Strong Dollar

Treasury Secretary Geithner said, as recently as October 3, that “it is very important to the United States that we continue to have a strong dollar,” as reported by Bloomberg. Yet, the dollar continues to slide: 12 percentfrom its peak this year in March as measured by the Federal Reserve’s trade- weighted Real Major Currencies Dollar Index.

As of this point, investors no longer believe this rhetoric, which is standard for Treasury Secretaries:

“Since the dollar has been weak and weakening for years, Geithner was using a code phrase, a carry-over from the Bush administration,” said David Malpass, president of research firm Encima Global in New York. “It means that the U.S. approves of a constantly weakening dollar but doesn’t want a disruptive collapse,” said Malpass, the former chief economist at Bear Stearns Cos. and deputy assistant Treasury secretary from 1986 to 1989.

The government has used the phrase for so long that “I don’t think it has much meaning left for the markets,” said Vassili Serebriakov, a currency strategist at Wells Fargo Bank in New York. “Once you have this policy in place I don’t think there’s any possible choice but for the Treasury to stick to what it’s been saying all this time.”

The problem is that the desire for the dollar to be strong is in conflict with the need to adjust to the large current account deficit. US economic recovery requires an increase in exports, and current account adjustment requires that plus reduced imports, and that requires a weak, rather than a strong dollar. Economic policies pursued to combat the recession do not induce expectations of a stronger dollar in the future.

The problem, of course, is the fundamental conflict between internal and external objectives of economic policy. To be the world's reserve currency requires sacrificing internal concerns for external ones, so that confidence in the currency is maintained. This is hard to do when we are in a deep recession.

More on the bailout

Most of the analysis of the Treasury's takeover of Fannie and Freddie focuses on the need to cope with the housing crisis. But the most important motivation to do this now was to prevent a financial crisis. It is important to note that a large portion of the debt of the two corporations was held by foreigners.

The top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds, according to the U.S. Treasury's most recent "Report on Foreign Portfolio Holdings of U.S. Securities."

This capital inflow is a response to large US current account deficits. The debt of the GSE's, while not explicitly guaranteed, clearly bore an implicit Federal guarantee (as is now totally evident). Foreign investors who purchased GSE debt were naturally worried. If the GSE's went bankrupt they would perhaps gain cents on the dollar. The bailout announced by the Treasury will hurt shareholders, but will probably keep bondholders whole. Hence, the bailout reassures foreign investors at a time when we need them.

Of course what remains to be seen is whether the current bailout plan will suffice. As many have noted (for example, Paul Krugman here, or Mohamed El-Erian here), we are now in a process of de-leveraging. This is the reverse of the process in the boom when leverage is used to maximize returns. Now the race to safety means a rush to sell assets to bolster balance sheets. But what is good for the individual may not work for the economy as a whole. The rush to sell drives down prices which further worsens balance sheets and leads to more selling. Liquidity dries up. This is Irving Fisher's debt deflation. Japan went through this in the 1990's. Can we escape it?