Recently I had dinner with a college friend of my oldest son. It surprised me, but he was interested in how the US dollar was doing. I likened the current situation to the five stages of grieving.
The first stage is denial. As it respects the US Dollar, in the initial phases in the decline of the US Dollar, most foreign finance ministers and central bankers are pretty happy. After all, foreign exchange reserves are at an all time high. Export industries are booming. The government loves the exchange rate policy that keep the US Dollar artificially rich against the foreign currency. The banks are flush, credit is booming… what could be better? After all, you can’t have too much in the way of US Dollar reserves, can you? (They never have to worry about a currency crisis again!) The government is happy with them, especially since they are supported by the exporters.
Anger is the second stage. The dollar reserves are worth less and less on a relative basis, and they keep coming in. The wisdom of having a fixed rate, crawling peg, or dirty float against the dollar is questioned. Goods inflation is rising in the foreign market, and credit creation is getting out of control. The finance minister or central banker face the hard choice of revaluing the currency up versus the US Dollar, which slows the economy, particularly exports, or let the situation continue, and build up more US Dollar reserves. (“What will we ever use all these Dollar reserves for?” they might ask in a moment of lucidity. “What if the US Dollar fell a lot further? That would reduce the value backing our currency… Why is the Fed loosening so much? Don’t they care about the Dollar?”)
So, some of them revalue their currency upward versus the US Dollar, some reduce the basket weight of the Dollar, some let the peg crawl faster, and some do nothing… and the US Dollar predominantly falls in value. Some finance ministers complain about the Dollar, and net exports to the US begin to decline. This is where we are now, and I don’t know how long it will take to get to the next stage.
The third stage is bargaining. The foreign finance ministers and central bankers are stuck. They are getting pressure to lower the value of the currency against the dollar from exporters, and the politicians that they support. They wonder if an intervention on the foreign exchange market might do it. They call their opposite numbers around the globe, proposing an intervention to raise the value of the dollar. Enough agree to do it, and the coalition of the willing does what they don’t want to do. They sell their own foreign currencies, and buy more dollars. The surprise works! They caught the FX traders leaning the wrong way, on a day when economic news was going their way, they cooperated, and they did it BIG! The US Dollar rises a full five percent. (“See you at the party tonight!”)
Only one problem, which is clear the next day to Finance ministers, Central bankers and FX traders alike. (“What are we going to do with all the new US Dollar reserves that we bought? We already have too much of that…”) The FX traders pounce, and take the opposite side of the trade, and push the US Dollar lower.
Stage four is depression. (“There’s no way out, and we got snookered by the neo-mercantilist exporters who got us to keep the currency too low versus the US Dollar.”) The US Dollar is below the earlier intervention level, and there have been a few additional failed interventions, where the FX traders ate the central banks for lunch. The US Dollar continues to fall.
Finally, stage five, acceptance. The foreign currencies rise to sustainable levels versus the US dollar. Inflation and real economic activity decline in the foreign countries. They begin buying more goods and services from the US, and dollar claims are redeemed. Inflation and interest rates rise in the US, as we have to produce more to pay off the dollar reserves now being redeemed by foreigners. (Send us goods and it will pay off your debts! Amazing how the US got good terms on both sides of the transaction.”)
Well, maybe. It will take a while before all major trading parties in the world float/adjust their currencies to fair levels. At the time that happens, though, it will be obvious that the US is less important to the global economy. The relative value of all US assets will be a smaller proportion of global assets, though it will still likely be the largest share in the world. My view is this process to get to stage five will take no more than 10 years. By that point, the hopelessness of Federal social insurance programs like Social Security and Medicare, plus underfunded Federal and state retirement plans, will force benefit reductions and tax increases on the US, and crimp borrowing capacity, unless they borrow in a currency other than dollars. There are five stages of grieving for US social welfare programs as well, but I am afraid we are only in the first stage now, denial.
That is a topic for another day, and not one that I am excited to talk about.