Dollar Paused in Troubling Times

April 22, 2015

In spite of disappointing U.S. growth for a second straight quarter, dollar demand sizzled in January-March.  Trading has been consolidating this month, and not merely pausing after such an upward spurt or even because of some convergence of macroeconomic trends between the United States and Europan. 

These are disturbing times.  Each day, more bad news than good seems to get reported, and worst-case scenarios seem considerably more consequential than the imaginable benefits of best-case scenarios. The dollar-centric international monetary system since the Second World War has managed to survive for 70 years because of U.S. exceptionalism as an economic, military, and geopolitical superpower and because of the stability of the U.S. brand of capitalism, democracy, and legal system.  This system hasn’t always translated to an appreciating dollar, but it has bestowed on the United States unique prosperity-enhancing advantages.  With the benefits have come oftentimes unpopular responsibilities that had to be met to maintain world confidence in the system.  America abrogated such responsibilities after the First World War, and a mess ensued.  Those mistakes were not repeated after the WW2, when initiatives such as the Marshall Plan and Truman Doctrine were instead introduced to help allies and enemies alike.  But the aftermath of the Cold War in disturbing ways resembles the 1920s more than the late 1940s and 1950s. 

The challenge for the United States and therefore the dollar is whether its leadership remains relevant on the world stage.  This is not the kind of exceptionalism that conservatives mean by the term but rather building a foundation that turns out the top students in the world and one of the healthiest populations in the world.  It means not being distinguished for locking up the most prisoners or for resisting world efforts to preserve a life-sustaining environment on earth.  It means projecting an image of shared national purpose, which doesn’t allow the parochial interests of regions and special interests to paralyze the federal government from promoting the general welfare and meeting its daunting challenges.  Notwithstanding the sloppiness that has always been a part of a democratic process built on checks and balances, America these days seems to have crossed the line between healthy give-and-take and fundamental dysfunction.  America’s been there before.  The Articles of Confederation, which vested power in the states but not a central authority, flopped from the get-go.  The lead-up to the Civil War and the aforementioned post-WW1 era are other examples.  What makes these times different is that an international monetary system is in place that’s vitally dependent upon the good judgment and competence of U.S. leadership. Without such, it’s a matter of when, not if, the dollar’s role is transformed.  Timing is clouded because the troubles of other lands are more severe and more urgent than are America’s.

Extending the European Union’s economic and political integration to a common currency was the highest kind of policy crime.  Even when launched in 1999 by eleven participating countries, the eurozone did not constitute an optimal currency area, and it has become much less so through the subsequent addition of eight other economies including Greece.  As hard-wired by treaty-mandated rules, Economic and Monetary Union is a recipe that will not be sustained in a socially satisfying manner, but the framework ensures catastrophic consequences if any nation leaves.  The six-letter word Grexit sounds innocuous enough, and given the lapse of years since that risk first surfaced, many people have convinced that the consequences are vastly overrated.  The truth will never be known until it happens, just like the engineered bankruptcy of Lehman Brothers or the destruction of an atomic bomb.  The near-term chances of Grexit mounts by the day and it is the mother of all uncertainties especially given the possibility of artificial efforts to control the market reaction through restrictions on capital flows.  All this makes the euro a poor substitute for assuming some of the reserve currency roles of the dollar.

The Chinese yuan is no better substitute.  China’s currency doesn’t trade freely offshore, automatically disqualifying its candidacy.  Besides, the Communist government’s attempt at steering China toward a soft landing rather than a hard one is proving difficult, and continuing political repression makes China’s money an unsuitable reserve currency hegemon for the foreseeable future.  Given China’s bloated debt, moreover, it will take at least a decade to know if the economy can avoid the fate that fell Japan some twenty-five years ago.  In the late 1980s, analysts talked about Japan the way China has been viewed now.  But rarely without war has an economy suffered as big an image downgrade as Japan has undergone. 

Net foreign demand is finally responding nicely to the yen’s slide from highs near 75 per dollar in 2012 to about 120 per dollar now.  Export volume expanded 4.1% on year in the first quarter of 2015, up from growth of 0.6% in 2014, negative 1.5% in 2013, -4.8% in 2012 and -3.8% in 2011.  But overall growth, business investment and personal consumption are soft.  Real GDP at an annualized rate recorded a quarterly gain of just 1.5% in the final quarter of 2014 after nasty tumbles in the middle two quarters of the year.  Japanese officials, moreover, cannot decide if the economy would be better served by further yen depreciation to help lift inflation or an extended trendless period for the dollar.

The main topic of currency market chatter still concerns future Federal Reserve policy.  Investors want to know which meeting will see the first interest rate hike and how frequently Fed officials tighten thereafter, but the really interesting question concerns how the U.S. economy handles policy normalization.  An intermediary question involves the reaction of the dollar and long-term U.S. interest rates to Fed tightening.  Containing those reactions is a big reason why so much effort is being put into preparing markets for the event, and it’s fair to assume that there will be rhetoric designed to assuage market volatility.  If insufficiently effective, more concrete measures will be undertaken.  One thing is sure, officials do not want the dollar to keep strengthening anywhere as rapidly as it has done since the second half of 2014.  Getting what they want may not be possible, but they probably welcome the recent pause of the dollar’s uptrend as something they really needed.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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