Will the Dollar Keep Rising, and Is that Desirable?

July 13, 2012

Defusing the euro area’s debt and banking crisis is like solving a single equation containing two unknown variables.  It cannot be done no matter how much good faith effort is expended.  Uncorrectable mistakes were made when the economic and currency union was designed in the 1990s, first enabling unsustainable disparities in competitiveness to develop among members and second by ensuring the absence of any legitimate means to rectify imbalances either within or outside the confines of the single currency area.  Like all earlier attempts, the accord announced two weeks ago failed to meet the fundamental litmus test by which such efforts are judged, which involves the differential between funding costs in the troubled peripheral economies and the core nations.  These grossly excessive spreads have hardly changed since June 27.  Europe’s crisis remains virtually at square one, and the claim is an illusion that a remedy exists if only the competitive and uncompetitive sides stop their disingenuous posturing and offer serious compromising concessions. Cliches like “where there’s a will, there’s a way” don’t apply to the trap into which Euroland has wandered. 

Kicking the can down the road is a rational strategy when the other options carry unbearable downside risk and uncertainty.  Delay at least allows the possibility that a very positive game-changer may arise.  From a market point of view, the status quo of muddling along from one temporary fix to another has not delivered a Lehman moment.  It has taken four years for the euro to retreat from its record high of $1.6038 on July 15, 2008 to a low today of $1.2165, which is a manageable 6.7% per year slide.  The euro is still stronger than its December 31, 1998 opening level of $1.1720, its lifetime average of $1.2087, or its $1.1757 mean accrued during the period between its record low of $0.8228 in late October 2000 and its record high in mid-July 2008.  From a broad historical perspective, no impediment looms to further euro depreciation.  The currency is merely back near to its center of gravity according to a variety of benchmark measures. 

In a number of fundamental economic respects, moreover, continuing euro losses would be understandable.  When the dollar was very weak in the summer of 2008, long-term German interest rates were about a half-percentage point higher than comparable U.S. yields.  German rates are now below U.S. levels as they were when the euro was launched at the start of 1999 and at the time of the euro’s weakest levels in 4Q00.  The U.S. will continue experiencing sluggish growth, but Euroland is in recession.   Rumors surfaced this week that the ECB may implement a negative deposit rate in a month or two.   Euroland has a marginal current account surplus, whereas the U.S. is again growing and above 3.0% of GDP.  Euro weakness is not limited to its relationship with the dollar.  From the 2008 peak, it has lost 43% against the yen, including 3% this year.  The lure for investors is meanwhile mounting for European currency hedges other than the frozen Swiss franc to guard against euro weakness.  Roughly half of the euro’s 18% trade-weighted loss over the past four years has happened since late October 2011.

The second half of 2012 will be a fateful period for the United States.  The usual excuse given for why the dollar hasn’t appreciated more sharply already against the euro is the prevalence of uncertainty surrounding U.S. policies on taxation, medicaid, medicare, social security, banking regulation, monetary policy and a multitude of other regulatory areas.   Six weeks remain before the Republican National Convention that starts August 27.  Another 8-1/2 weeks lie between the end of the Democratic Convention on September 6 and Election Day.  The decision by voters will break the current gridlock, right?   Well not exactly.  Polls show a close presidential race between Obama and Romney, who offer vastly different visions.  The closeness is not really surprising, since tightly contested elections in 2000 and 2004 indicate a deeply divided nation.  It’s also instructive that Bush43 had an easier time passing his agenda in 2001 than Obama in 2009 even though Obama won a much bigger voter mandate than Bush.  That, too, is not surprising because the Republican Party is more disciplined and monolithic.  It would seem that a substantial disappearance of uncertainty occurs only if Romney wins.  I believe he will.

From next November through February, nonetheless, uncertainty is apt to be more elevated in the United States than now.  Party transitions at the White House can often be confusing times.  A lame duck Congress has to deal with the fiscal cliff.  Promised immediate changes made during the Romney campaign need to be implemented quickly to show that his word can be trusted.  Cabinet nominations and hearings will occur fast and furiously.  The identity and character of the Treasury Secretary will be revealed, and Fed Chairman Bernanke would become a lame duck and raise serious questions about central bank independence and credibility.  Little reason exists to expect a night-and-day acceleration of U.S. growth after November.  The spending policies favored by Romney are similar to those of the past two years, when real government expenditures contracted by a combined 3.3%, and huge tax cuts under Bush43 coexisted with a period a decelerating growth.  Every remote comment about U.S. trade, China or the dollar from anyone in the incoming government will be parsed by investors.  Rhetorical faux pas in currency policy occur early with most new U.S. administrations.

A substantial rise of the dollar from present levels poses obvious problems for the world economy.  It would impede a convergence of national current accounts.  A massive deleveraging  of debt still has to be done, and will stretch over several more years.  In the process, nations with current account deficits like the United States and Euroland peripherals need to reduce those imbalances, while the surpluses of Germany, Japan, Switzerland and China also must narrow.  The United States doesn’t have deflation.  Neither did Japan in 1995, and deeper U.S. disinflation would not serve the U.S. or emerging market economies well.  The peak in oil prices at $147.91 per WTI barrel on July 14, 2008 coincided with the peak in the euro against the yen and dollar.  Such had been at $12.15 when euro parities were locked in at end-1998.  Oil now costs less than $90, and if the dollar keeps grinding upward, one can probably expect commodity costs to stay down.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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