How long can the U.S. dollar defy gravity?
NEW YORK/WASHINGTON (Reuters) - The only time the U.S. dollar ever took a serious shellacking in the marketplace, the wounds were almost entirely self-inflicted.
Facing mounting inflation and the escalating cost of the Vietnam War, President Richard Nixon, on August 15, 1971, took the United States off the gold standard, which had been in place since 1944 and required that the Federal Reserve back all dollars in circulation with gold.
The move amounted to a made-in-America double-digit devaluation, shocking the country's foreign creditors.
Deep inside the New York Federal Reserve Bank's fortress in lower Manhattan, Scott Pardee, then 34, was fielding frantic calls from central bankers around the world. They were demanding the United States cover the foreign exchange risk on their reserves.
"The whole roof came in on us," recalled Pardee, a former New York Fed staffer who is now an economics professor at Vermont's Middlebury College. "That is the kind of situation the U.S. doesn't want to be in."
Nearly 40 years later, the dollar still dominates world trade. At the height of the financial crisis in 2008, investors fled to the dollar as a temporary safe haven. But the dollar has been falling steadily since 2002, and as the world economy recovered last year, dollar selling resumed, reviving doubts about how long it could remain the world's unrivaled reserve currency.
The Greek debt crisis, which has sent investors stampeding back into the U.S. currency, has provided a reprieve. The dollar has gained some 10 percent against the euro since December. And following the Fed's decision last week to hike the discount rate it charges banks for emergency loans, the dollar rose even higher as some investors bet it would benefit from the eventual end to the Fed's post-crisis regime of easy money.
But a number of economists, investors and officials here and abroad interviewed for this story say the longer-term prognosis is far from rosy.
As the United States racks up staggering deficits and the center of economic activity shifts to fast-growing countries such as China and Brazil, these sources fear the United States faces the risk of another devaluation of the dollar. This time in slow motion -- but perhaps not as slow as some might think. If the world loses confidence in U.S. policies, "there'd be hell to pay for the dollar," Pardee said. "Sooner or later, the U.S. is going to have to pay attention to the dollar."
French President Nicolas Sarkozy isn't on anybody's short list for the Nobel Prize in economics. But at January's World Economic Forum in Davos Sarkozy proposed, to scattered applause, creating a new version of the Bretton Woods currency accord, which set up the very gold standard that Nixon brought crashing down.
Most economists doubt a return to the gold standard is feasible in today's interconnected world, with so much capital crossing borders at the click of a mouse.
Yet, as Gian Maria Milesi-Ferretti, a foreign exchange expert at the International Monetary Fund in Washington, put it: "Post-crisis, a lot more things are on the table. It is true among policymakers and in the markets that people are much more willing to look at unconventional proposals and even some proposals that may seem antiquated."
Some argue the dollar's recent rally against the euro and yen (it's up almost 6 percent against the Japanese currency since December) is less a vote of confidence than a realization that it's simply the best of a bad bunch.
Per Rasmussen, a retired currency trader who worked at Chase in the late 1970s in London, called it a "reverse beauty pageant" in which investors pick the "least ugly" contestant. Since rising above $1.50 in November, the euro has tumbled more than 10 percent and was last changing hands around $1.3550, near a nine-month low.
The currency has been battered by doubts about whether Greece and other wobbly euro zone economies can manage the spending cuts needed to rein in out-sized budget deficits. The worries have weakened confidence in the whole concept of European monetary union.
Thomas Kressin, who helps manage PIMCO's $100 million GIS FX strategy fund, said the euro is in danger of entering into an extended downtrend that takes it as low as $1.22 -- which he described as fair value -- over the next three to five years.
But the euro's lurch lower has done nothing to change traders like Axel Merk's dim view of the dollar's future.
Based in Palo Alto, California, Merk has been trading for 16 years and is currently president and portfolio manager of Merk Investments, the biggest mutual fund manager dealing exclusively with currencies.
He acknowledges he has had to scramble in his short-term funds to avoid being on the wrong side of the euro's nosedive. But over the next decade and beyond, Merk said the dollar has nowhere to go but down.
Investors will balk at "reckless U.S. fiscal and monetary policies" and start looking for alternatives to the U.S. currency, he said.
Others might take refuge in commodities. A recent U.S. Securities and Exchange Commission filing showed billionaire investor George Soros' New York-based firm more than doubled its bet on the price of gold during the fourth quarter.
Merk, whose $550 million Hard Currency Fund is designed to profit from a steady dollar decline, said he believes Washington is banking on a gradual dollar devaluation to shrink its monstrous debt and fuel an export boom to propel the economy.
"Now I am convinced that (U.S. authorities) consider a weaker dollar the solution to many of their problems. But you can't turn your policies upside down and expect the rest of the world to put up with it forever."
That view is at odds with the official line from U.S. policymakers. They insist that "a strong dollar is in the U.S. interest," a phrase repeated so often by former Treasury Secretary Robert Rubin in the 1990s it became his mantra. The person in the job today, Timothy Geithner, has made this mantra his own. Treasury officials, who routinely defer to the Treasury chief as the only authorized spokesman for dollar policy, declined to provide comments for this story.
SHARING THE SPOTLIGHT
What's clear is that America's debt-holders aren't the passive, pliant bunch they used to be. Some of the biggest holders of U.S. dollar assets are also among the fastest growing economies and they are hardly bashful about criticizing U.S. policies, particularly now that the financial crisis has eroded America's influence and its reputation for sound economic management.
China alone holds $2.3 trillion in foreign exchange reserves, with nearly $800 billion in U.S. Treasury debt. And at a press conference last year, Premier Wen Jiabao did not mince words: "We have lent a massive amount of capital to the United States and of course we are concerned about security of our assets. To speak truthfully, I do indeed have worries."
Terrence Checki, who has acted as the Federal Reserve Bank of New York's chief international trouble-shooter for two decades, warns that the U.S. cannot afford to ignore such concerns.
"We are no longer alone as the central axis for the global economy," he told a gathering of influential bankers and policy-makers during a Foreign Policy Association dinner at New York's St Regis hotel in December. That, he added, implies "recognizing that our leverage will not be what it once was. We also need to be attentive to the messages we receive, such as rumblings about the dollar and our policies and priorities, even when we disagree with them."
History suggests that a currency is supplanted the same way Ernest Hemingway said a man goes broke: gradually, then suddenly. In terms of economic might, the United States surpassed Britain in the late 19th century. But it took another 60 years and two world wars to strip sterling of its reserve status.
Even so, some worry time is not on the United States' side. Emerging markets already account for roughly half of global output and that share is rapidly increasing. In 2003, Goldman Sachs said the size of China's economy would surpass that of the United States by 2041. Five years later, it revised the forecast to 2027. China is expected to surpass Japan as the world's second largest economy this year.
All of which would be fine were it not for the fact that the United States continues to live beyond its means. The recent spike in borrowing and spending following the financial crisis is creating a debt burden that, in the word of Moody's Investors Service, is trending "clearly, continuously upward."
THE KINDNESS OF STRANGERS
For the last 60 years, reserve currency status has conferred upon the United States what former French President Valery Giscard d'Estaing, during his time as finance minister, called "the exorbitant privilege."
Because the dollar is in high demand, U.S. borrowing costs remain low. That makes it easier for the government to fund domestic priorities and military commitments and the average citizen to buy a home or start a business.
It also means the United States need not borrow or repay debts in foreign currencies, making the value of its currency a less urgent concern than it would be for other borrowers who borrow and pay for imports with dollars.
But such easy access to capital has led to huge deficits. With Americans spending more than they save, the money to finance the shortfalls has to come from abroad.
"We are plainly overextended in our budgetary terms and in our dependence on foreign capital; we resort to the kindness of strangers to meet our deficits," said former Federal Reserve Chairman Paul Volcker at an Economic Club of New York speech last month. Volcker is now head of President Barack Obama's Economic Recovery Advisory Board.
That kindness probably has a limit.
China and Russia have both talked publicly about long-term alternatives to the dollar. Some central banks, including Russia's, have said they intend to hold a greater amount of their foreign exchange reserves in other currencies.
Chinese central bank governor Zhou Xiaochuan also made waves last year when he said the dollar should one day be replaced, perhaps by a "super-sovereign" reserve currency based on Special Drawing Rights, the IMF's in-house unit of account.
Economists have interpreted the comments as an attempt to give the yuan, China's currency, a more prominent role in global finance, in keeping with the nation's growing clout on the world stage.
Of course, that won't happen overnight.
"There might be some progress toward multi-polarization of the international monetary regime, but there will be no immediate change to the dollar's role as the main international currency," said Zhang Zhigang, chief economist with the China Center for International Economics Exchanges.
But over the last year, China has voted with its pocketbook. It quietly struck currency swap accords worth some 650 billion yuan ($95 billion) with central banks in Asia, Latin America and Eastern Europe that allow importers to pay for Chinese goods in yuan instead of dollars.
That could set the stage for greater use of the yuan for offshore financial and investment purposes. And that is a precondition if the currency is to achieve greater international status.
For now, however, central bank reserve managers have few options beyond the dollar. No country is close to outranking the United States -- economically, militarily or politically. The euro, which many see as the dollar's most immediate rival, is tied to an economic area with no common political or fiscal policy. That's part of what makes solving Greece's debt woes so difficult.
It also lacks a common bond market. Veteran Brown Brothers Harriman currency strategist Marc Chandler likens Europe's sovereign bond markets to those for U.S. municipal debt -- lots of issuers of varying size and credit quality, but none that on its own can rival the deep, liquid U.S. Treasury market.
The U.S. Treasury, in an addendum to its October 2009 currency report, cited the disparate sovereign debt markets as the key reason the euro doesn't take an equal share of global reserves, even though the eurozone approximates the United States in economic power.
But other rivals will likely continue to gain strength. Ten years ago, China "was hardly even on the radar screen" in Washington, said Jeffrey Garten, a professor at the Yale School of Management and a former undersecretary of commerce during the Clinton administration.
"So people who say their currency is nowhere near an international currency and that it's going take at least 20 or 30 years -- I think they're living in a dreamworld," Garten said.
As they open up and develop their capital markets, emerging economies such as China, Brazil or India could see their currencies occupy a larger portion of central bank reserves in coming decades, according to the October U.S. Treasury report.
It also asserts that as long as the United States maintains sound macroeconomic policies and open, deep and liquid financial markets, the dollar will remain "the major reserve currency."
Some worry, however, that the parlous state of U.S. public finances makes betting on long-term dollar dominance dicey. The White House this month said the 2010 budget deficit would reach $1.565 trillion -- at nearly 11 percent of output, the largest shortfall since World War II.
But America was running large trade and budget deficits before the financial crisis. "We went into the crisis in a weak fiscal position," said C. Fred Bergsten, a former assistant Treasury secretary and current director of the Washington-based Peterson Institute for International Economics.
Dean Baker, co-director of the Center for Economic Policy Research in Washington, said U.S. finances are still manageable and a weaker dollar is necessary to boost exports, cut the trade deficit and end a multi-decade spending binge.
Provided America invests in education and infrastructure, maintains high output and productivity and keeps people employed, he said it can overcome the challenges it faces.
"We are moving to a world that's going to be multi-polar, a world where the dollar is not going to be as dominant as today," he said. "But if we do things to keep the U.S. economy strong, we will be able to finance ourselves going forward."
The United States found ready buyers for roughly $1.7 trillion in new debt issued in fiscal year 2009, which brought total debt held by the public to $7.89 trillion, some 55 percent of output.
There are, however, some early signs that buyers may be growing sated. Treasury plans to issue another $1.5 trillion to $2 trillion this year -- a record $126 billion this week alone. Yet auctions for $41 billion in long-dated debt earlier this month attracted only modest interest. The yield demanded by buyers of fresh 30-year debt was the highest in more than two years.
The United States still pays less than 4 percent on its 10-year Treasury notes -- well below an average of 7-9 percent in the 1980s and 1990s. But economists also worry about the government's unfunded pension and health care liabilities. Last year, Dallas Fed President Richard Fisher estimated that the United States may be on the hook for as much as $99 trillion, much of it tied to Medicare. That's about seven times the size of the entire U.S. economy.
"The bottom line is that we can't keep borrowing at this pace forever," said Kenneth Rogoff, Harvard University economist and former chief economist at the IMF. "That only works if the Chinese are willing to lend us unlimited amounts of money at near-zero interest rates, and that just isn't going to last forever."
When it ends, Rogoff said the U.S. will have to deal with higher interest rates, higher taxes and slower growth, all of which will further undermine its economic might.
WHEN LEVERAGE ISN'T LEVERAGE
Of course, much as the United States depends on Chinese savings to finance its deficit, China depends on U.S. consumers to keep buying its exports.
Few think this mutual dependence can last indefinitely. U.S. authorities and a number of economists claim the problem is China's inflexible exchange rate that pegs the yuan to the dollar, thus keeping it undervalued to support exports.
Analysts at the Washington-based Peterson Institute say that given China's massive growth, the yuan may be undervalued against the dollar by as much as 40 percent.
Since President Barack Obama assumed office, the U.S. has twice declined to label China a currency manipulator, a move that could trigger trade sanctions. But the administration has repeatedly complained of China's unfair trade advantage.
Recently, the White House even pledged to double U.S. exports in five years, a goal that economists say would require a significantly weaker dollar.
It's not clear how much other nations, particularly China, will go along.
In the post-Cold War era, currency talks are the rough equivalent of nuclear arms reduction negotiations. In language evocative of the U.S.-Soviet face-off, Chinese military officers have proposed punishing Washington with "a strategic package of counter-punches" that includes dumping U.S. government bonds.
While the military plays no role in setting China's foreign exchange holdings, the comments underscored the rising level of tension and mistrust between the two powers.
Nicholas Lardy, a senior Peterson Institute fellow, dismisses such threats, noting that China's vast dollar wealth would start to evaporate and its currency to rise if it started unloading Treasuries.
"The Chinese are in the classic dollar trap. They have so many dollars that they can't diversify," he said.
Marc Leland, head of Leland & Associates and deputy undersecretary of the Treasury during the first Reagan administration, said: "It's only leverage if one thinks they can pull the trigger. I don't think they can."
Morgan Stanley Asia chairman Stephen Roach isn't so sure. He said that if the U.S. eventually resorts to trade sanctions against China -- not unthinkable in a U.S. election year, with the unemployment rate near 10 percent -- Beijing would likely retaliate.
China might boycott a Treasury auction, he said, which could cause the dollar to plummet and interest rates to spike.
"I spend a lot of my time talking to the Chinese about that, and if it happened, I think they would feel compelled to stand up and take strong retaliatory actions, even though, yes, there would be consequences for them as holders of Treasuries and other dollar-denominated assets," Roach said.
Merk, the investor who is betting against the U.S. currency, said the dollar's future may depend on Washington assuming a more humble attitude.
"Once you believe that you are better and greater than everyone else, you have a problem," he said, "because today, the competition is right around the corner." That may be especially true for any winner of a reverse beauty context.
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