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Alternatives to the Dollar?

We are asked quite regularly what we see in store for the dollar.   This is a difficult question because nearly every commentator on the matter has an answer that is, for lack of better words, ideologically motivated.  For whatever reason, people want to love or hate the dollar.  For some, the dollar is a source of national pride…for others an example of everything wrong with what the government has become.  

Our view of the dollar can be explained by tweaking Winston Churchill’s defense of democracy: “Democracy is the worst form of government except for all those others that have been tried.”  

To adapt Mr. Churchill’s words, the dollar appears to be the worst currency in the world…except for all those others. 

We agree that the stimulus programs from the Bush and Obama Administrations should cause the dollar to fall.  But against what?  Most Asian currencies are actively kept weak by their respective central banks.   The UK economy is even more exposed to the global financial crisis than the US, making the British pound sterling a risky alternative.  Even the Swiss franc, legendary for its stability, is looking somewhat suspect these days given the financial woes facing the country’s biggest banks, UBS and Credit Suisse. 

The dollar’s main competitor today, the euro, may not even survive this current recession if it proves to be as prolonged as HS Dent’s research suggests.  Already, Italy has threatened to quit the euro, and some of the weaker Mediterranean states may leave or be asked to leave if they cannot get their fiscal houses in order.

Consider the excerpt from Landon Thomas’s article from the New York Times:

For some of the countries on the periphery of the 16-member euro currency zone — Greece, Ireland, Italy, Portugal and Spain — this debt-fired dream of endless consumption has turned into the rudest of nightmares, raising the risk that a euro country may be forced to declare bankruptcy or abandon the currency.

So, the question remains.  If dollar falls, what exactly will it fall against?  While we agree that the United States government is fiscally irresponsible, so is practically every other government in the world, with very few exceptions. US debt as a percentage of GDP is more or less in line with the major European economies, and it is substantially lower than that of Japan. So, if budget deficits are bad for currencies, it’s hard to see how the United States is uniquely bad in this respect. What about the trade deficit? Surely America’s reliance on imports puts the dollar at risk? Again, recent history has not shown this. The United Kingdom had import/export imbalances every bit as large as the United States, yet the pound sterling was one of the strongest currencies in the world for most of the 2000s!What about a renewal of the carry trade?

The Federal Reserve is keeping interest rates low for the foreseeable future…shouldn’t the dollar lose ground to higher-yielding currencies? Again, the history here is mixed. In general, higher-yielding currencies tend to rise against lower-yielding currencies of similar “quality.” But today, virtually all major central banks are lowering rates to near zero. 

To show how contradictory currency movements can be, during the worst parts of the credit crisis, which was centered in the United States, the dollar actually rose.  It actually soared relative to the strongest currencies of the past decade, such as the pound, the euro, and the Aussie and Canadian dollars. Why? Because hedge funds and other leveraged investors unwound their “carry trades” en masse, selling their long positions in the currencies mentioned above and closing out their shorts in the dollar and the Japanese yen. So, even in the midst of the greatest American banking and currency crisis since the Great Depression, the dollar rose substantially.

Our advice?  All else equal, your income should be mostly in the same currency as your expenses.  For Americans, this means keeping a substantial amount of your liquid assets in dollars.  Investment or speculative assets are a different story, however.  For maximum safety, investors can diversify their currency holdings among several currencies that are historically strong.