News in Charts: Strong dollar – privilege or curse?

The status of the US dollar as the world’s reserve currency has been referred to as an ‘exorbitant privilege’, as it reduces domestic and external borrowing costs, aiding net returns on its international investment position.  Observers have also noted the geopolitical leverage that it confers. However, some have increasingly pointed out that the costs are not all one way. Critics suggest that the desire to hold US assets pushes up the value of the dollar.  We find that there is some merit to this view, with our analysis pointing to a 20% overvaluation versus fair value on average since 1980.

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A strong dollar has no doubt reduced the competitiveness of US manufacturing and contributed to chronic trade deficits. The sum of persistent current account deficits are part of the reason for a large and rising negative net external asset position. Although it is also worth noting that a lot of the most recent move reflects valuation effects, as the value of foreign holdings of US equities has soared.

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One path to a more sustainable net external asset and trade position is a weaker dollar. But how likely is that? Some have pointed to a ‘Mar-a-Lago Accord’, whereby the US and other large trading partners agree to work toward a weaker dollar. This grand bargain is modeled after the 1985 ‘Plaza Accord’ that achieved the same thing. However, there are a couple of critical differences between now and then. The first is that the US and its close partners made up a much larger share of overall trade back then. Any such accord would probably require Chinese participation. Given both what happened to Japan after the Plaza Accord, and Sino-US strategic competition, that is unlikely to be forthcoming. Meanwhile, the cyclical position between the US and other large economies was very different then, allowing a large narrowing in short-term interest rates that helped to contribute to dollar weakness. That is not the case right now.

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An alternative to coordinated action would be for the US to attempt to unilaterally weaken the dollar. One precedent for this was when the Swiss National Bank (SNB) maintained a peg with the euro for several years during the European debt crisis, promising to buy unlimited euros to help maintain it. The assets on its balance sheet rose by 30 percentage points of GDP during this period, and eventually it was forced to give up. Nonetheless, even after dropping the official peg, the SNB’s balance sheet continued to soar as it intervened repeatedly to weaken the franc. This rise during the official peg period rather crudely implies around USD10 trillion in Fed purchases. This would be a political headache at home and abroad, as the Federal Reserve would be acquiring a large amount of the world’s outstanding sovereign debt.

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With both multilateral and unilateral options facing challenges, the upshot is that there is unlikely to be a large (20%) decline in the dollar real effective exchange rate. At the same time, the US budget deficit is expected to remain large for the next few years. That means that we can continue to expect trade imbalances, with the US trade position remaining in the red. One path out that we considered in Fathom’s recent Global Outlook was that large creditor economies, such as China and Germany, could add meaningfully to global demand. That still appears to be forthcoming in Germany. But the recently agreed US-China deal makes no mention of structurally weak Chinese demand. Whether it will form part of a longer-term strategic agreement, as US Treasury Secretary, Scott Bessent, has suggested, remains to be seen.

For more information on Fathom’s Global Outlook, please see: https://www.fathom-consulting.com/global-outlook/