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Don’t Blame The Fed… Here’s How to Fix the U.S. Dollar

It’s an idea that most people won’t even challenge: That the Fed’s loose monetary policy and expanding money supply are responsible for driving the U.S. dollar into the global basement.

Right?

While that “feels” true, the facts paint a completely opposite story. I’m going to give you that story right now, because believing the conventional wisdom threatens to damage our economy and our standard of living.

The Great American Folly

Okay, let me say one thing right off the bat: Financial reporting is difficult. The issues at hand are often more complex than most people appreciate – and are consequently misunderstood.

The widely accepted narrative goes like this: “The Fed prints money, our debts increase, and the value of the dollar declines.

Pretty simple, right?

Too simple. That simplicity has become so accepted that it’s now very difficult to dislodge it from the mind of the American public.

So allow your fear filters to relax for a moment and consider the real reason why the dollar is in trouble. Especially since there just might be something we can do about it…

The Common “Knowledge” is Usually Dead Wrong

Mark Dow, a former economist and full-time macro trader for the Pharo Management hedge fund sums up the argument well at Reuters. Let’s take a look and expand it a bit…

Most folks have accepted as gospel truth the fact that the dollar started declining once the Fed started printing money.

But they conveniently forget that the dollar had been plummeting long before the Fed’s balance sheet became more bloated.

In fact, the dollar is only just now returning to the levels it saw during that earlier decline.

But how can the Fed printing money not lead to a declining dollar?

Banks to Fed: “Thanks for the Cash!”

First, the Fed printing money and expanding its balance sheet doesn’t actually add to the money supply. Much of the money created now sits idle in banks’ cash reserves. It’s essentially “phantom” money.

So while the Fed pumps more money into the economy, the bulk of it sits in banks as excess reserves. My colleague, Louis Basenese, likens it to trying to inflate a balloon that has a hole in the other end.

Now, if the banks had actually lent more of this stimulus money to businesses and consumers in order to increase the money in circulation and boost the economy, it would be a different story. But they haven’t. They’re sitting on it.

This is why the hyper-inflation hawks have misread the situation since 2008. And it’s why Fed policy isn’t responsible for the dollar’s decline.

And even if you don’t believe that the true money supply isn’t growing, it turns out that national currencies don’t fluctuate based on supply and demand, as the Fed-bashers suggest.

The Truth Behind Currency Movements

Since at least 1983, no studies have definitively tied economic fundamentals – like money supply – to the strength of a currency.

If they did, wouldn’t we see currencies like the euro and the yen fall? Each have their own crises and debt problems (which Mark Dow refers to as “the wounded and the living dead”), but the truth is, the dollar has fallen nearly as much against the euro and the yen as it has fallen against stalwarts like the Swiss franc.

Since currencies are priced on future expectations, like all traded financial assets, shouldn’t the dollar rebound at this point? After all, the Fed’s quantitative easing will soon come to an end and interest rates are more likely to rise within the next year than decline.

So if the dollar looks forward, why do we think it’s going down based on current account levels?

The Real Story

First, you have to look at the dollar’s long-term story. It boils down to this: Economically, the United States isn’t the only game in town any longer.

America only accounts for 20% of global output, but 63% of global reserves are priced in dollars.

Now that there are other viable currencies around the globe, there’s no reason for all those assets to be held in dollars.

As the global economy diversifies its currency holdings accordingly, the demand – and, in turn, the value – of the dollar will decline.

The financial crisis fooled us. When it looked like the global economy was collapsing, a flight to quality created a newfound demand for the dollar, driving it back up.

Now that the dollar has collapsed as the Fed eases policy, it’s little more than a coincidence.

So it’s time to quit bellyaching about the phantom causes and start taking real steps to fix the dollar.

There’s No Quick Fix to the Dollar

Part of the appeal of the current incorrect story of the dollar is the simple solution that results. Namely that the Fed has to stop printing money and raise interest rates.

It’s not that easy.

The dollar is declining as the proportion of global trade that takes place in dollars declines. The solution is to boost our economy in order to capture a greater share of global trade.

Easier said than done, right?

Ironically, one piece to this puzzle is a declining dollar. As the dollar decline, U.S. exports become more competitive and grow. Eventually, the two sides to this equation will find a balance.

The second step to take, in my opinion, is to create job growth and increase productivity by fostering innovation through government policy and funding.

For example, Samuel Morse received a $30,000 grant from Congress to expand his telegraph line. The military has funded countless innovations, most notably DARPA’s creation of the internet. The sewing machine, the agricultural reaper and the Colt revolver also all benefited from government encouragement and protection.

The major growth opportunity right now would be subsidies that encourage a shift to clean energy.

The second step to take, in my opinion, is to create job growth and increase productivity by fostering innovation through government policy, funding, encouragement and protection. For example, a major growth opportunity right now would be subsidies that encourage a shift to clean energy.

So those who claim that the dollar’s decline is an act of monetary villainy only compound the problem. While we absolutely need to cut deficit spending, it needs to come from reducing healthcare costs and cutting wasteful programs like outdated farm subsidies.

However it’s done, if you want to fix the dollar, America needs to reclaim its role as a leading (and growing) economic power. And it will happen the old-fashioned way: Through hard work.

Ahead of the tape,

Matthew Weinschenk

Matthew Weinschenk