Forex Traders'  Instablog

The flow of funds data released a while ago by the Federal Reserve summarizes the purported recovery of this year in a succinct, and striking fashion. During the first quarter of this year, domestic financial debt in the U.S. grew by around 4 percent in annualized terms, while both the household and corporate sector obligations shrank. The growth in debt was entirely the result of massive government spending on both the state and federal levels. Both the speed of expansion in government debt, and the speed of contraction on the private sector exceed the levels of the previous recession in 2001 by a large margin.

So the question is, will this massive government intervention allow the private sector the breathing space it needs in order to shrink its balance sheet, regain its health and resume its role as the driver of economic growth? The answer would be yes, in the absence of any unpredictable shocks external to the economic picture.

We do know that the deleveraging in the consumer and corporate sectors is a healthy, and expectable development which will eventually allow the economy to stand on its feet again. The problem is that the deleveraging process will take many years to be completed, making the claims about an incipient bull market untimely.

Reducing debt to a reasonable level, while increasing the amount of household savings, is a process that will take a long time to be completed. Meanwhile, dollar bears and doomsayers argue that the U.S. lacks the resilience to maintain its status as the superpower of the world as this process takes place, with the dollar being the main victim of the collapse, and as some argue, hyperinflation being the result.

Fortunately for the U.S. the symbiotic relationship between China and the United States, Japan’s dependency on American security guarantees in the face of its nationalistic and surging neighbor to the east, the fragmented nature of the Arab World, the reliance of the tiny oil rich sheikhdoms on American protection all ensure that the U.S. is still the most powerful nation in the world not only militarily, and economically, but diplomatically as well. Unless the American leadership itself makes a conscious decision that the debt burden is impossible to manage without monetization, and that domestic dynamism is insufficient to take us out of the present debacle, there is hardly any evidence that the U.S. will be forced into debasing the dollar in response to market pressures. And there is every indication that the political leadership of the nation still considers the devaluation option an extreme, and at this stage unnecessary choice.

Contrary to what is often assumed by analysts and commentators, it was Mr. Bernanke himself who initiated the 2008 upsurge in the dollar by making repeated references to its importance for the Federal Reserve as a central bank, and finally bringing rate cuts to a halt, in spite of exceptionally difficult circumstances, in April 30th, 2008.

In sum, the government is happy with a slowly depreciating or stagnant dollar, but it is also against any sharp acceleration in the downtrend (if it indeed exists). Indeed, given how dependent the global system is on stability and confidence, a dollar collapse would be the most counterproductive outcome at this stage. It is hard to argue that the government knows what it is doing, but it certainly isn’t trying to save the U.S. economy by burning the U.S. currency.

We believe that the dollar is unlikely to suffer any major collapse anytime soon. It is without doubt that the American economy is suffering from massive imbalances and inefficiencies, but as long as the rest of the world has no perceptible benefit in a destroyed standard of trade, and possesses nothing to replace it, the dollar death scenario will create new problems, without solving any of the outstanding issues.