Stagflation and the Dollar

I’ve been surprised — in a way pleasantly surprised — by the resilience of the dollar in the face of record deficits and debt.   Still, these policies combine the federal reserve’s decision to pump money into the system to threaten to undercut the value of the greenback.   Ill advised over-extension of American military forces in the Mideast have already caused people to doubt US military capacity; these budgetary moves could do the same with economic policies.  The result could be a worsening of the economic crisis, with no clear path out.

I noted last year that the dollar was defying expectations and staying strong, something I considered a short term phenomenon.   At that time (late November) the dollar was  at $1.28 per Euro, now it’s at $1.40.  That’s not a major change, but it could be the start of a slipping of the dollar’s value.   The dollar remained stable through March, when its value was about $1.25 per Euro at the beginning of the month.   By the end of April the dollar was slipping to $1.33 per Euro, with a sharper decline last week.   The dollar is still better than it’s historic low, around $1.60 per Euro hit last summer as oil prices skyrocketed.   Moreover, while the dollar has been losing value, it has been a stable, slow decline – there is no panic selling.

There are a lot of reasons to consider the dollar overvalued.  Last summer the driving force was fears about a possible recession due to high oil prices, and ongoing concern over the large current accounts deficit the US had been running for years.  It grew steadily until it hit a peak of 6% of GDP in 2006.   This almost always leads to pressure on a country’s currency, something the US had avoided by becoming a haven for international investors, most of whom felt that investments in the US were likely to yield good returns.

The dollar’s weakness really started to show in late 2007, as the subprime crisis and the bursting of the housing bubble caused speculators to start to bet against the dollar.   High oil prices, recession fears, and reaction to the collapse of Bear Stearns (and fears that other such financial firms, such as Lehmann Brothers, could be next) kept up the pressure.  On September 15, the day that the current economic crisis became public knowledge as the economic tsunami hit, the dollar stood at $1.43 — off it’s lows, but at a value lower than it stands today.

It’s not hard to see why.  For about a week after the concerns about American financial markets became public, the dollar dropped — by September 23rd it was at $1.48.   Then suddenly it turned around, and by mid-October was around $1.35 per Euro, then in November got down to $1.25 per Euro and until recently stayed around a pretty narrow range.   The first week of the September 2008 crisis saw the Europeans and others believe they were relatively immune.  In fact my blog entry on September 23rd was “Schadenfreude in Europe,” commenting on that sense that this was an American financial problem.   Quickly it was clear that was not the case — the next week the news from Europe turned sour, and by October the crisis was recognized as truly global.   Only then did people flock to the dollar — not because America’s economy was seen as strong, only because the US was the dominant world power, both militarily and economically, and there was no place else to turn, at least in currency markets.   The value of gold, of course, rose even faster.

Since then the Obama administration has tackled the recession aggressively.  Recognizing that the collapse of credit markets could easily spiral into a depression as deep and broad as that of the early 30s, they felt quick action injecting money into the economy, the financial system and credit markets (to keep interest rates low so that home sales would hopefully become lucrative) the White House and the Federal Reserve Board each worked to prevent economic collapse.

This was criticized by many on the Left and Right as being too cozy with big money — bailing out the people who caused the problem.   Many on the right believe we should just let the banks fail and trust the market to adjust.  But there is no guarantee the markets will adjust — it’s more likely the collapse would have continued as it had in the early thirties.   People on the left tended to believe that the focus should be more on aid to the poor and help to people losing jobs and homes.  To them the model should be FDR, and his programs to get people to work.  The compare Obama’s plan helping big money to FDR’s public works program, and conclude that Obama is helping the wrong people.

To Obama, Geithner and Barnacke, the difference between Obama and FDR is three years.   FDR got started in early 1933, as the depression had already gripped the US with the Hoover Administration having done little but hope that the markets would simply correct and adjust.   Acting earlier to try to fix root of the problem — credit and financial markets  — the hope is that this will avoid a fall into depression and allow the world economy to avoid another Great Depression.   In theory it could work — fire up the economy, avoid total collapse, and then manage the recession.

The two big problems with this theory are: a) the risk of inflation due to large deficits and injections into the money supply; and b) the fact that the economy needs restructuring — the practices before last year were unsustainable.  While a depression can overshoot the adjustment and spiral in on itself, efforts to prevent necessary corrections are doomed to fail.   The Obama administration is trying a balancing act to restructure adequately while preventing collapse.

So eyes on the dollar — if the decline continues, or if panic selling starts, then we may be in for a very rough ride.  Stagflation would bring a second and more brutal round to the current crisis, with no clear path except to ride the storm out.   If the dollar can stay relatively strong and the economy turn around, then maybe Obama will pull this off.   But even if he does, the heady days of the bubble economy are gone — like the roaring 20s, they were built on sand.  That doesn’t mean a restructured economy can’t boom again, like we did after WWII.   But for that we’ll need a new international economic order (a “Bretton Woods II”), environmental sustainability, fiscal responsibility (cut debt and deficits), and a better balance of production and consumption.

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