Will Paulson Save the Dollar?
On May 30, 2006, Henry "Hank" Paulson was nominated to succeed John Snow as Treasury Secretary. During John Snow's reign the dollar lost 18% versus the euro and 46% when measured against the price of gold.(*) Can and will Paulson stop or reverse the fall of the dollar?
Paulson is the outgoing Chairman and CEO of Goldman Sachs. Paulson has a trading background; the investment bank's trading unit has become its most profitable division under his leadership. Paulson is known as someone who does not let himself be pushed around; whereas Snow and his predecessor Paul O'Neill had little authority, except to promote the Administration's policies, it is widely expected that Paulson has only accepted the job after being promised that he will be an active participant in shaping policies.
Most commentators believe that convincing Paulson to accept the nomination has been one of the best moves of the Administration. Is it enough to cure the deficits? Let us examine how Paulson could influence a couple of key parameters that put the dollar most at risk. We focus on the current account deficit, which amounted to over $800 billion, or about 7% of Gross Domestic Product (GDP) in 2005; foreigners need to finance the current account deficit by buying more than 2 billion dollars worth of US denominated assets every single day (please also see our recent discussion on The Current Account Deficit Matters). Key ways to alleviate the pressure on the current account deficit include increasing domestic savings, lowering domestic consumption, increasing foreign consumption or increasing foreign investments in the US.
Domestic savings: Paulson has favored tax cuts to stimulate the economy, but he also favors fiscal restraint. He may have been hired to increase pressure on Congress to cut spending to get the budget deficit under control. Unfortunately, as an unelected official, it is doubtful he can influence Congress run by voter-conscious politicians as much as he could influence "profit-conscious" traders and bankers. The "discretionary" budget is rather small, and depending on what your political persuasion is, you may think that many essential programs have already been cut to the bone. Paulson will likely be more successful in shaping spending policies than his predecessors, but we should not expect him to convince the Administration to drastically cut e.g. its military budget. Let us also not forget that the current Administration is more or less a lame duck already; it is difficult to envision radical reforms. If nothing else, he might be able to convince the Administration - which has never vetoed a bill - to veto an over-bloated budget. Also, Paulson is known as an environmentalist and might be able to convince the Administration that "green" policies can be good for business.
Promoting lower consumption as a way to reduce the current account deficit has never been popular in Washington as it seems political suicide. However, unless accompanied by higher real income, higher savings tend to be directly accompanied with lower consumption (or lower government spending). The Federal Reserve has a bigger role to play in reigning in consumption by tightening available credit; this is a separate discussion we have held; we will update it in due course based on recent comments from Fed officials, but it goes beyond an analysis of Paulson's ability to save the dollar from falling further.
Increasing foreign consumption. If foreigners only were to spend more, our current account deficit wouldn't be so huge. There are signs that indeed both Europe and Asia is spending more, but will it be enough given the huge imbalances? And more importantly, what will Asian consumers buy exported from the United States as they increase their appetite? Even a lower dollar will not resurrect our manufacturing industry. Having said that, Paulson can make a real difference when it comes to trade. Paulson has traveled to China over 70 times; he is known and respected throughout the world. We have been rather concerned that increased protectionist sentiment will make the adjustment process for the dollar more painful as it would punish those businesses that have been able to adopt. Paulson might finally be a politician who can communicate the pros and cons of globalization; he can contribute a great deal to have politicians at home and abroad understand the real issues, so that populist ideas might be held at bay. Whether he succeeds remains to be seen, but this is an area where he can make a true difference. As far as the dollar is concerned, rising protectionism is a major risk because of our dependence on foreigners to buy over 2 billion dollars worth of US dollar denominated assets every single day, just to keep the dollar from falling. Many ill-designed policies in recent years have lead to a disillusioned public that is working harder than ever while making less in real terms; it is all too easy to blame China and other emerging countries for the challenges we face. We need someone who can apply pressure abroad where pressure is due; but we also need someone to apply pressure at home to strike a balance.
Should it come to a crisis in the derivatives markets, Paulson knows these markets and industry participants well. While we doubt Paulson may be able to reverse the trend of the falling dollar, he can contribute to make its decline orderly.
It remains to be seen what the Administration's dollar policy will be. John Snow's talk about a "strong dollar policy" was - at best - a joke amongst traders and journalists. There is a lot of pressure applied to China and Asia to have these countries appreciate their currencies. We have been arguing that these countries are extremely reluctant to allow their currencies to appreciate, as it would cause a double whammy on their inflated economies if accompanied by a slowdown in their primary export market, the US economy. Paulson understands the structural issues China's banking system is facing, and may be able to lobby for more understanding and patience on the US side, while applying pressure on the right levels in China to accelerate reform.
Some cynics have pointed out that Hank Paulson may be making the best trade of his career by accepting the nomination. Paulson took Goldman public, but has never sold any shares; as Treasury Secretary, he may be forced to sell out of his position. If indeed rougher times are ahead, this is the most elegant way of liquidating his investment; had he sold as CEO of Goldman, it would have caused quite a stir.
Taken together, the nomination of Paulson is a positive for the dollar. But we doubt it is enough to alleviate the pressures on the currency that may persist.
We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.
(*) The period measured is from John Snow's nomination until Henry Paulson's nomination May 30, 2006. Source for exchange rates is www.xe.com/ict: 1/13/2003 EUR 1 = USD 1.0539; 1 troy oz gold = 352.65; 5/30/2006 EUR 1 = 1.2867; 1 troy oz gold = 656.97.