The diminishing dollar
Oct 22nd 2009
From The Economist print edition
Why it’s unlikely to turn into a dangerous collapse
ONE of the few calamities that has not befallen the world economy during the past two years is a dollar crash. During the bubble era that preceded it, many (including The Economist) fretted that foreigners, tiring of America’s gaping external deficits, would send the greenback slumping and interest rates soaring. In fact, the opposite occurred. The crisis began within America, and the deeper it became, the more the dollar strengthened as fearful investors sought safety in Treasury bills. Between September 2008 (when Lehman Brothers failed) and March 2009 (when America’s stockmarkets hit bottom), the dollar rose by almost 13% on a trade-weighted basis.
That history is worth bearing in mind when assessing the latest bout of fretfulness about the dollar’s future. For the past six months the greenback has been sinking steadily, hitting a 14-month low against a basket of leading currencies and $1.50 to the euro this week. The slide has unnerved policymakers in economies whose currencies are rising (see article), notably Brazil, where a 2% tax on foreign capital inflows has been imposed. Coupled with the extraordinary looseness of American policy, the weak dollar has also revived fears of a currency crash. With the budget deficit in double digits and the Federal Reserve’s balance-sheet swollen, dollar bears are once again forecasting that the slide could become a rout and spell the end of America’s status as the world’s reserve currency.
This dollar declinism is overblown. It exaggerates the scale of the slide and misunderstands its cause. Much of the recent weakness simply reverses the earlier safe-haven flight to dollars, a sign of investors’ optimism about riskier assets rather than their fears about America’s currency. On a trade-weighted basis the dollar today is close to where it was before Lehman failed. Yields on Treasuries have not risen and spreads on riskier dollar assets continue to shrink. If investors were growing leerier of dollars, the opposite should have occurred.
Furthermore, a weaker dollar is what you would expect, given the relative cyclical weakness of America’s economy. Thanks to the hangover from its financial crisis, America’s recovery will be slower than that of other economies, especially emerging ones. That suggests America’s monetary policy will stay looser for longer, pushing the dollar down. A weaker dollar should also assist global economic rebalancing by helping to reorient America’s economy towards exports. So in general, it should help rather than hinder the global recovery.
That does not mean the worriers’ fears are baseless. Three dangers remain. First, the dollar’s decline is distorted. The world’s most buoyant big economy, China, has kept its currency tied firmly to the greenback. This is stymieing the adjustment of China’s economy, fuelling dangerous domestic asset bubbles and placing an unnecessary burden on other, more flexible currencies. Second, America’s fiscal and monetary policies are unsustainable. The public-debt burden is set to double and, on today’s policies, will still be rising in a decade’s time. Third, the financial crisis has accelerated the relative shift of economic heft away from America—which will hasten the eventual erosion of the dollar’s dominance.
Even so, this is unlikely to provoke a sudden crisis. Although America’s fiscal mess will last for years, it is not acute (see article). Inflation will not soar suddenly. With neither the euro nor the yuan yet ready to usurp it, the dollar will not quickly lose its reserve-currency status. The lesson of the past year is that it is still a currency to flee to, not from. None of this absolves American policymakers from hard choices. But a dangerous collapse in the greenback is unlikely.