Dollar holds its own despite huge budget deficit

This year, like last, public policy makers once again warned of "impending disaster" for the U.S. dollar due to the record budget deficit. And once again, the reports of the dollar's demise were greatly exaggerated.

The deficit was supposed to produce a mass exit out of the dollar amid concerns that the U.S. Federal Reserve's quantitative easing policy would flood the market with dollars, reducing their value.

It hasn't happened. If we date the start of the financial crisis to June 2007 -- when Bear Stearns first had to "prop up" one of its hedge funds after losses from mortgage-backed securities tied to subprime mortgages -- the dollar has actually strengthened about 12 percent versus the euro, and 21 percent versus the British pound.

The battling buck

Moreover, the dollar has basically held its own against the euro and pound as the United States started implementing its record $787 billion fiscal stimulus package to increase commercial activity in those markets where the Fed's quantitative easing program has restored liquidity. Since February 2009, the dollar has weakened about 10 percent versus the euro and 11 percent versus the pound -- not small declines, but certainly not the currency and purchasing power catastrophe predicted by some public officials.

Why hasn't the dollar (so far) suffered a worse fate? Two reasons: companion major currency weakness and risk aversion.

First, the financial crisis, large housing and bond market losses, and recession are not unique to the United States. Continental Europe and the United Kingdom are dealing with comparable but not identical problems, and have used similar monetary and fiscal policies to address them, resulting in comparable declines in their currencies. In other words, the U.S.'s financial condition may have worsened, but so have the financial conditions of euro-zone Europe and Britain -- dragging down their currencies as well, lessening the valuation impact of the U.S.'s budget deficit and quantitative easing.

Second, risk aversion -- or the flight of institutional investor money to the world's reserve currency during times of economic sluggishness (or worse) -- benefits the buck, as the dollar remains the world's reserve currency. In theory, the yen could challenge the dollar for that title, but institutional investors remain concerned about the Bank of Japan's habit of intervening to weaken the yen -- which is good for Japan's export sales, but bad if you hold yen in large quantities.

So, unless some unexpected event intervenes, the dollar, as the world's reserve currency, will continue to benefit from risk aversion -- supporting its value, despite all those extra dollars floating around in the world.

Fed's main worry: deflation

And another point about all those extra dollars: some public officials said the stimulus and quantitative easing would lead to rising inflation, domestically. So far the opposite is closer to the truth. The core consumer price index is up just 1.8 percent in the past year, and the Fed says that, on balance, the greater risk to the U.S. economy remains deflation, not inflation.

Dollar Analysis: In sum, the dollar continues to retain its value, despite enormous quantitative easing and federal spending -- two very Keynesian acts -- to deal with the financial crisis and recession. The critics like to talk about inflationary consequences of "all this federal spending," but they present a distorted picture of the economic landscape -- a half-truth. They fail to mention "all the dollars taken out of circulation" from the housing market bust, stock market plunge, commodity price declines, and lack of consumer spending from large job losses. These events have taken far more dollars out of the system than the Fed or Congress have added, limiting price pressure. And, as noted, the dollar is also benefiting from risk aversion.

Still, the above should not prevent Congress from getting the U.S. fiscal house in order after the recovery starts. Once global demand picks up, some investors will shift out of dollar-based investments and into higher-returning, emerging market investments, and interest rates will rise. To limit those rate rises, Congress will have to reduce the U.S.'s borrowing by cutting federal spending and raising taxes. And that's no exaggeration.

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