What does the strong dollar signal?

Original Article

2015 is off with a bang of higher currency volatility than in past years. Switzerland’s mid-January surprise abandon of its currency peg to a declining Euro — causing an overnight 16 percent upward spike and instant revaluation of the Swiss Franc — looks to be followed by Denmark. The long established exchange-rate of the Krone that Denmark pegged to the German mark and now the successor Euro currency is about to break for the same reasons that prompted the Swiss move.

These are the consequences of currency wars from countries seeking to “beggar-thy-neighbor” through currency devaluation, a policy with winners and losers that has led to real wars in the past. Surprisingly, the legitimacy of currency wars has just been embraced at the G-20 meeting of finance ministers on Feb. 11. Currency devaluation helps export-dependent countries, like Japan and Germany, by making their exported goods cheaper in foreign markets.

Generally, the financial health of a country, as measured by deficits and debt and forecasts of deficits and debt accumulation, plays an important role in driving the relative currency valuation of a particular country. Countries that have chronic deficits and growing debt burdens ultimately end up in a weaker position in the foreign exchange markets, albeit sometimes with considerable lag times.

The first European debt crisis of 2010-11 caused a nearly 20 percent drop in the Euro against the U.S. dollar. Then, when S&P downgraded U.S. government debt in August of 2011, the U.S. dollar began to weaken. Today, four years later, the U.S. debt has grown by more than $3 trillion, yet the dollar is on the rise against almost all other major currencies. What gives?

The world is in turmoil and not just because of geopolitical instability from ISIS and related radical Islamist jihadists, Iran’s near completion of a nuclear bomb and Russia’s military adventurism into Ukraine. Central banks are also stoking the fire of risk and uncertainty with unprecedented money printing and debt. Japan is economically comatose with a declining native population and national debt at nearly 250 percent of GDP. Europe is now facing its second debt crisis in four years, with Greece once again headed for insolvency, unable to meet its debt obligations.

In the face of all this uncertainty, the U.S. dollar is seen as a safe haven that provides a deep and liquid market. But the reason for a strong dollar may be only partially due to confidence in the U.S. relative to other countries. By several standard ratios, such as national debt to GDP, and tax revenue to national debt, the U.S. debt problem is worse than any of the largest, most economically important European countries, such as Germany, France, the U.K., and the Netherlands. True, the U.S. deficit has fallen the last two years, but the Congressional Budget Office and the White House both project dramatic deficit increases starting a few years hence—adding about $7.5 trillion to the U.S. national debt over the next ten years.

The fact is confidence in central banks and major fiat currencies is increasingly frayed. Quantitative easing, massive money printing, bailouts, zero and even negative interest rates have been relatively ineffective in stimulating economic growth. The recent flight to the dollar is only in part due to the relative strength of the U.S. economy. The dollar is also a weigh station of relative safety in the face of the next looming financial crisis that could start with any of the major fiat currencies — the euro, dollar, or the yen.

The present strength of the dollar is temporary and can also be seen as the penultimate stop in a flight to safety. When the next financial crisis unfolds — as it surely will — gold, precious metals and even structured alternatives like bitcoin are likely to be the next and last stop.

Scott S. Powell

Senior Fellow, Center on Wealth and Poverty
Scott Powell has enjoyed a career split between theory and practice with over 25 years of experience as an entrepreneur and rainmaker in several industries. He joins the Discovery Institute after having been a fellow at Stanford’s Hoover Institution for six years and serving as a managing partner at a consulting firm, RemingtonRand. His research and writing has resulted in over 250 published articles on economics, business and regulation. Scott Powell graduated from the University of Chicago with honors (B.A. and M.A.) and received his Ph.D. in political and economic theory from Boston University in 1987, writing his dissertation on the determinants of entrepreneurial activity and economic growth.