Saturday, January 12, 2008

Dollar vertigo

Hank Paulson did it again. Earlier this week, the Treasury Secretary repeated his “strong dollar” talk with the earnestness of a confessor and the conviction of a tiger attacking its prey! Check this out: “It comes from my mind, my heart, my experience -- a strong dollar is in the nation's best interest.” Never mind that the dollar kept on falling last week.

It’s not the first time. With the dollar nose-diving from its heights in late 2000, Paulson speaks as if he hasn't been watching... A dollar vertigo? This is Paulson at the Fortune Global Forum in India, last October: “I am strongly committed to a strong dollar.” And this is Paulson again speaking with CNBC’s Maria Bartiromo, in August 2006: “Let me say this, Maria. I believe very strongly that a strong dollar is in our nation's interest. And that currency value should be determined in an open and competitive market, based upon underlying economic fundamentals.”

So let’s talk “fundamentals” then. Because they matter indeed, and they are not necessarily flattering for the prospects of the dollar in the coming months.

There are a number of economic factors (or “fundamentals”) that affect the path of a currency like the dollar in the medium term. (In the short run, economists are pretty lousy in predicting currency movements, and so is everyone else!) As a start here I will mention two, promising more in posts to come.

One is the so-called “external imbalances”—a fashionable term for America’s vast trade deficit. Large external deficits are a symptom of an America living beyond its means for years now, helped by borrowing from foreigners. Eventually there comes the payback period—or “adjustment.” This occurs either by a decline in consumption and investment (aka recession) and/or a hefty depreciation of the dollar to help US exports become more competitive abroad and to stop you from buying all those Nintendo Wii’s.

So where do we stand today? Despite some improvement from the 2006 peaks, the November trade data were a reminder that US export growth may have hit a ceiling despite the plunging dollar, as foreign demand may be slowing. The import bill however is accelerating, inflated by the surging price of oil. Doesn’t bode well for the dollar.

Then we have interest rates. With the Fed increasingly fearful of an impending recession , markets now expect more cuts than before in the federal funds rate. This means lower interest on your dollar savings. Now why would anyone—especially those fickle foreigners who loved us so much only a few months back—keep their money in dollars if they only earn interest of around 3 percent, when they can buy German T-bills and earn 4 percent? Or even more than 6 percent if they go down under for the more “exotic” Australian bills? In sum, differences in interest rates tend to affect the demand for currencies, and this was partly why we saw more dollar dumping late last week.

Paulson would do himself a favor, then, if he talked about the weather next time he’s asked about the dollar. It's an embarrassment to his intelligence and track-record, especially if you notice a not-so-flattering parallel with neighboring Venezuela: In the midst of skyrocketing inflation, President Chavez decided to inspire confidence in the economy by replacing the old currency, the “bolivar” with a new one, which he called… “the strong bolivar!”
His motto was “a strong bolivar, a strong economy, a strong country.” Sounds familiar?

Glossary: fundamentals, external imbalances, adjustment, vertigo, Nintendo Wii , strong dollar, dollar

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