Deficits and the Dollar's Declining Value

One of the questions that has arisen from the posts I have put up over the last several months has to do with my statement that the international financial community doesn’t like government deficits and tends to believe that a lack of fiscal discipline will result in an increased monetization of the debt. The feeling that the central bank of such a country cannot, in the longer run, overcome the fiscal imprudence of its national government and act independently of that government has resulted, time and again, in a decline in the value of the currency of the country being examined. The dollar is no exception.

Let’s look at the following information.

Average Yearly Increase in Gross Federal Debt (in billions of dollars)

Nixon/Ford $49.5

Carter $90.2

Reagan $258.6

Bush 41 $359.3

Clinton $232.1

Bush 43 $541.1

Now let’s look at the decline in the value of the dollar from the start of an administration to the end of that administration. I will use the trade weighted index of the United States dollar versus major currencies. The series begins in January 1973. Up until August 1971 the United States had a fixed exchange rate. At that time President Nixon announced that he was allowing the dollar to float in foreign exchange markets and was taking the United States off of the gold standard.

He also announced that “We are all Keynesians now!” meaning that he was going to stimulate the economy with budget deficits (so that he could get re-elected) and to protect against inflation he was freezing wages and prices. He created the Cost of Living Council and the Committee on Interest and Dividends to administer these controls as well as controls on interest rates. As can be seen from the above figures, the Gross Federal Debt increased by an average of almost $50 billion every year during the Nixon/Ford years. This compares with those spendthrifts John Kennedy and Lyndon Johnson who introduced Keynesian economic policies to the United States and who only increased the Gross Federal Debt by an average of less than $10 billion per year.

Change in the value of the dollar (as measured against major foreign currencies).

Nixon/Ford - 1.0 %

Carter - 10.4 %

Reagan - 5.7%

Bush 41 - 1.9 %

Clinton + 16.6%

Bush 41 - 21.6%

Note that the only administration to see a rise in the value of the dollar over the past forty years was the Clinton administration. Note, too, that the only break in the continued increase in the Gross Federal Debt outstanding was during the Clinton administration. As you may recall, the last four years it was in office, the Clinton administration ran budget surpluses.

Also, one can remember the accolades received by Paul Volcker, when he was the Chairman of the Board of Governors of the Federal Reserve System, for bringing inflation under control. Volcker was Chairman from August 1979 until August 1987. Volcker did bring inflation under control and early on this effort was reflected in a rise in the value of the United States dollar. The value of the dollar reached a short term bottom in July 1980 and then, accompanying the decline of inflation in the United States, the dollar rose in value by 55 percent to peak out on March 1985.

However, even Volcker could not hold out against the massive deficits that the Reagan administration was piling up and the value of the dollar fell from that peak by 31 percent through the month at Volcker left his position at the Fed. Even someone as strong as Paul Volcker could not fight against the increasing deficits that were being posted by the Reagan administration. The value of the dollar closed lower at the end of the Reagan years than it was at the start.

The only conclusion one can draw from these data is that participants in international financial markets do not like the currency of countries that lack discipline over their fiscal affairs. This, of course, has very strong implications for the Obama administration. With the possibility that the Gross Federal Debt is on a trajectory in which the debt will increase in the $1.0 trillion range per year, at least for the near term, the implications seem clear. There will be continued pressure on the value of the United States dollar in the upcoming years.

The specific argument for this relationship is that increased federal deficits will result in increased monetization of the debt. Increased monetization of the debt will result in an increased rate of inflation. An increased rate of inflation will cause the value of the currency to decline. So, the question being posed by skeptics right now is “where is the inflation?” The time seems more right for deflation rather than inflation.

In the short run it is hard to argue against this logic. The only thing one can fall back on to answer this question is the fact that when budget deficits increase and there is no relief from substantial increases in the debt of the country, participants in international markets tend to sell the currency. What we have seen in the past is that any inflation that results from the massive increase in the debt outstanding can come in many forms that are not all registered in the computed price indices like the Consumer Price Index. Something like the CPI is an estimate, a guess at what is happening to prices. The important thing to remember about massive increases in debt is that they have to go somewhere and where ever they go they will have large consequences. We hope that we can measure these consequences and measure them in a timely manner. However, that does not always happen.

And, where else are we seeing action? India has now joined China and Russia and Brazil in calling for a discussion at the upcoming G-8 conference of the place of the United States dollar in the world’s monetary system. China is tired of continuing to support its currency against the United States dollar. Given the likelihood of a further decline in the value of the dollar, China faces the need to buy more and more dollars and invest in more and more securities from the United States.

This, in the longer run, is not in China’s best interest. Nations, other than England and those from the Eurozone, are getting tired of the United States abusing its privilege of having the only reserve currency in the world. Although nothing is going to be done to change the monetary system at this time, this talk is going to get stronger and stronger. And, if the value of the dollar continues to decline in the future, the arguments are going to resonate more and more with others in the world. The basic approach to fiscal policy in the United States over the past 50 years has not been the most productive one in terms of maintaining a sound dollar currency.

Comments

[Prudent Man...:]

BHO continues to mention that he won the election with the implication he can do whatever he wants. George Bush was elected twice and if he made a statement like that the media would have gone ballistic.

The Congress of the U.S. passes spending bill, all of which must originate in the House. Quite frankly, I am tired of partisan finger pointing as we all know that Congress is on the take.

That said: I am concerned with what is going on now not what FDR, JFK, GHWB, Nixon, etc. did or did not do. The issues today is what is going on now and it is a horror show. That is all we can affect. Wal-Mart has proven the Crony Capitalism wants a health bill that will hurt their competition and reduce their costs at the taxpayers expense. This is just one of the corporate elite.

If anyone is interested in our Country, Freedom and Free Enterprise support Congressional Term Limits Now an remove those who keep getting re-elected because the play field in favor of the incumbents who get the special interests money.

We cannot have a deficit without the Congress' approval. Recently they have stuffed trillions of dollars into programs that will give BHO the control he wants and their political contributors a fortune. Sooner or later it is up to Congress and BHO is just a robot controlled by statists who pull his strings.

Jul 05 08:07 PM

[Steven Hansen:]

it is obvious that lack of fiscal control weakens a currency.

i would never defend the abuses the last two administrations did to the dollar.

but i would never accept criticism from any government who did not let their currency float. true float would have strengthened the bric currencies and reduced the trade imbalances.

Jul 05 10:15 PM

[Paul Bogdanich:]

This analysis is good but does not factor in indirect deficits like the expansion of the Fed's balance sheet. If one takes the position that the marginal portion of the Fed assets (about 60% under Bernanke's expansion) should be added to the gross deficit then the picture looks even worse. And who got the benefit from all this largess? Overwhelmingly the finance industry. The habit of honoring all the CDO and CDS obligations of AIG wiothout question, examination or renegotiation will prove to be one of the worst decisions in financial history. Right up there with tightening monertary policy at the start of the depression. In 75 years the consensus will be that we caused our own problems (the worst of which are still in front of us by the way) through incompetence. But back to the deficits, where are the cuts going to come from? From the programs that generally tend to benefit taxpayers and of course defense. Our days as an aggressive imperial force with world wide power projection are rapidly coming to a close. We simply can't afford it any further. We didn't generate enough value from our previous campaigns. To much ideology; freedom, democracy and all that hoohey. So in sum it would appear that the whole affair was nothing more than just a very sophisticated rape of the treasury. Declining empires are quite the sight if one adores ugliness.

Jul 06 12:33 PM

[ExOut:]

Why does everyone seem to forget that the dollar was purposefully devalued in 1985; partially to contend with the huge trade deficit with Japan? Plaza Accord anyone?

Jul 06 03:26 PM