-->The Dollar and The Euro
The New Capital Wars


“The dollar is about to weaken. The main question is: against what?”

We wrote this in May 2000 (Euro Weakness: It’s The Dollar, Stupid!), concluding that, for lack of alternatives, the dollar would weaken against the Euro. But, we warned, there was no point in looking to Europe for early signs of this reversal, since the trigger would be the deflating of unrealistic investors’ expectations in the United States.

Subsequently, the dollar continued to fluctuate around Euro 1.10 for a year, before losing almost a quarter of its value. It now stands at 0.85 Euro. A legitimate question, at this point, is whether the recent strength of the Euro has merely been a good trading opportunity, or whether it foreshadows greater changes in the global environment.

To try and answer this question, one needs to go beyond the old textbooks.

The Markets Are The Fundamentals

In school, we were taught that fundamental economic trends (growth, inflation, trade) and interest rates drive currency movements:

A country with a trade deficit was either overheating (with excess domestic demand) or un-competitive (with an overvalued currency) -- sometimes both. If inflation was not an immediate threat, it could devalue its currency, which would make exports cheaper and imports more expensive. Otherwise, to make up for the money flowing out as a result of its trade deficit, a country needed to attract foreign capital.



Historically, the policy reaction to trade deficits and a weakening currency had been to raise interest rates. This would make local money markets more attractive to financial investors and attract volatile foreign capital. While such a stopgap measure could not be expected to work forever, the higher interest rates also tended to eventually straighten the fundamentals: by slowing domestic demand, thus depressing imports and helping to correct the trade deficit.

Over the past twenty years, however, this logic has been turned on its head.

As financial flows between countries and currencies grew exponentially with the progress of globalization, they came to dwarf the money flows merely associated with trade in goods and services. Today, a country’s current account balance (trade plus various transfers) has little impact on a currency. Rather, it is financial flows that actually determine a country’s current account balance. When foreign capital flows into a country to be invested, it tends to raise local consumption and investment, while at the same time boosting its currency. Naturally, as a result, imports tend to rise and exports to stagnate; the trade balance deteriorates and eventually falls into deficit.

From Market Bubble To Dollar Bubble
Over the past decade, the United States has siphoned global capital at unprecedented rates. This was the result, initially of the manufacturing revolution of the mid-1980s, and then of the high-tech innovation wave of the 1990s. Huge gains in productivity and the (often illusory) promise of extraordinary profits from new technologies offered the prospect of very high returns that attracted massive amounts of foreign capital into the United States.

As the stock market bubble got under way, by the mid-1990s, this trend became self-fulfilling and, as often in financial matters, began to look like an unstoppable virtuous circle. The massive flows of capital into the United States starved other nations from liquidity, thus depressing investment and slowing economic growth abroad, while the seemingly irrepressible appreciation of the dollar only served to convince foreign investors that they should pour more money into the United States. As the economy grew faster than it could have afforded in a normal financial environment, America’s trade deficit ballooned, of course, with exports generally stagnating while imports surged.

But, since there was more money flowing in than even an overheating economy and exuberant stock market could absorb, the United States invested some of the surplus capital abroad, thus positioning the dollar as the world’s currency and the U.S. financial markets as a clearinghouse for global capital.

Meanwhile, Asia, where much of that capital was recycled, was fast becoming the world’s manufacturing workshop and cheap imports from China, in particular, served to keep U.S. and global prices in check. The inflationary pressures that would otherwise have appeared at this stage of the cycle never materialized.

It seemed, for a while, that the United States could do nothing wrong from an economic perspective and that the dollar had assumed an impregnable, imperial position among the world’s currencies. But this perception was, in fact, intimately tied to the speculative financial bubble the country was experiencing.

The Other Side Of The Bubble
Today, the bubble has burst. Investment opportunities in the United States (real or perceived) have shrunk. And the dollar is on the decline. But old thinking habits die hard.

For example, some say that the gaping U.S. trade deficit (largely ignored during the bubble years) is not a problem. They argue that foreigners were happy to finance that deficit throughout the 1990s, and that there is no reason why they should feel differently now. But there is a huge difference. In the 1990s, the United States attracted foreign capital by offering the promise of extraordinary returns on investments in private businesses. Today, instead of outstanding profit opportunities, the United States is offering foreign investors low-yielding government paper originating in its burgeoning budget deficits. The supply of dollars seeking to invest into the United States is likely to suffer for an extended period of time, especially since former investors in business or the stock market are unlikely to massively become investors in treasuries.

A Lengthy Adjustment
Unless the United States experiences a sudden, unexpected boom in exports, most of the restoration of its trade balance will have to come from a decline of imports - not necessarily in absolute terms, which would be extremely painful and may be avoidable, but at least as a percentage of the Gross Domestic Product (GDP).

Since the U.S. current account deficit presently stands at 5% of GDP, correcting it without much help from exports should significantly detract from domestic growth for several years.

Of course, the correction could take the form of a deep and protracted recession, which would suppress domestic consumption and investment and, as a result, would shrink imports. But this is a very unlikely occurrence over the near term. A huge fiscal stimulus package has just been adopted, which should at least sustain domestic demand (perhaps boost it) until the November 2004 presidential election. As for the Federal Reserve, which seems most worried about deflation, it remains on a solid track of easy and cheap money. If U.S. consumption and investment are sustained for the next eighteen months, imports, too, are likely to remain high.

There is equally little hope for a rapid improvement in the export side of the trade balance. It should not be overlooked that a significant portion of U.S. trade takes place with countries whose currencies are officially or effectively pegged to the dollar -- particularly the Chinese Renminbi. Thus, while the dollar is down 27% from its early-2002 high against the Euro, it is down less than 10% on a trade-weighted basis. In fact, it is likely that any dollar devaluation is more likely to benefit Asian exports to Europe and Japan than to directly help U.S. exports - although indirectly, of course, U.S. exports to Asia should get some benefit from the region’s export boom.

Absent significant, immediate trade gains, a dollar devaluation will mostly affect the US trade balance through… blackmail.

Do We Have A Weak Dollar Policy?
Because of the size and volume of transactions attained by foreign exchange markets in recent years, government intervention in the currencies markets has become a futile exercise. At best, it can be used to smooth fluctuations and, occasionally, to “punish” currency traders with raid-like operations whose main effect is to calm the speculative game for a while. Otherwise, governments - especially that of the United States - have increasingly resorted to jawboning, announcing that they “welcome” or “disapprove of” current currency trends, and alluding to unspecified powers that they might have over currencies. But these powers have all but evaporated with the growth of international capital markets.

Some countries, whose currency is an important determinant of exports and economic growth, still intervene regularly - mostly to prevent their currencies from appreciating. Japan is a good example, although their success in that endeavor remains debatable. China and some other Asian exporters also have recently been major buyers of dollars. They have, so far, been successful in preventing their currencies from appreciating because their foreign exchange markets are either small or largely closed. Nevertheless, by acquiring dollars from local exporters and recipients of foreign capital investments (and issuing local currency in exchange), they tend to boost local money supplies and inflationary pressures. While this has not yet been a major problem in a deflationary environment, this blessed combination may not last forever.

So, why does the United States appear to have been “talking the dollar down” in recent official statements? Many conspiracy theories have been advanced to explain this new tack. The most credible is the blackmail one. The United States means to pressure Japan and Europe into injecting more stimuli in their economies. Arguably, because many commodities and transactions are priced in dollars and China’s Renminbi is pegged to the U.S. currency, a weak dollar will benefit the United States less than it will hurt Europe and Japan. On the other hand, a revival of domestic spending and investment in Japan and Europe would help U.S. exports, which have suffered from the weakness of these traditional markets.

Hence the recent statements, often contradicted but re-iterated, that the United States “welcomes” the dollar weakness or, at the very least, views it with “benign neglect”. Translated, these statements mean that, either Europe and Japan take measures to boost their domestic economies, or the United States will encourage a further weakening of the dollar.

What Is The Right Price For The Dollar?
Many economists who refuse to abandon their obsolete notions about currencies point to various calculations of Purchasing Power Parity (PPP) to justify their hope that, after a nearly 30% decline against the Euro, the dollar cannot be far from a bottom. PPP models purport to show where currencies should sell on the basis of fundamentals, by taking as a base some “normal” years and calculating the erosion of the purchasing power of various currencies to inflation since then.

There are at least two fallacies in the PPP arguments. First, as we have argued, fundamentals have little left to do with currency behavior - at least in a causal way. The relative impoverishment of a nation through inflation thus means little about its competitiveness or the future of its currency. Second, to be relevant, PPP calculations would need to be made only on internationally-traded goods, and then on the specific goods imported and exported by each country: the more precise one would try to be, the more imprecise the statistics used would become and the more inextricable the problem.

Our simple observation is that the Euro was introduced in 1999 at a level only slightly below where it now stands against the dollar. There were some ramblings at the time, as would be expected in a consensus exercise, and it is possible that the level selected was a bit expensive, to fend off any inflationary pressures emanating from the new currency’s introduction. But, basically, no one complained loudly that the introductory level was exorbitant or damaging to business. Since there has been little inflation worldwide since, we doubt that the Euro today is grossly overvalued against the dollar… on a “fundamental” basis.

Why Should The Euro Be Attractive?
One notion that has much currency these days is that, while the United States is passing through an economic adjustment, its economy remains one of the most dynamic and versatile in the world. In contrast, Europe is sick, flirting with recession and faced with seemingly insurmountable structural and social problems. We have no argument with this assessment.

However, this is how things stand now. And now is what is priced into the current Euro/dollar parity. But markets will price the assets they trade at the margin: from this point on, it will take only one participant changing his mind about either economy’s prospects to move that parity.

The current social unrest in France and Germany may well be regarded as “more of the same” for old Europe. But the truth is that it is the direct result of these countries’ governments deciding to take action - for the first time -- against the social paralysis that has plagued their countries. Should they meet with some success on that front, even moderate, the Euro might get a further boost. Meanwhile, the U.S. economy may be about to undergo a long-term re-assessment, with the lingering effects of recent scandals and the re-uniting of the “twin deficits” (budget and current account).

To summarize, pricing at the margin means that the United States tomorrow could overwhelmingly remain the world’s strongest and most dynamic economy, while Europe gets only slightly better, and that would be enough of a change to cause a further rise of the Euro against the dollar.

Capital Wars
In a prescient article for The International Economy magazine (July/August 2000), Criton M. Zoakos wrote: “…A new model is required that views market developments … (as a result of) … the protracted struggle between the major central banks of Europe, Japan and the United States to influence international capital flows”.

Old-fashioned mercantilism, which attempted to influence trade-flows to each country’s advantage, has been supplanted by a modern form of mercantilism, which tries to influence capital flows because governments have now discovered that these flows will, in turn, determine the fate of their countries’ other economic indicators.

In the struggle for capital, the United States remained unchallenged for nearly a decade. The recent strength of the Euro, though minor by historical standards, may foreshadow some momentous changes in the global environment over the coming decade.

The Short And Long Of It
Just as we saw in 1995 a combination of factors that announced “The Decade Of The Dollar” (a few printed copies are still available), we believe that we now have entered “The Decade Of The Non-Dollar”. This period should be marked by the strength of other major currencies (including the Euro) against the U.S. dollar and also, possibly, by a flight into harder assets. But this does not tell us what to expect in terms of cyclical fluctuations.

Because currency trading is so disconnected from economic fundamentals, it has become a field of predilection for technical analysts, who use charts, momentum measures, deviations from moving averages and other purely market-related indicators.

At the moment, most of these indicators seem to indicate that the dollar has fallen too far, too fast. Thus, a fairly meaningful bounce would be a logical occurrence in the weeks to come.

But, in view of our long-term perspective on global developments, we would consider such a rally as a great opportunity to switch into Euros.

François Sicart

June 16, 2003
© Tocqueville Asset Management L.P.