Enter the era of dollar devaluation

By J Saft
November 4, 2010

We’ve entered a new era in global financial markets: the U.S. is intentionally devaluing the dollar.

For the U.S., which has long espoused a strong dollar but in reality had a policy of benign neglect, this is the equivalent of pushing the big red eject button in the jet cockpit: something big is going to happen and we will have to see how it will work out.
The Federal Reserve on Wednesday moved to open a second round of quantitative easing, pledging to purchase a total of $600 billion of longer-dated Treasuries between now and the end of the second quarter of next year. As well, the Fed will reinvest $250-300 billion in the same period, meaning that the central bank will be buying up $110 billion a month in Treasuries and creating a like amount of new money out of the ether.

Perhaps the principal way QE will boost the economy, the Fed hopes, is by lowering effective interest rates, enticing investors to move into riskier assets, some of which may generate inflation and jobs. As well there is the wealth effect; the old canard of spending more because your retirement account and house have gone up in nominal terms.

The bald fact, though, is that by turning on the printing presses the Fed will drive down the value of the dollar absent a similar move in another currency. Much of the new investment created by QE will be made not in the U.S. but will be money borrowed in the U.S., exchanged into a foreign currency, probably an emerging markets one, and invested overseas. That will drive the dollar down, which will help to make U.S. industry more competitive.

There you have it; competitive devaluation, a beggar-thy-neighbor policy. It is not much of a lever, but it is one of the few which the Fed has left to pull.

Don’t expect anyone from the Fed or the Treasury to tell you this in simple declarative sentences, but it’s true nonetheless.

“Devaluation is the intention, and devaluation is what is going to happen,” Avinash Persaud, Chairman of Elara Capital told the Forex Forum conference in New York on Tuesday.

We can surely expect the U.S. to deny this, as Treasury Secretary Timothy Geithner did in October, but the truth will be seen in the foreign exchange markets, where the dollar has been falling and will fall further as the year winds down.

GETTING THE GENIE BACK INTO THE BOTTLE

It is most certainly in the power of the U.S. to begin a period of competitive devaluation. The U.S. dollar is a global reserve currency and the marginal cost to Bernanke of printing more is very low indeed. Less certain are the reactions of the rest of the world.

While the U.S. will surely have prepared the way for QE2 with its major trading partners (and in fact may be deliberately ticking off the Chinese) there remains a strong chance that a falling dollar sets off a range of tit-for-tat reactions. Already Korea and Brazil are moving to stem the appreciation of their own currency. Look too for the possibility of other countries joining in to QE, in part so that the Japanese yen, to name just one, does not rise too much against the dollar.

A currency war blossoming into a trade war has to be one of the outside but significant risks of 2011. If global growth can recover significantly this may be averted, but this is far from promised.

The second and maybe more important risk is that the U.S., having lost control over its own monetary policy many years ago due to recycling of capital by the Chinese, now loses control of its currency. Like going broke, this can happen little by little and then all of a sudden.

On the Fed’s reckoning it will go like this; QE2 and very low rates go on for an extended period, but almost as a matter of mechanics, when the Fed begins to tighten, the dollar recovers. The Fed has used the dollar lever to ease and then uses it to help to tighten. The dollar remains the principal global reserve currency and investors respond to the Fed’s incentives.

The alternative is that QE is not terribly successful in improving U.S. growth but does touch off a round of speculative investment elsewhere, investments that make returns in a shrinking dollar look worse day by day. When the time comes that the Fed, perhaps hurrying to prove its control, decides to stop QE2, bond investors want compensation for holding U.S. debt — a lot of compensation. U.S. equities, which have been held aloft by QE, duly fall sharply, as does the dollar, while yields spike. This is not a central case, but it is a possibility, and as it would be a disaster, one that needs to be watched closely.

Extraordinary times surely call for extraordinary measures, but those measures sometimes bring extraordinary results, and not always the ones we hope for.

(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.

8 comments

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“Extraordinary times surely call for extraordinary measures, but those measures sometimes bring extraordinary results, and not always the ones we hope for.”

Yes, and the previous rounds of similar ‘extraordinary’ measures were ineffective to a point they resulted in the Democrats losing big time in the midterm elections.

Posted by yr2009 | Report as abusive

It’s hard for the USA to win a currency war with China, when the Chinese have pegged their currency to the dollar!

Posted by Cranios | Report as abusive

It makes no sense to purchase treasuries in the attempt to lower long term mortgage rates. This must be another giveaway to Goldman Sachs.

If the Fed wanted, they would tell Americans that they can all refinance their homes at 2% (appraiser must be used. The appraiser must use today’s values.)If any of the trillion is left, it can be used to refinance second homes.

NO new mortgages because people still in their homes are the only solvent people around.

Posted by DeltaJordan | Report as abusive

The dollar must be sacrificed for growth. The only alternative is deflation, which, unlike inflation, can become uncontrollable. In an economy of falling prices, the producer stops producing because he fears selling at a loss. The CPI fell 40% in the 30s.FDR tried everything for ten years and finally became an economic dictator. He doubled GDP in 5 years by contracting with 32% of the economy for defense. Inflation can be stopped. Volker stopped it on a dime, throwing us into a brief recession. We will not have deflation because of the burgeoning underground economy , which may generate 5 trillion in GDP next year. The US is becoming a vast criminal enterprise. It was estimated at 30% the magnitude of the reported economy in the days before the Net. These trillions will continue to support earnings. We have devalued the dollar 11% since June and are still at 1% inflation. China, Thailand et al. and WMT are eating the 11%. Will they eat more? Sure they will. So fear not my homies. I have been telling you to buy global large caps with me. XOM a month ago. Here.
Russ Stahl
Greatest living economist and analyst

Posted by letsgetgoing | Report as abusive

QE1 helped global large caps . Look at the earnings that are coming in. QE2 should continue this trend. The S&P500 earn half their revenues abroad . The cheaper dollar and 4.8% global growth should increase this to 60% next year. The domestic economy has an unreported component which is burgeoning and will give us a 20 trillion GDP next year. This will support earnings also. I look for large caps to earn 30% plus more next year. I aint sellin.

Posted by letsgetgoing | Report as abusive

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The fact is that the USA is left with no alternative but to devalue. If other countries fail to let the dollar reach a level that will result in a reasonable amount of productive economic activity here that employs the bulk of the population, then we will have the end of free trade here. That is not really our choice but that is what will happen, with all the dire consequences here and abroad. But the result would be better for the American people as a whole than continuing as we have.

The rest of the world must recognize this. The status quo ante is not an option. Sorry. No American Government can survive trying to make it so. In fact, the stresses are looking grave enough to cause significant structural change in our Government. If the old Constitution can be manipulated to turn the bulk of the American population into serfs, we will have a new one. One that would be very unpredictable in form.

Posted by txgadfly | Report as abusive

[...] The QE2 is “quantitative easing”, that is, the the Fed’s move to buy an additional $600 billion in government securities which will flood the economy with more printed money. Enter the era of dollar devaluation. [...]

[...] prices have already increased following the Fed’s QE2 proposal. The move is a deliberate devaluation of the [...]

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I disagree, with the above comment, inflation can become uncontrollable also! In the past 50 years the price of house’s, and cars have gone up 1000% percent, while wages have only increased by 200 to 300%. Deflation would be a normal cyclical declination, and establish a New baseline. Combating deflation, protects the status quo, and Big Business Profits, that’s all. If you have a 10 billion dollar company, that’s suddenly worth only 3 billion, who’s is hurt by that?
The Asset class that’s who! Now the big banks have had a great ride for the past 50 years, 1000% increase in asset value, just great for them, but a catastrophe for the Now extinct middle class!

Posted by mvcharet | Report as abusive

You made some nice points there. I did a search on the topic and found a good number of people will consent with your blog.