By Alen Mattich | WallStreetJournal.com
August 23, 2010, 1:26 PM GMT
Could the Federal Reserve’s decision to restart its quantitative easing program trigger a dollar collapse?
That’s what John Hussman, a fund manager, argues in his latest weekly note to investors. And the case he makes is strong… as long as one ignores the fact that other central banks don’t want and are unlikely to accept a big dollar devaluation.
Hussman notes that while, longer term, currencies tend to move to equalize purchasing power between different countries, most short-term foreign exchange fluctuations hinge on interest-rate differentials. Here, differences in inflation rates and yields on offer between countries will determine the flow of capital, which, in turn, will affect relative changes in currencies. So countries with relatively high interest rates can see their currencies trade well above where they should do according to purchasing power parity arguments.
So much for the theoretical background.
Hussman then notes that two thirds of the Fed’s balance sheet is made up of securities issued by government-sponsored enterprises, namely Fannie Mae and Freddie Mac, that are being bailed out by the Treasury, which is to say these are holdings the Fed won’t be able to reverse easily. In other words, this represents the more or less permanent printing of new money.
When set against the fact that the government has lost control of its finances, the long-run inflationary threat posed by fiscal and monetary policy is huge. But the dollar’s position is made even more precarious by the zero interest rates being pursued by the Fed in response to economic weakness.
On an interest-rate parity basis, then, the dollar needs to depreciate rapidly and considerably–in order to offset the future inflationary surge and the current lack of yield.
But this is exactly what the U.S. economy needs, isn’t it? A dollar devaluation.
Well, yes, on purchasing power parity grounds, the dollar ought to be depreciating to improve the relative position of U.S. exporters. After all, the U.S. trade balance has been worsening lately, even as the economy’s rebound runs out of steam.
The problem is the speed of adjustment and the fact that a sudden dollar devaluation would likely overshoot its equilibrium level. In other words, the dollar could become too cheap too fast. Such a sudden and dramatic move could cause all sorts of disruptions and trigger a sudden and rampant bout of inflation.
And were the rest of the global economy in a healthy state and were exchange rates fully flexible, this is indeed what might happen.
But China’s dollar peg is likely to prove a drag on a massive dollar devaluation. At the same time, countries like the U.K. are likely to respond to any sudden appreciation of their own currencies with their own programs of quantitative easing. As might the European Central Bank. Or there could be more direct currency intervention–the sort the Japanese and the Swiss have tended to resort to.
The upshot is likely to be not just a U.S.-driven inflationary push, but a global one, where all countries aim to devalue their way to economic health at the same time.
The result will benefit borrowers at the expense of savers worldwide. But, then again, maybe given the state of global imbalances–too much debt in the U.S. and other Anglo-Saxon economies; too many assets held by Chinese, Japanese and oil-producing countries–maybe a massive bout of global inflation is the only way forward.