The dollar has had its ups and downs, but the downs have clearly dominated of late. The greenback has lost more than a quarter of its value against other currencies, adjusted for inflation, over the last decade. It is down by nearly 5% since the beginning of 2011, matching the lowest level plumbed since the Bretton Woods system of pegged exchange rates collapsed in 1973.
An obvious explanation for this weakness is the US Federal Reserve’s near-zero interest rate policy, which encourages investors to shift from dollars to higher-yielding foreign assets. Predictably, the Fed’s critics are up in arms. The central bank, they complain, is debasing the dollar. It is eroding the currency’s purchasing power and, with it, Americans’ living standards.
Even worse, the Fed is playing with fire. Its failure to defend the dollar, the critics warn, could ignite a crisis of confidence. At some point, the Fed’s tolerance of a weak dollar would be taken as a lack of commitment to price stability. Frustrated investors would then dump their US treasury securities. Bond yields would shoot up. The dollar would plummet. There would be financial distress and a deep recession.
Scary stories sell newspapers, but in truth all of this sniping at the Fed is overdone. Historically, a 10% fall in the dollar translates into only a 1 percentage point rise in inflation. This means that the dollar’s 5% fall so far this year will add only half a percentage point to the inflation rate.
And it is not as if US inflation were out of control. Food and fuel prices may be up, but labour costs remain firmly anchored—not surprisingly, given the country’s 9% unemployment rate. In this environment, the Fed can well afford to maintain its stance of benign neglect towards the dollar.
While Fed chairman Ben Bernanke paid obeisance at his recent press conference to the talisman of a “strong dollar”, the Fed is probably quite happy to see the greenback trending down. With domestic demand still weak, more export demand is just what the doctor ordered for an anaemic economy. And a weaker dollar is one way of delivering foreign markets.
Moreover, those who warn that the Fed might fail to raise interest rates if inflation picks up don’t understand that the Fed’s culture of inflation targeting is deeply ingrained. Indeed, the very fact that the Fed is under such intense political scrutiny makes it all but certain that it will take the first opportunity to re-establish its price-stability bona fides.
If there is a threat to the dollar, it stems not from monetary policy, but from the fiscal side. What is most likely to precipitate a dollar crash is evidence that US budgets are not being made by responsible adults. A US Congress engaged in political grandstanding might fail to raise the debt ceiling, triggering a technical default. Evidence that the inmates were running the asylum would almost certainly precipitate the wholesale liquidation of US treasury bonds by foreign investors.
And even if this immediate hurdle is overcome, the US will still have only limited time to get its fiscal house in order. Financial crises almost always occur around the time of elections. The US has a big one coming at the end of 2012.
Some critics object that a collapse of US treasurys and a dollar crash are not the same. The dollar, they observe, is the funding currency for banks around the world. When banks borrow on the wholesale money market to finance their investments, they borrow in dollars. Thus, when volatility spikes and liquidity dries up, those same banks scramble for dollars. Indeed, even when problems originate in the US, the dollar strengthens. We saw this in the summer of 2007, when the subprime crisis erupted, and again in 2008, following the collapse of Lehman Brothers.
In the short run, then, a US treasury market crisis might lead to some knee-jerk appreciation of the dollar. But with evidence of deep problems in US financial markets, global banks would start looking for other ways to finance themselves. The period of dollar strength would be brief.
The result would be the Fed’s worst nightmare. With treasury yields spiking and economic activity collapsing, the Fed would want to cut interest rates and flood the markets with liquidity. But a sharply lower dollar would, at the same time, mean sharply higher inflation, requiring it to tighten policy. Caught on the horns of this dilemma, the Fed could do nothing to solve the US’ problems.
Bernanke regularly warns of the dire consequences of not facing the country’s fiscal problems head-on. Congress, indeed everyone in the US, should take him seriously.
Barry Eichengreen is professor of economics and political science at the University of California Berkeley, and the author of Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System
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