Politically Colored Glasses?

The nice part about being a pessimist is that you are constantly being either proven right or pleasantly surprised.

-George F. Will

Democrats were the doomsayers before the last presidential election; they said the country was headed in the wrong direction, spending was out of control, everyone hated us, our president was an embarrassment, overseas investors would pull their money from our markets and the dollar would surely crash. It's now the turn of the Republicans; they warn us about soaring deficits, higher taxes, an incompetent and intrusive government, the specter of runaway inflation, a Fed that has lost its independence and perspective and a dollar that will be rendered worthless by a combination of those factors. Apparently, pessimism is alive and well on both sides of the aisle. What both camps said on different occasions and under different circumstances over the past few years is that the dollar will weaken dramatically and that they regard that as an undesirable outcome.

The dollar did not do too well under the Bush administration, but it did not collapse either. Treasury secretaries since James Baker have talked about a "strong dollar policy," but all of them have only paid lip service to the concept which is understandable. We have had many years of relatively benign inflation and even more years of mounting trade deficits. With no real inflation problem and an overwhelming need to boost export competitiveness, allowing the dollar to slide while calling for a stronger dollar to calm the nerves of our creditors has made perfect sense - it still does. We complain about other countries manipulating their currencies - and some do - but so have we through benign neglect and often accompanied by a wink and a nod.

Stripping out the political rhetoric and self-serving statements, what are we likely to face then? A dollar resurgence, a renewed slide or a collapse? Let's look at the "facts."

Our economy will take a couple of years at minimum to start growing at trend (three to four percent GDP growth); the Fed will raise rates later than most; our trade deficit is shrinking, but will not come close to disappearing; and budget deficits will continue to grow. Even if we succeed in reinventing ourselves on the lines the current administration hopes we will, by focusing on exports and investment and decreasing consumption's share of GDP it will be only at the margin - anything more will take decades. In the interim we will continue to depend on foreign capital and any positive change in our trade imbalance will need a competitive (i.e., weak) currency. We have to balance that need with a semblance of stability to avoid scaring away overseas investors.

A sluggish economy with low rates and high deficits does not sound like a recipe for currency strength. It is not. Having said that, the long-term picture can be clouded by short-term capital movements and by favorable comparisons. In other words, other regions may wind up performing worse than the U.S. The dollar is fairly valued to somewhat undervalued currently; there are probably extensive speculative short positions in the market and risk aversion; and M&A activity and other factors could lead to sudden bursts of dollar buying.

In my opinion, however, those are short-term events. Barring a dramatic change in underlying fundamentals, the dollar will lose ground over time to the currencies of up-and-coming countries, unless another emerging market crisis occurs such as we saw in Asia in 1997. Led by China, these countries include the BRIC nations, some of the OPEC countries and other high savings, high surplus nations in Asia and elsewhere. They have several benefits over us: faster growth rates, younger populations, higher levels of individual and national savings, trade surpluses and lower costs. They generally have faster population growth rates as well, ensuring that they will represent an increasingly larger share of the world's population and GDP and grow in importance, both economically and politically. Despite attempts to keep these currencies stable to weak, market pressures will ultimately result in currency appreciation versus the dollar.

It is very difficult to rank the dollar versus the euro, the British pound, the yen and other developed market countries. They face similar macroeconomic and demographic trends and are collectively at a disadvantage in terms of valuation, GDP growth rates and reserve accumulation. Europe and Japan have higher savings rates than the U.S. (though that could change if our savings rate keeps climbing), but growth has been significantly slower than in the U.S. making it hard to determine where the advantage lies. Britain is the most similar to the U.S. with lower savings and higher deficits, but faster longer-term growth rates.

We know politics can change people's perceptions, but can politics also reshape the fundamentals so completely that they alter the future trajectory of the dollar? It is possible, but I think the impact will be fairly marginal.

As an example, take the current administration's plan to boost government spending with a view to boosting investment in clean technology, alternative energy, etc., thereby boosting economic growth. It is all well-intentioned, but there are legitimate questions about the government's ability to make the right choices and the commercial viability of some of these endeavors. They are often subject to exogenous influences, such as the price of oil, and as we know all too well, the impetus behind alternative energy fades every time oil prices slump - consumers have short memories and businesses often lack the ability to ride out the slumps. Even if some of these initiatives bear fruit, commercial success is dependent on our ability to compete in an increasingly global market and boosting growth through exporting clean and green technology. Once again, a weak dollar can only help.

Another part of the proposed reshaping of our economy is based on a vision of a society that consumes less. However, consumption along with our financial system has been the main engine of growth in our economy. If both contract abruptly, it could be a rude awakening in the form of slower growth, but potentially reduced capital availability as well. Consumer spending and our indebtedness created a need for foreign capital while financial innovation provided creative, often lucrative investment vehicles for that capital. One of the side effects of that capital inflow was protecting the dollar's value when deficits soared. If that capital is no longer needed or investment alternatives are more attractive elsewhere, flows could turn against the dollar. Once again, more dollar weakness is the likely outcome.

Looking at it as objectively and impartially as I can, I think folks on both sides of the political spectrum would be right to expect a weak dollar over the next few years. It could rally meaningfully in the next month or two. It could certainly rally meaningfully several years from now if the structural underpinnings of the global economy change, but I see it losing ground to some currency blocs over the next couple of years. To reiterate, that does not include the EUR and JPY; they could remain stable or decline versus the dollar, even as it slides versus other currencies.

A dollar collapse would be a catastrophe as it would destabilize our economy and result in hyperinflation, but I think that is highly unlikely. In my opinion, a weaker dollar is likely and will be a helpful, even positive development under most scenarios, so I don't label myself a pessimist - of any political persuasion.