Strong Dollar Policy: What??
"I believe deeply that it's very important to the United States, to the economic health of the United States, that we maintain a strong dollar," U.S. Treasury Secretary Geithner recently told reporters. Indeed, it seems to be a pre-requisite to apply for the position of U.S. Treasury Secretary to be able to utter these words. In the meantime, the greenback seems to be falling further and further; the 'strong dollar commitment' appears to have become a farce. Just what, then, would be a strong dollar policy?
Bloomberg Radio asked me last week what I would like to hear from Federal Reserve (Fed) Chairman Bernanke to support the dollar. I responded he had done enough talk, and that I would like to see some action. Indeed, as Bernanke spoke at the Economic Club in New York on Monday, the dollar rallied for a few seconds when his speech was released; in it, Bernanke said, "our commitment to our dual objectives [price stability and full employment] ... will help ensure that the dollar is strong..." The reason the dollar rallied was because initial media reports suggested the Fed will ensure the dollar is strong, whereas all Bernanke had said is that the Fed is committed to its dual mandate and, as a result, the dollar should be strong.
Let's look at the action, then. The Fed has been buying hundreds of billions worth of government bonds and mortgage-backed securities (MBS) by printing dollars - not currency in circulation, but virtual dollars by entering a few keystrokes on the Fed's computers; in Fed talk, we talk about an expanded Fed balance sheet, as the size of the Fed's balance sheet represent the dollars that have been "printed". Generally speaking, when you increase the supply of something - be that gadgets or dollars - the value of any one gadget - or dollar - should fall assuming constant demand. Our interpretation - Fed actions do not support a strong dollar.
What may support a strong dollar is if an "exit strategy" were implemented, not merely discussed. A true exit strategy would be to shrink the Fed's balance sheet again, to get rid of all those securities and replace them with nothing. Instead, for now, the Fed's exit strategy seems to be about reducing the rate at which it is printing money to purchase additional securities. For those to whom the Fed balance sheet is an abstract concept, think of it as super-money from which all credit originates. A dollar printed by the Fed can multiply by up to a factor of 100 by the time it has worked its way through the economy: a bank may lend about ten times more than it has in reserves; the recipient of the loan then deposits the money; the depositor bank then turns around to makes new loans based on the fresh deposit, and so forth.
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The Fed's action to weaken the dollar goes beyond printing money. By printing money to buy MBS and government bonds, interest rates may be low, but these securities are now intentionally overvalued; rational investors - not just foreigners, but also domestic investors - may be inclined to take their money overseas in search of less manipulated returns. Our interpretation - Fed actions do not support strong dollar.
What may support a stronger dollar, in this market environment, sounds evermore like a novel concept: let the market determine the price of securities. Indeed, if we allowed market forces to play out, the credit contraction could run its course, may induce more consumer savings and push up the dollar.
Talking about low interest rates: a policy to keep short-term rates near zero is, in our humble opinion, not action that supports a strong dollar. A strong dollar policy would, in our view, include higher interest rates.
Let's talk about what the one trump card U.S. policy makers have been talking about: the current account deficit is shrinking. Indeed, over the past year, the U.S. current account has been coming down from what we believe had been unsustainable extremes. The current account deficit is exactly the amount foreigners need to buy in U.S. denominated assets to keep the dollar from falling; every day, foreigners need to buy about US$2 billion, just to keep the dollar from falling. It would be laudable to have a shrinking current account deficit if it came from a policy that fostered savings and investment. However, when the current account deficit shrinks because our imports are plunging (recession) and because consumers simply can no longer run up their credit cards and extract money from their homes, it sounds more like a disease policy makers haven't found a cure for, rather than a policy shift. Indeed, as some of the reflationary efforts are starting to work, the trade deficit - a key component in the current account deficit - is rising once again. Aside from the trade deficit, external financing requirements, in particular to finance government debt, factor into the current account deficit. Indeed, the best ways to promote a strong dollar over the long-term may be to institute policies that foster savings and investment. How about:
- Allowing corporations to expense capital investments rather than requiring them to amortize them over years, in some cases decades. Fostering investments may help the dollar; a cash for clunkers program is foremost expensive.
- Raising interest rates to reward saving;
- Reducing or simplifying regulation in all industries to encourage investment.
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Instead, the "incentive" for foreigners to invest in the U.S. is that the dollar has fallen so far that there may be bargains to be had. That sounds like offering your children candies as a reward for brushing their teeth, not exactly the recipe for healthy teeth in the long-run. There are many more ways in which tax and regulatory policies could foster savings and investment. In practice, we may hear a politician talk about the need for greater savings, but it invariably never progresses: after all, every politician wants the spending to happen now, and the saving later, to boost short-term growth.
Furthermore, we can't help but conclude that the Fed is mostly interested in boosting short-term growth. That's not surprising: when a country has a current account deficit, economic growth is the typical way to attract capital from abroad. But how about actively working on a more balanced economy that isn't as dependent on inflows from abroad? Japan and the Eurozone are two areas with economies that are roughly in balance; as a result, an economic downturn does not automatically lead to a weaker currency. Instead, Fed policy all decade long has been fostering global imbalances rather than stemming against them. This all should have ended with the credit bust last year; unfortunately, policy makers appear to want an alternative ending to the drama; it is our fear that to achieve a happy ending, we need to change course rather than reflate what got us into trouble in the first place.
Let's shift gears and talk about fiscal spending. The absolute level of government debt is a bad predictor of exchange rates; instead, prices are set by marginal buyers and sellers, cash flow items. As such, as deficits soar, financing requirements to pay for interest soar as well. By shifting to what may be the equivalent of an adjustable rate mortgage for government debt, the government has been able to keep its interest expenses at an artificially low level. In recent weeks, the Treasury has embarked on a major effort to extend the duration of government debt, realizing that it may be imprudent to refinancing trillions in the very short-term markets. An increase in supply of long-dated Treasury Bonds may push up long-term borrowing costs. The higher cost of borrowing may encourage the government to spend less - here we go, that would be a plus for the dollar. There's a debate on whether a potential gridlock in Congress at the mid-term election would reign in government spending. Unfortunately, any such gridlock is likely to affect only discretionary spending; as a percentage of the overall government budget, discretionary spending has been declining over the years. Said differently, we are not optimistic that fiscal spending is going to be contained anytime soon. Because of the daunting challenge, policy makers seem to favor inflationary growth policies; regardless of political persuasion, we do not see how either the Democratic or Republican party is truly proposing policies that support a strong dollar.
What about individuals? Aren't consumers to blame for the mess we are in? Some believe U.S. consumers are wired to run up their credit cards to shop, shop, shop. Genetically, U.S. consumers are no different from others in the world; sure, habits are hard to break - just as Japan has lost a generation of consumers. However, ultimately, consumers react to policies. When you flood the market with cheap credit, consumers will likely take the bait; the only reason why they aren't right now is because money is only reaching those with pristine credit. But that hasn't stopped policy makers from trying.
This analysis is not intended as a mere bashing of policies. We would like to illustrate that it is possible to have policies that encourage a strong dollar policy. The U.S. dollar has become the world's reserve currency because, over many decades, the U.S. pursued more prudent policies than many other countries. In the meantime, it is in no one's interest to have a weak dollar. But policy makers abuse that position and impose policies that may push a lower dollar on the rest of the world. There is only so much that the rest of the world can absorb. The fruits of the weak dollar policy may include a lower standard of living, a greater wealth gap, inflation and a rather unstable U.S. and global economy. That's a high price to pay, even when paid in today's depreciated dollar.
The ultimate strong dollar would be one based on a gold standard or modern variation thereof. Recent actions are a stark reminder that when you give the government the power to inflate, it invariably becomes the most politically convenient solution to solve the day's problems.
We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com. Separately, I just published a new book: Sustainable Wealth: Achieve Financial Security in a Volatile World of Debt and Consumption that explains the dynamics playing out in more detail, in addition to being a personal finance guide to allow investors to take charge of their financial destiny.