Budget debt, the deficit, the Administration, the Fed, monetary expansion? Everybody has their reason for why the dollar is weakening and plumbing lows that we haven’t seen since 2007 but what is it really that is driving the weakness and why is it important?
First, there is one reason why a weaker dollar is good. For centuries empires have used currency debasement as a method to repay debt that could not otherwise be paid. For example, the value of the denarius in Roman currency gradually decreased over time as the Roman government altered both the size and the silver content of the coin. Originally, the silver used was nearly pure, weighing about 4.5 grams. From time to time, this was reduced. During the Julio-Claudian dynasty, the denarius contained approximately 4 grams of silver, and then was reduced to 3.8 grams under Nero. One reason a government will debase its currency is financial gain for the sovereign at the expense of citizens. By reducing the silver or gold content of a coin, a government can make more coins out of a given amount of specie. Inflation follows, allowing the sovereign to pay off or repudiate government bonds. However, the purchasing power of the citizens’ currency has been reduced. So, while the fiscal policies of the government are driving the value of the dollar lower this does provide for a way to effectively default on our debt obligations without actually defaulting.
The Fly In The Ointment
There are a few problems that come along with a weaker dollar. Not only is the purchasing power of the citizens reduced but in a global economy as we have today there are other implications. First, a weaker dollar is a deterrent to the attraction of foreign capital investment in the US because if I live in Australia and make an investment in the US – if the US dollar declines by 20% and I make 20% on my investment when I convert back to Australian dollars by net return was zero. Secondly, it weakens our position as the reserve currency in the world which jeapardizes our position of being able to sell our bonds to foreign holders. Third, it won’t meaningful diminish our trade deficit as 40% of the trade deficit is oil and that is priced in dollars. Finally, a weaker US dollar impacts the price of goods that we import from our foreign trading partners making them more expensive and thereby reducing the real net income of the average American consumer. This is a double edged sword as well. As products get more expensive which results in a decline in purchasing power we are, in turn, forced to purchase less. For countries like China, who depend on a large degree for the strength of their US economy for exportation, a slowdown in the US very quickly translates into a slowdown in their economy. As their economy slows down their consumption also slows which in turn impacts the exports that we send to them. It is a vicious circle.
Most importantly, as the debasement of the dollar is NOT a new thing. While the media is full of advertisements on buying gold to protect wealth lately, the real issue is that the decline, as shown in the chart, has been going on since the early 80’s. As the decline in purchasing power, combined with lower wage growth, has forced more and more consumers into using credit to maintain a standard of living this in turn has reduced the ability of the economy to grow.
As we have shown in “A Structurally Manageable Debt Level”, the amount of total credit market debt (of which consumers make up the majority of) rose above 150% of debt to GDP for the first time in the early 1980’s. The introduction of the “live on credit” society led to more consumption but less productive investment and savings which slowed economic growth over the last three decades. This slowing economic growth is a direct result of the continued decline in the US currency and is showing the real net effect of the destruction of purchasing power. With total credit market debt at more than 350% of debt to GDP with will take a significant about of debt reduction (about $30 Trillion in total) to return the economy back to a level where an increase in savings can occur for the consumer and productive investment can once again lead to economic growth. Then and only then can we really expect to see a long term and sustainable trend of strengthening in the US dollar.
As investors the thing that we need to be focusing on is not the “fear mongers” that are predicting the end of the world and recommending stocking up on gold, bullets and beanie-weenies, but rather we must focus on our ability to save, reducing debt and leverage, and making sure that our savings are growing at a rate to offset the decline in purchasing power caused by the decline of the dollar. For the last decade investors have chased the worst performing asset class, stocks, trying to do this when an investment in fixed income would not have only offset the decline in purchasing power but would have protected the underlying principal investment. Don’t get me wrong, there are periods in history where investing in stocks over bonds has been the place to be – like the 80’s and 90’s – but during secular bear markets, like we are in now and will continue to be in for most likely another 5-8 years, stocks are the last asset class to chase.