The Mighty Dollar
Life would be much easier for many speculators if anyone could explain the behavior of the U.S. dollar. It has risen to lofty heights against all other currencies although many economists expected it to decline. In fact, it is higher now than anytime since 1985 when it spiked to 129 of the Federal Reserve's dollar index. But it then fell back to 90 as rapidly as it had soared. We now wonder whether the dollar will repeat its behavior of the 1980s and, if it does, when it will commence its retreat.
There was considerable agreement as to why the dollar was so strong in 1985. Economists pointed to the relatively high interest rates in the United States. With the Fed discount rate at 8 percent, the Japanese rate at 5.5 percent and the rates of West Germany and other European Community countries at 5 percent, foreign capital sought higher returns in the United States, giving strength to the dollar. With industrial output slowing dramatically during 1985, the Fed lowered its rate in order to stimulate the economy by facilitating faster monetary expansion. Yet its expansionary policies together with a huge federal budget deficit were only moderately successful in supporting the flagging economy and depressing the exchange value of the dollar. It took an agreement between the leaders of the Group of Five (United States, Japan, West Germany, the United Kingdom and France) to intervene in the foreign exchange market and succeed in putting great downward pressure on the dollar.
The last time the dollar soared versus other currencies was in 1997 during the Asian financial crisis. Several Asian financial systems collapsed when the markets throughout the region burst the official pegs to the dollar. Thereafter much Asian capital sought refuge in the United States, bolstering the dollar.
In recent months the dollar again has soared against nearly every other currency except the Mexican peso. Its stellar rise versus the Japanese yen is understandable. The Bank of Japan is clinging to a near-zero-interest rate policy, seeking to revive a sluggish economy and prevent a serious depression. The low Japanese rate creates powerful incentives for speculators to borrow yen funds, purchase U.S. dollars, and invest them in U.S. Treasury bills yielding 4.5 percent or 10-year notes yielding 5.2 percent. The rate difference gives rise to active yield-curve trading, which obviously lends strength to the dollar. But why is the dollar so strong against the new European currency, the euro? Why does it maintain its remarkable strength although the Fed has been easing credit conditions at a breathtaking rate? The Fed's four half-point cuts this year, which brought the federal funds rate to a seven- year low, were the most in so short a time. And there may be more to come.
Most economists are puzzled about the great strength of the dollar although the Federal Reserve has been cutting interest rates more aggressively than any other central bank in the world. The Fed discount rate now stands at 4 percent, the federal funds rate at 4.25 to 4.5 percent, commercial paper rates at 4.1 to 4.4 percent, and the prime rate at 7.5 percent. Although the rates of the European Central Bank are not directly comparable with the rates of the Federal Reserve System, they are similar. The ECB "main refinancing rate" stands at 4.75 percent, the three- month money market rate at 4.7 percent, and the "loans to enterprises rate" at 7.2 percent. (European Central Bank, Monthly Bulletin, March 2001). The astonishing strength of the U.S. dollar obviously does not rest on an interest-rate incentive that would lure European capital to American shores. On the contrary, the four rapid rate reductions by the Fed should be expected to effect a repatriation of much European capital which would lend strength to the euro.
This economist is rather skeptical about the mighty dollar's enduring strength, but is confident that the dollar will show surprising resilience in the months ahead. No matter how expansionary Fed policies may be and how they may erode the purchasing power of the dollar, a singular European event presently is giving support and strength to the dollar. The new euro will arrive in the form of crisp new bills on January 1, 2002 and become the only legal- tender money in twelve European countries (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain). After a two-month grace period the old currencies of these countries will become worthless. Between now and February 28, 2002 we must expect a liquidation of the cash savings and mattress hoards throughout Europe. It is unlikely that countless billions of Belgian francs, French francs, German marks, Italian lire, Spanish pesetas and Netherland guilders, which in the past escaped tax collectors and auditors, will emerge on January 1 and openly seek conversion to euros. Throughout Europe, farmers, merchants and manufacturers presently are exchanging their own currencies for U.S. dollars. Bitter experience has taught them not to trust their governments in monetary matters and not to rely on commercial banks to shield private deposits from the view of government. The Mafia organizations of Europe surely will not deposit their caches and apply for conversion; they undoubtedly are buying U.S. dollars now. The German mark is an important European reserve currency and second only to the U.S. dollar in the world; it is under special liquidation pressures now. The dollar as the only surviving reserve currency is in great demand and may rise against the euro despite the expansionary Fed policies. When, in 2002, the European currency liquidation will have "run its course" the euro will seek its purchasing power parity.
In the meantime a strong dollar has many advantages. It raises the purchasing power of all dollar holders and boosts their levels of living. It allows Americans to purchase more foreign goods and suffer balance-of-trade deficits. It attracts foreign capital seeking appreciation, which increases the amount of capital invested per head of population and thus boosts American labor productivity and wage rates. But a strong dollar also poses considerable disadvantages and risks. It worsens the competitive position of American producers in international markets. It hampers American exports and encourages foreign imports. Americans are likely to buy fewer homemade Cadillacs because German-made Mercedes become less expensive. The result may be industrial stagnation at home, business losses and fewer jobs for American workers. It explains why many governments facing economic difficulties and mass unemployment favor strong foreign currencies and weak currencies of their own. It also illustrates why exchange rates tend to be "dirty" rates that are purposely managed by central banks and rigged by governments. In unhampered money markets the rates are determined solely by the interaction of foreign trade, capital movements, speculation and even arbitrage. They create an overall rate which hinges about the "purchasing-power parity", that is, the rate at which the purchasing power of various currencies tends to be equal.
We speak of a "strong currency" whenever a currency's exchange rate rises in foreign exchange markets. All currencies may lose purchasing power, but "the strongest" may lose less than others. The U.S. dollar has lost less than many others, which has made it a "strong currency" despite the Fed's easy-money policy. Its special strength rests on its extraordinary demand as the world's primary reserve currency; it may also point to increasing stress and fragility of the world credit system. It gains in strength whenever a financial crisis looms on the horizon.
The global credit system resembles an inverted pyramid which continues to grow sporadically. Its very base consists of U.S. dollars and Federal Reserve Bank credit which are expanding relatively moderately; the layered credit superstructure is growing at ever faster rates, which is increasing the danger of financial crises. A few statistics may illustrate the pyramid.
Total Reserve Bank credit, which is the money base on which all other money rests, rose $21.99 billion during the last twelve months, or just 3.9 percent. Currency in circulation rose $23.62 billion, or 4 percent. M3, which is the broad money measure consisting of currency as well as demand and time deposits, surged more than $576 billion, or 9 percent. Commercial banks expanded their credits more rapidly. In 2000 bank credit rose from $4.792 trillion to $5.263 trillion, or 9 percent; Federal and Federally sponsored credit soared from $1.616 trillion to some $1.9 trillion, or 17 percent; mortgage debt from $6.38 trillion to some $6.9 trillion, or 8.1 percent; consumer debt from 1.43 trillion to 1.569 trillion, or 9.7 percent; and total nonfederal debt rose from $13.72 trillion to $14.85, or 8.2 percent (Federal Reserve Bulletin, April 2001).
Many banks practice loan securitization, that is, the conversion of bank loans and other assets into marketable securities for sale to investors. They securitize pools of mortgages, auto loans, credit card receivables, leases, and other types of credit obligations. The packaging and sale to investors release the banks from any obligation to the buyer for loan defaults or changes in market value of the securities sold, which allows them to make new loans from the proceeds of the securities sold. They lend, securitize, sell, and lend again, in a continuing process of credit expansion, standing ever ready to provide ample funds to eager investors and speculators.
Massive non-bank credit is helping to build the world credit pyramid. While it may enable bank credit and monetary aggregates to grow more slowly, it may expand rapidly, unperturbed by onerous regulation and control. It has been an important source of fixed investments in physical assets in developing countries; many now are suffering from excess capacity in manufactured products which is exerting downward pressure on product prices. Non-bank credits also financed heavy investments in information and communication technology which connects the world markets in a common network of information and cooperation.
An ominous symptom of the pyramid is the phenomenal growth of the derivatives market in which commercial banks play a leading role. Derivatives such as futures and options are designed to reduce or even eliminate investment risk. Managers of large pools of money such as pension and mutual funds hedge their exposure to changes in prices, interest rates, or currencies by buying or selling futures or option contracts. By promising to remove all risk from stock and bond investment, if properly handled, the derivatives provide the intellectual climate and psychological disposition for the bubble euphoria and the frenzied rise in stock prices. Commercial banks are the primary providers of derivatives. According to the Comptroller of Currency, the volume of options and other derivatives written by banks now exceeds $21 trillion, which generate many billion dollar profits to banks.
Offshore banking adds more liquidity which is driving the stock and bond markets. Offshore branches of banks accept American and foreign deposits and make loans in the Euro-currency market, unrestricted by any monetary authorities or governments. The major offshore centers for U.S. banks are the Bahamas, the Cayman Islands, Hong Kong, Panama, and Singapore, which offer favorable regulatory and tax treatment. They provide the liquidity for the "carry" trade lending money to numerous hedge funds that borrow Japanese yen at minuscule rates, convert the yen to dollars, thereby boosting the dollar, and invest the funds into U.S. Treasury bonds. Their purchases bolster the bond market and give support to the stock market.
The chronic current-account deficit is adding its liquidity to foreign credit markets. Year after year the U.S. balance of payment is showing deficits in excess of $300 billion. Linking their national currencies to the U.S. dollar, foreign central banks are encouraging the influx of dollars which they purchase with their own money, thereby stabilizing the dollar while inflating their own currencies. They are purchasing huge quantities of U.S. Treasuries. During the last three years alone total dollar reserves of central banks have risen nearly $400 billion, to more than $1 trillion. Without this massive dollar support, the U.S. dollar would have plummeted long ago under the weight of the deficits.
As never before, trillions of dollars are sloshing about in the credit markets of the world. World-wide competition is restraining consumer price inflation, but world-wide credit expansion is causing global maladjustments that lead to frequent crises. They tend to be worse at the top of the credit pyramid, that is, in foreign markets resting on multilayered credit expansion. Indonesian banks, for instance, expand their credits based on rupiahs which the Bank of Indonesia is inflating at double-digit rates on the basis of U.S. dollar credits which American commercial banks are expanding with support of the Federal Reserve System. There are 174 central banks in the world, most of which are actively engaged in building the credit pyramid on the foundation of their dollar reserves. The Federal Reserve may not feel responsible for the crises at the top but may not want to take any chances with the economy in its charge.
The Fed is likely to fight an economic decline with all its weapons. It may continue to lower its rates and encourage commercial banks to expand their credit. But it is doubtful that the Fed will be able to prevent the economic stagnation and readjustment. Recessions, after all, are the corrections of the preceding excesses and maladjustments; they may be delayed for a while but cannot be avoided once the harm has been done.
The world credit pyramid consisting of multilayered fiat moneys and fiduciary credits is in constant danger of crumbling in various parts. It may first disintegrate at the top of the pyramid where the central banks of the developing countries manage their meager dollar reserves, or at the bottom where the Federal Reserve performs a precarious balancing act. Both scenarios would instantly affect the position and purchasing power of the U.S. dollar. At the top of the pyramid financial difficulties tend to strengthen the dollar as overextended debtors scramble for dollar credits. At the dollar base of the pyramid any difficulty may have ominous consequences not only for the U.S. dollar but also the world economy. It explains the frantic reaction of the Federal Reserve to the economic decline. With the current-account deficit now exceeding $400 billion, with American corporations choking on debt, with consumers without savings and up to their necks in debt, any readjustment would likely be severe.
In our judgment, the Fed is defending the maladjustments which are clearly visible in S&P stocks selling at three times revenues, 24 times earnings, six times book value and a dividend yield of just 1.2 percent. To lower the Fed discount rate and encourage bank credit expansion not only supports the maladjustments but also facilitates more price inflation. In the coming months the specter of inflation rates of 4 and 5 percent probably will reappear, which would cause all market interest rates to rise and compound the economic difficulties. The yields of all notes and bonds are likely to rise, which would call a halt to the current refinancing boom and pierce the mortgage finance bubble led by federal and federally sponsored institutions.
The volatility of global stock markets and the precipitous fall of the NASDAQ seem to indicate that the readjustment has begun. We do not know how painful it will be in the coming months and how it will end. The monetary policies of the Fed and the fiscal policies of the U.S. government will greatly affect its length and severity. If, in old statist fashion, the Fed will endeavor to stimulate the economy with ever lower interest rates and the U.S. government will want to recreate prosperity through massive spending, the recession is likely to be long and severe. In the past the Fed managed to calm the markets in several previous crises by flooding the credit markets with its high-powered funds. But we do wonder how long the Fed can continue its balancing act before the American economy sinks into a deep recession and the mighty U.S. dollar loses some of its luster and strength.
Hans F. Sennholz