The U.S. Dollar and the Limits of Irresponsibility

Promises, promises. How many ways can the politicians dream up to spend money that they don’t have? Perhaps it’s easy when you are the world’s reserve currency, and few argue with taking down IOUs denominated in US dollars, at least for now.

But there are limits. When looking at the US dollar today, the markets have kind of a benchmark that they use as their default scenario:

• Fed funds will not drop below 1.5% at the bottom of this cycle.
• CPI inflation will not rise above 5% for this cycle.
• Nominal GDP growth will not drop below 4% for this cycle.
• The US current account deficit will improve, albeit fitfully.
• Total Federal Debt will not grow faster than $600 billion per year. (you didn’t know it was growing that fast, now did you? )

Of course, this is just my view, and I could be wrong. But the US dollar has gotten trashed, and in order for it to get hit further, the powers that be will have to exceed the current “Limits of Irresponsibility.” As for the default scenario that I have laid out above, those are key parameters that I think are baked into the current low level of the US dollar. Violate those levels, get a lower dollar. Get further away from those levels, and dollar could rally.

When I gave my talk to the Society of Actuaries, one of my recurring themes was, “It is wonderful to be the world’s reserve currency.” Consider especially slide 32, where the weak dollar combined with strong overseas equity markets flattens out the net foreign assets to GDP ratio at near -20%. We ship our losses overseas, and that isn’t counting all of the subordinated structured product that they bought… yet.

I am not a doom-and-gloomer by nature. I try to recognize what is wrong, analyze what could be done to ameliorate the situation, and consider what could go right. I am not an optimist on the US dollar, though I don’t see how it falls much further from here. There is room for the US dollar to rally, if only a few things go less wrong.

In the long run, though, there are imbalances that the US needs to change, and the long run path of the dollar will rely on those changes. I believe that the markets embed an improvement in US policies long run; if that fails, we will continue to see the dollar deteriorate.

Comments

[gaucho]

You have stated several parameters that must not be violated. I think that several shall be violated.

1. CPI inflation will not rise above 5% for this cycle. Producer price index is already well above that number. Are you talking the real CPI that we must pay or the rosy scenario that the FED paints?

2. Nominal GDP growth will not drop below 4% for this cycle. This is a given we are sliding fast into the abyss and will be lucky if it is zero.

3. The US current account deficit will improve, albeit fitfully.
This depends on the Oil prices and the dollar value. See the above.

4. Total Federal Debt will not grow faster than $600 billion per year. (you didn’t know it was growing that fast, now did you? ) With a major recession looming and the Idiots economic policies in place for at least 1 more year I think that smoke and mirror number will be taken out.
I actually thought 700-800 given the smoke and mirrors but this is just an uneducated guess given the history of deception by the FED on the economic numbers.
A dollar level of 2 to the Euro would not surprise me.

[special1person]

"if only a few things go less wrong."

In other words, Situation Normal per the last 7 years...

"If only a few things go less wrong, in 6 more months, I think we'll be turning a corner..."

Six months later...

"If only a few things go less wrong, in 6 more months, I think we'll be turning a corner..."

Six months later...

"If only a few things go less wrong, in 6 more months, I think we'll be turning a corner..."

[DSX Lover]

There's no Reason why the U.S. should have so much Debt in its Books.
Over $6 Trillion in Debt, is irresponsible for the richest Nation in the World. It should pay all of its debt and them become a Creditor Nation.
Then see what happens to the Greenback. The Bernanke move to accept all kinds of Leveraged assets with a haircut in exchange for Treasuries in the Discount Window is going to be remembered as one of the best moves in the FED's history. Not only is the Fed giving Treasuries at the lowest yield ever in history, but is also letting the Banks reliquify their Balance sheets with liabilities (Treasuries that are going to worth less, because there's a Bubble in these prices, and yields will go up), while their assets get repriced higher.

[Afam]

The only corner I see has a truck coming round it at 70 mph!

Consumer debt could not contine growing at the rate seen between 2001 and 2007. And that which cannot continue indefinately must stop - one way or the other. And indeed true to law it has.

Government debt can not continue to grow at the rate at which it has grown over the past 8 years. Some where around that corner it must stop. Don't ask me how, that would be like giving away the name and coulour of the car around the corner. But if the driver doesnot stop it (discipline) then nature will find a way.

Despite what Bernanke, Greenspan and the popular press believe about tight labour market and fast economic growth. Inflation happens when the money supply (coins, notes, account balances and debt) grows faster than the supply of goods and services. Bernanke is minting money big time, after going to wherever it hangs out, at some point it will come home, causing inflation (perhaps not immediately - as the amount of credit is currently diminishing), but at some point around that corner 5% CPI will seem like a walk in the park.

The US is lurching from financial crisis to financial crisis the smoking gun apears always to be with the fed/financial markets and the solution always apears to pour more money on the fire (with the exception of 70s, when Volker doused the fire.) And the crisis apear to be apearing closer and closer together, a sign that it is coming to a head (given the six years between 01 and 07 - I predict that the next crisis, being fuelled by the solution to this crisis will come within 3 or 4 years.)

[Dude59]

To add to what Gaucho stated above:

1. Fed funds will not drop below 1.5% at the bottom of this cycle. I believe thaqt this will hold, as lowering the rate is not helping lower mortgage costs, which is the primary drag on the financial system. Unfortunately many more homes will foreclose as house prices reset to the mean, which is 3 to 4 times average incomes.
2. CPI inflation will not rise above 5% for this cycle. Do YOU believe the CPI Numbers? Well, since the cost of houses will come down another 10 to 25% depending on region, I suspect that this will be counted with enough emphasis to bring the overall inflation rate down, even though it was not counted as moving inflation up previously.
3. Nominal GDP growth will not drop below 4% for this cycle. Since the CPI deflater to GDP will remain deflated, there is a good chance that this number can also be adjusted.
4. The US current account deficit will improve, albeit fitfully. This will only happen if Oil is not included.
5. Total Federal Debt will not grow faster than $600 billion per year. Since it already grew by $500 billion in the first six months of this fiscal year, I would bet that this one will fall also.

In conclusion, I feel that most of your "Limits of Irresponsibility" will fail, assuming that you look at more than the "Official Government Propaganda", whoops, I meant information.

[iThinkBig]

Ummm, how about declaring an energy crisis, increase subsidies to $200 B instead of $7 B and create a global investment opportunity in America to compete against oil? I believe we will surpass all of the benchmarks the writer mentions and then some, UNTIL we give the global consumer what it actually needs. Coincidentally, such a plan would give the financial community also what it needs, a new market to create loans for a product that is the #1 demand of the globe. How can I be so bright? I just don't reside in encapsulated Washington :)

[flow5]

The dollar is doomed. Two principal factors were responsible for the origin of the E-D banking system; (1) the possession by foreign commercial banks of an EXCESS VOLUME OF SHORT-TERM CLAIMS AGAINST THE U.S. DOLLAR, (I.E., OUR CURRENT ACCOUNT DEFICIT) and (2) the preeminence (at that time) of the U.S. dollar as the reserve, standard-of-value, and transactions currency of the world.

The volume of prudential reserves held by each E-D bank presumably is dictated by “prudence” – not by any legal requirement administered by a monetary authority. All prudential reserve banking systems have heretofore “come a cropper”. Money creation by private profit institutions is not self-regulatory- the “unseen hand” simply does not function in this area. Invariably the systems created too much money, speculation became rampant, inflation distorted and destroyed economic relationships, confidence that the banks could meet their convertibility obligations eroded, “runs” on the banks caused mass banking failures, and entire economies were left in ruin.

If the E-D system is not to repeat the tragic record of all previous prudential reserve banking systems two thins are necessary: (1) the U.S. dollar must remain acceptable as the world’s transactions currency (This requires that the chronic deficits in the U.S. balance of payments cease), and (2) the E-D system must be subjected to the restraints of controllable legal reserves and reserve ratios.

But this is only the beginning. After the legal structure has been put in place we will still need monetary authorities who understand the economics of money creation, the consequences of excessive money creation – and are willing to force on the governments and business communities of their respective countries the discipline of a properly regulated money supply. The latter problem will be with us whether control is vested in the central bankers, or the International Monetary Fund is made a world central bank and control of the E-D is vested in it.

But the alternative is, at some point in time, a flight from the U.S. dollar and, therefore, the Euro-dollar. This will GENERATE HYPERINFLATION IN TERMS OF DOLLAR DENOMINATED ASSETS, and an international financial crisis of unprecedented proportions. If history is a guide it is obvious these requisite conditions will not be achieved.

[zenalgorithm]

The dollar will truly become bullish when:
1. U.S. pulls out of Iraq.
2. FED starts raising interest rates.

The dollar is in no-mans-land until then.

[Ames Tiedeman]

The U.S. Trade Deficit is a huge problem. We will either end up being owned by foreigners or we will simply fade away. Both prospects are quite un-American. Some basic facts: The U.S. has not had a trade surplus with the world since 1974. We have not had a trade surplus with Japan since April of 1976. We stopped having trade surpluses with Eurpoe in 1983. Fifteen years ago we did not have a trade deficit with China. Now we have a 250 Billion a year deficit with the People’s Republic. A nation that does not make anything is a worthless nation. Worse, the longer we go without making the needed investments in our manufacturing infrastructure, the more knowledge we lose. We will either forget how to manufacture or we will simply not be good at it. Our creative energy fades away if we do not use it. Also, it is innate to want to make things. Kids play in sand boxes, youg men build tree forts. This is human nature. All of this is being taken away from the American people by idiots in Washington who do not know how to make trade deals. And you think the dollar is going up?

[atauber]

by jan 2009 the Euro will be back to 1.10 -1.15