The Almighty Dollar

By Charles Webb

A weak currency is the sign of a weak economy, and a weak economy leads to a weak nation - Ross Perot

In April, we wrote an article about this county’s exploding Federal debt problem. This month we’d like to expand on that topic by looking at a closely related subject -the dollar’s steep decline and its implications.

The quality of a country’s debt is directly linked to the value of its currency. The reason for this has to do with a specific type of risk associated with sovereign debt.

There are basically two types of risk when investing in foreign sovereign debt. The first and most obvious risk is credit risk, or the risk of outright default. That is to say that the country simply can’t make the interest payments and can’t repay the debt at maturity. Since most countries can print their own currency, the risk of outright default is very unlikely. The exception to this is if the country is part of an economic union such as the Euro and thus can’t print money at will – i.e. Greece, Spain, Ireland, etc.

The second type of risk associated with foreign debt is currency risk. This is the risk of a decline in the value of the currency of which the debt and payments are being made. It is possible for an investor to lose money on a foreign bond if its currency declines at a rate higher than the bond’s coupon. For example, if a bond pays 4% per year but the underlying currency depreciates at 5%, an investor would cumulatively lose around 11% over ten years. That’s not exactly a risk-free investment and is one of the reasons the international community is so concerned about the persistent decline in the value of the U.S. dollar.

So what causes the value of a currency to decline? There are many factors that lead to changes in the value of one currency relative to another. The biggest one, though, is greatly expanding the supply of that currency.

As we mentioned in the last article, in this electronic age, the money supply isn’t grown by the printing press but done so via the central bank’s open market operations. The current phrase for this is “quantitative easing”. The Fed does this by purchasing bonds (usually their own – i.e. treasuries) in the open market and paying for them by crediting the seller’s bank account.

Since the housing bust and the ensuing banking crisis, the Federal Reserve has attempted to support the economy by pumping billions of dollars into the banking system. These activities are in addition to the government’s fiscal activities or stimulus spending and have greatly expanded the money supply.

The flood of new dollars has created a kind of soft default on our debt that is calling into question the soundness of our Treasury bonds and their AAA rating. Foreign investors have become very concerned about what they perceive as an unstated weak currency policy which is leading to real losses on the trillions of dollars of treasury debt held by foreigners.

So why does this matter to us? After all we’re not taking the losses, it’s the other guy. Quite simply those are our creditors and we depend on their appetite for our bonds to fund our government’s spending binge. At some point, our creditors will lose faith in the soundness of the dollar and demand higher rates on our bonds to compensate for the currency losses. Those higher rates will affect everything from mortgage rates to business loans, not to mention how it will exacerbate the deficit.

A Breif History of the Dollar

Since 1945, most of the world has been on a dollar standard. Today, for emerging markets outside of Europe, the dollar is used for invoicing both exports and imports, it is the intermediary currency used by banks for clearing international payments, and the intervention currency used by governments. To avoid conflict in targeting exchange rates, the rule of the game is that the U.S. remains passive without an exchange-rate objective of its own.

After World War II, the Bretton Woods agreement put the dollar at the center of foreign trade by requiring the U.S. to exchange gold for dollars at the request of trading partner governments. Other countries would hold dollars in reserve to underpin their own currencies. The gold standard imposed discipline on the U.S. and gave everyone else a stable and liquid reserve currency.

The plan worked well until the 1960’s, when U.S. deficits led to a meaningful increase in the money supply. Wary trading partners then began to exchange dollars for gold until 1971 when the U.S. closed the gold window, refusing to trade gold for dollars.

Instead of switching to another reserve currency, the global economy kept on buying dollars. At that point, it was as if the U.S. was given a virtually unlimited line of credit from the rest of the world.

Americans proceeded to borrow more and more in the ensuing years. This addiction to debt crept into every level of society - from federal and state governments, to consumers and businesses. From 1970 to 2009, total debt in this country rose from 170 percent to 350 percent of GDP.

The Dollar Today

So why are foreigners still willing to loan us money? Quite simply, we’re the only game in town. Countries that run large trade surpluses with the U.S. find themselves with ever-growing balances of dollars on their hands. They have to do something with this cash and they find themselves with little alternative but buy U.S. treasuries with those dollars.

The lack of alternatives is the key. If there was an alternative, you would see an immediate drop in the number of investors lining up at the treasury auctions. With fewer interested buyers, rates would be bid up, leading to higher interest rates throughout the economy.

These higher rates would devastate consumer spending, the real estate market and business growth. In addition, the percent of tax receipts required to service $8 trillion of debt rolling over at these higher rates could easily double. This would create a death spiral of higher deficits leading to higher borrowings and yet higher rates and so on.

This is why it’s so important for the federal government to get its fiscal house in order. The United States has benefited greatly in many ways due to its standing in the financial community. The threat posed by our massive deficits that seem to have no end could permanently reduce our standard of living.

The key to maintaining our global prominence rests on the dollar’s reserve status. Because of the uncertainty of our monetary policy, long-term, the rest of the world is actively looking for an alternative. Fortunately for us there isn’t one. At one time it was hoped that the Euro would be become an alternative. Europe’s own debt crisis has dashed any hopes of that and has bought us more time to fix things here. Let’s hope Washington can get their act together in the meantime.