Will the G20 Summit Stop the Falling Dollar?

November 5, 2010

The dollar is being depressed by a U.S. monetary policy that is looser than the credit policies of other central banks.  Since August 27 when Fed Chairman Bernanke began preparing the public for a second round of quantitative easing, the dollar has lost over 10% against the Australian and New Zealand dollars, and commodity prices for oil and gold have risen more than that amount.  The dollar has lost around 10% against the euro and 4-7% against the the Swiss franc, Canadian dollar, Japanese yen, and British pound.  Many emerging market currencies do not float freely due to intervention or the existence of capital controls, and these units have not risen as sharply.  The Chinese yuan, for instance, has advanced 2.0%.  Dollar/yen has flattened, passing this past week within 40 pips of its 79.85 all-time low but closing the week with a slight net rise.

The dollar also rose over the course of the first U.S. experience with quantitative easing. From December 2008 when with the Fed’s interest rate was last cut and policy shifted to a quantitative approach through end-March 2010 when asset purchases associated with QE1 were completed, the dollar on balance gained 3.6% against the yen and 1.6% against the euro.  However, U.S. monetary policy during QE1 was more in step with the policy stances of other central banks than will be the case as the Fed now embarks on a second round of quantitative easing.  Likewise, the dollar appreciated sharply early in the 1980s when the Fed was tightening quantitatively and other central banks ran more conventional credit policies.

Several factors make QE2 potentially more toxic for the dollar than QE1.  First, risks associated with quantitative easing are greater this time because the Fed’s balance sheet is engorged and so investors are worried that the policy will create inflation.  Second, QE2, unlike QE1, is harder to justify from a business cycle standpoint. QEI was announced a full year after the United States entered a recession which was then intensifying rapidly, while QE2 is getting launched 17 months after the onset of the ensuing economic upswing.  Third, insofar as there’s less scope this time for a positive wealth effect and falling long-term interest rates, the success of QE2 is more dependent on its ability to weaken the dollar than QE1 was.  At the end of QE1, the DJIA was 22% higher than at the beginning, and the advance from the March 2009 trough stood at a much larger 66%.  A 13-17% rise of stock values since Bernanke’s late August pre-announcement of QE2 is already discounted into the market, and the scope for incremental declines in long-term interest rates from current levels appears more limited than at the comparable stage of QE1.

A fourth reason that QE2 may hurt the dollar more than QE1 is that the limitations of quantitative easing are better understood, so the policy is being second-guessed and introducing fresh anxieties into an already fragile psychology.  Currencies perform better when monetary policy is deemed appropriate than when, as now, it carries as much or more risk as potential for reward.  QE1 didn’t prevent core consumer price inflation from dropping to 1.1% by March 2010 from 1.8% in December 2008.  It didn’t keep unemployment from climbing 2.3 percentage points to 9.7% or the level of jobs from dropping 3.3% and 4.48 million between the start and completion of the program.  Although the stock market flourished and corporate profits turned around impressively after March 2009, the recovery of GDP was atypically slow, and the access of small businesses to credit remained stingy.   Those results were not terribly surprising.  Economists have known for some time that quantitative tightening and quantitative easing are not equally effective tools and that fiscal policy is better suited for combating deficiencies in aggregate economic demand.    However, fiscal spigots have already been shut to a trickle.  U.S. real government spending rose only 1.1% in the year to last quarter, down from gains of 1.5% in the year to 3Q09 and 3.0% in the year to 3Q08.

Fifth, the current situation is unlikely to evolve quickly.  QE1 had an assigned end-point from the get-go.  QE2 doesn’t.  The optimists think U.S. unemployment might decline by a half-percentage point per year, which would be a drop in the bucket when over one person out of every six wanting full-time work in a skill-appropriate field cannot find one at present.  QE2 is more likely to be terminated eventually in response to rising inflation than an acceptable fall in unemployment, but we are several quarters away from such a time.  And when tightening does occur, the Fed will not move as aggressively as it would with a healthier labor market.  So the end of the Fed’s path is unlikely to produce a significant and sustained dollar turnaround.

President Obama will hear complaints at the upcoming summit of G20 leaders in Seoul on November 11-12.  Treasury officials have given lip service only sporadically to wanting a “strong dollar” and are doing nothing action-wise to back up their word.  After the election, Obama’s hands are tied.  His credibility has suffered.  He hasn’t the ability to make policy guarantees.  An early test of the new shared-government landscape will be the fate of the Bush tax cuts, which expire in two months unless new legislation is passed.  The smart money is betting that the summit fails to produce a meaningful breakthrough in coordinated currency policy.

Looking back to the first half of 2010, it is now apparent that the currency’s better tone then was fully attributable to developments outside the United States.  Most importantly, the European debt crisis created speculation about a break-up in the common currency and, at the very least, suggested that hopes the euro might someday share equal status with the dollar in reserve asset portfolios were over-stated.  The problems of Europe’s peripheral members with troubled public finances remain a clear danger, but not one sufficiently present to make a defection or debt default possible in the next year or two.  It will take such a danger to override the negative bias in the dollar imparted by the Fed’s ultra-accommodative policy.

The lack of any serious dollar rival in reserve asset portfolios is not a sufficient factor to appreciate the dollar.  Having no serious challengers since flexible exchange rates began nearly 38 years ago didn’t stop the dollar from depreciating extensively.  The euro is no longer a top reserve asset contender, and China has too many capital market rigidities to become one inside of five or more years.  The United States has a pretty free pass and will continue to exploit the unique advantage of being able to debase its currency at will without serious repercussion. 

It will be up to other governments to erect obstacles to block the appreciation of their currencies, but there’s not much that can be realistically accomplished.  Emerging economies can get away with capital controls.   For advanced economies, the benefits probably would not outweigh the costs of doing that.  In the 1970s, a decade when capital and foreign exchange controls were widely prevalent in the developed as well as developing world, such barriers did not prevent the dollar from declining substantially.  Unilateral Swiss intervention this year failed, and Japanese intervention failed to reverse the yen’s direction.  Meanwhile, if the G20 fails to produce a Louvre-like accord to stop dollar depreciation, big holders of dollars may diversify into the euro with more urgency, and such action will promote the very possibility they want to avoid, which is more dollar depreciation.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.


One Response to “Will the G20 Summit Stop the Falling Dollar?”

  1. Jimbo says:

    I always look forward to reading your G20 articles.