For serious people to talk this way gives you some sense of the melodrama surrounding the fall of the dollar. Before World War II, banks held gold in reserve as proof of their stability. Afterward they shifted to dollars, in recognition of America’s burgeoning status as sole superpower. Following a 9 percent plunge in the dollar against the euro this year, the emerging consensus is that the bottom is a long way off. Does the fall end with the dollar’s losing its status as the world’s reserve currency or melting down like the Argentine peso, as the African banker warns? “We think not,” wrote Gartman, “but we are certain our friend is right that the central banks of the world” will shift away from a “preposterously imbalanced” bias for holding dollars above all other currencies.
This is no ordinary swing in the dollar. It’s a belated backlash against the hype of the New Economy, when foreigners buying American stocks or bonds drove up the price of the dollar to levels as inflated as the bubble itself. Now, with the United States struggling to avoid recession, foreign investors are demanding better prices, spooked by the rising U.S. deficit and attracted by higher interest rates elsewhere. Even bankers in China, key financiers of the U.S. deficit, warn that they can’t keep buying dollars fast enough to sustain America’s $1.9 billion-a-day borrowing habit.
When the U.S. Federal Reserve hinted last week that it is starting to worry about deflation (as well as inflation) for the first time, investors saw this historic shift as another reason to dump the dollar. If American prices are at risk of falling, why hold dollar assets? After the Fed’s remarks, the dollar fell a further 2 percent against the euro. Jim O’Neill, global currency strategist for Goldman Sachs, expects the dollar to sink for four to five years more: “We are nowhere near the end.”
The strong-dollar era is ending in a clash of the two most powerful legacies of the 1990s: the bubble hangover and the spread of free-market ideals. Most analysts expect a gradual but not painless collision in which markets allow a sharp correction in the dollar, which makes U.S. exports more competitive, reviving the U.S. economy and the world economy with it. Merrill Lynch currency strategist Alex Patelis points out that the U.S. economy grew from 1985 to 1987, during a period when the dollar was falling. Eventually, U.S. growth picked up the value of the dollar, too. “People will always buy [dollars] at a price,” says Patelis. “Left to its own devices, the market will clear the problem away.”
Even though Treasury Secretary John Snow officially reaffirmed Washington’s strong-dollar policy last week, market watchers are skeptical because the United States has much to –gain from a weak dollar. It would raise the price of imports and entice Americans to Buy American–effectively importing a welcome bit of inflation but also exporting deflation, with all its crippling effects (following story).
But there are a few snags in the gradual-correction scenario. The U.S., European and Japanese economies are all sluggish, and could all use a cheaper currency to boost exports–but they can’t all devalue at once. And governments may intervene to protect domestic markets against cheaper U.S. goods on the ground that America is trying to beggar its neighbors. One reason the dollar made headlines last week is that many European companies announcing first-quarter earnings, including Bertelsmann publishing and Volkswagen, blamed weak sales on the weak dollar. “The next few weeks are going to be critical,” warned a London money manager last week, requesting anonymity. “America’s interests are in conflict with the rest of the world. Watch for further falls in the dollar, followed by new calls for protection and trade friction. And wear a seat belt.”
That was Tuesday. On Wednesday the European Union warned the United States to end a special tax subsidy for exporters or face $4 billion in European sanctions. On Friday Washington responded by leaking plans to file a World Trade Organization complaint against the EU ban on genetically modified foods. The battle begins?
The meltdown scenario is gaining followers. Bernard Connolly, strategist for AIG Trading Group, thinks the dollar must fall an additional 25 percent before it begins to help the U.S. economy–an impossible target at a time when most of the world is too weak to grow without exporting to the United States. The rest of the world, Euro-zone countries in particular, will use all means necessary to protect their economies from an aggressively cheap dollar, warns Connolly. “We can’t square the circle at the world level,” he says. “I think we’re in deep trouble.”
It’s still unclear how the new dollar politics will play out. Just about everyone agrees that in the long run, the dollar is a better buy than other currencies. The United States still has higher economic growth potential (about 3 percent) than Europe (2 percent) or Japan (1 percent), and that would normally be enough to protect its reserve-currency status were the postbubble world not so out of whack. As it is, notes Gartman, nations that now trade heavily with Europe, but still hold few euros in reserve, are likely to move quietly to correct that imbalance over time. That means selling dollars to buy euros–and the end of cheap loans and easy money in America. Dollar holders, beware.
