Saturday, July 05, 2003
The decline of the mighty greenback
Posted by David Smith at 09:24 PM
Category: David Smith' s magazine articles

The expression “roller-coaster ride” is one of the most overused amongst journalists. For once, however, it may be appropriate. If we look at the performance of the dollar over the past few years, it does indeed appear to have given a fair impersonation of the big dipper.

At the start of 1999, when the euro came into being with great fanfare as an electronic and accounting currency, it was worth about $1.17. Many people predicted that the euro would strengthen from that level, as central bank and other portfolios were shifted in favour of the new currency. There was also a hope that the single currency would prove to be the economic elixir that Europe so badly needed.

The euro strengthened, but only for a day or so, and then embarked on a long decline. That was partly a euro story; people soon saw that Europe’s economy was not being transformed and they were unimpressed with the new European Central Bank. But it was mainly a reflection of the dollar’s remarkable strength.

Remember that in 1999 the great bull market was not over. It had, in fact, yet to experience its final, exuberant spurt. Remember too that at that time talk of an American recession seemed fanciful. The “new” US economy, driven forward by IT and other technological innovations, was carrying all before it. The question was not of a normal business cycle; it was whether America would grow at 4% or 5% a year.

So the dollar rose, making a mockery of predictions that the euro would wipe the floor with it. Its climb was a reflection of America’s economic dominance. Japan was in trouble, mired in deflation and bureaucratic indecision. Europe remained economically sclerotic. Investing on Wall Street provided the quickest way into America’s remarkable new economy.

The euro mirrored that rise, dropping through one-for-one parity with the dollar before eventually hitting a low of just 83 US cents - $0.83. The pound, while exhibiting some of its longstanding special relationship with the dollar, and thus not falling as far as the euro, also dropped. Sterling fell from the mid-$1.60s to $1.40.

Then, of course, the new US economy was proved to be not all it had been cracked up to be. It did not insulate Wall Street from a crash, as was in most spectacularly in the case of the Nasdaq, which peaked at more than 5,000 in March 2000 and subsequently plunged to a quarter of its value. And it did not insulate America from recession, which duly arrived in 2001, and predated the September 11 terrorist attacks.

Curiously, not all of this immediately impacted on the dollar, which was still supported by its earlier momentum. By the beginning of 2002, however, when the euro entered its second and final stage as a physical currency, the tide had begun to turn. And, as far as the dollar is concerned, it has continued to ebb away.

Soon, the euro was back through parity against the dollar. This year, the dollar’s slide has accelerated. At time of writing the euro was trading just below $1.20 – higher than at its birth at the beginning of 1999 (and nearly 50% above its lows) – with analysts predicting a climb to $1.30 or $1.40. The pound has retraced its steps back from $1.40 up to the mid-$1.60s and may also have further to go. The mighty greenback is no more.

Why is this? The first and most plausible explanation relates to America’s $500 billion current account deficit. The deficit was building during the dollar’s rise and, indeed, the strong dollar contributed to it by making imports cheaper and US exports uncompetitive. Somehow, though, it did not seem to matter then. The deficit was more than offset by huge capital inflows, as foreign investors bought into the new economy dream. On a simple flow of funds argument, the dollar rose.

Now, however, foreign investors have much less of an appetite for US financial assets. Their fingers were burned by the Nasdaq, and they are concerned that the strong budgetary position George W.Bush inherited from Bill Clinton is no longer there, replaced by deficits stretching out into the indefinite future. On that same flow of funds argument the dollar has lost its visible means of support.

Second, currency dealers have detected an important shift of strategy within the US administration. Following Bush’s reshuffle of his economics team last year, bringing in John Snow as treasury secretary, it not longer seems that America sets much store by the strong dollar policy of the past, despite paying lip service to it. US economic policy is now seen to be driven by the sole aim of achieving strong enough economic growth to secure a Bush election victory next year. If a weak dollar is the consequence, that is seen as a price worth paying.

Third, the diversification out of dollars into euros, predicted in 1999, may finally be happening. Central banks are increasing the proportion of euros in their official holdings. There is talk that the oil producers, partly for political reasons, will switch to euro pricing. The euro has its troubles but as an international reserve currency it may slowly be coming of age.

The decline of the greenback is not costless. While it probably will help the American economy, it promises to do quite a lot of damage in Europe. An already very weak growth prospect among the euroland economies now starts to look even dicier. Eventually, Europe’s economic weakness will pave the way for a dollar revival (assuming Japan also stays weak). That, however, may take a little time. For the moment, the dollar’s fall looks to have further to run.

From Professional Investor, July-August 2003

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