Several years ago, at a meeting at the Peterson Institute for International Economics with economists who were beating up on the U.S. dollar’s poor underlying fundamentals, Paul Volcker raised a pertinent point. For the dollar to depreciate, it has to depreciate against another currency. He then raised a rhetorical question. Bad as the dollar’s economic fundamentals might be, which major currency had better fundamentals than did the dollar?
Paul Volcker’s insight is particularly relevant today. To be sure, the U.S. does have a major public finance problem that has to raise questions about the dollar’s long-run future. But so does Europe and Japan.
Meanwhile, the U.S. economy is now recovering from the pandemic at a much faster pace than those economies, which beckons an earlier start of a Federal Reserve interest rate increase cycle than those in Europe and japan. At the same time, it has very much deeper capital markets than those economies, which still affords its currency a safe haven status in times of economic stress.
With a public debt now approaching 250 percent of its GDP, Japan makes the U.S. public debt position look remarkably healthy. Meanwhile, a glance at Italy’s public finances would suggest that the Euro, the dollar’s main competitor as an international reserve currency, has much more serious public debt problems than does the U.S. dollar.
In the wake of the pandemic, Italy’s economy, the Eurozone’s third largest, swooned by around 10 percent and its budget deficit ballooned. As a result, that country’s public debt skyrocketed to 160 percent of GDP, or to the highest level in its 150-year history.
Stuck within the Euro straitjacket, which precludes depreciation as a means to offset the contractionary impact of budget belt-tightening, Italy has little prospect to grow its way out of its public debt problem. That in turn would seem to make it only a matter of time before the Euro is beset by another round of the European sovereign debt crisis once global liquidity conditions tighten.
Something similar might be said of the currency crises waiting to beset the emerging market economies. Never before have those economies had as high public debt levels and as large budget deficits as they do today. Meanwhile, unlike the United States, those countries are still a long way off from bringing their COVID-19 pandemics under control, which would seem to be a precondition for them to restore their economies to economic health. The only thing now keeping those countries afloat are low U.S. interest rates that are forcing investors to stretch for yield abroad.
In the period immediately ahead, the dollar is likely to benefit from large capital inflows associated with higher interest rates at home than abroad. With the U.S. economy now receiving its largest peacetime budget stimulus on record at a time that the economy is already recovering strongly and at time that there is large pent-up demand in the economy, it must be only a matter of time before the Federal Reserve starts to raise interest rates. Meanwhile, the same cannot be said of the European Central Bank and the Bank of Japan, since both the European and Japanese economic recoveries are yet to gather strength.
To be sure, the start of a Federal Reserve interest rate hiking cycle could very well burst the many equity, housing and credit market bubbles that now characterize the global economy. It could also trigger a large reversal of capital flows to the emerging market economies. However, as has occurred on many previous occasions of global financial market stress, the bursting of today’s “everything” asset and credit market bubble would benefit the dollar. It would do so because of the safe haven status that the country’s highly liquid and deep capital markets afford the dollar.
All of this is not to say that the U.S. dollar will not eventually face a day of reckoning because of its budget excesses. However, it is to say that there are many reasons to think that the dollar’s day in the sun will continue for the next couple of years.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.