pronged strategy was called for – reducing the US budget deficit to decrease government dissaving, raising economic growth abroad relative to the US in order to stimulate US exports and increasing the flexibility of exchange rates, especially in China, to facilitate the adjustment.

You can see the strategy being implemented now. The budget deficit has come down sharply to 1.2 per cent of GDP, well below historical averages and less than in most other countries. World economic growth – especially in emerging markets – has been strong, even as US growth has slowed. And China’s exchange rate has become more flexible – appreciating by 10 per cent since the peg was abandoned. Forward markets project further appreciation...

Including both the direct investment effect [in housing] and the personal saving effect, about three-quarters of the reduction in the current account deficit can be attributed to the housing market turmoil. So while the agreed economic policies have begun to improve the current account, and will continue to do so, they have had important assistance. The housing market correction has been an important factor in the current account correction; as a result we are seeing a dramatic beginning of a welcome rebalancing of the world’s investment and saving flows...

Throughout the recent world econ­omic expansion, many have warned that the current account deficit would cause a sharp collapse of the dollar and a global currency crisis. That has not happened. The dollar depreciation has been gradual, with low volatility serving as a stabilising force during the six-year expansion. A US exchange rate policy that has stressed market forces, avoided exchange market intervention and not tried to talk the dollar down has worked well. It should be continued. To the degree that the improvement in the current account is caused by the housing turmoil, further depreciation of the dollar is less likely. But it is best to let the market decide that.

Meanwhile, Krishna Guha of the FT offers a more cautious assessment. While acknowledging that the sanguine assessments above may come true, another scenario involving massive loss of international investor faith in the dollar may have far-reaching effects stateside:

Whose problem is it anyway? As the dollar sank to new lows this week, a growing number of people began to question how long the US can remain relaxed about its weak currency.

The US has a long (if not unbroken) tradition of indifference to dollar weakness, dating back to John Connally, the Nixon-era Treasury secretary, who famously told a group of visiting Europeans that the dollar was “our currency, but your problem”. The official line today is that the US has a “strong dollar” policy. But it does not appear to mean much beyond support for a market-determined exchange rate...

To date, the decline has indeed been largely a problem for foreigners. Companies based in Europe and other regions with floating exchange rates have lost competitiveness relative to US businesses. Foreign investors have suffered miserable rates of return on dollar investments when translated back into their own currencies. By contrast, US net exports have picked up. The Federal Reserve’s interest rate cuts in September and October were intended in part to boost US exports further by weakening the dollar...

However, the weak dollar may not be as trouble-free for the US in the future as it has been in the past. The decline in the dollar has become so marked and so sustained that there is an increased risk of imported inflation. This is augmented by the fact that energy and commodity prices are being pushed up in dollar terms by strong demand in Asia...

The dollar decline is fuelling economic and trade tensions. At the same time, it adds to the risk of inflation and asset price bubbles in fast-growing emerging markets, such as China, that tie their currencies to the dollar. In short, it crystalises the structural problems in a world economy in which some major trading powers have fixed exchange rates while others have floating rates.

David Woo at Barclays Capital says the dollar has lost its safe haven status as the credit crisis has progressed. Some commentators even say the market is behaving as if the dollar has lost its status as the world’s reserve currency. Currencies do not lose their reserve status overnight. But global confidence is clearly rattled.

One of three things might happen.

The dollar could stabilise. The Fed thinks investors may have already priced in the decline needed to moderate the US deficit. If it does stabilise, it will remain largely a problem for foreigners.

The dollar could continue to decline, but in an orderly manner, with no increase in the risk premiums foreign investors demand to hold US assets. If so, it will also remain largely a problem for people outside the US.

Or the dollar could continue to decline in an increasingly disorderly fashion, accompanied by rising risk premiums on US assets. If so, it will become a big problem for the US. This should not be ruled out. The risk of a US recession has increased following the credit squeeze, reducing the attractiveness of US assets.

Meanwhile, the likelihood has increased that one or more of the nations that tie their currencies to the dollar could break the peg, reducing a source of demand for dollars. Moreover, the spectacle of US banks struggling to figure out how much they have lost on credit products has shaken confidence in US markets.

The latest decline in the dollar has been accompanied by a falling stock market and rising credit spreads. This could be a coincidence – US long-term bond yields remain low. But it could be a sign that foreigners are starting to demand higher returns on dollar assets. In a worst-case scenario, fears about the dollar could lead to a scramble for the exit. The Fed would come under pressure to raise interest rates to prop up a collapsing dollar and offset its inflationary impulse – at a moment when the economy might desperately need rate cuts. Such an extreme outcome is still unlikely. But even if this episode ends happily for the US, there are lessons to be learnt.

First, as monetary policy works increasingly through exchange rates, central banks will be exposed to international political controversy.

Second, the large US current account deficit complicates the Fed’s efforts to deal aggressively with risks to growth, because a deficit economy is always potentially vulnerable to a loss of global investor confidence.

Third, there are circumstances in which the Fed might not be able to rescue the economy and US financial markets. For investors accustomed to believing the Fed is all-powerful, this is a sobering thought.