State of the Dollar
May 27, 2011
These should be good times for the dollar. Risk aversion has made a partial comeback as analysts have revised global growth prospects lower. Japan is in recession, and the European Monetary Union faces an extremely uncertain future and perhaps death in its current form. U.S. GDP is likely to expand roughly twice as rapidly during 2011-12 as GDP in the euro area, Great Britain or Japan.
I prefer to judge the dollar’s performance against the euro, Swiss franc, and yen to gauge overall sentiment rather than the broader trade-weighed indices favored by many analysts. The Swissy and yen were two of the three currencies that acquired the label of “hard currency” in the initial years after the dollar floated. The third was the German mark, the euro’s nearest ancester. While the euro is a hybrid of the mark and sixteen other components, ECB policy is modeled after the Bundesbank’s, and the euro in behavior has resembled the mark or Austrian schilling more closely than the Spanish peseta, Italian lira, Greek Drachma or Portuguese escudo. If the dollar is to transform into the kind of super currency one might expect of the world’s dominant reserve asset, it will need to outshine the yen, Swissy and euro, not just for a few months or a year but on a chronic basis. Just 2-1/2 months shy of the 40th anniversary of the dollar’s severed convertibility into gold, such a transformation remains elusive.
The dollar plunged 3.3% against the franc this past week and lost 0.9% against the yen and 0.8% relative to the euro. It also fell 1.3% against sterling. Since the end of 2010, the dollar has depreciated about 9% against the franc, over 6% versus the euro and Aussie dollar, over 5% relative to sterling and nearly 2% against the Canadian dollar. True, the drop against the yen since December 31 is only a half percent, but a Japanese policy not to allow their currency to strengthen past 80 per dollar has been a key artificial dollar support. Compared to five years ago, the dollar has lost 30.5% against the franc, 28.2% versus the yen and 10.9% against the euro. Over the past ten years, it has netted losses of 52.1% against the franc, 38.8% against the euro, and 33.2% against the yen. The dollar also has lost substantial value against precious metals.
One truth revealed by this chronic weakness is that the world role of dominant paper currency impairs external value more than it enhances such. Being the hegemon of reserve asset portfolios and the most widely used currency in international trade results in very abundant offshore dollar holdings. The temptation to diversify reserve currency portfolios grows with time. Previous dominant reserve currencies like sterling suffered a similar fate.
Through the years, Democratic and Republican administrations have encouraged dollar weakness by acts of commission and omission. Officials in America are not the only ones to bad mouth or to commit acts of benign neglect toward their currencies. ECB President Trichet famously called the euro’s $1.50-1.60 range “brutal” in 2008 when the global economy faced recession. His remarks were understandable given the context of those times. President Obama expressed concern this month about the risk of a weaker euro against the dollar. That’s a much more provocative remark given the movements of the U.S. currency since end-2010 and over the last five years and ten years. U.S. officials have complained that the dollar is too strong against the yuan. The endorsement of a strong dollar policy rarely explains why a strong dollar might be beneficial. And when pressed on the subject, as Fed Chairman Bernanke was at his April press conference, U.S. officials say that they are promoting a strong dollar through policies that will foster faster growth and price stability. That’s very revealing. U.S. officials see causation running from other economic objectives to the dollar. What happens to the currency is merely incidental. Do other things correctly, and the dollar will take care of itself. If the U.S. commitment to a strong dollar were genuine, it would be really a commitment to a stronger dollar, and the dollar’s strength would be a top priority. Do whatever it takes to strengthen the dollar, and other priorities will fall into place.
When the dollar falls for a long time or substantially in magnitude, big holders of the currency naturally complain about its management. The word “diversification” is heard frequently in market chatter, and such is not mere idle talk. However, 40 years of floating dollar rates has underscored that it takes more than diversification to knock a currency off the dominant reserve currency pedestal. So long as the dollar holds that special position, its depreciation will not threaten the U.S. economy in the way that excessive weakness in other currencies can spread harm. Long-term U.S. interest rates aren’t lifted, for example. And since the cost-benefit breakeven point for currency depreciation is different than in other countries, U.S. officials will continue to play a game of bluff with their currency.
This needn’t be a permanent state of dollar affairs. But it’s a fact of life for now. Even with the end of QE2 just a month away, the dollar lacks good traction.
Copyright Larry Greenberg 2011. All rights reserved. No secondary distribution without express permission.
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