Enter the era of dollar devaluation
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.