"Paulson is way too cautious; he'll never do it," was the response of a recently departed Treasury Department official when I asked about the chances of Treasury Secretary Hank Paulson ordering up an old-fashioned currency intervention—the last one was in 2000—to reverse the tumbling dollar.
And maybe that's for the best, anyway. Right now the weak dollar is helping boost our exports and offset damage from the battered housing market. And for all the concerns about a weak dollar being inflationary, falling bond yields are screaming that the big risk out there is weak growth, not higher inflation. It would also look a bit hypocritical to prop up the dollar right at the same time we are telling the Chinese to quit propping up their currency.
Plus, getting back to Paulson's caution, what if the intervention failed? What if the global currency markets shook off Treasury action the way bond markets ignored the Fed a few years back, pushing rates lower even as short rates went higher? It's better to be perceived as powerless than to go ahead and remove all doubt.
Yet I will be the first to admit to a visceral repulsion at the sight of the declining greenback, and part of me would love to see Paulson try to give a kick to the keisters of all those dollar bears out there. Still, it's at those moments that it's critical to understand what is really going on with the dollar.
1) The falling dollar is not some international verdict on our trade or current account deficits. For starters, the trade deficit looks to be narrowing—in September, it was at a 2½-year low overall—as a percentage of gross domestic product going forward. But I doubt whether that gap has been a factor in the first place. A more likely factor is greater currency diversification by other countries. As Morgan Stanley currency analyst Stephen Jen astutely notes:
Exchange rates are no longer driven by trade or concerns about trade imbalances. We don't remember the last time someone told us that they were selling the USD because of [the current account] deficit. Rather, more than ever, exchange rates are driven by cross-border flows, e.g., diversification flows by central banks in Asia and the Middle East, and structural portfolio adjustments in the private sector, as "home bias" [the propensity of investors to use their savings to finance domestic investment rather than overseas investment] declines worldwide.
2) Another big reason we are seeing greater global currency diversification is that U.S. economic growth looks shaky because of the mortgage meltdown and credit crunch. Dollar bears are economy bears. The fourth quarter should prove critical in this regard. If the bears are correct, this is the time when the consumer should roll over, helping drag down growth and pushing the Fed to cut rates further. But if the Fed is right, the economy will be strong enough to weather these various crises on its own without further cuts, leading to a reacceleration in 2008. That scenario, plus a narrowing trade deficit, might mean we are seeing the lows for the dollar.
3) The rest of the world matters, and the dollar's retreat, as JPMorgan Chase economist Jim Glassman argues, "is a reflection of a healthier, better-balanced global economy, not the result of 'global imbalance' chickens coming home to roost, as the doomsayers often portray." He notes that the dollar's retreat back to the levels seen in the 1970s and between 1985 and 1995 is as much about booming global growth providing more options for global investors: "The rise of the dollar since the mid-1990s was the result of recessions across Asia, a Japanese economy that was struggling with deflation, and subpar growth in Europe" with the U.S. economy accounting for some two thirds of real GDP growth in the industrialized economies.
4) Forget about a "strong dollar policy." America needs a "strong economy policy," Glassman contends. That means keeping inflation low and economic growth high. With the current political debate focusing on immigration, trade retaliation, and income inequality, I am not sure that will give international investors much confidence that America is actively pursuing a "strong economy policy."