A comment in the Financial Times, “The world’s currency could be a US problem,” by Krishna Guha, does a good job of setting forth various scenarios for the dollar’s future course, and discusses the implications for the US and other economies.
The piece give a nice summary of the background of the problem, and concludes that the only scenario that will cause trouble for the US (as opposed to everyone else) is a disorderly fall in the dollar, accompanied by an increase in the risk premium the world demands to hold dollar denominated assets.
He also acknowledges the notion that our friendly neighbors are already becoming less keen about our currency. That could worsen simply due a further decline, independent of its velocity Even vendors in the Maldives are turning up their noses at greenbacks.
From the Financial Times:
Whose problem is it anyway? As the dollar sank to new lows this week, a growing number of people began to question how long the US can remain relaxed about its weak currency.
The US has a long (if not unbroken) tradition of indifference to dollar weakness, dating back to John Connally, the Nixon-era Treasury secretary, who famously told a group of visiting Europeans that the dollar was “our currency, but your problem”. The official line today is that the US has a “strong dollar” policy. But it does not appear to mean much beyond support for a market-determined exchange rate….
However, the weak dollar may not be as trouble-free for the US in the future as it has been in the past. The decline in the dollar has become so marked and so sustained that there is an increased risk of imported inflation. This is augmented by the fact that energy and commodity prices are being pushed up in dollar terms by strong demand in Asia.
This week, Nicolas Sarkozy, the French president, warned Congress: “The dollar cannot remain someone else’s problem. If we are not careful, monetary disarray could morph into economic war. We would all be victims.”
The dollar decline is fuelling economic and trade tensions. At the same time, it adds to the risk of inflation and asset price bubbles in fast-growing emerging markets, such as China, that tie their currencies to the dollar. In short, it crystalises the structural problems in a world economy in which some major trading powers have fixed exchange rates while others have floating rates.
David Woo at Barclays Capital says the dollar has lost its safe haven status as the credit crisis has progressed. Some commentators even say the market is behaving as if the dollar has lost its status as the world’s reserve currency. Currencies do not lose their reserve status overnight. But global confidence is clearly rattled.
One of three things might happen.
The dollar could stabilise. The Fed thinks investors may have already priced in the decline needed to moderate the US deficit. If it does stabilise, it will remain largely a problem for foreigners.
The dollar could continue to decline, but in an orderly manner, with no increase in the risk premiums foreign investors demand to hold US assets. If so, it will also remain largely a problem for people outside the US.
Or the dollar could continue to decline in an increasingly disorderly fashion, accompanied by rising risk premiums on US assets. If so, it will become a big problem for the US. This should not be ruled out. The risk of a US recession has increased following the credit squeeze, reducing the attractiveness of US assets.
Meanwhile, the likelihood has increased that one or more of the nations that tie their currencies to the dollar could break the peg, reducing a source of demand for dollars. Moreover, the spectacle of US banks struggling to figure out how much they have lost on credit products has shaken confidence in US markets.
The latest decline in the dollar has been accompanied by a falling stock market and rising credit spreads. This could be a coincidence – US long-term bond yields remain low. But it could be a sign that foreigners are starting to demand higher returns on dollar assets. In a worst-case scenario, fears about the dollar could lead to a scramble for the exit. The Fed would come under pressure to raise interest rates to prop up a collapsing dollar and offset its inflationary impulse – at a moment when the economy might desperately need rate cuts. Such an extreme outcome is still unlikely. But even if this episode ends happily for the US, there are lessons to be learnt.
First, as monetary policy works increasingly through exchange rates, central banks will be exposed to international political controversy.
Second, the large US current account deficit complicates the Fed’s efforts to deal aggressively with risks to growth, because a deficit economy is always potentially vulnerable to a loss of global investor confidence.
Third, there are circumstances in which the Fed might not be able to rescue the economy and US financial markets. For investors accustomed to believing the Fed is all-powerful, this is a sobering thought.