This week, the dollar set a new 52-week low by breaking through the spot rate close previously set in November. The dollar's descent has closely resembled that of 2007 and is only about 8% away from the lows reached in 2008. The dollar's decline has both policy and structural causes, but separating the two can be difficult.
The recent decline of the greenback comes as the dollar's international reserve status is being increasingly questioned. In a provocative argument, Barry Eichengreen argues in the Wall Street Journal, "The dollar's reign is coming to an end. I believe that over the next 10 years, we're going to see a profound shift toward a world in which several currencies compete for dominance."
The argument is that shifts in technology and the rise of new currencies "“ such as the euro and the yuan "“ mean that more countries will conduct trade and finance using other currencies. In turn, this will mean that:
In this new monetary world, moreover, the U.S. government will not be able to finance its budget deficits so cheaply, since there will no longer be as big an appetite for U.S. Treasury securities on the part of foreign central banks.
Nor will the U.S. be able to run such large trade and current-account deficits, since financing them will become more expensive. Narrowing the current-account deficit will require exporting more, which will mean making U.S. goods more competitive on foreign markets. That in turn means that the dollar will have to fall on foreign-exchange markets "“ helping U.S. exporters and hurting those companies that export to the U.S.
This shift would have enormous consequences for American consumers and businesses. Only 9% of U.S. gross external debt "“ public and private sector borrowing from foreigners "“ was denominated in a foreign currency at the end of 2009. By comparison, 21% of Germany's external borrowing occurred in other currencies. Avoiding currency mismatches and hedging costs are huge advantages enjoyed by U.S. business. Similarly, the fact that U.S. consumers pay for goods in the world's reserve currency lowers prices as foreign exporters seek to generate dollar-denominated revenues to pay for dollar-denominated borrowing. Eichengreen's estimate puts the impact of the rising prices of imported goods as a 1.5% of GDP reduction in living standards, or $225 billion in today's dollars.
Tensions surrounding the global role of the dollar and the need to finance the federal government will almost surely start to dominate monetary policy discussions. (Be sure to check out the e21-SOMC symposium in New York on Friday morning). As Bill Gross, manager of PIMCO, notes, as many as 70% of the annualized Treasury issues since QE2 began have been purchased by the Fed, while much of the remainder was purchased by foreign governments for reasons related to the dollar's singular global status.
This telling statistic puts the Fed in a very uncomfortable position come June 30, when the QE2 policy is scheduled to end. If markets respond by dumping the dollar and losing credibility in the Fed to adequately manage its domestic money supply; that will only hasten the demise of the dollar as a global reserve currency. It would also make future attempts to service the government debt more onerous.
On the other hand, as Bill Gross asks, "Who will buy Treasuries when the Fed doesn't?" Regardless of the suitability of further easing, the Fed may now be trapped in a position where it must continue to be one of the chief purchasers of government debt, lest government yields rise to fiscally unacceptable levels.
While the Fed may not have a lot of good policy levers to pull in the near term, it's also worth pausing to consider the role of fiscal policy in this arrangement. For years, we have been told that deficits resulting from stimulus programs and further government spending are desirable as the costs of financing these deficits would be minor. It's now increasingly clear that a large portion of this deficit management was handled through ultra-low interest rates generated by the Fed, paired with the large-scale monetization of debt resulting from new Fed bond purchases. This policy decision has left the Fed holding an enormous balance sheet of government debt, and has made it the dominant source of government financing. This is definitely not a sustainable situation, and the manner of its unraveling certainly bears watching.
Read Full Article »