Wednesday, August 18, 2010
Here, in a nutshell, is my version of the history of the dollar's history, with a focus on its major turning points. As a point of reference, I'm using the Fed's Real Broad Dollar Index (chart above), which measures the dollar's value against a large basket of trade-weighted currencies, all adjusted for changes in relative inflation. It's arguably the best measure of the dollar's true value against other currencies. I've marked 6 key turning points in the dollar, and I explain here the key events occurring around the time of each turning point. I also opine on the future of the dollar.
A: Most measures of the dollar's value only go back to 1973. That's unfortunate, since the modern history of the dollar begins in August 1971, when Nixon ended the dollar's convertibility into gold. Prior to that point, the dollar had been fixed to gold at $35/oz. since 1934, and most of the world's currencies were pegged in some fashion to the dollar. Nixon's decision to abandon the gold standard was the catalyst for what would eventually prove to be a major devaluation of the dollar. The underlying cause of the dollar's collapse, however, was the Fed's decision to ease monetary policy in support of Great Society spending programs. The Fed's easy money policy started in the mid-1960s, and it was reflected in a steadily increasing outflow of gold. The Fed was holding interest rates at artificially low levels, and this was undermining the world's confidence in the dollar. Central banks began demanding gold in exchange for their dollar holdings, until Nixon's decision put an end to that. That decision effectively relieved the Fed of the need to raise interest rates significantly, which in turn exposed the fact that there was a huge excess supply of dollars in the world.
By early 1973, when this chart begins, the dollar had lost about 10% of its value. Despite the Fed's repeated attempts to tighten monetary policy by raising interest rates throughout most of the 1970s, the Fed's efforts were on balance "too little too late." The dollar collapsed, and investors scrambled to sell the dollar and buy gold, commodities, and real estate. Inflation soared to double digits.
B: By early 1979, the collapsing dollar, double-digit inflation and the feckless Carter administration had combined to create a deeply pessimistic outlook for the U.S. It's no wonder that the dollar fell to an all-time low against other major currencies around this time. Then in August 1979, Carter had the foresight to appoint Paul Volcker to head up the Fed with a mandate to stop inflation. Over the next few years, Volcker slammed on the monetary brakes, causing interest rates to soar. When tight money combined with the confidence-boosting Reagan tax cuts in the early 1980s, the dollar began to take off.
C: The dollar reached an all-time high against other currencies in early 1985. It was benefiting from a powerful combination of tight money, high real interest rates, falling inflation, low taxes and strong economic growth. It's hard to imagine a better combination of forces. Sadly, however, it soon became fashionable among politicians and pundits to complain that the strong dollar was too strong—too much of a good thing was not welcome, especially among industrialists that were having trouble exporting because of the dollar's strength. So it was that the Plaza Accord was signed in September 1985, in which the world's major governments agreed to lower the dollar's value. Volcker did his part to weaken the dollar by expanding bank reserves by more than 30% in the space of just 18 months.
Alan Greenspan took over the Fed in August 1987 at an inauspicious time. The dollar had lost almost one-fourth of its value in just over two years, and the Reagan administration was faltering, having agreed to a 40% hike in the capital gains tax. Confusion abounded, confidence faltered, and the stock market cratered in October. Greenspan successfully navigated the storm, eventually tightening policy enough to halt the rise in inflation that followed in the wake of the dollar's collapse—the CPI rose from a low of 1.1% in late 1986 to a high of 6.3% in late 1990.
D: By early 1995 the dollar hit an all-time low, burdened by the high inflation of the late 1980s, the weak presidency of Bush I, the disappointing recovery following the 1990-91 recession, the tax hikes in the early years of the Clinton administration, the threat of HillaryCare, and the Fed's surprise tightening of monetary policy in 1994 (the CPI was a relatively low 2.5% when the Fed stunned the bond market in early 1994 with a tightening).
Despite the dismal state of affairs that prevailed as 1994 drew to a close—recall the Orange County bankruptcy and the Mexican peso devaluation of December '94—things began to improve shortly thereafter. The Republicans, led and inspired by Newt Gingrich's Contract with America, took charge of Congress in early 1995, and Clinton saw the wisdom of triangulation. The economy began to boom, and federal spending was held in check. Confidence rose as the capital gains tax was reduced in 1997 and the housing market began to elevate, boosted by Clinton's decision to exempt most homeowners from paying capital gains on the sale of their house. Meanwhile, the Fed kept real interest rates high from 1995 through 2000, worried that the economy was "overheating." The dollar received a major boost in 1997, as a wave of S.E. Asian currency devaluations sharply boosted the demand for dollars.
E: The dollar hit a high note in early 2002, supported largely by the view that the U.S. economy was likely to outperform other major economies, even though the recovery from the 2001 recession was modest. Plus, fears of a global deflation/depression were running high at the time, as commodity prices and gold hit lows in late 2001 and early 2002, and corporate defaults soared.
Things turned around as the Fed embarked in earnest on an easing campaign which eventually took the Fed funds rate down to 1% in mid-2003, where it stayed for one year even though the Bush tax cuts helped the economy boom in the latter half of 2003. That was followed by a very cautious and gradual rise in the funds rate, in a manner reminiscent of the 1970s. The Fed seemed always to be raising rates by too little, too late. The CPI rose from a low of 1.1% in mid-2002 to a high of 5.6% in mid-2008. The final phase of the dollar's weakness came in 2006-8, as the U.S. housing market began to implode, eventually culminating in the subprime mortgage crisis, the failure of Lehman Bros., and the deepest recession since the early 1980s.
F: The thing that turned the dollar around after it plumbed fearsome lows in early 2008 was the global panic-driven demand for dollars that developed as economies began collapsing. This didn't last long, however, since the dollar reversed course starting in March of last year as it gradually became apparent that a global deflation/depression was not in the works as so many had feared. Fed policy helped accentuate the dollar's ups and downs, because the Fed was slow to accommodate the intense dollar demand that developed in the latter half of 2008, and then reluctant to tighten policy as dollar demand fell and the economy recovered in mid-2009.
The future: The value of a currency can be strongly influenced by demand for that currency, and that demand can in turn be driven by factors affecting the prospects for economic growth. Politics can also influence the value of a currency. Ultimately, however, the central bank has the final word. Thus, the dollar's future value is critically dependent on what the Fed does over the next year or two, especially given the enormous and unprecedented expansion of the Fed's balance sheet over the past two years.
Today the dollar is only 4-5% above its all-time lows relative to other currencies, and the dollar—along with almost every other currency on the planet—is at all-time lows against gold and most commodity prices. The dollar is still benefiting from safe-haven demand to some extent, but fundamentally it is very weak. The prospects for the U.S. economy are not very bright (many in fact are calling for another painful recession), and Obama's and Congress' approval ratings are abysmally low. Taxes are going to rise after the end of this year, unless the Congress votes to extend the Bush tax cuts. States and municipalities are reeling from their fiscal burdens. The Fed is promising to be massively accommodative for as far as the eye can see. Washington is pounding the table for the Chinese to weaken their currency, which is a polite way of saying they'd like to see a weaker dollar. The news is seemingly bad on all fronts, with almost no hope for any improvement.
This is where my contrarian instincts kick in. The news is bad, the fundamentals are horrible, and fiscal policy and politics are absymal. No wonder the dollar is close to an all-time low. But for the dollar to get weaker, things have to deteriorate even more than they already have.
If instead of deteriorating, things just improve a little, the dollar could hold these levels and perhaps improve with time. If things began to change for the better in a big way, it's difficult to imagine how strong the dollar might be several years from now. What if the Fed manages to pull off a reversal of its quantitative easing in time to avoid a massive overhang of dollars and an eventual hyperinflation? What if Congress votes to extend the Bush tax cuts? What if the November elections result in a massive shift in the balance of Congressional power, and a new wave of Tea Party-inspired politicians rescind ObamaCare and the remainder of the failed stimulus package?
Call me an incurable optimist (as so many here have), but I think there's a decent chance that the fundamentals behind the dollar can improve. Things are so bad now that the future could easily be less awful—and maybe even much brighter—than the market seems to believe.
Full disclosure: I am very long the dollar at the time of this writing.
Posted by Scott Grannis at 12:31 PM