US Dollar Strength and Global Growth: causality

by George Hatjoullis

The popular view is that further US dollar strength will harm global growth and that the Federal Reserve should take this into account when formulating US monetary policy. The US Federal reserve is unlikely to do so except to the extent that global growth feeds back into US economic activity. However, this latter linkage is not thought to be very strong and US monetary policy continues to be set as if the US is a closed economy. The US can affect the rest of the world but is largely immune to events elsewhere. This is a simplistic view. In one particularly important respect the US is clearly affected by the rest of the world, namely the demand for US dollars.

The US dollar is the global reserve currency. It is international money. It is used to price traded goods, as the medium for exchanging traded goods and as an international store of wealth. Central banks around the world keep US dollar reserves and reserve assets out of proportion to their trade with the US. Many fix or stabilise their own national currencies with respect to the US dollar. International loans are predominantly denominated in US dollars. This status is supported not by the strength or weakness of the US dollar but its depth. If you want to hold a risk free international asset the US dollar offers the best and unchallenged liquidity.

The key is the existence of a federal US authority issuing such debt and having a clear and unambiguous relationship with the central banking authority. Contrast this with the eurozone. There is no federal authority and no asset class that is jointly and severally guaranteed by the eurozone. The relationship between the eurozone and the ECB is at best unclear because the eurozone is still, strictly speaking, 19 sovereign nations bound by some rules. There is no eurozone equivalent of an US treasury bill and near equivalents lack depth. The recent QE undertaken by the ECB, and hotly disputed by the Bundesbank, has taken the eurozone one step closer to having international currency status but it is not quite there yet. The US dollar reigns supreme.

The purpose of this blog is to extend the theme of my (many) blogs looking at the consequences of the destruction of risk free assets following the 2008 crisis. In particular, the loss of money stock as the reality of uninsured deposits dawned on wealth-holders. It has been my contention that this has been behind the deflationary bias that we have experienced since the crisis. Households and corporations needed to rebuild holdings of (risk-free) money and near money assets and the result was an excess demand for such assets. The price of such money and assets is just the goods that they will buy and hence a deflationary bias emerged. The price of money in terms of goods and services went up.The channels whereby this takes place is not important here. The largest stock of money and near money risk free assets is denominated in US dollars. It is unsurprising that the US dollar has appreciated in this context. However, it is clearly a consequence rather than a cause of the deflationary bias that has emerged.

Of course, this does not mean that US dollar strength could not feed back into the global economy and exacerbate the deflationary bias. It is not, however, strictly speaking a cause. Nor is it necessarily a negative for global growth, though this is the popular view. The deflationary bias should be evident to all by now though. The simplest way to offset this is to allow some version of monetary financing by governments, an argument that I have articulated repeatedly in these blogs. It is unlikely to happen any time soon. The next best thing is for governments to allow larger public deficits. The adoption of fiscal orthodoxy is now complete so this is even less likely to happen. Finally, there is some hope if societies can engineer significantly less unequal distribution of income. I am not hopeful. Global growth is likely to be subdued (relative to desires) and inflation even more so but do not blame the US dollar. US dollar strength is a symptom not a cause.