Dollar debasing and other short stories
By Mark Dow
The opinions expressed are his own.
We hear a lot of explanations for the fall of the dollar. The overwhelming emphasis seems to be on cyclical stories for its decline: money printing, fiscal crisis, current account deficit, financial weakness and reduced U.S. policy credibility.
In markets such stories are important, powerful, and to a surprisingly large extent, self-reinforcing ‚ÄĒ even when they are wrong. (I would recommend the books ‚ÄúAnimal Spirits,‚ÄĚ by Akerlof and Shiller, and ‚ÄúThe Social Animal,‚ÄĚ by David Brooks, if you doubt the importance of stories and emotions relative to fundamentals and reason.) In fact, the single most eye-opening thing I have learned since I stopped being an economist and became a macro trader is the frequency and extent to which stories do end up being wrong.
Our cognitive abilities have always been hamstrung by the tyranny of the simple idea: when an idea is simple, easy to explain, and intuitively compelling, it can be extremely difficult to disabuse people of it ‚ÄĒ no matter how false it might be. It is even more powerful when the simple idea reduces the distance between an individual and what that individual wants to believe. In today‚Äôs super wired world, when stories can very quickly go viral, the amplitude of market dislocations can be that much greater.
In this case, the simple idea is clear. The Fed is printing money, and when you increase the supply of money, the value of that money goes down.
How could that be wrong?
Easy. First, the dollar has been declining since 2002, not since 2008. Since 2002 we‚Äôve had periods of robust growth. Fed rates have gone up (sometimes aggressively) and down. Still, through all that, the dollar declined, almost in linear fashion. The only interruption to the downtrend was during the financial crisis (ironically when the Fed was expanding base money most aggressively).
Second, the dollar has not only been declining against emerging market countries and others with clearly superior fundamentals. It has also been declining against the wounded and the living dead. Look at Europe and Japan. Our fiscal, growth, and demographic problems are not as bad (or, if you are less generous, at least comparable) to those of Europe and Japan. And while the ECB‚Äôs stance at this point in time, ceteris paribus, does favor the euro, the Bank of Japan‚Äôs certainly does not. Yet the dollar has been falling all along against both the euro and yen (in fact, even more so against the yen).
Third, it presumes that changes in the supply of money drive a currency‚Äôs value. The cross-country data indicate that currencies often tend to appreciate when money supply is growing strongly, because changes in demand, in the form of risk appetite and credit demand, drive the broader money supply, not the changes in base money by the monetary authorities. Behavioral economics teaches us that changes in risk appetite and perception can be much more powerful than changes in supply or price in equilibrating markets (read ‚ÄúThe Price of Everything,‚ÄĚ by Eduardo Porter, if you have your doubts).
Fourth, it presumes that the expansion of the Fed balance sheet means an increase in the money supply.¬† By now, after some hysteria in late 2008 (remember the references to Zimbabwe and Argentina?), most of us have figured out that this is not the case, and the argument has shifted to the expectation that expanded base money will inevitably, at some point, lead to rapid money supply growth. Fine. Chairman Bernanke says the Fed will reel its balance sheet back in when they see loans start to pick up. Time will ultimately tell. But for now all we have is a bloating of the Fed balance sheet and a bloating of the balance sheets of the banks that turn around and deposit this liquidity with the Fed. The effects of the Fed on global liquidity are largely indirect and psychological and, if you look hard at the facts, grossly overstated.
To me, all of this suggests something else is at work ‚ÄĒ despite the power of the simple narrative.
That something is structural. There are two tectonic forces at work.
There is a global dollar overhang that is being unwound. This is not a result of the U.S. monetary policy of the past 10 years, but rather the legacy of the last 60 years when liquid wealth across the planet had only one currency choice: the U.S. dollar. In the wake of WWII, as global trade increased, global wealth grew, and precautionary financial buffers got fatter, the global demand for dollars soared. We are now witnessing the backside of that slope.
The decline of the dollar started in 2002 largely because this is when the paradigm shift in emerging markets began to take hold and people across the world began, slowly, to trust their home currencies. The financial deepening of foreign markets everywhere supported this process, as did the decline in transactional demand for the dollar (hotel bills in India and Brazil are now, for example, in local currency, not dollars).
But this phenomenon doesn‚Äôt stop there. Central banks are major part of this unwind, too. As other currencies became more trustworthy and alternatives became available, they realized it is sub-optimal to hold such a large percentage of their reserves in one currency. Many of them have been seduced by the cyclical story as well. So they are trying to bring their dollar holdings down to a level that that more accurately reflects their trade and financial exposures. And the faster the dollar goes down, the more frenetically they force the pace of unwind.
This stock adjustment will continue until a new equilibrium is found. The dollar is some 63% of global reserves, but the U.S. is now only 20% of global output. I am not suggesting that equilibrium is at 20%, but 40% doesn‚Äôt seem like an intellectual stretch. In any event, these statistics from the BIS (plus the flow dynamic of the feedback effect from heavy currency intervention in many EM countries) suggest the unwind of the global dollar overhang is far from over.
Second, there has been massive supply shock to the U.S.labor pool. Technology over the past 10 years has effectively increased the labor force U.S. companies have access to by a large multiple. This presents an enormous structural challenge and, unfortunately, will keep downward pressures on real U.S. wages for a long time. Since nominal wages are notoriously sticky to the downside, one of the ways (but not the only one) for the ‚Äúconvergence‚ÄĚ with the rest of the world to take place is through dollar depreciation.
Policy makers are aware of these two structural stories, but really can‚Äôt do much about it. All they can do is try to support economic recovery, macroeconomic stability and ensure any decline in the dollar be orderly. We can vent at them all we want, but these two realities are not going to go away.
Mark Dow is a senior portfolio manager at Pharo Management LLC, a global macro hedge fund specializing in currencies and global fixed income, and a Washington policy refugee.