Dollar Bill Days: To Cite Twain, Reports Of The US Dollar’s Death Are Greatly Exaggerated

Analysis

 @JosephLazzaro
on January 18 2013 2:16 PM
Dollar, Inflation
True, the verdict is not in yet regarding quantitative easing’s impact on the dollar, long-term. That said, reports of the dollar’s death are greatly exaggerated. Reuters

Despite unprecedented quantitative easing by the U.S Federal Reserve -- an unconventional monetary policy few thought would last this long -- and $1 trillion-level U.S. budget deficits, the U.S. dollar continues to hold its own against a basket of the world's other, major currencies.

The U.S. Dollar Index, which tracks the greenback against a basket of currencies, lost 0.5 percent in calendar year 2012 and was at 79.17 Friday, compared with 80.61 a year ago on Jan. 18, 2012. However, that's still higher than the low at/near 78.85 registered in the fall of 2012 (Sept. 14, 2012).

Without question, the financial crisis era has not been a roaring one for the buck -- the dollar index is down about 12 percent since hitting a high at/near 90 during the financial crisis' acute stage in winter 2009, but the decline is far from the dollar collapse some had forecast as a result of the flood of easing and stimulus dollars hitting global markets. At the time, many conservative economists -- and other Fed critics -- viewed those new dollars in the system as the worst possible tactic to maintain prices and the dollar's value. Further, it was not uncommon to hear economic/social commentators, such as Glenn Beck, charge that the United States was destined for a period of double-digit inflation (a better than 10 percent annual increase in U.S. prices) or even "hyper-inflation" (a plus-20 percent price surge).

The Resilient Dollar

But that high inflation -- let alone hyper-inflation -- has not materialized, and the dollar has not plunged. Why hasn't the dollar collapsed? There are several reasons.

First, the flood of quantitative dollars added to the market is offset by dollar-denominated wealth destruction that occurred in the U.S. stock market and housing market. True, stocks, as measured by the Dow Jones Industrial Average, have roughly doubled since the onset of the financial crisis, but the U.S. and European housing markets are still net-negative since late 2007. In other words, although there are more "quantitative and stimulus" dollars circulating in global financial markets, the full effect of both the quantitative easing and the fiscal stimulus has been muted.

Second, the dollar remains the world's primary reserve currency. The euro has served as an alternate dollar, but that new role may not hold, especially if Europe does not resolve its sovereign debt crisis in a way that also protects the value of the euro over time. To be sure, the latest aid package to Greece, combined with structural changes implemented by Athens, leaves institutional investors somewhat less pessimistic regarding Greece's debt service capability, and the mood regarding Spain, Italy and Portugal has also improved -- but the financial crisis is far from over in Europe. In other words, the euro remains, but few are convinced the high-debt nations can service their debt without stronger GDP growth.

Europe: In A Bind

And as the above suggests, achieving higher GDP growth is a bit of trick for European policy makers. On the one hand, if they don't provide an adequate bailout for debt-laden countries, the euro zone risks a default and/or contagion -- another wave of the financial crisis; an austerity-constrained nation, such as Greece, could even try to leave the euro zone -- triggering sheer mayhem. (Some argue that a Greece departure from the euro zone will be "net-positive" for the global financial system and economy, but that's not the view from here. Consider: Greek bond holders will not respond passively to word that, instead of being paid back in euros, they will receive the "new Greek currency." Talk about loss of purchasing power!) On the other hand, if euro zone leaders provide a bailout that's too large and/or that asks bond holders to sacrifice too much, they risk increasing inflation, weakening the euro or losing the confidence of lenders.

All of the aforementioned problems facing the euro zone have prompted institutional investors to take a more-cautious stance toward the euro as a reserve currency. Investors still want to diversify into euros, but as of early 2013, the euro is not going to displace the dollar as the world's primary reserve currency.

Further, while various forums / international meetings have discussed the establishment of a new, global currency that could be a counter to, if not a replacement for, the dollar, the nation-states that have been meeting have been unable to determine how national-level monetary policy could be coordinated to enable the creation of the new currency -- and which constraints would be placed on fiscal policy. Moreover, as Europe has found out, establishing a currency without coordinating both monetary and fiscal policy is a prescription for a policy headache, at the least.

Third, the United States, despite its large budget deficit, trade deficit, slow-growth economy and the seemingly endless partisan fight between Democrats and Republicans in Washington, the U.S. economy still, in many ways, remains the envy of the world.

Historically, the U.S.' economic system has proven to be remarkably flexible and resilient -- able to withstand losses of whole sectors and, via ingenuity and new technologies, create new engines of both GDP growth and job growth. Still, economists caution that no two recovery cycles are identical, and this cycle, and its uniqueness -- the globalization era with its lower cost structure -- will present the toughest hurdles for the nation's job creation machine since the demobilization at the end of World War II.

In other words, there are still several unknowns regarding the structure of the U.S. economy; even so, in general, institutional investors still view the U.S. as a promising place to deploy capital. That attractiveness boosts the value of dollar-denominated assets, and that obviously supports the dollar's value.

2013 Greenback Outlook

The dollar in the initial 12 years of the 21st century has taken it on the chin -- it's been experiencing its toughest period since the stagflation period of the mid/late 1970s. Further, until policy makers can find ways to increase U.S. GDP growth to at least three percent per year, the dollar will likely struggle to gain value versus the pound, yen, Swiss franc, Canadian dollar and Australian dollar.

But in the long term, the dollar's prospects remain at least as promising the world's other major currencies and better than the euro's. Institutional investors -- the big guns who determine the value of stocks, bonds and other assets -- are saying as much with their continued willingness, even amid unprecedented quantitative easing, to hold a substantial amount of dollars, despite the U.S.' worst economic and financial problems since the Great Depression.

In their view, the dollar is down, but not out.

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