20 March 2009

[US] Fed primes printing presses, U.S. dollar skids

The following, written by Thomas Walkom, appeared in today's "Toronto Star".

Think of the world economy as resting on a three-legged stool. The first leg, representing the financial system, is riddled with termites. The second, representing the real economy, is sawn half through. And now the third leg, the international currency system, has begun to wobble.

That's the significance of yesterday's abrupt slide in the U.S. dollar. It fell against the euro, the Japanese yen, the British pound and the Canadian dollar.

In fact, it slid against just about every major currency.

The reasons were fairly straightforward. Currency is like anything else. Its value depends largely on scarcity. If a central bank prints a lot of dollars, the value of those dollars falls – both against goods (that's called inflation) and other currencies.

These days, the U.S. Federal Reserve, that country's central bank, has been printing a lot of dollars. Using what it calls quantitative easing – that is, printing dollars to lend money to worthy borrowers – the Fed has more than doubled its so-called monetary base over the past year.

Two days ago, the Fed announced it was ramping up its printing presses in order to buy about $1 trillion (U.S.) more in assets, including $300 billion worth of U.S. Treasury bonds.

When a central bank starts lending its own government large amounts of newly minted cash, it's getting perilously close to what economists call monetizing the debt – paying for public spending by printing money.

Given the massive, $1.75 trillion deficit that U.S. President Barack Obama is proposing to run this year, it's not surprising that his country's central bank would want to help out. For governments, monetizing the debt is much cheaper than borrowing. And, at times, it's the right thing to do.

Both Britain and Japan have announced that their respective central banks are pumping up the money supply in part to monetize government debt. Yet their currencies remain relatively strong.

The problem for the U.S. is that the value of its money rests on a slender reed. Using normal economic criteria such as the current account balance (the difference between inflows from abroad and outflows), the greenback is already significantly overvalued.

Indeed, until the financial markets began to unravel last fall, the American dollar was in decline.

But last fall's financial meltdown sent investors scurrying for a safe place to park their funds. To most, the safest assets in the world appeared to be U.S. Treasury bills denominated in U.S. dollars. That sent the greenback up again.

Now, it seems that at least some of these investors are changing their minds about the dollar. They fear inflation and depreciation, both of which would lead to losses for U.S. dollar holders, and are searching out new safe havens.

Yesterday, the price of gold – the world's traditional hedge against inflation and dodgy currency – hit a six-month high.

Probably matters will stabilize, at least temporarily. We're not talking Germany 1923 here. Americans are not about to require wheelbarrows full of cash to buy one potato.

But the writing is on the wall. The most widely traded currency in the world is wobbly. At a time when everything else is under attack, this doesn't help.

Indeed, a precipitous decline in the American dollar could set off a round of competitive devaluations as other countries try to protect their industries from what would then be cheaper U.S. imports. That's the currency equivalent of a trade war.