Dollar faces long journey downward

October 13, 2009

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- James Saft is a Reuters columnist. The views expressed are his own –

Even putting aside the spectacular but hard-to-measure risks of a financing crisis or the loss of its special status, the dollar faces really serious headwinds from boring old fundamentals.

The dollar has been weak for months and markets have been fretting over a host of big picture worries.

Perhaps the world’s oil exporters will stop using the dollar as the medium for petroleum trade. Or maybe the so-far patient and docile buyers of Treasuries will finally turn jittery. Either could be a disaster for the dollar, but you don’t need conspiracies or crises to be bearish on a currency from a country which on some measures has run the largest-ever deficit between what it imports and what it sells abroad.

One of the most interesting side effects of the first part of the financial crisis was that the dollar actually rose despite being the locus of the credit bubble and despite the U.S. consistently importing far more than it exports. That strength, which has now been reversed in part, was largely because the freezing up of markets set off a scramble for dollars.

The acute phase of the crisis is over and a return to something approaching normalcy is not treating the dollar kindly; from its peak this year the dollar has fallen more than 13 percent against a trade-weighted basket of currencies. The current account deficit — the balance of exports to imports — has also been reduced greatly, from a peak north of 6 percent of GDP to below 3 percent at the end of June, with further narrowing in the months since. That is because a weaker dollar makes U.S. products more competitive, but also because the price of oil, of which the U.S. is a net importer, has dropped, and consumption at home is flagging.

It is far too early, however, to say that the dollar adjustment has done its work and the deficit will now close.

“The U.S. current account shortfall was primarily driven by a consumption surge rather than an acceleration of investment on the back of productivity growth and high profitability,” Citigroup currency strategist Michael Hart wrote in a note to clients.
THINGS THAT CAN’T GO ON FOREVER DON’T

That is bad news for the dollar and bad news for the outlook for U.S. growth. A 2005 paper by Caroline Freund of the World Bank and Frank Warnock at the University of Virginia <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=875699> found worse outcomes for the countries that ran current account deficits to finance consumption as opposed to those which ran deficits in aid of investment.

Industrialized countries which, like the U.S., run current account deficits for consumption, find that the currency depreciation that follows tends to be deeper. What’s more, the adjustment in the deficit lasts longer and is often twinned with lower growth. It is not, I suppose, a big surprise that importing more than you export and then consuming it leads to depressed growth. The real wonder is the way in which the U.S.’s special status and the generous financing terms offered by its trade partners made this possible without more immediate damage to the dollar.

There is also the possibility that globalization has permanently raised the “natural” level of the U.S. current account deficit. Huge swaths of the U.S. manufacturing base and a growing wedge of the country’s service sector have been offshored or simply moved out of the U.S. Many of these goods and services are still consumed by the U.S., but now much of the money generated by those sales will be the result of dollars being sold to buy pesos, ringgits or yuan.

This may place more structural pressure on the dollar to fall over time.

Australia’s decision to raise interest rates last week hurt the dollar and for good reason. It demonstrated that as a recovery happens the action will not be in the U.S., but in resource-based economies and in places, mostly in Asia, where the best prospects for productive investment lie. The U.S., where the Federal Reserve will likely need to keep rates low for a very long time, will have a hard time capturing the imagination of investors.

For policymakers, and not just U.S. ones, the puzzle is how to allow the dollar to fall gently without precipitating trade friction or a disastrous loss of confidence. Because it’s more or less in everyone’s interest, it will probably more or less be avoided. A weaker dollar, though, is simply consistent with the outlook for the U.S.

A long shamble downwards rather than a fall off a cliff looks to be in the dollar’s future.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. )

68 comments

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I would be interested in seeing what the components of production, imports, consumption and exports are for the US. Maybe a long journey downward will be a pleasant one, like a tired old 737 jet coming in for its last landing to be replaced by a zippy new technology and way of thinking.

Posted by Casper | Report as abusive

There’s so much talk of late about the dollar falling, it surely follows that somebody has a vested interest in seeing it go that way. One doesn’t have to look too hard to figure out who might be involved. [Hint: it's not who it should be.]

Amid all the chatter, what seldom gets mentioned is the degree to which our currency policy now quivers coyly in the hands of an unregulated US finance industry, rather than those of the Treasury.

Underpublicized also are the long-term risks of this presumptuous trend toward total privatization of the national interest. It’s been going on so long now, it’s just “one of those things”.

With the Treasury Department devoting obscene amounts of its time and resources to massaging certain parts of private financial services industries in a suspiciously sensuous fashion, instead of focusing on the vast and troublesome domestic implications of an unruly greenback’s mood swings careening entirely out of public control, the overall situation becomes that much more volatile and vulnerable to catastrophic outcome.

Clearly this concerns the banks not one whit. Boldly using taxpayer funds as gaming chips, you’ll see them short the U.S. Dollar wholesale in a New York minute. And damn the consequences – as long as they come out ahead on paper, they really don’t give a hoot how low the domestic currency sinks and at what inevitable cost to the American public.

Europe On $500 A Day, anyone?

(At the time of publication the writer didn’t seem to have too many dollars.)

Posted by The Bell | Report as abusive

Thank you for the article.

Posted by enoch apaibinyesim | Report as abusive

So much of this discussion is overblown. The U.S. is the most innovative and hard working on the planet. Our currency is the most transparent and trusted. Period. Until China can produce something other than the plastic garbage sold at big box stores and the EU has a longer work week (and ends its bickering), the USD will continue to be the currency of choice. Another point, oil’s influence on the USD stops when we find transparency (working according to the EIA)- or an alternative abundant and practical energy resource.

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