“The Dollar – Don’t They Care?”

Sydney M. Williams

Thought of the Day

“The Dollar – Don’t They Care?”

February 15, 2012

While I have worked in the financial industry for forty-five years, when it comes to currency markets I feel like a novice. My simplistic approach has been to use common sense, which tells me we are on a dangerous, downward path that is accelerating. In general, my attitude has been governed by two beliefs: 1) A strong currency is better than a weak one; its strength should be encouraged, and 2) Buying currencies in which one has no obligations is speculating.

Nevertheless, the long term loss in value of the dollar has affected all Americans. And, since the dollar functions as the world’s reserve currency, a declining dollar affects the entire world. Against a basket of currencies, the dollar has fallen by 20% in the thirty-nine years since the Dollar Index was created in 1973. During those same years, inflation, the silent and insidious tax, has caused an 80% decline in the purchasing power of the dollar. “For forty-seven years,” Warren Buffett wrote on February 9th in a piece entitled, Why Stocks Beat Gold and Bonds, “the implicit inflation ‘tax’ was more than triple the explicit income tax.” It is the over-abundance of a commodity that keeps prices low; as long as supply exceeds demand, prices will stay cheap. And money has been in abundant supply and cheap for most of the past decade, especially since mid January 2009 when the Federal Reserve pushed Fed Funds Rate to a range of 0.00%-0.25%.

Three and a half years ago we were in the midst of the worst financial crisis in the postwar years. The TED spread in early October, 2008 had widened to about 480 basis points, from a more normal 25 basis points. Fed Funds, at the time, were 2%. Reacting rather than anticipating, the Fed lowered the Funds Rate to 0.25% in December after the TED spread had already narrowed to less than half of what it had been in October. In January 2009, with the TED spread about 100, the Funds Rate was lowered to a range of 0.00% to 0.25% where it remains to this day. (By September 2009, though, the TED spread was 16 basis points, lower than it had been at the end of 2006.) And, if Mr. Bernanke is to be believed, Fed Funds will remain at this level until early 2014.

Additionally, three rounds of quantitative easing have kept the short end of the Treasury curve low. Through Operation Twist the Fed has bought anywhere from 58% to 91% of all gross issuance of Treasury bonds dated six years or longer, since its announcement last September, according to Chris Martenson, author of The Crash Course. A cheap commodity is a boon to those who use it as a raw material. The dollar is cheap. For bankers and speculators, money is their raw material. Before the crisis it helped banks facilitate reckless lending to marginal home buyers in the U.S. and peripheral sovereign nations in Europe. There is little doubt that banks needed saving three and a half years ago, and granted there is interconnectedness among banks. Also, banks did not act in a vacuum; they were encouraged by politicians, while serving consumers with little sense of personal responsibility. But aren’t we now favoring some of those who helped precipitate the problem? Their thanks to voters is to get exercised over the Volcker rule. It’s hard to feel much sympathy for them.

Despite the fact that the dollar has declined over many years, consumers have been protected from its more negative effects, due to imports from newly industrialized, emerging nations operating with cheap labor. Inexpensive imported soft goods, electronic products and appliances have acted as governors on inflation, allowing consumers to continue the binge that began in the aftermath of World War II. A thirty-year decline in interest rates has only encouraged the embracement of consumption over savings, and made consumers, until very recently, fearless of debt.

Iran, with the third largest oil reserves in the world, is getting into the act of dollar bashing. According to London’s The Telegraph, the Iranian oil bourse will start trading oil in currencies other than the dollar beginning on March 20th. It presents an interesting challenge, not only to the U.S., but to a Europe that imports 500,000 barrels a day from Iran, imports that are scheduled to end on July 1st, when the trading ban with Iran is expected to go into effect. Iran is now aggressively looking toward Asia as a market for their oil. Europe may have to look to its nemesis – Russia.

Things are changing. The golden age for American consumers is coming to an end, if it has not already done so. A continuing weak dollar coupled with higher prices for imported goods will raise costs for consumers, at a time when unemployment remains high and pressure on wages creates the potential for a period of stagflation. With baby boomers reaching retirement age at the rate of 10,000 a day, and with retirement coffers relatively slim, the government is going to have to encourage saving and investment if they don’t want poverty to spread. Interest rates that benefit the prodigal at the expense of the prudent will only make more expensive the cost of retirement. A dollar that buys less each year works against those nearing, or in, retirement. Making more complex an already too-complex tax code, coupled with higher taxes on capital gains and dividends for average Americans are exactly the wrong prescriptions.

There are those who worry that the United States is headed toward a period of Japanese-style deflation. But there are significant differences between the countries. We are a pluralistic society whose population continues to expand. We are aging, but a lower rate than any other nation in the developed world and substantially slower than Japan. Federal debt in Japan is high, but most of it is owned by their people. And, over the past twenty years, in spite of stagnant growth and a stock market that remains more than 50% below where it was twenty years ago, their currency has rallied 40% against the dollar.

The fundamental cause of the dollar’s weakness is the rapid growth in the nation’s debt. When an individual or business sees their debt expand faster than their income, they know they are headed for trouble, as millions learned to their dismay during the housing collapse and as sovereign states in Europe are learning today. The same arithmetic applies to our federal government, the difference being that Washington has access to printing presses, while counterfeiting by individuals is a crime.

Beginning in the 1970s, federal debt began increasing at a rate faster than growth in GDP. In 1970, GDP was about $1.040 trillion and federal debt was about $375 billion. Today the respective numbers are about $14.9 trillion and $15.2 trillion. During the past four years, the nation’s income has grown at 1.1%, while our federal debt has expanded 59%. If this trend does not reverse itself – if GDP growth does not begin to expand at a rate faster than the growth in debt – we are doomed to a fate like that now infecting Greece.