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Cheers for the Not-So-Mighty Dollar
06/19/2012 9:00 am EST
For all our fiscal woes, the greenback should remain the world’s dominant currency for another decade—mostly because the alternatives are worse. Here’s what that means to us, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.
Let’s hear it for the euro. With Greece giving enough votes to the conservative New Democracy party that the country is likely to keep the euro (for now, anyway), the common European currency has survived for another day.
But in spite of the euro’s rally after the Greek vote, if I had to pick the best global currency for the next ten years, my choice would be the US dollar.
It’s not because US political and financial leaders are smarter, more virtuous, or more disciplined than their counterparts elsewhere in the world. (It may come as a shock, but they’re not.)
It’s because the kind of self-interested, shortsighted muddling through that these leaders are likely to produce should keep the dollar ahead of the pack for another decade—if only because US self-interest is reasonably well aligned with the interests of the global economy.
Before you go all ballistic on me—How can you pick the dollar? Don’t you know how fouled up the US government budget is and how overextended the Federal Reserve is?—parse my statement in detail.
First, I’m not saying the US dollar will be the best currency in the world over the next decade, only that it will be the best global currency. To win that contest, it doesn’t have to best the Canadian loonie or the Colombian peso. It just has to beat the yen, the euro, and the yuan.
There simply aren’t that many currencies with enough trading volume and enough market depth to be viable global currencies. (For the record, over the next ten years I’d much prefer to put my money in stronger local currencies. For more on that preference, and a dividend-income strategy based on it, see my columns "Profiting from the Dollar’s Might" and "10 Fat-Dividend Stocks for Lean Times.")
Second, as I’ve said repeatedly, the US dollar doesn’t have to be a good currency; it only has to be better than the competition.
And third, being the "best global currency" doesn’t mean that the US dollar will be a good store of value over the next decade, or that assets such as gold or commodities or real estate won’t hold their value better. If you’re looking to protect your wealth against inflation or currency depreciation, I think you can do better than the dollar.
But nonetheless, if the US dollar gets another decade at the top of the global currency heap, it has profound significance for the US and global economies—and for the returns investors can expect from stocks, bonds, and other assets.
Here’s my argument for the continued global reign of the dollar.
Leading a Weak Field
Look at the competition. The euro had looked to be a contender, but the current crisis has damaged it so severely that it will take years to put its reputation back together.
Consider the Greek bond haircut. The European Central Bank played a key role in orchestrating a deal that rewrote the terms of existing bonds to the detriment of current bondholders, but it refused to write down its own holdings of Greek bonds. Care to put your trust in that system?
And there’s more. Contingency plans on dealing with a run on Greek banks have envisioned a situation in which Greece is still in the Eurozone, but where no one in Greece can take euros out of the country. That, to me, looks like two currencies with one name.
Or, finally, consider the failure of the European bank to assume the role of the lender of last resort for the Eurozone. This has exposed a key weakness in the euro system: The European Central Bank is, for better or worse (and it’s been for worse in this crisis), not a central bank with all the powers of the Federal Reserve.
It’s reasonable to ask now, who stands behind the euro? Asking that question at all shows how much faith has been stripped away from the euro. And, of course, the Greek vote doesn’t actually solve any of the euro’s problems.
The yen? Are you kidding me? Japan’s public debt was 231% of gross domestic product at the end of 2011, a level that makes every other country in the world look the picture of fiscal health.
I know that it has become popular to point out that Japan has managed to survive—and the yen to appreciate—even as debt has soared to these levels. But that doesn’t mean that no level of debt is significant.
And it doesn’t mean that investors should discount the way that Japan’s rapidly aging population creates another demand on the nation’s huge savings pool. Or that the slide of the country’s trade balance into negative territory in 2011 isn’t worrisome. Japan can’t continue to age and create retirement liabilities and continue to spend money it doesn’t have. (The 2012 budget looks to carry a 10% deficit.)
That leaves China’s renminbi. China is clearly moving to loosen controls over its currency. At some point on the current trajectory, that would turn the renminbi into a freely traded global currency. And at that point, investors should think about the renminbi as a true competitor to the US dollar.
But China’s pace on the path toward a freely traded renminbi has been slow, and it’s not clear that China is fully committed to reaching that end point. A freely traded renminbi would expose China’s very stressed banking sector to even more stress. And it’s not clear to me that China will decide to take that risk, or that it can afford to.
My best estimate now is that the renminbi won’t be ready for a full global role within my ten-year time frame.
The Dollar’s Faults
And what about all the problems facing the US dollar? The budget deficit for fiscal 2011 (which ended in September 2011) came to 8.7% of GDP. The Federal Reserve’s balance sheet hit $2.85 trillion in the week ended June 13, including $1.66 trillion in US Treasuries.
Eventually, the thinking goes, the Fed will have to sell some of what it bought to stimulate the economy back to the financial markets—or pay the price in higher interest rates and a falling dollar. The US public debt is more than 100% of GDP and is certain to go higher.
This isn’t exactly the profile of a strong currency.
You’ve probably got doubts that US politicians will do anything to fix these problems. And you’ve got a well-founded suspicion that they’ll do things to make the problems worse. I’d say that’s extremely likely.
But I’m not counting on any sudden Road to Damascus conversion to fiscal rectitude to support my view of the US dollar. Instead, I’m assuming that politicians will muddle along, making thing gradually worse but not doing anything that really disturbs the current pattern of a gradual slide in the nation’s credit rating from AAA to AA (in 2011) to A (in 2013 or later).
But because the interests of global investors are so clearly aligned with the interests of US politicians, I don’t see that slide accelerating or making much difference to the global role of the US dollar over the next ten years.
From the financial market’s point of view, it’s not like there’s an oversupply of AAA- or even AA-rated, liquid debt in the world. (How long do you think it is before even Germany loses its AAA-rating under the pressure of the Eurozone crisis?)
As the history of Japan’s public debt illustrates, financial markets will shrug at deficit figures as long as they don’t see any signs that they won’t get paid back on time. (And, so far, the US is good for that.)
From the politicians’ point of view, the best of all solutions will be to do nothing drastically painful to fix US problems (because that would cost votes and require courage), while at the same time doing just enough to keep the situation from getting worse so fast that it’s really noticeable.
Remember the recipe for how to cook a frog? Put the frog in a pot of cold water. Put a small flame under the pot. The frog won’t notice the gradual increase in temperature in time to jump out before it is cooked. The hope will be that US voters won’t notice the gradual worsening of US finances until they’re completely cooked.
(Warning to politicians: The folklore about how to cook a frog makes an interesting metaphor, but it’s not actually true. The frog gets more and more active in trying to escape as the temperature of the water goes up. See the Snopes.com entry titled "FrogBoil.")
All this talk about frogs aside, what’s the real investment world effect if the US dollar remains the best global currency for one more decade?
There are major advantages to being the world’s reserve currency, it is frequently pointed out. Chief among them, financial cynics say, the United States can print money to pay its increasing debt and pass along the costs, or at least some of the costs, to the rest of the world.
This can go on for a long but not unlimited period. (For more on the advantages of being the global currency and the role of trust in currencies, see "Tear Up Your Paper Money."
Let’s count some of the advantages to the United States—and costs to the rest of the world—of another decade of the US dollar as the global reserve currency.
- US interest rates will rise more slowly than they would otherwise. Demand for US dollars created by the world’s need for dollars to conduct trade and financial transactions, and by the use of the US dollar in foreign-exchange reserves, will keep US interest rates lower than they might have been. It’s still reasonable to project that US interest rates will climb with any modest stabilization in the global economy, but the rate of increase will be relatively slow.
- The US dollar will depreciate but more slowly than it would otherwise. The argument is the same as that for a slow increase in US interest rates.
- Global inflation, especially commodity inflation, will move faster because of that falling dollar. If the dollar remains the dominant global currency, then many commodities—oil and grains, for example—will continue to be priced in dollars. As the dollar depreciates, the dollar price of these commodities will rise. Add that to whatever price increases you expect from sources such as the rising costs of extraction or the rising cost of inputs such as fertilizer and fuel.
- Low US interest rates will delay the onset of the US fiscal crisis. It makes a huge difference to the US budget deficit whether the government has to pay 2% or 6% to finance that debt.
- US companies will be able to raise money at cheaper rates than if the dollar dropped out of the running for top global currency. That will provide inexpensive capital for investment in plants, for share buybacks, for dividend increases and for acquisitions. Low interest rates on bonds make stocks more attractive investments (all else being equal). And these uses of cheap money will add to that attraction.
- That’s a good thing, because earnings growth in US and other developed economies looks anemic over the next ten years. I’m hoping for 5% a year on US equities on average over the next ten years. That’s below the 7.5% annual average long-term return. The advantages the dollar gains from remaining the dominant world currency would sure make attaining 5% more likely.
- And finally, if the US dollar remains the best global currency, that would assure that New York and US financial companies remain key players in global markets. The trend may be headed in Asia’s direction, but the speed of that shift is important.
In the end, my argument for the US dollar remaining the best global currency for another decade isn’t especially optimistic. It’s based on the comparative weakness of competitors more than on US strength.
It assumes a continued deterioration in the US financial position and in the value of the dollar—but assumes that it will occur more slowly than if the US dollar lost its role as the global reserve currency.
It would be better, of course, if the United States actually dug in and intelligently addressed its fiscal problems. I just don’t think the odds of that are especially good.
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