As the fiscal cliff approaches, the implications for the dollar become more apparent. Even as federal deficits may be unsustainable, stocks and bonds are up while the dollar resumes its long-term downward trend. The author looks at how different tax policies might affect the US dollar.
December 5th, 2012
As election euphoria settles and the "fiscal cliff" approaches, what are the implications for the dollar? Even as federal deficits may be unsustainable, stocks and bonds are up, and while the dollar may have resumed its long-term downward trend, the greenback has hardly fallen off a cliff. We look at how different tax policies might affect the U.S. dollar.
In our assessment, the fiscal cliff, that is the looming simultaneous tax increases and spending cuts, is mostly a distraction. It's a distraction because, as significant as the short-term impact on GDP may be, "going over the cliff" does not solve our long-term fiscal problems. Indeed, we might as well call it European style austerity, as before factoring any slowdown induced by the cliff itself, the U.S. would continue to face a deficit exceeding 3% of GDP. More importantly, Medicare reform, in our view key to long-term budget sustainability, remains elusive.
The most attractive attributes of the dollar may well be its liquidity. A side effect of issuing record amounts of debt is that central banks have a place to deploy their dollar reserves without impacting markets too much. However, the Federal Reserve (Fed) may be crowding out other investors, as it gobbles up an ever-growing chunk of federal debt, in an effort to keep down U.S. borrowing costs. Still, the Fed has shown its willingness to provide liquidity in times of crisis, providing comfort to many.
And while we take it for granted, the ability to take one's money out of the U.S. is also a key reason why investors put money into the U.S. The best thing that could happen to global financial stability is if emerging markets opened their capital accounts and developed their domestic fixed income markets, making them less dependent on U.S. dollar funding. Instead, policy makers from Brazil to Switzerland that are afraid of speculative inflows impose roadblocks, then engage in ill-fated efforts to manage the fallout from their policies. Countries might be better served preparing their economies for a world where the dollar is no longer the only game in town, rather than deploying billions to provide the illusion of a world order that we believe won't come back.
Like any asset, currencies are driven by supply and demand. Investors buy U.S. dollar denominated assets if they believe they get a worthy return. Because the U.S. has a current account deficit, the greenback has a continuous uphill struggle: foreigners must buy U.S. dollar denominated assets to pay for U.S. deficits: all else equal, the current account deficit is exactly the amount of U.S. dollar denominated assets foreigners must buy to keep the dollar from falling. In turn, the dollar may benefit when the U.S. is an attractive place to invest in; in many ways, this explains why the U.S. is always in search of growth. In contrast, the Eurozone's current account is roughly in balance and as a result austerity and any accompanying economic slowdown, even select government defaults, are not ex-ante euro negative.
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