Bearish on the Dollar

April 9, 2008

It will take more than central bank credit lines to needy institutions to restore a normal-working financial system. The problem is not just a matter of insufficient liquidity, and the further house prices fall, the more complicated the solution will be come. Japan’s banking system problems of the 1990’s had shades of insolvency, and so will this one when house prices have fallen at least 25% and possibly up to 40%.

Chronic dollar weakness and banking system misfunctions are related but very distinct issues. The latter has complicated life for the dollar because of the mountain of U.S. debt and relative weakness of its economy. But a healthier banking system and the introduction of new safeguards to forestall a meltdown will not remove all that is troubling the dollar, which outside of 2005 has been falling since early 2002. After so much depreciation and a backdrop of policy neglect, it becomes difficult to restore credible two-way currency risk without an activist and coordinated approach from officials. Whomever is the next president of the United States — McCain, Obama, Clinton or somebody not even in the race yet — a whole new administration unconnected to the present one is coming to Washington. It’s hard to build trust in a new currency policy in the face of such uncertainty. Meanwhile, with the Fed likely to cut interest rates during the next six months by more than other central banks and U.S. GDP poised to expand more slowly than than other economies, the dollar should stay vulnerable. The U.S. is saddled with a near-zero savings rate and a current account deficit that is nearly 5% of GDP. Such imbalances tend to be currency liabilities at times such as these when financial markets are not operating optimally.



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