It seems that in order to qualify for the job, U.S. Treasury Secretaries must be able to recite 'A strong dollar is in the interest of the United States' anytime and anywhere. Robert Rubin, Treasury Secretary during the second half of the 1990s, was highly credible when he said it. However, when Secretary John Snow uttered the same words, the ritual had been diluted to providing the appropriate sound bite to the media. Hank Paulson, successor to Snow and current Treasury Secretary, is a straight talker, but knows that his job comes with what amounts to a marketing responsibility. In the meantime, investors are at a loss what the U.S. policy towards a dollar truly is; there seems to be a disconnect between what ought to be in U.S. interest, and what current policies promote.
Abby Joseph Cohen, chief investment strategist at Goldman Sachs, who may be best known for her perpetual appetite at increasing price targets for U.S. markets, called the weak U.S. dollar the "icing on the cake"; she was referring to the potential positive effect on stock valuations given that foreign earnings translate into higher earnings for U.S. companies conducting business abroad.
Congress would like to pressure the Chinese to allow their currency to appreciate, i.e. to weaken the U.S. dollar versus the Chinese yuan. If the Chinese were to oblige, it would almost certainly increase the cost of goods we import from China; and because the Chinese recycle a lot of their dollar holdings into U.S. Treasuries, any move on behalf of the Chinese to reduce their dollar holdings would put upward pressure on U.S. interest rates (because of the inverse relationship between bond prices and interest rates).
Breaking with longstanding tradition of leaving all discussions pertaining to the dollar up to the Treasury Department, Federal Reserve ("Fed") Chairman Bernanke has not shied away from commenting on the impact the dollar has on the economy. Bernanke, who considers himself a student of the Great Depression, says, "to understand the Great Depression is the Holy Grail of macroeconomics." He laments in his analysis of the Great Depression that keeping up the value of the dollar (by preserving the gold standard) increased the hardship on the people.
But the Treasury secretaries are correct: a strong dollar is in the interest of the U.S. For starters, we live in a global world, and a weaker dollar makes America less competitive. We may be able to sell a gadget cheaper that is produced in the U.S. (because it costs less when purchased in euro or yuan); but there is little left that is produced in the U.S. Also, a weaker dollar won't rebuild industries that have been lost to Asia. Sure, profits generated abroad through services provided abroad translate to higher dollar earnings, but the positive impact may be limited to a quarterly earnings release. Just as dollar cash is less competitive when it is devalued, so is a stock price when measured in a weak currency. Foreign companies can use both their stronger currency as well as their stock prices valued in hard currencies to acquire U.S. assets and enterprises.
As the dollar weakens, our purchasing power erodes. Look at the price you pay at the gas pump if you believe a weak dollar does not impact you. The oil cartel OPEC has made it clear that their price target for oil floats upward as the dollar weakens.
American consumers are not irrational; they react to monetary and fiscal policies. When interest rates are excessively low, and tax policy is geared at encouraging consumers spending, consumers spend until they drop. A weak dollar further discourages savings, as those savings erode in value. But given our current account deficit, we urgently need policies in place to encourage more savings and investments to reduce the pressure on the dollar (for more detail, please read 'The Current Account Deficit Matters').
A strong currency is also a matter of national security. Politicians are complaining that foreigners hold too much of U.S. debt. Paulson has rightfully said that by all means, we should try to maximize the demand for U.S. debt to minimize the interest rate we have to pay; this includes allowing foreigners to buy the debt. The solution, of course, would be curtail the supply of debt. In plain English: cut your spending, or foreigners will dictate in due course what you may spend your money on (that would be interest payments to them).
A weak currency is inflationary. Wall Street analysts focus on "core inflation" excluding food and energy; most have forgotten that the reason food and energy prices have traditionally been ignored is because of their volatility. But these prices have been moving upward for years now, with U.S. energy secretary Bodman already forecasting high gasoline prices for next year. Given the new love affair politicians have with ethanol, food based on corn is bound to be increasingly expensive; so far, we have only heard of the Mexican tortilla crisis, where Mexican consumers are complaining that their corn based tortillas are no longer affordable; but U.S. food prices are also affected as corn (and notably corn syrup) is in countless food items.
Globalization and the internet have held back, but not eliminated inflation. Items we don't need - mostly those we import from Asia -, have experienced tame inflation (mostly due to Asian overproduction, partially a result of their weak currencies). But just about everything we do need, from the cost of healthcare to the cost of education and local craftsmen has experienced significant inflation.
Preserving purchasing power should be in the interest of every policy maker, and in particular be in the interest of the Federal Reserve. But policy makers allow eroding purchasing power to act as a substitute to finding solutions on how to pay for obligations ranging from government debt to social security. Once a country is hooked on growth through inflation, it is difficult to change bad habits. Italy is still struggling to cope with the rigidity of the euro after decades of inflationary policies.
The Fed has allowed an unprecedented credit expansion to take place. Bernanke seems to believe there is no need to impose tighter credit to fight excesses that have been building up in the economy. However, if one allows a credit bubble to take place, one must also be willing to allow a severe recession or depression to take place to rid the economy of excesses that have been built up. Those who are most concerned about the dollar do not believe the Fed will allow such a correction to take its full course; there is already talk of a Fed interest rate cut in a few months. In our assessment, the Fed is rather concerned that a credit contraction combined with high levels of consumer debt could create a Japanese style deflationary spiral; to avoid having to deal with deflation, the Fed rather induce inflation.
The Fed can tighten money supply. The Fed can make money available. But Fed has very limited tools to encourage people (or businesses) to actually borrow money. As consumers have overextended themselves, they may be reluctant to take on more debt. Aside from lowering interest rates, one of the few tools the Fed has to encourage credit expansion is to apply a tax on savings through inflation. This, of course, is in direct violation of its mandate to pursue price stability.
Investors interested in taking some chips off the table to prepare for potential turbulence in the financial markets may want to evaluate whether gold or a basket of hard currencies are suitable ways to add diversification to their portfolios. We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.
