Strong Dollar

Aside from some short-term notes from the Wall Street analysts, there's been a consensus for a while now that the dollar needs to weaken significantly to eliminate the global imbalances in the economic system. Generally, the argument goes that America has a large and unsustainable trade deficit, which foreign central banks are financing by buying US Treasury bonds. If the foreigners tire of financing our trade deficits (the 2007 version is "profligate consumption" but this seems not to apply so much anymore), they will dump US assets and the dollar will weaken. The only way to bring things back into balance is for the dollar to weaken in order to make US goods more competitive on the global market. Exploding US budget deficits only increase the required adjustment. I don't think it's going to happen this way.

In the near term, it's true, as many Wall Street analysts have pointed out, that a renewed downturn in the global economy could lead to dollar strength when investors flock to quality assets such as US Treasurys. But this isn't what I have in mind. Instead, I think we're going to see a new secular trend of dollar strength combined with narrowing global imbalances, for a number of reasons.

1. Rising U.S. savings. American households are tapped out debt-wise. Corporations don't want to borrow to invest because they have so much spare capacity. That means Americans want to buy US securities instead of importing foreign goods and energy. So this is a large new source of demand for dollars -- if the personal savings rate rises from 0% to 10% this is $1 trillion in extra annual demand for dollar securities right there. Not all of this is new demand for dollars since some of it is replacing demand for US goods, but a lot of it is.
2. Fiscal issues are worse other places. Sure, the US needs to get its fiscal house in order. But the budgetary and demographic situation in Europe and Japan is *far* worse than it is in the US. Let's face it, a basket of AUD, CAD and BRL is simply not going to become the world's new reserve currency, and neither is the yuan. China is a country that is not so politically stable and has had two revolutions, a civil war, and an occupation by a foreign power in the last century. The legal system is not exactly conducive to foreigners enforcing their property rights. In the nightmare scenario, do you want to have your money in renminbi?
3. Demographics mean foreign savings rates will fall. At the vanguard of this movement is Japan, where the savings rate has already fallen into the low single digits as the population ages. As this continues, Japanese retirees will liquidate their savings to purchase imported goods, and Japan will become a trade-deficit country, reversing a half-century trend. Europe is not far behind. The emerging economies have a different issue: as they catch up to the West, they will want to consume more and save and invest less. That will lead to a preferences-driven increased taste for imports, weakening their currencies.
4. Deflation or disinflation in the US. The US is in a balance sheet recession. (Read "The Holy Grail of Macroeconomics" by Richard Koo if you don't know what I'm talking about.) A long period of weak demand growth will lead to subdued inflation or perhaps even outright deflation. That will keep a floor under the dollar.
5. The dollar is already cheap by PPP standards. There's only so far it can go before Toyota and Mercedes start opening factories in the US instead of abroad -- oh, wait, they already have!

I hope to post a lot more on this theme in the future. But we shouldn't be surprised if several years from now, dollar-euro trades at parity and the yen is back in the 130-140 range. Only sterling is about right at $1.60 to the pound.