U.S. dollar woes bad for financial stability: Expert

By Mark Noble | September 11, 2008 | Last updated on September 11, 2008
5 min read

The long, steady decline of the U.S. dollar, particularly over the last year, has one internationally recognized economist worried that recent bailouts will do little to ensure depositors and investors keep their money in institutions like Fannie Mae and Freddie Mac.

Dr. Ben Steil, director of international economics at the Council of Foreign Relations in New York, told attendees at the World Alternative Investment Summit Canada in Niagara Falls, Ontario, that the world’s dominant reserve currency is starting to show similarities to the rest of the world’s currencies in how it behaves with respect to the laws of supply and demand. Steil warned this could have a destabilizing effect on the world economy.

About two-thirds of the world’s currency reserves are in U.S. dollars, he pointed out, and this is even higher in Asia and the Middle East, at around 90%.

This position as the world’s primary reserve currency has given the U.S. Federal Reserve tremendous latitude in its ability to set rates without taking into consideration global economic factors that generally dictate the rate decisions of the rest of the world’s central banks.

“The Federal Reserve is for all intents and purposes the only sovereign reserve bank. It is the only central bank that can set interest rates really without regard for what’s going on in the rest of the world,” he said. “In the past, as the U.S. dollar depreciated, investors generally did not go out looking for alternative investments to boost their returns. That gave the Fed the opportunity to lower interest rates without provoking depreciation.”

Of course, there were fundamental economic reasons it could do this, as the scale of its economy was so immense.

“The main reason the United States is generally not importing inflation is because of the size of the economy. There are enormous opportunities for what we call substitution effects. When imports become more expensive, the United States — which is the largest self-contained economy in the world — can more easily substitute internal production for what was an imported predecessor,” he said.

Steil said the Fed has been abusing these powers of late, ignoring the dollar’s role in global transactions and not being realistic in its rate decisions, given top-line inflation numbers represented by the consumer price index and the economic problems it’s facing domestically.

Investors are noticing. Over the last year, its ability to substitute internal production in the face of rising import costs has completely broken down, and as a result, the greenback is beginning to take on the characteristics of a developing market currency.

“The U.S. is acting exactly like a developing country now. Appreciation has become so significant in the U.S, it can no longer substitute with internal production,” he said. “There is anecdotal evidence to support this. For example, the Wall Street Journal recently wrote an article that there were record flows from U.S. mutual funds into foreign denominated bonds.”

If confidence in the U.S. economy and its currency is shaken, investors may deal with the dollar the way they do the rest of the world’s currencies. The U.S. would not be immune to the currency shocks that rocked Asia and Latin America in the 1990s. Indeed, Steil observes similarities with the U.S. to those economies before they had their respective crises.

“If you go back to the crises we saw in Asia and Latin America in the 1990s, in the run-up to those crises we did not see significant spikes in inflation. What we did see was significant spikes in asset prices. When their currencies finally did collapse, then we saw soaring inflation. In fact that’s just what we are seeing in the United States,” he said. “We’ve seen a huge run-up in asset prices, obviously real estate being foremost among them. It wasn’t until recently, when depreciation really sank in, that the inflation figures starting trending upward.”

Which brings things back to financial institutions. If a full-blown currency crisis occurred in the U.S., there is a real likelihood that the Fed would be impotent as a lender of last resort, Steil noted.

“We are already seeing some effects of that recently. The Fed has been lowering rates very aggressively. Right now Federal funds are at 2%, with inflation at 5.6%. If you look at borrowing rates in the markets, they have actually been rising over the course of this year,” he said. “In the case of a financial crisis, you need a central bank to print money and stand behind the banking system so don’t we have mass withdrawals.”

Steil points out that, historically, printing money in the developing world doesn’t work, and it actually creates a run on banks because depositors don’t have confidence in the real value of the currency.

“It’s not because people in the developing world believe the banks are going to collapse. They know governments will always stand behind the banks like the U.S. stands behind Bear Stearns, Fannie Mae and Freddie Mac,” he said. “What they are concerned about is the depreciation that will come when the central bank prints the money to bail out those institutions. Around the world, any time you see that type of crisis the depositors withdraw their money anyway and buy dollars.”

Steil expects declining confidence in the value of the U.S. dollar, as the world’s reserve currency would create more of the same scenario for U.S. depositors during a full-blown currency crisis.

“If the U.S. Treasury and Federal Reserve keep behaving as they do, Americans will draw precisely the same conclusions: that they will need to buy euros, gold or alternative monetary assets because of depreciation and inflation,” he says. “If the Fed loses its powers as a lender of last resort, I find that pretty frightening, but if they keep abusing their powers to the extent they have over the last year, I think that’s the direction we are moving.”

Steil urges the U.S. to consider changing its monetary policy to head off this sort of crisis.

“We probably need more than a single mandate to restore the credibility of the Fed,” he said. “We need a statutory framework that acknowledges the global role of the dollar and forces the Fed to pay attention to it. This includes paying attention to people moving into alternative monetary assets like gold. I think if we had such a framework, the Fed would be behaving quite differently.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com


Mark Noble