May 04, 2011

Who's afraid of a sinking greenback?

This writer misses the fact that the large reason our bond auctions have come off without a hitch and without the demand for a higher rate of return is because we are buying a tremendous amount of our own paper, in some instances 80+%.  Pull the Fed out of the market and things can get scary fast.

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Who's afraid of a sinking greenback?

THE dollar has been falling:

Does this matter? Well, sure, it matters in some ways. A falling dollar is an important mechanism through which the American economy makes needed adjustments. It increases import prices, which could fuel inflation but which will also reduce import growth. Similarly, it makes American products cheaper abroad, which boosts American export industries. A declining dollar is a natural means through which America's trade imbalances are resolved, and it is the mirror of adjustments in large trading partners, where appreciation is the order of the day.

Long-term weakening of the dollar is also likely to accompany efforts to diversify global reserve holdings away from the greenback. Other countries don't like the fact that when it comes to global reserve currencies, the dollar is the biggest game in town. That lack of reserve portfolio diversification leaves countries like China, which holds large reserves of dollar assets, heavily exposed to movements in the greenback. The problem for these countries is that good alternatives are still lacking. The euro would be a natural reserve currency (and indeed, the hawkish ECB's decision to raise rates has boosted euro fortunes), but for questions about euro-zone stability. China would like its currency to play a bigger role, but that will require the Chinese government to dismantle many of the financial controls it currently uses to manage capital flows and the value of the yuan. This process will take time.

But still, it's quite natural to expect that dollar hegemony won't continue forever, and there's no reason to expect that this end will be catastrophic for the American economy. So why do so many financial writers act as though dollar decline is a scary thing?

One reason may be a misguided conflation of dollar strength and American power. But another issue is a worry about what Neil Irwin describes here:

If global investors suddenly lost confidence in the value of the dollar, they would demand higher interest rates to lend money to the U.S. government. That could make it more expensive for the government to continue financing its debts, aggravating the budget crisis further.

So, one quick point to make is that while the dollar has recently declined, American government-bond yields have been low, and quite often falling. Having said that, it's not impossible to imagine that dwindling confidence in the dollar could hit a tipping point, at which point ...

Thanks Billy Bayne

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